The Late Great Gas Utility

Deck: 

By abandoning R&D and marketing, the gas industry may have sealed its own fate.

Fortnightly Magazine - April 2008

Once upon a time, there was a happy energy industry in the United States that served every market sector—residential, commercial, industrial, and power generation. This industry provided the country’s dominant fuel, and faced a promising future of endless profits.

Then three things happened: regulatory pressure; the emergence of competitive fuels; and what appeared to be an easy path forward to secure the industry’s fortunes—namely, continued demand from the power sector.

The fuel producers liked the last part, and focused most of their attention on satisfying the electricity generation market. Meanwhile, fuel distributors, no longer being supported by producers, decided one by one not to fight as hard as they previously had for the residential, commercial and industrial market. Eventually most of that market was lost, leaving the producers reliant on electricity generators.

This wasn’t a happy ending for the distributors, and, as it turned out, not a happy ending for the producers either. Because the electricity generators eventually found better, more economic alternatives, and that fuel’s share of the power generation market began to decline—leaving the industry scrambling.

This parable—more or less—describes the history of the coal industry in the U.S. But it could just as well describe what is happening to the natural gas industry today.

Death Spiral

Every segment of the U.S. natural gas industry benefits when natural gas demand grows. 1 However, the focus of the natural gas producers and local gas utility companies differ. The gas utilities primarily are interested in growth in the residential, commercial and industrial markets. 2 Natural gas producers are more ecumenical. They are interested in growth in all markets—but especially electricity generation, which uses a substantial amount of gas at each site. The interstate shippers tend to be agnostic as long as their pipes are full—although as with the producers, they like large volumes demanded from as few customers as possible. Unfortunately, the demand for gas in residential, commercial and industrial markets is declining—as demand for coal did more than 50 years ago—and the gas industry, in general, has not been doing much to address that situation. Unless this can be turned around, demand in these markets will continue to decline until the industry becomes overly dependent on the electricity generation market.

For gas utilities, this would be a death spiral—but it might not be much better for gas producers. Producers who hope the electricity generation market will continue compensating for declines in other markets may be sorely disappointed.

First, non-power markets represent almost three-quarters of natural gas consumption. That’s a lot to compensate for. But more important, for gas producers to put all their eggs in one basket would be a very risky strategy. As the coal industry is fond of saying, “America is the Saudi Arabia of coal.” Today, government and the coal industry are investing heavily in resolving the largest barrier impeding coal-use growth—namely, how to sequester the carbon dioxide produced from burning or processing coal. If and when this technical problem is solved, cheap, abundant coal likely will capture most of the new power plants.

Therefore, it is in the economic interest of all segments of the natural gas industry to stop and reverse the slide in gas use in the residential, commercial and industrial markets, and further accelerate growth in the natural gas vehicle market.

What Happened and Why

According to the U.S. Energy Information Administration (EIA), from a high of 22.39 trillion cubic feet (Tcf) in 2000, annual natural gas consumption in the U.S. has declined to 21.72 Tcf in 2006—about a 3 percent drop. But when electricity generation is excluded, gas consumption has fallen almost 19 percent. In the past seven years, while the demand for natural gas to fuel electricity production has increased (over 93 percent), demand for natural gas in all other major markets has declined—residential (10 percent), commercial (9 percent) and industrial (26 percent).

Part of the explanation for these declines is price-induced energy efficiency and conservation, and, in the industrial market, the loss of industrial customers to other countries. During that period, the real price of natural gas at the wellhead almost doubled. But most of the decline arguably can be attributed to the fact that the natural gas industry, primarily the natural gas utilities, simply stopped marketing their product. Except for a few exceptions,3 most utilities drastically have reduced their efforts on research and development (R&D), advertising, promotion and sales.

Product R&D: Every industry must invest in R&D to continue to improve products and keep up with the competition, but the natural gas industry virtually has stopped doing so. The gas industry once had in place a national R&D organization—the Gas Research Institute (GRI)—funded at up to $300 million a year. The funding was provided voluntarily by natural gas pipelines (with oversight by FERC) and by co-funding from R&D sponsors. Up to $85 million a year was directed at “energy utilization,” i.e., for developing gas appliances and equipment for new uses, and making existing gas products more energy efficient, less polluting or otherwise better. Many gas utilities also conducted their own well-funded gas utilization R&D programs. In 1998, the natural gas industry voted to phase out GRI and its funding mechanism, and, with a few exceptions, the gas utilities’ energy-utilization R&D programs now are gone too. Further, only a tiny amount of money is being invested by the gas appliance and equipment manufacturers in making their natural gas products more economically or environmentally competitive. As a result, the evolution of natural gas appliances and equipment virtually has stopped.

Marketing and Advertising: Some industries grow through word-of-mouth communications, but that’s unlikely for a mundane commodity like natural gas. If its sales people are to be successful, the gas industry continuously must remind their existing and potential customers about the economic, environmental and other benefits of natural gas. At one time, gas utilities did this through their own extensive marketing and advertising programs. This was complemented by the advertising and marketing programs of the gas utilities’ national association—the American Gas Association. Unfortunately, these programs mostly have been eliminated.

Sales: At one time, many gas utilities had large and aggressive sales staffs. The goal of the residential sales people was to convince builders to install five, six or seven burner tips or appliances per house. Not just a furnace and water heater, but a gas clothes dryer, range, oven, fireplace and outdoor grill. Some gas utilities also had industrial energy experts available. These were cadres of engineers who were experts in iron and steel, heat treating, industrial drying, smelting, etc. They routinely would visit local factories and identify where new gas technologies could be used to increase efficiency or reduce cost. Many gas utilities had similar experts to serve the commercial market. But for the most part, these programs are no longer funded by gas utilities (and, in fact, now that this expertise has been dismantled, it might no longer exist). The total number of sales people employed by gas utilities is a tiny fraction of what it once was.

Eliminating product R&D, marketing, advertising and sales is hardly a prescription for success. It’s no coincidence that the rapid drop in natural gas consumption in the residential, commercial and industrial markets coincided with the decimation of these programs. This contrasts with growth in the use of propane, largely attributed to the industry’s very aggressive marketing and R&D programs.

Laying Blame

Many gas utilities now are recognizing this downward demand trend. They’re concerned and want to do something about it. But do they want to resurrect R&D, marketing, advertising and sales programs, and compete more aggressively in the marketplace? Unfortunately, in general, the answer is no.

Instead, the industry is looking to state regulators to solve this problem. Specifically, the industry as a whole is advocating the use of decoupled rates, where the gas utilities’ profitability per customer is disconnected from the amount of gas that a customer uses.4 Decoupled rates, as a concept, have some significant benefits for society. However, regulators must implement this concept with great care. Otherwise, it could further exacerbate the downward trend in gas use in the non-electricity generation markets, and accelerate the slide of the gas utility industry toward oblivion.

Clearly, this would be a problem for the gas industry and their shareholders. It also would be a problem for the country because, in general, customers won’t be using less energy. They simply will shift to other forms of energy—mostly electricity, and some petroleum. For almost all thermal applications, much less energy is used when converting natural gas to heat at the point of use (such as a furnace) than when converting energy to electricity and then converting that electricity to heat at the point of use. Cooking, clothes drying, water heating and space heating all are examples of applications that use less energy, on a full-cycle basis, when natural gas is burned at the point of use. 5 It would be terrible national energy policy for these thermal applications to shift to electricity, but this is exactly what is happening.

No one group is at fault for the gas industry’s decline. There’s plenty of blame to go around—starting with the regulators.

Beginning in the 1990s, state public utility commissions began adopting a more market-oriented regulatory philosophy. This shifted the risk-reward equation for gas utilities, making near-term financial implications far more critical. At one time, gas utilities had planning windows of 20 years or more. Today, those planning windows have collapsed to a handful of quarters. At one time, gas utilities’ senior managers often were drawn from the ranks of engineers and marketers. Because of the regulatory philosophy change, the backgrounds of the senior managers are now predominantly law, finance and accounting. This is not to say that gas utilities were just pawns in the regulatory process. They often pushed for these changes. Once implemented, however, gas utility managers had a fiduciary responsibility to act in the best interest of their shareholders, and they acted accordingly.

Another trend that has undermined gas marketing has been the merger of the gas and electric utility companies in many parts of the country. While this has provided efficiencies, in general, most of these companies have opted not to market one of their products (natural gas) against another (electricity), and instead let the market decide which energy would be used. This has had some perverse effects for the country. For example, electric water heaters tend to cost more to operate than gas water heaters and consume far more energy, on a full-cycle basis, but electric water heaters cost less to buy and install. Since gas utilities no longer are informing homebuyers of the economic benefits of gas water heating, home builders increasingly install electric water heaters instead of gas. As a result, in 2006 electric water heaters outsold gas water heaters for the first time. 6

Another segment of the gas industry that deserves some blame is the gas producers. It’s difficult to think of an industry where the producer of the product is not involved in its promotion and marketing. But that has been the situation in the U.S. natural gas business. In general, producers were happy to leave the promotion of gas to utilities.

Road to Recovery

There is nothing magic about how to remedy the situation. In one sense, natural gas is no different from Coca-Cola, Chevrolet or Colgate toothpaste. The only way to turn around declining demand is for the industry to get behind natural gas end-use marketing, advertising, sales and R&D. And the term “get behind” means fund. This can happen if regulators, utilities and producers take steps in the right direction:

State Regulators: Since direct use of natural gas improves energy efficiency, reduces greenhouse gases and saves customers money, it would be enlightened public policy for state public utility regulators to heavily favor the use of natural gas for thermal applications in lieu of electricity. When renewable-based electricity begins displacing a significant amount of fossil fuel for existing power plants, this assertion may become invalid. But that time likely is many decades in the future. In the meantime, state regulators can adjust gas utilities’ rate structures so shareholders financially benefit, both long-term and short-term, from expanding the use of natural gas in the residential, commercial, industrial and vehicle markets. Gas utility managers generally will not invest in marketing, advertising, sales and R&D when their shareholders are penalized for it, but they will if shareholders are rewarded.

Decoupled rates are not a problem in and of themselves, nor are incentives that encourage gas utilities to promote energy efficiency and conservation, through which customers use less energy to get the same amount of energy service. But rate structures also should encourage gas utilities successfully to promote more gas appliances and equipment to replace electric thermal equipment in residential, commercial and industrial facilities, and to promote natural gas use for vehicles to reduce petroleum consumption while reducing urban air pollution and greenhouse gas emissions.

Gas utilities will promote gas use if it’s in their shareholders’ interests to do so. It’s up to the state regulators to establish the rules that provide that incentive.

Gas Utilities: Gas utilities must again aggressively promote natural gas use, locally and nationally, and support natural gas appliance and equipment R&D. If regulators provide incentives to do that, so much the better. But even if they don’t, these programs are necessary investments in a strong future. It also would be useful if gas utility managers and their boards of directors fully understood the long-term financial implications for their shareholders of a continued slide in gas demand nationally and locally. The long-term decline of the industry as a whole could have dire consequences even for gas utilities that have service areas experiencing growth.

Gas Producers: For gas producers, natural gas is different from Coca-Cola, Chevrolet or Colgate toothpaste. It’s a commodity. Promoting Coca-Cola may benefit other soda manufacturers a little by raising the demand for all other sodas, but most of the benefits accrue to the Coca-Cola Company. Conversely, it’s difficult for gas producers that opt to promote natural gas to capture most of the demand growth that results from that promotion. This calls for a collective approach to funding a long-term national gas marketing initiative, including a national gas advertising program, as well as a GRI-type national R&D operation.

For an endeavor like this, free riders are always a problem. All gas producers would benefit from national advertising—whether they help fund it or not. One option for dealing with this problem is a national natural gas promotion check-off program. Such quasi-governmental programs have been used very successfully in commodity industries such as egg, beef, pork, milk and even propane. Such a program has been discussed for years in the natural gas industry but there never has been a consensus for it. With the situation for natural gas growing increasingly dire, now might be the time to successfully pursue such a program.

Increased natural gas use offers a host of benefits to the nation and to customers—including reduction in oil imports, urban air pollution, greenhouse gases, energy inefficiency and cost. It is in the country’s interest to use an increasing amount of natural gas for thermal applications in the residential, commercial, industrial, and transportation markets. Right now, the industry is moving in the wrong direction. If all segments of the gas industry—including its regulators—work together, it can quickly change to the right direction.

 

Endnotes:

1. Arguably this isn’t true because of inadequacy of natural gas supply. But the truth is the United States has a huge natural gas resource base that is more than adequate to support growing demand for natural gas in high priority applications.

2. To this list can be added the natural gas vehicle market, which percentage-wise is growing very rapidly, albeit from a small base.

3. A handful of natural gas utilities around the country—Southern California Gas, PG&E, National Grid, Questar and Laclede—continue marketing natural gas aggressively, with the result that their gas load has increased considerably.

4. The cable TV model provides an example. Regulators allow cable companies to charge customers a certain amount per year, and they bill customers 1/12th of that amount each month. They are economically indifferent to how much television customers watch. Decoupled gas rates would work basically the same. All the gas utilities’ annual costs for providing service to customers (including profit) would be billed to customers in 12 monthly installments. Any natural gas that customers use in a month would be added to their bill at the cost the gas utility pays for it (i.e., no mark-up). Like the cable company, this makes gas utilities indifferent to how much gas each customer uses. Among the benefits attributed to decoupling is that, since gas utilities no longer would benefit from increased gas use, they would be more inclined to promote conservation.

5. “Full-cycle” refers to all the energy used for an application – from production through transmission through distribution through end-use. So, for example, at the point-of-use, electric water heaters are more efficient than gas water heaters. But because much more energy is used in making and moving the electricity to the customer, on a full-cycle basis, natural gas is far more energy efficient. For purposes of public policy, all energy comparisons should be made using a full-cycle analysis.

6. This trend can be expected to worsen. Gas utilities serving colder climates have always been confident that new home builders will install gas furnaces and also gas water heating. That confidence now seems to be misplaced. Frost-belt builders of entry-level homes have discovered that they can save money by installing a high efficiency condensing gas furnace along with an electric water heater, eliminating the need for an expensive chimney. As a result, gas utilities are losing the water heater load (a year-round base load), and the heating load is substantially reduced because of the more efficient furnace.