The natural gas pipeline industry continues to operate under regulations that no longer reflect the needs of customers or of the industry itself. The time has come to reform these regulations so that they not only protect the public interest but also allow for flexible pricing and use of the system.
Like all energy industries, the natural gas industry is affected by volatility in world oil markets. Fluctuations in the price of oil impose enormous pressure on the gas industry to adjust to changes in competition from other fuels. The resulting fluctuations in gas demand lead to increased risks in contracting for gas supplies and in investing in natural gas reserves, pipeline capacity, and storage facilities. However, because of regulation, the gas industry does not have the flexibility to respond quickly and efficiently to changes in market conditions. The regulations involve rigid pricing formulas and ponderous entry and exit conditions that prevent the industry from meeting the competition, from balancing demand and supply, and from increasing capacity where it is needed. These regulatory constraints can work perfectly well under stable market conditions where demand, costs, and prices are either constant or growing at a smooth pace. But in a volatile environment, the rigidities created by price and entry regulations prevent the kinds of adjustments that are necessary to maintain economic efficiency.
Many of the same problems arise in all regulated industries, but the pipeline industry stands out among its regulated cousins when it comes to pricing the use of fixed capital assets. While it is not uncommon in the electricity, telecommunications, or public transportation industries to vary prices according to peak and off-peak demand periods, such a practice is virtually unheard of in the gas industry. The prices of pipeline transportation services, in particular, are fixed at the same level whether capacity is scarce or abundant. As a consequence, it is commonly accepted that transportation rates are too low during peak demand periods and too high during off-peak periods. These price rigidities not only encourage an inefficient pattern of use of the existing pipeline system, they also create the perception of a need for additions to the pipeline system when they may be unnecessary, and they distort the incentives to invest in storage capacity.
It is easy enough to devise new rate designs that would allocate the use of the pipeline system more efficiently, including methods for establishing peak and off-peak prices. However, the problem is not simply one of finding a pricing formula that works better in today's market. Tinkering with rate design formulas means simply substituting one set of rigid pricing rules for another. The efficiency problem has to do with pricing rigidity, not just the pricing formula.
The problem of pricing rigidity
Since there is reason to believe that energy markets will continue to exhibit substantial price volatility in the foreseeable future, the efficiency problems created by regulatory rigidities will not go away. The challenge for regulators is to reform the regulations in ways that will allow for flexibility in pricing and reduced barriers to entry and exit while still protecting the public interest from the potential abuses of market power.
Natural gas regulation has a long way to go—perhaps further than most other regulated industries. Still embodied in the regulations is a philosophy that comes from the days when the primary role of regulation was to stimulate the development of the gas industry by protecting investments and guaranteeing rates of return. Limiting competition became the primary means by which the regulator protected existing investments. Consequently, an elaborate system developed in which gas reserves were dedicated to specific customers, and competition among pipelines was carefully avoided. In the process, pipelines were placed at the center of planning for the entire industry: producers had to look to the pipelines to market their gas, while distribution companies had to depend on pipelines to assure themselves of adequate supplies. Financial risks, however, were shifted downstream to ultimate consumers.
There was also an economic efficiency rationale for limiting competition, namely, the natural monopoly argument. By this reasoning, fixed costs are relatively invariant to the number of customers that are served over a wide range of a total volume (throughput). Competition merely divides the market into smaller segments, so that fixed costs are spread over fewer units of throughput and fewer customers. Limiting competition therefore provides an efficiency gain that can be passed on to customers in lower prices. Of course, price controls are necessary to ensure that the gains from natural monopolies are in fact passed along to customers.
Unfortunately, the accepted system of price controls established prices on the basis of embedded costs of service. This approach shifts the focus of attention of the regulator from pricing issues to judgements about the prudence of costs incurred, a responsibility that the regulator is not well equipped to fulfill even in the best of circumstances. The best of circumstances, as pointed out before, prevail when costs are constant and demand is stable. Volatility in costs and demand makes the regulator's job impossible to perform well and raises the question of whether the gains achieved from regulation are worth the cost—that is, whether imperfect competition would be a better protector of the public's interest than imperfect regulation.
Rigid controls on the entry of new pipelines made more sense when the industry was in its infancy. Now that the pipeline system has matured to the point where many consumers and producers in different regions are directly or indirectly connected, pipeline additions have diverse and interdependent implications. As a consequence, legal proceedings conducted for the purpose of issuing a "certificate of public convenience and necessity" soon degenerate into complex, global cost-benefit analyses of a proposed new pipeline. In these proceedings it is not surprising that objective standards of economic efficiency play a minor role compared to individual perceptions of fairness.
The extensive development of the interstate pipeline system also undermines the natural monopoly rationale for limiting entry of new pipelines. It is now possible to increase competition among interstate pipelines for end-use markets at very small additions to fixed costs. This may be achieved through the construction of short spur lines that link end-use markets with alternative interstate pipelines.
Brokering pipeline capacity
The current system of pricing transportation services does not ensure that the existing pipeline system is used efficiently, and the resulting inefficiency makes it all the more difficult to determine when and where new capacity is needed. Transportation rates are determined on the basis of historical costs of service and are fixed during the interval between one rate hearing and the next (normally a three-year period). The only pricing flexibility embodied in the current system arises in connection with the price of interruptible service, which refers to pipeline capacity that is contracted for but temporarily unused by the original entitlement holder. However, interruptible service is substantially inferior to firm service, and even interruptible capacity is allocated on a first-come- first-serve basis and, hence, is only coincidentally consistent with economic efficiency.
While the current system needs to be improved, it is also recognized that it is not feasible to allow transportation rates to fluctuate according to what the market will bear. The existence of market power would soon lead to excessive prices, underutilization of existing capacity, and underinvestment in new capacity.
The proposal recently issued by the Federal Energy Regulatory Commission (FERC) to allow brokering of pipeline capacity attempts to insert market-based incentives in the use of pipeline capacity while at the same time limiting the exercise of market power. Contract prices paid to the pipeline for the initial allocation of transportation entitlements would continue to be regulated on a cost-of-service basis, as they are now. However, pricing flexibility would be allowed in the resale of transportation rights held by shippers.
Pipeline transportation prices are the same whether capacity is scarce or abundant.
In many markets, shippers do not possess any market power. In these cases, maximum pricing flexibility could be allowed to allocate capacity from lower-valued uses to higher-valued uses. In a tight-capacity situation, no shippers would be forced to give up their existing transportation entitlements. However, potential buyers would have an institutional mechanism provided by brokering to offer financial incentives to shippers to voluntarily reduce or delay their use of capacity. The price of brokered capacity in tight markets may be expected to rise above regulated rates, because this is the way the market rations scarce capacity. As long as all available capacity is being used, the higher price does not include a monopoly profit that results from exercise of market power.
In situations of surplus capacity the brokered price could fall below existing interruptible transportation rates. This would still be acceptable to shippers who sell unused capacity because they would benefit from any resale that earns a positive price.
However, buyers would be more attracted to short-term firm service than to interruptible service, and may be expected to absorb more of the available capacity. If enough new buyers are attracted by the availability of firm service, it is possible that they could in some circumstances bid up the price above the previous interruptible rates.
To make the incentive system work, it must be possible to transfer revenues from buyers of brokered capacity to sellers of brokered capacity. Local distribution companies (LDCs) and other holders of entitlements to capacity must be able to offer financial incentives to their customers to encourage them to alter the volume and timing of their demands. Also, LDCs must be allowed to retain some of the profits earned from brokering to make it worthwhile to reallocate transportation rights. Finally, pipelines must be allowed to restructure rates to recoup fixed costs now assigned to interruptible service, for these costs otherwise would not be recovered if the surplus capacity were brokered.
Brokering not only promises to improve utilization of the existing transportation system, it should also provide information to pipelines that would help them restructure their rates in subsequent rate hearings. This information should also help to justify proposals for new construction to relieve critical bottlenecks.
Easing entry barriers
The FERC controls entry of new pipelines to prevent unnecessary duplication of facilities that would raise capital costs paid by consumers. The problem is that FERC is not in a position to effectively control pipeline costs, so that consumers end up paying more for pipeline services than necessary. While regulations should not be expected to be perfect, one should periodically reconsider whether there are better ways to achieve the objectives of regulation, including the possibility of less regulation. Competition might limit pipeline costs more effectively than regulation, even allowing for higher capital costs that would result from building duplicate facilities. The challenge is to find a way to balance the gains from additional competition against the additional capital costs of allowing competitive entry into the market.
This balance is likely to favor more competition in situations where there is currently little competition and where the additional pipeline facilities are not extensive. Using the Department of Justice standard for measuring the degree of market concentration, for example, we might expect little or no gain from additional competition in end-use markets already served by four or more independent interstate pipelines. Conversely, the fewer the number of independent pipelines serving a given metropolitan area, the greater the gains from additional competition. At the same time, the cost of adding new pipelines declines with the length of the line, among other things, so that lines shorter than (say) 100 miles might be accorded lighter regulatory scrutiny in a certificate proceeding than pipelines longer than 100 miles.
That a great deal of potential competition could enter the market at low cost is suggested by the findings of a recent (but still unreleased) study done at the Federal Trade Commission. Of the 208 standard metropolitan statistical areas (SMSAs) currently served by interstate pipelines, none could be said to be competitive according to the Department of Justice definition (that is, no SMSA is currently served by four or more independent pipelines). Of these 208 markets, 134 are conservatively estimated to be sufficiently large that they could undertake to build a spur line to an independent pipeline, less than 100 miles away, at an addition to fixed costs of no more than 5 percent. That is, the cost burden of the duplicate facility would be small.
The potential competitive effect of allowing free entry of spur lines of less than 100 miles in length is startling. Of the 134 larger markets, all but 15 could be served by four or more independent pipelines with spur lines no longer than 100 miles (and of these 15 markets, 6 are located in Florida, which of course has a natural geographical barrier to potential hook-ups). It is emphasized that all four spur lines need not be built to obtain the benefits of competition. Merely the threat of new entry that could occur when the differential in prices between existing service and potential new service exceeds 5 percent can provide competitive pressure on existing suppliers. In these circumstances existing suppliers would be conscious of the need to control costs in order to reduce the prospect that competitors would encroach on their markets. The key to achieving this competitive pressure is the speed with which a potential entrant can receive a certificate of public convenience and necessity and begin construction. The longer the delay, the less the pressure on incumbent pipelines to worry about the threat of new competition.
While such an approach may be conceptually desirable, the question is whether it could be implemented in practice. The FERC has attempted to move in this direction (through what is known as the Optional Certificate Program), but that program is not yet well defined and is not aimed at the specific objective of speeding the processing of applications for spur lines in highly concentrated markets.
An additional institutional barrier in the certification process is the requirement to conform to National Environmental Policy Act (NEPA) guidelines. Environmental impact statements are time-consuming, and they impose much the same analytical requirements as traditional certificate applications. In many cases, the FERC decisionmaking process will be slowed more by environmental than economic regulatory issues.
If the Optional Certificate Program cannot be successfully modified and the NEPA procedure cannot be streamlined, it is worth exploring whether the statutes that establish FERC's authority to regulate pipeline entry should be modified. The class of spur lines described above could be deleted from FERC's jurisdiction—if not FERC's entire certification jurisdiction—and left to state and local authorities to determine whether applications meet the public interest. There is precedent for such an action, since oil pipelines and electric transmission lines do not require federal certification. Moreover, this option eliminates the need to conform to NEPA guidelines, since new gas pipeline construction would no longer entail a significant federal action.
Continued volatility in energy markets means that regulation of the natural gas industry must be reformed to allow the industry to adapt to changing market conditions. Wellhead price decontrol and open-access transportation would be important steps in that direction. In addition, transportation rates must become more responsive to prevailing market forces and barriers to entry of new pipelines should be relaxed. FERC's proposed rulemaking on brokering pipeline capacity goes a long way toward fixing transportation rate problems, while an optional certificate program that differentiates spur lines in concentrated markets would be an effective way to ease entry barriers. Only time will tell whether the regulatory and political processes can generate such desirable outcomes.
Douglas R. Bohi is director and a senior fellow in RFF' s Energy and Natural Resources Division. He was formerly chief economist at the Federal Energy Regulatory Commission. This article is drawn in part from an article that appeared in Natural Gas, March 1989.
A version of this article appeared in print in the May 1989 issue of Resources magazine.
