Moving ahead with gas deregulation: separating Gas Merchant and distribution functions

Thomas Adams
Energy Probe
January 31, 1996

Presenter: Thomas Adams
Director of Utility Research,
Energy Probe Senior Consultant,
Borealis Energy Research Associates

Ontario’s gas local distribution companies (LDCs) and their regulator, which have together done a very good job of serving their customers and the public interest, must make a break with the status quo and embrace further commodity purchase deregulation. Ontario was once in the lead in gas deregulation, but we are no longer in the lead. For example, the Manitoba Public Utilities Board has created a docket for separating the merchant and LDC functions. The road forward is to fully deregulate that which can be competitive and finish the job Ontario started 10 years ago. Full gas purchase deregulation cannot be achieved without institutionally separating the merchant function from regulation.

Energy Probe advocates further deregulation to improve value for consumers, make gas a more aggressive competitor against less environmental attractive fuel forms, and provide a successful model of market reform which can be applied to electricity sector reform. We are confident that further deregulation will lower regulatory costs, improve flexibility and responsiveness to changing market conditions, and diversify the range of interests participating in the industry.

Gas commodity deregulation by the Ontario Energy Board (OEB) could have the counter intuitive effect of strengthening regulation. The OEB does not have a direct mandate to strengthen competition. Keeping the gas merchant function within the regulatory ambit protects utilities from the federal Competition Act. Utilities may be able to claim a defence of “regulated conduct” in reply to charges of anti-competitive behaviour as allowed under the act. Without the shield afforded by regulation, competitors would have a stronger case for pursuing federal remedies in the case of abuse of dominance.

Separation of the distribution function from merchant functions must be structural. Ideally, separate ownership of the distribution company and the marketer would develop. However, this ideal may be difficult to achieve given that holding companies currently control the major LDCs. Some of the benefits of separation could be obtained even if a common parent continues to control the two functions, although regulatory scrutiny of affiliate transactions will still be necessary.

Because of years of regulatory protection, Ontario’s gas LDCs are today quasi-governmental organizations. Energy Probe is generally of the view that minimizing the direct role of government in the energy business is good policy. One example where Ontario’s gas LDCs have excessive, governmental-type powers is the LDCs’ power of life or death over agents, brokers, and marketers (ABMs) through the management of displacement volumes.

How should we understand the lack of interest utilities express in response to the invitation to spin off a currently non-profit function and convert it into a for-profit function? We have some misgivings about using customer surveys as the basis for a case against separation as the utilities have suggested. It is unfortunately true that gas customers are poorly informed about the operation of the gas system. Some customers, when asked if utilities should be allowed to sell gas, may wonder if they are being asked if fuel should be delivered to users. Lack of knowledge on the part of customers is at least in part due to billing practices and rate structures that have obscured the actual underlying costs of service. Energy Probe is very impressed by the commitment of Consumers Gas to break out customer, commodity and capacity costs on the customers’ bills and hopes that this initiative will improve customer awareness.

In part, utility resistance to separation may arise out of the measured conservatism that is needed to manage an industry with a very slow rate of capital rollover combined with extreme capital intensiveness. Or utilities may be seeing system gas customers as valuable assets in the event that “lighter regulation” is implemented. Utilities might also see now underutilised customer information as a strategic asset in the event that more competition breaks out. I recommend an appreciation for the quasi-governmental nature of utilities. I suggest to you that utility managers are behaving like government department heads protecting turf and pursuing managerial, rather than commercial, incentives. Although shareholders may be attracted to the invitation to create a new profit centre from a currently non-profit activity, managers may be repelled by the implications of losing automatic cost recovery.

More than two years ago, at the Direct Purchase hearing, Energy Probe developed and promoted the concept of fixed-price/fixed-term gas contracting for residential consumers. Under our scheme gas marketing would work like mortgage marketing where terms are offered to consumers who can select from a menu of packages featuring various levels of price risk and time duration. The marketer would offset customer requirements by making matching orders to buy from gas sellers.

Because of our interest in customer choice, we are pleased to see the Agency Billing and Collections bundled transmission service (ABC) option being developed now by utilities and ABMs. We hope that ABC will be used to give customers the option of price security for fixed terms.

When we originally proposed fixed-price/fixed-term service, our purpose was to correct instability created by the weighted average cost of gas. Fixed-price/fixed-term service provides a way of moving closer to marginal cost pricing. However, if utilities develop fixed-price/fixed-term service within their regulated operations, there are potential risks for the continued development of fair competition. Our enthusiasm for fixed-price/fixed-term contracting has not waned but that enthusiasm does not make us supporters of price differentiation within regulation through gas streaming. As the OEB found in its decision in the 410-II/411-II/412-II case “gas purchased by the LDC should arrive in Ontario without being streamed to specific customers or customer groups” (1.33).

Regulated price streaming could have many negative effects on competition. Because of their control over billing information, utilities could easily target customers interested in special terms. Risks created by utilities engaging in aggressive marketing, or failure to hedge sales commitments with offsetting purchases, could be subsidized by non-participating customers of the utility.

Borrowing jargon from the demand management lexicon, separation transition issues should be managed in accordance with the no-losers test. Intelligently implemented commodity deregulation should make everyone better off. In making the transition to complete commodity deregulation, it is unreasonable to demand predictions about exactly how the benefits will come. The specifics of how newly liberated competitive markets will behave are impossible to predict. We cannot presume to know what kinds of new products will arise or what synergies will be discovered. Nor can we prove or guarantee that further deregulation will lower rates, but we have strong reasons to believe that it will, especially given the success to date of limited deregulation.

Some may suggest that deregulation be stalled to retain the capacity of the OEB to enforce measures aimed at protecting the environment. Energy Probe lauds the purpose but opposes the means. In our view, the OEB is a rate regulator, not an environmental regulator. If the Board does wade into environmental regulation it should be wary of environmental boomerangs. Efforts by the Board to achieve environmental objectives by imposing special costs on gas, costs that are not imposed on other fuel forms with worse environmental consequences, are likely to increase rather than decrease environmental harm. Environmental regulation should be applied across sectors and fuel forms.

Energy Probe does not support proposals that would set out arbitrary targets for market shares of participants in the new world of gas marketing. Market shares should arise, not by design, but by the interplay of market forces in a climate of fair competition.

Government action is needed to modernize the OEB Act. The obligation to serve needs to be redefined as an obligation to deliver. Gas trades at the customer’s meter must be permitted. Allowing gas trades to be transacted in Ontario is necessary for a local hub price to develop. A local hub price may facilitate more efficient use of existing facilities, a more efficient market in secondary pipeline capacity, and better price signals to guide expansion decisions.

Separation will raise some questions that the OEB will have to deal with. These include:

Can gas marketers formerly associated with utilities trade under the utility’s name?

Who should be responsible for naturally competitive businesses now within the LDC umbrella like billing, meter reading, and collections?

Although existing meters in rate base should be grandfathered, in the future, who should own the customer’s meter?

Can load balancing needs be met by market mechanisms, or is there a natural monopoly in this area?

The time has come for the OEB to encourage the LDCs to divest themselves of the merchant function. Such separation will assist in protecting the public interest. Just as the utilities now oppose separation, they once opposed direct purchase deregulation. If the Board and the government choose separation, I am willing to bet that in a few years even the utilities who now oppose separation will look back on the decision as the right thing to have done, just as they do now with the direct purchase decision.


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