EL LIBRO DEL TAO

Given the size of the overall market, the scope for significant changes to the competitive structure is very limited. As such it may be relevant to consider some proxy for the competitive pressure that exists in other markets. There are two broad options for achieving this:

 ex-ante retail price controls; and

 ex-post, or real time, monitoring of Isle of Man prices against an appropriate benchmark comparator or cost index.

These are discussed in more detail below.

7.1

Ex-ante price controls

Ex-ante price control is the formal regulation of allowable levels of fuel prices. South Africa and the Canadian province of Nova Scotia provide two examples of jurisdictions that have adopted formal price regulation for road fuels. In both jurisdictions, the price is based on the cost of product established from an international benchmark, and a defined wholesale and retail margin. This margin is related to allowed costs of operation and a fixed margin of profitability. Detailed case studies of their experiences are

covered in Annex A.

While formal price regulation is effective in controlling prices, it is:

 costly to institute and manage; and

 may stifle innovation in retail models or wholesale contracting.

To determine how material an impact this may have, an ex-post hypothetical analysis of how prices may have evolved in the Isle of Man within a South African or Canadian price regulation framework was conducted. Figure 35 below highlights petrol prices under a Canadian and South African approach, while Figure 36 highlights diesel prices under the Canadian price regulation.56

56 _{Monthly ARA refinery prices have been used as cost of product - South Africa product price is}

determined monthly, whereas Canadian product price is determined weekly. Pöyry have also used the regulated margins (transportation, shipping, storage) across all years as a percentage of net of tax prices.

Figure 35 – Comparison of outturn Isle of Man unleaded prices, with prices under a hypothetical South African or Canadian price regulation, in ppl 80 85 90 95 100 105 110 115 120 125 Jan-05Mar -05 May -05 Jul-05Sep-05Nov-05Jan-06Mar -06 May -06 Jul-06Sep-06Nov-06Jan-07Mar -07 May -07 Jul-07Sep-07Nov-07Jan-08Mar -08 May -08 Jul-08Sep-08Nov-08 Penc e per lit re

IoM avg (unregulated)

Pump price (Canadian style regulation) Pump price (SA style regulation)

Source: Shell, Total, Pöyry analysis

Figure 36 – Comparison of outturn Isle of Man diesel prices, with prices under a hypothetical Canadian price regulation, in ppl

80 90 100 110 120 130 140 Jan-05Mar -05 May -05 Jul-05Sep-05Nov-05Jan-06Mar -06 May -06 Jul-06Sep-06Nov-06Jan-07Mar -07 May -07 Jul-07Sep-07Nov-07Jan-08Mar -08 May -08 Jul-08Sep-08Nov-08 Penc e per lit re

Pump price (Canadian style regulation) IoM avg

Analysing the above figures plotting by unregulated and hypothetically regulated Isle of Man prices, it can be seen that the general level of the product at the pump would be very similar in regulated or unregulated environments.

In the regulated scenario, oil companies are unable to smooth out fluctuations in retail prices and as a result the regulated price drops faster in line with a falling refined product prices but in addition prices may go higher more quickly.

Much depends on the level of cost chosen at various stages. This analysis selected the retail and wholesale prices as a percentage of net of tax prices over the period as comparable cost metrics. Tighter allowable margins would lower price, but also risk the unintended consequences of causing a supplier to leave the market.

Table 24 presents the annual differential between the outturn prices under the current market structure and what they would be under a hypothetical South African and Nova Scotia regulation methodology.

Table 24 – Road fuel differentials between current market system and a South African and Canadian style regulatory approach, ppl

Unleaded Diesel

Nova Scotia regulation

methodology regulation methodology South African Nova Scotia regulation methodology

2005 1.73 -0.58 -4.62

2006 1.64 -0.69 -3.37

2007 1.43 -0.90 -3.91

2008 2.87 0.50 -8.76

Source: Pöyry Energy Consulting analysis

The hypothetical Nova Scotia style regulation would have yielded consistently lower unleaded prices but consistently higher diesel prices. The South African approach on the other hand would have yielded marginally higher unleaded prices. These results are highly indicative and are not presented as definitive evidence for or against regulation, but are highlighted to illustrate the range of options that other non-market approaches may provide in pricing.

7.2

Exerting external competitive pressures

An alternative to ex-ante price controls is to provide an external competitive pressure by linking Island prices to changes in a benchmark index. There are two ways of doing so:

 applying and enforcing a specific margin (pence per litre) differential trigger assessed over a defined time frame; or

 applying a trigger based on an international cost of product benchmark that is accessible and transparent such as a time weighted average of ARA spot prices assessed over a defined time-period.

7.2.1.1 Applying and enforcing a specific margin (pence per litre) trigger

A specific margin differential trigger is similar to the recommendations provided in the 2006 OFT report. That report recommended that a differential of 3 ppl between the Isle of Man average retail price and the average for all UK dealer owned sites be accepted as justified and around 4 ppl on average be allowed for some short-term discrepancies and time-lags. A differential of 5 ppl or more was to trigger further detailed examination and could lead to a Section 19 report to the Council of Ministers.

The limited success of the 2006 trigger justified reconsideration of this mechanism works and whether or not the monitoring or threshold was appropriate. Whilst it appears that the threshold was appropriate; however the time period was left undefined.

The advantage of applying and enforcing a specific margin is that it is less costly to implement than price regulation and if accompanied by price transparency would comparatively improve the competitiveness in the market.

7.2.1.2 Applying and enforcing a cost-based benchmark

A cost based benchmark links changes in prices to cost as would be expected in a competitive market. This may appear simple and transparent given the transparency of wholesale markets, but has some disadvantages:

 the relationship between different cost components change over time; the benchmark therefore needs to be able to adjust to fixed cost changes

 it imposes a contracting strategy

Consequently a price-based differential comparator would be easier to monitor and more transparent to the general public.

7.2.2 An enhanced monitoring regime

There are two steps to developing and enforcing a suitable monitoring regime, namely:

 defining an appropriate benchmark – comparator, level of cost difference and time period for monitoring breach; and

 defining an early warning system and a series of enforcement measures in case of breach.

The most relevant short term benchmark for road fuels are dealer owned filling stations in the UK. Dealer owned stations reflect the characteristics of the Isle of Man market which is predominantly dealer owned and dealer operated. The throughput at the retail level is also similar. The UK average on the other hand is heavily influenced by the share of supermarkets which comprise 36% of the total volume of road fuel sold. Given the competitiveness of supermarkets, prices in this benchmark are likely to be lower and the appropriate differential higher. It is accepted that the availability of appropriate time series of data may require the continuation of review against a UK average reported price such as from the Department of Energy and Climate Change (DECC) rather than a dealer average price from data providers such as Catalyst.

The second component of the benchmark is the identification of an appropriate

differential. Given the lack of complete information on the cost differences between the Isle of Man and the UK, the original differential of 3 ppl recommended in the 2006 OFT

study remain an appropriate trigger – as noted in Section 3.5.3 1.5 ppl and 3.3 ppl of the differential can be accounted for.57

The third and final constituent is the definition of an appropriate time frame. It is proposed that a consistent divergence from these differentials for eight rolling weeks is a reasonable time frame. While this is an arbitrary cut-off, it balances transient changes in differentials due to inventory holding, fuel contracting strategies versus longer term cost changes or increases in profitability.

7.2.2.1 How to ensure compliance

Compliance requires incentives. It is suggested that the industry should be made aware of the benchmark and the various triggers suggested and that data should be reported. To improve compliance, industry stakeholders should report weekly on their retail prices providing information on changes in their underlying cost structure such as changes in cost of product. Since the price monitoring is on retail prices it is likely that retail forecourt operators will be primarily responsible for data submission to the OFT. The data submitted should be compared against an 8-week rolling average, with results published on a monthly basis alongside the comparative heating schedule. This would require some additional reporting of prices by the fuel suppliers and/or retailers in addition to the reporting that is currently provided on the heating fuel side. It is accepted that this imposes an administrative burden on retailers that may need to be ensured through regulatory provision.

The eventual design of the monitoring program will depend on the timing and availability of comparator data. The frequency and timing of submissions should reflect comparator data, thus if the comparator data is only available on a monthly basis, it may make sense to institute a monthly submission to the OFT rather than weekly or fortnightly submissions.

It is also accepted that in the event of a breach the OFT currently has only those options provided by Section 19 of the Fair Trading Act as amended. However, the transparency in pricing that could result from suppliers submitting regular pricing updates means that it will be easier to establish whether a breach is in fact a change in cost to serve rather than increasing profits. In the absence of pricing information as in the current status quo, a breach that could have been explained instead, triggers a formal inquiry.

7.3

Summary

The limited competition in the Island suggests the need for a closer monitoring of market participants than is currently being undertaken. This may be in the form of ex- ante control or exertion of external competitive pressures.

Ex-ante price controls or formal price regulation, if implemented correctly, lead to faster and fuller cost pass-through and greater transparency in retail prices and price

constituents. However the analysis of its application in the Island context suggests that it likely to be too costly to justify.

The exerting of external competitive pressure by linking Island prices to the UK is recommended – in particular defining an appropriate benchmark, monitoring the price

differential with the UK through timely data series and ensuring that fuel suppliers submit regular prices and price differentials to the OFT as described.