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Home > Speeches and Presentations > Speeches and Presentations 2004 > The New Balancing Act: Reconciling Markets and Regulation

The New Balancing Act: Reconciling Markets and Regulation

Presented by
Deborah Emes
Board Member
National Energy Board

26 May 2004

Thank you very much for inviting me to speak today. The theme of this conference - The New Balancing Act: Reconciling Markets and Regulation - focuses on a question which has been concerning me for sometime.

NEB Mandate

In order to provide some context for my more substantive remarks, I thought that I would give a brief description of the National Energy Board. For those of you who don't know, the NEB is somewhat analogous to the US Federal Energy Regulatory Commission. It was established in 1959 through the National Energy Board Act and has additional responsibilities established through other Acts such as the Canada Oil and Gas Lands Act. The Board's mandate is outlined on this slide.

Gas Pipelines - Oil Pipelines

Currently, the Board regulates over 45 000 km of international and interprovincial pipelines while the export of natural gas, oil and electricity accounted for approximately $40 billion in revenue to Canada last year.

NEB Corporate Goals

In carrying out its mandate, the Board has regard to the five goals listed on the slides.

NEB Corporate Goals (cont'd)

It is under Goal 3 - Canadians derive the benefits of economic efficiency - that the topic of today's conference falls.

Goals of Regulation

I decided to begin my remarks today with a brief overview of the goals of regulation, since the way in which we reconcile regulation and markets should be reflective of the goals we wish to achieve.

I would suggest that the fundamental goals of regulation have been to ensure

• that all socially desirable infrastructure is built, but no more than the socially desirable amount; and
• that market power abuses are prevented.

If these goals are met, the following benefits accrue:

• society obtains the infrastructure it desires,
• all costs of production are met, including a fair return on investment, and
• utility service is provided to all those who are willing to pay its cost of production but not to those who are unwilling.

These outcomes are also associated with competitive markets. An additional outcome associated with competitive markets, the encouragement of innovation and efficiency to lower long run costs and increase customer choice, has typically not been an outcome of regulation.

Pressures for Change

Beginning in the 1980's and 90's, substantial pressure arose to see if. the encouragement of innovation and efficiency, and increase in customer choice, could not somehow be captured. For the National Energy Board, these pressures were often manifested in terms of complaints from shippers that the regulatory regime

• provided little incentive for pipelines to operate efficiently, and in fact provided incentives for pipelines to gold plate their systems to increase rate base and earn higher returns;
• provided little incentive for pipelines to meet shippers' needs for additional and innovative service; and
• produced tolls that did not always reflect market conditions, but were based strictly on the cost of provision of service.

Early solutions took the form of attempts to 'tweak' the model through such means as incentive mechanisms and performance based rate making. Although these measures gave some success, they did not provide the same level of benefit as a competitive market. As a result, pressure to examine whether greater reliance could be placed on markets continued to build. Indeed, some might argue that this led to the construction of the Alliance Pipeline.

However, neither the existence of complaints about regulation nor the fact that greater reliance can be placed on the market in some areas means that the concerns which regulation was devised to address have disappeared.

Markets or Regulation

Given that the problems which regulation was designed to address still exist, at least to some degree, but at the same time, greater reliance can be placed on markets, at least in some areas, how do we determine when and how to intervene?

It seems to me that we need to answer three questions. First, what are the goals we wish to achieve; i.e. what do we want? Second, what are the conditions that need to exist for the goals to be realized; i.e. what do we have to do? And third, what costs are associated with establishing these conditions under both a regulated environment and a more market based environment; i.e. what will we have to pay?

Earlier I suggested that what we want is socially desirable infrastructure, the prevention or limitation of market power abuse, and innovation for customer choice and efficiency.

What do we have to do? For the provision of infrastructure, I would suggest that we need to establish an appropriate investment climate; that is, one in which there is a reasonable expectation of a return commensurate with the risk of the investment. For the prevention or limitation of market power, I would suggest that we need to have a clear understanding of what constitutes abuse and implement measures that either prevent its occurrence or withdraw the rewards which accrue from the behavior.

It is the third question, what are the costs associated with each approach - market or regulation- which is the most difficult to answer but which also determines how we should proceed. Essentially, it is the third question which forces us to address the issue of trade-offs.

Requirements for Infrastructure

For investment in infrastructure to take place, there needs to be a a clear understanding of the rules under which the investment is being made and confidence that the rules will not be changed in an arbitrary fashion.

Traditional cost of service regulation, in an environment in which there is little or no outside competitive pressure, has been effective in providing this certainty.

However, when competitive pressures are added, traditional cost of service regulation is less effective in providing this certainty, whether these pressures comes from non-regulated competitors or other regulated competitors; e.g. increased pipe on pipe competition. As a result, the willingness of investors in a traditionally regulated, incumbent service provider to continue to invest in desirable infrastructure becomes less sure. There can also be impacts on the willingness to invest of potential new investors who will look to see whether incumbent service providers have been treated fairly by regulators.

This suggests that if we wish to garner the benefits of competition without impairing the attractiveness, from an investment perspective, of incumbent service providers, we need to acknowledge the impact of allowing competitive influences to operate on an incumbent service providers' bottom line and be open to examining new ways to allow an appropriate investment climate to exist for them.

What might some of these ways be? Each situation will have to be judged on its own merits and with regard to individual circumstances. However, in making judgments which seek to balance the benefits of increased competition with the maintenance of an appropriate investment climate, the following considerations may be relevant:

• the size and certainty of benefits from allowing competitive influences to operate
• the distribution of the benefits amongst customers
• the impact on the incumbent service provider's financial position
• the related impact on tolls to remaining customers
• the ability to make offsetting changes to ensure an appropriate investment climate is achieved
• the impact these changes may have on customers both in the short-run and the long-run.

Requirements to Limit Market Power

It's tempting to think that the introduction of competitive elements into previously regulated markets would mean that regulation to prevent market power abuses would no longer be necessary. However, this is unlikely to be the case. In many cases, incumbent service providers will continue to have significant advantages, which if left unchecked, could result in market power abuses. This abuse could be shown in the ability to shift costs from non-regulated portions of their operations, where they should properly accrue, to regulated portions, or to offer services in the competitive arena at prices below their cost of provision.

Therefore, the question of how to limit or prevent market power abuses is related to the problem described with respect to infrastructure and the investment climate. Too weak limitations, on the incumbent service provider's ability to compete, reduce customer choice and inhibit the efficiency and innovation that arise from competition. Too stringent limitations negatively affect the incumbent service provider's financial position and may also lead to inefficiencies in the provision of services (e.g. not being allowed to provide a service even though it would be the lowest cost provider).

In addressing these trade-offs, some relevant considerations may be the following:

• the opportunity for market power abuse. We need a clear understanding of the difference between a legitimate competitive advantage (depreciated assets) and an unfair or abusive advantage (the ability to shift costs from non-regulated to regulated lines of business).
• the amount of regulatory intervention required to limit the abuse. For example, would an adhered to 'code of conduct' be sufficient or is a prohibition from entering the line of business needed?
• the existence of tools to monitor the situation to see if the initial regulations are preventing the abuse.
• the provision of sufficient resources to ensure that the tools can be used. For example, sufficient auditors to ensure that codes of conduct are being followed.
• The existence of penalties sufficient to deter abuse.

Smart Regulation

As in the United States, Canadian regulators are grappling with the question of how to properly balance reliance on markets and reliance on regulation; that is, how to achieve "Smart Regulation". This phrase entered the lexicon as a result of the September 2002 Speech from the Throne (the Speech in which the Government explains its proposed legislative program) and was followed by the establishment of an External Advisory Committee to recommend

What does Smart Regulation entail? According to the Chair of the External Advisory Committee, Smart Regulation is not about deregulation, reducing paper burden, or culling regulation that has outlived its usefulness. Instead, Smart Regulation does the following:

• It instills trust, confidence and credibility
• It enables innovation
• It is effective in protecting the public interest.

NEB Smart Regulation

These ideas are consistent with the approach our Board is currently taking. At the NEB Smart Regulation means that we are focusing our efforts on critical areas and that we are focusing on outcomes and not on processes. It also means that we rely on market forces where possible and encourage parties to resolve issues through negotiations where a reasonably level playing field for negotiation can be established.

One area in which this approach can be seen is the way in which gathering and processing is handled by the Board. In general, rates are not directly regulated but are negotiated by parties, subject to complaint to the Board. Similarly, small pipelines are generally subject to toll regulation only on a complaint basis.

Larger pipelines subject to Board jurisdiction have also established tolls and tariffs through negotiated settlements based on the Board's Settlement Guidelines. These Guidelines state:

• The process must be open to all
• There can be no fettering of the Board's ability to carry out its mandate
• There must be adequate information on the public record for the Board to come to a determination; and
• The Board will not accept settlements containing provisions that are illegal or contrary to the NEB Act.

It is important to note that the Board has said that it would not pick and chose among the elements of a settlement, but would either accept or reject it in its entirety. In this way, the Board respects the trade-offs made by parties to the negotiations. In addition, the Board has indicated that if these Guidelines are followed, in most cases, the Board would be able to determine that the resultant tolls are just and reasonable, without a public hearing.

Successful settlements have reflected both a cost of service model and more market oriented considerations. Generally, the settlement process has worked well for oil pipelines, although not as well for gas pipelines. Challenges have included difficulties in finding scope for operating efficiencies and obtaining agreement on capital cost efficiencies.

I should also add that where successful negotiation is not possible the Board stands ready to fulfill its regulatory duties.

Further Information

More generally, the Board's over-riding objective is to provide a clear and consistent regulatory framework. By providing this framework, investors can proceed secure in the knowledge that they understand the rules of the game and that there is an enduring regulatory framework that supports the business model underpinning investment. At the same time, consumers can be assured that there is a forum in which their interests are also considered, that customer choice is being encouraged, and market power abuse is being limited.

However, the establishment of a framework is not enough. The Board also recognizes that it must monitor markets on a consistent and ongoing basis to ensure that adequate infrastructure is being provided, that consumer desires are being responded to, and that market power abuses are not being allowed to run unchecked.

Although this monitoring has been an ongoing part of the Board's activities for many years, we are taking steps to improve in this area by developing performance measures. Some of these measures are high level, e.g. pipeline utilization rates, utility bond and equity ratings, approved return on equity vs actual return on equity. Other are mid or low level indicators that examine specific elements. These are still in development but give promise as early indicators of where attention needs to be devoted.

In addition, the Board continues to undertake periodic audits of pipelines under its jurisdiction to ensure that they are in compliance with regulatory requirements.

With respect to customer choice, we are currently working towards obtaining better information from our major pipelines on shipper satisfaction with their services. TransCanada and Maritimes and Northeast, for example, have been sharing the results of their in-house surveys with the Board. In addition, we are working towards a standard set of questions that we would like to see put towards the shippers. The intent is to have the results filed with the Board for all major pipelines. Although it is not the Board's intent to use the results to take any direct regulatory action, they could be a starting point for discussion around areas that could be improved.

In conclusion, the issues surrounding the reconciliation of markets and regulation are not easy ones. We need to be aware that our actions - either in regulating or refraining from regulating - have both costs and benefits and we must weigh them carefully. In all cases, our over-riding principle must be the protection of the public interest.

Thank you.

 

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Date Modified:

2011-10-28