Gas regulation report

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PETROLEUM PRODUCT PRICES AND PRICE REGULATION IN NOVA SCOTIA:A CONSUMERS PERSPECTIVE

Final Report submitted to Service Nova Scotia and Municipal Relations

Roderick Hill, PhDProfessor of Economics, University of New Brunswick, Saint John, N.B. E5N 6P9

email: HREF="mailto:[email protected]" MACROBUTTON HtmlResAnchor [email protected]

2 April 2011

TABLE OF CONTENTS

Page

Executive Summary iiiINTRODUCTION 1

Background and objectives 1Outline 2Caveats and Limitations 3

PART 1: THE RETAIL GASOLINE MARKET AND GAS PRICEREGULATION: AN OVERVIEW

4

1.1 Gasoline market and consumer interests 41.2 The regulation of gasoline prices in Nova Scotia 8


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1.3 Price regulation and consumer interests 121.4 Gasoline prices: a brief overview 15

PART 2: REGULATION AND BEFORE-TAX CONSUMER PRICES 192.1 Marketing margins before and after regulation 19

2.2 How competitive are local gasoline and diesel markets? 282.3 Promotions and other discounts available to consumers 332.4 Comparisons with other markets in Canada 352.5 The variability of prices 382.6 Summary and main conclusions 42

PART 3: AFTER-TAX CONSUMER PRICES: THE CONSUMER-CITIZEN SPERSPECTIVE

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3.1 Fuel taxes in Nova Scotia and elsewhere 453.2 Why fuel taxes? 513.3 Fuel taxes in practice as a user charge for roads and highways 54

3.4 Who pays fuel taxes? 663.5 Fuel taxes to deal with external costs 673.6 Concluding remarks 67

PART 4: SUMMARY AND CONCLUSIONS 69

APPENDICESAppendix 1 73Appendix Tables 75Appendix Figures 83

Appendix 2 92

BIBLIOGRAPHY 94

EXECUTIVE SUMMARY

This report examines petroleum product prices and price regulation in Nova Scotia from aconsumer viewpoint. It considers the effects of regulation on before-tax retail prices of gasolineand diesel as well as the excise taxes on fuel that help to determine after-tax prices.

Before-tax prices.Before-tax prices in Nova Scotia are among the lowest in Canada for both gasoline and diesel.These are the prices that matter most to individuals in their role as consumers because this is whatthey pay producers for their fuel.

The maximum and minimum wholesale plus retail gross margins for gas set in 2006 by regulationwere in line with historical experience. Consumers faced higher prices just after regulation beganbecause retailers set maximum prices, which lay above historical trends. However with


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competition, gas prices fell to the regulated minimum price in larger urban areas. Retail pricesremained at the maximum in Yarmouth and in some rural areas, but these were likely relativelyuncompetitive markets before regulation. Diesel markets were less competitive markets thangasoline and so consumers only benefit from regulation was a price cap.

Real wholesale and retail margin declined over time since regulation began, reducing the costs ofthese services to consumers. This happened because inflation eroded the real value of the nominalwholesale and retail margins (and transportation costs) set by regulation. This resulted in netsavings to consumers of between $8 and $20 million over the first five and one-half years ofregulation.

When margins and fuel transportation costs were adjusted upwards as of January 2012, retailersreal margins increased and caught up with inflation. However, consumers can expect real marginsto fall in the future as they have in the past.

Price changes are more predictable with regulation with two benefits for consumers: unexpected

large price increases are almost eliminated and there are modest monetary benefits for those whotime their purchases knowing the direction in which the price is likely to change. Finally, pricedifferences between different regions in Nova Scotia now are more closely connected to fueltransportation cost differences rather than to fluctuating differences in competitive conditionsbetween different markets.

Were price regulation to be removed, the most likely outcome would be a reversal of these effectsof instituting regulation: higher prices in uncompetitive markets, and perhaps in competitive ones;less predictable price changes and regional diversity in prices not based on transportation costs.

After-tax prices.Excise tax rates in Nova Scotia for both gasoline and diesel are now about the Canadian average.They have been declining and are at their lowest rates in more than 20 years. Because these taxescontribute to publicly-provided goods and services, their justification depends on the views ofconsumers-as-citizens about public policy objectives. Should users of roads contribute to their costor should roads be paid for from general tax revenues? Should polluters face prices reflecting thecosts of their pollution?

If drivers dont pay for the benefits they receive (and the costs they generate), there will be toomuch driving, resulting in excessive road costs, road congestion and pollution. Fuel taxes haveacted as such charges, although potentially better alternatives are possible that are linked moreclosely to road use.

In Nova Scotia, gas tax revenues and other road-related revenues must be used for road spending.Currently, road users are paying about 80 percent of the cost of the provinces roads, but closer to50 percent if municipal spending is included. Similarly, other provinces road users are not payingthe full costs through these kinds of charges. Fuel taxes reduction pollution, but if they do notcover road costs, they are insufficient to reduce pollution to socially-efficient levels.

INTRODUCTION


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Background and objectives

This report examines petroleum product price regulation in Nova Scotia from a consumerviewpoint. It follows several other reviews made both before and after regulation began on July 1,

2006. The first,Economics of the Nova Scotia Gasoline Market(Gardner Pinfold and MJ Ervin,2005), examined the structure of the market as a whole with particular emphasis on the decline inthe number of retail gasoline outlets while examining a variety of approaches that might addressthat issue. The second (Gardner Pinfold 2007) reviewed the experience of the first six months ofthe regulations to examine the extent to which regulation was attaining its objectives. Two yearsafter the introduction of regulation, a third review (Gardner Pinfold 2008) was undertaken to assessthe regulations in light of further experience.

Issues closely related to consumer interests were an important part of the stated objectives indeveloping the regulations, but they were not the only objectives. Section 2 of the Regulations1 thataccompany thePetroleum Products Pricing Actreads:

The purpose of these regulations is to ensure just and reasonable prices for specified petroleumproducts, taking into consideration all of the following objectives:(a) preserving the availability of specified petroleum products in rural areas;(b) stabilizing prices of specified petroleum products;(c) minimizing the variances in prices of specified petroleum products across the Province.

Thus the earlier studies also concerned themselves with the changing structure of the industry itself and how thatrelates to the first objective of preserving the availability of supply in rural areas.2

This study focusses on questions of consumer interest in the regulation of prices of petroleum products (henceforth,gas , which should be understood to include non-commercial diesel oil). It will briefly update some of the groundcovered in the earlier studies, which looked at whether regulation had stabilized prices and minimized the variabilityof prices across the provinces, two of the explicit objectives noted above, but it will also examine other questions.

The central consumer interest is surely the level of prices, both the before-tax (or ex-tax) prices produced byprivate markets and the post-tax prices that are the result of public policy. Because these involve fundamentallydifferent issues and interests, I treat them separately in this report.

Of course, consumers would like prices to be as low as possible, but the phrase in the Regulations about just andreasonable prices (cited above) gets to the heart of the matter. If ex-tax gas prices rise, consumers may not like it,but it will be much less onerous if consumers have reason to believe that the prices are nevertheless just andreasonable under the circumstances. What role does price regulation play in this regard? How competitive areregulated and unregulated gasoline markets?

What effect did gas price regulations have on the level of prices in Nova Scotia? Can we saywhether prices would likely have been higher or lower, on average, had regulation not been inplace since July 2006? The official objectives of regulation say nothing one way or the other aboutthis question. The previous studies, cited earlier, assume that prices, at least in some places, wouldhave to rise to meet the first objective of regulation, the preservation of sufficient supply in ruralareas.

s 1 The current regulations are Petroleum Products Pricing Regulations, N.S. reg. 128/2010.. 2 Preserving rural supply also has a consumer interest aspect, noted later in the report.


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To address this question, this report examines ex-tax prices of regular gasoline before and afterregulation. These prices are closely related to gas prices in the New York Harbour market onwhich the regulated prices are based. That relationship is of key importance in inferring the likelyeffects of regulation. Also instructive is to examine the evidence from individual local marketsabout how retailers have set prices for gas and diesel after regulation. Have they set the maximum

prices allowed by regulation or have they competed prices down to the minimum allowed? I alsocompare ex-tax prices for gas and diesel in Nova Scotia before and after regulation with those inother Canadian markets to see if that offers any further evidence about how regulation has affectedex-tax consumer prices.

If the tax-inclusive price of gas is to be just and reasonable, then the gas taxes themselves needjustification. This requires justifying not only the existence of these taxes themselves, but also theirlevels. Different jurisdictions in Canada and elsewhere have made very different decisions aboutthe levels of these taxes. Can we say who has made the right decision? What areconsumer-citizens getting for their taxes?

To address these questions, I review the evolution of these taxes in recent decades in Nova Scotia,the rest of Canada and (more briefly) elsewhere and describe the current levels of these taxes. Aswe will see, one of the main justifications for gas taxes is their use as a kind of indirect usercharge for roads and highways. What do roads and highways actually cost and what do gas taxescontribute towards that? The other main rationale for gas taxes is to alter behaviour so as toproduce less traffic congestion and less pollution such as smog and carbon dioxide. I briefly reviewthis in the final part of the report.

Outline

Part 1 briefly describes the basic structure of gasoline and diesel price regulation in Nova Scotia. Itthen gives some context to the remainder of the report by providing a description of some of themain features of the retail market for gasoline that are of particular interest for consumers. Give thenature of retail gasoline markets, what role might regulation play from a consumer viewpoint? Theactual regulations in Nova Scotia are then described. Finally, to give some further context,consumer prices of gasoline in Canada and in Nova Scotia are compared with prices elsewhere.

Part 2 addresses consumer issues related to the regulation of the before-tax price of gas. Thecentral focus here is on whether regulation raised or lowered before-tax prices, on balance. It alsodeals with how competitive local gas markets are in Nova Scotia, the variability of prices acrossthe province and the predictability of regulated prices compared with unregulated ones. It alsocompares prices in Nova Scotia before and after regulation with prices in the rest of Canada.

Part 3 examines issues dealing with the post-tax price of gas, an important source of pricedifferences between provinces and countries. It first reviews the evolution of excise taxes on motorfuels in Nova Scotia and elsewhere. It then turns to the economic justifications for these taxes, withemphasis on the idea that these taxes could play an important role in having the users of roads andhighways pay for their costs and what the benefits of that would be. Finally, it reviews the extent towhich gas taxes actually cover road system costs in Canada and (briefly) in the United States.


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Part 4 summarizes the conclusions. Appendices contain details about calculations and data.

Caveats and limitations

This report relies on publicly available data and documents. It necessarily focusses attention on the

data about retail price that are at hand, but it should be borne in mind that these data areincomplete. Retail price survey data, formerly collected by MJ Ervin & Associates and now byKent Marketing Services are limited to the areas around just four cities and towns in Nova Scotiabefore regulation (Halifax, Sydney, Yarmouth and Truro) and to six cities and towns after it(Kentville and New Glasgow being included in the spring of 2006). While these provideinformation about the posted retail prices available to about two-thirds of the provinces residents,there is no information about prices in other areas, particularly small towns and more isolated ruralareas, locales where market behaviour might be different from the places surveyed. As well, thesesurveys can only record posted prices, not the actual prices consumers may pay net of the variousdiscounts and promotions that may be available to them.

The MJ Ervin/Kent Marketing Services retail price survey takes place on Tuesdays, so the day today fluctuations in price that would be important in understanding behaviour (particularly in anunregulated market) are not available. The survey data even just in Nova Scotia are based upontens of thousands of individual prices and some reporting errors, transcription errors and othermistakes have undoubtedly crept into the survey data which reports average prices for eachlocation. Some of the prices reported there are not credible. Unfortunately, there is no other publicsource of retail price information available.PART 1

THE RETAIL GASOLINE MARKET AND GAS PRICE REGULATION: AN OVERVIEW

1.1 Gasoline markets and consumer interests

The importance of gasoline in consumers spending

From a consumers perspective, gasoline is an important good. Gasoline currently has a weight of5.8 percent in the overall Consumer Price Index (CPI), reflecting its importance in the averageconsumers spending.3 This weight depends both on how much gasoline people buy and what its price is.

People buy gasoline frequently and, at least in unregulated markets, its price fluctuates unpredictably, making itsprice highly visible. Figure 1-1 shows the average retail price of gasoline in Truro from 2002-2010, in 2011 dollars.4

The volatility of gas prices, even over short periods of time, is striking.

. 3 This reflects a fixed 2009 basket of consumer purchases at April 2011 prices. This weight effectivelyassumes that consumers did not reduce their purchases as prices rose. See Statistics Canadas Weighting Diagramof the Consumer Price Index - 2009 Basket at April 2011 Prices, Canada, Primary Classification, athttp://www.statcan.gc.ca/imdb-bmdi/document/2301_D48_T9_V1-eng.htm.

. 4 The adjustment for inflation is necessary so prices can be compared properly at different periods of time.


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In 2009, when gasoline prices collapsed (along with crude oil prices) in the worst part of the severe global recession,the same amount of gasoline that now takes up 5.8 percent of consumers budgets then took up 4.4 percent. In otherwords, the gas price increases since then have absorbed more than $1 of every $100 spent by consumers.

Most things that consumers buy are purchased in markets where prices do not fluctuate like that of gasoline. Theprice of clothing or laundry detergent, for example, does not change from day to day (or moment to moment) in the

way in which prices fluctuate in markets such as those for commodities like oil, gasoline, metals, or in stockmarkets, or in wholesale markets for fresh fruit and vegetables.

The retail prices of fresh fruits and vegetables may also be very volatile, but they make up a smaller portion ofoverall consumer spending (2.5 percent, according to the Consumer Price Index). As well, if the price of one type offresh vegetable rises sharply because of bad weather in some valley in California, it is possible to substitute it foranother type of vegetable. That is not possible with gasoline.

Neither gasoline nor diesel fuel purchases have increased much in the last ten years. As shown inFigure 1-2, on a per capita basis, Nova Scotians demand for gasoline is higher than in the countrymore generally. Demand in New Brunswick is the highest in Canada, 15 percent above that inNova Scotia; Quebec and British Columbia also the provinces with the highest gas taxes are

the lowest at 1,050 litres/person, 18 percent less than Nova Scotia.

Per capita demand for diesel is much lower than for gasoline. Nova Scotian demand is below theCanadian average.


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Consumers responses to price changes

A lack of responsiveness to price changes, particularly in the short term, is another importantfeature of consumers demand for gasoline. Consumers tend to find themselves locked in to aparticular pattern of consumption as a result of their past decisions about where to live, where towork, and what kind of vehicle to drive. As a result, if the price of gasoline goes up, consumersfind it difficult to cut back gasoline purchases significantly. Instead, they are forced either to cutback on spending on other things or to save less.

When the price of fuel changes, people can change how much they drive to some extent, but in theshort term they cannot and will not scrap their cars unless it they are old and near the end of theiruseful lives. (If a person sells a car and gets a more fuel efficient one, someone else will havepurchased the car. Only when less fuel-efficient cars are removed from the road does fuel

efficiency as a whole rise.) Households can also decide whether and how many vehicles to own,but significant changes here can also take time.

As oil and therefore gasoline prices oscillate, people generally dont know whether the gas pricechanges are temporary or permanent. There is no point in undertaking expensive adjustments ingasoline use if the price change is temporary, so they will tend to wait and see, slowing reactionfurther.5

This observation is relevant in thinking about changes in taxes on gasoline to attain possible policy goals like havingusers of roads pay for them or reducing pollution. Large sudden changes in taxes may have little effect on behaviourin the short term, and recognizing this, governments phase them in over a longer period so that consumers can usethe time to adjust to what they know will be a permanent change in prices. (This is what British Columbia is doing

with its carbon tax.)

Finally, the ability to respond to price changes varies from household to household. Not everyone is in the samecircumstances. In a study of Canadian consumer demand, Nicol (2003) found systematic differences in theresponsiveness of consumers to gasoline price changes depending on household size and whether they were rentersor had a mortgage (renters being more responsive to gas price changes, as one might expect). A 10 percent rise ingasoline prices can lead to decreases in long-term gasoline consumption ranging from 1 or 2 percent for some typesof households to 8 or 9 percent for others. Demand always decreases by a smaller percentage than prices increase,which implies that consumers spend more on gasoline when prices rise, even when they have had time to try toadjust their consumption.6

When households incomes rise, they will tend to buy more fuel, perhaps having more or larger vehicles or moreincome to take vacations by car. But typically, an increase in income of 10 percent (for example) will lead to anincrease in fuel consumption of less than 10 percent. This is typical of goods that can be thought of as necessities.So as real (ie., inflation adjusted) incomes grow, gasoline demand (and thus revenues from a gas tax at a given rate)will grow much less quickly.

. 5 Sperling and Gordon (2009), pp.159-60).

. 6 With the advent of electric cars and hybrid vehicles, new long-term alternatives to gasoline haveappeared. As they become more widespread and less expensive, we can expect long-term responses to gasoline pricechanges to become larger.


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Gasoline is a special good from consumers perspective. Gasoline makes up a significant part of consumer

spending, yet its price is volatile and unpredictable. Worse, for many it is a necessity and they have difficulty

responding to price increases by reducing their purchases.

Competition in gasoline markets

In the long term, it is in both consumers and producers interests that sellers of gasoline be able tocover their full costs, which includes a reasonable rate of return on the their capital investments.Sellers, however, would prefer to do better than that the ideal would be a rate of profit as high asa monopolist (i.e., single seller with no competition) would be able to get in the market. As aresult, there is a zone of conflicting interests between consumers and producers that revolvesaround prices. Competitive prices would allow producers to just cover their costs, while at theother extreme, monopoly prices would generate monopoly profits.

The retail markets for gas are visibly dominated by the brands of large multinational corporations,making consumers suspicious about the competitiveness of the market. How do actual gasolineretail markets behave in practice?

Retail gasoline markets are complex and have been the subject of a great deal of research byeconomists who are interested in such things as how the composition of firms in the market (eg.,share of independent retailers in markets dominated by large vertically-integrated firms) and howthe changing numbers of retailers in a market affects consumer prices .7

A lack of competition in a market like that for gasoline can come about in several ways.

(1) A retailer can have no competition because other retailers are a long way away. This is a so-calledlocal monopoly. The retailer has a captive market and can set a non-competitive price. Whether or not thisresults in high profits depends on the retailers costs; if volumes are low, average costs per litre may behigh.

(2) A group of retailers can collude to establish a carteland to set what would be, in effect, monopolyprices. Their motto could be that of the grain processing company, Archers Daniel Midland: Thecompetitor is our friend and the customer is our enemy.8 The Competition Bureau takes a dim view of thispractice. Competition law in Canada make it illegal to collude to set prices or carry out a variety of otheranti-competitive practices.

The Competition Bureau has recently secured a series of convictions against gasoline station operators inthe Sherbrooke, Victoriaville, Magog and Thetford Mines areas of Quebec.9 However, according to theCompetition Bureau (2008), price fixing and other anti-competitive practices are confined to "local marketsand isolated incidents. To date, no inquiry has ever produced evidence suggesting that there is a national orregional conspiracy to limit competition."

(3) A group of retailers can instead carry out tacit collusion. This type of collusion is perfectly legal, butcan have much the same consequences for consumers as the illegal type. Retailers can form an unspokenunderstanding to keep prices above competitive levels. This is thought to be easier to bring about the

. 7 Recent Canadian studies of these questions are Sen (2005) and Sen and Townley (2010).

. 8 Frank (2004), p.64.

. 9 See Competition Bureau (2012) for a brief summary. Further convictions have just taken place inKingston, Ontario, and investigations continue in Ontario. Clark and Houde (2011) offer a technical analysis of thiscase. More details of the Bureaus investigations in gasoline markets are available atHREF="http://www.competitionbureau.gc.ca" MACROBUTTON HtmlResAnchor www.competitionbureau.gc.ca


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smaller the number of companies in a local market. Repeated interactions through price setting can lead toa kind of informal communication: you raise your price, Ill raise mine, for example.10

Alternatively, a local gasoline market might have a competitive outcome where prices fall to a level that, roughlyspeaking, permits those remaining in the market to at least cover their costs in the long term. As we will see later inthis report, most Nova Scotian gasoline markets for which we have information have been competitive in the periodafter regulation.

Consumers have a strong interest in markets for gasoline being competitive. But some markets will not be

competitive either because retailers lack any local competition or because the local competition has decided not

to compete. Other markets will be competitive. Only the evidence can decide which is which.

1.2 The regulation of gasoline prices in Nova Scotia

Before considering the possible benefits and drawbacks to consumers of gasoline price regulation,it will help to review briefly the essential features of regulation as it has been implemented in NovaScotia.

ThePetroleum Products Pricing Actof 2005 began the most recent period of regulation forpetroleum products prices in Nova Scotia.11 It deals with the markets for regular, mid-grade and premiumgasoline and with ultra-low-sulphur diesel oil. The central feature of regulation is the regulation of wholesale andmaximum and minimum retail prices, which began on 1 July 2006 and was administered by Service Nova Scotiaand Municipal Relations (SNSMR). New Brunswick began its petroleum products price regulation on the same day.Newfoundland and Prince Edward Island already had long-standing price regulation at that point.

How regulated prices are set

The regulated prices for the three grades of gasoline are based on the recent spot prices of unleaded regular gasolinein the New York Mercantile Exchange, where large volumes of gasoline are traded. Similarly, the regulated price ofdiesel is based on spot prices in that same market. This market is usually referred to as the New York Harbour

(NYH) market because the harbour is where the fuel is actually delivered once it is sold in the market. Because noone buyer or seller has any significant and lasting influence on the market price, the prices in this market arepresumed to be determined in a competitive way.

Prices in NYH have historically influenced gasoline prices in eastern North America. For example, if prices fall inNew York, a buyer of gasoline could buy it there and transport it to another location, such as eastern Canada. Thiswould limit the price at which gasoline could be sold by refiners in eastern Canada to the NYH price plustransportation costs.12 The actual prices at which refiners post (the rack price) are higher than the NYH price byabout 3 cents/litre, but these prices do not reliably reflect the actual transactions prices, which typically take place atvarying discounts from the rack price.13 This is why the NYH price has been selected as the benchmark by allprovinces in Atlantic Canada.

. 10 Studies of some Canadian markets find evidence consistent with this kind of behaviour. See Eckert andWest (2004, 2005a and 2005b).

. 11 An Act Respecting the Price of Petroleum Products, Chapter 11, Acts of 2005.

. 12 The process works in reverse; high prices in New York could attract shipments of gasoline from easternCanada, reducing supply and rasing prices. That limits how low wholesale gasoline prices could get in easternCanada before it would be worthwhile shipping supply to other markets. World markets for commodities in generalare linked in this way. This is the so-called law of one price: prices will be the same everywhere in awell-informed market, except in this case for transportation cost differences.

. 13 Gardner Pinfold and MJ Ervin, 2005, p.7.


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Table 1-1 summarizes the way in which price regulation has been implemented in Nova Scotia, using a numericalexample with the actual values behind the prices that were set to take effect on Friday 23 December 2011. Theseprices were based on the average of the NYH prices from the Thursday of the previous week (15 December) throughto the Wednesday of that week (21 December). This average is termed the benchmark price.

The benchmark price may then be adjusted by an amount called the forward averaging correction. In this case, theadjustment lowered the benchmark price by a small amount.

Table 1-1

Determination of regulated prices for the week beginning Friday 23 December 2011

(all values in Canadian cents per litre)

Regular gasoline Diesel

Previous benchmark price (announced 16 December 2011) 71.0 78.8

New benchmark price (average of NYH prices fromThursday 15 December to Wednesday 21 December)

70.3 78.1

+ Forward averaging correction+ Winter blending adjustment for diesel

- 0.2 - 0.8+3.1

+ Wholesale margin+ Zone 1 transportation allowance

6.0 + 0.3[= 76.4]

6 + 0.3[= 86.7]

+ Federal & provincial excise taxes 10.0 + 15.5 4.0 + 15.4

Wholesale selling price 101.9 106.1

+ Minimum and maximum retail margins 4.0 5.5 4.0 5.5

+ 15% HST 15.9 16.1 16.5 16.7

= Minimum & maximum self-serve retail prices 121.8 123.5 126.6 128.3

This was done because, as Table 1-1 shows, the prices in NHY had been declining. When themaximum and minimum regulated prices had been set the previous week, they were based on a

71.0 cents per litre (cpl) benchmark price and retail prices reflected that. However, as the weekwent on and prices fell in New York, the wholesale prices at which retailers could buy also fell.But the retailers did not lower their selling prices. Their actual gross margins (the differencebetween their buying and selling price for a litre of gas) went up and they made more money.14

Consumers paid more than they would have if retail prices had reflected the lower wholesale price.

Now, by knocking down the benchmark price a bit, the regulator is lowering the margin that retailers will receiveand the price that consumers pay, recouping the consumers losses of the previous week and evening out the marginthat the retailers receive.15

A 6 cpl wholesale margin is then added to the benchmark price to cover the costs of gasoline wholesalers. Added tothis margin is an estimate of the actual cost of transportation of the gasoline from the refinery in Halifax. The

province is divided into six zones, each with its own transportation allowance. These allowances were raised at thebeginning of 2012.

. 14 The report will use the term margins to denote gross margins as defined here. Retailers and wholesalershave costs which would have to be deducted to determine their net margins, or profit per litre of fuel sold.Regulation only directly influences gross margins.

. 15 This works in reverse. If the benchmark price is rising, a positive forward averaging correction is applied.


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Next, the federal and provincial government excise taxes for these fuels are added on. The result is the maximumwholesale price, in this case 101.9 cpl for gasoline, 106.1 cpl for diesel.16

To cover their costs, retailers are allowed a maximum margin of 5.5 cpl, but are guaranteed a minimum margin of4.0 cpl. Once the Harmonized Sales Tax is applied to this, we have the maximum and minimum self-serve retailprices shown in the bottom line of Table 1-1.

The maximum and minimum prices remain in effect until the following Friday, unless some large and sustainedchange in the NYH market occurs in the view of the regulators. In that case, the price can be interrupted and a newmaximum and minimum price announced. This happens rarely.

The regulator, now the Nova Scotia Utility and Review Board, approved an increase in the minimum self-serviceand full service retail mark-ups of 0.8 cents/litre and in the maximum self-service retail mark-up of 1.1 cents/litre.The new retail margins are therefore 4.8 cents minimum and 6.6 cents maximum. Increases in transportationallowances also took place (as reviewed later in Part 2 of this report). These changes took effect 6 January 2012.

The adjustments to the regulatory regime

Gas price regulation, like any regulatory system, is changed as time passes, reflecting the experiences with it. Theprevious two reports that examined the extent to which regulation was attaining its objectives undoubtedly

contributed to that.

Prices, initially set biweekly, were set weekly by May of 2007. In mid-2007, the maximum mark-up for full servicegasoline of 7.5 cpl (two cents above the self-service maximum) was removed. This was done "to allow the limitednumber of dealers (mostly rural) still offering full-serve more flexibility to realize higher margins" (Gardner Pinfold2008, p.6). Given the limited nature of the full-serve market, this likely had little significant impact across theprovince as a whole.

On 30 September 2009, responsibility for regulation was transferred to the Nova Scotia Utility and Review Board(henceforth the Board). This follows the practice in the rest of Atlantic Canada of assigning the regulatory functionto an organization at arms length from government. While I have seen no evidence that this changed the nature ofregulation (regulated prices being governed by the same rules as before), one of the intangible benefits to consumersof price regulation is the confidence that maximum prices are just and reasonable and have been determined by a

process seen to be as impartial and as free as possible from any suspicion of political influence. An independentBoard with experience in regulating utilities is probably better able to do that than a government department.

1.3 Price regulation and consumer interests

Before delving into the specific experience with gas price regulation in Nova Scotia, we can pauseto think about how price regulation in general might promote or harm consumer interests. Whilethe details of how regulation is implemented will obviously be important, some possibilities thatfollow from the nature of gasoline markets should be kept in mind.

How price regulation could be beneficial to consumer interests

1. Limiting uncompetitive pricing by having a maximum priceBecause of the potential for tacit collusion by retailers, described earlier, setting maximum pricescan limit the extent to which sellers of gasoline can enjoy profits in excess of competitive levelsthrough a high-price strategy. Retailers can still charge the highest price possible, but it will be onedetermined by the regulator, not by the retailer.

16 In the cases of midgrade gasoline, an extra 3 cpl is added and for premium gasoline, 6 cpl.


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When introducing regulation, the Nova Scotia government did not try to show that such tacitcollusion existed in some markets, or that consumers were victims of monopolistic pricing. It hadother objectives, as we have seen. Nevertheless, from the consumers viewpoint, a pleasantbyproduct of setting maximum prices in a market is that sellers power to set monopoly prices is

effectively curbed as long as the maximum price is set below the monopoly price. We will seesome evidence later in the report that this probably has happened in some places in Nova Scotia, toconsumers benefit.

2. Consumers gain by wholesale and retail margins being fixed in dollar termsRegulated maximum mark-ups are set in nominal terms (eg. in cents/litre) and remain fixed for aconsiderable length of time. But as time passes and prices in the general economy creep up, thevalue of the dollar slowly erodes. When adjusted for inflation, the nominal mark-ups decline inreal terms, i.e., in terms of their purchasing power.

Regulated mark-ups have indeed behaved like this in Nova Scotia and in Atlantic Canada more

generally. However, such fixed nominal mark-ups do not (and could not) persist forever;wholesalers and retailers would eventually not be able to cover their costs, so consumers benefitsare temporary, but real.

3. Increased predictability of price changesWith regulation consumers know when prices will change. If prices are based on observed pastprices in New York, it is not difficult to predict the direction of price changes. For consumers whocare, this removes an important part of the aggravation from buying gasoline and can save them amodest amount of money in the long term.17

4. The setting of minimum prices prevents predatory pricingWhile consumers like low prices, perhaps there can be too much of a good thing. A local price war among

retailers can have longer-term consequences that are not to consumers advantage. That is the reason for theexistence of competition laws concerning predatory pricing, the attempt by a retailer to destroy competitors duringa price war. If some of the predator s competitors are driven from the market, the predator may be in a position toreap the rewards through higher, non-competitive prices.

If competition laws are ineffective at curbing this behaviour, minimum price laws can complement them. Forexample, Quebec "has had a minimum price floor on retail prices since 1996. This law is similar to sales-below-costlaws in the United States and was enacted to guarantee independent retailers a minimum profit. The law wasintroduced amid concerns that vertically-integrated refiners were using predatory pricing strategies aimed atweakening and reducing the market share of independents."18 In Nova Scotia, this was not the official rationale forhaving a minimum price, but it serves this purpose nevertheless.

How price regulation could be detrimental to consumer interests

1. The setting of maximum prices in the market could lead to tacit collusion where it did not exist before

How might the setting of regulated maximum prices affect actual market prices? One possibility isthat there is no effect. This would happen if the actual market price would have been between themaximum and minimum values anyway andif the existence of the regulated prices themselves did

. 17 I offer a numerical example in Part 2 of this report, based on actual price changes since regulation began." 18 Sen, Clemente and Jonker (2011), p.538, n.17.


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not affect actual price setting. But the evidence we will see later suggests that the setting ofregulated prices may well affect how actual prices are set.

One idea in economics is that tacit collusion can be made easier by having a maximum priceposted in the market. Without it, retailers would have to try to find a mutually acceptable price in

some way. Perhaps one would be a price leader and the others would follow. But they might beunsuccessful and attempts at co-operation might collapse. But with the posting of a maximumprice, everyone in such a co-operatively minded market knows right away what price to set. Thus,in this scenario, the regulator is actually helping retailers to collude. The result could be higherprice than consumers would otherwise have faced. (As we will see in Part 2 of the report, thisprobably did happen for a while across Nova Scotia when regulation began.)

2. The setting of a minimum price in the market could prevent prices from being lowerThis is the polar opposite of the previous point. In a competitive market, by setting a minimumprice in the market, some sellers could be prevented from setting even lower prices. Setting asidethe predatory pricing scenario mentioned earlier, this supposes that the equilibrium of the

competitive market lies below the minimum price

.19

In fact, that is the stated reason behind having a minimum price in Nova Scotia: at least in some places, lower-costsellers are prevented from competing directly on the basis of price with some high-cost sellers who could not matchtheir prices in the long term.

3. If regulated margins (and thus prices) are set too high sellers get higher profits and consumers get higher pricesThis could happen, at least for a while, if the prices particularly the minimum price set by regulators depend onlyon the history of past prices and margins and if those margins reflected excess profits enjoyed by sellers because ofuncompetitive pricing.

4. Regulation offers wholesalers and retailers an opportunity to use the regulatory system to their advantageProducers are typically better-organized and have more resources than consumers, and the gasoline market is noexception. Although a Consumer Advocate is appointed for Board hearings, he or she is outnumbered by industryrepresentatives (not all of whom will necessarily have the same interests on all questions, however). Producers alsohave an informational advantage: they know their own costs and profitability better than anyone and will naturallypresent their case in the best possible light. The regulator will necessarily have to make decisions based onincomplete information.

An obvious counterpoint to this is that the regulator, the Board in this case, understands this situation as well andwill make their decisions accordingly, taking these imbalances into account.

How price regulation could benefit both consumers and retailers

Much of the previous discussion stressed the differences in the interests of consumers and producers: consumerswant low prices, producers want high profits which could mean high prices. But there is one area of commoninterest in which regulation might help.

Because of the special characteristics of the gasoline market, described earlier, it is particularly difficult forconsumers to know whether the prices they are being asked to pay are just and reasonable. There is no shortage ofclaims that gas prices are always and everywhere unreasonably high and that consumers are being ripped off, yetagain.20

. 19 It also supposes that a unique and well-defined market equilibrium actually exists in this setting.

. 20 See, for example, the Canadian Centre for Policy Alternatives (CCPA) Gas Price Gouge Meter, atHREF="http://www.gasgouge.ca," MACROBUTTON HtmlResAnchor www.gasgouge.ca, or the Atlantic


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In unregulated markets, retailers bear the brunt of consumer complaints and dissatisfaction whenprices are rising. Regulation provides consumers with guidelines established by a disinterestedthird party as to what actually constitutes a just and reasonable price. Retailers have an interest inhaving good relations with their customers and being able to point to a regulated price as an

indicator that their price is, in fact, reasonable given market conditions, might help in that task.

Price regulation like that in Nova Scotia can have outcomes that are beneficial for consumers

or are detrimental to their interests, or perhaps a combination of both. The details of how

regulation is implemented matter. Whether the average consumer is made better off or worse

off cannot be predicted a priori. It depends on the empirical evidence.

1.4 Gasoline prices: a brief overview

Average prices for gasoline and diesel vary greatly across countries, as shown in Figures 1-3 and

1-4. The figures show both the before-tax prices and the prices after all taxes are included.

While there are some significant differences in the before-tax prices, largely reflecting differencesin overall costs of production, it is clear that the largest part of price differences between countriesreflects different decisions about how these fuels should be taxed. The difference between Canadaand the United States is large, but the figures also make it clear that other industrialized countrieshave chosen much higher tax rates. Part 3 of this report examines these taxes and the rationales forthem in some detail.

While consumers in Nova Scotia may take some comfort that gasoline prices are higher in manyother countries, what is of more immediate interest is how prices in Nova Scotia compare withprices closer to home. Figures 1-5 and 1-6 replicate the previous figures, but now for averageprices in 2011 for the capital cities of the provinces (as a simple way of illustrating prices acrossthe country). They show that we get a similar pattern to that seen internationally: price differencesbetween places are largely a result of different taxes rather than different before-tax prices.

Institute for Market Studies (AIMS) Gouged at the Pumps meters atHREF="http://www.aims.ca/en/home/reportcards/gaspriceregulation.aspx." MACROBUTTON HtmlResAnchor

www.aims.ca/en/home/reportcards/gaspriceregulation.aspx. Hill (2009) describes why the AIMSfigures are wrong. The CCPA figures are also not credible, but an explanation liesoutside the scope of this review.


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Before-tax prices do differ, reflecting differences in costs (including transportation) and incompetitive conditions locally. Gas prices in Halifax were relatively low; only Edmonton waslower. Diesel prices were the lowest of any of the 10 cities. It is hard to do better than that, from aconsumer perspective.

After-tax price differences reflect both different provincial excise taxes and sales taxes. Taxes on alitre of gasoline in Nova Scotia were the second highest among the ten cities; only Quebec washigher. For diesel, Nova Scotia taxes were tied for third-to-fourth highest, after Quebec and NewBrunswick.

What should count for consumers the before-tax price or the after-tax price? At first glance, onemight think that it is obviously the after-tax price. That is the total amount that consumers actuallyhave to pay for a litre of gasoline or diesel. But that conclusion would be wrong.

It is the before-tax price that is important for consumers. This is what the consumer is actually

paying the suppliers for the gas itself and their services in getting it through the production processand into the consumers gas tank.

But when the consumer-citizen pays 83.6 cents/litre for gas and 41.9 cents/litre in taxes on that gas(the average values for Halifax in 2011), he or she gets in return a litre of gas and additionalgovernment-supplied goods and services that cost 41.9 cents. Because the link between paying the41.9 cents in tax and getting those goods and services (eg., road and highway maintenance andconstruction, snow plowing, and so on) is not nearly as visible or immediate as getting the litre ofgas, people can easily forget about that part of the transaction.

If taxes go up, people simply see a litre of gas costing more; if taxes go down, they see a litre ofgas costing less. The error in this is that it assumes that either (a) taxes pay for nothing of anyvalue or (b) the goods and services produced by government are free and so require nocontributions by citizens to enjoy them. Obviously, neither of these assumptions is true.

In thinking about after-tax prices, people should adopt two perspectives: the consumer perspective,that considers the before-tax price, and the citizen perspective that considers the tax payment thataccompanies it. Because of its central role for consumers, Part 2 of this report looks in some detailat these ex-tax prices and how regulation may have affected them. Part 3 of the report considers thetax treatment of motor fuels from the consumer-citizens perspective to ask whether theseparticular taxes are needed and what people are getting for their money.


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PART 2. REGULATION AND BEFORE-TAX CONSUMER PRICES

A major set of issues of interest to consumers revolves around before-tax prices. These are thesubject of this part of the report.

Among the questions of primary interest are: Have the regulated maximum and minimum pricesthat have been set during regulation been reasonable ones from the consumers viewpoint? Howmuch have consumers been paying wholesalers and retailers for their services? How have thosepayments been changing during the last five and a half years since regulation began? Would priceswithout regulation have been higher or lower than they have actually been?

How do prices in Nova Scotia compare with prices in other Canadian markets? Have before-taxprices in Nova Scotia risen or fallen compared with prices elsewhere and what might account forthe changes?

Regulation has affected things other than the levels of prices that also interest consumers: thevariability and predictability of prices over time and their variation across the province. How havethese changed with regulation?

To address these and other consumer concerns, we have to begin by looking at the relationshipbetween before-tax retail prices in Nova Scotia and the New York Harbour market on which thoseprices have been based since regulation began. What was the relationship between them beforeregulation? What was the relationship after regulation began? Can we infer anything from thatabout the effects of regulation?

2.1 Marketing margins before and after regulation

The marketing margin denotes the difference between the ex-tax retail price and the New YorkHarbour (NYH) price. The marketing margin is of interest both because it is the focus of settingthe margins for regulation, but also because other margin measures, such as the difference betweenposted retail prices and posted refinery prices are possibly less reliable.21

. 21 As noted in Part 1, refineries posted rack prices are typically not the actual transactions prices, so theNYH price is a more reliable benchmark for comparison.


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The marketing margin can be measured in nominal terms, that is in current dollars, or it can be adjusted for inflationand expressed in real terms. Ultimately what both buyers (and sellers) are interested in are real margins. Thesemeasure the value of the real goods and services consumers have to give up to buy the services of wholesalers andretailers. If the real margins fall, as they indeed have under regulation, then this is good news for consumers.22

The nominal marketing margin, before and after regulation

Regulation initially set the sum of minimum and maximum wholesale and retail margins in nominal (ie money)terms, at 10 and 11.5 cpl respectively above the New York Harbour price. Those nominal margins remained fixedfrom July 2006 until the beginning of 2012, when the minimum margin was raised to 10.8 cpl and the maximummargin to 12.6 cpl.

From a consumer viewpoint, a very important question is how those margins influenced the prices that otherwisewould have prevailed in an unregulated market. For example, a high minimum margin compared with what onemight have expected margins to be would suggest that regulation must have pushed prices up to a higher level thanwould otherwise have been the case.

Weekly survey data for retail prices (excluding tax) are available for Halifax, Sydney, Yarmouth

and Truro from Tuesday 9 June 1998 onwards. I calculated a population-weighted average of theiraverage weekly retail prices. The difference between this 4-city average and the NYH price givesan estimate of a marketing margin for Nova Scotia.23 (A somewhat broader measure is available after June2006, when Kentville and New Glasgow retail prices become available.) This 4-city nominal marketing margin forthe 1998-2011 period is shown by the red line in Figure 2-1.

We can start by examining the nominal marketing margin prior to regulation. As detailed in Appendix 1, I estimatedthe underlying trend from mid-1998 to mid-2006. The margin trended upward at about 3 percent annually, onaverage. This rate was almost exactly the 2.9 percent average annual rate of inflation in Nova Scotia during thattime, as measured by the Consumer Price Index. While wholesalers and retailers of gasoline buy quite a differentmix of goods and services than the typical consumer, the rise in the margins could nevertheless be related togradually rising costs that reflect this underlying rate of inflation.

Trends before and after regulation

The best statistical description of the trend was the blue curve in Figure 2-1, which shows an increasing rate ofgrowth. (An alternative trend line with a constant growth rate is shown by the black line in the diagram.)24 By July2006, the value of this trend was 11.0 cents per litre. After regulation the trend completely disappears; the averagemarketing margin fell slightly at about -0.3 percent per year. This is the green trend line shown in Figure 2-1.

The lack of a trend after July 2006 is not surprising because fixed nominal margins determined the regulatedmaximum and minimum prices and those margins remained constant from July 2006 until December 2011. Whilethe margins set by regulation are not the actual margins experienced by retailers from week to week (which dependon the actual prices at the time at which they buy supplies and the prices at the time they sell that supply), they doconstrain what the actual margins can be, on average.A broadly similar pattern exists for the individual cities. Pre-regulation margins increased by an average of 2.7%

annually in Halifax, 3.7% in Sydney, 3.6% in Yarmouth and 3% in Truro. After regulation began, nominal margingrowth became negative in all locations (including Kentville and New Glasgow), with the exception of Yarmouth(+0.8%).

. 22 Whether it is bad news for wholesalers and retailers depends on the levels from which those real marginsare declining as well as how their costs have changed. If they are able to take advantage of sales-enhancing orcost-reducing innovations, they can be left with a satisfactory rate of return, even if real margins fall.

. 23 Appendix 1 contains details of how the marketing margins were calculated.) 24 Appendix 1 contains further details on the estimate of the trends.


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The underlying trends in the growth of nominal margins in each location allows us to estimate what I will call theexpected margin at the end of June 2006, when regulation began and to compare that with the margins that wereactually set. Given that there are many ways of calculating the marketing margin, the objective here is modest: canwe say whether the original margins set when regulation began in July 2006 were broadly in line with past

experience?25

Table 2-1 shows the actual wholesale plus retail margins used to set minimum and maximum prices in the zones inwhich the four cities are located. It also shows my best estimates of the average margins that could have beenexpected based on the trend in the margin estimated for the 1998-2006 data for each city and for the average of thefour cities. With the exception of Sydney, the expected margins of the best estimate lie above the margin used to setthe minimum price and all are below the maximum margin that was set.

Table 2-1

Expected margins and regulated margins, gasoline, cents per litre, July 2006

Expected margin based onJune 1998-June 2006 trends

Margins set in July 2006*

Minimum Maximum

Range of possible price changesafter regulation if prices are set atthe...Minimum Maximum

Halifax 10.8 cpl (10.2 cpl) 10.3 cpl 11.8 cpl - 0.5 to +0.1 +1 to +1.6Sydney 11.9 (11.3) 12 13.5 - 0.1 to +0.7 +1.6 to +2.2

Yarmouth 11.6 (12.1) 11.2 12.7 - 0.4 to -0.9 +0.6 to +1.1

Truro 11.4 (10.4) 11.2 12.7 - 0.3 to +0.2 +1.3 to +2.3

4-City Average 11.04 (10.52) 10.73 12.23 - 0.3 to +0.2 +1.2 to +1.7

Note: The first value in each cell in the first column is for the increasing growth rate trend shownin Fig.2-1. The second value, in brackets, is for the constant growth rate trend also shown inFig.2-1.* includes transportation amount for each zone. The weighted average is 0.73 for the four cities.

Values for the alternative estimate the black line in Figure 2-1 are shown in brackets. Thesetrend values lie about 0.2 cpl below the regulated minimum, on average, but with considerablevariation for each location.

Walking through an example will help in interpreting Table 2-1. Consider Halifax wherepre-regulation trend operating margins were between 10.2 and 10.8 cpl.

If retailers managed to set the maximum regulated prices once regulation began, marketingmargins would total 11.8 cpl, which is then an increase of between 1.0 cpl (ie., 11.8-10.8) and 1.6cpl (ie., 11.8 - 10.2). Expected prices would rise by the same amount.

If instead retailers prices at the minimum regulated price, then marketing margins change bybetween -0.5 cpl (ie., 10.3 - 10.8) and +0.1 (ie., 10.3-10.2). Thus, whether prices would tend to riseor fall in Halifax after regulation depends critically on how retailers are able to price within thebounds set by regulation. We will see later in this report that they did both: pricing first at themaximum, then at the minimum.

? 25 The simple average of NYH prices for the particular days chosen is not the only option; the days chosenwould have been varied. Greater weights could have been assigned to more recent NYH prices, and so on.


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The final pair of columns in Table 2-1 summarize similar calculations for the other cities. Theseare clearly just rough estimates, but the major point is that the effect of regulation on prices couldgo in either direction.

I conclude from this evidence that the margins set by regulation for gasoline were broadly inline with historical experience. Minimum margins lay close to or below the historical

average; maximum margins lay above it. Whether consumer prices went up or down after

regulation depended critically on whether retailers were able to price at the maximum or

behaved competitively and priced at the minimum regulated price.

The real marketing margin, before and after regulation

What matters to consumers is the realmarketing margin, the nominal margin adjusted for inflation.Because inflation has continued at a low, but positive rate, a constant nominal margin means thatthe real marketing margin has declined, on average, during the period of regulation. A nominal

margin of 10 cents, for example, shrinks in real terms as the general level of prices rises and so the10 cents will buy fewer goods and services. As a result, all else equal, this means that regulation,by fixing nominal margins, has tended to lower real before-tax prices facing consumers. (All elsehas not been quite unchanged, something that will be considered shortly.)

The behaviour of the real marketing margin in Nova Scotia is illustrated in Figure 2-2 .26 The trendbefore regulation was virtually flat; nominal margins grew, on average, at the rate of inflation, as noted earlier. But,as shown by the blue line, real margins declined unmistakably after regulation began.

Note that the left-hand end of the blue trend line, where regulation begins (at 12.2 cpl), lies above the right-hand endof the pre-regression trend line (11.6 cpl) by 0.6 cents. This suggests that the average real marketing marginsincreased somewhat just after regulation. But we can see that by the end of 2011, the post-regulation trend line hasfallen to 10.8 cents, 0.8 cents below the pre-regulation level of 11.6 cents.

On balance, did consumers benefit from changes in real margins?

The previous analysis of trends suggested that in the post-regulation period, real margins were, onaverage, initially above their previous trend and then gradually fell below it. How did this comeout, on balance, for consumers as a whole?

A very simple calculation can give a rough answer. I calculated for each week from July 2006 toDecember 2011 the differences between the pre-regulation real margin of 11.6 cpl (the right-hand

end of the black line seen in Figure 2-2) and the post-regulation trend (illustrated by the blue line).The average of these differences was -0.12cpl, meaning that if we spread the net saving acrosseach week of the five and a half years of regulation, that would be the per-litre saving. Multiplyingthis by average gasoline sales of 1,188 million litres per year in 2005-2010, gives an average

. 26 All real values are in December 2011 dollars for monthly or weekly data. Real values using annual dataare expressed in 2011 dollars. The Consumer Price Index for Nova Scotia is used to make adjustments for inflation,unless otherwise noted.


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saving for consumers of $1.4 million/year, giving a total over the five and one half years ofregulation of about $7.8 million, a modest amount.27

Figure 2-3 illustrates the data in another way, summarizing the changes in real marketing margins before and afterregulation for the Nova Scotia average and for the individual communities. All show the same overall pattern; realmargins went from no or positive growth before regulation to negative growth after it. Margins fell the least in

Yarmouth, a market that, as we will see, is the least competitive one in the group.

Table 2-2 reports the averages of these real marketing margins before and after regulation for the Nova Scotiaaverage and for the individual communities.28 The population-weighted average fell by 0.2 cents per litre if wecompare the five and one-half years before regulation with an equal period after regulation. (If the marketing marginis instead measured using posted rack prices in Halifax, the result is similar. As shown in Appendix Table A4, theweighted average margin falls by 0.3 cents per litre across these two periods. The difference in values between thistable and Table 2-2 reflects the roughly 3 cent difference between NHY and rack prices in Halifax.)

When compared with the 0.12 cpl estimated average saving, these rough estimates of consumer savings of 0.2 to 0.3cpl would give a proportionately higher estimate of total savings, roughly $13 million to $20 million in total.

Table 2-2

Real marketing margins, gasoline, cents/litre (December 2011 prices), before & after regulation

Halifax Sydney Yarmouth Truro Population-weighted average

Before regulation: June 1998-June2006

11.5 12.6 13.3 11.6 11.8

Before regulation: January2001-June 2006

11.5 13.1 13.7 11.6 11.9

. 27 The calculation is -0.12 cpl x 1,188 million litres/year = 142.6 million cents/year or $1.4m. Then 5.5 x1.4 = $7.8 million over the five and a half years of regulation.

. 28 Appendix Table A2 details the real margins for each year.


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July 2006-December 2011 11.3 13.1 13.6 11.9 11.7

Note: calculated using differences between weekly retail prices and average NYH prices in the previous week,adjusted by the CPI (all items) for Nova Scotia.

The lengths of the particular periods being compared in this way matter. While there was no trend

in the overall real marketing margins in the 1998-2006 period before regulation, real marginsimmediately after regulation began were generally higher than in the immediately preceding years.A comparison of average real margins before and after regulation would result in differentconclusions about the possible impact of regulation if it compared (for example) the first two and ahalf years before regulation (when they averaged 12.0 cents) with an equal periodafter regulation began (when the margins averaged 12.2 cents). But as Table 2-2 shows, taking alonger perspective reverses the result.

From the consumer viewpoint, on balance, regulation provided some before-tax price benefits aswholesalers and retailers combined nominal margins are limited by the regulatory cap. This slowsqueeze on margins also provides some incentive for sellers to implement technological change to

reduce costs, but in the presence of a low, but steady, inflation rate, there will inevitably beapplications for margin increases. Consumers can expect that the industry will make the case forthe largest margin increase it thinks it can attain, anticipating that those margins will be fixed forsome period of time. At some point, the margins will be raised, as happened in late 2011, raisingboth the nominal retail margin and the transportation charges that make up the regulated prices.

The recent increases in margins and transportation charges

If we consider the margin increase that the industry has just received, how should this be judgedfrom the consumers viewpoint? How do the current margins compare with historical trends andtrends of inflation?

Consumer prices in Nova Scotia from July 2006 to December 2011 increased by 10.24 percent.The Nova Scotia Utility and Review Board increased the minimum retail mark-up from 4 cents to4.8 cents, a 20 percent increase, while the maximum retail mark-up rose from 5.5 to 6.6 cents,again 20 percent. Transportation allowances rose from 8.5 percent to 50 percent, depending on thezone. However, the nominal 6-cent wholesale mark-up remained unchanged. The last two columnsof Table 2-3 summarize the overall change for each zone, including the cities for which we haveretail price data, comparing margins and transportation costs before and after the recent change.

Table 2-3

Marketing margins, December 2011 - January 2012

Nominal margins in effect untilDecember 2011*

Minimum Maximum

Nominal margins in effect starting January 2012,and percentage change in the margin*

Minimum Maximum

Halifax(Zone 1)

10.3 cpl 11.8 cpl 11.25 cpl(+9.2%)

13.05 cpl(+10.6%)

Sydney(Zone 6)

12 13.5 12.97(+8.1%)

14.77(+9.4%)

Yarmouth(Zone 3)

11.2 12.7 12.29(+9.7%)

14.09(+10.9%)


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Truro(Zone 5)**

11.2 12.7 12.29(+9.7%)

14.09(+10.9%)

4-city average 10.73 12.23 11.70(+9.0%)

13.50(+10.4%)

Kentville (Zone 2) 10.7 12.2 11.79(+10.2%)

13.59(+11.4%)

Zone 4 11.2 12.7 12.31(+9.9%)

14.11(+11.1%)

6-city average 10.75 12.25 11.73(+9.1%)

13.53(+10.4%)

* including transportation costs; ** New Glasgow is in Zone 5.

I noted earlier that Figure 2-2 shows that the trend value of real margins by December 2011 was0.8 cents below the pre-regulation trend. In fact, 0.8 cents is exactly the amount by which theBoard raised the minimum retail margin as of the beginning of 2012. But because the Board alsoincreased the amount for transportation, averaging about 0.2 cpl across the six cities in the retail

price data, the average minimum margin is now 0.2 cpl above the average real trend level in June2006. This suggests that sellers have caught up with inflation with a small cushion that will soonbe eroded by inflation.29

I conclude that real margins have declined over time since regulation began, reducing the costs of wholesale and

retail services to consumers. This decline has come about because of the effect of inflation on the nominal

wholesale and retail margins and transportation costs that are put in place by regulation. These resulted in net

savings to consumers of between $8 and $20 million over the first five and one-half years of regulation.

When those margins and transportation costs were adjusted upwards in 2011, retailers real margins increased

and caught up with inflation. Consumers can expect real margins to fall in the future as they have in the past.

2.2 How competitive are local gasoline and diesel markets?

This leads us to an important question that has not been addressed so far. Regulation sets minimum and maximumprices, but where do prices actually end up? That will surely depend on how competitive the individual local marketsare. As the discussion in Part 1 pointed out, in uncompetitive markets, retailers may be able to price to the maximumprice much of the time. In competitive markets, they will be unable to, and the minimum price will become morerelevant.

Which of these outcomes or (more likely) what mix of them occurs is of primary interest to consumers, who wouldclearly prefer more competition among retailers to less. What does the evidence from the years of price regulationtell us?

We can get some strong evidence by looking at how actual before-tax retail prices in Nova Scotia compare with the

regulated maximum and minimum prices. For each market for each week, I calculated the average retail price minusthe regulated minimum price. In principle, this number should lie between zero (when retailers are pricing at thelowest possible price) and 1.5 (when retailers are pricing at the maximum price).

Gasoline

. 29 For example, at 2 percent inflation, an 11.7 cent minimum margin will be 11.7/1.02 or 11.5 in one year.


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The six panels in Appendix Figure A1 illustrates the results of these calculations for each of the sixmarkets for regular gasoline which we have survey data. When regulation began, prices in everymarket were set at or close to the maximum. However, with the notable exception of Yarmouth,retailers were not able to maintain maximum prices. In Halifax, six months after regulation began,prices were set at the minimum level and, with a few temporary upward blips, they have remained

at the minimum level.30

This is not particularly surprising; Halifax is a larger market where many retailers can beexpected to have large volumes and to withstand relatively low margins.

The story for Sydney, New Glasgow and Kentville is broadly similar: prices initially set near the maximum endedup at the minimum within six months to nine months. Retailers in Kentville were successful in maintainingmaximum prices for longer, but co-operation collapsed suddenly in 2007 and, while many attempts to restore itseem to have been made in 2007-2008 (as average prices oscillated between the minimum and close to themaximum), the market ended up with minimum prices being set most of the time after the middle of 2008.

The data from the market in Truro is harder to interpret because it appears at first glance from the figure that pricesbelow the legal minimum were being charged most of the time, which is hardly plausible. However, Truro is inZone 5 but close to the line going through Colchester County that separates Zone 5 from Zone 1. Zone 1 has atransportation charge of 0.3 built into the price, while the transportation charge incorporated in Truros prices is the1.2 cents of Zone 5). It is almost certainly the case that some of the retailers surveyed in the Truro region areactually located in Zone 1. This lowers the average price reported for Truro to below the Zone 5 minimum. If wemake allowance for that, the story the data tell about Truro is much like that for the other markets: initialco-operation in setting maximum prices quickly broke down with attempts to restore it giving way to pricing nearthe minimum.

Yarmouth, the smallest urban area in the group, stands out as an exception. Retailers quickly established andmaintained maximum prices for gas after regulation began and have maintained them since. Yarmouth is thesmallest and most isolated community in the survey sample and it is not too surprising that the behaviour of retailersthere is markedly different from what is seen in other, larger markets, at least for regular gasoline.

Yarmouth may be representative of some similar smaller centres in Nova Scotia that are not near larger urban areas.For example, Michael Gardner has recently written: "The price in most urban markets drops to the minimum end ofthe range soon after the weekly adjustment. Prices in rural markets tend to stay at the upper end of the range."31

Given the large gap in the retail price data for small towns and rural areas, this must be borne in mind when wecome to make an overall assessment of how consumers in different places have been affected by price regulation.32

To sum up: there is persuasive evidence that with price regulation, larger centres ended up withcompetitive markets. The maximum prices set by regulators have not provided retailers with afocal point around which they could co-operate in a sustained way. They tried initially and thetemporary boost that give to their margins will be partly responsible for the higher initial realmargins under regulations, described earlier.33

. 30 Whether retail prices were actually below the minimum or whether these represent errors in the survey

data is discussed later in the report. The reliability of the data and the enforcement process for the regulations isdiscussed later in this section.

" 31 Michael Gardner, Response to information requests by the Consumer Advocate, Nova Scotia Utilityand Review Board, 26 July 2011. This was related to the Boards review of retail gasoline margins.

. 32 Gardner Pinfold (2008, p.50) reports responses from consumer focus groups around the provinceconcerning the goal of maintaining rural retail station. Those with "few choices claimed to be more willing tosupport their local station, including paying a slightly higher price to keep them open", however, those who hadmore local choices were "generally not willing to pay extra" to maintain them, "or to maintain stations elsewhere inthe province". Fortunately, the data suggest that consumers across Nova Scotia generally have not had to pay extrato keep some rural stations operating.


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At first glance it would seem that the maximum price is irrelevant in these markets; if it were removed, perhapsnothing would happen. However that assumes that current retailer behaviour in the market would be the same as thebehaviour in the absence of regulation, something for which there is no guarantee. The maximum price in thesemarkets can be seen as a kind of long-term insurance policy for consumers against possible tacit collusion byretailers.

Nor does the maximum price appear to be redundant as the case of Yarmouth, where it seems to be actuallyrestraining prices. But an alternative possibility is that the maximum price simply acted as a focal point that wasnot there before and thus made life easier for Yarmouth retailers, possibly to the detriment of its gasolineconsumers .

To distinguish between these possibilities, we would need to know how effectively retailers in Yarmouth were ableto carry out tacit collusion in the absence of regulation. I cannot give a definitive answer to that with the sparseevidence available, but it is instructive to look at the price differences between uncompetitive Yarmouth andHalifax, which is likely to be always a more competitive market.34

The data are summarized in Table 2-4. As we can see, often, but not always, Yarmouth retailers were able tomaintain a high price differential. Recall that Yarmouth has transportation costs 0.9 cpl higher than that allowed inthe Halifax area under regulation. Only in two or three of these years was the Yarmouth-Halifax price difference lessthan this. This pattern, compared to the consistently high pricing in Yarmouth since regulation began, suggests to me

that tacit co-operation between retailers was somewhat more difficult to achieve without regulation, but was stillcommon.

While that would mean that consumers in Yarmouth might have paid more for their gasoline than they would havewithout regulation (and the same would be true of similar towns), counterbalancing this is the cap the maximumprice puts on average margins. Retailers can collude more easily, but the rewards are limited. With regulation, ex-taxprices cannot be more than 2.4 cents higher than in Halifax (0.9 cpl for the transportation differential and 1.5 centsas the gap between the minimum and maximum price, before the recent margin and transportation cost increase). Intwo of the years before regulation, the yearly average gap was bigger than that. A regulated maximum price wouldcertainly have saved Yarmouth consumers money in those years.

On balance, then, consumers in places like Yarmouth may have been somewhat better off or somewhat worse offwith gas price regulation. With the information available, a firmer conclusion seems unwarranted.35

Table 2-4

Ex-tax retail gasoline prices in excess of Halifax prices

(Annual average, cents per litre)

Yarmouth Sydney

1998 1.4 0.7

1999 0.2 0.5

2000 0.5 - 1.1

2001 2.5 2.3

2002 2.0 1.3

2003 2.7 1.2

2004 1.5 1.4

2005 0.8 0.3

. 33 This is consistent with the conclusion of Sen, Clemente and Lu (2011), who found that regulation led to aprice increase of about 1 cent/litre. The data they examine went to only 2007.

. 34 Competitive conditions likely did fluctuate in Halifax too, making these price differences more difficultto interpret.

. 35 Using Table 2-1, we can see that Yarmouth retailers priced so that they shared the maximum operatingmargin of 12.7 cpl with wholesalers. The 10.24 percent inflation between July 2006 and December 2011 erodedtheir margin to 12.7/1.1024 or 11.5 cpl, which is below the expected margins in July 2006, as shown in Table 2-1.


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2006 1.5 1.5

Note: differences are not adjusted for inflation.

Diesel

The six panels in Appendix Figure A2 summarize the comparisons between the reported surveydata for self-serve retail non-commercial diesel prices and the regulated minimum. The resultsappear quite different from those for gasoline. There is no market in which prices are consistentlyset at the legal minimum and most are far from that. There are strange price spikes, both positiveand negative, outside the expected bounds of 0 and 1.5. I will return to the nature of the likely dataerrors shortly, but lets focus on where the markets appear to have come to a kind of equilibrium.

We can see that the Halifax market has settled down to a price around 0.5 cents above theminimum, and Truro is likely at about 0.75 cents (if we take into account the likely presence ofZone 1 retailers in this data). In the rest of the markets, retailers seem to be pricing at themaximum.

Clearly, the market for non-commercial diesel is more limited and the legal maximum price playsan important role. But what is that role? Has it brought down prices in an already uncompetitivemarket (which seems most likely), or has it facilitated collusion?

Real marketing margins may provide some clues. Figure 2-4 shows these values for diesel in thesix Nova Scotia centres from 1999.36 These fell significantly just a year or two before regulation. Whether thiswas due to some increase in competition or to other factors, I cannot say. Since regulation, real margins have shownno significant trend, one way or the other. There is no indication here that regulation raised margins, nor was itassociated with any significant decline.

. 36 The data with details on their calculation are in Appendix Table A3.


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Finally, some comment is needed about the many anomalous numbers in the graphs in Appendix Figures A1 andespecially A2. The price regulations are enforced through a complaints based system in which complaints from thepublic are received and then investigated and resolved. If someone is selling at below the minimum price, acompetitor has every incentive to complain, as noted earlier. This is not a situation that can be expected to persist.

Similarly, consumers have an incentive to complain if persistently high prices are being charged by retailers. Thenumbers in Appendix Figure A2 suggest that prices were repeatedly above the maximum in Sydney, Yarmouth, andNew Glasgow during some periods. It strains credulity to believe that no diesel consumers in any of these placesever noticed that prices were in excess of maximum amounts or that if some did notice, not a single one everbothered to complain.

I think a more plausible explanation is that there have been repeated reporting errors from a gas station in each ofthese locations (that in most cases was eventually corrected because the more recent data are plausible). Perhapssome reported a full-serve diesel price if that was all that was available at that station, for example. The price ofdiesel is also a less high-profile price than regular self-serve gas, and so perhaps more prone to a reporting error. Itsalso plausible that there have been occasional transcription errors during the process of recording information fromthe telephone survey. It takes only one wrong digit for an apparent outlier to occur. This is the most likelyexplanation for the occasional spike seen in Appendix Figure A2.

Conclusions

(1) Consumers faced higher average prices just after regulation was introduced, because retailers were able to

set maximum prices, which lay above past historical trends. However in larger urban centres, gas prices fell

towards the regulated minimum price fairly quickly. The erosion of minimum margins by inflation has

subsequently left consumers with net gains in prices, on balance.

(2) For consumers in small, isolated markets, prices have likely remained at or close to the regulated maximum.

However, these were likely the most uncompetitive markets prior to regulation as well, because of the small

number of retail outlets in the locality.

(3) Consumers of diesel face relatively uncompetitive markets compared with consumers of gasoline, at least in

larger markets. Regulation cannot alleviate that except to place a maximum price in the market.

2.3 Promotions and other discounts available to consumers

The retail price survey data for Nova Scotia, used throughout this the report, are somewhatmisleading because they record only the posted prices for gasoline, not what the consumer actuallypays. Sellers in many different markets often offer discounts to certain customers, and the gasolinemarket is no exception.37 These discounts, or promotions as they are called here, often require some effort onthe customers part to seek them out and to take advantage of them. The more price-sensitive customers the sort ofcustomer that sellers would like to offer a lower price to thus sort themselves out from the less price-sensitivecustomers, who are charged a higher price.

In his study of the responsiveness of consumer demand to gas prices, Nicol (2003, p.203, 210) found that thedemand of households with low incomes was much more responsive to gas price changes than that of householdswho had higher average incomes. It is reasonable to suppose that such households are also more likely to shoparound for a better price and to take advantage of promotions and discounts.38

. 37 The practice is termed price discrimination. Sellers find it profitable to charge different prices todifferent customers. Typically, customers who tend to be more price-sensitive (who have more price-elasticdemand) will be charged a lower price, if the seller can find some way of identifying them.

. 38 Note that consumers responsiveness to changes in the price of gas in the market as a whole is a differentconcept from consumers responsiveness to a change in the price at one gas station, holding the prices at other gasstations constant. In this second case, individual gas stations face much more responsive demand to a price change


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Note that the prevalence of such discounts is not, by itself, an indicator that the market is competitive. Sellerswithout any competition at all (monopolists) will also find it profitable to offer discounts to particular types ofcustomers to increase their sales and their profits.

Although gas price regulation sets a minimum price in the market, that does not now constrain the use ofpromotions. Initially, it did; promotions were limited to those already in effect between 1 May 2005 and 1 June2006, before regulation began. The regulations prohibited any enhancement of existing promotions or theestablishment of new ones.39 The current regulations, dating from September 2010, are much less restrictive. Anypromotion is permitted as long as 5 business days notification is given to the government and as long as it does notinvolve a purchase of more than 100 litres of fuel.

Information about the promotions is posted on the website of Service Nova Scotia and Municipal Relations.40 As of4 March 2012, there were 14 retailers (some with multiple locations) offering 26 promotions. Two were temporary,the remaining 24 were on-going promotions, all but two of which seem to have been in effect since before regulationbegan.

Promotions take a variety of forms: rebates on gas purchases; discounts for paying cash; getting a special card froma retailer that gives a discount on all gas purchases; discounts on a future gas purchase based on a current purchase;discounts on other merchandise whose value is determined by gas purchases; discounts for premium gas or full

service gas offered on a particular day of the week; bundling of gas purchases with other services (such as a carwash) that offers a lower price for gas.

As a result, even in markets where retailers are posting the maximum price, some discounts will still be available. Inthe competitive markets, many consumers will be able to buy gasoline at less than the regulated minimum price. Nopublicly available data exist about the extent to which that happens or where it happens, but the prevalence ofpromotions and their widespread availability across the province suggests that it is an everyday occurrence, at leastfor those who take the trouble to seek them out.

This does not mean that the regulated minimum price is unimportant. As it moves, many of thepromotional prices move too because they are often set as a certain number of cents off the pumpprice.

Price-sensitive consumers will have benefitted from the effective removal in 2010 of

restrictions on new promotions.

2.4 Comparisons with other markets in Canada

How do before-tax prices for gasoline and diesel in Nova Scotia compare to prices elsewhere in thecountry? We will compare Nova Scotia prices with some measures of average ex-tax prices inCanada, adjusted for inflation.

than do gas stations as a whole if the market price rises.

. 39 N.S. Reg. 97/2006, Schedule A, Regulations Respecting Petroleum Products Pricing, Section 13.

. 40 The link is HREF="http://www.nsgaspromos.ca" MACROBUTTON HtmlResAnchorwww.nsgaspromos.ca.


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Gasoline

Figure 2-5 illustrates average Nova Scotia gas prices with two measures of Canadian averageex-tax prices (adjusted for inflation).41 Appendix Table A5 provides more detail, comparing differences inNova Scotia prices with various measures of prices in Canada or other regions of Canada.

All of these comparisons show that, as of 2011, average prices in Nova Scotia were less than averages in the rest ofthe country, even in large markets where many gas stations have high volumes and could af

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