Brief history of oil, gas and electricity network markets

History of oil, gas and electricity is an important component of understanding how energy systems and markets came to be.

Oil and gas

Oil production and trading was first reported by the Arabs in 800AD. There was export of oil export but the first first oil boom was in 1885 and 1920. Oil was discovered  in Baku (now known as Azerbaijan) in 1846 and the Nobel Brothers built an oil (kerosene) pipeline and kerosene tanker to the UK in 1877.

Oil and pipeline development in North America started to emerge in the mid 1850s. In 1859, “Colonel” Edwin Drake, one-time railroad conductor, drilled the first commercial oil and gas well in Titusville Pennsylvania. J. D. Rockefeller became the richest man in the world from oil. His fortune started from his first oil refinery in 1863. The development of a oil and pipeline monopoly in 1879 (80% of the world’s refining and transportation) and Rockefeller’s Standard Oil drove great efficiency and quality standards. In 1890, the passing of the Sherman Antitrust Act ended the Rockefeller domination and divided Standard Oil into 7 regional oil companies (now Exxon, BP, ConocoPhillips and Chervon Texaco). Without Henry Ford’s mass production of automobiles, there would have been no market for excess kerosene. Throughout the 1920s, pipeline construction surged in a very American way. Entreprenuerial firms were racing to arrange long term gas contracts to get financing for pipelines to take the free gas from oil discovery to cities where gas was needed.

In the 1930s was a period of restructuring. The economic and political forces of the Great Depression led to the federal Public Utility Company (1935) and Natural Gas (1938) Acts which forces spin off of holding company pipelines and their distribution systems as state based ‘local distribution companies’. It also gave the Federal Power Commission authority to regulate the independent interstate pipelines as public entities. Regulation brought in accounting standards and gave priority to customers. Clearly defined accounting methods removed conflict and uncertainty.

After WWII, the gas pipelines continued to grow but the issue of how to regulate gas purchase costs persisted. 1954 Phillips Decision ruled that anyone selling gas to pipelines for resale in the interstate market was a ‘natural gas company’ under the NGA’s definition and would be subject to Federal Power Commission regulation. In 1954, wellhead gas price regulation was established. Overall, rising production of middle-east and US gas kept prices low.

The 1960s was a golden age for oil and gas production which grew rapidly. Developments in nuclear energy in meant that there were no concerns over price. This all came tumbling in the 1973 oil crisis. The Yom Kippur war in the middle east caused many Arab oil producers to announce an embargo on oil exports to the US. While there was little effect on physical supplies and lasted only a few months, this instilled panic and while oil prices soared, US oil and uncontracted gas prices also spiked.

Natural Gas Policy Act (NGPA) of 1978 was introduced to replace the wellhead gas price deregulation which replace old price with new higher price for ‘new’ and deep gas; removed impediments to transactions between interstate and intrastate pipelines and replaced Federal Power Commission (FPC) to a new Federal Energy Regulatory Commission (FERC).

In 1979/80 the second oil crisis was due to a revolution in Iran that caused oil prices to double again. This lead to the believe that high oil prices and supply disruptions would be the new norm. In response, there was pressure to faster decontrol wellhead gas prices, reverse decline in domestic oil production and the US Synthetic Fuels Corporation (SFC) was created to advance US ‘energy independence’. SFC was shut down in 1985 when oil prices dropped. In the early 1980s, the regulations had resulted in destructive competition, fuel switching between gas back to oil and by 1985, many interstate pipelines were facing bankruptcy due to take-or-pay costs that they had to pass through to their customers when demand for gas fell. This was the start of decade long negotiations amount pipelines, LDCs and FERC.

Unlike the USA which had a very entrepreneurial approach in oil and gas pipeline infrastructure in the 1900s, Australia’s first commercial gas discovery was not till 1960s. By this time, the technology was very well developed and governments played major roles in the development of gas and pipelines. For example, the Gas and Fuel Corporation in Victoria ‘negotiated’ a favourable contract for Bass Strait gas and then built a very profitable integrated gas monopoly (owned and operated from 1968 to 1998). Hence, gas networks were formed within single states, largely unconnected to other pipelines/states and were owned by or fully contracted to state owned enterprises – pipeline authorities, power utilities or distribution systems. States encouraged oil exploration after WWII and this lead to more gas being discovered in new oil reserves.

Electricity

For electricity, Edison knew that his light bulb (invented 1879) would be useless if he didn’t develop a network to distribute electricity. By 1882, he developed an entire electric power system that generated and distributed electricity producing direct current to shop keepers using steam engines. This allowed for electrical appliances, electrically operated street cars and transport to be developed.

When Samuel Insull joined Chicago Edison, he learned that he could ‘s maximise profit from increasing the ‘load factor’ (ratio of average daily or annual power use to the maximum load sustained in the same period. He also introduced off-peak rates because it would increase profit without increasing the need for new capital purchases. It also increased overall profit to cover for the purchase of equipment to meet peak load demand. Samuel Insull’s famous speech also called for government regulation of ‘natural’ power monopolies as the best way to capture scale economies, protect consumers and stablise prices and profits.

In 1933 to 1950, the US Federal Government became a regulator of private utilities in the 1930s; it also became a major producer of electricity beginning in this period. The 1933-1950 period was also characterized by continued growth of the industry, increased consolidation and interconnection, and increasing economies of scale. In 1935, the Public Utility Holding Company Act (PUHCA) required that each regulated gas and electricity utility operate either only in a single state or contiguous multistate region and that any unregulated business with regulatory (SEC) approval and as a separate company. This change was followed by a period of strong growth.

The 1973 oil embargo, electric utilities substituted coal for oil generation and there was an increase in the demand for gas. In the late 70s, utilities were facing a spiral of death: higher prices, lower demand. Nuclear energy turned out to be more expensive than originally believed.

The period from 1951 to 1970 experienced utility prosperity. Following the end of World War II through 1970 marks a time of essentially uninterrupted prosperity for the electric utility industry. Demand for electricity grew rapidly, consistently, and predictably, while electricity prices continued to fall. The arrival of commercial nuclear power held the promise of an even more prosperous future. Problems that would later affect the industry dramatically had not yet emerged.

The 1980s in the US were marked by the 1978 Public Utilities Regulatory Policy Act which made already troubled electric utilities worse off. The Act forced utilities to buy power from any ‘qualifying facility’ at the utility’s avoided cost (this term was not itself defined).

In Australia, each state had its state owned monopoly electricity provider. In the 1990s, microeconomic reforms stimulated by the Hilmer Report led to the adoption of a national competition policy that applied to state-owned enterprises and private firms. Victoria had a particularly inefficient system and was the first to lead the privatisation of state owned utilities.

Types of energy displacement networks

The gas and electricity requires central coordination and control in both the short run and long run because of:

1. operational displacement and externalities (what goes in may change but the equivalent must be transported to where it is needed)

2. asset scale economies and specificity (high fixed cost of network assets that are costly to move or convert to other uses)

Hence, displacement network with fixed assets and large economies of scale requiring the transport (‘carriage’) of goods to various points are natural monopolies requiring regulation. The degree and how it is regulated (with ‘cost base’ or ‘performance-based incentive regulation) is an important issue.

There are three common forms of carriage which is associated with various forms of regulation

1. Common carriage: exclusive franchise to operate a service but must serve all customers equally

2. Contract carriage: contract to fulfill agreed arrangement

3. Market carriage: operations are managed by trading and pricing the commodity and network capacity in an integrated and centralised market. This is the model widely adopted for energy displacement networks and is the model used in Australia.

The market design is important to understand how it may influence the reliability and cost diversity of supplies, volatility of demand, storability, speed of transport and complexity of operational externalities. The world oil crisis of the 1970s was instrumental in triggering the development of, and strongly influenced the form of, network markets. The US lead the market carriage, open access approach. In 1990’s, the privatisation of state owned enterprise and development of the National Electricity Market (NEM) were moves towards the ‘US Model’. When this approach did not work well, Victorian electricity market reform evolved differently in 1989 and a hybrid was adopted by  other states in 2010.

Types of monopolies

Vertically integrated monopoly are optimised in the short run (entry meet exit points) and co-optimised in the long run so that network and supply meet total demands. Optimising monopolies can work well with competent and politically independent management and regulation but are difficult to motivate efficiency and innovation. Using microeconomics, market systems allows a behavioural and mathematical way to solve constrained optimisation problems.

Ways to introduce competition

– Single buyer/reseller: Buy some supply resources it needs to meet demand rather than build or own generation and to let suppliers compete with each other and with the monopoly to meet monopoly defined needs.

– Third party access TPA: Allow a ‘third party’ supplier to compete with the monopoly to supply network customers. However, this is not very efficient as there is a incentive for the monopolist to overstate the costs to the TPA and discriminate in operations. TPA can only be ‘successful’ if regulators require the monopoly to subsidise its competitor but can’t support a truly efficient and effective competition.

– Open access: Create a network only monopoly where the monopoly is out of the commodity business. It must operates under an open-access transmission tariff (OATT)  v and must be market-based to be efficient and non-discriminatory.

Transmission Systems Operator

The transmission system operator understands and has information over the internal workings of the energy distribution network. Australian Energy market Operator (AEMO) is the National Energy Market Operator and planner, playing a role in supporting the industry to deliver a more integrated, secure, and cost effective national energy supply.

Gas pipeline investment in the early 2000s also led to the establishment of an interconnected gas grid connecting all eastern and southern states of Australia. This, together with the increasing integration of gas and electricity markets, led to the establishment in 2009 of a single operator, AEMO, to oversee and further integrate infrastructure planning and trading activities across different energy transmission systems.

With AEMO’s establishment in 2009 and commencement of the gas Short Term Trading Market at the Sydney and Adelaide hubs in 2010 (and Brisbane in 2011), Australia became one of the first countries in the world to establish highly competitive and transparent gas and electricity markets, underpinned by a common governance structure.

Generally, the TSO’s first concern is the schedule of energy entry points and exit point are safe and feasible given the network capacities (operationally sound). While economic efficiency and optimisation is secondary (operational optimisation), the adoption of market carriage leads the focus away from it’s main objective. The operational model represents the network operations and its constraints.

In the National Electricity Market, commodity trading and pricing is used to deal with network constraints and congestion management. Constraints and congestion can be ignored, commoditised or integrated into the market.

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