Do Americans Consume Too Little Natural Gas?

While industrial customers face prices that are close to marginal cost (2.5 percent markup), most residential and commercial customers face prices closer to average cost (40 percent markup).

In Do Americans Consume Too Little Natural Gas? An Empirical Test of Marginal Cost Pricing (NBER Working Paper No. 15885), co-authors Lucas Davis and Erich Muehlegger measure the extent to which prices exceeded marginal costs from 1991-2007 in the U.S. natural gas distribution market. They find large departures from marginal cost pricing in all 50 states, with residential and commercial customers facing average markups of over 40 percent.

While industrial customers face prices that are close to marginal cost (2.5 percent markup), most residential and commercial customers face prices closer to average cost (40 percent markup), with most revenues coming from per-unit charges, rather than through fixed monthly fees. Based on conservative estimates of the price elasticity of demand, these distortions impose annual welfare losses of $2.7 billion compared to marginal cost pricing, roughly 3 percent of total market value. The current system with low fixed fees and high per unit prices implies that there are an inefficiently large number of natural gas customers, each consuming too little natural gas.

High markups have important implications for environmental policy. The average markup for residential and commercial customers is equivalent to a tax of over $55/ton of carbon dioxide. In part, the preference for low fixed fees and high per-unit markups may reflect efforts by regulated companies to maximize the total number of customers and thus the total rate base. It could also be related to distributional considerations: low fixed fees will attract small customers while potentially leading some large consumers to switch to other energy sources, depending on the distribution of customers of different sizes and the ease with which they can substitute across fuels. Attempts to increased fixed fees typically face substantial political opposition, because they would result in increased expenditures for low-income groups and small businesses, both of whom are more price-sensitive than high-income households.

-- Claire Brunel