FERC’s ‘Workable Competition’ Standard: A 1992 Note for Today

“What is underemphasized or missing in the working paper is consideration of real-world competition as the industry understands it. In other words, rate discounting, surplus capacity, new entry and bypass, alternative fuel competition, and other factors make markets very competitive whatever the market shares of its individual participants.”

“[FERC] never considers the imperfections of regulation itself. It is assumed that regulation is a costless alternative to correct imperfect pipeline markets.”

In a previous life, I worked for an interstate gas transmission company that was rate- and service-regulated by the Federal Energy Regulatory Commission (FERC). During this time, I tried to make a case for deregulation where both entry/exit and rates would not be regulated under cost-based public utility regulation.

Following neoclassical economics, FERC did not consider interstate pipelines “workably competitive.” Using a technical approach instead of a common-sense, real world approach, FERC could not see what those in the business saw on a day-to-day basis: that the pipeline business was very competitive, and discounts from maximum rates proved so.

Also, FERC’s static view of competition failed to appreciate dynamic efficiency where ‘monopolistic’ action by existing pipelines would spur new entry and other forms of competition.

I wrote this memo, dated December 15, 1992, to executives at Transwestern Pipeline Company (Enron Corp.), titled “Evaluation of FERC Discussion Paper Assessing Competition in Natural Gas Transportation.” My audience ‘got it,’ the difference between overly theoretical economics and real world (market process, ‘Austrian’ economics). But I had no audience at FERC….

Dick O’Neill and his staff at the FERC’s Office of Economic Policy have prepared a working paper to evaluate whether natural gas transportation markets are workably competitive. The working paper and its appendices are very technical, manipulating market concentration ratios to arrive at a structural test for pipeline markets.

What is underemphasized or missing in the working paper is consideration of real-world competition as the industry understands it. In other words, rate discounting, surplus capacity, new entry and bypass, alternative fuel competition, and other factors make markets very competitive whatever the market shares of its individual participants.

For example, the California gas market is not workably competitive under the HHI index because one supplier (El Paso) has a market share over 50% (or HHI of over 2,500). Yet this market is extremely competitive because a 20% capacity surplus has forced discounting by pipelines to attract incremental business.

Second, the static approach of formal modeling to measure competition ignores the fundamental points that competition is a process and not a state. In other words, to the extent that an imperfect market allows transporters to earn monopoly rents or offer inferior service, incentives are created for existing suppliers or new suppliers to rectify the situation. Point-in-time analysis misses the fact that markets are often self-correcting as entrepreneurs continually try to improve upon the status quo.

Third, the paper never considers the imperfections of regulation itself. It is assumed that regulation is a costless alternative to correct imperfect pipeline markets. If the working paper assessed a realistic estimate of the cost of FERC regulation, then a range of alleged pipeline-market imperfections could be accepted as optimal. Policy reform could also focus on removing anti-competitive regulations to allow pipeline markets to be workably competitive.

The working paper reflects one school of thought on the competition issue—the so-called “structure-conduct-performance” school. In the last decade, however, a new orthodoxy has emerged. The so-called “New School” or “Chicago School” of industrial organization tends to a process view of competition and emphasizes institutional factors such as asset specificity and transaction costs to explain

i) how industrial concentration had emerged and

ii) the high cost of imposing atomistic competition.

As Paul MacAvoy recently told the INGAA board on this issue, the Chicago School is now the dominant one in the profession.

Although a quarter century old, the arguments of this memo still stand tall. With the new political winds of change at FERC, a new theory of competition could inspire a reinterpretation of “just and reasonable” ratemaking under the Natural Gas Act of 1938.