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FERC Flipflops on Great Lakes Case

Fortnightly Magazine - September 15 1995

Does it make good business sense to offer a service that brings in considerable revenue but virtually no profit?

In the past, special circumstances explained why local distribution companies (LDCs) sold natural gas to customers without earning a profit. But circumstances have changed. With the advent and proliferation of gas transportation services, it is time to reassess the business.

Up a Tree

That LDCs sell as well as distribute gas stems from three historic elements: the obligation to serve; the notion of

bundled service; and cost-of-service regulation.

While the obligation to serve was rarely stated explicitly in statutes, over the years it became well-established in the regulatory compact. In essence, that compact granted the LDC an exclusive right to provide natural gas service within a defined territory. In exchange, the LDC complied with rates, terms, and conditions of service approved by a state public utility commission (PUC). As sole supplier of fuel and transportation, the LDC saw no compelling reason to unbundle the price into separate components.

Meanwhile, cost-of-service regulation guaranteed a reasonable opportunity to recover prudently incurred expenses, plus a reasonable return on capital investment. Rate design broke costs down into specific charges for each customer class, but treated the cost of gas as a simple expense. Thus, unless the LDC invested capital for items such as peak-shaving or storage facilities, its gas sales would normally have no direct tie to profitability. Since the price of gas often displayed greater short-term volatility than other expenses, many PUCs allowed monthly adjustments to gas prices to track

purchased-gas costs.

During the 1980s, a series of orders (em culminating in Federal Energy Regulatory Commission (FERC) Order 636 and various offspring (em fundamentally changed the gas industry. LDCs and large end users now enjoy competitive options. Just as the interstate pipelines had to open their systems to unbundle transportation services, LDCs typically had to offer unbundled transportation service across their distribution systems (em at least for their large-volume customers. Those customers are now well-accustomed to managing their own gas purchases. Smaller industrial and commercial end users are following suit. Widespread residential gas transportation looms on the horizon.

With gas-supply obligations fundamentally changed, the LDC ought to reconsider its role in fuel supply. Today if an LDC does a good job of managing its fuel supply, it can expect to recover one dollar of revenue for every dollar it spends. If the state PUC finds that the LDC did not do a good job of managing its fuel supply, it may allow even less. From a shareholder perspective, the best the LDC can hope for is to break even.

LDC management thus finds itself up a tree, with only two options: Climb higher and find a way to profit from gas sales, or climb down and quit the gas sales business.

Against the Grain

Consider the basic economic structure of the gas distribution and gas sales

businesses:

s The management of a gas distribution system is likely to remain a monopoly function.

s Price regulation will probably remain for gas distribution.

s Gas-supply procurement lies open

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