Retail Gas Reform: Learning from the Georgia Model

Fortnightly Magazine - April 15 1997

New legislation would tackle the most difficult problem (em low load factors for small-volume customers.

We commend the Natural Gas Competition and Deregulation Act, SB 215, passed by the Georgia General Assembly in March. (Governor Zell Miller was expected to sign the bill in April.) The Georgia legislation envisions a new framework for regulating the retail gas market. In the broad sense, the Georgia plan eschews experimental pilots in favor of creating a new industry structure that is amenable to competition, and a new regulatory scheme to be administered by the Georgia Public Service Commission. The Georgia reforms can, and should, serve as a model for gas retail reform legislation in all states.

Over the past decade, the Federal Energy Regulatory Commission's restructuring of the wholesale gas market has produced enormous gains to consumers and to the performance of the U.S. economy. By unbundling the competitive from noncompetitive wholesale functions and by subjecting the structurally competitive functions to the discipline of the market, the FERC has reduced costs, improved quality, spurred innovation and increased the menu of alternatives available to purchasers. %n1%n

Wholesale gas prices have declined by 52 percent. Service reliability has improved. Moreover, every function affected by competition (em exploration, production, wholesale trade, pipeline transportation, and storage (em has seen significant, efficiency-enhancing innovations that have improved the price-quality relationship and increased the range of service options available to wholesale purchasers.

Nevertheless, the natural gas revolution is not yet complete. The retail market remains relatively untouched. Additional gains are available by extending the reforms to the retail level. Any effective reform of retail gas markets should include at least three public policy goals: 1) greater access for small customers, 2) broader service options for consumers, and 3) more incentives for entrepreneurs.

Untapped Areas

Generally speaking, small-volume consumers have yet to reap the full benefits from the competitive market. That deficiency should be erased. The combination of wholesale competition, bypass and local distribution company responses to threats of bypass has produced an environment in which most large consumers can take full advantage of competition. But while large consumers can choose among suppliers and have experienced a 60 percent decline in the prices they pay, small consumers have obtained proportionately smaller gains. Few have gained access to multiple alternative suppliers. The prices they pay have declined only 32 percent to 38 percent. First, therefore, small consumers should have access to competition now available to large consumers.

Second, market reforms should broaden the service options available to consumers. The range of service options available at the retail level remains extremely narrow. Traditional command-and-control, cost-of-service regulation of a franchised monopolist tends to produce a one-size-fits-all approach. Consumers would refuse to tolerate this service in any other market and should not be forced to tolerate it in the gas market.

Third, any worthwhile reform should unleash the entrepreneurs willing to pursue a new vision of the future. Regulated monopoly retards the rate of technological and entrepreneurial innovation. Every restructured market that permits market forces to play a greater role has experienced immediate, substantial and continuous innovation. Reform of the retail gas market would yield analogous socially beneficial results. The timing of retail gas market reform could not be better. Present trends toward convergence of the gas, electricity and telecommunications markets, combined with the rapid technological innovation in all three of those markets provide exciting opportunities for entrepreneurs. Advances in these fields of information technology and risk management also will aid in this evolution.

Once these three goals are set, however, a successful reform plan must accomplish four specific tasks: 1) unbundle structurally competitive functions from natural monopoly functions; 2) create the conditions necessary for effective competition; 3) make small consumers more desirable targets for competitive service providers; and 4) replace cost-of-service regulation of natural monopoly functions with performance-based regulation.

Functional Unbundling and Marketing Affiliates

The first step in any reform initiative is to distinguish monopoly functions from those that can be performed in a structurally competitive retail market. A good first approximation in drawing the line between competitive and noncompetitive functions is to distinguish between merchant functions and physical distribution functions. The Georgia plan goes

further by including an innovative feature that can render even some physical distribution functions susceptible to effective competition. This feature of the plan also makes small consumers more attractive to competitive service providers.

Simple unbundling, however, is not enough. Many LDCs have formed affiliated marketing companies. To reap the full benefits of a competitive market, care must be taken to avoid both sources of bias in favor of an LDC's marketing affiliate and against such an affiliate. The Georgia legislation accomplishes both purposes well. It includes the by-now familiar cluster of rules severely limiting transactions and communications between an LDC and its marketing affiliate to preclude LDCs from conferring unfair advantages on their marketing affiliates. It also includes several less familiar provisions that address effectively the equally important sources of potential bias against an LDC's marketing affiliate.

These features eliminate the risk that LDCs or their marketing affiliates will be uniquely burdened with the costs associated with a supplier-of-last-resort role, e.g., the obligation to serve customers who are high credit risks and customers who elect to buy from marketers who default. The legislation has three features that address this problem: 1) Marketers must go through a state certification process that reduces the risk of marketer default; 2) Customers who do not elect a marketer are randomly assigned to each marketer in proportion to its market share; and 3) A Universal Service Fund that provides compensation to marketers for uncollectible accounts.

The Small-Customer Problem

Small consumers have not yet been able to obtain the full benefits of competition. States have not yet allowed most small consumers access to competitive alternatives and, as the Supreme Court has recognized, %n2%n small consumers are not very attractive to gas marketers. Because small consumers individually purchase small quantities of gas at low load factors, marketing efforts targeted at small consumers tend to generate low revenues relative to the costs of attracting and serving them.

The Georgia plan responds to this obstacle to competition in an innovative way. It authorizes marketers to aggregate the firm distribution capacity necessary to serve each small consumer who elects to purchase from the marketer and resell the unused firm capacity as interruptible capacity. This clever mechanism transforms a characteristic of small consumers that is usually considered a liability (em their low load factor (em into a major advantage from the perspective of a marketer.

Under the Georgia Plan, for each small customer the marketer can attract, the marketer will secure two sources of revenue: 1) the proceeds of the gas sale to the small customer, and 2) the revenues from the resale of firm distribution capacity not used by the customer. This innovative feature of the Georgia plan also will benefit large consumers by providing access to multiple competing suppliers of interruptible distribution service and deregulating the interruptible distribution function once consumers have access to competitive alternatives. Improving the LDC's system load factor by increasing the volume of interruptible sales also is likely.

The Georgia plan recognizes that most retail distribution functions must remain subject to state regulation as a natural monopoly. It also recognizes, however, that traditional cost-of-service regulation should be replaced with performance-based regulation. Cost-of-service regulation creates inadequate incentives to perform in an efficient manner. Moreover, cost-of-service regulation is far too slow and static to coexist with the dynamic competitive markets that increasingly govern other functions which must be performed to provide gas service at the burnertip. %n3%n

Any gas retail reform plan must include replacement of cost-of-service regulation with performance-based regulation to have any realistic chance of attaining beneficial results. The Georgia plan authorizes the PSC to start performance-based regulation of all noncompetitive distribution functions and sets forth the criteria the PSC should use while crafting performance-based rates.

The Quickest Road

to Benefits

Adoption of a retail reform plan of the type under consideration in Georgia should yield some benefits as reduced prices. We anticipate that small consumers can expect price reductions in the order of 10 percent because of the enhanced incentives for efficiency created by the introduction of competition to govern some functions and performance-based regulation to govern other functions.

The biggest gains from such a reform likely will appear in two other areas. First, the menu of service options available to consumers likely will expand significantly. Each consumer could choose which of the many options best meets his or her needs. Second, the service options made available will include some that we cannot even imagine today but that consumers will find far preferable to the plain vanilla, one-size-fits-all traditional form of retail gas service. Once the regulatory barriers to technological and entrepreneurial innovation are removed, we are confident that some firms will design wholly new and better ways of competing to satisfy consumer needs.

Most states are delaying retail gas reform to await the results of various small scale "pilot programs." Such delay imposes unjustifiable costs on consumers. We already have access to the results of a decade of full-scale retail reform in Canada. %n4%n That experience provides data far more reliable than we can expect to get from small scale pilot programs. Pilot programs are too small, too short and subject to too many artificial conditions to provide data that we can rely on as the basis for predicting the performance of a comprehensive retail reform plan. %n5%n Retail reform will begin to produce significant consumer benefits immediately. There is simply no reason to make consumers' wait for these benefits. t

George Hall is a managing director of Putnam, Hayes & Bartlett in Washington, D.C. Richard Pierce is Lyle T. Alverson professor of law at George Washington University.

At a Glance: Georgia's Gas Restructuring Proposal

Various features would encourage retail competition

SB 215 includes a number of features that would encourage the development of competition in Georgia's retail natural gas markets and market-based, cost-reduction regulatory incentives. Among other features, SB 215 would:

• Permit companies that operate gas pipelines or distribution systems to file rates using an "alternative" form of regulation, which includes, among other innovative systems, performance-based ratemaking (PBR). (See, SB 215, proposing the "Natural Gas Competition and Deregulation Act," Section 2 [p. 2], adding Code Section 46-2-23.1);

• Allow gas marketers to make retail sales within the service territory of a gas company. (SB 215, Section 3 [p. 8], adding Article 5, 46-4-153);

• Permit gas marketers to "use intrastate capacity available to it from a gas company to provide interruptible distribution services when not required by the marketer to provide firm distribution service." (SB 215, Section 3 [p. 9], adding Article 5, 46-4-153(a)(4));

Encourage gas companies (operators of pipelines or distribution systems) to unbundle their services and to establish separate rates for each service, thereby becoming an "electing distribution company." (SB 215, Section 3 [pp. 11-121, adding Article 5, 46-4-154(a)(1) and 464-154(c));

• Encourage electing distribution companies to develop methodologies for allocating their intrastate capacity and interstate pipeline rights and storage to gas marketers. (SB 215, Section 3 [p. 12], adding Article 5, 46-4-154(c));

• Provide a framework for determining whether competition exists in the provision of ancillary services to gas marketers and for pricing ancillary services until competition is developed. (SB 215, Section 3 [pp. 13-14~, adding Article 5, 46-4-155(a)-(c));

• Set forth a framework for determining when effective competition exists for distribution service, and providing for electing distribution company rate deregulation and removal of the distribution company's obligation to serve upon that determination. (SB 215, Section 3 [pp. 15-16], adding Article 5, 464-1 56);

• Provide strict limitations on the relationship between an electing distribution company and an unregulated marketing affiliate. (SB 215, Section 3 [pp. 19204], adding Article 5, 46-4-158);

• Provide for a Universal Service Fund to cover uncollectible accounts and contributions in aid of construction. (SB 215, Section 3 [pp. 24-26], adding Article 5, 46-4-162);

• Provide for random assignment of customers who do not designate a supplier. (SB 215, Section 46-4-156 (e)).

Residential Pilot Programs and Unbundling Initiatives

Six local distribution companies in four states start residential natural gas pilot programs this year nationwide, joining LDCs in eight other states. Overall, more than 12 million homes will have a choice of gas suppliers by 2000. That's more than 20 percent of the total number of residential customers in the U.S. Potential demand is 1,121 Bcf, about 23 percent of 1995 residential consumption.

POTENTIAL # POTENTIAL IN-SERVICE

STATE COMPANY OF HOMES DEMAND (Bcf) DATE PROGRAM NAME

California Pacific Gas & Electric 3,300,000 198 Gas

Accord

Southern California Gas 450,000 27 In Service

Georgia Atlanta Gas Light 1,215,000 138.9

Illinois Central Illinois Light Co. 10,000 1.3 10/96 Therm

Quest

Indiana Northern Indiana Public Service 20,000 2.3

Alternative Regulatory Plan

Iowa MidAmerican Energy 875 .1 Terminated Rock

Valley

Maine Northern Utilities 15,000 .9 11/99

Maryland Columbia Gas 10,000 .9 In Service Columbia

CHOICE

Washington Gas 6,000 .5 11/96 Maryland

Residential Delivery

Service

Pilot Program

Massachusetts Bay State Gas 10,000 1.0 In Service Pioneer

Valley Customer Choice

Boston Gas 475,000 45.6 11/97-2000

Michigan Battle Creek Gas 1,000 .1 4/97 Battle

Creek Option Plus

Consumers Power 40,000 5.4 4/97

Michigan Consolidated Gas 47,000 6.4 4/97

Montana Montana Power 115,000 12.3 By 2001

New Jersey New Jersey Natural Gas 30,000 3.1 By 1999 Natural

Choices

Public Service Electric & Gas 60-65,000 6.4 Select

Gas

South Jersey Gas 2,500 .3 Early 1997

New York Throughout the state 4,040,000 398.7 In Service

Ohio Columbia Gas of Ohio 1,150,000 141.7 4/97 Columbia

CHOICE

East Ohio Gas 1,025,000 126.3 4/98

Pennsylvania Columbia Gas 20,000 2.3 In Service Columbia

CHOICE

Equitable Gas 3,800 .4 11/96 Pleasant

Hills

Wisconsin Wisconsin Gas 1,000 .1 11/96 Gas

Advantage

Wyoming KN Energy 9,000 .9 In Service Choice

Gas Service

TOTAL 12,058,675 1,120.9

*

Source: American Gas Association, Arlington, Va.

1See Robert Crandall & Jerry Ellig, Economic Deregulation and Consumer Choice 9-17 (1997).

2 See General Motors Corp. v. Tracy, 65 U.S.L.W. 4086, 4093 (1997).

3See Richard Pierce, Regulation and Competition in Natural Gas Distribution 42-55 (1990).

4 See Kevin Costello & J. Rodney Lemon, Unbundling the Retail Gas Market: Current Activities and Guidance for Serving Residential and Small Consumers, National Regulatory Research Institute (1996).

5See J. Schuler, "Residential Pilot Programs: Who's Doing, Who's Dealing?" PUBLIC UTILITIES FORTNIGHTLY, p. 16 (Jan. 1, 1997); J. Schuler, "A Round Robin of Residential Unbundling," PUBLIC UTILITIES. FORTNIGHTLY, p. 25 (Oct. 15, 1996); "Wyoming: No Choice Without Competition," PUBLIC UTILITIES. FORTNIGHTLY, p. 27 (Oct. 15, 1996).


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