Public Utilities Reports

PUR Guide 2012 Fully Updated Version

Available NOW!
PUR Guide

This comprehensive self-study certification course is designed to teach the novice or pro everything they need to understand and succeed in every phase of the public utilities business.

Order Now

Pipelines: Are Regulators in for the Long Haul?

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

Fortnightly Magazine - July 2005

For example, pipelines have argued that market forces require them to discount rates below tariff levels for released capacity and short-term and interruptible service, while longer-term transactions largely are priced on the basis of rigid cost-of-service principles.

• More than anything, regulation can be blamed for the deficiency of long-term contracts, which in the long run may jeopardize the expansion of sufficient new pipeline capacity to meet future gas demand.

The Economics of Long-Term Contracting

There are three distinct categories of transactions: spot, longer-term contracts, and internal organization. The last occurs when a firm is vertically integrated and looks to itself rather than the market for purchases of required inputs. Spot transactions are extremely short-term transactions where prices are determined by short-run supply and demand. Spot transactions provide flexibility to the buyer in balancing supply with demand. Long-term contracting represents what can be viewed as an “in-between” transaction, where the seller and buyer rely on the market, but they desire more certainty in price and other attributes of a trading arrangement than contained in a spot-market transaction. (Spot markets also require repeated trading, which over time can drive up transaction costs, discussed below.) Contracting has several dimensions that are negotiated between the buyer and seller, with the outcome largely dependent on market conditions, which include predictability of the future and the relative bargaining strength of each party.

What we have found across a wide spectrum of industries is that long-term contracting becomes the predominant form of governance for large investments with limited alternative use. Under this specific condition, long-term contracts may be needed to protect the financial interest of investors by mitigating intolerable risk.

As an illustration, let us assume that a factory’s production line is designed to produce customized widgets for a single customer. The factory manager likely would require a long-term contract with provisions that protects the factory’s financial interest in the event that the customer decides either not to buy at all or only continues buying if a low price is offered. The economic reason for a long-term contract lies with the factory expending large sums of dollars to design its production line to provide the kinds of widgets that the customer desires. Such relationship-specific investments usually require contracts of a long duration. Both economic theory and real-world observations support this trade governance.

Another way of describing this, in the arcane jargon of economists, is that the condition of imminent opportunistic behavior in the presence of expensive specialized assets is highly conducive to long-term contracting or, under extreme conditions, vertical integration. The absence of long-term contracting can then lead to under-investments. These are the basic arguments being advanced by pipelines in lamenting the erosion of long-term contracts in recent years.

Economic theory supports the idea that transaction costs are crucial for shaping the institutional arrangements for the exchange of goods and services. According to transaction cost theory, which category of trading arrangement (spot, longer-term contracting, vertical integration) is consummated depends on the attributes of a transaction. For example, when asset specificity, sunk costs, and a high degree of complexity