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.
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/
Categories
Energy Institute Blog 
This was a good read.
This is what I love in your post
[Result-start]
Great blog post! It’s important to examine whether we really need all this new natural gas pipeline capacity. The evidence presented by Leila Safavi in her research raises some compelling questions about the over-investment in natural gas pipelines. What are your thoughts on potential regulatory reforms to address this issue?
[Result-end]
Thanks, Ely
Reading this piece, I couldn’t help but think of the role stranded energy assets played in the California electricity crisis of 2000-01. In particular, PG&E and Southern California Edison were desperate to recover their hefty stranded costs in the San Onofre and Diablo Canyon nuclear plants in negotions on AB 1890, which “deregulated” the IOU electricity market in 1996. (I’m not wading into the debate here over whether they should or should not have been able to recover these costs from ratepayers.) On the one hand, they had a fiduciary obligation to shareholders to recover these costs, but that recovery effort led to some very short-sighted concessions — just stupid, to be frank — most notably the retail rate freeze that essentially eliminated demand elasticity. The state was wallowing in cheap electricity amid a major surplus of power when AB 1890 passed, and that surplus appeared to the IOUs, CPUC, legislators, and Gov. Wilson to stretch into the distant horizon. (To be fair, FERC’s failure to adhere to the Federal Power Act’s stipulation that rates must be just and reasonable is absolutely on the FERC more than it is on the aforementioned state stakeholders, but those stakeholders didn’t understand the extent to which the FERC would control the wholesale market after the IOUs divested their natural-gas powered plants.)
And speaking of natural gas, it’s ironic that the possible “consumer burden” from standed assets now, as Leila has highlighted, is tied to “capacity inflation.” A primary catalyst of the second, and most devastating, wholesale electricity price surge in 2000 (begining in November) was a purported lack of NG capacity in crucial NG piplines in California controlled by El Paso Corporation. Something seemed fishy, and it was. As CPUC attorney Harvey Morris noted more than 20 years ago, El paso “basically kept so much of the capacity to themselves, the prices went through the roof. It was the same as closing off part of the pipeline.” In a 2003 settlement negotiated by Attorney General Bill Lockyer, California recieved $1.45 billion from El Paso.
What’s happening now with over-capacity, as Meredith describes, is above-board and approved by FERC. But just as reforms came about as a result of the El Paso scheme, judicious reforms are needed in the very near future to deal with over-capacity.
With the shift to electricity where will the generation come from…..natural gas?
Good point. PG&E used to have 50% of its energy from fossil fuels, oil and coal in 2004. Today it is only 8.5% from natural gas only. The problem is PG&E charges more than double for its energy than utilities using fossil fuels like coal. The State of California allows the privately owned utilities collect for damages from Natural disaster and legacy costs to the rate payers. PG&E is one of the greenest utilities in the country with loads of solar and wind power and more coming online every day, it is the politics of California to take from the rich and give to the poor that also makes rates for those on one of the poverty rate programs so high. PG&E is also a leader on energy storage on a utility scale, but it will take 30 years of energy storage construction to get us to a totally fossil fuel free winter market. As conservation has basically lowered the homeowner’s energy usage, overall, legacy costs, pensions and maintenance have all gone up and is also reflected in the rates they ask for from the CPUC. Wages of the working class have been stagnating in comparison to inflation over the past 30 years. Transitioning to clean energy is expensive as old infrastructure has to retire early and new infrastructure has to be built to be fossil fuel free. The state of California, that mandates the changes, should be helping out of funds derived from the graduated income taxes but instead make the utilities collect the funds from rate payers. For the homeowner, off-grid solar and batteries are the only way out of the crunch coming their way.
I’m glad to see the interest in gas issues at the Energy Institute and would love to see work on the challenges of the gas-electric interface, which have repeatedly caused winter reliability problems. Some of the most recent problems are documented in this FERC report: https://www.ferc.gov/media/analysis-pjms-winter-storm-elliott-report-2023
“…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.”
The Public Utility Holding Company Act of 1935 (PUHCA) specifically banned U.S. energy holding companies from owning both gas and electricity subsidiaries to prevent these inevitable conflicts of interest. Holding companies were subject to annual audits by the SEC, and were forbidden from making campaign contributions. Lobbying was heavily restricted.
Today, PUHCA could be amended to prohibit holding companies from owning both pipeline and electricity subsidiaries, but the Act was repealed in 2005. And as was the case during the 1920s, the more gas that is wasted by electricity utilities (and the more pipelines that are built), the more profitable their parent companies become.
Electricity prices are skyrocketing. Should we be surprised?
What makes the poor incentives especially sad is that we have a tremendous need for electricity transmission. During the electricity transition, we can expect a doubling of electricity demand and a need to move much of this power from areas with excellent renewable resources. Infrastructure should be built to maximize social welfare in forward-looking planning models that co-optimize transmission and resource investment. We need to do this in electricity, gas, and transportation.
Hi Meredith, Thank you for the interesting post. Just a nit — the pipelines don’t necessarily deliver to trading hubs. They do deliver to the “citygates” of local distribution companies (LDCs) and, in some cases, directly to large natural gas power plants. For example, if you look at the Figure 1 map there are no red boxes in Florida but Florida Gas Transmission, a pipeline, delivers to LDCs throughout Florida as shown on the FGT system map here, https://fgttransfer.energytransfer.com/ipost/FGT/maps/system-map Best wishes, Steve Huntoon
>
FERC allows a 14% return in a market where typical returns are more like 7%. No wonder the gas pipeline companies press so hard to build new pipelines. If the excess returns were brought under control, most of this problem would disappear.
Natural gas is an emergency peaking and load following fuel. My hourly models on https://egpreston.com show we cannot get rid of the natural gas capacity even as we are reducing the amount of energy supplied by fossil fuels. Look at https://egpreston.com/Preston2023.mp4 to see what happens when we phase down the burning of fossil fuels in a non nuclear plan and a plan with nuclear power in ERCOT. The gas pipelines will be needed if there is gas demand which it appears will be needed in extreme weather events. It would be nice if these lines can be converted to a green fuel in the future.
The only totally green fuel is off-gid solar or wind turbine electricity generated and stored for use at all hours. Batteries have gone up in price 30% over the last two years just about the same as the IRA 30% tax credit program. With NEM 3.0 and Battery prices go so high, time to let the market thin the herd of solar installers and high-priced batteries. Many solar companies will be going out of business especially those that have the highest prices like Tesla Solar Roof and Sunpower unless they drop their prices and do off-grid installations instead of grid tied installations like they do now. Of grid solar gets the same tax credits as grid tied but no one installs off-grid rooftop solar. WHY?