Natural Gas and Electricity Gas Experience Can Steer Power Away From Deregulation Snags

Jeffrey J. Leitzinger
Micronomics Inc.
Los Angeles

It is unusual today to pick up the business section of any major newspaper or business periodical and not read about deregulation. Trucking, airlines, telecommunications, financial services, and natural gas have all seen substantial deregulation. It is widely accepted-not so much as a matter of scientific proof but as a matter of faith-that this is a good thing.

This brand of religion goes something like this: Regulators are generally ineffective regulating rates which reflect only the necessary costs of doing business. Moreover, regulators don't provide correct incentives to lower costs and figure out that next better mousetrap. At the same time, they insulate regulated companies from the innovation-creating and cost-saving energies of their unregulated counterparts; new entry is not allowed until a public need for additional capacity is demonstrated-which is to say, no new entry if it is likely to displace sales of (competes with) existing sellers.

Consequently, if you deregulate several good things happen. New competitors enter the industry, increasing customer choice and offering better prices. In so doing, they rescue customers from sluggish, protected monopolies. Prices go down. New competitors take over the business. Innovation goes up. And, along the way, we save the costs of maintaining interventionist regulatory commissions.

There are, of course, other benefits to competition. One longer term benefit is market control-as opposed to regulatory control-over long-run investment decisions. Not only will the market likely do a better job of deciding which new technologies warrant investment, in what amounts, at what point in time, the market is less compromising in its judgments about the wisdom of investment choices and thereby reduces uncertainty. Indeed, these may, in the end, be the best reasons for the current deregulation initiatives.

We are now in the early stages of deregulating the electric industry. There are great expectations for the kind of market-driven changes described above. Customer savings from competitive rates are routinely promised in the tens of billions of dollars. Scores of would-be competitors in generation and marketing services are crowding deregulation dockets and conferences around the country. The gas industry trade press is full of articles trying to measure just how big new generation-related markets for natural gas will be.

It is worthwhile to step back from the excitement for a moment and ask how we know all of this will happen. Is it just faith in economics (or even economists)? Some part of the answer may be just that. Some part of it may rely on past studies measuring the benefits from deregulation in other industries-although, for every such study there are others professing to explain why the benefits are greatly exaggerated. However, most of it seems to be anecdotal. We've seen what has happened in other industries, and it confirms what our faith in free-market economics tells us should happen.

I discuss one particular anecdote in this article, deregulation in the natural gas industry. That experience is cited often in the high expectations for the electric industry. Of all industries deregulated over the last 25 years, it is probably most like the electric industry. For that reason, it is generally regarded as a prototype both for what initiatives to create competition in the electric industry should look like and what they will offer when implemented.

Emergence of competition

On its face, the gas industry experience makes a good case for deregulation. As deregulation took hold, regulated suppliers of gas merchant service lost almost all of their business (even before Order 636 turned de facto changes in the marketplace into legal boundaries). That is just what one would expect assuming that years of regulatory protection had dulled competitive instincts for better service and lower costs.

The emergence of competition in the gas industry is given credit for substantially lower prices and customer savings of at least $50 billion. Again, just what one would expect.

It is no wonder that customer groups who have zealously protected tight regulatory control in the past are now pushing for deregulation. Similarly, it's no surprise that firms in the gas industry-whether winners or losers in their own deregulation process-are supporting the same initiatives in the electric industry. They see it as a great force for change, and that means new markets.

The problem, in my view, is that this experience has been almost entirely misread. One thing we did learn from the gas industry experience is that the process of deregulating needs to be improved. Indeed, most of the dramatic changes seen in that industry may well be more the result of an ill-conceived process than the fruits of the competition it created.

Deregulation of some sort probably is a good idea for the electric industry. And, possibly, deregulation will create substantial benefits for customers by squeezing new efficiencies out of the industry. Just don't count on it happening because it supposedly happened in the gas industry. As we fix the deregulation process-and it appears we will-much of the driving force behind the changes seen in the gas industry will disappear.

Gas industry background

Prior to 1985, regulated interstate gas pipelines operated much like today's electric industry. Pipelines provided a bundled service to customers that included transportation (and transportation-related services such as storage) and the gas commodity.

Unlike electric utilities, pipelines did not generally produce the commodity. Instead, they bought it from unaffiliated gas producers under long-term contracts at regulated prices. Customers paid the cost of gas under these contracts on a pass-through basis in their rates. Unlike electric utilities, which earn a return on the commodity they generate and include in their rates, pipelines made no profit on the purchase and sale of gas.

In the mid-1980s, pipelines' contractual commitments to buy large amounts of gas at escalating regulated prices for decades into the future-the costs of which would flow through to their customers-were very much akin to the high-cost generation capacity in the rate bases of many electric utilities today.

Prompted by 1970s service curtailments (resulting from gas shortages) and projections of future oil prices exceeding $100/bbl, pipelines signed up large volumes of long-term gas supplies under high incentive prices provided by the Natural Gas Policy Act of 1978 (NGPA). By the mid-1980s, things had changed. Shortage of gas had disappeared; oil prices had stopped well short of $100/bbl; industrial customers who could switch from gas to oil or other fuels were doing so. Yet, despite weakening gas markets, resale rates regulated by the Federal Energy Regulatory Commission continued to rise.

The culprit was the high-cost gas commitments made in the late 1970s and early 1980s. As market prices for gas were declining, so too was production from older, low-priced supply sources. On the other hand, the volume of high-priced gas under post-NGPA contracts was rising. Under cost-of-service rules, which made the average cost of all gas purchased a pass-through item in resale rates, customers were seeing higher and higher rates.

In most cases, this increase in the volume of high-cost supplies did not result from a failure on the part of pipeline supply managers to recognize or react to changing market conditions. Many high-cost, post-NGPA contracts had acreage dedication (or similar provisions) which, in effect, bound the pipeline to buy all that the producer chose to deliver from his reserves. Of course, with energy prices falling generally and pipeline contracts that provided for price escalation, producers made every effort to develop and produce existing reserves while these contracts remained in force. As a result, post-NGPA gas supplies with escalating prices assumed a larger and larger role in most pipelines' supply portfolios.

In the current jargon of deregulation, which first appeared in the order for pipeline divestiture in 1991, this was a stranded cost problem, although at the time high-cost supply contracts were discussed as a prudence issue. Market conditions had changed, creating an opportunity for substantial gas cost savings. The problem was that past contractual arrangements approved-pipelines would say prompted-by regulators had locked in prices based upon an energy crisis mentality of prior years, and consumers were seeing no savings.

FERC's options

There were several ways of dealing with the problem. The FERC could have declared prices under the high-priced contracts imprudent, preventing further pass-through of the premium above current market. Pipelines and producers would then have been left to decide who should absorb the loss under their respective contracts.

Alternatively, the FERC could have decided that competitive wellhead gas markets would afford customers the best opportunities and the best protection and, on that basis, deregulated the commodity side of the gas business (the course it eventually followed with Order 636). Premiums over market in existing gas contracts would then have been stranded by lower priced, competitively available supplies-presumably requiring a stranded-cost sharing mechanism. FERC (at least initially) did neither.

Instead, the FERC identified the problem as being one of poorly functioning market signals. As FERC described it in some of the initial orders intended to address the problem, current gas market values were not having their full and appropriate effect on pipeline or customer gas purchase decisions. To solve that problem, the FERC took steps to make the consequences of ignoring market signals severe enough to command better attention.

In 1984, the FERC issued Order 380 outlawing contractual provisions (known as minimum bills) under which customers had agreed to pay for contractually committed supplies even if they did not actually take delivery. Pipeline customers suddenly found themselves with new freedom to seek out low-cost supplies and avoid paying for high-cost gas flowing under old contracts.

In 1985, the FERC issued Order 436, which required pipelines desiring to provide transportation service to the newly expanding market of direct purchasers (that is, customers who were buying direct from producers or marketers rather than through a pipeline under its sales tariff) to give their existing sales customers the option of converting to transportation service under equally favorable terms. In concept then, regulated pipeline suppliers-still selling gas under rates established through cost-of-service regulation-would coexist with unregulated competitive gas sellers who would contract for transportation service from the same pipelines with whom they competed. Competition from those unregulated sellers would act in turn to ensure that current market signals (i.e., gas prices) were reflected in pipeline rates.

Concept problems

The concept did not work.

First, by prohibiting the collection of gas costs in non-volumetric tariffs (a la Order 380) the FERC gave customers a free ride on their traditional suppliers. The merchant service traditionally provided by pipelines necessarily involved costs that did not relate to volumes actually taken.

The traditional regulated interstate pipeline sales service gave customers broad flexibility over the amount that they could take both each day and over the course of each year. Customers would contract for a peak day entitlement and the right to a maximum contract quantity over the course of the year. They were allowed to take much less than their peak entitlement on any day. Moreover, they could take substantially less than their maximum annual contract quantity.

In a very real sense, these contracts bound the pipelines to stand ready to supply exceptionally high daily or annual requirements if weather conditions warranted. Under the customer service agreements as originally framed, customers often had to pay for gas available under this standby service which they chose not to take. Even where not provided explicitly in the service agreement, customers were obligated to pay costs associated with maintaining standby supplies as long as the FERC deemed them prudent.

Since pipelines now could charge for gas costs only on a volumetric basis, customers received the benefit of standby service at no additional charge. That meant non-regulated supply competitors had little reason to try to compete with pipelines in their mainstay merchant business-no-notice, firm sales. Not surprisingly, they saw little potential in developing products to compete with regulated firms who were, in effect, being forced to give part of the product to customers for free.

Second, it proved impossible to specify terms for an arms-length transportation service agreement that were truly comparable to the service pipelines themselves offered as vertically integrated merchants. In the gas industry, a pipeline operator accomplishes physical delivery to a customer through a variety of means. These include delivery of gas supplied into the system by producers, flexible peaking contracts with other pipelines, storage gas, line fill gas, and various exchange mechanisms.

There proved to be no good way to specify, in advance, access rights to those same devices for third parties given that no one knew in advance (e.g., at the time of the transportation service contract) which devices would be needed or available. For these reasons, third party firm transportation contracts generally did not include the same options available from the pipeline owner, and thus the services were not comparable. Third-party competitors and suppliers knew that. As a result, competition for firm, no-notice gas service did not develop.

Host of proposals

Over the next decade, a host of new merchant and transmission rate design proposals emerged to solve these problems. These included gas inventory charges (a fixed premium per unit of peak-service entitlement), deficiency charges (surcharges based on deficiencies in annual contract entitlement), zone transmission rates (in place of traditional postage stamp rates), market/production area rates, and telescoping rates.

In many cases, the deregulation process took the form of horse-trading, with the regulated pipeline supplier proposing initiatives to get customers to take responsibility for outstanding obligations under existing supply contacts (e.g., stranded costs) in exchange for expanded transmission service options which would in turn give customers better access and more competitive choices for supplies.

None of it worked. The FERC would not approve pipeline proposals to charge customers for maintaining stand-by supplies which the customer didn't take-charges which might have induced customers to try outside suppliers-for fear that non-volumetric charges would interfere with market signals. Third parties would not compete directly with pipelines because the FERC would not approve tariffs for pipelines that reflected true costs. Customers would not relinquish their entitlement to free standby service until there were established third-party providers of the same commodity service and until they could get the transmission and storage service with the same flexibility they had always enjoyed as pipeline merchant customers. Pipelines would not (and perhaps could not) offer their customers broad flexible transportation service, thereby surrendering flexibility in operating their bundled merchant service as long as customers still retained rights to call on that service.

Nearly 10 years after the problem was first recognized, the FERC finally resorted to divestiture. The merchant function was removed from the pipelines and left to contractual dealings between customers and unregulated suppliers/merchants. The merchant sale of the business was, thereby, effectively deregulated.

Competition and prices

Lesson #1: Competition was not the reason customers saved money.

It is commonly believed that the advent of competition saved natural gas customers tens of billions of dollars. On closer examination, however, the notion that savings enjoyed by customers flowed from competition does not hold up.

Consider Fig. 1 [30736 bytes]. It shows wholesale average prices for natural gas before and after restructuring. It also shows two components of those average prices, gas costs and wholesale margins. Clearly, average wholesale prices have declined substantially over the course of the restructuring. But, just as clearly, that decline has come predominantly in the cost of the gas itself, not the margin.

This suggests buyers of gas at wholesale did not save money as a result of added competition. The premise behind merchant deregulation was that wellhead gas markets were already competitive. Accordingly, one cannot have expected that merchant deregulation would somehow create more wellhead competition, lowering wellhead prices. If competition created by deregulation did lower prices, it would have done so by reducing the margin paid to merchants. Based upon a simple before-and-after comparison of the margin levels, that did not happen.

Then, what of the billions in consumer savings? The answer goes back to the gas industry's stranded cost problem.

The multi-billion dollar estimates of customer savings typically are calculated by comparing gas commodity costs as they now stand with estimates of where they would have been had gas supply contracts of the early 1980s been fully performed without buy-outs or reformation. Energy markets generally saw larger real price declines during the 1980s than in any post-war decade. Those declines are reflected in today's post-deregulation commodity prices (Fig. 1 [30736 bytes]). Old NGPA contracts, if left in place, probably would have caused commodity rates to rise. Hence, before/after comparisons of customer costs yield big savings. But the reason for those savings is that high-cost gas contracts were reformed or terminated during the deregulation processes, not added competition.

Widespread contract re fo rma tions/terminations were the product of the evolving deregulation process. First, as noted above, the FERC let customers who were otherwise bound to buy the high-priced gas under their service agreements reduce purchases without making contractually required, minimum bill payments. Second, the FERC made sure through open-access rules that customers who rejected their high-priced supplies would find ample cheap spot gas to take its place. Finally, the FERC was careful not to make any commitments concerning the ability of pipelines to recover costs associated with supply contracts where customers failed to purchase the volumes pipelines had committed to take. The FERC even suggested that continued takes under high-priced controls might be unreasonable and imprudent.

Together, these steps forced pipelines and producers to absorb the stranded costs associated with older, high-priced contracts. Fig. 2 [34103 bytes] shows just how much they absorbed. I have totaled the amount of above-market contract settlement costs borne by producers, pipelines, and customers, using pipeline filings made in connection with Orders 500 and 636-both of which provided some opportunity to have customers share buyout and reformation costs, assuming pipelines and producers also absorbed their "fair share."

Over 80% of the total settlement cost, some $40 billion in contract relief, was paid by producers and pipelines. They did so because 1) they could not sell the high-cost gas, and 2) because they did not know what the FERC would do concerning the regulatory bargain associated with pipelines' agreement to these contracts in the first place. The risk of leaving the contract in place and accumulating continuing liabilities as customers chose to buy gas elsewhere was simply too great.

Lesson #2: Traditional suppliers didn't lose their business because of competition.

Within 2 years of Order 436 (the first open-access initiative) merchant pipelines had lost much of their gas sales business to marketers and to direct purchases made by their former customers. While it is easy to conclude, as a result, that competitive efficiencies unleashed through open access account for changing supplier roles, there is much more to it than that.

The starting point, again, was Order 380. By outlawing non-volumetric payments for gas service, the FERC removed the means used by pipelines to collect for the merchant service they provided. At the very same time, pipelines remained bound by regulatory and contractual obligations to provide reliable service when needed. Therefore, pipelines became the backstop against which short-term spot commodity arrangements could take over the industry.

There was simply no reason to buy gas any other way. You could buy solely the commodity at a commodity-only price and get other aspects of the traditional merchant service, when needed, by purchasing limited volumes from the contractually bound pipeline supplier. In the end, rather than competing with one another, pipelines and other marketers complemented each other. Pipelines provided the peak-day reliability, and marketers provided the commodity. Marketers and direct purchasers flourished because pipelines gave customers a free ride on other necessary services, not because marketers or direct purchasers were more efficient.

There is a sense in which pipelines were less responsive than their unregulated supply counterparts, but it was a problem born of the regulatory rules under which they operated, rather than inefficiency. The FERC continued to require pipelines to make semiannual filings setting forth the commodity costs which would then-along with other system costs-determine their resale rates. Therefore, pipelines could not rapidly adjust prices to account for changing market conditions; they could not use pricing as a competitive tool to build long term customer relationships; there was little or nothing they could do when one of their customers came to them with a better offer in hand. In all likelihood then, even had it not been for the reliability free-riding that allowed marketers to prosper, rate-setting procedures would have doomed them competitively.

In short, the natural gas merchant business changed hands because existing suppliers were taken out of the contest by the deregulation process, not by competition. Order 636 came along in the end and mandated just that result.

This history should not provide much optimism to gas producers or marketers looking to increase sales for electric generation. It does not seem likely to be repeated. This time around, pricing for the full range of services that come along with the commodity-including reliability- is receiving a great deal of attention. Moreover, it also seems clear that the mix of regulatory and market-based rules which is arrived at for setting prices will be applied evenly to all participants.

Conclusion

In a real sense, the deregulation effort presently being mounted for the electric industry seems better conceived than that which occurred for the gas industry. The fact that deregulation will strand costs, the importance of investment bargains made years ago, and mechanisms for holding customers to their past bargains are all getting much more attention, much earlier today than they did for the gas industry. Rules for a truly level playing field where both existing utilities and new entrants can stay in the game are being hammered out in state regulatory forums across the country.

Indeed, we have already learned a great deal from the gas industry's experience. But we should also recognize that much of the dramatic change that went with the gas industry experience happened precisely because the process wasn't well-designed.

The tremendous rate savings, the turnover in suppliers were all side effects of the process, not inherent benefits of its conclusion. As we "fix" the deregulation process in the course of applying it to the electric industry we should not be surprised if, in the end, what we pay and to whom we pay it isn't all that different from what it is today.

The Author