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December 17, 2001=20



Competition Approved for California's Intrastate Natural-Gas Pipelines=20



By Will McNamara
Director, Electric Industry Analysis




[News item from Associated Press] California state power regulators voted D=
ec. 11 to deregulate further the transmission of natural gas within Souther=
n California, a decision hailed by the industry and derided by consumer adv=
ocates. The California Public Utilities Commission (CPUC) voted 3-2 to appr=
ove a proposal that allows Southern California Gas Co., the nation's larges=
t gas utility, and San Diego Gas & Electric Co. (SDG&E) to sell space on th=
eir "backbone" transmission pipelines. These pipelines carry natural gas fr=
om out of state to a smaller distribution system in California that then tr=
ansports it to homes, businesses, factories, and power plants.

Analysis: This controversial vote by the CPUC took place last week, but has=
 not received a great amount of industry analysis. This is rather surprisin=
g because the vote carries enormous potential impact for the way in which n=
atural-gas capacity is bought and sold along pipelines owned by Southern Ca=
lifornia Gas Co. and SDG&E in the southern part of the state. Considering t=
he fiasco that opening the state's electric market became over the last yea=
r, it is a risky move for California's regulators to open a competitive mar=
ket for the right to transport gas along these pipelines at this time, even=
 though the issue has been under debate at the commission for years. Howeve=
r, the rationale for the decision is that the new system will allow custome=
rs to better control the point from which their natural-gas supply originat=
es, which theoretically should lower costs and preserve space along the pip=
elines that the customers don't need. Critics of the plan, especially The U=
tility Reform Network (TURN), say that allowing competition along the natur=
al-gas pipelines in California could allow fewer companies to control most =
of the pipeline space, which could in fact cause the opposite of the intend=
ed effect and drive up energy costs. A case that has been used by both side=
s of the debate is that of El Paso Corp., which found itself in a lengthy l=
awsuit this year when it was charged with giving preferential access to its=
 pipeline to one of its affiliates, which allegedly played a role in drivin=
g up energy costs in the state.

Before analyzing the potential impact of the CPUC's ruling, let's first est=
ablish specifically what the ruling entails and some background of the comp=
anies involved. Put into a nutshell, the ruling creates a competitive marke=
t for the right to transport and store natural gas along the pipelines owne=
d by Southern California Gas and SDG&E, which are both subsidiaries of San =
Diego-based Sempra Energy (NYSE: SRE). As noted, Southern California Gas is=
 ranked as the largest natural-gas distribution utility in the country and =
serves a territory of 23,000-square-miles that ranges from central Californ=
ia to the Mexican border.

Following a standard that is already in place among interstate pipelines, i=
ncluding the ones that transport power into California, both of these compa=
nies will now be allowed to sell large industrial customers space on their =
intrastate "backbone" pipelines, giving customers firm transportation right=
s on the pipelines. The pipelines are referred to as "backbone" because the=
y are part of the smaller distribution system that transports power to fact=
ories and power plants (along with homes and businesses). It is important t=
o note that the CPUC's ruling impacts only large consumers of natural gas i=
n California, which includes electric generating plants. Residential and sm=
all business consumers that use natural gas will continue to have regulated=
 gas-transmission costs.=20

Under the new auction system, power producers and industrial natural-gas cu=
stomers of the two companies will bid to buy pipeline space, with preferenc=
e being given to those bidders that intend to reserve space for the longest=
 period of time. According to the CPUC, the ruling creates three "tiers" of=
 accessibility to the capacity on the pipelines. The first tier includes re=
sidential and small business customers, who are not included in the new com=
petition and will automatically have about 1,044 million cubic feet per day=
 of capacity on the pipelines reserved for their use. The second tier inclu=
des industrial customers who will now be able to participate in the competi=
tion, and will be allowed to bid on half of the remaining capacity. The thi=
rd tier includes all other market participants, including natural-gas marke=
ters, which will be allowed to bid on whatever capacity is left. Both South=
ern California Gas and SDG&E reportedly intend to phase in auctions by the =
end of 2002 for their largest customers to transport natural gas. The aucti=
ons will be for transmission rights that can be traded to other parties.=20

The CPUC also established two different levels of payment options for the b=
idding process. As one option, bidders can pay a fixed price of 7.2 cents p=
er million British thermal units (MMBtu) that would cover all of the capaci=
ty on the pipeline that they have reserved, regardless if it is ultimately =
used or not. As a second option, bidders can pay for only 50 percent of the=
 reserved capacity at the fixed price of 7.2 cents per MMBtu, and 50 percen=
t at a higher price that only applies to the capacity that they ultimately =
use. In addition, the ruling allows for the trading of capacity space, an i=
mportant point that critics claim could allow buyers to gain more control o=
ver the pipeline than allotted in the ruling.=20

As noted, the measure passed the CPUC in a 3-2 vote. The ruling will remain=
 in place until 2006, at which time the commission can decide to renew it. =
The three commissioners that supported the measure were Richard Bilas, Henr=
y Duque and Geoffrey Brown. Loretta Lynch, president of the CPUC, and Carl =
Wood voted against the measure. Wood said he opposed the measure because it=
 was based on data accumulated before natural-gas prices dramatically incre=
ased during the winter of 2000-2001.

Another reason why the three commissioners voted to approve this measure wa=
s a belief that deregulating gas transmission in the state would help to ke=
ep large customers from leaving intrastate pipelines in favor of using inte=
rstate pipelines, which are not regulated by the CPUC. An exodus among indu=
strial users from intrastate pipelines, according to the three commissioner=
s, could leave residential and small business consumers with higher costs a=
ssociated with maintaining the pipelines. However, regulators were quick to=
 qualify their vote by saying the decision to allow competition for the cos=
t of transporting natural gas for industrial users did not represent total =
deregulation. Instead, the commissioners said that the ruling simply amount=
s to "less regulation."=20

As I mentioned, the case against El Paso Corp. (NYSE: EPG) was used as an e=
xample to support both sides of the debate over allowing competition among =
the natural-gas intrastate pipelines. The case against El Paso Corp. is a v=
ery complicated one, but it essentially comes down to one core issue. The c=
ase revolves around allegations that during the period of May to November 2=
000, El Paso improperly shared market-sensitive information with one of its=
 affiliates, which drove up natural-gas prices, pre-empted competition from=
 non-affiliated companies and resulted in extra costs for fuel in the range=
 of $3.7 billion for Californians. El Paso Corp. has consistently maintaine=
d that it engaged in no wrongdoing. According to a report issued by the sta=
te Assembly, natural-gas prices in California increased from $6.6 billion i=
n 1999 to $12.3 billion in 2000 to $7.9 billion for only the first three mo=
nths of 2001. In October, El Paso Corp. was absolved of the charges of mani=
pulating natural-gas prices in California, but an investigation continues r=
egarding any improper sharing of information between affiliates. The releva=
nce of this case is that those opposed to opening up California's intrastat=
e pipelines to capacity believe the new rules could allow for one company t=
o step in and gain control over a portion of the pipeline and thereby be ab=
le to drive up price.

Those in favor of the CPUC's new ruling say the comparisons to the El Paso =
case are unfounded. For starters, the ruling restricts companies from ownin=
g more than 30 percent of the pipeline, which theoretically should prevent =
a company from gaining an ability to control prices. Critics, however, say =
that the ruling allows for the trading of capacity space, which could poten=
tially provide a loophole that would give a company control over more than =
30 percent of pipeline capacity.=20

The issue of potential price spikes associated with natural gas is one of t=
he remaining questions that only time will be able to answer. Critics of th=
e ruling such as TURN say allowing competition among the natural-gas pipeli=
nes creates the same market dynamics as deregulation of the state's electri=
city market, which some say opened the door to gaming and market manipulati=
on. In other words, TURN argues, the CPUC ruling opens the door for one com=
pany to enter the market and buy up a significant amount of capacity along =
the intrastate gas pipelines, thereby giving that company the opportunity t=
o control prices. As the new ruling won't take effect until another year wh=
en Southern California Gas and SDG&E begin receiving bids for capacity spac=
e on their pipelines, we won't know any time soon if prices will be impacte=
d. However, critics claim that a sharp downturn in temperatures in Californ=
ia during the winter season that drives up demand could be the first indica=
tor of whether or not the new ruling will lead to a sharp increase in energ=
y prices.

Moreover, the opening of competition along capacity space on California's i=
ntrastate natural-gas pipelines is a surprising departure from the state's =
discontinuation of deregulation within the power sector. It is too early to=
 tell how the new ruling will impact energy prices, and of course this ques=
tion is the source of great debate (with one side saying that prices will d=
rop and the other side saying that prices will increase). Perhaps the large=
r issue, however, is the control over the state's pipelines that could be i=
mpacted by this ruling. Even 30-percent capacity control, the amount that t=
he CPUC is opening to competition, would be considered excessive by some ot=
her states. For instance, in Texas 20-percent control is considered a maxim=
um standard. Again, whether or not the allowance of competition will spark =
the abuse of capacity control on the intrastate pipelines is something that=
 remains to be seen. We do know that electric competition in California bec=
ame a disastrous experiment, but even with this history the state is moving=
 forward with bringing competition to its intrastate natural-gas pipelines.=
=20


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