Thomas Adams
Energy Analects
February 19, 1996

After 10 years of success with deregulation of gas, provincial regulators of gas local distribution companies (LDCs) should finish the job. The road forward is to fully deregulate that which can be competitive. Gas merchant functions still under the regulatory umbrella should be separated from rate regulation entirely. The invigorated competitive environment created by this change will benefit customers and the public interest. Further deregulation will lower regulatory costs, improve flexibility and responsiveness to changing market conditions, and diversify the range of interests participating in the industry.

There once was a time when gas transactions in most parts of Canada were entirely controlled by powerful monopolies and their regulators. Producers and consumers were but pawns in a game controlled by external masters. Gas deregulation, which originated in the Western Accord, started to change all that. Signed March 28, 1985, by the governments of Canada, Alberta, British Columbia, and Saskatchewan, the accord was premised the need for a more flexible and market-oriented environment. The Accord led to the Agreement on Natural Gas Markets and Prices of October 31, 1985, which became known as the Halloween Agreement.

In 1986, Ontario became a leader in gas deregulation by embracing the Halloween Agreement. The Ontario Energy Board (OEB) was the first regulator in North America to allow all customers to circumvent utility system gas by switching to gas directly purchased from non-utility suppliers. Not only were big business customers allowed to shop for gas, but homeowners, schools and hospitals could also shop of for better deals. The results have been dramatic. Homeowners in Toronto have seen their rates drop 36 percent in inflation-adjusted terms since deregulation. Based on the Ontario precedent, jurisdictions across North America began opening up their gas markets.

Ontario is losing its position as a leader in deregulation. The Ontario Energy Board, lacking support from the provincial government, is merely reviewing separation in loose public forums. Meanwhile, the Manitoba Public Utilities Board has created a docket to examine separating the merchant function from the LDC function and will commence hearing the case in April.

Gas commodity deregulation by provincial utility regulators could have the counter intuitive effect of strengthening regulation. Provincial regulators generally do 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. This is a new form of protection since most provincial regulators do not concern themselves with competition issues directly.

Separation of distribution and merchant functions must be structural. Ideally, separate ownership of the distribution company from the marketer would develop. A method of achieving this end would be to separate the functions, issue existing shareholders with stock in each new company, and allow the ownership pools to drift apart. However, separate ownership may be difficult to achieve in cases where holding companies control LDCs. Some of the benefits of separation could be obtained even if a common parent continues to control the two, although scrutiny by the regulator of affiliate transactions will remain important.

Private LDCs are now being urged, often by competing marketers, to convert their gas sales departments, which are generally operated as not-for-profit services, into for-profit, deregulated, competition-oriented affiliates. Yet, the private utilities resist.

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 underutilized customer information as a strategic asset in the event that more competition breaks out.

Because of years of regulatory protection, gas LDCs are effectively quasi-governmental organizations. Utility resistance may result from managers 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.

Finishing the job of deregulating commodity gas purchasing will bring an end to average-cost pricing for gas. The use of Weighted Average Cost Of Gas (WACOG) is a carry-over from the foregone era of regulated prices. The apparent simplicity of WACOG appeared attractive in a regulated environment where market and consumer behaviours were controlled. However, the veneer of simplicity presented by WACOG conceals a gross inefficiency, which dregulation reveals.

WACOG is inherently unstable in a market environment. Customers, at liberty to move to and from utility system gas, abandon system gas when market prices are falling. Conversely, when market prices are rising, customers flock back to system gas. Customers who seek security by staying on system gas are buffeted by these moves as WACOG reacts to changing demands and prices in a lagged fashion.

More than two years ago, 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.

Happily, some utilities are now starting to facilitate customers and brokers, or marketers, being able to make arrangements for fixed-price/fixed-term service. The three major Ontario LDCs have recently committed themselves to provide Agency Billing and Collections bundled Transmission service (ABC T) for customers and their representative brokers or marketers. Hopefully, the ABC T concept will be used to give customers the option of price security for fixed terms.

Fixed-price/fixed-term service corrects the inefficiency created by WACOG while enhancing consumer choice. Fixed-price/fixed-term service is a marginal-cost pricing concept.

If utilities develop fixed-price/fixed-term service, there are potential risks to the 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 through gas streaming. As the OEB found in its decision in the 410-II/411-II/412-II case in 1987 “gas purchased by the LDC should arrive in Ontario without being streamed to specific customers or customer groups” (1.33).

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 to utility marketers, such as risks from aggressive marketing or failing to hedge sales commitments with offsetting purchases, could be subsidized by non-participating customers of the utility.

Borrowing some jargon from the demand-side 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 toward 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.

The transition to fully deregulated markets should not be guided by regulators setting 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.

Separation will raise some questions that the regulators 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 regulators and government policy makers 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 regulators and governments 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 generally do now when looking back at the first steps toward deregulation.