The draft gas reservation scheme falls horribly short

However desirable the objective, government intervention in markets should be done with surgical instruments rather than sledgehammers. And adverse consequences must be carefully managed. The draft scheme framework includes an unnecessary sledgehammer and several impractical proposals that do not recognise the way markets work in practice.

This is a federal scheme that, at least initially, is designed to solve problems on the east coast, where potential gas shortfalls have been a regular concern since the first LNG exports from Gladstone in 2015 opened the domestic market to international pressures including high and volatile prices.

The reservation scheme will place a domestic supply obligation (DSO) on LNG exporters. In practice, there are three, effectively unconnected, regional gas markets in Australia – Western Australia, the Northern Territory, and the east coast. The DSO should be implemented in phases that recognise regional differences, beginning with the east coast. Western Australia will need alignment with its current scheme, and the NT will need new connecting infrastructure.

Changes to the central elements of the draft scheme must be considered as a connected whole.

The draft design proposes a DSO calculated as 20 per cent of LNG production. Since the objective is to meet domestic demand, which is already largely supplied by domestically focused sources, it would be logical to base the DSO on the domestic market’s needs.

On the east coast, a 20 per cent sledgehammer DSO based on LNG production would add more than 250 petajoules to a market of about 500 petajoules.

It’s an important reform but, to the dismay of both producers and consumers, the current design falls horribly short of what is required.

Rather than depend on ministerial discretion to adjust the oversupply, the Australian Energy Regulator (AER) should set the DSO to meet any projected shortfall as advised by the Australian Energy Market Operator (AEMO). This way, producers and consumers would have a predictable arrangement, and the government would still get what it wants.

Producers and consumers are seeking a return to multi-year contracts to facilitate investment, risk management, and planning. To provide reasonable predictability, AEMO’s gas market projections should be used to set a five-year DSO with a firm first year and subsequent years revised and rolled forward annually.

To place the downward pressure on prices sought by the government, the AER should add a modest oversupply, 2 per cent to 5 per cent of demand, to the DSO. As an indication, based on a domestic market demand of 500 petajoules and a projected shortfall of 30 petajoules, a 5 per cent oversupply would set the DSO at 55 petajoules. Compared to the current proposal, this obligation would be a far more manageable 4 per cent of annual LNG production of around 1300 petajoules.

The oversupply will still need to be addressed. As with any market, a forced oversupply by LNG producers will displace other supply from domestic producers in the short term and could lead to supply destruction in the longer term.

The draft design proposes that oversupply could be exported once the domestic market is supplied with enough gas, including a reasonable level of short-term market liquidity. This release valve directly contradicts the firm obligation to supply, and there is no detail on how it could be implemented in practice. Without that detail, the firm supply obligation should be retained and its adverse consequences accepted.

The Energy and Climate Change Ministerial Council (ECMC) is expecting the reservation scheme to address the risk of gas shortfalls emerging in the south-east as local supply declines and there is inadequate infrastructure to deliver gas from the north.

Expecting that the DSO could deliver commercial arrangements for such infrastructure on its own is almost certainly wishful thinking, and the ECMC should return to its plans from early this year to identify and implement an effective solution.

The reservation scheme goes to the heart of what happens when governments intervene in markets without fully considering the consequences. But, as The Australian Financial Review recognised in an editorial last week, some form of government intervention is long overdue.

This scheme is an important policy reform but, to the dismay of both producers and consumers, the current design falls horribly short of what is required. It is possible to create a workable version of the scheme that maintains the centrality of markets and meets the government’s primary objective, while reflecting market realities and consequences.