By David Schumacher

A US court of appeals said in April that the Federal Energy Regulatory Commission can continue with an experiment to allow companies that hold rights to transport gas on interstate pipelines to sell, or “release,” their rights at market prices to other companies that need the capacity.

Releases of capacity at market prices are allowed currently only in short-term increments of less than a year. The experiment had come under fire from a mix of pipelines, gas producers, consumers and state regulatory commissions, some of whom believe the FERC experiment goes too far and others of whom believe it does not go far enough.

The court ruling opens the door for FERC to allow such sales to become a permanent part of its capacity release program.

It could provide interesting opportunities for power projects to monetize their firm gas transportation rights.

Capacity Sales

FERC issued new regulations in 2000 as part of Order No. 637 that were supposed to enhance competition in the interstate gas transportation markets. The most significant rule change allows holders of firm transportation capacity to release firm capacity to a third party for a term of less than one year at any rate that the market will bear, even if the rate charged exceeds the maximum rate the pipeline can charge under cost-based rate regulation. Because the rule constitutes such a significant departure from FERC’s usual cost-of-service ratemaking, FERC drafted the rule to expire on September 30, 2002. FERC said it would review the results of the experiment and decide whether or not to extend it.

The experiment with short-term capacity releases has been in effect, notwithstanding the litigation. Implementation of the program was not blocked while the courts heard the case.

In upholding the experiment, the appeals court said that the use of market rates in the short-term capacity release market is consistent with FERC’s mandate under the “Natural Gas Act” to ensure just and reasonable rates. The court reasoned that competitive alternatives to released capacity would act to constrain rates such that, on an annual basis, rates for released capacity would roughly approximate cost-based rates. Even price spikes during peak periods are, in the court’s view, the result of competitive forces and not monopoly power.

The court made these findings even though FERC did not undertake an extensive analysis of market forces in various product and geographic markets, as FERC has been required to do in other instances when it has approved the use of market-based rates for utility services (including the wholesale sale of energy).

The court also noted that FERC has in place certain procedural safeguards to protect consumers from the unlawful exercise of monopoly power. Specifically, FERC can monitor the prices in the capacity release market to ensure the market is working efficiently and can consider complaints brought by market participants.

The court rejected calls by certain pipelines that FERC should have extended the use of market prices to interruptible transportation service sold directly by the pipelines. The court said it was not unreasonable for FERC to take a gradualist approach to market prices for transportation service. The court also noted that the pipelines do have the option to seek market price authority from FERC by demonstrating that competition will preclude their unlawful use of market power.

The court’s ruling opens the door for FERC either to extend its market-based rate experiment or to make it permanent. Because this experiment will end on September 30, 2002, FERC may make a decision as soon as this summer on whether to continue it.

If FERC does allow the continued use of market-based rates in the short-term capacity release market, power projects that hold firm pipeline transportation contract may be able to make better economic use of their firm transportation rights. For example, a project company that operates a “peaker” may be able to release short-term capacity during periods of peak gas usage at rates above what it is paying the pipeline, particularly when peak gas usage does not correspond to peak energy usage or when the project can economically rely on oil to operate.

Other Issues

The court also upheld two other important aspects of the FERC rule.

It agreed that FERC can require pipelines to revise their “imbalance penalty” mechanisms to provide shippers with more imbalance mitigation services and ensure that penalties more accurately reflect the harm imposed on the pipeline. Imbalance penalties are fees designed to deter pipeline users from taking out more or less gas than they put into the system. Additionally, with one technical exception, the court generally upheld FERC’s requirement that holders of firm capacity must be permitted to subdivide, or “segment,” their capacity to allow multiple uses of the capacity, so long as the pipeline can provide such segmentation rights in an operationally feasible manner.

However, the court sent back to FERC for further work a rule that would give holders of firm transportation capacity who pay the maximum cost-based rate for the service certain “rights of first refusal” to maintain their rights to this capacity at the end of their contracts by matching the rate and term of any third-party bid for the capacity. The existing holder of the capacity could maintain its rights by bidding on service for as few as five years, regardless of the term bid by any third party. The court said the five-year period was arbitrarily selected. Responding to the court’s decision, FERC said in a mid-May order that current pipeline tariffs would govern the term that existing shippers must bid when exercising their rights of first refusal until FERC can consider the issue further.

As a result of the court’s ruling on this issue, if a project company is holding a firm transportation contract and wants to keep its contract at the end of the term, the project company may be required to match the bid of a third party seeking the capacity for a term that far exceeds the term of service for which the project company was hoping to contract.