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Converging Markets: The First Real Electric/Gas Merger

Fortnightly Magazine - October 1 1996

anchor its portfolio of electric and gas contracts. To become a national energy company, however, Enron requires physical generation east of the Mississippi, which suggests that Enron will acquire another electric utility.

Enron is unlikely to remain the only national energy company for long. Large gas companies and some electric utilities will also adopt Enron's strategy. Some large, integrated gas companies will acquire electric utilities; some electric utilities will acquire local gas distribution companies (LDCs). Indeed, it is surprising that we have not yet seen a rash of LDC takeovers by electric utilities, since the electrics are flush with cash and eager to expand.

Even without mergers, electric and gas markets are likely to converge. Gas and electric companies largely hold the same customer base. End uses overlap for their energy products and services. Success in a nationwide market will hinge on the willingness of management to embrace competition. In this regard, gas companies enjoy distinct advantages.

Similarities and Distinctions

Gas LDCs essentially provide retail customers with two services: 1) transportation (from pipeline to customer) and 2) supply (the purchase and resale to the customer of the transported gas). The LDC provides gas transportation for all of its customers and gas supply for those that do not choose to purchase gas from a third party. It earns a regulated return for gas transportation, but nothing for gas supply, which remains essentially a customer accommodation with no markup. The gas LDC earns the same transportation fee no matter who supplies the gas. It thus sees no inherent incentive in opposing competition in gas supply.

Indeed, competition offers indirect financial benefits to a local gas distributor. If a third-party supplier can undersell the LDC, customers that switch will enjoy a reduced price for gas. Assuming some price elasticity, the reduced price would lead these customers to buy more gas. The LDC would see its earnings rise, since it would earn a transport fee on the increased throughput.

A gas LDC can also benefit from competition, at least for the present, by forming a subsidiary that will act as an independent third-party gas supplier in competition with its basic gas-supply service. If the gas LDC's subsidiary can buy gas cheap enough that it can add a markup and still sell the gas to the customer at a lower price than it does as an LDC, customers would have incentive to switch to the subsidiary's low-price service. The subsidiary would earn a profit equal to the markup on the gas it supplied. And if the reduced price should lead customers to increase their gas purchases, the LDC would also benefit from increased throughput.

An electric utility's role in producing the power it sells carries risks that do not apply to a gas LDC. The gas LDC has no financial stake in the wholesale price since it buys the gas it supplies. The electric utility, on the other hand, has an enormous stake in the wholesale price of power.

The current regulatory system immunizes the electric utility against price risks in the wholesale market. As an integrated