Reforming the Regulation of Natural Gas Markets

Ideally, consumers should pay a price for natural gas equal to the marginal costs of supplying it and distributors should recover the costs of pipeline infrastructure in hookup fees. In practice, however, evidence suggests that prices exceed marginal costs, resulting in a considerable loss of economic efficiency, and a potential bias toward more carbon-intensive fuels.

Ideally, consumers should pay a price for natural gas equal to the marginal costs of supplying it. Marginal cost pricing coordinates actions between buyers and sellers, ensuring that the efficient level of natural gas is used and allocating gas across buyers to its most productive uses.

In many markets, marginal cost pricing arises naturally due to competition. However, natural gas distribution is a natural monopoly. It would not make sense, for example, to have two different sets of pipelines delivering natural gas on the same street. Natural gas distributors face large fixed costs of building and maintaining distribution networks, and marginal cost pricing typically does not provide enough revenue to allow firms to recuperate these fixed costs.

How regulators set prices for natural monopolies has been well studied by economists. A standard finding is that efficiency requires that prices should be set equal to marginal costs and that fixed costs should be covered through fixed charges that do not vary with consumption. For natural gas, this would mean that much of the fixed costs of distribution networks would be recovered through hook-up fees.

Pricing rationales beyond marginal cost                               

Although the efficiency rationale for marginal cost pricing is clear, there are two possible reasons why regulators may implement price schedules in which prices are marked up above marginal cost.

First, regulation creates a particular set of incentives for regulated firms. Under traditional rate-of-return regulation, firms receive a fixed rate of return on capital investments. If this rate is higher than the market rate of return, then the firm has incentive to increase capital expenditures, and the easiest way for natural gas distributors to do this is to increase the number of customers. More customers mean more miles of network, more connections, and more metering equipment. And the best way to increase the number of customers is to charge low monthly fees. That way, even customers who want to use only a very small amount of natural gas are persuaded to hook up. Consequently, regulated firms may strongly petition the regulator to allow lower hookup fees in exchange for higher per-unit markups.

Second, distributional consideration may lead regulators to set prices above marginal cost. If regulated prices are above marginal cost, high-volume customers cover a disproportionately large share of fixed costs of operating the natural monopoly. Where monthly fees are exactly zero, for example, a customer consuming 100 units annually pays twice as much as a customer consuming 50 units. This structure is likely to have positive distributional consequences. For example, to the extent that high-income households own large homes and consume high levels of natural gas, they will also pay a large share of total costs.

What do we find?

Examining the natural gas market from 1989 to 2008, we find that price schedules differ substantially from marginal cost pricing. On average, customers pay markups of 36 percent above marginal cost. Pricing above marginal cost is prevalent in all 50 states and for all customer classes. Price schedules are particularly distorted for residential and commercial customers, who face markups that average 45 percent and 42 percent respectively. Conservatively, these results imply that the current pricing system yields annual welfare losses of $2.5 billion, compared to marginal cost pricing. In the United States total expenditure on natural gas in 2008 was $92 billion so this represents approximately 3 percent of the total market.

An additional consequence of current price schedules is that they may bias the fuel mix away from natural gas toward other fuels. If this primarily results in greater use of coal or heating oil, higher carbon emissions may occur or meeting an emissions cap could be more costly. It is important to consider the existing markups when designing policies to address carbon emissions. The average markup of 36 percent that we find is equivalent to a carbon tax of about $170 per metric ton of carbon ($46 per ton of carbon dioxide). This is considerably higher than the level of a carbon tax envisioned by most economists. If you believe that the external damages from carbon emissions are less than $170 per ton of carbon, then customers are already facing a marginal price that is higher than the efficient price.

What can be done?

Of the available approaches for addressing these departures from marginal cost pricing, the most natural approach would be to have regulators work with distribution companies to level rate structures, lowering the price charged per unit. Hook-up fees could then be increased from their currently very low level to recoup lost revenue. There is some precedent for this. For example, in May 2008, a new rate structure was approved for Duke Energy Ohio in which the monthly fixed delivery charge increased from $4.50 to $10.00 with an offsetting reduction in marginal prices. The Public Utilities Commission of Ohio argued that the rate structure is more equitable, “making sure that each customer pays only their share of the costs Duke must cover to deliver gas to their home.”

Such a transition would have distributional consequences and it will be important for leveling to be accompanied by targeted assistance for low-income households. Again, Duke Energy Ohio provides precedent. Along with the rate changes, Duke introduced an income payment plan that reduces hook-up fees for low-income customers. Although regulators are typically resistant to allowing widespread differences in rates across customers within customer classes, there is broad experience with such need-based programs and they can be implemented at relatively low cost.

Lucas W. Davis is an assistant professor at the Haas School of Business at the University of California, Berkeley and a faculty research fellow with the National Bureau of Economic Research. His research focuses broadly on public finance, applied microeconomics, and energy and environmental economics.

Erich J. Muehlegger is an assistant professor of public policy at the John F. Kennedy School of Government at Harvard University. His research interests include empirical and theoretical industrial organization, especially those related to the regulation.