Should WA’s gas retailers be obliged to maintain a supply contingency?

The Issue

In 2008, two major gas supply disruptions in WA resulted in a significant supply shortfall in the State’s gas market and imposed significant costs on gas users. The State Government responded by establishing the Gas Supply and Emergency Management Committee (GSEMC) and tasked it with reviewing the security of WA’s gas supplies and assessing how future supply disruptions should be managed.

GSEMC’s report included several recommendations, one of which was to require gas retailers to have adequate back-up supply arrangements to ensure continuity of supply for small-use customers.  This recommendation was based on an assessment that gas retailers, and the domestic gas market more broadly, were inadequately prepared to respond to major gas supply disruptions and as a consequence inefficient costs were being incurred.

While a gas contingency service obligation may be beneficial, our client (the Public Utilities Office), was interested to know whether it was in the long term best interest of customers and the State more broadly to introduce such an obligation.

The Solution

Synergies approached this question by assessing whether there is a market failure in the way gas retailers manage their upstream supply risk, and hence a potential need for regulation.

There are two possible reasons why retailers may not be optimally managing the risk of a supply disruption. First, when confronted by a disruption a retailer may act to call force majeure on its contracts with large customers as a means of maintaining supply to small use customers. This imposes costs on large customers that are not compensated for by the retailer. In effect, it is an externality cost of assigning priority supply to small use customers. Second, retailers may not have sufficient incentives to minimise their costs of responding to a disruption if they can pass costs through to customers as tariff increases without recourse or regulatory scrutiny. These risks are greatest in circumstances where there is limited retail competition.

While there may be scope for retailers to depart from an optimal risk management strategy, the question for this study was whether the incentives to behave in this way are sufficiently material to justify intervention by government in the form of a mandatory gas contingency service obligation.

The Results

Drawing on the findings of extensive stakeholder consultation and cost-benefit modelling, we found that the WA domestic gas market has matured significantly over the past five years and there are now multiple, competing gas suppliers. This means that it is more cost-effective for utilities to manage their supply risk through a mix of forward contracts and purchases on the spot market as opposed to being required to hold a mandatory contingency reserve.

While curtailment of gas to large users remains an option for retailers in responding to a supply disruption, the majority of stakeholders consulted indicated that retailers would action other options ahead of curtailment if possible. The availability of diverse sources of gas supply at relatively low prices (compared to several years ago) means that sourcing additional supply on the market or through pre-existing options contracts would be utilised by retailers ahead of curtailment.

Conclusion

It was concluded that there is no economic case for a gas contingency service obligation because the gas requirements of small use customers can be maintained at relatively low cost by responding to an event when, and if, it happens.

Further, it is evident that retailers are currently hedging some of their risk exposure through contractual means and, given the relatively small volumes of gas that would need to be found to maintain small use customer demand, there would be minimal, if any, economic benefit from requiring retailers to adhere to a mandatory contingency service obligation.