Do Gas Cost Incentive Mechanisms Work? A Nation-Wide Study

By Hlasny, Vladimir | American Economist, Spring 2006 | Go to article overview

Do Gas Cost Incentive Mechanisms Work? A Nation-Wide Study


Hlasny, Vladimir, American Economist


I. Introduction

Natural gas is a fuel used by most households and industries in the US. Since it is distributed with decreasing average costs, and since the demand for gas is inelastic, the industry is often regarded as a classic natural monopoly requiring regulatory oversight (on the theories of regulation, see for instance Stigler, 1971, and Posner, 1974). Ever since the late 1800s, the responsibility over the industry supervision shifted between various levels of authority, and the means of regulation--as well as the theory behind them--evolved dramatically (for instance, refer to Priest, 1993).

A recent shift in the political atmosphere in the industry is the usage of incentive mechanisms by many public service commissions (PSCs) (1) throughout the 1990s. Incentive mechanisms allow approved utilities (or local distribution companies) to earn extra profits by outperforming certain benchmarks in terms of commodity costs, service costs, service quality or other parameters. Under the gas cost incentive mechanisms (GCIMs), utilities are given higher rewards--relative to the traditionally regulated utilities--for seeking lower-cost gas. The savings that the utility accumulates over a specified benchmark are shared between the utility's shareholders and ratepayers.

Utilities, state commissioners and public advocates have had more than a decade to evaluate gas cost incentive mechanisms, but their impact on prices is still ambiguous. (2) Consumer advocate groups assign different merit to the GCIMs than the utilities who have benefited from them. Beside periodic regulatory reviews of individual mechanisms within each state, there are no comprehensive nationwide evaluations of the performance of these mechanisms.

This study estimates the effect of the GCIMs on the level of utilities' residential and small commercial prices across the US. Its main objective is to abstract from the case-specific circumstances from which individual regulatory reports suffer. Given the wide-spread use of the GCIMs today and their potential in the future, this study provides a general statement to the state regulators regarding the performance of the GCIMs. Figure 1 demonstrates that the number of the GCIMs and the number of states that adopt them are growing. This study controls for other regulatory efforts on the state and utility levels for two reasons: to directly control for their effects on prices, and to use these mechanisms as proxies for the effect of the state political environment, which may not be entirely removed by the fixed effects procedure.

The next section describes the evolution of the industry and its regulation. The following section describes the relevant incentive mechanisms. Section IV introduces the empirical model and the variables, and Section V describes the regression results. Section VI elaborates conceptually on the effects of the GCIMs that this paper identifies and wraps up with directions for further research.

II. Industry Background

Prior to the 1890s, the federal government oversaw the natural gas industry, and municipalities oversaw individual gas utilities, but there was no agency involved on the state level (Priest, 1993). In the following decades, state commissions emerged in most states, and today they are the most influential body responsible for supervision of utilities. Today, all states but Nebraska have public commissions that oversee utilities in the state. (3)

Most of the recent deregulation activity in the industry has occurred on the production side where prices became completely competitive after the 1979-1989 deregulation process (DOE website). In the gas transmission, pipelines are regulated by the Federal Energy Regulatory Commission (FERC) and their prices today are deemed relatively competitive. The least progress in the deregulation has occurred on the delivery segment. On her regulation-to-market continuum, DOE's Barbara Mariner-Volpe estimates that producers, pipelines, and utilities have achieved 90%, 75%, and 50% of a free market status, respectively (Mariner-Volpe, 2000). …

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