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 Economic Considerations in Pipeline and LDC Operations


Concerns Relating to the Recovery of Fixed Costs

It is important to recognize that pipelines and gas distribution systems generally require the companies building them to make large capital investments. These facilities are generally usable over a relatively long period of time. Apart from the cost of the gas itself, most of the transportation companies' costs are fixed and are not affected by the volume of gas transported. For example, debt coverage, property taxes, insurance, company payroll, fringe benefits, rents, and other general and administrative costs do not change, regardless of how much gas is moved. But the large amount of fixed costs does make the average or unit cost of providing service extremely sensitive to the volume of gas transported.

Thus, when a pipeline company or LDC builds a new pipeline or extends its existing system, it is important for the new facility to be built at the proper size. A project too large for the loads it will serve will have high average unit costs, making it difficult for the company to get customers to switch from their alternative fuels. Only by increasing its gas volumes will the pipeline or LDC be able to lower its average cost. If, on the other hand, the project is undersized, it will have to be subsequently expanded, which is more costly than building a system of sufficient size in the first place.

To reiterate: the unit cost of transporting gas decreases as volumes increase. This occurs in two ways. First, for any given pipeline size, the average cost is minimized when the maximum potential volumes are transported through it. For example, if we assume that the annual cost of transporting 1 MMBtu/day of gas for 365 days is $365 with no variable cost, the average cost is $1.00/MMBtu [($365/year) / (365 MMBtu/year)]. This rate for calculating the average cost of transporting the maximum annual contract quantity of gas is referred to as the 100 percent load factor rate. However, if the customer transported only half the maximum annual volume, or 182.5 MMBtu, the fixed cost would still be the same $365/year, but the average cost would be $2.00/MMBtu [($365/year) / (182.50 MMBtu/year)]. This would be a 50 percent load factor rate.

Second, although it costs more to build a larger diameter pipeline than a smaller one, the increase in maximum flow rate for the larger pipeline is greater than the increase in cost. This means that the unit cost of a larger pipeline is less than the unit cost of a smaller pipeline. A study by the University of Calgary, for example, showed the increase in cost between a 20-inch pipeline and a 24-inch pipeline would be about 31 percent, while the 24-inch pipeline would be able to deliver 55 percent more gas. The figures change, depending on the sizes of pipeline being compared, but in all cases studied, the cost increased by a lower percentage than the volume percentage increase. This is a very important factor in designing pipeline projects and laterals. It reinforces arguments presented by companies at the public hearings that the large industrial loads are a very important factor in the economic viability of constructing laterals.

Basic Business Risk of the LDC

Again, the pipeline industry typically requires a very large capital investment to install a new pipeline, which has a long economic life. Therefore, in deciding to construct and finance a pipeline project, a company exposes itself to a considerable amount of business risk.

Building a pipeline or an LDC is similar to buying a new house. The project sponsors must put some equity at risk and must also borrow additional money to pay for the construction. Banks will not loan the money without reasonable assurance that the company will be able to pay it back over the term of the loan. In the case of a gas pipeline or LDC, a company's ability to repay the investment will be determined by whether or not it can sell the transportation service it provides at a price high enough to repay the loan and cover its expenses.

Competitive businesses start and fail all the time. However, it is unusual for a gas distribution company to fail. Traditionally, gas distribution companies have been among the most stable of businesses, largely because of governmental regulation, which permits prices that cover costs plus a return on investment. However, the risks associated with starting a new gas distribution company are much greater than running an existing, mature distribution company. For a new LDC, achieving profitability will likely take a relatively long time. In determining who should be awarded a gas distribution franchise, the government should evaluate a bidder's overall business plan and evaluate the company's ability to finance the business over the long term.

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