Do Americans Consume Too Little Natural Gas? An Empirical Test of Marginal Cost Pricing

Transcription

1 Do Americans Consume Too Little Natural Gas? An Empirical Test of Marginal Cost Pricing Lucas Davis 1 Erich Muehlegger 2 1 University of California, Berkeley 2 Harvard University RAND Journal of Economics, Winter 2010 Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

2 Overview Natural gas delivery is a classic state-regulated natural monopoly. This paper studies state-regulated retail prices for natural gas. Outline: 1 Why should we care about regulated prices? 2 How much do regulators markup natural gas prices above marginal cost? 3 How much surplus is lost as a result? 4 What do regulated markups imply for environmental policy? Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

3 Why study regulated prices? Long literature discusses optimal regulation of natural monopoly. How closely does actual regulation match what economists would consider optimal? Relevance to Environmental Policy Governments regulate retail prices for many types of energy but much of our intuition about externality-correcting taxes implicitly assumes prices are set in competitive markets. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

4 Motivation for Environmental Taxes or Permits P MSC tax p* p MPC D q* q Q Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

5 Motivation for Environmental Taxes or Permits P MSC tax p* p MPC D q* q Q Is the assumption that p reflects the MPC a reasonable one for regulated markets? Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

6 Why Might Regulated NG Prices be Above MC? Natural Gas Supply Chain: 1 Production (competitive) 2 Interstate Transportation to City-gate (unregulated, open-access) 3 Local Distribution (state regulated) 4 End Users. Local distribution is a classic natural monopoly. High fixed costs (pipeline network), low marginal costs. States regulate prices to meet two objectives: 1 Cover monopoly s fixed costs, while 2 Prevent monopolist from earning excessive profits. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

7 Regulated Pricing: Linear Prices P D Consumer Surplus Lowest linear price that allows the firm to break even (p ) Deadweight Loss p AC MC q Q Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

8 Regulated Pricing: Two-part tariff P D Optimal Two Part Tariff: A+p*q Step 1: Set p = MC Efficient Quantity Step 2: Collect fixed fees (A) from consumer Surplus to cover monopolists fixed costs. p*=mc FC covered by fixed fees AC MC q* Q Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

9 Regulated Pricing in Practice Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

10 Regulated Pricing in Practice Two-part tariffs are common: A + p q... Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

11 Regulated Pricing in Practice Two-part tariffs are common: A + p q......but few regulators set p = mc. Fixed monthly hookup fee. Per-Unit Transportation Fee. Per-Unit Commodity Charge. Typically, Transportation Fee + Commodity Charge > MC ng Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

12 Regulated Pricing in Practice Two-part tariffs are common: A + p q......but few regulators set p = mc. Fixed monthly hookup fee. Per-Unit Transportation Fee. Per-Unit Commodity Charge. Typically, Transportation Fee + Commodity Charge > MC ng In this paper: 1 We estimate how much TF + CC is greater than MC. 2 We compare these markups to reasonable carbon prices from the environmental economics literature. 3 We estimate deadweight loss from the prices set by regulators. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

13 How do we estimate the markups over marginal cost? We examine a panel of state-level, monthly data from For residential, commercial and industrial customers, we observe: Sales Revenues Delivered Quantities Marginal Cost (measured by spot transactions at the city gate) Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

14 How do we estimate the markups over marginal cost? We examine a panel of state-level, monthly data from For residential, commercial and industrial customers, we observe: Sales Revenues Delivered Quantities Marginal Cost (measured by spot transactions at the city gate) Intuition for Empirical Strategy: Consider the relationship between net revenues (revenues less commodity costs) and quantities. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

15 How do we estimate the markups over marginal cost? We examine a panel of state-level, monthly data from For residential, commercial and industrial customers, we observe: Sales Revenues Delivered Quantities Marginal Cost (measured by spot transactions at the city gate) Intuition for Empirical Strategy: Consider the relationship between net revenues (revenues less commodity costs) and quantities. Average Cost Pricing / Monthly Fee = 0 Net Revenues positively correlated with usage, Intercept zero. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

16 How do we estimate the markups over marginal cost? We examine a panel of state-level, monthly data from For residential, commercial and industrial customers, we observe: Sales Revenues Delivered Quantities Marginal Cost (measured by spot transactions at the city gate) Intuition for Empirical Strategy: Consider the relationship between net revenues (revenues less commodity costs) and quantities. Average Cost Pricing / Monthly Fee = 0 Net Revenues positively correlated with usage, Intercept zero. Optimal Two-part tariff / Marginal Price = Marginal Cost Constant Net Revenues, Intercept = Fixed Fee Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

17 High Markup State: Massachusetts (2006) Figure: Residential Natural Gas Price Schedule For Massachusetts for 2006 Massachusetts Net Revenue Per Customer (in dollars) Oct Jul Sep Jun Aug May Nov Apr Dec Feb Mar Jan Consumption Per Customer (in MCF) Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

18 Low Markup State: Oklahoma (2006) Figure: Residential Natural Gas Price Schedule For Oklahoma for 2006 Oklahoma Net Revenue Per Customer (in dollars) Jun OctMay Aug Sep Jul Nov Apr Mar Feb Dec Jan Consumption Per Customer (in MCF) Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

19 How Do We Estimate Average Markups? Calculate Net Revenues = Total Revenues - City Gate Cost. Test of MC Pricing: NetRevenues icmy = α icy + β icy Q icmy (1) α is an estimate of total monthly fixed fees. β is an estimate of the per-unit transportation fee. β = 0 implies Marginal Cost Pricing. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

20 How Do We Estimate Average Markups? Calculate Net Revenues = Total Revenues - City Gate Cost. Test of MC Pricing: NetRevenues icmy = α icy + β icy Q icmy (1) α is an estimate of total monthly fixed fees. β is an estimate of the per-unit transportation fee. β = 0 implies Marginal Cost Pricing. Result 1: Reject marginal cost pricing for each state, year or customer class. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

21 How Large Are Per Unit Markups? Table 3 Average Deliveries, Revenues, and Markups By Customer Class Per-Unit Markup Over City Gate Price Fraction of Total Fraction of Total Core LDC Deliveries LDC Net Revenues Percent Levels (per McF) Residential Customers 54.1% 71.1% 47.9% $3.38 (0.7%) (0.04) Commercial Customers 27.3% 25.2% 43.0% $3.05 (0.7%) (0.05) Industrial Customers 18.4% 3.7% 2.5% $0.16 (4.2%) (0.27) All Customers, Pooled 100.0% 100.0% 38.4% $2.70 (0.9%) ($0.05) Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

22 High Markups Have Implications for Environmental Policy Current markups for residential and commercial customers imply carbon costs of over $200 per ton of carbon ($55 / ton CO2) As a point of comparison, Nordhaus (2007) uses a baseline of $35 per ton of carbon ($10 / ton CO2) Thus, setting the socially optimal natural gas price incorporating impacts of carbon emissions would lead to substantially lower marginal prices and more consumption. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

23 Actual Versus Carbon-Optimal Pricing Current Residential Prices Versus Optimal Residential Prices with a $35/ton Carbon Cost. D $3.38/McF = Actual Markup $0.54/McF = Efficient Markup P p p* p Current price = MC ng + per-unit markup MSC = MC ng + $35/ton of Carbon MPC = MC ng q q* q Q Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

24 Regulated Prices Generate Substantial Deadweight Loss Table 6 Estimates of Annual Deadweight Loss (in Millions) U.S. Natural Gas Distribution Market, Assuming Marginal Assuming Marginal Assuming Marginal Cost of Carbon Cost of Carbon Cost of Carbon of $0 per ton of $35 per ton of $55 per ton Residential Customers 1,297 1,197 1,146 (535) (491) (468) Commercial Customers (241) (222) (212) Industrial Customers (492) (434) (407) All Customers, Pooled 2,719 2,491 2,381 (771) (696) (659) Elasticity Estimates from Table 4: Residential Demand = (s.e ), Commercial Demand = (s.e ), Industrial Demand = (s.e ) Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

25 Why Do Regulators Set High Markups? Other Potential Explanations: Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

26 Why Do Regulators Set High Markups? Other Potential Explanations: Distribution Concerns High Markups / Low Fixed Fees shift burden of fixed costs to high-volume customers. But, many means-tested programs offer lower rates for eligible households. Moreover, consumption is not a terribly good proxy for income. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

27 Why Do Regulators Set High Markups? Other Potential Explanations: Distribution Concerns High Markups / Low Fixed Fees shift burden of fixed costs to high-volume customers. But, many means-tested programs offer lower rates for eligible households. Moreover, consumption is not a terribly good proxy for income. Other Environmental Externalities City-gate price may not reflect true social marginal cost of NG consumption. But, natural gas pollutes less than alternatives. High markups potentially push high volume consumers to dirtier fuels on the margin. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

28 Why Do Regulators Set High Markups? Other Potential Explanations: Distribution Concerns High Markups / Low Fixed Fees shift burden of fixed costs to high-volume customers. But, many means-tested programs offer lower rates for eligible households. Moreover, consumption is not a terribly good proxy for income. Other Environmental Externalities City-gate price may not reflect true social marginal cost of NG consumption. But, natural gas pollutes less than alternatives. High markups potentially push high volume consumers to dirtier fuels on the margin. Regulatory Capture With imperfect information, regulators may overestimate fair rate of return Incentive to maximize rate base. Low fixed fees and high markups make NG more attractive to small users. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18

29 Conclusion 1 Do regulators set optimal prices? No! Strong evidence that regulators recoup fixed costs primarily through per-unit markups rather than fixed fees. 2 How much surplus is lost by suboptimal regulation? Markups of 48% and 43% for residential and commercial customers. Estimated DWL of $2.7 billion per year. 3 What do regulated prices imply for environmental policy? Per-unit markups justified by a carbon cost of $200 per ton. Optimal price that incorporates carbon costs are lower than current marginal prices. More broadly, it is important to take pre-existing distortions into account when determining environmental policy. Davis,Muehlegger (Berkeley, Harvard) NG Regulation Feb / 18