This year the Federal Energy Regulatory Commission (FERC) plans to examine the resale of firm natural gas transportation rights, often referred to as the secondary market. The current regulatory structure, which provides for "capacity release" through an electronic bulletin board (EBB), was born in November 1993. How would this secondary market behave under different regulatory or market assumptions? How would that affect economic efficiency and public policy?

Under FERC Order 636, holders of firm transportation service rights may "release" their unused capacity. To release capacity for a period greater than 29 days, the firm capacity holder (also called the releasing shipper) must inform the pipeline and set out the terms governing the capacity to be released: the time period of the release, right to recall if allowed, the amount of capacity, and so on. The pipeline must immediately post this information on its EBB and then resell the capacity to the applicant who meets the shipper's terms and offers the highest price. The resale price cannot exceed the firm transportation rate. The pipeline must post the capacity release on the EBB even if the releasing shipper brings the pipeline a prearranged deal with another party seeking the capacity. The revenues from capacity-release sales go to the releasing shipper.

Several issues arise:

s Should the FERC allow selective discounts by pipelines on transportation rates?

s Should the FERC force releasing shippers to post secondary transportation sales on an EBB?

s Should the FERC impose a ceiling on the price for natural gas transportation in the secondary market?

s If the FERC maintains a ceiling, what is the appropriate level?

Selective Discounting (em

Still Valid?

Back in 1985, in a rulemaking that culminated in Order 436, the FERC first proposed to allow pipelines to engage in selective discounting. It predicted efficiency benefits and countered charges of rate discrimination.

FERC's Rationale. The FERC policy allowed gas pipelines to discount firm and interruptible transportation rates selectively between a maximum rate based on fully allocated cost and a rate based on variable cost. The FERC gave three reasons to fight off charges of undue discrimination.

First, all floor rates would not fall below the average variable cost of providing transportation service, which would keep pipelines from engaging in predatory pricing. Second, all ceiling rates would be fully allocated, cost justified, just, and reasonable. Under FERC regulations, the pipeline would project transportation units it expected to sell at the full tariff rate.1 This projection would help determine the tariff rate that would meet the pipeline's revenue requirements. If the pipeline could not sell as many units at the ceiling price as it projected, it would not meet its revenue requirements. Consequently, the pipeline would only discount when it could gain additional revenue. Third, the FERC argued, a pipeline might decide to discount to one customer to collect some contribution to the costs allocated to the transportation service, rather than lose the customer and receive no contribution to fixed costs. Although pipelines would assume the risk of meeting revenue requirements at the full rate, their full-tariff customers would gain in future rate cases by sharing in the incremental revenue above costs earned from selective discounting. Also, some customers would now find natural gas transportation attractive at the discounted rate. These customers presumably would be better off than without selective discounting. Since selective discounting would make some customers better off without making other customers worse off, selective discounting would increase economic efficiency.

The FERC contrasted selective discounting against a fixed tariff or a uniform discount, finding the later options inefficient. First of all, a uniform discount would imply a tariff above the level required to balance supply and demand, thus leaving some pipeline capacity unused. And why would a uniform discount imply a tariff above the market-clearing level? The reason is price inelasticity. Unless demand is highly responsive to price, the lost revenues from discounting current customers will more than offset the additional revenues from new customers.

After Capacity Release. Today, in a world with pipeline capacity release, selective discounting is still beneficial. Nevertheless, it is now less important for efficient resource allocation.

The introduction of capacity release allows holders of firm capacity rights to sell these rights either as firm capacity rights or as capacity rights subject to recall. Before capacity release, firm capacity was economic as long the value of its use exceeded variable cost. This was the situation under Order 436. With the introduction of capacity release or brokering, the opportunity cost of using firm capacity was made equal to its value in the capacity-release market. When this value exceeds the variable cost of firm capacity, then capacity release will reallocate firm capacity more efficiently than without a secondary market.

How does this change affect selective discounting? The impact of capacity release on selective discounting depends on the number of competitors in the capacity release market. If the market features many competitors, the price of capacity in the secondary market will allocate capacity efficiently without selective discounting. Selective discounting is simply not needed. On the other hand, in a market with few competitors, resource allocation may be improved substantially by selective discounting.

Monopoly Behavior. If one shipper controls the rights to all firm transport capacity, the shipper will attempt to behave as a monopoly and set the price above the competitive market price for released capacity. But if the capacity is not used, it reverts to the pipeline. If the pipeline is allowed to discount selectively, it will behave as described under Order 436, and the competitive market level of transportation will be achieved.

Again, if our shipper attempts to use the excess capacity, it can only temporarily affect capacity availability. For example, the shipper could use more capacity than is optimal by increasing storage injections in the market area. But once storage is full or is drawn down at the end of the peak season, this use of excess pipeline capacity will stop. So storage injections will affect pipeline supply only by shifting the timing of capacity availability. If a shipper holds firm capacity and sells natural gas to other capacity holders or would-be holders, he has not affected the overall demand for pipeline capacity. Rather, he has only increased his portion of the market served by that pipeline. Consequently, this attempted monopoly behavior should not affect the price of transportation capacity.

This analysis suggests that the FERC should allow selective discounting only in markets with few competitors. Unfortunately, the matter is not so simple. Capacity release introduces a complex array of potential new services, diminishing the power of pipelines to control prices. Which is why the FERC devised notice rules for EBBs.

Secondary Offers (em

Why a Bulletin Board?

Two major arguments support a rule to force releasing shippers to post proposed secondary sales of transportation services on an EBB. One argument says that posting improves market transparency. Participants would find it easier to "discover" the market price. The other argument concerns fairness: Posting would expose any local distribution company (LDC) seeking to protect its own distribution customer, and would ease the FERC's concern that state regulators might influence LDCs to keep control of pipeline capacity serving their state.

Market Transparency. Transparency will likely develop without the requirement to post transactions on an EBB. After all, price transparency has developed in commodity markets without formal exchanges. For example, trade publications provide indices of gas price transactions in most active markets, and marketers and brokers act as effective intermediaries to facilitate exchange. These publications are now quoting prices on the capacity-release market. Nevertheless, there is some validity to the second argument: FERC's concern that public utility commissions (PUCs) might influence LDC behavior. But attempts to limit this influence are likely to come at a high cost.

PUC Influence. For example, PUCs could treat revenues differently for sales of released capacity versus distribution capacity. This difference could cause the LDC to sell its spare transmission capacity to existing customers to make sure it obtains revenues on its distribution system. For this reason, the LDC may offer to sell transmission capacity at a price below the market-clearing level. This action would make interstate capacity available to customers of an LDC when other customers would value it more highly. The requirement to post capacity on an EBB should prevent an LDC from selling its capacity below this level. But several strong arguments work against this posting requirement.

Alternatives. First, under the current system, pipelines have an incentive to market interruptible capacity themselves, where they can accrue the revenues, rather than through the posting mechanism for capacity release, where they cannot. Second, the posting requirement may force LDCs to deal with unknown customers. Third, posting encumbers the negotiation of complex arrangements where there is give and take on the part of both parties. Fourth, there is a more attractive alternative to pipeline EBBs (em independent developers offering EBB services. Fifth, great efforts will be made and costs incurred to avoid the posting requirement because of the reasons listed above and the desire to avoid additional regulation. Most transactions have taken the form of rolling 29-day and one-day deals, which avoid the EBB requirement. Also, buy/sell arrangements will continue to be used to avoid the capacity-release mechanism (see "Gray Markets," below). Finally, if capacity cannot be reassigned to marketers or bundled with gas supplies, the capacity-release mechanism could prohibit aggregation of capacity and the rebundling of services. When Order 636 was issued, the FERC argued that the loss of aggregation and bundling would be replaced by independent marketing organizations for those who needed bundled services. By strictly enforcing the posting requirement, however, the FERC may eliminate services it expected to develop under Order 636.

Secondary Sales (em

Why a Price Ceiling?

The secondary market for transportation is likely to be more competitive than would be indicated by a typical analysis of industry concentration. In the short run, the supply of pipeline capacity is fixed. Any attempt by primary holders of transportation rights to hold capacity off the market and raise prices would make transportation capacity available to the pipeline. Unless the pipeline colludes, the allocation of pipeline capacity is likely to be efficient. The likelihood of collusion is reduced by allowing selective discounting.

Also, most interruptible customers enjoy alternate fuel capability, which imposes market competition when the delivered price of gas is high enough for customers to switch. These factors seem to indicate that a secondary-market price ceiling is unnecessary. On the other hand, some markets are not very competitive. Where a market is served by a single pipeline whose capacity is controlled by a LDC, that LDC might hesitate to release capacity if it would facilitate transportation service for its distribution customers. Such a market might not warrant removing the price ceiling. Equity may also justify a ceiling. Nevertheless, because the cost of enforcing price ceilings is likely to be extremely high, a compelling argument supports its removal in the secondary market.

Gray Markets. Because of the high costs and the posting requirement, many buyers and sellers will find ways around them (in fact, they already are doing this). One method is the so-called "gray market," a term used to describe transactions that market firm capacity without using the capacity-release mechanism.

The most common form of gray market activity is the so-called "buy/sell" arrangement. Buy/sell arrangements are not well defined, but generally involve a holder of firm capacity such as an LDC, which buys gas designated by second party, ships the gas using its own firm capacity rights, and then resells the gas delivered to the second party. These arrangements not only avoid the regulatory requirements of capacity-release arrangements; they also allow the sale of the joint product of unregulated gas and regulated transportation at market prices.

End Runs. For example, assume the market price of natural gas into the pipeline is $2 per MMBtu, and the highest-cost transportation to that market is $1.20. These economics suggest that a marginal shipper would expect to pay $3.20. However, if an LDC previously acquired rights to pipeline capacity at a cost of $0.65 per MMBtu (instead of $1.20), it can avoid the price ceiling on capacity release and share in the higher marginal price, by simply charging a higher commodity price for the gas (em as much as $2.55 (that is, $3.20 - $ 0.65).

Other arrangements can also circumvent price ceilings. For example, a buyer can simply purchase gas at a market center.2 Since the buyer only cares about the delivered price, sellers with lower-cost transportation capacity can make up the difference in the commodity price of gas. Bundling gas supply and transportation re-quires the owner of transportation capacity to buy and resell gas supply, which may prove less efficient than direct negotiations between the producer and consumer. These efforts to avoid the capacity-release mechanism can produce inefficiencies because transactions are often structured to satisfy legal implications. In the example shown above, the purchaser could have negotiated separately for transportation services and gas volumes.

To prevent such machinations, the FERC will have to impose onerous restrictions such as the en-forced bundling of natural gas and pipeline capacity sales and other inefficient market transactions.

Rather than go to all that trouble, the FERC should instead lift the ceiling on the price of capacity in the secondary market and eliminate the requirement for posting of these transactions on EBBs.

If a Ceiling (em How High?

If the FERC should insist on a price ceiling for released capacity in the secondary market, finding the appropriate level involves two steps: 1) setting the annual average ceiling needed to recovery the pipeline's revenue requirement, and 2) allocating that amount throughout the year, across different seasons.

Revenue Requirement. A secondary market for capacity release affects the firm tariff rate that a pipeline needs to meet its revenue requirement. But under current FERC regulations, any revenues from the secondary market go directly to the releasing shipper. Thus, to cover cost of service, pipelines must look to firm-capacity tariffs and sales of interruptible capacity. But if the capacity-release market is efficient, it will depress sales revenues for interruptible capacity. Moreover, an efficient release market plus excess capacity should lower the combined revenues from capacity release and interruptible transport in the secondary market (em all the way down to variable cost.3 This effect arises in many markets during the nonheating season.

If firm rates had to cover the entire cost of the service, they would substantially exceed existing rates. For example, interruptible and released firm transportation accounted for 35 percent of total transportation capacity in 1993.4 If this capacity was being sold presently at 100 percent of the firm tariff (as occurs for some pipelines), then a shift of the sale to the secondary market would force a 53-percent increase in firm transportation rates to offset the revenue loss to the pipeline, assuming no loss of load through the higher tariff. If interruptible transportation is sold at half the firm rate, firm transport rates would need to rise by 21 percent. Thus, the natural tendency of the system would increase the ceiling through rate shifting toward holders of firm capacity.

Data through the middle of 1994 shows interruptible transportation accounting for 20 percent of total transportation, and released firm capacity accounting for 8 percent. The 20-percent figure compares to a previous low of 32 percent in 1986 for mid-year data, the first year that INGAA (Interstate Natural Gas Association of America) began tracking interruptible transportation. So reallocation of revenues to holders of firm-contract capacity is already taking place. As pipelines submit new tariffs, this reallocation will force higher firm transportation rates.

Seasonal Factors. The FERC's current approach to imposing a price ceiling on the secondary market for transportation services involves using the monthly billing rates for firm service. But monthly billing rates have no relationship to the value of firm capacity each month and force firm capacity holders to carry a greater share of the pipeline cost than would be determined by an unregulated secondary market. The allocation of this ceiling over the year should consider the seasonal value of capacity. There are many ways to improve the current approach. The FERC could encourage a move to seasonal rates or impose a ceiling that would apply a 52-week moving average of capacity-release transactions. While Order 436 encouraged seasonal rates, FERC staff did not. In fact, seasonal rates filed by pipelines were rejected when initially proposed. However, Order 436 did not involve capacity release or brokering; as a result, seasonal rates altered the monthly billing of the capacity but not the annual cost to the customer. Thus, seasonal rate design is more important now under Order 636.

Fairness. Considerations of equity may support rate ceilings on transportation services, but current policies impose these ceilings at a high cost. Current policy has encouraged development of excess pipeline capacity, but not enough storage, peak shaving, or interruptible loads (em other factors that could lessen seasonal demand on the pipeline system. By raising the ceiling on the release of firm capacity to the level that would occur if there were no offsetting revenues and allowing the ceiling to change on a seasonal basis,

the FERC could encourage more efficiency. t

Ronald C. Denhardt is a principal at Jensen Associates, Inc., a Boston-based energy consulting firm. Mr. Denhardt has over 15 years' experience in the energy industry, focusing on natural gas and electric utility markets. His experience in the natural gas area includes gas-supply contracting, acquisition analysis, risk mitigation, regulatory analysis, and strategic planning. Mr. Denhardt has a BS in Finance from the University of Maryland and an MS in Economics from the University of Wisconsin.

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