Gas Price Legislation in Canada

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Introduction

The National Energy Board (NEB) was established through the National Energy Board Act to make sure that long-run supply of natural gas in Canada will be adequate enough to meet the needs of the country before any export license could be issued. Towards this end, a Market-Based Procedure (MBP) was adopted by the Board in the year 1987. This procedure is based on the argument that market conditions would ensure the competitiveness and efficiency of the natural gas industry and subsequently fair market prices for consumers. For this to be realized however, it was expected that no abuse of market power or barriers to entry would exist as is the case in monopoly markets. The MBP was implemented immediately after the Government of Canada and the governments of the three gas-producing provinces – British Columbia and Saskatchewan – entered into a treaty to deregulate the natural gas industry. This treaty, known as the Agreement on Natural Gas Prices and Markets was signed on 31 October 1985 (National Energy Board (a) 1). The policy has had a significant impact on the natural gas industry as well as on the entire Canadian economy.

The Agreement resulted in a landmark alteration of the Canadian natural gas market by permitting the buyers of the gas to enter into direct supply contracts with producers, marketers and other agents involved in the distribution of the gas at prices which have been freely negotiated by the parties concerned. Before the Agreement was signed, the price of the natural gas distributed between provinces was under stringent regulations by the federal government and the government of Alberta. In addition, consumers of gas from non-producing provinces could only purchase the commodity from a pipeline company at a bundled price which incorporated the price of the commodity itself, the cost of production as well as the cost of transporting the commodity from the point of production. This bundled price was much higher thereby making the natural gas too costly for most consumers. The deregulation of the natural gas industry was therefore a blessing to consumers because it increased competition in the industry forcing the market players to bring the commodity closer to the consumers at relatively fair prices. However, did not affect the deregulation policy the pipeline transmission segment of the industry due to its monopoly features. One of the prerequisites for creating a competitive natural gas market was the provision of a transparent non-discriminatory access to all distributors of gas across provincial borders. Despite the deregulation, the industry is still closely monitored by the Board to ensure that the prevailing market conditions reign in the industry (National Energy Board (a) 1-2).

The formation of natural gas price in Canada

The price of natural gas that is paid by the final consumers such as residential or commercial consumers has three components namely: the gas commodity price, transportation costs and distribution fees. This price is dependent on the quantity of gas bought. Whereas the price of the gas commodity itself is not regulated, the transportation costs and distribution charges are regulated by different authorities. In Canada, the interprovincial and international transportation cost – that is, the cost of moving the commodity by a pipeline from the production points to final distribution points – is regulated by the National Energy Board. On the other hand, interstate and international transportation costs in the United States are regulated by the Federal Energy Regulatory Commission (FERC). The importance of mentioning the U.S. in this case is because of the integration of the Canadian and American natural gas markets which formed the North American gas pipeline. In the two countries, distribution fees are controlled by the respective provincial, territorial and state government officials (NEB (b) 4).

The structure of transactions in Canadian natural gas market

The purchase and sale of natural gas continue to be an evolving process which is detected by the prevailing market conditions. Presently, the commodity can be purchased or sold on either short-term or long-term basis depending on the preferences of the consumers. Such prices are established in particular sites, referred to as trading hubs. Trading hubs are the locations where the natural gas is physically traded. The price of natural gas purchased and sold can be established “on a daily, weekly, monthly, seasonal, annual, or longer-term basis” (NEB (b) 5) and varies from one trading hub to another. Whereas a longer-term contractual sale of natural gas is allowed, the actual price is normally determined by a monthly reference price of a trading hub other than the hub in which the contract is being made. Market liquidity of the natural gas market is affected by the length of the long-term contract. That is, a longer contract decreases the market liquidity while a shorter contract increases the market liquidity. The majority of the contracts are between one and three months. These contracts also witness the trade of the greatest volume of the commodity. This trend is evidenced by the increase in the short-term export orders and a decrease in the long-term export orders.

Integration of the North American market

The deregulation of the Canadian natural gas industry brought about significant changes in the industry, one of them being the integration of the Canadian and the U.S. gas markets into the North American gas market. The deregulation resulted in the elimination of numerous barriers which in turn created a conducive business environment for the market integration. Indeed, the integration began immediately after the agreement came into effect in 1985. The market integration implies that the purchase and sale of the commodity can be done freely from the two countries’ numerous market centers. This is realized through the North American pipeline grid. As a result of the integration, the natural gas industry is subject to market forces of demand and supply operating in the North American region. Such market forces affect not only the price of the commodity but also the flow of the commodity in Canada and within the North American region. For instance, if the price of natural gas in Canada increases relative to the price in the U.S., natural gas sellers would prefer to sell the commodity in Canada where they are assured of fetching higher revenues. On the other hand, the supply of the commodity in the U.S. would fall. As more and more suppliers shift to Canada relative to the U.S., market forces would put a downward pressure on the price of the commodity in Canada and it will start to fall. On the other hand, the scarcity of the commodity in the U.S. would put an upward pressure on the price of the commodity in the U.S. and the price of the commodity would start to rise. This process would continue until equilibrium in the market is restored (National Energy Board (b) 6).

Other economic effects of the deregulation policy

The deregulation of the price of natural gas in Canada means that such prices are determined by the market forces. This policy has significant economic effects on the Canadian economy some of which are: demand, supply, and market psychology.

Demand for natural gas following the deregulation policy

High demand for energy is determined by a strong economy. During the 1990s, the North American economy was very strong as evidenced by the economic boom particularly of the housing and construction sectors. The growth of these sectors significantly increased the demand for natural gas. National Energy Board (b) states that “from 1991-1999, two-thirds of the new homes and 57 percent of the new multi-family buildings constructed were heated with natural gas,” (9). The demand for natural gas was also high in the commercial and industrial sectors. The high demand has been partly due to the increased efficiency in the production of the commodity as well as relatively fair prices resulting from stiff competition in the market following the deregulation policy.

Closely linked to the increased demand is the increase in the volume of natural gas sales. Before the implementation of the policy, all direct sales of the commodity were carried out in Alberta. The direct sales volume at that time represented a mere nine percent of the total gas sales volume. By the year 1995 however, the direct sales volume of gas had increased by fifty percent to fifty-nine percent of total sales volume. The deregulation policy enabled commercial and industrial consumers to take complete advantage of the opportunity to buy the commodity directly from the suppliers as well as the stiff competition between suppliers.

Competing fuel prices

National Energy Board (b) states that, “fuel switching is a temporary change from one fuel to another fuel at a particular facility and acts to limit gas price increases,” (10). Consumers often make decisions concerning the type of fuel to use at any particular time. Such decisions are usually based on different factors such as relative prices of the fuels, availability of the fuel, and fuel efficiency. Unfortunately, the ability of consumers to switch from one fuel to another is not well developed in Canada as compared to her neighboring U.S. This inability is partly as a result of unavailability of alternative fuels and partly due to underdeveloped infrastructure necessary for the fuels’ distribution. Nevertheless, the prices of natural gas are closely related to the prices of oil. Hence, if the price of oil increases due to conditions in the world market, the prices of natural gas will also increase and vice versa.

An illustration is the increase in oil price that happened in the late winter of 2001/2002. During this time, oil price increased from US $20/bbl to US $28/bbl within a span of few weeks. Following suit, the price of natural gas also increased from US $2.50/MMBtu to US $3.40/MMBtu within the same period of time (NEB (b) 10). Such price fluctuations often cause great supply and demand problems in an economy. The situation is worsened when suppliers take advantage of the situation and hike the prices well above the market prices. The only option for consumers in such situations is to switch fuels at least until normalcy returns. Consumers who lack alternative fuels suffer the most because they are forced to consume the commodity at those exorbitant prices (Don and Frank 254). Lack of regulation in such a market therefore harms consumers because the government lacks the ability to control the high prices charged by suppliers and producers. This is one of the greatest disadvantages of the deregulation policy adopted by the Canadian governments in relation to the natural gas industry.

Natural gas storage

Storage of natural gas is important in ensuring that high demands for the commodity during peak seasons are met. In Canada, the peak season for natural gas normally lasts between November and March of the following year. The other months are normally considered to be the non-heating season. It is the season which gas suppliers use to build their stock of supplies in preparation for the peak season. Besides addressing increased demands during the peak seasons, gas storage is also used to physically cushion the market against price fluctuations. The volume of gas stored in the storage facilities is a great determining factor of the prices of natural gas. If the stored gas is not adequate enough to meet the needs of consumers, the demand for the commodity will be higher than the supply and thus the prices would rise significantly, and vice versa.

The increased competition in the Canadian natural gas industry as a result of the deregulation policy ensures that the commodity’s suppliers have adequate storage of the commodity to meet consumers’ needs (NEB (b) 10-11). Suppliers who do not store adequate gas supply are likely to lose out on consumers and revenues too. The deregulation policy therefore provides a great advantage to consumers in this respect. On the other hand, the stored gas may not be adequate enough to meet consumers’ needs particularly in situations of increased demands. When this happens and the utilization capacity of the stored gas approaches optimal levels, it is only natural for prices of gas to skyrocket. Lack of regulation in this scenario is harmful to the consumers because the government cannot protect the consumers from exploitative behaviors of suppliers (Don and Frank 254).

Market psychology

Deregulation of prices and the subsequent high competition in the market create what Economists term as “market psychology”. This phrase refers to the behaviors of suppliers and consumers when they anticipate the occurrence of certain events that are likely to alter the prevailing market conditions. For instance, when suppliers anticipate that there will be shortage of commodity in the commodity, they are more likely to hoard the commodity at the present so that they can sell it in the future at inflated prices. The reversed scenario is also possible. For instance, suppliers may anticipate increased supply of a commodity and therefore they will lower the commodity’s price. Natural gas as a natural resource is very sensitive not only to the world market conditions but also to natural and political occurrences. As a result, anticipation of any future event by suppliers will affect the supply/demand equilibrium as well as the gas prices. Without regulation of the commodity’s prices by the government, consumers are more likely to suffer from exploitation (NEB (b) 11).

LDC purchasing practices

Immediately after the deregulation policy was instituted, the commodity price in the local distribution companies’ (LDC) gas purchase agreements was bargained on a yearly or bi-annual terms, without any room for price alterations afterwards. At the present, majority of LDC gas purchase agreements are based on the market forces where prices are determined by index-based devices which change on a monthly basis. For instance, from 1993 the pricing mechanisms of long-term agreements between LDCs in Ontario and Manitoba and TransCanada Gas Services have been done using an index-based mechanism that uses the prices listed on the New York Mercantile Exchange (NYMEX). In addition, the companies have been able to implement risk management strategies that have enabled them to cushion themselves against price volatility (NEB (a) 30).

Summary

Advantages of the deregulation of gas prices in Canada

Increased competition in the market – the policy enhanced competition in the gas market which in turn has enhanced the efficiency with which the commodity is produced and sold, and the supply of the commodity.

No abuse of market power – the deregulation policy led to the elimination of the possibility of market power abuse due to stiff competition in the industry. Abuse of market power is only possible in monopoly markets.

Direct contact between the consumers and suppliers – the policy has enabled consumers to purchase the commodity directly from suppliers thereby lowering the price of the commodity significantly.

Increased sales volume – the deregulation policy has increased the volume of gas sales in the country. This is because consumers can make use of the direct sale contracts that the policy introduced.

Market integration – the policy led to the integration of the Canadian and U.S. natural gas markets. This integration provides many economic opportunities for the two countries.

Disadvantages of the deregulation of gas prices in Canada

Potential for exploitation of consumers by suppliers – deregulation of the natural gas fails to protect consumers from exploitation by suppliers for instance when demand surpasses the supply.

Problem with market integration – the market integration that was made possible by the deregulation policy poses significant vulnerabilities for the Canadian gas industry. Any market condition that negatively affects the gas industry in the U.S. will also affect the Canadian gas industry.

Competing fuel prices – the deregulation policy also cannot protect consumers from exploitation that results from competing fuel prices. If oil prices increase, the gas prices will also increase. Due to lack of regulation in the market, suppliers can easily take advantage of the situation and exploit the consumers.

Market psychology – the determination of gas prices through the market forces creates market psychology among suppliers and consumers. Anticipation of future events has significant impact not only on the supply/mechanism interactions but also on the price of the commodity.

Conclusion

The deregulation policy of the Canadian natural gas industry was introduced in 1985 with the signing of the Agreement on Natural Gas Prices and Markets by the Canadian governments. The price deregulation affected only the commodity price and not the transportation costs or distribution fees involved. The policy still exists today. Since then, many changes have taken place in the gas industry. On the one hand, the policy has increased the potential for suppliers to exploit consumers in certain situations. On the other hand, the policy has had significant positive effects on the Canadian economy such as increased competition, enhanced efficiency, increased sales volume and market integration with the U.S. natural gas market. Indeed, the Canadian economy, particularly the natural gas sector, has grown tremendously since the deregulation policy came into effect.

Works Cited

Don, Anderson, and Finn Frank. “Regulation and deregulation of the supply of bulk liquid petroleum gas in Queensland: A case study.” Economic Record, 70.210(1994): 253-261.

National Energy Board. Natural gas market assessment 10 years after deregulation. Calgary, Alberta: Regulatory Support Office National Energy Board, 1996.

National Energy Board. Canadian natural gas market. Dynamics and pricing: An update. Calgary, Alberta: The Publications Office National Energy Board, 2002.

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