No. ME/1361/01
A report under section 125(4) of the Fair Trading Act 1973 on the advice of the Director General of Fair Trading, given on 31 August 2001, to the Secretary of State for Trade and Industry under section 76 of the Act
Dynegy Europe Limited (Dynegy) is a wholly owned subsidiary of the US company Dynegy Holdings Inc, which in turn is a wholly owned subsidiary of Dynegy Inc. Dynegy Inc is a leading energy merchant and power generator in North America, the UK and continental Europe. Dynegy is an active player in UK energy markets and holds a Gas Shipper's Licence.
BG Storage Limited (BGS) is a wholly owned subsidiary of BG Group plc (part of the former British Gas), an integrated gas major with operations spanning exploration and production, Liquefied Natural Gas (LNG), transmission and distribution. BGS owns and operates two gas storage facilities (Rough and Hornsea) and has a 73% stake in the Easington onshore gas processing terminal.
Dynegy announced on 16 July 2001 that it had agreed to acquire BGS (together with some other assets currently owned by other BG Group subsidiaries, including the remaining 27% interest in Easington) for £421 million. Subject to regulatory approval, the transaction was expected to be completed during September.
The merger satisfies the assets test of the FTA. The ECMR does not apply.
The transaction potentially affects both the means of securing flexibility in gas supply (which include physical gas storage), and the wholesale gas market, comprising gas shipping and trading. Dynegy is currently active only in the wholesale market, where BGS is not present. There is thus no horizontal overlap between the parties to the merger.
Gas storage facilities allow gas to be stored for use in peak periods. A narrow definition of physical gas storage would include only the Rough and Hornsea facilities, together with other, much smaller, facilities at Hatfield Moor and Hole House (owned by Scottish Power and Aquila respectively). Although further physical storage facilities are being developed, these are relatively small and unlikely in themselves to affect the position of Rough and Hornsea. The LNG facilities owned by Transco also constitute a form of storage. Such facilities are characterised by their high speed of deliverability, which means that significant stocks of gas can be brought onto the market very quickly. However, it takes a long time to fill them up, and they only hold sufficient stocks of gas for five consecutive days.
The main alternative source of onshore flexibility available at present arises from the use of interruptible contracts, whereby shippers may interrupt supplies to customers for a maximum of 45 days per year. Some flexibility is also available from increasing the volume of beach gas supplied by producers, and potential also exists for greater imports of gas via the interconnector to continental Europe. However, at present none of these alternatives appears to provide sufficient competition to affect the strong position of the owner of Rough and Hornsea in the provision of flexibility of supply of gas.
A broad market definition would encompass a range of sources of flexibility of supply. Overall, however, I take the view that the characteristics of physical storage facilities such as Rough and Hornsea are sufficiently distinct for them to be regarded, at the least, as being of such significance that ownership of a high proportion of their capacity gives rise to competition concerns.
Gas shippers and traders operating in the wholesale gas market are users of gas storage facilities such as Rough and Hornsea. Shippers are required, by their licences, to ensure that on any day their supplies of gas are equal to their customers' demands. Potentially severe financial penalties (and regulatory sanctions) exist for shippers who cannot balance their portfolio and match demand for gas with supply in any 24 hour period. Most shippers will hold a variety of contracts with both suppliers and customers, giving them varying degrees of flexibility.
Trading provides a means by which gas shippers can match changes in demand or supply. Gas held in storage sites and gas intended for commercial customers (commercial interruption) can be sold in the wholesale market if the prices are sufficiently attractive. Increasingly storage has been used as a source of flexibility, although it still remains a major source of peak supply gas.
The owner of Rough and Hornsea will hold a very high share of physical gas storage capacity (in excess of 80% even if LNG facilities are included) [see Note 1]. At present, substitutability on both the supply and demand sides appears to be relatively limited. While some further storage facilities are proposed, it is unclear when these will become operational, and they will in any case be very small by comparison with Rough and Hornsea. The prospect of further entry in the short to medium term is constrained by regulatory and planning controls, and the number of suitable sites is in any event likely to be very limited.
In the absence of regulation, potential would exist for the owner of Rough and Hornsea to exploit its market position, for example by withholding storage capacity from, or raising prices to, or offering discriminatory terms to, its customers in the wholesale market. This would, in turn, be likely to lessen competition in the wholesale market, particularly when the owner of storage capacity itself operates in that market. Under the present ownership, this issue is addressed by the 1999 assurances, which require BGS to auction storage capacity. These assurances apply for the five years up to and including the 2003-04 storage year, by which time it was envisaged that sufficient additional flexibility might have developed (through such means as new storage facilities, enhanced interconnector capacity, and greater use of interruptible supply contracts) such as to render the Rough and Hornsea facilities less important. Were the assurances to lapse now as a consequence of the acquisition by Dynegy, I consider that there would be a clear risk that Dynegy could use its position in gas storage to exploit market power and lessen competition in the wholesale market, and that this would warrant reference of this merger to the Competition Commission.
The 1999 assurances also provide for the effective separation of the storage business from BG's other commercial activities, including those in the wholesale gas market. The purpose of this separation is to ensure that information acquired in its role as an operator of storage facilities (for example, on the use being made of those facilities by other traders) cannot be used to benefit it in its role as a trader.
Following the proposed merger, Dynegy would have interests in both the storage and wholesale markets, with the same potential for misuse of information. Again, I take the view that, in the absence of continuing effective regulation following the proposed merger, this would give rise to a clear risk of an adverse effect on competition in the wholesale gas market, which would warrant reference of the merger to the Competition Commission.
Dynegy has indicated its willingness to give assurances to Ofgem [see Note 2]. Dynegy has, however, suggested that the objectives of the assurances might be achieved in a better way, and it had been Ofgem's intention, were the merger to be cleared subject to the assurances offered, to conduct a consultation exercise which would allow Dynegy's ideas to be considered by customers and competitors.
The process originally envisaged by Ofgem would, however, involve you granting clearance (subject to the interim assurances) without knowing quite what form of assurances would eventually be negotiated following the consultation process. Furthermore, such assurances would be informal and non-statutory, and the potential sanction of action under the Competition Act or the monopoly provisions of the FTA seems to me to be less satisfactory than addressing the potential competition concerns directly as part of the merger control process.
These concerns could, in my view, be addressed by requiring the non-statutory assurances which Dynegy has already offered to be reinforced by means of undertakings in lieu of reference under the FTA, which would essentially require Dynegy to comply with the terms of the assurances given to Ofgem. The consultation exercise envisaged by Ofgem could then take place following the announcement of your decision, with a view to reaching early agreement on the form of both the assurances and the undertakings covering them. I would then be able to advise you in the normal way on whether these were sufficient to address the potential adverse effects, and should therefore be accepted.
The assurances, underpinned by the undertakings, would have the same duration (to the end of the 2003-04 storage year) as the current BG assurances. It is possible that competition problems will continue beyond this date. But such problems, were they to occur, would not be a result of the merger, and mergers policy would not be the way to address them. My advice on merger references is confined to possible adverse effects arising from mergers.
A number of customers and competitors have already responded to a consultation exercise conducted by Ofgem on the proposed merger, with some of them arguing that the issues discussed above should be addressed by means of assurances or undertakings in similar terms to the assurances currently applying to BGS. These third party views have been taken into account in the analysis set out above.
The assessment above has identified competition problems in the gas market which would, by virtue of the fact that the existing assurances given by BG would no longer apply, be a consequence of the acquisition by Dynegy of the Rough and Hornsea storage facilities.
In my view the adverse effects are capable of remedy by maintaining a similar form of regulation to that provided by the existing assurances. For the reasons given above I propose that this regulation should be in the form of a short undertaking under the FTA, which would require Dynegy to comply with assurances given to Ofgem, who are best placed to monitor and enforce them.
Neither Ofgem nor Dynegy believe that these assurances are yet in their optimal form. Publication of the assurances following the announcement of your decision will enable consultation to take place, with a view to redrafting them in the light of comments from all interested parties. I understand that Ofgem are prepared to carry out the consultation exercise, with a view to agreeing revised assurances, with the minimum of delay following the announcement of your decision.
I therefore conclude and recommend that you should announce as soon as possible your intention to refer the merger to the Competition Commission unless Dynegy gives satisfactory undertakings in lieu of a reference to address the potential adverse effects arising from the merger.
NOTES
1. Dynegy argue that the market should be defined in terms of deliverability, rather than physical storage space. On that basis, the market share of Rough and Hornsea is estimated at 43.6%.
2. Details of assurances offered to Ofgem by Dynegy omitted at Dynegy's request.
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