Incentives for Vertically Integrated Firms in the Natural Gas and Electricity Markets to Manipulate Prices.

• Author: Hinchey, Nathalie

In 2019, the EIA projected that natural gas combined-cycle units were likely to be the marginal supply for electricity generation in the U.S. through 2050 (EIA, 2019). While the overall supply of natural gas has expanded as a result of the "Shale Gas Revolution", limited pipeline capacity for delivering that supply to some regions has resulted in sometimes fierce competition between different potential customers. These customers can typically be grouped into three different categories: retail (residential and commercial), industrial and electric. Historically, retail sector demand for residential heating dominated natural gas demand, particularly in northern locales where cold weather outbreaks lead to strong winter peaks in demand. These retail customers tend to be supplied by utilities, which purchase natural gas for their customers through the wholesale market. Demand for industrial use and electricity generation, on the other hand, are often supplied directly from the wholesale markets.

The key issue I examine in this paper is the possibility of vertically integrated firms that own midstream and downstream natural gas assets, as well as gas-fired electric generation, manipulating gas supplies to increase electricity prices and thus increase overall profits. My point of departure is a recent study by the Environmental Defense Fund (Marks et al., 2017), which claims that two natural gas local distribution companies (LDCs) in New England, whose parent entities also own electricity generators, purposely withheld pipeline capacity from wholesale purchasers to increase natural gas prices and hence increase profits for their electricity generators. They calculate that the claimed action imposed losses on the order of $U.S. 3 billion on electricity and natural gas ratepayers. Their study prompted an investigation by the Federal Energy Regulatory Commission (FERC, 2018), presumably into whether the two accused firms' scheduling practices were orchestrated to manipulate the market in withholding natural gas pipeline capacity to the wholesale market in New England from 2013-2017. The FERC's investigation found no evidence of anticompetitive withholding of natural gas pipeline capacity by either company.

While FERC ultimately determined that there was no anticompetitive withholding by the two LDCs in the New England natural gas market from 2013-2017, the Environmental Defense Fund study and subsequent FERC investigation raise interesting questions of a more general nature regarding the increasingly interconnected electricity and natural gas markets in every geographic region. In particular, under what conditions would vertically integrated firms be motivated to withhold pipeline capacity from the wholesale market to artificially increase the price of natural gas, potentially increasing generation costs for electricity, and consequently increasing the profits they earn in the electricity market? Furthermore, if a vertically integrated firm allocates more pipeline capacity to the retail market than it ultimately ends up using, could such behavior be viewed as an attempt to withhold pipeline capacity from the wholesale natural gas market and manipulate electricity prices? (1)

This paper provides an analytical framework that allows one to assess the potential for vertically integrated firms to profit from withholding natural gas pipeline capacity. It shows that firms can choose to allocate more pipeline capacity to the retail market than the wholesale market for a variety of reasons. In particular, a firm may choose to allocate more pipeline capacity for retail gas, holding all else equal, if doing so will 1) reduce the likelihood of facing retail market penalties, 2) increase its profits in the wholesale natural gas market, or 3) increase profits earned in the electricity sector. Importantly, the first two reasons do not constitute market manipulation because they each serve a stand-alone legitimate business purpose: the first is the avoidance of penalties and the second is the traditional exercise of market power. (2) The third reason, however, could be considered a cross-market manipulation. Market manipulations are generally defined to occur when an economic decision is not profit-maximizing on a stand-alone basis, but rather undertaken to increase profits in unrelated markets. Recently, Ledgerwood et al. (2019) defined market manipulation to be an action that "injects information into the market to cause demand or supply to 'falsely' or 'artificially' deviate from their economic fundamentals."

This analysis will show that integrated firms may be motivated by legitimate and/or manipulative reasons when determining their allocation of pipeline capacity between the wholesale and retail natural gas markets. It finds that in order to suggest a manipulation has occurred, it must be shown that penalties and profits in the gas markets have little effect on the firm's allocation mechanism and that it is instead guided by profits in wholesale electricity markets. Furthermore, it finds that it is easier to detect manipulative behavior when pipeline constraints are not binding, as there are less confounding factors that arise when there is sufficient pipeline capacity. It is important to note that for the previous statement to be true, there must be the pipeline equivalent of a "pivotal supplier" with sufficient contracted capacity such that its supply of pipeline capacity is necessary to clear the market. The pivotal supplier could theoretically reduce pipeline supply and artificially make the constraint binding, thus rendering a potential manipulation profitable. More generally, the framework provides a basis to understand the decision to allocate supply, which is scarce as a result of limited pipeline capacity between the wholesale and retail natural gas markets. The results of this paper should aid policymakers in formulating regulations to increase efficient market outcomes by providing a theoretical understanding of the current incentives in the natural gas markets.

1. RELEVANT LITERATURE

   This study was inspired by the FERC's recent investigation into the alleged market manipulations of natural gas prices in New England and the FERC's decision to drop its investigation of anticompetitive withholding in the natural gas capacity market. The FERC's investigation was motivated by Marks et al. (2017), which claimed two firms scheduled more gas than they actually delivered, consequently reducing pipeline capacity and creating price spikes. Marks et al. (2017) claim that state regulations, which require firms to repatriate the majority of their profits earned in the wholesale market back to ratepayers, encourage integrated firms to withhold pipeline capacity. They analyze panel data of pipeline scheduling and find that firms operating in states with higher pass-through rates tend to schedule more natural gas than they actually sell. Marks et al. (2017) construct a counterfactual scenario where they find natural gas and electricity prices were 38% and 20% higher, respectively, due to the alleged capacity withholding. In response, Levitan and Associates, Inc. (2018) argued that the contested behavior could be explained primarily by demand forecasting errors and penalties incurred when an LDC fails to reserve sufficient space for its retail demand.

   Apart from the specifics of the New England case, there is an extensive and growing literature on vertical integration and its effects on competition. Riordan (2005) provides a comprehensive review of the field, grouping and categorizing the literature by unifying themes. Riordan (2005) discusses the importance of market power assumptions in the upstream and downstream markets when determining the effects of vertical integration on consumer welfare. Hart and Tirole (1990) develop a theoretical model to examine vertical integration and how it affects competition both in upstream and downstream markets, and use their model to assess some well-known vertical mergers. Rey and Tirole (2007) provide an overview of market foreclosures, which occur when a firm restricts output by using its market power in another market, and their impact on consumer welfare, as well as potential remedies.

   An important concept considered in the literature described above is what is known as raising rivals' costs, which is discussed in Salop and Scheffman (1983). This occurs when an upstream firm increases the prices of production inputs to the rivals of their downstream counterparts, thus increasing market prices and profits for their downstream counterparts. With respect to the energy markets, Hastings and Gilbert (2005) examined the West Coast wholesale gasoline market from 1996-1998, finding that mergers between retail firms and refineries in the gasoline market led to higher wholesale prices of gasoline. In a context more like the New England case outlined above, Barquin et al. (2006) discuss the potential costs for consumers from allowing a merger to occur between a prominent Spanish electricity producer and a natural gas distributor, and illustrate the potential market manipulations that could occur with such a merger.

   Hunger (2003) also examines the incentives to manipulate prices when natural gas and electric utilities merge. He argues that the elasticity of supply in the downstream market, as well as the amount of inframarginal capacity in the electricity market held by the vertically integrated firm, are crucial in understanding a merged firm's incentive to manipulate prices. If the conditions outlined in Hunger (2003) aren't met, the author argues the merged firms have no incentives to manipulate market prices and should thus not be accused of intentionally doing so. The model that I develop corroborates and formalizes some of the insights from Hunger (2003).

2. REGULATION OF LDCS

   An LDC's decision to allocate limited natural gas pipeline supply between the wholesale and retail markets...