[Federal Register Volume 60, Number 30 (Tuesday, February 14, 1995)]
[Notices]
[Pages 8356-8375]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-3631]



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DEPARTMENT OF ENERGY
[Docket No. RM95-6-000]


Alternatives to Traditional Cost-of-Service Ratemaking for 
Natural Gas Pipelines; Request for Comments on Alternative Pricing 
Methods

February 8, 1995.
    The Federal Energy Regulatory Commission (Commission) requests 
comments on criteria to evaluate rates established through methods 
other than the traditional cost-of-service ratemaking method. The 
Commission's traditional approach to rate regulation sets an annual 
revenue requirement based on operating and capital costs occurring 
during a historical test period, adjusted for known and measurable 
changes expected to occur by the time suspended rates take effect. 
Rates are generally designed to recover the annual revenue requirement 
based on contract capacity entitlements and projected annual or 
seasonal volumes.
    Recently, the Commission has received a number of requests from 
natural gas pipeline companies to approve rates based on various other 
pricing methods, some of which are cost-based, and some of which are 
not. For example, the Commission has approved a number of proposals for 
market-based rates for storage services.\1\ In Stingray Pipeline 
Company,\2\ the Commission approved a one-year experimental 
interruptible transportation rate based on costs allocated to 
Stingray's interruptible service, subject to a price cap. In KN 
Interstate Gas Transmission Company (KN),\3\ the Commission addressed 
KN's proposal to offer market-based rates and negotiated terms and 
conditions of service on its Buffalo Wallow System. Most recently, 
Florida Gas Transmission Company's section 4 filing in Docket No. RP95-
103-000 included a ``Market Matching Program,'' under which shippers 
would have the option of negotiating rates and terms of service 
different from the tariff rates and terms of service. Florida Gas also 
proposed an experimental inflation indexing mechanism for rate changes, 
using cost-of-service rates as the starting point.

    \1\Avoca Natural Gas Storage, 68 FERC 61.045 (1994); Koch 
Gateway Pipeline Co., 66 FERC 61,385 (1994); Bay Gas Storage 
Company, LTD. 66 FERC 61,354 (1994); Petal Gas Storage Co., 64 FERC 
61,190 (1993); Transok, Inc., 64 FERC 61,095 (1993); Richfield Gas 
Storage System, 59 FERC 61,316 (1992).
    \2\66 FERC 61,202 (1994).
    \3\68 FERC 61,401 (1994).
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    The Commission is interested in developing a framework for 
analyzing proposals involving alternative pricing methods for natural 
gas pipelines. There are a number of different ratemaking methods that 
could be used instead of the traditional individual company embedded 
cost-of-service method. In addition to market-based pricing, there are 
a number of cost-based methods that vary from the individual company 
cost-of-service method traditionally used by the Commission. The 
Commission recognizes that it may be necessary to develop different 
criteria for evaluating alternative pricing proposals, depending upon 
the method proposed. To this end, the Commission's staff has prepared a 
paper, which is attached, proposing criteria for the evaluation of 
proposals for market-based rates. The staff paper draws from basic 
antitrust market power analysis, that has been used in the past by the 
Commission and in other contexts, to develop a proposed analytical 
framework to use in evaluating gas pipeline market-based rate 
proposals. The Commission is interested in receiving comments on all 
aspects of the staff paper, including the following:

    1. a. Under what circumstances are market-based rates 
appropriate for natural gas pipelines and services regulated by the 
Commission?
    b. Please identify and discuss any legal issues, beyond those 
discussed in the staff paper, that should be considered.
    2. a. Are the Department of Justice/Federal Trade Commission 
Horizontal Merger Guidelines, from which the staff proposal is 
drawn, the best framework to evaluate market power in the interstate 
natural gas pipeline context?
    b. Are there other approaches to evaluating market power that 
would be less burdensome?
    3. a. Are the criteria proposed in the staff paper reasonable, 
too strenuous, or not strenuous enough?
    b. Should the Commission use a different standard for different 
types of service, such as mainline transmission, storage, or market 
hub services?
    4. a. Should the Commission consider treating companies with a 
small market share differently from larger or dominant sellers, and 
if so, under what circumstances?
    b. How should the Commission view cases in which large sellers 
face large buyers (that is, where a single buyer represents a large 
share of a transporter's market?
    c. Can a buyer's monopsony power mitigate a seller's market 
power, and if so, how should the Commission analyze such cases?
    5. Do commenters agree or disagree with staff's analysis that 
capacity release does not constitute a good alternative to firm 
transportation?
    6. What procedures should the Commission employ to evaluate 
market-based rate proposals; should the Commission change its 
current policy of using declaratory orders or ruling on pro forma 
tariff sheets?
    7. Are there particular requirements the Commission could impose 
that would increase the availability of shippers' service 
alternatives and mitigate the market power of a natural gas company 
that would not otherwise qualify for market-based pricing?
    8. Are there regulatory policies or ratemaking methods that 
would better serve the Commission's regulatory goals of flexible, 
efficient pricing in today's environment? For example, should the 
Commission focus on ``backstop'' proposals, where pipelines would be 
free to negotiate rates and terms of service, so long as customers 
could always choose service under traditional cost-of-service rates 
and terms of service?

    In addition, the Commission also invites comments on the criteria 
for evaluating incentive rate proposals. While the Commission currently 
has a policy for evaluating cost-based incentive rate proposals, to 
date no natural gas company has submitted a proposal in response to the 
Commission's invitation to submit incentive rate proposals for an 
experimental period. The Commission's October 30, 1992 policy statement 
on incentive regulation defined the essential elements of an incentive 
ratemaking policy and set guidelines for incentive rate proposals.\4\ 
The policy statement adopted two general principles: That incentive 
regulation should encourage efficiency, and that starting rates under 
incentive regulation must conform to the Commission's 
[[Page 8357]] traditional cost-of-service ratemaking standards. The 
policy statement also established five regulatory standards for the 
evaluation of specific proposals--that incentive proposals must: (1) Be 
prospective, (2) be voluntary, (3) be understandable, (4) result in 
quantified benefits to consumers, and (5) demonstrate how they maintain 
or enhance incentives to improve the quality of service. The standard 
pertaining to the quantification of benefits requires the inclusion of 
an absolute upper limit on the risk to consumers, with the overall cap 
on incentive rate increases based on projected traditional cost-of-
service rates. In view of the lack of response to the October 30, 1992 
policy statement and the changes in the natural gas market that have 
occurred since the issuance of the policy statement (principally the 
implementation of Order No. 636), the Commission believes it is 
appropriate at this time to revisit the issue of incentive rates for 
pipeline services and requests comments in response to the following 
questions:

    \4\Policy Statement on Incentive Regulation, 61 FERC 61,168 
(1992).

    9. Why have there not been any incentive proposals under the 
policy established in Docket No. PL92-1-000?
    10. a. Should the Commission change its existing standards for 
incentive rate proposals?
    b. If so, what specific criteria should the Commission employ 
when evaluating incentive rates?
    11. Are there models for incentive regulation that the 
Commission should consider, such as the California performance-based 
program?
    12. a. What are the benefits and drawbacks of incentive rates, 
and the policy objectives the Commission should pursue with an 
incentive rate method?
    b. Is incentive ratemaking appropriate for the natural gas 
companies regulated by the Commission?
    c. Please identify and discuss any legal issues that the 
Commission has not yet considered with this type of rate method.

    There are other pricing methods which are neither market-based nor 
incentive-based, such as reference pricing (in which the rate is 
determined by reference, e.g., to the rates of another company or the 
price of another product). The Commission also requests comments on 
criteria for evaluating such proposals:

    13. What other rate methods should the Commission consider 
beyond the market-based and incentive-based methods covered above?
    14. a. What would be the benefits and drawbacks of any such 
methods?
    b. Please identify and discuss any particular legal or 
procedural issues raised by a specific method.
    15. What criteria would the Commission use to evaluate such 
proposals?

    The Commission is requesting written comments on these questions 
and the attached staff paper on market-based rates. The Commission 
requests parties to identify the numbered questions in their comments 
to the maximum extent possible. An original and 15 copies of written 
comments should be filed with the Secretary of the Commission within 60 
days of the issuance of this notice, and should refer to Docket No. 
RM95-6-000.

    By direction of the Commission.
Lois D. Cashell,
Secretary.

Table of Contents

I. The Applicable Legal Standards
II. The Commission's Prior Experience With Market-Based Rates
    A. The Gas Inventory Charge Cases
    B. The Storage Cases
    C. The Oil Pipeline Cases
    D. The Electric Cases
III. Proposed Criteria for Evaluating Market-Based Transportation 
Rate Proposals
    A. General Framework and Criteria
    B. An Example of the Analysis Applied to Firm Transportation
    C. Application of Criteria to Other Services
    D. Review of Market Power Findings

Appendix: Analysis of Other Industries

Market-Based Rates for Natural Gas Companies

A Staff Paper

    The Commission has been requested by various companies to approve 
market-based pricing for both firm and interruptible transportation, 
for capacity released in the secondary market, for storage and for 
market hub services such as the ``switching'' and ``parking'' of 
natural gas. Approval of any of these proposals is contingent on the 
Commission finding that the company in question lacks significant 
market power. The purpose of this paper is to propose criteria that 
could be used to evaluate these proposals.
    In developing these criteria staff has reviewed the Commission's 
prior experience with market-based ratemaking for natural gas 
companies, oil pipelines, and public utilities. In those cases the 
Commission consistently used the same general framework to evaluate 
requests for market-based rates. In addition, the experiences in three 
other industries (railroads, telecommunications, and airlines) also 
have been reviewed to determine whether there are lessons that can be 
drawn. For illustrative purposes the paper applies the proposed 
criteria to a hypothetical case. Finally, the paper discusses the other 
services that may qualify for market-based rates as well as factors the 
Commission may want to consider in monitoring market-based rates.

I. The Applicable Legal Standards

    Operating under the ``just and reasonable'' standard of the Natural 
Gas Act (NGA), the Federal Power Act (FPA), and the Interstate Commerce 
Act (ICA), the Commission generally authorizes rates based on the cost 
of service. However, as the Supreme Court has ruled on numerous 
occasions,\1\ the just and reasonable standard does not limit the 
Commission to any particular ratemaking methodology; rather, the 
Commission has flexibility in selecting ratemaking methods.

    \1\See Mobil Exploration & Producing Southeast Inc. v. United 
Distribution Companies, 498 U.S. 211 (1991) (affirming the 
Commission's Authority to consolidate existing ``vintage'' price 
categories and set a single ceiling price for ``old'' gas); Duquesne 
Light Co. v. Barash, 488 U.S. 299, 310 (1989); Permian Basin Area 
Rate Cases, 390 U.S. 508, 517 (1979); FPC v. Hope Natural Gas Co., 
320 U.S. 591, 602 (1944).
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    Courts have held that non-cost factors can legitimate a departure 
from cost-based rates. Departures from cost-based rates have been found 
to be justified when: (1) The changing characteristics of the industry 
make advisable or necessary a new approach;\2\ (2) the deviations from 
costs are not unreasonable or inconsistent with statutory 
responsibilities;\3\ and (3) the regulatory scheme acts as a monitor to 
determine whether competition will keep prices within a zone of 
reasonableness or to check rates if it does not.\4\ However, in ruling 
that rates need not be linked to costs in order to be just and 
reasonable, the court in Farmers Union II held that the Commission 
cannot merely assume that competition will ensure just and reasonable 
prices: ``[m]oving from heavy to lighthanded regulation within the 
boundaries set by an unchanged statute,'' can only ``be justified by a 
showing that under the current circumstances the goals and purposes of 
the statute will be accomplished through substantially less regulatory 
oversight.''\5\

    \2\Farmers Union Central Exchange, Inc. V. FERC, 734 F.2D 1486, 
1503 (D.C. Cir. 1984) (Farmers Union II), cert. denied sub nom., 
Williams Pipe Line Co. v. Farmers Union Central Exchange, Inc., 469 
U.S. 1034 (1984) (citing Permian Basin Area Rate Cases, 390 U.S. 747 
(1968)).
    \3\Farmers Union II at 1502 (citing Mobil Oil Corp. v. FPC, 417 
U.S. 283 (1974)).
    \4\Id. at 1509 (citing Texaco, Inc. v. FPC, 474 F.2d 416, 422 
(D.C. Cir. 1972), vacated, 417 U.S. 380 (1974) (the court of 
appeal's decision was vacated on other grounds)).
    \5\Id.
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    The Commission's authority to approve market-based rates under the 
[[Page 8358]] appropriate circumstances was recently and clearly 
affirmed in Elizabethtown Gas Co. v. FERC.\6\ There, the court upheld 
the Commission's approval of a natural gas pipeline's proposal, as part 
of a pre-Order No. 636 restructuring settlement entered into with its 
customers, to sell gas for resale at market-based prices. Noting that 
the Supreme Court has held on numerous occasions that the just and 
reasonable standard does not dictate any single pricing methodology,\7\ 
the court held that where there is a competitive market, the Commission 
``may rely upon market-based prices in lieu of cost-of-service 
regulation to assure a `just and reasonable' result.''\8\ In sustaining 
the Commission's approval of market pricing in this case, the court 
alluded to the Commission's specific finding that the pipeline's 
markets were ``sufficiently competitive to preclude [the pipeline] from 
exercising significant market power in its merchant function* * *.''\9\ 
Specifically, the Commission had determined--and no record evidence to 
the contrary was cited on appeal--that adequate divertible supplies of 
gas existed to give customers options to buy from sellers other than 
the pipeline, thus assuring that the pipeline would have to sell its 
own gas at competitive prices. This finding, the court reasoned, 
justified the Commission's conclusion that the pipeline would be able 
to charge only a price that was just and reasonable within the meaning 
of section 4 of the NGA.

    \6\10 F.3d 866, 870 (D.C. Cir. 1993) (Elizabethtown).
    \7\The court cited Mobil Oil Exploration v. U.S., 111 S. Ct. 
615, 624 (1991): ``* * * the just and reasonable standard does not 
compel the Commission to use any single pricing formula * * *.'' 10 
F.3d at 870.
    \8\Id. (quoting Tejas Power Corp. v. FERC, 908 F.2d 998, 1104 
(D.C. Cir. 1990).
    \9\10 F.3d at 870-71 (quoting Transcontinental Gas Pipe Line 
Corp., 55 FERC 61,446 at 62,234.
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    In reaching this result, the court of appeals in Elizabethtown 
distinguished the Supreme Court's decision in FPC v. Texaco, Inc. 
(Texaco),\10\ in which the Supreme Court had remanded an FPC order 
exempting small gas producers from direct regulation of their prices. 
The Commission order under challenge in Texaco provided that small 
producers' prices would be subject to scrutiny only as a part of the 
rates of pipelines and large producers to whom they sold their gas, and 
then only through review of the pipeline and large producer rates. This 
indirect review procedure was found by the Court to be permissible 
under the NGA.\11\ However, the order was remanded because the 
Commission had not clearly shown how, or even whether, the just and 
reasonable standard would be applied to the small producers' prices in 
this process.\12\ The Court admonished that on remand the Commission 
must adhere to the principle that ``the prevailing price in the market 
cannot be the final measure of 'just and reasonable' rates mandated by 
the Act.''\13\

    \10\FPC v. Texaco, Inc., 417 U.S. 380, 397 (1974).
    \11\417 U.S. at 387-91
    \12\The Commission stated that the just and reasonable standard 
would be applied, and enumerated various factors, in addition to 
prevailing market prices, that would be taken into account. The 
Court observed that these representations were relevant to the 
validity of the order, but ruled that because they were not made in 
the order itself--only on appeal--they were unavailing. 417 U.S. at 
397.
    \13\417 U.S. at 397.
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    The court in Elizabethtown reasoned that the point of Texaco was 
only that if Congress has subjected an industry to regulation because 
of anticompetitive conditions in the industry, the market cannot be the 
``final'' arbiter of the reasonableness of a price.\14\ Further, the 
court in Elizabethtown stated, in the Texaco proceeding the Commission 
had not even mentioned the ``just and reasonable'' standard, but rather 
appeared to apply only the marketplace standard in determining the 
reasonableness of small producers' rates. In contrast, in the order 
challenged in Elizabethtown, the Commission had made it clear that it 
would exercise its section 5 authority if necessary to assure that a 
market rate is just and reasonable.

    \14\Elizabethtown, 10 F.3d at 870.
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    A hybrid cost/market-based pricing scheme under the FPA was 
approved by the court in Environmental Action v. FERC.\15\ There the 
Commission had approved the application of certain regulated and non-
regulated electric utilities to operate a power pool in which 
transactions would be priced according to the market, subject to a 
uniform ceiling price based upon a hypothetical average utility's 
costs. The court, in rejecting challenges to the pricing mechanism, 
emphasized the speed and administrative efficiency benefits of market-
based pricing. In addition, the court also cited the Commission's 
expressed intention to monitor transactions and invoke its 
investigatory powers under section 206 (either sua sponte or upon 
complaint) to redress abuses. Thus, the court concluded that ``[i]n 
sum, FERC sought to preserve the Pool's efficiencies even as it guarded 
against price gouging. On the facts in evidence, we find no basis for 
concluding it acted unreasonably.''\16\

    \15\996 F.2d 401 (D.C. Cir. 1993).
    \16\Id. at 410. See also National Rural Telecom Assoc. V. FCC, 
988 F.2d 174 (D.C. Cir. 1993) (approving flexible pricing for local 
exchange companies, subject to a ceiling rate).
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    The court's treatment of market-based pricing policies implemented 
by other agencies offers little guidance to the Commission since much 
of the focus on increasing competition and reducing federal regulations 
has been through statutory reform, rather than through agency 
interpretation of existing statutory authorities. The bounds of agency 
authority to interpret existing statutory procedural requirements in a 
manner to facilitate a move to market-based pricing was addressed by 
the Supreme Court in MCI Telecommunications Corporation v. American 
Telephone and Telegraph Company (MCI II),\17\ and by the court of 
appeals in Southwestern Bell Corporation v. FCC (Southwestern 
Bell).\18\ However, MCI II and Southwestern Bell do not speak to the 
substantive validity of market-based regulation under a just and 
reasonable statutory standard. Judicial precedents, as explained above, 
uphold the use of market-based ratemaking, or some variation thereon, 
if the agency finds that clearly delineated non-cost factors (including 
the Commission's oversight and remedial authorities) are sufficient to 
protect the interests of consumers.

    \17\114 S. Ct. 2223 (1994).
    \18\Nos. 93-1562, 93-1568, 93-1590, and 93-1624 (D.C. Cir. Jan. 
20, 1995).
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II. The Commission's Prior Experience With Market-Based Rates

A. The Gas Inventory Charge Cases

1. The Analysis Used
    In 1988, the Commission began its movement towards light-handed 
regulation of some aspects of natural gas markets. The light-handed 
regulation first appeared with the implementation of market-based gas 
inventory charges (GIC) for pipeline sales service. In determining 
whether a pipeline could implement a GIC mechanism, the Commission 
looked at three key factors: Market definition, the availability of 
divertible gas supplies and measures of market power. Additionally, the 
Commission considered whether the transportation of alternative 
supplies would be on a comparable basis to the terms and conditions of 
transportation service provided for gas purchased under the GIC. If the 
supply markets were found to be competitive and transportation terms 
and conditions [[Page 8359]] comparable, pipelines were permitted to 
implement a GIC.\19\

    \19\See Transwestern Pipeline Company, 43 FERC 61,240 (1988); 
El Paso Natural Gas Company, 49 FERC 61,262 (1989 and 54 FERC 
61,316 (1991); and Transcontinental Gas Pipe Line Corporation, 55 
FERC 61,446 (1991) aff'd Elizabethtown, supra.
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    In applying these standards in El Paso, for example, the Commission 
found that the relevant product market was delivered firm gas. El Paso 
maintained that the product market was not simply natural gas, but 
energy generally (i.e. fuel oil, coal, propane, hydroelectric power, 
and purchased power). However, El Paso did not provide sufficient 
evidence to make such a case. Thus, the Commission excluded alternative 
fuels from the product market.
    The Commission established that ``firm'' gas was a dimension of the 
product market since El Paso was proposing to sell firm gas under its 
GIC. The Commission also found that ``delivered'' gas was a second 
dimension of the relevant product market because firm gas supplies that 
could not be transported to the city-gate were not substitutes for 
supplies under the GIC.
    In defining El Paso's geographic market, the Commission 
acknowledged that it could consist of the entire United States or North 
America. The Commission stated, however, that the relevant geographic 
market was the geographic area containing those suppliers that can 
affect any attempt by El Paso to exercise market power. The Commission 
decided to take a cautious approach and considered three areas of gas 
supplies in order of the most narrowly defined: (1) The counties in the 
three basins where El Paso purchases gas that are already connected to 
El Paso's system, (2) all counties in the three basins, and (3) all 
counties from which El Paso purchased gas in 1987, including counties 
outside the three basins. The Commission reasoned that if El Paso 
lacked market power in the most narrowly defined market, then it would 
also lack market power in a more broadly defined market. Alternatively, 
even if El Paso could exercise market power in a narrowly defined 
market, it might be demonstrated that El Paso nonetheless lacked market 
power when the definition was expanded.
    The Commission found that 1.07 Bcf/d was the minimum measure of the 
amount of divertible, or alternative, gas supplies needed to prevent El 
Paso from exercising market power. The 1.07 Bcf/day represented the gas 
dedicated to El Paso under long-term contracts, together with its 
affiliates' volumes. The Commission determined that sufficient 
divertible supplies existed in each of the defined geographic markets, 
at competitive prices, such that El Paso would be precluded from 
exercising market power. The Commission defined divertible supplies as 
those that were uncommitted, or committed under contract to a buyer for 
no longer than some short period such as one year.
    The Commission then measured each seller's share of the market. To 
compute El Paso's market share the Commission used its sales to each 
customer at the time of peak usage. These market shares were then used 
to compute the level of concentration in the market using the 
Hirschman-Herfindahl Index (HHI).\20\ The Commission used an initial 
screen of .18 to determine if the market concentration was low enough 
to indicate that the competitors in the market could not exercise 
market power.\21\ The Commission found that the market concentration 
was low, i.e., below .18.

    \20\An HHI is calculated by summing the squares of each seller's 
market share. For example, if there are two sellers of a product 
having shares of total sales of 75 percent and 25 percent, 
respectively, then the HHI will equal 
(.75)<SUP>2+(.25)<SUP>2=.5625+.0625=.625. Rounding to two 
significant digits, the HHI is .63.
    \21\An HHI of .18 is equivalent to having 5-6 equal sized 
competitors in the market. In El Paso, the Commission indicated that 
it would use a case-by-case approach to determine the lack of market 
power. The HHI was used as an initial screening tool only. El Paso, 
49 FERC at 61,920. See also Petal Gas Storage Co., 64 FERC 61,190 
at 62,573 (1993) (market power determined on a case-by-case basis).
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    The Commission also found that the transportation service to be 
provided by El Paso for the transportation of third party supplies was 
comparable, with certain modifications, to the transportation provided 
under the GIC.
    Therefore, based on this analysis, the Commission found that El 
Paso lacked market power and permitted the implementation of a market-
based GIC.
2. The Subsequent History of the GIC Cases
    On May 11, 1988, the Commission found that Transwestern lacked 
market power with respect to the gas commodity. Southern California Gas 
Company (SoCal), the only company directly affected, had sufficient 
alternative gas supply sources that Transwestern's prices would be 
constrained. Therefore, the Commission approved, with some 
modifications, Transwestern's proposed market-based Gas Inventory 
Charge (GIC).\22\

    \22\Transwestern Pipeline Co., 43 FERC 61,240 (1988).
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    When Transwestern attempted to put its GIC charges into effect, 
SoCal nominated zero volumes of Transwestern's gas.\23\ This is an 
extreme example of a lack of market power; an attempt to get a premium 
above the available spot price led to virtually a 100 percent reduction 
in Transwestern's sales.

    \23\Foster Natural Gas Report, No. 1741, for the week ended 
September 21, 1989, pp. 2-3.
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    In July, 1990, in Tejas Power Corp. v. FERC,\24\ the court of 
appeals emphasized the importance of a market power determination in 
the approval of a GIC mechanism, even in the context of a settlement. 
In Tejas, the court found the Commission's reliance on the agreement of 
the LDCs, in approving a GIC settlement proposed by Texas Eastern 
Transmission Corp., was misplaced because there was no finding, 
supported by substantial evidence, that the pipeline lacked significant 
market power. All of the Commission's subsequent market-based GIC cases 
examined the market power of the pipeline applicant.

    \24\908 F.2d 998 (D.C. Cir. 1990) (Tejas).
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    The series of pipeline-by-pipeline GIC cases allowing market-based 
pricing for the gas commodity was broadened to a generic finding in 
Order No. 636. The Commission allowed pipelines to have market-based 
pricing for unbundled gas sales upon full compliance with the final 
rule.\25\

    \25\FERC Regulations Preambles, 30,939 at 30,439.
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    In conclusion, the Commission's experience with deregulation of the 
gas commodity has shown that competition can restrain prices. In fact, 
the statutory wellhead deregulation and the Commission's open access 
policies have led to a current price for the gas commodity that is well 
below the regulated prices that prevailed several years ago.

B. The Storage Cases

1. The Analysis Used
    Starting with the the Commission's order in Richfield Gas Storage 
System (Richfield)\26\ in June 1992, the Commission has permitted 
companies to institute market-based storage rates subject to light-
handed regulation when the applicants have shown that they lack 
significant market power. In making these market determinations, the 
Commission primarily looked at the defined markets, the availability of 
good alternatives, and measures of market power. However, the 
Commission also considered other factors, such as the fact that the 
applicants were generally new entrants, the applications were generally 
unopposed, and the possibility of other [[Page 8360]] new entrants. In 
applying these standards in Koch, for example, the Commission agreed 
with Koch's definition of product and geographic markets. Koch applied 
a narrow and broad definition to both markets. Koch argued that if it 
did not have market power in narrowly defined markets, it would not 
have market power when the definitions were broadened.

    \26\Richfield Gas Storage System, 59 FERC 61,316 (1992).
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    Koch defined the narrow product market as natural gas storage. The 
narrow geographic market was defined to contain those storage 
facilities in the states of Texas, Louisiana, and Mississippi that are 
connected to Koch.
    The record showed that Koch owned only 11.9 percent of the contract 
storage capacity and 6.1 percent of the contract storage deliverability 
in the narrow market. The market concentration was computed using the 
Hirschman-Herfindahl Index (HHI) to be .13 for capacity and .12 for 
deliverability indicating a relatively low concentration in the narrow 
market.
    The Commission also reviewed the fact that five new suppliers may 
enter the market by 1996 that would potentially have direct connects to 
Koch.
    The broader product market was defined to include non-storage 
alternatives and storage alternatives not connected to Koch, such as, 
capacity release of storage in new or existing storage facilities, 
purchase of natural gas from producers or other marketers, selling gas 
to customers that have several suppliers, access to no-notice storage, 
to name a few. The broader geographic market was defined as 
alternatives outside of Texas, Louisiana and Mississippi.
    The Commission gave much consideration to whether or not the 
alternatives identified by Koch were ``good'' alternatives. The 
Commission defined a good alternative as one that is available soon 
enough, has a price that is low enough, and has a quality high enough 
to permit customers to substitute the alternative for Koch's service. 
In addition, the alternative must be available in sufficient quantity 
to make Koch's price increase unprofitable.
    The Commission found that good alternatives were available in 
sufficient quantities and at competitive prices. The Commission 
determined that unutilized storage capacity was available in large 
quantities in Texas, Louisiana and Mississippi during peak periods 
based on statistics found in EIA's Natural Gas Monthly. The Commission 
reasoned that if this unutilized capacity was not under contract it was 
available for purchase. Unutilized capacity that was committed under 
contract, the Commission reasoned, would be available through capacity 
release. Therefore, given the small size of Koch in relation to other 
storage providers, the abundant storage alternatives available to 
Koch's customers, and that the alternatives are ``good'' alternatives, 
the Commission concluded that Koch could not exercise market power in 
providing storage service.
2. The Experience After Approving Market-Based Rates
    The market-based storage cases approved by the Commission 
(Richfield, Petal, Transok, Bay State, Avoca, and Koch) are quite 
recent. The companies in question were not subjected to any special 
reporting requirements. Thus, there is little information currently to 
evaluate these decisions. In addition, the pipelines in several of 
these cases executed long term contracts at the same time they were 
seeking market based rates. The contracts set the prices for the term 
of the contract. No complaints have been filed so far regarding the 
market based storage rates. However, one would not expect to see the 
complaints so early in the process. Complaints would be more likely to 
occur when the parties seek to negotiate new pricing provisions at the 
end of the contract term, if new capacity becomes available, or if the 
circumstances which served as the basis of the Commission's decision 
changed.
    Earlier, however, the Commission approved an experiment wherein 
Koch storage was allowed to charge any price it could negotiate up to a 
cap which exceeded the cost-based rate. The Commission did not make a 
finding that Koch lacked significant market power. The results of the 
``Market Responsive Storage and Delivery Service'' (MRSDS) experiment 
suggest that competition constrained Koch to prices actually below the 
cost-based rates. All market-based MRSDS rates charged by Koch were 
below the cap. During the two full heating seasons of the experiment, 
customers fully subscribed all the capacity allocated to MRSDS.\27\

    \27\Koch Gateway Pipeline Co., 66 FERC 61,385 at 62,301-302 
(1994).
---------------------------------------------------------------------------

C. The Oil Pipeline Cases

    In the oil pipeline area, two companies have the authority to 
charge market-based rates--Buckeye Pipe Line Company, L.P. (Buckeye) 
and Williams Pipe Line Company (Williams). In both cases the Commission 
determined that the pipeline lacked market power in markets for which 
each was allowed to charge market-based rates.\28\

    \28\Buckeye Pipe Line Company, L.P., 53 FERC 61,473 (1990). 
Williams Pipe Line Company, 69 FERC 61,136 (1994). Both cases were 
litigated and the Commission made its findings that certain markets 
were competitive based on the records presented at the hearings.
---------------------------------------------------------------------------

1. The Analysis Used
    In conducting its analysis of whether the applicant had market 
power, the Commission first defined the product and geographic markets. 
It then evaluated whether the applicant had significant market power in 
those markets by first doing an initial screen for market concentration 
in each market (using the Herfindahl-Hirschman Index) and then 
considering, weighing and balancing a number of other factors, such as, 
the potential entry of competitors into the market, available 
transportation alternatives, market share, availability of excess 
capacity, and the presence of large buyers able to exert downward 
monopsonistic pressure on transportation rates.
    In Buckeye, for example, the relevant product market was defined as 
the transportation of refined petroleum products. The Commission agreed 
with the ALJ and rejected the position advanced by ATA that the product 
market should be markets in which Buckeye transports only jet fuel. The 
Commission concluded that the ease of product substitution among 
pipelines is an important reason why the relevant product market should 
be the transportation of refined petroleum products rather than the 
transportation of a specific petroleum product, such as gasoline, fuel 
oil or jet fuel.
    The relevant geographic markets were defined as the areas that 
include all supplies of transportation from all origins to United 
States Department of Commerce, Bureau of Economic Analysis Economic 
Areas (BEAs).\29\ The Commission concluded that the evidence of record 
supported the findings of the ALJ that BEAs are shown to be appropriate 
geographic markets since they are convenient, easily identified and 
have been used in past studies of the oil pipeline industry.

    \29\BEAs are geographic regions surrounding major cities that 
are intended to represent areas of actual economic activity.
---------------------------------------------------------------------------

    The Commission also concluded that an analysis of market 
concentration using HHIs should be the first step in evaluating the 
likelihood of market power being exercised in a given market. Knowing 
the degree of concentration in a market provides useful information 
about where on the competitive spectrum that market lies and what other 
factors will have to be weighed to enable a finding as to the existence 
or absence of significant market power. For measuring market 
concentration, the Commission concluded that a proper screening device 
is an HHI.\30\ The Commission also concluded that the use of delivery 
data, e.g., deliveries into each BEA, is the best method for 
calculating HHIs in Buckeye. [[Page 8361]] 

    \30\The Commission used an HHI of .18 as an initial screen in 
Transcontinental Gas Pipe Line Corp. (Transco), 55 FERC 61,446 at 
62,393 (1991).
---------------------------------------------------------------------------

    In Buckeye (Opinion No. 380), market power was defined as the 
ability to profitably raise the price above the competitive level for a 
significant time period. Significant market power was defined as the 
ability to control market price by sustaining at least a 15% real price 
increase, without losing sales, for a period of two years. The 
Commission further concluded that the relevant price for the purposes 
of making a determination of whether Buckeye can profitably increase 
its transportation prices above the competitive level is the delivered 
product price. Because shippers or customers in the destination market 
often have the option of switching away from purchasing transportation 
into the market, and, instead, purchasing the delivered product itself, 
suppliers of transportation must compete with suppliers of the 
delivered product.
    There were 22 markets examined in Opinion No. 380. The Commission 
found that in 15 Buckeye lacked significant market power; in two 
Buckeye had no tariffs on file thus no finding was warranted; in one 
the record was insufficient and so continued regulation was necessary; 
and, in four, Buckeye was found to have market power.
2. The Buckeye Experiment
    In Opinions No. 380 and 380-A, the Commission also authorized a 
three year experimental program proposed by Buckeye.\31\ During this 
experiment, rates in each competitive market were subject to two 
limitations: (1) Individual rate increases could not exceed a ``cap'' 
of 15% real increase over any two-year period, and (2) individual rate 
increases would be allowed to become effective without suspension or 
investigation only if they did not exceed a ``trigger'' of the change 
in the Gross Domestic Product (GDP) deflator plus 2%. Rate decreases 
were presumably valid but could not result in rates below marginal 
costs.

    \31\53 FERC 61,473 and 54 FERC 61,117.
---------------------------------------------------------------------------

    In the markets the Commission did not find to be competitive, no 
rate could be increased by more than the volume-weighted average rate 
increase in the competitive markets. Conversely, every rate in the 
``non-competitive markets'' had to reflect the volume-weighted average 
of rate decreases in the competitive markets.\32\

    \32\On March 24, 1994, the Commission accepted a tariff that 
extended this experiment for an indefinite period (66 FERC 61,348). 
However, the Order stated that Buckeye was subject to the 
requirements of Order No. 561, the simplified and generally 
applicable ratemaking methodology for oil pipelines, when they take 
effect on January 1, 1995. On December 6, 1994, the Commission 
permitted Buckeye to continue its experimental program as an 
exception to the Commission's oil pricing policies, subject to 
future reevaluation. Buckeye Pipe Line Co., L.P., 69 FERC 61,302 
(1994).
---------------------------------------------------------------------------

    No protests of rate changes or complaints against existing rates 
were filed during the three year experiment. In addition, no protests 
were filed in opposition to Buckeye's filing to extend the experiment 
indefinitely.\33\ Buckeye noted that this lack of opposition to its 
market-based program was ``in sharp contrast to the years of complex 
and expensive rate litigation that preceded adoption of * * *'' this 
program.\34\

    \33\66 FERC 61,348.
    \34\October 26, 1994 Buckeye Pipeline filing in Docket No. OR94-
6-000, et al.
---------------------------------------------------------------------------

    No rates were changed by more than the GDP+2% trigger during the 
three year period. In the competitive markets, rate increases were 
generally well below the trigger, and in the non-competitive markets, 
rate increases were below the allowed volume-weighted average increase 
in the competitive markets. The allowable and average actual rate 
changes are shown in the table below.

                          Buckeye Rate Changes                          
------------------------------------------------------------------------
                                                               Non-     
                                            Competitive     competitive 
 Year (April       Cap         Trigger        markets         markets   
 1 to March     (GDP+15%)     (GDP+2%)     average rate    average rate 
     31)        (percent)     (percent)       change          change    
                                             (percent)       (percent)  
------------------------------------------------------------------------
90-91.......      19.16          6.16           3.86            3.58    
91-92.......      22.32          5.16           3.14            2.74    
92-93.......      20.69          4.53           1.45            0.97    
------------------------------------------------------------------------

    Since all changes in rates are based on an index not reflecting the 
pipeline's costs, there is no danger of the raising of rates in non-
competitive markets through shifting costs attributable to competitive 
markets.\35\ This attribute is not exclusive to the Buckeye program; 
approaches which base rate changes on something other than the 
pipeline's costs would eliminate this concern about cost shifting.

    \35\While there was concern that Buckeye might be able top 
``manipulate'' the program by raising prices in the competitive 
markets solely to raise prices in the non-competitive markets, the 
Commission found this to be a very unlikely event under the approved 
program. It nevertheless committed to monitoring for this occurrence 
during the experiment (53 FERC 61,473). Since the growth rate of 
revenues was higher in the competitive markets than in the non-
competitive markets (constant annual growth rates of 6.54% versus 
2.78% (66 FERC 61,348)), this demonstrates that this potential 
problem did not occur during the experiment.
---------------------------------------------------------------------------

    Finally, under the market-based program Buckeye was able to engage 
in some successful marketing in very competitive situations. For 
example, in Indianapolis, where Buckeye held less than three percent of 
the market in 1990, Buckeye raised its share to 17 percent in 1993. 
``These increased volumes resulted from Buckeye's deep price discounts 
(as deep as 40%) in 1991 and later a volume incentive tariff to attract 
new refinery business from a recently restarted independent refinery * 
* *''\36\ As a result of Buckeye's actions, the total size of the 
Indianapolis market increased and its concentration decreased.

    \36\February 22, 1994 ``Statement of James A. Spicer on behalf 
of Buckeye Pipe Line Company, L.P.''
    In contrast to oil pipelines, natural gas pipelines are 
permitted to selectively discount. Thus, gas pipelines would be able 
to structure such a deal under the Commission's traditional cost-
based rate regulation.
---------------------------------------------------------------------------

D. The Electric Cases

    Since 1986, the Commission has approved many applications from 
public utilities to sell electricity in wholesale transactions at 
negotiated market-based rates. In a recent order addressing a request 
for market-based rates from an electricity marketer affiliated with a 
traditional public [[Page 8362]] utility, the Commission summarized its 
position. The Commission:

    * * * allows market-based rates if the seller (and each of its 
affiliates) does not have, or has adequately mitigated, market power 
in generation and transmission and cannot erect barriers to entry. 
In addition, the Commission considers whether there is evidence of 
affiliate abuse or reciprocal dealing.\37\

    \37\Heartland Energy Services, 69 FERC  61,223 (1994).
---------------------------------------------------------------------------

    Applicants for whom the Commission approved market-based rates are 
required to file periodic reports or studies to demonstrate their 
continuing lack of market power and the absence of abusive affiliate 
practices.
    The first step in evaluating market power in generation is to 
identify the relevant product and geographic markets.\38\ In those 
markets, suppliers' market shares are calculated. Low market shares 
demonstrate that the seller is unlikely to be able to assert market 
power in that market.\39\ An applicant with a high market share would 
be subject to further scrutiny.

    \38\See, e.g., Kansas City Power & Light, 67 FERC  61,183 
(1994).
    \39\In PSI, 51 FERC 61,367 (1990), order on reh'g 52 FERC 
61,963 (1990), the Commission determined that a seller with a 
market share of less than 20 percent did not dominate the market.
---------------------------------------------------------------------------

    For example, in Enron Power Enterprises Corporation,\40\ the 
Commission looked at the market for generating services bid to New 
England Power Company (NEPCO). In that market, Enron's market share was 
4 percent. Furthermore, there were 18 projects out of 22 finalists that 
were not selected. Thus, NEPCO had numerous additional alternatives to 
choose from other than Enron. In addition, NEPCO negotiated several 
favorable provisions in its agreement with Enron suggesting that Enron 
was not a dominant supplier at the time of the solicitation.

    \40\52 FERC  61,193 at 61,708-61,709 (1990).
---------------------------------------------------------------------------

    There have been two additional factors of concern to the Commission 
in electricity cases: Affiliate abuse and the ability to erect barriers 
to entry. With respect to affiliate abuse, in recent cases, the 
Commission has required the affiliated parties to file separately for 
any sales or purchases of electric power between the marketer and its 
affiliated utility. In addition, the Commission requires the affiliated 
marketer to purchase any transmission services it may receive from its 
affiliated utility under a generally applicable, open-access, 
comparable tariff.
    With respect to an applicant's ability to erect barriers to entry, 
only a few electric cases have raised this issue. Some affiliates of 
natural gas pipelines have sought market rate approval for sales of 
electricity.\41\ However, the Commission has looked to Order No. 636 
procedures mandating open access transportation on jurisdictional 
pipelines to preclude pipelines from erecting barriers to entry.

    \41\See, e.g., Hartwell, 60 FERC  61,143 (1992).
---------------------------------------------------------------------------

    As a result of Enron and other cases, the Commission has developed 
considerable experience in analyzing generation markets. Recently, in 
Kansas City Power and Light,\42\ the Commission concluded that new 
generating facilities were being built by many different parties and 
that there was no evidence that any party could assert market power in 
markets being served by new facilities. Consequently, as did the 
Commission in its series of GIC decisions, market power analysis is no 
longer required when the applicant is proposing sales from new 
facilities.

    \42\67 FERC  61,183 (1994).
---------------------------------------------------------------------------

    The Commission's treatment of transmission market power does not 
parallel its treatment of market power in generation. The Commission 
has basically equated applicant ownership or control of transmission 
facilities with the applicant having market power in transmission in 
that region.\43\ The Commission therefore requires transmission owners 
to file generally applicable open-access, comparable transmission 
tariffs before the Commission will permit them to charge market 
rates.\44\

    \43\See Enron Power Marketing, 65 FERC  61,305 (1993), order on 
reh'g, 66 FERC  61,244.
    \44\The current policy was announced in Hermiston Generating, 69 
FERC  61,035 (1994).
---------------------------------------------------------------------------

III. Proposed Criteria for Evaluating Market-Based Transportation Rate 
Proposals

A. General Framework and Criteria

    To date, in all cases where the Commission has considered market-
based rates, the applicant has been required to show that it lacks 
significant market power in the relevant markets. Market power is 
defined as the ability of a pipeline to profitably maintain prices 
above competitive levels for a significant period of time.
    While the Commission has not adopted a mechanistic approach to 
assessing market power, it has consistently used the same general 
framework to evaluate requests for market-based rates.
    Using this general framework, Commission staff proposes criteria to 
evaluate the competitiveness of transportation services. To show a lack 
of market power over firm transportation, for example, staff 
anticipates that a pipeline would need, initially, to show that its 
customers have four to five good alternatives to the applicant's firm 
transportation service. This is the equivalent of an HHI of .18, which 
the Commission has used as an initial screen in previous cases.\45\ 
Staff suggests that only capacity that the applicant shows will be 
available on other pipelines when the applicant institutes market-based 
rates could be considered as an alternative.

    \45\E.g., Transco, 55 FERC at 62,393.
---------------------------------------------------------------------------

    One necessary element of showing that customers have alternatives 
would be the pipeline's agreement to give existing firm transportation 
customers the right to renominate their contract demand levels if a 
pipeline is allowed to charge market-based rates under existing 
contracts. Otherwise, the applicant clearly has market power over its 
customers if existing contracts prevent its customers from freely 
choosing alternative service or renegotiating their contracts at the 
time market forces are permitted to control the rates for services. 
This situation did not exist in the storage cases where the Commission 
permitted market-based pricing. In those cases, the applicants were 
either new entrants or existing entities offering new services. There 
were no existing contracts in effect that the Commission needed to 
address. This condition is consistent with the Commission's practice in 
the GIC proceedings where it allowed customers to renominate their 
sales contract demand levels if a pipeline instituted a GIC.
    The framework proposed would be the same for all types of services. 
It consists of three major steps:

1. Define Relevant Markets
    a. Product market: identify good alternatives to the applicant's 
product; and
    b. Geographic market: identify sellers of good alternatives.
2. Measure Firm Size and Market Concentration
    a. Measure the size of the market, calculate each seller's 
market share, and evaluate applicant's market share;
    b. Estimate market concentration using the Herfindahl-Hirschman 
Index (HHI); and
    c. Evaluate market concentration by using an initial HHI screen 
of 0.18; a finding in that range is equivalent to finding that 
customers have at least four or five equal-sized alternatives to the 
applicant's service.
3. Evaluate Other Factors
    a. If the applicant's market share is large or the market 
concentration is high (i.e., HHI exceeds 0.18), examine other 
factors that might prevent or limit the exercise of market power; 
[[Page 8363]] 
    b. These other factors might include ease of entry, excess 
capacity held by competing sellers, and buyer power.

    Each of these steps is discussed further below. In section B of 
this part is an example showing the application of this analysis to a 
hypothetical interstate pipeline in a market supplied by a number of 
pipelines.
    There are some services that are more likely to pass these criteria 
than others. These are discussed more fully in section IV.C. below.\46\ 
For example, IT and hub services have different characteristics than 
firm transportation and might more easily satisfy these criteria. If 
the capacity release program is functioning well, IT service may 
compete with capacity release offered by all of the pipeline's 
customers in the relevant zones. Capacity release may be a good 
alternative for IT service. There are, by definition, several pipelines 
at each market hub.\47\ Each of the pipelines at the hub may be able to 
offer the same hub services as good alternatives to each other.

    \46\This paper does not attempt to analyze the capacity release 
market or IT service in any detail but the same general framework 
would apply to these.
    \47\See ``Importance of Market Centers,'' Office of Economic 
Policy, FERC (Washington, D.C.), August 21, 1992. Some pipelines 
have defined market hubs differently.
---------------------------------------------------------------------------

    As a practical matter, it may well be difficult for long-term firm 
transportation to qualify under this framework. The nature of the 
transportation grid ensures that pipelines typically face few direct 
competitors in delivering gas from one point to another. In addition, 
given the long-term contracting for firm transportation service that 
exists, staff believes it may be difficult for pipelines to show that 
customers have the ability to freely move to alternative long-term 
transportation. For example, if a pipeline that proposes market-based 
rates for firm transportation has existing long-term contracts for that 
service, the pipeline would need to allow its customers to terminate 
their contracts to freely move to alternative services.
1. Market Definition
    Market definition identifies the specific products or services and 
the suppliers of those products or services that provide good 
alternatives to the applicant's product or service. In this market 
staff would test the applicant's ability to exercise market power. 
Naturally, the more narrowly the market is defined, the harder it is to 
show a lack of market power.
    The Commission's order approving market-based storage rates for 
Koch Gateway, defined good alternatives as follows:

    A good alternative is an alternative that is available soon 
enough, has a price that is low enough, and has a quality high 
enough to permit customers to substitute the alternative for Koch 
Gateway's service.\48\

    \48\Koch Gateway, 66 FERC at 62,299.
---------------------------------------------------------------------------

a. The Product Market
    The applicant's service together with other services that are good 
alternatives constitute the relevant product market. The applicant must 
fully, and specifically, define the product market. For example, the 
applicant must be specific in defining whether the product market 
consists of firm transportation only, or if the product market consists 
of off-peak interruptible transportation service only, etc. The 
applicant must also be responsible for developing and justifying any 
substitutes for the relevant product that can be considered competitive 
alternatives, e.g., storage delivery services, gathering services, etc. 
For example, pipelines might suggest numerous alternatives to FT in 
their applications: IT, storage services, residual fuel oil, etc.
    It is likely that applicants will argue that the market should be 
defined broadly. Given the natural monopoly features of many 
transportation services, staff suggests that the Commission take a more 
conservative approach and define the product market narrowly as only 
firm transportation. For purposes of defining relevant gas 
transportation markets, staff focuses here on the pipeline customers' 
peak.\49\

    \49\During the winter peak period we would expect that excess 
capacity would be at a minimum and that customers' alternatives 
would be fewer than in off-peak periods.
---------------------------------------------------------------------------

i. Timeliness
    Generally, antitrust authorities have used one year as the time 
period in which to test whether a product can become a substitute. This 
is probably not appropriate for long-term firm transportation because 
capacity on competitors would typically need to be available 
simultaneously to offer a viable alternative to customers. If the 
pipeline applicant relies on the existence of capacity that will not be 
available immediately, it would also need to show that its customers 
would not be committed to long term contracts on its system under the 
operation of the right of first refusal rules, so that the alternative 
would not be available.
ii. Price
    Along with showing that alternative capacity will be available in a 
reasonable time frame, the applicant must demonstrate that the price 
for the available capacity is low enough to effectively restrain the 
applicant from increasing prices. In prior cases, the Commission has 
defined such a threshold price level as being at or below the 
applicant's approved maximum cost-based rate plus 15%.\50\

    \50\In Buckeye Pipe Line Company, L.P., Opinion No. 360, the 
Commission held that a 15 percent increase was an appropriate level 
to measure market power. 53 FERC 61,473 at 62,681 (1990), order on 
reh'g, Opinion No. 360-A, 55 FERC 61,084 (1991). However, in 
Williams Pipe Line Co., Opinion No. 391, the Commission declined to 
adopt a specific rate increase as a litmus test for market power. 68 
FERC 61,136 at 61,657. In Koch Gateway Pipeline Company, the 
Commission suggested that potential alternatives would include 
services that though presently not used, would be economic if 
prevailing prices were to rise by a modest amount, e.g., five to 15 
percent. 66 FERC 61,385.
---------------------------------------------------------------------------

    The regulated price has been used as the prevailing price--a proxy 
for the competitive price. This is necessary because almost all prices 
for transportation are regulated and a competitive price level would be 
at best a guess. However, the use of prevailing prices presents 
analytic problems. For example, three pipelines that follow parallel 
courses may have radically different rates because of different 
historical costs, despite the fact that in a competitive market they 
would offer almost identical services at almost identical prices. Which 
of the alternative pipelines' prices should be used as the 
``prevailing'' price? This question would have to be addressed in 
deciding whether the prices of alternatives are appropriate references.
iii. Quality
    A good alternative must provide service in which the quality is at 
least as high as that of the service provided by the applicant. In 
order to make this showing the applicant must first be required to 
describe its own services. Then, the applicant must demonstrate that 
any available third party capacity must be comparable in service to the 
transportation service provided by the applicant.
    Staff believes that with Order Nos. 436 and 636, all interstate 
pipelines currently provide operationally comparable firm 
transportation (FT) service.
    However, even if a customer can find available capacity on an 
alternative pipeline, the overall package of services available may not 
be comparable to that it currently receives from the applicant. For 
instance, no-notice service may not be available from other pipelines 
(though a similar service might be available from third parties). Under 
Order No. 636 interstate pipelines [[Page 8364]] which offered no-
notice sales service prior to restructuring were required to offer no-
notice transportation service to their existing sales customers at the 
time of unbundling. Pipelines had the option of making no-notice 
service available to non-sales customers. Thus, while many interstate 
pipelines currently provide no-notice transportation service, they do 
not and are not required to offer such service to new customers. Thus, 
comparable no-notice service probably is not available on other 
pipelines.
    Also, applicants may wish to demonstrate that intrastate pipelines 
offer comparable firm transportation service. Transportation services 
offered by intrastate pipelines under section 311 of the NGPA are also 
subject to the same open-access and non-discriminatory access standards 
as interstate pipelines are under Order No. 436. Therefore, to the 
extent that intrastate pipelines offer firm transportation service, 
Staff believes that such service would be offered under terms and 
conditions that are substantially comparable to the firm transportation 
services offered by open-access interstate pipelines. However, 
intrastate pipelines are not required to offer firm transportation 
services and currently only a few intrastate pipelines offer firm 
transportation. Thus, firm transportation services may not be available 
on intrastate pipelines.
    Applicants wishing to make a showing that interruptible 
transportation services make good alternatives to the applicant's firm 
services would have to demonstrate that an adequate amount of capacity 
is unsubscribed during peak periods so that the quality of the IT 
service would be comparable to that of the applicant's FT service.
b. The Geographic Market
    In addition, in defining the market, one must identify all the 
sellers of the product or service. The collection of alternative 
sellers and the applicant constitutes the relevant geographic market. 
Specifying the relevant product and geographic market tells us what 
alternatives the customer has if it attempts to avoid a price increase 
imposed by a seller.
    Geographic market definition is particularly important in 
transportation markets. Gas pipelines can transport gas out of a 
producing or origin region. They also deliver gas into a consuming or 
destination region.
    The applicant must specify both the origin and destination markets 
for its FT service. Only in that way can the applicant identify good 
alternatives to the pipeline's service.
    Staff proposes a two-step process of defining the geographic 
market. First, the applicant would identify those alternative sellers 
who offer service between the same origin and destination markets. 
Second, the applicant would identify those competitors that provide 
service either out of the origin market or into the destination market. 
This two-step process generally follows the analytic approach developed 
in the Report of Commissioner Branko Terzic on Competition in Natural 
Gas Transportation (May 24, 1993).
i. Transportation Between Markets
    The first stage of the analysis identifies sellers offering 
transportation service over the same route. Examining different sellers 
serving the same transportation link simplifies the analysis. For 
instance, there is no need to consider whether different producing 
areas offer ``good'' alternatives to each other.
    To show that another pipeline provides a good direct alternative, 
the applicant must show that customers could purchase the relevant 
service from the alternative supplier. Such a demonstration will 
probably include showing that capacity would be available on the 
alternative, that the customer can obtain any services needed to use 
the competitor's facilities in both origin and destination markets over 
the term of the service receiving market-based rates.
    If a customer has a continuing obligation to take gas at a 
particular receipt point, or to deliver gas to a specific delivery 
point, beyond the term of its FT contract, competition from parallel 
pipelines is particularly important in evaluating market power on a 
pipeline seeking market-based FT rates. Then the applicant may have 
market power over the shipper even if both the origin and destination 
markets are otherwise competitive. While the shipper will have good 
alternatives to the applicant for getting gas to the city-gate, it may 
not have good alternatives for getting gas from that particular point 
to its city-gate. It could, of course, sell its contract gas from that 
particular point on the spot market in the production area and buy an 
equal amount of spot gas in an area where it had good transportation 
alternatives. But the spot price at which it sells might be lower than 
the spot at which it buys, causing extra expense and providing some 
opportunity for the applicant pipeline to raise its price. 
Additionally, the shipper may value the reliability of the contract gas 
and be concerned that it might not be able to buy spot gas when it 
needs it.
    In practice, parallel route competition is most likely to occur in 
two situations. One is the secondary market (including pipeline IT) 
where parties offer service on the same facility. The other is for 
transportation between well-functioning market centers, as illustrated 
in the example in part B.
ii. Transportation at Origin and Destination Markets
    Parallel route competition is not the only source of market 
discipline on gas transporters. A shipper in the production area will 
typically have alternative destination markets to which it could send 
gas. Similarly, a downstream shipper will typically have a choice of 
several producing areas from which to buy gas. Pipelines that provide 
such alternative service may offer an additional check on the market 
power of a shipper.
    Natural gas transportation typically originates in the production 
area. In the production area (or the mainline receipt point), the 
applicant must identify the transportation alternatives available to 
customers. Customers could include producers with gas supplies attached 
at a receipt point, LDCs, and endusers with firm long-term supply 
contracts. To define a particular region as an origin market, the 
pipeline must identify all pipelines which compete with it to move gas 
out of that area. To demonstrate that these other pipelines are good 
alternatives (that is, are in the market), the applicant must show that 
its producer/shippers are physically connected to these other pipeline 
transportation alternatives.\51\ The applicant must also show that 
these transportation alternatives provide a netback\52\ to producer/
shippers roughly the same as they would receive if they used the 
applicant's transportation.\53\ An alternative is not a good 
alternative to a producer seeking to move gas out of the origin market 
if the alternative is [[Page 8365]] associated with a much higher cost 
than the applicant's cost-based rates, i.e., it must give roughly the 
same netback.

    \51\Alternatively, the applicant could include a seller in the 
market if the seller can connect to the customer sufficiently 
cheaply that the customer receives a netback as least as large as it 
would receive if it used the applicant's transportation service.
    \52\The netback is the delivered price of gas less the 
transportation costs paid by the producer. That is, the netback is 
the net price received by the producer.
    \53\The geographic market is a region in which a hypothetical 
monopolist that is the only present or future provider of the 
relevant product at locations in that region would profitably impose 
at least a ``small but significant and nontransitory'' increase in 
price. In the case of an origin market, the hypothetical monopsonist 
will impose a small but significant and nontransitory decrease in 
netbacks. Thus, a service is a good alternative if the netback using 
the alternative is at least as big as the netback using the 
applicant's facilities after the netback decrease.
---------------------------------------------------------------------------

    In contrast, the ultimate destination market for gas is typically a 
city-gate. There, the applicant must identify the transportation 
alternatives available to endusers and LDCs who want to receive gas in 
this area. To define a destination market, the applicant must 
demonstrate that its customers are physically connected to alternative 
gas transportation facilities that move gas into the area.\54\ The 
applicant must also demonstrate that those alternatives will deliver 
gas at a price no higher than would be paid with the use of the 
applicant's transportation service to deliver gas into the area.\55\

    \54\The applicant could include a seller in the destination 
market if the seller can connect to the customer sufficiently 
cheaply that the customer pays a delivered gas price no higher than 
that paid when using the applicant's FT service.
    \55\The geographic market is a region in which a hypothetical 
monopolist that is the only present or future provider of the 
relevant product at locations in that region would profitably impose 
a least a ``small but significant and nontransitory'' increase in 
price. In the case of an destination market, a service is a good 
alternative if the delivered gas price using the alternative is less 
than or equal to the delivered gas price using the applicant's 
facilities after the price increase.
---------------------------------------------------------------------------

    Applicants for market-based rates might allege that LPG and LNG can 
be good alternatives to the use of applicant's transportation service. 
If so, the applicant must show that there are sufficient quantities of 
these available, and the transport of LPG and LNG into the destination 
market (e.g., by truck) provides gas at an overall delivered price no 
higher than the overall delivered price from pipeline transport with a 
fifteen percent transportation rate increase on the pipeline's 
transportation rate.
c. Summary and Conclusion
    Thus, in order to specify a gas transportation market, the 
applicant must first identify all products and services available as 
good alternatives to the applicant's customers. Next, the applicant 
must identify the origin and destination of that transportation. The 
relevant geographic market will be defined in two steps: First, those 
alternative sellers that offer service between the same origin and 
destination markets and second, all economically substitutable 
transportation sold by pipelines (or other good alternative products 
and services) serving either the origin market or the destination 
market.
2. Firm Size and Market Concentration
    Pipelines might be able to exercise market power if customers have 
few good alternatives to the pipeline's service either, in the first 
instance, over a given route or, in a second analysis, separately in 
origin and destination markets. The applicant might have market power 
in the origin market if producer/shippers have few good alternatives to 
transport their product out of the origin area. In the destination 
market, pipelines might be able to exercise market power if downstream 
customers have few good transportation alternatives that reach their 
city-gates. If customers have long term supply contracts, it will be 
particularly important for the pipeline to demonstrate that it has no 
market power over customers on a given route.
    There are two ways in which a seller can exercise market power. It 
can attempt to raise its price acting alone or it can attempt to raise 
its price by acting together with other sellers.
i. Acting Alone
    One of the indicators which has been examined to determine whether 
a seller could exercise market power acting alone is the seller's 
market share. A large market share is generally a necessary condition 
for the exercise of market power. If the seller has a small market 
share it is unlikely that it can exercise market power. But, a company 
with a large market share may not be able to exert market power if 
entry into the market is easy\56\ or there are other competitive forces 
at work.

    \56\Given the nature of the interstate pipeline industry, ease 
of entry would be difficult to show except in cases involving minor 
facilities. For major facilities, the cost of construction and the 
time needed for environmental analysis would suggest that entry may 
not be easy.
---------------------------------------------------------------------------

    The applicant must submit calculations (and supporting data) of its 
market share in all relevant origin and destination areas.
ii. Acting Together with Other Sellers
    A second way in which a seller can exercise market power is to act 
together with other sellers to raise prices. To evaluate whether a 
seller can act together with others to exercise market power, the 
Commission has typically examined the market's concentration.
    To measure market concentration, one generally considers the 
summary measure of market concentration known as the Herfindahl-
Hirschman Index (HHI). If the HHI is small, less than .18, then one can 
generally conclude that sellers cannot exercise market power in this 
market. A small HHI indicates that customers have sufficiently diverse 
sources of supply in this market that no one firm or group of firms 
acting together could profitably raise market price. If the HHI is 
greater than .18 then additional analysis is needed to determine if the 
seller can exercise market power.
    The applicant should be required to submit calculations of the HHI 
for the relevant markets. The HHI must be computed for each origin 
market as well as each destination market. The Commission should 
require applicants to submit information for each mainline receipt 
point (origin market) and each delivery point (destination market). If 
the applicant wishes to argue for a broader market definition it should 
also include calculations for its market definitions. Only sales or 
capacity figures associated with good alternatives should be used in 
calculating the HHI. In calculating the HHIs, the applicant should be 
required to aggregate the capacity of affiliated companies into one 
estimate for those affiliates as a single seller.\57\

    \57\The capacity on pipeline systems owned or controlled by the 
applicant's affiliates should not be considered among the customer's 
alternatives. Rather, the capacity of its affiliates offering the 
same product should be included in the market share calculated for 
the applicant. Similarly, alternative pipelines must be aggregated 
with their respective affiliates in order to identify meaningful 
alternatives to customers. It is not reasonable to expect a profit-
maximizing firm to allow its affiliates to compete with one another.
---------------------------------------------------------------------------

    In the GIC cases, the Commission established a threshold level for 
the HHI at .18.\58\ In an oil pipeline case, the Commission used .25 as 
an initial screen.\59\ The Commission may wish to establish a standard 
under which it will presume no potential for the exercise of joint 
market power exists. Since the Commission has a positive obligation 
under the Natural Gas Act to ``protect consumers against exploitation 
at the hands of natural gas companies,''\60\ staff believes it would be 
appropriate to use the relatively strict initial screen of .18. This 
would indicate that there are four to five good alternatives to the 
applicant's service in each market.

    \58\El Paso Natural Gas Company, 49 FERC 61,262 (1989). See 
also Buckeye, 53 FERC at 62,667.
    \59\See Williams Pipe Line Co., Opinion No. 391, 68 FERC  
61,136 (1994).
    \60\FPC v. Hope Natural Gas Co., 320 U.S. 591, 610 (1944). See 
also Elizabethtown, supra n. 6 (sustaining the Commission's approval 
of market pricing based on the Commission's conclusion that the 
pipeline's markets were sufficiently competitive to preclude it from 
exercising significant market power); Farmers Union II, supra n.2 
(holding that the Commission cannot merely assume that competition 
will ensure just and reasonable prices).
---------------------------------------------------------------------------

3. Entry and Other Competitive Factors
    Even if the applicant's market share were large in a concentrated 
(and properly identified) market, one might not conclude that the 
applicant would be able to exercise market power. For 
[[Page 8366]] example, if the applicant were to increase its price, 
entry into the market might be so easy that sellers attracted by the 
profit opportunity created by the higher price would quickly take 
customers away from the applicant by offering a lower price. This would 
make the applicant's price increase unprofitable. Thus, the applicant 
would not be able to exercise market power, despite its large market 
share and despite the high market concentration.\61\

    \61\As stated before, entry would probably only be relevant for 
gas pipelines in the case of minor facilities such as facilities 
that could be constructed under a blanket certificate.
---------------------------------------------------------------------------

    Ease of entry is one of several competitive factors that might lead 
to the conclusion that an applicant lacks market power. It is most 
likely to apply to circumstances that do not require the large sunk 
costs of major construction--for instance, perhaps in offering short-
haul market center services. Another competitive factor that might be 
alleged by an applicant would be the presence of buyer power. An 
applicant might argue that if a single buyer is a large customer of the 
pipeline, is knowledgeable and sophisticated in its buying, and has 
been in business for a lengthy period of time, the buyer may have the 
knowledge and large-scale purchasing power to negotiate reasonable 
rates even in a concentrated market. However, just because buyers 
develop sophisticated purchasing systems and market knowledge as the 
result of dealing with various suppliers in numerous markets, there 
still is reason to have some skepticism that a buyer in a single 
destination area served by one or a few pipelines will have such 
capabilities.
    The applicant must demonstrate that sufficient quantities of good 
alternatives are available to its customers to make a price increase 
unprofitable. In other words, the applicant must show that customers 
would replace a significant proportion of its throughput with other 
transportation alternatives if the applicant raised its price.

B. An Example of the Analysis Applied to Firm Transportation

1. Introduction
    To illustrate the application of the market power analysis 
discussed above to a request for market-based transportation rates, 
staff shows an analysis of a hypothetical filing by an interstate 
pipeline. In that hypothetical filing, the ABC Pipeline Company seeks 
Commission approval to offer firm transportation (FT) at market-based 
rates. ABC's primary proposal is for market-based FT rates for its 
entire system (see map). As an alternative, ABC requests market-based 
rates for firm transportation between two market centers, the Free 
Parking Hub, located in the production area, and the Just Visiting Hub, 
located in its market area. In its alternative proposal ABC Pipeline 
offers cost-based rates for service upstream of the Free Parking Hub 
and downstream of the Just Visiting Hub. Finally, as part of its 
alternate proposal ABC Pipeline is proposing to add facilities so that 
it will interconnect with all the pipelines at the Free Parking Hub. 
The interconnections will allow ABC to provide switching service at the 
hub. ABC proposes market-based rates for the switching service.

                                                 BILLING CODE 6717-01-P
[[Page 8367]]

[GRAPHIC][TIFF OMITTED]TN14FE95.004


BILLING CODE 6717-01-C
[[Page 8368]]

    The facts in this hypothetical are patterned after the facts of a 
large pipeline company and one of its major customers. Facts have been 
added or changed to better illustrate points in the analysis.
    In order to analyze ABC's proposal, staff identifies the relevant 
product and geographic markets, measures the size of the market, and 
calculates market shares and the market's concentration using the 
Herfindahl-Hirschman Index (HHI). Where market shares and the HHI are 
high, staff examines other competitive factors that might constrain the 
exercise of market power.
    A two step analysis is used to examine both of ABC's proposals. 
First, one examines whether there is sufficient competition along 
parallel routes for the proposed market-based services. Second, if 
there is not, one examines if there is sufficient competition in the 
origin and destination markets to constrain the exercise of market 
power. The Commission would deny ABC Pipeline's request if it finds 
that ABC has market power over customers on the relevant routes and in 
either origin areas or destination areas of the geographic market. To 
identify relevant geographic markets, one first identifies pairs of 
origin and destination markets. The pipeline might identify one such 
pair as the hypothetical Baltic field and City Distribution Company 
(City).\62\

    \62\Of course, the pipeline would need to provide the same 
information for all other origin and destination markets.
---------------------------------------------------------------------------

2. The Applicant's Primary Proposal
a. The Relevant Facts
    City Distribution is a large natural gas public utility that serves 
millions of customers. Its service area covers a large metropolitan 
area. City's service area is located 100 miles downstream of the Just 
Visiting Hub.
    City has its own storage facilities with a maximum daily storage 
withdrawal capability of 1.0 Bcf/day and a total working gas capacity 
of approximately 30 Bcf. Its peak day system demand is approximately 
3.0 Bcf/day. Thus, at full utilization of its storage, City needs at 
least 2.0 Bcf/day (3.0 Bcf/day--1.0 Bcf/day) of transportation capacity 
on its peak day to meet customer demand.
    City has over 30 interconnections with five interstate pipelines: 
ABC Pipeline Company, the Short Line Pipeline Company, the Boardwalk 
Pipeline Company, the Ventnor Pipeline Company, and the Pennsylvania 
Pipeline Company. Table 1 shows City's contract rights to, and use of, 
transportation capacity on all pipeline connections to its city gate 
for 1994. Table 1 shows the total capacity of the pipelines in City's 
metropolitan area. The totals include capacity used to serve another 
LDC within that metropolitan area.

                                 Table 1                                
------------------------------------------------------------------------
                                                MDQ                     
                  Pipeline                     Rights    USE    Capacity
                                               (Bcf)    (Bcf)     (Bcf) 
------------------------------------------------------------------------
ABC Pipeline (FT)...........................      1.3      1.5       1.5
The Short Line Pipeline.....................      0.3      0.2       0.3
Boardwalk Pipeline (FT).....................      0.2      0.2       0.7
All Sources of IT...........................  .......      0.3  ........
The Ventnor Pipeline........................      0.2      0.2       0.7
The Pennsylvania Pipeline...................      0.1      0.1       0.1
                                             ---------------------------
  Total.....................................      2.1      2.5       3.3
------------------------------------------------------------------------

    City currently purchases a portion of its peak day from gas 
produced in the Baltic field. ABC Pipeline is currently the only 
pipeline that connects to the gathering system in the Baltic field. 
Table 2 displays the nearest pipelines and the estimated cost to 
connect these pipelines to the Baltic field gathering system :

                                 Table 2                                
------------------------------------------------------------------------
                                                              Connection
                         Pipeline*                              costs   
------------------------------------------------------------------------
The Atlantic Pipeline......................................   $1,000,000
The Ventnor Pipeline.......................................    2,400,000
The Boardwalk Pipeline.....................................   17,000,000
The St. James Pipeline.....................................   15,000,000
The Park Place Pipeline....................................  12,000,000 
------------------------------------------------------------------------
*The Atlantic and Ventnor Pipelines are affiliated, as are the Boardwalk
  and Park Place Pipelines.                                             

b. Product Market
    In its filing to the Commission, ABC might allege that there are 
numerous good alternatives to its FT service for City. It might start 
by alleging that two other pipelines directly connect areas that are 
very close to the Baltic field and City's city gate, and offer good 
alternatives to customers on both ends of the pipeline. It might 
further argue that customers on each end can use FT and interruptible 
transportation (IT) service on other pipelines leading to different 
market areas (in the case of Baltic field shippers) or other supply 
areas (in City's case).
    FT on other pipelines may be a good alternative to ABC Pipeline's 
FT. However, ABC must demonstrate that its customers can actually get 
firm capacity on these other pipelines and that the quality of such FT 
is comparable to its own. Also, ABC must demonstrate that other 
pipelines can provide FT that is price competitive with ABC's.
    IT service on other pipelines might be a good alternative for FT. 
Indeed, Table 1 shows that City used 0.3 Bcf of IT to meet its 
transportation needs on its 1994 peak day. ABC might argue that similar 
levels of IT have been available at peak for many years and can be 
expected to be available in the future. If so, this suggests that, at a 
minimum, IT was of a sufficiently high quality (i.e., had a 
sufficiently low probability of interruption) that it could substitute 
for FT in the past and could probably do so in the future. However, ABC 
Pipeline would need to present evidence that IT was provided at a price 
that rendered the price of delivered gas using IT at or below the price 
of delivered gas using FT. That might not be the case if City's receipt 
of IT required payment of IT rates on several upstream pipelines, 
thereby making IT not price competitive. City might have been forced to 
purchase IT even if its price were much higher than that of FT. Also, 
the IT shown in Table 1 was received by City over several pipelines, 
including ABC Pipeline. Thus, because ABC would be able to affect the 
delivered price of gas using IT service, it cannot be counted as a good 
product alternative to ABC Pipeline's own FT.
    Therefore, for both the primary and alternate proposals, staff is 
defining the product market to include ABC Pipeline's FT and FT on 
other pipelines. However, interruptible transportation is included in 
the product market for switching service at the Free Parking Hub.
c. Geographic Market: Parallel Route
    In its application, ABC might argue that three pipelines provide 
service from the same production area as the Baltic field to the same 
metropolitan area as City and thus are parallel routes: ABC Pipeline 
(with 1.5 Bcf of capacity), the Boardwalk Pipeline (with .7 Bcf of 
capacity) and the Ventnor Pipeline (with .7 Bcf of capacity). ABC 
computes an HHI of .39 for these three routes--equivalent to about 
three equally large firms. ABC might argue that this provides some 
degree of competition, which combined with other factors, would justify 
a market-based rate. One of the factors ABC mentions is that City has 
buyer power because of its size. However, ABC Pipeline does not provide 
sufficient factual basis to evaluate the level of City's buyer power, 
so staff is unable to consider this factor.
    A closer examination of the example would show that there are no 
parallel route pipelines. Neither of the other [[Page 8369]] pipelines 
directly connect with the producers in the Baltic field. Each would 
need to build significant facilities to reach the same origin market. 
Finally, the applicant has not shown that capacity would be available 
on either of the two other pipelines in the same time frame for which 
it seeks market-based pricing.
d. Geographic Market: Destination Area
    The relevant geographic destination market includes all alternative 
sellers that can provide FT to City's city-gate priced at or below 
transportation services over ABC's system, assuming a 15 percent FT 
price increase by ABC. If ABC Pipeline wished to include all the 
pipelines listed in Table 1, it would have to demonstrate that their 
transportation services met this criteria. It would also have to 
demonstrate that the transportation services over those pipelines at 
least matched the quality of transportation service over ABC Pipeline.
    Consider a simple measure of market size and concentration first. 
Table 3 displays market shares and market concentration for the FT 
suppliers to City in 1994. Market shares are calculated based on 
capacity at City's city-gate. There is additional pipeline capacity 
within the metropolitan area. ABC Pipeline, however, has not provided 
evidence to show that the capacity could be easily connected to City's 
city-gate. Absent such a showing staff has used the lower capacity 
rights figures in our calculations.

                                 Table 3                                
------------------------------------------------------------------------
                                           MDQ                          
                 Seller                   rights   Market   Contribution
                                          (Bcf)     share      to HHI   
------------------------------------------------------------------------
ABC Pipeline (FT)......................      1.3       .62         .38  
Short Line Pipeline....................      0.3       .14         .02  
Boardwalk Pipeline.....................      0.2       .10         .01  
Ventnor Pipeline.......................      0.2       .10         .01  
Pennsylvania Pipeline..................      0.1       .05       --     
                                        --------------------------------
  Total................................      2.1      1.01         .42  
------------------------------------------------------------------------

    In this instance, ABC has a very large market share, 62 percent. 
Also, the HHI is quite high (.42) indicating that the market is 
concentrated. The market's HHI is well above the threshold levels of 
.18-.25 commonly used by antitrust authorities to identify competitive 
markets. Were ABC to seek Commission approval for market-based 
transportation rates, it would have to document that there are other 
factors, such as ease of entry, excess capacity, etc., that would 
eliminate the ability to exercise market power that is not ruled out by 
these high market shares and high HHI.
    ABC Pipeline might also allege that released capacity on its own 
system and on other pipelines would provide good alternatives for City. 
However, in one very important respect released capacity, especially on 
ABC Pipeline itself, will have little, if any, impact on the assessment 
of ABC Pipeline's underlying market power in the primary long-run FT 
market. An analogy might help. Suppose there were only one manufacturer 
of automobiles, but robust used-car and leasing markets. Would the 
manufacturer have monopoly power? Yes. Even with a perfectly 
competitive secondary market for automobiles, the manufacturer could 
``contrive'' a scarcity by making fewer new automobiles and charging a 
higher price than necessary to cover costs.\63\

    \63\See U.S. v. Aluminum Co. of America, 148 F.2d 416, 424 (2d 
Cir. 1945). The main issue in this case was whether secondary scrap 
aluminum was in the same market as primary aluminum. Judge Learned 
Hand held that since Alcoa had produced the metal reappearing as 
reprocessed scrap, it would have taken into account in its output 
decisions the effect of scrap reclamation on future prices, and 
therefore secondary scrap should not be in the same market as 
primary aluminum.
---------------------------------------------------------------------------

    Similarly, if a pipeline has market power, it would exploit it by 
``contriving a scarcity.'' Although a pipeline with a well-functioning 
capacity release program might not withhold existing capacity, it could 
choose not to expand. Customers can only release capacity they don't 
need; they can't build. As demand grows, a pipeline with market power 
could simply enjoy higher prices and refuse to build even if its 
customers were willing to pay the incremental cost of expansion. It 
would build only when the market clearing price for FT went above the 
monopoly price.
    Thus, this analysis suggests that the secondary market on ABC 
Pipeline may discipline market power the pipeline may have in selling 
IT and unsubscribed or ``short-term'' FT, but not in new primary FT. 
Released capacity on other pipelines might discipline any market power 
ABC Pipeline may have in the long-term FT market, but the secondary 
market on ABC Pipeline can do little to discipline its market power in 
supplying primary FT.

e. Other Competitive Factors

    ABC Pipeline might argue that entry is sufficiently easy that ABC 
would be constrained from exercising market power by new firms quickly 
entering the market at relatively low cost. It seems unlikely that 
building major new transportation facilities to serve City would be 
inexpensive or timely. Rather, in a densely-populated urban area, 
building a new pipeline would likely be a contentious political and 
environmental issue. ABC Pipeline might, however, argue that the 
Boardwalk Pipeline or other pipelines could expand their existing 
interconnections with City. To support this argument it would need to 
show that the connections could be made without great expense or delay.
    It may be that the four other pipelines have significant amounts of 
excess capacity at or close to City's city-gate. In the event that ABC 
Pipeline were to attempt to exercise market power, arguably such excess 
capacity could be used by City to defeat such an attempt. However, 
evidence currently at hand suggests that only the Short Line Pipeline 
has excess capacity.
    Finally, staff did not address ABC Pipeline's argument regarding 
buyer power since the destination market was so highly concentrated and 
the analysis was not fully developed.
f. The Destination Area: Caveats and Conclusion
    The market share and HHI calculations in this example are based on 
simplifying assumptions which minimize market shares and market 
concentration. First, by assuming that any of City's customers could be 
supplied by any of the five pipelines connecting to City, staff has 
intentionally expanded the market and thereby lowered market shares and 
HHI.
    Second, staff did not include no-notice service. For this higher 
quality service City may have very few alternatives indeed, since no-
notice service would only be available to pre-restructuring customers 
on the alternative pipelines.
    Rather than ABC Pipeline, the Ventnor Pipeline or the Short Line 
Pipeline might file for market-based transportation rates to serve City 
on the basis that the market shares shown in Table 1 document their 
lack of market power, despite the destination market's high HHI. If, 
however, City fully utilized all of its FT at peak, then the Ventnor 
Pipeline or the Short Line Pipeline would be able to exercise market 
power despite their small shares of the market. Therefore, the Ventnor 
Pipeline or the Short Line Pipeline would have to demonstrate that City 
had alternatives at peak, as well as demonstrating that they lacked 
market power in the origin markets.
[[Page 8370]]

g. Geographic Market: The Origin Area
    ABC's pipeline is connected with the gathering system in the Baltic 
field in Louisiana. ABC Pipeline is the only inter or intrastate 
pipeline that is connected to this gathering system.
    As for good alternative suppliers in the origin area, ABC Pipeline 
would have to demonstrate that the quality of FT on other pipelines is 
comparable to its own. Also, ABC would have to demonstrate that other 
pipelines can provide FT that is priced competitively with ABC's.
    To show that other pipelines could become good FT alternatives, ABC 
Pipeline would have to show that other pipelines could easily connect 
with the gathering system in the Baltic field. Or, ABC Pipeline might 
argue that the producers could build gathering lines to connect to 
these other pipelines at a nominal cost. In either case, ABC would have 
to show that building these facilities would not reduce the netback to 
these producers.
    In this example, all of the pipelines would have significant 
connection costs. At most, it appears that only on Atlantic would the 
cost of connecting the Baltic field result in a price increase of less 
than 15%. Thus, in the Baltic origin area, producers seem to have at 
most one good pipeline alternative to ABC Pipeline. The conclusion, 
therefore, is that staff cannot rule out the possibility, indeed 
likelihood, that ABC Pipeline has market power over shippers 
transporting gas out of the Baltic field origin area.
h. Primary Proposal: Conclusion
    Our conclusion from analysis of this hypothetical is simple and 
straightforward. It is conceptually possible to demonstrate that 
pipelines lack significant market power over shippers buying 
transportation from supply fields to their city-gate customers. 
However, the City example suggests that such a showing would be 
difficult.
3. The Applicant's Alternate Proposal
a. The Relevant Facts
    ABC Pipeline has also included a more limited market based proposal 
in its filing. ABC argues, at a minimum, it should be able to charge 
market-based rates for service between two market centers on its 
system, the Free Parking Hub and the Just Visiting Hub, and for its 
proposed new switching service at the Free Parking Hub. Table 5 shows 
the six pipelines at the Free Parking Hub and their capacity:

                                 Table 5                                
------------------------------------------------------------------------
                                                 MDQ                    
                                                rights   Market    HHI  
                                                (Bcf)    share          
------------------------------------------------------------------------
ABC Pipeline.................................      2.0      .21      .04
Oriental.....................................     *1.8      .29      .08
Vermont......................................     *1.0  .......  .......
Reading......................................      2.3      .24      .06
Pacific......................................       .8      .08      .01
Mediterranean................................      1.7      .18      .03
                                              --------------------------
  Total......................................      9.6     1.00     .22 
------------------------------------------------------------------------
*Since Vermont and Oriental are affiliated their capacity has been      
  combined in computing market shares and HHIs.                         

    Table 6 shows the five pipelines at the Just Visiting Hub:

                                 Table 6                                
------------------------------------------------------------------------
                                                 MDQ                    
                                                rights   Market    HHI  
                                                (Bcf)    share          
------------------------------------------------------------------------
ABC Pipeline.................................      2.0      .20      .04
Short Line Pipeline..........................       .5      .05  .......
The Pennsylvania.............................     *2.7      .54      .29
Reading......................................     *2.5  .......  .......
Oriental.....................................      2.1      .21      .04
                                              --------------------------
  Total......................................      9.8     1.00     .37 
------------------------------------------------------------------------
*Since the Pennsylvania and Reading are affiliated their capacity has   
  been combined in computing market shares and HHIs.                    

    Three pipelines provide firm transportation service between the two 
hubs. Their capacity on the route is shown in Table 7. In computing 
market shares and HHIs staff has used the lower of the pipeline's 
capacity at the Just Visiting and Free Parking Hubs as our estimate of 
the maximum amount of capacity that shippers can reserve between the 
two hubs.

                                 Table 7                                
------------------------------------------------------------------------
                                                 MDQ                    
                                                rights   Market    HHI  
                                                (Bcf)    share          
------------------------------------------------------------------------
ABC Pipeline.................................      2.0      .33      .11
Reading......................................      2.3      .38      .14
Oriental.....................................      1.8      .30      .09
                                              --------------------------
  Total......................................      6.1    *1.01     .34 
------------------------------------------------------------------------
*Total does not equal 1 due to rounding.                                

    ABC Pipeline generally defines the product market as firm 
transportation. However, ABC argues that interruptible switching 
service at the Just Visiting Hub and the Free Parking Hub is the 
functional equivalent of firm service.
b. Geographic Market: Parallel Route
    In the example, three pipelines provide firm transportation service 
between the Free Parking Hub (origin market) and the Just Visiting Hub 
(destination market): ABC Pipeline (with a .33 market share), Reading 
Pipeline (with a .38 market share), and Oriental (with a .30 market 
share). This results in an HHI of .34 for this route--equivalent to 
three equal sized firms. ABC Pipeline might argue that the three 
parallel route pipelines provide some degree of competition. ABC might 
argue that when this is combined with additional competition at the 
origin and destination markets there is sufficient competition to 
justify market-based rates.
    In its alternate proposal ABC has not proposed market-based rates 
for transportation upstream of the Free Parking Hub or downstream of 
the Just Visiting Hub. Instead, it proposes a regulated rate for such 
services that would recover only the (relatively small) costs of the 
facilities between the Baltic field and the Free Parking Hub or between 
the Just Visiting Hub and City's city-gate. This would ensure ABC could 
not use market-based rates to exercise market power over shippers at 
the extremities of its system. However, such a proposal would raise 
serious cost allocation issues between ABC's market-based and cost-
based services.
    In the alternate proposal there is the possibility of parallel 
route competition because there are three pipelines that serve both the 
origin and destination markets. However, this is only the beginning of 
the analysis. ABC Pipeline must also show that: its customers can 
switch gas between ABC and the alternative pipelines at a low cost; its 
customers can actually get firm capacity on the Reading and the 
Oriental Pipelines; and the quality and price of firm service on these 
alternative pipelines is comparable to that provided on ABC Pipeline.
    ABC argues that the Free Parking Hub is a header that offers firm 
switching service at minimal cost and that the Just Visiting Hub offers 
interruptible switching service among all the pipelines. The first may 
offer the customers good alternatives. The second probably does not. 
Potential market power problems here might be mitigated if firm 
switching service was offered at the Just Visiting Hub.
    ABC argues that capacity release programs can make capacity 
available on the alternative pipelines. However, it has not shown that 
customers can obtain the same long-term FT service through the release 
program. Potential market power problems might be mitigated if ABC 
could show that its customers could buy the same long-term service 
through the release market (perhaps if the customers had many 
[[Page 8371]] years remaining on their contracts) or at some future 
time when the capacity on all the pipelines would be available 
simultaneously. It would also need to show that such alternatives would 
be competitively priced. It could do this either by analyzing regulated 
prices or by showing that all other pipelines would be able to match 
any likely market-based price on ABC. This would be a difficult showing 
for any pipeline if it was the only pipeline in the market seeking 
market-based rates.
    In the alternate proposal there is possible parallel route 
competition between the origin and destination markets. However, even 
if all additional market power problems were mitigated, the HHI of the 
route is still well above the .18 screen staff is using. So, staff 
moves to the second step in the analysis to examine the origin and 
destination markets separately.
c. Geographic Markets: Destination Markets
    ABC Pipeline might argue four other pipelines serve the Just 
Visiting Hub and each of these pipelines would serve as a good 
alternative to its service. ABC might also argue two other pipelines, 
the Ventnor and the Boardwalk have facilities near the Just Visiting 
Hub.As with the parallel route analysis, these pipelines cannot be 
considered good alternatives unless ABC Pipeline can demonstrate its 
customers can get firm transportation capacity at a price and quality 
comparable to its own service.
    The data indicate that the Just Visiting Hub is highly 
concentrated. In computing the HHI for the destination market the two 
affiliates, the Reading and the Pennsylvania, are treated as one firm. 
Because these two pipelines control half the capacity at the hub, the 
HHI of .37 is actually higher than that for the parallel route.\64\

    \64\This example demonstrates the effect that pipeline 
affiliation can have on market concentration. If Reading and 
Pennsylvania were not affiliated, the HHI for the Just Visiting Hub 
would be .22, significantly lower than the .37 HHI calculated with 
affiliate market share combined. An HHI of .22 is much closer to a 
level which might be deemed indicative of an unconcentrated market.
---------------------------------------------------------------------------

    If ABC Pipeline could show that the Ventnor and the Boardwalk 
Pipelines could easily connect to the Just Visiting Hub this would 
significantly reduce the HHI and make it easier to support market-based 
rates for ABC Pipeline. Alternatively, ABC Pipeline might argue that 
market power at the Just Visiting Hub is minimal if it could show that 
there are other market centers close to the Just Visiting Hub that 
could be accessed by pipelines serving the Free Parking Hub. If ABC 
Pipeline could not show additional competitive factors that reduce 
market power, the data would not support market-based rates.
d. Hub Services
    To justify market-based rates for service between two markets, ABC 
must show that both the origin and destination markets are competitive. 
ABC has not shown that the destination market, the Just Visiting Hub, 
is competitive. Therefore, it has not supported its proposal for 
market-based rates between the two hubs. However, ABC has also 
requested market-based rates for hub services at the Free Parking Hub.
    To support its proposal for market-based rates for hub services, 
ABC Pipeline might argue that currently the Mediterranean Pipeline 
interconnects with the five other pipelines at the Free Parking Hub. 
When ABC builds its additional interconnections there will be two 
pipelines that connect with all the pipelines at the Free Parking Hub. 
In addition, these pipelines have several other alternative points of 
interconnection within a 100 mile radius of the hub and within the same 
rate zone. ABC argues that its customers can get the equivalent of 
ABC's switching service at these points of interconnection. ABC has 
provided a chart which shows that in addition to its proposed new 
facilities a shipper on any one of the five other pipelines has at 
least three alternative interconnections for each pipeline within the 
same rate zone. Some of these are direct interconnections and some 
require switching service at other nearby production area hubs. 
Further, interruptible capacity is consistently available within the 
production area and is of a very high quality, i.e., curtailments are 
rare. Thus, each shipper has at least three good alternatives to ABC's 
proposed switching service at the Free Parking Hub. This means that the 
highest HHI for ABC's switching service with any pipeline is .25.
    The HHI of .25 for switching service is above staff's initial 
screen. However, there are other competitive factors that would reduce 
ABC's ability to exercise market power. One of these factors is the 
open access requirement that all open access pipelines must receive or 
deliver gas to other pipelines if capacity is available. By scheduling 
receipts and deliveries at the alternative points of interconnection a 
shipper can get the equivalent of switching service. And, when this is 
part of the basic point-to-point transportation service, there is no 
additional charge. Another competitive factor is ease of entry. In this 
area some of the pipelines could build additional interconnections at 
minimal cost. It would be economic to build these interconnections if 
ABC attempted to exercise market power by charging excessive rates.
    ABC has shown that its customers would have good alternatives to 
its switching service. Therefore, market-based rates are appropriate 
for its switching service at the Free Parking Hub.
e. Conclusion
    Given the high level of concentration in the route and in the 
destination market, it is unlikely that ABC Pipeline could justify 
market-based rates for service between the two hubs. However, using the 
same criteria, market-based rates can be supported for hub services at 
the Free Parking Hub.
    In the example, staff has assumed that a pipeline might have both 
cost and market-based FT rates on its system. Any such proposal would 
require a method for allocating costs between cost-based and market-
based services.\65\

    \65\For example, it would be necessary to identify the cost of 
the facilities used for the market-based services as well as any 
related operation and maintenance costs. Also, there would need to 
be an allocation of common and joint costs, such as administrative 
costs, between the cost and market-based services.
---------------------------------------------------------------------------

4. Results of Analysis of Hypothetical
    Staff must conclude that ABC would find it difficult to justify 
market-based rates for point-to-point FT on its system. Based on 
current data ABC may be able to justify market-based rates for some hub 
services. In the future, ABC may be able justify market-based rates for 
more services. As the transportation market evolves, pipelines may find 
it economic to build connections to more hubs. This will increase the 
number of alternatives at each hub and thus will make it easier to 
satisfy the criteria for market-based rates for hub services or for 
transportation between hubs.

C. Application of Criteria to Other Services

    Under the standards proposed above, as the example involving ABC 
Pipeline shows, it is unlikely that FT rates for any city-gate customer 
would be market-based. The same is true for any rates paid by producers 
directly attached at the other end of the pipe. What role, then, beyond 
the gas commodity and storage services, would market-based prices play?
    The answer is that market prices may play an important role in 
capacity-release, IT, and market-center services.
    As illustrated in the ABC Pipeline example, the many new sources of 
FT [[Page 8372]] potentially available through the capacity release 
market will have little or no effect on a pipeline's long-run market 
power. They may, however, have a strong effect on either the primary 
capacity holder's (i.e. LDC's) or the pipeline's ability to exercise 
market power in the capacity release market, the short-term firm 
market, or the IT market. For these services, there are very few 
existing long term contracts. Moreover, a major interstate pipeline may 
have 10 to 20 different holders of FT capacity within a zone. Flexible 
(secondary) firm receipt and delivery point rights, in concept, give 
any of these primary holders or their replacements the ability to move 
gas to any upstream city-gate on the system. Thus, the secondary market 
in FT may well be unconcentrated. If released FT can be shown to be a 
good substitute for IT or short-term FT from the pipeline, then the 
released FT, IT and short-term FT market will be unconcentrated.
    Any such arguments would depend on the effectiveness of the 
capacity release program in making released capacity at least the equal 
of IT. While it is doubtful that any such showing could be made now, 
with further improvements in the capacity release program this could 
occur.
    In addition, part of the showing must contain evidence that LDCs 
could not frustrate ``secondary firm'' firm deliveries made at their 
city-gates by controlling the flows behind their own city-gate delivery 
points. Flexible receipt and delivery points are the key to a 
competitive finding; if an LDC is, aside from the pipeline, the only 
source of FT to its city-gate then it has market power. If secondary 
firm is an effective alternative, however, then there is a good 
likelihood that these markets would pass the stringent tests laid out 
above.
    Some market-center services, such as short-term switching and 
parking, may also pass the test. Market-centers, by their nature, are 
where many pipelines intersect and, often, where there are multiple 
suppliers of storage service. In such cases, it is likely that the 
providers could show that customers will have many good alternatives at 
the market-center itself or in nearby market-centers.
    In conclusion, application of the standards laid out in part IV.A 
is likely to mean continued cost-based regulation of primary FT, but 
may permit market pricing for released FT, IT and short-term FT and for 
market-center services such as switching and parking.
    All-in-all, the potential for further reliance on market pricing is 
rather modest. On the other hand, market pricing in the capacity 
release and market-center services markets could be a key to their 
success. Hubs could play an important role in further perfecting the 
spot market for gas, but to do so is likely to require creative 
approaches to new services and new ways of adding value to the gas 
commodity. Creative, economical, new services are far more likely to 
develop under market pricing than under a cost-of-service approach.
D. Review of Market Power Findings
    As discussed in part I, an important factor to the court of appeals 
in Elizabethtown, in which the Commission permitted gas sales at market 
prices, was the Commission's assurance that it would exercise its 
section 5 authority if necessary to assure that the market price was 
just and reasonable. This means that the Commission must consider how 
it will monitor market-based rates so that it can exercise its 
oversight responsibilities.
    In past cases the Commission established, on a case-by-case basis 
some reporting requirements for companies authorized to charge market 
based rates.\66\ The Commission may want to consider developing 
standard periodic reporting requirements on prices and quantities in 
market-based transactions. Periodic reports would make it possible for 
the Commission to monitor market-based rates to ensure that the rates 
are within a zone of reasonableness. The Commission may also want to 
establish a more formal procedure for reporting changes in 
circumstances that could affect the market power finding, i.e., 
circumstances that reduce the number of good alternatives in a 
market.\67\ If circumstances change the Commission could either 
reconsider its prior market power findings or wait until a complaint is 
filed to take action.

    \66\For example, Transwestern was required to file monthly 
reports of market based sales under Rate Schedule ISS. 43 FERC 
61,240 (1988). Buckeye was required to file annual reports showing 
rates, volumes, and revenues for each destination market. See 66 
FERC 61,348, for a review of these reports. For electric utilities, 
the Commission has required power marketers selling at market based 
rates to file quarterly reports showing prices and quantities for 
individual transactions [e.g., Heartland, 68 FERC 61,223 (1994)]. 
Among other things, the reports are intended ``to provide for 
ongoing monitoring of the marketer's ability to exercise market 
power.''
    \67\For example, assume in the original market power analysis 
the Commission found there were four good alternatives in an origin 
market. A subsequent corporate merger of two of the pipelines and 
the abandonment of facilities by another would reduce the number of 
good alternatives to two. There have been no new entrants into the 
origin market. These changes probably would significantly affect the 
continuing validity of the original market power finding.
---------------------------------------------------------------------------

Appendix: Analysis of Other Industries

    As discussed in the paper, the FERC has consistently used the 
same general framework to evaluate when the market, rather than 
cost-of-service rate regulation, could be relied upon to produce 
just and reasonable rates. This framework has been evolving for over 
one hundred years in antitrust litigation and analysis and has now 
been codified in the DOJ/FTC merger guidelines. FERC is neither the 
first agency to choose light-handed regulation where a lack of 
significant market power can be shown, nor the only one to use 
antitrust standards as a framework for the showing. The general 
framework, however, is far from a set of mechanical rules; the 
application of the framework to a particular industry calls for many 
specific decisions and to an individual case requires many judgement 
calls.\1\

    \1\Judge (now Justice) Stephen Breyer gives an example of how a 
merger ``pessimist'' might assess a proposed airline merger quite 
differently from a merger ``optimist,'' though both use the same 
antitrust framework and agree on all the facts. See discussion of 
the interplay between antitrust and deregulation of the airline and 
telephone industries in his contribution to the ``Symposium: 
Anticpating Antitrust's Centennial: Antitrust, Deregulation and the 
Newly Liberated Market Place,'' 75 California Law Review 1005-1047 
(May 1987).
---------------------------------------------------------------------------

    The Interstate Commerce Commission (ICC), the first national 
regulatory agency and pioneer in cost-of-service ratemaking, was 
also among the first to move toward deregulation or light-handed 
regulation for railroads and trucks. About twenty years ago the ICC 
began to lessen or eliminate regulation of railroads and trucks, the 
FCC allowed new entrants to compete for long distance telephone 
service and the CAB relaxed its price and entry controls over the 
airlines. The experience of these three agencies may provide some 
useful guidance for the Commission in deciding whether certain 
natural gas pipeline transportation services should be permitted 
market-based pricing and, if so, how those services should be 
identified.
    Railroads, airlines, long distance telephones and natural gas 
pipelines all have much in common besides being regulated. They are 
all transportation/transmission networks characterized by a high 
ratio of fixed to variable costs, making ``load factor'' the key to 
unit operating costs, and, with the possible exception of airlines, 
all have significant economies of scale (an element of ``natural 
monopoly''). However, there are also significant differences among 
all of these industries so analogies and policy conclusions based on 
their similar characteristics should be made cautiously.

A. Interstate Commerce Commission Regulation of Railroads

    Railroads and natural gas pipelines have some important 
characteristics in common. Both transport using assets that are 
immobile once they are constructed, though railroads invest in 
``rolling stock'' as well track and roadbed. Further, both exhibit 
the same ``natural monopoly characteristic'' that the construction 
costs necessary for one company to transport a given amount between 
two points are usually significantly [[Page 8373]] lower than the 
construction costs necessary for two companies to jointly transport 
the same amount between those points. Finally, both industries make 
extensive use of eminent domain granted from Federal and state 
governments to acquire land to build networks.
    One significant difference between the two, however, is that 
pipelines carry a fungible product while railroads generally do not. 
That is, a pipeline customer who tenders gas in Louisiana and 
withdraws gas in Chicago, does not care if the gas withdrawn came 
from Appalachia while the tendered Louisiana gas went somewhere 
else. In contrast, a railroad customer in Chicago expecting a 
shipment of Louisiana shrimp will be very unhappy if Appalachian 
coal is delivered instead. Another important difference is that 
railroads face major intermodal transportation competition (air 
competition and trucks everywhere and barges in some areas), while 
there is no viable intermodal competition to pipelines in 
transporting natural gas.
    Important characteristics are similar enough between railroads 
and pipelines that the Interstate Commerce Commission's (ICC's) 
handling of market-based pricing may inform FERC's handling of the 
issue. Of particular note are: (1) The ICC's initial rejection 
followed by the acceptance of the traditional economic paradigm used 
to evaluate competitiveness, (2) the guidelines now used by the ICC 
in evaluating competitiveness, and (3) evaluations of the effects of 
increased reliance on market forces.

1. Recent Changes in Railroad Regulation\2\

    \2\The information provided here on the Interstate Commerce 
Commission is drawn from the Interstate Commerce Commission 
Decision, ``Product and Geographic Competition'' Ex Parte No. 320 
(Sub-No. 3), October 24, 1985.
---------------------------------------------------------------------------

    Before 1976, all rail rates were subject to regulation by the 
Interstate Commerce Commission (ICC) under the statutory ``just and 
reasonable'' standard.\3\ The Railroad Revitalization and Regulatory 
Reform Act of 1976 was enacted to restore financial stability to the 
industry.\4\ This restoration was to be accomplished partially 
through reducing regulatory restraints on railroad pricing decisions 
by limiting ICC jurisdiction over maximum rates to situations where 
railroads have ``market dominance.''\5\

    \3\Former Section 1(5) of the Interstate Commerce Act.
    \4\Pub. L. No. 94-210, 90 Stat 31, February 5, 1976.
    \5\Market dominance was defined in the statues as ``an absence 
of effective competition from other carriers or modes of 
transportation for the traffic or movement to which a rate 
applies.''
---------------------------------------------------------------------------

    Market dominance determinations thus became of the utmost 
importance when rates were challenged. The ICC initially adopted 
three ``presumptions'' of market dominance: the railroad handled 70% 
of traffic (the ``market share'' presumption), revenues exceeded 
160% of the variable costs (the ``cost'' presumption), and the 
shipper had a substantial investment in rail-related plant or 
equipment (the ``rail investment'' presumption). Any one of these 
presumptions being established and unrebutted would establish market 
dominance and ICC jurisdiction.
    The ICC determined that the relevant market in the ``market 
share'' presumption would be confined to direct carrier competition 
for the specific product movement. The ICC explicitly rejected the 
traditional antitrust framework used to evaluate competition; the 
ICC determined that product competition (competition by other 
products), or geographic competition (availability of the same 
product from alternative sources or destinations) was not relevant.
    Several years of experience combined with the need to implement 
the Staggers Rail Act of 1980,\6\ caused the ICC to abandon the 
initial presumptions and adopt new guidelines which incorporate the 
traditional economic paradigm for evaluating competition. The ICC 
``. . . concluded that the presumptions did not necessarily reflect 
the degree of railroad market power, and therefore, yielded 
inaccurate market dominance determinations.* * * The quantitative 
measures (i.e., the market share, cost, and rail investment 
presumptions) were found to be poor indicators of market dominance 
in the widely varying fact situations to which they were designed to 
apply.''\7\

    \6\Pub. L. No. 96-448, 94 Stat. 1895 (1980). One part of the Act 
directed the ICC to make a finding of no dominance if the carrier 
shows that a challenged rate would yield a revenue-to-variable cost 
percentage less than a given percentage. More generally, the Act 
made it federal policy to rely on competition, rather than 
regulation, to establish reasonable rail rates. Additionally the Act 
allowed railroads to enter into confidential agreements with 
shippers, cancel existing joint rates with other railroads that were 
not sufficiently profitable, and set time limits on the abandonment 
process.
    \7\``Product and Geographic Competition,'' supra. The adopted 
guidelines were listed in Appendix C.
---------------------------------------------------------------------------

2. Current ICC Guidelines for Evaluating Market Dominance

    Some of the ICC market dominance guidelines have no apparent 
relevance to FERC because they deal with intermodal transportation 
competition. However, other aspects of the ICC guidelines deal with 
issues nearly identical to those important to FERC in analyzing 
competition. These potentially informative portions of the 
guidelines are briefly summarized here.\8\

    \8\It is interesting to also note, that while developing these 
guidelines, the ICC refused to adopt specific HHI levels for reasons 
that are similar to those stated by FERC when refusing to adopt 
specific HHI levels in Gas Inventory Charge and Oil Pipeline cases.
---------------------------------------------------------------------------

    The ICC ``market dominance'' guidelines lay out what type of 
evidence is considered important.
    Regarding competition from other railroads, the number of 
alternatives and the feasibility of alternatives are important. 
Feasibility is evidenced by (1) the physical characteristics of the 
alternative, (2) the direct access of both the shipper and receiver, 
(3) the cost of using the alternative, and (4) the evidence of 
relevant investment or long-term contracts.
    Regarding geographic competition, considered important are: (1) 
The number of alternative destinations for shippers or alternative 
sources for receivers, (2) the number of alternative destinations or 
sources served by alternative carriers, (3) the suitability of the 
product available at each relevant source or required at each 
relevant destination, (4) the operational and economic feasibility 
of transportation from alternative sources or to alternative 
destinations, (5) the accessibility of alternative transportation, 
(6) the capacity of alternative sources to supply the product or 
alternative destinations to absorb the product, and (7) the evidence 
of relevant investment or long-term contracts.
    Regarding product competition, considered important are: (1) the 
substitutability and availability of the substitute products, and 
(2) all costs of using the substitute product relative to using the 
product in question.

3. The Effect of Reducing Railroad Regulation

    The 1976 Railroad Revitalization and Regulatory Reform Act and 
the 1980 Staggers Act were intended to improve the financial health 
of the railroad industry. By most measures, the railroads' financial 
condition has improved since 1980. Return on investment averaged 
about 4.9% from 1980 to 1988; this is up from the 2.5% average in 
the 1970s. Debt has declined from about 36% of total capital in 1980 
to about 24% in 1988.\9\

    \9\General Accounting Office, ``Railroad Regulation: Economic 
and Financial Impacts of the Staggers Rail Act of 1980,'' May 1990.
---------------------------------------------------------------------------

    While the regulatory reforms were successful in improving the 
financial condition of railroads, these reforms have not achieved 
total financial health for the industry. ``[T]he railroad industry 
as a whole has not achieved revenue adequacy--that is, its return on 
investment has not equaled or exceeded the current cost of 
capital.''\10\

    \10\Id. at p. 5.
---------------------------------------------------------------------------

    Regarding the effects on rates rather than on the railroad's 
financial condition, a recent journal article concludes ``* * * the 
effect of deregulation on prices has generally been to lower them. 
With price decreases and cost savings from deregulation, welfare 
gains from deregulation are likely to be positive.''\11\

    \11\Wesley W. Wilson, ``Market-Specific Effects of Rail 
Deregulation,'' Journal of Industrial Economics, 62 (March, 1994), 
pp. 1-22. See this article's ``References'' for other articles 
evaluating the effect of deregulation on prices.
---------------------------------------------------------------------------

B. Market-Based Rates in Long Distance Telecommunications

    To the extent there are similarities between long distance 
telecommunications and natural gas pipeline services, lessons can be 
learned from the FCC's experience with market based pricing. The FCC 
used a market power framework in its Competitive Carrier 
Proceedings, when determining the appropriate regulation for long 
distance service.

1. Comparison of the Industries

    The long distance telecommunications market has some 
similarities to the natural gas pipeline market. First, with the 
original copper and, most recently, fiber optic cable methods of 
providing service, it has natural monopoly characteristics. Second, 
it has long been considered a public utility and until recently, was 
subject to standard cost-of-service regulation. Third, it provides 
long- [[Page 8374]] line service, and (since divestiture in 1984) 
inter-connects with independent local networks to deliver the 
service.
    There are several differences as well. First, there is no 
production area nor market area for calls, although call 
concentration is higher in metropolitan areas. Second, the customer 
cannot determine the route that his calls take on a carrier, and may 
not switch carriers within the path. Third, calls are not fungible 
or interchangeable, as are gas molecules. For example, a customer 
wants to talk to his or her family, friends, or business associates, 
not someone else's.

2. History of Long Distance Service

    The history of telecommunications regulation has been one of 
playing catch-up to technological change. Local and long- distance 
services were assumed to be natural monopolies, to be provided by 
AT&T. The fixed plant was expensive, and subject to a declining 
average cost of service, and all customers needed to be 
interconnected.
    The natural monopoly disappeared with microwave technology 
because after a critical mass, more traffic requires a roughly 
proportionate increase in towers and more transmitters.\12\ In 1977, 
the FCC allowed MCI into the market. It also allowed general OCC 
(Other Common Carrier) entry in 1977. In 1979, the FCC began the 
Competitive Carrier proceedings which ultimately effectively allowed 
market-based pricing for carriers other than AT&T. The two largest 
OCCs, MCI and Sprint, currently control 25% of the long-distance 
market.\13\ Local services remained a natural monopoly.\14\

    \12\Huber, Peter W., The Geodesic Network II: 1993 Report on 
Competition in the Telephone Industry, p. 3.4.
    \13\Wall Street Journal, July 22, 1994, p. A2.
    \14\Meanwhile, technology has begun to remove the local natural 
monopoly for telephone service. There are a large number of 
potential and credible providers of local service including cable 
television providers and radio-based and cellular carriers.
---------------------------------------------------------------------------

3. Light-Handed Regulation of Non-Dominant Firms

    In the Competitive Carrier proceedings,\15\ the FCC minimized 
the regulation of OCCs. It based its actions on two principles: 
First, in order to retain business with prices above total costs a 
firm must possess market power and some firms did not. Second, 
regulation imposes costs. There are the administrative costs of 
compiling, maintaining, and distributing information necessary to 
comply with reporting and licensing requirements. More significant 
costs on society come from the loss of dynamism which can result. 
The FCC cited to the Averch-Johnson effect in which rate of return 
regulation can distort the input choices of a regulated firm away 
from production at minimum cost. It also discussed effective 
competition being limited by firms being required to give advance 
notice of innovative marketing plans and having those initiatives 
subject to public comment and review. The FCC said that the posting 
of prices and legal obligation to refrain from ``unjust and 
unreasonable discrimination'' may well result in artificially 
stabilizing prices to the consumer's eventual disadvantage.

    \15\First Report and Order, 85 F.C.C. 2d 5 (1980).
---------------------------------------------------------------------------

    Competitive Carrier characterized carriers as dominant 
(eventually only AT&T) or non-dominant. Initially, it defined 
dominant firms as firms with market power.\16\ The FCC said that it 
focused on certain market features to determine if a firm can 
exercise market power: The number and size distribution of competing 
carriers, the nature of barriers to entry and the availability of 
reasonably substitutable services.\17\

    \16\Notice of Inquiry and Proposed Rulemaking, 77 F.C.C. 2d at 
350 (1979); and First Report and Order, at p. 21.
    \17\First Report and Order at p. 21.
---------------------------------------------------------------------------

    As the FCC refined its determination of which carriers could be 
subject to lighter-handed regulation, it concluded that once a 
determination of market power was made, it would look at the degree 
of power before determining whether regulations conferred greater 
benefits on customers than costs.\18\

    \18\Further Notice of Proposed Rulemaking, 84 F.C.C. 2d at 499-
500 (1981); and Second Report and Order. 91 F.C.C. 2d (1982).
---------------------------------------------------------------------------

    The agency reasoned that non-dominant carriers lacked 
(substantial) market power, and that the costs outweighed the 
benefits of regulating such firms. It held that non-dominant firms:
    <bullet> Can't charge excessive rates;
    <bullet> Can't discriminate without losing their customers; and
    <bullet> Can't pass on the costs of inefficient investments to 
customers.
    Applying its definitions, the FCC determined that AT&T was a 
dominant carrier because of its historical market power, immense 
financial and technological base, control over monopoly 
interconnection facilities, and substantial cross-subsidization 
potential. In addition, it is an effective price leader.\19\ Over 
time, the FCC found that all other carriers were non-dominant.

    \19\Notice of Inquiry and Proposed Rulemaking, 77 F.C.C. 2d at 
352-353; and First Report and Order, supra.
---------------------------------------------------------------------------

    The FCC decreased the regulations for non-dominant carriers in 
two phases: streamlining and forbearance. Under both, non-dominant 
carriers were required to charge just and reasonable and non-
discriminatory rates. With streamlining, the FCC presumed that 
tariff filings were legal, and required no cost justification of the 
tariffs.\20\ Forbearance went further than streamlining, by not 
requiring tariff filings from non-dominant firms. The Supreme Court 
later overruled this, as discussed in part I above.

    \20\Streamlining also gave (1) blanket approval for expansions, 
(2) reeduced the filing period (substantially) to 14 days, and (3) 
required no financial information.
---------------------------------------------------------------------------

C. The Cab and Airlines

    Airline transportation and its regulation has many similarities 
to gas pipeline transportation. On any given trip, the variable cost 
of flying the aircraft is essentially the cost of the fuel used, 
just as the variable cost of transporting gas is the fuel used by 
the compressors. Unit costs, therefore, are highly sensitive to 
utilization or load factors. Economies of scale attainable through 
the use of larger airplanes, however, have been thought to be less 
important than for gas pipelines.\21\ Airline companies, like 
pipeline companies, needed a public convenience & necessity 
certificate to serve or abandon any interstate route; rates and 
terms and conditions were strictly regulated. Discounts were 
allowed, if at all, after a hearing at which competitors could 
either challenge the proposed rates or match them.

    \21\Bailey et al., provide some of the evidence indicating that 
economies of scale are modest at pp. 50-54. Fred Kahn, however, 
suggests that, from hindsight, economies of scale were 
underestimated. The ``thoroughgoing'' movement to a hub and spoke 
system was not foreseen. See ``Surprises of Airline Deregulation,'' 
American Economic Review, May, 1985, 316-322.
---------------------------------------------------------------------------

    Differences were and are important. Airlines generally have 
little substantial investment in immobile assets like roadbed, track 
or in laying pipe. Airports, landing slots and air-traffic control 
are generally government supplied. Economies of aircraft scale, 
while present, are less pronounced than for pipelines. Air traffic, 
in contrast to natural gas, is not fungible. When you go to pick up 
your grandparents at the airport, you expect unique rather than 
generic grandparents to deplane. Regulation was thought necessary, 
not because airlines were a natural monopoly, but because they were 
thought to be subject to ``excessive competition.'' Under this 
theory, regulation was necessary to prevent airlines from 
bankrupting each other through overbuilding and excessive price 
competition.\22\ Another purpose was to provide direct subsidies to 
encourage the growth of general aviation. The history of airline 
deregulation also differs greatly from that for natural gas 
pipelines. While the CAB itself, under Alfred Kahn, initiated some 
important changes in 1977 under the Civil Aviation Act (1938), 
Congress decided, in 1978, to phase out all CAB regulation and the 
agency itself by 1985. The change from a highly regulated 
environment designed to minimize competition to a free entry 
environment emphasizing price competition occurred in a remarkably 
short time.

    \22\See Stephen Breyer, Regulation and Its Reform, Harvard, 
1982, 197-221; and Elizabeth Bailey, David Graham and Daniel Kaplan, 
Deregulating the Airlines, MIT, 1985, 11-26.
---------------------------------------------------------------------------

1. Problems That Led to Deregulation

    The Senate held hearings on airline regulation in February 1975. 
The study released later that year was highly critical of the 
CAB.\23\ Stephen Breyer,\24\ summarized the study as revealing 
several ``serious defects'' relating to rates, routes, efficiency 
and agency procedures, two of which were:

    \23\Senate Comm. on the Judiciary, Subcomm. on Admin. Practice 
and Procedure, 94th Cong., 1st Sess., Civil Aeronautics Board 
Practices and Procedures. (1975).
    \24\Breyer was the Committee's chief investigator.
---------------------------------------------------------------------------

    Rates. Regulation led to high prices and overcapacity. Because 
the airline industry was highly competitive and because the CAB 
prevented price competition, the airlines channeled their 
competitive energies into providing more and costlier service--more 
flights, more planes, more frills * * * Yet the planes themselves 
flew more than half empty. (Breyer, 1982, 200)
    Routes. Regulation effectively closed the industry to newcomers 
and guaranteed relatively stable market shares to firms already in 
the industry. (Id., 205)
    The Airline Deregulation Act was signed into law in 1978. The 
Act phased out the CAB's authority and the Board itself ceased 
operations entirely by 1985.

2. The Role of Market Power Analysis in Airline Deregulation and Merger 
Policy

    Market power analysis was an important factor in the rapid 
deregulation of airlines and an even more important factor in the 
merger policy that controlled consolidation within and exit from the 
industry. An important element of the case against regulation was 
that but for regulation, the industry would be much less 
concentrated at the national level than it was under CAB regulation. 
The relevant market for the traveler was usually defined to be the 
``city-pair,'' the two cities between which the traveler wishes to 
fly.\25\ Advocates of deregulation did not argue that each airline 
would find itself battling hosts of actual competitors. They claimed 
only that the threat of entry into a particular market by airlines 
not currently serving that market would hold prices down. An airline 
that serves city A and city B, but does not fly between them, can 
enter the A-B market at very low cost, and there are several such 
airlines serving most major routes. [[Page 8375]] 

    \25\The analog for pipeline transportation would be ``origin-
destination'' pairs, but both the Commission and DOJ have generally 
analyzed pipeline origin and destination markets separately. Why the 
difference? Oil and gas are fungible, airline passengers and freight 
are not.
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    The Board based its assessment of the likely effects of a merger 
on two related findings: that concentration measures based on city-
pair markets alone are not an accurate gauge of competitive 
performance and that potential entry would have an important 
disciplining effect on performance. (Bailey et al, 1985, 173-202). 
Market definitions were often contested. The DOJ in the Northwest/
Republic merger, for example, argued that the relevant product 
market was ``non-stop'' flights between city- pairs. In other cases 
witnesses have argued over whether the appropriate definition should 
be airport pairs, city pairs, or the complex of services 
representative of a hub and spoke network. But in all cases the same 
general relevant market definition framework has been used.
    Breyer (1987) suggested that antitrust rules designed to deal 
with industry in general may not properly reflect the unique 
features of the airline industry. For example, he cautioned against 
applying the ``optimistic'' merger view that is more lenient on 
higher concentration thresholds and places great store on 
``potential competitors,'' fearing that such an antitrust view would 
not be stringent enough. On the other hand, he would be more lenient 
than the merger guidelines with respect to the ``failing company'' 
or efficiency defenses for merger, to reflect that fact that the 
airline industry is emerging from forty years of regulation.

3.The Effects of Airline Deregulation

    Virtually all observers agree that airline fares have been much 
lower and traffic immensely larger than they would have been absent 
deregulation.\26\ However, as Alfred Kahn put it, there were some 
``unpleasant surprises'' as well.\27\ Although in the early years 
there was much new entry, most failed and national concentration in 
the industry failed to decline as most proponents of deregulation 
had predicted. Quality of service declined. Another unpleasant 
surprise to Kahn was ``the persistence-indeed, intensification-of 
price discrimination * * *'' despite which the airline industry has 
experienced severe losses and only a few carriers have been 
profitable.

    \26\Elizabeth Bailey, David Graham, and Daniel Kaplan, 
Deregulating the Airlnes (MIT, 1985), and Steven Morrison and 
Clifford Winston, The Economic Effects of Airline Deregulation 
(Brookings, 1986).
    \27\Alfred Kahn, ``Supreses of Airline Deregulation,'' American 
Economic Review (May, 1988).
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[FR Doc. 95-3631 Filed 02-13-95; 8:45 am]
BILLING CODE 6717-01-P