China: economic regulation of long-distance transmission and urban gas distribution

33285 CHINA: ECONOMICREGULATIONOF LONG- DISTANCETRANSMISSION AND URBAN GAS DISTRIBUTION Public-Private Infrastructure Advisory Facility The World Bank The Institute of Economic System and Management, SCORES April 2002  Table of Contents Copyright 2002 The Institute of Economic System & Management, State Council office for Restructuring Economic System No. 1. Nan Cao Chang Street Xi Zhi Men Nei, Beijing, P.R.C. The World Bank 1818 H Street, N.W. Washington, DC.20433, U.S.A. All rights reserved Manufactured in the People's Republic of China First Print July 2002 This report (discussion paper) presents the results of a sector analysis and research that is published to encourage discussion and comments within the oil and gas community in China and for dissemination to parties interested in sector reform in other countries. The findings, interpretations and conclusions expressed in this paper should not be attributed in any manner to the Chinese Government, the World Bank, to its affiliated organizations, or to the members of its Board of Executive Directors or the countries they represent, or to experts from the institutions consulted during the preparation of the report. The Chinese Government and the World Bank do not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for the consequences of their use. 2  Table of Contents CONTENTS Preface 6 Acronyms and Abbreviations 9 1. Executive Summary 11 1.1 The Background...............................................................................................................11 1.2 Long-Distance Transmission and Distribution Systems: The Case for Economic Regulation of Natural Monopoly............................................................................................................12 1.3 Creating the Legal Instrument for Monopoly Regulation and Market Oversight: A Gas Law and Its Coverage....................................................................................................................12 1.4 The Government Regulatory Institution: A Gas Regulatory Commission..................................13 1.5 Principles for Downstream Gas Regulation ..........................................................................14 1.6 Techniques for Downstream Gas Regulation ........................................................................16 1.7 The Gas Commodity: The Case for Market Pricing with Regulatory Oversight.........................17 1.8 Transitional Changes in the Interim Regulation Period ..........................................................18 1.9 Policy Recommendations ..................................................................................................19 2. China's Gas Industry: Policy Objectives and Their Achievement by Economic Regulation 21 2.1 The Government of China's Policy Objectives for the Sector..................................................21 GOC Objectives and Their Origin ......................................................................................21 Comments on the Objectives.............................................................................................22 2.2 International Experience and China's Policy Objectives.........................................................23 2.3 A Vision of China's Future Gas Industry..............................................................................24 2.4 Achieving the Vision: Economic Regulation of the Downstream Sector...................................25 The Downstream Gas Sector..............................................................................................25 The Scope of Economic Regulation of the Downstream Gas Sector.........................................25 The Coverage of Downstream Gas Regulation......................................................................26 Additional Activities in the Regulation of Downstream Gas...................................................27 Economic Regulation of Downstream Gas and the Achievement of China's ................................ Policy Objectives..............................................................................................................28 2.5 Achieving the Vision: Why Is Regulation Needed?................................................................28 The Economic Case for Regulation.....................................................................................28 Regulation and the Evolution of Competition .......................................................................29 2.6 The Current Situation: Regulation and Competition ..............................................................30 Regulation .......................................................................................................................30 Competition......................................................................................................................31 Vertical Integration ............................................................................................................32 2.7 The Gas Law, Policy, and Regulation ..................................................................................32 The Gas Law....................................................................................................................33 The Policy Framework......................................................................................................33 Policy Guidance to the Regulatory Agency .........................................................................33 Regulatory Decisionmaking ..............................................................................................33 2.8 Recommendations ............................................................................................................33 3. The Gas Regulatory Commission 35 3.1 Definitions and Context.....................................................................................................35 3.2 Duties ............ 35 3.3 Powers........... 37 Powers of the Regulatory Commission................................................................................37 Delegation .......................................................................................................................37 Controls ...........................................................................................................................39 3.4 Jurisdiction..... 41 Areas of Regulatory Commission Authority..........................................................................41 Disputes...........................................................................................................................41 3  Table of Contents 3.5 Organization ... 42 The Decisionmaking Level................................................................................................42 Alternatives for the Decisionmaking Level..........................................................................42 The Working-Level Organization........................................................................................43 3.6 Procedures...... 44 Procedures That Should Be Addressed in Law......................................................................44 Procedures That May Be Addressed in Law .........................................................................44 Working-Level Procedures.................................................................................................45 3.7 Staffing.......... 46 3.8 Funding.......... 46 Alternatives for Funding the Regulatory Commission............................................................46 Regulatory Independence and "Industry Funding"................................................................47 Regulatory Independence and Salary Levels.........................................................................47 Assessment of the Likely Resources Needed for Downstream Gas Regulation..........................48 3.9 Reporting ....... 48 3.10 Transparency. 48 3.11 Independence 49 3.12 Public Input.. 50 3.13 Powers of Regulated Entities............................................................................................50 Powers to Obtain Rights of Way.......................................................................................50 Powers to Collect Approved Rates ....................................................................................50 Limitations on the Powers of Regulated Entities .................................................................50 3.14 Place of the Regulatory Commission within Government.....................................................51 3.15 Recommendations...........................................................................................................51 4. Principles for the Regulatory Activity 53 4.1 The Regulatory Jurisdiction over Transmission Pipelines.......................................................53 4.2 The Tasks of Economic Regulation: Gas Transportation and Regulatory Authorizations.............54 Exclusivity......................................................................................................................54 Methods of Operation: Contract vs. Common Carriage.........................................................56 Implications for Reform in China.......................................................................................58 4.3 The Tasks of Economic Regulation: Access to Service...........................................................59 Transmission....................................................................................................................59 Distribution .....................................................................................................................60 4.4 The Tasks of Economic Regulation: Setting Tariffs...............................................................60 Objectives .......................................................................................................................61 Tariff Structure.................................................................................................................61 Tariff Regulation Options ..................................................................................................61 Tariff-Setting Principles.....................................................................................................62 4.5 Recommendations ............................................................................................................63 5. Regulatory Techniques 65 5.1 Transmission: Regulatory Techniques..................................................................................65 Terms and Conditions of Access.........................................................................................65 Transmission Tariff Methodology .......................................................................................72 Regulation of Transmission Tariffs......................................................................................75 5.2 Distribution: Regulatory Techniques ...................................................................................79 Development of Unbundled Distribution Service..................................................................80 Regulation of Bundled Distribution Service.........................................................................82 5.3 Recommendations ............................................................................................................82 Transmission....................................................................................................................82 Distribution .....................................................................................................................83 6. Transitional Changes in the Interim Regulation Period 84 6.1 Definition of Terms...........................................................................................................84 6.2 Assumptions about Principles for the Regulatory Framework.................................................85 4  Table of Contents 6.3 Basic Concepts for Interim Regulation ................................................................................85 6.4 Responsibilities of the Interim Regulatory Agency in Relation to the Ministries........................... and Agencies... 86 Definition of Terms..........................................................................................................86 Maintaining Relationships ................................................................................................86 The Interim Regulatory Agency as a "Buffer"......................................................................87 6.5 Recommended Measures for the Interim Regulatory Agency to Achieve the Objectives for the Transition .......................................................................................................................87 6.6 Monitoring Progress and Monitoring Competition ................................................................89 Monitoring and Reporting of Sector Restructuring and Policy and ..........................................89 Regulation and Changes ....................................................................................................89 Regulatory Monitoring of Competition................................................................................89 Monitoring of Regulatory and Market Change by a Third Party? ............................................90 6.7 Authority of the Interim Regulatory Agency.........................................................................90 Powers of the Interim Regulatory Agency............................................................................91 Power of Delegation .........................................................................................................91 Scope of Regulation by the Interim Regulatory Agency.........................................................91 Processes of the Interim Regulatory Agency.........................................................................91 Provisions for Transparency...............................................................................................92 Independence in Decisionmaking .......................................................................................92 6.8 Arrangements for the Transition Period................................................................................92 6.9 Recommendations ............................................................................................................93 7. A Schedule for the Deregulation of Natural Gas Prices 95 7.1 Introduction.....................................................................................................................95 7.2 Present Control of Upstream Gas Prices ..............................................................................96 7.3 The Process of Gas Price Determination in Uncontrolled Gas Markets.....................................96 7.4 When Is Government Control of the Gas Price Desirable?......................................................97 7.5 Governments and Gas Pricing: International Examples..........................................................97 7.6 The Structure of Gas Markets in China: Is Government Control of Gas Prices needed ...............98 7.7 What Are the Upper and Lower Sustainable Limits to Upstream Gas Prices?............................99 7.8 Recommended Schedule for Decontrol of Upstream Gas Prices............................................100 7.9 Conclusions and Next Steps .............................................................................................101 Appendix 1: Terms of Reference: China-- Regulatory Framework for Gas Development 102 Appendix 2: List of Experts That Participated in the Work Group Meetings 108 Appendix 3: Summary of the Structure, Operation, and Regulation of Gas Markets 110 Appendix 4: Deriving the Cost Base for Transmission 112 Appendix 5: Draft Code of Conduct 126 Appendix 6: General Terms and Conditions 134 Appendix 7: Glossary 166 Boxes 2.1: A Vision of China's Future Gas Industry 2.2: The Downstream Gas Sector Tables 5.1: Alternative Regulatory Mechanisms 5  Preface PREFACE This report is one of the results of the joint project, "Study on China's Oil and Gas Sector Regulatory System,"which was implemented by the World Bank and the Institute of Economic System and Management, which is part of the State Council Office for Restructuring the Economic System (SCORES) during the second stage of the study. The results for the first stage were published in March 2001 under the title "Modernizing China's Oil and Gas Sector: Structure Reform and Regulation"(the Joint Report). Overall policy framework, as well as concepts of structure reform and the establishment of a modern regulatory regime, were elaborated systematically in this Joint Report. The present report is a summary of the conclusions obtained from an in-depth study of issues concerning the establishment of modern regulation in the downstream gas sector within the scope of the Joint Report. This report was funded by the Public-Private Infrastructure Advisory Facility (PPIAF) as a part of the project on the Implementation of the Regulatory Framework for China's Downstream Gas Sector. It responded to the March 2000 Terms of Reference (TOR) (see Appendix 1) and took as a given the GOC's general objectives to introduce competitive market forces wherever possible in the oil and gas sector and its specific policy objectives for the gas industry. Because of the key role of prices in terms of competition and market functioning. The report also recommended a schedule for the deregulation of gas prices. A subsequent report will present the proposed legal framework. The joint report proposed that a start be made toward implementation of the recommended new style of oil and gas regulation. It suggested that the downstream gas industry is an obvious area for such a "demonstration project"in modern regulation. This proposal has been followed up by means of the project on the "Implementation of the Regulatory Framework for China's Downstream Sector" supported PPIAF, which was carried out by consultants and a Bank team working jointly with a counterpart team led by the Institute of Economic System and Management. The work began in July 2000 and was followed by missions in October and December 2000 and in March 2001. Active participants in the meetings included officials and experts from the State Development Planning Commission, State Economic and Trade Commission (SETC), Ministry of Construction, State Council Office for Legislative Affairs, PetroChina Company Limited, China Oil and Petrochemical Company (SINOPEC), and China Offshore Oil Corporation, as well as representatives from relevant local governments and urban gas distribution companies (UGDs) of Beijing, Shanghai, Chongqing, Hefei, Chengdu, and Wuxi. The report was then drafted by Bank experts and consultants on the basis of rich information and valuable comments provided during these discussions. Senior staff of the Institute for Economic system and Management, SCORES organized, chaired and fully participated in these meetings and revised all versions of this report. The consultants and World Bank team highly commended the Chinese counterparts'work; the institute was most appreciative of the World Bank experts'effort, ingenuity, and efficiency. At the same time, the two sides were sincerely appreciative of the active cooperation of all other parties concerned. The feedback and comments provided by experts from these institutions were very helpful, although it is recognized that the points of view expressed in this report may not be consistent with the opinions of all of the different institutions that were consulted. 6  Preface List of the Joint Working Group Group Leaders: World Bank: Noureddine Berrah Task Team Leader, Energy Program Coordinator, World Bank Institute: Chen Li Executive Deputy Director Members: World Bank/PPIAF: Bent Svensson Lead Energy Economist Elaine Sun Energy Program Coordinator, World Bank, Beijing Paul T. Hunt Consultant Peter L. Miles Consultant Roland Priddle Consultant Institute of Economic System and Management, Office of Restructuring the State Council: Huan Guoyu Office Director, Professor He Xiaoming Professor Li Xiaodong Associate Professor Wang Jianmei Research Assistant State Economic and Trade Commission Zhou Yubo Deputy Director-General, Department of Economic Laws and Regulations Zhou Hao Department of Economic Laws and Regulations Ministry of Construction Liu Heming Division Chief , Department of Urban Construction Xing Jun Deputy division Chief, Department of Economic Laws and Regulations Office of Legislative Affaires of the State Council Zhang Yaobo Deputy Division Chief, Department of Industry, Communication and Commerce Beijing Municipal Administration Commission Guo Weiqi Director, Gas Office China National Petroleum Corporation (CNPC): Tang Yali Vice President, Natural Gas and Pipeline Company Jiang Lixin Deputy Economist General, Secretariat of the Board of Directors Xu Wenman Economist, Natural Gas and Pipeline Company Cui Hongsheng Deputy Division Chief, Natural Gas and Pipeline Company Zhao Bo Deputy Division Chief, Beijing Gas Transmission Company SINOPEC: Zhang Xuzhi Team leader of Strategic Research Team Liu Yan Deputy Director General, Department of Comprehensive Planning Fang Zhongyu Deputy Division Chief, Petrochemical Planning and Engineering Institute China National Offshore Oil Corporation (CNOOC): Liang Zhili Advisor, Legal Department Zhou Shengwei Division chief, Office for Restructuring the Economic System 7  Preface China United Coal Bed Methane Corporation Peng Li Deputy division Chief, Department of International Cooperation Beijing Gas Group Corporation Ltd. Wu Liya President The list of experts who participated in the Joint Working Group meetings is attached as Appendix 2. 8  Acronyms and Abbreviations ACRONYMS AND ABBREVIATIONS ABC Activity-based costing Bcm Billion cubic meters BG British Gas Capex Capital expenditure CAPM Capital Asset Pricing Model CCA Current cost accounting CER Commission for Electricity Regulation in Ireland CNOOC China National Offshore Oil Corporation CNPC China National Petroleum Corporation CPI Consumer price index CSRC China Securities Regulatory Commission DGM Dividend Growth Model DV Deprival value E&D Exploration and development EFET European Federation of Energy Traders EU European Union FERC U.S. Federal Energy Regulatory Commission GOC Government of China GJ Gigajoule HCA Historic cost accounting IOC International oil company IPO Initial public offering ITSA Interruptible Transportation Service Agreement LDC Local distribution company LNG Liquefied natural gas MAR Market-to-asset ratio MDQ Maximum daily quantity NAV Net asset value NEB Canadian National Energy Board NPC National People's Congress NPV Net present value NTS U.K. National Transmission System O&M Operation and maintenance OCM On-the-Day Commodity Market ODV Optimized deprival value GEMA U.K. Gas and Electricity Markets Authority Opex Operating expenditure ODRC Optimized depreciated replacement cost ORC Optimized replacement cost PPIAF Public-Private Infrastructure Advisory Facility 9  Acronyms and Abbreviations PSC Production-sharing contract PSO Public service obligation R&C Residential and commercial RONA Return on net assets RP Receipt point RPI Retail price index (in the United Kingdom) SAPCI State Administration for the Petroleum and Chemical Industries SCORES State Council Office for Restructuring the Economic System SDPC State Development Planning Commission SETC State Economic and Trade Commission SINOPEC China National Oil and Petrochemicals Corporation SOE State-owned enterprise TOR Terms of Reference TSA Transmission Service Agreement UAG Unaccounted-for gas UGD Urban gas distribution company WACC Weighted average cost of capital WTO World Trade Organization A glossary of special terms is provided at the end of the report (Appendix 7) 10  1. Executive Summary 1. EXECUTIVE SUMMARY 1.1 The Background In 1998 the Government of China (GOC) reorganized the oil and gas sector and began a reform of the state-owned companies in the The downstream gas regulatory sector with the objective of creating market-oriented, efficient, framework proposal is an internationally competitive energy companies. outgrowth of efforts going back In 1999 the GOC asked the World Bank for advice on establishing to the 1998 oil and gas sector a new market-oriented, modern regulatory framework for the oil reform and is consistent with and gas sector. The Bank and its Chinese counterpart team, whose international practices. core membership was drawn from the Institute of Economic System and Management, State Council Office for Restructuring the Economic System, formed a joint working group. They prepared a report on oil and gas sector reform that set the framework for further work.1 The present report builds on these previous efforts directed toward reform of the oil and gas sector and focuses on the implementation of a regulatory framework for the downstream natural gas sector, in particular on the economic regulation of the sector. It explains the need for regulation, describes the institution that is needed to implement it, explains the principles and techniques that should be applied, and proposes changes for the transition toward modern regulation, as well as changes in the regulation of gas commodity prices. Countries in North and South America and in Europe, and others such as Australia and New Zealand, have already experienced the favorable economic effects of gas market opening combined with modern regulation. This opens up for China the vision of an expanding, efficient gas market, drawing supply from multiple sources, served by growing long-distance transmission and urban distribution systems, all contributing to economic growth, energy supply diversity, and a cleaner environment. 1 It was published under the title "Modernizing China's Oil and Gas Sector: Structure Reform and Regulation,"March 2001 (the "Joint Report"). 11  1. Executive Summary 1.2 Long-Distance Transmission and Distribution Systems: The Case for Economic Regulation of Natural Monopoly Transmission and distribution, together with storage and shipping operations, are the principal activities of the downstream gas Modern economic regulation of sector. Economic regulation involves control and direction, by an natural monopolies is essential agency of government, of those businesses that are characterized for China's expanding gas by monopoly and are therefore not adequately disciplined by industry. competitive forces. Typically, gas transmission is a natural monopoly; for example, there is room for only one efficiently sized West