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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

Guidelines, or ex ante rules, can include a commission’s general position on long-term contracting, cost-recovery criteria articulating what constitutes reasonable actions by a gas utility, and the scope of a hindsight review (which would depend on the degree of commission commitment upfront to long-term contracting). In evaluating a gas procurement/supply strategy that contains long-term contracting, a commission should consider the risk on a utility and its bundled-sales-service customers.

State commissions should take a neutral position on long-term contracting and should support long-term trading arrangements when they are an integral part of a utility’s optimal gas procurement/gas supply portfolio. While long-term contracting may have a useful function, it should not be a requirement for local gas utilities and other shippers. These purchasers of gas and transportation are under increased pressure to achieve a targeted level of reliability at the least cost, which may involve relying little, if at all, on long-term contracting for pipeline services.

At the federal level, FERC should consider giving pipelines more pricing flexibility in marketing their capacity. This would enhance the pipelines’ opportunities to market their unsubscribed capacity.

While FERC allows a limited degree of pricing flexibility with regard to short-term transactions and released pipeline capacity, less flexibility is allowed for long-term contractual arrangements, where rates largely are determined by rigid cost-of-service criteria. (In FERC Order No. 637 , however, pipelines were encouraged to offer shippers lower rates for longer-term contracts—what FERC calls term-differentiated rates; so far, pipelines have not been active in proposing such rates, which could provide a stimulus for long-term contracting.) FERC has recognized that departure from the typical straight-fixed variable rate design may occasionally be necessary to make under-subscribed capacity more marketable. This can help to soften the revenue risks associated with short-term transactions. FERC also can consider reducing a pipeline’s depreciation period to, for example, better match capital recovery with actual contract durations. Such ratemaking changes, which have been proposed by pipelines, can help compensate a pipeline for absorbing higher risk because of market developments.

An important empirical question, and one that has yet to be answered in addressing the pipelines’ argument, relates to the extent to which the evolution of shorter-term transactions has hampered investments in new pipeline capacity. As FERC has reported, new pipeline capacity is being built in all parts of the country (especially in the Rocky Mountain region, where the economics are most attractive), with no apparent evidence of expected capacity shortfalls, except perhaps in isolated locales. The latest long-term energy forecasts by the Energy Information Administration 2 identified public opposition to the building of pipeline capacity as a potential problem that could lead to higher natural gas prices; it made no mention, however, of the deficiency of long-term contracts as an impediment to pipeline expansion. Skeptics of long-term contracting have argued that other industries making large investments under competitive conditions do so without any prior guarantees of capacity utilization.

The changing market environment, rather than state or federal regulatory actions, better explains the radical shift toward shorter-term transactions since the mid-1980s. The natural gas market seems to be responding