February 26, 1996

 

Energy Probe’s Prefiled Evidence in Manitoba Public
Utilities Board June 1996 Inquiry into the Future Role
of Centra Gas Manitoba

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Separating Gas Merchant from Distribution Functions in Manitoba
Pre-filed Testimony on Behalf of Energy Probe

Thomas Adams Senior Consultant Borealis Energy Research Association

Presented to the Manitoba Public Utilities Board

Regarding

REVIEW OF NATURAL GAS SUPPLY PROCUREMENT, TRANSPORTATION AND STORAGE FUNCTIONS OF CENTRA GAS MANITOBA INC. AND REVIEW OF GUIDELINES FOR ACCEPTABLE CONDUCT BETWEEN CENTRA GAS MANITOBA INC. AND AFFILIATED COMPANIES

Preamble

The following pre-filed testimony is submitted on behalf of the intervenor, Energy Probe. A résumé for the author is attached as Appendix A. The testimony responds to the “List of Issues” attached to the Board’s letter of January 19, 1996. A preliminary description of the testimony was provided to the Board in a letter from Energy Probe’s counsel, Mark O. Mattson, February 15, 1996. This testimony focuses primarily on issues of principle and regulatory policy rather than on empirical, quantitative analysis.

The Board’s Issues List and Our Response

Issue 1

i) Please describe current market conditions from the well head to the customers’ meters in the context of their structure, behaviour and stability in the areas of supply, transportation and storage. ii) In discussing the structure, behaviour and stability of the current market, please describe any constraints or concerns that unfavourably impact on the current marketplace.

Response

This testimony addresses key elements in the current market conditions in Manitoba related to market structure, the basic methods of price formation, and customer information.

Centra Gas Manitoba Inc. has a dominant position as gas merchant in Manitoba’s core gas market. This position is a reflection of past regulatory practice. Opportunities exist to change the market structure to benefit the public interest.

System gas pricing issues are now administered by way of a forecasted weighted average cost of gas (WACOG) and a deferred purchase gas variance account (PGVA). Direct purchase pricing is managed by way of monthly buy/sell reference prices. Residential customers receive a bundled price for system service.

WACOG is widely recognized as an inefficient means of price formation which leads to the likelihood of inaccurate prices being received by consumers in the marketplace. Average cost pricing is an undesirable residue of administered pricing regimes which existed prior to the advent of market pricing. WACOG is based on forecasts of market prices and customer use volumes, forecasts which can and have been significantly in error. The result often is inefficient pricing signals being provided to the market. Average cost pricing for energy commodities leads to many well recognized ill effects, particularly incentives for excess conservation during times when the average cost exceeds market price and incentives for excess consumption during times when market price exceeds average cost.

Under the former regime of totally regulated gas prices, WACOG created the appearance of price stability. However, evolution toward market pricing has revealed WACOG to be inherently unstable. Customers, at liberty to move to and from utility system gas, have an incentive to 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.

Reliance on a forecasted WACOG creates a need for a PGVA. PGVA protects utilities from price forecast error, which in itself is good. However, PGVA does not solve the fundamental problems created by WACOG. PGVA adds to inefficiency and administrative burdens while creating unfairness. Use of PGVA results in rate making after the fact. Clearing PGVA balances can lead to significantly distorted prices in the market place whereby current users contribute to, or benefit from, the activities of previous users.

Buy/sell reference prices are artificial pricing constructs that also create inefficiency. Reference prices have the potential to deflect from market prices. Reference prices may also deflect significantly from WACOG and the prices received by customers. In addition, reference prices can constitute an artificial barrier to the development of competition. Non-utility gas vendors are exposed to the risk of reference prices fluctuating not only due to changes in the underlying market prices but also due to actions of buy/sell price administrators.

Bundled prices, which Manitoba residential gas consumers now receive for gas service, pose an additional and substantial artificial barrier to entry for competing suppliers. Some of the key costs within the service bundle include costs for the commodity, transmission, storage, load balancing, metering and billing, and distribution. Without completely unbundling prices, the further development and differentiation of the gas market—whether driven by customer knowledge and choice, or by the entrance of competing suppliers of some of these services that are suited for competition—will be hampered unduly.

Looking at the prevailing market conditions from the vantage point of the small user, gas commodity competition is weak as it is dominated by utility gas, what competition exists presents itself to the customer as an opportunity for rebates rather than pure prices, price drivers are artificially bundled and opaque, and choice among purchase options is virtually non-existent.

Issue 2

i) What changes in the current marketplace do you recommend? Please explain your recommendation providing estimates of the economic benefits and risks of such changes by customer class. ii) In making your recommendations, please discuss the anticipated market structure, behaviour and stability in the changed environment including any constraints or concerns that may impact on the function of such a changed marketplace.

Response

I recommend that the Board move in an orderly but determined way toward a pure utility by completely separating from regulation all functions suited for competitive market delivery, particularly the merchant function. My purpose in recommending enhanced supply competition is to improve efficiency, expand customer choice, and strengthen customer protection. Competition in the merchant function is best achieved through separation from the distribution business. In turn, separation of the merchant function is best achieved by restructuring elements of the utility currently performing the merchant function into a separate enterprise and selling that enterprise to different owners. My second main recommendation is that the Board should move the utility toward maximally efficient, unbundled prices for regulated goods and services.

Gas deregulation to date has produced many successes: lower rates for consumers, improved utilization of capital resulting from developments such as the secondary market for pipeline capacity, and more efficient gas purchasing practices. Even those who have not participated in direct purchase have benefitted from commodity deregulation. These gains suggest strongly that consumers and the public interest will benefit by pursuing further deregulation.

The public interest is unlikely to benefit by keeping regulatory control over the pricing and provision of energy goods and services if they are suited for delivery to customers in a competitive market.

Selling the merchant business at its market value is a method of achieving complete separation while keeping existing shareholders whole.

By boosting competition, separating the merchant business from the distribution business will have the beneficial effects of encouraging a greater range of products and services to further customer choice and of enhancing the flexibility of the gas market to respond to changing market conditions. In addition, separation will simplify the regulatory process by eliminating the effort associated with commodity regulation, thereby allowing regulators to focus more on decisions related to the pure utility. Competition increases the range of interests participating in the gas market, which can have many indirect effects such as strengthening the regulatory process by expanding the range of perspectives available to the Board.

I recommend that the Board pursue unbundling of prices for discrete goods and services remaining within the regulatory ambit. Unbundling will benefit consumers directly by empowering them to make more informed energy decisions. As well, unbundling will benefit consumers indirectly by enhancing the potential for competition to develop. Candidates for unbundled prices include, but are not limited to, transmission services, storage services, customer accounting including metering and billing services, and load balancing. Unbundled prices will reveal to customers the underlying factors that drive their cost of service. Non-utility service providers will be able to acquire utility services for re-bundling with competitive services to provide new products that meet customer needs and enhance choice.

The Board should commit the gas industry in Manitoba to moving away from WACOG and buy/sell reference prices, and to replace them with market prices. Separating the merchant function for regulation will assist in this transition. The gas commodity market, in its current state of development, can be described as mature, highly liquid, competitive, and continental in scope. Market prices, in my opinion, are an excellent reflection of marginal cost. Beyond eliminating the inefficiencies and competition damping tendencies of WACOG and buy/sell reference prices, the positive benefits I would anticipate from market pricing for gas include increasing awareness of the seasonality of the value of gas, enhancing incentives for energy conservation on peak, and reducing costs for achieving service security during times of supply constraint.

One method of eliminating WACOG and buy/sell reference prices while enhancing customer choice is now being advanced in Ontario. The development of innovative Agent, Billing and Collection (ABC) service in Ontario, which I expect will provide significant benefits to customers, is a concrete example of benefits from both commodity deregulation and unbundling.

More than two years ago, Energy Probe developed and promoted the concept of fixed-price/fixed-term gas contracting for residential consumers. Under Energy Probe’s scheme, gas marketing would work like mortgage marketing in that competing marketers could offer consumers 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. Small users would gain the opportunity to eliminate uncertainty in commodity gas costs.

Happily, some utilities are now starting to enable customers and non-utility suppliers to make arrangements for fixed-price/fixed-term service. The three major Ontario distributors have recently committed themselves to provide ABC service for customers and their non-utility suppliers. Use of the ABC concept will allow residential and small general service customers the option of price security for fixed terms. For customers of Consumers Gas on ABC service, bills will separately identify fixed monthly charges, delivery charges, and commodity costs. The commodity supplier will also be identified on the bill along with its contact phone number. This separately identified information will allow customers to become much better informed about their gas service.

Under ABC, the price that customers receive for their commodity gas is negotiated directly with the supplier and not reliant on WACOG or buy/sell reference prices.

In Ontario, the organizational drive to develop ABC has come from non-utility suppliers seeking methods of responding to customer needs. Utilities are facilitating ABC by sufficiently unbundling and expanding their service offerings to allow marketers to couple Western Bundled T-Service with an Agency Billing and Collection service agreement. Without deregulation and unbundling, fixed-price/fixed-term service would probably not have become available.

ABC service is now before the Ontario Energy Board for approval in the current Consumers Gas rates case. I anticipate that ABC service will be in place for residential and small general service customers by the fall of this year.

Unfortunately, the future of the ABC option is clouded by the expressed intentions of Ontario distribution utilities to offer competing options through streamed prices. If the utilities pursue fixed-price/fixed-term service within the ambit of regulation, the integrity of the competitive environment could be threatened. Potentially, competitors will be unwilling to commit themselves to fully develop the market due to the threat of utilities competing against them using the many special advantages inherent to monopolies. The Ontario utilities have not yet released the details of their fixed-price/fixed-term rate plans. If their plans allow these rate options to remain outside and unrelated to regulation, gas customers will be better off.

Issue 3

Please describe the role of Centra Gas Manitoba Inc. in any changed marketplace including a description of what is the “minimum level of service” that can or should be provided by the utility.

Response

Any changes to the prevailing service arrangements in Manitoba must ensure protection of the interests of default customers—those who, for whatever reason, do not choose to deal with non-utility suppliers. Default customers should be supplied with system gas. System gas would be priced on as short a term as practical. The purpose of short term pricing is to eliminate the problems created by WACOG. Customers on system gas who seek price stability would be able to make arrangements with a non-utility supplier.

Issue 4

If the minimum level of service does not include natural gas procurement, transportation or storage, please discuss separation issues related to existing contracts, security of supply, obligation to serve, backstopping, nominations and load balancing.

Response

Under my merchant function separation and service unbundling proposals, the distributor’s obligation to supply would be unchanged. Existing commitments must be met regardless of separation decisions. I have commented on backstopping under Issue #3 and only have comments on load balancing to add.

As the gas market in Manitoba matures further, utility load balancing may eventually be reduced in importance and phased out from the pure utility. Utility load balancing may be replaced by efficient, alternative means of meeting the need. The development of an efficient and liquid spot market price for gas at relevant delivery points within Manitoba, particularly if combined with more advanced means of pricing gas at the meter and communicating those prices to consumers, could eliminate the need for utility load balancing services. Demand-sensitive prices in a mature market may eventually contain sufficient information to stimulate appropriate responses from transmission and storage service providers as well as consumers in order to balance loads reliably.

Issue 5

Describe what regulatory directives or legislative amendments may be required to support such changes. Please discuss what regulatory framework would be required in the new environment.

Response

I have no specific submissions on amendments to Manitoba laws or regulatory directives to implement these proposed changes.

Issue 6

Please describe any transitional considerations as well as a timetable for transition. Please discuss the dissemination of market information under the changed environment.

Response

The Board should encourage the utility to maximize supply flexibility. Flexibility will ensure that future commitments to storage, transportation, and commodity gas are not “strandable.” In the interests of fairness, all gas users should be allowed to come and go from system supply only on terms that leave other users unaffected. However, the flip side of this commitment ought to be that utilities manage themselves so as to maximize customer choice. Put another way, inflexible supply commitments, being impediments to customer choice and competition, ought to be minimized.

The market share of gas supply competitors after separation should be allowed to develop in a climate of fair competition. Complete separation in the merchant function is a most effective way to achieve fair competition. However, in the short run, the former utility affiliated gas merchant might enjoy substantial market share. I recommend extreme caution or forbearance in using regulation specifically to dilute market share. Assigning the appropriate market share would be entirely arbitrary. Competition will cause market shares to evolve over time.

Deregulation has been a success to date. However, the exact manner in which consumers have benefitted would have been impossible to predict at the outset of the process of deregulation. Similarly, it would be unreasonable now to demand predictions about the benefit of further deregulation. Deregulation will create incentives for producers to develop new products and find efficiencies, but we cannot now know what they will be.

Issue 7

Please discuss the guidelines for acceptable conduct between Centra Gas Manitoba Inc. and affiliated companies, including the methodology and costing for the transfer of assets, the sharing of resources including human resources and the use of a common name.

Response

Incomplete divestiture of the merchant business would be a costly second-best relative to complete separation. Problems created by adopting the second best include the question of how to manage and regulate affiliate transactions, who should bear the cost of regulating affiliate transactions, how to impute a value for the use of the utility’s name, what to do about the utility’s special access to information about customers such as load patterns and credit history, and how to ensure comparability of service to affiliates and competitors. Each of these problems is highly complex and controversial. A complete enquiry into these subjects would be a major undertaking. In the event of incomplete divestiture, affiliated companies and utility parents will have powerful profit-based incentives to skew the outcome in their own interest. At every turn, regulators will be confronted with impediments to their ability to serve the public interest.

Cleanly separating the merchant function from the distributor through a change in ownership eliminates these difficult problems. Affiliate transactions would not be an issue because the divergent interests of different owners would eliminate the problem of cross-subsidies. Without the risk of cross-subsidies, there would be no need for regulatory oversight over the merchant. The value of utility’s name and reputation would be recognized in the sale price. Similarly, information obtained by the utility merchant would be recognized in the sale price but after the sale, the former utility merchant would have to obtain market information by the same means available to any other vendor.

This concludes my pre-filed testimony.