Independent storage is ready for Hackberry policy

The US Federal Energy Regulatory Commission needs to create a regulatory environment conducive to the continued development of natural gas storage capacity. The National Petroleum Council’s 2003 study projected that 700 bcf of new storage capacity will be needed to accommodate growth in the natural gas market.1

FERC’s 2002 Hackberry policy has been credited with spurring much needed investment in LNG import terminals in the US.2 Under the Hackberry policy, the parties determine by contract the rates, terms, and conditions of LNG terminalling services and are not bound by FERC’s open-access rules, including open seasons for assigning capacity, regulated rates, or standardized terms and conditions of service.

Pat Wood, FERC chairman at the time, questioned whether there was some regulatory impediment whose removal could generate the kind of interest in storage investment that Hackberry had done for LNG. While Congress and the FERC have taken some significant steps in fostering a hospitable investment climate for storage development, Chairman Wood’s question remains unanswered.

Maybe it’s time for FERC to apply its Hackberry policy to independent storage.

History of storage policy

About the same time FERC was weighing its policy options in the Hackberry case, a little known storage application was wending its way through the commission’s certificating process. Red Lake Gas Storage LP had sought approval to construct and operate natural gas storage in northwestern Arizona and provide interstate storage and bundled sales services at market-based rates.

At first blush, this case should have been easy for FERC. Infrastructure development was a top priority following the Western energy crisis,3 the region needed additional storage, and there were few options for additional pipeline development.4 FERC could not see its way through to granting Red Lake market-based rates for its storage services, however, or to allowing it to sell natural gas bundled with its storage or transportation services.5

FERC believed that a large entrant into a new (and thus highly concentrated and constrained) market would, at least for some time, have market share and be able to exert market power.6 And so, FERC voted to deny market-based rate and bundled sales authority for Red Lake, effectively killing the project.7

Independent storage

In the months that followed, FERC took a closer look at the concept of “independent” storage as a business model for which FERC could relax some of its regulatory requirements. In April 2004, on rehearing of Order No. 2004, FERC exempted independent storage from the definition of a “Transmission Provider” under the Standards of Conduct for Transmission Providers.8

Because storage is considered transportation under the Natural Gas Act,9 storage service providers are normally required to comply with the Standards of Conduct. In general, transmission providers must be physically separated from and functionally independent of any commodity marketing or sales service employees and any affiliate that performs commodity marketing or sales services.10

By exempting independent storage from the definition of “Transmission Provider,” FERC opened the door for business models that would allow independent storage operators to capture additional economic value from storage assets. In order to obtain the exemption, an independent storage provider must show that it:

• Is authorized to charge market-based rates.
• Is not interconnected with the jurisdictional facilities of any affiliated natural gas pipeline.
• Has no exclusive franchise.
• Has no captive customers.
• Has no market power.11

In October 2004, FERC devoted its natural gas markets conference to the subject of storage. In a report issued just before the conference and intended to promote discussion, FERC staff offered several possible options for stimulating storage investment, including granting market-based rates to all new independent storage providers.12

In staff’s view, new independent storage projects “add incremental capacity to existing markets, thereby giving customers new choices for services, and with the provision that all market risks lie with the projects’ owners (i.e., no captive customers).”13 FERC relied on a similar argument in approving its Hackberry policy: that LNG developers took all of the cost-recovery risk.14

At that point, the outlook for a regulatory breakthrough for independent storage appeared good.

Mixed signals

FERC took a step backward, or at least paused, in its policy toward independent storage in a series of orders in April 2005.15

In three cases, the commission issued certificates for independent storage projects and granted market-based rate authority for the storage services. In doing so, however, FERC employed a traditional market-power analysis.

FERC did not grant market-based rate authority on the grounds that the new storage projects were “independent.” Rather, the commission reasoned that each storage project lacked the ability to exercise market power justifying the grant of market-based rates, largely because the projects would be located in the production area where alternative storage services are readily available.

Moreover, the storage providers asked for flexibility in providing storage services to optimize the value of the storage assets-the kind of flexibility presaged by FERC’s exempting independent storage from the requirements of Order No. 2004. For example, the Starks Gas Storage project, in Calcasieu and Beauregard Parishes, La., sought authority to own its own merchant gas in the storage facility and to make bundled sales.

Starks Gas Storage LLC argued that permitting it to utilize unused capacity within the facility to generate revenue through sales would provide additional economic value for capital recovery before the facility is fully subscribed. FERC rejected Starks’ request, requiring instead that Starks adhere to open-access principles and provide storage services unbundled from any commodity sales.16

In the end, therefore, FERC passed on the opportunity to craft new policy options that could provide incentives for development of independent storage and instead applied existing, long-standing policies.

Legislation; regulatory response

The Domenici-Barton Energy Policy Act of 2005,17 among other of its provisions, authorized FERC to grant market-based rate authority to new storage projects even if the storage provider could not demonstrate a lack of market power.18 It also required FERC, in exercising that authority, to determine that market-based rates were in the public interest and necessary to encourage construction of the project in the area needing storage services and that customers would be adequately protected.

It further granted FERC authority to impose terms and conditions to protect customers and required the commission to review periodically whether market-based rates continue to be “just and reasonable” and not unduly discriminatory or preferential.19

In response to this statutory directive, on June 19, 2006, FERC issued Order No. 678 set down rules under which storage providers could obtain market-based rates.20 As mandated by the law, FERC rules require applicants to demonstrate that market-based rates are in the public interest and necessary to encourage construction of storage capacity in the area needing storage services.21 In addition, FERC proposed to require applicants to provide a means of protecting customers from the potential exercise of market power.

In that regard, FERC mandated no specific method of customer protection. Instead, the commission stated that conditions that limit the withholding of capacity and rate protections, such as cost-based rate caps, might satisfy the statutory standards.22

In addition to implementing the storage provision of the law, FERC revised its market power analysis for all storage providers seeking market-based rate authority by broadening the kinds of alternatives that could be used to demonstrate a lack of market power.23 In particular, the commission stated that storage services compete with available pipeline capacity, as well as local gas production and LNG import terminals. And thus, in its determining whether a storage provider has market power, the relevant market could include these close substitutes.24

Outlook

Notably absent from the commission’s storage rule is any policy advancement in the notion of independent storage. Again, FERC has missed an opportunity. Absent progress on a generic basis, policy development for independent storage will likely shift to proceedings on individual storage projects.

Despite the mixed signals from FERC, there may be opportunities to advance the policy objectives of independent storage. For example, the commission should be willing to consider Hackberry treatment for a storage project integrated with an LNG terminal. In Hackberry, it moved the point of open access to the tailgate of the terminal where the facility interconnects with the pipeline grid, thus allowing the LNG terminalling services to be governed in the first instance by the commercial arrangements of the parties.25

If a storage facility were to be integrated into the LNG terminal so that its injections and withdrawals occurred upstream of the pipeline interconnection-i.e., upstream of the point of open access-there is no reason the storage facility shouldn’t be entitled Hackberry treatment as well. In such a scenario, the LNG terminal and the storage developer could establish by contract the commercial terms, and they would not be bound by the commission’s open-access policies.

Thus, the storage facility could be proprietary to the LNG terminal, and the parties could determine how to share the economic benefits of the intrinsic value of storing the regasified LNG and making sales later. The legal underpinnings of the Hackberry policy would apply equally as well to the storage facility: The costs of the storage facility would be recovered entirely from deregulated sales of natural gas at or downstream of the tailgate of the terminal.

Moreover, the legal framework may also be in place to extend the Hackberry policy to other independent storage projects in the production area. In its proposed storage rule, the commission determined that local gas supplies and LNG terminals can compete with storage as close substitutes under a traditional market-power analysis. Indeed, when storage services compete to serve a portion of an end user’s load-duration curve, some storage services, particularly those in the production area, look like supply sources to the end user.26

Storage facilities in the production area essentially become supply points connected to load by the interstate pipeline grid. Since gas production is essentially deregulated and LNG terminals are now only lightly regulated under Hackberry, a level playing field could be created for independent storage by application of the Hackberry policy to independent storage in the production area.

Under a Hackberry policy, independent storage providers would have flexibility in creating storage services to meet the market’s needs not bound by the standardized terms and conditions mandated by the open access regime.

To address concerns regarding adverse impacts on customers and possible erosion of open-access principles, the commission could limit Hackberry treatment to only those storage projects in the production area that meet the definition of “independent storage” as set out in Order No. 2004-A, i.e., an independent storage provider is one that:

• Is authorized to charge market-based rates.
• Is not interconnected with the jurisdictional facilities of any affiliated natural gas pipeline.
• Has no exclusive franchise.
• Has no captive customers.
• Has no market power.27

With such a definition of independent storage, the pipeline grid would remain under open-access rules, and customers would continue to have access to multiple supply sources and would have access to a variety of storage providers, including rate-regulated, market-based, and independent storage under Hackberry. The interstate pipeline grid would continue to deliver storage volumes from all such sources under open-access rules.

Comment

Applying a Hackberry policy to independent storage could certainly generate the kind of interest in storage investment that Pat Wood initially contemplated. With parties determining by contract the rates, terms, and conditions of storage services, storage providers would have the flexibility to craft the services that the market desires while at the same time maximizing the value of the storage assets.

Although the project developer would bear the entire market risk, its investors would have greater certainty regarding investment return. In order to address concerns about any potential adverse impact on customers, FERC could accord Hackberry treatment only to truly independent storage projects in the production area and continue to apply open-access rules to the interstate pipeline grid to ensure that customers have access to multiple supply sources and storage options.

References

1. National Petroleum Council, Balancing Natural Gas Policy: Fueling the Demands of a Growing Economy, Vol. II, p. 261 (September 2003).
2. Hackberry LNG Terminal LLC, 101 FERC 61,294 (2002). In the Energy Policy Act of 2005, Congress codified FERC’s Hackberry policy. Energy Policy Act of 2005, Sect. 311(e)(3), Pub L. No. 109-58, 119 Stat. 594, 686 (Aug. 8, 2005).
3. See Final Report on Price Manipulation in Western Markets, FERC Docket No. PA02-2-000, at pp. 1-3 (March 2003), finding that natural gas transportation constraints contributed to a scarcity of gas supply relative to demand that led to higher gas costs for California customers.
4. See El Paso Natural Gas Co., 99 FERC 61,244, at p. 62,003 (2002), finding that El Paso’s full-requirements services allowed load growth to take place without any added revenue responsibility and thus provided no incentive for El Paso to build additional facilities.
5. Red Lake Gas Storage LP, 102 FERC 61,077, order denying rehearing and terminating proceeding, 103 FERC 61,277 (2003).
6. 102 FERC, at para. 39-40.
7. Red Lake had indicated to FERC that without market-based rate authority, the project cannot proceed. 103 FERC, at para. 1.
8. Standards of Conduct for Transmission Providers, Order No. 2004, 68 FR 69134 (Dec. 11, 2003), III FERC Stats. & Regs., 31,155, order on rehearing, Order No. 2004-A, III FERC Stats. & Regs. 31,161 (2004).
9. See Schneidewind v. ANR Pipeline Co., 485 US 293, 295 note 1 (1988; “... ‘transportation’ includes storage.”).
10. 18 CFR, sect. 358.2.
11. Order No. 2004-A, at para. 39.
12. Current State of and Issues Concerning Underground Natural Gas Storage, Staff Report, Docket No. AD04-11-000 (Sept. 30, 2004; “Storage Report”).
13. Storage Report, at p. 30.
14. Hackberry, 101 FERC, at para. 23.
15. See Starks Gas Storage LLC, 111 FERC 61,105 (2005); Caledonia Energy Partners LLC, 111 FERC 61,095 (2005); and Freebird Gas Storage LLC, 111 FERC 61,054 (2005).
16. Starks, 111 FERC, at para. 51.
17. Energy Policy Act of 2005, Pub. L. No. 109-58, 119 Stat. 594 (Aug. 8, 2005).
18. Energy Policy Act of 2005, sect. 312, 119 Stat. 688.
19. Ibid.
20. Rate Regulation of Certain Natural Gas Storage Facilities, Order No. 678, 115 FERC 61,343 (2006).
21. Ibid., at para.125.
22. Ibid., at para.153.
23. Ibid., at para.25.
24. Ibid.
25. Hackberry, 101 FERC, at para. 23.
26. Staff Report, at p. 24.
27. Order No. 2004-A, at para. 39.

The author