Regulating a Transitioning Gas Market

In the past few months, the eastcoast gas market has been subjected to a flurry of government interventions in response to a globally disrupted gas market, significant increases in gas prices, concerning forecasts by the ACCC of dwindling gas supplies and the absence or ineffectiveness of existing security mechanisms. This paper overviews these interventions and evaluates their nature, scope and utility. 

The Emergency Price Order 

Following a year of significant price fluctuation in the eastcoast gas market, on December 23, 2022, the Albanese government imposed a price cap for 12 months. The cap was imposed pursuant to the Competition and Consumer (Gas Market Emergency Price) Order, at A$12 per gigajoule.  The order only applies to domestic wholesale contracts entered into after 23rd December, 2022 between gas producers and commercial or industrial users in Australia. The order does not apply to contracts for international gas exports and is operative for 12 months. The objective of the order is to address escalating east coast gas prices following global price hikes after the Ukrainian war, Russian sanctions and supply chain disruptions. Price hikes were a particular concern on the east coast gas market as, unlike the West Australian market, this market has never been subject to any reservation mandate.

The Mandatory Code of Conduct 

In addition to the 12 month price order, the government has proposed amending Part IVBB of the Competition and Consumer Act 2010 (Cth) to provide for the implementation of a new mandatory code of conduct. The aim of the code is to ensure new domestic gas supply contracts are negotiated at a reasonable price and on reasonable terms. The code is likely to come into effect by the middle of 2023. Once implemented, gas producers will need to ensure that gas is supplied in accordance with what is known as the reasonable price provision. The code sets out relevant factors for this assessment which include an evaluation of the operating expenses of a producer, depreciation and a reasonable return on capital. Where an agreement on a reasonable price cannot be reached privately, the matter may be determined via arbitration however arbitrators will also be bound by the reasonable pricing provision. Unlike the price cap, the code is likely to continue well beyond 12 months as the draft provisions indicate that it will operate until the ACCC reports that a sufficient supply of gas exists in the domestic east coast market at a reasonable price.

The Australian Domestic Gas Mechanism (ADGSM)

The ADGSM was implemented by the Federal government in 2017 with the aim of improving energy security. It effectively confers power on the federal minister to declare a shortfall and, in response, to impose export restrictions. To date, the ADGSM has never been activated and to do so is a lengthy process. Under existing provisions, the federal minister must notify industry by October of the preceding year that they are considering making a determination that the following year will be a gas shortfall year. If a determination is made, LNG producers exporting more than they produce domestically may be subject to pro-rata volume restrictions during the shortfall year. The level of restriction will depend upon the shortfall volume the minister believes will be required. 

The current framework for the ADGSM has always been problematic. The major issue is that it takes so long to have any effect. Practically, export restrictions take up to eight months to have an impact. This means that if volume restrictions are imposed, and this has never occurred to date, they may not generate enough to alleviate the current shortfall. Further, restrictions may only be applied to exporters drawing more gas from the market than they put in. To date, the ADGSM has never functioned as an effect export control mechanism capable of addressing domestic supply concerns.

In response to these regulatory failures, the government proposed amendments to the ADGSM framework in February 2023. The Draft ADGSM Guidelines (Customs (Prohibited Exports) Operation of the Australian Domestic Gas Security Mechanism Guidelines 2023) were released in early February, 2023, and their stated objective is: 

…to ensure a sufficient supply of natural gas to meet the forecast needs of Australian gas consumers by controlling, if necessary, LNG exports through the imposition of allowable volume permissions. 

To achieve this, the proposed guidelines have significantly tightened the timeframes for declaring a shortfall. Under the proposals, the Minister will be able to make a domestic shortfall determination quarterly rather than annually. Notification of such a determination and a corresponding intention to intervene in the LNG export market may be made three months prior to the start of the quarter. In practical terms this means a determination of a domestic quarterly shortfall for the first quarter must be made in October of the preceding year.

For the second quarter it must be made by January, for the third quarter by April and the fourth quarter by July.

Further, under the new guidelines, the basis for making a determination will be that the Minister has reasonable grounds that there will not be a sufficient supply of gas for Australian consumers unless exports are controlled. Factors relevant to this assessment include: the extent to which limiting exports could be expected to reduce a shortfall, external factors influencing the gas market, the practical impact of export restrictions, the availability of any alternative industry-led solution and the past performance of producers including any strategic behaviour or ‘gaming’ of the ADGSM. The proposed ADGSM guidelines do allow for some LNG producers to have imposed restrictions increased where they cannot fulfil contractual obligations. This may occur where the Minister finds that the LNG producer has exhausted all other commercial avenues to fulfil existing contractual obligations and following a consideration of the economic and social impacts of the gas shortfall are taken into account.  

Will the interventions work? 

The primary rationales for these interventions have been summarised in the consultation paper. They include: limiting increases in domestic wholesale gas prices, minimising distortionary impacts in energy markets, ensuring producers make a reasonable return on investment and that a sufficient diversity of suppliers exists, retaining incentives for future investment, preventing excessive uncertainty in gas market functionality, allowing producers to meet existing contractual obligations and supporting Australia’s emission reduction targets.

The effectiveness of the temporary price cap will depend, in part, upon whether the government has been too generous. After all, before the Ukraine war and Russian sanctions hiked prices up, the average price gas producers were asking to supply gas next year was around $9.20 per GJ, with 96% of price offers being under $12. And certainly, if you look West, the cap may be regarded as overly generous. Western Australia’s gas prices are roughly $5.50 per GJ. However, this is a consequence of the domestic gas reservation policy in place in Western Australia since 2006, which requires 15% of locally produced LNG to be kept for the local market. This policy has largely immunised WA from global price hikes with prices averaging between $5.50 and $6 per GJ. A reservation mandate has never existed on the eascoast and the price cap reflects this reality. 

The utility of the reasonable pricing provision and the mandatory code lies in the fact that it is longer term measure than the price cap that seeks to promote transactional fairness in negotiations between LNG producers and domestic wholesale purchasers. Whilst some producers and lobby groups have argued it will push investment away from Australia to other countries, greater oversight in energy transactions is increasingly imperative in a globally disrupted market. Higher energy prices are likely to be with us for the foreseeable future and gas will continue to influence energy pricing until the rapidly expanding renewable sector gains further traction.  

The framework proposed by the government is reflective of the changing face of the Australian energy market and is unlikely to go away. The aim of each of these measures is to improve gas market security on the east coast and prevent a repeat of the price hikes of 2022, when gas prices went up to around $45 per GJ. Such price hikes are unsustainable and distortionary in a country like Australia which has an abundance of gas. Whilst free market purists would argue that the government should not intervene but rather, let the market decide, without intervention many consumers were facing the prospect of energy poverty.

As Rod Sims, former head of the Australian Consumer and Competition Commission, pointed out, failing to act would have undermined the social fabric of the community.  

Whilst producers have variously described the interventions as reckless, rushed, ill-considered and a sovereign risk, the truth is they are balanced and responsive. The price cap is generous and temporary, the reasonable price provision injects objective oversight into contractual negotiations that impact the energy security of millions of Australian consumers and a stricter and more reactive ADGSM is better able to function as a security mechanism rather than a rhetorical flourish.  Such protections have been a long time coming for the eastcoast and are vital in a transitioning market as they seek to balance domestic energy security imperatives with reasonable commercial expectations.