# Presentation: 355323

## Natural Gas Conveyance and Rates

- Barbara Mariner-Volpe
- February 2001
- Bangladesh Ministry of Energy and Mineral Resources
- barbara.marinervolpe@eia.doe.gov

- <date/time>

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## Scope of Presentation

- Natural gas transportation market
- Competition vs. market power
- Rate structures
- Cost-of-service
- Performance based rates

## Evolution of the U.S. Natural Gas Industry

**Era of Development: 1910 - 1950**

**Era of Regulation: 1950 - 1970’s**

**Era of Market Inefficiency: late 1970’s - mid 1980’s**

**Era of Adjustment/Restructuring/Deregulation: **
**late 1980’s - 2000**

## Era of Market Inefficiency: Late 1970’s - Mid 1980’s

- Market signals not transmitted - prices not market driven
- Curtailments, followed by market restrictions
- Growing perception of supply scarcity, then supply “bubble”
- Disincentives to efficiency improvements

## Pre Restructuring Paradigm:
heavy regulation 
efficiency not rewarded
 Post Restructuring Paradigm: 
principles of competition and choice, while recognizing a continuing, although greatly reduced role for regulation

- heavy regulation
- efficiency not rewarded
-  Post Restructuring Paradigm:
- principles of competition and choice, while recognizing a continuing, although greatly reduced role for regulation

- The Paradigm for the Gas Market Has Changed

## Regulatory - Market Continuum Within the U.S. Natural Gas Industry

## Regulations/Laws Affect the Production/Supply Segment of the Gas Industry

- State
- Conservation Laws - well spacing, mineral rights, environmental impact, production rates, draining
- Federal
- Environmental Protection Agency (EPA) - emissions
- U.S. Department of Energy - authorizes import/exports, Strategic Petroleum Reserve
- Bureau of Land Management, Minerals Management Service - leasing
- Other
- U.S. Coast Guard, U.S Dept. of Transportation, Natural Gas Act, Energy Policy Act, Laws affecting access to wilderness areas and offshore

## Regulations/Laws Affect Natural Gas Pipeline Companies

- State
- Regulate intrastate pipeline companies
- Federal
- Federal Energy Regulatory Commission (FERC) regulates interstate pipeline rates, construction and certain operations
- U.S. Department of Transportation - pipeline safety, inspections
- EPA - emissions
- Treasury Department

## Regulations/Laws Affect Local Distribution Companies

- State
- Regulate local utility rates, certain operations, siting, construction, emissions
- Federal
- Environmental regulations - emissions, ground water impact
- Local Jurisdictions
- Regulate municipal utilities rates and operations

## Federal Energy Regulatory Commission

- Independent regulatory agency that regulates aspects of the electric, natural gas and oil pipeline and nonfederal hydropower industries.
- Ensures that rates, terms and conditions of service are just and reasonable
- Authorizes construction of natural gas pipeline facilities
- Ensures hydropower licensing, admin. and safety actions are consistent with the public interest.

## Bureau of Land Management
Minerals Management Service
Bureau of Indian Affairs
U.S. Geologic Survey
Forest Service
Office of Fossil Energy

- Minerals Management Service
- Bureau of Indian Affairs
- U.S. Geologic Survey
- Forest Service
- Office of Fossil Energy

- Federal Agencies Affect the U.S. Gas Market

- Department of Agriculture
- Department of Energy
- Department of Commerce
- Department of Treasury
- Environmental Protection Agency

- Department of Interior

## Regulatory Developments

- Federal
- Order 637 - certain price caps on transportation removed
- State
- Unbundling programs stalled in some areas
- Evaluating programs and impacts
- Issues: reliability, consumer prices, standards

## Average Monthly Wellhead Prices Currently Exceed the Highest Level Over the Past 20 Years

## Average Annual Consumer Prices for 2000 Have Not Risen to the High’s of the 1970’s

**Residential**

**Commercial**

**On-System**
**Industrial**

**Citygate**

**Electric**
**Utility**

**Wellhead**

## Purpose of Regulated Rates

- Protect captured consumers from monopoly pricing
- Promote public welfare
- Promote national policy objectives
- Balance cost incurrence with cost assignment among classes of customers
- Provide opportunity for reasonable profit to utility

## Transportation Rates

***Transportation Rates***

## The Ratemaking Process

- 1.		Cost of service determination
- 2.		Cost functionalization
- 3.		Cost classification
- 4.		Cost allocation
- 5.		Rate design

## Transportation Rates:Postage Stamp vs. Mileage

**Postage Stamp Rate** - Flat rate for transportation service without regard to the distance the gas is moved
**Mileage-Based Rate** - Rate designed to reflect the distance involved in transporting the gas

**Notes:**
Add following text to another slide on rate structures

## Part 1 - Reservation Fee or Demand Charge - paid to reserve the right to have service.  Cost depends on the amount and quality of service.  Firm or guaranteed service requires a premium over non-firm service.

- Structure of Transportation Tariffs in the U.S. - Two Part Rates

- Part 2 - **Usage or Commodity Charge** - a charge based on the use of the service (typically calculated on a per unit basis).

## U.S. Pipeline Rates Have Had Varying Allocations of Fixed Costs to the Tariff Components

**METHOD****	****	****ALLOCATION OF FIXED COSTS**
- United			  25% Reservation Charge 75% Commodity Charge
- Seaboard		  50% Reservation Charge 50% Commodity Charge
- Modified Fixed-Variable    All in Reservation Charge except return on equity and   			    associated taxes
- Straight Fixed-Variable	  All fixed costs in the Reservation Charge
- In all cases, above the variable charges are allocated to the Commodity Charge

## Chronology of Major Trends in U.S.Rate Design Description

## Chronology of Major Trends in U.S. Rate Design Policy Rationale

## Rate Design Changed With Restructuring:Modified to Straight Fixed Variable

## Cost of Service Regulation

- Some argue  leads to a "cost plus" mentality and little/no  incentive for efficiency gains or cost reductions

## Do Cost Of Service Rates Provide Any Incentives to Minimize Costs?

**Answer**:   Yes, some.
- Providers under cost of service pricing are allowed to keep all of the revenue that exceeds total cost of service between rate cases.
- However, similarly providers may not collect additional funds to make up for revenue short-fall.
- The longer the time period between rate cases, the greater the incentive to reduce costs.

**Notes:**
CHECK WITH MICHAEL TITA ON THIS ONE --  IS THERE A RECONCILIATION AT THE TIME OF THE NEXT RATE CASE?   SO THE ONLY BENEFIT IS THE TIME?USE OF THE OVERRECOVERY BETWEEN RATE CASES

## Some Rate Structures Are More Competitive Than Others

**More **
**Competitive **
**Rates**

**Less **
**Competitive **
**Rates**

- Cost of Service
- (Max Rates)

- Fixed Price

- Cost of Service
- Bounded Rates
- (Max, Min)

- Performance Based (Incentive) Rate

- Market
- Based
- Rates

## How Does Incentive Regulation Differ From Cost of Service Regulation?

*Answer*? Fosters long-term efficiency by:
- Separating rates from the underlying cost of service
- Lengthening the period between “rate cases” (when rates are revised)
- Sharing the benefits of cost savings between consumers and stock holders on a current basis

## Examples of Incentive Rate Mechanisms

- Automatic Rate Adjustment Mechanisms
- Performance Targets
- Flexible Pricing
- Benefit Sharing

## Automatic Rate Adjustment Mechanisms

- Rates are indexed and change automatically to correspond to changes in an index approved by the regulatory agency
- Would extend the interval between rate cases and permit greater flexibility in intermediate price changes

## Performance Targets 

- A company would be allowed to keep a portion of the savings if it exceeds its target, or it would have to absorb a portion of the losses if it fails to achieve the target
- Performance targets could be set for almost any cost – interest, salaries, operation and maintenance, and taxes

## Flexible Pricing

- Allows different prices for different situations
- An example of flexible pricing is selective discounting

## Benefit Sharing

- Benefit sharing allows both the company and the customer to benefit from incentive rates, by sharing cost savings
- Bonuses can reward companies for serving customers well.  For example, the allowed rate of return could rise or fall depending on how well the company improves service or cuts prices.

## Incentive Regulation 

- Opportunities for reward may be offset by a symmetrical downside risk
**rewards** service providers that reduce costs, expand services and streamline operations
**penalizes** service providers that fail to achieve efficiencies

## Criteria to Consider When Evaluating Incentive Rate Proposals

- Rates Should Be:
- Prospective
- Voluntary
- Understandable by all parties
- Demonstrate incentives to improve service quality

## In Addition, Incentive Rates Should Also...

- Include performance benchmarks that do not rely on measurements that are ambiguous or subject to manipulation
- Include mechanisms to ensure that reduction in costs and/or increases in operating efficiency are shared with customers

##  Negotiated Rates and Services

- Recent option for transmission service
- Cost-based recourse rates must be available
- Allows buyers and sellers to negotiate on non-price terms
- Improves the attractiveness of long-term contracts
- Provides an incentive to innovate new services while minimizing risk
- Downside - may allow exercise of market power

## Recourse Service

**A viable alternative to negotiated service**
- The purpose of recourse service is to act as a check against market power by the service provider

## Possible Checks Against the Exercise of Market Power with Negotiated Rates and Services

- If the following conditions are **Not** violated
- No undue discrimination or Preference
- No degradation of the quality of existing services
- No impairment of tradability (customization versus standardization)
- No significant reduction in competition
- No unwanted tying arrangements (e.g. to other services)
- Transparency of negotiated transactions (possibly designate services as non-negotiable, negotiable and potentially negotiable)

## Why Do Some Service Providers Charge Penalties? 

- U.S. Pipelines can ensure reliability through penalty and operation flow order (OFO) tariffs that levy severe penalties for shipper imbalances and overruns
- 	To: maintain operational integrity
- DOWNSIDE - some argue that
- pipelines can manipulate penalties to their benefit
- customers (e.g. shippers) can take advantage of arbitrage opportunities between differences in penalty structure of competing providers.
- May be considered a revenue stream. Should penalty money be credited to those who were in balance

## Auction v. Bilateral Contracting

- U.S. Regulators have considered a "universal" auction of all-available short-term (<1 year), interstate pipeline  capacity.
- It has been suggested that bilateral contracting not be precluded - as it allows terms that meet the tailored, unique needs of individual buyers and sellers. A standardized auction contract would not be able to do this.

## Is a Competitive Market Preferable?

- YES
- Because competition can discipline markets more quickly and effectively than can regulation
- Because cost of service regulation imposes significant costs on all participants in the market (including regulators)  - costs of preparing, litigating, deciding rate cases

## A Competitive Market...

- Allows consumers and service providers to make individual decisions about managing and allocating risks and associated costs.
- Can benefit informed customers who may choose the terms and prices that best meet their needs.

## Goals of Competition

- Minimize costs
- Maximizing economic efficiency needs to be balanced by considerations of the effects of competition on supply security, environmental policy and social equity.
- Tradeoffs between lower prices and supply security

## ADD-On Pricing Versus Netback Pricing

**Add-on Pricing:**
- Wellhead (regulated) price
- + Pipeline mark-up
- + Local Distribution Co. mark-up
**= Sales Price to Consumer**

**Netback Pricing:**
- Price of Consumer’s Competing fuel
- + Distributor transportation charges
- + Pipeline transportation charge
**=** **Netback price at the wellhead**

## Under What Circumstances are Market- Based Rates Appropriate for Service Providers? 

*Answer*:  According to federal regulators in the U.S., they are appropriate when a market is sufficiently competitive that it precludes exercise of market power.

##  What Are the Signs of a “Sufficiently” Competitive Market?

- Competitive Markets generally possess one or more of the following characteristics:
- Many buyers and sellers
- Many product options
- Relative ease of entry and exit
- Risk, on the part of the service provider, of losing money if they do no operate efficiently

## Market Power

- Ability of a single company or a group of companies to increase and sustain a price that is measurably above the competitive market price. (may also relate to non-price elements such as burdensome terms and conditions of service that effectively obstruct competition)
- Difficult to detect/measure (at times)
- The absence of market power is a competitive market
- Often associated with size and market share of the firm.

## Horizontal - cases where the company has little competition for the same type of services or has competition only from affiliates  which may be favored
Vertical - cases where a company can favor itself or an affiliate for complementary services e.g. local distribution company favoring its marketing affiliate.

**Vertical** - cases where a company can favor itself or an affiliate for complementary services e.g. local distribution company favoring its marketing affiliate.

- Types of Market Power

## To Avoid Market Power

- Eliminate Barriers to (reasonable) Market entry/exit - level playing field
- Monitoring of regulated and unregulated affiliates to prevent cross-subsidies
- Easily accessible information on market choices

## Some Elements to Consider in Developing A Framework to Detect  Market Power

- Define relevant markets:
- Identify good alternatives to the company’s product
- Identify sellers of good alternatives in the same geographic area
- Measure firm size and market concentration
- Evaluate market share
- Estimate market concentration
- Evaluate other factors
- Are there externalities that might limit market power?

## Detecting Market Power

- Depends on the availability of reliable data
- Herfindahl-Hirschman Index (HHI) - equals the sum of the squared market shares
- Lerner Index (or similar series) - premium of price over marginal cost. Equals the markup of price over marginal cost as a percentage of price.

## To Allow Competitive Markets to Develop and Function Effectively 

- Actions May Be Needed That:
- Foster choices that serve the public interest
- Promote system efficiencies
- Reduce regulatory uncertainty
- Support development and commercialization of technologies that reduce costs and increase  choices available to consumers

## What is the Key to Attracting New Markets and Retaining Existing Markets?

*Answer*: Greater flexibility in service and products and prices
- Some examples of flexibility in the U.S. gas market:
- development of market hubs
- secondary market for trading capacity rights
- introduction of new services
- commoditization of capacity (e.g. more flexible receipt and delivery points)