A talk with two LDCs. First, PSE&G appears content to cede sales to marketers, Second, NW Natural intends not to give in just yet.

This much is clear: Energy utilities are headed for an unbundled future.

As states from both sides of the country implement residential and commercial natural gas unbundling, require residential choice pilot programs and grapple with electric industry restructuring, competition shows no signs of slowing. To boot, some members of Congress seem eager to give competition a national push.

But while a federal approach appears to have guided the restructuring of interstate natural gas pipelines in a way that has benefitted the gas industry as a whole, some experts doubt that local distribution companies, under state regulatory jurisdiction and subject to state laws and the vagaries of local economic conditions, are appropriate candidates for a "one-size-fits-all" approach.

I interviewed executives of two large, long-established gas utilities, one on the East Coast and one in the Pacific Northwest, asking how they have reacted to the winds of change.

PSE&G:

Enlisting the Enemy

New Jersey's largest gas utility, Public Service Electric & Gas Co. of Newark, responded to a call from the state Board of Public Utilities for a residential choice pilot program by opening up four towns in different parts of the state to gas marketers interested in competing with PSE&G to supply gas to homeowners. So far, no one has chosen to enter the market.

It's not because of a lack of PSE&G effort. Eager to demonstrate to the BPU that it is serious about the pilot, PSE&G tried to recruit competitors for residential gas supply after carefully choosing the towns for geographical balance and for the social, economic and racial makeup of the state.

"I've personally made calls to marketers urging them to enter the program," says Dave Wohlfarth, general manager of gas supply for PSE&G. "We've had two or three who said they would look into it, but none has decided actually to solicit customers."

The utility's experience on the industrial and commercial side has been completely different. Supplier choice has been in effect in New Jersey for more than two years, and marketer interest has been lively from the start. "We started with about 20 suppliers delivering into our marketplace," Wohlfarth says. "As time has gone on, two things have happened. One, the number of suppliers has increased. Now I believe we have more than 40 suppliers that are qualified to sell.

"But what we've also seen (em and I think this is a classic example of the way the marketplace works (em is a thinning out of the real active marketers," Wohlfarth says. "Initially, we got a lot of marketers that were very new to the business. One in particular that called me up was a customer of ours in a completely different business. ... I said this is a little different from the wholesale gas marketing business, where you could provide gas on an interruptible basis. You're going to be selling to firm customers and you have to have firm supply and capacity commitments behind you. This is not going to be that easy."

In fact, Wohlfarth says, that company is no longer in the gas marketing business. Despite the growth in the number of marketers qualified to sell to industrial and commercial customers in PSE&G's service territory, only five to 10 marketers are what Wohlfarth calls "truly active." He refers to this phenomenon as a "thinning-out process between the contenders and the pretenders."

About 14,000 of PSE&G's 180,000 firm commercial and industrial customers have become transportation-only customers since supplier choice began. That's only 8 percent by number of customers. But they represent 35 percent of PSE&G's industrial and commercial load.

"The marketers are going to those customers that present the best opportunity to achieve profitable margins," Wohlfarth says. "Those are the largest usage and highest load-factor customers. It's left us, from a supply perspective, in a less desirable position, because it's easier and more cost effective to serve the higher load-factor customer."

To respond to the decline in load factor, PSE&G is undertaking a comprehensive review of its gas supply and capacity portfolio. "We're looking at what we have under contract now," Wohlfarth says. "Is it the optimum type of capacity mix, meaning a combination of firm transportation on the pipelines, storage contracts with the pipelines and our peaking capabilities? We'll be taking the necessary steps to try and match up what would be the most economic portfolio to meet this changing marketplace."

The utility has taken an equally significant step on the regulatory side. Its industrial and commercial unbundling program called for a review after two years. As a result of negotiations among marketers, BPU staff and the state ratepayer advocate, PSE&G got out from under its service obligation.

Says Wohlfarth: "Our position was that if unbundling is supposed to bring better economic supplies to the marketplace, [the obligation to serve] is really counter to that because we would be keeping contracts that were no longer useful but were being held for that particular point in time when a customer may decide, 'Well, gee, I didn't like unbundling, I want to come back to PSE&G as my supplier.'"

Under the new arrangement, when an industrial or commercial customer opts for transportation-only service on PSE&G, he has the right on the first anniversary of that choice to come back to the utility at the regulated sales service rate. "If he elects not to come back at that anniversary date, he no longer has our regulated sales service available as an option," says Wohlfarth. "This allows us to go out and terminate contracts, restructure contracts with our pipelines and other suppliers and try to get the most cost-effective portfolio. This benefits all our remaining sales customers.

"If the customer does make the election not to come back, we are not precluded from supplying that customer at a later date with a sales service, but that sales service would in essence be a market-price service," he says. "We would supply it to the customer just like any other marketer would supply it."

PSE&G also has responded to market transformation by changing the way it obtains gas supplies. On the commodity side, "we're in what I'll call the monthly or even daily trading business these days," says the PSE&G g.m. "We no longer, from a gas supply standpoint, have long-term contracts." In addition, PSE&G has an agreement with BPU staff and the ratepayer advocate that allows it to make off-system sales of surplus gas or capacity. Customers get 80 percent of the margin the utility makes on such sales, while PSE&G keeps the remaining 20 percent.

And PSE&G is taking a hard look at its substantial interstate pipeline transportation and storage portfolio. It has tremendous flexibility in its contracts. Starting in 1998, the company has transportation and storage contracts that come up either for termination, renewal or renegotiation. "So I feel very comfortable about our ability to effectuate the kinds of changes we need to match our portfolio with the changing load requirement that we have," Wohlfarth says.

As for residential choice, that story is clearly not over. Wohlfarth concedes that perhaps PSE&G's four-town plan was probably not as attractive to marketers as a broader-based program would have been. Another New Jersey utility took the approach of opening choice to 5,000 customers on a statewide basis, and its program was sold out in a matter of weeks. But in addition, Wohlfarth says, PSE&G's gas costs are very competitive. "Our supply and capacity costs on an aggregate basis are the lowest in the state," he says. "I think marketers are looking at our gas costs and how much savings they can give the residential customer and the effort to go out and sell to that customer, and are probably deciding it's just not going to be a successful effort."

There hasn't been an outcry from residents in the four towns targeted about the lack of gas supply competition. This raises the question of whether residential choice is a "politically desirable event or truly something the customer wants.

"Clearly the interest [in choice] is much greater on the industrial and commercial side, as we find when we do our customer surveys," Wohlfarth says. "We get tremendous high marks when we talk about reliability and service, across the board (em industrial, commercial and residential. When you get to price, the bigger the customer, the more interested he is.

"We've encouraged letting competition play out in the industrial and commercial market, and we have no problem with that happening in the residential market as well," Wohlfarth says. "But you can't force a customer to buy from someone else if he doesn't want to."

NW Natural:

Pro-Choice, But No Surrender

At NW Natural, known until recently as Northwest Natural Gas Co., Rick Harper pointedly notes that he is not opposed to choice. Harper, v.p. of marketing and gas supply for the Portland, Ore., utility, says the company has been incorrectly labeled as an opponent of allowing residential gas customers to choose their suppliers. He wants to set the record straight.

"I just want to make it clear that we are pro-choice and pro-competition," Harper says. "But more than pro-choice and pro-competition, we are pro-customer satisfaction."

And customer choice and customer satisfaction are at odds now in many parts of the country where residential pilot programs are offered, NW Natural believes. "Where we've seen supplier-driven initiatives around the country, they have not resulted to date in better products and lower costs and improved customer satisfaction," Harper says. "It's been a mess."

"We don't see any reason, when the customers are not asking for something, to force upon them a supplier-driven initiative that may result in lower satisfaction with our product," he says. "That hurts not only our business but it hurts everybody. It hurts producers, it hurts transporters and it hurts marketers."

NW Natural, Harper stresses, is protective of the image of natural gas and concerned about anything that could detract from that image. The company has managed to achieve impressive customer satisfaction ratings and significant market gains in its own territory, which includes western Oregon and southwest Washington. It claims the highest overall customer satisfaction rating by far of any company doing business in western Oregon, including the Nordstrom department store chain, renowned for customer service. And in a region with the lowest electricity rates in North America, natural gas is getting 95 percent of all single-family new home construction in the primary applications of space heating and water heating, says NW Natural.

Existing homes offer more of a challenge, however, since gas has only 31 percent of the space heating and 24 percent of the water heating market. But Harper reports that about 7,000 customers annually convert from electricity or oil to gas.

This success is attributable in part to aggressive marketing. "We've launched an all-out attack for anything new," Harper says. "We try to make sure our advantage is recognized immediately where new installations are going in." There's also the fact that, like electricity, gas costs less in the Pacific Northwest than in any other place in North America. NW Natural's average city-gate price is approximately $1.10 per Mcf delivered, less than half of what it is in the East. Gas has a price advantage over electricity that is currently in the 35- to 40-percent range.

But competition in the region is still fierce, and NW Natural isn't sitting back and counting profits. "In the new world, there are two theaters of competition," Harper explains. "First and foremost for us is getting the customers to use gas for equipment, appliances and processes in all markets (em industrial, commercial and residential. ... That's the main battle for us, and it will continue regardless of what happens on commodity choice."

"Once the customer has decided what equipment and what process to use, then the question of which commodity supplier comes into play," Harper says. "That's ... a secondary theater of competitive operation for us. We currently do all of that [purchasing and transporting gas] for our residential and small-commercial customers. We will willingly allow others to come in when we're sure that it's going to result in a benefit for customers. Right now, it's clear to us it's not a benefit for customers, and we're anxiously waiting for all the marketers who seem to think they've got the capability at the residential level to do a better job to prove they can do it somewhere else."

Unbundling at the industrial and large-commercial level is a different story, Harper says. His company has almost 10 years in the supplier choice business for these categories of customers. Currently, about half the utility's total deliveries are to industrial and large-commercial markets, and of that 50 percent, about 80 percent (by volume) is transportation-only service.

"[Gas is] going to be competitive because the market's very transparent and the commodity market is very open," he says. "The low cost benefits us because it encourages people to use our product for new equipment."

To ensure that its gas costs stay low, Northwest has set up a trading room and actively engages in hedging and financial derivative products. It has access to diverse supply bases, including British Columbia, the Rocky Mountains and the San Juan Basin. Over time, it has shifted more of its supply to British Columbia as drilling there has ramped up.

Even if marketers don't prove to NW Natural that they can satisfy consumers through residential unbundling, there is always the chance that, as in other states, local regulators will champion the concept. Harper says NW Natural has been "talking actively" about the concept with the Oregon Public Utility Commission.

"We don't want to be legislated out of the supply business," he says. "We want to be a participant when that happens. We don't intend to be a dominant participant. We've got something less than a 20 percent market share in residential. It's a fiercely contested commodity world here, and we would see the same kind of thing ultimately in residential."

Richard Reiten, Northwest's president and CEO, believes residential unbundling will be under way in Oregon in the next three to five years. "But I also believe that a utility like NW Natural Gas should be allowed to continue to provide fully bundled services," he says.

S. Lawrence Paulson is a principal of Hoffman-Paulson Associates, a Maryland communications firm. Paulson is a former communications officer at the Interstate Natural Gas Association of America.

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