Do Americans Consume Too Little Natural Gas?
An Empirical Test of Marginal Cost Pricing
Lucas Davis1
1 University
Erich Muehlegger2
of California, Berkeley
2 Harvard
University
RAND Journal of Economics, Winter 2010
Davis,Muehlegger (Berkeley, Harvard)
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Feb 2011
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Overview
Natural gas delivery is a classic state-regulated natural monopoly.
This paper studies state-regulated retail prices for natural gas.
Outline:
1
2
3
4
Why should we care about regulated prices?
How much do regulators markup natural gas prices above marginal
cost?
How much surplus is lost as a result?
What do regulated markups imply for environmental policy?
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Why study regulated prices?
Long literature discusses optimal regulation of natural monopoly.
How closely does actual regulation match what economists would
consider optimal?
Relevance to Environmental Policy
Governments regulate retail prices for many types of energy...
... but much of our intuition about externality-correcting taxes
implicitly assumes prices are set in competitive markets.
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Motivation for Environmental Taxes or Permits
P
MSC
p*
MPC
tax
p’
D
q*
Davis,Muehlegger (Berkeley, Harvard)
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q’
Q
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Motivation for Environmental Taxes or Permits
P
MSC
p*
MPC
tax
p’
D
q*
q’
Q
Is the assumption that p’ reflects the MPC a reasonable one for
regulated markets?
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Why Might Regulated NG Prices be Above MC?
Natural Gas Supply Chain:
1
2
3
4
Production (competitive) →
Interstate Transportation to ”City-gate” (unregulated, open-access) →
Local Distribution (state regulated) →
End Users.
Local distribution is a classic natural monopoly.
High fixed costs (pipeline network), low marginal costs.
States regulate prices to meet two objectives:
1
2
Cover monopoly’s fixed costs, while
Prevent monopolist from earning excessive profits.
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Regulated Pricing: Linear Prices
D
Consumer
Surplus
P
Lowest linear price
that allows the firm
to break even (p’)
Deadweight
Loss
p’
AC
MC
q’
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Regulated Pricing: Two-part tariff
D
P
Optimal Two Part Tariff: A+p*q
Step 1: Set p = MC
Efficient Quantity
Step 2: Collect fixed fees (A) from consumer
Surplus to cover monopolists fixed costs.
AC
FC covered by fixed fees
p*=mc
MC
q*
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Regulated Pricing in Practice
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Regulated Pricing in Practice
Two-part tariffs are common: A + p ∗ q...
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Regulated Pricing in Practice
Two-part tariffs are common: A + p ∗ q...
...but few regulators set p = mc.
Fixed monthly ‘hookup’ fee.
Per-Unit ”Transportation” Fee.
Per-Unit Commodity Charge.
Typically, Transportation Fee + Commodity Charge > MCng
Davis,Muehlegger (Berkeley, Harvard)
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Regulated Pricing in Practice
Two-part tariffs are common: A + p ∗ q...
...but few regulators set p = mc.
Fixed monthly ‘hookup’ fee.
Per-Unit ”Transportation” Fee.
Per-Unit Commodity Charge.
Typically, Transportation Fee + Commodity Charge > MCng
In this paper:
1
2
3
We estimate how much TF + CC is greater than MC.
We compare these markups to “reasonable” carbon prices from the
environmental economics literature.
We estimate deadweight loss from the prices set by regulators.
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How do we estimate the markups over marginal cost?
We examine a panel of state-level, monthly data from 1991-2007.
For residential, commercial and industrial customers, we observe:
Sales Revenues
Delivered Quantities
Marginal Cost (measured by spot transactions at the city gate)
Davis,Muehlegger (Berkeley, Harvard)
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How do we estimate the markups over marginal cost?
We examine a panel of state-level, monthly data from 1991-2007.
For residential, commercial and industrial customers, we observe:
Sales Revenues
Delivered Quantities
Marginal Cost (measured by spot transactions at the city gate)
Intuition for Empirical Strategy: Consider the relationship between
net revenues (revenues less commodity costs) and quantities.
Davis,Muehlegger (Berkeley, Harvard)
NG Regulation
Feb 2011
9 / 18
How do we estimate the markups over marginal cost?
We examine a panel of state-level, monthly data from 1991-2007.
For residential, commercial and industrial customers, we observe:
Sales Revenues
Delivered Quantities
Marginal Cost (measured by spot transactions at the city gate)
Intuition for Empirical Strategy: Consider the relationship between
net revenues (revenues less commodity costs) and quantities.
Average Cost Pricing / Monthly Fee = 0
→ Net Revenues positively correlated with usage, Intercept zero.
Davis,Muehlegger (Berkeley, Harvard)
NG Regulation
Feb 2011
9 / 18
How do we estimate the markups over marginal cost?
We examine a panel of state-level, monthly data from 1991-2007.
For residential, commercial and industrial customers, we observe:
Sales Revenues
Delivered Quantities
Marginal Cost (measured by spot transactions at the city gate)
Intuition for Empirical Strategy: Consider the relationship between
net revenues (revenues less commodity costs) and quantities.
Average Cost Pricing / Monthly Fee = 0
→ Net Revenues positively correlated with usage, Intercept zero.
Optimal Two-part tariff / Marginal Price = Marginal Cost
→ Constant Net Revenues, Intercept = Fixed Fee
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High Markup State: Massachusetts (2006)
Figure: Residential Natural Gas Price Schedule For Massachusetts for 2006
Net Revenue Per Customer (in dollars)
100
Massachusetts
Mar
Feb
Apr
Jan
Dec
Nov
Oct
Jun
0
Sep
Jul
Aug
May
0
Davis,Muehlegger (Berkeley, Harvard)
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10
Consumption Per Customer (in MCF)
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Low Markup State: Oklahoma (2006)
Figure: Residential Natural Gas Price Schedule For Oklahoma for 2006
Net Revenue Per Customer (in dollars)
100
Oklahoma
Jan
Apr
Nov
Mar
Feb Dec
0
OctMay
Jun
Sep
Aug
Jul
0
Davis,Muehlegger (Berkeley, Harvard)
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Consumption Per Customer (in MCF)
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How Do We Estimate Average Markups?
Calculate Net Revenues = Total Revenues - City Gate Cost.
Test of MC Pricing:
NetRevenuesicmy = αicy + βicy Qicmy
(1)
α is an estimate of total monthly fixed fees.
β is an estimate of the per-unit transportation fee.
β = 0 implies Marginal Cost Pricing.
Davis,Muehlegger (Berkeley, Harvard)
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How Do We Estimate Average Markups?
Calculate Net Revenues = Total Revenues - City Gate Cost.
Test of MC Pricing:
NetRevenuesicmy = αicy + βicy Qicmy
(1)
α is an estimate of total monthly fixed fees.
β is an estimate of the per-unit transportation fee.
β = 0 implies Marginal Cost Pricing.
Result 1: Reject marginal cost pricing for each state, year or customer
class.
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How Large Are Per Unit Markups?
Table 3
Average Deliveries, Revenues, and Markups
By Customer Class
Per-Unit Markup
Over City Gate Price
Fraction of Total
Core LDC Deliveries
Fraction of Total
LDC Net Revenues
Percent
Levels (per McF)
Residential Customers
54.1%
71.1%
47.9%
(0.7%)
$3.38
(0.04)
Commercial Customers
27.3%
25.2%
43.0%
(0.7%)
$3.05
(0.05)
Industrial Customers
18.4%
3.7%
2.5%
(4.2%)
$0.16
(0.27)
100.0%
100.0%
38.4%
(0.9%)
$2.70
($0.05)
All Customers, Pooled
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High Markups Have Implications for Environmental Policy
Current markups for residential and commercial customers imply
carbon costs of over $200 per ton of carbon ($55 / ton CO2)
As a point of comparison, Nordhaus (2007) uses a baseline of $35 per
ton of carbon ($10 / ton CO2)
Thus, setting the socially optimal natural gas price incorporating
impacts of carbon emissions would lead to substantially lower
marginal prices and more consumption.
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Actual Versus Carbon-Optimal Pricing
Current Residential Prices Versus
Optimal Residential Prices with a $35/ton Carbon Cost.
$0.54/McF = Efficient Markup
$3.38/McF = Actual Markup
D
P
Current price =
MCng + per-unit markup
p’’
MSC = MCng +
$35/ton of Carbon
p*
p’
MPC = MCng
q’’
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Q
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Regulated Prices Generate Substantial Deadweight Loss
Table 6
Estimates of Annual Deadweight Loss (in Millions)
U.S. Natural Gas Distribution Market, 2001-2007
Assuming Marginal
Cost of Carbon
of $0 per ton
Assuming Marginal
Cost of Carbon
of $35 per ton
Assuming Marginal
Cost of Carbon
of $55 per ton
Residential Customers
1,297
(535)
1,197
(491)
1,146
(468)
Commercial Customers
524
(241)
485
(222)
465
(212)
Industrial Customers
897
(492)
809
(434)
770
(407)
All Customers, Pooled
2,719
(771)
2,491
(696)
2,381
(659)
Elasticity Estimates from Table 4:
Residential Demand = -0.409 (s.e. 0.122),
Commercial Demand = -0.223 (s.e. 0.104),
Industrial Demand = -0.711 (s.e. 0.298)
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Why Do Regulators Set High Markups?
Other Potential Explanations:
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Why Do Regulators Set High Markups?
Other Potential Explanations:
Distribution Concerns
High Markups / Low Fixed Fees shift burden of fixed costs to
high-volume customers.
But, many means-tested programs offer lower rates for eligible
households.
Moreover, consumption is not a terribly good proxy for income.
Davis,Muehlegger (Berkeley, Harvard)
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Feb 2011
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Why Do Regulators Set High Markups?
Other Potential Explanations:
Distribution Concerns
High Markups / Low Fixed Fees shift burden of fixed costs to
high-volume customers.
But, many means-tested programs offer lower rates for eligible
households.
Moreover, consumption is not a terribly good proxy for income.
Other Environmental Externalities
City-gate price may not reflect true social marginal cost of NG
consumption.
But, natural gas pollutes less than alternatives. High markups
potentially push high volume consumers to dirtier fuels on the margin.
Davis,Muehlegger (Berkeley, Harvard)
NG Regulation
Feb 2011
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Why Do Regulators Set High Markups?
Other Potential Explanations:
Distribution Concerns
High Markups / Low Fixed Fees shift burden of fixed costs to
high-volume customers.
But, many means-tested programs offer lower rates for eligible
households.
Moreover, consumption is not a terribly good proxy for income.
Other Environmental Externalities
City-gate price may not reflect true social marginal cost of NG
consumption.
But, natural gas pollutes less than alternatives. High markups
potentially push high volume consumers to dirtier fuels on the margin.
Regulatory Capture
With imperfect information, regulators may overestimate fair rate of
return → Incentive to maximize rate base.
Low fixed fees and high markups make NG more attractive to small
users.
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Conclusion
1
Do regulators set optimal prices?
No! Strong evidence that regulators recoup fixed costs primarily
through per-unit markups rather than fixed fees.
2
How much surplus is lost by suboptimal regulation?
Markups of 48% and 43% for residential and commercial customers.
Estimated DWL of $2.7 billion per year.
3
What do regulated prices imply for environmental policy?
Per-unit markups justified by a carbon cost of $200 per ton.
Optimal price that incorporates carbon costs are lower than current
marginal prices.
More broadly, it is important to take pre-existing distortions into
account when determining environmental policy.
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