An economic perspective on long-term contracting for gas pipeline service.
Kenneth W. Costello is the senior institute economist at the National Regulatory Research Institute. He may be reached at 614-292-2831, or by e-mail at Costello.firstname.lastname@example.org.
Predictably, pipelines and other industry stakeholders are among the biggest supporters of long-term contracting for pipeline services, as they try to make life easier for themselves.1 In its 2003 natural gas study Balancing Natural Gas Policy— Fueling the Demands of a Growing Economy, the National Petroleum Council (NPC), mainly an industry group, argues that long-term contracts are essential for stimulating adequate investments in gas pipelines needed to meet future natural gas demand. The study points out that 75 percent of pipeline contracts, which are mostly long term, will expire by the end of 2008. NPC is predicting that new contracts will be much shorter in duration, to a large extent the result of state commission policies that allegedly frown upon long-term contracts. The NPC calls for state regulators to reassess the environment that they have created through their past actions and policies (which the NPC characterized as “regulatory barriers”)—namely, one where gas utilities are reluctant to sign long-term contracts because of the fear that they will be financially penalized if events turn out unfavorably.
Last year’s study, An Updated Assessment of Pipeline and Storage Infrastructure for the North American Gas Market, funded by the Interstate Natural Gas Association of America (INGAA) Foundation, echoes the NPC concerns. The study mirrors the views of pipelines in Federal Energy Regulatory Commission (FERC) proceedings and other forums, specifically recommending that state commissions reassess their policies that “discourage [gas utilities] from entering into long-term capacity contracts for transportation and storage that are necessary to underpin new infrastructure projects.” These policies pertain to retroactive prudence reviews and support for “increasing the competitiveness of third-party marketers.” The study also argues that long-term contracts can help to compensate pipelines for being precluded from capturing the market value of transportation in their rates during peak periods. (Pipelines, for a number of years, have argued before FERC that they are forced by market pressures to discount prices below tariff levels during off-peak periods.)
The study faults FERC for not recognizing the risks that pipelines face from the dearth of long-term contracts when setting a rate of return. The study correctly observes that shippers, whether regulated entities or not, have been less willing to commit themselves to long-term contracts. But the serious problem, as articulated in the study, is that the reluctance of shippers to sign long-term contracts significantly will stifle support for new pipeline projects.
FERC has come down on the issue by expressing, at least in one report (State of the Markets Report) that long-term contracting is crucial in evoking additional pipeline capacity. The same report acknowledges that gas utilities rationally are responding to market conditions by not committing to long-term pipeline capacity because, for example, of the uncertainty caused by retail unbundling. The report also stated that “pipeline investment appeared to be appropriate given basis signals.”
Over the years, FERC policy has evolved to where it now does not require shipper commitment in certifying new pipeline facilities. In its 1999 Certificate Policy Statement, FERC required that an applicant demonstrate that public benefits exceed adverse effects, in addition to showing that new pipeline capacity can be financially supported without relying on subsidization from existing customers (emphasis added). Showing market demand for the new capacity, in the absence of long-term contracts with shippers, can suffice as a means to receive FERC approval.
Of course, long-term contracts with shippers for a significant portion of new capacity would indisputably demonstrate the need for new capacity; but it is not a requisite for receiving certification. One important indicator of demand, recognized by FERC, is the basis differential between market centers/hubs (specifically, basis differentials in excess of long-run marginal cost would signal the commercial viability of additional pipeline capacity).
As an aside, as long as adequate pipeline capacity is available in a region, the tendency of shippers would be to transact on a shorter-term basis for nonfirm capacity (for interruptible service, as an example, the shipper could avoid paying demand charges). When regional capacity starts to tighten, however, the same shippers would be more willing to go longer term, as well as to sign up for firm service, in their pipeline capacity purchases. This would signal to pipelines that additional capacity is required.
A 2002 Keystone Center report, Expanding Natural Gas Pipeline Infrastructure to Meet the Growing Demand for Cleaner Power, summarizing a policy dialogue among industry stakeholders and policymakers (including gas pipelines), concluded that “participants found that FERC’s current policy on the certification of new interstate natural gas pipeline facilities provides an appropriate balance between, on the one hand, regulatory oversight to protect against the adverse consequences of overbuilding and, on the other, market-oriented philosophies that will allow the infrastructure to grow with the market” (emphasis added).
The report also says “FERC’s policy statement [on certification of new pipeline facilities] provides a number of incentives for pipelines to plan for and construct the optimal level of capacity.” In other words, the consensus was that FERC’s certification criteria seem to pose no special barrier in expanding economically-justified pipeline capacity.
The collective arguments of supporters of long-term contracting can be summarized as follows:
• Unless we see more long-term contracting, new investments in pipeline capacity will be deficient. Specifically, as pipelines have become susceptible to higher market risk, they may be prevented from receiving the necessary financing from Wall Street. Especially with the “turnback” of large amounts of capacity under expired contracts, pipelines have argued that the trend toward shorter-term contracts will become even more pronounced in the future.
• Regulatory uncertainty at the state level discourages gas utilities from signing long-term contracts. The threat of hindsight review imposes the risk of stranded costs that would tend to shift utilities’ preference toward shorter-term transactions.
• State commissions should recognize the importance of long-term contracts in a local gas utility’s supply and transportation portfolio.
• FERC’s pricing practices artificially have inflated shorter-term transactions by shippers. For example, pipelines have argued that market forces require them to discount rates below tariff levels for released capacity and short-term and interruptible service, while longer-term transactions largely are priced on the basis of rigid cost-of-service principles.
• More than anything, regulation can be blamed for the deficiency of long-term contracts, which in the long run may jeopardize the expansion of sufficient new pipeline capacity to meet future gas demand.
The Economics of Long-Term Contracting
There are three distinct categories of transactions: spot, longer-term contracts, and internal organization. The last occurs when a firm is vertically integrated and looks to itself rather than the market for purchases of required inputs. Spot transactions are extremely short-term transactions where prices are determined by short-run supply and demand. Spot transactions provide flexibility to the buyer in balancing supply with demand. Long-term contracting represents what can be viewed as an “in-between” transaction, where the seller and buyer rely on the market, but they desire more certainty in price and other attributes of a trading arrangement than contained in a spot-market transaction. (Spot markets also require repeated trading, which over time can drive up transaction costs, discussed below.) Contracting has several dimensions that are negotiated between the buyer and seller, with the outcome largely dependent on market conditions, which include predictability of the future and the relative bargaining strength of each party.
What we have found across a wide spectrum of industries is that long-term contracting becomes the predominant form of governance for large investments with limited alternative use. Under this specific condition, long-term contracts may be needed to protect the financial interest of investors by mitigating intolerable risk.
As an illustration, let us assume that a factory’s production line is designed to produce customized widgets for a single customer. The factory manager likely would require a long-term contract with provisions that protects the factory’s financial interest in the event that the customer decides either not to buy at all or only continues buying if a low price is offered. The economic reason for a long-term contract lies with the factory expending large sums of dollars to design its production line to provide the kinds of widgets that the customer desires. Such relationship-specific investments usually require contracts of a long duration. Both economic theory and real-world observations support this trade governance.
Another way of describing this, in the arcane jargon of economists, is that the condition of imminent opportunistic behavior in the presence of expensive specialized assets is highly conducive to long-term contracting or, under extreme conditions, vertical integration. The absence of long-term contracting can then lead to under-investments. These are the basic arguments being advanced by pipelines in lamenting the erosion of long-term contracts in recent years.
Economic theory supports the idea that transaction costs are crucial for shaping the institutional arrangements for the exchange of goods and services. According to transaction cost theory, which category of trading arrangement (spot, longer-term contracting, vertical integration) is consummated depends on the attributes of a transaction. For example, when asset specificity, sunk costs, and a high degree of complexity characterize the trading environment, vertical integration may be most economical. (This would be especially true with the presence of high transaction costs from coordinating, synchronizing, and harmonizing different complicated processes through market arrangements.)
In the case of contracts, transaction costs originate from:
(1) search and information acquisition;
(2) initial negotiation;
(5) haggling at contract renewal; and
(6) deviation of evolving market conditions from contract terms and conditions.
When these costs are high relative to the transaction costs of spot transactions and vertical integration, contracting becomes untenable. In terms of the optimal duration of a contract, two opposing forces come into play. The first, favoring longer-term contracts, pertains to the cost of negotiating terms of trade on a period-by-period basis (for example, annually, or even more frequently as in the case of a spot transaction), which other things held constant, would drive up transaction costs over time. The second, causing longer-term contracts to be less attractive, relates to the risk of being constrained under an inflexible arrangement over a longer period of time. The main problem here is that this rigidity could be highly costly in an uncertain market environment and could lead to the shipper being stuck with overpriced gas to sell.
The Context: The Current Gas Pipeline Sector
Long-term contracting is a legacy of the pre-1980s natural gas industry. Contracts were generally for 20 to 30 years, at fixed prices, for both producer-pipeline transactions (take-or-pay contracts) and pipeline-local gas utility transactions (minimum-bill service agreements). The unraveling of long-term contracting, especially with rigid terms and conditions, coincided with the restructuring of the natural gas industry in the early 1980s, with wellhead price liberalization and major FERC actions opening up wholesale gas markets. In fact, a major impetus for restructuring of the natural gas industry was the high social cost associated with rigid long-term contractual arrangements that became more evident as the industry transitioned to a more liberalized structure.
With the natural-gas sector restructuring from a highly regulated industry to a much more market-oriented one, trading arrangements have become much more short term and flexible in both price and in terms and conditions. We have observed this phenomenon throughout the natural-gas sector, from gas procurement, gas storage, and retail transactions, to capacity contracting for pipeline services.
The primary force behind this broad reshaping of trading arrangements lies with simple economics. For example, retail consumers now have more choices of suppliers and gas utilities face more uncertainty over future prices and their load requirements. As gas utilities downsize the bundled-sales-service side of their business, they will invariably have less demand for long-term pipeline capacity. Overall, competitive pressures have made long-term commitments a more expensive proposition for gas utilities as well as other shippers by increasing risk.
The pronounced trend away from long-term contracting during the past 20 years is the result of the natural-gas industry becoming more open and competitive. The shifting of trade toward shorter-term arrangements, for both gas supplies and transportation, is compatible with the dramatic change in the market environment that has occurred over this period of time. In line with transaction-cost economics, these changes have lowered the relative transaction costs of shorter-term trading arrangements. In other words, the market participants are acting rationally in preferring shorter-term transactions as the natural-gas market environment has evolved.
Although many shippers, especially local gas utilities, generally prefer multi-year contracts for firm gas transportation, they also have opted for shorter-term and more flexible arrangements. These transactions make it easier for a shipper to vary its take in adapting to changed conditions in the absence of irreversible commitments. The evolution of market centers and hubs has expanded the market services by providing shippers with greater gas supply and transportation choices.
Price basis differentials (for example, the difference between gas prices at two market hubs located in different regions) and perceived demand are the driving forces for pipeline capacity expansion. In the past several years, most local gas utilities have procured a portfolio of pipeline arrangements. Many non-utility shippers, such as marketers and large gas consumers, have preferred shorter-term arrangements strictly for economic reasons. (For example, electric generators selling power without long-term commitments from its buyers would be hard pressed to economically justify signing a long-term contract with a pipeline.) Overall, emphasis has shifted toward shorter-term transactions and flexible arrangements with regard to the amount of pipeline capacity reserved, as well as the duration of contracts.
Trying to Make Sense of This
The evolution of the natural-gas market has made long-term contracting for pipeline services less attractive for shippers, whether local gas utilities, marketers, or large gas consumers. Shorter-term transactions have become the economically preferred arrangement for transacting gas pipeline services in addition to transactions for the gas itself and other industry services that have become more competitive over time. Local gas utilities see the risks associated with long-term contracts with inflexible terms and conditions, particularly when they endure beyond their planning horizons, which have shortened in recent years.
As they often do, local gas utilities have long-term contracts with pipelines, but they generally prefer a portfolio of pipeline arrangements that gives them more flexibility in adapting to changing market conditions. In FERC Docket No. RM98-10-011, when discussing the matching-term cap under the right-of-first-refusal mechanism, the American Gas Association (AGA) argues that long-term (beyond 5 years) agreements with pipelines “may expose the [gas utility] and, ultimately, the end-use consumer, to investments for capacity commitments beyond needs specifically identified simply because a lengthier contract term would be required in order to secure supply in the short term.” AGA goes on to say that a “lengthy contract” could force a gas utility to “bear all the risk associated with that contract, including the underlying financial obligation, regardless of future events that might lessen its capacity requirements.”
Events in the natural gas industry over the last several years have made new pipeline capacity less of a relationship-specific investment (which, as discussed above, is the primary condition for long-term contracting). This is partially a result of increased competition in the wholesale gas market induced by the creation of market centers/hubs and the secondary capacity-release market. For example, since FERC Order No. 636, the gas pipeline network has become substantially more interconnected between spatially distinct markets (meaning individual pipelines have enlarged markets), with competition consequently improved. The effect of the increased density of producers and pipelines over the last several years has attenuated the specificity of production and pipeline capacity, with the effect of a reduced need for long-term contracts to support investments in pipeline capacity. This development also has increased shippers’ ability to bypass and thereby reduced their preferences for long-term price protection. Simply put, with a more open market that has evolved in the natural-gas industry, long-term transactions have less economic appeal to shippers.
Notwithstanding these developments, which seem highly sensible and reflective of a well-functioning gas market, the pipelines may actually have a legitimate gripe that longer-term contracting may be underused because of the policies of FERC and state commissions. This argument stems from the possibility of market and regulatory distortions leading to a non-optimal mix of trading arrangements. Specifically, this refers to: (1) regulatory uncertainty at the state level over the prudence of long-term contracts (which local gas utilities fear easily could lead to regulatory opportunism and a potential stranded-cost problem); (2) the design of some gas choice programs that allow customers to switch suppliers on short notice and consequently make it difficult for a gas utility to contract on a long-term basis for default customers; (3) the unwillingness of some state commissions to hold retail marketers to the same standard of reliable service as the default gas utility; and (4) FERC’s pricing policies, which, as some industry observers have argued, may induce excessive demand for short-term transactions (which include interruptible service and capacity-release transportation) in relation to longer-term transactions.
All or some of these, arguably, could have artificially shifted preferences by shippers toward shorter-term contractual arrangements with pipelines. As an example, pipeline rates for short-term service may be too low relative to rates for long-term service. Regulatory uncertainty at the state level may discourage local gas utilities from signing long-term contracts that could, with hindsight, turn out to be inefficient and burdensome on retail customers. But this argument overlooks how state regulators place such high priority on gas utilities having highly reliable service—which most regulators believe requires some long-term contracts in a utility’s portfolio mix.
Policy Implications for Regulators
Local gas utilities should have the discretion to sign long-term contracts for pipeline transactions. State commissions should approve these transactions as long as they can appropriately fit in a utility’s gas portfolio or supply strategy. Commissions may want to consider granting upfront approval of long-term contracts and their costs within the context of a strategy proposed by a utility.
Giving preapproval may alleviate a utility’s doubts over whether the costs associated with long-term contracts ultimately will be recovered. To say it differently, preapproval could overcome a potential stranded-cost problem for gas utilities providing default service. Of course, on the other hand, preapproval of costs shifts risks onto retail customers.
A less extreme measure could have a commission establish guidelines that would reduce uncertainty for a gas utility. Guidelines, or ex ante rules, can include a commission’s general position on long-term contracting, cost-recovery criteria articulating what constitutes reasonable actions by a gas utility, and the scope of a hindsight review (which would depend on the degree of commission commitment upfront to long-term contracting). In evaluating a gas procurement/supply strategy that contains long-term contracting, a commission should consider the risk on a utility and its bundled-sales-service customers.
State commissions should take a neutral position on long-term contracting and should support long-term trading arrangements when they are an integral part of a utility’s optimal gas procurement/gas supply portfolio. While long-term contracting may have a useful function, it should not be a requirement for local gas utilities and other shippers. These purchasers of gas and transportation are under increased pressure to achieve a targeted level of reliability at the least cost, which may involve relying little, if at all, on long-term contracting for pipeline services.
At the federal level, FERC should consider giving pipelines more pricing flexibility in marketing their capacity. This would enhance the pipelines’ opportunities to market their unsubscribed capacity.
While FERC allows a limited degree of pricing flexibility with regard to short-term transactions and released pipeline capacity, less flexibility is allowed for long-term contractual arrangements, where rates largely are determined by rigid cost-of-service criteria. (In FERC Order No. 637, however, pipelines were encouraged to offer shippers lower rates for longer-term contracts—what FERC calls term-differentiated rates; so far, pipelines have not been active in proposing such rates, which could provide a stimulus for long-term contracting.) FERC has recognized that departure from the typical straight-fixed variable rate design may occasionally be necessary to make under-subscribed capacity more marketable. This can help to soften the revenue risks associated with short-term transactions. FERC also can consider reducing a pipeline’s depreciation period to, for example, better match capital recovery with actual contract durations. Such ratemaking changes, which have been proposed by pipelines, can help compensate a pipeline for absorbing higher risk because of market developments.
An important empirical question, and one that has yet to be answered in addressing the pipelines’ argument, relates to the extent to which the evolution of shorter-term transactions has hampered investments in new pipeline capacity. As FERC has reported, new pipeline capacity is being built in all parts of the country (especially in the Rocky Mountain region, where the economics are most attractive), with no apparent evidence of expected capacity shortfalls, except perhaps in isolated locales. The latest long-term energy forecasts by the Energy Information Administration2 identified public opposition to the building of pipeline capacity as a potential problem that could lead to higher natural gas prices; it made no mention, however, of the deficiency of long-term contracts as an impediment to pipeline expansion. Skeptics of long-term contracting have argued that other industries making large investments under competitive conditions do so without any prior guarantees of capacity utilization.
The changing market environment, rather than state or federal regulatory actions, better explains the radical shift toward shorter-term transactions since the mid-1980s. The natural gas market seems to be responding rationally and efficiently in adapting to the more open and competitive environment. We should expect to see more interest in long-term contracting in the future if and when the price for short-term transactions starts to rise because of scarcity in regional pipeline capacity. But other than this development, the lower preference for long-term contracting by shippers is compatible with their self-interest. More important, shorter-term transactions have fostered a more efficient and socially desirable natural-gas industry.
Advocates of long-term contracting have not made a case for their position, which comes across more as self-serving than anything else.
1. As defined here, although other market observers may disagree, long-term contracts have time durations of 5 years or more.
2. EIA’s Annual Energy Outlook 2005.