Want auctions for gas capacity? Don't think pipeline. Think online.

In July 1998, the Federal Energy Regulatory Commission signaled its intent to try one more time to make greater use of electronic auctions in the pricing and allocation of regulated gas pipeline transmission capacity. The proposed rule, issued in Docket No. RM98-10, marks the third major effort by the commission in this area. Several workshops have already been held. Formal comments are due Jan. 22.

Since the commission began in 1992 to encourage electronic markets for pipeline capacity, several private ventures have sought to create trading products. None has succeeded, however. The publicly reported losses of those who tried are measured in the tens of millions of dollars.

Nevertheless, while private auctions for regulated transmission capacity have failed, auctions in closely related, but freely tradable unregulated commodities have succeeded quite nicely. Today, AltraTM Streamline and QuickTrade's Power Trading System, which provide electronic auctions for natural gas at a variety of delivery points, are known and accepted industry institutions.

Moreover, since the commission last examined the use of auctions, electronic merchants and auctioneers on the World Wide Web have begun to redefine the roles of buyers and sellers. They are radically changing conceptions of how business is conducted, including such fundamental questions as what "inventory" is and who provides it. The question of "where" a business even exists becomes problematic. Over time, these new virtual merchants will change the very physical landscape in which we live and work.

Accordingly, as the commission considers possible regulatory changes involving electronic auction markets, it may find it valuable to understand why its prior efforts to encourage electronic auction markets in capacity have failed, and why other electronic markets and auctions have succeeded. In particular, the commission should be attentive to the experience of online merchants and auctioneers in unrelated commodities. It should stay open to lessons that may apply as well to the regulated gas industry. This article is intended to help open the public discussion of these complex, important matters.

Redefining the Bounds of the Possible

Politics, it's been observed often, is the art of the possible. What happens, though, when the range of possibilities is suddenly and radically redefined in totally unanticipated ways? This question will come before the FERC this year in its pending auction inquiry.

What is already uncontestable is that the technological and institutional revolution known as the Internet is radically remaking the bounds of the possible in commercial transactions. In 1992, when Order No. 636 was issued, the World Wide Web barely existed. It has been estimated that there were only about 50 "http" servers in existence in January 1993.fn1 During the ensuing five years, while the gas industry has focused on creating and refining its institutional structures and business processes to make open access to the gas grid a success, the World Wide Web has been working radical changes in the way buyers and sellers interact in the rest of the commercial world.

The extent of this change is reflected in the valuations applied to the securities of those companies that are viewed as mastering the new model. In mid-November, one of the best-known cyber-merchants, Amazon.com, was sporting a market capitalization of approximately $9 billion. The online auction company, eBay Inc., was valued at a little less than $6 billion. To put these numbers into perspective, consider that Amazon would be valued considerably higher than all of the gas distribution utilities in the Commonwealth of Massachusetts, combined. The market values of Amazon and eBay together would exceed the market capitalization of Pacific Gas & Electric Company. Consider further that the online merchants have been in business for, at most, about three years - while the gas distribution business began operating in Massachusetts in the 1820s, which is to say, during Thomas Jefferson's retirement.

It would be foolish to try to predict exactly how these changes will play out in the coming decades. What already is clear, however, is that the ability to exchange and transfer information in the new ways is working radical changes in the way ordinary business transactions are carried out. These changes have clear implications for commission policy involving the natural gas and electric power industries.

One simple example may help illustrate how electronic communication can revolutionize something as simple as "inventory."

It used to be that a merchant kept available in the store (typically on the premises) a certain quantity of the goods to be sold. This practice allowed the customer to view the goods as well as to take possession upon sale. In the 19th century, Sears, Roebuck and Co. pioneered a revolution in marketing by putting drawings of its goods in a catalog and distributing the catalog widely via the mail. This business model (updated to substitute the hand-drawn sketches with photographs) is still used commonly by a great many specialized merchants.

In the years after World War II, the "discounter" appeared. The discounter took advantage of the radical change created by the automobile, which brought distant suburbs - and cheap, undeveloped land - into easy reach. Relying on these changes, the discounters began constructing ever-larger stores at ever-greater distances from established population centers. This development reached a reductio ad nauseum in the "category killer" store, one that sought to have on hand an extraordinary inventory of nearly all goods of a certain kind. During the last 50 years, these trends (reinforced, of course, by zoning, tax and various other policy incentives) have brought us cheap prices with expanded consumer choice - plus unrelenting suburban sprawl.

The cyber-merchants are preparing to send a multi-ton wrecking ball swinging through this business model. Under the Amazon business model, the bulk of the inventory cost is carried by the producer or distributor of the good, not the retail merchant. The concepts of "warehouse" and "inventory" fall under attack. The need for cheap land and plentiful parking must be profoundly re-thought.

This shift was made exceptionally concrete to this author when, one quiet midnight in 1997, he listed a self-published adventure novel with Amazon's online catalog - thereby integrating the unsold books in his attic inventory into Amazon's worldwide cyber-warehouse. The scope of the changes resulting from the business models was driven further home in late 1998 when he received an order from Amazon's competitor, Barnes and Noble. To his astonishment, the author discovered that the unsold books that lay in his attic had somehow been listed in a second worldwide catalog, this time without his having done a thing to list the book there.

Like Darwin staring at fossilized fishes 12,000 feet above the blue Pacific, I was struck by a colossal discontinuity. Today, in the new distribution/marketing business, the availability of cheap, well-organized information is replacing cheap green suburban fields. Evanescent electrons begin to substitute for a concrete pad, steel beams and a parking lot - not to mention tires, gasoline and a few fast food joints.

Creating a Well-Lit Marketplace

First-generation cyber-merchants such as Amazon continue to buy goods from suppliers and resell them at retail to consumers. Other businesses, however, are pushing the model one step further.

eBay, for example, has created what might be termed a "pure auction" business. eBay never owns the goods at any point in the transaction. Instead, it serves merely as the humble meeting place for the buyers and sellers to get together - something like the role played by New York, Paris, Rome and London. The auction business tries to provide a convenient, well-lit marketplace. It enforces a few basic ground rules for buyers and sellers, earning commissions on each transaction. These are fees that might have been called "rent" under the older business model.

A variant - or rather, a complement - of both the cyber-merchant and cyber-auction models is the electronic comparison business model. Here, the service provider merely offers an electronic tool for comparing prices and terms set elsewhere. Already evident is a variety of such services, including CompareNet (www.compare.net) and others. In its simplest form, this variant is merely a service that surveys publicly available prices and presents them in a side-by-side comparison. These sites serve a market-policing function, enabling buyers and sellers to learn what prices are available in other transactions. These sites may grow into purchasing cooperatives as well, as appears to be a goal of such companies as electricitychoice.com and energy.com.

Importantly, an auction house such as eBay has every reason to design and operate a fair and efficient marketplace. Since the auctioneer makes money from successful listings, it has every incentive to encourage buyers and sellers to return time and again to its marketplace. Obviously, that means first and foremost maintaining the integrity of the marketplace. Honesty is the only successful policy for a web-based merchant, since violations (both actual and suspected) are sanctioned in a New York nanosecond with a click of the mouse.

Righting Mistakes of the Past

Which of these merchant/auction models would work best for natural gas or electricity? The short answer, of course, is that no one knows, least of all the FERC. What we do know is that given the freedom to innovate, software designers and entrepreneurs have proven able in just a few short years to create businesses that are valued much more highly than regulated businesses born in the days of Thomas Jefferson.

Under this perspective, the key question the commission should be asking in the rulemaking proceeding is why the existing auction houses and cyber-merchants do not already offer auction services for pipeline capacity. It would soon learn that the reasons are rooted in the commission's prior rulings that define the transfer of such a right as a jurisdictional act for which the commission, as a matter of policy, will not grant a Natural Gas Act certificate. By prohibiting what it termed "capacity brokering," the commission sought to force posting all such transactions in the form of "releases" conducted on pipeline electronic bulletin boards.

Unfortunately, this policy posed a dilemma for potential buyers and sellers of capacity in a cross-pipeline market. They faced the prospect of having to re-post and re-consummate transactions as "releases" on disparate pipeline EBBs - deals that the parties had already conducted on the open auction board. Faced with inefficient pipeline-specific EBBs in any event, market support for the cross-pipeline auction boards evaporated. That drained the liquidity from the auction services and ensured their demise.

The second great obstacle to successful electronic auctions in capacity flowed directly from the first. By viewing auction transactions as jurisdictional and seeking to force traders through the grinder of pipeline-specific EBBs, the FERC discouraged the development of electronic tools for evaluating transmission paths across various pipeline systems. One of the key commercial problems an electronic auction mechanism seeks to solve is how to provide buyers with the ability to link segments that cannot readily be "seen" as linked (for example, because they involve non-contiguous segments of the same pipeline, non-contiguous pipelines or even different fuels).

Just as Amazon's electronic links allow a self-publisher to establish relational links between books in the attic and a school librarian, so a well-designed auction service should allow buyers, as an economic matter, to link paths on pipelines a thousand miles apart. While that is done today through privately negotiated swaps and basis differentials across pools, it is a relatively inefficient process. It lacks the transparency that would come from efficient cross-pipeline auction markets.

Moreover, as the electronic and energy markets mature and converge, sellers may seek ways to link things that the commission never dreamed would be joined in a single transaction. Examples might include the sale of light with books,fn2, gas with groceries,fn3, heat with mortgage servicing,fn4, or electricity with religious charities.fn5 In a nation of hundreds of millions, no one should expect everyone to want their molecules or electrons painted the same color. It bears remembering that insisting on producing a single-color automobile cost Henry Ford the dominant position in the U.S. automobile industry for decades.

The FERC need not renounce jurisdiction over capacity assignment for this innovation to proceed. All that is required is the withdrawal of that portion of the proposed rule that seeks to define by law the terms of the auction market. Instead, to the extent the commission believes its jurisdiction is implicated, it should issue a blanket certificate to any software company that designs, implements and operates an electronic auction mechanism that allows willing parties to transfer the rights to receive transportation service. The certificate could be made contingent on providing the commission with access to the audit trail of all jurisdictional transactions.

This approach gives the commission a valuable role: It is the FERC that takes responsibility for preventing abuse of a dominant position in the market - not the software developers. It also allows auction designers to modify the auction mechanism as necessary as experience is gained, without the need to conduct a formal rulemaking proceeding, while providing the commission with the real-time information that is required to respond to allegations of market abuse.

Some may argue that the commission lacks authority to remove the regulatory obstacles preventing the rapid development of electronic commerce in gas and electricity. But after all, the commission recently ordered a hydroelectric dam barring a small river to be removed; why not remove the regulatory dam across the Amazon? We know that since 1995, new industries worth billions of dollars have emerged from scratch to offer choices to consumers to buy what they want, when they want, for prices they want. Why bar the gas industry from this historic transition?

Philip M. Marston is an attorney and consultant who has written and spoken widely on regulatory issues affecting the natural gas industry. He conducts his energy law practice from Alexandria, Va. Marston's e-mail address is PMMARSTON@aol.com.

1 "Http" stands for "hyper text transfer protocol." Http is the set of communications instructions that are used for the bulk of web communication.

2 How about "Make a good book better - gentle light for tired eyes"?

3 See netgrocer.com.

4 Marketers already have experimented with such bill-consolidation efforts.

5 The marketing slogan might be "Let There be Light."

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