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Regulation of Natural Gas Distribution Using Policy Benchmarks

McCombs School of Business, University of Texas, Austin, Texas 78712
School of Business Administration, Al Akhawayn University, Ifrane, Morocco
Department of Industrial Engineering, University of Arkansas, Fayetteville, Arkansas 72701
kumar.muthuraman{at}mccombs.utexas.edu
t.aouam{at}aui.ma
rrardin{at}uark.edu

Local distribution companies (LDCs) play the role of purchasing and delivering natural gas to their consumers, and state regulators oversee the pricing of natural gas to consumers. The common method of regulation, based on the cost of service, provides arguably little incentive for the LDC to optimally manage their procurement activities. In the light of recent deregulation and other changes, benchmarking-based regulatory schemes are being increasingly perceived as the right direction to pursue. Various states are experimenting with simple benchmark mechanisms that have inherent deficiencies and are often criticized. In this paper, we propose and characterize a new kind of benchmark that we call a policy benchmark as a mechanism for regulation. Using variance as the measure of risk, we formulate the regulator's and the LDC's problems as multiple-objective optimizations. We provide rigorous characterizations of the dominance frontiers for a two-stage model. We also provide multistage formulations that take into account various natural gas market microstructures. We compute solutions under parameters estimated from relevant real-world data and illustrate that the structures of the dominance frontiers remain unaltered from the characterizations provided by a stylized two-stage model.

Subject classifications: natural gas; regulation; benchmarks; linear incentive contracts; policy benchmarks.
History: Received January 2007; revision received September 2007; accepted September 2007.