The technology and cost structure of a natural gas pipeline: Insights for costs and rate-of-return regulation

Abstract

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.

Rate-of-return regulation to unlock natural gas pipeline deployment: Insights from a Mozambican project

“…In light of both the scarcity of domestic capital and the poor performance of state-owned enterprises in developing countries (Parker and Kirkpatrick, 2005), the participation of an FDI-financed private sector is needed to provide the energy infrastructure. However, the natural gas pipeline sector has "natural monopoly" features because its long-run cost function is strictly subadditive (Perrotton and Massol, 2018). As that characteristic can lead to a variety of economic performance problems (i.e., excessive prices, production inefficiencies), some form of economic regulation is necessary.…”

Rate-of-Return Regulation to Unlock Natural Gas Pipeline Deployment: Insights from a Mozambican Project

“…features because its long-run cost function is strictly subadditive (Perrotton and Massol, 2018). As that characteristic can lead to a variety of economic performance problems (i.e., excessive prices, production inefficiencies), some form of economic regulation is necessary.…”

“…Using an engineering approach, Perrotton and Massol (2018) recently proved that the technology of that infrastructure can be approximated by a single production equation of the Cobb-Douglas type:…”

“…We now adopt a numerical perspective to examine the implications of setting the allowed rate of return at the level s λ for the pipeline technology studied in Perrotton and Massol (2018), that is, . For various conceivable values of the demand price elasticity 1 ε listed in Table 3 (column I), we consider a series of values of the ex-post demand expansion parameter λ in the range 0 λ λ < < where the upper bound value is Table 3 -column II).…”

“…In a recent note, Perrotton and Massol (2018) To compare that lower bound with the ideal case of a regulator implementing the socially desirable rate of return opt s , we adopt a numerical perspective. In Table 4, we evaluate, for various conceivable values of the demand price elasticity parameter, two versions of the net social welfare gain ratio obtained ex ante that has been presented in section 4.1.…”