16

The creation of new types of 

contracts and financial services 

is driven by the development of 

spot energy markets and related 

price volatility. 

III. New Service Availability

One of the fundamental rationales for deregulation or restructuring of

formerly monopolistic industries is the concept that a market-based structure

will induce creativity, leading to the creation of services which regulators and

monopolistic producers would not have anticipated or provided. This

concept, which is related to Schumpeter’s insight that competition induces a

“gale of creative destruction,” implies that many of these products and

services will be unanticipated, and the value created by their appearance

cannot be duplicated within a cost-of-service regulatory framework. New

energy markets, in other words, bring with them the opportunity to provide

consumers with choices that go beyond simply a wider range of suppliers of

their traditional products and services. Consumers can also gain the benefits

of products and services that had not even been imagined before.

As commodity energy markets become more competitive, the provision of

commodity source options transforms the types of services offered to

consumers. Once viable commodity source options become available,

wholesale energy marketers and wholesale spot markets rapidly appear. A

natural consequence of the opportunity to compete for wholesale customers

is the creation of marketers. These new entities, whether independent

companies or affiliates of regulated utilities, begin to work as intermediaries

between suppliers and customers by arranging for the provision of energy

through a range of new types of contracts. Spot markets develop, in which

short-term commodity energy is available at prices that are set by market

forces instead of regulators. Indicators to track the number of commodity

source options and the development of spot markets are discussed in Section

II, Commodity Markets, while price formation and the role of prices is taken

up in Section IV, Price Information.

The development of spot markets for wholesale energy, and the resulting price

volatility, leads to the creation of entirely new types of contracts and financial

services. Transportation of energy, for example, becomes more flexible with

the provision of new types of delivery contracts. Consumers and marketers

can protect themselves against the riskiness of price volatility through hedging

instruments such as forward contracts, and further opportunities for trade

arise using derivatives and other sophisticated transactions which allow the

price volatility itself to be used as a market opportunity.

Finally, the increasing competitiveness of energy markets has led to an

increased awareness of consumer needs. The existence of competitors creates

for the first time the risk of gaining or losing customers as a result of the

quality of service provision and other types of marketing. A wide range of

marketing strategies has developed, offering consumers the chance to find the

most appropriate source for their energy needs, while forcing service

providers to pay more attention to the quality of their customer service.

At the same time, continuing problems in the area of service availability can

block access to commodity energy markets. The Commission’s ongoing

Background and

Regulatory Context
Federal Energy Regulatory Commission State of the Markets 2000

17

activities in this area are directed at addressing these continuing issues in both

electric power and natural gas markets.

Electric power markets. Even after the implementation of Order No. 888,

the Commission’s understanding of market developments showed that there

were still barriers and impediments to the achievement of fully competitive

electric power markets. The Commission identified two broad categories: (1)

the engineering and economic inefficiencies inherent in the current operation

and expansion of the transmission grid, and (2) continuing opportunities for

transmission owners to unduly discriminate in the operation of their

transmission systems so as to favor their own or their affiliates’ power

marketing activities.

The transmission facilities of any one operator in a region are part of a larger,

integrated transmission system which, from an electrical engineering

perspective, operates as a single network. Each separate operator usually

makes independent decisions about the use, limitations and expansion of its

piece of the system based on incomplete information, even though their

independent actions can have major and instantaneous effects on the

transmission facilities of all other transmission operators (these network

characteristics of energy markets also play a large role in how market prices

behave, as discussed in Section IV, Price Information). The resulting

economic and engineering inefficiencies, while in a sense traditional, have been

exacerbated in recent years due to increases in bulk power trade, large shifts

in power flows, and an increasingly de-integrated and decentralized

competitive environment.

Further, when utilities control monopoly transmission facilities and also have

power marketing interests, they have poor incentives to provide equal quality

transmission service to their power marketing competitors. The functional

unbundling mandated by Order No. 888 does not change the incentives of

vertically integrated utilities to use their transmission assets to favor their own

generation, but instead attempts to reduce the ability of utilities to act on

those incentives. However, instances of actual discrimination may be

undetectable in a non-transparent market and, in any event, it is often hard to

determine, on an after-the-fact basis, whether an action was motivated by an

intent to favor affiliates or simply reflected the impartial application of

operating or technical requirements.

Transmission pricing reform was also identified as an issue which should be

addressed by the Commission. Some of these continuing inefficiencies

included:

• pancaked rates, which require transactions to incur multiple charges as

they pass across a fragmented transportation grid;

• loop flow, or the difference between a contract path and the actual flows

of power, which leads to uncompensated costs and reliability problems;

and

• poor congestion management, which can also lead to unnecessary costs

and reliability problems.
Federal Energy Regulatory Commission Federal Energy Regulatory Commission State of the Markets 2000 State of the Markets 2000

18

Through Order No. 2000, the 

Commission is encouraging 

transmission owners to join 

regional transmission 

organizations (RTOs). 

Restrictions on capacity release 

transactions can adversely affect 

the efficiency of natural gas 

markets. 

To address these concerns, the Commission issued Order No. 2000 late last

year. Order No. 2000 calls on all transmission owners to join regional

transmission organizations (RTOs). The Commission’s goal is encourage the

operation of high-voltage transmission on a regional basis, with few economic

or operational impediments to trade (including elimination of opportunities for

discriminatory transmission), a high level of transparency, and ease of entry

or exit for commodity source options. RTOs should also be adaptable to

changing conditions and institutional learning over time, through the use of

open architecture design principles.

Natural gas markets. The Commission also came to the conclusion that the

reforms of Order No. 636 had to be revisited. In the unbundled environment,

it became increasingly clear that the value of gas transportation, particularly

during peak periods, was not related to the maximum tariff rates for the

transportation. This largely resulted from the fact that gas commodity

markets now largely determine the economic value of gas transportation in

many areas of the country. Because pipelines legally can discount below their

maximum transportation rates, pipelines and shippers can adjust transportation

rates to the off-peak demand in the market. However, during peak periods,

the Commission’s maximum rate cap did not allow unbundled transportation

prices to equilibrate with demand. Particularly during peak constraint periods

on pipelines, preventing transportation prices from exceeding the pipeline’s

maximum rate can reduce the options of shippers purchasing in the short-term

market, and a shipper may not obtain the capacity or the amount of capacity

it needs regardless of whether it places the highest value on the capacity. 

Such a shipper then must either purchase gas in a bundled transaction in the

downstream market at a price reflecting the market-determined value of

transportation, or simply take the gas out of the pipeline and pay the pipeline’s

scheduling or overrun penalties. The shipper generally will not be able to

obtain released capacity at the capped price, because holders of that capacity

are unlikely to release capacity at a price less than the amount they can receive

by making a bundled sales transaction. 

Thus, during a peak day, capping the price of released capacity does not

effectively limit the price a purchaser has to pay to obtain transportation

service. It only serves to limit the purchasing shipper’s capacity options.

However, to use its own gas supplies to meet its peak day needs, the shipper

would have to pay substantial penalties for overrunning its transportation

contract. Shippers accumulating overruns also compromise the operational

integrity of the pipeline’s system, leading to a degradation of service for all

shippers, including the possibility of service curtailment through operational

flow orders, during peak periods when shippers most need the system to run

efficiently.

The Commission found that these restrictions on capacity release transactions

limit the development of an efficient and viable capacity market and can skew

customer capacity choices. Capping capacity release transactions during peak

periods at the current maximum rate system also harms captive customers
Federal Energy Regulatory Commission Federal Energy Regulatory Commission State of the Markets 2000 State of the Markets 2000

19

The number of oil pipelines 

requesting market-based rates 

rose by nearly 70 percent in 

FY 1999. 

holding long-term contracts on the pipeline. These customers have to pay

maximum pipeline rates for both peak and off-peak periods. During off-peak

periods, when prices are generally low, they cannot recover the cost of their

service through capacity release. But, when demand increases the value of

capacity, captive customers cannot reap the benefits of the higher value

through a straight-forward release of capacity. Instead, their only alternative

in selling capacity is to seek to make bundled sales transactions, regardless of

whether this is the most efficient economic alternative. The answer to this

problem may lie in the creation of robust secondary markets for short-term

capacity, where the market value of the released capacity can be recovered

through unregulated transactions.

Thus, this year, in Order No. 637, the Commission waived the price ceiling for

short-term released capacity (less than one year) until September 30, 2002.

The effectiveness of this unregulated secondary market for short-term

capacity will be assessed after the trial period. The Commission also

permitted pipelines to propose contracts for capacity with peak/off-peak and

term differentiated rate structures. Order No. 637 also sought to improve

competitiveness, efficiency and access to transportation by making changes

in regulations relating to scheduling procedures, capacity segmentation and

pipeline penalties and narrowing the right of first refusal by parties to expiring

transportation contracts. Finally, Order No. 637 improves reporting

requirements to provide more transparent pricing information and to permit

more effective monitoring for the exercise of market power and undue

discrimination.

Petroleum markets. The effort to reduce the regulatory burden on oil

pipelines resulted in the issuance of Order No. 561, et al. This series of

orders established various ratemaking procedures to be used by common

carrier oil pipelines designed to permit the industry to respond more quickly

and easily to changes in market conditions.

The Commission has established a generally applicable indexing methodology

that allows for greater efficiency and ease in filing rate changes while

protecting users of the pipelines’ services. It has also delineated three

alternatives to that methodology: traditional cost-of-service rates; marketbased rates; and negotiated or settlement rates. Most pipelines have taken

advantage of the new lighter-handed regulations when filing rate changes

under the simplified indexing program. 

The pipelines are also using the other modified procedures, such as waiver

requests for short-notice filings to streamline filing procedures. As an integral

part of the generally applicable indexing methodology, the Commission will

conduct a review of the selected index after 5 years of experience. This first

review, beginning in July, 2001, will examine the relationship of the annual

change in the index to the actual cost changes experienced by the industry. 

As part of its efforts to establish a more market-driven regulation for the oil

pipeline industry, the Commission has also adopted regulations for filing

requests for market-based rates by oil pipelines. This methodology is an
Federal Energy Regulatory Commission Federal Energy Regulatory Commission State of the Markets 2000 State of the Markets 2000

20

Service availability and supply 

options present the best

indication of what consumers 

perceive as a result of

competition.

alternative to traditional cost-of-service based regulation. While still relatively

more burdensome then the light-handed indexing methodology, several oil

pipelines have chosen this alternative. In this past year, the number of oil

pipelines requesting market-based determinations has increased by nearly 70

percent over the entire previous ten-year period. In a recent case involving

the Explorer Pipeline Company, the Commission’s order resolved a number

of ambiguities involved in its prior orders on market based rates for the oil

pipeline industry and developed a clear template for future applications for

market determinations.

Thus, as the industry attempts to structure new proposals to compete more

effectively in the market, the Commission has become a working partner in

resolving problems, while continuing to provide mandated protection for the

pipelines’ users. For example, the Commission is exploring means of

segmenting oil pipeline operations and costs to allocate costs between markets

that are competitive and those that are not. This will allow pipelines to apply

for partial exemptions for their competitive markets while retaining shipper

protections for the markets in which a pipeline may still have market power.

While the Commission does not have jurisdiction over oil pipeline mergers, it

is monitoring these transactions to determine their possible impact on the

competitive structure of the oil pipeline industry and how this might impact

the use of market based rates.

Service availability, then, is one way to describe the broad range of new

opportunities for consumers to receive energy. As a type of performance

measure for the Commission’s performance in the area of market

development, service availability indicators (along with supply option

indicators) present the clearest picture of what consumers actually receive as

a result of more competitive energy markets. In a sense these are indicators

of the physical results of market development, as opposed to prices or other

indicators of the economic results of market development. 

Defining service availability in contrast to supplier options, where suppliers

are defined as being the providers of the energy commodity, services are

defined as the means of delivering the commodity to consumers and any

related offerings which allow the commodity to be more valuable to

consumers. In this context services include the transportation of the

commodity, service delivery, and financial instruments such as those based on

price volatility.

Transportation services. Increasing commodity source options, along with

the development of spot markets and the resulting opportunities for cost

savings, have led to the creation of numerous innovative options for

transportation service over the electric power transmission and interstate

pipeline networks. Customers seeking to access the commodity markets are

now being offered more options for moving the energy commodity once it is

purchased. 

Delivery services. Similarly, the ability of wholesale customers to shop

around for their energy services has led to a greatly increased focus on

Developing

Performance

Indicators: Methods

and Data
Federal Energy Regulatory Commission State of the Markets 2000

21

customer service on the part of market participants. The range of delivery and

service choices is growing extremely rapidly. The types of delivery services

now available to customers includes, for example, customized pricing and

billing, sophisticated real-time metering, integrated energy portfolio

management, and a full range of energy audit and strategic energy service

planning services.

Financial instruments. The development of competitive pricing in spot

markets, and the resulting price volatility, has spurred new financial markets,

instruments and services. The basic motivation for these financial instruments

is hedging against commodity price volatility. This has led to the development

of active futures contract markets such as those operated by the New York

Mercantile Exchange (NYMEX). In addition, new types of financial arbitrage

instruments such as derivatives allow market participants to translate

underlying market conditions and the resulting changes in commodity prices

into value in the marketplace.

Performance indicators in the area of service availability should be able to

trace the development of innovative service options, and to show how

developments in competitive energy commodity markets (or other changes in

the way energy markets are structured) are related to the development of

service options over time. Traditionally, the Commission has not been

tracking service availability indicators. Data on service availability is by

nature difficult to interpret because of the great variation in the types of

services being developed, and because many transactions in the energy

markets are private and therefore not necessarily revealed in a public

information context. 

However, major innovations in service are often advertised and marketed, and

there has been a rapid growth in the role of the trade press in reporting on

some types of services. And information directly from the Commission’s

customers about what kinds of services they want and what kinds they can

actually get forms an important part of the Commission’s overall

understanding of markets and customer needs. Performance indicators in the

area of service availability will continue to develop as the Commission

rethinks its information needs and how to achieve goals regarding the use of

external information (as opposed to information which is reported directly to

the Commission).

Performance indicators in the area of service availability should demonstrate

how the Commission uses information about the markets to make informed

policy and further its mission. The development of information about the

natural gas transportation market leading into the rulemaking for Order No.

637 is a timely example. The map below shows the national natural gas

wholesale spot prices and the direction of flows on interstate natural gas

pipelines in April of 1996. 

Performance

Indicators: Examples
Federal Energy Regulatory Commission State of the Markets 2000

22

Sources: Gas Daily, Weekly Weighted Average Prices and PI Grid. Data through December 31, 1998.

Note: Tariff rates are IT rates from Columbia, $0.45; Tennessee, $0.59; Texas Eastern, $0.57; and Transco, $0.44. 

1995 1996 1997 1998

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

to $10.08 to $6.54

Implicit Price of Transportation from Sou th Louisiana to New York

Average Weekly New York Spot Price minus Average Weekly South Louisiana Spot Price

Range of MaximumTariff 

Rates for Transportation

Natural Gas Spot Price Differences Between Selected Points

Source: Natural Gas Week . Data through April 29, 1996.

Notes: Monthly average prices for selected delivery points for deals in April. Prices for Alberta and Niagara are for Canadian spot transactions of 12 months or less. 

Prices used for Detroit are from Columbia Gas at Maumee, Ohio. Spot prices reflect transactions of 31 days or less. Monthly price is the median of the prices 

assigned to a market center area.

April 1996

Calgary, Alberta

Overthrust

Permian

Panhandle/Hugoton

Chicago

Detroit

Leidy New York

Niagara

Texas Gulf Coast

South Louisiana

Kern

Atlanta

$1.78

$.33

$1.49

$.04 $.23

$.10

$1.17

San Juan

Direction of Flow

Prices inconsistent

with direction of flow ($.XX)

$.05

Lebanon

$.31

North Louisiana/East Texas

$.11

$.32

$.25

$.14

$.17 $.97

$.41

$.12

$.01

$1.39

$.09

$.11

$.12

$.22

$.18

$.17

$.02

$.19

$.28

What is important about this information is the fact that the developing natural

gas market produced a situation where the differences in prices between

distant regions created powerful market forces which dramatically changed

the implicit price of gas transportation. This is shown in the following graph,

which presents the implicit price of transportation service between New York

and South Louisiana, compared to the regulated rate caps placed on that

service. 

The inter-regional spot price disparity created a value for transportation which

was at times far in excess of what pipeline companies could charge for the
Federal Energy Regulatory Commission State of the Markets 2000

23

service. This implicit value of pipeline transportation, which could not be

recovered through flat rates, led to efforts by market participants to recover

this value through other means. Through the use of informed analysis such

as this, the Commission determined the need for a major rulemaking on shortterm natural gas transportation services, culminating in the issuance of Order

No. 637.

Performance indicators in the area of service availability should also be able

to trace the pace of development of new services as the impact of commodity

market competition leads to more market opportunities and innovation. This

is again an area where the Commission has not typically collected information

in a systematized way. However, an inventory and chronology of innovative

service offerings, categorized in a sensible fashion, should be an attainable

goal for preliminary performance indicators. The following is a preliminary

example of such a categorized set of new services in the electric power and

natural gas industries:
Federal Energy Regulatory Commission Federal Energy Regulatory Commission State of the Markets 2000 State of the Markets 2000

24

General General

Category Category

Specific Specific

Service Service

Date First Date First

Offered Offered

Current Current

Status

Comment Comment

s

Transportatio Transportatio

n Services n Services

Open-Access

Pipeline

Transportation 

Tariffs

Transportatio Transportatio

n Services n Services

Open-Access

Electric

Transmission

Tariffs

Transportatio Transportatio

n Services n Services

Gas Pipeline

Electronic

Bulletin Boards 

(EBBs)/Internet 

Systems

Transportatio Transportatio

n Services n Services

Electric

Transmission

OASIS Sites

Transportatio Transportatio

n Services n Services

Gas Market

Centers

Transportatio Transportatio

n Services n Services

Electric Power 

Exchanges

Transportatio Transportatio

n Services n Services

Secondary

Markets for

Pipeline

Capacity

Delivery Delivery

Services Services

Development of 

Asset and

Portfolio

Managers

Delivery Delivery

Services Services

Development of 

Independent

Gas Marketers 

Delivery Delivery

Services Services

Development of 

Independent

Power

Marketers

Delivery Delivery

Services Services

Development of 

"Gray" Market

for Gas

Deliveries

Delivery Delivery

Services Services

Development of 

Independent

Service

Operators for

Electric

Transmission 

Delivery Delivery

Services Services

Development of 

Independent

Service

Operators for

Electric

Transmission 

Financial Financial

Instruments Instruments

Futures

Contracts

Financial Financial

Instruments Instruments

Arbitrage

instruments