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Barbarians at the City Gate

Fortnightly Magazine - September 15 1995

In the wake of Federal Energy Regulatory Commission (FERC) Order 636, gas marketing entrepreneurs gained unprecedented opportunities to compete for noncore, industrial loads. That market has matured. Competition is intense, and margins in the noncore market have fallen below 5 cents per thousand cubic feet (Mcf).About a year ago, gas marketers began reaching beyond the noncore market to target core customers (em commercial and residential customers that lack alternate fuel capability and rely on firm service for space heating and other

temperature-sensitive needs. Some states, particularly New

Jersey, have actively encouraged marketing to core customers through regulations mandating 636-style unbundling at the local distribution level. In all cases, the entrepreneurs offer core customers what seems a bargain. Some marketers see today's efforts as the thin end of a wedge that will shatter the local utilities' domination of the core market. One has already trumpeted "the day when unregulated merchants and outraged captive customers smash the rate base and storm the Bastille."2

Marketer access to the core

market is becoming the major

industry issue of the late 1990s, and resolution of this issue may well determine the future of gas utility service. Regulators must, at the very least, look beyond the sales pitch to determine whether entrepreneurial marketing to core customers will provide genuine economic value, or so much smoke and mirrors.

The savings touted by marketers do not arise from superior efficiency or some other positive contribution to economic welfare. Rather, the marketers' alleged benefits depend in large part on false economies rooted in using nonfirm pipeline capacity to supply firm requirements to core customers. Using nonfirm capacity in this way carries grave implications, both for service reliability during severe weather and for the prospect of building needed capacity expansions in the future.

When we hear the marketers' cry to storm the Bastille, we might recall that the first Bastille Day was followed by a five-year Reign of Terror. Caution and careful analysis should stand as watchwords, lest we make decisions that cannot be undone.

The New Regulatory Arbitrage

Marketers do not contribute true economy in serving core market customers. Instead, they offer savings off utility rates by exploiting particular features of the existing rate and tax structures. This exploitation may prove benign if it merely exposes cross subsidies in regulated rates and artificial distinctions in tax policy, but not when it takes advantage of a false economy (em for example, by imposing uncompensated risks on core-market customers. The marketer is then no longer profiting from repackaging components of gas service, but from shifting risk to the utility's core customers.

To understand this phenomenon we must recognize that the utility's firm sales rate features four basic components: 1) gas commodity costs (what is paid to

producers for the gas itself); 2) pipeline costs (what is paid to pipelines for the transmission and storage of the gas); 3) the utility's distribution margin (the utility's own cost of service for its facilities and operations); and 4) in most states, a gross receipts tax surcharge. If one or more of these components is reduced, the