Natural Gas and Electricity Gas And Power Industries Linking As Regulation Fades

Stephen W. Bergstrom, Terry Callender
NGC Corp.
Houston

Although natural gas precedes electricity in the march away from rate-based, cost-of-service regulation in the U.S., the restructuring of the natural gas industry is far from complete. In addition to fine-tuning the federal initiatives that began the process, the application of Order 636 principles to promote competition and customer choice behind the city gate is a very active arena.

Also, implementation this summer of Federal Energy Regulatory Commission (FERC) Orders 888 and 889, which will begin the restructuring of the wholesale bulk power market, is yielding innovations useful to the gas industry and its regulators.

The perspective here is that of a company with a subsidiary, Natural Gas Clearinghouse, that has functioned as an independent gas marketer for 12 years-defining and redefining customer service, participating in regulatory processes, and managing growth and change in a very dynamic business environment. Natural gas is an important component of the energy budgets of our customers, but it is only one component of their total energy costs.

Operating under the "energy store" concept-under which we provide a multicommodity, energy-product-and-services resource-we have modified our trading and marketing activities toward the ultimate convergence of markets for natural gas, electricity, and other energy commodities. In 1994, we established Electric Clearinghouse Inc. (ECI) as a power marketing subsidiary, applying many of the principles we developed as a nonaffiliated gas marketer.

Principles in common

Although the gas and electricity markets have their organizational and operational idiosyncrasies, the principles of a competitive market apply to both. The gas industry model of functional and services unbundling, and the elimination of the pipeline merchant function should be emulated.

This process of one industry learning from another is inevitable as electricity and natural gas come to be traded in a nearly unified energy market. As their markets merge, two once-distinct industries will become much more alike, each borrowing the best features of the other and leaving less-desirable features behind.

For natural gas, interaction with the lagging but more rapidly deregulating electricity industry can provide cures to competitive imperfections that survived gas industry deregulation. The electricity industry's concept of independent system operators (ISOs), in particular, provides a model that the gas industry might use to remedy concerns about a competitive market for pipeline transportation capacity and associated services.

ISOs have been proposed in tandem with restructuring of the power market as an experimental alternative to corporate divestiture of the transmission systems of the vertically integrated electric utilities. Although the exact responsibilities of ISOs that have been proposed have not been fully agreed upon, the objective is to mitigate transmission market power by putting a third party, the ISO, in charge of operating the transmission system of one or more utilities and ensuring nondiscriminatory access to those systems by third parties.

The application of the ISO concept to the natural gas pipeline industry could have several benefits. For example, the FERC and pipelines often wrestle with issues surrounding capacity release and market-based rates. Recently, the FERC has supported negotiated rates with cost-based, straight-fixed variable (SFV) rates as recourse rates for nonnegotiating transportation customers.

If an ISO were established to administer the commercial transportation transactions, not the physical operation, of a pipeline-or a group of pipelines-then the pipeline's unsubscribed capacity could be marketed on par with the capacity of the releasing firm shippers without concerns of exertion of market power by either the pipelines or the firm shippers. If this process were administered electronically by the ISO, preferably utilizing Internet technology and competing information service providers, the market would be satisfied that capacity information was not being withheld or manipulated and the sellers of that capacity would be able to receive the market price for their product.

From EBBs to Internet

In a related area in which the electricity industry has struck out on its own, the gas business is watching developments closely.

The electricity industry rejected proprietary electronic bulletin boards (EBBs), such as those that developed in the gas industry with the encouragement of FERC Order 636, as focal points for market information. Instead, power companies are jointly developing systems that make use of the Internet.

One reason for this collegial effort is that the power industry works with very short lead times, so the utilities have historically worked very closely with each other to share critical operating information. Transmission for power companies is reserved at least a day ahead of delivery, but hourly adjustments to energy schedules are possible and common.

By Nov. 1, all electric utilities in the U.S. are supposed to have tested and be prepared to use the Open Access Same-Time Information System (OASIS) now under development.

The gas industry may follow suit. The Gas Industry Standards Board (GISB) has a task force that is pilot testing Internet applications to the gas market, where gas nominations will certainly have ever-shorter lead times. Intra-day nominations will become more common if natural gas is to continue to capture market share as a power generation fuel supplier. The need for prompt response will also grow as electricity producers face increasing competition for markets and as fuel arbitrage opportunities become more common in this total energy marketplace.

In addition, the interstate pipeline industry is exhibiting substantial interest in providing what might be deemed the counterpart to the electric industry's "ancillary services." These services might include sales of fuel gas, parking, loaning, and other services that might not be provided only by a natural monopoly. Where there is competition from multiple providers to provide these services, they might also be provided in the same fashion as transportation capacity: electronically administered by an ISO. Otherwise, the use of regulated assets to provide these services should be price-regulated.

Access to capacity

To NGC and other companies responding to opportunities in the rapidly approaching market for energy, competitive access to pipeline capacity and related services remains a subject of great importance. If a pipeline feels there is sufficient competition and is willing to take risks, it should be permitted to charge market-based rates. Then the capacity user that values capacity the most will pay the most.

Competition of just such intensity is essential if natural gas is to both fulfill its potential as a power-generation fuel and hold its own in markets where it and electricity compete. But central to NGC's view is the proposition that pipelines must become increasingly willing to assume risk as regulation melts away. This means accepting the consequences of competition, some winning and some losing, without the backstop of the rate payers.

It clearly is not merited that the owner of a regulated asset should reap the benefits of competition against unregulated entities while, at the same time, it is undergirded by the safety net of a rate base to protect it from any down side.

Current problems

The capacity release market for interstate gas transportation has resulted in much more competition for transmission services than occurs just between pipelines. Each firm shipper in effect owns the rights to a piece of the pipeline and has the ability to sell or assign to third parties, in whole or in part, access to its capacity.

This enhanced competition has been a positive result of the FERC's regulatory efforts. In such a market, pipelines and firm shippers that are willing to accept the corresponding risk should be able to charge what the market will bear for capacity. This, of course, not only involves the FERC's evaluation and approval, but each state's utility commission should also be keenly interested in the capacity marketing efforts of its jurisdictional utilities.

But such a market does not yet exist. No pipeline has stepped forward and declared its willingness to exchange regulatory oversight for the ability to charge what the market will bear. At the same time, most local distribution companies (LDCs) and their associations are actively advocating that FERC remove the price cap for capacity release transactions.

Considering the widespread activities in the "gray market," whereby the LDCs make bundled sales of gas and transportation in order to capture the true market value of their pipeline capacity ownership, the FERC and the states could better assess the scope of competition for transportation if they were in a better position to monitor transactions. Removing the price cap in the capacity release market might diminish the justification for the gray market.

With its recent policy decisions, though, FERC has taken an intermediate step to move the industry in the right direction. The commission now allows negotiated rates for customers with special requirements. A capacity user thus can match its rate profile with its load profile, paying more than maximum rates in high-demand periods and less than maximum rates when demand is low. The user can pay any combination of fees that the pipeline is willing to accept, including an above-maximum rate all year round for systems or segments in high demand.

For capacity holders not wanting to negotiate rates, the SFV tariff design favored by FERC Order 636 still applies. This recourse, or "safe harbor," rate is anticipated to continue to be available to protect customers against discrimination or exercise of market power.

The commission's requirement that negotiated rates be filed and posted does a fair job of assuring that pipelines aren't discriminating against nonaffiliated customers, because these deals can be reviewed on a monthly basis. Review for discrimination by pipelines, exercise of market power, and subsidization by recourse customers can also occur when a pipeline files its next rate case.

An outstanding issue is how much leeway the FERC will allow the pipelines in their negotiations with customers for terms and conditions of capacity use. On this, the commission has yet to rule. Terms and conditions can include, for example, special balancing provisions, seasonal differences in tolerances, and nomination deadlines.

One concern here is that services provided for recourse customers not be subject to degradation by "superpriorities" negotiated by others. It might be possible, for example, for a holder of firm transmission rights under the standard tariff to find its service priority subordinate to rights established under a negotiated deal involving a shipper willing to pay more than the SFV maximum rate.

With the possibility of "firm transportation" coming to have different meanings based on how much customers negotiate to pay for pipeline capacity, holders of firm and interruptible service would probably feel pressure to pay more and more for their nevertheless inferior service priority.

This will not be an acceptable result for recourse service customers, who rightfully depend on the regulators to defend their interests. The industry will need to carefully investigate the potential impacts of free-for-all negotiation of terms and conditions.

Enhanced services

Similarly, there is a trend among pipelines to identify as many current functions as possible as "enhanced" or "value added" services and charge separately for them. Much of this effort is motivated by the formation of a new class of service providers that has come into being primarily as a result of Order 636: "hubs" or "market centers."

This effort can help the market by making it flexible and responsive to customers' needs. Or it can hurt by creating unwarranted layers of cost. NGC has already experienced the impact of increased costs related to the spin-offs and spin-downs of the pipeline gathering systems. Where we once dealt with one entity for contracting, nominations, EBBs, imbalances, and accounting, now we deal with two or more of each: the pipeline, its affiliated gatherer, and maybe a third-party gatherer.

While we understand the need to compete on a level playing field with unregulated competitors, these activities have done little to ease the movement of gas across the pipeline grid. The industry and its regulators should be careful that additional unbundling of pipeline services under the guise of creating enhanced or value-added services does not further confound the competitiveness of natural gas by making it more difficult or expensive to transport.

At present, charges for services such as pooling, title transfer, and tracking are part of basic transportation rates for many pipelines. Pipelines, of course, would like to be able to charge extra for them or not be required to provide these services at all. If they can charge extra for them, then the interstates believe the services should be provided at market-based rates.

This would be acceptable only if costs for basic transportation service fell in proportion to the reduction in total service. Studies of other industries that have been deregulated suggest that this is not likely to happen. Pipeline customers will pay the same rates as before for less service, and to secure the same service level as before they'll have to pay more.

The difficulty lies in distinguishing between basic and enhanced services and allocating related costs properly against the regulated rate base, on the one hand, and market forces, on the other. In the absence of a clear and fair solution, it is unreasonable to use the regulated assets of an interstate pipeline to provide unregulated services at market-based rates.

If a pipeline is willing to assume all the risk of providing service and collecting costs determined totally in a competitive environment, there is no problem. But it cannot have cost-of-service tariffs and be said to be competing in a market. There is too much potential to subsidize enhanced services with the rate base, which is in place because the regulated asset is a monopoly, making it impossible for non-rate-base companies such as NGC to compete.

Before pipelines receive authorization to charge what the market will bear for services, they should have to agree not to return to the FERC seeking cost-of-service relief.

Some pipelines can work this way. Others probably cannot. The FERC should recognize that there is room in the market for both types of pipeline, but not for pipelines that try to mix market-based regulation and cost-of-service philosophies.

Other issues

Several other issues loom for the electricity and natural gas markets as they move toward convergence in a national energy market. They include:

• Mergers. Like power utilities, gas transmission companies are merging. To some extent, this is good business, if not essential to survival. These mergers are quite often acceptable because they do not include contiguous supply and market areas, so competition is not diminished.

  Mergers of power companies, however, tend to take advantage of adjacent systems within relatively confined regions. This isn't so in the gas business, which is witnessing the merger of two companies-El Paso Energy Corp. and Tenneco Energy-whose systems are essentially on opposite sides of the country.

  In both industries, mergers reduce the number of parties active in the market. But the effect of this reduction may be greater in the electricity industry, where, unlike the gas business, transmission customers must request capacity between specific points on a utilities transmission system, even if the related energy doesn't follow the specified route. For this and other reasons, when two interconnected electric utilities propose a merger, questions about market power naturally arise.

  Similar questions will arise if many electric utilities take over gas companies. Combination of gas and electric utilities in retail markets previously shared between distinct, unaffiliated gas and electric companies may offer efficiencies but raise issues about market power and customer choice.

• Power industry restructuring. Important decisions are before FERC and state utility commissions regarding power industry restructuring.

  In FERC-jurisdictional tariffs, it is important that retail restructuring activities at the state level are anticipated and accommodated. It is important that no restrictions be applied to the abilities of load aggregators to have gas and power transported for ultimate retail consumption, even though third-party access to retail customers may not yet be available.

• Stranded costs. FERC wants states, in their retail restructuring activities, to handle the issue of power industry assets that lose value due to restructuring. The commission also has said it favors 100% recovery of such costs.

  This concerns the gas industry, which was not allowed to recover all of the costs of restructuring in its rates. Vertically integrated power utilities allowed to recover 100% of the costs of restructuring could impose surcharges sufficient to discourage customers from switching to lower-cost suppliers.

  The effect would be subsidization of old coal-fired or nuclear generating capacity. The subsidies would squeeze out new, gas-fired generators that otherwise could provide power at lower cost.

Expanding opportunities

A new era of expanding opportunities has begun for the once heavily regulated natural gas and electricity industries. Already, the businesses are learning from one another in an era of rapid change.

The process of change is certain to continue and maybe even to accelerate as the power and gas markets merge.

The Authors