The American Economic Association held their annual meeting this weekend in San Diego. There were many excellent presentations on energy, but one of my favorites was by Paul Joskow on the history of deregulation in the natural gas industry.
Joskow’s paper, which will be published in the May issue of the American Economic Review, argues that deregulation of natural gas and pipeline markets helped set the stage for the shale gas revolution.
While readers of this blog are likely familiar with the impact shale gas has had on natural gas markets, the figure below summarizes the story with prices. As recently as 2008, wellhead prices for natural gas were more than five times as high as their 2012 low. The increase in shale production drove the enormous – and unexpected – price reduction.
If wellhead prices were still regulated as they were from 1954 to at least 1980, the administrative apparatus for establishing prices alone would have slowed down development of these new resources. The cost-of-service mentality of the federal regulators would have undermined incentives to invest in a new and changing production technology (p. 16).
For example, he argues that:
The absence of liquid spot markets, short-term term contract markets, derivative markets along with pipelines and customers tied up for years with long term contractual commitments would have reduced market opportunities for shale gas, especially in the early years when many of the most innovative producers were small firms (p. 16).
Deregulation has become a dirty word to many people, as financial deregulation is often named as one of the factors precipitating the Great Recession. In energy circles, the California electricity crisis brought efforts to reform regulation in that industry to a screeching halt. Given the recent history, it’s useful to remind ourselves of the benefits of removing government oversight.
Joskow also points to the role of pipeline deregulation:
[M]any of the most promising shale plays (e.g. Marcellus, Utica) are not located in traditional producing areas and do not have in place the pipeline infrastructure to get the gas to market. The development of faster and more efficient pipeline permitting rules, pricing and contracting flexibility, and the evolution of a merchant pipeline sector that can develop and build new pipeline projects quickly and take on merchant financial risk, have made it possible for new and existing pipeline investors relatively quickly to build new pipeline capacity to serve these new producing areas (p. 16).
Low prices are certainly a boon to natural gas consumers and coal-to-gas switching has led to sizable reductions in carbon emissions in the US. But, the shale gas revolution has also drawn considerable attention for the negative environmental impacts. Detractors are as high profile and unexpected as Matt Damon, who stars in the recently released Promised Land. So, should the environmental issues color our interpretation of the benefits of deregulation?
Thinking about the answer to that question reminds me of being a nervous second-year graduate student in Joskow’s course on regulation. One of the first points he made as he described the course syllabus was that it’s important to distinguish economic regulation on the one hand from regulation of health, safety and the environment on the other.
Economic regulation refers to situations where regulators control economic variables, such as the prices firms can charge or the markets they can enter. It is often difficult, though not impossible, to justify this kind of heavy-handed government intervention. The economic arguments for regulating health, safety and the environment are usually easier to make, as there are often externalities or other market imperfections.
On the environmental consequences of shale gas drilling, Joskow notes that:
There are numerous pathways through which the various components of the exploration, development and production process can have adverse environmental effects (Resources for the Future (a) 2012). The scope and quality of state regulation varies widely (Resources for the Future (b) 2012), best practices need to be developed, the division of responsibility between state and federal regulators needs to be defined more clearly, the importance of different environmental impacts need to be measured much more precisely, and the industry needs to recognize that increased transparency will accrue to its benefit (p. 19).
He also points out that some of the states with the largest shale gas reserves, like Pennsylvania, New York and Ohio do not have recent experience regulating drilling. In a nod to the benefits of effective environmental regulation, he calls for new, stronger regulatory frameworks in these states.
 In the interest of full disclosure, Joskow was my dissertation advisor.
Catherine Wolfram is the Cora Jane Flood Professor of Business Administration at the Haas School of Business, Co-Director of the Energy Institute at Haas, and a Faculty Director of The E2e Project. Her research analyzes the impact of environmental regulation on energy markets and the effects of electricity industry privatization and restructuring around the world. She is currently implementing several randomized control trials to evaluate energy efficiency programs.