Repsol YPF MADRID

Home , Alberto Ruiz, Irwin Stelzer, Price Drop, Shell Centre

Madrid, 1999 III

CONTENTS

FOREWORD...... VII

EDITOR’S NOTE ...... XI

OPENING SESSION WELCOME MR. ALFONSO CORTINA...... 1 «ENERGY AND THE COMMUNITY OF MADRID» THE HONOURABLE ALBERTO RUIZ-GALLARDÓN...... 7 «DEFINING THE DECADE: ENERGY MARKETS AND ENERGY POLICY» PROFESSOR WILLIAM W. HOGAN ...... 11

KEYNOTE ADDRESS «THE POLITICAL ECONOMY OF MEXICO´S ENERGY REFORMS» THE HONOURABLE DR. LUIS TÉLLEZ ...... 17 DISCUSSION ...... 25

SESSION I HOW WE GOT HERE AND WHERE WE ARE GOING: OIL INTRODUCTORY REMARKS MR. JOSÉ LUIS DÍAZ FERNÁNDEZ...... 31 «THE PAST IS PROLOGUE: BACK TO THE FUTURE» MR. BIJAN MOSSAVAR-RAHMANI...... 33 «THE OPEC FACTOR» MR. NADER H. SULTAN ...... 39 «OIL INDUSTRY CONSOLIDATION: DOES SIZE MATTER?» DR. J.J. TRAYNOR...... 47 IV

«MERGERS AND MARKETS» DR. IRWIN M. STELZER ...... 53 DISCUSSION ...... 61

SESSION II HOW WE GOT HERE AND WHERE WE ARE GOING: NATURAL GAS, ELECTRICITY, AND REGULATION INTRODUCTORY REMARKS MR. PABLO BENAVIDES...... 67 «THE COMING AGE OF ENERGY GASES» MR. ROBERT A. HEFNER III ...... 71 «RESTRUCTURING NATURAL GAS MARKETS: THE VIEW FROM SPAIN» MR. ANTONIO BRUFAU ...... 77 «PRIVATIZING ELECTRICITY MARKETS: OPPORTUNITIES PAST AND FUTURE» MR. ROGER W. SANT...... 85 «THE ROLE OF GOVERNMENT: REGULATION AND REGULATORS» THE HONOURABLE WILLIAM L. MASSEY ...... 91 DISCUSSION ...... 97

SESSION III THE ENVIRONMENT: CLEAN, CLEANER, CLEANER STILL INTRODUCTORY REMARKS THE HONORABLE MARIA TERESA ESTEVAN BOLEA.... 107 «BUSINESS AND ENVIROMENTALISM» MR. MICHEL DE FABIANI ...... 109 «INGREDIENTS OF A PROACTIVE REGULATORY POLICY» DR. STUART L. DOMBEY ...... 115 «CLEAN FUELS» MR. JAN J.F. TIMMERMAN...... 123 «CLEAN CARS» MR. JUAN ANTONIO MORAL GONZÁLEZ...... 131 V

DISCUSSION ...... 139

CLOSING SESSION SUMMARY AND COMMENT DR. IRWIN M. STELZER ...... 149

BIOGRAPHIES OF SPEAKERS ...... 163

LIST OF PARTICIPANTS ...... 171 VII

FOREWORD

The Tenth Repsol-Harvard Seminar, whose Proceedings you will find in this volume, marks a special anniversary, a milestone in our series of meetings focused on international energy policy. As such, it provided an opportunity to look back to past Seminars: to reflect on positive achievements as well as on occasionally failed prognoses. It was also an occasion to look ahead: to analyze and preview the changes and challenges the international energy industries may expect at the dawn of a new century.

When the initial Repsol-Harvard Seminar took place in 1987, Spain was far less integrated into global energy markets. Instead, most oil, gas, and electric companies were either state-owned or operated as monopolies. Today, however, Spain is a free and open market where a great many international energy companies are active in a competitive environment.

Repsol, too, has experienced deep structural change and significant growth during that period, becoming one of the leaders of Spain’s VIII Foreword

private sector. Repsol’s most recent step in the process, successfully concluded in June 1999 (even as the Seminar was taking place), was the merger between Repsol and YPF, the leading energy company of Argentina. The new corporation, Repsol YPF, is a member of the top ten oil companies worldwide. This merger was not a goal in itself, but an important stage in our company’s growth and international expansion.

Coming back to the milestone Tenth Seminar, I would like to briefly highlight some of the guidelines for strategic planning that emerged from the discussions of those days. (Please be sure that I do not attempt to compete with the brilliant conclusions that Irwin Stelzer presented at the Seminar’s close.)

• Liberalization, privatization, and free markets have produced huge benefits, but regulation and regulators are omnipresent and are likely to remain so for the foreseeable future.

• The recent wave of mergers and acquisitions in the oil industry has created a number of enormous companies, but well managed second-tier companies will also have a chance to grow, to expand, and to be profitable.

• At future Seminars, it will not be enough to predict the future; we will need to discover tools and mechanisms to influence that future.

• The oil industry has a promising future despite the uncertainties it faces. However, the development of alternative fuels and the presence of increasingly stringent environmental regulation will be a part of the future landscape.

• Finally, we must be aware of the incredible pace at which the energy industry is changing. Indeed, we should expect that our Twentieth Seminar will differ from this Tenth Seminar even more than our first meeting in 1987 differed from our 1999 conference. Foreword IX

I would like to acknowledge and to thank Bill Hogan and his Harvard team, Irwin Stelzer, and Bijan Mossavar-Rahmani, not only for their planning and organizing of this Seminar but for their commitment to the Seminars from the very beginning. Their vision of what these meetings might accomplish is surely evident.

Finally, I would like to extend special thanks to all our distinguished speakers and guests for their active participation during the Seminar, particularly in the open debates following each session. These participants, like all those who have attended earlier Seminars, have inspired us to continue the series for the past decade and to look forward to future meetings. I hope to see you in Seminars in the next century.

Alfonso Cortina Chairman and CEO Repsol YPF XI

EDITORS´ NOTE

In 1987, our group from Harvard first met with officials from INH to consider the idea of holding a seminar in Spain on petroleum policy. Our goal was to bring together leaders from the oil industry, government, and academia —men and women who shape, even as they are shaped by, the ongoing rush of events in this turbulent industry— and to allow them to pause, step back a bit, and reflect on current developments and plan for future ones. The seminar idea grew into the Repsol-Harvard Seminars on Energy Policy.

In subsequent years, INH became Repsol, and Repsol has become Repsol YPF. But whatever its form, the corporation has continued to support the goal and sponsor the Seminars. With serendipitous timing, the recent tenth anniversary Repsol-Harvard Seminar in Madrid coincided with the merger negotiations between Repsol and YPF of Argentina. We can only admire Alfonso Cortina for his consummate élan and intelligence as he simultaneously hosted the Seminar and shaped the future course of his company.

To capture the substance of the presentations, the vitality of the discussions, and the broadening nature of the energy industry, we publish a volume of the Proceedings from each Seminar. One of the Semi- nar’s founders, Bijan Mossavar-Rahmani, formerly of Harvard XII Editors´ Note

and now of Mondoil Corporation, has been as instrumental in editing and producing the Proceedings as he has been in creating the Semi- nars, and no acknowledgments would be complete without mention of him. His ongoing contributions have been crucial ingredients in the success of this series.

Those of us who have been fortunate to participate in these programs —and to partake of the accompanying marvelous Spanish hospitality— are indebted to the leadership of Repsol YPF headed by its chairman Alfonso Cortina, and assisted by Jorge Segrelles, Simeón Vadillo Zaballos, and lván Cieker, and to Fundación Repsol and its president, José Luis Díaz Fernández, for their generosity in sponsoring this series. Once again we express our thanks to Susan Meyers of Repsol YPF and Pilar Suárez-Careño of SC Comunicación, for the tireless work they contribute every year to make this Seminar such a sparkling event.

A brief word about the ground rules of our sessions. They are always strictly off-the-record; presenters and participants represent themselves, not their organizations. All can and do speak freely, and nothing said in any session has been attributed herein without permission. In editing these Proceedings, the revised versions have been presented to the speakers for their amendment and approval.

For editorial assistance, we want to thank Patricia Bull of Cambridge, Massachusetts, who, for the third year, has served with distinction as copyeditor, and Michael Ames and his team at Puritan Press of Hollis, New Hampshire, who have made the editorial process of this publication a pleasure.

William W. Hogan, Guest Editor Harvard University

Irwin M. Stelzer, Guest Editor Hudson Institute

Constance Burns, Series Editor Harvard University PREPARING FOR THE TWENTY-FIRST CENTURY 1

OPENING SESSION

WELCOME

MR. ALFONSO CORTINA REPSOL YPF

It gives me great pleasure to welcome you to the Tenth Repsol- Harvard Seminar on Energy Policy. Our ambitious theme this year is “Preparing for the Twenty-First Century.” Throughout the course of the Seminar we will review and examine recent developments in the oil, gas, and electricity industries, and in the areas of energy and environmental policy, and then speculate on what directions the future may take, as the new century begins. To fulfill this challenging task, we are fortunate to have with us a group of brilliant speakers who will analyze the topics, and an audience of distinguished guests who will contribute to the discussions that will follow each panel.

Since these Seminars were launched in 1987, we have met in a series of delightful Spanish cities —Segovia, Toledo, Barcelona, S’Agaró, Granada, Seville, and Santiago de Compostela— all of them fondly remembered by those who were present at the time. It is not by chance that the Tenth Repsol-Harvard Seminar, the final one of this entury, is being held in Madrid. This special anniversary Seminar 2 Opening Session

required a very special setting; what better than young and cos- mopolitan Madrid, a city that is also full of history and rich in art and culture. In the past, Madrid was the capital of an empire; today it is Spain’s political and business center.

Madrid was established as a fortified town in the ninth century during the Moslem rule of Spain. For 200 years Madrid was a defensive center and starting point for the holy war in the Christian territories in the north. Even after Madrid’s conquest by Fernando I in the eleventh century, the city did not lose its border and military character, being constantly attacked and besieged. Finally, after the Christian reconquest in the South, it began to grow; it was made the royal seat by Philip II in 1561.

However, I will say no more about Madrid’s history because I am sure that the events we have planned for you here —a visit to the Thyssen- Bornemisza Museum; a dinner hosted by the Honorable Alberto Ruiz-Gallardón, President of the Autonomous Community of Madrid, in the historic Casa de Correos; a tour of the Prado Museum; and, finally, a special tour of the Royal Palace— will enable you to appreciate Madrid far better than my words can do.

PRESSURES AND RESPONSES

Now to turn to the essence of the Seminar. Oil companies will remember 1998 as one of the worst years in industry history: prices fell continuously from more than $16 a barrel to around $10 by the end of the year. Although prices have recovered somewhat in the first half of 1999 —thanks to the agreements among oil producers to limit their output— the situation is still far from being resolved.

However, factors such as the buoyant U.S. economy, an improving situation in Europe, the upswing in Asia, and the positive developments in Latin American markets still emerging from crisis, enable us to be moderately optimistic about the second half of the year. Welcome 3

Other developments also significantly influenced the positioning and performance of industry players. As major oil companies took drastic measures to reverse the sharp decline of their earnings, two alternative actions —mergers and restructuring— became prominent. We have seen the merger, acquisition, or absorption of major companies, notably BP with Amoco and then with Arco, Exxon with Mobil, and TOTAL with Fina. Other companies such as Shell have undertaken widespread restructuring, reducing corporate segments to achieve significant cost savings. In many mergers, the lack of real synergies between the companies was obvious. In such cases, the decisions were directed toward increasing corporate size (not to be confused with growth) and eliminating overlapping business segments. In the case of restructuring, the first goal has been to boost margins and the second to cut costs.

REPSOL’S PHILOSOPHY

At this point I would like to make a few comments about Repsol’s perspective on mergers. We have always believed that mergers in themselves are not a magic solution to corporate or industry problems. And purely defensive mergers —to make hostile takeovers by third parties more difficult by simply increasing the market value of the new company— are certainly not a guarantee of success. Indeed, many mergers based on this criterion have failed. To acquire companies because they are up for sale, without any analysis of the potential advantages to all parties, is to run the risk of a short lifespan. To ensure a successful outcome from a merger, decision makers must consider the affinities of the corporate cultures, the degree of complementary elements and synergies, and consequently, the real growth possibilities of the resulting new company.

Repsol’s ambitious operation currently taking place —our acquisition of Argentina’s YPF— provides a useful case study of a merger that promises a successful future. Repsol raised the idea of merging with YPF or of buying YPF not because all or part of it was up for sale. We did it because the strong and weak attributes of each company fit 4 Opening Session

almost perfectly, producing a new company that is not only larger but also better balanced. It has a larger international presence in areas of common priority that offer significant growth potential.

YPF’s contributions strengthen three of Repsol’s four strategic pillars: oil and gas reserves rise from 1,000 million barrels of oil equivalent (mboe) to 4,200 mboe; the international presence is reinforced, particularly in Latin America; and the integrated gas chain, including generation of electricity, is increased. And YPF will benefit, as Repsol plans to invest more than $3 billion in the new company.

This is a good example of one plus one being much greater than two. In addition, cultural affinities between the two companies and the two countries of Spain and Argentina will make it easier for the employees of Repsol and YPF to work together to position the new institution among the world’s largest, most effective oil companies.

TOWARD THE TWENTY-FIRST CENTURY

With this as background, I will briefly note the topics that will be discussed at each session as our speakers look at the past and the future, the challenges and opportunities, underlying the competitive and fast-changing energy industries. Their analysis, coupled with the discussions that follow the panels, will enable us all to consider how to better direct our activities on the threshold of the twenty-first century. I invite all our guests to participate actively in the discussions: collectively you represent the highest levels of industry, government, and regulation, and the worlds of academia and research.

• In the Opening Session, the Honorable Alberto Ruiz-Gallardón, President of the Autonomous Community of Madrid, will welcome us to Madrid and provide some comments on the achievements and status of the energy sector in his region. He will be followed by Professor William Hogan of Harvard University, who will extend Harvard’s welcome and offer a careful analysis of developments of the past decade that have affected the energy world. Welcome 5

• For our Keynote speaker we are honored to have with us the Honorable Dr. Luis Téllez, Secretary of Energy of Mexico. Dr. Téllez will outline Mexico’s ongoing program of energy reform in the context of its own political economy and pressures from the outside world.

• The first session, “How We Got Here and Where We Are Going: Oil,” will be chaired by Mr. José Luis Díaz Fernández, President of Fundación Repsol and a person of wide experience in the energy world. The panel will take a broad look at world oil markets and the likely direction of their evolution.

• The second session, “How We Got Here and Where We Are Going: Natural Gas, Electricity, and Regulation,” will be chaired by Mr. Pablo Benavides, Director-General for Energy in the European Commission, who will share his personal observations as an experienced regulator. Our panel of senior executives and regulators of these industries will give us their perspectives and offer comments on the future.

• As has been our tradition, the third session is focused entirely on one specific issue: “The Environment: Clean, Cleaner, Cleaner Still.” We at Repsol attach the greatest importance to this topic, as underscored by the unilateral measures for environmental protection that we have adopted, and will continue to adopt, in advance of government regulations.

This session will be chaired by the Honorable María Teresa Estevan Bolea, member of the European Parliament, whose experience on the European Parliament’s Energy and Environmental Committees makes her particularly well qualified to chair the session which will include industry executives on the forefront of regulatory activities.

• The Closing Session will once again provide an authoritative summing up and comment by Dr. Irwin Stelzer, Director of Regulatory Policy Studies at the Hudson Institute. Once again Irwin 6 Opening Session

will assume the challenging dual responsibility of summarizing all that has been said, debated, and concluded over the course of these two days, and also of editing with Bill Hogan the Proceedings of this Tenth Seminar.

Lastly, I do not want to end without thanking Bill Hogan, his team at the Kennedy School of Government at Harvard University, Bijan Mossavar-Rahmani, and Irwin Stelzer for the hard work and enthusiasm that they brought to the planning and production of this Tenth Seminar. Together, I trust, we will maintain —and even surpass, if that is possible— the high quality of the previous Seminars. 7

«ENERGY AND THE COMMUNITY OF MADRID»

THE HONORABLE ALBERTO RUIZ-GALLARDÓN AUTONOMOUS COMMUNITY OF MADRID

I want to express my thanks to Repsol, the Fundación Repsol, and Repsol YPF Chairman Alfonso Cortina for choosing the Region of Madrid, and its capital city Madrid, as the location for the Tenth Repsol-Harvard Seminar on Energy Policy.

The Madrid Regional Government endorses the measures to liberalize the Spanish economy, particularly the energy sector. We are sure that this is the best path to take into the next millennium —one that offers competitive prices and high-quality services to all our citizens. In accord with the directives of both the European Union and the Spanish government, Madrid’s policy is to consolidate liberalization in the energy sector, to make it more transparent and competitive, thus bringing lower prices.

Liberalization of oil and oil products in Spain began in 1992 and has accelerated with the passage of the recent Hydrocarbons Law. This law also liberalizes the natural gas sector. Liberalization of the electricity 8 Opening Session

sector was implemented by the Electricity Protocol of 1996, and was strengthened further by laws passed in 1997 and 1999. However, the government retains its interest in security of supply, the rights of consumers, and the obligations of the parties to the larger society.

ENERGY USE IN THE MADRID REGION

I would like to talk briefly about energy in the Community of Madrid. Our region, the capital region of Spain, and to a great extent its economic engine, is a huge energy consumer. The latest data indicate an annual consumption close to 7.3 million tons of oil equivalent (mtoe). But the Madrid region produces very little energy itself, making it almost totally dependent on outside sources.

Consumption data clearly establish the importance of the oil sector in the Madrid region. In recent years, oil and gasoline consumption has been increasing at an annual average rate of 1.54 percent. Sixty- seven percent of regional energy consumption is from oil and oil products, 20 percent from electricity, 9 percent from gas, and only 4 percent from solid fuels. The largest energy consumer is the transportation sector (52 percent); our region has three million cars and is the nation’s communications center. The next largest consumer of energy, the residential heating and air conditioning sector, follows at 21 percent, and the industrial sector is third at 16 percent. Although Madrid’s industrial sector is the second largest in Spain, it consumes relatively little energy because it consists primarily of technologically advanced companies.

To create wider energy diversification, we are working to increase natural gas consumption. Currently there are over one million natural gas consumers in the Madrid region, and we expect pipeline gas consumption to increase 11 percent annually in the coming years. This has been a recent development, for it was not until May 1987 that natural gas first came to Madrid through the construction of the Enagas Northern Gas Pipeline. That pipeline is now connected to the south and, via the Cordoba connection, to the Magreb-Europe «Energy and the Community of Madrid» 9

pipeline. We are also expanding the gas network infrastructure, which now extends 4,550 kilometers.

Let me turn now to the region’s electricity sector. The electricity infrastructure in the Community of Madrid is good; there is no area without electricity, in part because the Madrid system is part of the Red EIéctrica de España. We still depend heavily on power imported from other regions, as the 36 power stations in our region produce only 4 to 5 percent of the electricity we consume. We expect the demand for electricity this year to grow by 3 percent in Spain, and slightly more in Madrid, due to our higher economic growth.

PLANS AND PROGRAMS

The Community of Madrid is working to implement the EC energy directives and the programs of the Spanish Ministry of Industry and Energy, as well as our own local initiatives. In the electricity sector, our Plan for Improvement in the Quality of Electricity Supply has replaced the old rural electrification plans and mandates infrastructure improvements in many areas. Further, the Community has established incentive programs for achieving savings in electricity consumption, for example, by increased use of energy-efficient equipment and for reduction in the use of installed power. The Savings and Energy Efficiency Plan has defined three goals: increase the use of renewable energy; diversify sources of energy; and improve energy savings. Finally, we have begun a study on the structure of energy consumption in our region that will serve as a basis for designing future energy planning measures.

We are particularly pleased about our agreement with Repsol to locate the Repsol Technology Center and the Repsol Energy Institute in Móstoles, near the campus of King Juan Carlos University, a public university of the Community of Madrid. The citizens and government of the Community are grateful to Alfonso Cortina and to Repsol for establishing these two pioneering energy research centers in our region. The Repsol Technology Center will be the first of its kind in 10 Opening Session

Spain, able to compete with the best energy research centers in Europe. Repsol’s choice is logical because Madrid accounts for over 32 percent of the R&D work in the nation. The company plans to invest nearly 11 billion pesetas in the center project, which will open in 2001.

IN SUMMARY

As the new century dawns and our nation moves to increase competition among energy companies, the Community of Madrid is developing policies in support of this goal. Further, we are working to promote increased diversification to guarantee security of supply and to increase the market share of renewable energy sources. The Community of Madrid offers an outstanding environment in which consumers and industries alike can take advantage of the benefits of liberalization.

Members of the Tenth Repsol-Harvard Seminar on Energy Policy, I am delighted to welcome you to Madrid. 11

«DEFINING THE DECADE: ENERGY MARKETS AND ENERGY POLICY»

PROFESOR WILLIAM W. HOGAN HARVARD UNIVERSITY

This seminar series began little more than a decade ago. Our discussions and the development of energy policy in the last years of the millennium followed a trend already underway and likely to continue well into the future. Energy policy and the role of government changed from working against markets to working with markets as the instrument of public purposes. Market forces dominate. By contrast, many public policies that have been effective in diverting market forces have been counterproductive, exacerbating energy shortages. Activist public policies that might be effective in improving energy market outcomes have been unpopular and rare. There have been exceptions, but in the domain of energy, the most successful public policies have been those leading to a narrowing of public responsibility and an expansion of the market. The experience helps guide the formulation of good questions for the analysis of energy policy problems. 12 Opening Session

GOOD ANSWERS AND GOOD QUESTIONS

At the end of the Repsol-Harvard Seminar of 1988, Irwin Stelzer captured his summary of the meeting with the apocryphal story of the last words of a famous wise person. In short, the story goes: At the final moment, after a lifetime of contemplation and thinking, a wise person was approached by a humble disciple who asked “What is the answer?” The wise person responded “What is the question?”

This framework provides a good beginning for the X Repsol-Harvard Seminar on Energy Policy. It resonates with the advice given regularly to doctoral students anticipating dissertation preparation. Before the experience, students view the process as linear. Somewhere or somehow, a good question presents itself, and the task of the researcher is to dig into the details and find a good answer. After the experience, however, the new scholar has learned that the process is much more iterative. Good answers are easy to find once you have a good question. Proper formulation, and reformulation, of the question is the real challenge. Typically, the more you learn about a subject, the more you realize that the initial question that focused the search for an answer was not quite right. Rather, a slightly different formulation of the question, theory or model, would be in order. The new question changes the direction of inquiry, often in small ways that turn out to be important. And the process reinvigorates the researcher. It is always a great moment when you recognize that you have asked the wrong question, and understand why a new theory or model would be better.

The debates in energy policy of the last decade, reflected in the evolution of this Seminar, have had this same character of redefining the questions and refocusing the inquiry. By its very nature, the process is never complete. However, as we look ahead to the discussion here and to the developments to come in energy markets and energy policy, it is useful to be mindful of the crucial task of formulating —and reformulating— the right questions.

The subtitle of this presentation captures an element of this story. Our seminar series began in the early days of what would become known «Defining the Decade» 13

as the period of low oil prices. Before that time, any energy policy discussion would have been dominated by the tasks of government in managing the problems of high prices and energy security through mandates and stockpiles. But the force of the market changed the focus from one of government intervention to government facilitation of markets. Now we talk more about energy policy in terms of restructuring the rules and regulations for greater market flexibility and transparency, or using the market to achieve environmental objectives.

The questions have changed because we have learned more about the subject. The public policy focus on energy issues continues to define those areas where markets work poorly or not at all. But the nature of the inquiry has advanced to identifying the role of government in changing the rules of the market to achieve indirectly what cannot be obtained directly.

The questions that interest us in these Seminars have identifiable fea- tures. A reminder of the interactions between energy markets and energy policy sets the stage for illustrations of good and bad questions from the past, as we look ahead to the future.

PUBLIC POLICY AND ENERGY MARKETS

An organizing view of the role of public policy in any market, including that for energy, is the concept of market failure, where market failure is described in terms of the inability of a market to achieve the best outcome from the perspective of the aggregate impact on social welfare. This is to distinguish between the more general use of the term “policy” as applied to energy markets, where the actions of many private actors may be described as a policy, presumably with the goal of making a profit. If the market has no “defects,” these private policies will also serve the public good. Public policy has a role when this equation does not apply.

A typical example of market failure is in the existence and treatment of externalities. These externalities produce a gap between the private 14 Opening Session

and social costs of production. Private costs for capital, labor, and materials are internalized in production decisions. Added social costs arising from pollution or security of supply concerns do not affect private production decisions. From the perspective of society as a whole, the total social cost should be the relevant measure, but the unfettered market decision would focus on the private cost, understating the impact of production and consumption.

The conventional theory of externalities looks to government and public policy to internalize social costs. According to the conventional argument, the market will produce an outcome where the price of demand and private production marginal cost intersect. However, the welfare maximizing point would equate the price of demand and marginal social cost, perhaps through the imposition of an optimal tax on consumption. Externality value and the optimal tax can vary with quantity of consumption. Imposing the optimal tax would increase welfare despite a reduction in conventional measures of GNP.

The theory of externalities and market failure is not limited to the case of pollution and welfare-enhancing taxation. Over the last decade, energy policy developments have emphasized another key role for the public sector in making the rules and designing the institutions for market interactions. All but the most ardent libertarians recognize that the magic of the market depends on the context of institutions and rules. For instance, the foundation constructed of property rights and contract law supports markets where entrepre- neurs can innovate and capture the benefits of their ideas and efforts. Too often the public policy discussion assumes away the importance of these institutional changes, arguing that the market alone can bring a panacea.

But both scholarship and common sense teach that markets may not be able to develop the essential institutions needed to create and enforce property rights. As Douglass C. North, the Nobel Prize winning economist, noted, “Without conscious government action inefficient institutions can emerge, persist, and produce economic stagnation.” [Institutions, Institutional Change and Economic Performance, Cam- «Defining the Decade» 15

bridge University Press, 1990, p. 7.] Only a glance at the past decade in the former Soviet Union should be all that is needed to illustrate the failure of markets when government fails to define and enforce the rules, or when market-supporting institutions do not even exist. In the United States, the recent resurgence of antitrust activities is an example of this understanding. And the development of energy market restructuring and regulation provides another.

If public policy must examine, and change, the rules for operation of the market, then the subject of public policy analysis extends to include the operations of the market. It is important to understand the workings of the market and the activities of the market participants. Hence, those who participate in the market and those who study public policy have overlapping interests. Both need a sophisticated and broad understanding of what is happening. The market participants can benefit from a periodic change of perspective to look at the forest containing the many trees of their immediate attention, and the policy analysts need to make sure that their model of the forest contains the right trees.

Hence, the value of our conversations in this Seminar. The market participants bring a wealth of knowledge and wisdom. The analysts bring their models and theories. Together we try to reformulate the questions. Once we know the question, the answer should be easy, even obvious. If the answer isn’t obvious, we don’t yet have the right question.

SUMMARY

These Seminars have seen significant changes in the focus of energy policy discussions. We continue to have an interest in the self-education required to understand trends in the operation of markets. Many of the sessions have this character of conveying new understandings of the dominant forces facing, and employed by the market participants. From a public policy perspective, the dominant thrust of this experience has been to focus efforts on defining the role of government in 16 Opening Session

facilitating the use of markets to achieve public purposes, rather than using government to overcome the incentives and almost irresistible pressures that the market produces. The new emphasis is on developing institutions and rules that will support efficient competitive markets. Where necessary, the task of government in addressing market failures is to indirectly affect the results by changing the incentives, rather than to directly mandate what the market or the political process will not support.

This text is an abridgement of the longer paper written for this Seminar, “Defining the Decade: Energy Markets and Energy Policy.” The complete paper is available from the author. 17

KEYNOTE ADDRESS

«THE POLITICAL ECONOMY OF MEXICO´S ENERGY REFORMS»

THE HONORABLE DR. LUIS TÉLLEZ MINISTRY OF ENERGY, MEXICO

I would like to thank Alfonso Cortina of Repsol and Bill Hogan of Harvard for inviting me to Madrid to give the Keynote Address at this tenth anniversary Seminar. I am honored to present the case of Mexico’s energy reform policy to this distinguished gathering.

MEXICO’S MODERN ECONOMY

Mexico has experienced a radical transformation of its economy over recent years. Under the leadership of the Institutional Revolutionary Party (PRI), the nation has turned into one of the most dynamic emerging economies in the world, with an annual growth rate of more than 5 percent over the past three years. More than a decade ago, the nation took its first significant steps on the path of economic reform and development with the commitment to stabilize the nation’s public finances. As proof of our success, note that in the 1980s the public deficit was more than 10 percent annually; during the 1990s, the average will be less than 1 percent. 18 Keynote Address

A second important step in our modernization effort was the integration of Mexico into the world economy. We joined the General Agreement on Tariffs and Trade (GATT) in 1986 and the North American Free Trade Agreement (NAFTA) in 1994; we negotiated other free-trade agreements with Latin American countries; and we agreed to participate in the Asia-Pacific Economic Cooperation Forum (APEC). Today, we are negotiating with the European Union to enter into a free-trade agreement, an opportunity that will further enhance Mexico’s role as a global player. Simultaneously, we have followed an aggressive program of structural reform at home: we are working to change the role of the government from a supplier of goods and services to a promoter of the private sector, within a competitive environment with well-defined property rights.

Challenges for the Zedillo Administration In 1994, Dr. Ernesto Zedillo, the PRI candidate, was elected president of Mexico. The Zedillo administration came into office committed to continuing the process of widespread reform that has been so important in the nation’s economic growth. The administration’s record confirms this commitment. Important reforms can be seen, for example, in the telecommunications and transportation sectors. Between 1995 and 1998, we received around $7 billion in investments, and we changed the ownership and managerial organization of the basic infrastructure of railroads, ports, airports, and telecommunications systems. Another important reform was directed to our national pension system. During our first year in office, the Zedillo administration changed the pension system from a pay-as-you-go system to a fully-funded system, and established the basis for increasing our savings rate by about 5 percent of GDP.

However, the immediate and daunting task that the administration faced in our first days in office was to deal with the most severe financial crisis in the history of contemporary Mexico. We faced potential economic disaster —of a magnitude that has since been experienced in several Asian and other Latin American countries. Short-term gover- ment obligations came to more than $30 billion, and short-term private «The Political Economy of Mexico´s Energy Reforms» 19

obligations were roughly $20 billion. It was clear that we needed the full support of the United States and of international financial institutions like the IMF to support the short-term debt. With the help of officials in the Clinton administration, we received a short- term loan of $20 billion from the United States. I am pleased to note that we repaid the loan at the end of the year. In short, we spent our first year in office working to achieve economic stabilization and avoid a major collapse of our economy. And we succeeded.

Yet, despite the all-engrossing economic crisis of that year, we also worked on domestic reforms, making major changes in the areas that I have mentioned: telecommunications, transportation, the pension fund system. These reforms were not politically sensitive and could be passed in Congress without too much opposition.

TURNING TOWARD ENERGY REFORM

With the economy stabilized and the reform process continuing in consensual areas, the Zedillo administration turned to the energy sector. The energy sector plays a fundamental role in the development of any country, providing the foundation for all productive and daily activities. Even more, in a global economy a nation’s success depends strongly on the competitiveness of its energy sector. In recent years, on a worldwide scale, technological change and sweeping shifts in governmental regulatory policies have helped transform the energy industry. In most countries, energy companies have evolved from simple input providers to integrated global service providers, and activities formerly carried out by fully integrated monopolies are today open to competition. Overall, these changes have resulted in important benefits to end users and to society in general.

The Mexican energy sector, we believe, should be both a resource base for governmental social programs and a driving force for our country’s economic growth. But if it is to fulfill these functions, the sector will need to undergo considerable structural reform. For historical and ideological reasons, no significant effort in energy reform 20 Keynote Address

had occurred prior to President Zedillo’s administration; our state energy monopolies in hydrocarbons and in electricity remained largely intact. Considering these realities, the Zedillo administration developed a strategy for the entire energy sector —oil, natural gas, petrochemicals, liquefied petroleum gas and, most important, electricity. The goal is to create the necessary conditions for growth and increased competitiveness.

Oil and International Diplomacy In the oil sector, the Zedillo administration has undertaken important steps to strengthen and modernize Mexico’s oil industry. By taking advantage of our low oil production costs, we are working to optimize the present value of our hydrocarbon wealth by expanding the reserves base, increasing the production of oil and natural gas, and modernizing and expanding the national refinery system and the state-owned petrochemicals industry. It is important to note that these efforts in the oil sector did not present major political problems in that they did not require constitutional amendments and the political consensus that this process requires.

Despite severe budgetary constraints, the administration increased Mexico’s oil production from 1995 to 1998 by 17 percent. Average annual oil production in 1998 measured more than three million barrels a day (mbd), the highest level in Mexican history. During the five years of the Zedillo administration, we will have invested about $31 billion in our oil industry. However, we have not tried to open the industry to private investment, foreign or domestic; such a program would have no chance of getting through Congress.

In the international oil market, from late 1997 through the first quarter of 1999, crude oil prices fell sharply, severely affecting Mexico’s budget. We are not dependent on oil in terms of our GDP or our exports: oil accounts for less than 2 percent of Mexico’s GDP and less than 6 percent of our exports. But we are still very dependent on oil for our fiscal revenues: oil accounts for around 30 percent of government income. That is why Mexico took important initiatives in international «The Political Economy of Mexico´s Energy Reforms» 21

oil diplomacy, promoting international agreements to reduce world oil supply and balance the market in order to stabilize prices.

On March 12, 1999, at a conference in The Hague, we entered into an agreement with other principal oil producers to cut output significantly —our own included, of course. After much discussion, we agreed to cut 125,000 barrels a day, as part of the overall agreement with Saudi Arabia and Venezuela. Administration officials were skeptical that this decrease in production would raise our revenue, but in fact, prices have moved up, resulting in an overall increase of about 70 percent in the price of the Mexican oil basket between February and March of 1999. If all the parties continue to comply with the agreement through the end of 1999, the market will be stabilized.

Domestic Oil and Natural Gas Reforms In addition to expanding the oil industry, we have worked to open other energy sectors to private investment and international competition. For natural gas, laws enacted in 1995 allowed greater private capital participation in infrastructure developments for transporting, storing, and distributing natural gas. This has enabled us to meet our growing natural gas demand by providing a reliable legal framework.

In the petrochemicals industry, the government proposed measures for some privatization, but they were met with strong political opposition. Congress required the government to continue holding the majority stake in the plants to be sold off. This restriction made it difficult to guarantee the necessary stability to private investors, and we were unable to sell the 49 percent stake in the plants we had hoped to privatize.

Electricity Mexico faces its most formidable challenge in the electricity sector, and that is where President Zedillo has undertaken his major reform effort. In the next six years, demand for electricity in Mexico will grow at a rate of no less than 6 percent a year. This implies not only that a minimum of 13 gigawatts of additional generation 22 Keynote Address

capacity must be installed, but also that the government will need to invest approximately $5 billion each year, merely to keep up with demand. Any attempt to meet these requirements solely with public resources will not only risk the modernization and expansion of Mexico’s power sector, but will also divert funds essential to meeting other needs of Mexicans.

To deal with this challenge, the president has courageously embarked on Mexico’s most ambitious energy reform program. In February 1999, he submitted a proposal to Congress to amend two articles of the Constitution in order to restructure and liberalize the Mexican electricity industry. It was clear from the beginning that passage of this most ambitious reform would be difficult, especially since the administration no longer held a majority in Congress. However, even opening the discussion on such a vital reform, regardless of its intensity or ultimate success, is a worthwhile endeavor in itself.

The reform proposal for electricity has the following objectives:

• The reorganization of the electricity industry to allow a greater degree of competition, with national and international private investors participating under a mixed-participation scheme.

• The establishment of a short-term wholesale electricity market in which generators will sell their energy under competitive conditions and in which prices will be freely determined.

• The strengthening of governmental authority to guarantee a level playing field and to avoid any conflicts of interest and thus assure competition.

• The creation of a transparent and efficient subsidy policy for residential and agricultural consumers, with explicit welfare aims.

• The development of a transparent and reliable legal framework to offer security to private investors and to allow the National Energy Regulatory Commission to regulate transmission and «The Political Economy of Mexico´s Energy Reforms» 23

distribution systems in terms of pricing, investment, and quality of service for the benefit of final consumers.

We designed this proposal to allow Mexico to join in the technological and regulatory advances in the electricity sector so prevalent around the world. If Congress approves this reform, it will guarantee the electricity supply that Mexico will require in the future, with the best possible quality and price, in an open and competitive environment.

WINDS OF POLITICAL CHANGE

During the last few years, as a consequence of the consolidation of Mexico’s political life, the PRI has lost its majority in Congress and faces increased opposition from all sides, slowing the pace of the energy reforms. Facing opposition from other leading parties, especially on the left and even from within our own party, we lack a decisive consensus on the need to promote structural change in the energy sector. Ideological, historical, and political factors have all delayed our plans.

Electricity reform in particular generated an intense political debate, and its main proposals have been strongly politicized by the parties, legislators, and electricity labor unions, which have a strong influence in the Mexican union movement. The electricity proposal also gave rise to a broad left-wing mobilization, mainly by the Mexican Electricity Workers Union, composed of workers at one of the oldest unions in the country, in the distribution company of Mexico City. On the other hand, we have had the support of the other electricity union, made up of employees of the Federal Electricity Commission (CFE), the largest generating company, which also owns transmission lines and distributes electricity outside of Mexico City.

Congressional committees are currently analyzing the proposed bill, and the Ministry of Energy continues to work closely with the different parties to reach a favorable legislative consensus. Despite initial support from the Sole Electrical Workers Union of the Mexican Republic (SUTERM), the union of workers in the generation and the 24 Keynote Address

transmission sectors, some of our colleagues in the PRI, and some members of the center-right National Action Party (PAN), the proposal was not included in the legislative agenda. While the proposal is still being scrutinized, the Ministry is moving to increase generation capacity, promote competition, and encourage cogeneration.

TOWARD THE TWENTY-FIRST CENTURY

To attain sustained economic growth, a modern economy needs to achieve three goals: economic stability; integration with the rest of the world on favorable terms; and ongoing structural change. Regardless of the short-term legislative outcome of this electricity reform proposal, substantial achievement has already been made toward these goals. I have no doubt that the effort to reform our electricity industry is only a first step in the opening of Mexico’s energy sector. We will achieve these goals, sooner rather than later. 25

DISCUSSION

DR. STELZER You speak glowingly of free markets and competition and equally glowingly of an oil cartel that is designed to reduce production and artificially raise prices. How can you reconcile those two preferences?

DR. TÉLLEZ That is a difficult question. We want free markets and competition within our energy sector, but Mexico is a paradigm of how difficult it is to change an area of the economy that is loaded with politics, history, and ideology. During Ernesto Zedillo’s campaign for the presi- dency, we proposed a program to open up the whole energy sector to market forces because it was clear that an economy as large as Mexico’s could not work well with a single, completely vertically-integrated monopoly in hydrocarbons. The energy reforms that we have worked for —in the distribution and transportation of natural gas, the privatization of petrochemicals, the creation of an open market 26 Keynote Address

in electricity— have all been on the margins of the current political consensus.

At the same time, the government does have a real interest in our oil wealth and oil revenues. We were concerned that the severe economic difficulties in Asia and Latin America would cause a slowdown in world economic growth and, consequently, we would face lower oil prices. Our hard-won fiscal stability would be threatened. To stabilize prices and avert another financial crisis, it was clear that, for the short term, we would have to work with other oil producers to limit production. So, for the first time in Mexican history, we charted an aggressive diplomatic policy to bring together several important oil producers that had been at odds within OPEC. But we undertook this policy as a pragmatic action, with a clear understanding that it would be temporary. We believe in free markets and competition.

QUESTION We are all aware that as markets begin to open up, “the devil is in the details.” For example, how much of its traditional role can a government keep and still enable markets to work? Where should a government retain control? What are the limits to the market?

DR. TÉLLEZ The limits that we faced were not economic but political and ideological. It is an article of faith in Mexico that electricity and oil should belong to the state. So, to promote energy reform, we have had to convince Congress that change was needed. On the other hand, let me note that there was only minimal resistance to NAFTA and to privatizing other parts of the economy. But energy reform faces enormous political resistance.

We will not attempt to institute a working market until we have put a complete and well-designed regulatory structure in place. The order of the steps to be taken is very important. First, create the legal frame work and then establish the regulatory institutions. Only then Discussion 27

start the process of opening up and privatizing the different generation and distribution companies and allowing the wholesale market to work. Some countries have had problems because they have opened up their electricity markets and privatized their distribution companies before designing a regulatory framework.

We have designed a competitive environment for the electricity sector, and we are moving forward to create the complete structure. In our initial proposals, the government’s role was that of regulator, and private companies comprised the entire electricity chain. Congress responded that the national grid and the hydroelectric system should be kept within the public sector. We could accept that stipulation because, with good regulation and credible institutions, a government-owned transmission monopoly can work well.

One of the most difficult tasks that we have ahead of us if we are to be successful politically (which I think we will be, at the end of the day), is dealing with the government electricity monopoly which produces 92 percent of the country’s electricity generation and distributes 82 percent. (The remainder is distributed by another state owned company in Mexico City.) Our proposal restricts the overall holdings a generating company can have, as well as cross-holdings between generation and distribution companies. The decision about how many generating firms and how many distribution firms to create out of that monopoly will be an important and difficult one to make.

Mexico today receives $10 billion a year in foreign investment. If the reform were to take place and all the investments it would generate were to come from foreign capital, we would be getting additional foreign investment of $5 to $7 billion a year.

QUESTION You mentioned the difficulties that President Zedillo´s government faces in pushing forward with oil sector liberalization.Accepting that liberalizing upstream oil will be extremely difficult, is there any hope of seeing partial or total liberalization of the downstream oil market in Mexico? 28 Keynote Address

DR. TÉLLEZ Mexico, with a $450 billion economy, relies entirely on PEMEX for its supply of oil and refined products. An economy as large as Mexico’s, and one that we expect to grow at perhaps 5 percent annually, cannot rely on a state monopoly. One of the most important tasks for the next president will be to open up both the downstream and upstream markets. He should do this in the first two years of his administration. Energy reform will depend very much on the political clout that the new president can bring to the government and on whether his majority in Congress is large enough to pass constitutional amendments.

Liberalization will continue to face enormous political opposition. Our proposal takes this reality into account. It is similar to the Nor- wegian system and does not privatize the basic resources. PEMEX would not be privatized —that is politically impossible. But the upstream market would be opened up with a system that retains the rents from oil production and incorporates a bidding system. We have invested more than $30 billion in PEMEX over the last five years, but that is not enough. Opening up the oil sector has a much greater net present value for the Mexican economy than keeping PEMEX as a monopoly. But this is more of a question of politics than of policy.

Speaking for myself, as a public official, an economist, and a Mexican, I am convinced that if we do not open up our oil facilities completely, our economy will be much less competitive.

QUESTION Trying to assess the probability of the success of the current proposals, does the entire PRI support the administration’s proposals?

DR. TÉLLEZ The PRI is the government’s party, and it is my party. It has been in power for 70 years. We have the full support of the PRI for the Discussion 29

electricity reforms, with the few exceptions that I noted. The PRI is a center-left party, and in the current political situation we need to make an alliance with a party on the right, the PAN. The problem lies with garnering the necessary votes from the PAN. Its members favor electricity reform, and if they had a majority in Congress, they would pass the bill. With the present balance of power, however, we will have to negotiate with the PAN to pass the reform measure. If we are not successful, we will have to present a very tight budget at the end of the year, one in which the electricity companies will have their $1 billion governmental subsidy sharply cut. This may put political pressure on Congress.

QUESTION I have a comment on alternate paths to privatization. We are all aware of the examples of successful partial privatizations that took place in Norway and Sweden. I would add another interesting example, that of Bolivia. As part of an agreement with the World Bank, Bolivia restructured its power markets, using what they called a “capitalization process.” Bolivia sold 50 percent of the government- owned companies to the private sector and put 50 percent into a pension fund. The plan was well received by American and Spanish investors, and the Bolivian government had no difficulty in selling these companies, even as it retained governmental oversight. What is your opinion of this option?

DR. TÉLLEZ In the electricity sector, we need to have a competitive generation market. For that to happen, the Mexican government will have to give up its position as the predominant generating entity. The government would not be a credible competitor if it maintained its present 80 or 90 percent of generating capacity, so we think that it is important to open the system completely to private investment. Whether it is privatized in the markets with a minority shareholder who holds control for operational reasons, or privatized through a full-scale bidding process, is a matter that we still need to discuss. 30 Keynote Address

PROF. HOGAN I have had an opportunity to examine the Mexican proposals. I can tell you from my experience in comparing such plans in many parts of the world, that the White Paper on energy reform in Mexico that Luis TéIlez and his colleagues have put together is both very sophisticated and very subtle. In their entirety, and in those all important details such as the sequencing of reforms, the legal structure, and the market design, the Mexican proposals are an impressive effort.

We are very grateful to Secretary TélIez for coming to Madrid to tell us about the Mexican government’s energy reform and to participate in this open discussion. Thank you very much. 31

SESSION I

«HOW WE GOT HERE AND WHERE WE ARE GOING: OIL»

INTRODUCTORY REMARKS

MR. JOSÉ LUIS DÍAZ FERNÁNDEZ FUNDACIÓN REPSOL SESSION CHAIR

The subject of Session I is of great interest to us at a time when profound changes are taking place in the industry. Let me first note some of the major changes that have occurred.

Important mergers are sweeping the industry. The poor results achieved by petroleum companies in 1998 and in the first quarter of 1999 are promoting concentrations in which the basic assumption seems to be that “bigger is better.” This assumption may result in a valid goal when the merging companies are complementary, but not when the combinations are formed only for increased size, leading to companies so large that management effectiveness will suffer. In any case, it is a new, apparently unstoppable trend which has not run its course.

Markets are being liberalized in many countries, and governmental regulation and environmental politics are increasingly affecting the energy industry. The greening of the world’s politicians is here to stay, and pressures to change the environmental status quo will continue. 32 Session I

The outlook of producer nations has evolved from nationalistic to realistic —opening production to outside investors who can contribute technology, management skills, capital, and markets. Middle East governments are almost ready to invite private investors to participate in developing their energy resources, and OPEC is once again a major influence.

I turn now to our distinguished panel, who will discuss these developments at greater length, and attempt to assess the future direction of the industry.

• Bijan Mossavar-Rahmani will analyze the changing relationships between producer nations and private oil companies. Then he will consider future developments and the implications they will have for the industry.

• Nader Sultan will give a brief history of OPEC; its past, present, and future objectives; the power it now holds to influence oil supplies and prices; and the power it is likely to have in the future.

• J. J. Traynor will consider whether the current restructuring of the industry into larger companies foretells increased efficiency or cumbersome bureaucracies, and then he will judge if size matters.

• Finally, Irwin Stelzer, as the wrap-up speaker, will first give us his well-seasoned observations on the recent wave of mergers and acquisitions and then will ponder their real causes and ask whether they will affect competition. 33

«THE PAST IS PROLOGUE: BACK TO THE FUTURE»

MR. BIJAN MOSSAVAR-RAHMANI MONDOIL CORPORATION

That the world oil market is cyclical is generally accepted, at least with respect to the behavior of supply, demand, and prices. In the past three decades, the seventies, eighties, and nineties, the period most of us here are of an age to remember or even to have experienced, a now-too-familiar pattern has repeated itself numerous times: weak oil prices lead to increased consumption and less investment in supply, creating tight market conditions and eventual price run-ups, resulting either from a production disruption somewhere or at least a change in market sentiment. Higher prices, in turn, dampen consumption growth and trigger new investments in drilling which, in turn, lead to more supply chasing fewer buyers and creating the conditions for weaker prices.

These cycles also invariably translate into short-term reversals of fortune for the various players in the world oil market —the producers at one end of the pipeline, the consumers at the other end— and the pipeline itself, that is, the international oil companies. 34 Session I

Since the inception of these Seminars, the market has been through perhaps three such cycles, and we have come together annually to discuss —and often to lament— the implications of higher or lower oil prices on our respective companies or governments and to review alternative strategies to insulate ourselves —or even to take advantage of— the ups and downs of the world oil market.

And while the oil market continues to cycle, there appears to be a secular downward movement in oil prices in real terms. Price spikes —when they occur— appear only as hiccups on the long-term price lines, nuisances that eventually go away.

That realization —whether stated explicitly or recognized implicitly— together with the certainty, and indeed the growing frequency, of these cycles, is leading to profound changes in the structure and organization of the world oil market. It affects, among other things, producer-consumer relations, producer-producer relations, and the relationship between producers and the international oil companies.

The last is the focus of my presentation.

BREAKING THE BARRIERS

I well remember addressing one of the first Repsol-Harvard Seminars in 1989. I had just left Harvard to join the oil industry, and reported to this group about what I saw as the exciting new opportunities then becoming available in the international oil and gas exploration and production business. The barriers to entry to outside investment —the legacy of the nationalizations and expropriations of the 1970s— were beginning to come down. Only about 20 or so countries remained off-limits, I reported enthusiastically, in the Soviet bloc, in much of OPEC, and in a sprinkling of countries in Africa, South America, and Asia.

In subsequent Seminars, we discussed how that list continued to shrink, virtually year-by-year, but we never anticipated that by the «The Past is Prologue» 35

end of the 1990s the list would be down to less than a handful of countries. Of those, only two matter —Saudi Arabia and Mexico. But Saudi Arabia, too, is toying with arrangements —albeit limited ones — for outside private investments in its oil and gas sector, while Mexico relies on outside technical services, often paid for with outside credits.

The doors are being flung open, and the international oil companies are walking through. The past seems prologue.

Still, the reversal of the OPEC decade is not total or complete, in the sense that the new arrangements for international upstream investment do not exactly mirror those prevalent in the 1950s or 1960s.

In the earlier period, only a handful of companies —principally the “Seven Sisters“— dominated the international industry. They en- joyed the substantial support of their own governments, they made or destroyed host country regimes to suit their business interests, they carved up the world into zones of influence and activity, and they negotiated attractive concessions or production-sharing agreements designed to be in force for decades. The world looks very different today. Or does it?

Well, yes and no.

A RETURN TO THE MIDDLE EAST

There is no question that the largest companies are back —and that they are becoming larger —and probably more dominant— still. Big Oil is becoming Enormous Oil. The implications of a BP Amoco Arco or of an Exxon-Mobil —even of a Repsol YPF— on the international upstream picture have yet to be measured. But this concentration of money, technology, and political muscle cannot fail to shape the landscape. Of course, the oil industry today has far more players than in the past —dozens of state oil companies and hundreds of independents of various nationalities— all vying for a piece of the pie. But with the creation of the super-majors and the opening of low-cost, high-reserves 36 Session I

countries in the Middle East, for example, most other players are likely to be relegated to supporting roles or to less prospective places.

For the super-majors will again focus on the super countries —the low-cost, high-reserves, easily accessible countries of the Persian Gulf. That is to say, on their traditional playgrounds —the countries of their own birth— or at least of their adolescence or growth.

Let me recite some statistics with which most of us are familiar. Five countries in the Persian Gulf —Saudi Arabia, Iran, Iraq, Kuwait, and the United Arab Emirates— hold over two-thirds of the world’s proven oil reserves. Much of these reserves are low cost —no more than $1 to $2 a barrel to extract. Global production outside these five countries appears to have peaked, while the share of the Big Five grows, up from about 15 percent in 1985 to about 30 percent at present. Let me repeat: the share of Persian Gulf oil in total global supply has doubled in the past 15 years. And that share will continue to grow.

A SEARCH FOR PARTNERS

It will do so in part because the oil sectors of these countries as a group are likely to become beneficiaries of substantial injections of outside capital, technology, and management know-how in the coming years, as they trip over each other —while bulldozing over others— to create partnerships with Big Oil —Enormous Oil— to add to their reserves and production capacity through new exploration and more efficient extraction from existing fields.

Each country is choosing a different model for now, but these approaches are likely to converge over time to look more like those of the good oil days. For now, mostly for political reasons, Kuwait and Iran, at least, are offering not the risk- and production-sharing contracts of the past, which are now common almost everywhere else, but essentially risk-free service contracts designed to keep the ownership of the underground reserves in the hands of the state, while assuring the companies a competitive rate of return on their «The Past is Prologue» 37

investments. Most companies are willing to sign on, given the opportunity to establish a knowledge base and relationships that might prove useful in future expansion of activities. A few companies, though, are shying away from such deals as they see their own raison d’être as risk-taking for huge possible rewards. The downside to the state from such service contracts, of course, is that with guaranteed returns to the investors, certain project risks, including price risk, shift to the state.

Why should the state be in the business of taking investment risk when the companies are so much better able and willing to do so? The answer lies in the history of relations —that is a polite term in this context— between the states of the Middle East and the international oil companies during the first seven decades of this century. The companies took, by hook and by crook, more than their fair share of the oil and made the whole effort seem so easy.

Today there is more transparency in the operations of the companies, and governments are more sophisticated about creating risk-reward sharing mechanisms, which tie the rewards to the risks of individual projects. But other pressures are at work. In many producers, national budgets have come under extreme pressure with rising populations and weaker prices. The oil sector is one sector where outside money is readily available, freeing up resources for other needs. There has been a realization that their own national oil companies have not kept pace with the international industry. In many instances, pushing out the international companies in the 1970s resulted in a giant step backwards.

Take Iran as an example. This country has had no real exploration activity in some 30 years, and its production technology, for the most part, is just as old. In the upstream arena, 30 years represents many, many generations of technological change. To put this in perspective, the advances in exploration and production technology —that is, in three dimensional seismic evaluation, directional drilling, computer hardware and software capability, offshore drilling reach, and platform design— in the past five years have exceeded all the improvements of the previous 25. And Iran has had limited 38 Session I

access to the technology of those past 25 years, much less to the latest advances.

Despite its long history of oil production, therefore, Iran is virgin terri- tory in oil terms, at least by the standards of 1999. Many international oil companies drill more wells each in a month, some in a week, than Iran drills in a year. So in 1998 Iran offered some 40 buy- back projects in which investors are guaranteed a negotiated rate of return and are offered long-term access to oil. Next door, Iraq has offered equity deals to those prepared to negotiate now for the post-sanctions period. Kuwait is talking —mostly to large companies— about taking over the management of fields near the Iraq border under long-term service contracts. First we had buffer stocks, now we have buffer fields. Saudi Arabia has been flirting with unspecified ideas for outside investment in a range of projects, probably initially involving only gas.

Eventually these different models will converge on some common and familiar mechanism for a sharing of risk and reward.

THE PAST IS PROLOGUE...

The world’s large, cheap, accessible oil reserves remain in the Middle East. The hype of the past few years, coming out of Washington and London, that the Caspian Sea was the next Persian Gulf, the new Great Game —well, that was largely hype. The oil that is being tapped in Central Asia is largely the oil Soviet geologists had already found but Soviet engineers and planners could not get out to market. As someone said, the Great Game, for better or for worse, still involves the states of the Persian Gulf.

Now, as 30 or 40 or 50 years ago, oil is cheap, the producing countries are technologically, financially, and in some instances, territorially challenged, and looking to the West for help. Enormous Oil and its smaller siblings are chomping at the bit to get in.

It’s back to the future. Again. 39

«THE OPEC FACTOR»

MR. NADER H. SULTAN KWAIT PETROLEUM CORPORATION

I have been given the considerable challenge to cover the past, present, and future of OPEC —in less than 15 minutes! So— let me begin. I will start with the past, with OPEC’s original objectives, and add a few observations on its track record from our present perspective. Then I will turn to the future and suggest what appear to be the key issues facing OPEC: the division of interests among members, the impact of technology, the continued dependence on oil, and the environmental challenge.

INITIAL OBJECTIVES

When Venezuela, Saudi Arabia, Kuwait, Iran, and Iraq formed OPEC in Baghdad 39 years ago, its objectives were as follows:

• to coordinate and unify petroleum policies of member countries and to determine the best ways of safeguarding their interests, individually and collectively; 40 Session I

• to stabilize prices to avoid harmful and unnecessary fluctuations;

• to secure a steady income to the producing countries;

• to ensure an economic, efficient, and regular supply of petroleum to the consuming countries; and

• to ensure a fair return to those investing in the petroleum industry.

REVIEWING THE HISTORICAL RECORD

In reviewing OPEC’s track record, it is important first to note its changing ability to control or influence the market. Despite 39 years of growth in oil demand, OPEC’s percentage of supply in the world market is the same today as it was in 1961: about 40 percent. How- ever, OPEC’s share has varied greatly from year to year —in 1973, for example, OPEC produced 56 percent of world supply, but in 1985 that figure dropped to only 29 percent. Yet the organization holds 72 percent of the world’s reserves. This erosion of OPEC dominance, and the resulting rise in non-OPEC production, had its foundation in OPEC’s policy of nationalization and in the price spikes of the 1970s. Nationalization forced the oil companies to invest elsewhere, and the price spikes created the price umbrella that allowed non-OPEC production to flourish.

Shifts in Member Ranking The historical record shows a change in the relative positions of the five founding members over the decades. As Table 1 shows, in 1961, the largest producer was Venezuela, followed by Kuwait, Saudi Ara- bia,Iran, and Iraq. The data show rises and declines in production levels, and currently all the founders are producing below their peak level. Venezuela is producing at a level below its 1961 output, which probably explains its drive to expand its production capability and increase its relative share within OPEC. «The OPEC Factor» 41

In 1961, all OPEC members had relatively equal status, but since that time member positions have shifted significantly, Today there is one clear political and production leader, Saudi Arabia. Currently Saudi Arabia produces 30 percent of OPEC’s volume, up from 16 percent in 1961.

Table 1 Changes in OPEC Member Positions

1961 1961 1998 Production Share of Share of Million OPEC Peak Peak 1998 OPEC OPEC Barrels a Production Production Production Production Production Country Day (mbd) (percentage Year (mbd) (mbd) (percentage)

Iran 1.20 12.82% 1974 6.02 3.63 12.62% Iraq 1.01 10.79% 1979 3.48 2.15 7.47% Kuwait 1.74 18.58% 1972 3.28 2.09 7.26% Saudi Arabia 1.48 15.81% 1980 9.90 8.39 29.17% Venezuela 2.92 31.19% 1970 3.71 3.17 11.02%

OPEC Total: 9.36 28.76 World Total: 22.45 66.87

Source: Annual Energy Review 1998, Energy lnformation Administration (EIA).

Stability or Volatility OPEC’s main poIicy emphasis has been in the area of oil prices: in the early years, by setting prices, and in later years, by controlling production to support prices. Regarding OPEC’s success in price stabilization, the jury is probably still out. In the peak year of 1979, OPEC countries earned $673 billion (in 1998 dollars). In 1998, their earnings were only about $100 billion.

A related issue is price volatility, When OPEC was formed, the world consensus was that oil was a scarce resource. Eventually, it was believed, oil would run out, and its price would rise dramatically as supply tightened and demand grew. Today we have a different consensus. We believe that there are more than abundant oil and gas reserves, and that the real challenge is how to extract these resources by the most efficient means. 42 Session I

From its earlier status as a scarce resource, oil has been transformed into just another commodity, subject to both short-term and long-term volatility, So it should come as no surprise that OPEC has been unsuccessful in minimizing price fluctuations. Nobody in OPEC, or inthe industry itself, could have anticipated the advent of the futures market and its dramatic impact on volatility.

Notwithstanding the substantial investment to expand capacity, regional politics and conflicts have caused serious disruptions in the OPEC objective of a steady supply of petroleum to the consuming countries. It is particularly sad to note that Iraq, one of the five founding members, actually chose to wage war on two other founders, Iran and Kuwait.

The Fortieth Anniversary What then has OPEC achieved? For one, the fact that it is approach- ing its fortieth anniversary is remarkable in itself. A year ago, many analysts felt that the OPEC era was over, that OPEC was dead. Yet two months ago (March 1999), OPEC was able to take action to sucessfully reverse a steep price decline. To understand the true measure of OPEC’s continuing power, one simply has to ask, where would oil prices really be if OPEC released its spare capacity onto the market?

Another achievement was the creation of new alliances. In the last two years,OPEC has reached out to other producing countries whose oil exports also play a crucial role in their national economies. This new step has enabled OPEC to increase its influence on the world marketplace.

TOMORROW’S WORLD

So much for the past —what about the future? A key issue now facing OPEC is to create a long-term strategy, The organization has been much better at putting out fires than preventing them. Recently, an investment analyst quipped that OPEC is like a tea bag: it works well «The OPEC Factor» 43

when you put it in hot water. Although we give OPEC credit for its recent decisions, it still does not have a coherent policy.

As Sheik Yamani recently asked, does OPEC want higher prices or higher volumes? These are two mutually exclusive routes to the goal of higher revenues, yet they have different effects and put different pressures on policymakers: higher prices require collective output, restraint, and collective discipline; higher volumes, on the other hand, require expanding markets, concurrent production capacity, and patience to accept that prices might not rise until the time is right. At the last few meetings OPEC went for higher prices.

Internal Conflicts of Interest The fact is, key OPEC members have very different interests. OPEC observers divide the membership into two groups: the volume chasers and the price chasers. It is said that the interests of large reserve holders (like Kuwait, Saudi Arabia, and the UAE) lie in high production volumes, low prices, and expanding oil markets. Every time these members cut production in defense of higher prices, they lose market share to the other producers, since large reserve holders must bear a disproportionate share of the output cuts. Conversely, producers with limited potential to expand output show little interest in higher volumes and expanding oil markets. Their immediate interest lies in higher oil prices now.

This industry is perhaps the only one in the world where high-cost producers do not shut in capacity when prices fall. It is, in fact, the low-cost producers who shut in capacity, Such a situation is economically unstable and is a constant source of frustration among low-cost producers.

Pressures from Technology Technology directly impacts OPEC in two areas: costs and product substitution. More efficient technology helps to reduce the cost of production for every producer, so the relative low-cost advantage of 44 Session I

OPEC is eroded. And efficiency gained by lowering costs shifts the cost flow to prices. The major growth in non-OPEC producers over the last 15 to 20 years is attributable to advances in technology. Just five years ago, it was assumed that deep-water production below 1,000 feet of water would be accessible only at a price level of $30 a barrel. In March 1999, a Shell field, in 4,000 feet of water, started producing at a total capital cost of $3.25 a barrel. At $4 a barrel operating cost, you can see how technology has an impact on price.

It has been estimated, however, that the majority of new developers worldwide require a break-even price of $10 a barrel to sustain them. Some would argue that if the large OPEC producers, such as Saudi Arabia, Iran, and Kuwait, were to open their doors to heavy production, then even new technology would not have much impact on halting this decline in production costs. Under such a scenario there would be very few incentives to look elsewhere for oil. Certainly a projected cost of $2 a barrel in the Arabian Peninsula makes it difficult to justify spending $9 a barrel in the Caspian region, $10 a barrel in West Africa, or $18 a barrel in some parts of Latin America.

Another impact of technology is the creation of potential substitutes for oil. Spurred by environmental pressures, automobile manufacturers are developing “greener” automotive technologies. Conventional vehicles with direct injection now have greater fuel efficiencies, and we are seeing electric vehicles, hybrid vehicles with both internal combustion engines and electric motors, and vehicles powered by fuel cells. As an OPEC producer, I was sobered by an observation made by Professor Robert Mabro of the Oxford Institute of Energy Studies, who noted that the Stone Age did not end because of a lack of stones, and the Coal Age did not end because of a lack of coal. What will cause the end of the Oil Age?

Diversifying National Economies Another long-term challenge for OPEC members is to reduce their dependence on oil income by diversifying their national economies. Currently the oil dependence is overwhelming. In Kuwait, for exampIe, «The OPEC Factor» 45

93 percent of our revenue comes from oil, producing 80 percent of our GDP. To look at the problem from another perspective, consider that Switzerland has a GDP which is larger than the combined GDPs of all the Gulf Cooperation Council (GCC) nations together.

Oil prices have come down in real terms, and national expenditures have increased in real terms, so that real income has been reduced. However, lower-cost production is not the key dimension for OPEC countries. The $2 a barrel prodzuction cost is not what matters — what really matters to the OPEC producers is the price level that allow them to have the minimum politically acceptable level of government expenditure. It is certainly not $2 a barrel— it is probably closer to $15 or $16 a barrel. Below that figure, there are tremendous pressures on their economies and societies.

Climate Change OPEC also faces environmental challenges. It is no secret that the organization considers the Kyoto Protocol, issued in December 1997 by the United Nations Framework Convention on Climate Change, to be a major threat to its well-being. The problem for OPEC is that oil is clearly linked with the downside of the climate change problem. The challenge is to ensure that measures taken to manage climate change do not place an unfair burden on the oil industry.

Dr. Rilwanu Lukman, secretary-general of OPEC, recently stated that one of the main aims of the global warming theorists is to cut fossil- fuel consumption, and that OPEC nations stand to lose more than most from such a solution. He also expressed OPEC’s continuing frustration that the finance ministers of consumer countries derive much more revenue from a barrel of oil than do the OPEC and non- OPEC producers. (In Europe, as much as 80 percent of the final price paid by the consumer is made up of duties and taxes.) In addition, Dr. Lukman made a strong case for continued dialogue, and offered this admonition: if OPEC invests heavily to ensure future supply well into the twenty-first century, then the organization requires high-level consultations about the security of demand as well. 46 Session I

MEETING NEW REALITIES

OPEC is still alive and well. Its original objectives have not been fully realized and, as the coalition has grown, so have the differences among its members. Nevertheless, the strong common interests shared by OPEC members should encourage them to face future challenges together. OPEC’s recent outreach to other leading oil exporters to achieve common aims has demonstrated a willingness to meet the realities of the changing world marketplace. 47

«OIL INDUSTRY CONSOLIDATION: DOES SIZE MATTER?»

DR. J.J. TRAYNOR DEUTSCHE BANK

As we know, 1998 was notable for the wave of mergers that crested in the oil industry, leaving behind it three super-majors: BP Amoco Arco, Exxon Mobil, and Royal Dutch Shell. I have been asked to talk about these dramatic consolidations —their causes and their implications for the industry— and to speculate on how much the size of a company actually matters. What I can do, in the time allotted me, is to give a stock market perspective on the combinations and then to answer whether size does matter.

DRIVERS FOR CONSOLIDATION

As well as the merger wave, the year 1998 was also notable for the dramatic collapse of oil prices, the most drastic since 1986, which resulted in sharp drops in earnings for oil companies. These headline developments occurred more or less together; prompting a query about causality. Did the sharp fall in revenues provoke the mergers, or did it simply provide the evaluation opportunity that pushed the consolidations to their final stage? I would suggest that the second answer is more on point: that a series of longer-term trends became 48 Session I

clear by 1998, and the industry responded to these trends by major consolidations. The concurrent price and revenue drops provided confirmation for the aggregations.

Even as deterioration of oil prices gave the oil industry its biggest shock since the 1980s, the cost bases of most companies were rising, indicating that the cost-cutting programs put in place earlier in the decade were running out of momentum. Earnings per barrel during the 1990s, as shown in Figure 1, indicate that cost cutting had not been enough to protect company returns when oil prices dipped to $10 a barrel. In particular, finding and development costs for new oil and gas fields were rising, indicating that cost cutting in the exploration and production sector (E&P) was not as successful as we had been led to believe.

Further, these rising costs in new fields have been linked to the check- ered results of the international exploration programs of the major oil

Figure 1 Earnings Per Barrel vs. Oil Prices 1990 to 1998

Earnings Brent Spot Price $ Per Barrel $ Per Barrel 6.00 25.00 5.00 20.00 4.00 15.00 3.00

10.00 2.00

5.00 1.00

0.00 0 1990 1991 1992 1993 1994 1995 1996 1997 1998

Earnings (Net Income) $ Per Barrel Brent Spot Price $ Per Barrel

Source: Deutsche Bank «Oil Industry Consolidation» 49

companies over the last five or six years. International activities have produced some tremendous success stories (North Africa, deep-water West Africa, deep-water Gulf of Mexico, for example), but many new areas have been disappointments. The Caspian is one example, and Russia is another. (Who is making any money out of Russia?) Other areas, such as Asia and Latin America, have ambiguous track records.

Another development that promises longer-term problems stems, ironically, from the technological breakthroughs that have brought so many economic benefits and so much optimism. The new technologies for drilling and production, notably seismic 3D and horizontal drilling, allowed companies to target very specific new areas for exploration; they also enabled companies to extract more oil, more quickly, from their old fields. Financially, of course, this produced wonderful news. But in the long term, the new technologies have depleted reserves more quickly than anticipated. In terms of the average reserves life, the decade will end with a lower average figure than when it began, despite new technologies and massive spending.

By contrast, some significant developments appear not to have been direct catalysts for consolidation. For example, developments in the gas industry, particularly in Europe where the EU is looking to create more competition, imply considerable long-term adjustments by the industry. But these have not driven the mergers in the way that rising costs and falling reserves have done.

A NEW CLASS OF COMPANY

What can we say about these new companies —the super-majors or the “Three Sisters” that now dominate the industry? The stock market offers a useful judgment; it shows steady outperformance by the three super-majors. Their market capitalization totals about $600 billion, more than the rest of the oil industry put together. Their annual shareholder returns have averaged 20 percent over the past decade, certainly an attractive number. The smaller integrated companies, Chevron and Texaco for example, have produced returns of between 50 Session I

10 percent and 15 percent; good, but not exciting. The E&P companies have averaged only 5 percent. The stock market is clearly rewarding the sheer size of these super-majors.

In terms of scale, the super-majors are a different class of company. When integrated oil companies and their total market value are compared in terms of enterprise value and reserves bases, the figures must be drawn on two different scales because the super- majors are so much larger. Their prospective earnings also set them apart; within the next three or four years, the super-majors could produce in excess of $10 billion each. And they will supply about 10 percent of total world oil and gas demand. The gap between the super-majors and the rest of the companies is so great that it would be difficult to create another giant without combining several other companies.

A SEARCH FOR STABILITY

How do these super-majors plan to use their dominance? They seem to be moving into a period of restraint, when they will not try to grow their volumes as aggressively as in the past, but rather will work to control their capital expenditures and their costs, thereby consolidating their gains.

Less Capital Spending Consider capital spending plans, for example. The majors increased their oil and gas capital expenditure significantly in the 1990s, but since these expenditures have not generated the sort of volume growth that the companies had desired, they are being curtailed. The same data analyzed in a different light —capital expenditures as a function of depreciation— also confirm that the sharp increase in capex in the mid-1990s did not result in the expected volumes. The current message coming from the aggregation of capex plans for the majors is that less money will be spent —and, of course, it will be spent by fewer companies. The future seems to be a picture of capital «Oil Industry Consolidation» 51

restraint with only gradual increases in capex and a focus on returns rather than volume growth.

As capital expenditures are cut, we expect another round of redun- dancies in the industry. This is particularly significant in the super- majors which employ 45 percent of all of the people in the integrated oil industry today. These employees represent a valuable resource pool that would enable companies to capitalize on major new investment opportunities, perhaps in the Middle East, perhaps in the Caspian. But unfortunately, overall, employee numbers seem to be considered a controllable cost.

Lower Volumes All that restraint, all that cost cutting, have implications for volume targets. During the past year we have altered our forecasts for company volumes and are now predicting an abrupt downward revision in product expectations for most companies. With Shell, for example, we have dropped our volume targets by 10 percent in the last 12 months.

VOLATILITY AND RETURNS

All these shifts appear to be part of a larger search for stability in a traditionally volatile industry. This volatility is often reflected in the fluc- tuating average returns for the industry sectors of E&P, refining and marketing (R&M), and petrochemicals. We can speculate how much of the recent consolidation is aimed at getting the right kind of balance among upstream, downstream, and petrochemicals.Today the stock market is not very keen on petrochemicals because of the cyclical downturn, but the sector is clearly an important part of the integration balance. Even though oil price have risen in E&P, company values have not recovered. That suggests that may see more acquisitions, with the larger integrated companies buying E&P stocks.

Again we sense that much of the consolidation has been aimed at linking stable earning streams to growth. There is a strong correlation 52 Session I

between volatility of earnings and the returns that the companies are delivering in the market. The message is simple: companies with the lowest volatilities generate the best returns over time. But this is the case only for the super-majors —and for the French oil companies. We see the same result when we measure the price that markets are prepared to pay for companies that deliver a higher level of return on capital expended. Again, the larger companies have higher ratings because their returns are more stable over the course of the cycle.

SIZE DOES MATTER

To strike a balance between growth and returns, the integrated majors have moved away from seeking volume growth and are working on capital discipline —returns, balance sheets, and share buy-backs. (Significantly, this parallels a similar shift in the OPEC countries, as they focus more on price than volume.)

From a market perspective, size does matter; the market is pre- paredto pay more for larger companies. There are reasons for this bias. We see the potential for very large economies of scale, coupled with the ability to cut costs and institute share buy-backs. These companies have global positions in R&M and petrochemicals, as well as in the upstream, which will allow them to deliver world-class integrated energy projects. The result should be higher returns and lower earnings volatility.

Much of the push behind the mega-mergers has been the goal of striking a balance between more stable earning streams and a good measure of earnings growth. This balance will provide a positive and stabilizing force. The oil industry has come through the phase of low oil prices stronger and more attractive to investors than it had been before. 53

«MERGERS AND MARKETS»

DR. IRWIN M. STELZER HUDSON INSTITUTE

Since my background is in competition policy, my first reaction to the recent oil industry mergers was to consider whether they are likely to have anti-competitive effects. If they do, they will probably be stopped by one of the many regulatory agencies that must review them in the United States, Europe, and Latin America. Thus the need for further analysis would end —as would the need for this talk.

But in the broad, it is difficult to divine any such effects. True, there are aspects of these mergers that the competition authorities will find objectionable, but a few judicious disposals of some petrol stations here, and perhaps a refinery there, should give the antitrust authorities sufficient comfort to allow these deals to go forward —even though one of them, the merger of Exxon and Mobil, reunites the two largest components of the Standard Oil Trust that the U.S. government broke up in 1911. True, too, it is not completely foolish to worry about the shrinkage in the number of sources of independent thinking in the oil industry at a time when such thinking is very much needed. But such worries are insufficient to call a halt to these mergers, at least insofar as we can tell, based on current published information. 54 Session I

For as the “Seven Sisters” have morphed into what some are calling the “Three Witches “ —Exxon Mobil, Royal Dutch Shell, and BP Amoco Arco— we find an industry with fewer players, but still quite competitive, for several reasons. First, state-owned companies remain as important rivals. For example, BP Amoco Arco is the largest non-state-owned oil producer, pumping some 2.6 million barrels a day. Saudi Aramco produces more than three times as much —and could produce more if it chose to do so. Second, the newly merged companies must always face competition from other companies that are consolidating their positions, Repsol being the most notable example, with its acquisition of YPF.

WHY CONSOLIDATE?

So the question is not whether the oil industry will remain competitive after the bigger have absorbed the merely big. It will —with the main impediment to free and open competition coming from the OPEC cartel, newly emboldened to collude to restrict output in order to raise prices. The real question is: What is driving these mergers, and where will it all end? I think it is fair to classify the mergers into two groups. The very largest of the consolidations represent retreat —a shrinking of the industry, a withdrawal of human and other assets; the next tier represents the opposite— a desire to grow.

Low Oil Prices Various explanations are given for the very largest mergers. The first is low oil prices. In this theory, low oil prices are forcing cost-saving consolidations upon the industry. As proof, we are offered estimates of the billions to be saved by elimination of duplicative facilities. Indeed, so great has been the attrition at Amoco after its acquisition by BP and a $2 billion cost-cutting exercise, that the industry joke is: “How do you pronounce BP Amoco?” Answer: “The Amoco is silent.”

Although it certainly is the case that fewer resources should and will be devoted to finding, say, $10 oil, than to finding $30 oil, such «Mergers and Markets» 55

prices do not necessarily force mergers upon the industry. Low oil prices, one way or another, would force capacity from the industry if managements responded to such low prices in the interests of their shareholders —that is, by maximizing profits rather than by maximizing organizational size. Viewed this way, mergers give managements an excuse to do what they should be doing in any event— and probably would, sooner or later, be forced to do: scale back exploration and development and reduce investment in downstream facilities.

And become more efficient. For many years at these Seminars we have heard how oil companies are developing cost-cutting technologies and managerial strategies to keep costs in line with available prices; but those moves are quite independent of, and indeed pre- ceded, the current wave of mergers.

So a low oil price is not a very satisfactory explanation of what is going on among the very largest companies. Indeed, since several of these mergers have occurred, crude prices have risen some 60 percent, but the ardor for combination remains undiminished. Rather, I think the explanation lies in a series of institutional factors that have come together to threaten the industry into believing that the status quo is unsustainable, and that somehow there is safety in size. These factors then became grafted onto the organizational imperative that prompts managers to maximize size and perks rather than efficiency and profits —what economists call an “agency problem.”

Return to the Middle East The first of these factors is the possibility that Middle East governments are once again prepared to invite private sector companies to participate in the development of their national resources. Oil industry executives offer two reasons why this development demands that their companies be big. First, any projects that do become available are likely to be large, so large, that only the biggest companies will have the resources required to undertake them. Sec- ond, Middle East governments prefer to do business with only the largest companies. 56 Session I

I find these justifications for mergers unpersuasive. If capital markets work, capital will be available for these projects to any company or partnership of companies, large or small, that can win the right to participate in the development of these resources. Capital is flowing into Internet companies and genetic research companies; there is no reason why it cannot flow into any oil ventures that promise a return commensurate with the risk.

As for the preferences of Middle East governments for business partners, I wonder why, in the interests of their own sovereignty, they do not prefer to deal with smaller companies, rather than with giants whose worldwide reach gives them greater bargaining power than their smaller, but nevertheless substantial, rivals.

In short, the argument that already-large companies must get larger still to participate in the re-opening of the Middle East to private enterprise does not seem entirely persuasive —coming as it does from companies that have already reached the size of say, pre-merger BP or Exxon.

The Advance of the Greens The second institutional factor that seems to be causing some sleepless nights to oil industry executives is the increasing greening of the world’s politicians. This is not the forum to decide whether these public servants are convinced by the scientific arguments that the earth is warming, as Sir John Browne of BP Amoco seems to be, or are attracted by the tax revenues and economic controls that professed belief in such warming might justify, as one might fairly conclude from listening to the analysis of Exxon Mobil’s Lee Raymond. Nor is it the place to decide whether the age of the internal combustion engine is over, as Vice President Al Gore fondly hopes, while being chauffeured around Washington amidst a fleet of sports utility vehicles, or whether the advances being announced by Ford (among others) truly promise engines sufficiently low in emissions and high in performance to preserve a role for these engines in the future. «Mergers and Markets» 57

All we need to agree is that the industry believes that the greening of the automobile and other fossil fuel-using devices is upon us, with dire consequences for its principal markets. In short, let’s assume that oil industry executives believe that they are in a declining industry, that they are in “the last days of the Age of Oil.” Thus, oil company revenues will decline slowly over time, but capital expenditures will decline more quickly as the opportunities for investment in oil production and in new refining and marketing facilities shrink. Salomon Smith Barney estimates that the 175 companies it follows will cut exploration and development spending worldwide by 25 percent in 1999. BP Amoco-Arco has budgeted $3.6 billion for exploration and production this year, versus $6.3 billion in 1998. The result, other things being equal: enormous cash flow.

In this case, it seems to me that one option for industry executives is to make a graceful exit —return the money to the shareholders, acknowledge the grateful applause of the people who, after all, own the business— and pursue their hobbies or alternative careers in the public or private sectors. I have often suggested just such a course of action to my friends in the electric utility industry —to leaders of companies that have sold off their generation assets and are wallow- ing in cash— only to find that their opinion of my wisdom, and, indeed, of my sanity, has been adversely affected. Shareholders, it seems, are not viewed by many managements as having a legitimate claim on corporate cash flow.

So it comes as no surprise to me that the new, greener hue of national policies is used as a justification for using freed-up oil industry cash to diversify into solar and other technologies that are not self-evidently related to the oil business. And to garner public praise for farsightedness.

Political Clout This is not to say that there is no sense to this policy. In the future, environmental regulation and environmental politics will increasingly affect the industry. Big companies do have more political clout and a 58 Session I

greater ability to cope with the regulatory behemoth than do smaller companies. Sir John Browne will find it far easier to get an appoint- ment with the prime minister than will an executive in some tiny oil company, and Lee Raymond is likely to have greater access to the White House, and to be better able to position his troops around the Environmental Protection Agency, than will some small wildcatter.

The argument that size brings with it political clout also makes sense in the context of developments in those parts of the world where politics trump economics —in Russia and the Caspian, for example. Big companies are better positioned than smaller ones to do what has to be done to win the favor of the political powers-that-be in remote corners of the world.

In short, there may be good political and institutional reasons for the very largest of mergers, but the proffered economic reasons are not convincing. And it is not even clear that the BPs and Exxons had to grow even larger than they were in order to reap the institutional and political strengths they will need in an increasingly politicized industry, and one which, as Richard Perle pointed out to us last year, is not renowned for its political acumen. In sum, I view the mega-mergers as a combination of retrenchment with honor and management positioning for diversification into new ventures, without the annoy- ance of going to capital markets for funds.

MERGERS IN THE SECOND TIER

The situation confronting the next tier of companies is different. Remember, the BPs, Shells, and Exxons were highly diversified geographically before they began the latest wave of takeovers. But smaller companies, such as Repsol, found themselves dangerously undiversified in a world that is changing rapidly, and with management talents that have now been honed in the private sector and are restless for new worlds to conquer. For Repsol and for companies like it, an increase in size means greater geographic diversity, greater enthusiasm from investors, and sufficient scale to vie with its «Mergers and Markets» 59

increasingly bigger rivals. It is interesting to note the announcements of mergers of the largest companies emphasize costs to be saved, while announcements of mergers of second-tier companies speak of growth opportunities to be grasped.

And unlike the larger companies that acquire organizations that duplicate their own resources, second-tier companies are acquiring firms that complement their skills and resources, positioning them for growth. In the case of Repsol, it can teach YPF about marketing, and YPF can teach it about production.

A PERSONAL CONCLUSION

Much of what I have said is based as much on intuition as on hard empirical data —not because I am lazy, or because the people of Repsol are marvelous hosts, but for other reasons. I distrust estimates of cost savings to be had as a consequence of the largest mergers, in the sense that I fail to see that these mergers are a necessary means of cost cutting. I equally distrust what investment analysts and investment bankers tell us about investors’ preferences; such information seems to vary as much with the analyst as with market conditions. I prefer to rely on a distinction between mergers aimed at retrenchment, which promise cost savings but little else for the long-term future, and those aimed at positioning a company for future growth. And I believe there are limits to economies of scale in management.

Finally, I have a soft spot in my heart for the Davids of the world as they take on the Goliaths, and rather hope that they will be as successful as the biblical wielder of the proverbial slingshot. 61

DISCUSSION

MR. DE FABIANI I think the use of the term “Three Sisters” is not appropriate. It makes reference to the former “Seven Sisters,” but the world that they once so dominated no longer exists. The new oil majors are three global companies; nothing more, nothing less. Second, cost cutting is not new. I have had the privilege of working at BP for many years, and I can tell you that from the very beginning I have been inculcated with the goal of competitiveness which includes cost cutting. My third comment is about employment and growth. Including the outsourcing of many activities, we employ, directly or indirectly, a large and increasing number of people. We do not live in a black-and-white world of growth or cost cutting; in reality, it is growth and cost cutting.

Let me ask the panelists if these mergers in the energy industry are so very different from what is happening in the automobile industry, the pharmaceuticals industry, or the banking industry. Are they not simply the consequence of the globalization of markets?

MR. SULTAN I agree that the oil mergers reflect worldwide trends: indeed, we might really wonder why the consolidations have been so long in 62 Session I

coming. Until the BP Amoco merger, the same “Seven Sisters,” with the same rankings (except for Chevron buying Gulf in the mid- 1980s), led the industry for two decades. No other industry has remained that stable. And we should remember that even after these mega-mergers, the market share of the new companies is small relative to those of, say, the Microsofts, the Boeings, the Airbuses, or the big multinational banks.

DR. TRAYNOR We have been surprised that the cost cutting is continuing after the mergers. I agree that cost cutting already existed in the oil industry, but the scale has accelerated dramatically as a result of the mergers.

Further, we should remember that shareholders exist. The super- majors are the companies that have balance sheets to allow growth as well as share buy-backs. The smaller companies just don’t have the balance-sheet strength to deliver both robust growth and returns to their shareholders.

QUESTION How large is large enough? If you are a large player, how do you position yourself? What focus do you choose, what access? It may well be that even these large players are insufficiently large, that they do not have portfolio structures that would allow them to exercise all the options that they would wish, particularly in light of the scale and scope of energy businesses across the board, from upstream to the variety and complexity of downstream positions.

Will these new publicly owned super-majors be able to build interfaces with companies that are still strongly affected by government policy and ownership? I am thinking particularly of Gulf State entities, but there are others, too, which you could well imagine coming together with private companies in joint ventures. What is likely to be the future relationship between the players with large oil and gas resources and the new super-majors that want to play on the global scene? Discussion 63

MR.MOSSAVAR-RAHMANI Irwin Stelzer suggested that some of the low-cost, large-reserves countries should, in fact, be seeking private capital from smaller, more agile, less politically dominant companies. He raised an important point, but as he himself said, the fact is that governments still prefer to work with the biggest players who have better technology, broader management, and deeper pockets over a longer time horizon, thus allowing them to stay the course. Smaller, more agile players do not have these assets.

More important, the largest companies have developed substantial political capital, while the smaller players have not. Recall that I ref- erenced the Kuwaiti policy of trying to bring in large companies on a service-project basis to create a buffer zone with Iraq. The political leverage that the largest companies bring to the table in their negotiations, discussions, and arrangements —with the Persian Gulf countries at least, where political clout is critical to the survival of their own regimes— means that size does matter very much.

QUESTION I would like to respond to some of Nader Sultan’s insightful comments. When oil prices were $10 or $11 a barrel, many analysts concluded that OPEC was under no real pressure to drive oil prices higher. That was wrong. Nader Sultan offered the correct analysis:the major players in OPEC remain completely dependent upon oil as their primary source of income, unable to diversify their economies. His observation that Switzerland has a larger GDP than the combined GCC countries was particularly telling when you consider that Switzerland has virtually no natural resources. You could call that “the oil curse.”

Nader stated that $1 5 to $1 6 a barrel is the social-stability price range, the real price range for most of the oil-dependent countries. From that perspective, the GCC countries are among the higher-cost producers. Because government takes in OPEC nations are so high, realized value is greater in higher-cost places than it is in the lower- cost ones. Therefore, active developers and investors in oil tend to 64 Session I

operate in non-OPEC countries. How will the Middle East attract the investments needed to develop its oil?

MR. SULTAN You referred to an “oil curse,” but probably 90 percent of the world would like to have that curse! However, you were correct in saying that a price of $13 to $15 a barrel is about right, for Kuwait government objectives. Unfortunately, when oil is at $15 a barrel, governments are lulled into a comfort zone that precludes them from seriously considering diversification from oil. With regard to attracting invesments, Kuwait, Iran, and other countries do want to attract international oil companies. But to do so, we must be realists and offer a competitive rate of return on their investments.

QUESTION Many of us who developed our careers in an OPEC country are realiz- ing that OPEC as we knew it is dead. What we see now is a new organization rising from the ashes of the old OPEC, one that must tackle the issues the old OPEC failed to confront. Would you comment on how Kuwait and other countries are evaluating the future?

MR. SULTAN Initially I was surprised that Mexico joined the alliance. In relative terms, Mexico’s revenues from oil are small compared to the big OPEC countries. Then I realized the common denominator among Saudi Arabia, Mexico, and Venezuela: the U.S. market. The alliance is not so much about OPEC and oil as it is about the fact that Saudi Arabia and Venezuela cannot take action to cut supply, if in so doing they lose market share in the United States, their biggest market.

As for OPEC’s future, it is going to move forward under the leadership of Saudi Arabia. It is difficult to think strategically if your house is on fire; first you have to focus on putting out the fire. We have now done that with our recent production agreements. With that Discussion 65

achievement and with a rising demand, we now have the luxury to think strategically. I do not think OPEC is dead; rather, it has developed into a broader alliance.

QUESTION My question is for Nader Sultan. You said that OPEC had not been able to achieve the objectives set by the founding partners —at least not in their totality. What mistakes did OPEC make? Or were its initial objectives simply unattainable?

MR. SULTAN OPEC has evolved over time, with changing leadership, changing policies in individual countries, and changing regional groupings. Every time OPEC has tried to move forward, it has been sidetracked by major political and regional conflicts. But in the last two years OPEC members have rallied, because everybody has been hurt by the low prices. In the future, however, the problem of coordinating the interests of different groups will re-emerge.

QUESTION With the advent of the super-majors, geographically diversified, fully integrated, and well financed, will we see a few big companies forcing down the price of oil and taking their profit margins in other areas of the industry —like power generation?

MR. SULTAN We do not know what will happen as the super-majors go back to their roots in the Middle East, where, with less capital invested, they can explore, develop, and extract much more oil. These developments may pose a dilemma for the Middle East producers if the super-majors are moving towards a strategy of volume rather than price. As to whether the net effect will be greater or less revenue, I do not know. 66 Session I

QUESTION I am concerned about the state of reserves: at the end of this decade we have fewer reserves than we did at the beginning. Yet alternative fuels are not increasing their share of energy markets because technology has created better ways of increasing production of conventional fuels. So we have accelerated the rate at which we drain our reserves rather than developing new reserves to substitute for what has been produced.

I am not optimistic about these mega-mergers: they are often made primarily for short-term stock market gains rather than for the long- term future. When we talk about the oil industry, we should talk about the future. The giant companies will not develop any reserve below a certain size, so I see the future in mid- and small-sized companies; producing countries may do better with them.

MRS. ESTEVAN As a member of the European Parliament’s Energy and Environmental Committees, I receive a great deal of information about the amazing technological advances that have occurred throughout the entire petroleum chain. This is one reason that I see a splendid future for oil. Another reason for my optimism comes from potential increases in demand, particularly if you include the huge amounts of consumption that the underdeveloped countries will require.

DR. STELZER If governments do not interfere with the markets by promulgating inefficient regulations, I agree that oil does have a spectacular future —in terms of volume. Whether it has a spectacular future as a source of profits for private shareholders is harder to predict. And I agree that, unless we do something bizarre, the huge developing world will indeed have a great appetite for energy. What that energy source will be —coal, or natural gas, or oil, or alternative fuels— the markets will determine, if the regulators let them. 67

SESSION II

«HOW WE GOT HERE AND WHERE WE ARE GOING: NATURAL GAS, ELECTRICITY, AND REGULATION»

INTRODUCTORY REMARKS

MR. PABLO BENAVIDES DG XVII ENERGY, EUROPEAN COMMISSION SESSION CHAIR

In 1997, at the Repsol-Harvard Seminar in Seville, I described the progress of the European Union in establishing internal markets in gas and in electricity, and predicted the course of future developments. Today it is with some satisfaction that I can report my forecasts, in general, proved to be accurate.

The electricity internal market in the European Union is now up and running, and the liberalization process is underway, although two or three member-states have not yet implemented the directives into national law. Prices are falling, and exchanges of electricity are taking place, and I expect these developments to continue. A number of sensitive mechanisms for the electricity market remain to be put into place, dealing with exchanges of electricity, transmission prices and tariffs, congestion, and transmission capacity. We are working with all the principal EU players —transmission operators, regulators, market operators, and so on— to complete these final details. 68 Session II

In natural gas, the process has been slower, but the Gas Directive was approved in June 1998. We will soon meet here in Madrid to work out details concerning transmission capacity, third-party access, tariffs, and take-or-pay or ship-or-pay contracts. We expect the gas market will be up and running in the next few months.

LOOKING AHEAD

What of the future? Let me make some new predictions.

Liberalization Liberalization in the European Union will continue, and possibly accelerate. In three years’ time we will review the implementation of both details of liberalization in all the member-states. What we want for the EU is not 15 different liberalized markets but one single, liberalized market.

Regulation Regulation will not decrease. Paradoxically, a liberalized market often calls for more regulation than does a non-liberalized market. A monopoly market does not need much regulation: you just do whatever you are told to do. The issue is what kind of regulation we will have; national or EU. The European Commission does not plan to launch new EU secondary regulation; rather, we expect the member- states to implement both the Gas and Electricity Directives in a harmonized fashion.

Prices and Services Prices will continue to go down, albeit more slowly than they have fallen up to now. The liberalized milieu will motivate the utilities to offer new and better services to consumers, as competition brings about new ways of thinking in the EU market. Introductory Remarks 69

Industry Structure Integration will continue in several forms: geographic, intersectoral, and vertical. Vertical integration, of course, must be accompanied with necessary unbundling, in order to avoid cross-subsidization among different activities of any single utility.

Outside Pressures This liberalized framework will have to be reconciled with a number of new challenges from outside the industry, among them environmental problems and the likely social and labor effects. We also have to address security of supply, which is a growing concern in some of the member-states.

WHERE WE ARE GOING

With this information as background, let me introduce our panel, who will give us a larger —indeed worldwide— perspective as these energy industries move from a highly regulated environment into a larger arena for market forces to operate.

• Robert Hefner has long believed that natural gas, once regarded as a scarce and wasting resource, has a key role to play in the world energy scene. Mr. Hefner will describe the forces that have brought natural gas to the fore as a fuel of choice and will offer his prediction of its role in coming years.

• Antonio Brufau will help us to see Spain as a case study in the restructuring of the natural gas market. Discussions from past Seminars have shown us that Spain is moving into the future at a rapid rate, deregulating more quickly than was once thought possible, and restructuring to meet new circumstances in local and international markets.

• Roger Sant, a pioneer in seizing opportunities created by electricity deregulation and market openings, will discuss the factors 70 Session II

that have enabled his company to thrive globally —in markets once reserved for regulated utility monopolies— and will speculate a bit on future opportunities.

• Finally, William Massey of the U.S. Federal Energy Regulatory Commission will discuss where regulation is going, especially as it relates to the wires and pipe businesses that retain strong monopoly elements. He will also outline the fundamental principles on which he and his colleagues rely when they review the issues that come before them. 71

«THE COMING AGE OF ENERGY GASES»

MR. ROBERT A. HEFNER III THE GHK COMPANY

Conventional forecasts of world energy production for the next century have consistently depicted natural gas remaining below both coal and oil as a percentage of global production. Moreover, these forecasts have often shown natural gas below even nuclear energy for the second half of the next century. But I predict a significantly different scenario unfolding: increased consumption of energy gases (including methane and eventually hydrogen) will displace oil, coal, and nuclear as the world’s principal sources of energy. By 2050, the consumption of energy gases will surpass both coal and oil; by the end of the century, these energy gases will have captured, like coal in its heyday, more than 75 percent of the global energy market. We are entering the “Age of Energy Gases.”

For more than 100 years, free markets and human ingenuity worked efficiently to decarbonize our energy systems. But, beginning in the 1950s, government (here I refer to the U.S. government) began to usurp the market —by tinkering with price controls, for example, and by allocating use of fuels among sectors of consumers. The result 72 Session II

was a recarbonization of the energy systems. Only now, after a decade of deregulation, are the energy systems beginning to return to their natural evolution, continuing the decarbonization process.

THE PERIOD OF RECARBONIZATION

From the 1950s through the 1980s, natural gas supply shortages occurred because of stringent, politically-motivated price controls, coupled with artificial increases in demand. As a result, the United States nearly regulated its cleanest fuel out of existence. During the years of price control, natural gas, compared to oil on a Btu basis, sold for only 30 percent of the price of oil. Yet natural gas in a free market would normally bring a premium because it is a cleaner and more efficient fuel than coal or oil.

Because both oil and natural gas companies during this period believed that the United States was running out of natural gas, they assumed we could not sustain its increased use. In 1978, for example, prestigious members of the energy industry gathered at the Aspen Institute in Colorado and heard presentations of woe predicting the end of natural gas in the United States. One noted economist stated, “We are running out [of natural gas], and it will be soon.”

Until the early 1970s, natural gas was considered at best a margin- ally economic by-product of the oil industry, in danger of total deple- tion. However, the sources that were being depleted were either natural gas produced in association with oil and discovered because of the non-regulated and profitable price of oil, or natural gas from giant shallow fields that could be discovered and produced profitably at very low, regulated prices.

At the same time, the Federal Power Commission published projections of pitiful, declining natural gas resources. These projections also contributed to the consensus that we were in the midst of a supply short- age of natural gas. Later forecasters predicted sharply higher prices, and the collective wisdom of the day was that even on the chance that there «The Coming Age of Energy Gases» 73

was enough natural gas to meet demand, it would be too expensive; hence there was no alternative to coal or nuclear for power generation. The resulting projection, therefore, showed natural gas prices skyrock- eting at approximately the same rate that supplies were plunging.

THE TURN TO NATURAL GAS

During the past 20 years, however, two developments occurred: natural gas began to achieve independent economic value; and in the 1990s, the abundance of the natural gas resource base was con- firmed by published governmental and institutional assessments.

Yet, in my opinion, virtually all the current estimates of fuel consumption and the mix of fuels to meet demand through the next century are as much in error as those of the 1970s. One such conventional forecast is shown in Figure 1.

Figure 1 "Conventional" Forecast: Energy Production 1910 to 2090

Percentage of Percentage of Total Market Total Market 100% 100%

Natural Gas Solar Power 80% 80%

Hydroelectric 60% 60% Oil

40% 40%

Nuclear Electric Power 20% 20% Coal

0% 0% 1910 1950 2000 2050 2090 Source: Dr. John D. Edwards, University of Colorado, Oil & Gas Investor (January 1999) 74 Session II

I believe this type of projection is wrong for three fundamental reasons. First, I believe that current rates of population growth are not likely to be sustained during the next century. The educational information that will be disseminated to people around the world via the new communication technologies will cause birthrates to begin to fall. Second, I believe that we will find efficiencies in the energy systems well beyond our imagination and total demand will not be as large as projected. Finally, the conventional projections are wrong because the fuel mix will not come close to what is typically depicted in forecasts.

If governments do not step in again to legislate energy markets, the free markets coming into existence around the world will work their magic to join in the decarbonizing of our energy systems over the next century and beyond. This will usher in what I call the “Age of Energy Gases.” In this new world, nuclear power will go nowhere; it is dirty, dinosauric, and too capital intensive; and coal will revert to its declining percentage of the market.

China and India are generally thought to be exceptions to the declining use of coal. But I believe they, too, will turn to natural gas sooner than is forecast. China has ample supplies of easily accessible coal. Since coal deposits are usually linked to natural gas, I believe that China is heavily endowed with natural gas. I base this judgment not only upon China’s enormous quantities of coal and the coal/gas relationship, but also upon research I conducted in the mid-1980s when I traveled in China. However, in the 1980s, China’s leaders did not believe my reports of abundant natural gas resources in their country any more than American leaders did when I estimated abundant U.S. natural gas resources in the 1970s.

Nevertheless, I believe China will soon begin to explore, produce, and consume its vast natural gas resources. The Chinese people will not tolerate pollution from coal much longer; they want clean air and blue skies as much as everyone else. Within the next few decades, I forecast that China will begin its conversion from coal to natural gas. «The Coming Age of Energy Gases» 75

As for oil, I believe it has peaked in its percentage contribution to the global energy market. So today natural gas is the only abundant clean fuel that is continuing to set new consumption records around the world. Several years ago, at the International Institute for Applied Sys- tems Analysis (IIASA) in Austria, I worked closely with Dr. Cesare Mar- chetti and Dr. Nebojsa Nakicenovic, who have done fine energy fore- casting work for over a decade, using market penetration models. Never subscribing to the herd mentality, they have forecast that the natural gas share of the energy market will move toward 70 percent in the late twenty-first century. If this forecast is even close to what our future holds —and I believe their models are on the right course— other fuels will be significantly displaced from the global energy system.

So if we combine lower population growth, more efficiency in the energy production-consumption systems, and natural gas assuming the lion’s share of the market, we will see curves that should look dramatically different, as shown in Figure 2.

Figure 2 "Unbounded Thinking" Forecast: Energy Production 1910 to 2090

Percentage of Percentage of Total Market Total Market 100% 100% Solar Hydrogen Power

80% 80% Natural Gas-Methane H yd ro ele 60% ctric 60% Oil

40% 40%

Nuclear Electric

20% Coal 20%

0% 0% 1910 1950 2000 2050 2090 Source: Robert A. Hefner III, (May 1999) 76 Session II

HAVING IT ALL

The earth, the solar system, and the universe are basically composed of two forms of matter, solids and gases. Liquids are simply a transitional state of matter. Therefore, in the big scheme of things, I believe the “Age of Oil” to be only a liquid transition between the “Age of Solids” (animal dung, wood, coal) and the “Age of Energy Gases.” Over the last 150 years we have moved from energy systems that are capital intensive, localized, inefficient, chemically complex, dirty, macro, and immobile, toward energy systems that increasingly are decentralized, distributed, efficient, chemically simple, clean, micro, and more mobile. The future has already arrived.

The future path of energy consumption will have continuing increased natural gas use, transitioning over time to hydrogen. Hydrogen is the ultimate renewable energy source because its combustion produces water and oxygen. I forecast that hydrogen will be produced from sea water by efficient, low-cost solar technology and will be used both as a primary fuel and for the generation of electricity.

The Age of Energy Gases, together with revolutionary advances in communications, information, and education, will enable the world economies to become increasingly capable of sustaining economic growth while enhancing the global environment, possibly even despite population growth. Our future is bright!

This text is an abridgement of the paper written for this Seminar, “The Age of Energy Gases.” The complete paper is available from the author. 77

«RESTRUCTURING NATURAL GAS MARKETS: THE VIEW FROM SPAIN»

MR. ANTONIO BRUFAU GAS NATURAL GROUP

Just as coal was the main energy source of the nineteenth century, and oil of the twentieth century, the most important energy source of the twenty-first century will be natural gas. Yet the history of natural gas in Europe is barely 30 years old —from the first discoveries in the Groningen gas fields in the Netherlands and construction of the pipelines to the European markets in the 1960s and the pipelines linking the former Soviet Union to Europe in the 1970s.

Even as the industry looks forward to the dominant role that natural gas will play in the next century, we recognize that there will be many challenges to face as gas assumes this new primacy. In my presentation today, I will begin with a brief review of the current status of natural gas in the European energy market; discuss the changes in governmental legislation related to these developments; turn to the growing consumption of natural gas in Spain; and,finally, comment on strategies for the new market environment. 78 Session II

NATURAL GAS IN THE EUROPEAN ENERGY MARKET

Today, natural gas accounts for 21 percent of primary energy consumption worldwide, compared to solid fuels (25 percent) and oil (36 percent). In the last 20 years, worldwide consumption of natural gas has increased by 60 percent. By contrast, consumption of oil has increased by 10 percent. If current trends continue, within the next 25 years consumption of natural gas will equal that of oil. Growing demand from power generation based on new technologies is particularly significant; it could account for 25 percent of total consumption growth. Proven world gas reserves of 146 trillion cubic meters (Tcm) would provide for more than 60 years of production at current levels. The extent to which natural gas resources will be exploited in the future will depend not on supply but on economic, political, and technological factors.

The increase in demand in the European Union (EU) over the period 1997 to 2020 is predicted to be almost 35 percent, rising from 364 to 483 billion cubic meters (Bcm). Of this total, 25 percent is expected to come from power generation. The gas combined cycle (GCC) turbines, with their improved efficiency, environmental advantages, and lower cost, will provide the basic equipment for most new generating plants.

At the same time, this growth in demand will be accompanied by a decline in domestic production and an increase in imports from non- EU countries. Total imports are predicted to reach 344 Bcm by 2020, increasing import dependency from 43 percent in 1998 to 71 percent. This growing dependence on imports will be met by just three principal sources of supply: an oligopoly of Algeria, Norway, and Russia. Each of these countries has but a single monopoly exporter: Sonatrach in Algeria, GFU in Norway, and Gazprom in Russia. Currently these three suppliers produce 42 percent of the natural gas consumed in the European market.

In markets with gas-to-gas competition —Argentina, Australia, Canada, Great Britain, and the United States— ample domestic «Restructuring Natural Gas Markets» 79

supplies exist, and suppliers are subject to national regulations. European governments seeking to create a competitive gas market within Europe do not, of course, have similar powers to regulate their supply side.

REGULATORY CHANGES IN THE EUROPEAN GAS SECTOR

European gas markets have traditionally operated with a balance between an oligopoly of sellers and an oligopoly of buyers: a limited number of suppliers, each controlling the entire export capacity of its country-source, and a limited number of buyers, each aggregating its national demand. The transmission companies have sold gas to local distribution companies, often municipally owned or with mixed public-private capital, and directly to large industrial consumers and power generation companies.

In this market, the suppliers and the national transmission companies have been able to create the infrastructure and develop the market for natural gas: they have built pipelines and LNG facilities, marketed the gas at a price competitive with other sources, and established long-term supply agreements. Leaving aside questions about the increased efficiency or lower prices that gas-to-gas competition might have produced, the achievements of this pre-liberalized system have been considerable: long-term security of supply has been achieved, and Europe has developed a competitive gas sector in record time.

The European Gas Directive At the dawn of the new century, pressures for liberalization are bringing about sweeping changes in gas markets. In June 1998 the long-awaited European Gas Directive was enacted, designed to create a single domestic gas market to conform with the European single market principles. Although delayed in coming, this directive is the result of many years of deliberation by the best experts in this field, and it addresses all the complexities of balancing supply and demand. 80 Session II

The European Gas Directive mandates creation of a system to autho- rize construction and operation of additions to the gas infrastructure; unbundling of accounts for different activities; third-party access to networks; and the progressive liberalization of gas markets. The directive will certainly stimulate the emergence of new suppliers, and even new exporters, from the three major producer countries. However, there must be a transition period during which the current long-term take-or-pay (TOP) contracts are protected and investments in new infrastructure are initiated.

National Responses These mandates are to be implemented by national legislation in each member-state before August 2000. Spain and the United Kingdom have already adopted their laws, and other nations are in process. As Figure 1 shows, the Spanish timetable for liberalization is considerably more ambitious than that of the EU.

Figure 1 Opening Up of Natural Gas Markets Spain and European Union: 1998 to 2013

Percentage (%) 100

90 3 Mm3 80 3 5 Mm3 3 Mm 70 5 Mm3 15 Mm3 60 15 Mm3 50 20 Mm3 40 5 Mm3 10 Mm3 30 25 Mm3 20 10 2000 2003 2005 2008 2010 2013 10/98 4/99 New Spanish Liberalization Measures Spanish Hydrocarbon Law EU Directive Source: Gas Natural Group «Restructuring Natural Gas Markets» 81

Spain´s record of conformity with the European Gas Directive has been impressive. Following the passage of the directive, Spain moved to implement liberalization. The Hydrocarbons Law was passed in November 1998 and was amended in April 1999. Starting immediately (1999), all consumers in Spain of more than 10 million cubic meters (10Mm3) —approximately 60 percent of the natural gas market— can choose their own suppliers. In 2008, all consumers (the entire market) will be eligible to make their own choice of suppliers. By contrast, the initial threshold for EU consumers is 25 Mm3— approximately 30 percent of the market. At the end of the transition period in 2013, the threshold will remain at 5 Mm3 or just 45 percent of the market.

THE PICTURE IN SPAIN

Spain has recently reversed its pattern of low gas consumption: the demand for natural gas has surged. From 1985 through 1998, gas consumption increased fivefold, from 2.3 Bcm to 13 Bcm, and this sharp rate of increase is expected to continue. Current use is heavily weighted in the industrial sector (78 percent). Demand in the residential/ commercial markets is 17 percent, compared to an average of 40 percent in other major EU countries. Demand in electricity generation is notably low, just 5 percent, versus the 15 percent average of the EU.

The most conservative forecasts for future demand assume at least a doubling of the market (including power demand) in the next quarter century, from the current 13 Bcm to at least 27 Bcm, depending on the demand for power generation. More optimistic forecasts suggest a demand as high as 32 Bcm. This contrasts with the 40 percent increase expected for all the EU countries together.

Spain must import virtually all of its natural gas: current sources are Algeria (62 percent), Norway (16 percent), and Libya (7 percent). Domestic supplies were only 4 percent in 1998 and they are expected to be phased out during the next two or three years. LNG comprises 43 percent of current supply, and Enagas is the principal distributor. 82 Session II

To handle the expected increase in demand, the Gas Natural Group is developing a major investment program of $4 billion (3,546 million euros) over the next five years. Approximately 40 percent will be allocated to investments in infrastructure and 60 percent to local distribution networks. Figure 2 shows the current and planned infrastructure. The current infrastructure includes five gas entry points via two pipelines: from Lacq in France to Calahorra in Spain (Lacq-Calahorra) and from Hassi R’Mel in Algeria to Cordoba in Spain (Maghreb-Europe); three regasification plants at Barcelona, Cartagena, and Huelva; three underground gas storage sites; and the main pipeline grid (30,000 km long as of early 1999).

Figure 2 1998 Iberian Natural Gas Infrastructure (Current and Planned)

Gaviota Santander La Coruña Lacq Oviedo Bilbao León Serrablo Calahorra Pipeline in iperation Barcelona Zamora Zaragoza Pipeline planned or Segovia being built Salamanca Madrid System entry points

Underground storage Valencia facilities

Lisbon Natural gas fields

Regasification plants Córdoba Murcia Regasification plants Cartagena Huelva Granada being studied Import pipelines: Poseidón Málaga Lacq-Calahorra Cádiz Maghreb-Europe Tangiers ALGERIA

Source: Gas Natural Group MOROCCO Hassi R´Mel

STRATEGIES FOR THE NEW MARKET ENVIROMENT

Governments worldwide have embraced the principles of the new economics, including deregulation, globalization, and competition «Restructuring Natural Gas Markets» 83

as catalysts for the energy sector. In the EU, the creation of the single internal market is an additional catalyst to break the traditional monopolies in the electricity and natural gas sectors. But legal initiatives are not the only forces for change.

Market forces also bring competition. There is no way to prevent large industrial consumers, already active in a competitive environment, from looking for alternative sources of supply beyond their traditional gas suppliers. New gas producers will do their best to find new markets for their output as well as seeking a share of existing markets. Consumer and producer pressure, combined with reduced governmental concern for security of supply, will inevitably enlarge markets for gas demand.

The new market structure will influence the way that the gas sector is organized as well. In those countries with liberalized gas markets, companies still offering bundled services are on the way out. The new structure will clearly differentiate among production, transmission, distribution, trading and marketing, and other energy-related businesses.

On the other hand, differentiation among energy sectors is expected to fade away. Oil and gas companies have generally maintained close relations via cross shareholding and joint participation in common oil and gas fields. Closer cooperation will result from the developments in cogeneration and in transport. The current race for mergers and acquisitions among energy companies confirms this convergence. 85

«PRIVATIZING ELECTRICITY MARKETS: OPPORTUNITIES PAST AND FUTURE»

MR. ROGER W.SANT AES CORPORATION

Thus far, this session sounds like a commercial for natural gas, so I should begin with a disclaimer that I do not have any vested interest in the gas industry. My company, AES, is in the electricity business, and originally we were in coal. Nevertheless, many of my conclusions are similar to those of my colleagues from the gas industry.

THE 1990s IN PERSPECTIVE

The electricity sector has been explosive —truly amazing developments have occurred during the last decade. If I had been at the first Repsol-Harvard Seminar in 1987, I would not have predicted any of these changes. In retrospect, though, it seems clear that there have been three principal drivers of this explosion. The first is restructuring, and everything accompanying it: competition, liberalization, and opening up of the developing countries to private investment. The second agent of change has been technology. The impact of technological innovation, particularly the gas turbine, has been extraordinary, 86 Session II

beyond anyone’s imagination. Efficiencies from these turbines in the combined cycle mode are now surpassing the 60 percent level, versus 40 percent ten years ago. The third driver has been low, stable gas prices. Let me expand on each of these factors.

The enormous worldwide liberalization of the electricity sector took place in just a decade. In 1989 the picture was bleak; the majority of countries were closed to foreign investment. Only the United States, possibly the United Kingdom (just emerging from a nationalized regime), and Chile offered any opportunities. Today almost the whole world is open, with the exception of a few African countries.

Of course, not all countries open to liberalization offer competition or have real restructuring underway. In China, for instance, there are few good opportunities for private investment, with little chance of change anytime soon. At the other extreme is a country like Argentina, where there are almost no constraints on investment: you can build anything that you can get a permit for, and you take your chances in the pool as to whether you can sell the power you generate.

Turning to the second driver of change, technology, let me mention its impact on the price of electricity, specifically for electricity generation using combined cycle technology. As Figure 1 shows, in the mid-1980s, most of the projects we looked at offered about 6.1 cents/kwh. Today we are looking at 2.8 cents/kwh —less than half of what we had seen in the 1980s in nominal terms, and even less in real terms. That price drop came from all three components of cost: fuel, operation and management, and capital. The capital cost improvement reflects the greater efficiency from the turbines.

I do not know how many of you, ten years ago, would have predicted a price of 2.8 cents/kwh in 1999. But that is the price available in any country that has natural gas for electricity generation. I am not talking only about the United Kingdom or the United States; I am talking about Bangladesh, Egypt, Bolivia —any place where natural gas is available. The only caveat is that when you use LNG, you must add extra cost. Nevertheless, 2.8 cents/kwh is a stunning number. «Privatizing Electricity Markets» 87

Figure 1 The Price of Electricity Generation New Gas Combined Cycle Plants

Levelized Cost: Levelized Cost: cents per kwh cents per kwh 8.0 8.0

6.0 6.0 6.1

4.8 4.0 4.0

2.8 2.0 2.0

0.0 0.0 Mid 1980s Late 1980s 1999

Fuel Operation and Management Capital

Source: AES Corporation

One heartening effect of the new gas combined cycle (GCC) plants has been the environmental benefits they bring, particularly in reduction of CO2. As we replace the present generating capacity with GCC plants, we will get significant reductions in pollution and will be in accord with the Kyoto Protocol guidelines.

Robert Hefner has already discussed what has happened to wellhead gas prices, so I will just add that delivered prices have shown a similar decline. Instead of doubling the price that we would have forecast in 1989, we have actually seen a 15 percent decline in the delivered price of natural gas for power generation in the United States. Hefner’s point is well taken: every year the predictions for gas prices have been wrong —prices have continued to decline.

All these factors have combined to produce an interesting picture in the electricity capacity markets. As Table 1 shows, existing capacity in 1997 was about 3100 gigawatts. Since then, there has been a further 88 Session II

expansion of 29 percent in announced additional capacity —an un- precedented increase. All that capacity will not be built, of course, but it shows how the market has grown and where it is going. Also significant is where it is happening: not in Europe and North America where you would expect the big markets, but in Central and South America, Africa, the Middle East and, of course, Asia.

Table 1 1997 Worldwide Electricity Capacity Existing and Projected

Number of Existing Capacity New Plants Percentage Region (in thousand mwh) Announced Increase

Europe 1040 84 8% North America 931 79 9% Asia 766 551 72% Africa and the Middle East 181 92 51% Central and South America 158 78 50% Worldwide Totals 3076 884 29%

Source: U.S. Department of Energy (DOE) and U.S. Information Administration (EIA)

LOOKING AHEAD: THE NEXT DECADE

As I look at the next ten years, I am excited about the new trends I see. The past is prologue of course, and the important developments of the past decade will continue. What captures my imagination now is the shift in focus to the customer. Wholesale marketing has always been with us to some degree, but it has expanded. Power/gas commodity trading has grown at an extraordinary rate in the United States, and it is starting in other places as well. But the move in retail power is toward a much more sophisticated marketing strategy: offering energy services instead of just Btus or kilowatt hours.

Recently I looked up the market capitalization of America Online (AOL). If you take AOL’s market cap divided by its 18 million cus- «Privatizing Electricity Markets» 89

tomers, it appears that the market is valuing each customer at about $7000. That is a striking number, if correct. If we were to make the same calculation for our 14 million customers, we would be worth about seven times our current value. I think the AOL example teaches a very interesting lesson about the value of customers and indicates a potential goldmine that we ought to explore.

We utility people have always taken our customers for granted. Any opportunity to offer new services (if AOL is any indication) ought to be explored. We could well come up with ideas that we had never considered before. Of course, this shift is still nascent; few people are giving much thought to the services sector. But ten years from now, some companies will emerge as having done an extraordinary job of providing new services to their customers.

Let me summarize. All the developments that we mentioned — restructuring, technology improvements, lower (or at least stable) gas prices— are likely to continue for the next decade. With the breakthrough GCC technology now capable of surpassing the 60 percent efficiency barrier —the energy equivalent to running a four- minute mile— we can only guess at how much farther efficiencies can go. Restructuring will continue, and the process will offer lucrative opportunities throughout the world.

Finally, the new businesses that I mentioned —power/gas commodity trading and developments in customer services— are the new benchmarks that will define success in the electricity industry of the next century. 91

«THE ROLE OF GOVERNMENT: REGULATION AND REGULATORS»

THE HONORABLE WILLIAM L. MASSEY U.S. FEDERAL ENERGY REGULATORY COMMISSION

Let me begin with some basic information about the U.S. Federal Energy Regulatory Commission (FERC) and the industries we reguIate. FERC is an independent regulatory agency of the U.S. government that has broad and diverse responsibilities. Five commissioners, appointed by the president, set policy and resolve disputes by majority vote. We regulate the rates, terms, and conditions of service of over 80 interstate natural gas pipelines and also approve the siting and construction of pipeline facilities, taking environmental issues into account. For the electric industry, FERC has jurisdiction over wholesale bulk power sales and over the high voltage transmission wires of 166 electric utilities. FERC also issues licenses to over 2,100 hydroelectric facilities.

TOWARD A PRO-COMPETITION POLICY

The landmark year in the shift to a more competitive policy came in 1987 with the adoption of Order No. 436, which introduced 92 Session II

open-access transportation concepts to the interstate pipeline industry. Order No. 636, adopted in 1992, mandated the unbundling of gas sales and transportation, and adopted open-access requirements as the new model for transportation services. We also created a secondary market for pipeline capacity through capacity release. The success of our gas restructuring efforts is now taken for granted. There is robust competition for supply over a highly reliable transportation grid, which will grow by 35 percent over the next 20 years.

FERC has followed a similar course in electric restructuring policy through Order No. 888, issued in 1996, in which 166 electric utilities were required to open their transmission wires on a non-discriminatory basis. As with our natural gas restructuring, we required utilities to func- tionally unbundle their merchant and transmission operations. We also provided for the utilities to recover their stranded costs from customers departing to take advantage of competitive supply opportunities.

Emerging Markets Dynamic commodity markets have developed in gas and electricity. A vibrant national market has developed for natural gas, accompanied by significant price transparency and financial transactions. The number of gas and electric marketers has multiplied tenfold. Our electricity policies are facilitating robust regional bulk power markets.

Industry Consolidation Mergers in the gas and electric sectors totaled $120 billion in 1998, double the 1996 level. The U.S. industry is rapidly consolidating, creating large market participants. Pipeline conglomerates are being formed, and traditional electric utilities are merging. In 1998, $30 billion in so-called convergence mergers took place —electric marketers and utilities merging with gas pipelines and gas distribution companies. Several market participants, particularly gas and electric marketers such as Enron and generation companies such as AES, are now national in scope. El Paso Energy’s pipeline facilities, for example, now stretch from California to New England. «The Role of Government» 93

Pipeline Hubs A national transportation network with market hubs has emerged. There are now 40 hubs where pipelines intersect, facilitating markets for both commodity and capacity transactions and a new array of market-responsive products and services (e.g., parking, loaning, title transfers, and hedging).

Natural Gas-Fired Generation Natural gas will virtually fuel a new generation of electricity, for both economic and environmental reasons. Gas use for electric generation will triple to 9.2 trillion cubic feet (Tcf) by the year 2020. Many of these facilities are merchant plants, built to sell into a market rather than to particular customers. These gas-fired facilities are creating demand to increase pipeline capacity by 35 percent over the next 20 years.

Regional Power Markets In electricity, FERC’s policy of promoting regional transmission organizations (RTOs) facilitates large, transparent regional power markets such as the Pennsylvania-New Jersey-Maryland Interconnector (PJM), which dispatches 50,000 megawatts (mw) daily. An RTO would operate and maintain the reliability of the grid, create real-time balancing and ancillary services markets, and monitor for market power abuses. FERC’s goal is for an RTO to operate in every region by December 15, 2001.

Grid Independence The objective of FERC’s RTO policy is that the electric transmission grid be operated (or owned and operated) by a corporate entity, not controlled by any seller of generation or other market participant. Such a corporate entity may be an independent system operator (ISO) or an independent transmission company (Transco). Roughly 80,000 mw of generation are in the process of being divested or have already been sold by vertically integrated utilities. 94 Session II

CORE PRINCIPLES

Five core principles have guided our natural gas and electric restructuring policies. These five principles will continue to be the driving force behind FERC policies as we address the complex second-and third-generation issues that have arisen as a result of our open-access initiatives.

Commodity markets are best regulated by the forces of competition. The price of natural gas as a commodity was deregulated completely by Congress, and gas now is bought and sold at market- clearing prices unencumbered by regulation. The retail sale of electricity continues to be regulated, but is sold wholesale at market-based rates. Federal policymakers believe that natural gas and electricity can be supplied through competitive markets; that competition can discipline commodity price better than regulation; and that competition unleashes the creative energies of market participants to develop innovative products and services.

Regulatory policies should facilitate larger markets having many commodity sellers. There is a vigorous North American market for natural gas. Through our policy promoting RTOs with efficient transmission pricing, we are attempting to eliminate balkanization and facilitate large regional markets for bulk power. RTOs will also be required to eliminate any barriers to trading with market participants in neighboring RTO regions. By increasing the number of competing sellers, larger markets can also mitigate horizontal market power concerns.

Pipelines and wires have monopoly characteristics and must be appropriately regulated to prevent monopoly abuse. FERC will continue to regulate rates, terms, and conditions of service for pipelines and electric transmission facilities. In addition, we have proposed more flexible rates and the use of negotiation for terms and conditions of pipelines. Performance-based rates may be appropriate for electric transmission, and congestion must be managed efficiently via techniques such as locational marginal pricing. «The Role of Government» 95

Pipeline transmission and electric transmission must be operated without discrimination or preference. Commodity markets require non-discriminatory access through the transmission network.Open-access tariffs with clear and non-discriminatory terms and conditions of service are key to creating vibrant commodity markets. FERC has proposed that the electric transmission grid be operated by RTO entities such as ISOs or Transcos that are independent of market participants.

Merger policy must be consistent with FERC’s broad pro-competition goals. The pace of mergers is likely to accelerate in the United States as energy companies position themselves to meet the demands of a competitive marketplace. We are not authorized to question whether a proposed merger reflects a sound business judgement: in the merger context, FERC’s core concern is with market power. A merger that raises concerns about horizontal or vertical market power will either be rejected or conditioned with appropriate and effective mitiga- tion measures such as asset divestiture or participation in an RTO.

QUESTIONS FOR REGULATORS

In conclusion, federal regulators in the United States are committed to pro-competition policies. As the marketplace continues to evolve, we face a number of challenging questions. Some of these questions may also be relevant to other countries.

When dealing with gas and electric companies that have been pri- vately owned for a century, should regulators mandate restructuring or use a combination of “carrots” and “sticks”? There is a philosophical divide on this question. FERC Orders 636 and 888 were mandatory programs, but our recent generic proposal promoting RTOs couples a voluntary program with the possibility of rate incentives for utilities that “volunteer” to form RTOs. We expect the utilities to volunteer.

Should regulators call the shots on critical market structure issues, or should they let the marketplace evolve naturally according to the 96 Session II

desires of market participants? Stated another way: How do we define the role of regulation in shaping the competitive landscape?

Will pipelines and electric wires continue to be defined by monopoly characteristics? The answer to this question may first seem to be “yes.” Yet, with any given U.S. pipeline, there are now a number of market participants competing to sell capacity in a highly active secondary market. A secondary market for electric transmission is developing as well. To some extent, these developments help lessen the monopoly power.

Can pro-competition goals be achieved in a reasonable time frame when authority is split between federal and state policymakers? Roughly 80 percent of electric utility revenues are regulated by 50 state regulatory bodies. FERC has jurisdiction over wholesale power sales and unbundled electric transmission, and states have authority over retail sales, bundled retail transmission, local distribution, and the siting of all electric transmission facilities. Consequently, no single regulatory body is in charge of the electric restructuring debate. This is a critical issue in the United States.

How can international markets be effectively structured and regulated? Again we must live with divided regulatory jurisdiction. For example, since the energy systems in the United States are physically connected to Mexico and Canada, we have declared that Canadian electric marketers selling into the United States must comply with U.S. market rules. But tensions may develop among U.S., Canadian, and Mexican electric policies.

What information about market participants and transactions should regulators require to be disclosed? What information is so commer- cially sensitive that it should be exempt from disclosure? Information is the fuel of a competitive marketplace, yet disclosure of commer- cially sensitive information may diminish competition. What is the appropriate standard for disclosure? 97

DISCUSSION

MR. DÍAZ FERNÁNDEZ Mr. Benavides noted how satisfied European Community members were with the effects of competition on electricity rates. I would like to mention three other factors that have contributed significantly to these rate reductions. First is the cost of money: in Spain, for instance, it has fallen five to seven points. Second, the cost of primary energy from fossil fuels has declined dramatically. Third, production costs have dropped, due to technological advances such as combined cycle turbines. Can the EC evaluate the relative impacts of these factors in producing the beneficial effects of liberalization, for example, in electricity?

MR. BENAVIDES Certainly the reduction in rates cannot be attributed exclusively, or even principally, to liberalization. The factors you mentioned —lower financial costs, fuel prices, and production costs— are significant. 98 Session II

There are local factors as well; for example, in Spain we have had two good hydrological years, which had a positive influence on Spanish electric rates. Furthermore, I believe that the advent of liberalization caused utilities to offer lower rates and better services in advance of liberalization.

QUESTION I think that we have placed too much emphasis on natural gas at this Seminar. Instead, I suggest that we enlarge our focus to include renewable energy sources, solar energy, for instance.

MR. SANT Since I am chairman of the World Wildlife Fund in addition to my job at AES, I have some credentials to talk on the subject of renewables. Currently the emphasis is on markets, and markets are not driving renewables right now. There is no renewable out there that can compete in the marketplace with the new, cheap energy from conventional fuels.

My opinion is that we have focused much too much on the term “renewable” rather than on the emissions that we are trying to eliminate. As an environmentalist, I would like to concentrate our efforts on the things that we really care about, such as air quality, and work to reduce the polluting emissions. In any event, the term “renewable” is too broad for my taste, particularly after having seen the environmental damage that hydroelectric dams can cause.

MR. HEFNER I agree with Roger Sant that if we focus on the issue of emissions, we must agree that natural gas is doing a fine job. I do not think that we have to worry that natural gas is in danger of being totally used up. We do not run out of a particular resource; rather, an alternative becomes better priced and more efficient. As we have heard, “the Stone Age did not end because we ran out of stones.” Discussion 99

QUESTION I have a few questions about natural gas deregulation in Europe and the United States. First, how do you compare deregulation in Europe (with a very limited number of suppliers) to deregulation in the United States (with so many suppliers)? Second, how can we encourage the huge investments needed to develop new infrastructure to meet the expected demand? Finally, how can we handle the arbitra- tion between the TOP contracts and the new competitors?

MR. MASSEY Certainly the U.S. policy for restructuring natural gas is successful in large part because there are so many competing suppliers. If there were only a handful, I would have much greater concern about market power problems. But literally there are thousands of suppliers.

MR. BRUFAU Speaking from the Spanish perspective, I agree that the expected increase in demand will require huge investments for infrastructure. On the TOP issue, both the EC Gas Directive and the Spanish Hydrocar- bons Law acknowledged the need to protect these contracts. But they cannot factor in the risk of an open market, which is a business risk. If we open 60 to 70 percent of the market on Day 1 and expect that market to grow at a 30 to 40 percent rate, then we have to be very sure we do not damage businesses at the expense of competition. There must be a balance between opening up the market and developing the infrastructure of the system, and these processes must be synchronized.

QUESTION When Mr. Massey talked about restructuring electricity and natural gas, he noted that regulation of transmission will continue because it is a natural monopoly. Yet not long ago, we believed the same was true of telephone wires, and we also thought that large, central-sta- tion coal plants were necessary to capture economies of scale in generation. Technological changes have eroded these beliefs, although 100 Session II

in some cases regulators were slow to pay attention. If distributed generation were to become competitive with traditional transmission and distribution systems, how confident are you that regulators will just stop regulating transmission and distribution, and get out of the way?

MR. MASSEY I think there will be a big role in U.S. markets for distributed generation. Would FERC be willing to cease its regulation if the monopoly characteristics of pipes or wires appeared to be seriously diminished? Yes.

We are not wedded to any particular form of regulation, but we do want to see vibrant markets. As long as our current policies produce such markets or assist them to develop, I think we will continue with the current form of regulation. Over time, the perceived monopoly of pipes and wires will certainly diminish, in part because of distributed generation. But there will always be a role for regulation in setting terms and conditions for service, ensuring that third-party access is non-discriminatory, and determining key issues of market structure.

QUESTION Some analysts are predicting higher prices for natural gas, based on lower productivity, reduced levels of exploration, and the necessity of importing substantial supplies from more distant areas. Does anyone on the panel expect higher prices?

MR. HEFNER Diminishing returns from current wells and a decline in proven reserves have been predicted for several decades now, but our research and activities have conclusively demonstrated otherwise. There are vast amounts of gas still to be tapped. I estimate U.S. resources at 3,000 to 4,000 Tcf. If you add to that the resources in Mexico, Canada, and South America, it is clear that there are ample gas resources to meet the demand for the future. Discussion 101

As to prices, when regulations on natural gas were finally phased out in the 1980s, the industry went back to normal, market-based pat- terns of activity. By incorporating technological enhancements — drilling in the shallow levels of gas fields, for example— we easily met the increased demand. Recently, however, drilling has fallen off a little due to the price collapse of both gas and oil, resulting in a tighter supply-demand balance that should lead to moderately higher natural gas prices.

QUESTION I would like first to comment on how natural monopolies can be deregulated. In the United Kingdom, British Gas was the sole owner of gas storage facilities. But in April 1999, this function was completely deregulated, after British Gas agreed to auction off its capacity. In return, the regulators have deregulated everything, including central service and prices. Now they are looking to do the same thing with the gas pipelines: auctioning capacity on the inputs, on the out- lets, and on the storage facilities. If this proves to be successful, it may offer a model of how to deregulate even natural monopolies.

My question is for Robert Hefner: you stated that your predictions for natural gas prices have always been for downturns, yet now you seem to be predicting an upturn. Why have you changed your view?

MR. HEFNER I think natural gas prices have bottomed out. The next step might be moving from wellhead prices of about $2/tcf to $3/tcf in the near term. If Roger Sant’s number of 2.8 cents/kwh for electricity generated by natural gas turns out to be correct, the marketplace can easily handle a small price increase in that commodity.

QUESTION You know that I have reservations about the EC Gas Directive, based on my experience in the United Kingdom. The U.K. law allowing 102 Session II

competition in the gas industry was passed in 1982 and was later reinforced in 1986. Yet the first competitive gas contract was not signed until 1991. When I inherited the gas regulator’s job in 1993, I found a key error in the system. To correct this, we had to make a rather dramatic intervention, which forced the separation of the ownership of the commodity from the ownership of the natural monopoly infrastructure —the pipelines. That action was what really got competition underway. I would like to see something like this happen in Spain, even though I realize that Spain is much more of an emerging market than the United Kingdom was in the early 1990s.

Today retail competition in the U.K. gas and electricity markets is thriving. Over 20 percent of British Gas customers have moved to independent suppliers for their gas. And in the electricity market, British Gas has almost two million customers, more than many of the regional companies. So these markets are quite robust.

MR. BRUFAU I think that comparisons between Spain and the United Kingdom are not really valid. It took 12 years to open the U.K. market — an extremely slow process, particularly for a country with its own domestic gas suppliers and a fully developed infrastructure. Spain, by contrast, is the first instance in which a system has been opened to competition while the sector is still in the process of development.

QUESTION My question to Mr. Massey is about the controversial issue of stranded costs —what we call “costs of transition to competition” (CTC) in Spain. In our country they have been awarded only to electric utilities. So we are interested in learning how stranded costs are handled in the United States. What criteria have been used to define the level of stranded costs and how are they allocated to individual companies? When is a company considered to have been repaid? Discussion 103

MR. MASSEY Recovery of stranded costs certainly has been one of the more controversial aspects of restructuring policy in the United States. FERC was well aware that, to the extent you allow the recovery of stranded costs, you may get less competition. But outweighing any possible reduction of competition was our belief that this was a matter of equity. And, from the standpoint of political realism, there was no way to effect restructuring at the federal level without this policy.

When restructuring of the natural gas industry began in the 1980s, pipeline companies had several billion dollars invested in high-priced TOP contracts. Under FERC Order 636 they were allowed to recover these costs, which they generally did by raising their customers’ transmission rates. Most pipeline companies settled for a recovery rate of between 50 to 75 percent of those costs, most of which have now been passed through the pipeline system.

FERC adopted a similar policy for the electric side. This policy was controversial in an economic sense, but it was politically popular and allowed us to reach an agreement and issue Order 888. This order required open access but granted cost recovery. Rather than spread- ing the costs out to all customers, we required that the departing customers pay the stranded cost charges. This was also controversial. Yet another contentious issue was the size of these stranded costs. Many utilities are selling their generation facilities and are getting back three or four times their book value. Such returns will substan- tially diminish the potential stranded cost charges.

PROF. HOGAN The details of the structure for newly opened markets are exceptionally critical in the electricity sector because there are so man complicated technical characteristics in this industry. I am particularly concerned about who determines market structure —markets or regulators.

If you look around the world at the countries that have produced reasonably good designs for market structure, you see that they 104 Session II

share two characteristics. One is that a relatively small group of people has led, or at least dominated, the process; people who shared the view that they were working to promote the public interest to set up an efficient market. The second shared characteristic is that these small groups have had technically competent people working with them, principally electrical engineers who understood how the system really worked and were able to explain which proposals were feasible and which were not.

On the other hand, to find models of flawed design you have only to look at places where large groups of stakeholders, motivated by a variety of interests, have designed the system. One example that I would call the “least common denominator” model is the Midwest Independent System Operator (MISO). Another model with a flawed design can be found in California where planners tried to separate markets that could not be separated.

Certainly regulators can get it wrong, so there is no guarantee in allowing them to set the rules. But it seems to me that it is the regulators who have the final responsibility to look after the public interest. Given the complexity of this problem, in the end they will have to scrutinize the details and say clearly which ones are essential, which systems work, and which do not work.

MR. MASSEY In the United States there is a huge philosophical divide over this issue. I would be inclined to have FERC set more market rules for the electricity industry in our new regional transmission organization (RTO) policy. As you know, we require the RTOs to operate a real- time balancing market, which is a step toward the model you are talking about. My guess is that in the upcoming hearings on the issue, we will be strongly urged to drop that provision. A significant part of the industry does not want that much structure and is not enamored of the pool concept. My view is we should move more aggressively in that direction. However, I don’t believe the votes are there to pass it. Discussion 105

We have the desire to create RTOs with the real-time balancing provision, but beyond that, I do not know. It may be that these pools will be designed using a collaborative, least-cost, lowest common denominator aproach, because politically that is about the best we can do right now. Or perhaps the politics will evolve. In any event, you are right in that the most critical question in restructuring right now is the extent to which regulators are willing to aggressively shape market institutions.

QUESTION Mr. Hefner, in your presentation you forecast increased consumption of gases with low or no emissions (natural gas, alternative energies, and nuclear energy) and declining consumption of solid and liquid fossil fuels. Nevertheless, I am reminded of the comment about coal’s large share in the worldwide production of electricity today. Would you estimate what the energy mix will be in the next century?

MR. HEFNER I do not have specific figures, but I believe that energy demand in the next century will be lower than is generally estimated. I do not believe we will have a straight-line population increase over the next hundred years. I believe we will make significant improvements in the efficiency of the entire energy system, particularly in the convesion of natural gas to electricity, which will lower demand per unit of GDP. As to the fuel mix, I subscribe to the evolutionary idea of solids to gases, with liquids as transition. It just seems to be the natural course of things.

I would like to correct one point you made: I do not include nuclear energy in the category of energy having sustainable growth. Nuclear is not clean and has many other problems as well. To me, nuclear is one of the dinosaurs remaining at the end of the age of solid fuels.

QUESTION I am interested in the implications of carbon emissions trading for various fuels. At a figure of perhaps $25 per ton of carbon, particularly 106 Session II

in the context of the power industry, there will be a tremendous economic motivation for pushing out oil and coal. My question for Mr. Massey is, do you see emissions trading as just another market de- vice? Or is it something more substantial— a vehicle that attacks the guts of some industries —like the coal industry— that enjoy a relatively protected position?

MR. MASSEY

The SO2 trading process in the United States has worked fairly well. But I agree with you that it is not neutral with respect to its impact on particular fuels. If we move further in that direction, I think coal would take a big hit, so policymakers certainly need to recognize that could be a consequence. 107

SESSION III

«THE ENVIROMENT: CLEAN,CLEANER,CLEANER STILL»

INTRODUCTORY REMARKS

THE HONORABLE MARÍA TERESA ESTEVAN BOLEA EUROPEAN PARLIAMENT SESSION CHAIR

The relevance of our session title derives from the fact that environmental concerns are having an increasing impact on all aspects of the energy business —costs, prices, the marketability of products, the competitive position of various fuels, and the future structure of energy companies.

As a member of the European Parliament, I am particularly aware of this impact. Perhaps 40 percent of all EU legislation deals with the environment, and there are more than 320 Community Acts on the books. Now we face the prospect of widespread revision of many of these laws. There are many reasons for all this environment-focused activity. First, despite enormous legislative and financial efforts, environmental problems are still very much in evidence. Continuing economic growth worldwide —causing increased energy demand— is another factor. Technological change is an added factor, paradoxically solving some old problems and creating new ones. 108 Session III

But it is important that we see these environmental problems not only as responsibilities, but also as opportunities: opportunities for brilliant research by industry and for creative policymaking by governments. I am convinced that the oil industry has a splendid future, and Parliament is eager to work with you in creating workable, effective regulations for the new century.

Our distinguished panel of industry representatives will offer the latest thinking on how to meet these pressures and opportunities, and how to make the regulatory process work better for both society and industry.

• Michel de Fabiani will provide BP Amoco’s perspective on the impact of these challenges. He will outline his company’s continuing proactive policies to deal with the changing regulatory and political environment.

• Stuart Dombey from the pharmaceutical industry knows a great deal about what makes for successful proactive participation in the regulatory and legislative processes. He will offer some guidelines to energy companies that also face a myriad of regulatory challenges in multiple jurisdictions.

• Jan Timmerman and Juan Antonio Moral, from the petroleum industry and the automobile industry, respectively, are on the front lines of environmental regulation. They will tell us how their industries are dealing with these challenges. 109

«BUSINESS ENVIROMENTALISM»

MR. MICHEL DE FABIANI BP AMOCO

BP Amoco, looking ahead 50 years, expects an increasing demand for energy, and we believe that oil and gas will be key in meeting that demand well into the twenty-first century. We intend to play a major role in supplying those commodities in response to our customers’ expanding energy needs. However, we also recognize that the extraction, refining, and use of hydrocarbons have environmental impacts. We have, therefore, assumed the dual responsibilities of meeting the demand for energy and striving continuously to reduce the environmental impact of our operations.

DEFINING AND DOING THE RIGHT THING

Our company is interested in taking the lead in creating positive and practical responses to environmental challenges. Passively awaiting government legislation in response to public pressure about environmental concerns is not the hallmark of a successful business; it is the 110 Session III

path to failure. Should this sound sanctimonious, let me stress that we also believe environmentalism and good business are closely linked. Doing “the right thing” because our staff, our customers, and the communities in which we operate expect it of us, positions us as a responsible corporate citizen in today’s society. Delivering a dis- tinctive business performance that impresses our shareholders requires us to be at the forefront of the environmental debate.

In short, we believe business should be competitive, successful, and a force for good. Our company policies, the foundation on which we conduct our business, apply to our more than 90,000 employees, and to 126 largely autonomous business units operating in more than 100 countries worldwide. They define what our company strives for and what society can expect from us.

Our people support these policies. Surveys indicated that more than 60 percent of our employees regard the most important issue that defines the quality of the company they work for is the use of BP Amoco’s skills and knowledge to address the environmental agenda. This is in line with public attitudes in the United States, where more than 70 percent of the public see business skills and technology as the answer to environmental challenges. Unfortu- nately, Europeans generally still believe environmental solutions are found in regulation and control. BP Amoco hopes to change this perception.

Our goals for health, safety, and environmental (HSE) performance are simply “ no accidents, no harm to people, and no damage to the environment.” These are commitments to minimize the environmental and health impact of our operations by reducing waste, emissions, and discharges, and by using energy efficiently. Specifi- cally, we have promised open consultation and dialogue with public interest groups, our customers, employees, and neighbors. We will work closely on environmental issues with our partners, suppliers, and competitors, as well as regulators. Finally, we will openly and honestly report our HSE performance —whether we meet, exceed, or fall short of our objectives. «Business and Environmentalism» 111

INITIATIVES AND INVESTMENTS

Recently, BP Amoco held an environmental forum to hear the views of a number of nongovernmental organizations (NGOs), among them Amnesty International, Oxfam, and Birdlife and Fauna and Flora International. The meeting coincided with the publication of our first Environmental and Social Report, which demonstrates our policies in action. The report noted, for example, that in 1998 our total air emissions fell 12 percent from 1997 levels, with the largest decreases in hydrocarbons (HC) and sulfur oxides (SOx) emissions. These reductions resulted from investments in pollution prevention equipment at all our business sites.

Such investments do, however, pose questions as to how a company responds to environmental problems. On the one hand is the rational approach toward environmental spending —allocating funds only to those projects clearly identified as cost-effective. On the other hand is the insistence on investment in “best-available” technology— regardless of cost or the significance of gains produced. BP Amoco is working to achieve a balance between these two approaches.

In 1998, BP (not including Amoco) had 54 more spills than in 1997, but more than 70 percent of the spilled oil — from vessels, pipes, tanks, ships, or trucks— was recovered. Also on the debit side in 1998, BP paid almost $250,000 for breaches of environmental regulations, and the combined BP Amoco bill totalled almost $2 million. Needless to say, these are stark reminders of the link between good environmental performance and good financial performance.

To further our goal of “no damage to the environment,” we intend to have the environmental management systems at all our major operating sites around the world certified to the ISOP 14001 international environment management standard. This standard has now been met by 30 of our operations; in addition, another 12 have achieved certification by the European Eco-Management Audit Scheme (EMAS). 112 Session III

CHOICES FOR PROGRESS

In April 1999, Sir John Browne, our group chief executive; received the award for individual environmental leadership sponsored by the United Nations Environmental Program (UNEP) and Earth Day New York. Sir Browne told the audience at the UN presentation that the notion that “you can have economic growth and pollution —or you can have a clean environment, but no growth” was an unacceptable trade-off for a progressive company. Not only was it politically and practically unacceptable in the United States and Europe, it was also morally unacceptable in the developing world, where people lacking decent housing and clean water have the right to have both economic growth and a healthy environment.

Our belief is that business can bypass the trap of this apparent tradeoff by transcending this “either/or” philosophy. We can offer people better choices for both growth and environmental protection. While BP Amoco does not have all the answers, there are several areas where we are offering choices and providing innovation and leadership: climate change, emissions trading, and cleaner fuels.

Climate Change Rarely in our industry has an issue spawned such divergent views as climate change. Even now, the science of climate change remains provisional. However, BP Amoco believes that there is enough evidence to suggest that precautionary actions are prudent. I have already mentioned our target set in 1998 to reduce carbon dioxide

(CO2) emissions by 10 percent by 2010. Perhaps 10 percent does not sound impressive at first, but note that without this target, our

CO2 emissions in 2010 were forecast to be 110 million tons, growing from 77 million tons in 1990. By seeking a 10 percent reduction on the 1990 figure (from 77 million tons to about 70 million tons), we are actually targeting a total reduction of some 40 million tons —a 36 percent reduction on what our emissions would have been without the target. «Business and Environmentalism» 113

Emissions Trading

Our goal is to bring about meaningful and measurable CO2 emissions reduction in the most cost-efficient way. The system we devised for our internal use allows those business units that exceed their emissions- reduction targets to “sell” the reductions to another site, thereby helping that site to meet its goal. Thus our business units are offered the choice of financing emissions-reduction projects or buying the reductions from another site. The advantage is that each individual operating site can find the lowest-cost method of meeting its GHG emissions-reduction goal.

Our pilot trading scheme, involving an initial 12 business units, was launched in September 1998. Trades are now being settled at between $17 and $25 a ton of CO2. We are developing the scheme as a real choice, working in partnership with the Environmental Defense Fund (EDF), to extend trading to all 126 business units by June 2000. We are more convinced than ever that emissions trading will be an integral part of how our businesses can meet their targets. We are not only eager to share our experience with others, but actively invite them to join us.

Cleaner Fuels We at BP Amoco believe that the oil industry and the automobile industry share the responsibility of moving people without polluting the air. BP Amoco is doing its part by introducing cleaner fuels, initially in 40 cities around the world where the problem is most acute, to optimize the performance of vehicle technology. We are doing this now, rather than waiting for legislation to come into force, because we are committed to continuous reduction of CO2 emissions and because we want to offer the public the option of using fuels that are lead-free and low in sulfur. We have just begun the program in the United Kingdom; soon we will launch clean fuels in cities elsewhere in Europe and in the United States.

Another example of our determination to offer choice is in our development of solar power. Today, BP Amoco is one of the world’s 114 Session III

largest solar companies, having invested $150 million over the past five years in capital expenditure and R&D. At present, solar power can only produce a small fraction of global energy needs; but it is estimated that within 50 years, solar power and other renewable sources of energy could meet half the world’s energy needs.

Finally, I would like to mention our goal to encourage the use of natural gas to provide an alternative choice to coal and the heavy emissions associated with it, particularly in emerging economies. By linking available resources to known markets, we can give people a choice by offering both a direct environmental improvement, re-

duced CO2 emissions, and security of supply. In June 1999, BP Amoco announced the creation of a global natural gas marketing business, reflecting the growing importance of natural gas in the company’s portfolio. Following BP’s merger with Amoco, gas has risen from 19 to 35 percent of our company’s production.

HEALTHY ENERGY

I trust that I have made it clear that the initiatives taken by BP Amoco are not driven by shallow public relations or empty rhetoric but are based on defined and measurable targets, decisive action, leadership, and a commitment deeply rooted in our company culture. Let me conclude by quoting Sir John Browne from his 1998 Elliott Lecture at St. Anthony’s College (Oxford): “The world needs energy just as people need food, but we can help keep the diet healthy.” 115

«INGREDIENTS OF A PROACTIVE REGULATORY POLICY»

DR. STUART L. DOMBEY PARKE-DAVIS

While reflecting on what constitutes a proactive regulatory policy in the pharmaceutical industry, I became impressed with the similarities between the energy industry and the pharmaceutical industry. We are both global in scope, and we are both experiencing consolidations through mergers and acquisitions. We also live in a world of external pressures where risks and rewards must be reevaluated constantly. And both industries live in a time of scientific and technological change so dynamic that regulators and regulations often cannot keep up with it. In this world of rapid change, we have the obligation to anticipate, and even lead, the regulators, rather than simply following them. This evolving relationship is what I want to discuss today.

THE IMPORTANCE OF INDUSTRY STRUCTURE

Before a company or an industry can deal successfully with regulatory bodies, it must be clear about its own goals. We need to know what we are trying to achieve. In response to increasing global scope and omnipresent regulatory pressures, the pharmaceutical industry has come to realize the value of structure: structure within one’s own 116 Session III

company, and structure within the industry. As a company, we find that the home office is critical for coordinating a common agenda and communicating discussions and conclusions. The real challenge is to reach company consensus —whether working on new legislation or participating in ongoing negotiations. It may seem easy to decide on specific goals, yet with multiple options and committed people, accommodation of views within a large company can be dif ficult. With electronic communication and teleconferencing, however, we have found that it has become easier to communicate among ourselves around the world.

As a global company we have representatives in every country, and we also have regional offices. Particularly in Europe, Latin America, and Asia, these regional offices develop and capitalize on synergies and efficiencies among countries. Regions can overlap in their activities as well: our Washington office also deals with European affairs through the U.S. Departments of Commerce, State, Treasury, and Health and Human Services, as well as through European embassies.

In addition, we work through trade associations. Examples are the Pharmaceutical Research and Manufacturers of America (PhRMA) and the Association of the British Pharmaceutical Industry (ABPI), which are active locally but also have global outreach. There are also regional trade associations such as the European Federation of Phar- maceutical Industry Associations (EFPIA) that offer committed support in Europe. And finally, we work through a global trade association, the International Federation of Pharmaceutical Manufacturer Associa- tions (IFPMA), on global intellectual property protection, and through the World Health Association (WHO) on international health issues.

INFLUENCING REGULATION

For the pharmaceutical industry this is not an era of deregulation. Rather, directives and statutes increase in scope and complexity as agencies and legislatures keep adding layer upon layer of new regulations. It often appears deceptively easy to simplify legislation, but «lngredients of a Proactive Regulatory Policy» 117

this is not so: the devil is in the details, and working out those details requires an ongoing dialogue between regulators and industry. It is possible that we know what we do better than the regulators who are trying to make us do it better. So dialogue between the two entities is crucial for our industry to get good laws and good regulations.

We work to influence legislation and regulation at all levels of government. But our primary tasks are to be accessible to legislators and regulators and to keep them informed about industry developments. Our world is very complex and fast changing, so it up to us to provide updates on all new developments to politicians and their staffs as well as the staffs of the regulatory agencies.

We need to appreciate the pressures on legislators and regulators. They live in a world that demands rapid response to fast-breaking developments. Because some of our products do lead to unexpected adverse events and because regulators are under pressure to respond to such situations, we must keep them informed about the adverse and positive effects of our products. There are, of course, legal obligations, but it is also in our interest to update regulators proactively. Protecting the public is a mission we share with regulators. Increas- ingly, we are working to change the emphasis of that mission from one of keeping products off the market to a broader objective of bringing innovative products to market as quickly as possible.

Transparency is an important issue that has several dimensions. We believe that regulators have an obligation to carry out their work in a transparent manner. The American system is more open than the Eu- ropean system. In Europe, decisions are still made behind closed doors. In the United States, there are public meetings with wide media cov- erage, and information on all decisions is immediately made available.

Another facet of transparency involves the disclosure of sensitive information. Since much of our data concerns individual patients, we are increasingly confronted with the issue of privacy versus freedom of information. We face a serious dilemma in deciding how open our research procedures and results should be and how much information 118 Session III

should be divulged. The current debate on the European Directive on Privacy reflects this dilemma.

Pricing is another major issue. In Europe, our primary purchasers are governments, and they are sensitive about the rising costs of health care. Their pricing decisions often produce serious distortions in the market, including parallel trade. This has caused the development of a whole new science of pharmacoeconomics to develop methods to support the value of new products.

And, finally, we must take into account the concept of intellectual property. We pride ourselves not only on our products but also on the basic research that enables us to create them. It can take ten years to get a drug to market, a process requiring a huge expenditure of resources. We expect that regulators will be sensitive in using the research information appropriately.

INNOVATIONS FOR GREATER INTERACTION

The regulatory process, while necessary, too often has pitted industry against regulators, a scenario that has been to no one’s advantage. However, recent innovations offer hope for improving this relationship.

In Europe First of all, let me mention European harmonization. After decades of tentative moves toward harmonization, the movement began in earnest in the late 1980s. The years from 1987 to 1993 were spent in a sustained effort to generate a single system for regulation in Europe, with extensive discussions taking place among member- states, the European Commission (EC), the pharmaceutical industry, and all other interested parties.

For pharmaceuticals, the effort culminated in a 1993 directive, creating the European Medicines Evaluation Agency (EMEA), now housed in London, whose activities eventually began in 1995. Even with «lngredients of a Proactive Regulatory Policy» 119

industry, national governments, and the EC all working together, it took eight years to implement a program. Although valuable, that directive is still not completely effective, because differences about interpretations remain among the member-states. Many countries prefer a national solution to a European solution.

In 1995, the EMEA was mandated to assess its own effectiveness after five years of operation. But now the European pharmaceutical industry has come forvvard with its own proposal. “Regulation 2000” outlines a new regulatory model and environment for the year 2000 and beyond, and is a good example of industry acting in a proactive manner.

In the United States Following collaborative efforts among the pharmaceutical industry, government, and regulators, the Prescription Drug User Fee Act (PDUFA) was passed in 1992 to allow user fees from the industry to pay for additional reviewers at the Food and Drug Administration (FDA). This act had a sunset provision, but it was renewed in 1997 because it was so successful in improving the FDA’s statistics. The potential downside is that it may be a future temptation for government to slash its funding because of the industry’s contribution.

Another cooperative initiative is the Food and Drug Administration Modernization Act (FDAMA). Passed by Congress in 1997, this act provides a charter outlining the relationship between the FDA and the pharmaceutical industry, and has resulted in greater understanding of controversial regulatory issues.

International Efforts The International Conference on Harmonization of Technical Requirements for Registration of Pharmaceuticals for Human Use (ICH) has been another major initiative of the last decade by the pharmaceutical industry working with regulators. In an ongoing effort since 1991, representatives from American, European, and Japanese industries and governments have been working together to 120 Session III

agree on the scientific basis for new product approvals. Previously, because the details of regulations were different from country to country, the standard product testing process had been to perform similar tests several times, each involving only minor differences in methodology.

During the early meetings, many of us were skeptical that there would be any agreement —but, thankfully, we were wrong. Work- ing together, Americans, Europeans, and Japanese have agreed on more than 30 harmonized codes, a major accomplishment. This now enables a single set of scientific principles to form the basis of global new product development. A byproduct of the harmonization negotiations has been that regulators from different countries and industry experts came to know each other as people and were able to build trust and mutual respect that had been lacking before.

The Transatlantic Business Dialogue (TABD) is not a pharmaceutical organization but a collaboration by businesses on both sides of the Atlantic to reach agreement on regulations regarding many issues —whether it be taxes, telecommunications, or automobiles. The European and U.S. industries worked together to persuade their governments to simplify regulatory procedures. One such example was a memorandum of understanding to accept inspections of pharmaceutical facilities by Euro- pean government inspectors in the United States, and vice versa.

This seemed like a small step, but it has proved to be a major hurdle, causing a great deal of anxiety in Washington. Finally, all the parties agreed to establishment of a three-year transitional period before any final decisions are made. Despite the delays, the industry is convinced that this has been a small step in the right direction of remov- ing unnecessary regulation.

LEARNING FROM EXPERIENCE

As we look forward to the new era of globalization in our respective industries, and hopefully in regulation, we have much to learn from our experiences. I would suggest the following conclusions: «lngredients of a Proactive Regulatory Policy» 121

• In response to complexity, regulation is increasing and is likely to keep increasing.

• Our dealings with regulators should continue to be open: this will increase understanding and trust.

• Our relationships with regulators need to be considered in the long term. We have to work with regulators to influence them.

• Because regulatory change is a slow process, we must be constantly vigilant to anticipate and influence proposed changes and to ensure the final result is acceptable to all parties.

• There are opportunities for innovation within the regulatory field.

• We prefer regional and even global regulation to national regulation, because it results in more efficient programs for industry and more consistent decisionmaking by governments. 123

«CLEAN FUELS»

MR. JAN J.F. TIMMERMAN EUROPIA

As I begin my talk on the important issue of oil and the environment, I remind myself that I am in a very unusual setting: I am simultaneously speaking to a senior representative of the European Commis- sion, Pablo Benavides, director-general of DG XVII; a member of the European Parliament, Marfa Theresa Estevan; the president of the Association of Spanish Automobile Manufacturers (ANFAC), Juan Antonio Moral; and many members of the oil industry, the people who pay my salary. These are all stakeholders with whom I normally speak separately on sensitive issues. At the end of this joint meeting, I trust I will still be on speaking terms with all of you.

The question I have been asked to address is how environmental reg ulation is formulated in Europe. To do this, I will review the regulatory milieu; I will reference the Auto-Oil Programme to show how the oil industry can affect that process; and I will conclude with reflec- tions on how we can go forward to present our case more effectively. 124 Session III

OIL, CARS, AND THE ENVIRONMENT

Let me begin with some background on the European oil industry. The European Union countries (EU-15) consume 20 percent of the world’s oil; on a per capita basis, this is half the amount consumed by the United States. Oil is still, by far, the principal energy source in Eu- rope, accounting for just over 40 percent of the energy balance — about twice as much as the second largest energy source, natural gas. Oil is a major European export sector; in the EU-15 countries, the industry employs —either directly or indirectly— some two million people and is a major contributor to Europe’s continued economic growth.

It is not news to any of us that oil is the favorite commodity of every nation’s revenue seekers: energy taxation has been at the top of the agenda of European policymakers for decades. Since 1980, for example, taxes in the EU-15 on gasoline have more than doubled, and taxes on diesel fuel have more than tripled. (My colleagues in Brussels sometimes perceive me as the representative of the world’s largest tax collector.)

THE PUBLIC’S PRIORITIES

In general, we believe that the public —those people who drive cars and buy petrol and pay taxes— want both clean air and good transportation. For their own transport, they want efficiency and economy as well as overall vehicle performance and durability. They also, naturally, want the environment to be protected. But that priority is not at the top of their list. As an example, in an opinion poll taken shortly before the June 1999 European Parliament elections, respon- dents were asked what issues they wanted the newly elected representatives to focus on. More than half (56 percent) of the respon- dents said their first priority should be reducing unemployment; tied in second place (33 percent) were reducing poverty and exclusion, and combating insecurity and violence; and tied in third place (16 percent) were fighting illegal immigration and fighting corruption. The sixth priority was preserving the environment. «Clean Fuels» 125

THE AUTO-OIL PROGRAMME

The oil industry is eager to find ways to both protect the environment and contribute to effective private transportation and mobility —not an easy balance to achieve. In the early 1990s, the oil and automobile industries joined the European Commission in a joint effort to lessen air pollution from vehicular emissions. Their goal was to develop changes in engine technology and fuel formulation that would lessen emissions. Thus the Auto-Oil Programme was created.

The Programme, which began in 1993, had the specific focus of achieving European air quality targets. It was based on several important principles: it would bring together industry with its technical expertise and governments with their regulatory authority; its activities would be founded on sound and sufficient science; it would be concerned with cost-effectiveness; and it would include provisions for ongoing evaluation of its results. The Programme published its first results in 1996. As a tribute to its effectiveness, a new version, Auto-Oil II, is planned for the new century.

The Auto-Oil I Programme has achieved some notable successes. The base case study for the Auto-Oil II Programme shows that the effect of measures implemented since 1990, up to and including those from Auto-Oil I, has been to reduce pollutants such as nitrogen oxides (NOx), particulate matter (PM10), carbon monoxide (CO), hydrocarbons (HC), and benzene by up to 80 percent. Figure 1 illus- trates the reduction of one of these pollutants, NOx.

The Auto-Oil Programme has demonstrated that the oil industry is aware of its social responsibilities and will continue to be an enthusi- astic and positive contributor to such efforts. It was unfortunate that Parliament was unwilling to allow the total Auto-Oil I process to finish before setting their new standards in 1998 for 2000 and 2005.

The follow-up Auto-Oil II Programme should confirm that no further significant environmental benefits can be obtained from the transport sector and that off-road measures will be more cost-effective. 126 Session III

Figure 1 Reductions NOx Emissions Levels 1990 to 2020

Nitrogen Oxides (NOx) Kilotons (Kt) per year 16,000

14,000

12,000

10,000

8,000

Road Transport 6,000 Process

4,000 Other Mobile Non-Industry Combustion Industry Combustion 2,000 Agriculture Energy Combustion 0 1990 1995 2000 2005 2010 2015 2020 Source: EUROPIA, Emissions Base Case Data.

BROADER REGULATORY ISSUES

In May 1999 (in accordance with the Maastricht and Amsterdam Treaties), the European environmental regulatory process entered a new phase when the powers of the European Parliament were increased. All environmental matters must now be jointly approved by the Council of Ministers and the Parliament.

In creating legislation, we believe that a rational, scientific, and cost- effective approach is the best basis for good legislation. We also believe that regulators should set targets rather than prescribe specific goals, leaving it to the creativity of our industry to develop innovations to meet those targets.

As it now stands, the legislative process is not sufficiently transparent and lacks a structured procedure by which technical and economic information can reach the proper regulatory authorities. «Clean Fuels» 127

We need to evaluate the economic and social impacts of environmental legislation —just as we integrate environmental criteria into energy, agricultural, industrial, and transportation legislation. We face an ongoing debate with those who take more drastic positions —for example, urging that only the best-available technology should be mandated by legislation— without concern for the larger effects on the economy or society as a whole. We need to remember that although competition, employment, and the environment are all very high on the public agenda, they are not always easily compatible with each other —despite what some may profess.

All legislation should address the concept of subsidiarity, which is an important principle not only in the Maastricht Treaty but in other European treaties as well. If Scandinavia has a concern over acid rain, for example, why impose emissions legislation in Spain where it is not a problem? If Rome and Athens have problems with motorbikes, why impose legislation on Scandinavia? Local solutions for local circumstances are more appropriate and more cost-effective for society at large.

LOBBYING OUR AGENDA

The oil industry needs to improve its reputation. After just one year as an industry representative, I acquired a new perspective on the agenda of the European oil industry. Whether justified or not, the oil industry’s reputation in Europe is not a positive one. We need to spend more time explaining the oil industry’s role in society and the contributions we make. In an increasingly value-driven society, reputation means credibility and credibility means influence in the regulatory process.

We need to be involved in Parliament’s legislative process much earlier, offering information and suggesting programs. And we must be positive. We can no longer say, “it is too expensive” or “the technology does not exist.” Increased activity by EUROPIA 128 Session III

will help Parliament to be better informed. We need to actively follow the work of Parliamentary committees to learn the concerns of individual representatives. The policies of individual member-states also play a major role in the legislative process.

We need to become more fluent in the language of politics. Many people in our industry are engineers. We tend to think we have the right solution, that we know what is best. Technically, in a limited sense, that may be true, but it also reflects professional arrogance. Politicians have different educational backgrounds and experiences. Too often we talk at each other, rather than to each other. And we should not be surprised when politicians take political positions: they, too, have their visions of what future is best for society.

We should be proactive on broad social issues. It is no longer enough to limit our discussions to parts per million (ppm) of sulfur; we must show our interest in social matters such as human rights, biodi- versity, and globalization, which are critical issues to international companies as well as to non-governmental organizations (NGOs) and society at large. We should talk more with NGOs and understand their language and concerns. We should become good listeners.

We should dialogue with all the stakeholders on these social issues. We should affiliate ourselves with groups that perform scientific and economic analysis of the impact of regulatory measures, as is more often done in the United States. And we need to constantly emphasize the impact of legislation on the economy: What good will it be if we make Europe into an impenetrable fortress surrounded by environmental regulatory barriers, and our products are unable to compete with those of other countries?

Finally, we must showcase our achievements. Many environmentalists dismiss our efforts as nothing more than “business as «Clean Fuels» 129

usual.” But as just one example indicates —reduction of sulfur from 5000 ppm to 50 ppm— our efforts are much more than business as usual. We should involve the media continuously and not just on the day that we believe we have a message. Today, many oil companies publish environmental reports, track and report results of health, safety, and environmental (HSE) initiatives, and involve themselves in climate change and human rights issues. We have always been too modest.

IN SUMMARY

Motor fuels in their reformulated versions will continue to be the major source of energy for transportation well into the next millennium. This continued dominance reflects several basic attributes of oil products:

• they are cheap to move and store (in terms of infrastructure);

• they are consumed globally;

• they rely on manageable technologies available in the most remote places; and

• they have no real competition or substitute in the transportation sector.

The European oil industry makes an essential contribution to sustainable growth through the supply of clean and affordable energy by

• acting with care for the environment;

• stimulating technical innovation;

• providing employment; and

• representing a major source of export revenue. 130 Session III

The oil industry increasingly accomplishes its mission in a transparent process of interaction with society at large, consumers, NGOs, political institutions, and shareholders alike. 131

«CLEAN CARS»

MR. JUAN ANTONIO MORAL GONZÁLEZ FASA-RENAULT, S.A.

Despite having been in use for more than 100 years, the automobile continues to be a young product with a promising future. The automobile is an efficient means of transportation, and it responds to our desire for freedom and need for mobility in ways public transportation cannot. At the same time, the automobile symbolizes the contradictions of progress: it offers unequalled freedom of mobility but it threatens the environment and livable conditions in our cities. Reconciling these contradictions poses a daunting challenge to the automobile industry as it seeks to produce vehicles that are useful for the public and non-threatening to the environment. Today I would like to summarize the industry’s responses to this dual challenge.

GROWING CONCERN AND RESPONSES

The second half of the twentieth century has been notable for a heightened awareness of mankind’s damage to the environment. 132 Session III

In the 1950s, concerns about air quality, particularly smog, began in individual areas. By the 1970s, evidence of the harmful effects of pollutants had become widely obvious, including harmful air quality in major cities and acid rain in forests. By the 1980s, the influence of pollutants on perceived changes in climate gave the problem a global scale.

Emissions from motor vehicles, both from fuels that are burnt and from engine technology, are a major factor in these problems. Gaso- line produces pollutants, including sulfur oxides (SOx) and nitrogen oxides (NOx), that affect air locally. The classic internal combustion

engine emits carbon dioxide (CO2), thus contributing significantly to global warming. In addition, the NOx produced by the high temperatures and pressures in the engine’s cylinders cause acid rain. And, combined with oxygen, NOx produce tropospheric ozone, one of the components of smog. There are also fuel by-products that contribute to pollution, such as anhydrous sulfates and traces of motor oil.

It should be noted that although emissions from motor vehicles are a major factor in environmental problems, they are not the only sources. The automobile, for example, is responsible for only 50 percent of the atmospheric pollution in urban centers; heating, cooking, domestic sprays, and biological gases are also contributors.

The Auto-Oil Programme This increasingly serious situation has prompted widespread efforts for improvement. In the 1970s, the European Commission (EC) began to set standards to curtail emissions, and the European Association of Automobile Manufacturers (ACEA) and the European Association of the Oil Industry (EUROPIA) began the search for improved engine technology and cleaner fuels to reduce emissions. These groups came together to initiate formal programs for improvement: the Auto-Oil Programme and the European Programme on Engine Tech- nology, Fuels, and Emissions. Their objectives have been to investigate and implement the most effective methods to improve the impacts of highway transportation on the environment. «Clean Cars» 133

As a result, increasingly rigorous standards have been formally set for emissions: in 1993 with the Euro 1 standards, followed by Euro 2 in 1996. Euro 3 and Euro 4 will be implemented in 2000 and 2005. As a result of these efforts, noxious emissions including sulfur, carbon monoxide (CO), NOx, and “free” hydrocarbons (HC) have declined significantly. By 1996, pollutants had been reduced to one-tenth the level of the 1970s, as Table 1 shows, and will diminish even more with implementation of Euro 3 and Euro 4 standards.

Table 1 Evolution of Fuel Emission Limits, EU-15 in grams per kilometer driven (g/km) Euro 0 through Euro 4

Euro 0: Euro 1: Euro 2: Euro 3 Euro 4: 1970s 1980s 1993 1996 2000 2005

CO 23.35 14.24 4.07 3.29 2.30 1.00 NOx + HC 9.88 3.36 1.12 0.58 0.35 0.18 NOx - - - - 0.15 0.08 HC - - - - 0.20 0.10

Source: Fasa-Renault, S.A.

CONTINUING THE SEARCH FOR SOLUTIONS

Environmental problems continue to call for further solutions which must focus on both emissions control and fuel efficiency. Although the automobile is responsible for only 22 percent of the CO2 emitted in the atmosphere by human activities, the ACEA made a commitment to the EC to reduce CO2 emissions by the year 2008 to 140 grams per kilometer driven (g/km), a 25 percent reduction from the current level.

To meet this pledge, the automobile industry is considering a number of possible solutions. Let me mention five: (i) improved internal combustion engines; (ii) exhaust emissions treatment; (iii) cleaner fuels; (iv) alternative fuels; and (v) zero-emission vehicles. 134 Session III

Improving Internal Combustion Engines Because of ignition requirements, traditional internal combustion engines use a mixture of fuel and air richer than what is strictly necessary. Consequently, the thermal output is not optimal, producing

residual CO and HC which must be oxidated to CO2 and water in a catalytic converter. It also produces NOx, which must be reduced to molecular nitrogen.

To meet the emission limits for Euro 2 in 1996 and Euro 3 in 2000, the three-way catalytic converter (TWC) was developed. The TWC requires a rich (stoichiometric) mix (14.7:1) to balance the reaction of the NOx reduction with the oxidation of unburnt HC and CO.

A poorer fuel mix that is rich in air would allow the burning of all the fuel, thus improving performance; however, not only would it be difficult to achieve ignition, but more NOx would be produced, which would have to be treated under very difficult conditions, for which the TWC does not work.

To employ a poor fuel mix efficiently, direct fuel injection engines are being developed for both diesel and gas use. The key to the solution is fuel injection: introducing into the cylinders a jet of poor (but stratified) fuel mixture —one having richer layers of fuel next to the ignition zone.

The new direct fuel injection engines will allow us to achieve the objective of emissions of 140 g/km. To achieve further reductions will require a drastically lower vehicle weight. Although very lightweight materials do exist, they are used only in the aerospace industry and would be prohibitively expensive for routine automobile manufacture.

Treatment of Exhaust Emissions The current TWC is adequate for meeting the Euro 3 norm, as long as the engines do not use a poor mix. In these engines —with a poor fuel

mix and direct fuel injection— the excess of NOx and CO2 and the relatively low temperatures make the reduction very difficult. To resolve this problem, two different strategies are being developed for gas engines. «Clean Cars» 135

The first is the NOx catalytic converters or lean nitrogen catalyzers (LNC). These reduce NOx in the presence of excess oxygen due to partially recycled hydrocarbons from the exhaust. The second strategy consists of using “NOx traps”: the NOx are caught in a poor environment in order to reduce them in cycles of a rich mix and high temperatures which occur periodically. For diesel engines, in addition to the NOx convertors, systems of “non-thermal plasma” and traps for particulate filters are being developed.

Cleaner Fuels However, the new catalytic converters have problems dealing with

SO2. Thus, the Auto-Oil Programme is considering further refinements in fuel formulation to allow even less sulfur and other pollutants and to utilize the converter to reduce fuel consumption.

Further, the American, European, and Japanese associations of automobile manufacturers have proposed a World-Wide Fuel Charter that would standardize three levels of fuels. The first level is for fuel with requirements for engine performance only. The second level, which meets the standards of Euro 1 and Euro 2, adds important sulfur reductions and some olefin reductions. The third level, meeting the Euro 3 and Euro 4 norms, includes direct injection and poor mixture engines to meet the requirements of 30 ppm for sulfur.

Use of Alternative Fuels Alternative fuels include liquified natural gas (LNG), liquified petroleum gas (LPG), biofuels (methanol, ethanol, and biodiesel), and hydrogen. Car manufacturers are prepared to produce vehicles adapted to these fuels —with the exception of hydrogen, because of the storage difficulties it entails. But there are drawbacks or uncertainties connected with each.

LNG and LPG offer some reduction in pollution but only slight reduction in consumption. LNG offers limited range and also requires 136 Session III

costly deposits due to the high pressure necessary. LPG needs lower storage pressure, but it requires a costly service infrastructure.

Among the biofuels, methanol is a relatively clean fuel but is unsuit- able for cold climates, is hard on engines, and is 50 percent more expensive than gasoline. Ethanol is a viable fuel used in some countries (e.g., Brazil) in a 10 percent mix with gasoline. It has fewer problems than pure methanol, but it is very expensive. Biodiesel (gas-oil produced from vegetable oils) is very low in sulfur and aromatics, but it is not competitive when crude oil is less than $30 a barrel.

Hydrogen poses enormous storage problems, is expensive to pro-

duce, does not reduce CO2 emissions, and does not avoid formation of NOx.

From a practical standpoint, all these fuels present economic, tax, and infrastructure problems. For the next ten years, alternative fuels will probably not exceed 5 percent of consumption in the OECD countries.

Zero -Emission Vehicles Zero-emission vehicles include electric vehicles, hybrid vehicles, and fuel-cell vehicles. Although these vehicles resolve the problems of lo-

cal pollution, they do not resolve the CO2 emission problem at the global level, because their energy is usually produced in electric generation plants and through hydrogen generation.

Pure electric vehicles are efficient in their traction but not in their energy storage. Their range and recharge time are unacceptable for normal consumer use. Important prototypes of batteries are being designed, but no definitive solutions have been reached.

Hybrid vehicles, dual-powered by combustion and electricity, can run in the combustion mode in unprohibited zones, with an unlimited range; then the batteries can be recharged to switch to the electric mode in prohibited urban center zones. These vehicles are currently available for consumer use, but their price is not competitive. «Clean Cars» 137

In the long run, the fuel cell for the battery-powered vehicle appears to offer the best solution. The technology offers a direct hydrogen reaction with oxygen from the air, producing water and electric energy without passing through the thermal energy phase. However, hydrogen poses formidable storage and generation problems, and the current prototype is expensive and heavy. Nevertheless, the industry is betting on fuel cells as the long-term solution.

CONCLUSION

The fight for clean air continues. The work of several decades has resulted in decreased pollution in large European cities, and we expect further improvements. This allows us to be guardedly optimistic about the future.

Drawing on this experience, we can establish priorities for reducing both local and global pollution caused by the automobile. These priorities will best be met by coordinated efforts among governments, regulators, and the industries involved.

• Renewing auto fleets. This is the quickest and most efficient step. More than one-third of vehicles on the road are over ten years old, and 20 percent of these vehicles cause 80 percent of the pollution. Moreover, they are not subject to the new standards.

• Utilizing direct fuel injection gas and diesel engines. Developing new fuels and new catalytic converters to meet the Euro 3 and Euro 4 norms.

• Fueling city buses, corporate fleets, and taxis with LPG and LNG.

• Encouraging the use of biofuels mixed with other fuels.

• Offering incentives for using zero-emission vehicles in corporate fleets. 139

DISCUSSION

QUESTION In a 1998 poll conducted in the United States, people were asked to name the companies they most respected. Those at the top were Microsoft, IBM, General Motors, AT&T, Ford, Wal-Mart, General Electric, Coca-Cola, Intel, and Boeing. You will notice there was no mention of an oil or gas company or electricity utility in the top group. Why not? Possibly because people still equate oil companies with pollution. If that is so, we have a great deal of work to do: we must put an updated picture of our industry before the public. We can no longer rank scientific and technical progress higher than the protection of the environment. Nor should we perceive environmental activities as constraints or additional costs.

MR. TIMMERMAN I agree. Yesterday, one speaker commented that in the 1960s big oil companies obtained what they wanted “by hook and by crook.” 140 Session III

That language, and expressions like the “Seven Sisters” or the “Three Witches,” speak volumes about how the oil industry is still perceived. So I agree that the reputation of our industry is a problem. But how can we solve it? Some companies believe it is futile to spend time and money trying to improve our reputation, while others believe such efforts are essential. I agree with the latter. We need to improve the image of our industry.

Communication is the answer. We must be prepared to engage in the wider societal debates —on topics like environmental issues and human rights— not as some kind of public relations gimmick but out of genuine concern, even if we remain divided on the timing of such actions. I think Michel de Fabiani’s description of work by one of the world’s largest oil groups (BP Amoco) is certainly a good example of the benefits which can accrue to such a policy.

QUESTION One aspect of environmental protection is a growing concern to oil- producing countries: ever higher taxes. As a result of pressures to decrease consumption, energy taxes in the consuming countries have been pushed to exorbitant levels, ranging as high as 60 to 80 percent of the end user price. Such taxes certainly benefit consumer governments, but they do not benefit either end users or the oil producers. Are energy taxes being used to fund the protection of the environment, or to reduce the budget deficits of the consuming countries?

MR. DE FABIANI We all have heard the saying that there is still “a little bit of gasoline in one liter of tax.” And we all know that the tax on oil products in Europe is prohibitively high. However, we live where we live. What we can do is make adjustments over the long term, by improving our image and thus gaining fairer taxation. The best way to correct a negative image is to broadcast the many specific actions we are taking, step by step, to protect the environment. Discussion 141

MR. BENAVIDES I have several comments on the pollution issue; the first deals with alternative mechanisms for control. Of the possible mechanisms listed in the Kyoto Protocol, tradeable permits for emissions are among the most widely discussed and also among the most difficult to implement. I seriously doubt that they can be implemented before, say, 2005. But we have not heard much about other mechanisms which could be used more easily: the joint implementation (JI) mechanism, for example, or the clean development mechanism (CDM). Obviously these necessitate a huge involvement by energy companies, in terms of technology transfers and so on. Would you comment on the possibility of JIs and CDMs being used in the near future? And we have not heard much about “sinks.” Is it really possible to rely on sinks, specifically reforestation, as a method of decreasing carbon emissions?

My second comment is on the car as a source of pollution. Over the next 15 to 20 years, CO2 emissions are expected to grow at a vertigi- nous rate. It is true that CO2 emissions from the transport sector currently do not represent more than 25 percent of total emissions. How- ever, all the studies we have done in DG XVII show that it will soon be possible to reduce a large percentage of stationary emissions. So our worry is about the future when emissions from the transportation sector will become the principal source of these growing pollutants.

Third, the role of alternative fuels. Mr. Moral suggested that alternative fuels such as biofuels might constitute 5 percent of the OECD gas consumption in the next few years. I am skeptical about this. Our information indicates that the use of biofuels is decreasing and that biofuel plants may close entirely. This precariousness is due, of course, to their non-competitive pricing.

My final comment is that we in the DG XVII feel the lack of an ongoing dialogue among the Directorate, the automobile sector, and the fuel sector. Currently we have individual dialogues with each sector, but what we need is a conversation —a “trialogue”— among EUROPIA, ACEA, and the EC. 142 Session III

MR. DE FABIANI We concur in principle on using alternative mechanisms for emissions control. Tradeable permits are one mechanism; JIs and CDMs are others. However, what one company alone can do is very different from what can be implemented within the larger scope of a general- ized program. You also mentioned reforestation. BP Amoco has a program in Turkey where we sponsor and support reforestation, but reforestation is probably an option only on a case-by-case basis. And you asked about biofuels. We welcome any fuel that can contribute to a clean environment on a fair economic basis, but I am not sure that biofuels fit in this category.

MR. TIMMERMAN When we talk about renewables, we need to identify our real goals. Are we principally concerned with increasing the use of renewables to aid in preserving the supply of conventional fuels —or to aid in decreasing emissions? As one of our speakers noted, the Coal Age did not end because we ran out of coal. And we do not believe the Oil Age will end because we will run out of oil. According to the latest forecasts, there will be enough oil for the next 40 years or so, at the present development rate.

So if we do not need to encourage renewable energy, since oil is not running out, why make all these investments and spend taxpayers´ money for development of renewables? If, on the other hand, the principal goal is the reduction of emissions, that is a very different matter. If that is our target, then a great deal can be done to develop cleaner fuels, with the added benefit of prolonging the internal combustion engine.

Turning to taxes, government officials often justify increased energy taxation as a means of reducing pollution by reducing consumption. However, the data show that while taxes on automotive fuels in Europe have more than doubled over the last 20 years, oil consumption has increased at an annual rate of 1.3 percent. Higher taxes have not resulted in lower consumption. Discussion 143

MR. MORAL The automobile industry is working to develop vehicles that can operate on any of these alternative fuels except hydrogen. As I noted earlier, such vehicles do exist, but the fuels present many difficulties. Methanol is a clean fuel, but it cannot be used in central and northern Europe because it has a problem igniting in cold weather. Ethanol’s energy level is closer to that of gasoline, but its principal drawback is its serious adverse effects on the vehicle’s motor. And the problem with biodiesel derives not from the automobile industry but from the fiscal and agricultural policies of individual nations. Would biofuels be considered seriously if government subsidies and resources were not available?

QUESTION There is no one magic bullet to solve environmental problems. Every alternative solution comes with its own drawbacks. In all complex environmental problems, and certainly climate change, we should consider solutions from every available sector instead of placing the full responsibility onto any one sector. We all have contributions to make.

One such solution may be solar energy. When we speak of zero-emission vehicles, it is important to remember that even though the cars themselves will produce no emissions, the fuel they use (electricity) has been generated elsewhere, and this traditional generation process produces CO2 emissions. However, using solar energy in the generation of electricity could contribute to reducing emissions.

MR. MORAL I think the use of solar energy for vehicles is not technologically feasible at the present time. The power generated per square meter simply does not permit this technology to be used in an ordinary car.

Even with a time horizon of ten years, we do not see a solution to the storage problem that would produce the mobility required by most motorists. At the present time, a set of solar batteries for a private car 144 Session III

provides a maximum distance of 120 to 150 km (75 to 94 miles) and requires six hours of recharging time. Even when energy generation by solar panels arrives on the scene —and this is just a matter of time— we do not foresee technical advances that will offer adequate mobility. But this is not the case for delivery fleets or other urban vehicles that travel limited distances and have access to technical assistance and recharge zones.

QUESTION The EC directives affecting the automobile and oil sectors were approved in 1998 and will be modified after joint discussions by the EC and the Parliament before the end of 1999. Do you worry that the final legislation will pass without adequate discussion?

MRS. ESTEVAN There may well be preliminary negotiations among the EC, the General Directorates (of Energy, Investigation, Industry, and the Environment), and the Parliament. I agree strongly that both EUROPIA and ACEA should be present at these sessions. But I emphasize that almost all the current directives will be modified during the next few years: there will be a great deal of new —and more stringent— legislation. The current environmental regulations are not being met, so we must be tougher.

MR. TIMMERMAN The oil industry is prepared and eager to cooperate with the EC, the Parliament, and the automobile industry. We strongly believe that a cooperative effort will lead to the best technical solutions, at the lowest cost to society.

MR. MORAL I am quite sure also that the automobile industry would be eager to join the Parliament, the EC, and our friends in the oil industry to frame this new round of legislation. Discussion 145

PROF. HOGAN My question is for Mr. de Fabiani. One interpretation of the approach that BP Amoco is taking is that it produces better products, lower costs, and a happier workforce, which is beneficial for the company, versus other kinds of direct benefits that profit the company. If that is what you were saying, it seems to me that there is an inherent contradiction in the fact that the internal trading permit price has a positive price, at the moment, as opposed to zero.

Another interpretation is that you see an important role for government and regulation, because in the long run most companies will not take action unless coerced or mandated to do so. I think there will be need for regulation to make companies act responsibly. Al- though it is not inherently profitable, it may be wise for a company to invest in advance of the regulatory and legislative process in order to get a headstart on what you see coming down the road, or to shape future regulation. Could you comment?

MR. DE FABIANI We need to make a profit and deliver dividends and added value to our shareholders, but we have other objectives as well. Trading permits have a price; there is no market when the price of anything is zero. Every commodity in every market fluctuates, and so will the value of trading permits. This is a pilot program: I have no idea what next year’s price will be of CO2 trading permits within our company. But we want to give the program a fighting chance to succeed.

On regulation, let me emphasize the value of having regulators formulate ambitious targets with specific dates. Visible deadlines allow the industry (which has always been a long-term industry) to anticipate and plan accordingly, to meet or exceed these targets. In the final analysis, regulations directed toward targets are useful for defining what the public wants from its regulators. Nonetheless, these targets should allow flexibility for the industry to decide what means it will use to meet them. We must also have the choice as to whether we enact changes close to the deadline or proactively, 146 Session III

depending on an individual company’s structural basis. We cannot reinvent or relocate our companies.

MR. SULTAN I would like to add two brief comments. I recall an economist at our 1997 Seminar making a pithy comment about energy taxes: “Taxes do not clean the air; they clean the pocket.” He cited the experience in United States, which has both lower energy taxes and lower emissions than Europe.

My second comment is about the public’s perception of the oil industry. A colleague of mine, a director at one of the super-majors, recently attended his son’s graduation from Cambridge University. Afterwards, at a graduation party that was expected to be a pleasant social occasion, he ended up having to defend the reputation of the oil industry for hours. His son’s friends categorically declared that they would never work for the oil industry!

Yet our communication problem is not one of the oil industry versus the environment or the oil industry versus the community. We are part and parcel of the community. Wherever you live or work or travel, oil and related industries —pharmaceuticals and chemicals— are among the major employers, whether in small towns or major cities. We are the community, so we have inherent respect for the environment.

MR. TIMMERMAN In reference to the growth of government regulation, I would like to point out a disconnection between governments and the public. Governments appear to have a strong urge, even a compulsion, to dwell on environmental issues, but the public has a more balanced set of concerns, among which the environment is only one of many. Perhaps the governmental urge for creating rules and regulations is exacerbated by the structure of European politics and by the ongoing need of politicians for headlines. In such a milieu they find it tempting Discussion 147

to focus on the environment and on the related issue of energy taxation. And yet polls throughout Europe show that concern about the environment is not high on the public agenda.

QUESTION Gasoline seems to be included in the same group as tobacco and alcohol: it is taxed for punitive or moral reasons. Once gasoline taxes were justified as a means to decrease consumption and aid security of supply. Now the justification is the environment.

My question is for Mrs. Estevan. When will governments become sensitive to consumers’ needs, pay less attention to treasury departments, and push for a reduction in these taxes?

MRS. ESTEVAN You should not expect energy taxes to decrease —they will not. Europe has a very important social welfare system, and we are not going to abandon it. With a large aging population, requiring enormous costs in pensions and related expenses, where can the money come from? From a splendid product, with a rigid demand curve, which the average consumer does not want to do without: gasoline.

You do not have to worry about prices; the consumers will pay what is asked if they can receive dependable supplies of energy, good electrical service, and enough pure water. However, we should not forget that in the European Union, people worry first about employment and economic issues. Environmental issues are tacked onto this basic concern.

In closing, let me repeat my earlier comment. Oil contributes greatly to the quality of life; that is the message you should give to the public. The energy industry plays a vital role in society, and I expect this role to increase in the next century. Your future promises to be brilliant. 149

CLOSING SESSION

SUMMARY AND COMMENT

DR. IRWIN M. STELZER HUDSON INSTITUTE

Mr. Cortina opened this year’s Seminar by reminding us that our Repsol-Harvard Seminars have always had “ambitious goals.” And so they have. We have dared to look into the future, not only to predict what might occur in the various industries in which we are all interested, but also to determine how we might devise policies to affect the future. In that sense we have been very much like our host: Repsol, too, has shaped a future very different from the one that existed when Harvard and Repsol first came together more than a decade ago to launch this seminar series.

As the Seminars have grown each year —despite our efforts to keep them to a manageable size— and have become more important, so, too has our host. As the issues we confront become more complicated, so too does the world in which Repsol operates. As the international reach of these Seminars has expanded, so, too, has the global reach of Repsol. I cannot help believing that the similarities between the development of Repsol and the development of these conferences is more than mere coincidence. Rather I think these 150 Closing Session

similarities are the result of the intense intellectual exchange between the Harvard organizers and the Repsol sponsors, of the marvelous friendships that have grown up among the participants, and of the deeper understanding of Spain’s history and culture that Repsol has encouraged. For all this, we thank Alfonso Cortina and his staff.

This Tenth Seminar (in our series of what Bill Hogan called “an ongoing conversation”) is perhaps more difficult to summarize than any of the previous ones. This is the case because we have treated sub- jects of extraordinary complexity, producing more contradictions, than did any of our previous gatherings.

THE MAGIC OF THE MARKETPLACE

The first of these contradictions deals with the roles to be accorded to markets and to regulation. Bill Hogan began with the cheering thought that over the course of the Seminars we have moved from discussing government actions to discussing market forces, from asking ourselves what governments can do for the energy industry to asking how we might formulate rules so that markets can work their magic for us. That formulation appealed sufficiently to Robert Hefner to have him, too, talk of the “natural magic of the marketplace.”

Other participants eagerly signed on, either directly or by implication, to the proposition that free, competitive markets are far superior to regulation in producing efficiency and in maximizing consumer welfare. Pablo Benavides spoke glowingly of the liberalization of the European Union’s gas and electricity markets, and looked forward to the day when the EU would have one single, linked, liberalized market —perhaps even including France.

Roger Sant joined the ranks of those extolling the virtues of liberalization and privatization by pointing to the consequences of those developments. Combined with technology and low gas prices, liberalization and privatization have driven electricity prices down, in some places by 50 percent, and have made gas cheaper and electricity Summary and Comment 151

cleaner. Bill Massey also joined in the pro-competition choir, and with good reason. He pointed out that his agency, the U.S. Federal Energy Regulatory Commission, has helped introduce what he called “vibrant competition” in both natural gas and electric markets by ad- hering to a list of core principles, the first item being that “commodity markets are best regulated by the forces of competition.”

Those of us who are always looking for ways to put regulators out of business —a God-given task that one has to assume through life— might consider the suggestion made by a former regulator who seems intent on living down her questionable past by returning to the real world. She suggested that we might follow a procedure that was used when deregulating gas storage facilities on which British Gas held a monopoly. As I understand it, the U.K. regulators set the terms by which British Gas was required to auction off capacity, and then they departed the scene, leaving it to the auction process to set prices. Whether that procedure is applicable to other monopoly facilities, I do not know. But it is something we ought to consider as a way of reducing the burden of regulation.

LIBERALIZATION —YET MORE REGULATION

All this is enough to warm an economist’s heart. And yet, with all this talk of competition, there was also much talk about the need for regulation, indeed, for more regulation than ever. Bill Massey, conceal- ing a sigh of relief, said there will always be a role for regulators. Among other things, he wants to regulate international markets — not having enough to do at home— and feels that there are sufficient monopoly elements in the wires and pipeline businesses to require continued regulation.

I am inclined to agree with that latter assertion, but I am also inclined to be skeptical of his response to the question as to whether regulators will know when to go away: “Will you recognize when distributed energy is providing sufficient competition for you to let go?” Bill Massey said he thought that they would, but I am a bit skeptical. A 152 Closing Session

wonderful little book by Alfred Kahn, Letting Go, describes how difficult it is for regulators to do just that. I worry that if the time comes when distributed energy is a real force, and if the utilities find themselves with stranded assets in the wires business, the regulators will once again step in and decide that consumers should bear the cost of managerial mistakes and reimburse the companies for those newly stranded costs.

It is not only monopoly facilities that would seem to require more regulation. According to María Theresa Estevan, a member of the European Parliament from Spain’s conservative Partido Popular, government has the responsibility to see that consumers get secure, high-quality supplies of energy, suggesting that this task cannot be left to market forces alone. Antonio Brufau worried that competition might interfere with the development of the gas business. And Pablo Benavides, who is director-general for energy in the European Com- mission, went further. He told us that regulation will not decrease; rather, it will increase because “liberalization requires more regulation than a monopoly market.” When a man who is justly proud of his role in liberalizing markets warns us that liberalization means more regulation, it behooves us to listen. Regulation is not going to go away.

Finally, my colleague Bill Hogan spoke glowingly of the magic that markets can produce. That was on Friday morning. By Friday after- noon, he was questioning just how we could avoid democratic procedures in restructuring markets. I should say at the outset that Bill Hogan has every right to want to avoid the intrusion of others into his restructuring schemes —events have proved him right and his critics wrong. But still, his proposition has to give us pause. Bill wants markets to work (possibly under the direction of some wise central dispatcher, perhaps Jan Moen), but only after “a small group of people takes it upon itself to set up something that is in the public interest.”

That is a terrifying statement to those of us who know a little Euro- pean history! The elite group would be advised, of course, by competent technical people, which probably makes the prospect a Summary and Comment 153

bit worse. Interested parties like stakeholders need not apply to be heard in this process. This is an arrogation of power that even Federal Reserve Board Chairman Alan Greenspan would not dare attempt. That does not mean it is wrong, but it does suggest that it will be wise men, not free markets, that restructure the electric industry in the world in which Bill would have us live.

“STABILIZING” OIL PRICES

All these proposals for regulation, if adopted, would merely slow the unstoppable march toward competitive electricity and gas markets. These are trivial impediments compared with the proposals we heard about oil prices and the need to impose what is called stability on the market for crude oil, a subject that was raised by our first panel.

When discussing the oil business, we generally agree that certain facts cannot be ignored. First, words do not always mean what they seem. For example, several panelists spoke of the need to “stabilize” oil prices. By that, they mean they want to raise prices, from $10 a barrel to $18 a barrel. So spell “stabilize” as “ra-i-s-e” when you hear that people want to stabilize oil prices.

Second, technology has driven down the cost of finding, developing, and producing crude oil. Nader Sultan pointed out that the oil industry is the world’s largest consumer of information technology, and he estimated that the cost of finding, developing, and producing oil from the next field capable of producing half a billion barrels a day is on the order of $2 a barrel. That is a stunning number to keep in mind.

Third, we may be on the verge of developments that will bring dis- covery of massive, new, low-cost reserves. Bijan Mossavar-Rahmani agreed with Nader Sultan’s $2 a barrel cost estimate and said that the Persian Gulf nations are groping for ways of once again permitting the major oil companies to participate in the development of their resources. The five countries in the Persian Gulf (Saudi Arabia, Iran, Iraq, Kuwait, and the United Arab Emirates) hold over two-thirds of 154 Closing Session

the world’s proven oil reserves. Allowed to play in that area after years of exclusion, the majors or the super-majors will inject capital and technical know-how into a region that needs both. This will increase its importance as an oil supply area, and will take us, as Bijan Mossavar-Rahmani said, “back to the future again.”

These developments in the Persian Gulf will raise questions for consuming nations about security of supply. It will also force us to consider that issue once again at some future Seminar, after years of complacency brought on by low prices and a world awash in crude oil. Bill Hogan may have to dust off some of his old energy security models, sooner rather than later.

Fourth, we have witnessed a substantial secular decline in the real price of oil. As Alfonso Cortina pointed out, in 1998 oil prices fell continuously from more than $16 a barrel to around $10, causing a massive transfer of wealth from producing nations to consuming nations. This transfer was, in part, responsible for the continuation of America’s long-running economic growth, since lower oil prices are the equivalent of a tax cut to American consumers. And it was a crucial factor in allowing America to be the consumer of last resort during the Russian, Asian, and Brazilian crises.

All of these facts are indisputable. But we heard little applause from the oil producers present at this Seminar for the market forces that created these low oil prices and these benefits to consumers. Instead, we heard a discussion of plans to “rationalize” the oil markets, to stabilize prices. We heard pleas for an end to confrontation and for a new era of cooperation between OPEC members and non-members, and between producers and consumers. Bijan Mossavar-Rahmani thought that something must be done to stabiIize —and he used the word in the correct sense— oil prices to provide sufficient assurance to companies contemplating long-term investments, which he believes futures markets are incapable of providing.

Even Luis TéIlez found that his responsibility for the well-being of his nation’s citizens overrides the economics he learned at MIT and this Summary and Comment 155

led him to broker the oil cartel’s price-raising production cutbacks. The enthusiasm for free-floating oil prices is not universal.

In short, this tenth session of our seminar series reflected conflicting views: sincere talk of the magic produced by markets versus equally sincere arguments that the invisible hand of the market must, at times, be replaced by the long arm of government regulators or private cartelists.

THE OIL INDUSTRY: PRESSURES AND PROSPECTS

Our tenth gathering also produced another set of contradictory trends. What is the future of the oil industry? Nader Sultan, not a man given to easy exaggeration, feared that oil might not play a major role in the next century and that substitutes might be developed, even for automotive use. Others worried that the agreements reached in Kyoto mark the beginning of an assault on the use of all fossil fuels, including oil. But those views were far from unanimous. Dr. Traynor felt that the oil industry has emerged from the latest period of low prices stronger than ever. Mrs. Estevan believes that oil has a spectacular future, because as the developing world becomes richer, its inhabitants will want millions of cars and energy-consuming appliances. This will come as good news to the two million people that Jan Timmerman told us are employed in Europe’s industry.

There can be no doubt that the oil industry will find itself under siege from regulators, from environmentalists, from tax-prone politicians, and, in some markets, from fuel substitutes. I do not think an industry of this size will suddenly disappear; but there are enough exampIes of industries that have disappeared to give us pause.

The fact is that we have not integrated all the information that we now have about the role of natural gas, about the impact of responses to the possibility of global warming, about the budgetary problems of producing nations, about the role of OPEC. We have not put all these together into a systematic look at where the oil industry might be going. And that is something we might want to consider for the future. 156 Closing Session

EMERGENCE OF THE SUPER-MAJORS

We do know at least one thing: the industry that will exist when we convene our Twentieth Seminar will be as different from the one that exists now, as the industry is today from that of ten years ago. Among other changes, it will be home to much larger companies. Bijan Mossavar-Rahmani pointed out that big oil has become enormous oil. And Dr. Traynor noted that the three largest companies have a market capitalization of $600 billion, which is more than the rest of the industry combined. These are very big companies.

But Bijan, who in earlier years extolled the role of swift, flexible, independent companies, apparently has come around to the view that size is necessary, at least for those companies that want to deal with host governments of producing nations. Those governments believe that larger companies have better technology, longer-term horizons, and greater political clout in their own home countries. This explains the attraction of having American companies along the border with Iraq. If their assets are threatened by Iraq, these companies will bring pressure on the U.S. government to protect them and, not inciden- tally, the countries themselves.

On this score, we received a warning from one participant who urged us not to overdo the role of political muscle. But he nevertheless agreed that size will be a crucial component in the years to come because we are moving into a world “where the large players may not be large enough to exercise all of the options available to them.” Commercial life is no different from private life in this particular. It consists of choosing among alternative options, weighing the opportunity costs associated with each choice. Bigger companies apparently have wider choices, but inevitably these choices will not be unlimited.

THE IMPORTANT SECOND TIER

Although our Seminar participants agreed that size will matter, there was no clear agreement on just how big is big enough to survive and Summary and Comment 157

prosper. The largest three companies have continued cost-cuttin- campaigns that they began before their mergers (not unlike the banking, auto, and other industries). But J.J. Traynor says that those cost-cutting campaigns are running out of steam. I do not know if that is true, nor do I think the companies know either.

It is fair to conclude that there will be enough room in the oil industry of the future for “Enormous Oil” (as Bijan calls it), for smaller but very substantial integrated global companies, such as Repsol, and for independents, although I do not think we have sufficiently explored the survival prospects of the independents to reach more than an in- tuitive conclusion about their prospects. For the moment, I will rely on the judgment of José Luis Díaz Fernández, who told us in 1998 that different companies are taking different paths: some are concentrating on specialization, others on diversification —expanding their product lines and the geographic scope of their operations. But whatever their paths, there will be no room for companies that, we are told, “do not keep their word to shareholders.”

A NEW OPEC FOR A NEW CENTURY?

Whether there is also room for OPEC in the oil industry of the future is a more difficult question. Dr. TélIez believed there is room for OPEC. He prided himself on what he called the “aggressive diplomacy that he used in reawakening both OPEC and non-OPEC producers to the need to curtail output to force prices up. Nader Sultan reminded us that the cartel has survived for 40 years, has kept some 40 mbd of capacity off the market, and has forged a new relationship with non-members. Nevertheless, he believed that OPEC must change if it is to be an effective force in the twenty-first century.

Success for OPEC would, he argued, consist of keeping prices high enough to provide producing nations with sufficient revenues for the social services demanded by their populations. And he fixed that number at about $15 a barrel (in 1999 dollars). At the same time, these nations must not become so comfortable as to ignore the 158 Closing Session

longer-term problems presented by their undiversified economies. This is a difficult balancing act. He was reasonably optimistic that OPEC will be able to achieve this so-called balance, which is very bad news for consumers. I think his phrase was, “having put out the fire, OPEC can now plan for the future,” the “fire” being the $10 oil prices that existed in early 1999.

Another participant noted that the OPEC future must include plans to cope with four issues: the threat of fuel substitution; technological change; environmental issues; and the role of futures markets in oil pricing. In reviewing past volumes of Seminar Proceedings, I found that we first considered the role of futures trading in oil prices at Toledo in 1989. Perhaps we should take another look at that topic.

NATURAL GAS: THE EMERGING CONSENSUS

I am not sure we have to give more thought to the natural gas industry. We have given much consideration to that industry in these Seminars, and the fact that agreement is so broad makes me wonder whether there are any questions that remain to be considered. Antonio Brufau summarized the consensus when he said that natural gas is the energy of the twenty-first century. Robert Hefner predicted the day when natural gas would have a higher share of energy markets than oil. Roger Sant pointed out that gas combined cycle turbines can produce electricity at a cost of 2.8 cents/kwh. The low cost of natural gas for primary energy use and for generating low-cost electricity may be why renewables are not assuming the role predicted for them some years ago.

But that is not to write off renewables. Mr. de Fabiani expressed faith in the future of solar energy —a faith reflected in the hundreds of millions of dollars that BP Amoco is committing to solar development. In any event, if Bob Hefner was right that we are in a transition from solid to liquid to gas as fuels— from dirty, expensive, cen- tralized systems to clean, efficient, decentralized systems —we do not have to worry about alternative fuels at all. Summary and Comment 159

There are two issues in the gas industry, however, that are worth further consideration. Pablo Benavides informed us that the liberalization of the European gas market is not proceeding as rapidly as is the liberalization of electricity markets. There seems to be a conflict between the desire to liberalize and the desire to maintain security of supply in nations that are not self-sufficient in gas resources. Coun- tries that have liberalized, such as the United Kingdom and the United States, have reliable domestic sources. So the question that arises is whether countries dependent on imports can rely on free markets to deliver sufficient security of supply to warrant repealing the regulations now in place. It is a question that will prove of considerable importance to the oil industry, too, if we become increasingly reliant on Persian Gulf supplies.

The second issue for the gas industry, one that we have not fully explored, is the relationship between the price of natural gas and the price of oil. One participant thinks the price of gas will be “a decisive factor in determining the price of oil.” If I understand Roger Sant correctly, he thinks they are decoupled at the moment. We may want to consider this issue.

THE ENVIRONMENT: DEFINING “PROACTIVE”

In our final session, on the environment, Michel de Fabiani kept us informed of BP Amoco’s progress in developing an internal tradeable permit program, an initiative in which we are all intensely interested. And he made a powerful case for a proactive policy that puts a company out in front, ahead of government. There seems to be a wide agreement with this view, as Jan Timmerman concurred. But how can a company get out front, and stay there?

We might learn some lessons from Stuart Dombey, who offered three suggestions that might be applicable to the energy industry. First, international cooperation among regulators can be cost-effective. For the energy industry it would be useful to have international cooperation among regulators for specifying engine types, emission 160 Closing Session

standards, fuel standards, and so on. After all, the automobile and the fuels markets are international. Second, Dr. Dombey suggested that ongoing education of legislators and regulators (a/k/a lobbying) is essential. Third, a “no secrets” policy and candor build credibility over the years. Stuart Dombey emphasized that credibility is a key, and Jan Timmerman agreed.

Stuart also noted that regulation must be based on “sound science.” Here we do have a problem because Mr. de Fabiani reminded us quite properly that at times it is essential to go forward even if the science is uncertain. Jan Timmerman bemoaned the poor public image of the oil industry. Juan Antonio Moral detailed the environmental issues raised by the automobile: these are products that intrude on the environment. There is no way to make them completely benign.

But the overall impression is one of substantial progress. Mr. de Fabiani described how one company can develop programs that cope with the possibility of greenhouse gases; Mr. Timmerman showed how much cleaner fuels have become; and Mr. Moral informed us of the auto industry’s plans to reduce pollution still more. In other words, progress is being made.

AN ECONOMIST’S FOOTNOTE

Permit me one footnote to this meeting —a warning to economists about excessive hubris. Economic analysis can inform but cannot determine policy decisions.

An important additional factor is history: history matters. Bijan said that the international oil companies “took by hook and by crook more than their fair share” of oil revenues, particularly in the Middle East. That is a widely-held perception that colors the relationship between producing countries and companies that want to operate there in the future, even though there is a clear economic advantage, to both parties, of full cooperation. Summary and Comment 161

A second factor is politics: politics matter. Dr. TéIlez made it very clear that politics in his country make it nearly impossible to do what an economist would want to do with the energy industries.

Third, culture matters. Alfonso Cortina pointed out that the merger of Repsol and YPF had been smoothed over by their common culture, and that absence of a shared culture has caused many mergers to fail.

So we economists have to keep in mind that history matters, politics matter, culture matters. We can be advisors, we can supply numbers, we can suggest what is economically rational, but we cannot, in the end, make the decisions.

In sum, what have we learned? Let me list six points:

• Liberalization and free markets have produced enormous benefits, but regulation is here to stay and may increase.

• The oil industry is now characterized by enormous companies, but well-managed second-tier companies can grow and prosper.

• OPEC has succeeded in raising prices recently, but will have to develop a new strategy if it is to survive through the next century.

• The oil industry is under threat from substitutes and environmental regulation, but nevertheless has a glowing future.

• Fossil fuels and the automobile create environmental problems, but solutions are being developed.

• Repsol continues to succeed both as an oil company and as a host. There are no caveats, no buts to follow that final lesson. 163

BIOGRAPHIES OF SPEAKERS

Pablo Benavides has been director-general for energy, DG XVII, in the European Commission since 1996. He entered the Spanish diplomatic service in 1964 and held a series of positions with wide-ranging responsibilities, including secretary to the Spanish delegation from the Ministry of Foreign Affairs, responsible for negotiations with the EEC (1966-1968), and secretary of the Negotiating Confer- ence for Spanish Accession Negotiations (1979-1981). In 1994, Mr. Benavides became director of the newly-created Directorate-General for External Political Relations of the European Commission, in charge of relations with the countries of Central Europe and the Commonwealth of Independent States. Mr. Benavides holds a law degree from Central University, Madrid.

Antonio Brufau has been chairman of Gas Natural Group since 1997 and president and CEO of Caja de Ahorros y Pensiones de Barcelona “La Caixa Group” since January 1999. After receiving his undergraduate degree in economics from the University of Barcelona, Mr. Brufau 164 Biographies of Speakers

joined Arthur Andersen & Co., S.R.C., and was made partner in 1980. Based in Barcelona, he headed the firm’s audit division from 1980 to 1988, and also served on the firm’s worldwide advisory council. He served as chairman of Port Aventura from 1994 to 1997 and as senior executive vice president of La Caixa from 1988 to 1999. Mr. Brufau presently serves on the boards of directors of Rep- sol YPF, Aigües de Barcelona, Acesa, Inmobilaria Colonial, and Banco Herrero.

Alfonso Cortina de Alcocer has been chairman and CEO of Repsol S.A. (now Repsol YPF) since June 1996. From 1984 to 1996, he served as vice chairman, chairman, then managing director of Portland Valderrivas, S.A., as well as chairman of the firm’s delegate commission. Mr. Cortina has had extensive experience in the banking industry, including executive positions at Banco de Vizcaya Group,Banco His- pano Americano, Banco Central, and Banco Zaragozano. His professional activities have included chairmanship of the Asociación Hipotecaria Española. He was honored by the Madrid Official Cham- ber of Commerce and Industry as “Businessman of the Year” in 1995. Mr. Cortina holds degrees in advanced industrial engineering and in economics from ETSII and Madrid University, respectively.

Michel de Fabiani is regional president Europe for BP Amoco and is also vice president of the European Petroleum Industry Association (EUROPIA). Mr. de Fabiani joined BP in 1969 and served in a variety of national assignments within Europe. In 1991, his career took on a broadly European focus when he went to Brussels as services and control director of BP Oil Europe. In 1997, Mr. de Fabiani was appointed CEO for BP Oil Europe, and in January 1999, he was also made regional president Europe of the newly-merged BP Amoco.Mr. de Fabiani is a graduate of the Paris Business School.

José Luis Díaz Fernández has been president of Fundación Repsol since its creation in January 1996, with a mission to coordinate Rep- sol’s work in promoting educational, cultural, and research activities relating to energy and society. After serving in the public sector as the director general for energy in the Ministry of Industry, Mr. Díaz Biographies of Speakers 165

Fernández moved to the private sector in 1975 and then to Repsol after its founding in 1987. He has served Repsol in many roles, including chairman and CEO of Repsol Petróleo and chairman and CEO of Campsa. Mr. Díaz Fernández has a Ph.D. in mining engineering from the Polytechnic University of Madrid, where he serves on the faculty of the School of Mines, and is a member of the Spanish Academy of Engineering.

Stuart L. Dombey has been vice president of international regulatory affairs at Parke-Davis in Ann Arbor, Michigan, since 1990, responsible for new-product approvals worldwide and for European regulatory strategy. Prior to joining Parke-Davis, Dr. Dombey worked at Squibb and Hoechst in a variety of medical and regulatory roles. He qualified in medicine at Liverpool University and is a fellow of the Royal College of Physicians of Edinburgh.

María Teresa Estevan Bolea is a member of the European Parliament where she serves on the Research, Technological Development, and Energy Committee and on the Environmental, Public Health, and Consumer Protection Committee. A member of Spain’s Partido Pop- ular, she was a representative from Madrid to the Spanish Parliament from 1987 to 1993, where she was a spokeswoman for her party on energy, environment, and equal opportunities for women. Mrs. Este- van is an industrial engineer by profession, and has worked on the design and construction of many large projects including chemical plants and refineries, and oil and gas pipelines. She has also served in the Ministry of Public Works as general director of environment. Ed- ucated at the Polytechnic University of Barcelona, Mrs. Estevan teaches graduate courses on energy and the environment at Spanish and Latin American universities.

Robert A. Hefner III is owner and managing partner of The GHK Company and chairman of the board, managing director, and CEO of Houston-based Seven Seas Petroleum Inc. After graduating with a geology degree from the University of Oklahoma, he formed GHK, a private natural gas and oil exploration and prodution firm with offices in Oklahoma City. GHK became known for its pioneering 166 Biographies of Speakers

deep high-pressure gas drilling and production in western Oklahoma and the Texas Panhandle, and for leading the industry in technological drilling innovations. Exploration in Colombia culminated in significant discoveries in the Magdalena River basin. GHK subsequently consolidated its Colombian oil interests with Seven Seas Pe- troleum Inc., a publicly-traded oil and gas exploration and production company. Mr. Hefner was a founding member of the board of directors of the Business Council for Sustainable Energy, and has served on the advisory council for the School of Advanced Interna- tional Studies (SAIS) at Johns Hopkins University, and the advisory board of the International Institute for Applied Systems Analysis (IIASA) in Austria.

William W. Hogan is Lucius N. Littauer Professor of Public Policy and Administration at the John F. Kennedy School of Government, Harvard University. Professor Hogan is also research director of the Harvard Electricity Policy Group (HEPG), which is developing alternative strategies for the transition to amore competitive electricity market. As a director of Navigant Consulting, Inc., he is involved in research and consulting activities on topics such as major energy industry restructuring, network pricing and access issues, and privatization worldwide. Professor Hogan received his undergraduate degree from the U.S. Air Force Academy and his Ph.D. from UCLA.

William L. Massey has served as a commissioner of the U.S. Federal Energy Regulatory Commission (FE RC) since 1993. He has actively participated in FERC’s restructuring of the natural gas industry, notably via Order No. 636, and was an architect in the development of Order No. 888, FERC’s historic electric restructuring initiative. Since 1997, Mr. Massey has served as FERC’s lead commissioner on the subject of merger policy. He has had extensive legal and policymaking experience in both judicial and legislative branches of the federal government, including service as senior member of the U.S. Senate Committee on Energy and Natural Resources. Before joining FERC, Mr. Massey was in private legal practice. He received an LL.M. from Georgetown University Law Center and a J.D. from the Univer- sity of Arkansas School of Law. Biographies of Speakers 167

Juan Antonio Moral GonzáIez is president of Fasa-Renault, S.A. and also serves as president of the Association of Spanish Automobile Manufacturers (ANFAC). Mr. Moral joined Fasa-Renault in 1961 as head of manufacturing, and subsequently held a series of posts inclu- ing industrial director and director of mechanical manufacturing of the Renault Group. In 1994, he was named president of Fasa-Re- nault. Mr. Moral holds a Ph.D. in engineering and a Licentiate degree in computer science. He is a knight of the Legion of Honor of France and has also been awarded the French Labor Medal.

Bijan Mossavar-Rahmani is Chairman of Mondoil Corporation. From 1988 to 1996, he was president of Apache International, Inc. Prior to joining Apache,Mr. Mossavar-Rahmani was assistant director for International Energy Studies at the John F. Kennedy School of Government, Harvard University. He is a director of both Compagnie des Energies Nouvelles de Cóte d’lvoire and Apache Cóte d’lvoire Pe- troleum LDC, and is active in industry and international affairs as a member of the Council of the U.S. International Executive Service Corps and the International Consultative Group on the Middle East. A former delegate to OPEC ministerial conferences, Mr. Mossavar- Rahmani has published numerous books and articles on international oil and gas markets. He holds degrees from Princeton and Harvard Universities.

Alberto Ruiz-Gallardón is president of the Autonomous Community of Madrid. A lawyer by profession and a member of the national executive committee of the Partido Popular, Mr. Ruiz-Gallardón has long been active in Spanish politics and government: in 1983, elected as a councillor to the Madrid Town Hall; in 1987, elected as a representative to the Madrid Assembly; and in 1987, elected as a senator to the National Parliament representing the Community of Madrid.

Roger W. Sant is chairman of the board of the AES Corporation, a leading global power company, which he co-founded in 1981. AES is dedicated to providing electricity worldwide in a socially responsible way. With assets in excess of $10 billion and projects under construction valued at $5 billion, AES currently owns or has an interest 168 Biographies of Speakers

in 91 power facilities worldwide. Prior to founding AES, Mr. Sant was director of the Mellon Institute’s Energy Productivity Center and served in the Ford administration, where he was a key developer of early initiatives to fashion a U.S. energy policy. Mr. Sant received a B.S. from Brigham Young University and an M.B.A. from the Harvard Graduate School of Business Administration. Since 1994, he has chaired the board of the World Wildlife Fund US, and is chairman of The Summit Foundation. Mr. Sant is co-author of Creating Abun- dance: America’s Least-Cost Energy Strategy (1984).

Irwin M. Stelzer is senior fellow and director of regulatory policy studies at the Hudson Institute in Washington, DC. He is a U.S. economic and political columnist for The Sunday Times (London) and The Courier Mail (Australia), and a columnist for The New York Post. Dr. Stelzer has written and lectured widely on economic and policy developments in the United States and the United Kingdom, particularly as they relate to privatization and competition policy. In 1961, he founded National Economic Research Associates, Inc. (NERA) and served as its president from 1961 to 1983. In addition, he served as director of the Energy and Environmental Policy Center at Harvard University and as director of regulatory policy studies at the American Enterprise Institute (AEI). Dr. Stelzer received a B.A. and an M.A. in economics from New York University and a Ph.D. in economics from Cornell University.

Nader H. Sultan is deputy chairman and CEO of Kuwait Petroleum Corporation. He began his career at the Kuwait Petroleum Company in 1971, and when the Kuwait Petroleum Corporation was formed in 1980, he was appointed executive assistant manager for Worldwide Product Sales. Mr. Sultan later served as the executive assistant managing director for planning and international downstream in the Marketing Division, and simultaneously, as president of Kuwait Petroleum International Limited (KPI), upon its formation in July 1993. Mr. Sultan received a B.Sc. in economics from the University of London.

Luis TélIez Kuenzler was appointed Mexico’s secretary of energy in October 1997, after having served for three years as chief of staff to Biographies of Speakers 169

President Ernesto Zedillo, as deputy secretary for agriculture (1990-1994), and as chief economist at the Ministry of the Treasury. Dr. Téllez did his graduate work at MIT, where he earned a Ph.D. in economics, concentrating on international economy, econometrics, and private finance. He has taught at the Autonomous Technological Institute of Mexico (ITAM) and at MIT, and is the author of numerous publications, including The Open Economy: Tools for Policymakers in Developing Countries (1998) with co-author Rudiger Dornbush; The Modernization of the Agricultural Livestock and Forestry Sector (1994); New Legislation on Land, Forest and Water (1993); and Fighting Inflation (1993) with co-author Carlos Jarque.

Jan J.F. Timmerman has been secretary general of the European Petroleum Industry Association (EUROPIA), headquartered in Brussels, since June 1998. Earlier, during a lengthy career at Shell International spanning more than three decades, Mr. Timmerman worked around the world for a variety of Shell business groups, including chemicals, marketing, and communications. He concluded his career at Shell as president of Shell Belgium-Luxembourg. Mr. Timmerman is a graduate of Brussels University with a degree in economics.

J.J. Traynor is senior oil and gas equity analyst for Deutsche Bank based in Edinburgh. Dr. Traynor has a specific analytical interest in the European oils sector, conducting research on companies including Eni, Norsk Hydro, OMV, Repsol-YPF and TOTAL Fina. Before becoming a financial analyst, he worked at BP Exploration for eight years, where he was involved in international exploration activities in the United Kingdom, the former Soviet Union, Southeast Asia, and deep-water West Africa. A geologist by training, Dr. Traynor holds an undergraduate degree from Imperial College in London and a Ph.D. from Cambridge University. 171

LIST OF PARTICIPANTS

H. H. Shaikh Abdulrahman bin Mr. Isaac Álvarez Fernández Saud al-Thani Director Director of Political Affairs Technical Staff and Acquisitions Amir Diwan Repsol YPF Doha Palace Avenida Presidente Roque P0 Box 1 777 Sáenz Peña Doha, Qatar C1035 AAC Buenos Aires, Argentina

Mr. Enrique Aldama y Miñón Mr. Gonzalo Anes President 5 Recoletos LAIN 28001 Madrid, Spain 336 Arturo Soria 28033 Madrid, Spain Mr. Abdelmadjid Attar H. H. Salman AI-Khalifa Chairman and CEO Deputy Chairman Entreprise Nationale Sonatrach Bahrain Petroleum Company 10 rue du Sahara Manana, Bahrain Hydra, Algeria 172 List of Participants

Mr. Abdel Khaled Ayad Mr. Pablo Benavides Chairman Director-General Egyptian General Petroleum DGXVII, Energy Corporation European Commission Palestine Street, 4th sector 226-236 Avenue du Tervuren New Maadi 1150 Brussels, Belgium Cairo, Egypt Mr. Michel Bénezit Mr. Juan Bachiller Araque Chairman and CEO Director TOTAL Overseas EU Representative Office 51 Esplanade du Géneral de Gaulle Repsol YPF 92907 Paris, France 327 Avenue Louise 1050 Brussels, Belgium Mr. Antonio Brufau Mr. Juan Badosa Chairman Chief Executive Gas Natural Group LP Gas 22 Avenida Puerta del Angel Repsol YPF 08002 Barcelona, Spain 10 Arcipreste de Hita 28015 Madrid, Spain Mr. Luis Carmona Elizalde Hon. Vicky Bailey Head of the Libyan Delegation Commissioner Repsol YPF U.S. Federal Energy Dat El Imad Complex Regulatory Commission Tower 3 888 First Street N.E. Tripoli, Libya Washington, DC 20426, USA Mr. lván Cieker H. E. Safiatou Ba-N’Daw Advisor for International Relations Minister of Energy Repsol YPF Ministry of Energy, Ivory Coast 278 Paseo de la Castellana 40 B.P.V. 28046 Madrid, Spain Abidjan, Ivory Coast

Mr. Raimundo Bassols Jacas Mr. Guillermo Colino Advisor in Foreign Affairs Subdirector General Repsol YPF Banco Bilbao Vizcaya 278 Paseo de la Castellana 1 Gran Vía 28046 Madrid, Spain 48001 Bilbao, Spain List of Participants 173

Mr. Alfonso Cortina de Alcocer Mr. Pablo Espresate Chairman and CEO Managing Director Repsol YPF PEMEX Services Europe Ltd. 278 Paseo de Ia Castellana 4 Grosvenor Place 28046 Madrid, Spain London SW1X 7HB, UK

Mr. Ged Davis Hon. Maria Teresa Estevan Vice President Bolea Global Business Environment Member of the European Parliament Shell International Limited Rue Wiertz Shell Centre 1047 Brussels, Belgium London SE1 7NA, UK Mr. G. Steven Farris Mr. Michel de Fabiani President and COO Regional President Europe Apache Corporation BP Amoco 2000 Post Oak Boulevard 455 Mechelsesteenweg Houston, TX 77056, USA B-1950 Kraainem, Belgium

Mr. José Luis Díaz Fernández Mr. Jesús Fernández de Ia President Vega Fundación Repsol Corporate Director 38 Juan Bravo Human Resoures 28006 Madrid, Spain Repsol YPF 278 Paseo de Ia Castellana Dr. Stuart L. Dombey 28046 Madrid, Spain Vice President International Regulatory Affairs Mr. Antonio Gomis Sáez Parke-Davis Director General of Energy Pharmaceutical Research Division Ministry of Industry and Energy 2800 Plymouth Road 160 Paseo de Ia Castellana Ann Arbour, MI 48105, USA 28046 Madrid, Spain

Mr. Hammouda EI-Aswad Mr. Antonio González-Adalid Chairman of the Board Executive Vice President National Oil Corporation Chemicals Bashir Saadawi Street Repsol YPF Benghazi 280 Paseo de Ia Castellana Tripoli, Libyan Arab Jamahiriya 28046 Madrid, Spain 174 List of Participants

Mr. Robert A. Hefner III Mr. Jan Moen Owner and Managing partner Director of Regulation and DSM The GHK Company Norwegian Water Resources 6305 Waterford Boulevard and Energy Directorate Oklahoma City, OK 73118, USA P.O. Box 5091 Majorstua N-0301 Oslo, Norway Mr. Antonio Hernández-Gil Vice Chairman Mr. Jacinto Monge Repsol YPF Executive Officer 87 Serrano EUROPIA 28006 Madrid, Spain Madou Plaza 1 Place Madou Prof. William W. Hogan B-1030 Brussels, Belgium John F. Kennedy School of Government Mr. Juan Antonio Moral Harvard University Gónzalez 79 JFK Street President Cambridge, MA 02138, USA Fasa-Renault, S.A. 24 Fray Bernardino Sahagún Mr. Fulgencio Jiménez de Ia 28036 Madrid, Spain Peña President Mr. Gian Marco Moratti Repsol Exploración Egypt, S.A. President 58 Road 105 Saras SpA Raffinerie Sarde Maadi 8 Galleria de Cristoforis Cairo, Egypt 1-20122 Milan, Italy

Ms. Eija Malmivirta Mr. Massimo Moratti Chairman Vice President-Member of the Board Merei Energy Consulting Oy Ltd. Saras SpA Raffinerie Sarde 2F Esterinportti 8 Galleria de Cristoforis Helsinki F-00240, Finland 1-20122 Milan, Italy

Hon. William L. Massey Mr. Carmelo de las Morenas Commissioner López U.S. Federal Energy Corporate Director of Finance Regulatory Commission Repsol YPF 888 First Street N.E. 278 Paseo de Ia Castellana Washington, DC 20426, USA 28046 Madrid, Spain List of Participants 175

Mr. Gwyn Morgan Mr. Miguel Angel Remón President and CEO Senior Vice-President Alberta Energy Company Ltd. Planning, Control and 3900, 421 7th Avenue S.W Strategic Development Calgary, Alberta T2P 4K9, Canada Repsol YPF 278 Paseo de Ia Castellana 28046 Madrid, Spain Mr. Bijan Mossavar-Rahmani Chairman Mr. José Manuel Revuelta Mondoil Corporation Corporate Director Monte Aplanado and Assistant to the Chairman Mora, NM 87732-0744, USA Repsol YPF 278 Paseo de Ia Castellana 28046 Madrid, Spain Mr. Luis Javier Navarro President Mr. Juan Sancho Rof BP Oil España Executive Vice-President 6 Maria de Molina Refining and Marketing 28006 Madrid, Spain Repsol YPF 278 Paseo de Ia Castellana 28046 Madrid, Spain Mr. Ramón Pérez Simarro Corporate Director Dr. Evanán Romero of Information Systems Visiting Scholar Repsol YPF John F. Kennedy School 278 Paseo de Ia Castellana of Government 28046 Madrid, Spain Harvard University 79 JFK Street Cambridge, MA 02138, USA Mr. Richard N. Perle Resident Fellow Mr. Juan Manuel Romero American Enterprise Institute Corporate Director of Finance 5 Grafton Street PEMEX Chevy Chase, MD 2081 5, USA 329 Avenida Marina Nacional 11311 Mexico DF, Mexico

Dr. Paul R. Portney Hon. Alberto Ruiz-Gallardón President President Resources for the Future Autonomous Community of Madrid 1616 P Street N.W. 7 Puerta del Sol Washington, DC 20036, USA 28013 Madrid, Spain 176 List of Participants

Mr. Roger W. Sant Mr. Nader H. Sultan Chairman Deputy Chairman and CEO AES Corporation Kuwait Petroleum Corporation 1001 N. 19th Street P.O. Box 26565 Arlington, VA 22209, USA 13126 Safat, Kuwait

Mr. Jorge Segrelles Hon. Dr. Luis Téllez Kuenzler Corporate Director for External Secretary of Energy and Investor Relations Ministry of Energy. Mexico and Managing Director of 890 Insurgentes Sur Refining and Marketing for Europe Colonia del Valle Repsol YPF Delegacion Benito Juarez 278 Paseo de Ia Castellana 03100 Mexico DF, Mexico 28046 Madrid, Spain Mr. Jan J.F. Timmerman Mr. Guzmán Solana Secretary General Executive Vice-President EUROPIA Natural Gas and Electricity 1 Place Madou Repsol YPF 1210 Brussels, Belgium 38 Avenida de América 28028 Madrid, Spain Dr. J.J. Traynor Ms. Clare Spottiswoode Senior Oil and Gas Equity Analyst Deutsche Bank PA Consulting Group 74 Kintore House 123 Buckingham Palace Road 77 Queen Street London SWIW 9SR, UK Edinburgh EH2 4NS, UK Prof. Robert N. Stavins John F. Kennedy School Mr. Simeón Vadillo Zaballos of Government Director for Investor Harvard University and Media Relations 79 JFK Street Repsol YPF Cambridge, MA 02138, USA 278 Paseo de Ia Castellana 28046 Madrid, Spain Dr. Irwin M. Stelzer Senior Fellow and Director Mr. Emilio Ybarra y Churruca Regulatory Studies Vice Chairman Hudson Institute Repsol YPF 1101 17th Street N.W. 81 Paseo de Ia Castellana Washington, DC 20036, USA 28046 Madrid, Spain 177

CONFERENCE COORDINATORS

Ms. Constance Burns Ms. Pilar Suaréz-Carreño Conference Coordinator President John F. Kennedy School SC Comunicación of Government 20 Velázquez Harvard University 28001 Madrid, Spain 79 JFK Street Cambridge, MA 02138, USA

Ms. Susan Meyers Conference Coordinator International Relations Repsol YPF 278 Paseo de Ia Castellana 28046 Madrid, Spain 178

FOR ADDITIONAL INFORMATION

SERVICIO DE PUBLICACIONES DIRECCIÓN CORPORATIVA DE FUNDACIÓN REPSOL YPF ASUNTOS INSTITUCIONALES Y CORPORATIVOS REPSOL YPF

3B Juan Bravo 278 Paseo de la Castellana 28006 Madrid, Spain 28046 Madrid, Spain Tel.: (34) 913 489 352 Tel.: (34) 913 488 001 Fax: (34) 913 489 370 Fax: (34) 913 482 821