Making Sense of Pipelines
Making Sense of Pipelines
The Lenses of the New Institutional Economics
Abstract and Keywords
This chapter returns to the broader economic, regulatory, and political issues illustrated by pipelines and reviews what a century of pipeline problems reveals. Pipeline transport can be competitive in construction and use, and the vehicle for unfettered fuel market competition. Neither the institutional foundation nor the final transition to competitive pipeline transport in the United States owed anything to the neoclassical economic tradition. Oil pipelines in the United States used a series of complicated and restrictive measures to limit access to preferred pipeline users soon after the ink was dry on its regulations. The lens of contract revealed common carriage and third-party access as inimical to the organization of an independent pipeline transport sector. Governance institutions explained why US oil and gas pipeline systems split onto different evolutionary paths.
Adopting the proper economic perspective means everything in making sense of pipelines. Oliver Williamson identified in his 2009 Nobel Prize address why the neoclassical tradition was so ill matched to analyzing and understanding certain industrial relationships: it employs the lens of choice rather than the lens of contract.1 The lens of contract illuminates asset specificity and the unsuitability of common carriage for organizing the pipeline industry. The lens of contract leads policy makers to strengthen the institutions needed to support long-term pipeline agreements of sufficient certainty to motivate pipeline investments. The lens of contract clarifies much that the neoclassical lens of choice overlooks about the governance of pipelines and the possibilities for competitive inland transport.
The pipeline industry is unlike other regulated businesses. Long-distance pipelines are neither public utility monopolies (like local energy or water distribution companies) nor transporters traditionally subject to price regulation but better left unregulated (like airlines or motor transport firms). Long-distance pipelines, burdened by asset specificity, present special problems of financing and contracting not encountered elsewhere. Applying traditional utility regulation to pipelines eliminates the prospect for competitive entry—stunting commodity markets. But deregulation of pipeline prices would leave customers geographically captive to a single pipeline subject to abuse. This volume shows that pipeline (p.176) transport can be competitive in construction and use and the vehicle for unfettered fuel market competition. But it also shows that the institutional foundation for such competitive transport is at once inflexible (as in the definition of regulated pipeline property) and nuanced (as in the ability of mature and independent regulators to let go of some traditional levers of regulation to grasp others). Indeed, a century of dealing with oil and gas pipelines shows just how hard it is to keep them from being used as John D. Rockefeller first discovered they could be—as levers to frustrate competition in commodity markets and as profitable tollgates lying athwart commodity trade routes. Remedies for such familiar pipeline problems have been hard won. The early attempts in the United States to limit the power of oil pipelines to concentrate commodity markets, or to exact excessive tolls, were a lasting failure. Drawing upon experience in rail regulation, those attempts only diffused or transferred that power because of the legitimate need for pipeline investors to protect the value of their long-lived and immobile capital assets. Recent attempts in Europe or Australia to strengthen pipeline regulation have been no more successful. By using regulatory models that are also ill suited to independent pipeline transport, those attempts have done more to create a state-based patchwork of opaque monopolies across those continents than to promote competitive pipeline transport and independent gas markets.
Much of this volume examines the story of how Congress and federal regulators learned over the decades to create meticulous and reliable governance institutions suited to pipelines. It was a group effort, combining reliable, legislated accounting rules, competent regulators, strong interest groups of pipeline users, and wise judicial decisions. The type of competition in intangible property rights that Ronald Coase foresaw in 1960 was not easy to impose upon an existing, investor-owned pipeline system in a country with long-standing institutions geared to prevent the marauding of the value of private property by legislatures or regulatory agencies. The idea of creating similarly competitive regimes on other pipeline systems—particularly for gas users in Europe, where pipeline transport competition would appear to have such promise—seems harder yet. Distressingly, much of the analysis and policy purporting to reflect economic theory, or wise utility pricing, has not helped.
Modern economists have done little to make sense of the industry, to place it in a conceptual economic framework from which to craft useful public policy. Much of the insightful work that went into the economic institutions upon which competitive pipeline transport now rests in the (p.177) United States was done by institutional economists in the first four decades of the twentieth century, prior to the birth of the neoclassical tradition. More was accomplished by farsighted politicians and jurists. It was an astute US senator who at a critical moment saved the gas pipeline system from the stultifying effects of nineteenth-century notions of common carriage. Through the three decades that common carriage as a governing institution was held at bay, the states, Congress, and the courts defined the individual regulatory elements that could make contract-based, transcontinental pipeline transport work. Thus, when public opinion demanded an end to the regulatory vacuum in which interstate gas pipelines lived, Congress had the tools to craft pathbreaking legislation sensitive to the particular concerns of collective groups of fuel producers, financers, and pipeline users. And in the inevitable legal challenge, the Supreme Court provided an objective definition of the value of pipeline property—in a ruling called by economists of the era, without hyperbole, one of the most important pronouncements in the history of American law. All of this regulatory, legislative, and judicial effort happened in the first half of the twentieth century—just before the neoclassical tradition began and decades before the latter-day institutionalists refocused economic analysis on transaction costs, governance institutions, and public choice.
The final transition to competitive pipeline transport late in the second half of the century was accomplished by an insightful regulatory commission, pushed by powerful interest groups of gas distributors and their advocates. Economists of the neoclassical tradition who wrote about pipelines during this era generally either were preoccupied with economies of scale (which counts for little in the larger view of the industry), wrongly accepted institutional barriers—such as common carriage—as natural barriers that would apply to all inland transport, or abstracted from transport markets to focus on commodities. Overall, neither the institutional foundation nor the final transition to competitive pipeline transport in the United States owes anything to the neoclassical economic tradition—contrary to other areas of regulatory reform, such as in airline transport, for which that perspective is better suited.
In many respects, the application of neoclassical economic analysis to pipelines has been counterproductive. Most of what has passed for hopeful innovation in regulated pricing among the world's privatized pipelines (e.g., marginal-cost-based pipeline pricing models, pipeline capacity auctions, half-hourly spot markets for pipeline service) ignores (p.178) asset specificity and frustrates the prospects for reliable contracting. The result of such efforts is large-scale pipeline monopolies immune from the threat of entry, perhaps coupled with “independent system operators” to deal with the inevitable desire among pipeline firms to remain vertically integrated. And for their part, those independent system operators can be predicted naturally to ally with the protectionist forces seeking to retain market power and freedom from the pressure of competitive entry.
Viewed through Williamson's lens of contract, a century of otherwise seemingly ad hoc elements of pipeline regulation and development comes into focus. Two elements of that perspective help. The first involves property: who provides the capital (investors or the public) and, if investor capital is involved, whether the value of that property is sufficiently well defined to permit predictable regulated prices to allow investors to be assured that the opportunity cost of their funds will be repaid over the useful lives of the assets involved. The second is common carriage or TPA: whether it is legal to organize the industry around contracts at all. Complementing the lens of contract are two other perspectives of the latter-day institutionalists that explain where existing institutions came from and whether they can reasonably be challenged: collective action (whether groups whose interest is advanced by the provision of competitive pipeline transport can press their case) and institutional and political history (whether the long-standing local customs or political boundaries encourage or disrupt the prospect for competitive transport).
The Value of Tangible Pipeline Property
Investor-owned pipelines existing in jurisdictions with vague definitions of the value of tangible regulated pipeline property have no practical ability to deal with asset specificity other than to foreclose competitive entry—either by evolving into large-scale, entry-protected utilities or through vertical integration. Among the world's pipelines, this question of whether pipeline property is cleanly and objectively defined is a sharp dividing line reflecting an evolutionary split more than a century old. The pipelines in the United States came first. At the start of the twentieth century, the utility executives who studied the public/private utility question tended to think that private financing was simply part of the American way of doing business. The reality was more complex, as the (p.179) first major US inland transport projects—the early nineteenth-century canals—were publicly funded. Private funding only replaced public funding for such inland transport in America after the market perceived that private capital accumulation for railroads had a more certain prospect of allowing investors to recoup their capital. Undoubtedly, both long-standing tradition and the failure of public transport funding contributed to the acceptance of the idea that pipelines in the United States would be investor owned.
Investor ownership had critical consequences for industry organization and regulation. First, it sharply limited how Congress could act to regulate the industry, as any legislation perceived as damaging to private property without due process would ultimately be struck down by the US Supreme Court as unconstitutional (an issue that always shapes legislative debate in the United States). Second, it called for standardization of accounting and transparency so that the newly formed, independent, and specialized regulatory commissions could deal effectively and objectively with the underlying conflict between private enterprise and the public welfare. Third, the Supreme Court had to invent a definition for the value of regulated property (in its 1944 Hope decision) tailored to the unique valuation problems facing private regulated industries. The existence of private property—particularly in gas pipelines—drove these institutional advances, which subsequently allowed contracts to deal with asset specificity in an independent pipeline industry.
Without pressing needs to value tangible pipeline property for regulatory purposes, the institutions essential to support pipeline contracting do not arise. The US oil pipeline industry, hobbled by its maladapted—but still binding—1906 legislation, never succeeded under its indifferent regulatory commission in developing objective methods to value tangible pipeline investments. For pipelines built with public funds, the whole private property question is moot. For public pipeline projects, there was never any need to create accounting or regulatory systems to ensure that individual pipelines paid for themselves over their useful lives.
The consequence of this lack of a need to value tangible regulated pipeline property is that for the privatized pipelines of the world, an independent, investor-owned pipeline transport business does not have the basic tools to deal with asset specificity. Lacking the ability to contract reliably for the long lifetimes of the assets involved, pipeline undertakings need other governing arrangements. Some pipelines remain in public hands, where the question of tangible property values continues (p.180) to be largely secondary and uncontroversial (or at least well buried in larger government budgets). Others, particularly those pipelines privatized as independent entities, are effectively regulated as franchised public utilities, which prevents competitive entry and the bypass of existing pipelines. Still others employ vertical integration to tie fuel supply, long-distance transport, and local distribution together into closed systems—also highly resistant to competitive entry.
The perspective of transaction cost economics, with its lens of contract, makes the organization of the world's pipeline sectors reasonably plain to see. Without the meticulous institutional foundation that contracting requires in the specialized case of tangible regulated property—freeing pipeline investors from fear of loss at the hands of either opportunistic regulators or opportunistic pipeline users—contract-based fuel transport on an independent, investor-owned pipeline system subject to competitive entry is impossible. Furthermore, no attention to regulated prices, service limits, auctions, or other detailed tariff-making or operational factors will help. There is no evolutionary path to competitive pipeline transport—through Coasian markets for intangible transport rights—that does not begin with settling the question of the value of tangible regulated pipeline property.
The Burden of Common Carriage and TPA
In the case of capital-intensive inland transport systems, the lens of contract highlights common carriage as a quaint but counterproductive nineteenth-century custom. While employing mild and seemingly inoffensive language about preventing discrimination, common carriage stops pipeline transacting in its tracks. The only sort of economic governance structures left for transport pipelines are vertical integration or the pipeline equivalent of a franchised public utility immune from the threat of entry.
The responsibilities implied by common carriage are so contrary to the needs of investors in pipelines that imposing them inevitably sets off a scramble to create other institutions to work around the restrictions. Oil pipelines in the United States created and applied a series of complicated and restrictive measures to limit access to preferred pipeline users soon after the ink was dry on its regulations. Ultimately, US oil (p.181) companies found that only through vertical integration and widespread joint-venturing, in addition to those other restrictive measures, could the problems presented by “common” access to a business with such asset specificity be overcome. A century of such evolution has created such a complex oil pipeline industry—with such interlocked vertical and horizontal relationships and complex operating rules—that the question of applying the gas pipeline regulatory advances in the United States to oil pipelines never even comes up. Without the lens of contract, the governance schism between these two pipeline systems is a mystery arising out of the mists of a complex industrial history. The lens of contract pierces that mist to reveal the source of the resulting convoluted and generally uncompetitive—by gas pipeline standards—industry structure.
The imposition of TPA on the pipeline systems in Europe, and to a certain extent in Australia, compounds the difficulty in writing life-of-pipeline contracts that could handle asset specificity. For most of Europe's gas pipeline industry, TPA means that incumbent pipelines act like franchised public utilities. The major, large-scale new “interconnector” pipelines are exempt from TPA—it could hardly be otherwise given the huge investments involved. But the owners of those interconnectors are generally the incumbent pipelines or major gas suppliers, and hence vertical integration still helps to bind the parties together to support such projects (similar to vertically integrated joint ventures in US oil pipelines).
The lens of contract illuminates common carriage and TPA as inimical to the organization of an independent pipeline transport sector. The layers of complex pricing and service rules, in addition to the embrace of institutions that inherently disrupt competitive entry—such as “independent system operation”—merely entrench such institutions and make competitive inland fuel transport harder to achieve. Viewed through such a lens, no amount of fussing with regulated prices or other aspects of governance clears the competitive roadblock represented by the prohibition of long-term contract-based access.
The Lens of Collective Action
Layers of institutions—legislation, judicial precedent, regulations—surround pipeline systems. Unique to peculiar local circumstances, each (p.182) layer is shaped by people who draw upon their own experience to craft solutions to particular social conflicts consistent with the apparent needs of the industry at particular points in time. But who describes those needs? The question for the development of pipeline markets is whether consumer pressure groups are able to stand eye to eye with small groups of pipelines or oil companies in counseling those who make the institutional and regulatory rules. Nothing distinguishes US and European gas pipeline systems more starkly than the existence of powerful pressure groups of independent distributors in the United States and their absence in Europe.
The creation of effective pressure groups of gas distributors in the United States, representing the interests of gas consumers, was attributable to Congress, which forcibly split gas transport from local distribution in what was rightly called by a contemporary economist the most stringent corrective legislation ever enacted against an American industry—a remedy suited to the patient. The remedy created pressure groups of well-funded local distributors who retained counsel and advisory economists through the second half of the twentieth century. Those pressure groups defeated attempts by oil and gas producers to deregulate wellhead prices prior to the creation of effective contract carriage on the US gas pipeline system. Later, those same pressure groups were instrumental in overcoming all of the various attempts by the interstate pipelines to retain elements of their traditional market power. Without the original radical surgery performed by Congress on an abusive and acquisitive industry of vertically integrated pipeline companies, it is unlikely that the persistent attempts by gas producers and pipelines to retain their sources of market power in the commodity pricing and inland transport of gas would have been so successfully overcome.
Vertical integration and the seemingly well-intentioned—but distinctly counterproductive—initiative of “full retail access” have denied to gas consumers the benefit of having well-funded advocacy groups to speak on their behalf. Without such advocates, those consumers are no match for vertically integrated national gas companies, or their respective national energy ministers. If Europe had independent gas distributors that acted on behalf of the continent's many millions of consumers, those consumers would face a fairer fight.
To be sure, even if independent gas distributors were to arise as a powerful pressure group on behalf of their millions of constituents in (p.183) Europe, the path forward to competitive gas transport would be a long and uncertain one. A plan to create a single EU pipeline regulator would require individual national regulators to cede jurisdiction over trans-European gas transportation—which is against the nature of any regulator. Creating a single publicly accessible accounting and information framework across the EU would require a level of transparency, for both business and operating records, that business managers or shareholders inherently do not want to provide. Proposals to bar incumbent pipelines from profitably trading in the gas they handle can be expected to motivate their strong opposition. Creating the conditions for the seamless cross-border use of the continent's gas pipelines is inconsistent with the incentives of those wedded to protecting their own vertically integrated “national champion” gas companies or to preventing the exposure of what a competitive transport market would label redundant pipelines.
Whether collective action on the part of consumer-oriented local gas distributors could overcome any of these institutional barriers—let alone all of them as Coasian bargaining would require—is a serious question. What Mancur Olson might have called the “lens of collective action”—or others today could call the “lens of public choice”—illuminates the prospects for encouraging rivalry in the organization of businesses wrapped in layers of such governing institutions. Without the purposeful creation of sophisticated advocates for fuel consumers—as happened both in the United States in the 1930s and in Argentina upon privatization—it is likely that fuel producers and their allied incumbent pipelines, for which competitive rivalry is unwelcome, will carry the day.
The Lens of Institutional History
The institutions that first arose to regulate pipelines were the products of social conflict between private enterprise and the public welfare. They came into being as people—legislators, judges, regulators—drew on the tools at hand to deal with immediate problems, thereby locking in institutional structures that subsequently would be viewed as “natural.” It is hard to widen the perspectives of those who take as natural the institutions they grow up with. Such is a problem for the analysis of pipelines, with the thick layers of politics, public policy, and legislation surrounding them. Consider the question of natural monopoly. It is easy for those (p.184) not disposed to view pipelines through the lenses of the new institutional economics to believe that a region's pipeline system is a natural monopoly when that assumption accompanied its monopoly planning and financing with public funds.
The institutional history of North America does not support such a natural monopoly view of pipelines. Since the nineteenth century, investor financing of transport projects, including railroads and pipelines, displayed elements of genuine competitive rivalry. Those who now study the pipeline industry's history there know that this mode of inland transport is a natural monopoly only in the narrowest sense. North American economists take for granted other institutions, formed many decades ago, dealing with legislated regulatory accounting, constitutionally protected property values, and administrative due process. The reverence with which those institutions are regarded by economists in both Canada and the United States tends to be a mystery to economists elsewhere.
For an industry of such reach, durability, and immobility, political boundaries are no less important than asset specificity in explaining institutional development and regulation. It is difficult to overstate the orderliness in the regulation of continental pipeline transport markets that flows from the US Constitution's commerce clause, which gives the federal government sole and unambiguous jurisdiction over pipelines used in interstate trade. The EU has no analogous institution that transcends the boundaries of its sovereign member states. Australia has only within recent memory moved some of the jurisdiction for pipeline regulation out of the hands of its states and into those of its federal authorities. Not having a single, authoritative regulator on a continental scale, for a continental pipeline transport system, muddies everything related to the prospect for either orderly regulation of the pipeline system or the promotion of competitive transport.
The lens of institutional history shows, as much as anything, that the evolution of institutions capable of handling such complex industries as major pipeline transport systems is at best quixotic and piecemeal. Not everything is up for grabs all the time. Indeed, very little is up for grabs most of the time. And even then, often what is up for debate is driven by public opinion, which works in unpredictable and complex ways. But a splendid Coasian script now exists for competitive pipeline transport, and perhaps the prospect for such a competitive advance elsewhere is greater because of it.
Pipelines are perhaps the ultimate industry by which to illustrate the power of the insights of the latter-day institutionalists. Pipelines sit in place for decades. There is little novel technology—and surely no romance—in pipelines as they have crossed the countryside transporting fuel from one point to another for over a century. The organization of the industry is necessarily about institutions of economic governance: public or private ownership, legal systems, political boundaries, and regulatory legislation. Economic theory that abstracts from such institutions has no chance of making sense of the organization of major pipeline systems or their competitive possibilities. Determining whence today's pipeline systems came, and where they are going, requires the multidisciplinary and historical approach of those who have fueled the resurgence of economic analysis based on governance institutions.
Pipeline transportation is an inherently difficult industry to study. The governing institutions are stubbornly dissimilar, highly complex, and often enough designed to frustrate rather than to facilitate economic analysis. Pipelines are literally buried far upstream from consumers, and the cost of the fuels they transport is figuratively buried in many millions of heating bills, in electricity prices, in manufactured goods, and in motor fuel. Those pipelines that hold market power—to set fuel prices or bar competitive entry into fuel transport—manifestly would prefer to exercise that power unseen. Only in the United States is pipeline accounting and operational information readily available, due to institutions imposed by the US Supreme Court in decades-old decisions. The secrecy that the industry works to maintain is demonstrated when European economists perform empirical pipeline studies not with European but with US pipeline data because those data are all they can get their hands on.
The study of international governing institutions is always difficult. But as the economic analysis of institutions has risen from almost total obscurity to prominence, since Coase, Williamson, Olson, North, and others made their contributions, it bodes better for the analysis of the pipeline industry and its competitive potential. Certainly for the study of a technologically straightforward industry whose evident diversity in worldwide organization and competitiveness owes to little else other than institutional diversity, it is the only kind of economic analysis that (p.186) matters. Governance institutions explain why US oil and gas pipeline systems split, on the floor of the US Senate on May 4, 1906, onto different evolutionary paths. Such institutions explain why pipeline systems outside of North America grew up with little attention to the value of the property they represented. Institutions explain why it is easy to determine which pipeline capacity exists—precisely where and at what price—to ship across the continental United States but impossible to do the same across the continents of Europe or Australia. The extent to which competitive pipeline transport—and related competitive inland fuel markets—spreads is thus a question of whether local governing institutions are pushed to evolve to support such competition or are purposely maintained to prevent it.
(1.) “For economists, if not more generally, governance and organization are important if and as these are made susceptible to analysis. As described here, breathing operational content into the concept of governance would entail examining economic organization through the lens of contract (rather than the neoclassical lens of choice), recognizing that this was an interdisciplinary project where economics and organization theory (and, later, aspects of the law) were joined, and introducing hitherto neglected transaction costs into the analysis.” Oliver E. Williamson, “Transaction Cost Economics: The Natural Progression,” American Economic Review 100, no. 3 (June 2010): 673. This was the revised version of Williamson's Nobel Prize lecture given in Stockholm on Dec. 8, 2009. (p.246)