Gas and Electricity Sector Convergence: Economic Policy Implications

Transcription

1 Gas and Electricity Sector Convergence: Economic Policy Implications Energy Week 99 The Global Shakeout The World Bank Washington, D.C. April 6-8, 1999 Jeff D. Makholm Senior Vice President National Economic Research Associates, Inc. INTRODUCTION In this paper, I examine some of the implications of the seeming convergence of the electricity and gas industries. As gas has become more closely identified as a fuel for electricity generation more policy makers both in developed countries and elsewhere have exhibited two tendencies. One is to attempt to learn from one industry when deciding how to structure and regulate the other. The other is to look upon both gas and electricity as a combined energy planning or regulatory exercise. I will comment upon these tendencies from a number of perspectives: 1. From an efficiency perspective, should gas or electricity be transported long distances? 2. What about the design of competitive markets for gas and electricity, respectively? 3. What are the principles of economic pricing that can prevent distortions? 4. What about vertical or horizontal integration in gas and electricity?

2 - 2 - I will touch on all of these questions from a number of perspectives, below. I. WHAT SPARKED THE DISCUSSION OF CONVERGENCE? It has become common in the past few years to look at the gas and electricity markets as if they have converged. Much of this convergence has come about because of technological gains in the electricity generating business along with other factors. Indeed, it is difficult to overstate the importance of generating costs and technology on the development of much of the modern electricity and gas businesses. Up until the late 1960s, for example, electricity generation technology showed continued progress down a seemingly endlessly declining long-run cost curve. In the United States, from the time of their inception, electricity utilities had had a history of offering voluntary rate reductions, from time to time, in order to avoid heavy regulatory scrutiny satisfying regulators that indeed they were working to keep prices down. By the late 1960s, however, the scale economics that had driven the electricity industry for decades had essentially been used-up. That factor, along with the sharply rising cost of oil in the early 1970s and the advent of high inflation in the US and many other countries, caused the seemingly steady advances in electricity productivity to stop short. From that time through the 1980s, the electricity business in the US and elsewhere demonstrated little technological gain and sharply increasing prices. 1 In the 1990s, however, a new technology changed the view of electricity generation as a natural monopoly led by large-capacity generating stations. Up until then, the business had been thought of as a natural monopoly because of the economies of scale exhibited by larger and larger plants. Particularly with respect to any other than the largest local electricity markets, such scale economies seemed to dictate a local monopoly in electricity generation. In about 1990, the business of electricity generation changed substantially. The optimal size of generating units, which up until that time had increased, turned around. Led by 1 See: Makholm, J.D., Sources of Total Factor Productivity in the Electric Utility Industry, Ph.D. Dissertation, University of Wisconsin-Madison, May 1986.

3 - 3 - advances in materials science, the space program and computer-generated turbine blades, among other things, gas turbines became much more efficient than they had ever been. Combined with the lifting of prohibitions on using gas to generate electricity, which a number of the western countries had imposed, the smaller, combined cycle gas generating plant turned on their heads both the notion of the scale economies of generation stations and the opinions of the value of the existing stations. 2 Thus gas became a much more important element in generating electricity at the same time that a number of countries most notably the US and Canada were heavily reforming the structure of those businesses and the way they were regulated. Genuine gas-to-gas competition resulted. Discussions of the convergence, as it were, of the two businesses were the inevitable consequence of two industries that seemingly had been thrust much closer together. II. GAS OR ELECTRICITY LONG-DISTANCED TRANSMISSION? A major element in the cost of both gas and electricity markets is long-distance transmission. Particularly in the gas industry, it is seldom that the resources exist close to the consumption centers. Thus, from a joint planning perspective, it is reasonable to ask which is more efficient electricity transmission or gas transportation when long distances are involved in moving the energy from the gas producing fields to the market. Notwithstanding the reasonableness of the question, however, it is important to note two things. First, in many major energy markets like that in Canada and the US the joint planning question is moot. No company or agency performs such plans, as the respective transmission networks are both spread among many different firms and over many different regulatory jurisdictions. Second, the technical/engineering parameters regarding which (i.e., gas or electricity) transmission is more efficient are almost certainly dominated by financing, environmental, regulatory, political and separate gas/electricity market concerns. That is to say, knowledge of which option is technically more efficient may only be a minor feature of information in a much wider landscape for energy planning. 2 See: Shuttleworth, G., and Hunt, S., Competition and Choice in Electricity, John Wiley and Sons,1996, pp. 2-3.

4 - 4 - Economic efficiency is the ultimate goal of deciding whether a transmission wire or a pipeline would be more appropriate. The capital needed to build each, future revenues, operational costs, etc., have to be taken into account when comparing alternatives. However, there are other factors that have to be incorporated, for example, whether these lines or pipelines have to cross a border with another country (a circumstance of great concern in many World Bank projects). Other factors include value added, jobs creation, political and financial situation and differences in regulation. Consider, as a simplified example, the problem facing a particular company. That company may be considering building a power plant either near the producing fields or near the city, which represents the consuming market. If the company chooses to build the power plant near the producing fields, it has natural gas all year long but has to compete for dispatch. If the company builds near the city, it needs to guarantee supply of natural gas to generate electricity. This company may suffer from curtailments in winter because natural gas regulations define the service to electric utilities as interruptible, or at least of secondary importance to space heating the highest-valued major use for gas. Therefore, the company may need to add dual capabilities of generation to continue producing during shortages of natural gas. Another issue to be considered is nodal factors. These factors greatly influence the decision to install a power plant in two different geographic locations. There are dynamic implications of nodal factors that cannot be ignored. When new generating facilities are added to the system and begin producing, the inflows and outflows in the transmission system will change, and also, the nodal factors. Therefore, long-term changes have to be incorporated in the investment analysis. These changes also affect the spot market and transmission charges. A power plant near the natural gas fields pays a lower price for its fuel than a similar facility that is located near the city because the latter also pays for transportation and distribution of the natural gas. Table 1 presents some differences that power plants face according to their location:

5 - 5 - Table 1 Plant Near Producing Field Plant Near City Technical Efficiency of Transport Line losses and transmission rates Transportation rates (includes compression costs) Transmission System Electricity - Common-carriage Natural Gas - Contract-carriage Regulatory Effects on Rates Uncertainty of electricity transmission rates Certainty of natural gas transportation rates Supply of natural gas From producing region From many basins Hold-up problems in the supply of natural gas If buying gas from one producer, very likely that can happen Not likely because there are other sources Horizontal Integration (producer that generates) Provides electricity for production of hydrocarbons and, also, the possibility to sell electricity Protects the producer against low relative natural gas to electricity prices No own use Arbitrage between selling natural gas and electricity when these prices differ Protects the producer against high relative natural gas to electricity prices Period of production All year long All year long but at a higher cost when using alternative fuels because of gas interruptions during winter My point in this discussion and Table 1 is to show that many considerations attend the decision to advocate one form of energy transmission over another. There are no easy rules of thumb that guide policy makers with respect to this specific decision. Indeed, perhaps the best rule of thumb for policy makers is to try to structure both gas and electricity markets in ways that allow private participants in each market to internalize and value all of these various risks and thus decide for themselves as happens in the most developed energy markets. For many applications, gas and electricity compete with one another and such competition spurs its own efficiency. Therefore, while planners (or the World Bank) may sometimes be in the unenviable position of having to make an administrative decision to transport gas or electricity, the most efficient decisions happen when the competing interests decide. If there is no other choice, then it is incumbent on decision-makers to assess the implications of the factors above, among others. Decisions based solely on technical/engineering factors (i.e., friction versus line losses) are not apt to be particularly well informed.

6 - 6 - III. WHAT ABOUT THE DESIGN OF COMPETITIVE MARKETS FOR GAS AND ELECTRICITY? The design of these markets is a highly complicated question. Many considerations prevent the easy application of the rules of one industry to the other. Further, the experience of competition in particular countries (e.g., the US/Canada experience in gas competition or the UK experience in electricity competition) is not readily transferable to other countries, for a large variety of institutional, geographic, industrial, legal and political reasons. Perhaps the best rule is not to use a single rule for any two countries or industries. Nevertheless, there are some fundamental factors that bode well for establishing competitive markets in both gas and electricity markets: 1. Competitive oil and gas producing sector. 2. Well managed, reasonably efficient (in a technical sense) and vertically separated transmission sector that is transparent in its costs and operations (in addition to effective regulation of the sector). 3. Effectively-regulated distribution sectors in both gas and electricity. Without a competitive gas producing sector, it is difficult to structure either competitive gas or electricity markets. This may appear manifest with respect to gas, but a number of countries have tried to implement gas industry competition despite the presence of a dominant producer (i.e., Argentina, Australia and Mexico). A transparent and well-managed transmission sector is the sine qua non of creating competitive markets for gas or electricity. To a large extent, the ability of the transmission sector to support such competition depends on whether it is independent and predictable in the way it will handle transmission so that producers and traders can count on the system for the purpose of making investments. I produce below an interesting example from the US gas market to show the efficient transmission sector working in conjunction with the gas market at its best. Regarding the design of gas markets in particular, an interesting case-study has formed in the US, where the acknowledged competitiveness of the gas market has recently extended

7 - 7 - into the transportation of gas as well. There is evidence that shows that gas marketers and traders have become increasingly adroit in buying and selling not only gas but transmission capacity during peak times as well. Case Study: Efficient Transmission Trading in the US Gas Industry In the US since 1992, the market for transmission capacity has been strictly separated from the competitive market for gas. Those separations were effective largely because of the experience of the industry and its regulators backed-up by agreed accounting and technical standards to dissect the transmission business effectively from gather and processing, on the one hand, and distribution and storage on the other. Nevertheless, remaining pricing restrictions remained on the purchasing and selling of released capacity (that is, secondary market capacity), and many participants worried that these restrictions could impair the efficient functioning of the pipeline capacity market. However, the market has developed methods by which both to circumvent such seemingly inefficient regulations and to learn as well to handle the most difficult periods of peak supply. Transmission companies in the US can sell unused capacity on their lines in the secondary, or released capacity market. In addition to selling their unused firm capacity in the release market, firm contract holders on those pipeline companies also have the option of using their capacity to transport gas to specific spot markets where they can sell the delivered gas. The sales price for the gas at the point of delivery includes both the purchase of the gas commodity and the pipeline delivery of the gas to the spot market. These transactions provide a forum for customers to transport gas where and when they need it. The price cap on release transactions provides an incentive for holders of firm capacity to eschew the release market at times when the imputed value of capacity is higher than the cap price. Delivery market transactions are thus referred to as the gray market. Figure 1 illustrates how the gray market has worked. The figure shows the implicit price of transportation capacity from Texas to Chicago for the time period February 1995 to October 1997 and Figure 2 shows temperature data for Chicago for the same time period.

8 - 8 - Figure 1: Implicit Price of Transporting Gas from Louisiana to Chicago: Evidence from Delivery Market Transactions ($/MMBtu) /6/95 4/6/95 6/6/95 8/6/95 10/6/95 12/6/95 2/6/96 4/6/96 6/6/96 8/6/96 10/6/96 12/6/96 2/6/97 4/6/97 6/6/97 8/6/97 10/6/

9 - 9 - Figure 2: Daily Maximum and Minimum Temperatures in Chicago, /1/95 4/1/95 6/1/95 8/1/95 10/1/95 12/1/95 2/1/96 4/1/96 6/1/96 8/1/96 10/1/96 12/1/96 2/1/97 4/1/97 6/1/97 8/1/97 10/1/ Chicago Max. Chicago Min. Figure 1 and Figure 2 illustrate three very important points. First, the price of capacity changed in response to demand at peak (peak gas demand coincides with extremes of cold weather), meaning that capacity was allocated to those who valued it most. According to trade press reports and FERC analysis of winter 1996 gas prices, there were no curtailments of gas supplies because the short term market worked, albeit the market sometimes cleared briefly at very high prices. Second, extreme price spikes do not occur every heating season. In winter 1997 the implicit price of transportation to Chicago rose occasionally above the maximum pipeline tariff rate, but it apparently never achieved anything like the levels seen in A customer can estimate the cost of purchasing delivered gas by performing a probabilistic analysis of the likelihood of such spikes.

10 Third, temperatures in winter 1997 were fairly similar to winter 1996, yet capacity prices did not rise to 1996 levels. Again, there were no supply curtailments. This suggests that gas transporters learned from their 1996 experience and better anticipated and prepared for their needs. The market again worked, though this time clearing at much lower prices. As such, it is clear that even during the worst of the winter peaks, gas transportation capacity in the US functions with considerable speed to efficiently serve demand. Further, the market mechanisms are sufficiently well defined and flexible to allow the players to learn and adapt to the demands of those periods. IV. PRICING TO PREVENT ECONOMIC DISTORTIONS The Chicago example presented above demonstrates that the market can be served efficiently despite the existence of regulations that may, from a narrow perspective, look inefficient. That is, while the federal regulators in the US retain a cap on the price of released, secondary market capacity, those who trade gas supplies have found effective means around those caps. The reason why the market is as efficient as it is has more to do with the nature of the contract-carriage commercial regime than with the pricing arrangements on the interstate gas transmission pipelines that operate between Texas and Chicago. That is, the gas pricing regime in the US makes no attempt whatever to force regulated transmission prices to mirror actual costs of using the pipeline during such times of peak demand. Instead, the regime defines property rights on the transmission carriers in a way that allows a decentralized purchasing and selling of capacity rights during the winter peaks. The pricing of the peak can be competitive, in other words, and it happens almost completely outside of the jurisdiction or control of the regulators involved. The transport companies regulated prices in the US continue to target the reasonable recovery of those transmission companies costs (to be sure, however, not all of those costs particularly where demand is declining). But no central agency, or independent system operator, oversees ultimately the disposition of capacity or the effective prices that are paid for its use during periods of peak demand.

11 V. CONVERGENCE AT THE DISTRIBUTION LEVEL Gas and electricity, while not perfect substitutes in the retail market, may be interchanged for a variety of household functions. Electricity powers devices, such as personal computers, that gas does not. However, for basic household heating functions, such as space heating, water heating and cooking, gas and electricity are substitutes and compete vigorously with each other. A fundamental principle of regulation is that its goal is to produce a result approximating what would be observed in a competitive environment. Even though gas and electricity are not perfectly substitutable, they are competitive enough that the removal of such competition would only serve to make the job of the regulator more difficult. Figure 3 and Figure 4 show how a merger of gas and electricity suppliers would affect energy delivery as a whole. Because customers must buy their energy locally, energy suppliers compete in local markets only. Figure 3 shows the distinct geographical regions of the country, each currently served by two competing energy suppliers. Figure 4 exhibits the new, post-merger energy market. Figure 3: Energy Delivery System Before Merger of Gas and Electric Distributors Gas Electric

12 Figure 4: Energy Delivery System After Merger Electric/Gas Comparative Performance Studies of Combined Gas/Electricity Firms In the U.S., the issue of combined versus straight utilities came to a head in 1970 with the introduction of Senate Bill This proposed legislation would have banned the ownership of combination utilities. In addition to barring future mergers between gas and electric utilities, passage of the bill would have required the divestiture of all existing combination utilities. The bill did not pass, due mostly to the gas shortages of the early 1970s. The evidence presented in favor of breaking up utilities was mixed. The general conclusion from studies performed around that time was that straight utilities were better than combination utilities in some respects. However, none of the studies concluded that the competitive benefits from breaking up an existing combination utility would outweigh the potentially enormous costs of divestiture. Since that time, no combination utilities have been allowed to form, but no existing ones have been forcibly broken-up either. A number of authors have recognized that a combined utility, without the threat of competition from another utility, may have fewer incentives to pursue efficient behavior. If a single entity controls both the gas and electric distribution systems, and another entity attempts 3 A combined utility is an entity which provides both gas and electric service. A straight utility provides either gas or electric service.

13 to enter into one side of the business, the combined utility can respond in several anticompetitive ways. Zielinski 4 gives a clear example of a combination gas and electric utility facing competition from an independent power producer (IPP) of electricity that needs gas to generate electricity. The combined entity would have both the incentive and means to make that gas more expensive for the IPP to acquire, whereas a straight gas utility would lack such an incentive, resulting in lower prices and a more efficient outcome. The early theoretical pieces surmised that the principal benefit of having a combination utility would be to save on customer costs such as metering and billing. Further, it was asserted that a combined entity would spend less on promotions and advertising. Although a combined utility may have lower unit costs, its market power might enable the utility to reduce quantities and increase prices. The outcome of this would be lower quantity sales at higher prices i.e., the classic monopolist outcome. In Economic Performance of Combination and Straight Utilities, Quan 5 provided a review and discussion of many other papers that have evaluated this issue. He concluded that compared to straight utilities, combination utilities exhibit the classic monopolist outcome of higher prices and lower output. Further, expected economies of scope were not realized, and the lack of competitive threats fostered inefficient behavior (also known as X-inefficiency). 6 Gas and electricity (and oil in some parts of the U.S.) compete with each other in two arenas: new home construction and conversions. 7 While the combined sum of these two categories is an almost minuscule fraction of the total housing market, these customers represent the market for which fuel suppliers compete. Because some customers can choose 4 Public Utilities Fortnightly, March 15, 1994, pages Quan, Nguyen T., Economic Performance of Combination and Straight Utilities, prepared by NERA on behalf of Sierra Pacific Power Company, February 22, The tendency for monopolistic enterprises to be less vigilant with respect to operational and managerial efficiency is often referred-to as X-inefficiency (after Leibenstein, H., Allocative Efficiency Versus X- Inefficiency. American Economic Review, Vol. 56 (1966), pp ). 7 The American Gas Association (AGA) tracks conversions and new construction installations closely as part of their Residential Natural Gas Market Survey each year. In 1993, 485,975 new households took gas, while 237,111 existing homes converted to gas (311,437 homes converted to gas from another fuel, while 74,326 switched to another fuel from gas).

14 between the two energy sources, gas and electricity suppliers compete, benefiting the rest of the customers as well. The service offered to these customers sets the price and quality of service level everyone else will face. Whether gas or electricity is preferred depends upon prices and climatic conditions in the geographic area. Prior to the introduction of geothermal electric heat pumps, electricity was not a serious competitor for the space heating market in the colder areas of the US. Correspondingly, in warmer areas where heat is seldom needed, the advantage goes to the heating technology with the lowest start-up costs, and this frequently is resistance-based electrical heat. Resistance heat is expensive per unit, but very inexpensive to install. From time to time, technology improvements are made which favor one or the other fuel. Currently in the US, there is an increase in electricity produced via gas-fired turbines by IPPs and in the use of the above-mentioned electric-powered geothermal heat pumps in new homes. Still, gas and electricity are always going head-to-head to some extent and this competition is enough to benefit the captive customers who comprise the majority of fuel companies' ratepayers. In the U.S., there is still debate about the desirability of combination utilities. In some other countries, the case against allowing combination utilities to form may be more clear. While utilities are watched rather closely in the U.S., the regulatory environment in some other nations is much less stringent. In short, a regulated firm can get away with a lot (this is arguably true in the U.S. too). However short it may be of real competition, the only form of competition that a local distributor of electricity or gas will face is from the other purveyor of energy.