November 15, 2005
The True Cost of Fixing Natural Gas Prices
The recent decision by our provincial government to limit Manitoba Hydro to only one rate increase of 6.1% for residential natural gas this coming winter surprised me. If market conditions warrant rate increases, should governments intervene at all? Does an across-the-board rate freeze truly protect consumers? Is the government justified in burdening Manitoba Hydro with the cost of underpricing energy or should Manitobans ante up and pay fair market value?
The provincial government justified its action on the grounds that a potentially larger increase in natural gas prices, possibly 20%, is expected in February and that it does “not believe consumers can handle two rate increases in one winter.” Two other provinces, British Columbia and Saskatchewan, have already announced substantially larger rate increases than Manitoba, 13.3% and 27% respectively, a clear signal that prices are expected to rise.
One must consider the impact of this policy on the affected parties and the future long-term effects for residential natural gas consumption. We should consider whether the policy is optimal and cost-efficient, or whether there are more efficient and less costly alternatives that can yield more equitable results.
The government of Manitoba is rightfully concerned with the effects of higher rates on those least able to pay more. In its order to the Public Utilities Board, it noted that “residential customers, particularly low- and fixed-income households, are less well-equipped to deal with current high costs.” The lower your income, clearly the less able you are to cover the additional burden. A policy to freeze the rate increase at 6.1% will certainly benefit this group, as it will shield them in the short term from the anticipated February spike in prices. But as a side–effect, middle- and upper-income earners also receive this benefit. In fact, they are likely to receive a larger benefit per household in dollars terms, since middle- and upper-income earners live in larger homes and consume more natural gas.
Economists have long argued that the most direct approach is always the most efficient. If the goal of the government is to protect the most vulnerable, a more feasible approach on equity grounds would allow Manitoba Hydro to adjust its rates based on market conditions, charge the market rate and then let the government rebate the difference to low-and fixed-income earners. This payment could be roughly equivalent to the increase in natural gas bills. That would completely shield low- and fixed-income earners, while those who could afford the increase would pay market value. The benefits to low- and fixed-income earners would, in fact, be larger under this scenario.
Moreover, this direct approach would also cost Manitoba Hydro less. Rather than fixing its rate and absorbing the cost across all residential consumers in the province, residential consumers would pay the higher rate. Even if the government drew on Manitoba Hydro revenue from electricity to subsidize lower gas rates, a key part of the announced policy, the utility would still be better off. Manitoba Hydro would implicitly cover only the costs for the lowest-income earners in the province, not all residential users.
That, however, is not the end of the story. The government’s across-the-board proposal has a number of negative side effects that are not immediately apparent. First, by keeping the price of natural gas artificially low, the government removes the incentive for Manitobans to become more energy efficient. As long as it’s relatively cheap to consume natural gas, why would Manitobans spend money on upgrades like new windows, insulation, furnaces or underground heating systems when the savings to our natural gas bill are not sufficient to cover the costs over a reasonable period of time?
This is precisely what has occurred with electricity consumption in Manitoba. Manitoba Hydro charges consumers in the province well below market rates and we are consequently the largest consumers of electricity on a per-capita basis in the world. If natural gas rates rise to market value, then consumers are more likely to upgrade and reduce energy consumption. The true cost to consumers who reduce energy consumption is then less than the announced increase in the gas rate.
In a world where reserves of natural gas seem to have peaked and future prices are likely to rise, a market-based pricing system creates the greatest incentives to alter patterns of consumption. From an environmental perspective, artificially maintaining a low price leads to greater consumption and faster depletion of a non-renewable resource. This is the opposite of what government policy should achieve.
Second, one wonders why Manitobans consistently undervalue what is arguably our most valuable asset. Not only does the province require Manitoba Hydro to sell electricity at below market value to Manitobans, but now it will also require that it sell its natural gas at below market value. The provincial government is using Manitoba Hydro as a public policy tool to cushion the blow of market factors that are beyond its control.
The provincial government should create an environment for Manitoba Hydro to be as profitable as possible. It should follow the lead of other provinces that use their natural resources as means of generating wealth. Profits earned by Manitoba Hydro could then be invested directly back into the province, not consumed away by higher energy use.
Finally, there is substantial evidence to show that price controls do not work. If the market price of natural gas does rise another 20% in February and continues to rise in the future, Manitoba Hydro may ask for a much larger price increase next year. Will the government intervene again and force Manitoba Hydro to keep prices artificially low? Eventually, Manitoba Hydro will have to raise its price to the market value or the provincial government will have to cover losses from general revenue.
The province claims that Manitoba Hydro can shield itself by using hydro-electric profits to cross-subsidize natural gas rates. What if Manitoba is hit with a drought this summer and electricity production declines, as it did in the summer of 2004? How will Hydro then finance this rate freeze?
While Manitobans should be concerned with potential price increases for not only natural gas but also other forms of energy consumption, the means to cushion the future burden is not by costly and inefficient government policies, but rather through reduced reliance on non-renewable energy sources. Costly government policies that distort market conditions and distribute greater potential benefits to high-energy consumers should be avoided. In their place, more targeted and selective policy options that directly benefit those in greatest need without distorting incentives to become more energy-efficient should be applied.
Michael Benarroch is a Professor of Economics at the University of Winnipeg. Professor Benarroch completed an undergraduate university degree at the University of Winnipeg, a Masters at Western Ontario and a Ph.D. at Carleton. The author of numerous articles and book chapters. his areas of interest concern international trade, economic development and environmental economics. Professor Benarroch is a regular commentator on radio and television on issues dealing with government finances and international trade.