Do Americans Consume too little Natural Gas? An empirical test of marginal cost pricing By : Lucas W. Davis & Erich Muehlegger Presented by: Fadhila

US Natural Gas Market I The US NG market consists of: o Gas Producers o 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

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 LDC o LDC does not has a good bargain power over those

Results I

Results II Calculate DWL: 1.Estimate elasticity of demand for each sector 2.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 oil o 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 I

Causes & Consequences of Current Rate Structure II 2.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 2.Environmental Externalities: o Comparison with CO 2 (residential & commercial customers exceeds marginal social cost) Based on $10 or $15 optimal tax, average NG customer pays $50 per metric ton of CO2 o 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 cost 2.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 cost 2.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 costs o Will create incentive for reducing carbon emission from NG productions Marginal connection costs should be included in fixed fee

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