Who Pays, Who Benefits, and Adequate Investment in Natural Gas Infrastructure

By Tye, William B Garcia, Jose Antonio

I. INTRODUCTION, OBJECTIVES, AND CONCLUSIONS[dagger] The issue of who should pay for natural gas pipeline capacity expansions and how the rates should be structured has been a subject of debate among interested parties during the past few years. The issue is whether the cost of a pipeline expansion should be borne only by the new expansion customers (incremental rates), or whether a pipeline company can spread the cost of providing the new service over all its customers, both existing and new (rolled-in rates).

On September 15, 1999, the Federal Energy Regulatory Commission (the FERC or the Commission) issued a Policy Statement, Certification of New Interstate Natural Gas Pipeline Facilities (1999 Policy Statement).1 The 1999 Policy Statement was a refinement of a policy statement issued in 1995 (1995 Policy Statement).2 Before the FERC’s 1999 Policy Statement, the Commission applied a presumption in favor of rolled-in rates when the cost impact of the new facilities would result in a rate impact on existing customers of five percent or less and some system benefits would occur. The 1999 Policy Statement, on the other hand, established that the threshold applicable to existing pipelines is whether the project can proceed without subsidies from their existing customers. This generally means that expansion projects will be priced incrementally, so that expansion shippers will have to pay the full costs of the project, without subsidy from existing customers that could lead to uneconomic expansion and discourage entry by new pipeline companies. However, the 1999 Policy Statement acknowledges that there are cases where costs can be rolled-in (for instance, “inexpensive expansibility” made possible because of earlier costly construction, existence of vintage capacity, or where facilities are needed only to improve service for existing customers).3 The absence of pipeline-to-pipeline competition has also been presented as a justification to permit rolled-in pricing.

The relevant academic literature on pricing of capacity pipeline expansions, as well as the more general literature on public utility pricing, shows that the desirability of rolled-in or incremental pricing as the most efficient and equitable policy depends on the particular characteristics of the project at issue and the particular ratemaking goals the author treats as paramount. It also supports the idea of considering all of the costs and benefits of a project in the test of public convenience and necessity. Any bias in favor of incremental pricing might then prove as harmful as any bias in favor of rolled-in treatment. An analysis of the relevant economic principles and their implementation in specific cases leads to the conclusion that a generalized bias towards incremental pricing is neither economically efficient nor equitable: (i) forcing pipelines to support new projects financially without relying on charges from existing customers fails to consider that many projects create significant benefits that go beyond just direct benefits to incremental customers; (ii) it may promote inefficient subsidization from new customers to existing customers; (iii) it would promote a risk-reward imbalance among industry participants that would strongly discourage the investment in pipeline infrastructure necessary to achieve system benefits and grid efficiency; (iv) it may promote undue discrimination in favor of existing customers who impose the same incremental costs but pay lower rates; and (v) it fails to achieve an equitable sharing of the costs and benefits of new additions since existing customers do not pay for the benefits they enjoy.

The natural gas industry is currently facing short-term and long- term interrelated concerns that can have disastrous consequences on domestic manufacturing competitiveness and consumer benefits: mainly, price spikes and price volatility, lack of adequate basic infrastructure connecting supply with demand, insufficient gas supply and the high vulnerability to a numerous range of hazards (for instance, coordinated terrorist attacks on energy infrastructures, natural disasters-hurricanes, earthquakes, floods, landslides, forest fires-or unintentional human errors).

The burden of the risk of cost recovery under incremental pricing, the forced roll-in of successful projects-i.e., projects in which incremental revenues are in excess of incremental costs-to confer their net benefit to existing customers, the possibility of later switching methods under “changed circumstances,” the reluctance of pipeline customers to sign long-term contracts and the increased contractual flexibility granted to shippers during the last five years due to the Commission’s open access policies Order 6364 and Order 6375 will tend to discourage the efficient investment of pipeline expansion to prevent bottlenecks, to assure system reliability, and to serve future demand additions. The huge cost of not having enough investment in core infrastructures justifies the immediate reconsideration of any policy that would create a bias in favor of incremental pricing. The implementation of an unbiased pricing policy will provide better incentives to the market participants to invest in needed basic infrastructures that will ultimately increase the flexibility of the energy system. This flexibility adds both reliability and security to the energy network.

The main objectives of this article are threefold. First, we introduce the main policy changes affecting the authorization and pricing of pipeline projects since 1960. We focus our analysis on the 1999 Policy Statement, since it constitutes the current analytical framework in certificate proceedings. second, we present an overview of the academic-economic literature on pricing of natural gas pipeline expansions. Our objective is to review the main economic arguments in favor of or against the use of rolled-in pricing methodology versus incremental pricing. Third, we provide an economic evaluation of any policy that would create a presumption in favor of incremental pricing. We recommend a balanced approach that would depend on the particular circumstances of the project, consider all the costs and benefits of a project (not just the benefits that can be financed out of charges to new customers) and eliminate any biases toward rolled-in or incremental pricing: (i) for those investments that grant benefits only to the existing ratepayers the only real solution is to roll-in the costs; (ii) unless there are extenuating circumstances, brand-new pipeline projects or expansion projects that are not part of a mainline system and confer benefits only to new customers should be financed entirely on an incremental basis; (iii) finally, the in-between cases, where benefits are conferred on preexisting and new customers, would be dealt with on a case-by-case approach to allocate the costs fairly. We believe that improved decisions can be readily achieved by simply articulating and applying a more clearly balanced policy. We believe this approach that corrects any perceived general bias in favor of incremental pricing can be easily accomplished within the framework of the 1999 Policy Statement. To erase all doubt, the Commission should clarify that projects will be evaluated by an unbiased, case-by-case approach. Any bias toward incremental pricing would apply only to projects that provide benefits only to new customers. As always, projects to create system benefits for existing customers would be automatically rolled in. Hybrid projects would be financed by a fair allocation of the costs based on cost-causation and benefits received. The implementation of these policies could be improved by clarifying the implementation of some of the methodologies to eliminate uncertainties and possible errors.

II. POLICY CHANGES ON AUTHORIZATION AND PRICING OF PIPELINE PROJECTS

A. “Battle Creek” Test

The Commission first set forth its factors to determine whether rolled-in rates are appropriate in 1960 in Battle Creek Gas Co. v. FPC.6 Under what has come to be known as the “Battle Creek” test, the Commission stated that it would permit rolled-in rates when expansion facilities are integral to the mainline system and are shown to grant positive benefits to all customers of the system.

Under the Battle Creek test, once facilities are found to be integrated into the mainline system and to provide a positive benefit to all customers, the costs of those facilities are considered to be part of the pipeline’s cost of serving all its customers. That is because the demand of all customers for system capacity creates the need for system expansion.

The Commission then concluded that “[b]ecause every shipper is economically marginal, the costs of increased demand may equitably be attributed to every user, regardless when it first contracted with the pipeline.”8’9

[T]he rolled-in approach ensures that two otherwise similar customers will not pay radically different prices for commingled gas coming from the same pipe, merely because one happens to have been receiving the service longer than the other. Use of the rolled-in method thus serves the interest of equal treatment for customers receiving equal service. Interestingly enough, the Circuit Court of Appeals for the District of Columbia recognized in the Battle case that either incremental pricing or rolledin pricing may be the most appropriate methodology depending on the particular characteristics of the project at issue.11 The Court recognized the value of rolled- in pricing since it recognized that:

[a] gas pipeline of this sort is not just a collection of discrete pieces and parts, but an integrated system serving all of its customers. Applying this approach the cost of the various assets of the system are collected or “rolled in” to arrive at the cost of the entire system which is then pro-rated among all of the customers.

However, the Court also noted that there are circumstances under which the use of incremental pricing may be optimal:

[u]se of a “rolled-in” approach alone is not adequate in all situations, particularly where some assets are used by the utility solely for the benefit of one customer. . . . At this point the facility becomes so identified with its function as a part of the local distributor’s gas plant that it may be unfair to charge its costs to all of the customers of the utility. This is particularly so where the extent and cost of such segregated facilities vary greatly among the customers. In such a situation the costs of these facilities are commonly charged as an “incremental” cost added in to the particular customer’s rate base.

This is precisely the kind of unbiased, flexible approach we urge below.

In 1991 two important decisions provided further guidance on the standard of proof to justify rolled-in pricing. In Algonquin Gas Transmission Co. v. FfAC14 the Appeals Court required the Commission to justify rolled-in pricing with substantial evidence that new facilities produce integration and system-wide benefits to customers.15 Furthermore, in Great Lakes Gas Transmission,^ the Commission abandoned its traditional standard (the Battle Creek test) and required a tougher standard of proof for rolled-in pricing. Rather than the twopart Battle Creek test (proof that the system was integrated and that qualitative benefits accrued to all customers as a consequence of the expansion), the FERC applied a “commensurate benefits” test, in which it compared the cost of expansion with the benefits accruing to existing users.17 The pipeline has to justify rolled-in rates by “showing that systemwide benefits to existing customers are commensurate with the increase in rates.”18

B. The 1995 Pricing Policy Statement

The 1995 Pricing Policy Statement amended the Battle Creek test and elucidated the FERC’s policy with respect to pricing of expansion facilities. According to Morgan, et al,19 the Commission designed the 1995 Pricing Policy Statement to minimize the impacts of two main concerns:

[(i)] [t]he [Commission was [worried] that the Battle Creek [T]est had resulted in a historical preference for rolled-in pricing that potentially required the pipeline’s existing customers to pay substantially higher prices without receiving proportionate system[- ]wide benefits[;] [and (U)] … the [Commission believed that the potential for subsequent price increases unduly harmed customers with long-term service contracts.

The 1995 Policy Statement sought to provide as much up-front assurance as possible of how an expansion would be priced so that the pipeline and expansion shippers could make informed investment decisions. Therefore, the Commission permitted pipelines to request in the certificate proceeding a determination of whether rolled-in rates would be appropriate in the next rate case. The Commission stated it would consider the extent to which the new facilities were integrated with the existing facilities and the specific system benefits produced by the project. When the roll-in of the costs of the new facilities caused a small rate impact (less than five percent), the proponents of roll-in only needed to make a general showing of system benefits.21 If the rate impact was above "5 percent, incremental pricing was thought to be appropriate unless there were system[-]wide benefits.”22 Under this scenario, the proponents of rolled-in rates had to show that the benefits were proportionate to the rate impact.23 Regulators took the view that existing customers should be able to share in the scale economy benefits created by the expansion of an existing system.

C. The 1999 Certificate Policy Statement and its Application

1. The 1999 Policy Statement and its Objectives

The 1999 Policy Statement constituted a refinement of the 1995 Policy Statement.24 The 1999 Policy Statement sets out the analytical steps the Commission will use. The first step provides that when “a certificate application is filed, the threshold question applicable to existing pipelines is whether the project can proceed without subsidies from their existing customers.”25 According to the Commission, this generally means that expansions will be priced incrementally, so that expansion shippers will have to pay the full costs of the project, without subsidy from the existing customers through rolled-in pricing. The second step in the process determines “whether the applicant has made efforts to eliminate or minimize any adverse effects the project might have on the existing customers of the pipeline proposing the project, existing pipelines in the market and their captive customers, or landowners and communities affected by the route of the new pipeline.”26 The Commission will then balance the public benefits against adverse effects in determining whether to approve the project. The Policy is summarized by the Commission in its approval of a certificate:

[u]nder this policy, the threshold requirement for pipelines proposing new projects is that the pipeline must be prepared to financially support the project without relying on subsidization from the existing customers. The next step is to determine whether the applicant has made efforts to eliminate or minimize any adverse effects the project might have on the applicant’s existing customers, existing pipelines in the market and their captive customers, or landowners and communities affected by the new construction. If residual adverse effects on these interest groups are identified after efforts have been made to minimize them, the Commission will evaluate the project by balancing the evidence of public benefits to be achieved against the residual adverse effects. This is essentially an economic test. Only when the benefits outweigh the adverse effects on economic interests will the Commission then proceed to complete the environmental analysis where other interests are considered.27

The objectives the Commission is attempting to achieve in implementing these standards are stated in its decision to issue a certificate to TransColorado Gas Transmission Company:

[o]n September 15, 1999, the Commission issued a Policy Statement providing guidance as to how proposals for certificating new construction will be evaluated. Specifically, the Policy Statement explains that the Commission, in deciding whether to authorize the construction of new pipeline facilities, balances the public benefits against the potential adverse consequences. Our goal is to give appropriate consideration to the enhancement of competitive transportation alternatives, the possibility of overbuilding, subsidization by existing customers, the applicant’s responsibility for unsubscribed capacity, the avoidance of unnecessary disruptions of the environment, and the unneeded exercise of eminent domain in evaluating new pipeline construction.

The Commission stated in its Order Clarifying the Pricing Policy Statement that the determination of whether a project was viable should be made by the market:

[t]he removal of the subsidy is necessary to ensure that the market finds the project is viable because either the pipeline or its expansion shippers are willing to fully fund the project. Having lower prices subsidized by existing customers can lead to overbuilding as new customers are wiUing to subscribe to the capacity only because the price of the capacity is subsidized.

One of the objectives of the 1999 Policy Statement was to eliminate possible subsidies to new projects by existing customers that could lead to uneconomic expansion and discourage entry by new pipeline companies:

[t]his no-subsidy requirement also is needed to ensure existing pipelines do not receive unfair advantage in competition for new construction projects with new entrant pipelines. The new entrant, by virtue of having no existing customers, must fully support a proposed project. In contrast, if the existing pipeline can receive a partial subsidy from its existing customers, this would create a bias favoring the expansion of existing facilities even where the pipeline of the new entrant would be more efficient. A rolled-in subsidy paid by the customers of the existing pipeline, therefore, may result in potential shippers favoring the less efficient project over the more efficient one.

Under the 1999 Policy Statement, the need for the pipeline will normally rely upon a market study and the applicant will not need to present contracts that sell any specific percentage of the new capacity.31 If the pipeline sponsor is bearing the risk through incremental pricing, the Commission is willing to take the sponsor’s word that there is a need for the project. Under this policy, the pipeline and its expansion customers could share the risks of the project, but they could not shift any of those risks onto existing customers.32

There are cases in which the 1999 Policy Statement explicitly recognizes that rolled-in rates are appropriate exceptions to this incremental pricing policy, such as in cases of inexpensive expansions that are made possible because of earlier costly construction, where a pipeline has vintages of capacity or if some customers have the right of first refusal to renew their expiring contracts. Customers could be allowed to renew their contracts at their original contract rate except when the incremental capacity is fully subscribed and there are competing bids for the existing customers’ capacity. In that case, the existing customer could be required to match the highest competing bid up to a maximum price set at either an incremental rate or a rolled-in rate in which costs for expansions are accumulated to yield an average expansion price, a sort of “rolled-up” rate. A requirement that the new project must be financially viable without subsidies does not eliminate the possibility that in some instances the project costs should be rolled into the rates of existing customers. In most instances incremental pricing will avoid subsidies for the new project, but the situation may be different in cases of inexpensive expansibility that is made possible because of earlier, costly construction. In that instance, because the existing customers bear the cost of the earlier, more costly construction in their rates, incremental pricing could result in the new customers receiving a subsidy from the existing customers because the new customers would not face the full cost of the construction that makes their new service possible.33

Another case where the FERC admits that rolled-in pricing would be appropriate is “where a pipeline has vintages of capacity and thus charges shippers different prices for the same service under incremental pricing, and some customers have the right of first refusal (ROFR) to renew their expiring contracts.”34

In addition, the Commission suggested rolled-in rates could be approved before the expiration of current contracts if the facilities are needed to improve service for existing customers, and raising existing customers’ rates does not constitute a subsidy of an expansion by existing customers:

Projects designed to improve existing service for existing customers, by replacing existing capacity, improving reliability or providing flexibility, are for the benefit of existing customers. Increasing the rates of the existing customers to pay for these improvements is not a subsidy. Under current policy these kinds of projects are permitted to be rolled in and are not covered by the presumption of the current pricing policy.

2. General Application of the 1999 Policy Statement

As a matter of logic, new pipeline expansion projects can be classified into three different groups according to the allocation of benefits caused by the investment in new expansion projects. At one extreme we have those projects that are planned to provide benefits only to new ratepayers (first group of projects). On the other extreme we have projects designed to provide benefits only to pre-existing customers (second group of projects). And finally, we have hybrid projects, that is, projects that provide benefits to both pre-existing and new ratepayers (third group of projects).36 Certificate orders from the Commission can be classified and analyzed according to this taxonomy, since the categories are mutually exclusive and exhaustive.

a. Projects Conferring Benefits Only on New Customers

The first group of projects introduces expansion projects designed to benefit only new customers. In principle, unless there are extenuating circumstances, brand-new pipeline projects or expansion projects that are not part of a mainline system (e.g., laterals to a single end-user) and are undertaken only for new customers should be financed on an incremental basis. However, by reviewing the certificate orders from the Commission since the 1999 Policy Statement certain vagueness comes up in the way the Commission applies the “threshold requirement” test. A first subgroup of certificate cases arises in which the Commission determined that where a pipeline proposes to charge incremental rates for service on new facilities, it automatically satisfies the “threshold requirement” of no subsidization by existing customers.37 However, in another subgroup of proceedings, the Commission concludes that there will be no inappropriate subsidy of the new project by existing ratepayers where all the costs associated with the projects are paid by the new shippers and the incremental rates paid by the new shippers are higher than those paid by the existing shippers.38 Obviously, these two tests are not identical since the first test would qualify projects that fail the second test.

b. Projects Designed to Benefit Only Existing Customers

The second group of projects comprises expansion projects characterized by system-wide benefits which are enjoyed only by existing ratepayers. Projects designed to replace existing capacity, improve reliability and provide flexibility are for the benefit of the existing customers. As a consequence, an increase in the rates of the existing customers to pay for these improvements is not a subsidy. This type of case is relatively simple to deal with since there are no new customers enjoying benefits and the only option is to roll-in the costs.39,40

c. Projects Granting Benefits to Both New and Pre-existing Customers

Finally, the third group of projects creates benefits for both new and preexisting customers. Hybrid projects are the most difficult cases because neither roll-in nor incremental pricing is the obvious choice. So far, the Commission has not faced many cases where investments simultaneously provide both types of benefits from the same facilities.41

The Commission stated in the order clarifying the 1999 Policy Statement that existing customers should pay for the costs of projects designed to improve their service by replacing capacity, improving reliability, or providing additional flexibility.42 However, it stated that this approach does not justify rolling-in the entire cost of an expansion simply because existing customers receive some positive benefit from the construction of new facilities: “there must be a specific benefit from the project for existing shippers rather than generalized benefits resulting from the project being integrated into the system.”43 The key factor as to whether to apply rolled-in versus incremental pricing to hybrid cases appears to be based on an inquiry to identify which group of ratepayers (new or preexisting customers) the project was primarily designed to benefit.44

In December 2000, the Commission denied Questar’s request for a predetermination supporting rolled-in treatment when it concluded:

While these factors may provide some benefit to Questar’s existing customers, it is clear that the project was not primarily designed to improve existing customers’ service. The M.L. No. 104 Project is an expansion project that primarily serves the specific needs of those identified expansion shippers. As the Commission explained in the order clarifying the Policy Statement, while existing customers should pay for the costs of projects designed to improve their service where the benefits are not tied to the provision of service to specific customers, this approach does not justify rolling-in the entire cost of an expansion simply because existing customers receive some positive benefit from the construction of the new facilities. In this case, the benefits of the project are tied to the provision of service to the expansion shippers. Any benefits that existing, non-expansion shippers may realize are tangential, and do not justify rolling-in the costs of this expansion project.

A similar decision was adopted by the Commission in its Order on Rehearing issued on November 8, 2005.46 In spite of the fact that the Commission recognizes that the expansion project gives shippers on the original facilities certain (although limited) access to additional supplies and reliability benefits, it found that those benefits are not specific benefits from the project but generalized benefits resulting from the project being integrated into the system. The Commission concludes that Bay Gas has not shown any real improvement in the pre-expansion service and sufficient benefits to shippers on the original facilities to justify the increase in the rates that roll-in would cause.47

The issue then in “hybrid” cases is whether there has been an evidentiary showing sufficient to justify rolled-in treatment. In Transcontinental Gas Pipe Line Corporation (March 26, 2004), the Commission affirmed the presiding Administrative Law Judge’s (ALJ’s) December 3, 2002, Initial Decision finding that rolled-in rate treatment for the Cherokee, Pocono, and SunBelt projects is not appropriate. However, it reversed the ALJ when it found Transcontinental Gas Pipe Line Corporation’s (Transco’s) proposal to roll in the costs of the Mobile Bay expansion to be just and reasonable. On August 5, 2005, the FERC issued an order denying the rehearing requests challenging the FERC’s acceptance of Transco’s proposal for rolled-in rates for the Cherokee, Pocono, and SunBelt projects.48 The Commission affirmed the ALJ’s rejection of Transco’s proposal to roll in the costs of these three projects. Like the prior Order on March 26, 2004, the Commission found that there was no evidence of any real improvement in the existing customers’ services (such as the need for fewer operational flow orders, better access to competitive gas supplies, etc.) and accordingly required that Transco implement incremental rates for the Cherokee, Pocono, and SunBelt projects. August 5, 2005, FERC Order further reaffirmed the roll-in of the Mobile Bay expansion.

In Northern Border Pipeline Company (June 13, 2006), the Commission denied rolled-in treatment to Northern Border of its gas plant acquisition adjustment. The Commission concluded that Northern Border failed to meet its burden of proof when it did not “provide evidence in two areas: (1) the rate impact of the project on existing customers[,] and (2) the specific and quantifiable benefits that accrue to the system as a result of the new capacity in comparison to the rate impact.”49 The Northern Border Pipeline Company (2005) case introduces some uncertainty in the methodology employed by the Commission to apply rolled-in versus incremental pricing in this third group of projects.50 Cases like Ouestar51 (2000) or Bay Gas Storage Company, Ltd52 (2005) suggested that the key element was to identify which group of ratepayers (new or pre- existing customers) the project was primarily designed to benefit. However, in Northern Border Pipeline Company (2005), the Commission’s language appears to suggest that revenues in excess of incremental costs is a necessary and sufficient condition for rolled- in treatment independent of who enjoys the benefits of the expansion and/or support the cost of the investment: “[g]enerally, to receive authorization for rolled-in rate treatment, a pipeline must demonstrate that the revenues to be generated by an expansion project will exceed the costs of the project.”53

The Commission issued Northern Border a certificate authorizing the expansion, subject to conditions, but denied its request for a pre-determination favoring rolled-in rates on the basis that the revenue generated by the new service using the currently effective maximum rates does not cover the cost-ofservice associated with the project.54

3. Inexpensive Expansibility Cases and the “Changed Circumstances” Argument

The first three categories classify the projects according to the distribution of benefits among existing and new customers created by the expansion investments. In addition to these three general types of projects, the Commission’s 1999 Policy Statement points to the fact that the causation of benefits can run in the other direction as well, creating a fourth category. That is, prior investments for the benefit of existing customers can create later benefits for new investment as well. The Policy Statement identifies inexpensive expansion projects providing benefits mainly to new customers that were made possible because of earlier costly expansion projects.55 Unlike the previous three groups of cases, individual proceedings under the fourth group of cases do not fall into mutually exclusive groups.

The 1999 Policy Statement correctly notes that “new customers would not face the full costs of the construction that makes [the] new service[s] possible” if incremental pricing is applied in the situation of “inexpensive expansibility,” i.e., where the inexpensive expansion of facilities was made possible because of prior costly construction.56 Since the existing customers bear the cost of the earlier, more costly construction or acquisition in their rates, incremental pricing of the expansion could result in the new customers receiving a subsidy from existing customers because the new customers would not face the full cost of the construction that makes the new service feasible. In such an instance, the Commission requires rolled-in rate treatment because it will reduce the rates of the existine customers.57

However, a certain ambiguity arises in the way the Commission applies the inexpensive expansibility test. More specifically, the actual certificate cases imprecisely define the necessary and sufficient conditions required to apply rolled-in pricing that were not clearly articulated in the Policy Statement. Two different tests seem to be applied by the Commission: (a) a two-step test in which, first, the Commission, identified either a specific prior investment that benefits new consumers, and second, it confirmed that rolling- in the costs of successful projects would produce lower rates for existing customers; and (b) a one-step test in which the inexpensive expansibility test has been reduced to merely testing whether rolling-in the costs of successful projects would lower rates for existing ratepayers.

(a) Two-step test for the approval of rolled-in projects: In a first group of inexpensive expansibility cases the Commission presented a two-step test to obtain approval of rolled-in. From the analysis of the certificate cases, it seems that the Commission uses two different methodologies to check whether rollingin a project would lead to lower existing rates. In a first subgroup of cases, the second step of the inexpensive expansibility test specifically checks whether or not rolling-in the project would generate lower rates for the existing customers. Under this subgroup of cases the “lower existing rates” test appears to constitute a necessary condition to apply the rolled-in pricing methodology under inexpensive expansibility.58 In a second subgroup of cases, the Commission does not check the effect on rates specifically but observes that incremental revenues of the proposed project exceed the incremental costs. The necessary condition to apply rolled-in pricing is thus a “revenues in excess of incremental cost” test rather than the “lower existing rates” test.59 In reality, it can be easily proved that when the “revenues in excess of incremental costs” test is met, rolling-in the project will lead to “lower existing rates” if, and only if, incremental projected revenues have been computed as a function of the preexisting rates.6 The FERC methodology requires applicants to calculate incremental projected revenues by using the pre-existing rates. Thus, both tests, the “revenues in excess of incremental cost” test and the “lower existing rates” test become interchangeable and certificate cases under these two subgroups of projects are fairly grouped into one single set of certificate cases.

(b) One-step test for the approval of rolled-in projects: In practice, a second group of certificate cases arises in which it appears that the inexpensive expansibility test has been reduced to merely testing whether rolling-in the costs of successful projects would lower rates for existing ratepayers (one-step test). In effect, a sufficient condition to determine whether inexpensive expansibility applies is whether or not rolling-in the facilities’ costs will lower the rates for existing shippers.61,62

The inexpensive expansibility cases do not fall into mutually exclusive groups from the first three groups. For instance, Eastern Shore Natural Gas Company63 (June 4, 2002), Tennessee Gas Pipeline Company64 (August 1, 2000), and Iroquois Gas Transmission System65 (October 31, 2002) could also be argued to belong to the third Group of cases since the Commission recognized that these projects also provided certain system benefits in terms of reliability, flexibility, and improved level of service to pre-existing customers.

Moreover, the Commission stated that the policy in favor of rolled-in pricing in cases of inexpensive expansions may be reversed in future cases. For example, revenues from new transmission facilities may initially be in excess of incremental cost, thereby requiring rolled-in pricing. But later, the same facilities may incur costs beyond the incremental revenues. In such a “changed circumstance,” the Commission indicated that the presumption in favor of rolledin pricing will be reexamined, i.e., the ratemaking methodology would switch back to incremental pricing, thereby requiring the pipeline to bear the costs of any shortfall. In other words, what is rolled-in today may be incrementally priced tomorrow if the circumstances change sufficiently to conclude that the expansion investments do not provide rate benefits to existing customers. This is most clearly stated in Iroquois Gas Transmission System:

As stated above, the Commission precludes pipelines from relying on subsidization from existing customers to support new service. Our predetermination that Iroquois may roll in the costs of its expansion in its next general rate proceeding is based on Iroquois’ projections that the revenues from the Brookfield Projects will exceed its cost of service. If circumstances change, e.g., the projected costs are exceeded to the extent that there would be no revenue benefit to existing customers, then Iroquois will not be authorized to roll the costs of the Brookfield Project into its system rates and will have to develop incremental rates for the service.

The Commission recognizes that the most appropriate pricing approach for expansions on a particular pipeline may change over time. However, the language of the Iroquois Order seems to suggest that the Commission is not relying on the “costs follow benefit” principle to determine whether rolled-in or incremental pricing is the proper pricing approach for a specific expansion project when circumstances change. The cost of the expansion project is not allocated based on the relative benefit received by each type of customer (either existing or new customer). In fact, the only decision variable that determines whether an expansion project will be granted rolled-in pricing is whether the projected benefits of the project exceed its costs. If the circumstances of the project change such that the existing payers do not enjoy a reduction on their rates as a result of the rolled-in pricing approach the expansion project will then be required to be incrementally priced. The decision to grant rolled-in status is independent of whether or not the expansion project provides benefits to the existing customers. Obviously the effect of such a policy is to confer the benefits of the “good years” onto existing ratepayers through forced roll-in and require pipeline investors to bear the cost of “bad years” through a forced switch to incremental pricing.

The “changed circumstances” argument was employed by the ALJ’s Initial Decision, (Transcontinental Gas Pipeline Corporation, December 3, 2002) to reject Transco’s proposal to roll-in the Mobile Bay costs in the rate case. The Initial Decision determined that circumstances have changed that prevented Transco from rolling-in the costs of the Mobile Bay Project. The Initial Decision seemed to employ the “cost follow benefit” principle when it argued in favor of incremental pricing in the Mobile Bay project. The Initial Decision found that the changed circumstance was that a Transcontinental Gas Pipe Line Corporation’s affiliate was the only shipper subscribed to the Mobile Bay Project. The Initial Decision held that the fact that a Transco affiliate would benefit one- hundred percent from an expansion for which it shouldered only forty- one percent of the costs is an unreasonable subsidization by existing customers and an undue preference between corporate affiliates.67 On August 5, 2005, the Commission issued its Order on Rehearing that reversed the ALJ’s decision and affirmed the roll-in of the Mobile Bay expansion. 4. Rolled-in Pricing in Non- Competitive Markets

The Commission issued Order Nos. 2005, and 2005-A, on February 9, and June 1, 2005, respectively, establishing the open-season regulations to govern any Alaska natural gas pipeline facilities.68 In these Orders, the language of the Commission seems to suggest that the actual and future degree of competition in the market constitutes a relevant variable to permit either rolled-in or incremental rates. The Commission concluded that rolled-in rates are also appropriate exceptions to the incremental pricing policy in markets in which there is no pipeline-to-pipeline competition because incremental rates in this case would discriminate against new customers:

In this rule, the Commission does not adopt a firm pricing policy for future expansions of an Alaska natural gas transportation project, but we do take this opportunity to provide guidance on this important issue, as it will assist participants in the initial open season. We conclude that there should be a rebuttable presumption in favor of rolled-in pricing for project expansions. Our existing lower-48 states policy favoring incremental rates for expansions does not apply in the case of an Alaska natural gas transportation project. There is likely to be only one Alaska pipeline, so there will be little or no opportunity for competition between pipelines. Incremental pricing of expansion could put expansion shippers at a significant rate disadvantage compared with initial shippers, and accordingjv could discourage exploration, development and production of Alaska natural gas.69

In Order Nos. 2005 and 2005-A, the Commission established a presumption in favor of rolled-in, as opposed to incremental, pricing of expansion facilities and concluded that rolled-in pricing may spur the investments needed to deliver gas to the lower forty- eight states and may reduce barriers to future exploration, development and production of Alaska natural gas.

IV. LITERATURE REVIEW: INCREMENTAL VS. ROLLED-IN PRICING METHODOLOGY

This section presents the arguments in favor of and against the use of incremental versus rolled-in pricing methodology available in the economic literature.70 It should be emphasized that in reviewing and discussing this literature, this paper is not endorsing the arguments presented. Rather, the review is intended to provide a comprehensive presentation of what has been said on the subject.

A. Arguments in Favor of Rolled-in Pricing Methods

Several authors support the use of rolled-in pricing under particular circumstances. Picker (2004) notes that under the presence of positive network externalities that benefit pre- existing users from addition of new users, full cost intemalization (through incremental pricing) will push too many costs onto new users.71 Thus, some sort of sharing, i.e., rolling-in, is preferable to incremental pricing. The same opinion is shared by John Wilson (1983) when, in the context of the telecommunications industry, he claims that there are circumstances where rolled-in ratemaking can serve a valuable purpose. For instance, Wilson argues that there is a logic to the roll-in of some local exchange plant costs since a local exchange plant is constructed to serve not merely the local subscriber but the entire system.72

A report written by Energy Markets Limited and Ramboll (2000) for the European Commission Directorate-General for Transport and Energy advocates using rolled-in pricing methodology to recover capital spending for incremental pipeline capacity.73 The authors recommend that the European Commission maintains the presumption in favor of rolled-in methodology “unless compelling evidence is presented by the pipeline that incremental pricing should be used,” based on the following grounds:

[b]efore deregulation, generally all pipeline capital investment was rolled-in and the cost spread over the existing customers. Those markets which have been deregulated the longest (UK, North America and parts of Latin America) show that as unbundling became more widespread there were more cases of incremental pricing. However the general presumption still is that pipeline capital investment is rolled-in to the existing asset base and recovered from all customers. Experience suggests that competition and trading develop faster when there is slight excess capacity rather than capacity shortages. “Rolled-in” pricing is more likely to ensure that capacity is built and made available.75

In the context of promoting a competitive gas market in the EU, the Energy Limited and Ramboll Report (2000) enumerates a number of advantages that, in its opinion, support pricing incremental capacity on a “rolled-in” basis:

[(a)] [i]t enables main line extensions and new markets to be developed at lower prices to these markets than pricing on an incremental basis; [(b)] [e]ventually all pipeline customers benefit from increased throughput and economies of scale, therefore all customers should pay; [(c)] [expansions and extensions will get built which otherwise would not get built, bringing operational and financial benefits to the system as a whole; [(d)] [b]y bringing new shippers and customers onto the system, rolled-in pricing will promote competition and provide a level playing field for competitors; [(e)] [i]t encourages infrastructure development, especially relevant for immature markets and growing markets; [and] [(f)] [i]t provides a mechanism to extend systems to rural and disadvantaged areas, meeting social and other national objectives.76

Similar conclusions are also shared in a report by Energy Markets Limited written in 2005.77 This study considers international experience in different countries in Europe, Victoria in Australia, and The United States to promote competition in the UK gas market. Energy Markets Limited (2005) further analyses the different methods to allocate the costs of gas infrastructures in all these jurisdictions: (a) rolled-in rates; (b) joint ventures with participation limited to parties involved in associated gas deals and/or the operator in the transit countries involved; (c) open season when the pipeline is charged for on an incremental basis; and (d) exemption from Third-Party Access (TPA) principles for major new projects. Energy Markets Limited (2005) notes that there is no consistent pattern across EU regarding the methods to allocate the costs of gas infrastructures: (i) rolled-in pricing has been adopted in Italy and the UK; (ii) joint ventures approach has been used widely in Germany, Belgium, UK, Austria, Switzerland and Poland;78 (iii) the incremental approach has been implemented in the pipeline project between Bacton in the UK and Zeebrugge in Belgium;79 and (iv) finally, TPA exemptions are heavily used in Europe (including the UK market).80

Alfred Kahn (1988) states that, in those cases in which demand by all customers for system capacity creates the need for the expansion, it is economically desirable to attribute the costs of the expansion to every user of the system, regardless of the order in which they arrive on the system.81 He concludes that because the demand for system capacity for all customers creates the need for system expansion, every shipper is economically marginal. And thus, the costs of the expansion may equitably be attributed to every user, regardless of when it first contracted with the pipeline.

Suppose, for example, the utility has two groups of customers, one. A, whose demand is stable, another, B, whose demand is increasing. And suppose expansion of the latter demand finally requires expansion of capacity. Does that mean, following our rules of peak responsibility pricing, that B are the marginal buyers on whom capacity costs alone should be imposed? Obviously not. True, it is the increase in B’s purchases that precipitates the additional investment; but the additional costs could just as well be saved if A reduced their purchase as if B refrained from increasing theirs. So A’s continuing to take service is just as responsible, in proportion to the amount they take, for the need to expand investment as B’s increasing needs, and A should therefore be forced just as much as B to weigh the marginal benefits of the capacity to them against the marginal costs they impose on society by continuing their demands. . . . Both should be forced to match those higher capacity costs against the satisfaction they derive from continuing to use the service.

This logic was first articulated in the Battle Creek Order, as discussed above.

B. Criticisms of the Rolled-in Pricing Methodology

Reiter and Cook (1999), in the context of electric distribution plant expansions, present arguments against an indiscriminate application of rolled-in pricing:83

In an era where competitive alternatives to monopoly services have developed, however, indiscriminate application of rolled-in pricing may actually harm the consumers it is intended to protect by masking the true cost of utility expansions in relation to available alternatives. The problem created by rolled-in pricing of electric distribution plant expansions is this: the costs of expanding distribution plant to serve new or increased electric load are hidden when they are spread among the utility’s entire customer base. Consumers may forego consideration of other, truly cheaper alternatives because they only pay a fraction of the actual cost of the plant expansion. The result is a mis-allocation of scarce resources and a reduction in competition from alternative technologies.84 A similar argument is shared by the Australian Competition and Consumer Commission (ACCC) in a report written in 2003, and by Herbert (2004).85 The ACCC analyzes the potential concerns on using rolled-in versus incremental pricing approach. ACCC concludes that a bias in favor of rolled-in pricing may diminish the investment attractiveness on new pipeline infrastructure, deter the entry of new competitors and create uncertainty in investment conditions:

rolling-in the costs of expansions is also problematic. For example: [(i)] A rolled-in tariff may deter investment in an alternative pipeline. Under a roll-in, the cost of expansion is averaged over all users. Therefore prospective users would not pay the marginal cost of incremental expansion but the average cost of all capacity. As a result, expansion of an existing pipeline is likely to be preferable on the basis of cost than the development of a new pipeline for prospective users. This disincentive for a new pipeline to be constructed can prevent the entry of a competitor[;] [and] [(ii)] A rolled-in tariff, particularly one which estimates tariffs depending on the amount of expansion which takes place, results in a degree of uncertainty for users.

Herbert advocates the use of incremental pricing when overlaid on a new deregulated and competitive environment. The author claims that as the industry becomes more competitive the best way for the FERC to accomplish its goals for a deregulated marketplace is to abandon its presumption for rolled-in pricing:

This presumption, born at a time when the industry was highly regulated, did not translate to a competitive marketplace where only the most economic expansions should be tolerated by the American consumer. The marketplace creates the incentives for siting of expansions, and accurate pricing signals ensure the correctness of those decisions.87

Morey (2003) discusses the regulation of independent transmission companies through performance-based and price-cap regulation.88 The author examines the potential benefits for transmission customers associated with the implementation of a price-cap plan and explores the efficiency of alternative pricing structures to recover the cost of transmission facilities. The author concludes that:

[w]hile the design of efficient pricing structures to recover the costs of transmission infrastructure in the presence of network externalities has always been more art than science, traditional designs using average rates based on rolled-in methods are well recognized to be inefficient. If customers are homogeneous, average prices are fairly simple to apply, but when customers are heterogeneous, average cost pricing of rolled-in costs becomes more complicated and problematic. Consumers as a whole can be made better off if the utility discriminates even a little based on characteristics of customer classes (again, a well known result). Consequently, the designs traditionally used to price transmission have included very little price discrimination, and therefore, fostered cross-subsidies between and within customer classes as the rule rather than the exception. Both license plate and postage stamp rate designs perpetuate this inefficiency and are less efficient for this reason.89

Morey further maintains that “[r]olled-in pricing methods can still be used for recovering costs of deep system facilities that provide reliability benefits to all customers, but the allocation of those costs may still be based on more efficient designs that reflect cost causation (such as distance sensitive access charges and related designs).”90

The Commission’s prior rolled-in pricing policy has been subject to the criticism that it produced an anti-competitive effect. For instance, Reiter and Cook argued that, rolling-in the costs of pipeline expansions may lead to unfair competition in the market since “a pipeline with a depreciated rate base can underprice its competitors, even though its incremental costs of expansion may be higher than the incremental costs of its competitors.”91

C. Arguments in Favor of the Incremental Pricing Methodology

Arguments in favor of the use of incremental pricing methods mirror the criticism of the rolled-in method. Picker compares both pricing methods and concludes that incremental pricing preserves a level playing field for competition between an incumbent and entrant, in contrast to rolled-in pricing that gives an incumbent a decided advantage.92

As discussed above, the Energy Limited and Ramboll Report (2000) advocates the use of rolled-in pricing. However, the report also opens the possibility to the use of incremental pricing under different circumstances. More specifically, it points out that as markets deregulate and unbundled services develop, the case for incremental pricing becomes stronger:

[i]ncremental pricing, however, is seen as appropriate in a number of cases where the beneficiaries of the investment are easily identifiable, where rolling-in would cause an excessive increase in the existing rates, where the projects contemplate an entirely new service or where the additional facilities have not been fully booked in advance and there is an element of “at-risk” investment.

D. Criticisms of the Incremental Pricing Methodology

Several authors maintain that the 1999 Pricing Policy Statement would make new infrastructure more expensive and as a consequence it may limit new expansions.94 The ACCC maintains that a bias in favor of incremental pricing may promote unfair competition in the market, limit new entry in the market, and reduce the incentive to finance the expansion of the pipeline infrastructure.95,96

Swanson, in a paper written in 2000, stresses that incremental pricing, the large capital costs required for the construction of pipeline infrastructures, the reluctance of local distribution companies to sign long-term transportation contracts, and the price advantages to a pipeline affiliate will diminish the investment attractiveness on new pipelines and the reliability of the pipeline system.97,98 The author concludes that lower reliability will be observed in the form of “greater frequency and longer duration of price spikes.”99 Swanson maintains that a bias in favor of incremental pricing will provoke high prices for the new transportation capacity and will amplify the risk of “unsold capacity or any cost overruns.”100 As a consequence, the author concludes that the incremental pricing provisions of the 1999 Policy Statement will lead to more economic decisions but will make adding capacity more difficult:

[g]enerally, but not always, the rates for incremental capacity will be greater than the rates for existing capacity. Thus, the holders of new long-term capacity will be at a competitive disadvantage to holders of existing capacity, which is likely to discourage them from such new long-term contracts. Alternatively, the pipeline company could offer a lower rate via negotiated rates or discounting, but such reduces the profit of the investment.101

The author maintains that new pricing policy creates strong incentives to restrain pipeline capacity growth since “the incentive for a pipeline without longterm contracts to build new capacity is unclear.”102 A similar opinion is expressed by a recent paper- Petrash (2006)-which analyses the trend over the last twenty years from relatively long-term contracts for natural gas supply and transportation to relatively short-term contracts and the benefits and risks of this pattern.103 The author concludes that longer-term contracts have benefits for consumers since they make it easier to construct needed infrastructure, result in lower capital costs, may serve to dampen gas price volatility and improve reliability of supply.104 In the context of changing institutional conditions and gas liberalization trends in Europe, Neuhoff and Hirschhausen maintain that not only producers but also “[c]onsumers . . . benefit from long-term contracts] [since] prices are lower under long-term contracting . . . than with pure spot sales.”105

Swanson expresses additional concerns and concludes that pipelines having marketing affiliates do not have a clear incentive to add capacity to remove a bottleneck under the presence of price spikes. The author claims that “[w]henever there is a price spike in a consuming[] area[,] a pipeline’s marketing affiliate can earn extra profits if it has firm capacity across the constraint point and can thus charge the high market price for [the] gas.”106 “[T]he marketing affiliate [allegedly] profits from a lack of capacity, and the integrated corporation lacks strong incentive to add capacity.”107

What about a pipeline competitor? Pipeline bottlenecks that lead to a large price spread may enhance the incentive of potential pipeline competitors to add new pipeline capacity into the system. However, as Swanson recognizes the reduction in the price spread as a result of the new investment on pipeline capacity may limit the opportunities to fully recover the cost of the investment:

if a pipeline expands capacity or a new pipeline is built to exploit the large price spread, as soon as the new capacity comes on stream, supply and demand are better balanced and the price spread narrows. With a narrow price spread, the new pipeline capacity is unlikely to be profitable. Thus, investment that solves the capacity bottleneck problem is not rewarded with profit; it probably operates at a loss.108

The author further concludes that:

Today, a pipeline will build new capacity where it believes that it can sell long-term transportation contracts or its marketing company can capture good profit from the new capacity. If the new capacity depresses price spreads and removes the marketing company profit, then the incentive for a pipeline without long-term contracts to build new capacity is unclear.109 Both authors, Swanson and Picker maintain that the change in the pricing policy to the use of incremental pricing will create a push to consolidation and larger integrated networks and will reduce the potential risks in pipeline investments.110

E. Conclusions

Analysis of the literature indicates that there is not a clear presumption in favor of either incremental pricing or rolled-in pricing methodology. Both proposed methods have their adherents but also their skeptics. The relevant literature on pricing of capacity pipeline expansions shows that the desirability of rolled-in or incremental pricing as the most efficient and equitable policy depends on the particular characteristics of each project and the particular ratemaking goals the author treats as paramount. The split seems to be based on whether the greater concern is proper incentive for competition at the pipeline level (by those supporting incremental pricing) or competition among customers (by those advocating rolled-in). There does appear to be a consensus that incremental pricing will have its intended result of discouraging investment. Whether that is a good or bad idea is disputed.

Not surprisingly, competition authorities in other jurisdictions (for instance, Australia) advocate, as we do in this paper, for a more discretionary approach that would eliminate bias and employ a fact-specific methodology on a case-bycase basis:

[c]learly there are advantages and disadvantages of both pricing approaches. Determining which approach is preferable involves assessing the balance of these advantages and disadvantages given the circumstances of a particular pipeline. Incremental pricing may be more appropriate for one pipeline, while rolled-in pricing is more appropriate for another. It may even be the case that the most appropriate pricing approach for expansions on a particular pipeline will change over time.111

A case-by-case approach is also the jurisdictional policy with respect to the allocation of cost of investment on new intrastate gas infrastructure (transmission and storage) in several states in the United States such as California,112 Illinois, Michigan, and New York. In these four states, the costs of investment on new intrastate gas infrastructure could either be rolled-in or incremental depending on individual circumstances.113

V. CRITIQUE OF A BIAS IN FAVOR OF INCREMENTAL PRICING

Analysis of the wording of the 1999 Policy Statement and a review of the certificate orders from the Commission generates certain confusion as to how the new policy has been articulated and implemented. The 1999 Policy Statement stated as a “threshold requirement” that “the pipeline must be prepared to financially support the project without relying on subsidization from its existing customers.”114 This statement, however, is accompanied by numerous exceptions and requirements to mitigate adverse impacts on existing customers from roll-in. From a logical point of view, applying a literal meaning of “threshold” that requires that this condition must always be met regardless of circumstances poses a paradox: in many cases one would almost never get to the exceptions and mitigation requirements because the project could never get past the “threshold” requiring incremental pricing. “Threshold” is therefore an unfortunate choice of terminology because the exceptions kick in only if one is past the threshold.

We take the “threshold requirement,” therefore to refer to an initial matter to be considered before proceeding to the next step. It makes no logical sense to apply this “threshold test” regardless of circumstances, such as to projects that generate no new customers and create benefits only to existing customers. The obvious solution, and the one often employed by the Commission in practice, is to apply the threshold literally only in cases where there are benefits enjoyed and costs incurred only by new customers.

Nevertheless, many commenters and industry participants have interpreted the 1999 Policy Statement as a generalized bias in favor of incremental pricing regardless of the circumstances, enforced by the “threshold test.” Although we believe this reading to be incorrect, we will analyze the economic implications of a generalized “bias in favor of incremental pricing.”

After examining the economic implications of a bias in favor of incremental pricing, we propose a more balanced approach that would eliminate bias and employ a fact-specific methodology that depended on the type of project. This balanced test is more consistent with sound economic policy and the actual implementation of the policy in many certificate proceedings, as discussed above.

We proceed now to identify a number of reasons to question the presumption that sound economic analysis supports a bias towards incremental pricing. The reasons may be summarized as follows.

A presumption in favor of incremental pricing is not necessarily consistent with economic efficiency

* A bias in favor of incremental pricing constitutes an inappropriate test for public convenience and necessity of expansion projects, thereby discouraging investment in hybrid projects.

Applying the “threshold requirement” literally, regardless of circumstances, does not constitute an appropriate test for public convenience and necessity. A bias in favor of incremental pricing is not necessarily consistent with economic efficiency, because it fails to consider that many projects create significant benefits that go beyond direct benefits to incremental customers. The appropriate test should consider all the costs and benefits of a project, not just the benefits that can be financed out of charges to new customers. Hybrid projects that confer benefits on both new and existing customers may never get constructe