Auctioning gas imbalances offers advantages over bidding on available pipeline capacity.
In a Notice of Proposed Rulemaking issued last summer, the Federal Energy Regulatory Commission proposed a series of auctions for all unutilized short-term rights in pipeline capacity, with the most frequent auction being for transmission rights for the next day. All transporters and the pipeline would be required to release available short-term capacity rights to be auctioned. (See FERC Docket RM98-10-000, Regulation of Short-term Nat. Gas Transp. Servs., July 29, 1998.)
Confusion abounded, however, when the FERC attempted to show how auctions would work in bidding for various segments in a multi-nodal pipeline network. At the FERC's Workshop on Pipeline Capacity Auctions, held Oct. 20, the Commission staff presented several examples. For ease of presentation, the model results were first presented for a three-node linear pipeline, then a four-node, network pipeline. Much of the confusion concerning this model could be eliminated by changing the nature of the auction.
Instead of auctioning available capacity as proposed by the staff's model, the better auction is of gas imbalances (i.e., the difference between the nomination and the actual delivery of gas). Such an auction of gas imbalances would acquire a number of desirable characteristics:
Universal Application. Every transportation customer has a minor gas imbalance daily that is generally ignored because the imbalance is within tolerance. By making even those small gas imbalances subject to auction, all transportation customers would become participants in the auction.
Commodity Bids (Not Derivatives). The value of pipeline capacity is derived from the difference between the commodity value of gas at either end of the pipeline. Pipeline capacity values are thus derivative of commodity values. Capacity rights can be viewed as commodity futures contracts, such as those traded on the New York Mercantile Exchange or the Chicago Board of Options.
Fewer Auctions. An auction of gas imbalances would require only a different price for each zone on the pipeline. An auction of transportation rights requires a different price for each pair of zones. With N representing the number of zones, the market will require N imbalance auctions. But the number of discrete capacity auctions rises to N3(N-1)/2.
Simplified Bidding. The price would change automatically depending on the market balance within the relevant zone of the pipeline. No "bid" is actually submitted by a participant. Instead, the amount of a bidder's imbalance is automatically priced at the zonal price, whether long or short.
Easy Bilateral Trading. With auctions applying only to gas imbalances, a bilateral trade would not affect the market balance within a relevant zone of the pipeline.
An Intraday Market. The auction price would be determined from the market imbalance, which could be measured instantaneously for gas, simplifying the creation of an intraday market. The settlement price would be the instantaneous price averaged over a longer period of time, such as a few hours or a day.
Pricing Gas Imbalances
I propose to change the nature of pricing for gas imbalances. Currently, most pipelines and local distribution companies use a penalty structure for gas imbalances. The utility allows the shipper to have a small tolerance without penalty. Cumulative net imbalances are cashed out at some slight penalty versus a nominal market price. Significant fixed penalties are charged for daily overruns during days of curtailment.
Instead we should institute a competitive market for imbalances, essentially creating a FERC-style auction. This competitive market would have daily or intraday cashouts of the entire imbalance. There would be neither a tolerance for small imbalances nor a specific penalty for large imbalances. The price for the cashout may become so severe that the customer feels a pinch similar to that of a penalty. However, the price would also be applicable to customers who have the opposite imbalance, though perhaps with a small (e.g., 5-percent) price differential to provide the pipeline with net revenue to compensate for its administrative services. The small price differential would be the only incentive for customers to trade imbalances.
The price of gas imbalances is already subject to FERC's jurisdiction. After all, the penalty structure described above is included as part of the pipeline's transportation tariff and is ruled over by FERC. My proposal changes the price from a fixed penalty structure to a varying competitive market price.
I propose that the price for imbalances be determined from a measured quantity such as gas pressure in the market area, line pack volumes, etc., as presented in the graph on the following page. The vertical axis is likely to be logarithmic, so that proportionate changes in the measurement of the market imbalance will change the price by the same factor. For instance, every 10 psi decrease in gas pressure could double the price of the gas imbalance. The second and third lines in the graph are for self-correction. As the market imbalance continues, the price curve for gas imbalances changes to increase the incentive for correcting that market imbalance. In this case, I have assumed that the market imbalance was a shortage and that the price curve shifts up on subsequent time periods.
A similar price curve appears in other papers I have written, including "WOLF Pricing," Public Utilities Fortnightly, Oct. 1, 1994, p. 69. That article was directed to the electricity market so there are different measurements for the market imbalance, and prices are for energy measured in kilowatt-hours instead of decatherms.
Since 1984 I have advocated the automated pricing of unscheduled flows of electricity. I call the concept "wide open load following," or "WOLF Pricing," as the price changes are unlimited, depending only on system conditions. The mechanics I have described for electricity are equally applicable for natural gas, the primary difference being the sophistication of the tools available for changing the price. Electric utilities have long used area control error and system frequency as indices of reliability concerns on the network. I say they are also market imbalance measures, as that term is used in the graph. Extended problems with system frequency provide another index of reliability concern: time error. The additional lines in the graph would be generated by time error, were the graph a plot of prices for electricity.
Make It Universal
As mentioned, the auction of gas imbalances will make every transporter a participant in the auction process, not just the few electric utilities that have dominated the gray market in flowing gas. This universal participation is accomplished without the customer changing its mode of operation. Transportation customers would continue to estimate their daily consumption and then nominate a delivery of approximately the same amount. They wouldn't also have to determine a strategy for setting the price of any available capacity because this price would be automatically determined. Pipeline imbalance penalties may now bias the nomination process, in that some customers will perceive an advantage to being slightly long during some periods and slightly short during other periods. However, the nomination is supposed to equal the amount of gas the transporter expects to use.
The actual take of gas always differs slightly from the nomination. In most cases, the slight difference is smaller than the tolerance allowed by the pipeline. The pipeline imposes no penalty for an imbalance this small and carries the imbalance over to the next day. Under an auction of gas imbalances, these slight differences would be cashed out at the auction price shown in the graph.
Avoid Trading in Derivatives
The NOPR acknowledges on page 15 that "the implicit value of transportation between two such points is the spot price of gas at the delivery point minus the spot price of gas at the receipt point." Thus, the value of the gas transportation rights that FERC proposes to auction is a derivative of other values. I discussed my concern about the market for such derivatives in "Electric Transmission Pricing: Are Long-term Contracts Really Futures Contracts?" Public Utilities Fortnightly, Oct. 15, 1994, p. 29.
Auctioning gas imbalances reduces the "futures contracts" nature of the auction. The commodities market typically identifies two types of markets: a spot market and a futures market. In a futures market, the seller has time to change production levels by such means as planting and harvesting a crop. In a spot market, the seller makes delivery on the spot from inventory, generally during the same time period or in the next two or three time periods. Natural gas is dispatched continuously; compressor settings may be changed several times per day. Thus the spot delivery of gas occurs now or perhaps in the next few hours from inventory already in the pipeline near the delivery point. This is certainly consistent with the term spot market as used when discussing the sale of gas imbalances.
Though financial derivatives are used to manage risk, derivatives such as capacity rights on a pipeline also can create inordinate risk. This was seen in the collapse of the Orange County, Calif., municipal system in 1996 and the collapse of the competitive market for electricity in the Midwest during the week of June 22, 1998, as I noted in "Electricity Is Too Chunky," Public Utilities Fortnightly, Sept. 1, 1998, p. 20. Selling gas imbalances via auction reduces the risk associated with financial derivatives.
Simplify the Process
Fewer Auctions. I see major problems with the auctioning of capacity as proposed by FERC. Since capacity is point to point (or node to node), the program proposed by FERC staff will have a separate auction for each combination of points. For N points, there are (N)3(N1)/2 combinations. While the number of combinations may be simple to compute with the fast computers available, a large number of auctions results in thin auction markets that are subject to manipulation
Fewer Bids. The computational simplicity touted as characteristic of the FERC auction of available capacity will be destroyed as participants introduce complexities into the bidding process. For instance, some participants claim to need a multi-period commitment, arguing that the ability to move gas on Wednesday is worthless unless the participant also has the ability to move gas on Tuesday and Thursday. Other participants claim a need for all or nothing, such as the right to move 10,000 Dt per day. The combinations are similar to the dispatch models built in the 1970s for electric utilities. These models were and are incredibly complex, and do not always yield consistent solutions.
Allow Bilateral Trades
By contrast to an auction of pipeline capacity rights, an auction of gas imbalances requires no determination of volumes. The volumes are already determined by the pipeline meters and by the amount each transporter has scheduled. Transporters can change those volumes by trading imbalances with other transporters in the same zone, but such trades are not part of the pricing algorithm. The trades are arranged as the gas is flowing.
There is reputed to be a huge gray market for flowing gas. A few large users of gas have considerable flexibility in the instantaneous use of gas. An electric utility, for example, can decide to redispatch its generators, burning more coal or oil and freeing more gas for trade with other users of gas, who may have been caught short by a sudden cold front. An auction of gas imbalances will not destroy this gray market for gas, just make it more efficient.
The efficiency of an auction versus the operation of a gray market for flowing natural gas can be determined from the price disparities that exist in the gray market. Some transporters are actively marketing their flowing gas, obtaining a transportation price significantly above the tariffed transportation price. However, most transporters have not set up a group to market their flowing gas and receive the tariffed transportation rate, depending on the pipeline balancing provisions. Conversely, some transporters are running short of gas and pay the utility penalty rate. The penalty rate for a gas imbalance is equivalent to a transportation price several times the tariffed transportation price.
IT Trading and Intraday Pricing
The prices derived from the gas imbalances graph relate to simultaneous market conditions. These market conditions can be determined instantaneously by such means as a measure of the concurrent gas pressure. Thus, the prices in the graph could be applicable to gas deliveries throughout the day. High pressures during the middle of the night and low draws of gas will result in low prices. Low pressures during the morning peak period will result in high prices.
Most customers are nominally price inelastic and use the same amount of gas at any price. However, customers that are price elastic generally are served by the utility on an interruptible rate schedule, where the price of gas is reduced, but the utility has the right to interrupt the customers' gas service. Under the price mechanism described by the graph, the interruptible transportation customer would receive lower prices automatically during periods of the day when the local distribution company is likely to allow this customer to operate. Conversely, the IT customer would be facing high prices during periods of the day that the utility would want it to be off-line.
Discourage Gaming
the System
The inadequacy of penalty rates for gas imbalances was demonstrated in Chicago during the winter of 1995-96. During a severe shortage, marketers were alleged to have sold gas to end-users at more than $40/Dt despite having neither the supplies injected into the pipeline at the well nor the right to move gas on the pipeline. The gas flowed to end-users because the accounting system was inadequate in telling operations to turn off the gas. The marketers eventually paid penalties of $10/Dt for the unauthorized use of gas-and earned a net income of $30/Dt by gaming the system. By contrast, the prices produced by the graph might have been $100/Dt, eliminating the gaming of the system by marketers out for a fast buck.
Mark Lively is an independent consulting engineer in Gaithersburg, Md., who specializes in economic issues affecting electric and gas utilities. He has worked for Kentucky Power Co. and American Electric Power Service Corp., and spent 15 years with Ernst and Young's Washington Utility Group. He can be reached at MbeLively@aol.com.
Addressing Industry Concerns: How an Auction of Imbalances Would Stack Up
In a recent "Frontlines" commentary, Fortnightly editor Bruce Radford listed seven issue areas and posed questions involving "the ins and outs of the gas day and other sorts of technical, operational concerns." (See "Those Gas Auctions," Public Utilities Fortnightly, Nov. 15, p. 4.) In the space below, I'll address each issue, showing what would happen with an auction of gas imbalances.
Price. Do winners pay what they bid or match a single, market-clearing price?
There is a single market-clearing price paid by those with negative imbalances. A slightly lower price is paid to those with positive imbalances. The price differential is a fee to the pipeline for cashing out the imbalances. Participants can avoid this fee and set their own price through bilateral trading of the imbalances; that is, through continued reliance on the gray market.
Fungibility. How to throw capacity rights into one pot when they differ in kind (recall conditions, firm vs. IT, different receipt/delivery point, etc.)?
Many have said the only electricity that is truly firm is that which has already gone through the meter. An auction of gas that has gone through the meter (or should have gone through the meter, in the case of a customer with a positive imbalance) is an auction of fungible gas, at least as far as firmness is concerned. Significantly different receipt/delivery points may require different auctions or geographic adjustments to the auction price.
Sequence. Auction all rights at once, even though a bidder might win midstream rights but lose on bids for upstream and downstream zones?
Sequence is not an issue in an auction of gas imbalances. An auction of gas imbalances is a solution to the sequence issue. The bidders exercised all of their rights prior to the measurement of gas imbalances. In fact, if some of the rights were not exercised or were curtailed, an auction of gas imbalances provides a cashout for the partial path used.
Storage. Auction that too?
The auction of gas imbalances will price any operation of storage that is contrary to the scheduled operation of storage. Further, the auction price is likely to be low during the periods when storage operators wish to obtain gas on their own and high when the operators have the opportunity to help the market with their gas. Also, an auction of imbalances can provide continuous prices for intraday imbalances, providing an incentive for storage systems that can inject and withdraw at different times during a gas day (e.g., the ancient gas holders owned by some LDCs).
Privacy. What information to reveal in bids?
For an auction of gas imbalances, no bids are submitted, no information is revealed. Instead, the physics of the gas system determines the price paid for imbalances. The only relevant information about an individual shipper is its gas imbalances.
Gaming. How to force pipelines to put all "available"
capacity up for bid?
The auction quantity is not capacity but gas imbalances, and all participants are "forced" to participate by the physics of gas imbalances. The pipeline can indeed affect the price by withholding compression, which would lower the pressure in the delivery area. However, if transporters respond appropriately to low pressure in the delivery area by reducing consumption and creating surpluses, the pipeline will find itself a net buyer of gas at a very high price.
Timing. Integrate auction schedule with NYMEX futures positions?
The creation of an auction price for gas imbalances should make NYMEX futures more liquid. The improved liquidity should expand the volume of futures trades. Further, an auction of capacity rights is a futures auction, since capacity rights are not a spot commodity but a hedge against some future delivery of a commodity. Accordingly, any tie between capacity rights and NYMEX futures positions creates a chain of hedges that is systemically unstable. A tie to gas imbalances is a tie to reality that will stabilize the NYMEX futures market.
-M.L.
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