The impending restructuring of the electric utility industry: causes and consequences - Applied Economics - Industry Overview

Business Economics, Oct, 1993 by R. Charles Moyer

THE DECADE of the 1980s witnessed a rapid deregulation of many industries, including trucking, airlines, and telecommunications. The economic rationale for regulation was never well established in the trucking and airline industries. Changes in technology rendered earlier rationales for regulation of the telecommunications industry inoperative. The benefits to consumers from deregulation in these industries have been extensive. For example, distribution costs as a share of GNP have dropped 33 percent since 1981, after the passage of the Motor Carrier Act.(1) Nevertheless, the process of moving from a regulated to a deregulated marketplace has been painful for many market participants.

Deregulation of the natural gas industry occurred somewhat later than deregulation of transportation and telecommunications but gained momentum in the late 1980s and early 1990s. Movement toward deregulation of electric utilities has been even slower. However, the passage of the Energy Policy Act of 1992 signals the end of the electric utility industry as we now know it. The final impact on the industry will be at least as great as deregulation of the interstate natural gas industry has been.(2)

A BRIEF OVERVIEW OF NATURAL GAS REGULATION(3)

Prior to the passage of the Natural Gas Policy Act of 1978, interstate natural gas industry regulation was similar to public utility regulation. The Natural Gas Act of 1938 directed the Federal Power Commission (FPC) to establish "just and reasonable" rates for pipelines and natural gas producers who sold natural gas in the interstate market. This form of regulation created problems during the late 1960s and early 1970s as the demand for natural gas increased. The price of "interstate gas" was held at artificially low levels by the FPC. At the same time, the price of natural gas sold in intrastate markets was not regulated, and it rose in line with increased demand. The net effect was an interstate gas policy that encouraged consumption, but discouraged producers from committing gas to the low-price interstate market.

In 1978 the Natural Gas Policy Act (NGPA) was passed. NGPA established a complicated system for eliminating the dual natural gas market. All gas, both interstate and intrastate, was included under new federal price controls. Various categories of gas were defined, and maximum prices for all gas in a category was set. One objective of this pricing policy was to provide incentives for the discovery of new gas, which could be sold at "premium" prices. Interstate pipelines, eager to rectify their supply shortfalls, made commitments to buy much of this so-called "new" gas. These new gas purchase contracts often included "take-or-pay" provisions, under which a firm agreed to pay for a significant portion of the contracted amount of gas at a price equal to the maximum NGPA price, whether or not the gas was needed by the pipeline's customers. As the incentives for new gas discovery bore fruit and the impact of the recession in the early 1980s reduced demand, significant surpluses developed in the marketplace and prices fell dramatically.

In 1985, the Federal Energy Regulatory Commission (FERC), successor to the FPC, issued Order No. 436 (later modified as Order Nos. 500-H and 500-I), which, in effect required pipelines to become open-access providers of transportation services for producers and users of natural gas. This completely reversed the role played by interstate pipelines, from merchants of gas that was delivered through their pipelines to the transportation of gas owned by others. For example, in 1984, 92 percent of the gas transported by pipelines was "their own" gas, and only 8 percent of pipeline throughput represented the transportation of gas owned by others.(4) By early 1992, the pipelines' role had been reversed, with "transportation gas" representing 79 percent of throughput.(5) Interstate pipelines that had contracted for substantial portions of their merchant gas in the form of high-priced, take-or-pay contracts found themselves in a crisis when gas prices declined and gas users (large industrial customers and local distribution companies) lined up their own lower-cost sources of supply. Many pipelines faced staggering take-or-pay liabilities from uneconomic gas supply contracts. By October 31, 1990, interstate pipelines had paid $9.1 billion to producers to settle take-or-pay obligations. The Department of Energy estimates that only $5.4 billion of this amount is eligible for recovery from pipeline customers under FERC regulations, leaving $3.7 billion in unrecovered payment (losses).(6) Unrecoverable take-or-pay obligations were the primary cause for the Chapter 11 bankruptcy declaration by Columbia Gas in July 1991. Current rules under consideration by the FERC would completely eliminate the merchant function of natural gas pipeline companies.

THE HISTORY OF ELECTRIC UTILITY DEREGULATION

The pace of deregulation of electric utilities has been much slower than in other, formerly regulated industries, in spite of substantial evidence that the declining cost rationale for its regulated monopoly status ceased to be operative in the early 1970s. Until recently, the electric utility industry has functioned almost exclusively as a regulated monopoly providing generation, transmission, and distribution services.(7)