Energy Bill [Lords]

Memorandum submitted by Sean Rush (partner, Memery Crystal LLP) in Respect to Sections 80-89 of The Energy Bill 2010/11 – Chapter 3: Upstream Petroleum Infrastructure (EN 24)

Background

1. I refer to the Energy Bill 2010/11 (the " Bill "), and in particular to Chapter 3: Upstream Petroleum Infrastructure - Sections 80 to 89.

2. By way of background, I have worked as a solicitor in the United Kingdom oil and gas industry for fifteen years, largely as an in house lawyer for both large and intermediate sized companies. I have sat on the industry trade association (Oil & Gas UK, formally UKOOA) legal sub-committee and am a past Chairman of the International Bar Association's UK Energy Lawyers' Group. I am currently the head of oil and gas at London law firm, Memery Crystal LLP.

3. In the course of my career I have developed new offshore fields utilising own and third party infrastructure in the UK and Dutch sectors of the North Sea and on the East Coast of Canada. In addition I have developed and utilized infrastructure in North America where access rights are commonly subject to tariff regulation. I have recently represented one of the Scott Field owners in respect to an application by the Rochelle Field owners for the Secretary to exercise his powers relating to access under the current legislation.

4. I have undertaken post graduate research through the University of Dundee in the area of petroleum law and policy and have chosen access to infrastructure on the United Kingdom Continental Shelf (" UKCS ") as the subject of a thesis. In the course of my studies I have researched and produced two articles on the subject , one dealing with the industry ’ s Infrastructure Code of Practice (" ICoP ") and a second one that describes how a common carrier system could be achieved using liberalization principles adopted in the onshore gas transmission market. These and further information about me can be found at my firm's web page ( http://www.memerycrystal.com/Our-People/Sean-Rush.aspx ).

5. My firm, Memery Cry stal LLP , act for a number of investors , nominated advisers and other financiers who invest in the oil and gas industry. However, whilst it is clear that there are substantial reserves on the UKCS that are capable of earning an appropriate return on investment, the ability to monetise that investment by getting producti on to market remains a block to investment and reduces the competitiveness of the UKCS internationally .

Introduction

6. I would like to congratulate the Government for addressing the issues involved in third party access to upstream petroleum infrastructure on the UKCS. Without question, open and non-discriminatory access to existing infrastructure is the only way that the UK will maximize the economic recovery of its indigenous reserves. It is an open question as to whether the Bill’s approach of "light handed" regulation that allows the market to set the terms for access will achieve that end. As new fields get smaller, their value to infrastructure owners diminishes and the negotiating position of new field owners gets weaker to a point where private, bi-lateral, contracts of carriage are difficult to secure using market forces.

7. As found by the Select Committee, [1] ICoP, the industry ’ s main tool for self regulation, "is not working well". This finding is supported by comments given in evidence by Oil & Gas UK, the Oil and Gas Independent’s Association and DECC [2] and are consistent with findings of non-compliance throughout its 15 year history by the PILOT [3] working group and other industry surveys and participants. [4] The reality is that ICoP asks infrastructure owners to act irrationally, in an economic sense, by prejudicing their own equity production in return for comparatively nominal tariff revenues. This legislation must be the code’s last opportunity to allow the market to succeed before more intrusive regulation is considered. As the Select Committee conclude "if it cannot be made to work then consideration should be given to introducing a common carrier system".

Summary of Submissions

8. Working within the existing framework of light handed regulation, I have a number of suggested improvements designed to drive compliance with the ICoP and facilitate negotiated agreement whilst minimising the opportunity for judicial review of a decision by the Secretary.

9. Powers to make Regulations – The Select Committee’s recommendation proposed that if the voluntary code could not be made to work then consideration should be given to introducing a "common carrier system". A light handed regulatory approach, as envisaged by the Bill, may be made to work but if it doesn ’ t, and investment falls, then facilities critical to new field development may be decommissioned, stranding reserves forever. I therefore propose that the Bill provide for a review mechanism, for example in 2015, and new powers for the Secretary to make regulations. This will allow the new legislation three (3) years to be trialed and, subject to certain restrictions and the outcome of the review, the Secretary will be able to fast track further regulation if required.

10. More Prominence for OFT - The Access to Infrastructure "issue" relates primarily to the dominant position of infrastructure owners within a local offshore geographic market and the abuse of that position. Such conduct is prohibited, generally, by the Competition Act 1998 (" CA98 "). Additionally, the Government has made commitments in the Third European Gas Directive [5] (the " 3rd Gas Directive ") in respect to third party access to upstream pipeline networks to prevent the abuse of dominant positions and to achieve a competitive market in gas. The prohibitions in CA98 and the proper function of markets generally are regulated by the OFT. In order to provide support to the light handed regulation it is suggested that the OFT be given a more prominent role whereby :

(i) the Secretary be required to consult the OFT before making a decision in respect to access; and

(ii) to close a potential loophole in CA98, that the definition of " United Kingdom " , used in the context of how a market must be affected before triggering the prohibitions of CA98, be amended to specifically include markets on the offshore UKCS.

11. Provide for "Operator Services" - The Bill does not specifically address whether the Secretary is empowered to grant the provision of operator services. The development of legislation in this area has focused on the transportation and processing of production downstream of a facility’s entry point rather than the obligation of the facility owners to manage the extraction of third party production upstream of the entry point. I propose that the Bill be amended to specifically provide for the provision of operator services as an ancillary right that the Secretary may award in addition to the right of access to infrastructure.

12. Cost Recovery – I suggest providing discretion for the Secretary to recover any costs associated with making a determination from the applicant or the pipeline/facility owner (determined according to the level of compliance with the ICoP that one or the other party has achieved during the negotiations). This is to address concern by some industry participants about the resources of DECC to undertake this type of process and to drive better compliance with ICoP

13. Drafting Amendments – There are two areas in the Bill where small amendments are suggested:

(i) Section 80(6)(d) (Secretary to take account of owners’ reasonable needs) should require owners to duly substantiate their reasonable needs for future capacity rather than the comparatively modest commitment for the Secretary to take account of the owners’ reasonable needs . The added language is part of the Government’s commitment made in the 3 Rd Gas Directive and is to prevent the practice of owners making tenuous claims for future capacity needs; and

(ii) Section 82(2)(a) (Compulsory Modifications) should be redrafted to allow a modification order to be made to secure the rights sought in the access application , rather than to increase its capacity . This is because modifications may be necessary that do not affect the existing capacity.

DETAILED SUBMISSIONS TO THE PUBLIC BILL COMMITTEE – ENERGY ACT 2010/11 CHAPTER 3 – ACCESS TO UPSTREAM PETROLEUM INFRASTRUCTURE

Powers to make Regulations

14. The Select Committee’s recommendation envisages consideration of moving towards a system of common carriage if the current system of bi-lateral, private contracts of carriage, utilising the voluntary code, can not be made to work. Such a shift would require the use of regulation.

15. Historically, large fields were of considerable commercial interest to infrastructure owners who were eager to enter into bi-lateral negotiations to secure contracts of carriage. Such arrangements could provide a revenue stream for a plateau period of a decade or more and were worth negotiating and taking on additional risk to service. The evidence suggests that most new field developments will be under the 20 million barrel recoverable threshold with some being under 5 million. [6] As fields get smaller the appetite of owners to enter into carriage arrangements diminishes unless tariffs that are in excess of the DECC Guidance are obtained.

16. As such, whilst a solution that seeks to let the market determine access rights may work for a period a day may come when regulation is necessary to maximize the economic recovery of reserves from the UKCS. It will be up to the industry, largely the success or otherwise of the ICoP, which will determine when that time might be. However, small satellite fields that generate nominal revenues are not a focus for many infrastructure owners. If such owners decommission their facilities, there is real concern that reserves will be stranded and not produced at all. Professor Kemp said in evidence to the Select Committee that if " investment falls down for two or more years then we could be on a slippery slope and there will not be enough incentive to maintain the infrastructu re and then it will be too late " . [7] As such, if a light handed approach does not work, we may not have the luxury of time to commence a new parliamentary process to enact further regulation in this area and so it is proposed to provide such powers under the Bill. In addition, knowing that the Secretary has such powers and the timetable for the review will likely drive compliance with the voluntary code for a longer period and promote better behaviour .

Prominence of the Office of Fair Trading (OFT)

17. The Access to Infrastructure "issue" can be defined in terms of competition law as a denial of access to an " essential facility " within a geographic location creating a barrier to the entry to the E & P market. Infrastructure owners seek to either extract a disproportionate amount of economic rent from the satellite owners in the form of tariffs or simply refuse to engage in negotiations at all. Whilst the competition authorities have defined the relevant market as global when considering the merger of E&P companies (e.g. Exxon and Mobil [8] ), in respect to the access issue the market may be defined by the geographic natural monopoly location of the relevant facility and relate to the downstream transportation, processing and operator " carrier " services of third party owned production rather than the upstream E&P segment.

18. Conduct that creates barriers to market entry is properly regulated by the CA98. In addition the United Kingdom is required to be compliant with the 3rd Gas Directive. [9] Article 34(2) of the Directive requires any Member State to apply the objectives of fair and open access, achieving a competitive market in natural gas and avoiding any abuse of dominant position . In the UK , other than sector specific regulators, the regulatory authority charged with ensuring markets are competitive and investigating claims of abuse is the OFT.

19. Sections 80(5) and 81(5) of the Bill gives certain parties the opportunity to be heard in relation to an access application, including the applicant, the owner, any person with a right to use the pipeline or facility, the Health and Safety Executive and any other persons as the Secretary of State considers appropriate. The OFT is not specifically given the opportunity to be heard.

20. However, it is submitted that the OFT should be included as a party that the Secretary of State is required to consult:

(i) In the DECC Guidance on Disputes over Third Party Access to Upstream Oil and Gas Infrastructure (the " DECC Guidance ") it is noted that the OFT considers that where negotiations for third party access follow the DECC Guidance then there is unlikely to be a breach of CA98. [10] The implication of this is that where negotiations do not follow the DECC Guidance then there is a potential breach of CA98. In practice an application will only be made when satellite owners believe the DECC terms will be an improvement on the terms that have been offered. As such, where an application has been made then the conduct of the infrastructure owners will be under challenge to meet the DECC Guidance and receive the associated support of the OFT. For this reason, and to ensure consistency of approach between the OFT and the Secretary , the OFT should give its views on the application and be involved at an early stage. This would be consistent with its mandate under Section 7 of the Enterprise Act 2002 which states that the OFT’s function is to make proposals or give advice in matters relating to any of its functions to any Minster of the Crown;

(ii) More importantly, competition authorities such as the OFT , have a long and successful record in dealing with vertically integrated organisations who adopt anti-competitive practices to preserve their own position including those that are owners of infrastructure in the North Sea. [11] The upstream sector, can be divided into:

(a) the E&P segment where equity production is found and produced; and

(b) the carrier segment that includes the downstream transportation, processing and operator services for third party production.

The vertically integrated nature of the sector creates barriers for new entrants to the E&P market as owners, acting rationally, favour their own equity production business when making decisions in respect to the use of capacity to carry production. [12]

21. The competition legislation is provided to correct an imbalance of negotiating positions in the market. If the light handed regulation is to succeed in allowing the market to make the correct decisions in respect to access terms then the market must be functioning in a manner that complies with CA98. CA98 provides an excellent deterrent to anti-competitive conduct as the OFT is able to fine companies up to 10% of their global turnover or obtain commitments that will eliminate anti-competitive conduct. In comparison, the enforcement provisions in the Bill (Section 86 provides for a Level 5 fine of £5,000) are light when one considers they may be levied against some of the world’s largest companies. Providing more visibility for OFT in access disputes will provide an added, and powerful, incentive for infrastructure owners to adopt the DECC Guidance and agree negotiated terms.

22. However, if the Committee were minded to accept this submission, a further improvement is suggested. Whilst the "sector specific legislation" that the Bill consolidates and extends is considered by DECC to be an alternative to the powers of the OFT and the courts under the CA98 [13] there is some ambiguity as to whether the prohibitions apply to offshore markets. Chapter I of the CA98 prevents agreements between undertakings which have as their object or effect the prevention, restriction or distortion of competition within the United Kingdom . Chapter II of the CA98 prohibits conduct on the part of one or more undertakings which amounts to the abuse of a dominant position in a market where it may affect trade within the United Kingdom .

23. However, it is not clear whether the prohibitions in the CA98 apply where the affected " market " is on the offshore UKCS rather than within the onshore territorial UK . Whilst the Civil Jurisdiction (Offshore Activities) Order 1987 governs whether or not civil law is applicable offshore, and in particular whether certain laws extend beyond the land and territorial waters to the Continental Shelf, the language of CA98 makes clear that the prohibitions must affect a market or trade in the United Kingdom . Given Parliament has adopted the approach of specifically providing for UK law to apply to the Continental Shelf (e.g. Sections 10 and 11 Petroleum Act 1998) it might be argued that a market in the "United Kingdom" would, in the absence of specific legislation to the contrary, be defined as a market on the onshore territorial UK, not the offshore. As such whilst CA98 will apply to the offshore, the prohibitions are only effective where a market or trade on the onshore territorial UK is affected. This could be problematic when seeking to enforce the CA98 prohibitions in the offshore context. In many cases oil is produced and loaded offshore and exported outside UK waters. Additionally, the geographic market for the provision of offshore transportation, processing and operator services is located on the facility to which access is sought, not the territorial UK .

24. In addition to being an important alternative to the sector specific legislation of the Bill, the provisions of the CA98 ensure that the United Kingdom is compliant with the 3rd Gas Directive. Article 34(2) of the Directive requires any Member State to apply the objectives of fair and open access, achieving a competitive market in natural gas and avoiding any abuse of dominant position . The CA98 is the main tool available to prevent the abuse of a dominant position and achieve competitive markets. If the prohibitions are not applicable to the offshore then there may be difficulties in implementing Article 34 of the Directive.

25. As such, it would be preferable to make it clear that the Chapter I and II prohibitions of the CA98 apply where any market on the UKCS is also affected by redefining "United Kingdom" in Section 2(7) and Section 18(3) of the CA98 to include the adjacent sea and any area designated under Section 1(7) of the Continental Shelf Act 1964. This would ensure that this valuable second option for securing access to infrastructure is available to a party developing a field and permit the Secretary’s new powers to be applied in a properly functioning market. The proposed amendments could be noted in Schedule 2 of the Bill .

Inclusion of Operator Services

26. The Bill provides a procedure that may require facility and pipeline owners to provide access to third parties for processing and transportation of third party production - a passive obligation. It does not make provision for the Secretary to require the owners to manage the delivery and introduction of such production to their facilities – the "operator services" necessary to service a third party offshore development upstream of their facilities - an active obligation. The imposition of operator services may be a significant burden on the infrastructure owners for which one would expect the pr ovision of specific legislation. T he owners would not merely allow the satellite owners to use their facilities but also to physically manage the production of the satellite field by arranging the injection of water, gas, chemicals, and provision of similar services, and the delivery of the resultant production from the wellhead to the entry point of their facilities. Put in terms of the rail transportation business it is analogous to expecting the rail operator to uplift the goods for transport from the owners’ premises and deliver them to the railway station as well as transport them on their own network. In terms of oil and gas it could be argued that it is up to the satellite owners to get their production to the host facility.

27. The existing legislation in this area was developed in a piecemeal manner. The provisions relating to "access" were designed to prevent the unnecessary proliferation of pipelines in the North Sea [14] not to maximise the economic recovery of reserves which is DECC’s objective. [15] The Energy Act 2008 did update the definitions of the different facilities in the various legislation to include works and services associated with the operation of pipelines (e.g. Section 78(1)(c)) but this does not go as far as including "operator services" that apply upstream of the entry point to the facilities.

28. Discussions with officials at DECC suggest that the provision of "operator services", could be addressed as an "ancillary or incidental right" under Section 80(10)(c) of the Bill. Section 80(10) states that the Secretary of State may give a notice for certain purposes including the right to access. Section 80(10)(c) states the notice may have the purpose of securing "to the applicant such ancillary or incidental rights as the Secretary of State considers necessary or expedient".

29. While "operator services" may potentially be covered by Section 80(10)(c) of the Bill as ancillary or incidental rights – this is not completely clear. It is arguable that "ancillary or incidental rights" must be of a similar nature to the rights secured in the Secretary’s notice - i .e. a passive obligation downstream of the entry point, rather than the active obligation that operates upstream of the facilities to which access has been sought. An example of an active obligation being specifically catered for are the compulsory modification provisions of Section 82 that could equally be argued as being "ancillary or incidental rights" to rights of access. The fact that these rights have been specifically provided for suggests that their nature is not ancillary or incidental. This ambiguity in the new statute could result in judicial review by an infrastructure owner of any decision of the Secretary that requires operator services to be provided. The length of such review, and the inevitable delay, could result in the loss of value to the new field owners jeopardising the fields’ economics. To avoid such delays it would be optimal if the Bill confirmed that the "provision of related services" (such as the injection of water, gas and chemicals into a reservoir) is an ancillary or incidental right, making it clear that an "access application" may potentially include an application for the provision of upstream related services.

Cost Recovery

30. In the DTI’s Summary of responses to the Department of Trade and Industry consultation on proposals for guidance on use of legal powers to settle disputes over third party access to infrastructure [16] it was noted at paragraph 33 " A number of respondents raised questions about the Department's competence, experience and availability of resources to deal with appeals to the Secretary of State. "

31. The conduct of the one application that has been made to date required considerable resources and it is speculated that it would be difficult for DECC to manage two or more applications at the same time under current resourcing levels. Many infrastructure owners know this and it may act as a barrier to applicants who need confidence that they will receive a timely decision. In order to address this issue and provide comfort to applicant’s that DECC will have the technical, commercial and legal capability to provide an effective and timely notice it is proposed that the Secretary have the discretion to recover any costs involved in the retention of specialist consultants or advisers from one or both of the parties.

32. In terms of how to determine who picks up the costs, the DECC Guidance (which will be modified due to the enactment of the Bill) could suggest that compliance with the ICoP would be the most relevant factor in determining whether costs will be recovered and, if so, the cost share. This would add further incentive for parties to reach a negotiated settlement and act to facilitate compliance with ICoP.

Drafting Amendments

33. Secretary to take Account of Owners’ Reasonable Needs - Section 80(6) of the Bill states what must be taken into account by the Secretary of State when considering an application. Section 80(6)(d) includes "the reasonable needs of the owner and any associate of the owner for the conveying and processing of petroleum". In order to be consistent with the language of Article 34(2)(c) of the 3rd Gas Directive, I propose that these "needs" should be "duly substantiated" to provide a higher burden on owners to demonstrate real and near term needs, for example, where funds have been irrevocably committed. This is to counter the practice of owners claiming no capacity is available on tenuous grounds.

34. Compulsory Modifications - Section 82(2) of the Bill states that a pipeline or facility subject to an application can be modified on the order of the Secretary of State. Section 82(2)(a) specifically limits the modification powers to those necessary to "increase its capacity". However, there may be numerous modifications that could be made that have no effect on the capacity of the pipeline or facility. This is another anomaly caused by the historic purpose of the original legislation mentioned at paragraph 2 6 . For example modifications may be required in order to provide additional operator services as described at paragraph 2 5 such as the addition of a desulphurising unit to treat "sour" gas o n an otherwise "sweet" platform; or the addition of sand removal equipment due to a particular sand management issue that relates wholly to the satellite.

Conclusion

35. I restate my support for the Government’s move to deal with this issue. Industry should be encouraged to update the ICoP to dovetail with the new legislation and the DECC Guidance. In a sense the move towards additional Government intervention signals a shift from private, bi-laterally negotiated contracts of carriage where, for small fields particularly, there is an imbalance of negotiating positions, to a system of predictable tariff setting principles that are generally applicable and common to all. Whether industry respond to the Government’s signals will determine whether further intervention by Government is required to shift the industry towards a wholly regulated system of non-negotiable terms for common carriage.

June 2011