Regulation of Short-Term Natural Gas Transportation Services

DEPARTMENT OF ENERGY

Federal Energy Regulatory Commission

18 CFR Parts 161, 250, and 284

[Docket No. RM98-10-000]

Regulation of Short-Term Natural Gas Transportation Services

July 29, 1998.

AGENCY: Federal Energy Regulatory Commission.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Federal Energy Regulatory Commission (Commission) is

proposing an integrated package of revisions to its regulations

governing interstate natural gas pipelines to reflect the changes in

the market for short-term transportation services on pipelines. Under

the proposed approach, cost-based regulation would be eliminated for

short-term transportation and replaced by regulatory policies intended

to maximize competition in the short-term transportation market,

mitigate the ability of firms to exercise residual monopoly power, and

provide opportunities for greater flexibility in the provision of

pipeline services. The proposed changes include initiatives to revise

pipeline scheduling procedures, receipt and delivery point policies,

and penalty policies, to require pipelines to auction short-term

capacity, to improve the Commission's reporting requirements, to permit

pipelines to negotiate rates and terms of services, and to revise

certain rate and certificate policies that affect competition.

DATES: Comments are due November 9, 1998.

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ADDRESSES: Federal Energy Regulatory Commission, 888 First Street, NE,

Washington DC, 20426.

FOR FURTHER INFORMATION CONTACT:

Michael Goldenberg, Office of the General Counsel, Federal Energy

Regulatory Commission, 888 First Street, NE, Washington, DC 20426.

(202) 208-2294

Erica Yanoff, Office of the General Counsel, Federal Energy Regulatory

Commission, 888 First Street, NE, Washington, DC 20426. (202) 208-0708

Ingrid Olson, Office of the General Counsel, Federal Energy Regulatory

Commission, 888 First Street, NE, Washington, DC 20426. (202) 208-2015.

SUPPLEMENTARY INFORMATION: In addition to publishing the full text of

this document in the Federal Register, the Commission also provides all

interested persons an opportunity to inspect or copy the contents of

this document during normal business hours in the Public Reference Room

at 888 First Street, NE, Room 2A, Washington, DC 20426.

The Commission Issuance Posting System (CIPS) provides access to

the texts of formal documents issued by the Commission. CIPS can be

accessed via Internet through FERC's Homepage (http://www.ferc.fed.us)

using the CIPS Link or the Energy Information Online icon. The full

text of this document will be available on CIPS in ASCII and

WordPerfect 6.1 format. CIPS is also available through the Commission's

electronic bulletin board service at no charge to the user and may be

accessed using a personal computer with a modem by dialing 202-208-

1397, if dialing locally, or 1-800-856-3920, if dialing long distance.

To access CIPS, set your communications software to 19200, 14400,

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data bits and 1 stop bit. User assistance is available at 202-208-2474

or by E-mail to [email protected].

This document is also available through the Commission's Records

and Information Management System (RIMS), an electronic storage and

retrieval system of documents submitted to and issued by the Commission

after November 16, 1981. Documents from November 1995 to the present

can be viewed and printed. RIMS is available in the Public Reference

Room or remotely via Internet through FERC's Homepage using the RIMS

link or the Energy Information Online icon. User assistance is

available at 202-208-2222, or by E-mail to [email protected].

Finally, the complete text on diskette in WordPerfect format may be

purchased from the Commission's copy contractor, La Dorn System

Corporation. La Dorn Systems Corporation is located in the Public

Reference Room at 888 First Street, NE, Washington, DC, 20426.

Table of Contents

I. Reexamination of the Transportation Market

A. The Developing Short-term Market

B. Implications for Commission Regulatory Policies of the

Changing Nature of Short-term Markets

II. Proposed Change in Regulatory Approach

A. A Different Model for Regulating the Short-term Market

B. Legal Basis for the Proposed Regulatory Change

C. Interrelated Proposals for Regulatory Change

III. Creating Greater Competition Among Short-term Service

Offerings

A. Nomination Equality

B. Segmentation and Flexibility of Receipt and Delivery Points

C. Capacity Auctions

D. Information Reporting and Remedies for the Exercise of

Market Power

IV. Penalties and Operational Flow Orders

A. Pipelines Should Provide, on a Timely Basis, as Much

Imbalance and Overrun Information as Possible

B. Transportation Penalties Must Be Necessary and Appropriate

to Protect System Operations

C. Pipelines Must Provide Services, to the Extent Operationally

Feasible, That Facilitate Imbalance Management

D. Pipelines Must Adopt Incentives and Procedures That Minimize

the Use and Adverse Impact of OFOs

V. Negotiated Rates and Services

A. Guiding Principles

B. Implementation of the Negotiated Rates and Services Policy

VI. Long-term Services

A. The Interaction Between Long-term and Short-term Services

B. Specific Impediments to Long-term Contracts

C. New Capacity Certificate Issues

VII. Reorganization of Part 284 Regulations

VIII. Information Collection Statement

IX. Environmental Analysis

X. Regulatory Flexibility Act Certification

XI. Comment Procedures

Notice of Proposed Rulemaking

Five years have passed since Congress, in the Wellhead Decontrol

Act, completed the decontrol of natural gas prices. Six years ago the

Commission, in Order No. 636, unbundled the purchase of gas from the

purchase of gas transportation. Since then, the natural gas market has

changed from a largely regulated market to one increasingly driven by

market forces. In order to continue to fulfill its statutory duties to

ensure just and reasonable rates in the rapidly evolving gas market of

today, the Commission has engaged in a comprehensive, critical

examination of the regulatory assumptions and procedures that it has

been using to determine whether other regulatory approaches would

better fit the needs of this changing marketplace.

Since Order No. 636, the natural gas marketplace has fundamentally

changed. Active short-term markets have begun to develop. Shippers are

trading gas at market centers on a daily or sometimes an intra-day

basis with prices varying from day-to-day. Prior to Order No. 636, the

majority of contracts were long-term with less price volatility. As

local distribution companies (LDCs) unbundle the gas commodity from

transportation, new players, such as electric cogenerators, industrial

end-users, and small businesses (such as restaurants) are entering the

gas marketplace with gas and transportation needs different from those

of the LDCs that previously transported and sold the majority of gas.

Increasingly, LDC unbundling is even bringing homeowners into the gas

marketplace. These new entrants often use marketers or other

facilitators to arrange for their gas supplies on a delivered basis.

The use of transportation capacity also has changed. Before Order

No. 636, shippers could acquire transportation only from the pipeline.

They could buy gas from the pipeline at the city-gate either on a

short-term or long-term basis, acquire long-term firm capacity from the

pipelines, often with 20-year contracts, or purchase short-term

interruptible capacity. In today's market, shippers have additional

options. They can acquire capacity from other firm capacity holders

through the capacity release market. They also can obtain capacity

indirectly by purchasing gas bundled with transportation from

producers, marketers, or aggregators for one delivered price (often

called a gray market sale).

The changes in the short-term market have caused the Commission to

closely examine its regulatory structure to see whether it provides a

good fit with the developing short-term market. The Commission has

received comments on the impact of these changes through a number of

proceedings, among them a prior Notice of Proposed Rulemaking (NOPR) on

the secondary market,\1\ a request for comments on whether pipelines

should be permitted to

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negotiate terms of service,\2\ and an industry conference on issues and

priorities in the gas industry.\3\

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\1\ Secondary Market Transactions on Interstate Natural Gas

Pipelines, Notice of Proposed Rulemaking, 61 FR 41046 (Aug. 7,

1996), IV FERC Stats. & Regs. Proposed Regulations para. 32,520

(Jul. 31, 1996).

\2\ Alternatives to Traditional Cost-of-Service Ratemaking for

Natural Gas Pipelines, and Regulation of Negotiated Transportation

Services of Natural Gas Pipelines, 61 FR 4633 (Feb. 7, 1996), 74

FERC para. 61,076, at 61,242 (1996).

\3\ Issues and Priorities for the Natural Gas Industry, PL97-1-

000 (conference held May 29-30, 1997).

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Upon review of the changes in the market and the comments it has

received, the Commission is concerned that its current regulatory

approach, which relies on a constant maximum rate in the short-term

market, may not be the best approach in light of the variability in

pricing in the short-term market. Due to the variability in

transportation value, the current approach may not provide the best

protection against the exercise of market power during peak and off-

peak periods. Or, the protection it does provide may come at the

expense of a more efficient capacity market during peak periods, when

shippers are most in need of a market that works efficiently.

The Commission recognizes that despite all the competitive

improvements in the short-term market, the short-term market still may

not be fully competitive. Thus, the Commission must continue to have a

regulatory presence in the short-term market to protect against the

exercise of market power and undue discrimination.

The Commission is, therefore, proposing in this NOPR a different

approach for regulating the short-term transportation market which is

designed to permit the market to function efficiently while continuing

to protect shippers against the exercise of market power. This approach

has a number of objectives. It is designed to improve competition in

short-term markets by facilitating the trading of capacity, so that

shippers will have a larger number of capacity alternatives from which

to choose. By expanding options, it seeks to help reduce the number of

captive customers. Additionally, it seeks to provide the opportunity

for greater flexibility in pipeline contracting practices so that

pipelines can design services that better meet the needs of existing

and new players in the gas marketplace.

The proposal uses different regulatory structures for short-term

and long-term markets. Long-term transportation prices (i.e.,

transportation of one-year or longer) would continue to be regulated

under a cost-based regulatory regime to protect against the exercise of

pipeline monopoly power. For short-term transportation services,

however, cost-based regulation would be eliminated. In its place, the

Commission proposes to regulate the short-term market through

regulatory policies that are intended to maximize competition in the

short-term transportation market, to mitigate the ability of firms to

exercise residual monopoly power, and to improve the ability of market

participants and the Commission to monitor the market for exercises of

monopoly power or undue discrimination. The goal of this approach to

the short-term market is to ensure that the Commission's regulatory

policy does not inhibit competitive market forces from creating

efficient capacity markets, while still providing captive customers and

others with protection against the exercise of market power in the

transportation market.

Specifically, to maximize competition (which is the best protection

against the exercise of market power) the Commission is proposing in

this NOPR to revise pipeline nomination and scheduling procedures, and

flexible receipt and delivery point policies so that capacity release

can compete on a more equal footing with pipeline capacity. To further

mitigate the exercise of market power and the potential for undue

discrimination, the Commission is proposing to require that all short-

term capacity be sold through capacity auctions. To improve shippers'

and the Commission's ability to monitor the marketplace the Commission

is proposing changes to its reporting requirements. To improve

competition across the pipeline grid, the Commission is making

proposals to change pipeline penalty procedures so that penalties,

although necessary to deter conduct inimical to system operations, do

not unnecessarily limit shippers' competitive alternatives.

At the same time, the Commission recognizes that changes in the

short-term market also influence shippers' decisions in the long-term

market. For example, the value of long-term capacity lies in the

guarantee of capacity at a relatively stable price as compared with

buying capacity at the more volatile short-term price. Long-term

contracts, therefore, are a means by which shippers and pipelines can

manage the risks inherent in the short-term market.

To foster greater innovation in pipeline services and to permit

pipelines and shippers to better allocate the risks of long-term

contracts, the Commission is proposing to allow pipelines' greater

flexibility in negotiating contracts with individual shippers, subject

to criteria that will protect captive customers against the risk of

undue discrimination. Further, to create a more efficient marketplace,

regulatory policies should not affect the allocation of risk between

acquiring short-term or long-term capacity. As part of this integrated

package, therefore, the Commission is proposing changes to some of its

policies governing long-term contracts to ensure that these policies do

not unfairly bias shippers' contracting decisions. The Commission also

is considering whether changes to its policies regarding authorization

for new construction are needed so that these policies do not

unnecessarily limit competition.

The Commission recognizes that the impact on the long-term market

of the changes in the short-term market go beyond the proposals

outlined above. Therefore, in a Notice of Inquiry (NOI) issued

contemporaneously with this NOPR, the Commission asks for additional

comment on the future direction of its policies for pricing of long-

term capacity.

I. Reexamination of the Transportation Market

A. The Developing Short-term Market

Natural gas markets have developed rapidly since wellhead price

deregulation and unbundling of pipeline merchant and transportation

services. In many ways, the gas market performs very well, without the

loss of reliability that many feared when Order No. 636 was being

contemplated.\4\

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\4\ See Pipeline Service Obligations and Revisions to

Regulations Governing Self-Implementing Transportation Under Part

284 and Regulation of Natural Gas Pipelines After Partial Wellhead

Decontrol, Order No. 636, 57 FR 13267, FERC Stats. & Regs.

Regulations Preambles [Jan. 1991-June 1996] para. 30,939, at 30,408

(Apr. 8, 1992), Order No. 636-A, 57 FR 36128 (Aug. 12, 1992), FERC

Stats. & Regs. Regulations Preambles [Jan. 1991-June 1996] para.

30,950, at 30,570 (Aug. 3, 1992) (concerns about providing

transportation service equal in reliability to bundled sales

service).

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Gas commodity markets have arisen, along with market mechanisms to

enable consumers to manage price risk for the gas.\5\ There are monthly

and growing daily spot markets for gas supplies which enable shippers

not only to buy their own gas supplies at the wellhead, but to trade

gas among themselves on a daily or even more frequent basis. Many of

these spot markets are organized around market centers that facilitate

trading of gas across pipelines as well as providing a variety of new

services, such as storage, wheeling, parking, lending, electronic gas

trading, and tracking of gas title

[[Page 42985]]

transfers.\6\ Active forward markets also have developed to enable gas

consumers to hedge against price risk. The New York Mercantile Exchange

(NYMEX) launched its natural gas futures contract in 1992, and it is

very heavily traded.

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\5\ See S. Walsh, A Hot (and Cold) New Investment Opportunity,

Washington Post, July 4, 1998, C12 (Business) (discussing

development of new weather derivative to enable companies to hedge

against abnormal weather patterns).

\6\ Department of Energy/Energy Information Administration, Pub.

No. DOE/EIA-0560(96), Natural Gas 1996 Issues and Trends, Chapter,

The Emergence of Natural Gas Market Centers (1996).

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Along with the development of a more liquid commodity market,

shippers' transportation options have expanded. In the past, shippers

could purchase capacity only from the pipeline and had, for the most

part, only two transportation choices: long-term firm capacity or

interruptible service. Pipeline offerings have expanded as well, with

pipelines offering short-term firm transportation service, pooling,\7\

hub services,\8\ parking and loan services,\9\ and both short-term and

long-term storage services.\10\

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\7\ See Standards For Business Practices Of Interstate Natural

Gas Pipelines, Order No. 587, 61 FR 39053 (Jul. 26, 1996), III FERC

Stats. & Regs. Regulations Preambles para. 31,038 (Jul. 17, 1996)

(requiring pipelines to provide pooling services).

\8\ See Moss Bluff Hub Partners, 80 FERC para. 61,181 (1997)

(firm storage and interruptible hub services); Egan Hub Partners,

L.P., 77 FERC para. 61,016 (1996) firm storage and interruptible hub

services).

\9\ See Mojave Pipeline Company, 79 FERC para. 61,347 (1997);

Colorado Interstate Gas Company, 83 FERC para. 61,273 (1998).

\10\ See Koch Gateway Pipeline Company, 66 FERC para. 61,385

(1994) (firm and interruptible storage); New York State Electric Gas

Corporation, 81 FERC para. 61,020 (1997) (issuing certificate).

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Non-traditional players also have entered the capacity market, so

that today firm shippers holding pipeline capacity include electric

utilities (21% of total pipeline firm capacity), industrial end-users

(5%), marketers (17%), pipelines (7%), and others, including producers

(6%) in addition to the traditional LDCs (44%). While many of these

shippers still hold pipeline contracts longer than a year, short-term

firm contracts are rising in significance. Among the shipper groups,

marketers are the largest users of short-term capacity, with over

three-quarters of the total.\11\

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\11\ Department of Energy/Energy Information Administration,

Pub. No. DOE/EIA-0618(98), Deliverability on the Interstate Natural

Gas Pipeline System 88-89 (1998).

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In today's market, shippers also have the added option of buying

firm capacity released by other shippers in a variety of ways (such as

on a fixed, or volumetric basis, or with other release conditions,

including provisions for handling capacity recalls). Since its

inception in 1992, capacity release transactions have been growing

dramatically.\12\ For instance, the amount of capacity held by

replacement shippers for the 12 month period ending March 1997, totaled

7.4 quadrillion Btu, a 22% percent increase over the previous 12 month

period and almost double the level for the 12 months ending March

1995.\13\ While the amount of capacity held by replacement shippers

declined during the heating season, EIA reports it still represents a

sizable amount.\14\ Despite the growing use of released capacity,

interruptible pipeline service also continues to be a viable service

option, maintaining a relatively constant share of throughput.\15\ As

in the case of released capacity, EIA reports that interruptible

service is available during the heating season.\16\

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\12\ Id. at 82 (representing about 16% of the gas delivered for

market).

\13\ Id. at 83.

\14\ Id. at 85-86 (2,960 trillion Btu from November to March

1996-97).

\15\ Id. at 85 (about 16% of total throughput for the 12 months

ending March 31, 1997).

\16\ Id. at 87 (2,000 TBtu moved during heating season).

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In addition to acquiring capacity from pipelines and releasing

shippers, purchasers in the short-term market have other capacity

options. Implicit in the Commission's decision to unbundle the gas

commodity from transportation was a recognition that the market would

develop so that customers who did not want to assume the responsibility

of purchasing or transporting their own gas could purchase delivered

gas from marketers or third parties with the marketer providing all or

a portion of the needed transportation, for example to a nearby market

center.\17\ Capacity rights holders can now sell gas as a commodity in

downstream markets at market-based prices.

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\17\ See Order No. 636, FERC Stats. & Regs. Regulations

Preambles [Jan. 1991-June 1996] para. 30,939, at 30,410.

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Further, as a result of Commission initiatives, the gas industry,

through the Gas Industry Standards Board (GISB), has developed

standards that make it easier to move and trade gas on individual

pipeline systems and across pipeline systems.\18\ These standards

establish a daily, along with an intra-day, nomination schedule which

permit shippers to adjust their nominations to conform to changes in

weather and other circumstances. The Commission recently adopted GISB

standards providing for three intra-day nomination opportunities.\19\

These standards also significantly enhance shipper flexibility, for

example, by giving shippers the ability to aggregate gas supplies from

numerous sources in a pipeline pool for nomination purposes and by

allowing shippers to assign priority rankings to gas packages.

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\18\ Standards For Business Practices Of Interstate Natural Gas

Pipelines, Order No. 587, 61 FR 39053 (Jul. 26, 1996), III FERC

Stats. & Regs. Regulations Preambles para. 31,038 (Jul. 17, 1996),

Order No. 587-B, 62 FR 5521 (Feb. 6, 1997), III FERC Stats. & Regs.

Regulations Preambles para. 31,046 (Jan. 30, 1997), Order No. 587-C,

62 FR 10684 (Mar. 10, 1997), III FERC Stats. & Regs. Regulations

Preambles para. 31,050 (Mar. 4, 1997), Order No. 587-G, 63 FR 20072

(Apr. 23, 1998), III FERC Stats. & Regs. Regulations Preambles para.

31,062 (Apr. 16, 1998).

\19\ Standards For Business Practices Of Interstate Natural Gas

Pipelines, Order No. 587-H, 63 FR 39509 (Jul. 23, 1998), 84 FERC

para. 61,031 (July 15, 1998).

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These changes, operating together, have changed the character of

short-term markets. Five years ago, most gas was purchased during bid

week under monthly contracts and transportation was arranged at the

same time on a monthly basis. Transactions occurring outside of bid

week were unusual and were referred to as the aftermarket. Today, daily

markets for gas and capacity are developing rapidly. Shippers now trade

gas on a daily or even an intra-day basis at various market centers and

pipeline interconnect points or at pipeline pooling points. For

example, at pipeline interconnect points or at pools, there may be

repeated sales of the same gas between producers and marketers before

the gas is scheduled for transportation. As described in a recent

proceeding, shippers can use pooling to effectuate gas exchanges (pool

to pool transfers) as a means of enhancing supply and pricing options

and of market hedging.\20\ For example, a shipper may buy gas from a

pool as insurance against a change in its system requirements and then

sell that gas to another pool if the load does not develop in its

market.

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\20\ El Paso Natural Gas Company, 81 FERC para. 61,174, at

61,760 (1997) (approving a limit on pool to pool transfers because

pipeline could not handle the volume of transactions under new

scheduling timeline).

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Shippers also can take advantage of trading opportunities by making

daily or intra-day changes to their gas nominations to react quickly to

changing weather, changing prices or supply sources, or other

circumstances. For instance, a shipper that loses a supply source can

submit an intra-day nomination to change its receipt point for gas so

that it can purchase gas from an alternate supply source. The reports

in trade publications of daily gas prices at delivered markets are

further evidence of the increasing scope of the developing short-term

market.\21\

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\21\ See, e.g., Gas Daily, March 2, 1998, at 1-2; Natural Gas

Intelligence, Jan. 5, 1998, at 4; Natural Gas Week, Jan. 12, 1998,

at 12, 17, 20-21.

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The developing gas market, however, is in some respects still in

its infancy and there are still impediments, both regulatory and non-

regulatory, to the

[[Page 42986]]

development of a well-functioning market. Price information, which is

crucial to a well-developed market, could be improved. While the

Commission requires the posting of information on capacity release

transactions, posting of pipeline discount transactions occurs well

after-the-fact and cannot be used by shippers to make daily market

decisions. Moreover, it is difficult for shippers to obtain accurate

information about delivered gas transactions or the value of

transportation inherent in such transactions. Shippers are left to

personal communication or trade publications to determine prices at

receipt and delivery points. Acquiring market information through

personal communication is time consuming and expensive, particularly

for small customers who would have difficulty canvassing a large enough

number of sources to obtain sufficient market information. Each trade

publication uses different reporting methods. Some mix long and short-

term transactions and some report price ranges while others report

averages, and most do not report quantities traded.

Also, capacity markets are fragmented. Different regulatory rules

apply to pipeline sales of interruptible and firm capacity, capacity

obtained through release transactions, and capacity used as part of

delivered gas transactions. For example, the nomination and scheduling

procedures and rate regulation differ among pipeline capacity, released

capacity, and delivered gas transactions. In addition, different rights

may apply depending on the type of capacity a shipper tries to acquire.

Shippers purchasing released capacity from certain firm shippers may

have to rely on alternate receipt or delivery points, and the use of

such points are sometimes restricted by pipelines' tariffs.

All of these factors increase the shippers' transaction costs by

increasing the difficulty and risk of doing business in the short-term

market. Absent good price and capacity information, shippers cannot

easily compare capacity alternatives or obtain full, comparable

information about the alternatives available at any time. This inhibits

their ability to make informed decisions about acquiring gas and

capacity and prevents them from finding the best gas and capacity deals

available. These costs may be particularly meaningful for small

customers, who do not have the time and resources to unearth, through

personal contacts, the information they need to make informed choices.

In the developing short-term market, market forces impact regulated

services. The growing emphasis on daily transactions means that

customers are more concerned with the daily price of transportation

capacity. For example, many short-term decisions are based on the

delivered price for gas (including transportation) on a daily basis.

Often narrow differences in delivered prices may affect shippers'

decisions.

The existence of a market price for gas at all points along the

pipeline grid has created a market-driven value for transportation

between receipt and delivery points. In effect, the implicit value of

transportation between two such points is the spot price of gas at the

delivery point minus the spot price of gas at the receipt point.

This market driven value can fluctuate widely on a daily basis. As

shown in the following example, many such valuations remain near zero

for long periods of time, only to rise during periods of peak demand.

On this illustration, the market-driven value of transportation

represents the difference between the spot price for gas at the

upstream hub in Louisiana and the delivered price for gas in the New

York downstream market. In other words, the price for delivered gas in

the downstream New York market reflects the spot price for gas at the

upstream hub plus the value of the transportation needed to deliver the

gas to the downstream market. The market value of transportation can

then be compared with the cost-based, regulated maximum interruptible

rates for the three pipelines transporting from Louisiana to New York

(represented by the dotted lines).\22\

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\22\ The source for the spot price data is the Gas Daily Weekly

Weighted Average Prices ($/MMBtu). The source for the maximum

interruptible tariff rate is from PIPELINE Grid published by the

Petroleum Information Corporation Logistics Solution. The range of

tariff rates includes the interruptible rates from Columbia Gas

Transmission Corporation ($.45/MMBtu), Tennessee Gas Pipeline

Company ($.57/MMBtu), and Transcontinental Gas Pipe Line Corporation

($.44/MMBtu).

BILLING CODE 6717-01-P

[[Page 4*ERR58*2987]]

[GRAPHIC] [TIFF OMITTED] TP11AU98.000

BILLING CODE 6717-01-C

This illustrates that the value of transportation during the peak

winter period of 1995-1996 rose to $10/MMBtu (20 times the maximum

daily tariff rates of between $.44 and $.57/MMBtu) and during the 1996-

1997 winter to over $1/MMBtu (2 times the maximum tariff rate). During

non-peak periods, the value of transportation was uniformly below the

maximum daily tariff rate. While the illustration may not portray

precise transportation values,\23\ it nonetheless does provide a

picture of the fluctuation in transportation values over time.

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\23\ For instance, gas from markets other than Louisiana may

have affected delivered prices in New York, and the data contain

unexplained anomalies, such as transportation values of less than 0,

indicating that the price of gas was lower in New York than at the

receipt point in Louisiana. During that time, either no gas moved

from Louisiana to New York or, if gas did move, the markets were not

clearing properly or the price data were not accurate.

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The fluctuation of transportation values raises questions about

whether the Commission's current rate policies are attuned to the

realities of the developing short-term market. The Commission currently

establishes a daily maximum rate for pipeline services and capacity

release by taking the pipelines' annual rate and converting it to a

daily rate (by dividing the yearly rate by 365). But this single rate

does not reflect the variability of daily pricing in the short-term

market. While the $10 value during the 1995-1996 may not be repeated,

transportation values during the next winter were double the maximum

rate.

These data on delivered prices, and derived transportation values,

do not establish either the presence or absence of market power.

Delivered markets for gas can, and probably do, coexist with the

continued exercise of market power over transportation. Pricing by a

pipeline with market power would exhibit the same pricing variability

as shown in the illustration, with higher prices during periods when

demand is greatest. Also, even though prices during off-peak periods

are below the maximum rate, that does not guarantee that market power

cannot be exercised.

The existence of a delivered market does not, in and of itself,

establish that the market is operating efficiently. Regulatory

impediments, such as poorly designed penalty structures or the maximum

rate cap, may create transaction costs, reducing market efficiency and

raising prices. The price

[[Page 42988]]

cap, for instance, can create a disincentive for firm capacity holders

to make capacity available for release during peak periods, because the

capacity holder is unable to realize the market value for its capacity.

This can create a less efficient market by depriving other shippers of

the ability to obtain capacity when they place a greater value on the

capacity than the shipper holding it.\24\ The buyer's alternative is to

try and purchase delivered gas. But the market for delivered gas may

not be as efficient as giving the buyer the added option of purchasing

transportation capacity in an open and transparent market in which the

buyer can decide for itself whether it obtains greater value by

purchasing delivered gas or using its own gas contracts and obtaining

transportation separately.

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\24\ See Mary L. Barcella, How Commodity Markets Drive Gas

Pipeline Values, Public Utilities Fortnightly, Feb. 1, 1998, 24, 25

(price cap limits shippers' incentive to release capacity and can

result in shutting out other shippers needing capacity).

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In sum, the short-term market is changing, with greater emphasis on

daily transactions and daily prices for the gas commodity both at

origin and delivered markets which vary with demand. The constant

maximum rate approach to regulation does not appear to fit well in this

new fast-paced market and may result in a less efficient market, with

increased transaction costs. Yet, market power over transportation

continues to exist and must be addressed.

B. Implications for Commission Regulatory Policies of the Changing

Nature of Short-term Markets

The development of active commodity markets at both ends of the

pipeline poses a significant challenge to the Commission's traditional

method of rate regulation. The current maximum rate provides some

regulatory protection for shippers during peak periods, because it

prevents pipelines from exercising monopoly power at least to the

extent that shippers cannot be charged prices above the maximum rate.

Even during off-peak periods, the maximum rate provides some protection

because it protects some shippers against discriminatory prices that

might otherwise exceed the cap. During off-peak periods, some shippers

still place a high value on moving gas, and the price cap limits the

price such shippers can be forced to pay. Moreover, the Commission

permits pipelines to price discriminate (at prices below the maximum

rate) during off-peak periods to provide benefits to captive customers

who hold long-term firm contracts. The added revenue the pipeline

generates by selectively discounting helps to reduce the reservation

charges owed by the captive firm shippers.\25\

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\25\ During off-peak periods, the pipeline can price

discriminate by offering discounts to some customers that are

greater than those offered to other customers. This practice brings

in more revenue than the pipeline would earn if it could only charge

the same price to all customers. The additional revenue benefits the

firm capacity holders because, in the pipelines' rate case, the

increased revenue reduces the reservation charges firm shippers

might otherwise pay. See Associated Gas Distributors v. FERC (D.C.

Cir. 1987) (selective discounting by a monopolist justified on

equitable grounds because it would reduce captive customers'

contributions to fixed costs).

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As the short-term market continues to grow, maximum rate regulation

in the short-term market may become an increasingly more ineffective

method of regulating the short-term market. Maximum rate regulation may

not provide shippers with the most effective protection against the

exercise of market power. Moreover, the protection it does provide may

come at too great a cost in efficiency.

The rate cap may, for instance, result in misallocation of capacity

where those shippers placing the greatest value on the capacity are

unable to obtain it. During peak periods, pipelines can only sell

capacity which is not under contract or used by those shippers holding

firm capacity. Thus, a pipeline may have little capacity to sell on a

peak day. Even if the pipeline did have capacity to sell, a particular

shipper placing the highest value on the capacity may be unable to

obtain that capacity. Under current Commission rules, when demand for

capacity exceeds the supply available, and all shippers bid the maximum

rate, the pipeline awards its capacity using a queue based on contract

execution date or on a pro rata basis. In either case, the shipper

placing the greatest value on the capacity may not obtain capacity or

not obtain as much capacity as it needs and for which it is willing to

pay.

The shipper's other alternative is to try to obtain capacity from

firm capacity holders, but in this market the price cap may not provide

much protection to the purchasing shipper. The price cap applies to

released capacity. But, the price cap has little effect on delivered

gas transactions, in which the transportation value may exceed the

maximum rate.

There is little hard empiric evidence on how extensive the

delivered market is, but the existence of delivered gas transactions

during peak periods suggests that, due to the price cap, capacity

holders with available capacity will choose to use that capacity to

make delivered transactions, where the profit opportunity is greater,

rather than releasing the capacity, where the price is capped. In

addition, a pending proceeding raises the question whether shippers

have developed other methods for avoiding the maximum rate that are

difficult to detect and prevent on a systematic basis.26

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\26\ Consumers Energy Company, 82 FERC ] 61,284 (1997). See

Inside FERC's Gas Market Report, December 1, 1995, at 14 (discussing

various methods of avoiding the price cap).

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Attempting to regulate the transportation component of delivered

gas transactions would be difficult. But even if this market could be

effectively regulated, it is not clear that such regulation would be

beneficial. If capacity transactions could not occur above the price

cap, then, as described above, capacity would not be allocated

efficiently; those customers most needing gas during peak periods would

be unable to obtain the gas they need and the market would not clear

efficiently.

In addition, as described earlier, the price cap may reduce the

efficiency of the delivered gas market itself by raising transaction

costs, thus resulting in higher delivered prices. Because unbundled

sales of capacity by releasing shippers cannot be made above the

maximum rate, the market may not operate in as open, transparent, or

efficient a manner as is possible. Information for delivered gas is not

publicly posted and shippers relying on word of mouth may not be able

to easily locate all available sources of transportation. The

difficulty of locating potential sellers and obtaining accurate price

information may lead some customers to pay higher than necessary

prices. 27 For instance, during the winter of 1996 when gas

prices rose dramatically, while the market worked well to prevent

shortages and ensure that customers received gas, it could have worked

more efficiently. According to the trade press, the delivered prices

for gas in Chicago on the same day ranged from $20.50 to $46.00 per

MMBtu.28 In an efficient market, one would not expect such a

wide differential in prices, but would expect transactions in the same

market to clear at roughly similar prices. The Commission seeks input

from the industry on whether the price cap creates transaction costs

and prevents

[[Page 42989]]

the development of an efficient short-term market.

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\27\ For example, in the automobile market, the time and expense

of comparison shopping may result in some customers paying higher

prices than others.

\28\ See Gas Daily, February 2, 1996, at 1.

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Maximum rate regulation may have an unintended effect by reducing

the capacity available during peak periods, the time at which the

industry would most benefit from having as much pipeline capacity

available as is possible. As a result of the maximum rate cap, firm

capacity holders may not find it sufficiently profitable to make their

capacity available. It may be that due to state restrictions not all

local distribution companies (LDCs) may be able to make delivered gas

transactions off-system. Thus, they may not make capacity available

during peak periods if they cannot receive the market price for their

capacity.

For instance, an LDC might have a peak shaving capability (storage

or liquified natural gas (LNG)) that costs more to operate than the

maximum transportation rate. The LDC might be willing to release its

transportation capacity and use the peak shaving device instead if the

price it could receive for pipeline transportation exceeded its cost to

operate the peak shaving device. By using its peak shaving device

instead of transportation, the shipper would be expanding the amount of

transportation capacity available for resale during a peak period. But

if the price cap prevented the shipper from obtaining a price higher

than the cost of turning on the peak shaving device, and the shipper

could not sell the gas on a delivered basis, the shipper would use its

transportation capacity, thus depriving other shippers (without peak

shaving) of the opportunity to acquire needed transportation capacity.

Thus, maximum rate regulation may actually reduce the amount of

pipeline capacity available for sale during peak periods. A restriction

on the amount of available capacity would cause peak period prices to

be higher than they would be without the cap. Comments should address

whether the price cap has these effects and whether it does

significantly limit the amount of capacity available in the short-term

market.

Maximum rate regulation during peak periods also may increase

shipper imbalances and penalties. During peak periods, penalties affect

the value of transportation.29 In a cold snap, a shipper may

be willing to pay a penalty for overrunning its contract demand to

obtain the gas it needs. If that shipper faced a $100/MMBtu penalty, it

might be willing to pay any amount for capacity up to $100 to avoid the

penalty. For example, if the value of capacity in an efficient market

were $80, the shipper willing to pay a $100 penalty would be better off

by $20 if it obtained capacity instead. But, as described above, the

price cap may reduce the efficiency of the marketplace, limiting the

shipper's ability to obtain the capacity it needs. The shipper,

therefore, may choose to overrun its contract demand and pay the

penalty. In this situation, the price cap may result in increasing

shipper imbalances, thereby increasing the penalty revenue paid to

pipelines, and perhaps decreasing the reliability of the system.

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\29\ See Industry Surveys the Damage as Winter's Strength Runs

Out, Natural Gas Intelligence, April 22, 1996, at 1, 4 (penalties

started to be a real factor in determining the price of gas in the

Midwest).

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During off-peak periods, the maximum rate cap does not affect the

efficiency of the market because market values do not appear to reach

the maximum rate ceiling. The rate cap, however, may not provide

sufficient protection against the exercise of market power. During off-

peak periods, pipelines and releasing shippers are not required to sell

available capacity at prices less than the maximum rate.30

By limiting the supply of capacity during off-peak periods, pipelines

or releasing shippers may be able to charge monopoly prices because

even a monopoly price may be less than the daily maximum rate. Since

pipelines are permitted to price discriminate at rates below the

maximum rate, they may charge shippers, at least those without other

choices, higher prices than would prevail in an efficient competitive

market. Although the Commission has permitted pipelines to price

discriminate by discounting below the maximum rate, it may be that the

benefits for captive customers holding long-term transportation

contracts come at too great a cost to other shippers or that the

benefits even to captive customers no longer warrant continuation of

this policy.

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\30\ See El Paso Natural Gas Company, 83 FERC para. 61,286

(1998) (pipeline not required to discount below the maximum rate);

Southern California Edison Company v. Southern California Gas

Company, 79 FERC para. 61,157 (1997), reh'g denied, 80 FERC para.

61,390 (1997) (no requirement that pipelines or shippers offer

discounts below the maximum rate).

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In summary, the interface between the regulated and unregulated

sectors of the gas industry has become much more complicated in the

last five years. Regulatory policies that worked well in one market

setting may not work as well today. For this reason, the Commission is

reassessing its current policies and proposing changes.

II. Proposed Change in Regulatory Approach

The Commission's regulatory policies must be attuned to the

realities of the market it is regulating. As became clear during the

period when wellhead prices were regulated, consumers receive little

benefit from artificially low regulated prices if such prices distort

the market and create shortages so consumers cannot acquire gas when

they most need it.31 Moreover, in fashioning regulatory

policies, it must be recognized that market power varies over a

continuum between perfect competition at one end of the continuum and a

single firm monopoly with impenetrable entry barriers at the other.

Thus, a regulatory approach appropriate for pure monopoly markets may

not be the best method for regulating the markets where market power,

while not absent, may be partially disciplined by market forces.

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\31\ See Transcontinental Gas Pipe Line Corporation v. State Oil

and Gas Board, 474 U.S. 409, 420 (1986) (Natural Gas Act's

artificial pricing scheme is a major cause of imbalance between

supply and demand); Atlantic Refining Company v. Public Service

Commission of N.Y., 360 U.S. 378, 388 (1959) (rate regulation should

ensure reasonable rates consistent with the maintenance of adequate

service).

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The changes to the short-term market raise the question of whether

the Commission needs to change its regulatory philosophy. Prior to

unbundling, maximum rate regulation in the short-term market was more

effective, because the short-term market essentially was limited to the

pipelines' interruptible transportation service.

However, as the short-term market continues to develop, the

continuation of maximum rate regulation in the short-term market may

become increasingly troublesome. First, maximum rate regulation, by its

very nature, inefficiently allocates capacity because those shippers

placing the greatest value on capacity may not be able to obtain it.

Therefore, during peak periods, when the market is under the most

stress, the rate cap may result in a less efficient and more opaque

market in which shippers cannot acquire capacity they need or must pay

higher prices for delivered gas than would have prevailed in a more

efficient short-term market. Second, maximum rate regulation may not be

the most effective tool for preventing the exercise of market power,

particularly for transactions during off-peak periods. Thus, while the

ostensible goal of Commission regulatory policy is to protect shippers

against the exercise of monopoly power by the pipelines, the current

system of maximum rate regulation may no longer be the best method for

meeting this goal.

[[Page 42990]]

A. A Different Model for Regulating the Short-term Market

To respond to the emerging short-term market, the Commission is

proposing in this NOPR a change in regulatory focus to better reflect

the way in which short-term gas markets function and to do a better job

of protecting against the exercise of market power and helping to

foster a more competitive commodity market. The Commission, however,

recognizes that the ability to exercise market power still exists in

the short-term market and, therefore, any regulatory approach it adopts

must continue to provide effective protection against the exercise of

market power.

To do this, there are several criteria that a regulatory approach

must satisfy. It should maximize efficient competition among releasing

shippers and between releasing shippers and the pipelines, because

competition and efficient markets are the best overall protection

against the exercise of market power. It should include policies that

will mitigate any residual market power and monitor for its continued

exercise. It should fairly balance the interests of those customers

that purchase long-term capacity and those who choose to acquire

transportation in the short-term market. And, it should promote

innovation in service offerings to attract new customers.

The Commission believes its statutory objectives can better be met

by a regulatory model that recognizes the distinction between short-

term and long-term markets. Therefore, in the short-term transportation

market, the Commission proposes to replace the reliance on maximum rate

regulation 32 with a regulatory approach focusing on

creating competitive alternatives for shippers, developing policies to

mitigate residual market power, and monitoring the marketplace for the

exercise of market power. In the long-term transportation market, the

Commission proposes to continue to rely upon regulated cost-based rates

to protect against the exercise of monopoly power by the pipelines.

Price regulation for the long-term transportation market will ensure

continued protection for captive customers with long-term contracts

with the pipeline. It will also help discipline the potential exercise

of market power in the short-term market by enabling shippers to

purchase long-term capacity at regulated rates.

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\32\ Minimum rates would be retained.

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The Commission fully recognizes that pipelines still possess

monopoly power in the transportation market as a result of economies of

scale and barriers to entry. This is particularly true in the long-term

market where the pipeline may be the only source of capacity. The

Commission also recognizes that simply because competition exists for

the gas commodity at receipt and delivery points on the grid does not

mean that the transportation between all points is necessarily fully

competitive.

On the other hand, in the short-term market, the Commission's

capacity release and flexible receipt and delivery point policies,

together with other market changes such as pooling, hub and market

center services, and storage services, have increased the competitive

alternatives available to buyers of capacity. While these measures have

not resulted in effective competition everywhere throughout the

pipeline grid, it cannot be disputed that they have increased the level

of competition and reduced the ability of pipelines to exercise

monopoly power. Thus, while a regulatory presence is still needed in

the short-term transportation market, the Commission may not need to

continue to regulate this market as if each pipeline was still a single

firm monopoly.

At the same time the Commission is proposing to eliminate maximum

rate regulation in the short-term market, it is proposing several

initiatives in this NOPR to maximize competition in the short-term

market, minimize the potential for the exercise of market power, and

monitor the marketplace for the continuing exercise of market power. To

maximize the extent of competition, the Commission is proposing a

number of measures to create more efficient competition among capacity

offerings so that shippers will have more choice in obtaining capacity.

The Commission is proposing to create more uniform nominating

procedures for released capacity so that it can better compete with

capacity from the pipelines and delivered gas transactions. The

Commission further is requesting comment on whether changes in

regulatory policy are needed to maximize shippers' ability to segment

their capacity to provide greater competitive alternatives. To further

improve competition in the short-term market across the pipeline grid,

the Commission is suggesting potential methods of reforming penalty

procedures to ensure that different penalty processes across pipelines

do not limit shippers' flexibility in using capacity or otherwise

distort shippers' decisions about how best to use capacity.

As an additional measure to mitigate potential market power, the

Commission is proposing the use of capacity auctions for all short-term

capacity. A properly designed capacity auction can protect against the

exercise of market power by limiting the ability to withhold capacity

and to engage in price discrimination.

To monitor the marketplace, the Commission is proposing to

establish reporting requirements to provide capacity and pricing

information to all shippers. This information will have the further

benefit of making competition more efficient by providing the pricing

information that a competitive market needs for shippers to make

informed decisions about their capacity purchases. All of these

proposals are addressed in more detail in Parts III and IV of this

NOPR.

In addition to these proposals for monitoring the short-term

market, the Commission proposes to conduct a generic review of the

operation of the short-term market without a price cap after two winter

heating seasons.

Because the proposed regulatory approach differs between short-term

and long-term services, there is a need to define the period

encompassed by each. The Commission is proposing to define short-term

transactions as all transactions of less than one year. The Commission

has traditionally drawn the line between long-term and short-term

transactions at one year.\33\ A term of one year corresponds with

naturally repeating weather and planning cycles for production,

transportation, and storage. A term of one year also corresponds with

the period used to calculate long-term rates.

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\33\ 18 CFR 284.221(d)(2) (right of first refusal applies to

contracts with a term of one year or more); Pipeline Service

Obligations and Revisions to Regulations Governing Self-Implementing

Transportation Under Part 284 of the Commission's Regulations, Order

No. 636-A, 57 FR 36128 (Aug. 12, 1992), FERC Stats. & Regs.

Regulations Preambles [Jan. 1991-June 1996] para. 30,950, at 30,627

(Aug. 3, 1992).

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The Commission, however, requests comment on whether a shorter

period, such as five months, should be used. If a period of less than

one year were chosen, it could either be a discrete period (e.g.,

November through March) or could refer to any transaction with a term

of less than the chosen period. A five month period, for instance,

would generally correspond to the length of time of the heating

season.\34\ The use of a period of less than one year could reduce the

outlay that any shipper would have to make in order to buy

[[Page 42991]]

capacity at cost-based rates to avoid the potential exercise of market

power. \35\

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\34\ In defining short-term for the purposes of capacity release

transactions, the industry, through the Gas Industry Standards

Board, defined short-term releases as releases of less than five

months. 18 CFR 284.10(b)(1)(v), Capacity Release Related Standards

5.3.2.

\35\ For instance, under a five month definition, the maximum

charge a shipper would have to incur to purchase long-term capacity

would be the current monthly rate times five.

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B. Legal Basis for the Proposed Regulatory Change

The Commission's statutory responsibility under the Natural Gas Act

(NGA) is to establish rates that are just and reasonable and that

protect consumers of natural gas from the exercise of monopoly power by

pipelines.\36\ In addition, the Commission has the obligation, under

the Wellhead Decontrol Act, to structure its regulatory framework to

``improve [the] competitive structure [of the natural gas industry] in

order to maximize the benefits of [wellhead] decontrol.'' \37\

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\36\ FPC v. Hope Natural Gas Co., 320 U.S. 591, 610 (1944);

Associated Gas Distributors v. FERC, 824 F.2d 981, 995 (D.C. Cir.

1987), cert. denied, 485 U.S. 1006 (1988) (``The Natural Gas Act has

the fundamental purpose of protecting interstate gas consumers from

pipelines' monopoly power.'').

\37\ Natural Gas Decontrol Act of 1989, H.R. Rep. No. 101-29,

101st Cong., 1st Sess., at 6 (1989); Pipeline Service Obligations

and Revisions to Regulations Governing Self-Implementing

Transportation Under Part 284 of the Commission's Regulations, Order

No. 636, 57 FR 13267 (Apr. 16, 1992), FERC Stats. & Regs.

Regulations Preambles [Jan. 1991-June 1996] para. 30,939, at 30,932

(Apr. 8, 1992).

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The courts have recognized that the Commission needs to be able to

develop flexible pricing programs that accommodate its regulation to

the needs of the marketplace. The Commission is not bound to ``use any

single pricing formula'' in determining just and reasonable rates,\38\

and cost-based regulation can be relaxed when the overall ``regulatory

scheme'' ensures that rates are within a zone of reasonableness.\39\

The case law makes clear that flexible rate regulation is permissible

as long as, on balance, the benefits of the program outweigh the

potential risks, and the Commission takes reasonable measures to

protect against the exercise of market power, even though not every

transaction would be free of market power.\40\ In Environmental Action

v. FERC, the court approved a flexible pricing program, which fostered

efficient trading of energy and transmission service, even though the

program created a risk that market power could be exercised over

captive customers. Given the benefits of effective trading and the

protections adopted by the Commission to limit the potential exercise

of market power, the court concluded that the Commission acted

reasonably in approving the program despite the potential risks.\41\

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\38\ Elizabethtown Gas Company v. FERC, 10 F.3d 866, 870 (D.C.

Cir. 1993) (approving market-based rates).

\39\ See Farmers Union Central Exchange v. FERC, 734 F.2d 1486,

1509-10 (D.C. Cir. 1984).

\40\ Environmental Action v. FERC, 996 F.2d 401, 408, 411 (D.C.

Cir. 1993) (approving flexible pricing program to permit efficient

trading of electric power).

\41\ As the court stated:

We acknowledge that the flexible pricing that fosters trading

among members of the Pool also permits price discrimination

especially against captive utilities. Yet, given the benefits of

this trading, the limited number of captive members, and the

provisions for monitoring transactions and remedying any abuses of

market power, we do not find that the Commission acted arbitrarily

when it approved the use of flexible prices despite their admitted

risk.

996 F.2d at 411.

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The Commission believes the model it is proposing satisfies the

Commission's statutory obligations by achieving the appropriate balance

between the benefits to be garnered from efficient trading in the

short-term market and the protection needed against the exercise of

market power. As discussed earlier, removing maximum rate regulation

from the short-term market provides significant benefits by allowing

markets to efficiently allocate capacity in an environment in which

cost-based solutions do not accommodate the volatile price changes in

the industry.

The potential risk of this approach is that it could give pipelines

or shippers greater latitude to exercise market power during peak

periods. Although competition clearly has increased in the short-term

market, the Commission is not making a finding that the short-term

market is sufficiently competitive to satisfy its traditional market

power analysis. Nor is the Commission making a finding that the

proposals in this NOPR will necessarily create a fully competitive

market. Rather, as discussed below, the proposed approach in this NOPR

is intended to place effective limits on the ability of pipelines and

shippers to exercise market power by enhancing competitive options in

the short-term market, mitigating market power by limiting the ability

to withhold capacity and price discriminate, and monitoring the

marketplace.

The proposed approach should provide benefits to all shippers--both

those holding long-term capacity, and those purchasing short-term

capacity. Long-term capacity holders would still be protected by the

cost-based rate in the long-term market and would benefit by being able

to realize the value of their long-term capacity. Shippers relying on

the short-term market would not be unreasonably harmed since the

proposals in the NOPR are designed to protect them against the

withholding of capacity and price discrimination, both during peak and

off-peak periods. At the same time, short-term shippers would benefit

because the proposals would help to create a more efficient marketplace

during peak periods, with capacity allocated to those valuing it most,

prices undistorted by regulatory allocation priorities, clearer price

signals, and more open, transparent, and efficient capacity

allocations. These benefits are fully described below.

The approach proposed here also appears better suited than other

potential approaches for responding to the changing dynamics of the

short-term market. The Commission, however, requests comment on whether

this proposal is the best approach for protecting against market power

given the realities of the short-term market. Commenters should address

whether the Commission should seek evidence to determine whether it can

make a finding that the market is competitive or pursue other

regulatory approaches.

1. Protection Against the Exercise of Market Power by Pipelines and

Shippers

The Commission's primary responsibility is to protect against the

exercise of monopoly power by pipelines. Even under the current maximum

rate approach, such protection is not absolute. Pipelines are able to

price discriminate below the existing price cap.

The approach proposed here seeks to control the pipelines' exercise

of monopoly power in a different way, by enhancing the competition from

firm shippers releasing capacity, by requiring pipeline capacity to be

sold through an auction that limits the ability to withhold capacity,

and by monitoring the marketplace for evidence of the exercise of

monopoly power. Moreover, the proposed approach would reduce the

ability of pipelines to withhold future capacity (by not expanding

their systems) in order to increase price and earn a supra-competitive

rate of return. If pipelines sought to limit capacity in order to earn

high returns on short-term transactions, shippers could purchase long-

term capacity at cost-based rates and capture the profit opportunities

in the short-term market for themselves by releasing the capacity.

Further, any revenues from short-term sales would be accounted for in

the pipeline's next rate case ensuring that the long-term benefits of

increased revenue from sales of short-term capacity go to the long-term

firm capacity holders. The Commission also could act under section 5 of

the NGA in cases where monitoring revealed that

[[Page 42992]]

the market rate is not just and reasonable.\42\

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\42\ See Elizabethtown, 10 F.3d at 870 (Commission can use its

section 5 authority to assure that market-based rates are just and

reasonable); Environmental Action, 996 F.2d at 411 (emphasizing

provisions for monitoring market-based rates to protect against

exercise of market power).

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The approach proposed here also can be expected to limit the

exercise of market power by firm capacity holders. Releasing shippers

face competition from other releasing shippers and from the sale of

pipeline firm and interruptible service. Firm capacity holders should

not be able to withhold capacity to raise price, because if they do not

use their capacity it then becomes available either as interruptible or

short-term firm capacity from the pipeline. The proposed auction would

then require the pipeline to sell that capacity at a market-determined

price. The auction also would limit the ability of firm capacity

holders to unduly discriminate. Moreover, the pipelines' ability to

build additional capacity is a final protection against releasing

shippers' exercise of market power. If the pipeline observes shippers

earning high returns from constrained capacity, the pipelines have

every incentive to try to capture those returns by building additional

capacity to satisfy that demand.

2. Protection for Shippers Relying on Long-term and Short-term

Capacity

While the Commission has an obligation to consider the interests of

all shippers, its paramount obligation is to protect long-term firm

capacity holders that cannot risk going without long-term

capacity.43 Interruptible or short-term shippers, by

definition, take the risk that they may be unable to acquire

capacity.44 The proposed regulatory model would protect

those shippers holding long-term capacity, while at the same time not

putting short-term shippers at unreasonable risk and perhaps even

providing them with benefits.

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\43\ See Maryland People's Counsel v. FERC, 761 F.2d 768 (D.C.

Cir. 1985); Maryland People's Counsel v. FERC, 761 F.2d 780 (D.C.

Cir. 1985) (remanding special marketing program because it excluded

core captive customers); Environmental Action, 761 F.2d at 411

(permitting flexible pricing program even though there was some

possibility of discrimination against captive utilities).

\44\ See American Gas Association v. FERC, 912 F.2d 1496, 1518

(D.C. Cir. 1990). The court remanded the Commission's decision to

permit pre-granted abandonment of all long-term contracts, because

of a concern about the pipeline's ability to exercise monopoly

market power over long-term capacity holders. The court, however,

found that holders of interruptible and short-term services did not

need similar protection against the exercise of pipeline monopoly

power.

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Under the proposed approach, shippers holding long-term capacity

would continue to receive the traditional protection accorded them

because long-term capacity would still be subject to cost-based

regulation. Indeed, removal of the price cap for short-term

transactions should benefit long-term capacity holders, because it

would permit them to recover more of their reservation charges during

peak periods. For those shippers holding long-term contracts that are

unable to sell delivered gas, the price cap currently limits their

ability to recover their reservation charges by releasing capacity

during peak periods when capacity is valuable. On the other hand,

during off-peak periods, competition from other releasers or the

pipeline may limit a shipper's ability to recover its reservation

charges. At the same time, interruptible or short-term shippers benefit

from the competition during off-peak periods because they pay prices

lower than what the pipeline charged when it was the sole supplier of

capacity. Thus, removal of the rate cap would permit long-term firm

capacity holders to realize the full value of their transportation

capacity during both peak and off-peak periods.

Even if a long-term firm capacity holder is unable to release its

own capacity during a peak period, it may benefit if the pipeline can

charge competitive rates for peak period capacity. In the pipeline's

next rate case, the revenue received from such sales would be used to

reduce the reservation charges for firm customers.

Nonetheless, the Commission expects that the proposed regulatory

model would not put shippers in the short-term market at unreasonable

risk and may even benefit them. These shippers would have the option of

buying long-term capacity at regulated cost-based rates, which should

help to limit the potential exercise of market power in the short-term

market. Pipelines would continue to be required to sell long-term

capacity to anyone offering the maximum rate regardless of the rates

bid for short-term capacity. Further, to ensure that long-term capacity

is available, the Commission would examine closely pipeline refusals to

construct taps requested by customers as well as pipeline refusals to

construct new capacity when demand for new construction exists.

This model also should work to the benefit of short-term customers

during both off-peak and peak periods. During peak periods, the price

cap offers only limited protection against the exercise of market

power, and may actually create inefficiency which reduces short-term

shippers' ability to obtain capacity when they need it. During peak

periods, when capacity is constrained, short-term customers currently

run a significant risk that they may be unable to obtain capacity from

the pipeline even if they place the highest value on that capacity. If

they instead seek to acquire capacity through a delivered gas

transaction, they receive little protection against the exercise of

market power and the price for such gas may be higher than it would be

in a more efficient market. By removing the price cap, but at the same

time offering initiatives for enhancing competition among capacity

alternatives, the approach proposed in this NOPR should be more

effective than the current system in creating a transparent and

efficient short-term market in which shippers, even on peak, can

acquire gas and capacity at efficient market-clearing prices.

During off-peak periods, the rate cap provides little protection

against the exercise of market power, because pipelines and shippers

are not required to sell capacity at rates below the maximum rate. The

proposals for increasing competition and the auction ought to limit the

pipelines' ability to exercise market power or price discriminate so

all short-term shippers would be paying prices closer to a competitive

level.

3. Alternative Approaches for Regulating the Short-Term Transportation

Market

The approach proposed in this NOPR appears better suited than other

possible methods of dealing with the dynamics of the short-term

transportation market.

An alternative approach would be to continue the current maximum

rate system, but allow pipelines and firm capacity holders to seek

removal of the cap in the short-term market upon a demonstration that

they cannot exercise market power. In effect, this approach presumes

market power is present and requires the parties to try to predict,

through market concentration data or other approaches, whether market

power will be exercised if the rate cap is removed. This is essentially

the approach the Commission uses with respect to market power in its

Alternative Rate Design policy, which focuses on the exercise of market

power in the long-term market for pipeline capacity.45

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\45\ Alternatives to Traditional Cost-of-Service Ratemaking for

Natural Gas Pipelines, and Regulation of Negotiated Transportation

Services of Natural Gas Pipelines, 61 FR 4633 (Feb. 7, 1996), 74

FERC para. 61,076 (1996).

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The approach of screening for market power is certainly a possible

alternative, but it would move the Commission in a direction very

different from the one

[[Page 42993]]

proposed here. The approach proposed here does not rely on a finding of

a lack of market power, relying instead on regulatory measures to

reduce or limit the exercise of market power.

The market power screen, in contrast, would require the Commission

to make a finding of lack of market power in each relevant market. This

not only could be a time consuming and daunting task to undertake on an

industry-wide basis, but it might have to be repeated periodically as

contracts expire or the competitive circumstances on individual

pipelines change. The market power screen approach also was developed

to isolate market power in circumstances in which the pipeline is the

sole source of capacity, and it, therefore, imposes a relatively heavy

evidentiary burden on pipelines seeking market-based rates. Such a

screen may not be discriminating enough or the most appropriate means

of dealing with market power in the short-term market where more

competition is clearly present. The use of the traditional market power

screen, therefore, might suggest the presence of market power in areas

that ought to be found reasonably competitive.

Moreover, in cases where the concentration data do not satisfy the

market power screen, the market analysis approach would continue to

rely on maximum rate regulation which, as discussed earlier, may not be

very effective in protecting against market power in the short-term

market and also promotes more inefficient short-term markets. The

Commission, however, requests comment on whether a modified version of

the market power screen could and should be developed for the short-

term market that would be easier to administer and could determine

whether market power is a significant problem.

Another cost-of-service option would be to attempt to develop a

cost-based, seasonal rate design that would better approximate pricing

activity that would occur during peak and off-peak periods. But price

swings can be very large on a daily, weekly, or monthly basis, making

the development of a rate structure that would accurately reflect

competitive market conditions particularly difficult. Moreover, if the

price cap is raised high enough to accommodate peak period competitive

prices, this approach is little different than simply removing the rate

cap, since it would afford firms with market power substantial latitude

to exercise that power at prices below the price cap.46

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\46\ See Environmental Action, 996 F.2d 401 (approving a

flexible pricing program for an electric power pool with a rate

ceiling based on the most valuable and expensive transportation

service).

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Of the regulatory options available, the proposed regulatory model

appears to create the best balance between achieving the Commission's

objectives of preventing the exercise of market power and creating a

regulatory environment that fosters a competitive, efficient commodity

market that is fair to all shippers. This approach would free the

short-term market from regulatory impediments that prevent the market

from responding to the competitive supply and demand forces that may

result in competitive prices exceeding the price cap. At the same time,

the proposals to increase competition in the short-term market should

help to keep the prices for most transactions within reasonable levels.

Because firm shippers would be better able to release capacity in

competition with the pipelines, the pipelines' ability to exercise

market power would be limited. At the same time, firm shippers' ability

to exercise market power would be restrained because, if they tried to

withhold capacity to raise prices, the pipelines would be required to

sell that capacity at market clearing prices. The proposed auction also

would restrain the ability of both pipelines and firm shippers to

exercise market power and to unduly discriminate in the allocation of

capacity. Further, the overall scheme of the proposal limits the

pipelines' ability to charge monopoly prices because shippers can

discipline the pipelines' exercise of market power by purchasing long-

term capacity at cost-based levels.

C. Interrelated Proposals for Regulatory Change

The principal focus of the regulatory changes proposed in this NOPR

is on improving efficiency and competition in the short-term

transportation market. Yet, the regulation of long-term transportation

service is an integral part of the Commission's proposal because

continued regulation of long-term services is an important back-stop to

protect against the pipelines' exercise of market power. Long-term and

short-term transportation services are linked in other ways since the

value of purchasing long-term capacity lies in its ability to insure

shippers against the risk of price swings in the short-term market.

Thus, the changing nature of short-term markets has a concomitant

effect on how shippers use the long-term market and, likewise, actions

affecting long-term contracts can affect the short-term market. For

example, if a pipeline can attract more shippers to its system, the

long-term rate will be reduced, which, in turn, would limit the ability

of pipelines to raise price in the short-term market. On the other

hand, policies discouraging shippers from entering long-term contracts

could reduce the extent of competition in the short-term market.

Because of the relationship between short-term and long-term services,

the Commission also is proposing in this NOPR initiatives to improve

competition and innovation in the market for long-term services and to

ensure that its regulatory policies in the long-term market do not bias

shippers' purchasing decisions.

The Commission is proposing to give pipelines more flexibility in

negotiating rates and terms of service with individual shippers.

Allowing greater flexibility in contract terms for long-term service

can be an important element in the allocation of risk between pipelines

and potential customers. Permitting negotiation of services will

provide an incentive for pipelines to innovate and create additional

value in transportation service.\47\ Also, negotiated rates and

services may permit the pipelines to attract new customers, which would

reduce reservation charges for existing customers.

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\47\ In unregulated and even in regulated industries, sellers

often create innovative service options for individual customers

while still providing a basic service to all. For instance,

telecommunication firms provide specialized services for small and

large businesses while still providing standard service to the

public.

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On the other hand, allowing the pipelines to negotiate individual

terms of service creates the possibility of discrimination against

captive customers as well as a risk that such terms could degrade

competition in the short-term market by limiting the range of capacity

alternatives available to shippers. To fully realize the benefits from

negotiated services while reducing the risks, the Commission is

proposing to permit pipelines and shippers to enter into contracts for

negotiated services, while also proposing criteria to protect against

the risks of undue discrimination or impairment of the competitiveness

of the short-term market.

Further, to ensure that contracting decisions are made efficiently,

regulatory policies should not unfairly bias shippers' contracting

decisions. Some Commission policies, like the right of first refusal,

may well create an asymmetry in the risks facing pipelines and capacity

purchasers and bias shippers towards shorter term contracts. The

Commission, therefore, is proposing certain changes in regulatory

policy to

[[Page 42994]]

eliminate provisions that may tilt shipper decisions towards the

purchase of short-term capacity.

The construction of new capacity also affects competition in the

short-term market. For instance, the ability of shippers to purchase

long-term capacity at cost-based rates is a protection against the

exercise of market power in the short-term market. The Commission is,

therefore, considering changes in certificate policy so that these

policies do not unnecessarily inhibit competition.

In addition, to better reflect the changing nature of services in

the short-term market and to consolidate pipeline reporting

requirements under Part 284, the Commission is proposing to reorganize

Part 284 to put the regulations into a more logical order.\48\

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\48\ The references in this NOPR to proposed regulatory changes

are to the new regulatory sections. References to existing

regulations are to the existing regulatory framework.

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III. Creating Greater Competition Among Short-Term Service

Offerings

Increasing competition is the best antidote to market power. As

long as buyers have good alternative sources of capacity, no seller can

exercise market power, because any attempt to raise price above the

competitive level will result in the buyer moving to another

seller.\49\ Prior to Order No. 636, the pipeline was the only source of

both long-term and short-term capacity. The Commission's establishment,

in Order No. 636, of the capacity release mechanism has significantly

increased competition on most pipelines both between the pipeline and

shippers and among shippers themselves.

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\49\ Market power can be exercised in two ways. A holder of

capacity may withhold capacity from the market to drive up the price

that all shippers pay for the remaining capacity, or it can price

discriminate by charging captive customers more than those customers

with more alternatives. In either case, however, competition will

prevent the exercise of market power.

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But there remain means of enhancing competition and improving the

substitutability of capacity alternatives. Three such improvements are

to make nomination and scheduling procedures more uniform for all

short-term services; provide shippers with a greater ability to segment

capacity and use alternate receipt and delivery points so

transportation alternatives are more comparable; and employ auctions

for all capacity to limit the ability of pipelines or shippers to

withhold capacity or discriminate. In addition, the Commission is

proposing changes to its reporting requirements to ensure that

comparable information about pipeline and release transactions is

provided. Improved information enables shippers to make more informed

capacity choices while it also permits the Commission and the industry

to monitor transactions for the potential exercise of market power in

the event the Commission's efforts to mitigate market power are not

successful. The Commission is committed to take appropriate and timely

action in individual cases to deal with the exercise of market power.

To this end, the Commission is in the process of considering

improvements to its procedures for handling complaints.\50\

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\50\ See Compliant Procedures, Docket No. RM98-13-000 (issued

contemporaneously with this NOPR).

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A. Nomination Equality

In order to foster a more competitive short-term market, all forms

of transportation--pipeline interruptible and short-term firm capacity,

released capacity, and delivered sales transactions--must be able to

compete on as equal a basis as possible. While there are obviously

differences in rights associated with the different types of capacity,

the Commission is concerned that differences in nomination and

scheduling procedures for capacity release inhibit the ability of

capacity release transactions to compete with pipeline capacity. The

Commission, however, requests comment on whether the existing

differences in nomination and scheduling procedures for capacity

release transactions reflect important differences in the nature of the

services that should be preserved.

Under current regulations, pipelines can sell their interruptible

and short-term services at any time and shippers can schedule such

services at the earliest available nomination opportunity. Similarly,

capacity holders making delivered sales can nominate and schedule at

every available opportunity. In contrast, nomination and scheduling

opportunities under capacity release transactions currently are

significantly circumscribed.

Under Commission regulations, shippers currently submit their daily

nominations at 11:30 a.m. to take effect at 9 a.m. the next gas day.

Pipelines presently are required to provide shippers at least one

intra-day nomination change after the 11:30 a.m. nomination, although

many pipelines provide additional intra-day nomination opportunities.

While a pipeline may sell interruptible or short-term firm service and

permit the recipient of that service to submit a nomination at the

earliest available nomination opportunity, shippers consummating a

release transaction must do so prior to 9 a.m. and can only submit a

nomination at 11:30 a.m. for the next gas day. They cannot consummate a

release transaction later than 9 a.m., nor can the replacement shipper

utilize an intra-day nomination opportunity to submit a nomination for

the current gas day.

The disparate treatment of capacity release transactions, if left

uncorrected, promises to become even more severe as a result of the

industry's agreement to enhance intra-day nomination opportunities. In

a final rule issued on July 15, 1998,51 the Commission

adopted the consensus agreement of the Gas Industry Standards Board

(GISB) to expand shippers' intra-day nomination opportunities by

establishing three synchronized intra-day nomination periods across the

grid. Under the industry's schedule, the three synchronization times

are 6 p.m. (for the next gas day), 10 a.m. and 5 p.m. (for the current

gas day). A shipper obtaining short-term firm or interruptible capacity

from the pipeline, or making a delivered sales transaction, will be

able to submit a nomination at any of these intra-day nomination

opportunities. Significantly, however, a replacement shipper cannot

acquire released capacity immediately prior to these intra-day

nomination times and nominate at these times. The replacement shipper

must consummate a capacity release deal by 9 a.m. and must wait a full

day before it can flow gas under the release transaction.

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\51\ Standards For Business Practices Of Interstate Natural Gas

Pipelines, Final Rule, 63 FR 39509 (July 23, 1998), 84 FERC para.

61,031 (Jul. 15, 1998).

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In order to place capacity release transactions on a more equal

footing with pipeline services, the Commission is proposing, in

proposed section 284.13(c)(1)(ii), that pipelines provide purchasers of

released capacity, like shippers purchasing capacity from the pipeline,

with the opportunity to submit a nomination at the first available

opportunity after consummation of the deal. This will enable shippers,

for instance, to acquire released capacity at any of the nomination or

intra-day nomination synchronization times and nominate gas coincident

with their acquisition of capacity.

In some cases, pipelines currently require replacement shippers to

pass a credit-worthiness check and execute contracts prior to

nominating. Under the proposed regulation, such requirements could not

prevent a replacement shipper from nominating when it completes the

release transaction. Proposed section 284.13(c)(1)(ii) would provide

that a pipeline that requires the replacement shipper to enter into a

contract must

[[Page 42995]]

issue the contract within one hour of submission of the transaction

52 and that the requirement for contracting must not inhibit

the ability to submit a nomination at the time the transaction is

complete.

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\52\ The current regulations require pipelines to issue

contracts within one hour. 18 CFR 284.10(b)(1)(v), Capacity Release

Related Standards 5.3.2.

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Pipelines have available several procedures which they can use to

protect themselves against the credit risk of the replacement shipper.

The pipelines can institute procedures under which replacement shippers

receive pre-approval of their credit-worthiness or receive a master

contract, like those used for interruptible shippers, permitting the

replacement shipper to nominate under that contract at any

time.53 For replacement shippers that do not have a master

contract, the pipeline could provide a contract number for nominating

as soon as the pipeline is notified of the release transaction. For

replacement shippers that have not received pre-approved credit, the

releasing shipper may agree to be liable for any usage charges incurred

by the replacement shipper while the pipeline conducts the credit-

worthiness check.54

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\53\ The Commission previously issued a proposed rule suggesting

that pipelines use pre-approved credit-worthiness procedures for

replacement shippers. Secondary Market Transactions on Interstate

Natural Gas Pipelines, Notice of Proposed Rulemaking, 61 FR 41046

(Aug. 7, 1996), IV FERC Stats. & Regs. Proposed Regulations para.

32,520 (Jul. 31, 1996). In the comments on the proposal, the

pipelines, in general, did not object to the use of pre-approval for

credit-worthiness or master contracts. Tenneco Energy objected only

to the use of master contracts, arguing that because capacity

release is a firm service, the pipeline needs prior notice of the

specific terms of the release including the firm transportation

quantity, the zones of the release, and the rights to primary and

secondary points.

\54\ Releasing shippers already are responsible for all

reservation charges under the Commission's capacity release

regulations. 18 CFR 284.243(f).

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B. Segmentation and Flexibility of Receipt and Delivery Points

1. Background

In Order No. 636, the Commission established two principles that

are important to creating efficient competition between holders of

capacity and the pipelines: segmentation of capacity and the ability of

shippers to use alternative receipt and delivery points. Segmentation

refers to the ability of firm capacity holders to subdivide their

capacity into segments to enhance the value of the capacity and the

capacity holders' ability to compete with the pipeline. In the example

used in Order No. 636, a shipper holding firm capacity from a primary

receipt point in the Gulf of Mexico to primary delivery points in New

York could release that capacity to a replacement shipper moving gas

from the Gulf to Atlanta while the New York releasing shipper could

inject gas downstream of Atlanta and use the remainder of the capacity

to deliver the gas to New York. In order for such a transaction to

work, both the releasing and replacement shippers need the right to

change their receipt and delivery points from the primary points in

their contract to use other available points.

Without the ability to segment and use alternate points, the New

York releasing shipper in the example would not be an effective

competitor to another shipper holding firm primary point capacity at

Atlanta. The ability to segment capacity and use alternate points,

therefore, provides a potential replacement shipper who wants to ship

to Atlanta with additional capacity options. It can buy from the

releasing shipper holding primary point capacity in Atlanta or from the

New York releasing shipper or any other shipper holding capacity

downstream of Atlanta.

However, under current Commission policies, the ability of the

releasing shipper in New York to compete with the pipeline or with the

shipper in Atlanta may be limited. Under the Commission's current

policies, the releasing shipper in New York only has a secondary

delivery point right at Atlanta, which is inferior to the primary point

right of the releasing shipper holding primary point rights at Atlanta.

In other words, if the pipeline is unable to make both deliveries to

Atlanta, the shipper with the primary right at Atlanta will be given

delivery priority over the releasing shipper in New York or the

replacement shipper buying capacity from the New York shipper, each of

which only has secondary point rights at Atlanta. To the extent that

this is a possibility, capacity from the releasing shipper in New York

is not equal in quality or fully competitive with the capacity from the

shipper holding primary point rights at Atlanta.

Receipt and delivery point flexibility is not applied consistently

across pipelines, and pipelines do not treat different types of

segmentation similarly. During the restructuring proceedings mandated

by Order No. 636, the Commission permitted certain pipelines to adopt

tariff provisions under which releasing shippers would lose their

rights to primary receipt or delivery points if replacement shippers

changed primary points under the release.55 The Commission

permitted such restrictions where the pipelines had pre-existing tariff

provisions that did not permit shippers' primary receipt and delivery

point CD rights to exceed their mainline rights. To prevent the

possible loss of primary point rights, the releasing shipper would have

to include a condition in the release prohibiting the replacement

shipper from changing primary points. The Commission, however, sought

to minimize the effect of this restriction on segmented releases by

adopting a policy for segmented releases under which:

\55\ See Transwestern Pipeline Company, 62 FERC at 61,659, 63

FERC at 61,911-12 (1993); El Paso Natural Gas Company, 62 FERC para.

61,311, at 62,982-83 (1993).

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the releasing and replacement shippers must be treated as

separate shippers with separate contract demands. Thus, the

releasing shipper may reserve primary points on the unreleased

segment up to its capacity entitlement on that segment, while the

replacement shipper simultaneously reserves primary points on the

released segment up to its capacity on that segment.56

\56\ Texas Eastern Transmission Corporation, 63 FERC para.

61,100, at 61,452 (1993). El Paso Natural Gas Company, 62 FERC para.

63,311, at 62,991. See also Transwestern Pipeline Company, 61 FERC

para. 61,332, at 62,232 (1992).

Under this policy [hereinafter referred to as the Texas Eastern/El

Paso policy], the releasing shipper could protect its delivery point

rights by choosing Atlanta as its primary receipt point and New York as

its primary delivery point, while the replacement shipper designate its

primary receipt point as the Gulf and Atlanta as its primary delivery

point. However, it is not clear whether all pipelines adhere to this

policy.57

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\57\ See Colorado Interstate Gas Company FERC Gas Tariff, First

Revised Volume No. 1, Third Revised Sheet No. 254 (replacement

shippers are not permitted to change primary points and can nominate

only the original primary or at secondary points).

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Even on those pipelines following the Texas Eastern/El Paso policy,

replacement shippers face limitations on their ability to change

primary receipt and delivery points.58 However, even at the

time the Commission permitted those pipelines with pre-existing tariff

restrictions on receipt and delivery point rights to continue such

restrictions, it was skeptical about the justifications for imposing

such limits.59 In fact, the Commission rejected applications

to impose similar

[[Page 42996]]

restrictions by pipelines without pre-existing

restrictions.60 In these cases, the Commission required

pipelines to permit replacement shippers to change primary points

without releasing shippers losing their right to return to their

original primary point at the end of the release. As the Commission

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explained in Northwest:

\58\ For example, if the replacement shipper seeks to change its

primary receipt point right from the Gulf to another point, then the

releasing New York shipper might lose the ability to return to its

primary Gulf receipt point at the end of the release.

\59\ See Transwestern Pipeline Company, 62 FERC at 61,659, 63

FERC at 61,911-12 (1993); El Paso Natural Gas Company, 62 FERC para.

61,311, at 62,982-83 (1993).

\60\ See Northwest Pipeline Company, 63 FERC para. 61,124, at

61,806-08 n.72 (1993).

Northwest's restriction on replacement shippers' ability to

designate primary receipt or delivery points different from those of

the releasing shipper unless the releasing shipper agrees to

relinquish the original primary point could operate to limit or

impair capacity release transactions. A releasing shipper may be

unwilling to enter into a short term release if, in so doing, it

loses priority to its primary receipt and delivery points for the

remainder of a 20 year contract. Replacement shippers may be

reluctant to bid on mainline capacity if they cannot be assured of

receipt and delivery point capacity at available points (not subject

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to bumping by shippers coming later in time).61

\61\ Northwest Pipeline Company, 63 FERC para. 61,124, at 61,807

(1993). See also Questar Pipeline Company, 62 FERC para. 61,192, at

62,306 (1993).

Under both the Texas Eastern/El Paso and Northwest policies,

replacement shippers can change primary points only if the new point is

available and is not fully subscribed. In addition, shippers can only

change to available points that are within the capacity path for which

they paid. Pipelines, therefore, are not required to permit shippers to

change primary points if doing so would mean that the pipeline's

mainline capacity would be oversubscribed.

During the restructuring proceedings, the Commission addressed

segmentation only in the context of release transactions. It did not

address whether a shipper could segment capacity, for instance, by

delivering gas to Atlanta and then shipping to New York for its own

use. It is not clear whether pipelines permit such transactions. Even

if pipelines do permit the segmented transaction, the shipper may be

unable to designate both Atlanta and New York as primary delivery

points.

In the Commission's NOPR on secondary market transactions

(Secondary Market NOPR),62 the Commission requested comment

on whether it needed to provide more flexibility for shippers and

replacement shippers to change primary points. Most shippers supported

providing more flexibility, arguing that a shipper using capacity on a

secondary basis within the primary path has the same rights afforded

transportation between primary points. The pipelines, however, opposed

increased flexibility, arguing that allowing releasing shippers to

return to previously vacated points would require the pipeline to hold

otherwise available capacity in reserve for shippers without collecting

reservation charges for that capacity.

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\62\ Secondary Market Transactions on Interstate Natural Gas

Pipelines, Notice of Proposed Rulemaking, 61 FR 41046 (Aug. 7,

1996), IV FERC Stats. & Regs. Proposed Regulations para. 32,520

(Jul. 31, 1996).

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2. Is There a Need To Revise Policies To Improve Competition Between

Primary and Alternate Point Capacity?

Shippers' rights to segment and use receipt and delivery points

clearly differ across pipelines. In today's gas market, shippers are

acquiring capacity from multiple sources and need the ability to use

their capacity more flexibly. The issue is whether, in operation, the

current system fairly allocates capacity so no changes need to be made

to the policies or whether changes are necessary to maximize the extent

of competition in the short-term market. The concerns involve two

interrelated areas: segmentation policy, including priorities for

primary and secondary points, and the confirmation process between

pipelines and between pipelines and other entities, such as LDCs.

The first concern, as discussed above, is whether on some

pipelines, replacement shippers may be unable to use certain receipt or

delivery points as primary points under segmented release transactions

and whether this significantly limits shippers' flexibility or raises

transaction costs. These limitations would be more severe on pipelines

that do not follow the Texas Eastern/El Paso policy by permitting both

releasing shippers and replacement shippers on segmented releases to

hold primary point capacity equal to their contract demand.

On some pipelines, delivery or receipt point priorities may be used

to determine priorities over constrained mainline capacity even if both

shippers have equal firm rights over the constrained mainline. For

example, if pipelines are unable to schedule competing firm

nominations, the pipelines may give higher priority to shippers moving

between primary firm points over shippers moving to secondary points

even if both sets of shippers have equal firm rights past the area that

has become constrained.63 It is not clear how frequently

pipelines use receipt or delivery point priority to allocate mainline

capacity in the event of constraints or whether the use of such an

allocation policy significantly limits shippers' flexibility.

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\63\ See El Paso Natural Gas Company, 81 FERC para. 61,174

(1997) (because the pipeline does not assign receipt point rights,

it effectively allocates constrained mainline capacity based on

whether customers are nominating to primary or secondary delivery

points).

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Second, confirmation practices may affect the allocation of primary

and secondary capacity at interconnects between two pipelines (which

includes interconnects between interstate and intrastate pipelines and

interstate pipelines and local distribution companies). Suppose there

are two shippers with firm capacity on pipeline A that covers an

interconnect with pipeline B, but shipper 1 holds the interconnect as a

primary delivery point and shipper 2 as a secondary delivery point.

Further, suppose there is insufficient capacity to effect both

deliveries and shipper 1 holds only interruptible capacity on pipeline

B, while shipper 2 holds firm capacity on pipeline B.

BILLING CODE 6717-01-P

[GRAPHIC] [TIFF OMITTED] TP11AU98.001

[[Page 42997]]

BILLING CODE 6717-01-C

Shipper 1: Pipeline A--Firm Primary at Delivery Point; Pipeline B--

Interruptible at Receipt Point

Shipper 2: Pipeline A--Firm Secondary at Delivery Point; Pipeline B--

Firm Secondary at Receipt Point

If both pipelines independently allocate capacity according to their

tariff-based priorities before seeking confirmation, neither shipper

would be able to flow, even though shipper 2 has firm capacity on both

pipelines.64

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\64\ Pipeline A would allocate the delivery point right to

shipper 1, whose primary firm right has priority over shipper 2's

secondary firm right. Pipeline B would allocate the receipt point

right to shipper 2, whose firm capacity right has priority over

shipper 1's interruptible capacity. Thus, the capacity allocations

would not match and neither would be confirmed.

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In some contexts, however, gas flows may be determined by the

decision of the downstream party as to which gas it will

accept.65 If that were the case in the above example,

shipper 2 would flow gas because it had the priority right on

downstream pipeline B.

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\65\ See, e.g., Southwest Gas Corporation v. El Paso Natural Gas

Company, 63 FERC para. 61,111 (1993) (finding that allocation of

delivery point rights had not abrogated Southwest's delivery point

priority since Southwest controlled the capacity to take gas away

from the delivery point). This case would seem to suggest that the

confirmation by the LDC takes precedence over upstream primary or

secondary delivery point rights.

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The confirmation practices of pipelines in this situation are not

specified in Commission regulations or pipeline tariffs. Thus, the

result in this situation is not predictable, which may raise the costs

of doing business.

The Commission is seeking comment on whether the current system

works efficiently or whether changes to the current practices are

needed. The comments should focus on: (1) How the current system works,

particularly with respect to any differences between interconnections

between pipelines and interconnections between pipelines and LDCs; (2)

whether the current system impedes efficient competition and

flexibility or raises transaction costs, and if so, whether the problem

results from current Commission policies, from a failure to understand

and adhere to those policies, or from a lack of uniform application of

Commission policies; and (3) whether changes in policies would help to

enhance competition and reduce the ability of pipelines or shippers to

exercise market power. To help focus comments, the Commission will lay

out below some options which commenters can consider. The first set of

options deal with segmentation and receipt and delivery point priority

issues, while the second deals with issues relating to pipeline

confirmation procedures.

First, the current system under which receipt and delivery point

priorities are determined on a pipeline-by-pipeline basis could

continue. This option would be appropriate if current policies do not

unfairly restrict competition or if non-uniform rules are necessary due

to pipelines' differing operational capabilities.

Second, all pipelines could be required to conform to the Texas

Eastern/El Paso requirement that, in a segmented release, both

releasing shippers and replacement shippers can designate available

primary receipt and delivery point capacity rights equal to their

contract demand. This would help to increase efficient competition by

giving buyers a better opportunity to substitute capacity acquired

through segmented releases for pipeline capacity or capacity provided

by a shipper with primary point capacity.

Third, to further expand the extent of efficient competition, all

pipelines could be required to adhere to the Northwest approach under

which replacement shippers could change primary point rights to any

available point without the releasing shippers losing their right to

return to their initial primary point at the end of the release. The

pipeline could still sell the vacated point to another shipper during

the term of the release. The Northwest policy also could be extended

beyond release situations to permit a shipper to segment its own

capacity. As described earlier, a shipper with firm capacity with a

primary receipt point in the Gulf of Mexico and a primary delivery

point to New York would be able to deliver gas to Atlanta as a primary

delivery point, while choosing a receipt point downstream of Atlanta as

a primary receipt point for making a delivery to New York as a primary

delivery point.

Fourth, pipelines could be required to provide all shippers with

firm capacity rights over the mainline with equal rights to flow gas

past a mainline constraint point.66 This would increase

shipper capacity options by giving released capacity flowing to

secondary points priority at a mainline constraint point along the

shipper's path equal to pipeline capacity or released capacity flowing

to primary points.

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\66\ See, e.g., Northwest Pipeline Company, 67 FERC para. 61,095

(1994) (mainline constraints allocated according to path rights

rather than point rights). As this case illustrates, even on web or

displacement systems, capacity path rights may be defined.

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This principle could be expanded so that all shippers with firm

capacity would have equal rights to receive or deliver gas at all

points along their path. This would provide a shipper moving to a

secondary delivery point along its path rights to deliver at that point

equal to shippers buying pipeline capacity or shippers buying released

capacity which have that point as a primary delivery point. Such an

approach would ensure that all capacity along the mainline path would

compete equally, giving shippers seeking capacity more capacity

alternatives from which to choose. A possible conflict might arise if

the receipt or delivery point could not accommodate all the receipts or

deliveries sought by the shippers. It is not clear how frequently such

a problem would occur.

Fifth, a monetary value could be developed for all receipt and

delivery points so that shippers could choose to pay for additional

primary point rights, especially those outside their contract path.

Under this approach, shippers would be able to buy unsubscribed primary

receipt and delivery point rights independent of mainline

transportation. One issue under this approach would be to determine a

value for additional receipt and delivery point rights. One option is

to take a strictly cost-based approach in which the pipelines would

have to establish the cost of making or receiving deliveries. Another

might be to conduct an auction for all available points.

The previous options deal with ways of enhancing the ability of

shippers with mainline capacity at secondary points to compete with

capacity from the pipeline or other shippers at primary points, but do

not address confirmation practices across interconnect points. One

possible approach would be for the pipelines to seek to confirm all

transactions before they apply tariff-based priority rules, and to

require that, in the confirmation process, pipelines must seek to

maximize the flow of firm transportation across an interconnect. Thus,

in the example given above, shipper 2 holding firm capacity on both the

upstream and downstream pipeline would get priority over shipper 1,

since shipper 1 holds only interruptible transportation on the

downstream pipeline.67/ Another potential option would be

for priority through pipeline interconnect points to be determined

based on which shipper has the take-away capacity on the downstream

pipeline. The Commission requests comment on these options as well as

the submission of other proposals for handling confirmations that would

create greater substitutability between primary and secondary releases

and lower the associated transactions costs

[[Page 42998]]

while still fairly allocating capacity among shippers.

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\67\ See text accompanying note 64, supra.

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C. Capacity Auctions

Auctions are often used as effective methods of selling goods and

services. A well-structured auction can assure that pipeline capacity

is allocated to the party placing the greatest value on the capacity

and can assure fairness in the allocation process by preventing price

discrimination or favoritism by the capacity seller. An auction

provides customers with equal opportunities to acquire capacity,

preventing the pipeline or releasing shipper from treating different

bidders differently. Auctions also have value because they provide the

market with accurate information on the value of capacity.

If a market is perfectly competitive with a sufficiently large

number of capacity holders, and equal access to market information, an

auction would not be necessary to limit the exercise of market power,

because market power would not be present. But, even in that case, an

auction may help reduce the transaction costs of trading capacity. Any

attempt to charge more than a competitive price would result in the

potential buyer looking elsewhere for capacity.

The current regulations seek to protect against pipeline exercise

of market power by requiring pipelines to sell capacity when they have

received an offer at the maximum tariff rate. This requirement prevents

the pipelines from withholding capacity at the maximum rate in order to

raise prices. The current regulations, however, do not require

pipelines to sell capacity at a discounted rate. Thus, pipelines may be

able to exercise market power at rates below the maximum rate because

the pipeline is not obligated to sell capacity (can withhold capacity)

at less than the maximum rate.

In markets where market power is present, an auction that limits

capacity withholding can be an effective method of limiting the

exercise of market power and creating a more efficient market. In

today's market, during peak periods, the price cap may restrict

shippers' ability to obtain capacity from the pipelines or may result

in shippers paying a higher price than necessary for delivered gas

either because releasing shippers exercise market power or because the

market simply is not transparent enough for potential buyers to be able

to locate and negotiate with alternative capacity sources. During off-

peak periods, shippers similarly may have to pay more than necessary to

obtain capacity if pipelines or releasing shippers can withhold

capacity or price discriminate. Placing all available capacity in an

auction would help ensure that shippers will pay lower prices both

during peak and off-peak periods, because the auction process helps to

ensure that prices reflect competitive market forces rather than

resulting from the exercise of market power or shippers' inability to

obtain accurate market information.

1. Proposed Auction Requirement

To help prevent the exercise of market power, the Commission is

proposing, in revised Sec. 284.10(c)(5), to require all available

short-term pipeline firm and interruptible capacity and released

capacity to be allocated through an auction process. The proposed

auction requirement applies to all sales of short-term pipeline

capacity, both interruptible and firm, and released capacity. Thus, all

capacity sold for a term of less than a year (or whatever other time

period is chosen to define short-term capacity) would be sold through

an auction process. Using an auction process for all capacity, during

both peak and off-peak periods, is necessary to limit the exercise of

market power and to allow the market to determine the value of

capacity.

The Commission is proposing that pipelines adhere to the following

principles in designing an auction:

all available short-term capacity must be sold through an

auction;

daily capacity from the pipeline must be allocated based

on the auction without the establishment of a reserve or minimum bid

price;

all eligible shippers must be permitted to bid with no

favoritism shown to pipeline affiliates or other shippers;

the procedures and rules for each auction, including the

auction schedule, must be disclosed in the pipeline's tariff in advance

of the auction and must be applied in each auction;

capacity must be allocated based on established criteria

and parameters known in advance to all bidders and the same criteria

and parameters must apply to pipeline and released capacity;

68 and

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\68\ See 18 CFR 284.10(b)(1)(v), Capacity Release Related

Standards 5.3.3 and 7.3.14 (three methods for valuing bids, highest

rate, net revenue, and net present value).

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shippers must be able to validate that the auction was run

properly either through the posting of information sufficient to permit

them to validate that the winners were selected appropriately or

through the use of other mechanisms, such as an independent third-

party, which will validate the results.

The requirement of an auction for short-term capacity still leaves

the question of whether to retain the current bidding procedure for

long-term capacity release transactions.69 Pipelines are not

subject to any auction or bidding requirements in selling long-term

capacity. To ensure comparability, the Commission, therefore, proposes

to permit shippers to release capacity on a long-term basis without

going through a bidding process. As is the case for the pipelines, no

sales of long-term capacity can exceed the pipeline's maximum rate.

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\69\ See CFR 284.243(e).

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The proposal for auctions of capacity raises issues about auction

design that will be discussed below. The first issue is whether to

permit pipelines or releasing shippers to establish a reserve or

minimum price below which they are not obligated to sell capacity. The

second is how to design the auction to work most efficiently.

2. Reserve Prices

The Commission is proposing two different auction methodologies for

pipeline capacity. For capacity sold for one day, the Commission is

proposing a daily auction in which pipelines cannot establish a reserve

price. Pipelines would not be required to sell below the minimum rate

(variable cost) in their tariffs. For auctions of longer than one day,

pipelines would be permitted to establish reserve prices.

Prohibiting pipelines from establishing a reserve price would limit

their ability to withhold capacity. Requiring pipelines to auction

their daily capacity, without a reserve price, should be sufficient to

prevent them from withholding capacity for longer short-term

transactions, for instance, a deal for three months' worth of capacity.

The pipeline should not be able to demand a monopoly price for three

months' worth of capacity because shippers would not pay that price. A

shipper would pay only the amount that it would expect to have to pay

if it purchased the capacity in the daily auction plus a premium for

the insurance value of locking-in the capacity and price for a set

period of time.

For capacity available for periods of longer than one day,

pipelines could establish reserve prices. Pipelines may have a

legitimate basis for believing that the market value for their capacity

on a single day is less than what the capacity will be worth at a later

date or if the capacity ultimately was sold on a longer-term basis.

The auctions of pipeline capacity would work in the following

manner. When a pipeline has firm capacity

[[Page 42999]]

available for more than one day, for instance six months beginning on

July 1, the pipeline could establish a reserve price for the six month

block of capacity. If that capacity was not sold by June 30, the

pipeline would have to sell the capacity for July 1 through the auction

process for that day. The pipeline, however, could continue the reserve

price for shippers willing to bid on the six month (less one day) block

of capacity. This process would continue until the capacity is sold.

The daily auction also would apply to available pipeline storage

capacity. But comments should address whether a daily auction for

storage capacity is practical, whether different rules should apply to

storage capacity, and whether storage capacity needs to be included in

the daily auction to prevent capacity withholding.

The Commission is proposing that all short-term releases of

capacity by firm shippers take place through the auction to ensure that

capacity is allocated on a non-discriminatory basis to the purchaser

placing the greatest value on the capacity. Releasing shippers would be

permitted to place reserve prices on their capacity, because they have

a legitimate basis for retaining capacity for their own use. For

instance, firm shippers may need to reserve capacity to meet

unanticipated weather changes, to replace depleted storage, or to

change to a substitute supply to ensure reliable service. Moreover,

firm capacity holders should not be able to withhold capacity because,

under the proposal, if a firm capacity holder does not nominate (use)

its capacity, the pipeline would be required to sell the unnominated

capacity as interruptible or short-term firm capacity through the

auction.

The Commission, however, requests comment on a number of aspects of

its proposed approach to reserve prices. Commenters should address

whether requiring pipelines to sell capacity at the bid price for only

one day is sufficient to limit the pipeline's ability to withhold

capacity. Commenters should address the question of the price at which

capacity should be sold. For example, should all shippers pay the

market-clearing price (lowest price necessary to get capacity)

70 or should each shipper pay the price it bids?

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\70\ The market clearing price is the price at which all

available capacity is sold and no shipper bidding that price or

higher would be denied capacity.

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Commenters also should address whether the proposed requirement to

sell pipeline daily capacity without a reserve price could cause cost-

recovery problems for some pipelines. If shippers on a pipeline where

capacity is not sufficiently constrained relied exclusively on the

daily auction, the revenue received may be insufficient to cover the

pipeline's costs allocated to interruptible and short-term firm

capacity.71 The daily auction without a reserve price also

may affect the ability of pipelines to resubscribe firm capacity at

maximum rates as contracts expire, which could cause cost recovery

problems. If the pipeline is expected to be uncongested, shippers may

prefer to rely on the daily auction rather than resubscribing to firm

capacity.

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\71\ Pipelines are generally considered to be natural monopolies

because they have very large fixed costs, with significant economies

of scale. Thus, it is less expensive to have one pipeline provide

service than to have two or more pipelines compete over the same

route. However, when a natural monopolist is at the efficient size,

where the cost of producing one additional unit (marginal cost)

equals the price that a customer is willing to pay (demand), that

price is not sufficient to cover the average costs of the firm. See

R. Posner, Economic Analysis of the Law, 251-264 (2d ed. 1977).

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On the other hand, it may be that most pipelines are sufficiently

constrained so that the daily auction requirement will not limit their

ability to recover their costs.72 The proposal to limit the

requirement to sell capacity without a reserve price to one day may

itself reduce the risk to pipeline cost recovery. Some shippers may be

unwilling to take the risk of not having firm capacity.

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\72\ Many pipelines, however, may be at less than efficient size

and, therefore, be sufficiently congested that they will be able to

recover their costs.

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In addition, on some pipelines, the requirement for a daily auction

may give large customers greater leverage over pipelines in negotiating

renewal contracts. When a large customer's firm contract expires, it

may well decide not to renew that contract and to submit low bids for

capacity in the daily auction. If the purchaser is the principal, if

not the only, shipper for a large block of pipeline capacity, it could

be reasonably confident that it would not be outbid by other shippers.

There are potential approaches to address these kinds of cost

recovery problems if they materialize, without rejecting the benefits

of an auction process. One set of possibilities is for pipelines to

charge a fixed access charge to all customers using its system to

recover fixed costs or a volumetric usage charge designed to recover

the fixed costs of the system. These are similar to methods that are

being considered in connection with congestion pricing in the electric

industry.73

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\73\ These options are discussed in the NOI on long-term

services which is being issued contemporaneously with this NOPR.

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Another alternative is to allow the pipeline to set a reserve price

in the daily auction that is above variable costs, but below the

current maximum rate. In effect, this would be a minimum price floor

below which the pipeline would not have to sell. The price floor could

be established by using the dollar amounts associated with specified

cost-of-service elements, such as rate of return, or could be

established at a percentage of the maximum rate. This approach would

still provide shippers with protection against the exercise of market

power and would prevent the pipeline from discriminating in the prices

it charges to specific customers while permitting the pipeline a

reasonable opportunity to recover its fixed costs. However, preventing

the pipelines from price discriminating may still result in cost

recovery problems.

Another approach would be to limit the auction only to transactions

above the maximum rate (as converted to a daily rate). The current

regulations require a pipeline to sell capacity at the maximum rate to

all shippers, thus preventing the pipeline from withholding capacity at

the maximum rate to derive a higher price. A requirement that pipelines

must auction capacity at the market clearing price, whenever such

prices exceed the maximum rate, would continue the protection in the

current regulations. It would protect against the pipelines'

withholding capacity to raise price and would prevent them from price

discriminating between shippers, because all shippers would pay the

market clearing price. It also would help to ensure that the pipelines'

opportunity to recover their cost-of-service is not impaired. However,

such an approach would not help to constrain the pipelines' ability to

exercise market power at prices below the existing cap.

Commenters should address the merits of the potential methods for

dealing with situations in which the requirement to sell capacity

without a reserve price would result in cost recovery problems for

pipelines. Commenters also should address whether solutions should be

determined on a pipeline by pipeline basis or whether there needs to be

a uniform approach applicable to all pipelines.

3. Auction Design

The Commission recognizes the need for the auction to work quickly

and efficiently.74 Shippers buying capacity

[[Page 43000]]

not only want the ability to consummate deals quickly, they also want

the assurance they can acquire capacity in sufficient time to finalize

their gas supply arrangements. The current system, which takes four

hours, and must be completed the day prior to nominations,75

is inadequate to meet the needs of the market.

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\74\ Shippers have complained that the Commission's current

bidding process for capacity release is too cumbersome and slow. See

Secondary Market NOPR, IV FERC Stats. & Regs. Proposed Regulations

at 33,244.

\75\ 18 CFR 284.10(b)(1)(v) (1997), Capacity Release Related

Standards 5.3.2.

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An electronic auction, designed properly, can be efficient and can

operate faster than the current process of sending facsimiles and using

telephones to arrange deals. Electronic auctions used for trading

stocks and other commodities demonstrate this efficiency.

There are a variety of auction formats that would meet the

Commission's criteria as well as provide the speed the market requires.

The Commission ultimately would decide on the proper auction format. It

could do so either through this rulemaking, through a subsequent

proceeding, or by reviewing proposals on a pipeline-by-pipeline basis,

and it requests comment on which approach would be preferable. To

assist the Commission in evaluating potential auction formats, comments

should focus on the details of how the auction or multiple auctions

should be conducted and on whether a uniform auction format should be

applied to all pipelines.

For example, different auction formats could be used for intra-day,

daily, monthly, and longer auctions.76 Auctions for capacity

of one day or less could be held as part of each intra-day nomination

opportunity or could be held continuously, every hour during the

business day. Consideration also should be given to establishing

standardized parameters for recall or other conditions in order to

facilitate trading for daily or intra-day capacity. To further expedite

the daily auction, it could be integrated with the nomination process

using a computerized auction process.

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\76\ The Commission's current regulations, for instance, provide

for longer posting and bidding periods for transactions of five

months or longer than for shorter-term transactions. 18 CFR

284.10(b)(1)(v), Capacity Release Related Standards 5.3.2.

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To accomplish such integration, releasing shippers could submit

nominations establishing the minimum or reserve price or prices at

which they would be willing to sell some or all of their capacity. For

capacity the shipper wanted to use, it could establish a very high

reserve price while for capacity it clearly wanted to release it could

establish a zero reserve price. Bidders would submit nominations with

the price they are willing to pay. Pipelines would be required to offer

the released capacity along with their own available capacity. The

pipeline would then apply Commission-approved procedures to determine a

market clearing price and all bidders submitting bids above this price

would be automatically scheduled.

Auctions for periods longer than a day could use a different

format, while auctions of monthly capacity could employ posting and

bidding periods that would coincide with the industry's monthly gas

purchasing cycle. Longer posting and bidding times might be needed for

auctions of greater than one month.

The Commission also requests comment on whether alternatives to the

comprehensive auction described above would be sufficient to protect

against the exercise of market power. One possibility would be only to

require pipelines to sell available interruptible capacity to the

highest bidder. While such an approach would not cover capacity

releases or sales of pipeline firm capacity, it may be sufficient to

ensure that capacity is not withheld from the market to raise price.

For instance, it would protect against the incentives present in a

duopoly or oligopolistic market in which firm shippers and the pipeline

recognize a mutual interest in withholding capacity. If the releasing

shipper tried to withhold capacity by not releasing it, the pipeline,

under this option, would be forced to sell the resulting interruptible

capacity to the highest bidder. Pipelines already are generally

required to allocate interruptible capacity based on price when they

are unable to satisfy all nominations for interruptible service at the

maximum rate.\77\ While this proposal would expand the requirement to

all transactions, it could be implemented using the same process.

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\77\ See Sea Robin Pipeline Company, 81 FERC para. 61,041, at

61,225 (1997); Pacific Gas Transmission Company, 76 FERC para.61,258

(1996).

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The information the Commission is proposing to require pipelines to

provide is intended to enable the market to effectively monitor

transactions. Indeed, the knowledge that information will be provided

to the market should itself act as a check against anticompetitive

transactions.

D. Information Reporting and Remedies for the Exercise of Market

Power

1. Reporting Requirements

In creating a competitive marketplace, information plays a crucial

role. Equal access to relevant information is necessary for shippers to

make informed decisions about capacity purchases and for markets to

perform efficiently. Market information also is needed so that the

Commission and shippers can monitor transactions to determine if market

power is being exercised.

The information needed by the market, both for decision-making and

monitoring purposes, falls into three general categories: information

on capacity availability, information on the structure of the market,

and information on capacity transactions, such as rates, contract

duration, and contract terms. Information on the amount of capacity

available at receipt and delivery points and on mainline segments as

well as on the daily amount of capacity that pipelines schedule at

these points will help shippers structure gas transactions and cast

light on whether shippers or the pipeline may be withholding capacity.

To assess market structure, shippers and the Commission need to know

who holds or controls capacity on each portion of the pipeline system

so they can determine the number of potential sources of capacity.

Transactional information provides price transparency so shippers can

make informed purchasing decisions as well as permitting both shippers

and the Commission to monitor actual transactions for evidence of the

possible exercise of market power.

The current regulations already require the posting of much of the

needed information. The proposals here would require expansion of these

current reporting requirements, but such expansion appears justified to

give shippers the information they need both for competitive and

monitoring purposes. Moreover, in some cases, the proposals are

designed to ensure that the same information is provided for competing

types of capacity. For instance, detailed information on capacity

release transactions, including the releasing and replacement shipper

names, the rate paid, and points covered by the release are already

being posted at the time of the transaction.78 In contrast,

pipelines are only required to file limited information on their

discount transactions well after the transaction has taken

place.79

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\78\ 18 CFR 284.10(b) (1)(v), Capacity Release Related Standards

5.4.1, 5.4.3.

\79\ 18 CFR 284.7(c) (6).

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[[Page 43001]]

a. Information on Available Capacity. For capacity availability,

the current regulations require posting of information about the amount

of operationally available capacity at points and on the

mainline.80 But, in order to effectively determine whether

capacity is being withheld, information also is needed to show the

total design capacity of the point or segment and the amount scheduled

on a daily basis. The Commission proposes in proposed section 284.14(d)

to add this information to the posting requirements.

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\80\ 18 CFR 284.8(b) (3); 18 CFR 284.10(b) (1) (iv) (1997),

Electronic Delivery Mechanism Related Standards 4.3.6; 18 CFR

284.10(b) (1) (v), Capacity Release Related Standards 5.4.13.

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The Commission also proposes, in proposed Sec. 284.14(d) to require

pipelines to post information on planned and actual maintenance or

system outages that would reduce the amount of capacity available.

While some pipelines currently post such information, it is not

currently a Commission requirement. Shippers can better make decisions

about their use of capacity if they know whether the available capacity

will be reduced on a particular day. Such information will also help in

monitoring capacity withholding by revealing reasons for reductions in

scheduled quantities.

b. Information on Market Structure. With respect to the structure

of the marketplace, pipelines currently file with the Commission, and

post on their Internet web sites, an Index of Customers, which (under

Sec. 284.106(c)(3) of the regulations, new Sec. 284.14(b)) provides

information on the names of shippers holding firm capacity, the amount

of capacity they hold, and the duration of their contracts. But the

Index of Customers does not provide information on the capacity path

held by the shipper, so the data cannot be used to determine which

shippers can compete in providing capacity on segments of the pipeline.

The Commission, therefore, proposes to add a requirement, in proposed

section 284.14(b), to include in the Index of Customers the receipt and

delivery points held under the contract, the zones or segments in which

the capacity is held, and the shipper's contract number. The contract

number is needed on the Index of Customers as well as on the report of

capacity release transactions so capacity can be traced through release

transactions to reveal how much total capacity each shipper holds.

Since the current capacity release requirements do not include the

contract number, the Commission is proposing to require that the number

be provided.

In addition, to permit effective monitoring of the capacity held on

pipelines, it is necessary to know affiliate relationships, which may

affect the amount of capacity held by a single parent entity. The

Commission, therefore, proposes to add a requirement in proposed

section 284.14(b) that pipelines disclose in the Index of Customers any

affiliate relationship between the pipeline and the holder of capacity

and any affiliate relationship between holders of capacity.

Additionally, the Commission would require disclosure of affiliate

transactions in capacity release transactions.81

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\81\ Some pipelines now require disclosure of affiliate

transactions for capacity release transactions. 18 CFR 284.10(b) (1)

(v), Capacity Release Related Standards 5.4.3. This requirement

would become mandatory for all pipelines under this proposal.

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The Commission also is proposing to expand its affiliate

regulations to provide more information to permit monitoring and self-

policing of affiliate transactions. The Commission is proposing to add

a new section 161.3(i) and revise section 284.286(c) to require

pipelines to post on their web sites organizational charts, and job

descriptions, including the names of senior employees,82 for

the pipeline, its marketing affiliates, and gas sales operating

units.83 The pipeline would not be required to include

employees whose duties are purely clerical or those who do not have

access to information concerning the processing or administration of

requests for service (such as employees who operate or repair the

pipeline facilities). The Commission also is proposing to include in

the Internet posting the list of the operating personnel and facilities

shared by the interstate pipeline and its marketing affiliate or gas

sales operating unit. The pipelines currently provide this information

in their tariffs, under Sec. 250.16(b)(1), and this requirement will

make all affiliate information easily available on the Internet. The

Commission has adopted a similar requirement in the electric industry

to help monitor, and protect against, improper communications between

transmission and wholesale merchant function employees.84/

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\82\ Senior employee would be defined as an employee who

supervises non-clerical employees engaged in transmission/

reliability or gas marketing functions.

\83\ Contemporaneously with this NOPR, the Commission is issuing

a final rule adding a requirement to 18 CFR 161.3 requiring

pipelines to post the names and addresses of their marketing

affiliates on their web sites. Reporting Interstate Natural Gas

Pipleline Marketing Affiliates on the Internet, Docket No. RM98-7-

000. For the NOPR, see Reporting Interstate Natural Gas Pipeline

Marketing Affiliates on the Internet, Notice of Proposed Rulemaing,

63 FR 27526 (May 19, 1998), IV FERC Stats. & Regs. Proposed

Regulations para. 32,530 (May 13, 1998). Should the Commission adopt

the regulations proposed in this NOPR, the changes could be

consolidated with the requirement for posting affiliate names and

addresses.

\84\ American Electric Power Service Corporation, 83 FERC para.

61,357 (1998).

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In addition, in the current market, shippers may be using agents or

asset managers to manage their capacity and such managers may be given

wide latitude over the way in which capacity is used. The Commission,

therefore, is proposing to add a requirement in Sec. 284.14(b) that

pipelines disclose such agents or asset managers when they control 20%

or more of capacity in a pipeline rate zone, as well as the rights of

the agent or asset manager with respect to managing the transportation

service. This information would help to show the degree of control over

pipeline capacity that an agent or asset manager may exercise.

c. Transactional Information. Pipelines already provide

transactional information for their own capacity transactions and for

capacity release transactions, although the type of information and the

manner of accessing it differ. For capacity release transactions,

pipelines provide via the Internet the names of the releasing and

acquiring shippers, the price, the receipt and delivery points under

the deal, the quantity of capacity traded, and the duration of the

deal.\85\ This information is posted immediately upon consummation of

the transaction. The information provided about pipeline transactions

is not as complete, nor is it as timely or as easy to access. Pipeline

discount reports are filed, but not posted, 15 days after the close of

the billing period applicable to the transaction and include only the

rate paid and the maximum rate, but do not include any information on

volumes, the receipt and delivery points under the transaction, or the

duration of the deal.\86\

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\85\ 18 CFR 284.10(b)(1)(v), Capacity Release Related Standards

5.4.1, 5.4.3.

\86\ 18 CFR 284.7(c)(6).

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To assure parity of transactional information, the Commission

proposes, as described, to require the pipelines to provide the same

information about their transactions as is currently provided about

capacity release transactions. The Commission recognizes that some

pipelines and shippers have previously expressed concern about posting

information on shipper names to preserve

[[Page 43002]]

confidentiality. However, shipper names currently are posted for

capacity release transactions and the Commission is unable to see how

other shippers can effectively monitor transactions for favoritism if

names are not provided.

In many cases, much of the transactional information would be

provided in a properly designed, transparent short-term capacity

auction. To ensure that the information is provided, the Commission is

proposing to add a new section, 284.14(c), that would require pipelines

to post on their Internet web site, and provide downloadable files of,

transactional information about their own capacity transactions and

released capacity transactions. For firm service, the Commission

proposes that the pipelines provide contemporaneously with the

execution of the contract, the same information already posted for

capacity release transactions: the parties to the contract; the

contract number for the shipper receiving service and for the releasing

shipper; the rate charged under each contract; the duration of the

contract; the receipt and delivery points and mainline segments covered

by the contract; the contract quantity; any special terms and

conditions applicable to the contract; and any affiliate relationship

between the pipeline and the shipper or between the releasing and

replacement shipper. For interruptible transportation, the following

information on a daily basis would be required: the name of the

shipper; the rate charged; the receipt and delivery points and mainline

segments over which the shipper is entitled to nominate gas; the

quantity of gas the shipper is entitled to nominate; and any affiliate

relationship between the shipper and the pipeline.

2. Remedies if the Exercise of Market Power Is Found

While the Commission's proposals should enhance efficient

competition and mitigate market power, the Commission is committed to

take remedial action when pipelines or shippers exercise market power.

Because the facts of each such case would be different, it is difficult

to describe in advance the type of remedy the Commission would impose

if market power is being exercised, and not all remedies would be

appropriate in every case. As a general matter, the Commission's

preference would be to use a structural remedy that would enhance

efficient competition. Examples of such remedies would include revising

contractual provisions that inhibit competition, strengthening the

capacity auction requirement, requiring pipelines to build taps to

increase access to capacity, or conducting auctions to determine

whether sufficient demand exists for additional construction. Another

potential remedy would be to use a benchmark for regulating price

increases based on price changes in comparable competitive markets.\87\

Reimposition of some form of price cap also would be a possible option

if other available remedies are not adequate. Commenters should address

the potential remedies suggested here as well as suggest other possible

remedies.

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\87\ See Buckeye Pipe Line Company, 53 FERC para. 61,473, at

62,683 (1991) (basing price changes in non-competitive markets on

the changes in competitive markets).

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IV. Penalties and Operational Flow Orders

A major goal of the changes proposed in this NOPR is to improve

competition in the short-term market both to improve the efficiency of

the market and to protect against the potential exercise of market

power. To improve efficiency and competition across the pipeline grid,

the Commission previously has adopted standards, promulgated by GISB,

as well as the Commission's own standards governing business practices

and electronic communication. But these standards have only partially

addressed the effect that pipeline operational flow orders, tolerances,

and penalties have on competition across the pipeline grid.

Penalties and operational flow orders (OFOs) are necessary tools to

deter shipper behavior that threaten the integrity of the pipeline

system. At the same time, they have a significant effect on efficiency

and competition by restricting shippers' abilities to effectively use

their transportation capacity. As just one example of the interrelation

between penalties and the short-term market, penalty levels can affect

the value of capacity in the short-term market; shippers needing gas

might be willing to buy transportation capacity at any rate less than

the penalty they would have to pay if, for instance, they overran their

contract entitlement. In this section, the Commission considers reforms

to its policies for regulating OFOs and transportation penalties to

ensure that they can continue in their legitimate role of protecting

pipeline integrity, while not unnecessarily limiting or restricting

competition in the marketplace.

These policies have their origin in the regulatory reforms

instituted by the Commission in Order No. 636. To promote competition

in the sales and transportation markets, Order No. 636 required that

pipelines unbundle sales and transportation services. The bundled sales

service provided considerable flexibility for the pipeline in how it

would meet the requirements of its customers, particularly on peak

days. In the implementation of Order No. 636, the Commission was

particularly concerned that the unbundled transportation services be as

reliable as the bundled sales service the pipelines previously

provided.

To address that concern, the Commission accorded each pipeline

considerable discretion and authority to operate its system to ensure

its reliability, particularly during peak and emergency times. One

important tool the Commission has sanctioned is the use by pipelines of

OFOs that can restrict service or require shippers to take particular

actions. As examples, Commission-sanctioned OFOs can: reduce or

eliminate tolerances for imbalances or contract overruns; institute

severe penalties; restrict intra-day nominations; restrict or eliminate

the use of secondary receipt and delivery points; and restrict firm

storage withdrawals and eliminate interruptible storage withdrawals.

Another means the Commission has provided pipelines to protect

system reliability is the approval of tariff penalties designed to

deter shippers from creating imbalances or from overrunning contract

entitlements. The Commission has approved particularly high penalties,

with little or no tolerance for imbalances or overruns, applicable

during peak or emergency periods to protect pipeline reliability. The

Commission also has approved penalties, usually at lower dollar levels

and greater tolerances, applicable during non-peak times to help ensure

that shipper imbalances or overruns do not create emergency conditions

on a pipeline that could have been prevented or minimized.

The Commission believes that a review of present policies and

pipeline practices in these areas is appropriate as part of the new

approach to pipeline regulation proposed in this NOPR-- and

particularly its objective of promoting competition in the short-term

market.

On initial review, it appears that some pipeline practices and

Commission policies regarding penalties can inhibit competition not

only with respect to transportation, but also in the sale of natural

gas. For example, an OFO that eliminates a secondary receipt point for

a shipper may eliminate the shipper's access to alternate suppliers

with the lowest priced gas or force the shipper to

[[Page 43003]]

points where it has no purchase or sales agreements. An OFO that limits

or eliminates a shipper's storage withdrawals may require the shipper

to purchase more costly gas on the spot market if the OFO allows the

shipper to shift to new points. The longer OFOs are in effect, the more

restrictive they become. Across all customers, OFOs may fragment

markets by making it impossible for many potential sales of gas or

transportation services to take place.

High penalties on contract overruns or imbalances as well as low or

no tolerances during peak periods may also operate to limit and distort

market forces. For example, not all shippers have immediate access to

metering information on their imbalances or even the volumes of gas

they receive at their delivery points. This lack of information may

adversely affect shippers in several ways. For example, to avoid

overrun and/or imbalance penalties, shippers may not maximize use of

pipeline transportation, and shippers may contract for more

transportation capacity than they need. Also, the lack of information

on imbalances and delivered volumes may inhibit shippers from trading

imbalances or transportation capacity that could alleviate or prevent

system operational problems.

The presence of severe penalties/tolerances during peak or

emergency periods also may preclude other uses of market forces that

could alleviate or prevent system operational problems. For example, a

shipper that delivers more gas than nominated into a pipeline when the

pipeline is short of gas would help to maintain system integrity. Yet,

under most currently approved tariff provisions, the shipper could be

penalized for doing so.

Moreover, Commission-authorized penalties may provide an

opportunity for shippers to engage in a form of penalty arbitrage. For

example, during the 1995-96 winter there was a shortage of natural gas

to serve Chicago markets. Shippers reacted by intentionally overrunning

contract entitlements on those pipelines and LDCs that had the lowest

penalties for contract overruns. 88 In that situation,

penalties appeared to have skewed choices shippers might otherwise have

made. The consequence was that pipelines in the Chicago area appear to

have entered into bidding wars for the highest overrun/imbalance

penalties, with penalties for large variances running as high as $200/

dth.89

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\88\ See Industry Surveys the Damage as Winter's Strength Runs

Out, Natural Gas Intelligence, April 22, 1996, at 1; Freezer Burn,

Gas Daily's NG, April 1996, at 30.

\89\ See Panhandle Eastern Pipeline Company, 78 FERC para.

61,202, at 61,876 (1997)(penalties ranging from $25 per Dth for

variances of 5-10% to $200 for variances over 50%).

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The fluctuation of transportation values also supports a

reexamination of Commission policies on OFOs and penalties. As

discussed earlier, the value of transportation varies widely. For

example, as shown on the earlier graph, during the winter of 1996-1997,

the value of capacity was double the maximum rate, while during the

winter of 1995-1996, spikes occurred on several occasions to much

higher levels, with the highest value reaching $10/MMBtu.90

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\90\ See text accompanying note 22, infra.

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The fluctuation in short-term transportation values during peak

periods suggests the need to increase opportunities, as much as

practicable, for shippers to obtain transportation services at the

lowest competitive price during such times. Yet, the pipelines' current

OFO and penalty structures may restrict shippers' options more than is

necessary.

Current pipeline tariff provisions for remedying monthly imbalances

of a shipper--often described

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