The Price Isn’t Right

Price caps fail

Suddenly politicians in Washington are concerned about a natural gas crisis. Indeed, Energy Secretary Spencer Abraham has convened the National Petroleum Council to discuss the matter on June 26 in Washington. Current natural gas prices are high – more than double their low prices five years ago – and futures prices indicate that natural gas supplies are likely to continue tight in the short run. Does that fact mean that we have a full-blown energy crisis and require government action? Maybe; but not the price caps that have been the frequent remedy for high prices in this and other industries.

First, some history. Natural gas markets have been largely deregulated since the late 1970s, after some initial fits and starts. Deregulation unleashed previously unknown value creation that benefited consumers and producers alike. As a consequence, by the 1990s natural gas was widely available at very low prices, so low, in fact, that some producers went out of business or confined their extraction to well-known deposits. This price and profit cycle has historically been lamented in the industry.

Another constructive development since natural gas deregulation has been the creation of thick, liquid, sophisticated financial markets for natural gas. Futures, options, puts, calls, and more complex derivatives – all have enabled risk spreading in natural gas markets. The ability to hedge risk across time and across different market conditions has substantially decreased the volatility in natural gas prices.

So, with this happy story of the ability of market processes to create value and stem price volatility, why this increase in natural gas prices? The price increase is not as sudden as has been the political realization of it. Natural gas prices have been increasing since the late 1990s. It is also, not surprisingly, the consequence of the interaction of demand, supply, and forces that shape demand and supply.

Many analysts and energy industry experts have, correctly, pointed to supply restrictions as the prime cause of the rigidity of natural gas supply. In particular, they argue that limitations on drilling on federal lands, in consideration of the environmental amenities attached to those lands, have constricted potential exploration options. Such limitations do indeed make supply more inelastic.

However, an emphasis on constrained domestic supply works in conjunction with the very important role that demand has played in increasing natural gas prices. Environmental regulations, formulated largely in the 1990s and in the wake of natural gas deregulation, are premised on the fact that natural gas is a clean and cheap fuel for electricity generation, particularly relative to bituminous coal. Based on that presumption, air quality regulations have led to a situation in which the only economical way to build new power plants is to fuel the facilities with natural gas. Furthermore, improvements to existing plants that have occurred in the past 30 years have overwhelmingly used natural gas to comply with the new source review regulations introduced in the early 1970s.

This focus on natural gas as the way to achieve air quality improvements without dramatically increasing power generation costs has had an unfortunate, and likely unforeseen and unintended, consequence of reducing the resiliency of natural gas markets. Regulatory mandates have constrained us away from being able to apply the lessons of portfolio diversification to our energy choices, and our inability to diversify our fuel input portfolios makes for markets that do not adapt to unanticipated and changing conditions. This is a very high price to attach to the environmental amenities of improved air quality, air quality that could conceivably have been achieved through other means had the regulations not so specifically stipulated natural gas as the fuel input.

The potential implementation of the Kyoto Treaty compounds and exacerbates this costly balkanization of fuel portfolios. Even if the U.S. does not ratify the treaty, imagine the consequences of Canada’s implementation. Canadian electricity generators would have to substitute into natural gas as they reduce their use of coal to meet the carbon dioxide reduction targets. If Canadian demand for natural gas increases to fuel their own power needs, then barring a substantial increase in Canadian drilling, there will be much less Canadian natural gas available for export to the U.S. Most of our imported natural gas comes from Canada, so the dislocation to the U.S. natural gas market would be staggering.

I started by suggesting that some government action could forestall this impending “crisis”. Unlike those who would recommend price caps and other forms of regulation to control prices, I suggest that government officials seek out further deregulation that would make energy markets more robust and resilient. Some of the required action is straightforward – remove existing obstacles to fuel substitution and to the importation of liquefied natural gas (LNG). In fact, retooling existing terminals to take some small LNG imports would be a low-cost first step toward creating integrated global natural gas markets. Construction of new LNG terminals can take up to a decade, taking into account siting and environmental regulatory processes, so imported LNG is more realistically seen as a long-run move furthering the resiliency and global integration of natural gas markets. Alan Greenspan recommended a similar course of action in his testimony two weeks ago in Congress on natural gas prices.

Regulatory obstacles that constrain supply, including limitations on LNG terminal construction, drilling on federal lands, and offshore drilling, should be evaluated and put to a benefit-cost test. This test would ensure that the combined environmental benefits of the regulations and the fuel supply benefits outweigh the costs, including the opportunity costs of the foregone environmental and fuel supply benefits.

On the natural gas demand side, we should rethink our approach to air quality regulation. Too much air quality regulation mandates inputs, such as the use of natural gas, or a particular coal emission scrubbing technology. We would all benefit from an air quality regulatory framework that stipulates air quality objectives and enforcement technologies that regulators will employ. Setting outcome-based air quality performance standards and a transparent means of evaluating and enforcing performance is vastly superior to input-based regulations because it will provide polluters with the flexibility to improve and innovate better ways of meeting the performance standard. This innovation will reduce costs, and will produce new technologies. New knowledge could enhance our ability to achieve higher air quality and make available different fuels at prices we are willing to pay.

One final piece of the constructive action that governments can take to make energy markets more resilient is to free state-level electricity regulations to allow retail competition and demand-side bidding in retail markets. Not only will an active demand in retail electricity markets discipline the ability of suppliers to raise prices, it will also equip consumers with their most effective energy conservation tool. Demand response, particularly in large industrial and commercial customers, can send signals to power producers of how much investment in generation they should undertake. Conservation and shifting of demand away from costly peak hours can actually decrease the amount of required investment in generation capacity, as well as reducing overall fuel use.

Price increases transmit valuable information to consumers that enables them to decide when it is worth it to them to conserve. Price increases serve as the most effective inducement to conservation, because they signal to consumers large and small that the relative value of natural gas has increased. They also tell suppliers when it is worth bringing more to market and when to invest in more capacity, and through this interaction across time and place, fuel portfolios become more certain and prices become more stable. Government removal of obstacles to this vital transmission of information through market processes is the most productive and constructive action that governments can take in the face of this impending “natural gas crisis”.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.