Rationale Behind Oil, Gas, and Electricity Industries Reforms:
Is There a Consistency
Mohammad Mazraati (Ph.D.); Institute for International Energy Studies (IIES); Address:
No. 125, Zafar St., Tehran, Iran; Fax: 98 21 2220149, Email:
Reza Fathollahzadeh: University of Technology, Sydney
Shahla Khaleghi: National Iranian Gas Company
22nd Annual North American Conference of the USAEE/IAEE
Abstract
Gas and electricity have special characteristics that make them distinguished from oil industry. This characterises the structural changes and reforms in these industries. The paper summarises the major structural changes and reforms within energy industries and sort out the purported rationales behind these reforms. The comparison between the ideas and reality reveals a discrepancy and shows that better performances and successes is simply ascribed to the structure changes and reforms. Outperformed restructured entities have affected by many factors including the reforms. The contribution of reforms in better performances, lower prices, lower costs, more competition, more choices and other alleged advantages is unclear.
1. Introduction
Oil, gas, and electricity industries are undergoing profound reforms in the world. Structure, ownership and regulatory frameworks of these industries are in throes of significant and fundamental changes. The history of contemporary reforms can be traced back to the OPEC oil embargo in 1970s. In oil industry, after World War II, the wave of nationalization followed by consolidation of oil companies continued till the early 1980s. The philosophy of the ‘small is beautiful’ lead to the wave of downsizing of the oil companies, with the aim of improving economic efficiencies in 1990s. Introducing competition, privatisation, and portfolio restructuring were the main feature of this period in the oil industries in 1990s. However, since 1998, pendulum swings back toward merger activities in the oil industry in the world. This time rationalization of assets and reduction of costs have been purported as the main rationales behind the new wave of reforms in oil industry.
Mergers and acquisition (M&A) in any shape of horizontal, vertical, or conglomerate integration is believed to bring expansion and growth initiated from synergies. Merger and acquisition are tending to create energy companies encompassing oil, gas and electricity segments. This time, it is believed that ‘big is beautiful’ and small is stupid!
Gas and electricity have special characteristics that make them distinguished from oil. The main features of these energy carriers are that they are economically difficult to store and thus technically inseparable from their transmissions. These special features, technological barriers, and subadditivity characteristic of cost functions caused these industries to be recognized as the ‘natural monopoly’. Thus, these industries were formed as vertically integrated industries for so many years. Gas as the best alternative for oil – cleaner and cheaper – has been an emerging industry, since the first oil shock. Since 1980s, gas industries have been significantly reformed, especially in North America and Europe. The considerable reduction in gas prices together with significant technological improvement in Combined Cycled Gas Turbines (CCGT) were trigger factors for Electricity industry reforms during 1990s. The contrasting features of gas and electricity industry reforms include segregation of production, transmission, distribution, and retail functions of the industry, through introducing competition, choice for customers and privatisation.
The comparison of alleged rationales and relevant realities of these industries reveals that there is an inconsistency in the purported rationales behind the reforms. Also, There is a lack of any serious analysis on the inter-relationship between the rationales of the reforms in oil, gas and electricity industries. The purpose of this paper is to investigate the main rationales behind oil, gas and electricity industry reforms with a view to examine the relationship between inter-industry reforms and ascertain the soundness of rationales.
Section two reviews the reforms fable in the oil industry. The third section addresses the reforms in electricity industry and the fourth section summarises the deregulation and changes in the shape of gas industry. The performance versus the alleged ideas is discussed in section five. In this section, intra-inconsistency between the oil, gas and electricity as well as finding the discrepancy between the alleged rational behind the reforms in theory and practice is analysed. Section six provides concluding remarks.
2. Oil Industry
Oil industry has practiced reforms in different aspects from the most aggregate to the company level. The terms of nationalization, NOC transformation, restructuring, competition, rebalancing, asset concentration, market dominance, reforms, consolidation and convergence, acquisition, merger, energy companies rather than oil companies, downsizing, commercialisation, efficiency, portfolio restructuring, business units (BUs) model, reorganization, reengineering of process, “small is beauty”, “Big is often better”, emerge of institutions and entities (OPEC, IEA, spot and paper markets, IT and E-markets) are among the words and phrases reveals the diversified aspects of what we call oil industry reforms.
As drawn in figure 1 oil industry has internationally practiced gradual structure changes during 1950’s and 60’s. In 1950 the seven sister oil merger were the main oil players. The oil nationalization in the world started at the down of this decade, the pioneer was Iran followed by other oil producer countries.
OPEC emerged to be a major player in the oil industry in 1960s. In 1970s a part of OPEC members used an iron fist to resolve international political conflicts. Security of supply for developed oil importers was threatened and the IEA created. In the early 1980s because of Iran revolution – Its exit from international market – the oil prices increased sharply which provided enough cash for oil development all over the world. The number of none OPEC oil producers increased and this along with the technological progresses increased the competition in the international oil markets. The formation of wet and paper markets in 1980s reshaped the oil industry. In mid-80s, lower oil prices, more oil companies, higher competition, enforced the oil companies for more efficiency and downsizing followed by consolidation in the early 1980s.
In 1990s the commercialisation and privatisation featured the oil industry reforms. Some national companies started commercialisation followed by gradual privatisation up to the end of the decade and finally joined to the stream of mergers (the state-owned BP, commercialised, privatised, finally merged BPAmocoArco, now bp) (Lynch, 2001). In recent years we witnessed a huge wave of mergers so as the M&A deals increased from $539 billion in 1994 to more than $3842 billion in 2000( Cassidy, 2001). The wave of mergers and acquisition in oil industry was started in 1998. The driving forces for M&A in oil industry are believed to be fluctuations in oil and gas prices, using the synergies, cost reduction, the herding effects, securing the company from uncertainties, low shareholder returns, volumetric growth targets, diversification of portfolios in geographical areas, making more robust balance sheets preventing from being acquired.
Although the actual effect of merger on the performance and key indicators of the super major and merged companies is not clear but one thing is for sure that the competition in the new environment is highly tight and threatened the competition itself.
Figure 1. Structural reforms in oil industry
The M&A in some cases has been due to convergence in the energy industry rather than oil. Companies are looking at all the sectors, oil upstream, gas transmission, gas distribution, and gas trading, wholesaling, power generation, electric utilities and electricity trading. Therefore it seems that the tendency is to be creation of “Gas& Power Companies” or “Energy Companies” rather than Oil Companies. The PFC ranking shows that still the first seven biggest companies are oil & gas companies with EXXONMOBIL as the pioneer with $297.7 billion marketed value. But among the top-50 companies four are diversified and six are electricity & gas companies (PFC, 2002).
Fully convergence beyond the energy activities in the fully energy deregulated area is a new tendency in market restructuring. But it is an ambiguus trend in the wake of the Enron collapse. The Enron was branded as an innovator company with new business models (West, 2000). The corporate scandal in U.S. showed how a deregulated market could be fragile. These events would affect the speed of reforms in gas and electricity industries.
Based on figure 1 different level of restructuring in oil industry could be realized. Emerge of OPEC, IEA, SPR, spot markets, paper markets, and realizing the international mergers depicts the international dimension of the oil reforms. National dimension includes nationalization, domestic mergers, regulation, and privatisation (corporate scandal and bearish situation). The role of a tight regulation in the privatised environment is revealed in the wake of Enron energy company scandal and other audits scandal.
Clarifying the interactions of the government and National Oil Companies (NOCs) is another form of reforms within oil industry. The triangle of policy- regulatory entity and operating companies in figure 2 could depict the density of regulation and mismanaged oil activities.
If all functions are definitely identified and recognized, then the least reform is needed otherwise a drastic changes in the structure would be expected. It is believed that the best case is one in which a country has all these separate entities. For example in Norway ministry of energy is responsible for energy strategy and policy making while the Norwegian Petroleum Directorate (NPD) is a regulatory entity (not completely independent) and the Statoil (partially privatised) and Norsk Hydro (acquired private Saga Company) as semi-state companies and IOCs are acting as operating companies. The Norwegian state companies are practicing a commercialised structure and competing the IOCs.
As for Iran oil industry, it is located in the middle of the triangle where all these three different functions and roles are mixed. There have been some efforts to spread up the functions and roles of the ministry of petroleum and the national oil company but still the situation is full of ambiguity. Now the ministry is responsible for the policy making and strategy defining and the parent companies National Iranian Oil Company (NIOC), National Iranian Gas Company (NIGC), National Petrochemical Company (NPC) and national Petroleum Refining and Distributing Company (NPRDC) are as operating companies. Still there is lack of a regulatory body. Although these operating companies have restructured themselves and trying to do their business based on a “Business Units model”. The restructuring is at the very beginning stage. Lack of meritocracy, professionalism, efficiency, incentivized quality people, are among the dominant factors disturbed the performance. Lack of autonomy, responsibility, budgetary autonomy, and discretion to make investment decisions within the affiliated companies have worsen the management of oil activities in Iran.
Figure 2. The mixture of roles in nationalized oil industry
Restructuring Iranian oil industry based on the so-called “Business Units model” could be called as pseudo BU model. Ignoring the above-mentioned problems the restructured oil sector would impose the society more costs.
3. Electricity Supply Industry (ESI)
ESI just like Oil and gas industries is a complex system of institutions. It is a dynamic sub-system of every economy. Thus, structure and mindset of ESIs is always subject to change. However, some times changes are significant and recognized as reforms. Throughout over 100 years history of ESI in the world; structure, ownership, and mindset of ESIs have experienced several distinguishable reforms worldwide. In this section, key evolutionary stages of ESI reforms are analysed. The features of structure, ownership of each period and main rationales behind reforms are discussed. Apparently, five stages can be distinguished in the history of ESI in the world, as follow:
1870s-1920s: In this period, the emerging new industry was very fragmented. Self-production was more common. This characteristic could be specially observed in industrial sectors, which continued till the first half of the century. There was no considerable transmission, but distribution grids were limitedly developed and fierce competition could be observed especially in dense consumption areas. The industries were largely privately owned and there was no effective regulation (IEA, 1999).
Most of the concerns in the mindset of ESI were focused on technological issues. For example, one of the most challenging issues was on the superiority of AC on DC technologies. DC system could only transmit power two miles. Ultimately, Thomson-Houston’s AC system overtook Edison’s DC system (EEI, 2002).
1920s-WWII: Publicly-financed and publicly-owned large power capacities was formed in this stage. Large Hydro power plants and transmission grids was developed and electrification programs vastly started (IEA, 1999). The structure of ESI included large number of companies – nonexclusive franchises. Separate companies provided electricity for different need, used different equipment, voltages, and frequencies. It was not unusual for franchises to be granted on the basis of unofficial institutions – bribes and payoffs of the city officials (EEI, 2002). The franchise process kept the industry fragmented, in many cases transmission lacking interconnection and with inadequate overall network control, resulting in large grid losses and uncertain supply. There were no central dispatching or system controls. There was no consistent framework for issuance of franchises. Thus, numerous short-term franchises created an uncertain and chaotic operating environment.
In this stage, still there had been no considerable changes in the mindset of the industry. The structure of ESI at this stage were only shaped and developed as consequences of technological achievements of the time. However the inefficient performance of the ESI at this stage initiated a special concerns for changing the structure in the next periods among entrepreneurs like Samuel Insull.
1945-1960s: At this stage, a fundamental change occurred in the structure of the ESIs, which still in some countries exist. The industry in most of the countries in the world started to be formed as a vertically integrated industry including generation, transmission and distribution functions. Central dispatching and system controls as a new institution was created. This reform brought considerable efficiencies as a result of economies of scale and economies of scope.
The rationale behind such profound change was rooted in the idea of ‘natural monopoly theory’, which were developed by economists. This was a turning point in the mindset of the industry. It was the first time that economic theories rather than merely technological aspects influenced the shapes of the structure of ESIs. The most interesting peculiarity of such reform was that even in the western countries – with the ideological belief on market economy – the idea of ‘market failure’ has been widely accepted and instead of competitive industry, a monopolistic industry was pragmatically selected. There were two different approaches. On the one hand, most of western European countries, Australia and New Zealand started to nationalize their ESIs. France created publicly owned EdF in 1946. Italy was the last European country to follow this trend by creating state-owned monopoly ENEL in 1962. In developing nations, mostly synchronously with their independence after WWII, same model were selected. Countries of Eastern block also had the same structure even though with different ideological reasons. On the other hand, United States selected private monopoly regulated by an independent regulatory commission. However, there existed public hydro power plants and some federal and municipal-owned power companies. The structure of ESI in Japan was almost the same as US. In both kinds of structure – private or public monopoly – regulatory institutions and frameworks were shaped.
In fact, Thomas Edison himself had already suggested the idea of monopolistic ESI. Samuel Insull, who had worked with Edison was a pioneer in penetrating this idea into practice. Things were going well and gained efficiencies were very satisfactory. But it seems that western societies were always been in the throes of fundamental difficulty with the new structure. The fundamental question always was: Should energy sector or ESI be considered as an exception in their general ideology – market economy, competition and choice?!
1970s: In this period the structure of ESI had no changes, but the mindset of societies was critically stirred up. For the first time, as early as 1962, Averch and Johnson showed regulated private monopoly had incentives to over-invest in capital assets. This followed by the ‘optimal regulation’ debates in the literature. The 1970s was decade of Oil shocks, which increased the price of key fuels of electric powers at that time. Nuclear programs were accelerated and some other substitution programs were developed – coal and gas. However, in the same decade first the real cost of nuclear power substantially rose due to inflationary expectation. Then public opinion against nuclear plants due to safety and environmental issue drastically increased. Formation of IEA was at this decade. In energy crises decade, a critical technological discovery was also made – independent generators can operate in a manner that does not destroy the stability of grid.
1980s-1990s (till present): In this period, drivers to reform were strengthened. Fundamental changes in optimal size of generating unit occurred. The development of combined cycle gas turbine (CCGT) was the most important technological innovation, which acted as a trigger factor to break down natural monopoly of generation sub-sector. Independent Power Producers (IPPs) came to the scene of electricity generation. Coordination eased by falling information technology (IT) costs. IT also holds a lot of promise for promoting contestability of transmission – the possibility for competition in ESI.