The Recent Past: Declining Gas Costs Offset Renewable Energy Gains

A consumer in 1980 might have predicted that renewable energy would soon reach price parity with natural gas in the U.S. electric generation market. Its price disadvantage still was large, but its cost was declining rapidly, while the wellhead price of natural gas had more than quadrupled since 1970. Contemporary observers expected the decline in renewable energy costs and the rise in natural gas prices to continue.³

Indeed, renewable energy costs did continue to fall. For example, the cost of electricity from wind turbines declined from over 50 cents per kilowatt-hour (kWh) in 1980 to 5-6 cents today (prices in 1994 dollars) in areas with good wind resources; the price is even less for the best projects. At this level, wind would be more than competitive with natural gas in 1997 if gas prices had followed their expected path. Instead, gas prices also fell. The real wellhead price of natural gas in 1995 was more than 40% below its 1980 level; the price delivered to electric generators had declined by nearly 56%.⁴ (See Figure 1.) As a result, natural gas today still enjoys a price advantage over renewable energy.

The most important forces driving the decline in gas prices were deregulation and competition. Ironically, the federal government had regulated the wellhead price of natural gas in order to protect consumers against rising costs.⁵ Price controls undoubtedly did limit the price paid by many consumers initially, but they also reduced and distorted production incentives. By the mid-1970's, these controls had created natural gas shortages in some regions. Partly in response to the shortages, the Natural Gas Policy Act of 1978 raised price ceilings for most gas supplies and created a mechanism for their gradual elimination.

The deregulation of wellhead prices was formally completed in 1992. Well before that date, however, price ceilings had lost their practical relevance. Market forces rather than regulation established the price at which producers sold their gas, and the administrative allocation of scarce supplies had been replaced by competition to sell a supply of natural gas that soon exceeded market demand.

A transformation in the role of natural gas pipelines increased the competition. In 1980, pipeline companies bought most of the natural gas sold by producers. They in turn resold the gas to end users and local distribution companies, most of which had few, if any, alternative sources of supply. Facing little sales competition, and knowing that they could pass the price they paid for gas directly to their customers, pipeline companies principally focussed on securing an adequate gas supply and only secondarily on the cost of the gas. Producers therefore shared the economic benefit of the pipeline companies' protected market position.

A combination of market forces and regulatory changes undermined the pipeline companies' position. The natural gas surplus that developed following the enactment of the Natural Gas Policy Act created a pool of uncommitted gas supplies, which market forces priced well below the prices that pipeline companies were required to pay producers under their long-term supply contracts. In response to gas users' calls for access to the cheaper supplies, the Federal Energy Regulatory Commission (FERC) effectively ordered the pipeline companies to transport the gas of competing sellers.⁶ Unburdened by long-term supply contracts, gas producers and marketers then could sell directly to the pipeline companies' customers. The new competitors steadily gained market share at the pipeline companies' expense.

By 1993, the transition was complete. The gas merchants' role had passed to producers and marketers; pipeline companies transported gas but no longer bought or sold it. Unlike the firms they replaced, the new merchants did not enjoy a protected market position; the pipeline companies that transported their gas to market were equally ready to transport the gas of their competitors.

Further changes in the regulation of pipelines are possible and perhaps likely, but analysts envision nothing comparable to the transformation of pipeline companies from gas merchants to gas transporters.

Deregulation and multiple gas merchants made the sale of natural gas a highly competitive business. To survive, producers streamlined their operations and embraced new technologies. Some producers nevertheless failed, but the rest sold gas profitably at prices that previously would have caused a loss.

The cost of natural gas to electric generators includes not only the price paid to producers but also the price paid to pipeline companies for transporting it from the wellhead to their generating plants. The potential for cost reduction was smaller for those companies than for the producers. If costs could not be cut, however, they could be shifted to other customers. The efforts of the pipeline companies to attract and retain large shippers combined with changed regulatory policies⁷ to produce a large shift in pipeline costs from electric utility and industrial customers to residential and commercial consumers. As a result, electric utilities' delivered cost of gas declined even more than its price at the wellhead.

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