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The Political Economy of PipelinesA Century of Comparative Institutional Development
By JEFF D. MAKHOLM
THE UNIVERSITY OF CHICAGO PRESSCopyright © 2012 The University of Chicago
All right reserved.
Chapter OneThe New Institutional Economics and Pipeline Transport
When President Jimmy Carter appointed Professor Alfred E. Kahn, of Cornell University, to reform the US airline industry in the late 1970s, Kahn described the nature of that business as marginal costs with wings—capable of moving its highly deployable capital as its market demanded, as long as it was unhindered by complex entry, exit, and pricing regulation. The subsequent abolition of the Civil Aeronautics Board (the US airline rate-setting authority) was, however, a more complicated affair than simply turning air carriers loose to compete. The development of hub-and-spoke routing and lack of capacity at some major hubs showed that the consequences of airline deregulation were unpredictable and more complicated than many foresaw. But in the end, airline capital did prove to be magnificently mobile—marginal costs with wings. The competitive response by carriers to deregulation, both in pricing flexibility and in routing—to say nothing of the demise of inefficient carriers—revolutionized air travel in the United States, bringing whole new generations of discretionary travelers into the air for quicker and safer travel. Lifting price regulation and abolishing the regulatory agency was a triumph of neoclassical economics over the protectionist forces that had used regulation to support the cartelization of a structurally competitive airline transport industry.
This book is a story about the triumph of latter-day economic institutionalists—rather than neoclassical economists—in providing the theoretical perspective to analyze how and why competition arose in the pipeline transport industry. So why begin by recalling airline deregulation? It provides such a usefully sharp contrast. Pipelines are marginal costs with a ball and chain. Pipeline capital is land bound and immobile—the antithesis of deployable capital in air transport. Pipelines are built from one spot to a distant one. By far the most efficient method of inland fuel transport, pipelines serve particular oil and gas producers at one end and refineries, gas distributors, or power plants at the other—often a continent away. Uncertainty or commercial opportunism at either end of the pipe, by the pipelines or their users, can strand facilities and wreck the value of the invested capital. The challenges are so great that, often enough, governments are left to build the pipelines themselves with public funds. If investors build pipelines, they make interlocking alliances with fuel suppliers and users. Promoting competitive pipeline transport, in the face of the immobility of capital and those resulting alliances, involves more complex problems than those Kahn overcame in promoting competition in air transport. Explaining the source of competitive pipeline transport calls for a more diverse economic theory.
The interlocking alliances that the pipeline industry requires lie at the heart of the matter. Chief among them is vertical integration. But vertical integration is problematic: oil and gas producers tend to use vertically integrated pipelines as weapons against nonintegrated rivals. Governments have taken various approaches to facilitating the flow of capital to pipeline transport—to efficiently serve the public's need for fuel—while trying to prevent oil- and gas-producing companies from using pipeline access to foil competition in fuel markets. The United States and Canada sought a solution through the regulation of investor-owned pipelines by appointed commissions, with widely varying measures of success over the course of the twentieth century. Most of the rest of the world turned to government-owned pipelines and various forms of direct state control. But the choice of private or public capital has had profound consequences. In North America the use of private pipeline capital helped shape the development—decades ago—of regulatory institutions of the sort required to pave the way for competitive pipeline transport. Why did North America, almost alone, choose that path?
What about competition itself? The signal qualities of pipelines might seem to bode poorly for competitive inland transport: long-lived, stationary pipelines and corresponding long-term agreements needed to protect capital investments. Indeed, the investor-owned pipeline industry's first century was typified not by competitive transport but by a combination of vertical integration and heavy regulation in combination with regulated fuel markets. In the twenty-first century, however, while the investor-owned gas pipeline system in the United States retains a regime of comprehensive cost-based regulated tariffs developed decades ago, it simultaneously exhibits unregulated—and highly competitive—markets for both the use and expansion of the pipeline system. Those competitive transport markets in turn support highly competitive spot and futures gas commodity markets. How did such competitive pipeline transport develop? Why did it take a century to appear? And why has the success of competitive gas pipeline transport in the United States not spread to other pipeline systems—even to that gas pipeline system's close oil pipeline cousin in the United States?
These are puzzling questions for economists. Pipelines are pipelines, in technology and operation, no matter where they are. But economic theories grounded in profit or welfare maximization, rational choice, and equilibrium—the foundations of modern neoclassical economics, which has dominated the field since 1941—provide no foothold for dealing with such questions. To be sure, most modern economists owe a debt to the neoclassical economic tradition for the order, rationality, and mathematical logic that it provided, as it displaced the essentially nonmathematical institutional economics of the early twentieth century. But while a neoclassical perspective embraces some elements of the basic cost structure of pipelines, it is not a sufficient analytical tool to address the organization of the pipeline industry. Finding common threads in the economic analysis of the industry means embracing the more diverse, interdisciplinary theoretical perspectives of what has been called the new institutional economics—relatively recent extensions and developments of economic theory. The institutional details and regional histories shaping complex industries—particularly transport—are important for those latter-day institutionalists who have developed the new institutional economics. Such theories help to explain the choice between employing private or public capital for pipeline projects; why the industry structure in one region diverges sharply from those in others; how contracts in some regions supplanted vertical integration; and why competitive transport has yet happened on only one pipeline system in a world of pipeline systems.
The new institutional economics employs such diverse analytical perspectives as legal institutions in a market economy, modes of industrial governance, contractual arrangements, public (political) choice, regulation, and institutional change. Four of its elements go far to explain the organizational diversity exhibited in the world's pipeline industry: transaction costs and asset specificity, institutional evolution, intangible property rights, and collective action.
Transaction Costs and Asset Specificity
Asset specificity as a concept arose among economists to explain why firms vertically integrate rather than either contract or deal in spot markets with one another. Certain kinds of investments are so sunk and dedicated to particular business relationships that they give rise to the risk of opportunistic "holdup"—a problem that vertical integration serves to allay. Pipelines display great asset specificity: immobile assets of great length tied to fuel producers, oil refiners, power plants, or local gas distributors. Vertical integration ties the interests of those producers, pipeline companies, refineries, power plants, or gas distributors together. Such ties greatly lessen—if not eliminate—the prospect that one party in such fuel transport arrangements can hold up another and limit the expected return on the sunk capital investments involved. The problem with pipelines is that while asset specificity pulls pipelines to vertically integrate, their inherent economies of scale limit their number, thus concentrating fuel markets around a relatively small number of vertically integrated pipeline companies.
Oliver Williamson, of the University of California–Berkeley, shared the Nobel Prize in Economics in 2009 for his theoretical work in transaction cost economics that deals with just such attributes. The theory explains why some economic transactions take place inside firms and others happen by contract in the marketplace. He coined the term asset specificity around 1980. Asset specificity compels investors to forge reliable commercial relationships before building pipelines. Building first and negotiating later would allow customers to take advantage of the immobility of investors' committed capital to extract concessions and sharply limit profitability.
Dealing with pipelines' asset specificity requires that producers, pipeline companies, refiners, gas distributors, and others transact reliably with one another. Such transacting has costs of two sorts: the lesser involves ex ante negotiating and drafting costs; the greater involves the ex post costs that arise if joint agreements fail to survive unforeseen events. A central tenet of transaction cost economics is that the contracts that define such relationships are always necessarily incomplete—the result of what Williamson called "bounded rationality." While human actors have the capacity to look ahead, uncover contractual hazards, and plan contractual and institutional arrangements accordingly, they can never eliminate such costs. Vertical integration, which avoids the potentially heavy ex post contracting costs, may seem to be the sine qua non for major oil and gas pipelines.
Neoclassical economic theory has a tendency to assume away transaction costs. In a world without transaction costs, decision makers possess perfect foresight. They can effortlessly write complete, uncontroversial, binding contracts. In such a world, economic governance institutions play a neutral role in the efficiency of the productive process. It does not matter whether production is organized via prices in spot markets or within a vertically integrated firm. Such perspectives cannot help but impair the analysis of industries for which such costs are so important. With so much riding on the ability of pipelines and their users to avoid the potentially costly consequences of asset specificity, Williamson's theoretical work on the costs and uncertainties of transacting rises to a level of preeminent importance.
That firms in general are specialized governance structures built to deal with the cost of transacting was proposed by economists long ago. Ronald Coase's famous 1937 paper on the nature of the firm focused on the choice between contracting with suppliers and integrating with them. Coase (the 1991 Nobel laureate in economics), of the London School of Economics and later the University of Chicago, had the insight that there are costs to using what he called the price mechanism (his term for spot markets) manifested by transaction, coordination, and contracting costs. Williamson extended Coase's insight by examining not just the cost of contracting but the threat of opportunistic behavior by contracting parties that can be forestalled through vertical integration.
For investor-owned pipelines, the costs of contracting dominated early relationships and led inexorably to vertical integration. The advent of the pipeline industry occurred during the early years of the US Industrial Revolution. Those first Standard Oil pipelines appeared before the era of timely and reliable business records, legislated regulatory accounting rules, reliable regulatory administrative procedures, or the Securities and Exchange Commission. The idea did occur to some of those who debated the first pipeline regulations early in the twentieth century that pipelines might merely serve as independent long-distance transport companies, like railroads or canals. But sharper legislative minds saw that these latter two transport systems embodied versatility in their respective markets that pipelines did not. Canals and railroads could develop as their diverse economic product bases developed without the necessity of vertical integration. Those same sharp minds of a century ago also saw that regulating pipelines without regard to their need to transact reliably at either end could doom the prospect for private pipeline funding or harm independent fuel producers or both.
The use of private investor capital for early US oil and gas pipelines put a spotlight on the inability to use then-existing institutions to deal effectively with the cost of transacting through contracts. The consequence, for both oil and gas, was the concentration of the industries around a limited number of vertically integrated pipelines by the 1930s. The options for dealing with the problem were few for oil pipelines with their existing common carriage legislation that explicitly forbade contracts. Gas pipeline regulation presented a blank slate, however, and the congressional response was the development of legal and accounting institutions that would lower the cost of pipeline contracting and facilitate the move toward an independent pipeline industry capable of attracting private capital.
Indeed, an array of institutions combined to bring down the cost of transacting and clear a path for the evolution of the pipeline industry away from the seeming sine qua non of vertical integration toward an independent and competitive inland transport business. Some of the basic institutions predated pipelines; others accompanied the early twentieth-century efforts in the United States to regulate investor-owned public utilities effectively; still others dealt with pipelines directly to remedy abusive or acquisitive practices. But such institutions do not generally appear outside of North America. If and when such institutions arose to reduce contracting costs explains much of the geographic and sector-specific (i.e., oil or gas) diversity exhibited by the various major pipeline systems in the twenty-first century. Economic theory that abstracts from the cost of transacting sees none of this.
Excerpted from The Political Economy of Pipelines by JEFF D. MAKHOLM Copyright © 2012 by The University of Chicago. Excerpted by permission of THE UNIVERSITY OF CHICAGO PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of ContentsPreface
Chapter 1. The New Institutional Economics and Pipeline Transport
Chapter 2. Existing Pipeline Studies and Private Pipeline Capital
Chapter 3. The Economics of Production Cost: Pipelines as Natural Monopolies
Chapter 4. Regulating Pipelines as a Response to Monopoly
Chapter 5. The Essential Contributions of the New Institutional Economics
Chapter 6. Transacting with Common Carriage: The Oil Pipeline Regulations of 1906
Chapter 7. Transacting with Private Carriage: The Gas Pipeline Regulations of 1938
Chapter 8. The Competitive Potential for the World’s Pipeline Systems
Chapter 9. Making Sense of Pipelines: The Lenses of the New Institutional Economics