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Profit Without Costs

An analysis of participant funding in natural gas and electricity markets.
Fortnightly Magazine - August 2004

electric bill, assuming that further blackouts could be prevented with an upgraded grid, but only if it is married to fairness. And fairness requires that all sectors of the industry-not just customers-shoulder their share of the cost.

It also is difficult to find a compelling argument to support rolled-in pricing when we consider how the Federal Energy Regulatory Commission (FERC) has addressed this issue in other industries it regulates. As we struggle with electric deregulation issues, we have been encouraged to look at how natural gas was deregulated in the 1990s. Generally, gas deregulation has been considered a success, and it is often held out as a model for electric practitioners. The gas model is particularly instructive on pricing issues because, after much deliberation and litigation, the commission has embraced a market-oriented pricing regime, including a threshold requirement that participants be able to fund pipeline expansions without subsidies from their existing customers.

FERC has not always held this point of view. At one time, the commission's preference, where equitable, was to roll-in expansion costs. 1 FERC's preference at the time aligned with the industry's attitude, which was to get pipe in the ground, build out the grid, and roll-in costs to do so. But there also was an awareness that this tactic had a cost, a high one, and one that often was paid for by native customers.

In one of the most important cases on the issue of rolled-in versus incremental pricing, the Circuit Court of Appeals for the District of Columbia in 1960 clearly laid out the two lines of thought. In a case involving the Battle Creek Gas Company, the court held: 2

There are two basic and potentially divergent methods of allocating new asset costs to be reflected in a utility's rate structure. The first recognizes that a gas pipeline of this sort is not just a collection of discrete pieces and parts, but an integrated system serving all of its customers. Applying this approach the cost of the various assets of the system are collected or "rolled in" to arrive at the cost of the entire system which is then pro-rated among all of the customers. ... 3

... At some point the facility becomes so identified with its function as part of the local distributor's gas plant that it may be unfair to charge its costs to all of the customers of the utility. This is particularly so where the extent and cost of such segregated facilities vary greatly among the customers. In such a situation the costs of these facilities are commonly charged as an "incremental" cost added in to the particular customer's rate base. 4

The court recognized that the rolled-in methodology had some serious drawbacks to it. Both the court and FERC have noted that:

The rolled-in rate method is generally disadvantageous, however, to old customers of an expanding pipeline. The cost of new facilities and new gas historically has risen steadily, and a rolled-in rate requires old customers to pay a higher price and bear part of the cost of an expansion