The Theory of Relationship Specific
Investments:
Long-Term Contracts and Gas
Pipeline Development in the United
States
Dresden University of Technology
Workshop on Energy Economics and Technology
21 April 2006
Jeff D. Makholm, Ph.D.
Senior Vice President
[email protected]
One Foundation, Two Markets
The Oil and Gas Pipeline Networks Look Alike
Major Crude Oil Pipelines
Natural Gas Pipeline Network 2000
Same Basic Pipeline Economics…
Economies of Scale
120.0
100.0
80.0
60.0
40.0
20.0
0.0
1
4
7
10
13
16
Average Cost
19
22
25
28
Same Basic Pipeline Economics…
Spatially Separated Markets
Production
Origin
Market
Pipeline
Consumption
Destination
Market
Same Basic Pipeline Economics…
Vertical Restraints
Production
Transport
Relationship-Specific
Investments
Consumption/
Refining
One Foundation: Similar Markets in 1935
Same Technology,
Basic Economics
Gas Pipelines
Oil Pipelines
Market Structure
Long-Term Contracts
Pipeline Capacity Markets
Integrated
Never
No
One Foundation: Different Markets in 2006
Same Technology,
Basic Economics,
Oil Pipelines
Gas Pipelines
Integrated
Market Structure
Separated
Never
Long-Term Contracts
Always
No
Pipeline Capacity Markets
Yes
What Happened?
Critical Institutional Milestones
Unregulated
Changed Regulators
Regulated: 1906
OIL
1900
1925
1950
1975
2000
GAS
Unregulated
Gas Price Problem
Regulated: 1938
Shortage/Surplus
Contractualized: 2000
Oil Pipelines: “Evolutionary Gradualism”
“Hepburn” Act
Vertical
Integration
1906
Common Carriage
Joint
Ventures
Batches, Tankage
“Uncommon Carriage”
Pro Rata Rules, Etc.
Darwin
De-regulate
Regulate
Gas Pipelines: “Punctuated Equilibrium”
Utility Holding
Company Act
De-regulate
Gould
s
a
G
1935
1938 Utility
Natural Gas Act
1986
Pip
es
ry
a
im city
r
P pa
Ca
Regulate
1992
Se
c
Ca ond
pa ary
cit
y
De-regulate
2000
Pre 1935 Problems Vertical Integration
„ Abuses of Holding Companies
„ Evasion of State Regulation
„ Uncertain Future/Growing Difficulty in Financing
„ Resulted in: “the most stringent, corrective
legislation that ever was enacted against an
American industry” (PUHCA of 1935)
Foundations for the Regulated Era
„ No new gas pipelines were built from 1936 to
1944. But legal and regulatory scholars were
very active:
z Uniform System of Accounts (1938)
z Hope Natural Gas Decision (1944)
z Administrative Procedures Act (1946)
z NARUC Policy on Depreciation (1943)
„ As a result, gas pipeline loans flowed easily
thereafter.
Problem with Delivered Gas Contracts
„ Contract Carriage not Imposed by NGA
„ Fear of Monopoly Abuse by Pipelines
z Affiliated Interest Transactions
z Exercise of Market Power by Producers
„ So: Supreme Court Extended FPC Regulation to
Producer Prices
What Happened to Monopsony?
So far as discrimination between various sellers in the
same field is concerned, the introduction and
widespread incorporation in long-term contracts of the
most-favored-nation and price-renegotiation clauses
have certainly tended to eliminate this, and in so doing
have substituted the threat of monopolistic for that of
monpsonistic exploitation.”
(Testimony of Professor Alfred E. Kahn: 1959)
…and Where is Professor Kahn in 2006?
Problems for the Regulated Era
„ New Pipeline Certification: “Administrative
Competition”
z Determining “economic need” administratively is hard
to do where there are competing interests.
„ Regulating a Volatile Commodity Pass-Through
Challenged Regulatory Competence
z …then, as now.
„ Complex market-Congressional-regulatory
interaction led to “voluntary” restructuring
z Capacity contracts as property rights
Contractualization Era
„ Competition to build new lines
„ Finalizing the regulation of “rents”
„ Diminished role for Federal regulation
Summary
A Case Study in Attracting Investment Despite
Widely Differing Industry Structures
z The Success/Failure of Vertical Integration
z The Success/Failure of Traditional Regulation Applied to
Gas Pipelines
z Unintended Consequences and Contracts
Throughout, Constrained by Old Legislation and
the Theory of Relationship-Specific Investments