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KEY ISSUES

This section of the report provides an analysis of key issues presented to the committee and provides the basis for the committee's recommendations on these issues.

Lateral Policy and Pipeline Access

As noted, the NEB has approved the M&NE Pipeline lateral policy. Under this policy, the pipeline will build laterals if revenues from them are sufficient to cover their construction and operating costs. A single or "postage stamp" rate will be charged all shippers using the main line or laterals in Nova Scotia and New Brunswick. Without this policy, customers taking service from a lateral would pay a main line charge and a separate charge for use of the lateral. The policy is in effect until the pipeline proposes its first main line expansion. After that, it may or may not disappear.

The committee recognizes that M&NE's lateral policy provides substantial benefits to the province. These benefits should not be jeopardized. To summarize, the key factors associated with them include:

     

  • Construction of laterals moves the reach of the pipeline and the its postage stamp toll farther into the province, with the cost underwritten by all main line shippers, most of whom are export shippers.

  • •Laterals will be built only if there are sufficient loads and revenues from the laterals to cover the pipeline's lateral costs.

  • •The lateral policy provides a limited window of opportunity, because it is in place only until the first main line expansion. Given the growing load in the United States, main line expansion will likely be required in the near future.

  • •A discounted toll (4 percent) for New Brunswick is in effect only for the first three years of pipeline operation.

  • •If M&NE goes into service without contracts signed to justify the laterals, the Sable Island producers will move to sell the capacity in available markets, which are likely to be in the U.S. This will probably be done under long-term contracts. Thus, a delay in deciding the lateral issue could cost the province this initial capacity opportunity.

The committee strongly believes the benefits offered by the lateral policy will be essential to the timely construction of facilities to serve the Northeast and Northwest regions of the province, and it encourages the New Brunswick Government to actively promote agreements between anchor load customers and M&NE Pipeline sufficient to justify construction of the laterals.

The committee also believes that government should ensure that natural gas becomes available to Northeastern and Northwestern New Brunswick as soon as possible. In the event that natural gas loads for these markets prove inadequate to meet the economic threshold toll test for lateral construction under the M&NE lateral policy, government should be prepared to provide a contribution in aid of construction to enable the pipeline to be built. In addition, access to natural gas for all of New Brunswick, including Northeastern and Northwestern parts of the province, should be a key criterion in evaluating proposals for any distribution franchise.

As a result of laterals being constructed by the inter-provincial pipeline, an important related issue is created which the committee must address -- direct access. Direct access is the connection of a customer to either the inter-provincial pipeline or a lateral without using a distribution system. Bypass is a different issue. It occurs when a customer of an existing distribution system seeks to connect directly to the inter-provincial pipeline. If allowed, bypass causes the distribution company and the rest of its customers to bear the costs of any facilities installed to provide service to the bypassing customer. Since no distribution systems currently operate in New Brunswick, bypass is not yet an issue. However, direct access is an important issue.

The committee is aware that the M&NE pipeline has signed agreements with prospective major industrial customers to provide these customers with direct access to delivered natural gas from a lateral in exchange for the customers' obligation to pay the cost of constructing the lateral. Without the industrial customers' willingness to commit to the pipeline contracts, it is unlikely the pipeline company would construct laterals.

Some potential LDC developers stated they would not be able to develop LDCs to serve commercial and residential customers unless large industrial customers were required to take their service from the LDC. These parties said it was necessary to have a distribution company set a meter between the pipeline and the end-user so that the LDC could collect transportation revenue from the large customers. Other potential LDC developers said they could develop distribution operations without requiring the large industrials to take service from the LDCs. These proponents stated they would be willing to compete for some of the large industrial business, but they anticipated that the potential margins from these customers would be very small as a result of inter-fuel competition.

For their part, some large industrial customers stated they would not be willing to pay the cost of the pipeline if they were also obligated to pay distribution charges to an LDC. These customers, who currently burn fuel oil, need to be able to take service directly from the pipeline in order to make converting to gas economical. Natural gas would make sense only if savings were sufficiently large to offset conversion costs and provide ongoing savings.

The committee feels obligated to take a position on the issue of whether, and to what extent, direct access will be allowed for large industrial or anchor load customers. If direct access is allowed without any modification, these customers would take service under rates regulated by the NEB, and the provincial government would not have jurisdiction over the transaction. In this case, no revenue would be available from the large customers to help develop the gas distribution business in New Brunswick.

If, on the other hand, direct access were prohibited, large industrial customers would have to take service from LDCs. Since LDCs have not yet been established, the industrial customers have no way of knowing how much the LDC would charge for the service. Industrial customers cannot commit to the contracts that the pipeline needs to build the laterals unless they know what their total costs will be and whether converting to gas will be economical. If the LDC attempted to charge the industrial customer anything other than a nominal rate, the industrial customer may not be willing to convert to gas in the first place.

The committee understands that anchor customers are essential to construction of laterals within New Brunswick. Without anchor customers, it is very unlikely there will be laterals, and without laterals, gas availability will be severely limited in the province. The imposition of distribution charges on anchor loads could threaten the economic viability of their conversions and, consequently, the viability of the laterals.

The committee also realizes that it would be very difficult for parties to bid for distribution franchise rights without knowing if the anchor loads will be customers of M&NE or the distribution franchise. Further, the anchor load customers need stable and predictable rates to justify their conversion commitments. The committee understands that it is necessary to preserve the economic benefits the anchor load customers have negotiated with the pipeline without relinquishing provincial jurisdiction.

Accordingly, the committee recommends that all consumption of natural gas in the province be included under a broad definition of gas distribution in order to bring these activities under provincial regulation. It further recommends that prospective anchor load customers be granted a single end-user franchise for a term of 20 years, or the term of their firm service agreement with the pipeline, whichever is less. The single end-user franchises would be required to pay an annual, fixed franchise fee, which, among other uses, would help cover the increased costs of regulatory activities by the Public Utilities Board (PUB).

Establishing Franchises

To implement the above recommendation and to facilitate a competitive bidding process for distribution franchises, the committee proposes the following course of action:

     

  • •Draft legislation that defines natural gas distribution as the receipt, transportation, or consumption of natural gas delivered from a federally regulated pipeline or intra-provincial gas gathering or transmission system.

  • •Require that any party wishing to distribute gas must do so only through a franchise awarded by the province.

  • •Establish three classes of franchises-- general, producer and single end-user.

  • •Make all three classes of franchises subject to provincial regulation. All franchises will pay an annual franchise fee and be required to supply any information required by the PUB to fulfill its statutory mandates.

  • •Establish an annual fee for all general and producer franchises based on the annual revenues of the franchise holder, while the single end-user annual fee should be a fixed fee. The annual fees would be intended to cover, among other things, the PUB's increased costs, which will arise as the PUB appropriately increases its responsibilities to respond to the challenges of the new industry.

Types of Franchises

A general franchise is awarded for the distribution of gas in a defined incorporated or unincorporated area to more than a single customer.

A producer franchise is awarded for gas produced in New Brunswick. The producer franchise should allow locally produced gas to be distributed to one or more end-users not served by an existing franchise.

A single end-user franchise is awarded where the distributor is the end-user and the end-user is directly connected to an inter-provincial pipeline.

The franchise fees charged to single end-user franchise holders should be fixed to provide for economic certainty over the life of the franchise, should carry an annual minimum that ensures that small - to medium-sized end-users will find value in being served by an LDC, and should not be so high as to jeopardize the development of laterals built by the pipeline.

The single end-user franchise should be made available only for gas taken off a pipeline for the direct consumption of the holder of the franchise. To preserve the integrity and value of general franchises, holders of a single end-user franchise will not be permitted to distribute gas to any other end-user. The term of this type of franchise will be the lesser of 20 years or the term of the customer's firm service agreement on the federally regulated pipeline. Single end-user franchises will pay no additional distribution changes above the M&NE Pipeline toll. They will, however, be subject to an annual fixed franchise fee.

An annual fee for all general and producer franchises should be established, based on the annual revenues of the franchise holder, while the single end-user annual fee should be a fixed fee. The annual fees would be intended to cover, among other things, the PUB's increased costs, which will arise as the PUB appropriately increases its responsibilities to respond to the challenges of the new industry.

The recommendation to create three separate classes of franchises provides provincial jurisdiction over the large industrial customers and promotes a practical and reasonable balance of interests regarding access to the pipeline. The committee also recommends that prior to the regulatory body issuing a single end-user franchise, it should be clear that the franchise is consistent with the objective of maximizing gas penetration in New Brunswick.

Future Laterals and Lateral Expansions

The committee has considered whether the policy articulated above should be different for new laterals or the future expansion of existing laterals. As long as M&NE's current lateral policy is in effect, it clearly benefits the province to have M&NE build the laterals. The committee also recommends that government provide a contribution in aid of construction where a lateral under the M&NE lateral policy has a revenue shortfall in meeting the economic threshold toll test. If, in the future, the lateral policy is no longer in effect, new facilities will be built by a distribution franchise holder under the jurisdiction of the province. The PUB should have the authority to decide on the appropriate rate to be charged on any facilities built by a distribution franchise holder.

Regulation

The committee recommends the PUB have flexibility in addressing issues under its jurisdiction. The PUB will also need expertise to decide those issues. It does have the authority to take evidence and consider all the facts on the technical, policy and legal matters. Accordingly, the committee proposes broad policy guidelines to the PUB and the Legislature for seven subject areas:

     

  • •Cost of service and incentive regulation

  • •Bundled and unbundled services

  • •Market power

  • •Revenue cycle services

  • •Supplier of last resort

  • •Load balancing

  • •Incentives for distribution system expansions

Cost of Service and Incentive Regulation

The issue to be addressed here is whether the PUB should be empowered to adopt forms of regulation other than traditional ones based on cost of service. Under this traditional form of regulation, a utility's revenue requirement is the sum of its operating costs, depreciation expense, taxes, and a return on investment. The latter is calculated by multiplying the utility's rate base (the company's net investment) by the rate of return approved by the regulatory body, and the total revenue requirement is allocated among the various services provided by the utility. The problem with this form of regulation is that it is essentially "cost plus," and therefore provides little incentive for cost control. Moreover, the inevitable cost of regulation is ultimately borne by the customer.

Recently, the telecommunications, railroad, gas, electric, and other regulated industries have begun to experiment with incentive regulation. There are various forms of incentive regulation, including price or revenue caps, indexed rates, and benchmarking.

The common purpose of these methods is to break the connection between the utility's cost and its revenue requirement. For example, under indexed rates, the utility's revenue requirement increases each year by the rate of inflation less a productivity offset. This increase is allowed, regardless of changes in the utility's actual costs. Therefore, to earn, or exceed, its target return on investment, the utility must control its costs. Breaking the tie between the revenue requirement and costs forces the utility to behave more like a company in a competitive environment. In most cases, the regulatory body also prescribes some quality of service standards, which are necessary to ensure that any cost savings are not made at the expense of the utility's service to its customers.

Regulatory authorities have also used rate structure to achieve public policy goals. Examples include economic development rates and incentive rates. This type of initiative is usually for a limited period of time, with a goal of encouraging the development of a particular form of energy. Again, the link between costs and rates is broken under this alternative form of ratemaking.

The PUB should be given the authority to use its discretion in choosing the form of regulation appropriate for determining the revenue requirement and rates of a particular utility. This will require revision of the current statutes governing the PUB's activity. These statutes are predicated on the use of cost of service regulation, which was the standard when they were written. It should be emphasized that the goal of traditional or incentive regulation is the same - to be fair to the consumer and compensatory to the utility. But compensatory does not mean the utility is guaranteed a return on its investment. It means, rather, that the utility is given a fair and reasonable opportunity to earn that return. Adoption of this regulatory approach will not jeopardize the objective of providing the consumer with the lowest reasonable rate.

The committee also recommends the PUB be given flexibility to establish rates for various customer classes, recognizing the province's social objectives and policies. Policies, such as the expansion of the distribution system, can be targeted through rate design initiatives, as could initiatives to help low income users or promote energy efficiency.

Bundled and Unbundled Services

Traditionally, distribution service has been provided on a so-called "bundled" basis, where the distributor is both the transporter and the merchant of the gas. The customer has no choice in who supplies the gas to the distributor and is also relieved of the responsibility for contracting for, ordering, and balancing a supply of gas. These functions are performed by the utility and the costs are passed on to the customer.

Lately, however, the development of the energy markets in the United States and Canada has led regulators to the conclusion that, in the long term, the merchant role is not appropriate for regulated electric and gas utilities. The new model is to regulate the true "natural monopoly" function -- transportation -- and let the competitive market forces "regulate" the merchant service. Thus, electric and gas utilities in many jurisdictions are in the process of relinquishing the merchant role, and becoming solely transporters of energy. That leaves retail service providers (marketers), who operate in a competitive environment, without price or rate regulation, to perform the merchant role.

A new or "greenfield" distribution utility, on the other hand, faces a different competitive environment than a mature distribution utility. As several of the applicants argued, a bundled service offering may make for an easier conversion from an existing energy use, particularly in the early years of development. Also, end-users vary widely in their knowledge of the energy markets and their desire or ability to deal with marketers.

The committee recommends that, in the Stage II Request for Proposals process, the government express a preference for distribution companies providing fully unbundled service, and that the merchant service be provided by unregulated third parties or by an affiliate of the LDC. And all bidders for distribution franchises should be required to propose standards of conduct, the goal of which will be non-discriminatory access and service to all users of the distribution system. Moving immediately to this form of service is intended to promote the development of a competitive energy commodity market, and to offer customers a choice of energy suppliers. The committee also recommends, however, that the Stage II Request for Proposals permit bidders to propose a bundled regulated service for a limited number of years (e.g., 3-4 years), if the bidder believes that this proposal will better meet the province's goals for development of the natural gas market. Such proposals should specify how long the bundled service will be offered and the benefits of this approach. Bidders should also be placed on notice that they will face a high barrier to any request for the recovery of stranded costs when the LDC is required to ultimately convert to fully unbundled service.

Market Power

One of the province's basic policy objectives is to provide increased competition in the energy market. The availability of natural gas will tend to make the energy market more competitive, but competition could be restrained if market participants are allowed to exercise market power. Currently, companies are active in several different segments of the energy market. There is nothing necessarily wrong with this as long as a company does not abuse the corporate relationship to gain a competitive advantage.

Before pipelines offered unbundled transportation, they owned all the gas that was transported through their systems. And in the early days of pipeline deregulation, it became clear that pipelines were reluctant to transport gas destined for a third party that competed with the gas the pipeline was trying to sell to its customers. Similar situations arose when distribution companies began to unbundle their systems.

The basic approach to encouraging competitive markets is to require "open access" transportation, where all gas, whether sold by a pipeline, a distribution company or a third party, will be transported under the same rules and procedures. In addition, standards of conduct have been developed that specify the way in which companies must deal with affiliates in conducting business. For example, a regulated distribution company cannot share customer information with a marketing affiliate unless these data are available to all marketers; further, distribution companies cannot offer transportation discounts to customers based on whether or not they purchase gas from an affiliate.

The committee recommends that standards of conduct be established by the regulatory authority to address any potential market power issues. At a minimum, these standards of conduct should include non-discriminatory open access to distribution services, forbid the sharing of customer information between the LDC and its affiliates, require that all utility information is accessible by all interested parties through the regulatory process, prohibit sharing of employees between the affiliate and the distribution utility, and require maintenance of separate offices and systems.

If questions remain about the effects of inter-affiliate dealings on the level of competition in the energy market, a market power test should be instituted when considering whether a distribution franchise should be awarded to a party engaged in the oil, coal, electric or natural gas production or transmission business. Any company with an affiliate engaged in any of these activities would be required to identify the steps they would take to reduce the possibility of the exercise of market power and would be required to file periodic reports on their affiliated transactions and activities.

Revenue Cycle Services

Revenue cycle services are services such as meter reading, billing, customer inquiry services, credit and collection services, etc. that have traditionally been part of bundled LDC services and now, as LDCs unbundle their service offerings, are sometimes offered by third-party vendors.

The committee is not in a position to determine what types of services distribution companies should provide and which services third-party vendors should provide. In a start-up operation, there may not be sufficient competition to have third-party vendors provide the required services. The committee recommends that the issues of which revenue cycle services the distribution companies should provide and which services should be provided by third parties be left to the PUB's discretion. For purposes of the Stage II Request for Proposals, bidders should be permitted to submit proposals with revenue cycle services being performed on either a bundled or a competitive unbundled basis.

Supplier of Last Resort

The supplier of last resort is an issue for distribution companies planning to leave the merchant function. In the traditional LDC environment, the LDC was the only seller of gas on its system. Now, for those LDCs which decide to unbundle their service and exit the business of selling gas at the retail level, there is usually an issue of who will serve those customers not choosing an alternative supplier or, for some reason, are not offered service by any of the active marketers on the system.

The committee suggests the PUB be given the authority to deal with this issue as it arises. For bids submitted on a fully unbundled basis, respondents to the Request for Proposals should be required to describe how they propose to assure end-users that they will be able to secure merchant service in the unregulated market. For bids requesting the use of interim bundled service, the respondent should be required to describe how the transition to fully unbundled service would occur, and how customers would be transferred or assigned to marketers.

Load Balancing

On any given day, the amount of gas actually used on a distribution system will vary from the amount of gas forecast and scheduled to be used. So, the operators of the system need to have a way of controlling it so that it remains in balance. (Minor load variations can usually be managed within the daily tolerance ranges of the pipeline.) A number of different approaches can be taken by distributors to manage the balancing. Some relatively large customers who have dual-fuel capability may, for example, be willing to switch fuels on short notice to assist the distribution company in managing imbalances. These companies would have to negotiate agreements that would benefit them and the distributor.

Accordingly, the committee recommends that respondents to the Stage II Request for Proposals describe how they expect to operate their systems and how they expect to manage daily imbalances.

Incentives for Distribution Systems Expansions

The committee recognizes that each bidder in the Stage II Request for Proposals process will have different approaches to developing and expanding its system. We recommend that the Stage II Request for Proposals require all bidders to specify their expansion policies and the incentives that they propose to use in developing and expanding their systems.

Franchises

The Province of New Brunswick wants to ensure that natural gas distribution service is made available to the largest possible number of New Brunswick citizens and businesses and that an effective regulatory program can be developed to protect the public interest. In the presentations offered by participants in the public hearing process, a number of positions were advocated, ranging from the establishment of a single franchise to serve the entire province to encouraging multiple franchises.

Advocates of a single general franchise for the province claimed that awarding a single general franchise is the best way to provide for equal rates and services throughout New Brunswick. They suggested multiple general franchises would mean there would likely be a potentially confusing array of services and rates offered by distributors. They pointed out that, if there were a single general franchise and a single set of rates for the whole province, the regulatory burden would be minimized. But, without a single general franchise, a single distribution rate throughout the province was highly unlikely.

These advocates of a single general franchise noted that the total number of potential natural gas customers in New Brunswick is relatively small, and that allowing multiple small general franchises would make it unlikely that any one distributor would be able to generate substantial economies of scale in its operation. This would lead to higher rates. In other provinces, a small number of large distributors operate, instead of a large number of small ones. The current trend in utility organization is toward consolidation of companies in order to generate maximum cost savings.

Some participants indicated they were interested in serving loads only in specific areas. One, for example, was primarily interested in customers near the Maine border. But other potential bidders did not appear interested in serving these particular markets. Two participants supported the concept of allowing local producers the opportunity to distribute directly to end-users, if this were the most economical way of reaching those customers. And there are clearly some areas that might be served by particular potential distributors that are unlikely to be served by developers of a single franchise for the province.

The committee feels it is not in a position to determine, at this time, whether a single franchise or multiple franchises would be most advantageous for the province. The decision can be best made when bidders have had the opportunity to complete the Stage II process. Therefore, the committee recommends that the province allow bidders to bid both on the basis of serving the entire province and on individual areas of it.

Local Gas Production

Several companies engaged in the exploration and development of indigenous gas in New Brunswick made presentations before our committee. They emphasized the potential value of these reserves to the province. One pointed out that it has already spent more than $6.5 million in Atlantic Canada on applied geology-geophysics, administration and drilling, and has budgeted over $8 million for next year. This proponent said that, if its current estimates prove correct, millions of dollars would be invested within the province on gas development.

Local production of natural gas can work in conjunction with the development of the Sable Island gas and the M&NE Pipeline to provide maximum benefits to New Brunswickers. And it is recognized that providing a suitable investment and regulatory environment would further encourage exploration for natural gas here. We feel local producers should be encouraged to make investments to develop their reserves and should have access to markets on a non-discriminatory basis. They should be allowed to access any pipeline or LDC for transporting indigenous gas to market. Where a distribution network is not yet in place, local producers should be given the opportunity to compete with a potential distributor in constructing a system that would supply natural gas to the area (i.e., a local- producer class of franchise). A local producer wishing to connect to a pipeline would, of course, be obliged to meet pipeline gas quality standards. The company would also be responsible for the direct costs of connecting to the LDC and the cost of the transportation service under the LDC tariff.

Municipal Involvement in Gas Development

Municipalities in New Brunswick are interested in the development of natural gas. They want businesses to enjoy this competitive, cleaner fuel. In appearances before the committee, they stressed that they should not, however, be expected to bear additional municipal costs as a result of the construction of a natural gas distribution system. These possible additional costs include damage to streets and other municipal property as infrastructure is built, hiring of persons with gas industry knowledge and experience, and increased emergency measure costs. Municipalities emphasized the economic development advantage and urged consideration of policies that would maximize the availability of gas throughout the province.

An important message heard repeatedly from municipalities was that the potential costs they might absorb during construction, pipeline installation and regular operations are significant, and they were concerned about having control over those costs and a method of recovering them. Resident taxpayers take on the financial burden and the inconvenience that results from utility cuts, construction, pipeline relocation, record-keeping, damage and liability issues. Furthermore, as a new fuel source, natural gas distribution will require public safety education, emergency response personnel training and specialized equipment to effectively respond to gas-related incidents. Municipalities feel strongly that these additional costs should not be at the expense of municipal taxpayers.

Municipalities suggested, and the committee agrees, that the province should have legislation similar to other provinces where natural gas is distributed. This would allow the municipalities to obtain revenue or recover costs from a utility. The legislation would provide for compensation for a utility's use of municipally owned property. At a minimum, operating agreements will be required between utilities and the municipalities to ensure that a fair and equitable relationship is developed.

Our committee recommends that existing legislation be amended to clearly enhance rights of municipalities relative to the use of local streets and other municipal real property, the ability to charge property taxes for such easements, and the ability to recover all direct and indirect costs relating to the natural gas infrastructure or to receive revenue from the utility. Municipalities should also have the ability to offer services for a fee.

Impact of Gas Industry Development on Electric Restructuring

There are obvious relationships between the natural gas industry and the electric industry. Natural gas is a major source of fuel for generating electricity in many markets, and with the construction of the M&NE Pipeline, New Brunswickers will have the opportunity to use natural gas for that purpose. Natural gas is also used for heating in residential and commercial markets, where it competes with oil as well as electricity.

The NEB-approved lateral policy is effective until the pipeline proposes its first main line expansion. Given the expected increase in demand for gas for electric generation in New England and the fact that Sable Island gas is an economical way of serving this market, the time that New Brunswick has to benefit from the lateral policy could be very short. The committee, therefore, recommends that the New Brunswick Government move quickly to implement policies, including possible aid to construction, that lead to construction of the maximum number of laterals in the shortest possible time. Large industrial loads, as stated previously, are the keys to obtaining these laterals under the policy.

In the longer term, it will be important for the province to deal directly with the relationship between natural gas and electrical restructuring. New gas-fired facilities are proposed to generate electricity for the export market. As well, using gas to fuel new generation facilities to compete in New Brunswick's electric generation market could have a direct impact on NB Power's stranded costs. The Select Committee intends to address these issues in its review of electric market restructuring and examination of options.




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