Natural Gas: Roles of Federal and State Regulators in Overseeing Prices
Published: 2006-09-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Following Hurricanes Katrina and Rita, natural gas prices spiked to more than $15 per thousand cubic feet, nearly seven times higher than in the late 1990s. As a result, policymakers have increasingly focused on better understanding how prices are overseen. The prices that consumers pay for natural gas are composed of (1) the commodity price, (2) the cost of interstate transportation, and (3) local distribution charges. Oversight of these components belongs to the federal government, through the Federal Energy Regulatory Commission (FERC), and the states. In 1993, federal price controls over commodity prices were removed, but FERC is still charged with ensuring that prices are fair. Recently, the Energy Policy Act of 2005 (EPAct 2005) broadened FERC's authority. GAO agreed to (1) analyze FERC's role overseeing natural gas prices, (2) summarize FERC's progress in implementing EPAct 2005, and (3) examine states' role in overseeing natural gas prices. In preparing this report, GAO met with officials from 10 states that regulate gas in different ways and analyzed relevant laws and documentation.
section_title: What GAO Found
paragraphs: Since natural gas commodity prices were deregulated in 1993, FERC's role in ensuring that commodity prices are determined competitively and are free from manipulation has been limited to (1) indirectly monitoring commodity markets to identify and punish market manipulation and (2) supporting competition in those markets. FERC faces challenges ensuring prices are fair, however, because staff cannot monitor all of the potentially millions of transactions and because it is difficult to identify market manipulation. FERC's oversight of commodity markets has risen in importance recently because the commodity price amounted to nearly 60 percent of the total consumer price in 2005 compared with about 30 percent in 1993. FERC also directly approves interstate transportation prices. FERC has completed action on four of the six new tasks identified by EPAct 2005 related to natural gas. FERC officials said that EPAct 2005 has achieved tangible results. For example, following FERC's issuance of a policy statement on enforcement in October 2005, some industry members have self-reported instances of noncompliance with FERC-approved rules in an effort to gain consideration for a lesser penalty. States directly oversee prices for local distribution of natural gas and have a limited role approving commodity and interstate transportation prices. States directly approve utilities' charges for local delivery of natural gas, but this represented only about 30 percent of the consumer price in 2005. While states can deny gas utilities from passing on the cost of the gas commodity to consumers, state officials told us this rarely occurs. State officials rely on FERC to ensure that commodity prices are fair, but some said they are unaware of FERC's oversight efforts. FERC officials agree that expanding the information they provide to stakeholders would improve stakeholders' understanding of FERC's efforts and could help deter manipulation.

section_title: Letter
paragraphs: High prices for natural gas have the attention of policymakers and the  High prices for natural gas have the attention of policymakers and the  public. After years of being relatively low, natural gas prices have trended  public. After years of being relatively low, natural gas prices have trended  upward over the past 5 years. More recently, following Hurricanes Katrina  upward over the past 5 years. More recently, following Hurricanes Katrina  and Rita in 2005, natural gas prices spiked to over $15 per thousand cubic  and Rita in 2005, natural gas prices spiked to over $15 per thousand cubic  feet, nearly seven times higher than they had been in the late 1990s. The  feet, nearly seven times higher than they had been in the late 1990s. The  high prices have created hardships for many consumers, particularly low- high prices have created hardships for many consumers, particularly low- income residential consumers and energy-intensive industries such as  income residential consumers and energy-intensive industries such as  fertilizer manufacturing.  fertilizer manufacturing.
The price that most consumers pay for natural gas is composed of three  The price that most consumers pay for natural gas is composed of three  major components. The first is the charges for the natural gas itself,  major components. The first is the charges for the natural gas itself,  referred to as the natural gas commodity. The second includes the charges  referred to as the natural gas commodity. The second includes the charges  for interstate transportation of the natural gas, generally through large  for interstate transportation of the natural gas, generally through large  pipelines from areas where it is produced to areas where it is consumed.  pipelines from areas where it is produced to areas where it is consumed.  The third includes the charges for local distribution by natural gas  The third includes the charges for local distribution by natural gas  utilities—the private companies that deliver natural gas to consumers in  utilities—the private companies that deliver natural gas to consumers in  homes and businesses. Utilities generally pass on to consumers the costs  homes and businesses. Utilities generally pass on to consumers the costs  of the commodity and interstate transportation, adding these costs to the  of the commodity and interstate transportation, adding these costs to the  charges for local gas distribution.  charges for local gas distribution.
Oversight of these components is shared by the federal government and  Oversight of these components is shared by the federal government and  the states. The Federal Energy Regulatory Commission (FERC) is the lead  the states. The Federal Energy Regulatory Commission (FERC) is the lead  federal agency with authority over certain sales of the natural gas  federal agency with authority over certain sales of the natural gas  commodity for resale (for example, the sales by interstate natural gas  commodity for resale (for example, the sales by interstate natural gas  pipelines or their affiliates to the natural gas utilities that, in turn, sell  pipelines or their affiliates to the natural gas utilities that, in turn, sell  natural gas to consumers) and over the interstate transportation of natural  natural gas to consumers) and over the interstate transportation of natural  gas. FERC is obligated to, among other things, ensure that natural gas  gas. FERC is obligated to, among other things, ensure that natural gas  prices under its jurisdiction are “just and reasonable.” Prior to 1993, FERC  prices under its jurisdiction are “just and reasonable.” Prior to 1993, FERC  regulated the commodity and interstate transportation prices subject to its  regulated the commodity and interstate transportation prices subject to its  jurisdiction by approving prices based on costs and other factors. While  jurisdiction by approving prices based on costs and other factors. While  the regulated market ensured stable prices, it also caused severe gas  supply shortages because, with artificially low prices, producers had no  incentive to increase production and consumers had no reason to curtail  their demand. The Natural Gas Wellhead Decontrol Act required that  certain natural gas commodity prices—generally prices charged by natural  gas producers—be deregulated by 1993 as part of an effort to address  supply concerns and provide other benefits to consumers. Since that time,  natural gas commodity prices have been largely determined in the market  by supply and demand. Deregulation improved the availability of natural  gas and initially lowered prices. The Energy Policy Act of 2005 (EPAct  2005) broadened FERC’s authority over natural gas commodity markets to  include, among other things, more authority to police natural gas markets,  punish manipulation, and impose greater penalties for other types of  violations. The act also identified six specific actions that FERC should  take related to natural gas oversight, including issuing a report to  Congress and promulgating regulations necessary to implement the new  authorities.
In the states, public utility commissions or their equivalents are  responsible for overseeing the operations of natural gas utilities. As part of  that oversight, the commissions are charged with approving utilities’  investments into new local pipelines and utilities’ charges to consumers  for local distribution of the natural gas commodity.
Given the high natural gas prices seen in recent months, policymakers  have increased their attention to better understanding the oversight and  regulation of the natural gas industry and how prices are determined. In  this context, you asked us to provide information about federal and state  oversight of natural gas prices. Specifically, you asked us to (1) analyze  FERC’s role overseeing natural gas prices, (2) summarize FERC’s progress  in implementing additional responsibilities and authorities under EPAct  2005, and (3) examine states’ role overseeing natural gas prices.
In preparing this report, we reviewed reports, legislation, regulations, and  other documentation on the natural gas industry, markets, and federal and  state oversight. We examined data on natural gas prices and consumption.  In addition, we interviewed officials from FERC, trade associations,  industry, and others. We also interviewed state regulators in 10 states— California, Colorado, Georgia, Iowa, Maryland, Pennsylvania, South  Carolina, Texas, Vermont, and Wyoming—about their activities and their  perspectives on FERC oversight. We selected these states to ensure a  broad representation of natural gas consumption levels, residential prices  paid for natural gas, purchasing options available to consumers, and  methods states use to approve natural gas rates. We conducted our work  from February through August 2006 in accordance with generally accepted  government auditing standards.
subsections: section_title: Background
paragraphs: Natural gas is a vital energy source used in a large variety of applications,  providing about one-fourth of the energy consumed in the United States.  Natural gas is a colorless, odorless fossil fuel found underground that is  composed mainly of methane and generated through the slow  decomposition of ancient organic matter. Most natural gas consumed in  this country is produced in North America, but an increasing portion is  shipped from overseas in the form of liquefied natural gas (LNG). Natural  gas is used in about 60 million homes and 5 million businesses in a variety  of ways, such as for heating, fueling industrial processes in manufacturing  operations, fueling electricity generation, and fueling some cars and buses.  Most natural gas consumers are residential users, but they use only about  24 percent of the gas consumed in the United States. Other natural gas  consumers include industrial consumers, electricity generators, and  transportation users.
The natural gas industry performs three separate functions to deliver  natural gas to consumers: (1) production of the natural gas commodity, (2)  transportation of the commodity between states, and (3) local distribution  within states. These major functions are illustrated in figure 1.
To produce the natural gas commodity, producers drill wells to reach  pockets of natural gas, either at sea (such as in the Gulf of Mexico) or on  land (such as in the Powder River Basin of the Rocky Mountain states).  Once the gas well has been drilled, the drilling rig is removed and the  natural gas flows to the surface, where it is combined with gas from other  nearby wells and moved locally through a network of progressively larger  local pipelines to processing plants. There, the raw gas is processed to  remove water vapor, hydrogen sulfide, and other compounds so that it can  be transported, bought, and sold nationally. Producers may choose to sell  the natural gas commodity to a variety of customers, including marketers,  traders, and a variety of consumers. Furthermore, the various players in  the market may, in turn, sell gas back and forth several times before it is  actually delivered.
Eventually, the natural gas is transported via a network of larger interstate  pipelines that connect various supply regions, such as the Gulf of Mexico,  to areas where natural gas is consumed, such as large cities on the East  Coast. Interstate pipelines converge at several pipeline network  interconnections, which link gas consumers across the United States to  several different production regions. As a result of this interconnected  network, prices of natural gas at different trading locations vary  somewhat, but they generally move together as the overall supply and  demand balance changes. Some interstate pipeline intersections have  become important locations for trading natural gas, such as the “Henry  Hub” pipeline interconnection in Louisiana.
Most consumers, particularly residential and small commercial  consumers, receive natural gas from local natural gas utilities. Utilities  generally operate as monopolies within service areas defined by states  and, as such, are the only entity delivering natural gas to most consumers.  In most cases, local gas utilities also purchase the natural gas commodity  for their customers. Local gas utilities receive natural gas from interstate  pipelines and route it into local delivery pipelines to homes and  businesses, where it is consumed. A smaller number of consumers—such  as operators of electric power plants or operators of industrial or  manufacturing plants—may completely bypass the local gas utility.  Because these consumers use large amounts of natural gas, they may  purchase gas directly from suppliers and receive natural gas directly from  interstate pipelines.
The federal government has authority to regulate certain sales of natural  gas and its interstate transportation and does so through two agencies.  FERC has primary responsibility for natural gas oversight. FERC is led by  five commissioners appointed by the President and approved by the  Senate. The Commodities Futures Trading Commission (CFTC) also plays  a role in federal oversight related to natural gas prices. It is responsible for  ensuring that fraud, manipulation, and abusive practices do not occur in  federally regulated financial markets, where some natural gas transactions  are conducted.
States directly regulate the local gas utilities that fall under their  jurisdiction. Because only one utility generally provides gas to a specific  service area, utilities lack competition and could take advantage of their  monopoly by artificially raising natural gas prices for consumers or by  taking other actions. To regulate investor-owned utilities, which distribute  over 90 percent of the gas delivered by utilities, states created agencies  called public utility commissions. States generally do not allow utilities to  profit from the natural gas that they resell, although they allow utilities to  recover the costs of purchasing the natural gas commodity by passing  those costs on to customers. Traditionally, utilities sold natural gas at a  single price per unit of gas—such as per thousand cubic feet—approved  by a commission. However, as consumer prices have become more  variable, states have generally started to allow utilities to use a “gas cost  adjustment” system, where utilities independently adjust the rates they  charge consumers, as long as utilities are not profiting from the gas sales.
section_title: FERC’s Role in Influencing Prices That Consumers Pay for Natural Gas Has Been Limited
paragraphs: Since natural gas commodity prices were deregulated in 1993, FERC’s role  ensuring that the price consumers pay for natural gas is fair has been  twofold and limited. First, FERC has an indirect role overseeing the  market that determines commodity prices, with activities generally limited  to monitoring the market to identify and punish market manipulation  while supporting the development of competition. Recently, this oversight  role has become more important because the commodity portion of the  price that consumers pay for natural gas has increased from about 30  percent in 1993 to almost 60 percent in 2005. FERC faces challenges in  carrying out its oversight of the commodity markets, including difficulties  ensuring that markets are competitive and completely free from  manipulation. Second, FERC directly approves rates that determine  interstate transportation prices. While FERC retains a direct role in  approving the rates for interstate transportation, this role has decreased in  importance because the interstate transportation portion of the price that  consumers pay has decreased from about 20 percent in 1993 to about 10  percent in 2005.
subsections: section_title: Since Deregulation, FERC Has Had a Limited, Indirect Role Overseeing Natural Gas Commodity Prices
paragraphs: In carrying out its responsibilities to help ensure that natural gas  commodity prices in deregulated markets are competitive and free from  manipulation, FERC’s Office of Enforcement polices wholesale natural gas  commodity markets for manipulation. Relying on a wide range of energy  data sources in FERC’s Market Monitoring Center, energy market analysts  in the Office of Enforcement monitor prices and volumes of natural gas  commodity transactions at many key energy market trading centers  nationwide to identify price anomalies or other unusual market activity  that might indicate market manipulation. FERC officials explained that  because natural gas prices at different locations generally move together,  FERC’s monitoring of prices at key energy market trading centers allows  them to understand the overall natural gas market. In addition, they  monitor other factors that may affect the market, such as storage levels,  imports and exports, weather, supply and demand for other fuels, and  electricity transmission constraints and outages. The Office of  Enforcement also operates an enforcement hotline, through which anyone  can anonymously offer information about suspicious market activities,  such as bidding anomalies or improper transactions between a company  and an affiliate. When Office of Enforcement staff identify unexpected or  unexplained deviations in price behavior or other anomalies, they examine  the anomaly and undertake informal or formal investigations when  needed. In response to unusual circumstances resulting in short-term  market changes, the office has increased its monitoring and enforcement  efforts. For example, in response to persistent high energy prices and  Hurricane Katrina, which substantially disrupted domestic natural gas  supplies during the fall and winter of 2005, the office initiated a daily  review of market activity and intensified its investigation of unusual  trading activity, according to office officials.
In addition, the staff conduct a variety of random and targeted audits of  individual companies to determine whether companies are following rules  and regulations regarding trading activities. For example, in 2004, FERC  completed 27 financial audits to determine compliance with its accounting  regulations and an additional 12 audits to determine compliance with  FERC standards of conduct and other requirements. Among other things,  these audits resulted in over 100 recommendations to remedy deficiencies  and uncovered $10 million in pipeline costs that were improperly  capitalized.
To further help ensure that natural gas commodity prices are competitive  and free from manipulation, FERC also supports the development of  competitive markets. It has done this primarily by promulgating rules that  prevent pipeline companies from giving undue preference to their energy  affiliates by requiring that pipeline companies completely separate (or  “unbundle”) their transportation, storage, and sales services and open  access of their pipeline to other entities. Recently, it has supported the  development of competitive markets by fine-tuning existing policies rather  than making major changes:  In 2003, for example, FERC Order Number 2004 updated rules of conduct  designed to prevent natural gas pipelines and public utilities from giving  undue preference to their affiliates.
Also in 2003, FERC developed standards and issued orders designed to  improve the information about natural gas markets published in price  indices—a key source of market information that market participants use  to make informed decisions about buying and selling natural gas.
While FERC’s role overseeing natural gas commodity markets has been  limited, it has become more important in recent years because the  commodity portion of prices that consumers pay for natural gas has  increased more than the other components. As shown in figure 2, real  natural gas commodity prices accounted for almost 60 percent of the total  consumer price in 2005, compared with about 30 percent in 1993.  Specifically, real natural gas commodity prices increased from $2.59 in  1993 to $7.51 in 2005—an increase of about 190 percent. Over the same  period, real interstate transportation prices and other charges decreased  from $1.48 to $1.13 and local distribution charges increased slightly from  $3.75 to $4.17.
FERC continues to face challenges ensuring that the gas commodity  market is competitive and free from manipulation. EPAct 2005 allows  FERC to gain access to information about virtually any natural gas  transaction. However, senior Office of Enforcement officials told us that  while they have increased the number and types of data sources they  actively monitor, they do not actively monitor all natural gas trades that  occur through established markets. The officials said that, even after  increasing the number of staff working in the Office of Enforcement  dedicated to market monitoring, they are still not able to examine all of  the potentially millions of transactions that occur in numerous physical  and financial markets. Since the passage of EPAct 2005, FERC also has  authority to police all markets that could affect natural gas for  manipulation, including sales that do not involve pipeline companies or  their affiliates. However, FERC officials have acknowledged that it is often  difficult to determine whether markets are competitive and completely  free from manipulation because, for example, it is difficult to determine  what prices should be under completely competitive conditions.
section_title: FERC Directly Approves Interstate Transportation Charges
paragraphs: In addition to its efforts regarding competitive natural gas commodity  markets, FERC continues to approve the prices that pipeline companies  charge for the interstate transportation of natural gas. The Natural Gas Act  of 1938, as amended, mandates that FERC regulate the rates that natural  gas pipeline companies under its jurisdiction can charge for interstate  transportation of natural gas to ensure that rates are just and reasonable.  Specifically, FERC requires that every natural gas company file schedules  with FERC showing all rates, contracts, and charges for interstate  transportation of natural gas subject to FERC. FERC staff analyze the  information provided by these companies to ensure that proposed rates  are just and reasonable. However, in practice, FERC officials told us that  typically, the proposed rate for each unit of service is calculated by  dividing a pipeline’s overall cost of service—that is, the company’s total  revenue required to cover the pipeline’s operations plus a just and  reasonable return on its investment in facilities—by the projected amount  of gas its customers will use. A just and reasonable return is typically  determined by evaluating the range of returns generally experienced in the  industry, and adjusted to reflect the specific investment risks of the  pipeline company as compared with the industry. Ultimately, the return on  investment must be sufficient to attract capital and compensate the  pipeline’s investors for the risks of their investment, but not higher.
FERC’s role in regulating the rates charged for the interstate  transportation component of the price that consumers pay for natural gas  has become less prominent in recent years because the rates that pipeline  companies charge for transportation of natural gas along interstate  pipelines have declined relative to the other components of the price  consumers pay. As a result, the interstate transportation portion of the  consumer price for natural gas accounted for less than 10 percent in 2005,  compared with about 20 percent in 1993, as shown in figure 2.
section_title: FERC Has Made Substantial Progress Implementing Additional EPAct 2005 Authorities but Has Not Begun Imposing Fines or Penalties
paragraphs: FERC has made substantial progress implementing the additional  authorities related to natural gas provided to it in EPAct 2005 but has not  yet used its new authority to impose fines or penalties authorized by the  act. EPAct 2005 identified six actions for FERC related to natural gas or  natural gas markets. As of June 2006, FERC has met all deadlines thus far  for implementing additional EPAct 2005 requirements, completing or  initiating work on five of the six actions identified in EPAct 2005. FERC  has not yet imposed any penalties for violations of rules and regulations  related to its new penalty authority since the enactment of EPAct 2005,  according to Office of Enforcement officials, because investigations of  violations that have occurred since the passage of EPAct 2005 are still  under way. Office of Enforcement officials told us that some investigations  will be completed soon, and FERC will use its authority if the  investigations warrant. Table 1 shows the status of the additional  authorities related to natural gas provided by EPAct 2005.
In addition, the Office of Enforcement has begun to use the authority  under EPAct 2005 to expand its monitoring and investigation of those who  violate its new antimanipulation rules. Following the enactment of EPAct  2005, FERC issued antimanipulation regulations implementing its new  authority to monitor, investigate, and impose fines and penalties on any  person under its jurisdiction that manipulated natural gas commodity  prices (action No. 3 in table 1). Previously, FERC could only penalize  behavior that manipulated natural gas commodity prices for a limited  number of transactions, such as those by owners of interstate pipeline  companies and other entities transporting natural gas on an interstate  pipeline. Under the new regulations that implement EPAct 2005, FERC’s  prohibition against market manipulation applies to transactions by  producers, financial companies, local utilities, and natural gas traders,  most of which were not previously regulated by FERC. According to  Office of Enforcement officials, to implement the authority, the Office of  Enforcement has dedicated more time and staff efforts analyzing  transactions and other market behavior in venues previously outside  FERC’s jurisdiction. For example, Office of Enforcement officials told us  they are now able to examine whether financial market transactions,  which are not generally under FERC jurisdiction, affect the physical  natural gas markets over which FERC has authority.
However, FERC has not yet imposed any penalties for violations of rules  and regulations related to its new penalty authority since the enactment of  EPAct 2005, according to Office of Enforcement officials. With regard to  antimanipulation rules, according to Office of Enforcement staff, proving  market manipulation is harder than it was before EPAct 2005. Instead of  proving that the market behavior had a “foreseeable” effect on market  prices, conditions, and rules, FERC must now prove that the conduct that  resulted in manipulated prices is intentional or reckless, which office staff  told us is a more difficult standard. Although the Office of Enforcement  has begun investigating possible violations that have occurred since  passage of EPAct 2005—and that may be subject to the new penalty  authority—the investigations are still under way. As a result, no penalties  have been levied under the new authority, but FERC staff told us they will  use its authority if warranted. Nevertheless, according to Office of  Enforcement officials, their efforts to implement the new authorities  granted by EPAct 2005 are already having tangible results outside of  FERC’s antimanipulation activities. Specifically, Office of Enforcement  officials noted that following the issuance of FERC’s Policy Statement on  Enforcement in October 2005, which explained the new market  manipulation rules and higher penalties, some industry members have self  reported instances of noncompliance with FERC-approved rules in an  effort to gain FERC’s consideration for a lesser penalty.
section_title: States Directly Oversee Utilities’ Prices for Local Distribution of Gas, but They Have a Limited Role in Natural Gas Commodity and Transportation Prices
paragraphs: States directly oversee the prices utilities charge for local distribution of  natural gas but have only a limited role approving natural gas commodity  and interstate transportation prices. States review and approve the local  delivery prices that utilities charge, and they review and approve the  charges utilities pass on to consumers to recover the cost of purchasing  and transporting the natural gas commodity. However, states generally  allow utilities to pass on commodity prices to local consumers, according  to state officials we interviewed. States rely on FERC to oversee  commodity and interstate transportation prices, and stakeholders told us  they lacked knowledge about FERC’s oversight of natural gas commodity  prices. Some stakeholders said they had little confidence that natural gas  commodity markets were free from manipulation. FERC officials  acknowledged that providing some additional information would increase  stakeholders’ understanding of FERC’s oversight of natural gas and help  deter market manipulation.
subsections: section_title: States Directly Approve Utilities’ Charges for Distributing Natural Gas to Retail Consumers
paragraphs: States directly oversee utilities’ charges for local distribution of natural  gas. In most states, utilities file proposals to set or change natural gas  distribution charges with state public utility commissions—state  regulators—that specify the rates utilities may charge consumers. These  rate proposals outline the utilities’ costs to distribute natural gas. In  general, states allow utilities to earn a regulated rate of return, or profit,  and the profits allow utilities to realize a return on their investment and  enable the utilities to make improvements. Utilities file rate proposals at  different intervals. Some follow a regular schedule, such as filing monthly  or annually, while others file only when they believe a price change is  needed. State regulators review these proposals and may either accept  them—enabling the utility to charge those prices to consumers—or deny  them, requiring the utility to charge a different rate.
Although state regulators directly approve local distribution charges, the  regulators cannot substantially lower utilities’ local distribution charges  without affecting service quality or long-term financial health, according to  state officials. Like any business, utilities must cover their cost of service,  which can include charges for the cost of expanding or maintaining the  gas pipelines, the cost of storage paid by the utility, or the cost of utility  employees to read consumers’ meters or provide other services. Unless  utilities cover these costs, they may eventually face financial problems or  go out of business.
Since deregulation, local distribution charges have risen slightly in real  terms, but they have decreased significantly as a share of the total  consumer price. Local distribution prices increased from $3.75 in 1993 to  $4.17 in 2005 (in constant 2005 dollars), but the share of the price  consumers paid for utilities to distribute natural gas decreased, dropping  from about 50 percent of the total price in 1993 to about 30 percent in  2005. As a result, state regulators’ ability to affect total natural gas prices  paid by consumers has decreased. This occurred primarily because of the  increase in natural gas commodity prices, which almost tripled in price  over the same period.
section_title: States Have a Limited Role Approving Commodity and Interstate Transportation Prices and Take Actions to Stabilize Consumer Prices
paragraphs: States exercise limited oversight of the gas commodity and transportation  components of consumer prices by reviewing the costs utilities pass on to  their consumers. States can deny utilities from recovering the costs of  these purchases from consumers if the costs of the gas purchases do not  reflect fair market prices; however, regulators in states we reviewed told  us this rarely occurs. Officials in only 4 of the 10 states we reviewed said  they had denied utilities’ recovery of gas purchases since 2002. Of these 4  states, the state officials recalled that they had done so infrequently— generally in only one or two cases, out of the dozens of rate changes  utilities have proposed since 2002. State regulators cited several reasons  why states rarely denied utilities from recovering their costs—for  example, they told us it is difficult to prove these costs were above a fair  market price. Also, some state regulators we talked to expressed a desire  to avoid being overly directive regarding utilities’ purchases because the  regulators said that utilities have greater expertise in making purchasing  decisions.
Because state regulators have limited oversight of consumer prices but are  concerned about recent high and volatile prices, they generally provide for  two types of actions to help stabilize consumer prices—they influence  how utilities purchase the commodity, and they sometimes implement  “customer choice” programs. First, most states encourage utilities to  engage in “hedging,” which reduces the need for utilities to buy from  volatile short-term spot markets. Hedging includes such techniques as  buying gas at fixed prices in long-term contracts or storing gas purchased  when prices are relatively low, to be used during times when prices are  high. Utilities in these states often engage in some form of hedging to  insulate consumers from “rate shocks,” where prices greatly increase from  one month to another. While hedging does not guarantee the lowest price,  it tends to smooth prices, giving consumers greater price stability.
Second, some states offer “customer choice” programs that allow  residential consumers to choose to purchase gas from natural gas  suppliers other than the utility provider. Customer choice programs may  encourage more stable natural gas prices because nonutility suppliers  have an incentive to hedge their gas purchases to minimize the risk of high  prices—unlike utilities, which fully recover their gas purchase costs from  the consumer. Therefore, nonutility suppliers may be more likely to offer  gas service to consumers at a set price for a period of months or years.  However, regulators in the states we reviewed told us that customer  choice did not necessarily lead to lower prices, because nonutility gas  marketers still purchase gas from the same natural gas commodity  markets from which utilities purchase. Moreover, high and variable natural  gas commodity prices have decreased participation in customer choice  programs. According to the Energy Information Administration,  participation in customer choice programs declined from 4.1 million  households in 2002 to about 3.9 million households in 2005—representing  about 6 percent of all gas users in the United States—and mostly  concentrated in two states, Georgia and Ohio.
section_title: States Rely on FERC to Oversee Natural Gas Commodity Prices, but Some State Regulators Lack Knowledge of FERC’s Oversight Activities
paragraphs: States rely on FERC to oversee the market and investigate market  manipulation. U.S. Supreme Court decisions and other legal  interpretations have established that the federal government has exclusive  responsibility for overseeing natural gas commodity prices. As a result,  according to the state regulators and other experts we interviewed, the  states must rely on FERC to monitor commodity markets and ensure  prices are fair. FERC officials acknowledge that it is important to inform  stakeholders about their oversight activities. In that regard, in recent  performance reports FERC listed actions it has taken to provide  information on its oversight, such as providing copies of its market  surveillance reports to state public utility commissions. Officials in the  Office of Enforcement told us they discuss their market-monitoring and  oversight activities during twice-yearly meetings with the National  Association of Regulatory Utility Commissioners (NARUC), a national  organization of state regulators. In addition, upon request, Office of  Enforcement officials have met with state regulators to discuss their  market oversight activities. FERC compiles data on the numbers and  subject areas of the informal and formal investigations it undertakes, and  it reports some of those data for completed investigations. For example,  FERC publicly reports the number of hotline calls it receives and some  statistics on closed investigations and audits through documents available  on its Web site, such as press releases, FERC staff reports, the agency’s  annual report to Congress, and its State of the Markets Report, which  summarizes information about energy market conditions and identifying  emerging trends.
However, FERC staff are prohibited from disclosing details about ongoing  investigations except by order from the FERC commissioners. In that  regard, FERC’s practice has been to release information about the  numbers and subject areas of ongoing investigations only rarely because it  has been its view that providing overly detailed information could risk  undermining FERC’s market-monitoring efforts. FERC officials recognize  that publicly disclosing some additional information about its oversight  activities, as long as it would not compromise ongoing investigations,  could serve to increase stakeholder understanding and, potentially, deter  market manipulation. In this regard, FERC has occasionally disclosed  information about ongoing oversight efforts at the commissioner’s  discretion, as it did in 2002 during the Enron investigation in an effort to  increase public understanding of FERC’s oversight activities and raise  public confidence in energy markets. FERC officials also told us that they  are developing a Web page to better inform the public about its oversight  activities in response to questions they received from the public.
Despite FERC’s past efforts, some stakeholders still do not have a full  understanding of FERC’s oversight activities and lack confidence in the  fairness of natural gas commodity prices. Some state regulators we  interviewed told us they lacked assurance that natural gas prices are free  from manipulation. For example, regulators from one state sent a letter to  FERC expressing concern about high gas prices and that FERC’s oversight  may not prevent market manipulation. In response, Office of Enforcement  officials invited the state regulators to their offices in Washington, D.C.,  for discussions and to tour FERC’s Market Monitoring Center to observe  firsthand how FERC monitors the market. Between October 2005 and  February 2006, FERC received similar letters from two other states and  one municipal government requesting information about rising natural gas  prices and possible market manipulation. Other state regulators we  interviewed told us they would benefit from greater coordination with  FERC regarding natural gas prices. Moreover, according to one state  commissioner on the NARUC gas committee, state commissioners vary in  their knowledge of what FERC staff do to monitor natural gas commodity  markets—and many members have limited knowledge. In addition, a  NARUC gas committee official elaborated that FERC outreach to the  states would help both FERC and the states better fulfill their respective  regulatory duties. Citing their concern over rising natural gas prices and  concerns over monitoring of commodity markets, attorneys general from  four Midwestern states commissioned a report to investigate whether  natural gas prices were artificially high as a result of market  manipulation.
section_title: Conclusions
paragraphs: Oversight of natural gas markets has evolved substantially from the days  when the federal government set prices based on costs for natural gas  produced at wells and controlled, together with the states, nearly all of the  rest of the costs of delivering it to consumers. However, aside from  FERC’s efforts to prevent market manipulation, neither the federal  government nor the states have much influence on the natural gas  commodity price that now accounts for the largest portion of the price  that consumers pay. As a result, the natural gas prices consumers pay will  remain highly affected by what happens in the commodity markets.
Nevertheless, federal oversight of the commodity markets remains a work  in progress. Stakeholders, including state regulators, other government  officials, and the public, are highly affected by the commodity markets  that FERC is charged with overseeing, but some of these stakeholders  remain largely unaware of FERC’s oversight processes and activities.  Because of regulatory limitations, FERC staff do not publicly disclose  information about informal and formal investigations unless the  investigations have been completed and have resulted in a formal penalty,  despite the advantages such information could have in increasing  stakeholder understanding of FERC’s oversight activities and, potentially,  deterring market manipulation. However, under current regulations, FERC  commissioners have it within their authority to disclose this information.  Furthermore, because the commodity component of the price that  consumers ultimately pay for their natural gas has taken on such  prominence and because states rely on FERC to oversee the commodity  market, it is increasingly important for stakeholders to understand what  FERC is doing to police this market. In this regard, FERC recognizes the  need to provide more information to stakeholders about its oversight  efforts and has multiple ways to do so, such as through its Web site. In  providing even more information to stakeholders on its oversight efforts,  including information, as appropriate, about ongoing monitoring and  investigation activities, FERC could both increase stakeholders’  understanding about FERC’s efforts to ensure the fairness of natural gas  prices and better deter market manipulation.
section_title: Recommendation for Executive Action
paragraphs: Given the potential benefits of providing more information on its oversight  activities, we recommend that the Chairman of FERC provide more  information to stakeholders, including state regulators, other government  officials, and the public, about actions taken by FERC to ensure that  natural gas prices are fair. This effort should be undertaken within existing  law and regulation, build upon the efforts that FERC already has under  way, and use the information FERC already compiles on its monitoring  and investigations. We agree that disclosure of information that is specific  or detailed could provide would-be market manipulators with information  about FERC’s sources and methods of operation. Therefore, we believe it  prudent that the Chairman have initial discretion on how best to do this.  The information we recommend that the Chairman consider providing to  stakeholders, including state regulators and, where possible, the public,  includes the following:  information on how the Office of Enforcement staff analyze natural gas  markets and how the staff go about identifying market anomalies or  unusual market behavior; information on the types of unusual market behavior that warrant further  investigation by the Office of Enforcement; and,   more timely information on the informal and formal investigations under  way, such as the numbers and subject areas but not the identities of those  under investigation.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided the Federal Energy Regulatory Commission with a draft copy  of this report for review and comment.
FERC generally agreed with the report’s findings, conclusions, and  recommendation and offered minor technical comments, which we have  incorporated, as appropriate. FERC’s written comments are reproduced in  appendix II.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, will send copies to the Chairman of FERC and  other interested parties. We also will make copies available to others upon  request. In addition, the report will be available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-3841 or wellsj@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix III.
section_title: Appendix I: Scope and Method
subsections: section_title: To obtain information about FERC’s progress in implementing additional authorities provided to it by the Energy Policy Act (EPAct 2005), we reviewed EPAct 2005 and relevant FERC regulations and information documenting FERC’s progress, such as its Policy Statement on Enforcement, memorandum of
section_title: We conducted our work from February through August 2006 in accordance with generally accepted government auditing standards.
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Karla Springer (Assistant  Director), Lee Carroll, James Cooksey, John Forrester, Jon Ludwigson,  Kristen Massey, Alison O’Neill, Frank Rusco, Barbara Timmerman, and  John Wanska made key contributions to this report. Others who made  important contributions include Casey Brown, Michael Derr, Glenn  Fischer, and Kim Raheb.