This note details a complete microeconomic characterization of the physical relationships between input use and the level of output of a simple point-to-point gas pipeline system and uses it to contribute to the public policy discussions pertaining to the economic regulation of natural gas pipelines. We show that the engineering equations governing the design and operations of that infrastructure can be approximated by a single production equation of the Cobb-Douglas type. We use that result to inform three public policy debates. First, we prove that the long-run cost function of the infrastructure formally verifies the condition for a natural monopoly, thereby justifying the need of regulatory intervention in that industry. Second, we examine the conditions for cost-recovery in the short-run and contribute to the emerging European discussions on the implementation of short-run marginal cost pricing on interconnector pipelines. Lastly, we analyze the performance of rate-of-return regulation in that industry and inform the regulatory policy debates on the selection of an appropriate authorized rate of return. We highlight that, contrary to popular belief, the socially desirable rate of return can be larger than the market price of capital for that industry.

This paper examines the deployment of a natural gas pipeline in a developing region where the rate-of-return (RoR) regulation has been implemented to attract investment. We assume that the pipeline firm considers the proven demand emanating from a few large industrial sites but ignores the eventual rise of other domestic-oriented uses. We first assess the magnitude of the overcapitalization generated ex ante at the planning stage by the application of RoR regulation (i.e., the Averch-Johnson effect). We then analyze the ex-post situation when the enlarged domestic demand materializes. We prove that the allowable rate of return can be set to obtain ex ante the degree of overcapitalization needed ex post to serve the enlarged demand in a costefficient manner. We finally discuss whether RoR regulation can fulfill two public policy objectives: optimally building ahead of proven demand and protecting society from monopoly prices.