Supply contracts, regulatory lag, and cost disallowance in the natural gas industry

This dissertation is concerned with the regulated firm's choices between alternative types of contracts for the purchase of inputs; although much of the thesis is applicable generally to regulated firms, the examples and motivation are drawn from the natural gas industry. I focus on the choice between contracts whose cost is uncertain in advance (spot market purchases or cost-plus contracts), and contracts with price and quantity terms fixed in advance (forward or fixed-price contracts). Regulation is viewed as placing both a ceiling and a floor on the firm's profits, but these bounds may be affected by alternative regulatory regimes.;The thesis is built around three related models of the above issues. First, a simple one-period model of the regulated firm's input contracts is developed, which suggests the importance of allowing customer self-selection between fixed and variable pricing plans. Second, the one-period model is extended to an infinite-horizon setting, in which questions of regulatory lag and different degrees of foresight on the part of the regulator can be considered. Third, the one-period model is extended to incorporate retroactive regulatory review of the firm's input decisions.;The majors results are summarized as follows. (1) Regulatory profit and loss restrictions distort the firm's choice between contracts with certain and uncertain costs, but the exact nature of the distortion depends on the firm's rate structure and may also depend on particular parameter values. (2) In a dynamic model, the firm with rates based on a myopic use of historical data may have incentives to lose money in the short run so as to manipulate the regulatory process and increase long-run profits. (3) In a dynamic model, the firm with rates based on rational expectations over the entire time horizon faces greater risks than does the static firm, and relies more heavily on long-term contracts to mitigate these risks. (4) Retroactive regulatory reviews that reward good outcomes rather than good decisions can induce expected-cost minimization if rate cases occur at fixed intervals; if rate cases occur only at the request of the firm or its customers, however, retroactive reviews will not induce cost minimization.