<p> COORDINATION MECHANISMS IN THE NATURAL GAS TRANSPORTION SEGMENT: A NEO-INSTITUTIONAL CONTRIBUTION </p><p>Marcelo Colomer Ferraro (UFF)</p><p>ABSTRACT</p><p>In Brazil, the consensus that natural gas regulation has failed to induce investment, especially from private companies, culminated in a new law for the natural gas sector, approved in March 2009 (Law No. 11.909). The most significant change brought by this new law was the new government role in coordinating investments in the transportation sector. The Brazilian government must plan network pipelines, estimate the size of demand for transportation services and organise bidding to select investors for new pipeline projects. Although the law has established a clear regulatory framework for the midstream sector, providing stability and legal certainty necessary for long-term investments in assets with high specificity, it could not fill all of the gaps that remained from Law 9.478. In this sense, aside from the challenges related to effective implementation of the regulatory attributes defined in Law 11.909, the absence of certain issues reduces the capacity of the new legal structure to encourage entry of new players in the transportation sector. In this way, this paper has identified, according to the neo-institutional view, the coordination mechanisms brought by the new law and the limitations of the new regulatory framework. </p><p>Key words: Natural Gas, Regulation, Pipeline Investment</p><p>RESUMO</p><p>O consenso a respeito da incapacidade da lei 9.478 em induzir o investimento de novos agentes, que não a Petrobras, no segmento de transporte de gás natural levou a elaboração e aprovação de uma legislação específica para a indústria de gás natural no Brasil. A principal mudança trazida pela Lei 11.909 (Lei do gás) foi o novo papel do governo na coordenação dos investimentos em novos gasodutos. Dentro do novo arcabouço jurídico e regulatório, o governo passou a ser responsável pelo planejamento da rede, pela estimativa de demanda dos serviços de transporte e pela realização das licitações de novos investimentos. Contudo, embora a nova regulamentação da indústria de gás tenha definido um arcabouço regulatório transparente para o segmento de transporte provendo a estabilidade jurídica necessária aos investimentos de longo- prazo em ativos específicos, ela não foi capaz de cobrir todas as lacunas remanescentes da lei 9.478 e da estrutura de mercado pré-existente. Nesse sentido, ao lado das dificuldades de implementação dos atributos regulatórios definidos pela nova lei, o não tratamento de certas questões regulatórias reduz a capacidade do novo arcabouço institucional de induzir a entrada de novos agentes no segmento de transporte de gás natural. Nesse contexto, este artigo teve como objetivo identificar, através da teoria neo-institucional, os mecanismos de coordenação trazidos pela nova lei e as limitações da nova estrutura regulatória.</p><p>Palavras Chaves: Gás Natural, Regulação, Investimento em Gasodutos </p><p>Área 8 - Economia Industrial e da Tecnologia JEL: L43</p><p>1 1. Introduction</p><p>The Brazilian Oil and Gas industry liberalisation that occurred in 1997 required new coordination mechanisms, as defined by the 9.478 Act that established the regulatory framework for both industries. Although Law 9.478 intended to encourage competition in the natural gas industry, after 10 years, Petrobras remains the leading company in the sector. The liberalisation effort in Brazil has not succeeded in providing incentives for private agents to invest in the natural gas transportation network. This suggests that the 9.478 Act did not implement adequate coordination mechanisms. The consensus that the 9.478 Act failed to induce investment has triggered lengthy political negotiations that culminated in the approval of a new law for the gas sector in March 2009 (Law No. 11.909). This new act has not affected the upstream sector, which remains regulated by Law 9.478 of 1997. The most significant change brought by the new regulatory framework was the new government role in coordinating investments in the transportation sector. In other words, the 11.909 Act brought new coordination mechanisms to the natural gas industry. In fact, these new coordination mechanisms contributed to reducing transaction costs in the natural gas transportation sector. However, Petrobras’ cross-participation in all sectors prevents this cost reduction occur for other potential investors. In other words, we find a huge transaction cost asymmetry between the incumbent company and new potential investors. Comparing the Brazilian case with the American and European models, one realises that the industrial structure, inherited from the state monopoly, is the main entry barrier to new agents, especially in the transportation sector. Thus, although Law 11.909 has contributed to the reduction of transaction costs, the industry's market design prevents the entry of new players in the industry. This paper highlights the evolution of the institutional framework of the Brazilian natural gas industry. In particular, it analyses how the new institutional and economic coordination mechanisms can reduce risks for public and private investors. Thus, this article will analyze the main changes introduced by Law 11,909 in the natural gas transportation sector. In this way, the second section identifies the investment characteristics of the natural gas transport sector from a neo-institutional view. In that section, we observe how the high transaction costs inherent to natural gas transport activity require a regulatory framework that is different from that required by other sectors. In the third section, two different regulatory models will be analysed. First, the tools utilised to reduce transaction costs in Europe (according to the EU rules) will be described. Then, the US model will be analysed. The fourth section will analyse the Brazilian natural gas transportation sector. First, the institutional evolution of the natural gas industry will be scrutinised. In this sense, we will observe the failure of the 9.478 Act to stimulate competition in the natural gas market and the changes brought by the 11.909 Act. Subsequently, we will identify the main challenges to the implementation of the new regulatory framework in Brazil and the new law’s limitation in terms of reducing transaction costs. Finally, we present the main conclusions of this paper.</p><p>2. Characteristics of the investment in the natural gas transportation network: through a neo- institutional lens</p><p>The natural gas business must be analysed as a network industry. According to the theory of network economics, the services provided by network industries are the result of different technologically distinct but complementary activities (PERROT [1995], ECONOMIDES [1996]). In fact, each industrial production is compounded by activities and services that strongly complement each other. However, what differentiates the network industries is the high physical interdependence between the assets of various sectors. This high dependence for investments on other sectors is much more important in the natural gas transportation sector. This explains the importance of the coordination mechanisms of investments in this sector. The inflexibility of natural gas transportation through pipeline networks is one of the causes of high investment risk in natural gas pipelines, especially in a less developed industry (ESTRADA 2 et al. [1995]). The investments in production, transport, distribution and market development have to be made simultaneously to make the industry profitable. Historically, vertical integration was the classical solution to decreasing investment risks when the gas industry was in its initial development stage. In this industry structure (market design), the main regulatory worries were the protection of consumers from “extra prices” charged by monopolies. Thus, the regulation is limited to a monopoly price control. According to the Transaction Cost Theory, an investment in the natural gas industry, especially in transport and distribution facilities, has high asset specificities (WILLIAMSON [1985]) and exhibits the potential for appropriation of quasi-rents (MAKHOLM [2009]). These characteristics explain the high transaction cost and, consequently, the high risk level to investors. A gas transportation service offers the capability of transporting gas from an entry point to an exit point. More precisely, the service traded is the property rights over the transportation capacity of the high-pressure pipes and auxiliary services that allow the gas to flow in the pipeline1. Natural gas transportation is not homogenous and is based on some technical and economic constraints that influence the investment decision. Among the peculiar characteristics of the natural gas transportation sector, we can highlight the high asset specificity, observed especially when the network is insufficiently connected to other markets through hubs and LNG plants. This explains why the transport capacity trade is often characterised by long-term, incomplete contracts. These two characteristics increase the possibility of opportunism behaviour and, consequently, increase the investment risks. Following Williamson (1996), we can identify three different kinds of asset specificity in the natural gas transportation sector: dedicated assets, site specificities and time specificity. Natural gas pipelines are the set of ducts, valves and compression stations that cannot be redeployed for other purposes than gas transportation in a specific region, at least not without expensive investments. The difficulty of rearranging the infrastructure for other uses and the importance of scale economies imply that in ‘immature’ markets, the remuneration of the transport investment is frequently dependent on a small number of players. It means that the transport infrastructures are often assets dedicated to one of a small number of possible transactions. Once the number of transport capacity consumers increases, the transport company dependence reduces. The site specificity is a consequence of pipeline immobility: once the investment in the gas transport network is made, it becomes almost impossible to displace the infrastructure2. The removal of the ducts, valves and pressure station to another site is very expensive, and thus, for the most part, there are no economic gains to be made in demolishing the infrastructure, even if it is not utilised. Therefore, the networks are actually a sequence of investment-adding infrastructures (GLACHANT and HALLACK [2010]). The site specificity explains the geographical interdependence between the transport companies and the other players that can physically access the facilities. Nevertheless, the network development and increase in the number of interconnections contribute to decreasing site specificity because more players, located in different areas, can have physical access to the infrastructure (GLACHANT [2002]). The time specificity constraint comes from the need to synchronise investments at different stages of the production line. Rious (2007) shows that in the electricity industry, the ex post decision to invest in a new generation plant is conditioned by the ex ante decision to invest in transmission. On the other hand, the ex ante decision to invest in transport is constrained by the need for investment in generation. This simultaneity of investment decisions across different sectors can be explained by the high costs of electricity storage. In other words, there is a relationship of mutual dependence. The coordination between actors is vital to investment decisions on both sides. In the natural gas sector, even if the storage is less costly than in the electricity industry, it is still too costly in the long term. Therefore, there is the same need for coordination of investment decisions in infrastructure and gas production. New technologies, such as LNG and CCGT, reduce part of the site and time specificities once they reduce the cost to store and increase the geographic mobility (COLOMER [2009]).</p><p>3 According to transaction cost theory, the asset specificities are a problem because of the incompletion of long-term contracts. According to Arrow & Debreu [1954], a complete contract includes every response for any future circumstances. In other words, a complete contract includes stipulations for every possible circumstance(HART [1988], SAUSSIER [1997] and MASTEN [2000]). As such, these contracts will never be revised. For Williamson [1985, 1996] and Hart [1988], a contract is incomplete if it cannot anticipate all appropriate actions for all future events. Thus, incomplete contracts only define appropriate behaviours for a short list of situations. For this reason, Williamson states that contracts must explain not only the devices ex ante but also the governance structure needed to ensure proper implementation of contracts ex post. The neo-institutional theory’s explanation to contract "incompleteness" lies in the behavioural assumptions of bounded rationality and information asymmetry. The contract “incompleteness” incentives a dispute for a quasi-rent appropriation, which explains the opportunistic behaviours3. The threat of opportunistic behaviour explains the high transaction costs for natural gas transport activity and thus explains the high risk of new investments in pipelines. Therefore, the development of the natural gas industry depends on the adoption of coordination mechanisms to reduce investment risks. Coordination among different industry actors reduces investment risks because it diminishes the incentive for opportunistic behaviours. In this way, the development of coordination mechanisms is essential to stimulating investment in industries with high transaction costs. A coordination mechanism is any structure that induces the agents to cooperate tacitly or by law enforcement. Its effect must perpetuates itself over time, as the agents are always considering the opportunity costs of their cooperation4. The concept of coordination goes beyond the economy. It is important for the establishment of any enduring social relationship. A nation’s legal system, traditions and customs are examples of coordination mechanisms in which relations between individuals are limited by rules established by consensus or by the State’s enforcement power. In the economic sphere, contracts are, par excellence, the main coordination mechanism. In most transactions, contracts are sufficient to induce cooperation among individuals, even if they are incomplete. In other words, for transactions in which asset specificity is low and transaction frequency is high, cooperation between economic agents can be easily and quickly restored. For example, considering an activity for which there are no high asset specificities, if a supplier reduces ex post the quality of the product to reduce its costs and thereby increase its profit, the buyer can easily cancel the contract with this supplier and make another contract with a new one without incurring the relevant costs. In this case, although cooperation between individuals is always evolving, there are always possible cooperation structures. However, in sectors with high transaction costs, the incompleteness of contracts prevents their functioning as a coordination mechanism. In this case, transaction costs are those costs associated with the establishment of a new cooperative relationship. The greater the specificity of assets and lower the frequency of relations5, the more difficult it is to redefine a cooperative relationship once the original relationship is broken. In such cases, coordination mechanisms should be developed to induce the agents to coordinate their actions. These mechanisms can be understood as a governance structure, according to Williamson’s theory. The different sectors integration into a single company can be understood as a coordination mechanism or a governance structure once the maximisation of company profit induces coordination between different departments of the firm. However, this interpretation can obscure certain types of problems that can occur within a vertically integrated structure. Even within these structures, there may be disputes between departments of a firm that can undermine cooperation within the company, duplicating costs and reducing productivity. Thus, even within these structures, it is necessary to develop managerial mechanisms of coordination. A second coordination mechanism stems from the coercive power of the state. The establishment of regulatory structures has the potential to induce cooperation among agents by setting rules and legal and economic constraints. Furthermore, the planning ability of the state has the potential to reduce uncertainties about the evolution of investments in sectors with high physical</p><p>4 and temporal complementarities. Not only should cooperation among the private agents be fostered, but cooperation between the public and the private sector must also be encouraged. Constant changes in government behaviour increase the uncertainties and risks of investment. However, coordination mechanisms should be viewed as structures that foster cooperation among agents by increasing mutual trust in the stability of the relations. Thus, when the economic policies of the State generate a new source of uncertainty, they do not work as a coordination mechanism and thus are not justified. Thus, the main objective of the State as a regulator is to induce cooperation between individuals when the coordination structure of the market is unable to do. As Berg [2000] states, regulation involves the establishment of rules that allocate value to consumers and suppliers in such a way that maintains incentives for the firm to create value, while promoting political legitimacy in the eyes of consumers and other stakeholders. Figure 1 shows the causes of high transaction costs and the importance of coordination mechanisms for mitigating this type of costs.</p><p>Figure 1 - Investment Risks</p><p>Source: Author’s elaboration </p><p>3. Liberalism in the natural gas industry in the midst of a transition from a monopolistic structure: two strategic examples for coordinating investment –US and EU rules </p><p>Now that we have observed the importance of regulation for investment in natural gas transmission assets, we must understand the differences between the various regulation models. For example, the US and the EU regulatory models of the natural gas transportation networks are based on different assumptions, as explained by Malkom [2009], and explain why the investment coordination mechanisms of these two countries are quite different. In the US, coordination is based on stakeholder decisions and on the guarantee of property rights. In Europe, the government and regulators play an important role in the investment choice. In the US, the EU and Brazil, the liberalisation process has been aimed at more efficient industrial organisation instead of the traditional vertical integration. In the US, the liberalisation process was based on long-term contracts that function as the main method for coordination of investments in the gas transportation network (BELLANTUONO [2009]). In the US, the main role of regulators is to control prices and supervise competition to prevent anti-competitive behaviour. These roles are clear in the FERC’s (Federal Energy Regulatory Comission) documents: “ Under section 7 of the Natural Gas Act, the Commission reviews applications for the construction and operation of natural gas pipelines. To meet the growing demand for natural gas,</p><p>5 the Commission respond when companies propose to expand and construct needed pipelines and related facilities” (FERC [2005] pp.4). In Europe, network development is mainly based on national development strategies, which were strongly recommended after the Third Directive and became one of the main missions of the GTE (Gas Transmission Europe) (GTE [2009a]). “ The EU should have a major role in defining the objectives that a European gas infrastructure should be seeking to achieve. This top down approach should be supplemented by national objectives which would address specific member state issues but complement the overall European objectives.” (GTE [2009b] pp. 2) Moreover, supply security and EU market integration are seen priorities in the development of gas networks and the main concern of ERGEG (European Regulators' Group for Electricity and Gas). As underlined in the ERGEG recommendations: “ According to the 3rd Package, ENTSOG shall adopt a non-bidding Community-wide ten year network development plan (TYNDP) every two year. The Agency for the Cooperation of Energy Regulators (Agency) shall provide a duly reasoned opinion as well as recommendation on the draft Community-wide TYNDP. The Agency shall provide a dully reasoned opinion, as well as recommendation on the draft Community-wide TYNDP. The Agency shall also monitor its implementation and check its consistency with national network development plans… The Community-wide TYNDP will hence be a tool for market integration and for security of supply.” (ERGEG [2010] pp. 1) Contrary to the US, the development of the natural gas transport service in Europe is based on homogeneous short-term contracts (BELLANTUONO [2009]). In the EU, the regulatory bodies do not implement ownership unbundling in most of the national networks. In the EU, the government (regulators, ministers and publicly owned enterprises) has played a crucial role in network development and investment coordination. It is done in Europe basically through the authorisation or not to insert the asset in the regulatory asset bases, over what the authorised revenue is calculated. The main differences between the US and EU investment coordination processes are the decision mechanisms and the cost-sharing. In the US, construction of a pipeline depends on private interest, and the shippers take all of the volume risks. In the case of the EU, the government plans network expansion, and it is the consumer who takes the volume risk of new investments. It is the authorisation to enter in the assets bases of the network that guarantees a return to the investor, regardless of whether the new transport capacity is used. In the US the pipeline investment is made separately. The shipper of pipeline A should not pay for the investment in pipeline B unless there is something to gain (TYE and GARCIA [2007]). In the EU, pipelines are viewed as a network, with entry and exit points. The shipper actually does not contract to use the service of pipeline A or B, but rather the transport service between entry point x and exit point y. Hence, the investment cost in the network is shared among all shippers. In other words, the strategy for coordinating investment in the US is basically based on a guarantee of property rights, free trade between stakeholders and protection against anti-competitive behaviour through the “commodity clause and price cost plus regulation”. These mechanisms decrease the pipeline investors’ risks because the volume risks are transferred to shippers through the primary capacity contracts, and the price risk is mitigated by regulation of prices. The shipper who sells and/or buys gas is responsible for developing the gas market, but on the other hand, the shipper has a right to transport or store gas inside pipelines (depending on the gas contracts). In Europe, investment coordination is mainly made through determinations of tariffs based on economic incentives (although there are some exceptions, as we will observe). In usual cases, there is a central or regional TSO (Transport System Operator), and the investment choice is based on ex ante central forecasting. This forecasting is made centrally and with no information revealed by shippers. Thus, the investment occurs without economic engagement by the shippers. In other words, there is no bidding information. In Europe, the forecasting is made by utilising the TYNDP</p><p>6 – an economic network model that calculates cost-optimised flows according to a set of hypotheses and scenarios regarding gas prices, supply, demand and infrastructure. However, investment planning is actually done at the national level based in national rules. There are two types of planning: first, the national network is planned utilising the TYNDP; second, the network planning is done based on price signals. In this case, rules are set to remunerate investment through tariffs. In Spain, for example, the investment is planned through a priority investment schedule; in Italy, the investment path is driven by different return rates that depend on the investment features; and in the UK, a consulting process plans the network according to open seasons models. In most of the cases, the stakeholders do not take a risk since there is no economic engagement. Investment planning is based on “regular” dialogue with stakeholders, through the organisation of workshops and meetings. Furthermore, aside from the regulated national TSOs, the European model of network development allows, through Article 22 (directive 2003/55/EC), some exemptions. Under this article, some infrastructures considered of priority by national and European regulators can be eligible for an exemption, which would allow for the beneficiary to refrain from offering third-party access (TPA) at regulated tariffs (ERGEG [2009]). On the one hand, in the EU, the investments that carry exemptions seem to be based on the same coordination principle as the US interstate pipeline. There are long-term contracts and no explicit rule of third-party access. On the other hand, the exemptions need to be first viewed as a transitory process, which in the end aims to be a general rule, meaning that the monopoly of the TSOs over the region is guaranteed. Second, the tariffs are not regulated, at least not ex ante. Third, there is nothing similar to the commodity clauses to guarantee the neutrality of ownership. The coordination becomes closer to a “semi-vertical” integration of pipelines that have not entered yet into the national tariffs system, built by shippers who want to maintain their supply capacity.</p><p>4. Changes brought about by Law 11.909 in the Brazilian institutional environment: new centralised coordination tools for investment</p><p>The institutional evolution of Brazil’s gas sector has been characterised by the search for new coordination mechanisms and reduction of investment uncertainty. The 1995 constitutional reform was the first step towards a liberalised market. Constitutional amendment No 9 states that the activities for which the Brazilian State has an exploitation monopoly can be carried out by private or state companies. In 1997, the 9.478 Act ended Petrobras’ monopoly over the petroleum and gas industries by implementing constitutional amendment No 9. The market was opened for new investors, natural gas prices were liberalised, and new institutions were created to regulate the sector. The 9.478 Act created the National Council of Energy Policy (CNPE) and the National Agency for Oil and Gas (ANP). The role of the CNPE is to approve the main directives of energy policy to be implemented by both the Ministry of Mines and Energy (MME) and by ANP. In turn, the ANP has been in charge of regulating the entire chain of oil and gas, except for gas distribution that is regulated at the state level. The upstream openness occurred from implementation of exploration auctions carried out by ANP. The auction attracted new companies to the Brazilian oil industry upstream, while natural gas production remains dominated by Petrobras. As can be observed in Graph 1, the company is responsible for more than 90% of the natural gas produced in Brazil.</p><p>7 Graph 1 - Brazil: Gas Production (2008)</p><p>Source: ANP [2009]</p><p>Although symbolically important, the 9.478 Act did not contribute to the expansion of private investment in the natural gas sector, unlike what occurred in the oil industry. Natural gas is treated by the 9.478 Act as a by-product of the activity of oil production. Thus, although the law provides a macro model for market liberalisation, it does not provide the necessary tools for implementation. The private investment incentives, especially in the transportation sector, are very low. To the natural gas industry, the regulatory framework, defined by the 9.478 Act, is very vague. The ANP regulation capacity depends exclusively on negotiations and publications of ordinances that do not have the same enforcement power of a law. The 9.478 Act defines that the natural gas transportation activity must be carried out by authorisation from ANP. Under this model, the investment risk falls entirely on the transport companies. Regarding other issues associated with gas transport activities, regulations basically depend on ordinances of the ANP (About 20). Thus, the few private investments that have been carried out in the natural gas sector were concentrated on the distribution sector. As we will observe, the dominant role of Petrobras represents a major barrier to private investment in the transportation sector. Despite the legal break-up of the Petrobras monopoly, the company has de facto industry control. This dominant position reduces room for cooperation with other private actors in the transportation sector, which increases the investment risks for new potential players. Thus, in 2009, the natural gas transportation infrastructure in Brazil was basically controlled by Transpetro and TBG and, consequently, by Petrobras, the major shareholder of both companies, as can be observed in Graphs 2 and 3.</p><p>Graph 2 - TBG Share Holds Graph 3 - Brazil: Natural Gas Pipelines Título do Gráfico [2009]</p><p>Others 20%</p><p>Petrobras Gas BBPP Holdings S/A Ltda 51% 29%</p><p>Source: Transpetro [2009], TBG [2009] Source: TBG [2009] and ANP [2009] </p><p>8 After more than 10 years of gas industry liberalisation, the Petrobras supremacy suggests that the energy industry reform failed to promote competition in the natural gas sector. Even in the distribution6 sector, where some considerable private investment can be found, the dominance of Petrobras is clearly noticeable. Of 24 distribution companies operating in 2009, Petrobras held stakes in 20 companies (Graph 4). </p><p>Graph 4 - Brazil: Natural Gas Distribution, 2009 100 90 80 70 60</p><p>% 50 40 30 20 10 L</p><p>0 S O</p><p>S S S S S S S R S S S S A S S P G S A Á N S I Á Á Á G S O Á Á Á Á A Á Á Á Á Á Á A I I Á R E E G A G G G G I G G S G M G G G G P R G G I G U C M S A R - L A L S L S S N E B R A I C I T T G S B M E P A E U A S A S C P I E A E G O H A A P O M O S S C G M A C G R O A P N G C O</p><p>R O B G S C B C</p><p>Á S G Á G</p><p>Petrobras Others Source: ABEGAS [2009]</p><p>In the mid-2000s, the natural gas industry actors came to an agreement that 9.478 Act was not appropriate for promoting competition in the Brazilian natural gas industry. This consensus sparked a lengthy political discussion, which culminated in the approval of a new law for the gas sector in Brazil in March 2009 (Law No. 11.909). This new law has not affected the upstream sector, which remains regulated by law 9.478. In the distribution sector, regulation remained the responsibility of state governments. The 1988 Constitution grants the states the responsibility for regulating natural gas distribution. Each state is empowered to regulate the distribution sector, regardless of federal regulations. Thus, each state has a different concession contract model. Except for Rio de Janeiro and Sao Paulo, no other states have opened their markets to competition – only the distribution company may sell gas to end consumers. The 11.909 Act, in fact, is concerned specifically with the natural gas transportation sector. The biggest change brought by the new law was the new government role in the coordination of investments in the natural gas transportation sector. Table 1 shows the main differences between the 11.909 law and the former regulatory model. </p><p>Table 1 - Change in the Natural Gas Regulatory Framework</p><p>Regulatory Attributes 9.478 Law and ANP Ordinances 11.909 Law Legal Separation without cross-holding Legal Separation without cross-holding Unbundling Rules restriction restriction Transportation Grant Authorisation Concession preceded by bid Scheme Each transport company operates Each transport company operates independently System Operation independently its network its network Open Access Unregulated. Bilateral Contract Regulated by ANP Primary Transport Through open season Through open season (Public Call) Capacity Allocation Although the assignment of capacity from a Capacity Secondary shipper to another is permitted the sale is No reference Market prohibited Transport Services Firm and interruptible contracts Firm, interruptible and extraordinary contract Allowed</p><p>9 Freely negotiated but depends on ANP Regulated by ANP through service cost approval, which suggests a methodology for Price methodology calculating Transport Capacity Regulated: The ANP defines the contract model ANP receives the contracts after signing Contracts and must approve it before it is signed. New Investment in Pipe Depends on market agent initiative Proposed by MME Source: Author’s elaboration </p><p>With the new gas law, the Energy and Mines Ministry (MME) has the responsibility for planning the expansion of the gas transportation sector through its planning subsidiary, EPE (Energy Research Enterprise). The MME is also responsible for implementing new economic mechanisms to reduce investment risks in natural gas transportation. According to the 11.909 law, the MME can indicate what pipelines must be built or expanded and can propose the concession of subsidies to the projects that are not economically feasible without this kind of support. The subsidies can be offered by public-private partnership contracts and/or by existing taxes funds from liquid fuels (the Contribution for Intervention in the Economic Domain – CIDE) and electricity (Energy Development Account). Therefore, the new law has created new mechanisms to make some projects economically viable if they are considered a public interest. The classification of the pipelines as "public interest" allows investment and cross-subsidies to develop the gas transmission network. This principle, which considers pipelines to be of public interest, diverges from the US model – in which long -term contracts are the main driver for investment coordination – and rather approximates the EU approach – in which capacity is built to meet priorities designed by governments. According to the new law, ANP has an important role in gas transport regulation. It has the responsibility to define the maximum amount of tariffs needed to cover efficiency costs7. The new transportation capacity construction must be preceded by an open season process carried out by ANP to allocate the new capacity. This process aims to identify potential shippers and the effective demand for gas transportation capacity. The shippers that, at the end of the open season process, have requested new capacity must sign a commitment contract with ANP. These terms of agreement, after the concession bid, are transformed into firm contracts with the transportation company. The term of appointment is irrevocable and becomes part of the bidding documents, which reduces the investment risk in pipelines. After the demand for transport capacity of the new project has been forecasted, ANP conducts a bid for the pipeline’s new capacity. The ANP should set the minimum tariff in accordance with the engagement terms signed by shippers and the costs of the project. The company that offers the greatest discount on tariffs wins the bid. The concession contracts have up to 30 years and may be extended for an equal period of time. The pipeline’s third-party access is guaranteed after a grace period set by the ANP. However, this grace period can be a maximum of 10 years. The terms of third-party access to the transportation pipelines can be set in firm or interruptible contracts. This contractual variability ensures the investment return of transportation companies. Alongside the planning of EPE, the pipeline projects can be proposed to the MME by any player. However, because the MME approves the proposed project, it is necessary that the ANP hold an open season to allocate the transport capacity and a public bidding procedure to select the transport company. The winning company may differ from the company that proposed the pipeline project. It depends on the bidding process. The 11.909 Act tries to stimulate investment in natural gas transportation by creating new coordination mechanisms. As was discussed in Section 2, the pipeline investments have some specific characteristics that demand forms of coordination different from those presented in the market. In other words, for investment in natural gas transportation to occur, some regulatory mechanisms are necessary to mitigate the risk of investment in assets with high specificities. Briefly, the 11.909 Act allows the government to coordinate the shipping and transport companies’</p><p>10 interests. Such coordination mechanisms reconcile the investment return guarantees demanded by transport companies with the low tariffs demanded by shippers. The nature of the Brazilian regulatory model, established by 11.909 Act, seems to fall somewhere between the European and US cases. On the one hand, the new MME role in the network planning is similar to the EU’s centralised model. On the other hand, the open season model, followed by a long-term contract signed by the shippers, and the bid procedures seem to be more closely aligned with the decentralised US model. However, if we consider industrial organisation, whereby Petrobras is clearly the dominant company in all sectors, the Brazilian model is much more closely aligned with the EU’s centralised model. In this sense, the competition in the transport sector, as in the EU, is discouraged by a vertically integrated organisation of the industry. </p><p>5. Regulatory mechanisms: necessary but insufficient conditions to stimulate investment in the natural gas transportation sector </p><p>The 11.909 Act creates some coordination mechanisms that contribute to the reduction of transaction costs and, consequently, to decreased investment risk in natural gas transport assets. Among these mechanisms, we can highlight:</p><p> o long-term expansion planning by the State; o long-term contracts to sell transportation capacity; o organisation of open season processes to sell transportation capacity to shippers; o organisation of bidding rounds to select investors in the transportation sectors; and o public-private partnerships to make some less attractive projects economically viable.</p><p>The MME planning of new pipeline projects ensures that competition between projects does not jeopardise the financial health of transport companies. In other words, the construction of pipelines that directly or indirectly serve the same market can raise the transaction cost due to the high asset specificities and high minimum efficiency scale of natural gas transport activity. Therefore, projects will only be approved by the MME if there is sufficiently high transport capacity demand. Another benefit of MME planning is that the project approval occurs independently of who proposes it. That is, when the MME approves a project proposed by a transport company, this project is offered to any company that wants to participate in the concession bid. In theory, MME planning stimulates ex ante competition between transport companies. In this sense, network planning for an autonomous agent ensures an efficient allocation of investments. The presence of regulated long-term contracts reduces opportunistic behaviour by the shippers and defines ex ante the investment schedule, annual revenues, tariff adjustment criteria, third-party access rules, dispute resolution mechanisms, breach of contract penalties and the exclusivity period that the first shippers will have to explore the pipeline capacity. The concession contracts attempt to solve the problems associated with the incompleteness of contracts by establishing ex ante the contract structure and the mechanisms for resolving possible conflicts ex post. According to Hart and Moore [1988], when contracts are incomplete and there is space for renegotiation, the underinvestment problem remains. The transport company will not have incentives to invest if the shippers can appropriate a larger portion of the quasi-rent. The regulation of long-term contracts contributes to reducing the negative effects associated with adverse selection and moral hazard, thus reducing the transaction costs associated with investments in natural gas transportation assets. The open season process and the commitment term limit the opportunistic behaviour of shippers and thus reduce transaction costs. The prior commitment of the shipper allows the transport company to know ex ante the transport capacity required and the minimum tariff that can be charged. Another benefit brought by the open season process is the reduction of trading costs. The primary capacity trade is not carried individually with each shipper. ANP gives the commitment terms signed by each shipper to the company that won the bid. Then, the transport 11 company turns them into firm transport contracts. As can be observed, the open season model defined by 11.909 Act encourages cooperation between the shipper and the transportation company. The public-private partnerships and the government’s financial resources help to stimulate new pipeline investments, even when the previously contracted capacity is insufficient to fund the project. In other words, the government, through the MME, guarantees the investment return by reducing the risks associated with prior capacity contracting. Figure 2 shows the coordination mechanisms brought by the 11.909 Act to the natural gas industry. </p><p>Figure 2 – Brazil: Coordination Mechanisms in the Natural Gas Industry</p><p>MME Policy coordination</p><p>EPE Project Planning Petrobras Planning and study of the network expansion projects</p><p>Others Transmission Company</p><p>Transport Capacity contracts ANP Capacity Auction Shipers Market Regulation Term of commitment Source: Author’s elaboration, source from</p><p>The analysis of 11.909 Act shows that the new regulatory framework of the natural gas industry creates some coordination mechanisms that contribute to the reduction of transaction costs associated with transportation contracts. However, as will be discussed below, this reduction of transaction costs is not enjoyed equally by all potential pipeline investors. The legal separation of the natural gas industry was established by the 9.478 Act. However, neither the 9.478 Act nor the 11.909 Act limits cross-holdings among companies from different sectors in the natural gas chain. Thus, although the natural gas industry presents itself as legally unbundled, in practice, Petrobras has a monopoly in the sector. Petrobras dominates the generation, transmission, distribution and marketing sectors what makes the company, both as the main shipper and major natural gas transportation company. In an integrated monopoly, the reduction of transaction costs brought by the 11.909 Act increases and consolidates the transaction cost asymmetries between the incumbent company and the potential investors in transportation assets. Within the existing industrial structure, any new transport company that is installed in the country depends on Petrobras. In other words, ownership of 92% of production and 96% of imports as well as Petrobras participation in the sector of natural gas distribution make the company the largest shipper in the Brazilian natural gas market. The dual role played by Petrobras in the transportation sector – as both a shipper and a transport company – makes the return of capital from new investors dependent on the stability of contractual relations with its main competitor, Petrobras. Thus, even considering the potential reduction in transaction costs brought by the new coordination mechanisms, Petrobras may adopt ex ante strategies to prevent the entry of new agents through a boycotting of the open season process. That is, Petrobras may strategically decide not manifest its interest in new transport capacity to derail a pipeline project. Even if other shippers demonstrate interest in new transport capacity, the absence of Petrobras in the open season process can make capacity demand extremely low. This low level of demand increases the minimum tariff necessary to cover the investment in transportation facilities. This tariff can make the project unfeasible or even shift the capacity demand to Petrobras pipelines.</p><p>12 6. A fake openness of the natural gas industry in Brazil</p><p>The 9.478 Act and the 11.909 Act aim to foster competition in the natural gas industry. The industry’s openness to foreign and national private investment, legal unbundling, third-party access regulation in the transportation sector, property rights separation between the commodity and the transport capacity, bid procedure for new investment in transport assets, open season process and long-term contracts are some of the regulatory mechanisms that were created to stimulate competition in the natural gas industry. Analysing these coordination mechanisms brought by industry reform that are far from the real context of the industry in Brazil, we are led to believe that the regulatory model adopted is similar to the US decentralised model. We are led to believe that the investments are driven by competition among transport companies and shippers. However, if we analyse the new regulatory framework in the context of the natural gas industry in Brazil, we can see a different picture. The low maturity level of the transport network (a reduced network and few interconnection points) and the industrial structure inherited from the State monopoly period prevent the new coordination mechanisms from stimulating competition. Although in the US, cross-holding is not prohibited, the huge number of players, both in production and in marketing, and the surveillance of anti-competitive practices by the FERC prevent the industry from creating entrance barriers. In other words, the transaction cost reduction brought by the new law is not sufficient to foster the entrance of new players in the market. As has been observed, the dominance of Petrobras creates significant barriers to entry of other potential investors, especially in the transportation sector. Aside from the industry organisation, the new role attributed to the MME centralises network investment planning into government hands. Thus, considering the industrial structure and the central role of the government in investment planning, we conclude that the network expansion plan remains in the hand of Petrobras. In this sense, despite all of the decentralised mechanisms brought by Law 11.909, the regulatory model adopted in the Brazilian natural gas industry seems to be more similar to the EU model. The network investment decision is determined not by price signals, as in the US. The investment in natural gas transportation assets is guided by the goals of public policy, as in the EU. Therefore, the 11.909 Act proves to be very important for improving the investment in natural gas transportation assets, but it does not sufficiently improve competition. The question under consideration is not whether the 11.909 Act is good. The question is whether it can meet its initial objectives of promoting competition in the natural gas industry. Based on the analysis made in this paper, the answer to that question seems to be that it cannot. </p><p>7. Conclusion</p><p>The natural gas industry has some characteristics that require investment coordination between the different chain sectors. The asset specificity, as previously discussed, can compromise the investment in a liberalised market if opportunistic behaviour increases investment risk. The new Brazilian legal framework brought by 11.909 Act aims to reduce the risk of new investors because it defines a new coordination mechanism structure. By defining the projects that will be approved, the MME aims to reduce the risks associated with the physical and dedicated asset specificities. Price regulation prevents the TSO from using its monopoly power to earn above- normal profits. In neo-institutional terms, price regulation prevents a quasi-rent appropriation. The open season reduces both the cost of trading and the ex post risk of opportunistic behaviour. Moreover, the signature of a commitment term signals a future revenue flow that facilitates project financing through securitisation mechanisms. The bid process is a way of introducing competition into natural monopoly structures. The concession contracts determine the quality specification of the services and the criteria of third-party access to the transmission network. Thus, the concession contract reduces the risks for both shippers and transport companies if it clearly defines the 13 operating rules of the transport service. Finally, the clear definition of the roles of each institution in planning and regulating the gas industry reduce the uncertainties related to government intervention. The definition of a stable institutional framework thus enables the reduction of regulatory and political risk, which increases the agents’ pre-disposition towards cooperation, not only among themselves but also with the government. However, the industrial structure of the natural gas sector in Brazil discourages the entrance of new investors, especially in the transport sector. From the neo-institutional view, the dominant position of Petrobras in the natural gas chain prevents transaction cost reductions from being transmitted to all potential investors. In other words, the industrial structure of the Brazilian natural gas sector creates a transaction costs asymmetry among all potential players, which contributes to industry concentration. This paper underscores that the new coordination mechanisms (regulatory innovations) are necessary but insufficient for promoting competition in the natural gas transport network. In Brazil, the characterisation of the new regulation framework of the natural gas industry seems to be between the decentralised US model and the centralised EU style. However, if we consider the dominant position of Petrobras in investment coordination and the new role played by MME in network investment planning, the Brazilian model appears to be much more similar to the EU model. Comparing the different paths adopted by other liberalised regions – the US and the EU –the consequences of the new model introduced by gas law 11.909 are unclear. In other words, it is still unclear how the Brazilian costs associated with central coordination decisions will be shared, or how the economic engagement of stakeholders may or may not drive investment decisions. Unless the industrial structure of the natural gas industry is changed, it is expected that investments in new pipelines will continue to be guided by central planning and, consequently, by Petrobras.</p><p>8. References</p><p>ALMEIDA, E. and PINTO Jr., H. (2000). Driving Forces of the Brazilian Electricity Industry Reform. Energy Studies Review, volume 9 no. 2, Toronto, Canada. ALMEIDA, E. and PINTO Jr., H. (2009). L’Évolution du Cadre Institutionnel des Industries Brésiliennes de L’Energie. Revue de l’Énergie, n° 592, Paris. ALMEIDA, E., RAMOS-REAL, F. and TROVAR, B. (2009). Efficiency and performance after reform: The Case of Brazilian gas distribution companies. IAEE conference, Santiago, Chile. ANP (2008). Anuário Estatístico 2008. ANP (2009). Anuário Estatístico 2009. Rio de Janeiro. In http://www.anp.gov.br/ ARROW, K.; DEBREU, G. (1954). Existence of an equilibrium for a competitive economy, Econometrica, Vol. 22, n°3 pp. 265–290. BELLANTUONO, G. (2009). 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New York: Oxford University Press.</p><p>Institutional: www.abegas.org.br www.iea.org www.eia.doe.gov www.enargas.gov.ar www.anp.gov.br www.mme.gov.br www.gasnatural.com www.cera.com</p><p>16 1 The auxiliary services are based on the short-term decision and are crucial to transport, as explained by Codognet (2006). 2 The displacement of some network pieces can happen in some rare cases, but it is a costly process and atypical. 3 Quasi-rent can be defined as the difference between the economic value of the same asset employed either by an asset specificity transaction or not. The asset specificity investment generates a possibility of a bigger surplus as a counterpart to the greater interdependency between players 4 Moreover, we can apply Game Theory: as explains Varian, [1992], there is no advantage to cooperating on the next to the last move, as long as both players believe that the other player will not cooperate on the final move. To make cooperation the strategy chosen by both players, we should have any guarantee or assurance that the two players will cooperate in all periods. It is here that the mechanisms of cooperation show their importance. 5 Being the frequency of relation the number of times that the contract is negotiated, as defined by Ruester 2010. 6 The distribution regulation is the responsibility of the states. 7 Costs of a company that operates efficiently. </p>