Let's hope that by now we all prefer market solutions to government mandates. Markets are generally more efficient and equitable. Recent experiences with deregulation for airlines and telecommunications have vindicated Adam Smith's notion that the "invisible hand" can prove superior to regulation.

Unfortunately, this knowledge offers little comfort today to natural gas pipelines (em even to those companies not saddled with a surplus of transportation capacity.

A Great Start (But Too Cautious)

Congress and the Federal Energy Regulatory Commission (FERC) FERC have made a great start in the deregulation of the energy industry generally, and the natural gas business in particular. Several industry segments are now completely deregulated. The balance of the industry is ripe for similar consideration. The apparent reluctance to extend competitive market principles to the interstate pipelines, even though such reform is warranted and justified, has proved frustrating.

The FERC has moved with excessive caution in some respects. In others, one could even say that it has bolstered regulatory barriers to open markets. This backward step comes in spite of the fact that the FERC has precipitated changes in some cases that break the "regulatory compact" that limits revenues earned by the pipeline industry in exchange for restrictions against would-be competitors.

The FERC broke with that traditional model a number of years ago when it moved the industry through deregulation, including capacity release and segmentation. Today there are major pipeline markets that carry a significant surplus of transportation capacity as a result of such regulatory changes. Because of this excess capacity, the pipelines serving those markets stand exposed to all of the market dynamics of competition, but remain tied to regulation that presumes the opposite. Even those pipelines serving markets with more limited current delivery capacity can take little comfort in their positions, as it is clear that potential competitors (who, in today's market, need not duplicate the pipelines investment in infrastructure) will be allowed freely to enter the market if conditions so warrant.

Other market segments have used the regulatory process as a tool to encourage the FERC either to delay or forego pipeline deregulation. Producers who suffered a drop in prices when wellhead deregulation caused a supply bubble now apparently feel that the pipelines haven't yet sufficiently shared their pain. On the other hand, marketers who built businesses on the arbitrage between unregulated and wellhead-controlled gas felt frustration in the early years with their limited ability to gain access to pipeline capacity as the FERC rewrote the rules, culminating in Order 636. Whatever those past frustrations or beliefs, the reality today is a robust and diverse market.

The energy industry must by now certainly recognize the merit in market solutions. It's time to put this idea to work in the transportation of natural gas. The FERC should direct its energy to pipeline deregulation to the maximum extent permissible under the Natural Gas Act. The Congress should give the FERC added flexibility to finish the job.

Market-Set Rates

(The Ultimate Outcome)

The obvious ultimate outcome is market-based and negotiated rates (plus terms and conditions) in a very competitive market.

In competitive markets, the ability to tailor pricing and services to the particular needs of a customer stimulates innovation and helps ensure that plant is built and used in a timely manner and at a scale that meets market demands. It is highly unlikely that today's regulatory regime for interstate pipelines will accomplish anything like this over time.

While market-based and negotiated rates supply the right answer, the current commission still appears unwilling to make that choice, at least in a single step.

In its recent Notice of Proposed Rulemaking (NOPR) and Pilot Program on the Secondary Market, %n1%n the FERC recognized (though not without division) that there is a logical intermediate step that it can take that will move the industry further along the competitive spectrum (em one that is easy to administer using a few simple tools. That step quite simply is to lift price caps (em on released as well as short-term firm and interruptible pipeline capacity (em price caps that by virtue of the gray market really constrain only the regulated participants. By providing comparable opportunities to pipelines to participate in these markets, the FERC would expand the number of participants or potential participants in every market. In so doing, it would stimulate even more competitive behavior among the participants. This step would help bring the benefits of market pricing to the gas consumer.

Market Power

(Dispelling Perceptions)

In either a fully or partly competitive environment, one of the first questions raised by both the regulators and other market participants will address the perception that pipelines (or other potential participants) may possess the ability in some way to exercise market power. Whether that concern is legitimate or simply an attempt to use the process to limit access, it must still be addressed (em and in a straightforward way.

In general, economists have used three approaches to evaluate market power: 1) ease of entry into the market, 2) market concentration, and 3) price behavior. These three principles can all be of use to the FERC in a multi-layer screening process designed to limit the need to hold full-blown hearings in any particular case. In simple terms, if a pipeline (or other participant about which the commission may have concerns) can demonstrate that it can pass any of these three preliminary screening tests it should be allowed to participate fully, without the need to go any further. In its NOPR and Pilot Program, the FERC also noted concern about local distribution companies that do not have open access. That issue, however, while important, goes beyond the scope of this article.

Ease of Entry

(Proof of Competition)

Ease of entry marks the classic approach to market power. To illustrate, the FERC's new policy statement on alternatives to traditional cost-of-service ratemaking %n2%n correctly notes that a "company with a large market share may not be able to exert market power if entry into the market is easy or there are other competitive forces at work."

While the argument is often made that pipelines are "natural monopolies" because of the high cost of market entry, nothing could be further from the truth, as has been demonstrated in market after market as surplus capacity has been created at the expense of the traditional market participants.

The presence of excess capacity in any market means that barriers to entry are not significant. All a potential entrant needs to do to get into the secondary capacity business is contract for firm capacity or released capacity and then start to resell it. Hence, even on pipelines with fully-subscribed primary firm, excess capacity can be generated through release and segmentation.

In this situation, should a pipeline attempt to price interruptible or short-term firm above a sustainable market price, any other party could simply buy available firm capacity at cost-based rates or released capacity from another shipper and release it at market rates. This "ease" of entry is an effective tool to discipline the markets and should serve as a prima facie proof of the market's competitiveness.

Market Concentration

(Beyond the Obvious)

While it is far from perfect, the Herfindahl-Hirshman Index analysis used by the Department of Justice (DOJ) and Federal Trade Commission (FTC) in their Horizontal Merger Guidelines %n3%n is a familiar tool that could be used in a preliminary screening process to measure the market power of natural gas pipelines. The underlying theory behind this tool is that the larger the number of sellers in a market, and the smaller the market share, the less likely it is that any player or group of players can dominate the market and set prices.

To use this tool most effectively, however, care must be taken to consider not only the obvious sources of competition on a single pipeline, but competition from other sources, including other fuel sources. For screening purposes, however, this may prove too complex. Instead, one could simply analyze the fragmentation of capacity at any particular delivery point on the pipeline. In doing so, the fact that downstream capacity holders have secondary rights to upstream delivery points, as well as holders within tariff zones, is a key aspect of secondary market competition that must be taken into account.

Price Convergence

(No Openings for Arbitrage)

Market power is about a seller or a group of sellers, and whether they can raise prices beyond what a free market would support over time. The FTC-DOJ guidelines note that a firm possesses market power if it can "profitably maintain prices above competitive levels for a significant period of time." Few if any pipelines would fail a preliminary screen based upon ease of entry or market concentration in all of their markets. In fact, most would pass both tests in many of their markets. Where that is the case, the movement of prices between those clearly competitive market points and those that are less clear can be analyzed on the basis of price convergence.

Economic theory says that if a geographically dispersed market is competitive, prices at different points on the network will be linked. Variations across different points in the network will simply reflect transportation and transaction costs. If this relationship exists between clearly competitive and linked markets, then both markets can be deemed to be competitive and free of market power.

Price convergence analysis uses a network arbitrage model that sees the gas market as a grid of interconnected trading points. If the network is competitive, then when a local condition causes prices to rise in a particular market, arbitragers will divert supply to that market. Prices across the network will converge within limits set by transaction costs.

The Time Has Come

The time has come to start deregulation of natural gas transportation and deregulation of secondary markets marks the next logical step in the process.

Granted, some obvious issues remain to be addressed, but the simple screening process described here should allow a significant increase in the number of market participants (em and will do so without the need for lengthy and expensive regulatory proceedings. t

Keith E. Bailey is president and CEO of The Williams Companies, Inc., which consists of one of the nation's largest-volume systems of interstate natural gas pipelines, and is a leading energy marketing and trading company. Bailey joined Williams in 1973, and served as president of two of its major subsidiaries and as the senior vice president of finance and chief financial officer of the corporate parent. He was elected to the Board of Directors in 1988, and became president of Williams on Jan. 1, 1992. Bailey also is a member of the Interstate Natural Gas Association of America's executive committee and chairman of the Secondary Market Taskforce.

1Secondary Market Transactions on Interstate Nat. Gas Pipelines, FERC Dkt. Nos. RM96-14-000, July 31, 1996, at 61 Fed.Reg. 41,046, Aug. 7, 1996.

274 FERC para. 61,076, clarified, 74 FERC para. 61,194, rehearing denied, clarified, 75 FERC para. 61,024 (1996) pet. for review pending sub. nom. Meridian Oil v. FERC, D.C. Cir. Nos. 96-1160, et. al. (Filed May 14, 1996).

357 Fed.Reg. 41,552 (1992).

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