The Role of Excess Capacity in Determining Market Power in Natural Gas Transportation Markets

Abstract

In 1996, the Federal Energy Regulatory Commission (FERC) established criteria for evaluating market-based rate proposals submitted by natural gas pipelines. According to one criterion, whose purpose is to ensure that a deregulated pipeline does not increase its transport price by restricting quantity, a pipeline applying for market-based rates must demonstrate that the quantity of excess capacity on rival pipelines is sufficient to replace any reduction in its pipeline's use in the relevant market. While it is true that when this criterion is met, the deregulated firm will have no incentive to restrict quantity, we demonstrate that this criterion is unnecessarily stringent for this purpose. In effect, FERC's criterion assumes that market demand is infinitely inelastic. Consequently, because demand elasticity is typically positive, FERC's criterion is too restrictive, leading to too few successful market-based rate applications. By carefully taking into account demand elasticity, we offer here a more precise, and so more effective, criterion for evaluating market-based rate applications.