Completed acquisition by Centrica plc of Dynegy Storage Ltd and Dynegy Onshore Processing

No. ME/1651/02

A report under section 125(4) of the Fair Trading Act 1973 on the advice of the Director General of Fair Trading, given on 11 February 2003, to the Secretary of State for Trade and Industry under section 76 of the Act

ASSESSMENT

Jurisdiction

The merger satisfies the assets test of the FTA.  It also satisfies the share of supply test in respect of the supply of flexible gas in the UK .  The EC Merger Regulation does not apply.  

The parties

Centrica plc (Centrica) was formed in 1997 by the de-merger of British Gas.  It is involved in gas production, trading (through Accord Energy), shipping and supply, as well as electricity generation and supply in the UK . It also has energy interests in Belgium , US and Canada . Centrica also provides a range of household services through subsidiaries including the AA, Goldfish, and British Gas Communications. In the year ended December 2001, Centrica reported pre-tax profits of £468 million on a turnover of £12.6 billion, and gross assets of £7.2 billion. 

Dynegy Storage Ltd and Dynegy Onshore Processing (DSL) were subsidiaries of Dynegy Europe Limited (Dynegy), whose ultimate parent is Dynegy Inc, an energy merchant, power generator and energy trader in North America, the UK and continental Europe. DSL owned and operated Rough, an offshore gas storage facility, and the associated pipeline and onshore processing facility at Easington, Yorkshire . In the year ended 31 December 2001 , Dynegy Storage Limited reported pre-tax profits of £20m on a turnover of £85 million, and gross assets of £500 million.

Relevant markets

Centrica owns no gas storage assets other than Rough, but controls a number of other sources of flexible gas, in particular the Morecambe gas field.

The merger involves the acquisition of a gas storage facility, which stores gas for gas suppliers and traders until peaks in demand caused by cold weather or imbalances in the gas network make using the gas necessary for gas suppliers to meet customer requirements, or make it profitable for gas traders to sell it to those suppliers. Gas used to meet extra demand in cold weather is known as winter gas and gas used to meet outages or imbalances in the network is known as daily gas.  At different times the facility may be substitutable for, or complementary to, a number of other gas storage facilities, offering different performance and prices, or other sources of flexible gas supply.

In addition to Rough, there are four other gas storage facilities in Great Britain : Transco's combined Liquefied Natural Gas (LNG) facilities, and storage sites at Hornsea, Hatfield Moor and Hole House. The other facilities may be substitutes for Rough to some degree, but each of them has very different characteristics in terms of duration, deliverability, and price.  For example, Rough can store four times as many days gas as Hornsea and thirteen times as many as the LNG facilities. Rough can deliver gas five times as fast as Hatfield Moor and twenty times as fast as Hole House.  The cost of peak storage using the LNG facilities is significantly more than that of Rough (LNG is mostly used for transportation of gas in any case) and Hornsea's average storage price for 2001 was about 40 per cent less than that of Rough.  Shippers may consider these characteristics important in selecting a storage site.  Certainly the duration of the facility is an important parameter in constraining price at other facilities, particularly for winter gas, which often requires longer periods of delivery compared to the sporadic demand for daily gas.  For example, LNG would only constrain the pricing of Rough on the few days in a winter when demand is at its highest.  Physical characteristics and prices suggest that other storage sites are complementary rather than substitutable.  Observations of demand in the winter of 2000-1 support this, showing that Hornsea is the only significant substitute for Rough in relation to daily gas and, to a lesser extent, for winter gas.

Storage capacity is sold by auction or bilateral deals in a primary market, with resale in a secondary market.  For a gas shipper who is unsuccessful in bidding for storage, or sees the cost as exceeding the expected winter/summer price gas differential, there are a number of other possible substitutes for gas storage. The most significant are:

contracts for gas from 'swing' gas fields, such as Morecambe, that are able to increase production at short notice : such contracts are generally long term and offer the buyer varying degrees of flexibility in the amount of gas they take at a range of prices.  Swing gas is reducing over time as gas production is switching to northern North Sea oil fields, which are far less flexible.  Observations of variations in output suggest that all swing fields can substitute for winter gas and that only Morecambe does so for daily gas;

demand side management by seeking to divert gas at short notice from customers with 'interruptible' contracts : these customers switch to an alternative power source, if this is available and economically viable, in return for cheaper gas.  A small number of these are long term interruptible (LTI) contracts. The limited impact of this form of flexibility is seen in the small amount of interruption observed in the last two years.  Given the opportunity costs of interrupting a customer's supply, it is likely that these contracts would substitute for Rough more closely for the short term demand of daily gas than for winter gas.  Observation of shocks to the gas supply indicates that interruption is a substitute for Rough for daily gas; and  

 

flexibility from the interconnector : this pipeline to the Continent is used to import or export gas, and, by increasing the former and decreasing the latter, some flexibility is available. The interconnector is a likely substitute for both winter and daily gas but it has not been possible to determine the exact nature of this substitution.

Physical and price differences between storage facilities may mean that in some circumstances there might be a case for defining the relevant market narrowly by reference to each gas storage facility.  A wider market definition would include some or even all forms of flexibility.  It is not necessary to define the relevant product market precisely, since the competition issues discussed below arise whatever framework of analysis is adopted.   

Geographic market

Transco operates the National Transmission System (NTS) across which shippers balance their inputs and offtakes of gas on a daily basis throughout Great Britain . Gas imports are relatively small. The relevant geographic market is therefore defined as being Great Britain .   

Horizontal issues

Rough represents 84.5 per cent of storage space (by GWh) and 70 per cent of deliverability (by GWh/day) of all gas storage in Great Britain , excluding the LNG facilities (see note 1). Centrica currently has booked around [25-30 per cent] (see note 2) of storage in Great Britain , which reflects the fact that it is the biggest domestic gas supplier in the country.  In terms of other sources of flexibility, Centrica controls 100 per cent of the Morecambe swing gas field, [50-60 per cent] of all swing gas, [10-25 per cent] of capacity in the interconnector and [20-30 per cent] of the total capacity available from interruptible contracts (see note 3).

As a result of the merger Centrica has [35-45 per cent] ([15-20 per cent] increment arising from the acquisition of Rough) of theoretical maximum capacity for daily gas and [35-45 per cent] ([1-5 per cent] increment) of theoretical maximum capacity for winter gas. Observation of gas flows between December 2001 and March 2002 showed that all sources of flexible gas except LNG and swing (other than Morecambe) come on line for daily gas and all sources except LNG, Hornsea and interruptible contracts are used for winter gas.  These observations suggest that, post-merger, Centrica controls [70-80 per cent] of daily gas ([25-35 per cent] increment) and [40-45 per cent] of winter gas ([5-10 per cent] increment)], rising to [65-75 per cent] if the level of base volume of gas supplied all year round (flat gas) is not considered (see note 4).

Control of Rough may give Centrica the ability and incentive to increase the price of storage to its competitors. Centrica has booked [25-30 per cent] (see note 5) of Rough for use in 2002-3. Once Centrica controls Rough it can withhold more than the capacity it has already booked by, for example, refusing access or imposing differential pricing that makes gas storage unprofitable for its competitors. As the availability of swing gas declines with the move to less flexible gas fields, the demand for storage is likely to increase.  With less capacity available other buyers may end up paying more for gas storage.  As the price of storage is a component of the price of flexible gas, this in turn could raise the price of securing that gas, thus placing Centrica's competitors at a competitive disadvantage.  Such a price increase might also affect the wholesale price of gas, although the price of storage is a minor element of the overall wholesale price of gas in relevant terms. 

The combination of Rough and Centrica's other sources of flexible gas may also diminish the incentive to develop Rough further or to manage the site in an innovative way. In its 1993 report on gas (Cm2314) the MMC expressed concern that a storage operator might not develop its assets in a way that facilitated competition. Dynegy and BG Storage both had unimplemented plans to develop Rough. Although the feasibility of such plans is unclear, it was estimated that capacity could be increased by 10 per cent.  Centrica is considering its plans for the facility.  It is possible that its (increased) market power and position vis-à-vis competitors would give it less incentive to develop Rough than an independent owner would have.

The cost of a new storage facility varies from £100 million to £1.4billion depending on the scale, and both finding a site and obtaining planning permission are difficult.  Four new storage sites are planned to become operational by 2007, each around the size of Hornsea.  However, such projects are subject to delay, with work not starting on one despite planning permission having been granted some years ago.  Both swing gas and LTI contracts are in decline, although there are firm plans to increase capacity in the inter-connector. Barriers to entry are therefore thought to be high, and it is unclear how much new entry there will be in the medium term.

Bilateral sales may allow customers to exercise some buyer power in buying storage services, although it is not clear to what extent this occurs or how the merger would affect buyer power.

Overall the merger appears likely to enhance Centrica's already significant market power in flexible gas supply and may lead to a substantial lessening of competition. 

Vertical issues

Centrica is the most vertically integrated energy company in the UK .  As well as having significant gas production assets, it is the largest gas shipper, has [10-20 per cent] (see note 6) of the gas trading market, and is the largest supplier of domestic gas and electricity.  While vertical integration may lead to efficiencies, the merger has the potential to give rise to anti-competitive effects in several downstream markets (in addition to the horizontal concerns discussed above).

Control of Rough will allow Centrica to know what price other shippers and traders have paid for their storage, what they are holding in store and the use to which it will be put. Centrica has acknowledged that this market-sensitive information can be used to advantage in its downstream activities. Such a concern also arose under the facility's previous ownership by BG Storage and Dynegy, and was addressed by means of assurances or undertakings.

Ownership of Rough could allow Centrica to favour its downstream businesses by discriminating in the operation of the facility and in the commodity charge levied when gas is taken out of storage. For example, in the event of operational constraints at Rough, Centrica could allow 'its' gas out of store and on to its customers as a priority.     

Centrica's control of a significant part of Great Britain 's flexible gas supply is enhanced by the acquisition of Rough and could allow it to reduce available sources of flexible gas to its competitors who may need such gas to meet peak demands. Acquiring flexible gas is a significant cost to shippers and suppliers. This is particularly the case for suppliers of gas to domestic customers as peak domestic demand is three times that of average domestic demand for gas and 50 per cent of total domestic supply costs is for gas.  A lessening of competition in the supply of flexible gas might therefore lead to a rise in the wholesale price of gas.  Downstream competitors to Centrica that are not vertically integrated upstream will have little or no extra revenue from gas fields to offset those costs. 

Assessing how large an impact a reduction in flexible gas supply from Centrica would have on the wholesale gas price is complex.  It would depend on, amongst other things, the extent to which other gas suppliers were exposed through the requirement to balance the market on a daily basis.  It is also not clear how much extra revenue would be generated by such behaviour, or the amount of extra costs for Centrica that the revenue would have to offset.  Accordingly it has not been possible to determine the significance or level of detriment created by the addition of Rough to Centrica's flexible gas supply assets.

Overall the merger also creates potential for detriment in relation to the use of confidential information and the ability to discriminate against downstream competitors of Centrica. 

Undertakings in lieu

Centrica acknowledged potential competition concerns arising from its ownership of Rough from a relatively early stage in the OFT's consideration of the case, and offered undertakings similar to those which Dynegy had given relating to separation of the Rough business from the rest of its business, as well as a limit of 30 per cent on its own acquisition of capacity at Rough.  Before the Mergers Panel met to discuss the case, the OFT wrote to Centrica to set out the potential competition concerns which it, in consultation with Ofgem, had identified, which were then discussed at a meeting between Centrica and OFT officials.  At that meeting, Centrica made a new and wider-ranging offer of undertakings in lieu of reference, including in particular limiting its own acquisition of capacity at Rough to 25 per cent and an undertaking that the Morecambe and Sean swing gas fields would produce maximum output when peak demand for gas exceeded [ ] (see note 7) respectively.

In previous written comments to the OFT, Ofgem had set out a minimum level of undertakings which it considered necessary to address the competition concerns arising from the transaction, including a 10 per cent limit on Centrica's acquisition of capacity at Rough.  The undertakings which Centrica had offered did not fully address Ofgem's concerns, and the OFT could certainly not be confident – particularly given the difficulties referred to above in measuring the extent of the detriment – that they were sufficient and proportionate to address clearly the expected adverse competition effects.  Uncertainty surrounded the quantification of the detriment to competition in the first place, and factors such as the percentage of capacity at Rough which should be reserved to Centrica, and the length of the contracts under which the remainder of the capacity should be sold.  Nor was it obvious that the form of remedy – regulating shares of capacity – in the undertakings under discussion was optimal.

Undertakings in lieu of reference are generally appropriate only where the competition concerns raised by a merger and the remedies proposed to address them are clear-cut and proportionate.  In this case, however, given the prospect that Centrica might be prepared to offer undertakings which would avert the need for a reference, OFT officials gave Centrica a further opportunity to discuss with Ofgem its concerns about the merger and the measures which it considered necessary to address them.  In order to address the issues of sufficiency and proportionality, Ofgem were also asked to justify to the OFT the terms of any undertakings on which it might be able to reach agreement with Centrica.

OFT officials remained in close touch with Centrica and Ofgem over the subsequent period of discussion between them, during which there was some movement in both their positions.  For example Centrica would now be prepared to limit its acquisition of capacity at Rough to 20 per cent and Ofgem would now accept 15 per cent.  Nevertheless, Centrica has not offered undertakings that Ofgem regard as acceptable.  Neither have the discussions established that such undertakings would be clear-cut and proportionate.

As discussion has progressed additional differences have emerged between Centrica and Ofgem on undertakings, for example concerning the indexation of long term contracts to gas prices.  This does not rule out the possibility that, given more time, Centrica and Ofgem could agree on the terms of undertakings.  Agreement between Centrica and Ofgem would however, not necessarily signify that a remedy has been agreed upon that the OFT could recommend to you in lieu of reference.  In any event, it appears that determining that undertakings remedied detriments to competition in a clear and proportionate manner would require a more in-depth examination than either Ofgem or the OFT is able to undertake at this stage.  The statutory deadline for reference of this completed merger is 13 March.  This leaves very little time for the further discussion with the parties, and public consultation, which would be necessary before the OFT could be in a position to recommend acceptance of finalised undertakings in lieu to you. 

We have, therefore, concluded that undertakings in lieu of reference are not appropriate in this case.

Third party views

Of the seventeen third parties that commented, six believed that a CC reference was necessary and ten believed this could be avoided with effective undertakings, mostly addressing Centrica's position as the leading domestic gas supplier.

CONCLUSION

The merger qualifies for investigation under the assets and share of supply tests of the FTA.  The parties overlap in flexible gas supply for winter and daily gas. 

The merger involves the acquisition of a gas storage facility, which stores gas for gas suppliers and traders until peaks in demand caused by cold weather or imbalances in the gas network make using the gas necessary for gas suppliers to meet customer requirements, or make it profitable for gas traders to sell it to those suppliers.  At different times the facility may be substitutable for, or complementary to, a number of other gas storage facilities.  Whatever view is taken of the substitutability of other sources of flexible gas, the acquisition of Rough appears likely to increase Centrica's market power.

There is a significant prospect that the acquisition gives Centrica the ability and incentive to increase the price of storage through withholding capacity from the market and, when combined with its other sources of flexible gas, weakens its incentive to expand capacity at Rough. 

As Centrica is a vertically integrated company with a leading position in several downstream markets including gas trading and gas supply, the acquisition might, moreover lead to some lessening of competition in those markets.

There is therefore a clear possibility that Centrica's ownership of Rough will give rise to a substantial lessening of competition.  Centrica has accordingly offered a range of undertakings in lieu of reference.  It is not clear, however, that those undertakings would be sufficient to address the competition issues which have been identified.  On the other hand, the complexity of the issues is such that it is difficult to be confident that more onerous regulatory undertakings would be proportionate (or superior to structural remedy if that were judged appropriate).  Undertakings in lieu of reference are appropriate only where the issues are clear-cut, a condition which cannot be said to be met in this case.  The CC exists, in part, to investigate such issues in depth.

 

I therefore conclude and recommend that you should refer this merger to the CC

 

NOTES

 

 

1. The addition of LNG would take these figures to 75 per cent and 33 per cent respectively.  

 

2. Actual figure replaced by a range at the request of Centrica.

 

3. Actual figures replaced by ranges at the request of Centrica. Figures are based on Ofgem/OFT analysis.

 

4. Actual figures replaced by ranges at the request of Centrica.  Figures are based on Ofgem/OFT analysis.  

 

5. Actual figure replaced by a range at the request of Centrica.

 

6. Actual figure replaced by a range at the request of Centrica.

 

7. Commercially confidential figure deleted at the request of Centrica.

 

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