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Pipelines: Are Regulators in for the Long Haul?

An economic perspective on long-term contracting for gas pipeline service.

Fortnightly Magazine - July 2005

the years, FERC policy has evolved to where it now does not require shipper commitment in certifying new pipeline facilities. In its 1999 Certificate Policy Statement, FERC required that an applicant demonstrate that public benefits exceed adverse effects, in addition to showing that new pipeline capacity can be financially supported without relying on subsidization from existing customers (emphasis added). Showing market demand for the new capacity, in the absence of long-term contracts with shippers, can suffice as a means to receive FERC approval.

Of course, long-term contracts with shippers for a significant portion of new capacity would indisputably demonstrate the need for new capacity; but it is not a requisite for receiving certification. One important indicator of demand, recognized by FERC, is the basis differential between market centers/hubs (specifically, basis differentials in excess of long-run marginal cost would signal the commercial viability of additional pipeline capacity).

As an aside, as long as adequate pipeline capacity is available in a region, the tendency of shippers would be to transact on a shorter-term basis for nonfirm capacity (for interruptible service, as an example, the shipper could avoid paying demand charges). When regional capacity starts to tighten, however, the same shippers would be more willing to go longer term, as well as to sign up for firm service, in their pipeline capacity purchases. This would signal to pipelines that additional capacity is required.

A 2002 Keystone Center report, Expanding Natural Gas Pipeline Infrastructure to Meet the Growing Demand for Cleaner Power , summarizing a policy dialogue among industry stakeholders and policymakers (including gas pipelines), concluded that “participants found that FERC’s current policy on the certification of new interstate natural gas pipeline facilities provides an appropriate balance between, on the one hand, regulatory oversight to protect against the adverse consequences of overbuilding and, on the other, market-oriented philosophies that will allow the infrastructure to grow with the market ” (emphasis added).

The report also says “FERC’s policy statement [on certification of new pipeline facilities] provides a number of incentives for pipelines to plan for and construct the optimal level of capacity.” In other words, the consensus was that FERC’s certification criteria seem to pose no special barrier in expanding economically-justified pipeline capacity.

The collective arguments of supporters of long-term contracting can be summarized as follows:

• Unless we see more long-term contracting, new investments in pipeline capacity will be deficient. Specifically, as pipelines have become susceptible to higher market risk, they may be prevented from receiving the necessary financing from Wall Street. Especially with the “turnback” of large amounts of capacity under expired contracts, pipelines have argued that the trend toward shorter-term contracts will become even more pronounced in the future.

• Regulatory uncertainty at the state level discourages gas utilities from signing long-term contracts. The threat of hindsight review imposes the risk of stranded costs that would tend to shift utilities’ preference toward shorter-term transactions.

• State commissions should recognize the importance of long-term contracts in a local gas utility’s supply and transportation portfolio.

• FERC’s pricing practices artificially have inflated shorter-term transactions by shippers.