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Hon Pete Hodgson
Minister of Energy

6 November 2002

To: The Chair
Cabinet Economic Development Committee

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Contents

• Purpose
• Executive Summary
• Background
  • Maui Gas Contracts
  • Gas Supply and Demand
  • Implications of Maui Pipeline Restrictions on Gas Supply in Northern Markets
  • Overcoming Maui Pipeline Restrictions Prior to 2009
  • Proposed Process for Achieving Open Access Prior to 2009
  • Government's Negotiation Stance
• Next Steps
• Consultation
• Fiscal Implications
• Human Rights
• Legislative Implications
• Regulatory Impact and Compliance Cost Statement
• Publicity
• Recommendations
• Appendix One: Estimated Overall Gas Supply to 2020
• Appendix Two: Maui Gas Supply and Demand in Northern Markets
• Appendix Three: Maui Gas Supply and Demand in Northern Markets Sensitivity Analysis

Purpose

1. This paper recommends a strategy for facilitating open access to the Maui pipeline prior to 2009 through commercial negotiation by the parties to the Maui contracts.

Executive Summary

2. The Government is a party to the Maui gas contracts, purchasing gas from Shell and Todd and selling the gas on to the Natural Gas Corporation (NGC), Contact Energy and Methanex. Maui gas is transported along the Maui pipeline (owned by Maui Developments Ltd, in turn owned by Shell and Todd). The Maui contracts, which expire by 2009, preclude non-Maui gas from using the Maui pipeline.

3. Maui currently supplies approximately 80 percent of New Zealand's gas requirements. However, Shell and Todd consider that the economically recoverable reserves are less than previously anticipated, and the supply of economically recoverable reserves may end in 2007 or 2008 (depending on the rate of use). A formal process of re-determining reserves is currently underway.

4. Modelling by the Ministry of Economic Development indicates that, even with the decline in Maui, there are sufficient known gas reserves available for reticulation and electricity generation purposes until at least 2010. However, if non-Maui gas cannot use the Maui pipeline prior to 2009, there could be shortages of gas in markets north of Taranaki for electricity generation before 2009. These shortages could begin as early as 2004 or as late as 2006/07. Security of electricity supply would be jeopardised, and electricity prices would rise as a result of any shortages.

5. Pursuing open access to the Maui pipeline through commercial negotiation is recommended to give greater certainty that sufficient gas can be transported to northern markets in a timely manner. Such negotiations are expected to be in the interests of the upstream and downstream contractual parties.

6. Officials recommend that the Government facilitate commercial negotiations for open access. It is suggested that the Government state that it is not seeking to improve its current position (thereby foregoing opportunities for commercial gains) but that it wishes to maintain the value of its existing contractual rights and will not accept any increase in commercial risk. This approach signals the Government's support in principle for open access prior to 2009 as well as providing the greatest chance for commercial negotiations to succeed and for the Government to minimise its risks.

Background

Maui Gas Contracts

7. Maui contractual arrangements currently involve the following key parties:

1. Shell and Todd own Maui gas and sell it to the Government. The Government buys Maui gas under a long-term take or pay contract that expires in 2009 (or earlier if economically recoverable reserves end earlier).
2. Maui Developments Ltd (MDL), which is owned by Shell and Todd, owns the Maui pipeline and operates the Maui field.
3. The Maui Gas contracts provide that only Maui gas can use the Maui pipeline until 2009.
4. The Government has contracts with "Users" (Natural Gas Corporation (NGC), Contact Energy (Contact) and Methanex) to sell them all the gas it is contracted to buy under the take or pay contract. The contracts with Contact and NGC expire in 2009, while Methanex has contracts to take gas from the Government (and Contact) until 2005. Reserve reductions resulting from the current re-determination process will result in a reduction in the Crown and users take-or-pay obligations and, depending on future off-take, could lead to users depleting their rights to reserves before the end of their contracts.
5. The Government faces significant risks if its contractual obligations under the Maui contracts are breached.

Gas Supply and Demand

8. As set out in the companion paper, Gas Sector Review - Paper 1: Background, Maui dominates both the supply of gas and the high-volume transport of gas to northern markets through the Maui pipeline. Supply from the Maui field reached its peak in 2001, during which it supplied 190PJ of gas. This was transported along the Maui pipeline for use in the following ways:

1. Electricity generation at the Taranaki Combined Cycle plant (owned by NGC¹), Huntly (Genesis), and Otahuhu (Contact). Approximately 92 PJ of Maui gas was used for electricity generation in 2001. This amount was higher than usual, because hydro-generation was less than normal in 2001.
2. Petrochemical production in Taranaki. Approximately 55 PJ of Maui gas was used for this purpose in 2001, almost all for methanol production. Production of methanol from Maui gas may end in 2005 (or earlier), depending on the availability and price of gas.
3. Reticulation to commercial and residential customers in Auckland, Waikato and the Bay of Plenty, and at several electricity co-generation plants. Approximately 43 PJ of Maui gas was used for this purpose in 2001.

9. Shell and Todd consider that the economically recoverable Maui reserves are less than previously anticipated and that Maui gas may now be expected to end sometime after 2007 - and possibly before 2009 - depending on its rate of use. More conclusive information is expected to become available later this year as part of the formal re-determination process being undertaken by the contracting parties.

Implications of Maui Pipeline Restrictions on Gas Supply in Northern Markets

10. Modelling by the Ministry of Economic Development (MED) indicates that there is expected to be sufficient gas supply available from already discovered fields to meet anticipated demand until at least 2010. While supply from Maui will decline, gas from other fields (such as Kapuni, Pohokura, Kupe and Rimu) will increase². At the same time, demand for reticulation and electricity generation is expected to increase, although demand for large-scale petrochemical production is expected to end in 2005.

11. The modelling also indicates, however, that not enough of the available gas can be transported to northern markets (from Taranaki to Auckland) to meet expected gas demand during the period before 2009 because of the contractual restrictions precluding non-Maui gas from using the Maui pipeline. Those contractual constraints will mean:

1. the amount of Maui gas available will reduce in line with the expected decline in Maui gas supply; and
2. additional gas can be supplied using the NGC pipeline that parallels the Maui pipeline, but this has a maximum capacity of only 10 - 11PJ per annum (compared with the Maui pipeline capacity to the Waikato of 125PJ per annum).

12. The transport constraint may begin anywhere between 2004 and 2007. While the Ministry’s “base case” suggests the transport constraint could begin as soon as 2004 (see Table 1), when it actually begins will depend on such things as:

1. the level of gas reserves (particularly in the Maui field) and its rate of off-take;
2. the period during which Methanex continues operating and its rate of gas use during that period (the longer it continues operating and the more gas it uses, the earlier the need for access to the Maui pipeline for non-Maui gas);
3. how much gas will be required for electricity generation. The base case shows significant increases are expected up to 2006 for electricity generation at Huntly (from the existing station and a new gas combined cycle plant Genesis says will be commissioned by the end of 2005) and, from 2006, for a new gas combined cycle plant likely to be built in Auckland.

   Table 1: Gas Supply and Demand in Northern Markets if Non-Maui Gas Cannot Use the Maui Pipeline 2002-2009 – Base Case (PJ/annum) ³

13. If steps are not taken to overcome the contractual restrictions that preclude non-Maui gas from using the Maui pipeline until 2009, electricity supply would be constrained for a number of reasons (with flow-on implications for supply security and prices):

1. Utilisation of existing gas-fired electricity generation capacity will be reduced. If the transport constraint prevents 20PJ per year of gas from reaching northern markets, a gas-fired generation equivalent to the size of Otahuhu B could not operate for that year. This equates to about a 6 percent reduction in electricity supply capacity.
2. The construction of new gas-fired power stations in northern markets would be delayed due to uncertainty of gas supply.
3. Alternative electricity generation sources such as using coal at Huntly would need to be used. This would be inconsistent with the National Energy Efficiency and Conservation Strategy and would increase greenhouse gas emissions.

14. Although there is some uncertainty surrounding around the date by which gas supply to northern markets will be constrained by transport limitations, the fact that a constraint will occur creates market uncertainty. This affects both the development of new sources of gas supply as well as inhibiting investment in new thermal generation capacity.

Overcoming Maui Pipeline Restrictions Prior to 2009

15. Officials have considered a number of options for overcoming the existing contractual provisions preventing use of the Maui pipeline to transport non-Maui gas prior to 2009:

1. By-Pass. A by-pass pipeline parallel to the Maui pipeline could be built. This is, however, unlikely to be practical because it is improbable that such a pipeline would be commercially viable in the long term (restrictions on use of the Maui pipeline end in 2009, and prices for transport on that pipeline from that date could be much lower than those on an new line given that Maui costs are sunk). Further, it is most unlikely that a pipeline could be constructed by 2004 when it may be required.
2. Gas Swaps. Gas swaps⁴ are sometimes used to provide gas wholesalers with increased flexibility in the location and use of available gas. Gas swaps do not, however, increase the availability of gas, nor do they remove the transmission capacity constraints arising from the Maui contracts.
3. Open Access to the Maui pipeline. Open access to the Maui pipeline prior to 2009 would allow non-Maui gas to use the Maui pipeline (to the extent it has spare capacity available). This will facilitate the flow of gas from the Pohokura and Kupe fields that are not yet in production. Any process to facilitate open access prior to 2009 would, however, need to be agreed by the parties to the Maui contracts (including the Government). In effect, this would mean, at the least, the partial re-negotiation of the Maui contracts.

16. Officials consider that the most practicable option is open access to the Maui pipeline prior to 2009, as this:

1. Could be achieved in time to overcome likely gas transport limitations;
2. Has the lowest overall economic cost as it uses an existing high-cost capital asset that will soon have spare capacity;
3. Should enable electricity generators to access gas, which is the most cost-effective means of generating electricity in the medium term; and
4. Will remove a barrier to the exploration for, and development of, new sources of gas supply.

Proposed Process for Achieving Open Access Prior to 2009

17. In pursuing open access to the Maui pipeline, the Government needs to be aware that, as a party to the Maui contracts, it faces significant contractual risks that require careful management. These are:

1. The Government's ability to deliver gas to Users of the quality specified in the Maui contracts may be compromised, leaving it open to sizeable damage claims if there is any impairment to plant or operations arising from the delivery of non-Maui gas.
2. The Government may be unable to meet its quantitative contractual delivery obligations for Maui gas. Without a guarantee of priority delivery for the three existing users, the Government would jeopardise its obligations under the downstream contracts and open itself up to large reparation claims. As an indication of scale, the Government's annual contractual quantity for 2001/2002 alone is 138 PJ, with users effectively paying around $330 million (including the Energy Resources Levy).
3. The Government may have a decreased ability to access its stock of pre-paid gas⁵, thereby reducing its value to the Government and increasing the risk that pre-paid gas would revert to Shell and Todd at the end of the Maui contract in 2009.  As at October 2001, 205PJ of pre-paid Maui gas was outstanding with an approximate value at Maui prices of $341 million. Much of the pre-paid gas is already committed to downstream users. The value of pre-paid gas is reduced to the extent that the ability to physically access it via the Maui pipeline is threatened or delayed (note that if Shell/Todd’s estimates of the early completion of Maui are confirmed in the re-determination process, the ability to draw down pre-paid gas is likely to be significantly reduced in any event).

18. The Government could consider two broad options for ensuring access to the Maui pipeline for non-Maui gas prior to 2009:

1. The Government legislating for open access to the Maui pipeline. Although legislation could enable open access to occur, it is undesirable as:
   1. It would be unlikely to achieve open access in a way that enabled the Government to manage the substantial contractual risks it faces. These risks result from the potential for claims against the Government for contractual non-performance, and related damages, in international courts from any party who suffered a loss as a result of the changes.
   2. It could result in serious adverse perceptions of New Zealand as a long-term investment destination as a result of the Government using legislation to overturn long-term contract obligations.
2. Achieving open access through commercial negotiation. Available information strongly suggests that it is now in the commercial interests of most, if not all, non-Government parties to the Maui contracts to pursue open access to the Maui pipeline prior to 2009:
   1. Shell and Todd would benefit from having an economic means of transporting gas from the Pohokura field to northern markets thereby enhancing the financial viability of the project.
   2. Shell and Todd, the owners of MDL, would also benefit from revenue for transporting non-Maui gas on the Maui pipeline prior to 2009.
   3. NGC and Contact would benefit from accessing additional gas to generate electricity and to increase supply to other electricity generation, commercial and residential customers.
   4. Methanex could benefit if sufficient non-Maui sources of supply are available to enable them to continue operating.

19. Officials recommend that open access arrangements for the Maui pipeline prior to 2009 be pursued through commercial negotiation. Such an approach is more likely to result in arrangements that enable parties to secure the benefits of open access and for the Government to manage the existing contractual risks. It also avoids the adverse perceptions arising from a regulated solution.

Government's Negotiation Stance

20. There are two broad strategies that the Government could adopt to commercial negotiations to open access:

1. An active, fully commercial, strategy, in which the Government takes a direct role in negotiations. Under this approach, the Government would negotiate directly with MDL (which owns the Maui pipeline) and the Government's contracted users, Methanex, NGC and Contact Energy.
   Adopting such a role in the negotiations might result in the Government obtaining some additional revenue from its contractual interest in the Maui pipeline. This additional revenue could be worth in the range of $0 to about $50 million per annum up to 2009, depending on the outcome of commercial negotiations ($50 million per annum would require 100PJ to be transported at 50 cents per GJ with the Crown receiving all of the proceeds). A more realistic expectation would be in the region of $5 to $15 million per annum. The actual amount of additional revenue gained would depend on the quantity of non-Maui gas transported and the outcome of fee negotiations.
   Adopting an active fully commercial strategy would, however, increase the possibility that the Government's actions would be used as an excuse by other parties for not reaching commercial agreement for open access, and applying political pressure to ensure that the Government’s commercial position is weakened.
2. A "facilitative" strategy, in which the Government does not take a significant role in commercial negotiations. Under this approach, the Government would set out its expectations to the other contractual parties. These would be:
   1. The Government does not seek to improve its current commercial position (i.e. not pursue potential additional revenue of $5 to 15 million per annum, as outlined above).
   2. The Government, however, seeks to maintain the value of its existing contractual rights. These rights relate, for example, to pre-paid gas. Open access may reduce the value of the pre-paid gas by deferring the time at which it is taken or create a risk that it cannot be accessed at all.
      Note: The effect of the first condition is that the Government will not seek any additional income. The effect of the second condition is that the Government will not give away any income that it is already entitled to under the Maui contracts.
   3. The Government will not accept any increase in the risk it faces as a result of the move to open access. These risks, which are discussed more fully in paragraph 17, relate to the potential for damages claims in the event that the Government is unable to meet its contractual commitments on gas quality and volume, and from an inability to access prepaid gas. Officials note that a number of these risks have already been advised to MDL.
   4. The access arrangements need to provide open non-discriminatory access to all potential users and cannot be biased towards those with an existing contractual interest in the Maui pipeline.

21. The "facilitative" approach has a number of advantages. It:

1. Clearly signals the Government's support in principle for open access to the Maui pipeline prior to 2009;
2. Places responsibility for finding a workable and acceptable outcome with the commercial parties MDL, Methanex, NGC and Contact Energy who have incentives to reach agreement; and
3. Reduces the risk that the Government's commercial negotiating strategy could be seen as holding up a negotiated solution.

Next Steps

22. If officials' recommendation of a "facilitative" approach to commercial open access negotiations is accepted, the next step would be for the Minister of Finance, in consultation with the Minister of Energy, to advise the Maui contract parties (MDL, NGC, Contact and Methanex) of the Government's requirements set out in paragraph 20 above. The companion paper Gas Sector Review - Paper 2: Market Structure and Economic Regulation contains a recommendation that the Government issue a Government Policy Statement setting out its expectations for gas market development. A Government expectation that open access will be negotiated by the parties to the Maui contracts with the Government adopting a "facilitative" approach is included in the draft Government Policy Statement.

Consultation

23. This report has been prepared by MED in consultation with DPMC, the Treasury, the Ministry for the Environment, and EECA.

Fiscal Implications

24. There are significant fiscal risks associated with pursuing open access to the Maui pipeline. These are discussed in paragraph 17 above. These risks arise to the extent that the Government is unable to meet its obligations under the Maui contracts and from any reduction in the Government's ability to access its stocks of pre-paid Maui gas.

Human Rights

25. There are no Human Rights Act implications associated with this issue.

Legislative Implications

26. There are no legislative implications associated with this issue.

Regulatory Impact and Compliance Cost Statement

27. There is no requirement for a Regulatory Impact Statement or a Compliance Cost Statement on the issues discussed in this paper.

Publicity

28. It is proposed that the Ministers of Finance and Energy make a public statement of the Government's position on open access to the Maui pipeline prior to 2009 and include it in a draft Government Policy Statement: Development of New Zealand's Gas Industry. Detail on the proposed Government Policy Statement and consultation processes is included in the companion paper, Gas Sector Review - Paper 2: Market Structure and Economic Regulation.

Recommendations

29. It is recommended that the Committee:

Appendix One: Estimated Overall Gas Supply to 2020

Appendix Two: Maui Gas Supply and Demand in Northern Markets

Base Case Key Assumptions

The following are the assumptions underlying the base case modelling.

1. Electricity demand growth averages 1.8 percent per annum.
2. Production from Maui ends in 2008.
3. Methanex closes in 2005 when its current contracts end.
4. Project Aqua (the new South Island hydro station) will produce 1,100 GWh from 2007, 2,200 GWh from 2009 and 3,300 GWh from 2011.
5. Huntly produces 1,000 GWh of electricity per annum from coal (about the same amount produced from coal over the last three to four years).
6. Renewables add 25MW of electricity per annum from 2004.
7. New gas combined-cycle thermal power plants are built north of Taranaki (to avoid Transpower transmission constraints and transmission losses arising from transporting electricity to Auckland).
8. The Taranaki Combined-Cycle thermal power station is able to run completely on non-Maui gas.
9. New Plymouth power station units are decommissioned in 2004 and 2006.
10. Demand for reticulation (including electricity co-generation) continues to increase at 1.7 percent per annum.

Appendix Three: Maui Gas Supply and Demand in Northern Markets Sensitivity Analysis

Year in which Access is Required to the Maui Pipeline for Non-Maui Gas

¹NGC has recently announced that it is seling its generation assets including its 360MW TCC plant, near Stratford.

²The gas supply assumptions underlying the gas sector modelling are set out in Appendix One.

^{3 This is a combination of Maui gas being sent along the Maui pipeline and non-Maui gas being sent along the parallel NGC pipeline (which has a capacity of about 11PJ per annum).}

⁴In relation to Maui, gas swaps involve a company accepting Maui gas from NGC or Contact, and supplying to NGC or Contact an amount of non-Maui gas in exchange.

⁵Pre-paid gas is gas paid for but not taken under the "take or pay" provisions of the Maui contract. Pre-paid gas may be taken in the last two years of the contract, or in any year where the Annual Contract Quantity is exceeded.