[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)2+(.25)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).
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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.
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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.
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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).
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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.
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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).
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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.
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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.
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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.
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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).
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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.
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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).
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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).
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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).
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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).
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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).
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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.
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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.''
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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.
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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.
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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.
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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.
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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.
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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).
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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.
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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:
Can't charge excessive rates;
Can't discriminate without losing their customers; and
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.
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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.
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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.
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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.
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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.
---------------------------------------------------------------------------
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
