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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

FERC Order No. 636, the gas pipeline network has become substantially more interconnected between spatially distinct markets (meaning individual pipelines have enlarged markets), with competition consequently improved. The effect of the increased density of producers and pipelines over the last several years has attenuated the specificity of production and pipeline capacity, with the effect of a reduced need for long-term contracts to support investments in pipeline capacity. This development also has increased shippers’ ability to bypass and thereby reduced their preferences for long-term price protection. Simply put, with a more open market that has evolved in the natural-gas industry, long-term transactions have less economic appeal to shippers.

Notwithstanding these developments, which seem highly sensible and reflective of a well-functioning gas market, the pipelines may actually have a legitimate gripe that longer-term contracting may be underused because of the policies of FERC and state commissions. This argument stems from the possibility of market and regulatory distortions leading to a non-optimal mix of trading arrangements. Specifically, this refers to: (1) regulatory uncertainty at the state level over the prudence of long-term contracts (which local gas utilities fear easily could lead to regulatory opportunism and a potential stranded-cost problem); (2) the design of some gas choice programs that allow customers to switch suppliers on short notice and consequently make it difficult for a gas utility to contract on a long-term basis for default customers; (3) the unwillingness of some state commissions to hold retail marketers to the same standard of reliable service as the default gas utility; and (4) FERC’s pricing policies, which, as some industry observers have argued, may induce excessive demand for short-term transactions (which include interruptible service and capacity-release transportation) in relation to longer-term transactions.

All or some of these, arguably, could have artificially shifted preferences by shippers toward shorter-term contractual arrangements with pipelines. As an example, pipeline rates for short-term service may be too low relative to rates for long-term service. Regulatory uncertainty at the state level may discourage local gas utilities from signing long-term contracts that could, with hindsight, turn out to be inefficient and burdensome on retail customers. But this argument overlooks how state regulators place such high priority on gas utilities having highly reliable service—which most regulators believe requires some long-term contracts in a utility’s portfolio mix.

Policy Implications for Regulators

Local gas utilities should have the discretion to sign long-term contracts for pipeline transactions. State commissions should approve these transactions as long as they can appropriately fit in a utility’s gas portfolio or supply strategy. Commissions may want to consider granting upfront approval of long-term contracts and their costs within the context of a strategy proposed by a utility.

Giving preapproval may alleviate a utility’s doubts over whether the costs associated with long-term contracts ultimately will be recovered. To say it differently, preapproval could overcome a potential stranded-cost problem for gas utilities providing default service. Of course, on the other hand, preapproval of costs shifts risks onto retail customers.

A less extreme measure could have a commission establish guidelines that would reduce uncertainty for a gas utility.