A framework for diagnosing the regional impacts of energy price policies

Resources and Energy 8 (1986) l-20. North-Holland

A FRAMEWORK

FOR DIAGNOSING THE REGIONAL OF ENERGY PRICE POLICIES

IMPACTS

An Application to Natural Gas Deregulation*

Susan BENbER, Harvard

Joseph P. KALT

University,

Cambridge,

MA

and Henry LEE 02138,

USA

Received July 1985, final version received September 1985 Energy policy debates in the U.S. have frequently centered upon asserted regionaI effects. ‘Consuming’ regions are commonly pitted -against ‘producing’ regions, with the latter purportedly gaining/losing at the expense of the former under higher/lower energy prices. Such simple views ignore (1) regional trade linkages, (2) the geographic distribution of ownership in energy using and producing firms, and (3) the microeconomics of the incidence of energy price changes. This study presents a framework which incorporates these factors and allows assessment of the net regional income effects of changing energy prices. When applied to U.S. natural gas policy, the study’s results indicate that the income effects of a rise in gas prices tend to be much more evenly spread than a naive assignment of increased costs and revenues to consuming and producing regions, respectively, would indicate. Under a number of plausible scenarios, in fact, it is likely that certain net gas consuming regions (e.g., the Pacific Northwest) have benefitted from the recent deregulation of U.S. gas prices.

1. The regional politics and economics of gas pricing

For decades, issues of natural gas pricing have sparked lively and, at times, bitter debate. In 1978, Congress passed the Natural Gas Policy Act (NGPA), initiating the phased deregulation of the nation’s gas supply. Under this Act, gas wells developed since 1977 were freed from federal price ceilings on 1 January 1985. The entire wellhead market will now gradually be decontrolled as depletion drives the market share of pre-1977 wells to zero over the next 5-10 years. Under the NGPA, gas prices have risen dramatically, and the nature of the gas market is changing radically. But still debate continues, as Congress considers a new batch of natural gas bills, some designed to decontrol gas prices fully and immediately, others designed to recontrol them. Needless to say, the fate of any legislative effort will turn significantly on the impacts of *Funding for this study has been provided by the Energy and Environmental Policy Center Research Fund. We wish to thank Robert Leone, Susan Baldwin, William Booth, Dan Dexter, David Johnson and Kevin Mohan for valuable comments and assistance. The editorial talents of Nancy Stauffer have also been greatly appreciated. 0165-0572/86/$3.50 0 1986, Elsevier Science Publishers B.V. (North-Holland)

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decontrol and recontrol - as these impacts are perceived by politically significant interest groups. The rancorous political deliberations over natural gas policy have traditionally focused on certain highly polarized interest groups. Two parties, in particular, are featured in the rhetoric of debate: energy producers and energy consumers. In the context of our geographically based political system, this dichotomy often takes on a regional dimension. With gas prices higher when unregulated, observers tend to portray regions that produce gas as winners, and those that consume gas as losers, under decontrol. Based on that premise, self-interested parties are able to promote policies that purportedly benefit, or at least protect, their own regions. In some cases, policies that might promote the health of the overall economy are blocked or emaciated by this internecine jingoism. Assuming that producing regions win (lose) and consuming regions lose (win) in an unregulated (price-controlled) natural gas market is too simplistic. A number of potent factors could cause the net effect of higher gas bills to differ from the popular regionalist caricature. First, the various regions within the U.S. all trade with one, another. Consumers in one region faced with higher gas prices may reduce expenditures on other goods; if those goods are produced in a gas-producing region, that region will lose income. Similarly, consumers in gas-producing regions might spend some of their added income to buy goods manufactured in gas-consuming regions. Second, while gas may be physically extracted in a certain region, the owners of the gas-producing companies - its stockholders - are generally geographically dispersed. Thus, when gas prices rise in an unregulated market some of the increased revenues from gas production flow to stockholders in gas-consuming regions. Third, the impact on a region’s industrial gas users of an increase in gas prices depends in large part on the position of such users relative to their competitors in other regions. Although a particular industry in a region might see higher gas input prices in an unregulated market, its competitors in other regions might see even higher prices. This holds the potential of improving the position of an industry in a given region, as the prices it receives for its output rise in national markets. The precise effect on the flow of any resulting net income gain to a particular region would depend on the location of that industry’s stockholders and the extent to which indigenous labor would share in the gains from improved relative competitiveness. Fourth, there may be nationwide net benefits from higher gas prices. For example, if higher prices cause domestic gas to be produced that costs less than what the nation pays for its marginal source of energy (i.e., imported oil), this additional gas will back some of the marginal energy out of the market and, thereby, save national wealth. To the extent the full cost of imported energy includes threats to national security, this increase in the

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national economic pie, or ‘efficiency gain’ (as the economists call it), would tend to benefit even the direct financial losers from decontrol. Thus, while the direct impact of gas decontrol may be a flow of income from gas consumers to gas producers, there are indirect effects that may offset some or all of that flow in certain regions. Here we try to account for such effects as we examine the impact of natural gas decontrol on the epitome of gas-consuming regions, the Pacific Northwest (Idaho, Oregon, and Washington). First, we look at the potential effect of a (hypothetical) policy of full decontrol of gas prices in the Northwest. Then we focus on the net effects of decontrol, looking first at the competitive position of the region’s industries and individual firms, then at the region’s overall income. As noted, natural gas policy is in a state of transition and flux. Hence, to give some definiteness to our investigation, we compare the impact of a policy of total decontrol against a base of price controls of the type that characterized the early 1980s. Read in reverse, our results provide a look at the regional economic consequences of moving to recontrol from a policy of laissez faire. For consistency of exposition, we talk in terms of moving to decontrol. The major focus of this study is not simply the determination of the regional effects of one public policy - the NGPA. Rather, our objective is to set forth a conceptual framework for thinking about regional energy price changes. Moreover, the framework offered is transferable to issues beyond natural gas, including regional electricity bills or the present trend toward lower oil prices. The hope is that the framework will allow analysts to credibly avoid the regional polarization that is prevalent in so many national energy policy debates. 2. Energy use and pricing in the Northwest

In the absence of regulation, the prices of natural gas and of fuels that could substitute for natural gas invariably become linked as suppliers of each fuel compete at the margin for energy customers. Therefore, to determine how Northwestern gas prices would respond in a deregulated market, we examine the region’s overall energy mix, identify natural gas users and suppliers, and investigate the prices at which those gas users might turn to substitute fuels. Fig. 1 shows Northwest energy use in 1980. The relative shares reflect the availability of low-priced hydroelectricity: electricity accounted for 48 percent of the region’s total energy consumption and 67 percent of its nontransportation energy. The industrial sector is the largest energy consumer, accounting for 37 percent of the region’s consumption in 1980 - about as much as the residential and commercial sectors combined. Within the

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d.0

30

20

10

0 tiydru

50

lndultrioi Source:

State

Administration.

Energy

R.sid/Camm

Tm?XpCA

Fig. 1. 1980 Pacific Northwest energy use. Data Report, 1982. U.S. Department of Energy, Energy Information

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industrial sector, electricity is again the dominant energy source. However, heavy electricity use is focused in certain industries. For example, in Washington in the late 197Os, the aluminum industry accounted for 53 percent of purchased industrial electricity or about 18 percent of all energy consumed by the industrial sector in the three-state regi0n.i In other industries, energy use looks more like the national pattern. Many of the region’s major employers - the paper, lumber, food, and transportation industries - all depend on gas and oil, as do most homeowners. One unusual feature of the Northwest gas market is the role of Canadian supplies. The Northwest has always relied heavily on imports from Canada. For example, during the middle and late 1970s about 65 percent of the region’s gas came from Canada.2 Access to Canadian gas has been a mixed blessing. On the one hand, it ensures that natural gas is readily available in substantial amounts for the foreseeable future. British Columbian producers have no means of moving gas eastward - and little incentive to do so, as their greatest netbacks come from sales in the Northwest and California. On the other hand, the high border price of Canadian gas in the early and mid1970s made gas more expensive on average in the Northwest than elsewhere in the nation. In the spring of 1983 Canadian gas was $4.40 per thousand cubic feet (mcf) at the border, whereas the average price nationwide was under $3.00. Two potential substitutes for gas in the Northwest are electricity and biomass. As recently as 1981, electricity prices were below 1.5e per kWh in Washington and 2.2#. in Oregon.3 These prices were well below the national average of 6.136 in 1982, and were low enough to compete with natural gas for certain uses.4 But by 1982 the price of electricity had risen to 2.45$, which exceeded the burner tip price of alternative fuels, at least for heating. As a result of rising electricity prices, the substitution of electricity for natural gas is quickly becoming uneconomical. Plentiful wood resources make biomass an important fuel in the Northwest, especially for industry. The extensive lumber and paper industries consume a great deal of biomass, most of it waste product from companies’ own production processes and thus of low cost. Because of the low cost of such a fuel, it is safe to assume that virtually all available wood waste is now being consumed. The next available increment of biomass - harvesting virgin wood for energy - would be extremely expensive. It ,seems unlikely that consumers would use it in place of natural gas, unless gas prices increased far more than presently seems plausible. ‘Data obtained from the Washington State Energy Offke and the U.S. Department of Energy Energy Data Report, 1981). ‘Data provided by Canadian Department of Energy, Mines, and Resources. 3Data provided by Washington State Energy Office and Oregon Department of Energy. ‘%.S. Department of Energy (Monthly Energy Review, April 1983).

(State

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Thus, in spite of the availability of low-cost hydroelectricity and biomass in the region’s energy mix, the chief competitor at the margin to gas in the Northwest is - as elsewhere in the nation - oil. Indeed, competition between these two fuels is a recurrent phenomenon in the Northwest. In 1970 oil was cheaper than gas: between 1974 and 1976 gas was less expensive, and by 1977 oil prices were again lower. As a buffer against such rapid price fluctuations, many large industrial firms have installed fuel-switching capability, giving themselves the ability to choose the cheaper of the two fuels at any time. Clearly, unregulated gas prices should be responsive to oil-price levels. 5 In this study, we take oil prices as the benchmark for unregulated gas prices, expecting the two to equate at the margin. It is important to note, however, that such a linking has often been broken by regulation. The NGPA, especially, has been notable for its impact on interfuel competition.6 In particular, the NGPA has provided for numerous categories of gas, with each category subject to its own ceiling rules. The combination of (1) some uncontrolled and some controlled gas under the NGPA, (2) the average-cost pricing rules applicable to pipeline and distribution companies, and (3) several years of declining oil prices has acted to generate a situation in which gas sellers have agreed to ‘take or pay’ for quantities of gas with high average costs - so high that they have even exceeded oil prices in some markets. This situation arose as gas sellers in the late 70s and early 80s anticipating ever higher oil prices, used revenues realized on low-cost pricecontrolled gas acquisitions to cross-subsidize purchase of unregulated gas at super-normal prices - only to have their anticipations dashed by the reality of the world oil market.’ For the nation as a whole, average gas prices have been held below competitive fuel prices. The Northwest, however, has been one of the regions of the country in which natural gas prices regulation, i.e., the NGPA, appears to have actually raised natural gas prices relative to an unregulated gas market. In early 1983, for example, Canadian gas was priced at $4.94 and overall average gas prices in Oregon and Washington were in the range of $5.00 per mmBtu, compared to industrial fuel oil selling at $4.10.’ Gas prices at these levels lead to the loss of, in particular, industrial customers. In order to hold onto industrial business, gas distribution companies have been permitted by PUc’s to load increasing proportions of fixed costs onto residential and commercial users. In addition, Canadian prices were lowered ‘For a more complete discussion, see Kalt, Lee and Leone (1982), and Bender, Kalt and Lee (1984). %ee, for example, Broadman and Montgomery (1981). ‘Of particular relevance to the Northwest, imported Canadian gas prices cannot be regulated by the NGPA. Canadian gas was priced above competitive oil prices for much of the early 1980s. By 1985, however, approximate parity had been obtained. ‘Data provided by Northwest Natural Gas Company and Northwest Pipeline Company.

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in spring 1984 and again in late 1984. By the last quarter of 1984, Northwest delivered industrial gas prices were equating with industrial fuel oil prices at approximately $4.85 per mmBtu, while residential gas prices at $7.68 were being set above heating oil prices by roughly 50$ per mmBtu.g Further adjustment in both Canadian and domestic gas prices can be expected, especially as the NGPA gradually moves domestic market toward full decontrol and its perverse influences wane. Full decontrol of domestic gas prices at the present time could be expected to accelerate the price adjustments that are already under way in American and Canadian markets. In the Northwest, then, gas prices would be likely to drop, or at least not rise, for many users. This possibility is investigated quantitatively in section 4 below. Decontrol from the current NGPA base, however, is not the only policy option open to decision makers. Gas prices, for example, might be recontrolled and held considerably below levels that are competitive with oil; or oil prices might once again rise abruptly, leaving even NGPA gas prices below market levels. Indeed, Northwest gas users could quite easily expect that while decontrol might bring lower gas prices in the near term, gas prices would be allowed to rise without cap upon the next oil price shock and that the overall trend in prices would be higher than with continued regulation. In order to assess the impacts of gas policy under these sorts of scenarios, we also examine below versions of decontrol which systematically raise gas prices in the Northwest. 3. Effect of decontrol on industrial competitiveness How the Northwest will fare if gas prices are decontrolled depends in part on how decontrol affects the competitive position of firms in the region. In a given industry, higher (or lower) prices will increase (or decrease) production costs. But the shifts in costs will not be uniform for each firm within the industry, as firms vary in their ability to either absorb or pass along increased fuel bills. For example, one firm may have an inflexible production process that can use only natural gas, while another firm might have a more flexible process allowing fuel switching according to price. The latter firm will be less affected by an increase in gas prices than the former. Such variation in firms’ abilities to respond to increased fuel bills can significantly affect their competitive positions. Firm specific data on fuel use and switching capabilities are relatively scarce. To provide insight into the potential effects of decontrol on different firms in different industries, we turned to not only standard sources for energy data such as the Census of Manufactures and state energy offices, but also to interviews with representatives of firms in the Northwestern region. ‘U.S.

Department

of Energy

(Energy

User’s

News,

various

issues).

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While the information thus acquired is incomplete and the ultimate impact of decontrol is firm-specific, we can make some generalizations. The most negative concern about unregulated gas-pricing was expressed by firms in the. food and fertilizer industries. Much of their demand for gas is inflexible for technological reasons. For example, half of the energy used by food companies must be clean and easily-temperature-controlled. Only natural gas fulfills these requirements. In the fertilizer sector, installed technology must use natural gas as its basic feedstock. In addition to these constraints, the food and fertilizer industries in the Northwest confront highly competitive national and international product markets that limit the prospects for passing on higher input costs. Beyond the food and fertilizer sectors in the Northwest, most firms in the region are substantially indifferent to gas-pricing policy. Their only concern is about the transition between a regulated and unregulated system - in other words, whether they can survive the short-term market disruptions that might accompany decontrol (or recontrol). Most important, as a result of regulation under the NGPA and Canadian pricing policy, gas prices for many users in the Northwest have been above the level that would have prevailed in a completely unregulated market. Thus, by 1984, gradual decontrol under the NGPA was putting downward pressure on gas prices in the Northwest. As a result, Northwestern firms might experience some gain in competitive standing relative to firms outside the region, which have tended to face higher gas prices.l’ This last conclusion holds with most force -in Washington and Oregon. In Idaho, on the other hand, many gas-using firms in many industries have very limited technical capability to use fuels other than gas. Thus, their demand is less flexible than that of typical firms in Oregon and Washington. Historically, Idaho has seen lower gas prices than its neighbors, but that trend may not continue. In the short run, gas prices could rise considerably above residual oil prices without much of Idaho’s industrial market switching to oil. The overwhelming concern of firms in the Northwest is not about natural gas prices, but about electricity prices. Fifty-six percent of the fuel used by industry is electricity, and some of that demand cannot be replaced by other fuels. As mentioned previously, electricity prices have risen dramatically in the Northwest - some 60 percent in October 1982 and another 27 percent in March 1983. Those price increases have substantial implications for industry in the Northwest. Aluminium and other primary metals industries originally settled in the Northwest because of the low prices of electricity - a fuel they require for electrolysis and other specialized uses. Now, the primary metals industry and (to a lesser extent) the paper and pulp industry are beginning to invest in new facilities outside the Northwest. Compared to these and other “‘See

Bender,

Kalt

and Lee (1984),

and Kalt

and Leone

(1984).

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effects of recent hikes in electricity prices, the impacts on industry of changes in natural gas prices are insignificant. 4. Regional income flows under alternative price policies

While gas is not the primary fuel in the Northwest, it does have a substantial role to play, being slightly more important than oil in nontransportation uses. Having no gas-producing capacity, the Northwest could be classified with other gas-consuming regions, which (according to popular perception) will be adversely affected by decontrol of gas prices. But several factors suggest that the situation is not so simple - that the net effect of decontrol on the region may not be negative. Most important, as noted, decontrol may not mean higher gas bills in the Northwest. Unlike the rest of the U.S. in the 198Os, gas prices in the Northwest have already been high - above heating oil for residential and commercial users and almost at parity with industrial fuel oil prices. As we have described, decontrol would intensify interfuel competition in the region. Were local regulators to move residential/commercial gas prices to parity with oil or become unwilling to allow discrimination against residential users, at least residential and commercial users’ gas costs would decline. This would also decrease the region’s aggregate gas bill and increase the disposable income of gas consumers in the region. Even under this optimistic scenario for the region, the Northwest would not be immune from the effects - both positive and negative - of higher prices elsewhere. Determining who reaps the benefits and who bears the burden is a complicated task. First, consider the benefits. Even income flowing to stockholders in gas-producing firms that reside outside the region might flow to the Northwest. Such income will be saved, or spent, or taxed and the Northwest is likely to be the immediate or eventual target of at least some of the associated investment, buying, or government spending. The income from higher gas prices would also accrue to the Northwest to the extent the region holds stock in gas-producing firms. The public caricature of the typical oil and gas man seems to be a wealthy Texan; but the ‘wealthy’ attribute is more accurate than the ‘Texan’ label. While stock ownership is concentrated towards the upper end of the income distribution, the geographic pattern of ownership is notably diffuse. About 72 percent of the adult population in the U.S. owns stock in gas-producing assets, either directly or through mutual and pension funds.ll Many of these direct and indirect gas ‘producers’ live in the Northwest, and stand to benefit from higher gas prices. l2 “These data are developed in Kalt and Leone (1984). ‘%x Ibid., American Petroleum Institute (1981), and Arthur Andersen, Inc. (1981). non-incorporated gas-producing firms are taken to reside in the region of production.

Owners

of

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At first glance, identifying the losers under higher gas prices would seem easier than identifying the beneficiaries: the losers would be the residential, commercial, and industrial consumers of gas. However, those consumers might be able to ‘pass on’ added gas costs. Residential customers facing higher gas bills might be able to pass part or all of that added bill along to the local industry by demanding higher wages. Industries may be forced to pay those wages in order to keep or attract labor. On the other hand, firms might be able to increase the prices of their products to cover all or part of their added costs of gas and/or employees. The buyers of affected industries’ output would thus end up paying part or all of the non-residential increase in gas costs. Of course, some firms might face output market conditions that make it very difficult to raise prices. For such firms, the burden of increased costs would fall on their stockholders, who - as suggested above - are likely to be geographically scattered.r3 Thus, the Northwest may be able to pass its losses along to consumers and stockholders elsewhere. Of course, other regions may engage in the same shifting of the burden of higher gas prices toward consumers and stockholders in the Northwest. The net effect is ambiguous; but, clearly, the stockholding, buying, and selling patterns of all regions’ residents and firms can have a profound effect on the Northwest’s fate under decontrol. One of the most important factors determining decontrol’s impact is trade among regions. By increasing gas bills for some regions and generating additional revenues for others, decontrol alters the level of disposable income within regions and shifts trade flows among them. An example will illustrate the complexity of the indirect effects of decontrol that can be due to trade. Outside the Northwest, natural gas prices have generally been below those of residual oil. Hence, with decontrol under the NGPA, gas prices outside the Northwest have been rising. A gas-using manufacturing firm in Colorado, for instance, has been seeing higher production costs. As it constricts output (in the attempt to realize a higher price in its market), it purchases fewer inputs - including inputs made in the Northwest. By not selling an additional ton of lumber or processed food to the Colorado firm, some Northwest manufacturer loses profits. The decrease in demand and hence in profits means that the Northwest manufacturer uses less labor and capital. Disposable income in the region tends to drop. On the other hand, it may be that a gas producer in Wyoming or Texas uses its increased revenues to buy, directly or indirectly, an additional ton of lumber from the Northwest manufacturer - a positive indirect impact. Whatever the outcome, it is clear that the indirect effects of an increase in gas prices are a complicated phenomenon. 13Data on the location of stockholding in gas-using firms are from New York Stock Exchange (1982) and U.S. Department of Commerce (Survey of Current Business, various issues 19811982). Owners of not-publicly-traded firms are assumed to reside in the region of firm operation.

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To track interregional flows of spending and income and to estimate their net effect on the Northwest, we have developed an interregional income flow (IIF) model of trade and natural gas pricing impacts.14 The model recognizes three regions - the Pacific Northwest, the seven major gas-producing states (California, Kansas, Louisiana, New Mexico, Oklahoma, Texas, and Wyoming), and the rest of the nation. Among other factors, it accounts for ten central economic forces: - each region’s consumption spending out of after-tax income for locally produced goods and services, - each region’s consumption spending out of after-tax income for goods and services produced in each of the other regions, - governmental expenditures in each region, - investment in each region, - taxation in each region, - exports from each region to countries outside the U.S., - imports to each region from other countries, - each region’s direct and indirect ownership of U.S. gas-producing firms, - each region’s direct and indirect ownership of U.S. gas-using firms, - each region’s consumption and price of natural gas in the residential, commercial, industrial, and electric utility sectors. Of these items, taxes and spending on imports from other countries and regions constitute subtractions from the income flow generated in a region, while all others are additions. Taking all these factors into account, the IIF model computes equilibrium regional incomes - Gross Regional Products that balance the national economic system in the sense that no region attempts to dispose of more or less income than it has. As a base point, we use data for 1980. Hence, our results provide a look at the impacts of the gradual decontrol that has been taking place under the NGPA - perhaps most of which have already occurred, albeit substantially unnoticed as a result of the extremely complicated interregional linkages that determine such impacts. More generally, our results provide perspective on the regional effects of a policy of decontrol from a base at which gas prices are substantially below market levels - as in 1980. To give insight into the effects of decontrol from a base at which regulated gas prices are generally closer and, in some regions, at or above unregulated market levels, we also investigate the IIF model using data from 1983 - when many of the perverse consequences (see above) of the NGPA had appeared. We first look at the direct effect of decontrol on the gas bills of the three regions, prior to any flow back of revenues to regions in their roles as 14The full mathematical structure of the IIF model is described in Kalt and Leone (1984).

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owners of gas-producing firms. In other words, we calculate ‘who pays’, assuming that consumers - business and residential - cannot pass through any increased
Changes

in

Table 1 direct regional natural gas due to decontrol (1980).b Pacific Northwest

Change in gross expenditures Billions of $ 0.03 Per capita $ 4.00 Change in net expenditures” Billions of $ 0.03 Per capita $ 4.00

expenditures

Producing region

Rest of the U.S.

13.50 293.00

10.90 65.00

10.93 -74.00

10.90 65.00

“Increased expenditures assumed to accrue as increased revenues to producing region. %Sources: U.S. Department of Energy, Energy Information Administration, State Energy Price System (1982) and State Energy Data Report Supplement 196080 (July 1982). See Bender, Kalt and Lee (1984) for discussion. “Bender,

Kalt

and Lee (1984,

p. 27).

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prices were fully decontrolled from a base as existed in 1983. Even if ‘negative bills’ are not allowed, the Northwest shows no increase in its gas bill upon decontrol. The producing states, meanwhile, would pay an additional $47 per capita and the rest-of-the-U.S. an additional $6.16 These small changes suggest that most of the impacts from the decontrol still underway under the NGPA had already occurred by 1983; and that debates over the prospective effects of allowing decontrol to proceed under the NGPA have been overblown. As indicated by the foregoing discussion, the regional impacts of natural gas decontrol are not captured by the changes in the direct cost a region bears for its gas. Table 2 shows the net impacts of complete simulations that track both direct and indirect effects to determine changes in regional incomes. We consider eight decontrol scenarios and allow both industrial and residential consumers to pass through their added costs. We assume that industrial and commercial business users of gas are able to pass through 60 percent of their increased gas bills to their customers - most likely, a conservative estimate. For residential consumers, we test two pass-through Table 2 Regional income changes due to natural gas decontrol (1980 $ per capita). Pacific Northwest Scenarios”

20%

(1) Base caseb (2) Base case with negative bills (3) Profits tax reduce deficit (4) Profits tax consumer rebate (5) 20% state severance tax (6) Split bill (7) Base case with eflkiency gains (8) Base case 1983 prices

-5 4

Producing region 50%

-15 5

50%

20%

50%

44

51

-26

-30

-4

45

51

-28

-31

14

-15

-8

7

4

-44

90

97

-50

-54

-22 -10

123 139

130 147

-73 -86

-77 -88

69

76

7 -1

20%

-12

7 -37

Rest of the U.S.

o+ -2

-3

-1

5

2

2

1

“See text for description of scenarios. ‘For purposes of scaling, figures are presented in dollars per capita. Regional populations are: Pacific Northwest - 7.7 mil.; Producing region - 49.3 mil.; Rest of the U.S. - 167.7 mil. “‘A residential passthrough. i61bid., p. 27.

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rates: 50 percent (a plausible upper bound) and 20 percent (a more realistic level, in our estimation).l’ Gas-using electric utilities are taken to pass through 100% of any increase in gas costs as a matter of PUC policy. Before we describe the scenarios and their impacts on income in the Northwest, a word ‘of caution is in order: the numbers produced by our model are most useful as relative, rather than absolute, measures. The results of our simulations are not meant to pinpoint current or future income shifts, but to provide a means of comparing the relative impacts of different policies on different regions, as well as the sensitivity of these impacts to crucial model parameters (such as the residential consumer passthrough fraction). Moreover, these comparisons shed light beyond the current natural gas arena onto any future efforts to fashion public policies that affect energy pricing. 4.1. The base case

In this scenario, PUCs are assumed to price delivered natural gas to all customers at its marginal opportunity cost, which is taken to equate to No. 6 residual fuel oil upon deregulation; but where gas prices in a state are higher than oil prices, they are not allowed to drop. The increased gas producer revenues that result from decontrol accrue as taxable income to the various regions in accord with the regional pattern of gas producer ownership.‘s The gas-producing region owns a disproportionate share of gas production. Thus, it is not surprising that the gas-producing region gains at the expense of the Northwest and (especially) the rest-of-the-U.S. region. It is important to point out, however, that one of the most obvious effects of the trade and ownership linkages between regions is to even out the impact of higher gas prices: the naive assignment of increased gross gas costs and revenues to consuming and producing regions (table 1) implied direct losses, in the Northwest and rest-of-U.S. of $4 and $65 per capita and a producing region gain of $74 per capita; but the net income changes for the three regions are in the ranges of - $5 to - $12, -$26 to - $30, and + $44 to + $51, respectively. There are several reasons for the negative outcome in the Northwest. The Northwest supplies less than half the goods consumed within its region; both exports to and imports from other regions are high.lg The region therefore has no shelter from the passthrough of rising gas prices in other parts of the country. Concomitantly, relative to other regions, a dollar spent by a . r7The lower residential passthrough fraction is more reasonable to the extent that the benefits of access to low cost price-controlled gas have accrued as locational (land) rents to a region’s real property owners. Under such an incidence of low gas costs, decontrol would alter property values rather than affecting, e.g., labor supply in a region. “See note 12 above. “Data are derived from Rodgers (1973), and are described in detail in Bender, Kalt and Lee (1984, pp. 59-60).

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consumer living in the Northwest is more likely to end up as income in some other region than it is to remain in the Northwest. The region also has a relatively low share in gas-stock holdings. ” Thus, what it pays directly and indirectly, in its purchased goods, for more expensive natural gas upon decontrol is not offset by increased gas ownership revenues. Finally, the base case does not recognize any efficiency gains that might offset trade losses in any of the regions. Note that the Northwest is better off as residential gas consumers pass through less of their higher gas costs. The increase in the residential (and aggregate) gas bill in the Northwest is negligible because gas prices are already high. In other regions, however, there are substantial increases in residential gas bills. If these increases are passed onto businesses’ costs by residential users across the country, the Northwest ends up bearing a considerable portion of other regions’ residential gas bills because of the noted dependence of the Northwest on the output of other regions’ goods and services. The general conclusion that emerges is that the interregional trade effects of a rise in any energy price is likely to be relatively more important to the Northwest than other regions - due to its dependence on imports of goods and services from other regions and its low share of energy stockholding. 4.2. The base case with negative bills

In this case, we assume that gas prices are brought into parity with No. 6 residual fuel oil prices, regardless of whether gas prices are initially higher or lower than this. Thus, a region’s gas bill could decline upon decontrol if regulation had been keeping its gas prices abnormally high. In fact, the change in the Northwest’s gross gas cost moves from an increase of $4 per capita in the base case (table 1) to a decrease of $15 per capita when ‘negative’ bills are allowed.21 Assuming the high (50%) residential gas consumer passthrough, the Northwest’s loss is only a third as much per capita as in the base case. Assuming the low (20%) residential passthrough, the change in regional income flow becomes positive. We believe that this scenario is more realistic than the base case. As explained previously, deregulation has been placing downward pressure on gas prices in the Northwest.” 4.3. Federal windfall profits tax with revenue used to reduce deficit

This scenario imposes a 50% tax on ‘windfall “The region holds approximately 2.1% its 3.5% share of national income [Bender, ‘IBender, Kalt and Lee (1984, p. 27). “See, also, note 17 above.

profits’ from gas sales and

of the ownership in gas-producing Kalt and Lee (1984, pp. 6&61)].

assets, compared

to

16

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uses the revenue to reduce the federal delicit.23 Under this policy, money in the capital markets would be freed up for private investment. We assign that investment to regions in proportion to each region’s share of new investments as recorded in the 1977 Census of Manufactures. Along with the Sun Belt, the Northwest. has been a region of rapid growth and has attracted relatively large levels of investment. The Northwest thus gains under this scenario, as does the rest-of-the-U.S., while the producer regions suffer a net loss. In essence, the windfall profits tax redistributes income away from the producer region and toward the Northwest and the rest-of-the-U.S. region. While the producer region attracts a relatively large share of investment, this share is not as large as the region’s share of ownership in gas-producing assets and the region is a net loser.24 4.4. Federal windfall profits tax with revenue rebated to gas consumers

Here we impose a 50% windfall profits tax and allocate the revenues back to the states in accord with their shares of the increase in the national gas bill upon decontrol. The states are then assumed to deliver these revenues directly to their own residents. Under this scenario, the Northwest - with only 1% of the increase in the national gas bill - faces significantly higher losses than in the base case. The producing states, who are also major consuming states, bear 55% of the increase in national gas costs and gain substantially under this policy. Paradoxically, the Northwest - ostensibly a ‘consuming region’ - suffers under a policy that attempts to direct the revenues from higher gas prices back toward consumers; and the producing region of the country benefits from such a policy because so much consumption of relatively low-priced gas takesI place there. 4.5. Twenty percent producing region severance tax

To ensure that they retain the benefits of higher gas prices, producing states might increase severance taxes on their gas exports. In this scenario, the producing states levy a 20 percent severance tax (up from an actual level of approximately 7%) and distribute the revenues within the producer region. The results are negative for the Northwest,‘though less so than under the previous scenario. Thus, the Northwest would be better off if producing states increased their severance taxes than if the consuming states managed to pass a windfall profits tax and redistributed the revenues according to gasconsumption patterns. Again, this outcome is due to the disproportionate 23‘Windfall profits’ here are taken to mean the change in revenue decontrol quantity of gas output. 24The producing region’s share of national investment is approximately 22% share of gas-producing assets [Bender, Kalt and Lee (1984, p. 61)].

realized

on

16%, compared

the

preto its

S. Bender

et al., Regional

share of gas consumption reliance on gas.

impacts

of energy

in the producing

price

policies

17

region and the Northwest’s

low

4.6. Split bill

As noted above, state PUc’s have shown a willingness to allow a twotiered pricing system under -which gas competes with No. 2 (heating) oil in the residential and commercial sectors, and with residual fuel oil in the industrial and electric power sectors. Under this pricing, the total national gas bill rises relative to the base case, in which all gas competes with residual oil. Interestingly, when the residential gas consumer passthrough is limited to 20 percent, the split-bill scenario actually increases regional income in the Northwest. The Northwest sells 23 percent of the goods it manufactures to gas-producing states. Under a split bill, the increased gas-production revenues boost spending on Northwest goods enough to offset the region’s higher gas bill and the higher cost of goods? that are purchased from other regions. The burden of the split bill falls most heavily on the rest-of-the-U.S. region. Because of its large size, 90 percent of that region’s manufactured goods stay within its borders, so it ‘cannot ‘export’ its increased gas costs, particularly when a large portion of the residential cost of decontrol is ultimately borne by residential users. 4.7. Base bill with efficiency gains

Thus far, we have ignored the gains in gas production and end-use efficiency that would be expected to come with decontrol. Such gains would arise from the expansion of gas production to the point where costs are comparable to the cost of the nation’s marginal energy supplies (i.e., imported oil), ‘and the reallocation of gas through market bidding to its most productive end-uses. Estimates of efficiency gains from decontrol have ranged from $3 to $6 billion per year. 25 To be conservative, we assume a gain of only $1.5 billion, all of the benefit coming from the more cost-effective mix of energy supplies that would result from the removal of restrictions at the production level. The effect on the Northwest of including efficiency gains is to improve the region’s position relative to the base case and, perhaps, absolutely. Relative to the base case, the efficiency gain scenario allows increased producer revenues to accrue directly and indirectly to the Northwest. More significantly, with only $1.5 billion in national efficiency gains in this scenario, each region appears to experience a net income increase upon decontrol. With the lower (20%) residential gas consumer passthrough, the rest-of-the-U.S. region “See

U.S. Department

of Energy

(1981a),

Loury

(1981),

and Kalt

and Leone

(1984).

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experiences a gain of $5 per, capita instead of a loss of $26 per capita, as in the base case. The producing region also benefits as its income increase rises from $44 per capita to $69 per capita. Thus, it appears that a relatively small efficiency gain could. trigger significant benefits for the nation as a whole. 4.8. Base bill using 1983 estimated data

Thus far, the scenarios described have been based on data for 1980, which is the most recent year for which official figures on variables such as regional income, trade, and taxes are available. Since 1980, however, the NGPA has brought a considerable measure of decontrol. To try to capture the effects that complete decontrol could bring given the gradual decontrol already underway, this scenario uses the same assumptions as in the base case regarding interfuel competition and models garameterization, but takes regulated gas priees as they stood in July 1983. Regardless of which passthrough assumptions we use, the results are negative for the Northwest - but only slightly. The Northwest’s direct gas costs are not affected at all by decontrol from a 1983 base. On net, however, the region loses income as a result of reduced exports to the producing region. The producing region is a net loser, as it receives 22 percent of the increase in producer revenues upon decontrol, but 69 percent of these revenues come from its own gas consumers. Meanwhile, the rest-of-the-U.S. realizes a gain, as it receives 75 percent of the increased producer revenues through its ownership of gas-producing assets and only 31 percent of these revenues come out of the pockets of its own gas users.“j This pattern reflects the fact that, as gradual decontrol has proceeded under the NGPA, the one region, since mid-1983, that has consistently faced delivered gas prices which have been significantly below market levels is the producing region. The increased cost of gas upon decontrol now fall primarily on this region. Notwithstanding the indicated directions of the changes in regional income attributable to decontrol from a 1983 base, the magnitudes of these changes appear to be absolutely negligible in all regions. In fact, these negligible magnitudes are cause for little faith in even the indicated directions of income change. What is clear is that,’ as anticipated, the bulk of any shifts in regional income due to decontrol have already occurred. Concern in the policy arena over additional shifts is probably overstated. 5. Conclusions If nothing else, it is clear that the regional economic impacts of a change in energy prices is determined by an extremely complicated set of relation26Bender, Kalt and Lee (1984, pp. 27, 61).

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19

ships between regions’ roles as owners of gas-producing assets, owners of gas-using assets, and interregional trading partners. The most important policy implication of this is that the characterization of net gas consuming regions (or states) as necessarily losers from a policy of allowing producers to receive higher prices can easily be a misleading oversimplification. Regions’ incomes are determined in a system in which the level of income flowing into and out of any given part of the country depends on the incomes of each other part. A central consequence of this regional interdependence is to cause the income effects of a rise in energy prices to be more evenly spread than naive assignment of increased costs and revenues to consumer and producer regions, respectively, would indicate. This means that the net income effects of higher energy prices and policies such as natural gas decontrol are theoretically ambiguous, and so-called ‘consuming’ regions might gain from higher energy prices. Determination of regional income effects can only be made by reference to empirical data regarding the parameters of interregional linkage. In this study, we have examined the regional economic effects of policies that allow the nation’s natural gas prices to move to market-determined levels, with particular focus on the Pacific Northwest. We find that in many plausible scenarios the Northwest has most likely been losing from decontrol. This conclusion may even hold when we recognize the impact of recent gas price control regulation and allow the Northwest to have negative bills that is, a decrease in gas prices upon decontrol. Things look worst for the Northwest when a Federal windfall profit tax is imposed and the tax revenues are allocated in proportion to the increase in gas costs that decontrol imposes on each region’s gas consumers. Things look best when a windfall profit tax captures producer revenues and redistributes them in accord with, e.g., regional shares of national investment, as could happen if the tax revenues go toward reducing Federal borrowing. Under most of the scenarios we have examined, the rest-of-the-U.S. region loses regional income upon natural gas decontrol. This loss, however, may have already occurred. Complete decontrol now, after the gradual decontrol already instituted under the Natural Gas Policy Act, would most likely benefit the rest-of-the-U.S. region - albeit only slightly. In fact, complete decontrol now might impose very small net costs on the Northwest and the gas-producing region. This conclusion could be reversed and leave all regions as net beneficiaries of decontrol if decontrol brings even modest improvements in the efficiency of gas resource production and use - as could reasonably be expected. Neither this last conclusion nor this study’s general criticism of the naive view that a consuming region necessarily loses from higher energy prices should be interpreted as necessarily strengthening the case for deregulating natural gas prices. Other factors must be considered. For example, our model

20

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says nothing about the effects of decontrol on incomes within regions. Even when all regions benefit, the impact will differ from state to state - and the politicians making the decontrol decisions represent not regions but states or even subdivisions and coalitions within states. Then, too, our model says nothing about certain standards of fairness. Our results, for example; provide no insight into the effects of decontrol on different income classes. In short, the decision to decontrol, recontrol, or otherwise regulate natural gas prices quite rightly turns on more factors than regional income effects. But our simulations do show that arguing the pros and cons of various gas pricing proposals based on changes in regions’ gross direct expenditures on natural gas is surely too simplistic. Stock ownership, interregional trade, and other microeconomic factors of the type we have attempted to model can have an overwhelming influence on the determination of regional income flows attendant to a change in gas prices. References American Petroleum Institute, 1981, Report on direct and indirect shareownership in sixteen U.S. oil companies (American Petroleum Institute, Washington, DC). Arthur Andersen, Inc., 1981, Oil and gas disclosures by public companies: Recent developments and survey of 1980 data (Arthur Andersen, Inc., Washington, DC). Bender, Susan, Joseph Kalt and Henry Lee, 1984, The regional income effects of natural gas decontrol: The northwest v. the rest of the U.S., Harvard Institute of Economic Research discussion paper no. 1034 (Harvard University, Cambridge, MA) Jan. Broadman, Harry and David Montgomery, 1981, Natural gas markets after deregulation (Resources for the Future, Washington, DC). Kalt, Joseph and Robert Leone, 1984, A model of regional income accrual under energy price decontrol, Harvard Institute of Economic Research discussion paper no. 1041 (Harvard University, Cambridge, MA) Feb. Kalt, Joseph, Henry Lee and Robert Leone, 1982, Gas>decontrol: A northeast industrial perspective, Harvard University Energy and Environmental Policy Center discussion paper no. E-82-09 (Harvard University, Cambridge, MA) Oct. Loury, Glenn, 1981, An analysis of the efficiency effects and inflationary impact of the decontrol of natural gas prices (Natural Gas Supply Association, Washington, DC). New York Stock Exchange, 1982, 1982 Factbook (NYSE, New York). Rodgers, John M., 1973, State estimates of interregional commodity trade, 1963 (Heath, Lexington, MA). U.S. Department of Commerce, various years, Survey of current business, various issues. U.S. Department of Energy, 1981a, A study of alternatives to the natural gas policy act of 1978 (U.S. Government Printing Office, Washington, DC). U.S. Department of Energy, 1981b, State energy data report (U.S. Department of Energy, Washington, DC). U.S. Department of Energy, 1983, Monthly energy review; April. U.S. Department of Energy, various years, Energy user’s news, various issues.