Gas Transport Rates
Why does FERC want to limit pipeline discounts?
It's certainly puzzling, if not downright peculiar.
That's the feeling one gets after studying the notice of inquiry (NOI) that the Federal Energy Regulatory Commission (FERC) launched late last year, after nearly 10 years of dragging its feet, to re-examine the wisdom of encouraging the practice of rate discounting by interstate natural gas pipelines.
Since 1985, and with the blessing of the courts coming two years later, the commission has allowed pipelines to go off the tariff and cut deals for customers for gas transportation, a service still treated under federal statutes as a natural monopoly governed by regulated rates tied to cost. It has even allowed the pipelines can recover the shortfall in a succeeding rate case, by deliberately understating throughput.
The current policy arose from FERC Order Nos. 436 and 636-as a natural outgrowth of the commission's highly successful effort, begun in the early 1980s to force the unbundling pipeline transportation from the underlying commodity markets. Under this unbundling regime, pipelines would sell only gas transport . Shippers would contract directly with producers or marketers for the natural gas volumes. To allow shippers to better align their purchases of pipeline services with their physical gas needs, they could release unused capacity on the open market, reselling transportation service back to the pipeline or to the highest third-party bidder.
By allowing shippers to release capacity and pocket the profits (subject at first to a price cap), FERC created a new class of market players to control a portion of pipeline capacity and to compete against the pipeline owners for sale of transport services. And so to allow the pipelines to meet this new competition (not to mention the competition arising from pipeline expansions or new projects), FERC allowed pipelines to offer discounts below cost-of-service rates stated in the tariff. By this device, regulators could hold on to the fiction that all service flowed at the maximum lawful (regulated) rate. The tariff, though mandated by the Natural Gas Act to reflect just and reasonable rates, in effect became nothing more than a classic price cap, especially since FERC also relieved the pipelines of any obligation to file periodic rate cases.
In retrospect, FERC's then-radical new policies-unbundling, capacity release, discounting, and so on-could be seen simply as a rational response to changing market conditions. Thereafter, in fact, gas prices fell for the greater part of two decades, with gas markets blossoming as never before. Hubs, futures, basis differential, and spark spread became the new coins of the realm. All of this left the feds free to bask in the sunshine of a notable regulatory success.
So why now would FERC choose to walk away from any aspect of this success? Why would it fault the pipelines for acting like any competent capitalist-by discounting prices when demand falls short of supply?
Contrast the historical experience with the call to arms sounded recently by William Froelich, director of the commission's very own Office of Administrative Litigation (OAL). In no uncertain terms, Froelich's office argues that the time may have come and gone for FERC's discounting policy:
"Given the rapidly escalating price of gas, there are sound economic reasons to question whether pipeline discounting should be encouraged at all."
Echoing arguments from some municipal utilities, who might be "captive" to a single pipeline, the OAL suggests that large local distribution companies (LDCs) attached to more than one pipeline have been able to play off one pipeline against another in search of deep discounts. By allowing an adjustment in the design of the pipeline's rates for such discounts, the commission, says Froelich's office, is in effect "causing the captive maximum rate customers to subsidize the discount."
The analysis from FERC staff recalls the spirit of the 1970s, when policy-makers took it as their sworn duty to discourage consumption and promote conservation of resources as a response to escalating prices:
"In an era when conservation is key … the threshold question that needs to be addressed is whether the commission, through its discounting policies, should still be encouraging marginal uses of gas when it is the demand for gas that has increased and caused prices to skyrocket." (See, Comments of the Office of Administrative Litigation, Notice of Inquiry on Policy for Selective Discounting by Natural Gas Pipelines, .)
Froelich's office argued that pipeline rate discounts shield customers from true price signals. The OAL even suggested that the commission should require any pipeline offering gas-on-gas discounts to submit a new rate case at least every five years. Such pronouncements have left FERC Commissioner Nora Mead Brownell just a little bit flummoxed. As early as last November, she had declared that the entire inquiry seemed to her as a classic "search for a problem."
Yet this debate did not arise in a vacuum. Grumblings were heard as early as 1997, when the Illinois Municipal Gas Agency (IMGA) had asked FERC to open a rulemaking proceeding to consider the effect of discounting on captive customers of interstate gas pipelines.
IMGA had filed on behalf of LDCs or other customers who took service from one pipeline and who lacked opportunity to choose to take service from a competing pipe. IMGA alleged that discount could harm these captive customers, since they could be left marooned on an under-subscribed and under-funded system-vulnerable to a "death spiral" if too many non-captives jumped ship to competing pipelines to take advantage of discounts. IMGA had asked FERC to develop a rule of general applicability that pipelines cannot have their cake and eat it too. That is, when pipelines offer a discount for the purpose of retaining a customer in the face of competition from a second pipeline (known as "gas-on-gas" competition), they should not be allowed to claim a rate-making adjustment in a subsequent rate case to hold themselves harmless. (Current policy presumes that gas-on-gas discounts are justified, as long as the beneficiary is not an affiliate of the discounting pipeline.)
IMGP took pains in its petition to distinguish this gas-on-gas discounting from discounting to compete against intrastate pipelines, or against alternate fuels. For example, a pipeline customer or second-tier retail end users might turn for their needs to an alternate fuel, such as no. 6 fuel oil for an industrial boiler. IMGA argued, however, that where gas-on-gas competition was concerned, discounting was simply a zero-sum game conferring no benefits on the consuming public, as gains in throughput on one pipe were matched by losses on another.
Nevertheless, as Brownell has pointed out, FERC rejected this very argument (no rate case adjustment for gas-on-gas discounts) over a decade ago, in the case of Southern Natural Gas, .)
Why is that ruling not still applicable?
Ain't Broke, Don't Fix It
The prevailing industry sentiment appears to support FERC's current discounting policy, and by a wide margin. Pipelines, LDCs (some, not all) and at least one state public utility commission (PUC) have all joined in a chorus of, "ain't broke, don't fix it."
Assuming, however, that the NOI might still attract support from FERC, it might be worthwhile to pinpoint some of the elements that might define a new policy:
Corporate Affiliation. Any new rule would likely target discounts offered to pipeline affiliates before attempting to curtail discounting to independent customers, which now is presumed to be beneficial. Contract Term. The shorter the term of service, the more likely that discounts have tended to be seen as appropriate.
Interfuel/Intrastate Competition.Some discredit gas-on-gas discounting as a pointless zero-sum game (IMGA, FERC's OAL, etc.), but even these naysayers tend to look more approvingly at discounts offered to meet competition from intrastate pipelines or alternate fuels.
Pipe Expansions.Discounting to attract shippers on brand-new pipes, or to retain shippers after costly expansions on existing pipes (compression, looping, etc.) attracts even more critics than standard gas-on-gas discounting. Expansion creates additional fixed costs, making it more difficult to argue that discounts help captive customers by preserving throughput. And discounting suggests that an expansion perhaps was not economically viable or necessary in the first place. Capacity Release. The question seems less settled on whether discounting to meet competition from capacity release by shippers should be included in the gas-on-gas category. Price Elasticity. Those who argue that the recent price spikes for the gas commodity should warrant a second look at FERC's discounting policy tend to focus on the behavior of shippers who receive discounts. They see danger in discounting to price-elastic shippers (that only exacerbates gas shortages and drives prices even higher). Yet price-elasticity also guarantees that discounts maintain or boost throughput, which, after all, is a key element of the case in favor of discounting. Rate Case Interval. FERC's OAL notes that several interstate pipelines have not had their rates reviewed by FERC in "well over ten years." To correct that, OAL and some others suggest that FERC should force any discounting pipeline to "refresh" its rates through an NGA sec. 4 rate case filed every five years. Yet the irony remains that it is only after the conclusion of a rate case-with its artificially adjusted throughput and reallocation of costs-that captive customers face risks from discounting.
According to the groups of municipal gas distribution utilities operating in the northern Midwest region, a prime example of the evils of gas-on-gas discounting can be seen in a case now pending at FERC in Docket No. RP05-181. The utility groups say that case shows that Northern Natural has offered discounts to CenterPoint Energy (Minnesota Gas) that approach 50 percent of Northern Natural's current maximum reservation rates. Moreover, the proposed rates would remain in effect for at least 12 years (through 2019), without any showing from Northern Natural, according to the municipal utility groups, that net throughput would be increased.
Yet, the Gulf South System, located in the Gulf Coast production area, says that it currently discounts over 90 percent of transportation service, and defends the practice as essential, owing to the plethora of competitors it faces.
As Gulf South explains, its system can boast direct connections to some 100 operational industrial plants and 19 power plants. But 41 of the 100 industrial plants can connect with at least one other pipeline, and 23 can connect to three or more competing pipes. Fifteen of the 19 gen plants can access at least one other pipeline, while nine can access three or more competitors. Fourteen of the 19 gen plants claim the capacity to use alternate fuels.
In such an environment, Gulf South has little choice but to offer discounts, as its maximum rate to serve an industrial customer in Louisiana runs about $0.14 per million Btu (MMBtu), while many competing intrastate pipes in Lousiana will typically charge about $0.05 to serve the same customer. And, as Gulf South notes, those intrastate rates will typically include reimbursement for fuel (costs incurred in pumping and compression).
A different but essentially similar case prevails in the northern Midwest, where the convergence of many systems also raises the level pipeline of competition. Consider, for example the system run by Natural Gas Pipeline Co. of America (NGPA), owned by Kinder/Morgan.
As NGPA notes, its delivery area is centered on Chicago, meaning that all of its larger LDC customers can take service from multiple pipelines or even other LDCs. For deliveries to NGPA's Chicago-area customers, competition comes from as many as 10 different large-diameter interstate pipelines: ANR, Northern Natural, Trunkline, Northern Border, Panhandle Eastern, Midwestern Gas Transmission, Alliance, Vector, Horizon, and Guardian. Thus, peak-day market demand in the Chicago area runs about 11 billion cubic feet per day (Bcf/d), says NGPA, while delivery capability from all sources can reach about 19 Bcf/d on an early season peak day.
According to NGPA, this surplus capacity virtually demands discounting against capacity release, and effectively kills any notion that a local customer could call itself "captive."
Thus, NGPA argues that truly captive customers represent only about 1 percent of its customer base, in terms of total contract requirements for firm transportation service. And if that wasn't enough NGPA says that it already favors such captive customers by holding them exempt from paying a capacity reservation charge. With captives paying only about 20 percent of what they would otherwise have to pay for a comparable level of firm service, how could anyone argue that they have been made worse by gas-on-gas discounting?
The Unvarnished Truth
Roughly five years ago, in its supporting opinion issued to accompany Order No. 637, FERC recognized clearly the extent to which competitive forces, expressed through the concept of basis differential, have come to control the market for natural gas pipeline services.
Quoting an article published in , FERC agreed that "gas commodity markets now determine the economic value of pipeline transportation services in many parts of the country. … It is within the commodity markets that one can see revealed the true price for gas transportation." (, quoting Mary L. Barcella, "How Commodity Markets Drive Gas Pipeline Values," , Feb. 1, 1998, p. 24.)
And more recently, as Gulf South explains, the pipeline auctioned off a large block of firm transportation service for a two-year term at a discounted rate that was generated through the auction and which was tied directly to the forward basis differential between Texas and delivery points Mississippi. (See, Comments of Gulf South Pipeline Co., L.P., at p. 18, FERC Docket No. RM05-2, filed March 2, 2005.)
Yet today, with its NOI, the commission seemingly would turn back the clock. It would target pipeline discounts as an evil that "shields" consumers from price signals. And yet any price signal embodied in cost-of-service tariffs must in the end prove false, as they themselves mask the true price, which is found in the basis differential, the difference in the gas commodity price at point of receipt and point of delivery.
Congress likely wants to believe that gas pipeline rates are still fully regulated, and who is FERC to want to convince them otherwise? Especially now, with gas prices rising and politicians more vulnerable than ever to a consumer backlash.
Yet, for anyone who does ask, it appears quite obvious that cost-of-service rates for gas transportation are little more than a memory. In spite of what the law says, pipeline rates aren't much regulated any more. FERC knew that once, but now seems to have forgotten.
Perhaps we should compare today's gas pipeline market to the airline industry, as Kinder/Morgan and NGPA suggest in their comments.
Suppose that federal regulators decided that because airline passengers don't always get a rock-bottom fare, but sometimes have to pay full fare on those few routes where there isn't much competition, that therefore "all consumers on all airlines on every flight must pay full fare as determined and mandated by regulation."
Without all those cheap air fares, how could FERC staffers get to all those regional meetings on industry restructuring?
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