Stranded Gassets – Energy Institute Blog - Energy Institute at Haas

Stranded Gassets - Energy Institute Blog

Stranded Gassets

New EI research finds that some utilities are over-investing in natural gas pipelines.

The momentum behind an accelerated clean energy transition is building. This transition has the potential to deliver significant GHG reductions. It could also leave some fossil fuel infrastructure under-utilized or “stranded” before capital investment costs have been fully recovered.

Stranded asset risk notwithstanding, the U.S. is plowing ahead with investments in natural gas infrastructure. According to the EIA, there are over 2,500 miles of approved/under construction interstate natural gas pipeline expansion coming online in the coming years and an additional 1,600+ miles awaiting approval. At an estimated construction cost of $10 million per mile, these in-the-pipeline pipeline expansions add up to real money.
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Do we really need all this new natural gas pipeline capacity? And if not, why the heck are we building it?

A new EI working paper by PhD student (and job market candidate) Leila Safavi brings some compelling – and concerning – evidence to bear on these questions. Leila’s research shows how vertical relationships between regulated utilities and natural gas pipeline owners can create incentives to over-build the natural gas pipeline capacity. This over-investment leaves utility ratepayers footing the bill for under-utilized natural gas pipeline infrastructure.

Natural gas transportation economics 101

To understand Leila’s intriguing research results, you need to understand some basic facts about how natural gas is transported, how this transportation is regulated, how contracts are structured, and who is on the buying side.

Natural gas transportation: In the United States, we rely on pressurized pipelines to transport natural gas from places where we extract natural gas (purple on the map below) to trading hubs (red on the map below).

Pipeline regulation: The transportation of natural gas across state boundaries is regulated by the Federal Energy Regulatory Commission (FERC). One of FERC’s primary responsibilities is to approve pipeline infrastructure projects. Prior to approving a new project, FERC must establish that the project “is or will be required by the present or future public convenience and necessity”.

Historically, FERC has considered long-term contracts between pipeline companies and potential buyers as proof that the public wants or needs a pipeline. This practice is premised on the argument that private companies would not sign a long-term contract unless there was sufficient market demand for the project. We’ll come back to this…

Contracting: The pricing structure of pipeline contracts is also regulated by FERC. Typically, a company that wants to build a new pipeline will enter into “precedent agreements” with buyers who want to reserve capacity on the new pipeline. These agreements specify fixed fees paid on each unit of capacity under contract. Importantly, buyers must pay these fees regardless of how much gas they actually transport.

Buyers: There are many kinds of firms on the buying side of these agreements. In her paper, Leila usefully classifies these buyers into two cross-cutting categories:

Affiliate buyers (A & C) are vertically integrated or “affiliated” with the pipeline company.

Utility buyers (A & B) supply natural gas or electricity generated using natural gas to their customers. Many of these utility buyers are subject to cost-of-service regulation. Once a utility’s natural gas transportation costs are approved by a state utility regulator, they can be passed through to utility customers.

“Self-dealing” in pipeline capacity

The fact that some pipeline companies are selling pipeline transportation to buyers owned by the same company need not be a problem. In fact, vertical mergers have been shown to generate efficiency benefits if affiliated companies can more efficiently coordinate operations.

The point of departure for Leila’s research, however, is that problems can arise when natural gas pipelines sell transportation services to a utility affiliate that is subject to cost-of-service regulation. Leila uses an economic model to elucidate the incentive problems running around in that red box above. I can’t do justice to the model in a short blog post. Instead, I’ll use a choice example to illustrate the crux of the issue (drawing heavily from this 2023 law review article).

Back in 2016, Spire STL proposed a project that would increase the pipeline capacity supplying St. Louis, Missouri. The company signed a precedent agreement with its utility affiliate in St. Louis. This was a controversial project because there was no demand growth projected for St. Louis. Regardless, FERC was not inclined to “second-guess” Spire’s business decision to pursue the project. With the precedent agreement in place, FERC approved the pipeline.

This example illustrates how profit motives are poorly aligned with the public interest when pipeline companies are affiliated with regulated utilities. As long as pipeline companies are able to find buyers, FERC allows companies to recover a 14% rate of return on these investments. Companies with regulated utility affiliates can thus increase profits by over-building a pipeline, selling this capacity to its downstream utility affiliate, and sending captive utility customers the bill.

An isolated case or a widespread problem?

The Spire case is a striking example of self-dealing. But it is just one case. To investigate whether this is a more ubiquitous problem, Leila heroically collected precedent agreements for almost all pipeline expansion projects completed between 2010-2021. She painstakingly documents the vertical relationships between the buyers and sellers implicated in these contracts, assigning each contract to one of the four categories summarized above. And then she tracks the prices and utilization rates for the pipelines once constructed.

With all these data in hand, Leila can carefully compare the utilization rates at pipelines built by companies with utility affiliates (A) against other types of pipeline projects. She estimates that average utilization rates on pipelines used by utility affiliates are 60% lower than utilization rates at expansions with just utility buyers (B) or just affiliate buyers (C).

At this point, you might be thinking that differences in *average* capacity utilization are not a great measure of over-investment if the value added by natural gas pipelines primarily manifests when demand for pipeline capacity is highest. Leila replicates her analysis focusing on days when pipelines are likely to be more congested and her results are qualitatively unchanged. Overall, the differences in utilization rates across buyer categories that Leila documents suggest that pipeline companies with utility affiliates have been over-building natural gas pipeline capacity.

Why worry about stranded gassets?

There are a number of reasons to be concerned about over-investment in natural gas infrastructure. One is the cost burden it imposes on consumers. Most U.S. households buy their natural gas from a utility that has at least one affiliated pipeline company. Leila’s back-of-the-envelope calculations estimate that this capacity inflation has led to a $2.4 billion transfer from consumers to pipeline owners. This cost burden further exacerbates concerns about recovering legacy costs from a shrinking consumer base as more households electrify their homes.

Amidst growing concerns over the cost and the climate impacts of building new natural gas pipeline infrastructure, it seems clear that we need increased scrutiny of pipeline expansion proposals going forward. What is not clear (to me) is what form this reform should take. Should be focusing efforts on FERC oversight, state utility regulators, or some combination of the two? The sooner we negotiate these regulatory reforms, the lower the risk that we build pipelines we don’t need for our clean energy future.

Suggested citation: Fowlie, Meredith, “Stranded Gassets”, Energy Institute Blog, UC Berkeley, November 20, 2023, https://energyathaas.wordpress.com/2023/11/20/stranded-gassets/

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