Gas pipeline reform is looming on the horizon like the stealth bomber. It faded from view a couple years ago, when the Federal Energy Regulatory Commission (FERC) completed Order 636 and turned to electric issues. Yet gas reforms are more pressing: They began earlier, their direction is clearer, and their completion is closer at hand. In fact, without a more price-responsive market for gas transportation, we cannot fashion an efficient and integrated energy industry. Electric restructuring, too, could fall short of its full potential.
New Players, New Theories
Deregulation in natural gas has created many new players, such as marketers, brokers, and service providers that offer natural gas balancing, price hedging, and storage capabilities. In this new environment, shippers have gained opportunities to tailor services to their needs.
As shippers and pipelines become accustomed to a more competitive market, regulators are responding. At the federal level, regulatory reform has included both market-based rates and incentive-based ratemaking. Some interstate oil pipelines are regulated today with this combination. In markets that have been declared workably competitive, the FERC has allowed oil pipelines to set their prices according to market. At the same time, however, the FERC maintained oversight by requiring shippers and pipelines to submit periodic reports to ensure the market remains competitive. In markets found not to be workably competitive, the FERC has turned to rate regulation, either by cost-of-service or by incentive-based ratemaking, limiting future rate increases to the average change in competitive markets.
Following its policy for oil pipelines, the FERC has recently requested comments on alternative pricing methods for natural gas pipelines. The FERC seeks to develop a framework for analyzing alternatives to traditional cost-of-service ratemaking proposals. While the request focuses on market-based rates, the FERC has in a previous rulemaking outlined policy objectives for incentive-based ratemaking.
True reform will not come piecemeal. It will cover all pipeline services. Otherwise, reform proposals will fail. The market for natural gas services consists of many different offerings that interact in complex ways. These services create a market that is extremely competitive in some respects and monopolistic in others. For example, firm transmission during certain times of the year may best be provided by a regulated monopolist. However, that same pipeline during its shoulder or nonpeak months may face extensive competition from capacity release.
Nevertheless, regulators should not act with too much caution. Efforts to blunt pipeline market power may actually impede competitive behavior. Natural gas storage provides a good example. In some situations, storage competes with firm transmission for seasonal peak and even daily peak loads. Storage markets are generally competitive, and there market-based rates are appropriate. Storage providers will set their rates and terms to compete with firm transmission services. But pipelines ought to be able to adjust their rates, terms, and conditions of service in response to competitive storage operations. Without this bilateral market activity, the full economic benefits of competition will not emerge. The situation becomes more complex when a pipeline also operates storage facilities. Any regulatory reform proposal must be robust enough to enhance competition while preventing abuses of market power.
Incentive Ratemaking with Market Pricing
When set up properly, market pricing can combine with incentive ratemaking to improve economic efficiency and provide necessary safeguards against market-power abuse in the gas pipeline industry. In open markets, competition spurs cost-cutting and innovation. Such competition will only increase as energy markets become more integrated in the future. Oil, natural gas, electricity, and other fuels such as propane and liquid petroleum gas will compete against one another. This competition will benefit customers that can switch fuels and seize price swings; other customers will also benefit from the associated downward pressure on prices.
But not all markets are competitive enough to allow for market rates. Pipelines in these markets still need the ability to compete, and it is good regulatory policy to allow them to do so. But the purpose of regulating pipelines is to prevent market power abuses, not to eliminate potential service providers in portions of a regulated marketplace where competition is possible. That is where incentive-based ratemaking offers an advantage.
Under cost-of-service regulation, where rate changes play a zero-sum game, the interests of shipper and shareholder are diametrically opposed. Incentive ratemaking can help realign shipper and shareholder interests. As applied to the interstate natural gas pipeline, incentive ratemaking should come with two pieces, working hand and glove. The first grants pipelines and shippers the ability to negotiate rates and terms of service. This negotiation process allows parties to search for ways to add value. For example, a pipeline might provide the right shade of "firmness" for a shipper who does not need firm capacity but is also not satisfied with interruptible service.
The second piece takes the form of a recourse (default) rate based initially on a FERC-approved
cost-of-service tariff. In future years the initial tariff is indexed to inflation minus a productivity factor, which shares efficiency improvements between shippers and shareholders. This recourse rate mechanism gives shippers leverage over the pipeline: If the pipeline and an individual shipper cannot agree on a specific flexible rate and service terms, the shipper can always select the recourse rate with its fixed terms of service.
Customers may or may not see lower rates. But they will see "better" rates.
Market Power Abuses
The FERC may raise legitimate concerns about the potential abuse of market power. First, markets must be characterized correctly to determine whether market-based rates are even appropriate. The merger guidelines developed by the Depart-ment of Justice and the Federal Communications Commission, which the FERC has relied upon extensively, offers an appropriate framework for making this determination. However, no evidentiary showing should be applied in a mechanistic fashion; the market for pipeline services is too complex.
In addition, the FERC should remain skeptical that market-based rates will yield just and reasonable rates. The FERC should maintain its regulatory oversight while approving market pricing. In the past, the FERC has proposed rates on an experimental basis. It may also insist shippers sign statements that the negotiated rate was preferred to the recourse rate and not paid as a consequence of market power. And both shippers and FERC staff, under the Natural Gas Act, can initiate a Section 5 proceeding if they believe pipeline rates are not just and reasonable.
Affiliate self-dealing marks another area of potential abuse. Restrictions on affiliate self-dealing, such as requiring pipelines to post their deals with affiliates or offer the same deal to other shippers, provide means to address this potential problem. Incentive-based rates reduce the attractiveness of passing costs on to captive shippers: Under an indexed tariff, the pipeline does not collect the additional costs associated with a sweetheart deal.
The Next Wave
Market reform will not stop with interstate pipelines. It must also embrace intrastate pipelines, local distribution companies, and combination electric and gas utilities. Those companies and states resistant to market pricing will squander efficiency gains (em while only delaying the inevitable. Addressing this issue on a state and distribution level should not distract from electric reform. Rather, it will complement electric reform by helping regulators, consumers, and utilities to integrate energy markets. t
Scott Jones is CEO and Frank Felder is senior analyst with the Economics Resource Group, Inc., a consulting firm based in Cambridge, MA.
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