Gas-on-Gas Discounting: Still a Zero-Sum Game
Captive shippers still face rate hikes without reward under the FERC's new rule on short-term pipeline capacity.
In its final rule issued on short-term gas pipeline capacity, announced Feb. 9 in Order No. 637,[Fn.1] the Federal Energy Regulatory Commission squanders a precious opportunity to end a discrimination inherent in its pipeline rate discounting policy.
In practice, that policy permits interstate pipelines to raise rates for captive customers to offset discounts they give to other customers that enjoy access to competing interstate pipelines. The theory behind this privilege is simple. The pipelines justify their discounts on the claim that all customers, including non-favored customers that get no discounts or lesser discounts, will benefit. How? The benefit, it is said, comes from an increase in units of service provided - a result of the discounting.
Alas, that common theory rests on a mistaken assumption. Not one more dekatherm flows in the interstate pipeline grid because of this pipeline-on-pipeline (or "gas-on-gas") discounting. Instead, one pipeline's increased units of service merely other pipeline loads; their combined units of service do not increase. Furthermore, the FERC's answer of adjusting ratemaking throughput[Fn.2] to recoup such discounts discriminates against non-favored customers because their higher rates subsidize discounts to the favored customers. The extra units of gas are not real. The gas-on-gas discounting emperor has no clothes.
The FERC's 1998 Notice of Inquiry,[Fn.3] heralding the Final Rule, asked two questions relevant to this issue. First: Do these discount-related rate adjustments unfairly affect captive customers (those whose short-term demands do not vary with price)? Second: What constitutes a reasonable limit on the extent to which pipelines can recover the costs of their discounts? For gas-on-gas discounting, fairness dictates two straight-forward answers: (1) "yes," and (2) "no rate adjustments are reasonable." Yet the Final Rule leaves those questions dangling, noting only that the FERC is "still considering ... whether to permit discount adjustments."[Fn.4]
While the Final Rule takes a pass, gas-on-gas rate prejudice against captive customers endures. The Final Rule's standard gas-on-gas regulatory model remains open to challenge, whether at the FERC by complaint as "pernicious,"[Fn.5] in pipeline rate case hearings, or in a later court appeal. Instead of waiting for such a challenge, the FERC should repair the gas-on-gas standard model.
The Policy: Blind Faith in Supply-Side Subsidy
Since opening access to the interstate grid in 1985, the FERC has allowed pipelines to discount their transportation services at will and then to regain those discounted dollars by commensurate adjustments lowering the volume of throughput that is entered in the ratemaking formula, thus raising rates. The FERC argues such subsidized discounting (by customers not awarded the discounts), including subsidized gas-on-gas discounts, benefits all customers by allowing a pipeline to maximize actual physical throughput, thus spreading fixed costs over "more units of service."[Fn.6]
The Final Rule acknowledges that pipelines exercise market power through such selective discounting at rates below the FERC-set maximum rate ("in effect price discriminating").[Fn.7] Nevertheless, the Final Rule then sets out the standard, broad-brush rationale that increased units of service, leading to higher annual revenues for pipelines, will benefit the captive customers paying maximum cost-of-service rates. According to this rationale, the increased service reduces, in the pipeline's next rate case, costs that otherwise would be recovered through rates paid by those captive customers.[Fn.8] Nowhere does the Final Rule recognize that pipelines actually reduce the level of throughput reflected in the ratemaking process to force non-favored customers to subsidize discounts.
Moreover, it overlooks an obvious problem: Discounting only furthers what is essentially a zero-sum game.
Gas-on-gas competition often takes the form of a pipeline's competing with another interstate pipeline for a customer. Favored customers with access to both pipelines - but not those customers captive to only one pipeline - get the discounts. Another typical form of gas-on-gas competition occurs among the users of a pipeline's own rate schedules for transportation service, including capacity release. When firm contracts expire, pipelines grant demand charge discounts to compete with their own interruptible transportation rates, which also often are discounted.
A pipeline's rates increase in step with its discounting to meet such gas-on-gas competition from other interstate pipelines or with itself.[Fn.9] Gas-on-gas discounting amounts to substantial dollars across the grid.[Fn.10] Furthermore, gas-on-gas, pipeline-on-pipeline, discounting (and related ratemaking throughput adjustment) by definition impacts more than one pipeline's customers. Yet after the deals are struck, not one additional dekatherm moves across the FERC-regulated pipeline grid.
Discounting to meet gas-on-gas competition fails to spread fixed-cost recovery over more units of service. Markets a pipeline wins in gas-on-gas competition with another pipeline, or among the pipeline's own rate schedules, merely displace units of service otherwise delivered by that other pipeline, or under another rate schedule. No real increase in economic output occurs.
The Rebuttal: A Case Ripe for Judicial Review
Not all discounts are bad; nor do they all discriminate. Some discounts aim to meet competition from alternate fuels or from pipelines not regulated by the FERC. These discounts may well increase units of service across the interstate grid, to the benefit of non-favored customers as well as customers getting discounts, which the gas-on-gas discount does not do. The question for this discussion, however, is whether the appellate courts recognize this distinction between load-building and zero-sum discounts and, if so, how might they rule on the FERC's current policy?
In the 1980s, in a slightly different context involving pipeline discounts of gas , not transportation, the U.S. Court of Appeals for the D.C. Circuit had occasion to test the FERC's policy to see if such discounts made a contribution to fixed costs that otherwise would not be made at all. When the court found that equitable justification to be "missing," it said "no" to the policy in question.[Fn.11]
In fact, on at least three separate occasions since then, the D.C. Circuit Court has insisted that the issue of pipelines adjusting their rates to offset discounts to meet gas-on-gas competition has not even been addressed, let alone analyzed or approved:
- Deferring the Issue. In 1987 the court explained that issues of rate differentials based exclusively on competition between transporters with similar cost functions [i.e., interstate pipelines] may "properly" be deferred to another day and another proceeding for ultimate resolution.[Fn.12]
- Withholding Any Opinion. The D.C. Circuit Court in 1995 ruled that the court has not specifically addressed the "legality of gas-on-gas discounts."[Fn.13]
- Emphasizing the open question. The court in 1996 defined standard model FERC selective discounting to include that 1995 ruling that the legality of gas-on-gas discounts has not been specifically addressed (on review of Order No. 636 unbundling of sales and transportation services).[Fn.14]
Even general rate design principles leave the gas-on-gas problem open to challenge. Correcting the problem would be required under the anti-discrimination discounting objectives of the FERC's 1989 Rate Design Policy Statement: (1) to maximize throughput, and (2) to "prevent subsidization of the discounts by the pipeline's nondiscounted rates."[Fn.15]
Disallowing ratemaking adjustments for gas-on-gas discounts actually promotes the second objective, by removing captive customer subsidies of discounts a pipeline gives to favored others. Moreover, the promotion occurs at no detriment to the first objective, because no units of service are lost to the pipeline grid by disallowing the practice.
In unbundling sales from transportation in 1992, the FERC took care to declare the Rate Design Policy Statement "still will be applicable to ... the discounting of rates."[Fn.16] Correction of the gas-on-gas, prejudicial rate methodology problem also would improve allocative and productivity efficiency under the Policy Statement, as encouraged by the Final Rule.[Fn.17]
The Remedy: Measures Less Severe on Captive Customers
The FERC's rule in Part 284 (Title 18 of the Code of Federal Regulations) requires that discounts, including gas-on-gas discounts, be provided without "undue discrimination or preference of any kind."[Fn.18] The Natural Gas Act "fairly bristles" with concern for undue discrimination that those regulations were issued to prevent.[Fn.19] Section 4 (b)(2) of the Act proscribes illegal discrimination as taking place between "classes of service."[Fn.20] Disallowing such prejudicial ratemaking also would be appropriate under the FERC's long-standing doctrine stating that the only legal rate is the FERC-filed rate.[Fn.21]
Rather than await a court challenge, the FERC could well accommodate some of the gains[Fn.22] it seeks in its discounting policy through means less severe on captive customers. The FERC should correct the discrimination inherent in its current model for rate discounting by these two measures:
No undercutting the reservation charge. Gas-on-gas discounting of reservation charges below the filed maximum reservation charges of a competing, FERC-regulated pipeline should not be allowed. Nor should adjustments for any permissible gas-on-gas discounting of the reservation charge be allowed in the design of rates. Pipelines could discount down to another pipeline's maximum reservation charge, but without standard model rate design privilege of recouping those discounts from other customers.
No discounting the usage charge. Gas-on-gas discounting of usage charges in firm rates also should not be allowed. Nor should any discounting of interruptible rates below usage charges of a competing, FERC-regulated pipeline, or any discounting of interruptible rates to compete with capacity released by a firm service customer of a FERC-regulated pipeline, be allowed. Pipelines could discount down to another pipeline's filed firm or interruptible usage charge, but, again, without rate design privilege.
At the end of the day, the Final Rule pays lip service to "reduced discount adjustments,"[Fn.23] but lifts not a finger to ease the gas-on-gas problem, let alone cure it. The FERC should assure that price differentials among transportation customers will benefit captive customers equitably by making a contribution to fixed costs that otherwise will not be made at all. Because no such assurance for gas-on-gas discounting exists, the FERC, or the courts on appeal, should take away the standard model rate design toy for playing that zero-sum game. There is no excuse for continuing to duck this matter.
1. Regulation of Short-Term Natural Gas Transportation Services, and Regulation of Interstate Natural Gas Transportation Services, Order No. 637 Final Rule, FERC Stat. & Reg. ¶31,091.
2. Adjusting ratemaking throughput is a mathematical step in the rate-setting process that takes the revenue requirement allocated to customers not receiving discounts and spreads it over a smaller throughput volume of gas, thus resulting in a higher unit rate for transportation.
3. Regulation of Interstate Natural Gas Transportation Services, Notice of Inquiry, FERC Stat. & Reg. ¶35,533 at 35,744.
4. Final Rule, supra, FERC Stat. & Reg. ¶31,091 at 31,267.
5. FERC analysis says, where it is clear the discount is solely at the pipeline's expense, selective discounts will not "ordinarily" be discriminatory; however, "[c]omplaints will be entertained as a means of determining whether a particular discount is pernicious." Regulation of Natural Gas Pipelines After Partial Wellhead Decontrol, Order No. 436-A, FERC Stat. & Reg. ¶30,675, 31,679-80 (1985).
6. Koch Gateway Pipeline Co., 84 F.E.R.C. ¶61,143, 61,779-80 & n.57 (1998); Panhandle Eastern Pipe Line Co., 74 F.E.R.C. ¶61,109, 61,404 & n.117 (1996).
7. Final Rule, supra, FERC Stat. & Reg. ¶31,091 at 31,271.
8. Id. & n.82; see also at 31,274-75. However, nothing in the court decision, comments, or treatise cited in the Final Rule considers that not one more dekatherm flows in the grid because of gas-on-gas discounts. To the contrary, the cited treatise says price discrimination is justified by "making fuller use of existing capacity," which does not happen across the grid due to gas-on-gas discounting. 1 A. Kahn, The Economics of Regulation 133 (1970).
9. Mississippi Valley Gas Co. v. FERC, 68 F.3d 503 (D.C. Cir. 1995)(at 507: "[T]he agency has decided to allow selective discounting to meet gas-on-gas competition"); accord Williston Basin Interstate Pipeline Co., 85 F.E.R.C. ¶61,247, 62,028-30 (1998)(at 62,029: "[D]iscounts are also permitted to meet competition from alternate natural gas pipelines").
10. Southern Natural Gas Co., 67 F.E.R.C. ¶61,155, 61,457 (1994)(two-thirds of discounts assertedly for gas-on-gas competition).
11. Associated Gas Distributors v. FERC, 824 F.2d 981, 1010-11 (1987), cert. denied, 485 U.S. 1006 (1988).
12. Id. at 1011-12.
13. Mississippi Valley, supra, 68 F.3d at 507.
14. United Distribution Cos. v. FERC, 88 F.3d 1105, 1142 (D.C. Cir. 1996), cert. denied, 520 U.S. 1224 (1997).
15. Interstate Natural Gas Pipeline Rate Design, et al., 47 F.E.R.C. ¶61,295, 62,056-57, order on reh'g, 48 F.E.R.C. ¶61,122 (at 61,449: FERC has a "policy of avoiding cross-subsidizations").
16. Pipeline Service Obligations and Revisions to Regulations Governing Self-Implementing Transportation; and Regulation of Natural Gas Pipelines After Wellhead Decontrol, Order No. 636, FERC Stat. & Reg. ¶30,939, 30,434.
17. Final Rule, supra, FERC Stat. & Reg. ¶31,091 at 31,262 & n. 71.
18. 18 C.F.R. §§284.7 (b), 284.9 (b), effective March 27, 2000; Final Rule, supra, FERC Stat. & Reg. ¶31,091, 65 Fed. Reg. 10,156, 10,219-20.
19. Associated Gas Distributors, supra, 824 F.2d at 998.
20. 15 U.S.C. §717c (b)(2).
21. Montana-Dakota Utilities Co. v. Northwestern Public Service Co., 341 U.S. 246, 251 (1951); see also Maislin Industries, U.S. v. Primary Steel, 497 U.S. 116, 126-36 (1990); MCI Telecommunications Corp. v. American Telephone and Telegraph Co., 512 U.S. 218, 234 (1994).
22. Associated Gas Distributors, supra, 824 F.2d at 1010.
23. Final Rule, supra, FERC Stat. & Reg. ¶31,091 at 31,263-64.
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