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The Triumph of Markets in Natural Gas

Fortnightly Magazine - April 15 1995

coordinator and planner; the regulated monopoly as its agent. Competition, it is argued, is not suitable for pipelines.

But this diagnosis is wrong, and the prescription faulty. It is wrong on several key points: It fails to consider that a pipeline forms but an element in a network. It assumes that the pipeline is organized noncompetitively. It misrepresents how coordination is achieved in a complex system. It lies at variance with how regulation works in practice. It badly misrepresents how markets work.

Pipelines are not natural monopolies, in spite of what the proponents of regulation have told us. They can be organized competitively. They can be stripped of monopoly power in a network of interconnected pipelines that offers many distinct paths between markets. Both these things can be accomplished by making transmission an asset that can be traded in a market open to producers, distributors, customers, brokers, and others.

when markets emerged . . .

Gas prices fell after they were deregulated. (This result has proved true for all the cases of deregulation we know of.) Thereafter, pipelines faced infeasible purchase obligations of high-priced gas. Many of them renegotiated their contracts with producers. In exchange for partial release from their purchase obligations, these pipelines offered to transport gas for producers or their customers. Open gas markets began.

The FERC approved these transportation transactions individually until it issued Order 436, permitting interstate pipelines to transport gas and separating the pipeline merchant and transportation functions. The number of pipeline applications and approvals for open-access carrier status grew rapidly from 1985 to 1990. Within three years of Order 436, nearly all the major pipelines had become open-access pipelines.

Open-access transportation gave customers and suppliers many alternative trading partners. Because these partners could arrange their deals themselves, regulators no longer stood as a barrier to mutually beneficial exchanges. After gas traders had made their purchase arrangements, they could bring the deal to the pipeline who would transport the gas. Within a few years of the first open-access order, so many pipelines were open that buyers and sellers could come together through many paths in the network. These paths gave structure to markets. Where a path between markets is open, prices will reflect this openness. When there are many paths, prices are constrained by the wide number of alternate sources of supplies and buyers that can be reached from any point in the network.

and made prices competitive . . .

Competitive prices tend to move together. Consider how the two prices in Figure 1 behave over time. The price difference narrows over time; eventually they become almost correlated. These two properties (em initial narrowing, then eventual correlation (em are integral to competitive markets. Our research looks at prices in the spot market for evidence of these properties.

Throughout a network of markets, competitive prices should move together within a band related to transportation costs, so that price differences within bands do not become so large that a profit can be made by arbitrage. Moreover, it should be impossible to use information about a given price change