BOOK 3: ENRON ASCENDING: THE FORGOTTEN YEARS, 1984-1996
Chapter 10 Internet Appendix
10.1 Competition: Real World vs. Theoretical
10.2 Enron Memos on Natural Gas Transmission Deregulation
References for Chapter 10 Appendix
10.1 Competition: Real World vs. Theoretical
The competitive position of Transwestern Pipeline in the southern California gas market in the mandatory open-access era (1985–) provides a case study of real-world competition versus the technical view of neoclassical economics.
This difference was a subject of Book 1, where “capitalist reality” was contrasted to equilibrium states that assumed away entrepreneurship (Capitalism at Work, chapter 4), as well as in these three Book 1 appendices: “Equilibrium versus Market Process; Entrepreneurship in Economics: From Unknown to Missing”; and “The Remarkable” Influence of Perfect-Competition Theory.”
Two Views
In 1988, Transwestern Pipeline (where this author worked at the time) sought to make a case for “workable competition” (per neoclassical economics) for the southern California natural gas market to persuade the Federal Energy Regulatory Commission (FERC) to lighten cost-based ratemaking pursuant to the Natural Gas Act of 1938 (NGA).
As interpreted by FERC, the “just and reasonable” rate (an NGA term) was cost-based, meaning a maximum rate based on a cost allocation of reasonable costs plus the allowed rate of return on invested capital. This rate ceiling was year-round without regard to demand conditions; charging peak-versus-off-peak rates, or seasonal rates, was impermissible, even if the average rate was at or below the legal ceiling rate.
Transwestern consultants Charles Cicchetti and Jeff Makholm (NERA Economic Consultants, or National Economic Research Associates) were tasked with the job of making a case for competition and thus rate flexibility/liberalization. Yet they described the southern California market as “one of the least competitive” in the country despite rate discounting from the legal maximum on many days and months of the year (Bradley memo, 1988). The Ph.D. economists also gave no weight for potential entry (new capacity), which, indeed, would be motivated as the result of market-based ratemaking.
Their view of economic efficiency was static, based on the neoclassical theory of “perfect competition” where innumerable distinct competitors working with perfect knowledge created a state of rest at which prices equaled marginal cost and no other welfare gains were possible. FERC was wed to this technical view, employing the Herfindahl-Hirschman index (HHI), which squared each firm’s percentage of the market to measure concentration levels between perfect competition’s zero and pure monopoly’s 10,000 (Bradley, Oil, Gas, and Government, pp. 839–42).
My meeting with Cicchetti and Makholm was one of the most frustrating of my 16-year Enron career. I went into the meeting expecting (naively as it turned out) real-world notions such as rate discounting (from pipeline-to-pipeline rivalry) and new entry (from pure profits) to carry weight. Such qualitative points were not “rigorous” to these two technical economists—and to FERC, which was wed to HHI evaluation of competition.
Cicchetti and Makholm made a different argument that would have currency under a neoclassical view of competition. Since Southern California Gas Company at the time was the sole buyer (creating a “monopsony”) for southern California, the two argued that the market was competitive from a monopsony/monopoly situation.
FERC, alas, never seriously entertained the notion that Transwestern’s primary market was competitive, allowing it to significantly relax rate regulation, much less implement full deregulation.
1992 Memo on FERC Competition Theory
In a memo to Transwestern executives Terry Thorn and Kevin Kernan (Bradley, 1992), I critically assessed FERC’s Discussion Paper Assessing Competition in Natural Gas Transportation.” I took issue with the “structure-conduct-performance” approach of Richard O’Neill/FERC to favor a real-world, market-process view of competition.
My memo is reproduced verbatim:
Dick O’Neill and his staff at the FERC’s Office of Economic Policy have prepared a working paper to evaluate whether natural gas transportation markets are workably competitive. The working paper and its appendices are very technical, manipulating market concentration ratios to arrive at a structural test for pipeline markets.
What is underemphasized or missing in the working paper is consideration of real-world competition as the industry understands it. In other words, rate discounting, surplus capacity, new entry and bypass, alternative fuel competition, and other factors make markets very competitive whatever the market shares of its individual participants.
For example, the California gas market is not workably competitive under the HHI index because one supplier (El Paso) has a market share over 50% (or HHI of over 2,500). Yet this market is extremely competitive because a 20% capacity surplus has forced discounting by pipelines to attract incremental business.
Second, the static approach of formal modeling to measure competition ignores the fundamental points that competition is a process and not a state. In other words, to the extent that an imperfect market allows transporters to earn monopoly rents or offer inferior service, incentives are created for existing suppliers or new suppliers to rectify the situation. Point-in-time analysis misses the fact that markets are often self-correcting as entrepreneurs continually try to improve upon the status quo.
Third, the paper never considers the imperfections of regulation itself. It is assumed that regulation is a costless alternative to correct imperfect pipeline markets. If the working paper assessed a realistic estimate of the cost of FERC regulation, then a range of alleged pipeline-market imperfections could be accepted as optimal. Policy reform could also focus on removing anti-competitive regulations to allow pipeline markets to be workably competitive.
The working paper reflects one school of thought on the competition issue—the so-called “structure-conduct-performance” school. In the last decade, however, a new orthodoxy has emerged. The so-called “New School” or “Chicago School” of industrial organization tends to toward a process view of competition and emphasizes institutional factors such as asset specificity and transaction costs to explain i) how industrial concentration had emerged and ii) the high cost of imposing atomistic competition. As Paul MacAvoy recently told the INGAA board on this issue, the Chicago School is now the dominant one in the profession.
10.2 Enron Memos on Natural Gas Transmission Deregulation
In February 1996, this writer, now director of public policy analysis at Enron, a corporate level position, formed a Task Force, the Future of Natural Gas Pipeline Regulation, to “think through, and even write, a ‘dream NOPR’ [Notice of Proposed Rulemaking] that covers the intersection of good public policy and what is good for Enron” (Bradley, “Ideas”). This initiative followed some industry interest in reopening the sacrosanct Natural Gas Act (1938) to “giving pipelines, and the gas industry in general, a more flexible system for filing rates” (“Gas Industry”).
This memo discussed how to mobilize support outside and inside the FERC, assuming the upside was worth the possible tradeoffs and lobbying expense. The result could range from “let’s make this happen” to “let’s stick with incrementalism in our rate cases.”
An April 1996 scoping meeting reviewed:
- Enron’s role in major post-Order No. 436 regulatory developments to date;
- The arguments for and against interstate pipeline regulation, particularly arguments that have not been part of the debate before;
- The effect of deregulation proposals on Enron’s financial reporting requirements (FASB 71);
- The regulatory positions of industry trade groups and constituencies and possible “win, win” combinations of deregulatory positions;
- The political process behind FERC nominations and NGA amendment. (Bradley and Hartsoe, 1996)
A June meeting of interstate pipeline representatives followed, at which the author issued a hypothetical trade press article (“FERC Announces”), dated the next year, which reported:
The new market-oriented FERC announced a sweeping reform package this week that would replace traditional Natural Gas Act regulation with market reliance and self-regulation through Commission-sanctioned settlement contracts….
The so-called “deregulation NOPR” would deregulate rates for existing and new capacity, covering both firm and interruptible capacity in the primary and secondary market…. On the service side, certification requirements for entry, exit, and new services would be terminated….
The Commission gave four reasons for the deregulation NOPR:
- “market competition has made rate and service regulation increasingly irrelevant;”
- “existing regulation itself was monopolistic, whereas self-regulation via individual contracting was ‘workably competitive’”;
- “value pricing, even when above embedded cost, promotes economic efficiency by fostering conservation on the demand side and new entry on the supply side”; and
- “self-help negotiations promote entrepreneurial outcomes and reduce regulatory costs for the entire industry.”
The visioning exercise ended with the above hypothetical. Alas, the market-oriented FERC that would have been needed to be nominated and confirmed for such a bold step did not eventualize. Congress, too, would have needed to amend if not repeal the Natural Gas Act to effectuate such sweeping deregulation. This left the status quo, incremental liberalization via rate cases and other FERC proceedings.
References for Chapter 10 Appendix
Bradley, Robert, Jr. Capitalism at Work: Business, Government, and Energy. Salem, MA: M & M Scrivener Press, 2009.
Bradley, Robert, Jr. “Evaluation of FERC Discussion Paper Assessing Competition in Natural Gas Transportation.” Enron memorandum, December 15, 1992.
Bradley, Robert, Jr. “‘FERC Announces Sweeping Deregulation Plan for Interstate Natural Gas Pipelines.’ Natural Gas Report, June 12, 1997” (hypothetical article by the author, 1996)
Bradley, Robert, Jr. “Ideas on a Task Force on the Future of Natural Gas Pipeline Regulation.” Enron memorandum, February 21, 1996.
Bradley, Robert, Jr. “Meeting with Charles Cicchetti.” Enron memorandum, January 29, 1988.
Bradley, Robert, Jr. Oil, Gas, and Government: The U.S. Experience. Lanham, MD: Rowman & Littlefield, 1996.
Bradley, Robert, Jr., and Joe Hartsoe. “Agenda for Deregulation Task Force.” Enron memorandum, April 8, 1996.
“Gas Industry Starting to Revisit Natural Gas Act.” Gas Daily, April 22, 1996.