When Utility Gas Affiliates Play by Monopoly Rules, Consumers Are Likely to Lose
Can monopolies with market power send business to other regulated monopolies? Can one monopoly create a “need” for which ratepayers will be charged by another related monopoly? As it stands right now, the answer to both these questions is yes. In the United States, we see utility holding companies owning up to eight regulated energy businesses in different affiliated corporations. Opportunities for self-dealing abound. Rules designed to govern transactions between regulated companies and their affiliates are in place in a few cases. Yet they form an inconsistent patchwork, with loopholes where states cannot act and federal agencies either have not stepped in or have been ineffective. Utilities by their very nature have “captive customers” who can be forced to pay for a service procured from an affiliate, regardless of whether that service is provided at an economical cost.
The separation of local gas distribution companies (LDCs) from their interstate pipeline-owning affiliates—and indeed from electric generation-owning affiliates and gas pipeline and distribution companies—has not been a focal point of regulation. But the question of these “codes of conduct” is increasingly important, and given the gaps in state-level rulemaking, may be an area where federal regulators need to step in.
How affiliates are regulated
Jurisdiction over various activities of a utility holding company and its affiliates is divided among states and the federal government. A holding company can own affiliates that:
- (1) own power plants/generation, (2) act as electrical distribution companies, (3) sell retail electricity, and (4) own local gas distribution companies, all activities primarily regulated by state utility commissions;
- (5) build and own bulk electric transmission, (6) build and own large interstate gas pipelines, and (7) buy and sell wholesale electricity, all activities primarily regulated by the Federal Energy Regulatory Commission (FERC); or
- (8) buy and sell gas supply, an activity primarily regulated by the Commodity Futures Trading Commission.
Six of these business activities have strong natural monopoly characteristics, which is why they are regulated (the exceptions are buying and selling natural gas and owning power plants, and some states continue to regulate the latter activity). Yet via their connections to affiliates, holding companies can create uncompetitive preferences for uneconomic investments, which are neither transparent nor scrutinized across these eight utility business types that can give higher prices or contracts to each other. This happens to the detriment of captive ratepayers, who always pay in regulated monopoly markets.
The lack of federal and state regulatory attention enables this opportunity for self-dealing. This can be seen in proposals for ratepayers to pay for large capital investments—at ample, FERC-regulated federal rates of return—that are rationalized by reliance on a “need” manufactured by contracts signed with a corporate affiliate. The appearance is one of captive ratepayers underwriting substantial returns on new capital investments by another member of the utility’s corporate family, investments that may or may not actually be needed because there is no arm’s-length transaction.
When restructuring of the electricity industry occurred in some U.S. regions in the late 1990s and early 2000s, a lot of effort at both the FERC and state levels went into developing appropriate codes of conduct to ensure corporate separation between regulated transmission and distribution affiliates and unregulated (or less regulated) generation and load-serving entity affiliates. This was necessary because of the concern that under the holding company structure, one business affiliate can “help” another to the detriment of ratepayers and the competitive markets. In the extreme, a regulated T&D utility could provide preferential energy transmission service or interconnection treatment to its own generation affiliate. For that reason, both FERC and many states require strict separations and impose codes of conduct limiting communications between affiliated companies. Many states also require verified arms-length procurement practices to avoid the risk of self-dealing. These codes of conduct and separation address vertically integrated monopoly interactions with unregulated affiliates.
But there are no similar separations and codes of conduct between affiliated businesses that are “horizontally” related. FERC Commissioner Richard Glick flagged this issue in January when he dissented from FERC’s approval of Penn East’s construction of an interstate gas pipeline. Glick pointed out that affiliates of PennEast hold more than three-quarters of the pipeline’s subscribed capacity and noted: “While I agree that precedent and service agreements are one of several measures for assessing the market demand for a pipeline, contracts among affiliates may be less probative of that need because they are not necessarily the result of an arm’s-length negotiation.”
Affiliates and the push for pipelines
More disturbing is a recent study by university researchers and the Environmental Defense Fund (EDF), which found a pattern on gas pipelines feeding New England in which affiliates of two major utilities reserved capacity for no apparent reason, creating an artificial supply constraint. This constraint pushed both natural gas and electricity prices higher during periods of high demand, including during the polar vortex of 2014–2015, costing New England ratepayers an additional $3.6 billion due to unreleased capacity that restricted natural gas imports during periods of need. Those same utilities own generation that benefits from higher electricity prices, and would collect a portion of the $3.6 billion as higher electricity prices. This study has now been peer-reviewed and published as a working paper by the widely respected Resources for the Future.
It is disturbing because both utilities examined in the EDF study also have affiliates with interests in additional natural gas pipelines proposed for New England. These new pipelines would cost ratepayers $3 billion to $6 billion more in capital and utility returns over many years—and their proposed construction is rationalized by a need to relieve supply congestion that would appear to have been created at least in part by affiliates of these same utilities.
FERC’s recent cryptic announcement that its review of the EDF study did not find “manipulation” misses the point that the practices cited could have resulted in billions in economic losses for New England ratepayers as well as justified billions more in new pipelines. Yet FERC’s rules arguably allow for this type of capacity withholding exactly when the pipelines are needed for both electricity and heating needs in New England. In short, the capacity reservations EDF found may have been an entirely “legal” manipulation.
Because jurisdiction over these horizontally related businesses is divided between federal and state authorities, and attention to their activities can therefore be uneven, it is unclear whether state utility commissions have the authority to act to address such situations as New England experienced. FERC clearly does have some authority. That, in turn, prompts the question of whether FERC should re-examine its current electrical market and gas market separation rules as the electricity sector continues to shift toward natural gas. Federal regulators are in the best position to ensure gas pipeline capacity is available—and not tied up in paperwork—when customers facing a cold snap need heat and electricity.