Building a competitive natural gas market in India: Lessons from a 'lost decade' in the UK
When the UK initiated gas market liberalization, British Gas (which later split into Centrica and BG Group) initially felt that markets would not provide the security of supply which would lead to value loss for shareholders. After finally embracing change and splitting into separate businesses, the companies saw their combined total valuation grow from around $8 billion in 1986 to a peak of about $160 billion just before BG Group merged with Royal Dutch Shell 30 years later. What can we learn for the future of natural gas in India from this story of lobbying, litigation and, ultimately, success for all?
Figure 1: BG Group's demerger into various businesses covering E&P, marketing, transmission and retailing
From the beginning of the natural gas industry in the UK, British Gas had an effective monopoly over the purchase, transportation and supply of gas. When the government decided to develop a fully liberalized gas market in 1982, a 10-year process followed during which British Gas avoided change and there was little competition.
The first big change came in 1982 when British Gas lost first right of refusal on gas purchases with the Oil and Gas (Enterprise) Act. Four years later, the first Gas Act sanctioned the privatization of British Gas, removed its monopoly to supply very large customers and obliged it to transport competitors' gas through its pipelines.
In 1988, an inquiry by the Monopolies and Mergers Committee recommended that British Gas should be allowed to contract no more than 90% of any 'new' gas brought to market. The lack of takers for the remaining 10% meant little changed for British Gas. The company, however, knew where this may lead and the damaging impact it may have on shareholders and consumers.
Building its case
British Gas believed its duty to create value for shareholders was at odds with the introduction of market forces to the gas industry. Many of the company’s long-standing leaders were mistaken and thought shareholders appreciated their safe, reliable approach and were similarly concerned about market reforms.
Soon, however, the 2.6 million new shareholders created by privatization—1.5 million citizens plus institutional investors—made their presence felt. Reports about the high of senior management at British Gas prompted public protests—and the company's realization that shareholders were no longer necessarily on the same page about reforms.
The second argument centered on security of supply. There wasn’t faith that a competitive market could deliver on this front. By framing this argument in emotive terms—talking about vulnerable people not being able to heat their homes—this became the strongest argument behind closed doors.
The company's reasoning also included the inability of consumers to manage the inevitable volatility that would accompany competition. It was equally unconvinced that gas would be cheaper for consumers after market liberalization or that a competitive market would encourage investment in infrastructure.
Disputing every detail
British Gas soon found itself lobbying even more for regulatory reform. In 1991, an inquiry from the Office of Fair Trading forced the company to reduce its market share and sell some of its gas to other suppliers.
A second Monopolies and Mergers Commission inquiry then required British Gas to separate, or “unbundle,” its three main divisions into independent subsidiaries. A year after the company complied with this ruling, the 1995 Gas Act was passed, paving the way for a fully liberalized gas market.
Throughout these years, British Gas challenged an assortment of proposed contractual and tariff arrangements. Many disputes led to costly, time-consuming and attention-diverting litigation. In the meantime, agile and ambitious competitors were entering the market and finding ways to capitalize on British Gas' tactics.
Shell and Esso, for example, decided to build their own demand centers—which led North Sea gas producers to contract directly with power generators. Some of these power stations used combined cycle gas turbines (CCGTs), helping this additional market for new gas emerge and develop. This is known as the so-called “Dash for Gas.”
This was not good news for British Gas, which was unable to corner the market and use its legacy incumbency to restrict new entrants. However, the Office of Fair Trading estimated that the Dash for Gas would reduce energy bills for consumers, enhance energy security through increased generation capacity, and enable the transition to cleaner fuels.
Caught between growing competition and momentum on one side and tighter regulations and oversight on the other, British Gas realized the time had come to change its strategy. Institutional fatigue and personnel changes played their part too, prompting a more forward-looking perspective after a decade of defensiveness.
There is no doubt that British Gas could have unlocked value from market liberalization much more quickly if it had not been mired in confrontation and investigation. Tying up management time in this way meant that during its 'lost decade', the company's value stayed relatively static, not even responding particularly well to inflation.
Debunking market myths
The UK's natural gas market went on to overturn all the main objections originally put forward by British Gas, and to find value that could not have been realized in the combined company.
Shareholders reaped the rewards of reform as the market grew and prospered, with the value of their shares rising 12-fold between 1986 and 2011. British Gas managers who stayed the course also did very well due to market liberalization—particularly middle managers, who had the greatest ratio of salary, pension and share options.
Figure 2: Market capitalization of BG Group companies before and after demerger
Source: Analysis from annual financial statements of BG Group, National Gas Grid and Centrica
In terms of capital growth, anyone who bought 100 shares in the offer at £1.35 in 1986 would, in 2011, following mergers and spin-offs, hold:
- 89 Centrica shares worth £266
- 29 National Grid shares worth £179
- 93 British Gas Group shares worth £1276
Fears about the security of supply also proved unfounded. The UK market demonstrated, as has every well-functioning liberalized market since, that its price signal delivers greater security of supply than in traditional markets.
Figure 3: Gas consumption in the UK as it grew over time
Source: Digest of UK Energy Statistics
We’ve also seen this in the US market. Price signals helped in the development of shale gas; as a result, production increased and prices fell— as figure 4 shows.
Figure 4: U.S. wholesale gas prices, gas production and consumption trends
Source: EIA & ICF analysis
An efficient competitive market should also provide signals to encourage investment in the required infrastructure and avoid the likelihood of stranded assets. While the UK already had a relatively well-developed gas grid, this benefit of reform is of particular significance in countries like India where many consumers are underserved.
In a competitive market, the signal for investment comes from consumers who want to be connected. In unreformed markets, it relies on vertically-integrated incumbents choosing to cross-subsidize business interests and build infrastructure. The consumer “pull,” rather than an incumbent “push,” means investment is directed where it is truly needed.
Unlocking additional value
Embracing change led to more positive outcomes for British Gas, gas customers and the country as a whole.
Being forced to separate its businesses enabled the different parts of British Gas to unearth underlying value by specializing in what they did best. The under-performing consumer goods and real estate arms were spun out, for example, and the strength of the remaining exploration and production businesses has been reflected in their share price ever since.
The UK consumer benefits of improved efficiency in the gas and electric system are estimated to be worth around £80 billion. Additionally, the country has been able to transform its energy mix, notably reducing coal share from 40% to 2%. By using natural gas to generate electricity, the power sector saw a 64% reduction in CO2 emissions between 1990 and 2016.
The UK's transition from a traditional to a liberalized gas market has certainly delivered on its promise. Progress could have been smoother and faster, but since the UK was only the second large country to embark on gas market liberalization, there was no established template to follow.
There is no one-size-fits-all solution. Reviewing the resistance of British Gas and the response of the UK government can, however, provide some useful guiding principles for streamlining and accelerating market liberalization.
5 guiding principles for gas market liberalization
1. Signal serious intent
Effective gas market transformation is as much about demonstrating commitment and maintaining momentum as it is about developing rules and enabling competition. One of the roles for policymakers is to give clear signals about where they want to get to and what it will take to get there.
This involves acknowledging that fear and uncertainty are inevitable parts of the process. It also means not being tempted to use virtue signaling to prove progress is being made. Issuing a new reforming rule to great fanfare, for instance, will not on its own magically make a market open up. In fact it may even delay progress if everything stops for months, or years, to allow time to see how the new regulation plays out before the next step is taken.
2. Ensure consistent policies
The policy framework for market reform developed by each country will be different but they share a need to be consistent over the whole period of the transition. The UK's liberalization project extended from the Thatcher era of the 1980s through three subsequent prime ministers. Despite their opposing political ideologies, these leaders ensured that the will of government to create a competitive and efficient market stayed the same.
3. Take a top-down approach
The UK learned the hard way that taking an incrementalist approach to opening up its gas market would not drive progress at the pace required.
Initially the government worked with British Gas, hoping for goodwill and small steps taken together to lead to major moves forward. Their differing agendas meant, however, that things didn't always go to plan—for either party.
When the government realized why the impact of some reforms was muted or failed to materialize at all, it changed tactics and adopted a top-down approach. By mandating, things like British Gas’s annual market share, public reporting and penalties for non-compliance, the government took control of the process. Reforms then accelerated very quickly.
There will have been regrets on both sides about the time lost and costs incurred during the long wait for the government to take this stronger stance. Not only would the liberalization process have been smoother and its benefits swifter to materialize, but British Gas could have avoided challenges if it had worked constructively towards liberalization from the start.
4. Monitor consumer interest
Gas market liberalization has been thwarted many times when consumer interest issues and perceived risks have been continually brought up. The world today is, however, very different from the times when British Gas was opening up.
Rapid strides in the development of information technology and data analytics make it very simple to monitor the impact of liberalization on key parameters like consumption, price and supply. Such analytics can provide timely feedback to the liberalization process, enabling policymakers to correct course quickly, reducing any side-effects of liberalization.
5. Maintain communication
Many times those responsible for change assume the benefits of change are easy to understand, but they do not spend enough time and effort communicating the change. Developing effective communication campaigns and toolkits for use throughout the transition process can go a long way in helping stakeholders understand what is happening, feel comfortable in a state of flux and look forward positively to the new regime.
Market liberalization has a certain value for everyone involved with producing, selling, buying, transporting and consuming gas. Keeping these benefits front of mind for all stakeholders, many of whom will inevitably have very natural doubts and concerns, should be a major focus of government activity.