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Monday, October 19, 2015

How U.S. Natural Gas and Electric Markets Were Liberated

Natural Gas and Electricity

Since the 1930s U.S. wholesale markets for natural gas and electricty, today totaling over $400 billion annually, are subject to comprehensive regulations that set every price. These laws and regulations remain in effect. Yet, today, electic and gas prices are largely set by free markets, just like those of other commodities. How can this be?

The responsibility for this seemingly impossible transition rests principally with two men: both of them brilliant lawyers and, perhaps even rarer than brilliance among lawyers, also highly numerate and economically sophisticated. In the 1980s, one of them was the chairman member of FERC and a moderate Democrat; the other was Reagan’s Deputy Secretary of Energy and a libertarianish conservative.As, purely by coincidence, decades later, both of these men—one still the most highly-regarded energy lawyer in the country; the other having moved on to more Article-3-ish pastures—also were the author’s direct bosses, he can also attest that, in addition, they are both uncommonly nice human beings. They would have to be to tolerate the author for years on end.

Under the Natural Gas Act and the Federal Power Act, every wholesale saleWith some notable, but numerically not that significant exceptions. of natural gas or electric power must be approved by FERC. In particular FERC must, for every single sale, determine that the price charged is just and reasonable and not unduly discriminatory or preferrential. As is commonly the case when a comprehensive command-and-control scheme is imposed on a putatively private market and prices need to be determined, the upshot was that prices were set to be essentially the seller’s cost plus a reasonable profit.

As such prices are fairly close to what one would be expect to arise in competitive markets during periods with little upheaval, such systems are not necessarily immediately disastrous. A price regulation which sets prices not too far from where they would have been anyway does not need to do a great amount of harm. There are of course the large transaction costs of producers needing to keep a byzantine set of documentation for costs (and the regulators needing to audit them) and being required to go to Washington and ask Mother, may I? every time prices need to change, but in a $400 billion market with a relatively small number of large transactions, this transaction cost need not overwhelm the market. So, for a few decades, the lights did not go out and the heaters continued to warm.

But when external circumstances started to change more rapidly and in ways unforseen and unpredictable to the legislators or regulators, the system started to break down. One precipitating factor were the various Arab oil embargos of the 1970s which rapidly moved prices for some electricity and natural gas up and down. Others were the rise of new technologies like nuclear power. Suddenly prices would need to change rapidly and often in ways apparently unrelated to any documentable accounting costs. Such complexity a command-and-control system of price regulation just could not handle.

One famous example of the pathologies induced by the then-present energy regulation is the Brownsville Turnaround.This example concerns oil which was not subject to the same regulations, but similar—if slightly less spectacularly idiotic—events occured thanks to natural gas and electricity price regulation. Congress, in its wisdom, had imposed quotas on oil imports. Whether this was caused by a general desire for energy autarky, a distrust of Arab oil producers in particular, favoritism to domestic oil producers, or some other inane reason is hard to say. Congress had aimed to explicitly exempt the large imports from Mexico and Canada and hence decreed that they should not apply to imports over land. Once domestic oil production dropped rapidly compared to domestic consumption and OPEC oil began to fill the gap, these quotas began a highly binding constraint.

Two consequences followed. The first is that oil pipelines from Canada which happened to run under lakes (such as the Great Lakes) suddenly became worthless for any oil that passed through them was not deemed imported over land. The other was the Brownsville Turnaround. Traditionally one of the premier oil tanker ports in the U.S. is Brownsville, Texas, from where oil was directly transported via pipeline to the nearby refineries. But once the import quotas ran into short supply, this sensible procedure could no longer work. So instead of pumping the oil from the tanker into the pipelines, the oil was instead dispensed into a waiting fleet of tanker trucks. These tanker trucks then drove across the border to Mexico, immediately turned around back to Brownsville, and then dispensed their oil—now deemed imported overland—into the refinery pipelines.

Thanks to regulations like these, the energy system lurched from regulatory disaster to regulatory disaster. The regulators probably usually tried to patch over every problem as soon as it occured, but even when they were willing, they often could not fix things before substantial harm arose.

This was no way to run a railroad, both of the aforementioned gentlemen concluded. But how could it be fixed when Congress would not repeal the underlying legislation requiring just and reasonable rates? And so a clever idea was born. Rates must be just and reasonable. And binding precedent states that this means that the rates must somehow be based on cost. But nothing required that the rates be based on the seller’s cost! In a competitive market, the price can be expected to be the marginal seller’s marginal cost. And the natural gas market, with a vast number of sellers and buyers competing atomistically against each other, is a competitive market par excellence.

Thus was issued the Natural Gas Blanket Marketing Certificate. This certificate sternly orders almost everybody in the natural gas marketsExceptions are some large pipeline systems which arguably have some market power. to buy and sell natural gas at exactly the prices they would if they were not subject to regulation—not a penny more or less! Under this sort of happy tyranny, ordering everybody to go about their business and do exactly as they would please absent the tyranny,One is reminded of the Great Libertarian Conspiracy to take over the world and make everybody do whatever they want. natural gas markets have worked well for decades (and with little regulatory transaction costs). Electric markets eventually and haltingly followed.