Do Americans Consume too little Natural Gas?An empirical test of marginal cost pricingBy : Lucas W. Davis

& Erich Muehlegger

Presented by: Fadhila

US Natural Gas Market I• The US NG market consists of:

o Gas Producerso Interstate Pipeline Operators o Local Distribution Companies (LDCs)

• Cost of LDCs depends on:

o No. of customers o The marginal customer cost that includes:

• Installing and maintaining gas meters• Processing bills• Taking customer service calls• NG Purchasing costs: commodity cost measured by city-gate price

US Natural Gas Market II• Rate-of-return pricing:

Total Revenue = Total operating costs + allowed rate of return on firm’s capital expenditure

• Best pricing techniques:A. “Ramsey-Boiteux” which consider the welfare-maximizing markup in

proportion to the inverse of the elasticity of demand.is a positive constant

B. Two price tariffs regulators (as suggested by Coase 1946) can set marginal prices = MC and fixed fees to cover fixed costs.

Data (1991 – 2007)• Sales, revenues, & no. of customers of each LDC

based on the ownership (municipally-owned & investor-owned)

• Prices by state level, period (monthly and annually), & customer classes (residential, commercial, industrial, & electric utility)

• Electric utility & non-core customers were omitted. Why:o Huge quantities, profitable to build their own dedicated pipeline & bypass

LDCo LDC does not has a good bargain power over those

Results I• Testing MC Pricing:

1. Plot the consumption and the net revenue by month for residential NG customer for Illinois state

2. Plot the fitted value of monthly net revenue from residential sales per customer NRt regressed on monthly gas consumption per customer qt

Where, is the average amount paid in fixed monthly fees is the average per unit markup over the city gate price

3. Allow and to vary by state, year, and customer class

Results II• Calculate DWL:

1. Estimate elasticity of demand for each sector2. Calculate DWL (area between MC and current pricing) 3. For each customer class regress the log of monthly consumption on

the: • log of average NG prices, • state*month of year fixed effects, • state*year fixed effects

• Include:o Spot prices of Brent crude oil in the demand equation as some

industrial customers has the option to switch between NG and fuel oilo Same month cooling & heating degree days with prices; to allow the

elasticity to vary with temperature*

Results III• Estimates of Annual DWL:

1. Current pricing system yields an annual welfare losses of $2.7 billion compared to MC pricing.

2. This represents approx. 3% of US 2008 NG total expenditure.

3. The magnitude of DWL is sensitive to the elasticity of demand for NG (in the long-run prices has larger elasticity than in the short-run)

Causes & Consequences of

Current Rate Structure I1. Profit Max. by LDC:

o Rate-of-return regulation incentiveThe allowed rate of return on capital investment = The firms market rate of return on capital for riskless assets

Averch-Johnson effect

Where is:R = revenue functionK = quantity of capitalL = quantity of Laborw = wage rates = the allowed rate of return

* (Visccusi, Harrington Jr. and Vernon 2005)

Causes & Consequences of

Current Rate Structure II2. Distributional Consideration:

o Low fixed fees means high demand customers pays large proportion of fixed fee compared to low demanders.

o Shift the burden from high user customers to low users

3. Environmental Externalities:

o Comparison with CO2 (residential & commercial customers exceeds marginal social cost) • Based on $10 or $15 optimal tax, average NG customer pays $50

per metric ton of CO2o No environmental justification for the size of the markup the results

observed

Ownership Structure and

Efficiency II

• 10 percentage point increase in the share of deliveries for Industrial & Electric customers will cause 12%-13% reduction in net revenue

• Approx. 25% to 30% of municipally-owned utility fixed costs borne by taxpayers instead of NG customers

• This creates social welfare of $733 million to NG customers• Tax collections introduces distortions in the economy

Ownership Structure and

Efficiency III

Privet-Owned Distribution Co.• Advantages:

1. More incentive to reduce cost2. Regulatory lag provide incentive to reduce costs 3. Managers are more motivated due to the threat that they would be

replaced by a disappointed regulator (takeover threat)

• Disadvantages:1. Difficult for regulatory to get detailed information about the firms cost2. Inefficiency might occur (e.g. overcapitalization)

Concluding Remarks I

• Strongly reject MC pricing

• Residential and commercial markups are the highest

• The current system (low fixed cost and high per-unit price) implies that there are too many NG customers each pay too little

Concluding Remarks II• Regulators to work with LDCs to “levelize” rate

structure by increasing per-unit price and decreasing fixed

• Add Carbon taxes to “levelized” rate which will;o Ensure that energy sector accurately price for privet and social costso Will create incentive for reducing carbon emission from NG productions

• Marginal connection costs should be included in fixed fee

Thank You