In the wake of Federal Energy Regulatory Commission (FERC) Order 636, gas marketing entrepreneurs gained unprecedented opportunities to compete for noncore, industrial loads. That market has matured. Competition is intense, and margins in the noncore market have fallen below 5 cents per thousand cubic feet (Mcf).About a year ago, gas marketers began reaching beyond the noncore market to target core customers (em commercial and residential customers that lack alternate fuel capability and rely on firm service for space heating and other

temperature-sensitive needs. Some states, particularly New

Jersey, have actively encouraged marketing to core customers through regulations mandating 636-style unbundling at the local distribution level. In all cases, the entrepreneurs offer core customers what seems a bargain. Some marketers see today's efforts as the thin end of a wedge that will shatter the local utilities' domination of the core market. One has already trumpeted "the day when unregulated merchants and outraged captive customers smash the rate base and storm the Bastille."2

Marketer access to the core

market is becoming the major

industry issue of the late 1990s, and resolution of this issue may well determine the future of gas utility service. Regulators must, at the very least, look beyond the sales pitch to determine whether entrepreneurial marketing to core customers will provide genuine economic value, or so much smoke and mirrors.

The savings touted by marketers do not arise from superior efficiency or some other positive contribution to economic welfare. Rather, the marketers' alleged benefits depend in large part on false economies rooted in using nonfirm pipeline capacity to supply firm requirements to core customers. Using nonfirm capacity in this way carries grave implications, both for service reliability during severe weather and for the prospect of building needed capacity expansions in the future.

When we hear the marketers' cry to storm the Bastille, we might recall that the first Bastille Day was followed by a five-year Reign of Terror. Caution and careful analysis should stand as watchwords, lest we make decisions that cannot be undone.

The New Regulatory Arbitrage

Marketers do not contribute true economy in serving core market customers. Instead, they offer savings off utility rates by exploiting particular features of the existing rate and tax structures. This exploitation may prove benign if it merely exposes cross subsidies in regulated rates and artificial distinctions in tax policy, but not when it takes advantage of a false economy (em for example, by imposing uncompensated risks on core-market customers. The marketer is then no longer profiting from repackaging components of gas service, but from shifting risk to the utility's core customers.

To understand this phenomenon we must recognize that the utility's firm sales rate features four basic components: 1) gas commodity costs (what is paid to

producers for the gas itself); 2) pipeline costs (what is paid to pipelines for the transmission and storage of the gas); 3) the utility's distribution margin (the utility's own cost of service for its facilities and operations); and 4) in most states, a gross receipts tax surcharge. If one or more of these components is reduced, the gas marketer can assemble a package of unbundled services to undersell the utility.

Note the absence of any component suggesting that utilities and marketers compete, in any material respect, on pure efficiency. The commodity cost is essentially a given, pipeline rates are determined by federal regulators, rates for local distribution fall under the purview of state regulators, and taxes are set by state legislators. Marketers can repackage the components but, almost by definition, do not control them. Ergo, the relative competitiveness of utilities and marketers has little to do with efficiency and much to do with exogenous factors. Consider also that the marketer does not offer any innovative service; instead, the marketer claims to offer the same firm service traditionally provided by utilities (em but at lower cost.

The Price of Pipeline Capacity

The biggest economic opportunity for gas marketers lies in the price of pipeline capacity. The price of reserving 1,000 Mcf of capacity on an interstate pipeline runs between $15-$20 per month, or $180-$240 per year. Let's call it $200 to keep things simple.

For noncore large industrial consumers that operate at a high load factor (say 90 percent), the maximum price of pipeline capacity on a usage basis would be about 60 cents per Mcf ($200, divided by 90 percent of 365). Of course, these consumers generally are interruptible and don't pay peak capacity costs, owing to competition among sellers of nonpeak capacity (which includes gas utilities releasing capacity and pipelines selling interruptible transportation). So, for the large noncore user, the price is much less than 60 cents per Mcf (›/Mcf). In fact, it can be estimated at a third to a half of that amount (20 to 30›/Mcf).

Compare that situation to the core-market commercial class. These customers generally exhibit substantial space-heating re-quirements, which makes them

temperature-sensitive. Load factors may average 50 percent. The price of pipeline capacity is then $1.10/Mcf ($200, divided by 50 percent of 365).

If a marketer can avoid the full price of pipeline capacity, it can substantially undercut the utility's rate for firm service and make a generous profit. Let's say a marketer decides to use nonpeak capacity at 20 to 30›/Mcf. There's an 80- to 90-cent difference between that price and the price of pipeline peak capacity incurred by the utility. Plenty of profit margin there.

In addition, when a utility encounters a monthly instead of a daily balancing requirement, a marketer can profit again by taking advantage of the big difference between the average daily and peak-day loads. For example, in January 1994 the average temperature in PECO Energy Co.'s service territory was 25 degrees, and our average daily load was 380,000 Mcf. On the peak day, January 19, 1994, the temperature was 2 degrees and the load totaled some 598,000 Mcf. Since the average daily load for the month equaled only two-thirds of the peak-day load, a marketer entitled to monthly balancing would have needed capacity for only two-thirds of its customers' true peak-day consumption. The difference would be made up with deliveries on warmer days of the month. Since peak pipeline capacity costs $1.10 per unit, shaving the maximum load by one-third drops the effective price to 73 cents, leaving a comfortable 37-cent profit. No utility can prudently "compete" on this basis because the utility's obligation is to cover the peak-day load (em not the average daily load.

Daily balancing reduces, but does not eliminate, opportunities to "game" the system. For one thing, the balancing requirement generally includes a tolerance band, permitting daily variations of around 10 percent without penalty. The tolerance band effectively becomes a 10-percent allowance for the peak day (em that is, deliveries to the utility can undershoot customer load by as much as 10 percent without penalty. Even if the deliveries fall more than 10 percent short, the penalty for unauthorized takes of utility gas seldom exceeds $25/Mcf. That penalty is small relative to the $200/Mcf cost of peak-day pipeline capacity, making it economic to fall short on capacity and incur the penalty.

These examples illustrate the significant, artificial profits that are potentially available from supplying core customers with less than firm pipeline capacity. Let's examine how this fact relates to the way utilities traditionally have operated.

The Marketing of "Virtual Firm"

Because of the nature of the business, gas utilities hold a very definite notion of "firm." When gas pressure is lost, the affected residences and businesses need to be visited twice: once to shut down the gas equipment, and again to relight the pilots. A widespread failure, particularly in harsh weather conditions, is a nightmare. The logistics of getting to each affected customer twice are daunting; risks and potential liability to missed customers are enormous.

To a gas utility, firm means whatever it takes to avoid this outcome. In the post-636 environment, firm means gas under contract from reliable suppliers and sufficient space reserved in the pipelines to transport that gas from the producing areas to the city gates. It may also mean reserved storage space and utility-owned, peak-shaving resources like liquefied natural gas and propane.

What marketers sell to consumers often is not firm in this traditional sense. The marketers instead rely on released pipeline capacity that can be recalled by the utility (em on a cold day, for example. Listen to what one marketer recently recounted:

"I know at least four guys who were 40-50 MMcf/day in the hole because their transportation got recalled and they had signed peaking contracts to sell gas to several end-users. They were pretty desperate."3Another tactic is called leveraging of firm, in which the aggregate customer peak-day load exceeds the firm capacity under contract. Leveraging of firm capacity can supply some of the customers all the time or all of the customers some of the time, but it can't supply all of the customers all of the time. Marketers may also rely on balancing tolerances and utility-owned gas to cover peak-day

customer load. Finally, they may depend on utility-granted flexibility to reallocate deliveries among customers after the fact as a fallback.

Marketers are, of course, aware that they are "leaning" on the

system to reduce costs and improve margins. That is why marketers protect themselves contractually from liability for failure to provide firm service. A typical "firm" end-user contract makes the marketer liable only for replacement fuel costs. If there is no replacement fuel, the customer may get a "credit" for undelivered volumes (i.e., the customer won't pay for what it didn't get). The marketer will disclaim all other

liability.

In this way, marketers substitute "virtual firm" for real firm. It is undeniably attractive to the customer and the marketer. The customer is paying less for "firm" gas; the marketer is doing very well. So what's wrong with this picture?

How it Shakes Out

One might observe that the gas industry has held up reliably since Order 636, and that the problem of virtual firm is just the complaint of utilities that can't compete. Why worry?

Anomalies need not manifest themselves overnight to create problems. Wellhead price controls were instituted in the 1950s, but curtailment didn't hit until the 1970s. That doesn't mean wellhead price controls were a good idea for the years in between.

The same is true of virtual firm. Right now it is background noise to the trillions of cubic feet that flow. The industry infrastructure that met demand in 1993 was still working in 1994 and in 1995. The pipeline and utility gas-control departments continue to do their job, just as they would if everyone involved in transactions and regulations disappeared from the face of the earth tomorrow.

The day of reckoning is a little further off. The spread of virtual firm will cause utilities to calculate lower peak-day requirements than needed for system supply. New peak-day capacity will not be built. Because design days occur infrequently, the day of reckoning could be years away. But it will come. And when the problem is made manifest there will be no quick fix (em new pipeline capacity cannot be created overnight.

But if the competitive market works elsewhere, why not here?

Good question. There are really two answers. First, the gas industry differs from most other

businesses (except other regulated utilities) in that the product is intrinsically commingled. Consider the gas industry's competitor, heating oil. The risk of nondelivery of heating oil to a consumer is a function of whatever preparation and arrangements the consumer has or has not made. Gas transportation customers can simply take it through the meter (em if they cannot use alternate fuels they will take the gas and there is no way to stop them. Risk is invisibly shifted from marketer customers to the utility's entire system.

Second, we have the political reality. The local gas utility is considered ultimately responsible for gas service. Imagine a scene in which patients are being evacuated from a hospital in sub-zero weather because some marketer had its capacity recalled. Can the utility expect to convince anyone that the shortage is the inevitable consequence of the hospital's unwise selection of a marketer promising lower-cost gas? Those in the utility business know that the competitive market flies out the window in such an emergency. Marketers know it too, and can bank on it.

There is no such thing as a free lunch, and revolutionizing the core market won't be the first exception. Reliability is like oxygen (em you won't miss it until it's gone. t

Stephen Huntoon is assistant general counsel at PECO Energy Co. The author thanks Reed Horting, Jim Marple, Gary Armstrong, Paul Bonney, and Steve Xander of PECO and Dan Regan of the Pennsylvania Gas Association for their insights. The views expressed here are solely those of the author.A Marketer's Play BookBuy Cheap. Buy cheaper, nonpeak pipeline capacity (either released utility capacity or interruptible pipeline transportation) to serve core, commercial firm load.

Shun the Peak. With monthly balancing, reserve capacity only for the average daily load. Ignore the monthly peak; you can make it up with deliveries on the warmer days of the month.

Pay the Fine. Even with daily balancing, if you fall short on the peak day just take extra gas from the utility; the penalty (seldom above $25/Mcf) is cheaper than peak-day pipeline capacity.

Play the Spread. Sell "virtual firm" gas using recallable, release pipeline capacity. If you're caught short, you're liable only for replacement fuel. Or you "credit" you customer for the gas he didn't get.A Defensive StrategyEmploy Remote Shutoff Valves. The utility instantly terminates the flow of gas to the customer, aided by accurate, real-time information from the pipelines. Should insufficient deliveries trigger the valve?

Certify Marketers. The utility qualifies marketers as reliable or not, perhaps risking liability for wrong decisions. But with the more aggressive, risk-taking marketers squeeze out the reliables?

Demand Guarantees. Utilities receive assurances from marketers. Affidavit? Surety bond?

Make Penalties Hurt. Penalize unauthorized takes. Convince marketers to sell real firm service. If the utility disqualifies marketers or customers from its service territory, can it ensure enough capacity to resume firm sales?

Enforce Mandatory Standby. Hold firm pipeline capacity under contract, back-stopping the marketer's service. Eliminate the profit margin in selling "virtual firm."

Maintain Monopoly. Keep control over the core market.

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