This document presents the results of an analysis by ZAO ERTA-consult of consequences for gas business of the adoption of the Methodology for Setting Rates for Trunk Pipeline Gas Transmission Services. The scope of the work included a review of current legislation forming the basis for government regulation of rates for natural gas trunk pipeline transmission, regulations of the federal executive branch agency for price and rate regulation (FTS of Russia) and current government regulation practice.

Executive Summary

The possibility of government regulation of tariffs for gas pipelining services follows from the provisions of Russian Federation Federal Law #147-FZ «On Natural Monopolies» of 17 August 1995 (hereinafter FZ «On Natural Monopolies») and is specified in the provisions of Russian Federation industrial Federal Law #69-FZ «On Gas Supply in the Russian Federation» of 31 March 1999 (hereinafter FZ «On Gas Supply in the RF»). It is the latter that states the definition of an «independent organisation», the principle of tariff setting by «costs plus» method and the possibility of OAO Gazprom applying internal tariffs for gas transmission.

The Government of the Russian Federation elaborated on the legislation in Decree #1021″On Government Regulation of Gas Prices and Tariffs for Gas Transmission Services within the Russian Federation» of 29 December 2000 (hereinafter «Decree # 1021»), which establishes the principles for tariff setting, and a special-purpose federal agency for government tariff regulation (currently the Federal Tariffs Service, hereinafter the FTS). Earnings from regulated activity are supposed to reasonable operating and capital costs and taxes (the «cost plus» principle).

The fundamental principle for setting tariffs for gas pipelining services under current practice has been the linear relationship between the cost of transmission and distance, that is, the basic tariff defining the cost of transporting 1000 m³ for 100 km.

The transmission tariff was calculated by assigning planned tariff earnings to the total volume of domestic transmission.

A uniform basic tariff was set for the whole Unified Gas System (hereinafter UGS). This resulted in the averaging of actual tariffs over different gas transmission organisations with different financial and technological performance parameters.

The drawbacks in implementing government tariff regulation largely result from the significant uncompensated strength that natural monopoly entities have when it comes to regulation and from the lack of demand on the part of independent organisations, which have just started showing interest in the subject.

The main disadvantage of the existing methodology for tariff regulation is the fact that the linear dependence of transmission cost is not adequate to the current economic situation (this was explained in terms of wholesale prices, as well as transmission cost separation).

This situation is aggravated by lack of synchronisation over time of the revision of wholesale prices and tariffs for gas transmission.

Another material disadvantage of the existing methodological approach is arbitrariness in determining transmission routes, which are set by the natural monopoly entity (the difference in the transmission distance for the same entry and exit points within a transmission system may be as much as 20%).

Last but not least is the problem of accounting in the tariff for the so-called «investment component», i.e., costs allocated by OAO Gazprom to the expansion of gas transmission capacities. The problem consists in lack of a transparent mechanism for eliminating bottlenecks and expanding of main routes over which independent organisations supply gas.

The Methodology for Setting Tariffs for Trunk Pipeline Gas Transmission Services (hereinafter «Methodology») is built on entirely new principles, although it contains proven components related to the procedure for furnishing information, but not the amount of information or cost calculation, etc. This is the first methodology regulating the transmission tariff that contains so many innovations[1].

The Methodology opens new vistas for users of gas transmission systems (hereinafter «GTS»). The fact that the Methodology must be used to set transmission tariffs increases their validity and predictability. Thus, conditions are improved for making investment decisions necessary for full-scale field development.

The abandonment of inter-regional subsidies for gas transmission and the trend toward the convergence of the economics of regulated wholesale gas prices and transmission tariffs offer expansive prospects for development of the gas market by independent producers (lower prices for gas transmission over longer distances provides access to new consumers).

The Methodology affords an economically valid opportunity to sell independent producers’ gas throughout the Russian Federation, although the efficiency of selling gas within the traditional «availability zone» will somehow deteriorate in comparison with today.

However, adoption of the Methodology will not eliminate the need to access OAO Gazprom’s GTS.

The flaws of the Methodology were heatedly discussed by experts as early as at the stage of its adoption. However, forced administrative compromises resulted in the necessity of further regulatory work to enhance the quality of methodological approaches. In particular, it is necessary to introduce a more clear-cut definition of the term «gas transmission». The mechanism for furnishing information on pipeline utilisation is primitive. Unit tariffs and tariff calculation must be localized by calculating weighted-average transmission costs. Development of the methodological approach demands complete abandonment of the tariff component depending on a particular route and on relating tariffs to costs. It is desirable to introduce charges for balancing and storage, and to «localize» costs in terms of specific transmission organisations and particular transmission route.

Summary of Conclusions and Recommendations

1. Introduction of the Methodology will result in drastic changes in the regional structure of the natural gas market and may significantly influence natural gas distribution business. The key forthcoming changes must be forecast and scenarios for modifying the company’s marketing structure must be devised.

2. GTS users have an opportunity to influence the key factors determining the consequences of the methodology’s introduction. However, it is not politically advantageous to advertise this activity. Meaningful actions should be taken to revise the regulatory framework anonymously or within a significant group of Independent organisations.

3. …

4. Utilisation of the «rate of return on capital» principle will significantly improve the economic indicators of the Regional Project.

5. Measures to counteract the FZ «On Competition» within the scope of the Regional Project include the organisational division of the Project by business type, the establishment of gas transmission tariffs and the application of unified standards for rendering services and selling commodities (gas). However, the existing regulatory framework makes it possible to arrange a flexible system of price (tariff) differentiation to implement the Project’s purported business strategy.

6. Upon completion of priority efforts to reduce tactical risks, it would be expedient to turn to orderly solution of strategic problems: harmonisation of the industry’s regulatory framework and organisation of regional natural gas market (protection against newcomers).

Description of Current Government Tariff Regulation Practice

Development of the Regulatory and Legal Framework for Tariff Regulation

The possibility of government regulation of tariffs for gas pipelining services follows from the provisions of Chapter 2, Article 6, of FZ «On Natural Monopolies», which states, among other methods of government regulation of natural monopolies, «price regulation by determination (setting) of prices (tariffs) or their caps». An interpretation of activities classified as those of natural monopoly entities is given in Chapter 1, Article 4, of the Law; in particular, they include «gas pipelining».

It should be noted that the necessity of government regulation of gas pipelining is established by Orders of the President of the Russian Federation #220 «On Certain Measures Concerning Government Regulation of Natural Monopolies in the Russian Federation» of 28 February 1995, and #221 «On Measures for Streamlining Government regulation of Prices (Tariffs)» of 28 February 1995.

The features of government regulation of gas transmission tariffs were specified in Chapter 6, Article 21, of FZ «On Gas Supply in the RF». It specifies that «by the decision of the Government of the Russian Federation regulation of tariffs for gas transmission may be replaced by government regulation of gas prices for end users using it as fuel and (or) feedstock and [government regulation] pf tariffs for gas transmission for independent organisations[2] under the procedure set forth by the Government of the Russian Federation». The same article further states that «in government regulation of tariffs for gas transmission, economically reasonable costs and profit shall be taken into account, as will the availability to organisations owning gas systems of funds to expand of gas production, pipeline networks and underground gas storage facilities». That is, the «cost plus» method is selected as the method of regulation. The last paragraph of Chapter 6, Article 21, stipulates that an organisation owning a gas delivery system independently set internal settlement prices for gas and internal settlement tariffs for gas transmission.

The legislative provisions were amplified by the RF Government’s enactment of «Fundamentals of the Establishment and Government regulation of Gas Prices Tariffs for its Transmission within the RF», approved by the Government Decree # 1021[3].

Clause 7 of Decree #1021 identifies the agency responsible for government regulation of tariffs for gas pipelining, which is the Federal Energy Committee (FEC) of the Russian Federation (at present its successor is the Federal Tariffs Service (FTS)). Clause 11 of Decree #1021 determines the principles for setting tariffs for transmission, namely:

• reimbursement of economically justified costs to organisations engaging in regulated activities;
• establishment for organisations engaging in regulated activities of a reasonable rate of return on capital used in regulated activities;
• accounting within the structure of marketable prices (tariffs) for all types of taxes and other mandatory payments in compliance with Russian Federation law;
• recognition of difference in the costs of gas transmission to different regions.

Decree # 1021 established that after 1 January 2001 OAO Gazprom organisations were to keep separate accounts of products (services) and costs for their production, including services for natural gas pipelining.

Decree # 1021 instructed the FEC of Russia, in coordination with the Ministry for Economic Development of Russia, to develop and approve methodological guidelines for calculation of tariffs for gas pipelining services. However, development of the Methodology continued almost to the end of 2005, and it was not until 23 August 2005 that the Methodology was approved by Order # 388-e/1of the FTS of Russia «On Approval of the Methodology of Setting Tariffs for Trunk Pipeline Gas Transmission Services». In spite of the fact that the Methodology had not existed before that time, tariffs for natural gas transmission not only had been established, but were annually reviewed, which allowed the regulatory agency to gain extensive practice collecting information, analyzing it and further monitoring the current situation, and this practice was actively used in developing the Methodology.

It should be noted that all these regulatory documents are applicable only to the domestic gas market of the Russian Federation and by no means regulate relations with respect to government regulation of gas pipelining tariffs outside the customs territory of Russia or tariffs for gas transit through Russia.

Principles of Tariff Setting (Previous)

The Methodology reflected the major aspects of the practice of tariff setting for gas pipelining services established at the time of its adoption. A review of this practice will make it possible to highlight all the up- and downsides of the method and to understand the fundamental logic of regulation.

Analysis of world practice shows that the principles selected in developing the tariff setting system are closely connected with the configuration of the GTS. A typical feature of Russia’s UGS GTS is its considerable length. At present, the GTS includes about 150,000 km of trunk lines and offtakes. The general view of Russia’s GTS is shown in Fig. 1.

Figure 1. Gas transmission system of the Russian Federation

Source: OAO Gazprom

It is for this very reason that the fundamental principle for setting tariffs for gas pipelining services in past practice was the linear relationship of the transmission costs on distance, that is, the basic tariff determining the cost of transporting 1000 m³ for 100 km was set.

The transmission tariff was calculated by assigning targeted earnings to the total volume of goods transmission in the domestic market.

All data for tariff-setting calculations were provided by the natural monopoly. Planned tariff earnings were based on a demonstration of the costs of the regulated activity covering all mandatory tax and duties plus profit, a part of which was used for the investment programme, while the other part was used to pay dividends to shareholders and to cover relevant operating losses. In this situation, the following challenges arose[4]. First, the procedure for cost allocation between the domestic and export markets. To settle this matter, principles for allocating transmission costs for a particular route in proportion to the amount of gas transported to various markets were developed. Second, principles for sharing the system-wide costs incurred by OAO Gazprom for gas transmission. Here costs were shared on the basis of the proportion of transmission costs to total transmission costs.

A uniform basic tariff was set for the whole UGS GTS. This resulted in actual tariff averaging over different gas transmission organisations with different financial and technological performance parameters. Averaging occurred both within the gas transmission organisation and over the entire UGS GTS, which resulted in cross financing, both between different transmission segments and between gas transmission organisations within the UGS.

Trend in Gas Transmission Tariff Modification

Now let us turn to particular figures characterizing efficiency of government regulation of tariffs for gas transmission for independent organisations.

Figure 2. Dynamics of established tariff rates for gas transmission through OAO Gazprom pipelines.

Source: FTS of Russia

Analysis of the establishment of tariff rates for export and domestic market transmission shows that the cost of transmission on the Russian Federation domestic market is systematically approaching the cost of export gas transmission. A comparison of gas transmission costs in Russia and worldwide shows that Russia is quite close to the world cost of transmission (the average world tariff rate is $1.50 — 2.00 /1000 m³ per 100 km).

Figure 3. Trend in costs of gas transmission by independent organisations

Source: OAO Gazprom

The rise in the costs for gas transmission through the UGD GTS by independent organisations shown in Fig. 3 is primarily attributable to the rise in the tariff rate, and only secondarily to the rise in the amount of gas transported, gas production and changes in gas transmission distance.

Here we should touch upon another relevant factor that determines the interest of independent organisations in gas transmission — that is, the correlation between the wholesale price for gas set by the government and the costs of its transmission.

Figure 4. Level of sensitivity of independent organisations’ business to tariff changes

Source: estimates by ZAO ERTA-consult

The wholesale price set by the government serves as main price point in gas sales by independent organisations. The wholesale price changes non-linearly depending on distance[5]. Theoretically, it is possible to calculate the «equal competition» radius at which the value of independent organisations’ gas, including transmission costs and a production cost equal to that of OAO Gazprom, will equal the price set by the FTS. The current «equal competition» radius is about 1600 km[6]. There is no doubt that a revision of wholesale prices and the tariff rate will shift this radius. The «equal competition» radius has a simple economic interpretation: at distances less than this radius, trade in gas is cost- effective; beyond this radius it is not.

Figure 5. Juxtaposition of price and tariff growth trends

Source: FTS of Russia

The rate of increase in the tariff over the last several periods is less than or equal to the increase in the wholesale price. On this basis, we can speak of the existing positive trend toward a gradual increase of the radius (equal competition), and, consequently, an increase in the area in Russia where it is cost effective to trade in independent organisations’ gas. However, while the increase in prices for natural gas is limited by the parameters of the RF Energy Strategy up to the Year 2020, there are currently no restrictions on the increase in its the transmission tariff.

Drawbacks of the Previous Tariff Setting Practice

To sum up the description of the practice of government tariff regulation, it is necessary to state the main factors against the background of which such regulation takes place, namely:

• the important role of OAO Gazprom in the Russian economy (8% of tax revenues to the consolidated budget of Russia);
• the Monopoly’s influence on the Regulator (this influence can be indirect, for example, through the President of the Russian Federation, or direct, for instance, by personal lobbying for certain decisions);
• lack of adequate information (furnished information is classified as a «trade secret», which substantially limits the framework for a broad discussion of this information);
• the Regulator’s lack of power (lack of leverage^[7]).

These drawbacks to government regulation of tariffs largely result from the significant uncompensated force that natural monopoly entities gain when it comes to regulation and from lack of demand on the part of independent organisations, which have just started showing interest in the subject.

The main disadvantage of the existing methodology for tariff regulation is the fact that the linear dependence of transmission cost is not adequate to the current economic situation (this was explained in terms of wholesale prices, as well as transmission cost sharing).

This situation is aggravated by lack of synchronisation over time of the revision of prices and tariffs for gas transmission.

Another major disadvantage of the methodological for setting a tariff rate is arbitrariness in determining transmission routes, which are set by the natural monopoly entity (the difference in the transmission distance for the same entry and exit points of the transmission system may be as much as 20%).

Figure 6. Ambiguity in determining a transmission route

Last but not least is the problem of accounting in the rate for the so-called «investment component», that is, the costs allocated by OAO Gazprom to expansion of gas transmission capacities. The problem consists in lack of a transparent mechanism for eliminating «bottlenecks» elimination and for expanding basic routes over which independent organisations supply gas.

Summary of the Section

Industry legislation provides for regulation of sale prices for gas or tariffs for its transmission. Government tariff regulation relies on the «costs plus» principle. But an organisation owning a gas system is allowed to set internal rates for transmission of its own gas.

The necessity of tariff calculation arose in December 2000 with adoption of Decree #1021, but until 2006 the calculation was done without any formalized methodological framework. The lack of external coordination for setting regulated wholesale prices for OAO Gazprom gas and for setting tariffs for transmission of independent organisations’ gas severely limited the distribution market for independent organisations’ gas. At the same time, while the increase in prices for natural gas was limited by the parameters of the RF Energy Strategy up to the Year 2020, there are still no formal restrictions on the increase in its transmission tariff.

The tariff set for trunk line gas transmission had a number of drawbacks, namely:

• the linear dependence of transmission cost is not adequate to the current economic situation;
• arbitrariness in determining transmission routes;
• lack of a transparent mechanism for eliminating bottlenecks and for expanding basic routes along which independent organisations supply gas.

Description of the New Tariff Methodology

General Content and Analysis of the Methodology

The Federal Tariffs Service approved the Methodology for Setting Tariffs for Trunk Pipeline Gas Transmission Services by Order #388-e/1 «On Approval of the Methodology for Setting Rates for Trunk Pipeline Gas Transmission Services» of 23 August 2005 . The Methodology is based on a completely innovative tariff setting system never before used in Russia.

The Methodology for Setting Rates for Trunk Pipeline Gas Transmission Services (hereinafter «Methodology») is built on entirely new principles, although it contains already proven components related to the procedure for furnishing information, but not the amount of information, cost calculation, etc. This is the first methodology regulating transmission service tariffs that contains so many innovations.

The Methodology regards transmission[8] as gas transit or transfer from pipeline system «entry zones»[9] to pipeline system «exit zones», which are defined as follows:

«Entry zone’:

• All points of connection to the trunk pipeline system of delivery pipelines supplying gas from gas fields, gas processing plants, underground gas storage facilities (hereinafter — UGGS) and from other sources to the trunk pipeline system;
• Points where trunk pipelines cross the Russian Federation border (for gas transmission for further delivery to Russian consumers from UGGS outside the Russian Federation).

 

Figure 7. Possible Breakdown of «Entry — Exit zones»

Source: results of simulation by ZAO ERTA-consult

 

«Exit zone»:

• All points of exit from the system of trunk pipelines within a the Russian Federation constituent (within the RF constituent in which the gas transmission distance exceeds 400 km one way, several exit zones may be identified);
• all points of UGGS connection to the system of trunk pipelines within a RF constituent;
• all points where trunk pipelines cross the boundary of the Russian Federation at location adjacent to an RF constituent.

The Methodology declares the legislated «costs plus» principle.

The tariff for gas pipeline transmission consists of two components. The first is the tariff for using trunk lines[10], which is expressly set by the FTS and amounts to about 70-80% of the total tariff; the second is the tariff rate for the gas transit, calculated according to established practice (set in roubles/1000 m³ per 100 km). Thus, the tariff contains a value that can be affected by route ambiguity, although it accounts for only 20-30% of the tariff. The utilisation rate varies nonlinearly as a function of distance, which is in more accord with the existing relationship of price to transmission distance.

Figure 8. Tariffs and wholesale prices

The utilisation tariff is determined for each specific «entry zone» — «exit zone» pair according to a pre-set algorithm, calculated over the average transmission distance. The results are presented in the form of a table or «tariff menu».

Figure 9. Utilisation tariff (calculation model)

The costs that form the tariff rate for transmission work include the cost of electric power, of gas for internal and technological needs, as well as expenses from profit. All other costs are included in the calculation of the utilisation tariff.

The ratio of the utilisation tariff and the tariff rate for transmission work within the total tariff approximately corresponds to the ratio of conditionally fixed and conditionally variable expenses within the total expenditure structure. According to OAO Gazprom estimates, the ratio of conditionally fixed and conditionally variable expenses is estimated at 9 to 1. Moreover,, the use of a of a dual-rate tariff s with a flexible cost distribution allows, if necessary, redistribution of tariff earning between the tariff rates, which adds flexibility to the system. However, flexibility of the system is also its downside, because the natural monopoly entity may influence the regulatory body and manipulate the costs ratio of the tariff rates, in its own interest.

It should be noted that both of these tariff rates are paid after delivery of the services (and calculated on the basis of the actual amount of gas transported). This is not an issue of the Methodology itself, insofar as it deals with the formation of payment, not procedures for collecting it. Moreover, there is the legal problem of obtaining payment for a service that was not rendered, as well as formal lack of regulatory correlation of this issue with the resolution of GTS access issue.

Implementation of the principle of tariff methodology stability requires either creation of clear forecasting tools, so that data used in tariff calculation does not diverge dramatically from actual values[11], or, what as done in the Methodology, the introduction of a tool to compensate income (expenditures) not accounted for during regulation in the succeeding regulation period.

The problem of new gas pipeline construction and of as elimination of «bottlenecks» in the existing gas transmission system is becoming more and more acute as the FTS realized when the Methodology was being developed and adopted. That is why the Methodology provides an opportunity to calculate tariffs not on the basis of reasonable costs, but on the basis of securing a certain rate of return on investment. Although this principle is not discussed in detail, just its existence can be considered a good sign. It should be noted, however, that whereas considerable experience studying and setting such tariffs has been gained in tariff regulation on the basis of costs, setting tariffs through the rate of return on capital would require extra efforts to gain such practice.

Overview of the Methodology

The main positive thing about the Methodology is that it has come into being. Adoption of the Methodology increases the transparency of government tariff regulation. Although the Methodology still includes a tariff component depending on route ambiguity, its share has been reduced to 20-30%. Besides, embedded in the Methodology is the conceptual possibility of calculating tariffs for new pipelines on the basis of securing fair rate of return on invested capital for investors.

The most debatable provisions of the Methodology

The most debatable provisions of the Methodology are:

• methodology for allocating costs between the rates;
• procedure for entry — exit zones selection;
• methodology for using adjustment factors;

Methodology for allocating costs between the rates. The initial calculation model did not have any tariff that depended on the transmission route. However, OAO Gazprom economists insisted on a systematic modification of calculation principles and had their way: this component remained in the Methodology, at least, at the first stage.

In spite of the fact that the logic of the Methodology correlates conditionally fixed and conditionally variable costs with different tariff rates, in fact, this correlation is artificial and does not reflect actual factors of tariff calculation. This scheme was elaborated during the conciliatory procedures exclusively for the purpose of retaining the route-dependent tariff component.

The procedure for entry — exit zones selection is stated in the Methodology as a recommendation. It is recommended that select entry zones of no more than 100 km, and exit zones — matching the size of the RF constituents be selected. No more specific modelling of zone topology was carried out in developing the methodology. At present, OAO Gazprom does these calculations.

The division into zones critically influences not only the economics of independent organisations and the radius of their efficient presence on the Russian Federation gas market, but it also influences areas of presence of OAO Gazprom itself. Division into «entry» and «exit’ zones may also make it necessary to reconsider existing price zones and the level of wholesale prices in them.

Adjustment factors were introduced into the text of the Methodology for the purpose of gradually bringing the economic of regulated wholesale prices closer to transmission rate economics. Instead of a logical wholesale price revision, however, the Methodology contains an additional degree of cross-subsidy. After the Methodology is introduced, short-distance will start subsidizing long-distance deliveries. Thus, the adjustment factors approved for the next three years will be gradually adapting the rate tariff to match the existing wholesale prices.

Role and Participation of Gazprom in the Process

The Methodology would never have been issued unless OAO Gazprom had approved it. OAO Gazprom and its transmission organisations are listed in the natural monopoly entities register, which means that they have to be regulated.

The drawbacks of the Methodology, which we are going to discuss below, reflect the conflict of interests that took place during its development and adoption, and players (the FTS, OAO Gazprom, the Russian Ministry for Economic Development, and independent gas producers — and the independent gas producers between them may also have conflicting interests among themselves) who participated in the process.

In spite of the fact that the Methodology development process was fairly open, its principal participants’ reluctance to have an open discussion of tariff setting problems and the limited experience in tariff regulation did not help make the work particularly efficient.

The timing of the Methodology’s approval (its approval by OAO Gazprom) shows that adoption of the Methodology was an administrative compromise with OAO Gazprom in approving the tariff for transmission for the year 2005.

Brief Analysis of Foreign Rate Regulation Experience

The Madrid Forum, organized by the European Commission to discuss gas industry issues not included in the Gas Directive 98/30/ЕС[12] which was force at that time, in particular, resulted in the following requirements for developing and setting gas transmission tariffs. The tariffs must:

• reflect transmission costs, with regard to peculiarities of gas flows and the geometry of the system as a whole;
• increase the efficiency of gas trade, foster gas market liquidity and the development of gas — gas competition;
• ensure a high level of transparency;
• establish conditions for the appearance of timely and efficient signals supporting efficiency of long-term investments in the transmission infrastructure;
• take into account the specifics and market characteristics of various transmission networks;
• provide a satisfactory rate of return on investment for the transmission organisation;
• have proper level of control;
• have structure such that any difference in tariff setting applied to different users offering the same package of services used would depend only on the relevant costs.

It should be emphasized that the majority of tariffs used worldwide are closely tied to the relevant countries’ systems of third party access to gas trunk pipelines. When one of the systems (rate setting or access) is considered separately, the harmonious picture breaks up apart and cannot be evaluated in its entirety.

After analysis of the recommendations above, experience implementing them and actual tariff setting in various countries, the following conclusions were made:

• The most common tariff setting system in the world is a modified «entry — exit» system
• The main principles of the tariff setting system are:
  • equality in terms of service conditions;
  • transparency;
  • generation of important long-term signals for the market;
  • no cross-subsidising between the users;
  • simplicity;
  • stability and predictability.

As a result of the imposition of conditions characterizing the Russian gas industry on current foreign experience, the following recommendations for the developed methodology were formulated:

• Due to a high level of UGS GTS specificity, none of tariff setting systems operating anywhere in the world may be directly used in Russia without modifying;
• The tariff setting system must be correlated with the existing system for granting access to the gas transmission system, including storage facilities and the general topology of the system.
• The structure of the tariff rate should comply with the model of the gas market that is being built.
• In tariff setting it is necessary to be quite clear about the list of services, including balancing of the gas transmission system, and their value.

Drawbacks of the Methodology, Compromises and Prospects for their Utilisation

The tariff setting Methodology still contains a tariff rate that depends on route ambiguity. Thus the choice of route still remains arbitrary, although its relative importance has been substantially reduced. There is a possibility of reasonably abandoning the practice of matching transmission to a particular route as the Methodology is further improved. However, these modifications have to be supported by serious studies that would provide a serious set of arguments for the approval of modifications to the Methodology text by the FTS and OAO Gazprom.

The Methodology does not fix entry — exit zones. Inclusion of a particular field (entry point) in a zone containing traditional OAO Gazprom production sites would significantly influence the calculation of the transmission tariff. Bringing together in one zone two pipeline stages that have no technical connection would lead to paradoxical formal results of methodology application. Thus, any «zone map» would be subject to serious criticism both in terms of the FZ «On Competition» and for purely technical reasons. Within the scope of such a discussion, a passive position on the part of the owner (user) of the entry point (gas field) can easily cause significant negative changes in business economics. On the other hand, the FTS will consider any reasonable requirements (comments) by independent participants in resolving this issue, for the reasons of lack of experience and competence in introducing such mechanisms.

The algorithm for calculating weighted average distances requires substantial elaboration. The general calculation principle, based on averaging goods transmission work along all the possible transmission routes from the entry zone to the exit zone, fails to answer many specific questions. In particular, what amounts of gas are used in the calculation: actual (historical) or contractual (planned)? How to account the exit of an amount of gas from the route and entry of outside gas? Should routes with zero utilisation be taken into account? The Methodology contains no satisfactory answers to these questions. Thus, the procedure for calculating weighted average distances requires a complete set of UGS GTS data, a complete calculation algorithm and a lot of calculations. This brings us to the conclusion that it is necessary to develop custom software and a data system to introduce the Methodology.

The Methodology’s poor validation of adjustment factors, i.e., methods for tariff adjusting tariffs to prices (price and tariff correlation is from prices to tariff). This adaptation would require reconsideration of price setting principles as part of the modification, but this may simultaneously interfere with their revision. At present the importance of absolute values for these factors is becoming obvious, as is the necessity of revising them the next time tariff values are approved.

Proposals for Improving the Methodology

Possible ways to develop and improve the Methodology adopted by the FTS of Russia:

• More clear-cut definition of the term «gas transmission».
• Development of mechanism for disclosing information on gas pipeline utilisation.
• «Localisation» of specific tariff rates and tariff setting by calculation of weighted average transmission costs.
• Abandonment of the route-dependent rate component.
• Abandonment of tie between the tariff rate and costs.
• Introduction of payment for balancing and storage. OAO Gazprom incurs huge expenses for gas balancing and storage.
• «Localisation» of costs in terms of specific gas transmission organisations and individual transmission routes.

Key Risks and Threats Contained in the Methodology

Traditional business risks

The methodology actually applies the «Expenses Plus» principle — costs represent actual monetary expenditure; and expenses — both monetary payments and generation of financial liabilities. Thus, the Methodology does not set any limit on increases in the tariff in connection with increase in the expenses of the company owning the GTS.

The «Basic Approach» of cost allocation by the parent company — in proportion to the costs of transmission subsidiaries as a percentage of the subsidiaries’ total costs — results in inclusion in the tariff of the huge administrative expenses of the OAO Gazprom holding company’s parent company, and growth of these expenses largely exceeds the growth of the transmission subsidiaries’ costs.

Expenses for gas transmission for internal needs are accounted for in the tariff calculation (clause 17 of the Methodology). As can be seen from the RF gas balance for the year 2005, OAO Gazprom consumes about 70 billion m³ of gas per year for its own needs, which is about one sixth of national consumption:

The Methodology disregards the problem of calculating cost items. The existing cost structure within the OAO Gazprom holding company is quite specific and reflects the existing current business management practice. In particular, capital asset leasing averages 34% of costs (for OOO Tyumentransgaz — up to 48%). Transmission accounts for more than half of the structure of OAO Gazprom capital investments. Thus, in a situation where no real separate cost accounting exists, there is a significant risk of overstating transmission tariff and simultaneously understating regulated wholesale prices.

There is no algorithm for calculating goods transmission work (hereinafter «GTW»): «…at the forecast level for the regulation period with regard to the contractual gas transmission volumes, as well as statistics on gas transmission and GTW volumes for the previous 3 years». Upon introduction of the Methodology, the regulatory body becomes fully dependent on the regulated entity, especially because no indirect methods have been stipulated for verifying data and calculations.

This approach is faulty for the following reasons:

a) it is impossible to trace a violation of the optimal transmission route;

b) GTW calculation error may reach double-digit percentages;

c) no procedure is envisaged for verification of contract fairness in an environment of shortage of supply;

d) the correlation between the existing established capacity of gas transmission plants and GTW is disregarded , resulting in a possible considerable overestimation of fixed costs and tariff distortion in any direction.

The methodology contains a simple (proportional) method for OAO Gazprom to account for its internal needs (costs). OAO Gazprom’s gas transmission system is enormous and consists of various gas pipeline segments with different pipe diameters and different utilisation rates. Estimates of flow rate may vary tenfold. The a flow rate determined by OAO Gazprom is 23-40 m³ per 1000 m³ per 1000 km. Analysis of technical documents on the range of compressor units that OAO Gazprom has shows actual flow rate of 14 to 101 m³.

The change in tariff calculation principles will change the marketing strategies of independent gas producers — the existing balance of interests will inevitably be destroyed.

Risks of the new owners of gas transmission infrastructure

…

Summary of the Section

In August 2005, the Federal Tariff Service approved the Methodology for Setting Rates for Trunk Pipeline Gas Transmission Services. The Methodology is based on a completely innovative system of tariff setting never before used in Russia.

According to the Methodology, the price of gas pipeline transmission consists of two components: the tariff for using trunk lines and the tariff rate for the gas transmission. Thus, the tariff contains a value that can be affected by route ambiguity, although its relative importance is reduced to 20-30%. The utilisation rate varies nonlinearly depending on distance, which is in more accord with the existing price dependence on transmission distance. The utilisation tariff is determined for each individual «entry zone» — «exit zone» according to a pre-set algorithm calculated for an average transmission route.

A separate section of the Methodology envisages the possibility of calculating the rate on the basis of securing a certain rate of return on investment.

The most debatable provisions of the Methodology are:

• the methodology of costs allocation between the tariff rates;
• the procedure for entry — exit zones selection;
• the methodology for using adjustment factors;

Possible ways to develop and improve the Methodology adopted by the FTS:

• More clear-cut definition of «gas transmission».
• Development of the mechanism for disclosing information on gas pipeline utilisation.
• «Localisation» of specific tariff rates and tariff setting by calculation of weighted average transmission costs.
• Abandonment of the route-dependent tariff rate.
• Abandonment of tie between the tariff rate and costs.
• Introduction of payment for balancing and storage. OAO Gazprom incurs huge expenses for gas balancing and storage.
• «Localisation» of costs in terms of specific gas transmission organisations and individual transmission routes.

Key risks and threats contained in the methodology

• The methodology actually applies the «Expenses Plus» principle
• The applied «Basic Approach» of cost allocation by the parent company results in the inclusion of the huge administrative expenses of the OAO Gazprom parent company in the tariff
• The Methodology disregards the problem of calculating cost items
• There is no algorithm for calculation of goods transmission work
• The methodology contains a simple (proportional) method of accounting for gas for OAO Gazprom internal needs (costs).
• The change in the tariff calculation principles will change the marketing strategies of independent gas producers — the established balance of interests will inevitably be destroyed.
• The methodology envisages different alternatives for calculating the gas transmission tariff for new projects. Selection of one alternative would materially influence the efficiency of implementation of the Regional Gasification Project.
• Selection of the set of entry — exit zones remains with the FTS of Russia. This selection may result in price differentiation in terms of consumers.
• The methodology is based on expense accounting by kind of activities, in compliance with current accounting regulations. Cost accounting according to Western standards would inevitably necessitate regular recalculation to bring the accounting into the format required by the FTS.

What Can and what Must Be Done Next

Participate in calculation and methodological work. Oversight over amendment and refinement of regulations should not be forfeited. Given the lack of experience in introducing this methodology, one can offer one’s own methods for solving critical problems (zone formation; calculation of route banks; calculation of inter-seasonal goods transmission work). The divergence of the interests of independent gas producers should also be taken into account.

Improve the principles of regulation. It has become genuinely possible to further modify the regulatory situation in the industry. Approval of the Methodology was used as an example of achieving constructive goals through discussion between FTS and OAO Gazprom experts. Further steps might be the refinement of the Methodology itself or revision of the «Regulation on Access to OAO Gazprom GTS» and «Rules for Gas Delivery in the RF».

Preliminary Recommendations

1. Introduction of the Methodology will result in serious changes in the regional structure of natural gas market. The basic trends in these changes depend on:

• the structure of OAO Gazprom costs submitted to the FTS;
• methodological approaches to the allocation of these costs stated in the Methodology;
• mechanisms for fine-tuning the Methodology «fine tuning» that are not formalized in the official text of the document (breakdown of the entry — exit zones, mechanism for calculation of weighted average distances and goods transmission work, etc.).

2. At present, these mechanisms are being used «blindly». Given the general purpose of introducing the Methodology on the national scale, little attention is given to special situations — possible economic «mismatches and imperfections» in certain regions and separate fields. OAO Gazprom economics are protected by the methodological principle of covering total costs. The economics of separate independent gas producers are susceptible to serious risks of «occasional fluctuations» both to the better and to the worse.

3. GTS users have an opportunity to influence key factors determining the consequences of the methodology’s introduction:

• development and analysis of consequences of options for fine-tuning the Methodology «fine tuning» — alternative calculation of entry — exit zones, weighted average transmission distances, and adjustment factors.
• further proactive refinement of the Methodology toward the principles adopted by the FTS to reduce the risks of their improper interpretation and application. The fact that the Regulator has no valid position may cause the Methodology to be discredited: elaboration of fair methodological logic is needed.

4. One should not «draw fire upon oneself». Relevant actions should be taken anonymously or within a significant group of independent organisations.

5. It is important to get involved in the process BEFORE the methodology is introduced. Discrimination against GTS users during introduction may turn to be very substantial.

Economic Consequences of the Application of the New Methodology

Description of the Model of Rate Calculation under the New Methodology

According to the Methodology, the cost of transmission of 1000 m³ of gas along trunk pipelines to the domestic market was calculated as a sum of the basic utilisation tariff between entry and exit zones and the product of the basic transmission tariff times the length of the particular transmission route.

The basic utilisation tariff set for gas transmission between the i-th entry zone and the j-th exit zone is calculated according to the following formula:

where:

— the constant component of the prime utilisation rate that does not depend on the transmission distance;

— prime utilisation rate for gas transmission to the domestic market;

s — number of gas transmission distance ranges between the i-th entry zone and the j-th exit zone;

— differential of the prime amount of the distance-dependent utilisation tariff rate set for the r-th transmission distance range (differential values depending on the transmission distance range are stated in Annex 3 to the Methodology);

— differential of the prime amount of the prime utilisation rate stated for the s-th transmission distance range;

— weighted average gas transmission distance from the i-th entry zone to the j-th exit zone;

— distance of the r-th transmission range (see annex 3 to the Methodology);

— the lower limit of the s-th gas transmission distance range.

The constant component of the tariff rate for utilisation is calculated under the following formula:

where:

— earnings required to cover reasonable expenses connected with operation of gas distribution stations (hereinafter GDS). Earnings are brought to a cost-effective level within 2 to 3 years;

— volume of gas passing through the GDS.

The prime utilisation rate for gas transmission to the domestic market is calculated with the following formula:

where:

— average specific utilisation rate;

— total GTW for gas transmission to the domestic market;

— GTW for gas transmission over the r-th transmission distance range;

h — maximum fixed number of transmission ranges (determined as per Annex 3 to the Methodology).

The average specific utilisation rate is calculated with the following formula:

where — expenses taken into account in calculating the utilisation rate.

The basic transmission rate is determined with the following formula:

where:

— expenses taken into account in calculating the transmission rate.

To determine the amount of expenses to be taken into account in calculating the tariff rate for utilisation and for transmission required earnings (НB) are distributed as follows: in calculating the transmission rate , expenses for electricity and gas for internal needs are taken into account, as are expenses from net profit; other expenses are taken into account in calculating the rate for utilisation . Total expenses taken into account in calculating the transmission rate may not exceed 30% and may not be less than 20% of the total amount НВ.

For comparison, the tariff rate for the linear tariff (to be applied until the rate calculation as per the Methodology is introduced) was calculated.

Where НВ are required earnings to cover all the expenses for gas transmission to the domestic market, GTW is all the goods transmission work on the domestic market.

Thus, to calculate tariff rates one must know the following data:

— total expenses (including expenses out of profit) allocated to gas transmission to the domestic market,

— GDS expenses,

— expenses for electricity and gas for internal needs and expenses out of net profit,

— the volume of gas passing through the GDS,

— the total amount of goods transmission work (GTW) in the domestic market,

— GTW distribution in terms of transmission ranges.

The division into transmission ranges (their distance) and adjustment factor values К for the years 2006 — 2008 are stated in Annex 3 to the Methodology:

Table 1 — Differentials for the specific utilisation rate

Number of the transmission distance range, r	Transmission ranges, km	Transmission range distance (lr), km	Regulation period
			2006	2007	2008
1	Up to 200 inclusively	200	1	1	1
2	over 200 to 500 inclusively	300	0.995	0.99	0.985
3	over 500 to 900 inclusively	400	0.99	0.98	0.97
4	over 900 to 1400 inclusively	500	0.982	0.964	0.946
5	over 1400 to 2000 inclusively	600	0.975	0.95	0.925
6	over 2000 to 2800 inclusively	800	0.967	0.934	0.901
7	over 2800		0.958	0.916	0.874

To calculate utilisation and transmission rates, OAO Gazprom indexes for the year 2004 allocated to gas transmission to the domestic market were used.

GDS costs were derived by expert appraisal on the basis of indirect data.

To calculate the «base» alternative, data on expenses were indexed so that the calculated value of the linear tariff rate coincided with the value in effect (approved by the FTS) in 2006 — 23.84 roubles/thousand m³ per 100 km.

Goods transmission work and its distribution in terms of transmission ranges and volume of gas were estimated on the basis of data on weighted average distances and volumes of gas transmission to the RF constituents in 2004. It was assumed that all the gas was passing through GDS.

Rates were calculated in accordance with the formulas above on the basis of the indexed expenses and GTW data.

To calculate payments for transmission between particular entry and exit points, the transmission distance was calculated with the help of the electronic «Oil and Gas Pipeline Atlas v. 2.2».

It was assumed that entry and exit points were the centres of the corresponding zones. Given the existence of several route alternatives, the weighted average distance between the entry and exit points was calculated on the basis of distances and annual average gas flows along the corresponding segments of the routes. That is, averaging was based on actual, not contractual gas flows (the methodology does not contain any clear-cut instructions as to which flows should be used for averaging, and no particular averaging algorithms are described).

Transmission costs were calculated for every alternative route.

Calculations under the linear and the new rate were compared, and the influence of the main parameters on the amount of the rate calculation under the new methodology was assessed.

Features of the New Tariff

The main features of the calculation of the new tariffs are:

§ averaging is based on the tariff rate utilisation along all possible routes connecting entry and exit zones,

§ the utilisation rate contains a constant component that does not depend on the distance between zones,

§ the utilisation tariff rate is nonlinearly dependent on the weighted average distance between zones (the longer the distance, the slower the rate increases).

For these reasons, the use of the new methodology involves cross-subsidising of long transmission routes at the expense of short ones. The graph illustrates examples of calculation of the transmission fee according to the linear tariff and the new methodology, which depends on the distance between the centres of entry and exit zones.

As the graph show, at a transmission distance of approximately 2500 km, the fee at the new tariff exceeds the fee under the old linear tariff. The distance where the payment values become equal, primarily depends on the prevailing gas flow distribution in the system, as well as on non-linear adjustment factors.

Variables

According to the new Methodology, the following parameters may be variable:

§ the percentage of GDS costs to be taken into account;

§ the expenses allocated to transmission rate (20 to 30% of all expenses);

§ the breakdown into transmission zones and adjustment factors (approved up to the year 2008);

§ the breakdown into entry and exit zones (no data at present).

Thus, the transmission fee under the new methodology depends on:

§ total costs allocated to gas transmission to the domestic market;

§ costs allocation by tariff rates;

§ adjustment factors;

§ the breakdown into entry and exit zones.

The following parameters were used as variables in the calculations:

§ the index for converting expenses to year 2004 values;

§ the percentage of GDS expenses (0 to 9.7% according to 2004 data);

§ the percentage of expenses allocated to the transmission rate (20 to 30% according to the methodology);

§ adjustment factors (in accordance with approved values).

Because of lack of data on breakdown into exit zones, this parameter was not varied in the calculations. It was assumed that the exit point coincides with the zone centre.

The following were used in the «base» calculation:

§ index for converting expenses to year 2004 values, equal to 1.299 (so that the value of the linear factor coincided with the current linear rate);

§ costs allocation by tariff rates in accordance with 2004 data;

§ adjustment factors approved for 2006.

Routes Used for Calculations

…

Annex 1 — Comparative Calculation of the Transmission Tariff

Initial data and statement of the problem

The purpose of the calculation was to demonstrate the change in the one-part gas transmission tariff that must be established under the two different approaches stated in the Methodology for Setting Tariffs for Trunk Pipeline Gas Transmission Services.

The estimates are demonstrative. Unfortunately, we cannot guarantee that the tariffs we calculated will exactly match those approved by the FTS because the input data are incomplete. However, the results accurately reflect all the qualitative regularities.

Following is the calculation under the Methodology for a one-part gas transmission rate in two scenarios: on the basis of section II (annual reimbursement of depreciation and production costs with specified profitability without discounting) and on the basis of section V (achieving the project NPV equal to 0 within the set payback period). The rate is calculated in «roubles/(thousand m³·100 km)».

Transmission expenses are not included in the tariff because of lack of input data. Thus, the component is calculated describing investment and production costs.

Reimbursement of the gas pipeline cost based on depreciation and the planned rate of return

To calculate the tariff under the Methodology in «close to traditional» scenario, the following formula must be used for every year in the life of the project:

where:

is total production costs (material costs, labour costs, uniform social tax, «other costs») and depreciation;

— profit tax, set at 24%;

— target profitability,

V — target gas transmission volume,

L — gas pipeline length, hundreds of km.

VAT was not taken into consideration in the calculation.

Substantiation: Methodology for Setting Tariffs for Trunk Pipeline Gas Transmission Services, part II, page 1 — 7.

The desired profitability was not set by year, it set as a uniform input parameter for the whole life cycle of the project.

It is necessary to specify the depreciation allocated to the gas pipeline.

Setting the tariff that ensures NPV = 0 at the end of the payback period

The Methodology supports tariff calculation to zero the NPV during the project life cycle.

According to part V of the Methodology, a uniform rate is set for the whole project payback period that would secure a net present value NPV = 0 for the project within the payback period. Obviously, in this case, the internal rate of return (IRR) of the project equals the present discount rate. The calculated tariff is a selected input parameter of the problem and makes it possible to determine annual earnings on the basis of forecast transported gas volumes.

Unfortunately, the payback period is limited in the methodology to 5-10 years, which is less than the depreciation periods contained in the tariff «based on depreciation» (approximately 16 years). This circumstance and the introduction of income discounting, results in a considerable gap between the two tariffs, increasing the scenario described here (NPV).

The desired project profitability is stated as a separate line of «additional expenses from profit» in the financial operations section. For correct comparison of the two tariffs, project profitability in both cases must be equal. Annual profitability is defined as a number that exactly coincides with the target net profit of the depreciation-based calculation:

.

Since expenses are added to the net taxable profit , it is not necessary to take into account tax in determining expenses .

Project earnings were discounted by the inflation rate, net profit — by the «time discount» (refinancing) rate.

Results of calculations

The demonstration calculation was based on the following assumptions. The profitability of the both projects was set at 13% (refinancing rate + 1%) — a uniform value for every project year; the inflation level as forecast annually by the customer; the time discount factor (refinancing rate) at12%.

For calculation, data were provided on capital costs for the new project, forecast gas supplies for 2008-2018, the depreciation plan and forecast annual operating expenses.

The depreciation-based tariff is calculated with formula (0). The NPV-based tariff is calculated by selection of a parameter, the tariff rate defining project revenues. At the same time, the IRR of the project is regulated. Please note that the condition NPV=0 means that it is necessary to select IRR exactly equal to the refinancing rate (grey reference field right of the regulated cell). If the input parameters are correct, the net present value (NPV) in the year of payback (5^th or 10^th) must be close to zero.

As expected, the second tariff scenario (NPV), which takes into consideration actual cash flows and introduces revenue discounting, contains a more «direct’ depreciation and «strict» rate of return. Under the first scenario, the resulting tariff was 170 roubles/(thousand m³·100 km); under the second, 490 roubles /(thousand m³·100 km) (810 roubles/(thousand m³·100 km) if the payback period is limited to 5 years).

All results are demonstrative, because we were unable to obtain reliable input data on capital costs for pipeline facilities and annual depreciation. We obtained data 1) separately for the pipeline; 2) for gas field facility construction as a whole. In the first scenario, the annual increase in depreciation is obvious; deductions did not match the initial basic production assets value. As for the second scenario, it was difficult to segregate book value and depreciation for the pipeline. However, the scenario using costs and depreciation «for the gas field as a whole» (2) showed that no basic production assets recalculation is stipulated and no methodology for allocating «variable» depreciation is prepared, and depreciation is reduced once in 10 years because of the writeoff of some equipment. Finally, the value of basic production assets was based of pipeline data (1) (input data on the «main» sheet), and depreciation was based on the sum of data items for the gas field «as a whole»(2). To obtain reliable results, data on depreciation and capital costs must be clarified.

There is a problem matching the annual level of inflationary revenue discounting and the production costs level embedded in the input data. We have no opportunity to verify the matching.

To account for transmission expenses requires only filling in the cells of the relevant line (highlighted in red), and the data will automatically be included in the calculation.

Annex 2 — Analysis of the Regulatory Framework

RF Federal Law # 69-FZ dated 31 March 1999 «On Gas Supply in the Russian Federation» (FZ «On Gas Supply in the RF»)

Article 2. Key Terms

gas system means a property production complex which consists of technologically, organisationally and economically interconnected and centrally managed production and other facilities intended for gas production, transmission, storage and delivery;

gas distribution system means a property production complex which consists of technologically, organisationally and economically interconnected and centrally managed production and other facilities intended for gas transmission and delivery directly to consumers;

gas transmission organisation means an organisation that engages in gas transmission and has trunk pipelines and offtakes, gas compressor stations and other production facilities on the grounds of property right or on other legal grounds;

supplier (gas supply organisation) is a gas owner or a person authorized by it that supplies gas to consumers under contracts;

Article 5. Gas Systems in the Russian Federation

Organisations comprising the Federal Gas System that own the Unified Gas system, organisations that own regional gas systems, organisations that own gas distribution systems and independent organisations regardless of their form of ownership and forms of incorporation are regulated by the uniform legal framework of market formation and price policy and uniform requirements for energy, industrial and environmental safety…

Article 7. Regional Gas Systems and Gas Distribution Systems

A regional gas system is a property production complex, which consists of technologically, organisationally and economically interconnected and centrally managed production and other facilities intended for gas production, transmission, storage and delivery, independent of the Unified Gas System.

A gas distribution system means a property production complex which consists of technologically, organisationally and economically interconnected facilities intended for gas transmission and delivery directly to consumers in the Russian Federation, independent of the Unified Gas System and regional gas systems…

When shares of regional gas system owners and gas distributions systems owners are traded and in other deals and transactions related to a change in ownership of these shares, foreign citizens or foreign organisations may not own more than 20 per cent of the total number of ordinary shares in these systems.

Article 17. Legal Framework of Further Gasification of the Russian Federation

Further gasification of the Russian Federation will be based on the long-term balance of gas production and consumption, and on duly adopted federal, interregional and regional programmes for gasification of municipal housing authorities, industrial and other organisations…

To finance programmes for gasification of municipal housing authorities, industrial and other organisations in Russian Federation constituents, under the procedure set forth by the Russian Federation Government, special markups on tariffs for gas transmission by gas distribution organisations may be established

Article 19. Quality of the Gas Supplied

Gas will be delivered to consumers only if the quality of the gas meets the requirements of national standards and the relevant certificates of compliance are available.

Article 21. Regulation of Gas Prices and Tariffs for Gas Transmission Services

Government regulation of tariffs for gas transmission applied the Federal Law «On Natural Monopolies» to the activities of natural monopoly entities will be by a federal executive branch agency for tariff regulation

By a decision of the Government of the Russian Federation, tariff regulation for gas transmission may be replaced by government regulation of prices for gas for end consumers using it as fuel and (or) feedstock, and tariffs for gas transmission for independent organisations under the procedure set forth by the Government of the Russian Federation. In government regulation of gas prices and tariffs for gas transmission, economically reasonable expenses and profit are taken into account, as is the availability to organisations owning gas systems of funds to expand gas production, the gas pipeline network and underground gas storage facilities.

For the purposes of settlements between organisations comprising a gas system, the organisation that owns the system sets internal settlement prices for gas and internal settlement tariffs for gas transmission.

Article 23. Regulation of Rates for Services by Gas Distribution Organisations

The Federal executive branch agency for tariff regulation approves tariffs for gas transmission by organisations owning gas distribution systems and the procedure for their application. These rates may be differentiated for the economic and social conditions for gas supply to some parts of Russian Federation constituents.

RF Federal Law #147-FZ dated 17 August 1995 «On Natural Monopolies» (FZ «On Natural Monopolies»)

Article 3. Definitions of Key Terms

A natural monopoly exists on a commodity market when demand on this market is more efficiently satisfied in the absence of competition because of the technological peculiarities of production (because of a substantial reduction of unit costs in proportion to output growth), and commodities produced by natural monopoly entities cannot be replaced in consumption by other commodities, which results in a situation where demand on the commodity market for goods produced by natural monopoly entities depends less on changes in prices for the commodities than on demand for other types of commodities;

Article 4. Activities of Natural Monopoly Entities

This Federal Law regulates the activity of natural monopoly entities in the following spheres:

gas transmission over pipelines …

Article 6. Methods for Regulation of the Activity of Natural Monopoly Entities

Agencies regulating natural monopoly entities may apply the following methods to regulate the activities of natural monopoly entities (hereinafter — regulation methods):

price regulation by determination (setting) prices (tariffs) or their caps …

Article 6. Methods for Regulation of the Activity of Natural Monopoly Entities [sic]

The list of goods (labour, services) of natural monopoly entities, prices (tariffs) for which are regulated by the government, and the procedure of government regulation of prices (tariffs) for these goods (labour, services), including the fundamentals of price-setting and procedures for government regulation and control shall be approved by the Government of the Russian Federation.

Article 8. Responsibilities of Natural Monopoly Entities

Natural monopoly entities are not permitted to refuse entering into contracts with individual consumers for production (sale) of commodities subject to regulation under this Federal Law, if the natural monopoly entity is capable of producing (selling) those commodities.

Natural monopoly entities are obliged to provide access to commodity markets and (or) produce (sell) commodities and services subject to regulation under this Federal Law on non-discriminatory conditions according to the requirements of anti-monopoly legislation.

Article 10. Functions of Agencies Regulating Natural Monopolies

Agencies regulating natural monopoly entities shall perform the following key functions:

They shall form and maintain a register of natural monopoly entities subject to government regulation and control;

Determine regulatory methods stipulated by this Federal Law relating to a particular natural monopoly entity …

Article 11. Powers of Agencies Regulating Natural Monopolies

Agencies regulating natural monopoly entities shall have the right to:

take decisions binding on natural monopoly entities, concerning the enactment, modification or termination of regulation and the application of the regulatory methods stipulated by this Federal Law, including those on setting prices (tariffs);

set rules for the application of prices (tariffs) for commodities (labour, services) by natural monopoly entities;

take decisions on including entities in or excluding them from the register of natural monopoly entities …

Law of the Russian Soviet Federated Socialist Republic #948-1 dated 21 March 1991 «On Competition and Limitation of Monopolistic Activity on Commodity Markets (FZ «On Competition»)

Article 4. Definition of Key Terms

dominant position means the exclusive position of an economic agent several economic agents on the market of a commodity that has no substitute or interchangeable commodities (hereinafter — certain commodity) that allows it (them) to exercise a dominant influence on the general conditions of the commodity circulation on that commodity market or to hamper access to the market by other economic agents. The position of an economic agent shall be considered dominant if the share of such agent on a certain commodity market is 65 per cent or more, except when the economic agent proves that, in spite of exceeding that number, its market position is not dominating.

monopolistic activity means actions (omissions) by economic agents that are contrary to antimonopoly legislation and are aimed at preventing, restricting or eliminating competition;

monopolistically high price means a commodity price which is set by an economic agent having a dominant position on a commodity market and with which that economic agent compensates or may compensate unreasonable costs and (or) gains or may make profit substantially higher than is possible under comparable conditions or under the conditions of competition;

Article 5. Abuse by an Economic Agent of Its Dominant Position on the Market

para. 1. Actions (omissions) by an economic agent (a group of persons) having dominant position that result or may result in the prevention, restriction or elimination of competition and (or) infringement of interests of other economic agents are prohibited, including actions (omissions) such as:

…

Creating conditions for access to a commodity market, exchange, consumption, acquisition, production, sales of commodities that put one or more economic agents in an unequal position in comparison with other economic agent(s) (discriminatory conditions);

Setting and maintaining monopolistically high (low) prices;

Reducing or terminating production of commodities for which there is demand or consumer orders if they can be produced on a breakeven basis;

Unjustified refusal to enter into contracts with certain buyers (customers) while it is possible to produce or deliver the relevant commodities.

Article 8. Agreements or Concerted Actions of Federal Executive Branch Agencies of Russian Federation constituents, local governments, or other authorities or organisations endowed with the functions or rights of those agencies

It is forbidden to enter into agreements in any form or to take concerted actions … that result or may result in the prevention, restriction or elimination of competition and (or) infringement of interests of other economic agents, including agreements or concerted actions that cause or may cause:

The increase, decrease or maintenance of prices (tariffs), except when entering into such agreements is allowed by Federal laws or regulations by the President of the Russian Federation or the Government of the Russian Federation;

market sharing in terms of territory, sales or purchases volume, in terms of the range of commodities sold or in terms of the set of sellers or buyers (customers)…

Orders by the FTS of Russia on Regional Systems

Order by the FTS of Russia # 570-e/11 dated 30 November 2005 «On Wholesale Prices for Gas Produced by ОАО Kamchatgazprom

para. 1. Approve and implement 8655 roubles per 1000 m³ (excluding VAT) as the wholesale price for gas produced by ОАО Kamchatgazprom and sold on the territory of Kamchatka Oblast.

Decree of the FEC of Russia #46-e/2 dated 24 July 2002 «On Approval of the «Methodological Recommendations on the Procedure for Determining Wholesale Prices for Natural Gas Sold in Kamchatka Oblast»

I. General

Para. 1. 1. The Methodological Recommendations on the Procedure for Determining Wholesale Prices for Natural Gas Sold in Kamchatka Oblast set forth the fundamental principles and procedure for regulating and calculating wholesale prices for gas sold in Kamchatka Oblast and shall remain in force during the payback period for the in the construction and operation of Kamchatka Oblast gas distribution system…

II. Procedure for Calculating Gas Wholesale Prices

para. 2.1. Gas wholesale prices calculated in compliance with these Methodological Recommendations must ensure a payback of the investment in the project for Kamchatka Oblast gas system construction and operation (gas production, preparation, transmission and sales) within 10 — 12 years

Order by the FTS of Russia #569-3/10 dated 30 November 2005 «On Wholesale Prices for Gas Produced by ОАО Yakutgazprom

Para. 1. Approve and implement 1103 roubles per 1000 m³ (excluding VAT) as the wholesale price for gas produced by ОАО Yakutgazprom.

Order by the FTS of Russia of #820-e/8 dated 27 December 2005 «On Wholesale Prices for Gas Produced by ОАО Norilskgazprom and on Tariffs for Gas Transmission Services over ОАО Norilskgazprom Pipelines

Para. 1. Approve and implement 890 roubles per 1000 m³ (excluding VAT) as the wholesale price for gas produced by ОАО Norilskgazprom sold to consumers of Taimyr (Dolgano-Nenetsky) Autonomous District (except the public).

para. 2. Approve and implement 194 roubles per 1000 m³ (excluding VAT) as the rate for gas transmission over ОАО Norilskgazprom pipelines.

Order by the FTS of Russia # 819-e/7 dated 27 December 2005 «On Wholesale Prices for Gas Produced by ОАО Rosneft — Sakhalinmorneftegaz, and on Tariffs for Gas Transmission Services over OAO Rosneft-Sakhalinmorneftegaz Trunk Pipelines to Consumers of Sakhalin Oblast and Khabarovsk Krai

para. 1. Approve and implement wholesale prices for gas produced by ОАО Rosneft-Sakhalinmorneftegaz and sold to consumers (except the public):

— of Sakhalin Oblast, 658 roubles 50 kopeks per 1000 m³ (excluding VAT);

— of Khabarovsk Krai, 772 roubles per 1000 m³ (excluding VAT).

para. 2. Approve and implement wholesale prices for gas produced by ОАО Rosneft-Sakhalinmorneftegaz and sold to the public:

— of Sakhalin Oblast, 417 roubles per 1000 m³ (excluding VAT);

— of Khabarovsk Krai, 523 roubles per 1000 m³ (excluding VAT).

para. 3. Approve and introduce tariffs for transmission over ОАО Rosneft-Sakhalinmorneftegaz trunk pipelines of gas produced by organisations not affiliated with ОАО Rosneft-Sakhalinmorneftegaz and intended for consumers:

— of Sakhalin Oblast, 39 roubles per 1000 m³ (excluding VAT);

— of Khabarovsk Krai, 154 roubles 60 kopeks per 1000 m³ (excluding VAT).

Federal Constitutional Law #2-FZK dated 17 December 1997 «On the Government of the Russian Federation» (FZ «On the RF Government»)

Article 14. Authority of the Government of the Russian Federation over the Economy

The Government of the Russian Federation:

Regulates economic processes in compliance with the Constitution of the Russian Federation, Federal constitutional laws, federal laws and regulatory orders of the President of the Russian Federation;

Decree # 239 of the Government of the Russian Federation dated 07 March 1995 «On Measures to Streamline Government Regulation of Prices (Tariffs)» (Decree 239)

para. 1. The list of industrial and technical goods, consumer goods and services for which prices (tariffs) on the RF domestic market shall be regulated by the RF Government and Federal executive branch agencies:

• Paragraph one of the List of Industrial and Technical Goods, Consumer Goods and Services for Which Prices (Tariffs) on the RF Domestic Market Shall Be Regulated by the RF Government and Federal Executive Branch Agencies: Natural gas, oil (associated) gas and dry lean gas (except for gas sold by gas producers not affiliated with Gazprom, Yakutgazprom, Norilskgazprom, Kamchatgazprom and Rosneft — Sakhalinmorneftegaz, and gas sold to the public and housing authorities), oil (associated) gas sold to gas processing plants for further processing, liquid gas for domestic needs (except for gas sold to the public)…

para. 1. List of Industrial and Technical Goods, Consumer Goods and Services for Which Prices (Tariffs) on the RF Domestic Market Shall Be Regulated by the RF Government and Federal Executive Branch Agencies of RF Constituents:

• Paragraph one of the List of Industrial and Technical Goods, Consumer Goods and Services for Which Prices (Tariffs) on the RF Domestic Market Shall Be Regulated by the RF Government and Federal Executive Branch Agencies of RF Constituents: Natural gas sold to the public and housing authorities …

para. 7. The government will not regulate prices (tariffs) or surcharges by any economic agents, regardless of their form of incorporation and departmental identity…, except for commodities and services stipulated in clause 1 herein.

Decree #1021 of the Government of the Russian Federation of 29 December 2000 «On Government Regulation of Gas Prices and Tariffs for its Transmission within the Russian Federation» (Decree 1021)

para. 2. Establish that organisations engaging in the production, transmission and sale of natural gas shall have to keep separate account of products (services) and costs for their production for the following activities:

Production of natural gas;

Services for natural gas pipelining;

Storage of natural gas;

Services for supply (sales) of natural gas.

I. General Provisions of the «Basic Regulations for the Establishment and Government Regulation of Gas Prices and Tariffs for Gas Transmission Services within the Russian Federation»

para. 2. «independent gas transmission organisation» means an organisation that provides gas transmission using gas pipelines belonging to it on the grounds of property right or on other legal grounds and is independent of organisations owning gas systems (the Unified Gas System, regional gas systems) and organisations owning gas distribution systems

«regulated activity» means an activity in which settlements for supplied gas (gas transmission) are based on prices and tariffs regulated by the government;

«retail gas price» is the price for gas sold to the public to meet personal needs;

«regulated wholesale gas price» means the duly set price at which gas suppliers (gas organisations) must sell gas at the offtake from the trunk pipeline system directly to end users using it as fuel and (or) feedstock or to organisations for resale to end users;

«regulated fee for supply and marketing services» means the duly established fee for supply and marketing services provided to end users that gas suppliers (gas organisations) charge on top of the regulated gas wholesale price.

Regulated wholesale prices for gas and fee for supply and marketing services are not applicable to gas produced by organisations that are not affiliated with Gazprom, Yakutgazprom, Norilskgazprom, Kamchatgazprom and Rosneft-Sakhalinmorneftegaz.

para. 3. The price of gas (any gas!) for the end user at the boundary between gas distribution networks and end user networks shall be based on the regulated gas wholesale price, tariffs for gas transmission over gas distribution networks and the fee for supply and marketing services.

If the end users’ networks are connected directly to the trunk pipeline transmission system, the price for gas for the end user at the boundary between gas distribution networks and end user networks shall be based on the regulated gas wholesale price and the fee for supply and marketing services.

If several organisations supply gas to end users, the regulated fee for supply and marketing services charged to end users shall be distributed among those organisations by agreement among the parties.

II. Government Regulation of Prices (Tariffs)

para. 4. Government regulation within the Russian Federation shall apply to:

a) gas wholesale prices;

b) tariffs for gas transmission over trunk pipelines for independent organisations;

c) tariffs for gas transmission over pipelines belonging to independent transmission organisations;

d) tariffs for gas transmission over gas distribution networks;

e) fees for supply and marketing services provided to end users of the gas (if gas wholesale prices are regulated);

f) retail prices for gas sold to the public.

para. 5. The government will regulate gas wholesale prices and tariffs for gas transmission over trunk pipelines for independent organisations until the transition to regulation of tariffs that would be uniform for all gas suppliers for gas transmission over trunk pipelines within the Russian Federation.

para. 6. The transition from government regulation of wholesale gas prices to government regulation of tariffs for gas transmission over trunk lines within the Russian Federation shall be in phases.

The first phase specifies government regulation of wholesale prices for gas and tariffs for its transmission over trunk lines for independent organisations, development of the methodology for calculating tariffs for gas transmission and its testing, establishment of one or more gas transmission companies for gas pipelining, and introduction into gas transmission of separate accounting of products (services) and costs allocated to the prime cost products (services).

In the second phase, the groundwork is laid for liberalisation of gas prices and limitation of government regulation of the gas industry through setting tariffs for gas transmission over trunk pipelines and gas distribution networks.

IV. Principles for the Establishment and Government Regulation of Gas Prices and Tariffs for Gas Transmission

The government will regulate gas prices and tariffs for gas transmission by setting fixed prices (tariffs) or their caps on the basis of:

a) reimbursement to organisations engaging in regulated activities of economically reasonable costs for gas production, transmission, processing, storage, distribution and supply (sales) (for wholesale price regulation), reimbursement of economically reasonable costs for gas transmission and distribution (for tariff regulating);

b) the establishment for organisations engaging in regulated activities of an economically reasonable rate of return on capital used in regulated activities (until the methodology for determination of capital assets, other tangible and financial assets used in regulated activities is developed, the object of accounting shall be the profit necessary to ensure the availability to those organisations of funds for servicing debt capital, development of production and financing of other reasonable expenses);

c) satisfaction of effective demand for gas and a balancing the economic interests of gas buyers and suppliers;

d) consideration within the structure of regulated prices (tariffs) of all taxes and other mandatory fees under RF law;

e) consideration of the difference in the cost of gas transmission and supply (sales) to various consumer groups and to various regions;

f) development of intra-industry (for gas supply) and inter-industry (between substitute fuels) competition.

para. 12. Regulated prices (tariffs) shall be based of methodological recommendations approved by the Federal Energy Committee of the Russian Federation in coordination with the Ministry for Economic Development and Trade of the Russian Federation separately for each organisation engaging in regulated activities, on the basis of separate accounting of products (services) and costs of their production.

para. 15. Tariffs for gas transmission over gas distribution networks and the fee supply and marketing services provided to end users by gas suppliers may be differentiated by consumer group depending on latter’s connection to networks at various pressures, gas offtake conditions, gas consumption and other factors.

Decree #162 of the Government of the Russian Federation of 05 February 1998 «On Adoption of Rules on Gas Supply in the Russian Federation» («Rules on Gas Supply»)

III. Procedure for Executing Contracts

para. 6. The preferential right to executive gas supply contracts (for gas by any producer!) shall be granted to gas buyers for government needs, for domestic and public needs, and to buyers that previously executed gas supply contracts, which will have the right to extend those contracts.

para. 8. The procedure for and conditions of gas transmission through the gas transmission system shall be established by the gas organisation or gas distribution organisation and shall be documented in a contract as per these Rules.

para. 9. A proposal to execute a gas supply contract is normally sent by the supplier to a buyer that previously submitted a bid to buy gas.

para 10. A gas organisation or gas distribution organisation normally sends proposal to execute a gas transmission contract to the supplier (buyer) simultaneously with a permit to access the gas transmission system issued in compliance with the procedure set forth by the Government of the Russian Federation.

IV. Conditions, Term and Procedure for Contract Performance

para. 17. In case of over-consumption of gas (of any supplier!) without prior approval by the supplier, gas transmission or gas distribution organisation, the buyer shall pay a surcharge for the gas taken in excess of the contractual amount and the cost of its transmission per day on the basis of the following factors:

from 15 April to 15 September — 1.1;

from 16 September to 14 April — 1.5.

This rule does not apply to gas consumed by the public or housing authorities.

p. 19. Executive branch agencies of Russian Federation constituents must approve schedules for:

Switching consumers to reserve fuels when it becomes cold and the procedure for implementing these schedules to ensure performance of the government contract for gas supply for government needs, of export contracts under international commitments, agreements for gas delivery for the needs of the public and housing authorities;

Limitation of gas supplies to buyers and the sequence for their cutoff if operating conditions in the gas transmission system are disrupted in an emergency.

Instructions for implementing these schedules and the corresponding change in the daily volume of gas supplied to buyers shall be provided by the Central Production and Dispatch Control of Gazprom.

These instructions from the Gazprom Central Production and Dispatch Control on conditions for gas transmission, supply and offtake will be binding on suppliers, gas transmission and gas distribution organisations and gas buyers.

VI. Settlements for Gas and Its Transmission

para. 30. Contracts under which gas distribution organisations act as suppliers must contain the following mandatory conditions for gas settlements:

Transfer of money received in specially opened transit accounts of gas distribution organisations for gas deliveries by those organisations;

Transfer of money credited to the special transit accounts of gas distribution organisations and the deduction of surcharges from gas distribution organisations to the settlement accounts of their suppliers no later than the day after the day when the money is received in these transit accounts.

para. 31. The terms of payment for gas transmission will be governed by the gas transmission contract on the basis of transmission tariffs set according to the procedure established by federal executive branch agencies.

---

[1] Moreover, some principles employed in this methodology form the basis for modernization of the methodology for setting tariffs for oil pipeline services[2] Chapter 1, Article 2, of the Federal Law «On Gas Supply» defines the concept of «independent organisation» as follows: an organisation that produces and supplies gas and is independent of organisations that own gas delivery systems, i.e., organisations that own gas distribution systems.[3] It is interesting to note that the «List of Non-consumer Goods, Consumer Goods and Services, Prices (Tariffs) for which are regulated on the domestic market of the Russian Federation by the RF Government and Federal Executive Branch Agencies», approved by the RF Government Decree «On Measures to Streamline Government Regulation of Prices (Rates)» of 7 March 1995 # 239, does not mention gas pipeline transmission.

[4] Here we do not discuss aspects of the determination of goods transmission; although they have their own intricacies, they are less susceptible to change over time, because the amount of gas transported the GTS and main delivery routes do not substantially change over time.

[5] This can be easily seen if regions are arranged according to their distance from the traditional gas producing regions

[6] This boundary was calculated on the basis of the wholesale price for industry, which is approximately 30% higher than the wholesale price for the public.

[7] After the Law «On Services of National Economic Significance» currently being developed by the FTS is enacted,, this problem will likely be solved

[8] For the first time in Russian practice of law, an attempt is made to formulate the definition of gas pipeline transmission.

[9] Recommended length — no more than 100 km.

[10] In the Methodology it is referred to as «tariff rate for using trunk pipelines», but since it is expressed in roubles/1000 m³, it would be more correct to call it «rate»

[11] The Methodology provides for averaging of data for the past three regulation periods, which makes the data «more even».

[12] At present, on the basis of the work by the Madrid Forum, Gas Directive 2003/55ЕС has been prepared and adopted

PDF-version with charts and diagrams.