JAKE MORRIS: Irregular regulation: a tale of Nersa, Sasol and industrial gas

The headline of Business Day’s July 11 newsletter, “Sasol to be prosecuted over gas price gouging for almost a decade” , caught my attention. The article explained the recent adverse finding against Sasol by the Competition Commission and noted how this may raise questions about the effectiveness of the National Energy Regulator of South Africa (Nersa).

It caught my attention because I had worked on the initial challenge brought by a group of industrial piped gas users against Sasol’s pricing a decade ago. My company was hired as the economics team working alongside a legal team on behalf of the complainants. I happened to move on from that company and profession soon after, but I have often thought about the case in the years since, because of its mindboggling outcome and, as this recent article suggested, the questions it raised about Nersa’s effectiveness. As the topic returned unexpectedly to my newsfeed a decade later, I thought the anniversary might be an apt time to share the tale.

In the late 90s Sasol acquired the rights to extract and process natural gas from the Temane and Pande fields in Mozambique and invested in a transmission pipeline to transport the gas to SA. This established a natural monopoly, a market in which it doesn’t make economic sense to have competition. An example is the underground fibre internet cable leading to houses or apartment buildings. It makes no sense for the road to be dug up and a new fibre cable laid every time users change their internet service provider.

Natural monopolies often arise with some form of government support and the monopolists usually don’t get left to do as they please. Regulators step in to ensure pricing strikes a balance between consumer protection and ensuring the monopolist makes enough money to encourage continued investment in the product or service. In this case, the deal was that in return for its investment Sasol would enjoy a special ten-year dispensation from Nersa, allowing it to price as it pleased. Thereafter Nersa would regulate.

Enjoyed dreamland

A secure monopoly position in a stable or growing market is a dream for any business, often the legitimate reward for taking risks and incurring large costs. Unencumbered by the presence of rival sellers or the threat of new entrants, the monopolist can set the market price, earning a cushy premium over costs and capturing most of the market’s value. It can get even better if, instead of a uniform price, the monopolist is able to charge different prices to different customers. This is where the monopolist’s profits go from great to extraordinary. Why? The problem with a uniform price is that while some customers are willing to pay even more than the market price, others are willing to pay more than the monopolist’s costs but not quite as much as the market price and therefore chose not to buy. Being able to price discriminate solves both problems, as the monopolist is able to charge each customer its maximum willingness to pay and extract all value from the market.

This was the dreamland Sasol was free to enjoy for ten years. It negotiated individually with big prospective customers and set the price just below that of the customer’s best alternative energy source. Knowing that large industrial customers would need to invest much money to convert their production facilities to run on gas, Sasol also needed to give assurance that it would not suddenly raise prices on a whim after these investments were made and the customers had lost any leverage in negotiations. This was achieved through long-term contracts that essentially locked in the price, and many customers were persuaded to take the plunge. It was a good outcome. Sasol made loads of money in return for bringing a new product to market, and no customers were worse off than they had been before.

Sasol’s unregulated dreamland wasn’t meant to last forever. As the expiry of the ten-year special dispensation drew near, it was time for Nersa to step in and regulate. As per the Gas Act, the legislation giving Nersa its mandate, Nersa’s job was to set a maximum price Sasol could charge that would enable it to cover its costs and earn a profit commensurate with risk.

Nersa had to estimate what the price would be in a piped gas market characterised by healthy competition, where sellers are disciplined by competition but able to earn a good enough margin to keep shareholders happy. This is not an entirely straightforward exercise, partly because there is no verifiably correct answer. We know it lies somewhere along the broad spectrum of pricing at cost, which would imply Sasol making zero profit, to the erstwhile status quo of discriminatory monopoly pricing, which was delivering Sasol the maximum profits possible. The applicable range can be narrowed down further by raising the lower bound from zero profits to a level that at least meets the cost of capital needed to pay for investment in the pipeline. The calculations can get a little tricky as one tries to establish Sasol’s true costs, including its cost of capital, and we are still left with a range of possible answers.

Curiously, Nersa didn’t seem interested in this question. What consumed it was the notion of price discrimination. Nersa decided it was unfair that different customers paid different prices for the same product, and accordingly seemed to define its role as protecting the SA consumer of piped gas from this unfair practice of discrimination.

This was a puzzling choice of focus. It is true that charging different prices to different customers on the basis of race, religion or gender would be ethically wrong and legally prohibited. But we also experience legitimate versions of price discrimination all the time. One person pays full price for a T-shirt, only for someone else to pay half price for the same T-shirt a week later in a clearance sale. Is that unfair? No, prices change as the circumstances of supply and demand change.

I wondered at the time what motivated Nersa to focus so much on this. Was it a well-intentioned but misguided notion that fairness equals sameness? Was it perhaps the especially negative connotation of the word “discrimination” in SA? Could it have been a lazy interpretation of the Gas Act, which mentions that pricing should be non-discriminatory unless on the basis of objectively justifiable differences between customers, with the last part of that sentence expediently ignored? I can only speculate. What did seem clear was that Nersa had price discrimination in its sights and had taken it upon itself to rid the piped gas market of this unwelcome trait.

More profit

Sasol and Nersa subsequently agreed on a revised pricing regime. Its purported achievement was that customers would now pay the same amount for piped gas — well sort of. Customers were divided into buckets based on order volumes. A sliding scale was applied so that higher volume buckets paid a lower price per unit of gas relative to lower volume buckets. But within each bucket all customers were charged the same price. Interestingly, this still featured price discrimination, only this time on the basis of order volumes.

While this description of the new pricing regime shows how prices compared between customers of different sizes, what is important to consider is how prices to customers changed from the old pricing regime to the new one. Despite large customers being given a volume discount relative to smaller customers under the new regime, most were charged a significantly higher price than under the old pricing regime. Conversely, despite smaller customers paying a premium relative to larger customers under the new regime, many were charged a lower price than under the old regime. What our calculations showed was that the net effect of these price changes across all customers was Sasol earned more profit under the new pricing regime than it did under the old one.

Wait, is that right? Surely the authority tasked with serving the public interest, who had arrived to rein in the unbridled monopolist, didn’t manage to somehow achieve the opposite? That is precisely what happened. I can only imagine Sasol’s representative in these proceedings, nodding earnestly in submission to Nersa’s authority while not quite believing what they were about to get away with. To go back to the T-shirt example above, what happened was the equivalent of representatives from a National Clothing Regulator knocking on the door of the person who bought the T-shirt on sale, explaining that the clearance discount was unfair because some other people paid full price, legally forcing the incredulous consumer to transfer the difference between the discounted price and full price to the clothing retailer, and then high-fiving each other as they walk away to congratulate themselves for protecting the public.

You might ask how it was even possible for Sasol to have made more money. If the holy grail of business is a secure monopoly with the ability to price discriminate, how could Sasol have surpassed this? The reason is that the one constraint Sasol faced was getting prospective customers to switch to piped gas in the first place, the market in which it enjoyed a monopoly. Sasol had to price lower than the alternative sources of energy used by these firms’ production facilities to convince them to make the costly investment of switching to gas. The pearl that Nersa delivered to Sasol was to allow it to go back to these customers after they had made the switch and were locked in, and say, “Sorry guys, I know we signed a long-term contract, but I am now obliged by the Powers That Be to renege on that agreement and charge you a higher price. Not my fault, I’m sure you understand.”

The removal of this one point of enduring leverage customers had imposed in their initial negotiations with Sasol changed the game and grew the jackpot for Sasol.

Severely flawed

To be sure, it was not just the big industrial users of gas who suffered. These companies are household name producers of many of the basic intermediate and final products at the heart of the economy, so while the monopolist earned more money the public faced price increases for staple goods. That makes it more than a business squabble; the decisions taken matter to us all. And so we should be asking how it was possible for a regulator to exert a degree of control over a monopolist in the public interest, and conjure up an outcome that led to an improved position for the monopolist and a worse position for its main customers and the public.

Mercifully, in 2019 it appeared that sanity would prevail, when Nersa’s approval of that new pricing regime was dismissed as irrational by the Constitutional Court. Alas, sanity would have to wait. Forced to revisit its methodology, Nersa adopted a new one, which anchored pricing not on Sasol’s cost base, but rather on international reference prices. The result? Sasol raised prices by 96%. There was such a backlash that Sasol retracted the price increase, but the point is that it was permissible under Nersa’s rules. In fact, Sasol stated that it could have raised the price by almost 300% and still been within the limits of Nersa’s approved calculation methodology. Recognising this failure, Nersa moved on to its third pricing methodology. According to the Industrial Gas Users Association of SA (Igua-SA), Nersa’s latest approach remains severely flawed and Sasol has applied for prices under this new framework which, if approved, would once again raise its monopoly profits.

And so here we are, with the bizarre outcome of what effectively amounts to a competition authority charging a regulatory authority with excessive pricing.

Whatever the technical merits of the Competition Commission’s findings under competition law, and however its case ends up after legal reviews, this is humiliating for Nersa.

Given the pivotal role that energy is playing in the determination of SA’s economic future, we can’t afford to slip up on policy or regulation. The past decade certainly begs the question, how effective is the national energy regulator and to what extent does it act in the public interest?

• Morris is COO of BMA, a management consulting company focused on manufacturing value chains. He writes in his personal capacity.