Introduction

The electricity and natural gas industries are related in many ways. Historically, both have used coal to produce manufactured gas and to generate electricity, which they then distributed to end-use customers. Earlier this century, electricity was substituted for gas as a source of lighting. Starting in the 1920s and 1930s, electricity and gas competed for water heating, space heating, cooking, space cooling, refrigeration, and clothes drying services as the quality of home appliances improved.

Today, natural gas is used to generate electricity, especially during periods of peak demand, and it is the preferred source of energy for most new capacity. Both industries are also network industries, in which energy sources are connected to energy users through a sometimes complicated path of transmission and distribution lines. In the future, the two industries will not only be related but also interrelated by new institutions, such as futures¹³¹ and spot contract markets. The degree to which natural gas will be a preferred energy source for peak electricity generation needs in the near future, or lose market share to electricity in the residential, commercial, and industrial sectors will be determined largely by these new institutions as well as the new business practices.

Natural gas supply has developed into a commodity market over the past 15 years, with active spot and futures markets. Electricity has been moving in the same direction during the past 5 years, with 2 futures contract markets established in 1996 and more expected by early 1998. Moreover, the number of generally recognized trading locations for electricity is growing.

The Federal Energy Regulation Commission (FERC) has begun opening up the electric transmission system in a way similar to that in which it opened up the interstate gas pipeline system. The electricity commodity and its transport are increasingly priced and provided as separate services. FERC has also proposed institutions for providing critical information—to be available to all interested parties in the industry electronically and in real time—about the price and availability of transmission space. Such information supports the development of competitive markets.

Institutions such as futures contract markets and electronic auction markets are important for greater integration of the natural gas and electricity industries. A principal challenge will be to improve the integration of the electricity and natural gas industries through these institutions to provide further support for the development of a competitive energy market.

This chapter discusses the importance of information and public markets for an integrated commodity market for gas and electricity and how electronic auction markets support integration. Price volatility is also examined, because it is both the source of growth for the futures market and a key motivator for the efficient allocation of resources. In addition, the growth of futures markets for electricity is illustrated. Some problems and challenges in the movement toward a more competitive market are also pointed out. The chapter ends with some general conclusions about expected changes in price and in capacity requirements for the gas industry as a result of electric power industry restructuring. A key point is that new institutions in both the natural gas and electricity industries are likely to affect suppliers of gas to electricity generators.

Market Evolution

New trading practices, institutions, and environments in the natural gas and electricity industries continue to develop and evolve as regulatory barriers to more open exchanges are removed. These new areas consist primarily of trading environments. For natural gas, the new institutions are futures markets, market centers or hubs—both at particular locations and along pipeline systems—and electronic auction markets. For electricity, the new institutions are futures markets, power exchanges, and the public reporting of prices and volumes traded at key locations.

The growth of the new institutions is a consequence of unbundling—of wholesale transmission and generation service on the electric side and of production, wholesale transmission, and storage on the gas side. These trading areas and institutions will continue to grow in importance and be modified, as electricity and natural gas unbundling is extended to the retail market. Innovations, such as electronic auction markets, have developed to improve the performance of cash markets. New institutions, such as futures contract markets, will both complement and compete with existing institutions, yet generally they will tend to improve the interrelatedness of markets for the two sources of energy.

Futures Contracts

The natural gas futures contract market has been a huge success, as indicated by the impressive growth in transactions. Every day there are about 200,000 contracts outstanding (open interest), which, in physical terms, translate into about 2 trillion cubic feet (Tcf) of natural gas—equivalent to almost 10 percent of the natural gas delivered in a year in the United States.

The growth of the futures contract market has provided several important benefits to the natural gas industry. First, it enables companies in the industry to manage unwanted price risk affecting expected gas transactions and thus protect themselves from some effects of price volatility. Second, it allows industry participants to discover readily the price of gas at any time, both for use in the negotiation of contracts for the commodity and as a clear reference point for price determination in transactions scheduled under a contract.

The typical market evolution for most industries is that active spot markets develop before futures markets are instituted. In contrast to this precedent, two electricity futures contract markets have been established even before a very active spot market has developed. This is a significant circumstance, because just as price discovery on the natural gas futures markets motivates exchanges of natural gas, price discovery on electric futures markets is expected to motivate exchanges of electric power both in kind and between natural gas and electric power. A major hindrance to the development of interfuel exchanges so far is that no electric futures market exists in the eastern part of the country to complement the highly successful gas futures contract market for delivery at the Henry Hub in Louisiana, which is well connected with many natural gas markets in the eastern United States.

Scheduling and Other Business Practices

Restructuring of the electric power industry in the United States is expected to influence business practices in the natural gas industry. For example, the scheduling of gas and transmission services (nominations) by wholesalers of gas will most likely be for increasingly shorter periods to better match operating and business practices in the electricity industry.

Although natural gas is used extensively for peaking service in electricity generation, gas contract terms often are not consistent with electric power needs. Hence, the amount of gas used for power generation is less than it could be only because it is much more timely and much easier to trade power than to purchase gas to generate power. At times, traded power is used rather than natural gas to satisfy a need even when generation from natural gas would have been the preferred choice.

Peak electricity prices can often be three times as great as nonpeak prices, and daily peak prices can increase several-fold over several days. Such large price fluctuations result in corresponding variation in the need to dispatch gas-fired generation because of the shifting relative economics. Consequently, rigidities in the flexible use of natural gas for power generation can cause significant lost opportunities for the industry. The continued opening up of the electricity industry and the increased availability of timely, reliable price information will provide a growing incentive for gas suppliers to shorten contract terms and increase the flexibility of scheduling practices to capture opportunities for expanded sales to the generation sector.

The Importance of Information in Competitive Markets

Liquid Markets and Price Transparency

Price transparency provides consistent, reliable information on market conditions to a wide number of market participants. This knowledge reduces transactional uncertainty and promotes a liquid market with ready buyers and sellers of the commodity. In the natural gas and electricity spot markets, the condition of liquidity is often inferred from the number of trades completed, since information on bid and ask prices is not yet available for many transactions. Simply stated, if a market has few or no trades on a day, it is considered an illiquid market. In an illiquid market, the amount of commodity exchanged can be very small, even though the amount of the commodity available to the market may be great. In fact, significant amounts of the commodity may lie idle when an illiquid market develops.

Price transparency is important for liquid markets and is especially important for markets that are inherently price volatile. Only if there is good price transparency will a sufficient number of buyers and sellers with different needs and preferences for risk be attracted to the market. A large number of candidate buyers and sellers with good market information and with ready access to transparent prices will be needed to support the development of liquid electricity and natural gas markets. Other things being equal, a significant number of transactions reduce the likelihood that market dominance will cause divergence between realized prices and a valid market clearing price.

The price spread between electricity and natural gas in markets with good information and many diverse participants is likely, on average, to be relatively constant. Exceptions will arise in periods of unexpected and significant shifts in demand and supply of the commodities. At such times, either the price of electricity or the price of natural gas will change significantly as demand for or supply of either fuel reacts. For example, if the electricity price increases significantly relative to that of natural gas because of a significant increase in power demand, there will be a tendency to purchase additional gas for the generation of electric power, thus raising the price of natural gas also. These changes in supply and demand will promote efficient increases in trade at critical times, as long as sufficient capacity is available to produce and deliver the energy.

Real-Time Information

When the demand for a commodity is highly variable between days (for example, because of difficult-to- predict weather changes) and the commodity is viewed as essential to quality of life, the relative value of real-time information about the commodity is enormous. In general, reliable market information supports the development of competitive markets with numerous exchanges between buyers and sellers. This includes not only reliable price information transparent to a wide number of industry participants in real time but also general market conditions.

Knowledge of the current market price is important because it promotes efficient behavior. FERC realized in developing Order 636¹³² that readily available information would have great commercial and operational value and would also support the development of competitive markets. Thus, Order 636 prescribed that pipeline companies ". . . provide timely and equal access to all information necessary for buyers and sellers to arrange for capacity reallocation." Additionally, FERC itself provides electronic access to much data on jurisdictional gas pipelines. Despite the intent of this activity, its development to date has not met the original goal to provide timely, comprehensive data useful to promoting a competitive market for transmission services.

Information is made available by both the pipelines and the FERC.¹³³ The companies post their tariff¹³⁴ schedules, available released capacity, and operational available capacity on electronic bulletin boards (EBBs). The two types of capacity information are used by interested potential firm shippers in acquiring the associated rights.¹³⁵ The FERC maintains various information on its EBB, including information on pipeline tariffs, the index of customers, and the discount report. The index of customers is a quarterly report on the applicable tariffs and capacity used in firm transportation and firm storage services on the first day of each 3-month period. The discount report is a filing by transporters to FERC that provides the customer name, the rate schedule for service rendered, and the maximum and actual rates charged for each customer that received a discount in the previous billing period. The discount report does not, however, provide the amount of capacity that is discounted.

Since the tariffs do not specify charged transportation service rates, the FERC and pipeline company EBBs do not provide timely information on prices paid by primary holders of transportation capacity. Therefore, transportation market participants are unable to determine the actual price primary holders of capacity pay for capacity prior to the start of service. In addition, bids for released capacity are not required to be posted on EBBs. The successful and unsuccessful bidders are notified of the results the day before nominations for service may take place. Further, capacity trades at the maximum tariff rate or with terms of one calendar month or less are exempt from the bidding process. These capacity trades are not posted until the day nominations for service may take place. In all cases, the price information for natural gas firm transportation service is available only after the close of the auction process. Absent a comprehensive data source, the extent and quality of gas market information on price and transactions completed varies significantly between companies. These information limitations are serious impediments thwarting widespread, effective use of EBBs to facilitate active trading.

The value of information is likely to increase over time as the natural gas industry continues to shift toward more streamlined operations under competition from a regulated, cost-of-service business. As excess capacity is reduced, the allocation problem becomes more pressing. Price risks from bottlenecks or congestion increase as available capacity declines relative to expected demand, which is growing. As the electric power industry evolves along similar paths, its data requirements will expand correspondingly.

Electronic Auction Markets and Information

Technological innovation has advanced the evolution of markets in a number of ways. A recent development involves the use of electronic auctions to promote efficient transactions in the cash market. In the past several years, electronic auction markets for the natural gas commodity have become increasingly common for a large number of locations.

Prices are very transparent on auction markets. Throughout the trading day, bid and offer prices and quantities are posted. When a buyer accepts a seller's offer price or a seller accepts a buyer's bid price that completes the deal, it is clearly indicated by a visual cue. At the end of the trading day, the aggregate amount of gas traded and the volume-weighted price are computed and transmitted to the trade press. The press then sends this material in tabular and graphical form to its subscribers, often with some additional commentary. Reporting of summary data for a day looks very much like the reporting of summary statistics in the Wall Street Journal for commodities traded on futures contract markets. This information and the right to trade gas are available for any company that is willing to pay a fee to the company for access to the auction market trading platform.

Companies are willing to pay a fee for participation in an auction market because it offers profit opportunities and, in some instances, a means of hedging price risk by fixing the price of gas (see box in the following section). Other companies are willing to pay a slightly reduced fee just to view the price information and not to trade. Some companies also subscribe to electronic data services, such as Bloomberg's, which provide price and other market information throughout the day from a wide variety of sources.

Before the advent of public auction markets, most companies in the industry relied on either futures market or trade press information for price discovery. This reliance had certain shortcomings. Futures prices represent the price at a particular location, which is not necessarily the location where a company would like to make or take delivery. If there is a uniform differential in futures prices between locations, changes in futures prices between days at one market may be thought also to represent price changes at other locations. However, the usual relative price structure between locations may not prevail under all circumstances, even for markets that are geographically near each other. At such times, the use of a single market price signal likely will lead to inappropriate supply or demand response in the other markets, distorting market behavior and often leading to profits or losses not commensurate with local market conditions. Nonetheless, futures markets are the most general and accessible source of price information, and there are ways to mitigate the impact of this source of price risk. Trade press data for particular locations also are subject to misreporting and measurement error.

Figure 14. Auction Markets, January 1996-November 1997 (Click graph to view full size)

Although public auction markets are just now being developed in the electric power industry, their significant growth in the natural gas industry (Figure 14) may inspire further development for electricity. Not surprisingly, companies involved in providing natural gas trading platforms (computer software support, credit rating checks, accounting and other services) have plans to provide similar platforms for the electricity industry. In fact, it is likely that electricity and natural gas will be trading on the same screen in a few years.

Price Volatility

Price volatility refers to rapid and significant price variability. Volatility can be measured as relative deviations around an average price value. Volatility is commonly higher for electricity and natural gas than for other commodities. Most commodities exhibit price volatility of less than 20 percent, whereas the average price volatility for natural gas and electricity generally exceeds 40 percent (Figure 15). For example, the average price variability during the 8-month period from November 1996 through June 1997 was about 45 percent for natural gas and for electricity, more than twice that for other commodities. The volatility for natural gas declined between December and May, but the volatility for electricity remained fairly constant.

The decline in the volatility of natural gas prices in the spring could reflect the simple fact that natural gas prices are influenced greatly by temperature, the variability of which is at its lowest in the spring. Natural gas, much more than electricity, is used for space heating, which is a very temperature-sensitive use of energy. On the other hand, electricity price variability is influenced not only by temperature variability but also by unplanned outages of generators and a greater number of transmission problems. In addition, the inability to store electrical energy means that buffer stocks are not available to respond to unexpected contingencies throughout the year.

The Need for Futures Markets in Price-Volatile Spot Markets

Significant amounts of price volatility in a market support the development and growth of futures markets because of the great price risk in such markets. Price volatility is a fact of economic life in deregulated commodity markets, subject to the whims of nature and other forces outside an industry's control. Companies need to manage price risk so that they can both concentrate their energies on other aspects of their business and protect income streams for investments. Hence, futures markets have been developed as a way to manage price risk. Because of the great volatility in natural gas markets, the growth of the natural gas futures market has been phenomenal. Most recently, the growth in the electricity futures contract markets has also been impressive (Figure 16).

Figure 15. Volatilities for Natural Gas (Henry Hub) and Electricity (California-Oregon Border) (Click graph to view full size)

Important factors for the development of a futures contract market typically are the availability of a standardized product and an active spot market. Spot markets for natural gas have developed all across the United States as the industry has become increasingly competitive. Natural gas and electricity are both highly standardized commodities. In fact, standardization is necessary in both industries to avoid operational problems. The characteristics of natural gas are similar in different markets scattered across the United States. This, in part, explains the growth in the volume of transactions on spot and futures markets for the commodity. There is usually much more variability in the characteristics of such well-known commodities as corn and wheat at different locations than there is for natural gas and electricity.

Figure 16. Electricity Futures Contracts (Click graph to view full size)

Because location is an important attribute even for a homogenous product, a delivery point must be established for futures trading. The location chosen for a delivery point for a futures market is usually where there is a very active spot market and where delivery problems are not likely to occur. Even though futures contracts are primarily financial instruments for price hedging or fixing the price of energy, deliveries through a futures contract do, in fact, occur, and when they do occur, the futures exchange has a great interest in maintaining ease of delivery.

Futures markets thrive on the frequent exchange of futures contracts. Frequent exchanges, in turn, are motivated by inherent price volatility and supported by market liquidity. An important objective of the futures contract market is to obtain broad and extensive involvement of the industry, which will support the liquidity of the market. Because participation is supported by the availability of information, futures contract markets are information-intensive markets. As new information is received about the condition of the markets, participants in the industry open and close out positions on the futures contract market, which again provides support for liquidity.

The futures exchanges want to involve every part of the industry—both buyers and sellers of the commodity—in hedging instruments, so that it will be easy for companies to open and close out futures positions at current prices. However, the futures exchange governing board understands that the industry participant will want to take delivery at times. In these arrangements, delivery capability should never be an issue or else the industry participants may lose interest in the futures contract market, which may reduce its liquidity.¹³⁶

In fact, recent growth in the electricity futures market as measured by the number of contracts was influenced in a significant way by an increase in the number of deliveries through futures contracts and the number of "exchanges of futures for physicals" (EFPs) (Figure 16). In EFPs, companies use opposite futures positions to help complete deals in the cash market. In an EFP, a prospective buyer opens a long futures position (equivalent to buying a futures contract for forward delivery) and a prospective seller opens a short futures position (equivalent to selling a futures contract for forward delivery).

The great appeal of the futures contract market is the superb price discovery associated with it and the capability of a buyer and a seller to arrange delivery some distance from the location of the delivery point for the futures contract. They accomplish this by negotiating the difference between the price on the futures contract market and the price at the location where they would like to complete an exchange. This type of arrangement is possible because both parties at different locations have the same price information available to them. They also alert the futures exchange that they intend to do an EFP, documenting the planned exchange. They simultaneously close out their opposite positions on the futures contract market when they complete the deal on the cash or physicals market.

While growth in standard deliveries can be viewed as positive from the point of view of a market providing a service, it is also suggestive of the stage of development of the electricity spot markets. If the market for 1-month deliveries of peak service (the specifications for delivery under a futures contract) had broad market participation and the futures and cash prices were converging, then participants in the futures markets would close out their positions and not take delivery through the futures contract, because delivery through a spot contract ordinarily would allow them more flexibility in terms of delivery options. Moreover, if price discovery and the delivery mechanism for 1-month peak deliveries at a large number of locations were good and the number of market participants were large, then EFPs would generally not be used to effect exchanges.

Convergence of the Natural Gas and Electricity Markets

New Institutions

In the restructured electricity industry, the independent system operator (ISO) will be an institution for preserving the operational integrity of the electricity transmission system in the short term. The ISO will be independent of the transmission companies that use its services. In the natural gas industry, the pipeline company, which provides services similar to those provided by an electricity transmission company, is responsible for the operational integrity of the pipeline system.

The fact that the pipeline company remains responsible for the operational integrity of the pipeline system has created concern in some segments of the gas industry and complaints at FERC concerning possible affiliate abuse. Concern arises that a pipeline company has an extensive catalog of detailed transaction records regarding the gas requirements and purchasing practices of many, if not all, participants in the traditional markets served by the pipeline. The marketing affiliate of a pipeline, being staffed generally by former pipeline personnel, may have a sizeable competitive advantage in gaining market share. Further potential abuses can arise if the pipeline company and its affiliate do not operate at "arm's length." Some possible abuses stem from the pipeline company's possible access to certain real-time information on the utilization of the pipeline system. In addition, the pipeline company can impose penalties based on this and other information.¹³⁷ Other companies complain that this access to information and the right to impose penalties could result in benefits to the marketing affiliate of a pipeline company.

In the electricity industry, the open access same-time information system (OASIS) requires all bid and ask prices for transmission space to be posted, including the capacity contracted for under a transmission company's tariff (primary capacity) and the primary capacity leased to another party on a capacity release market (secondary capacity). Regulatory reform of the gas industry led to adoption of electronic bulletin boards (EBBs), which are that industry's precedent to the electric power industry's OASIS. However, as discussed previously in this chapter, the gas industry EBBs generally have suffered from a number of inadequacies related to their information content and associated processing capability. At best, actual rates paid by holders of gas transportation service are posted only after the fact, if at all. These information limitations are serious impediments thwarting widespread, effective use of EBBs to facilitate active gas trading.

The information available for the electric and gas industries is not equivalent in extent or quality. As the electricity and natural gas industries continue to move toward markets in which different types of energy are increasingly substituted for one another, depending on price, and where an increasing number of companies are regularly exchanging both types of energy to lower costs and remain competitive, this disparity in information may become a growing issue. On the one hand, more complete posting of information in electric power markets may encourage the gas industry to report similar, more complete information. The motivation for change in this case would arise if companies believe that there are significant profits to be gained from taking advantage of differences in current supply and demand conditions in various energy sectors by substituting energy sources whenever changes in relative prices indicate such action would be wise. On the other hand, companies in the gas industry may resist the release of more information because they perceive greater competitive advantage in exploiting other information while details regarding their own transactions remain confidential.

Exchanging Natural Gas and Electricity and the Nomination Process

In the past several years, natural gas companies generally have needed to nominate for specific amounts of pipe space a day ahead of time before they could ship gas. In the spring of 1997, the industry moved to allow for intra-day nominations, whereby a company could arrange for shipments of gas on the same day it purchased the gas. This is a major step forward, with clear advantages for market participants to respond with minimal delay as conditions warrant.

The electricity industry already has a sizeable daily market in which power is actively traded on an hourly basis as needs change. The greater frequency at which electricity is traded reflects both the larger size of the hourly loads faced by particular companies and a much greater need to balance the loads on the electric system throughout the day to avoid operating the system beyond its limits.

The electricity industry has few options to adjust power supplies, in contrast to the gas industry, where the options include taking gas out of storage and changing compression within segments of the pipeline system. The inability to store electricity efficiently requires operators to meet consumption variations by dispatching fewer or more generation units. Broader tolerances for operating a gas system provide greater operating flexibility, which allows operators to prepare the system in a way that will allow them to better position themselves to serve anticipated demand or shifts.¹³⁸ For example, gas transmission and distribution companies can prepare for a demand rise by increasing line pressure, thus "packing" the lines with extra compressed gas. Additionally, deliveries can be drawn from gas stored in facilities stocked during the off-peak period.

Whether the gas supplies are stored in the line or in recognized storage sites, they are an important source of gas at peak. Flexible options are also available in case the demand does not develop as expected. The company can sell the gas on the spot market, divert it into an alternative storage site, or use "parking services" for the gas from a market center. A utility usually has some time to adjust its takes of gas to reduce any imbalance that develops on the pipeline system because of taking less gas than expected. These operational options do not exist for electricity transmission.

Market Centers and Exchanges of Gas and Electricity

Exchange of a commodity is naturally encouraged at a location where there are pipeline or electric transmission interconnections. The natural gas and electric industries have several locations at which many pipelines or transmission lines interconnect. In the natural gas industry, a good example of such a location is the Henry Hub in South Louisiana, where standard deliveries through futures contracts occur. Exchanges are also encouraged along those pipeline and transmission systems where a large number of users have complementary needs and where contract sizes are small, various contract terms can be readily accommodated, and the needs of the users change unexpectedly over time.

Contractual simplicity is an important factor influencing activity. For example, if several companies use a master contract in which only price, delivery, and receipt points need to be negotiated to complete a deal, it will encourage a much larger number of trades than there would be otherwise. Areas along pipeline or transmission systems where frequent exchanges of the commodity occur are often described as "pooling points" or "market centers."

Suppliers of natural gas and coal to electricity generators increasingly track the price of power at different locations in real time. When the price of electricity rises significantly at a location, they attempt to sell more gas or coal into a market near the location, sell gas to a particular generator near the location, or transport gas or coal to a particular generator and arrange to have the generator produce more power. In the latter case, the gas supplier may also arrange to sell the power—a practice known as "tolling." In a sense, these activities represent a race for generation, in which natural gas has the advantage over most other energy sources because of its greater operational flexibility and the ease with which incremental gas supplies can be moved to generators.

Another advantage of trading natural gas to generate power instead of trading power to satisfy demand is that it reduces the chance of congestion problems along transmission lines. Instead of moving power great distances over transmission lines, natural gas can be distributed to generators near markets experiencing significant unexpected shifts in demand for electricity. Since such shifts in electricity demand are more likely to occur in the summer, when significant space is available on gas transmission lines, this strategy implies a better use of industry infrastructure.

A good example of a market center along a pipeline system is Transco-Zone 6, which extends from Northern Virginia to New York City. Every day within this area many exchanges of gas are made between companies whose daily requirements vary from their daily rights to gas. Thus, a shipper who has an unexpected need for gas can balance it through exchange with a shipper who has an unexpected reduction in its requirements. Accordingly, the price statistics reported to the trade press for Transco-Zone 6 are considered to be reliable because they generally represent a large number of exchanges.

A good example of a trading area for electricity is the area near the Pennsylvania, Maryland, and New Jersey borders, designated PJM. This location is accessible to many utilities and other large customers in the area. Many of the major consuming centers within the PJM area also are included in Transco Zone-6. The rough geographic coincidence of these markets allow a comparative analysis of gas and electric prices to assess the potential for interfuel trading opportunities for operators in these markets.

The prices for the two fuels in this area have striking differences (Figure 17). The electricity price series is more volatile than the natural gas series and, overall, tends to be higher. If the average difference is sufficient to compensate for conversion loss and additional capital charges, there would appear to be profit opportunities for companies that use natural gas to generate electricity in this area.

The largest price spikes for electricity occurred in June and July, which is a nonpeak period for gas prices, providing arbitrage opportunities favoring electricity over gas. The largest gas price spikes occurred in December 1996 and January 1997, when electricity prices also surged, but not to the same degree. An examination of weather data indicates that temperatures were significantly below normal at those times. This suggests that very low temperatures similarly affect both prices in this area, but gas prices so much so that the usual relation is reversed, with natural gas prices above electricity prices. Thus, it would be valuable for electricity generators that depend on natural gas for peak generation to avoid spot market purchases with their high associated prices at such times.

Power trading is likely to grow in importance as the electricity industry continues to be restructured at the wholesale and retail levels. As the market for power becomes more open, with broader industry participation and competition, sellers of power will be strongly motivated to seek out the least expensive supplies. The net impact of increased power trading on gas use for electricity generation remains to be seen. As more power is exchanged between parties to satisfy peak load demands, the demand for peaking generation—and for the natural gas that is used heavily for peak-load power generation—will be reduced. It does not necessarily follow, however, that reduced use of natural gas at one generation facility will result in the use of a different fuel elsewhere. The fluid exchange of fuels and power, both within and between the markets for each, will facilitate trades that can realize locational advantages in generating power from the same fuel but in different markets. Such trades may be the preferred outcome whenever the price differentials between markets are sufficient to compensate for the incremental transmission charges.

Challenges for the Natural Gas Industry

The trading of electricity and natural gas is not nearly as synchronized as it could be. The amount of trading in electricity and natural gas needed to enable these markets to take advantage of arbitrage opportunities is less than it could be, limiting the liquidity of both markets.

The terms of the shortest-term natural gas contracts tend to be much longer than the terms of the shortest-term electricity contracts. The difference in terms of trade is such that a difference in price that may have inspired a decision to purchase natural gas for electricity generation may erode significantly by the time the exchange agreement is completed. In the worst case, a company could be motivated to contract for large incremental supplies of natural gas because electric power is selling at a much higher price than natural gas; however, when the company began receiving the gas for power generation, it might discover that the price of natural gas has risen to a prohibitive level relative to the price of electricity.

When the terms of gas contracts become shorter, when deliverability and flexibility improve, and when nominations for gas and electricity are better synchronized within days, a greater number of trades can be completed. As a result, the level of price volatility could be reduced, and the chances of regular price convergence could be increased.

In order to promote exchanges, it is important that transaction costs be a small proportion of the cost of exchanging power and natural gas. Reduction in transaction costs will tend to occur when contracts become increasingly standardized across natural gas and electricity. Only when such standardization occurs will a Btu market with broad industry participation emerge.

Business practices for contracting exchanges of natural gas for electricity have changed extensively in the past 5 years. Prior to the 1990s, electricity prices were based on the cost of the energy needed to generate electricity plus any additional direct and indirect costs of getting the energy source to the generation plant. When electricity prices are based on current supply and demand conditions, the most economical and operationally flexible energy source will be used for generation.

Figure 17. Spot Prices, November 1996-December 1997 (Click graph to view full size)

It is likely that metering and measuring gas flows throughout the industry will be increasingly important as more frequent exchanges of energy take place between participants in the marketplace. The increased importance of metering will also be a response to improved price information as price responds more to short-run shifts in demand and supply, especially because there will be more short-term contracts for natural gas and electricity being traded.

Peak load pricing likely will become increasingly common in the electricity and natural gas industries as market information is passed on to customers. When peak demand prices are much greater than average prices, this type of pricing should reduce electricity demand at peak times. If a significant portion of peak demand is satisfied from natural gas turbine generators, the demand for natural gas will increase.

Reliable information on price, available during the day to many participants in the industry, will lead to better allocation of the commodity. In the longer term, it will lead to better allocation of capital, because the industry will have additional price information for deciding where additional pipeline and transmission capacity should be placed. As a result, the average costs of transportation and services should be reduced, as well as the amount of planned generating capacity required as the electric power industry moves from a highly regulated market to a less regulated one. Thus, in general, both planned capacity and average prices for the natural gas and electricity industries are likely to be reduced in the future. These positive outcomes are likely to occur only if reliable information on current market conditions is readily available, prices are transparent, and market institutions for gas and electricity are designed to respond to short-run shifts in supply and demand.

Endnotes

131. Futures trading is used in this chapter as an illustrative example representing the overall group of financial instruments available for managing price risk, such as options trading.

132. FERC Order 636, known as the Restructuring Rule, was issued on April 8, 1992, and was designed to allow more efficient use of the interstate natural gas transmission system by fundamentally changing the way pipeline companies conduct business.

133. The present discussion is based on a representative description of available information. Any characterization of data posted on the EBBs by the companies or the FERC is subject to a number of exceptions, a number of which are identified. The general simplification is adopted for illustrative purposes.

134. A tariff is a compilation of all effective and superceded rates, rate schedules, general terms and conditions of service and forms of service agreements. While it contains a set of pricing alternatives, the tariff generally does not indicate the actual price paid for any transaction.

135. While a shipper may use operationally available capacity to move gas, an accurate measure of operationally available capacity will not be identified until the capacity release bidding and award processes are completed.

136. A company uses the futures contract market by opening a position on the futures market that is consistent with its position in the spot market. For example, if a company intends to sell power a month from now and wishes to fix the price today, it will sell a contract for forward delivery at a price quoted on the futures market for delivery in the forward month (called a short position on the futures contract market). If a company intends to buy power a month from now and wishes to fix the price today, it will buy a contract for forward delivery (i.e., open a long position). When a company opens a futures position, it has to pay a broker for handling the transaction and also has to post margin (a type of down payment) with the brokerage firm. The amount of margin varies with price volatility and also changes over time as the current price of the commodity on the futures contract differs from the price when the company opened its position.

137. The pipeline company has the right to impose imbalance penalties when a company has taken more or less gas than authorized under a contract. In theory, a pipeline might structure these penalties in such a way that it could penalize a group of customers substantially without impacting its marketing affiliate severely.

138. In the case of unexpected demand or supply shifts, the operational flexibility often allows operators along the system to react to changes without requiring these responses to be immediate. Delayed reaction to variation in electricity consumption can result in system collapse.