Lumpy Investment in Regulated Natural Gas Pipelines: An Application of the Theory of the Second Best

23 Pages Posted: 16 Jul 2010

See all articles by Dagobert L. Brito

Dagobert L. Brito

Rice University - Department of Economics

Juan Rosellon

Centro de Investigacion y Docencia Economicas

Date Written: June 1, 2010

Abstract

We address investment in regulated natural gas pipelines when investment is lumpy and the demand for gas is stochastic. This is a problem that can be solved in theory as a dynamic program, but a practical solution depends on functions and parameters that are either subjective or cannot be estimated. We then reformulate the problem from the standpoint of consumers that face incomplete markets. It is shown that for reasonable parameter values consumers prefer to pay for excess capacity rather than bear the risk of congestion. These strategies can be implemented with reasonably straightforward policies. Since the demand for gas is very inelastic, the welfare losses associated from small deviations from a first best optimum are minimal. This implies that the gas pipeline system can be regulated with a relatively simple set of transparent rules without any significant loss of welfare.

Keywords: Transmission Investment, Natural-Gas Regulation, Congestion Management, Gas Pipelines, Second-Best Theory

JEL Classification: L51, L95

Suggested Citation

Brito, Dagobert L. and Rosellon, Juan, Lumpy Investment in Regulated Natural Gas Pipelines: An Application of the Theory of the Second Best (June 1, 2010). DIW Berlin Discussion Paper No. 1024. Available at SSRN: https://ssrn.com/abstract=1640528 or http://dx.doi.org/10.2139/ssrn.1640528

Dagobert L. Brito (Contact Author)

Rice University - Department of Economics ( email )

6100 South Main Street
Houston, TX 77005
United States

Juan Rosellon

Centro de Investigacion y Docencia Economicas ( email )

Carretera Mexico Toluca 3655
01210 Mexico, D.F.
Mexico

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