Regulatory Risk in Gas and Power Markets

Last month I participated in a panel on “Risk in Gas and Power Markets” at the Alpha Insight Energy Risk Summit held October 23-25, in Houston Texas. My specific topic “Regulatory Risk in Gas and Power Markets” was something I had not looked at earlier. While “regulatory risk” has been a frequent topic in my writings and speeches the issue I addressed was that of regulation and its impacts on “public utilities” not on the risks on the competitive side of the business of “natural gas and electricity markets,”

In that regard there is a significant difference between the wholesale markets for natural gas and electricity. That difference is that natural gas prices are “deregulated” and electricity prices at wholesale are not.

The price of natural gas was regulated by the Federal Power Commission (FPC) (later the Federal Energy Regulatory Energy Commission (FERC)) starting in 1955 after the US Supreme Court ruling in Philips Petroleum Co. v. Wisconsin 347 U.S. 672 (1954). The FPC/FERC did such a bad job of price fixing of natural gas at the wellhead that they created the anomaly of sustained shortages of natural gas in interstate markets and artificially high prices. As a result Congress stepped in and natural gas markets were deregulated in phases after passage of the Natural Gas Policy Act of 1978.

The sale of electricity at wholesale, however, is still fully subject to regulations of the FERC under Section 824(d) of the Federal Power Act of 1935. Part II of the FPA authorized the FPC to regulate the interstate transportation and wholesale sale (i.e., sale for resale) of electric energy, while leaving jurisdiction over intrastate transportation and retail sales (i.e., sale to the ultimate consumer) in the hands of the state. Under the law the FERC must make a finding that the rates and changes (i.e. prices) for electricity are “just and reasonable”. Here’s the relevant language:

a) Just and reasonable rates

All rates and charges made, demanded, or received by any public utility for or in connection with the transmission or sale of electric energy subject to the jurisdiction of the Commission, and all rules and regulations affecting or pertaining to such rates or charges shall be just and reasonable, and any such rate or charge that is not just and reasonable is hereby declared to be unlawful.

Jumping ahead, the methodology which the FERC uses to insure “just and reasonable rates” is the reliance on a functioning power market free of any manipulation or market power abuses by any participant. To wit, if the market operates “fairly” the ensuing “prices” or “rates and charges” ( as required by the statute) will be “just and reasonable.  This method of ensuring “just and reasonable rates” has been approved by the U.S. Court of Appeals in Public Citizen Inc., et al., v. FERC et al., (October 13, 2012).

The failure to repeal the FERC’s rate setting authority under the FPA over sales of electricity in power markets means that the FERC can, upon whatever evidence of “market failure” it finds compelling, set prices on some other basis, set caps, prices floors and even order rebates. That is not a risk found in natural gas markets.

Here’s a bit of what I shared with my audience in Houston without the anecdotes and examples

The general risk categories for all businesses include: regulatory, execution, safety, reliability, economic, environmental, technical and financial risk. Looking at regulatory risk as:

Regulatory risk is the risk that a change in laws and regulations will materially impact a security, business, sector, or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of an investment, or change the competitive landscape.

Given that definition then “regulatory risk” can originate in my experience in:

• Legislation
• Regulatory rulings
• Judicial decisions
• Treaties and international agreements

These entities can change the risk for electricity and gas traders specifically by decisions which directly or indirectly affect:

• Supply
• Demand
• Market rules
• Access to markets

Here are some examples. Gas supply can be affected by regulatory permits which open or restrict new areas for drilling. Electricity supply can be affected by changes in environmental or the additional of DSM or aggregation to markets. Demand and supply can be affected by introduction of subsidies at retail or wholesale at the state level. Changes in market rules may favor or disadvantage incumbents or new entrants. Access to markets can be affected by state and federal proceedings to permit new electric or gas transmission infrastructure or the licensing of LNG facilities.

The best advice I could give the traders was to actively follow regulatory developments and assess potential impacts. A framework for this approach was provided succinctly by my former colleagues at Deloitte in their December 2018 report “Leading in Times of Change: Energy Regulatory Outlook for 2019”. Their advice was to:

• “First and foremost, regulatory requirements and/or industry standards applicable to the company are explicitly documented.
• Second, an agreed-upon operating model is in place that addresses the roles, responsibilities, expected control activities, and cadence for each of the identified self-assessment activities.
• Third, findings and observations from the assessments are captured in a report—with ongoing tracking of the corrective actions necessary to further strengthen the control environment for the organization's first line of defense.“

On reflection another piece of advice also comes to mind from firsthand experience. Regulation is a process which involves the public through solicitation of comments in legislative and rulemaking processes. Proposed changes are announced in advance and gas and electricity traders, with their intimate knowledge of energy markets, must participate by response and comment. Peter Drucker rote years ago that it was the responsibility of business to “get” the regulations it needed to function efficiently. That still holds true.