At about the same time as the ICC's development of rate of return standards, the 1941 Consent Decree between the Department and the major vertically integrated pipelines was entered.25 That decree, still in effect today, establishes that dividends paid by defendant pipelines companies to their shipper-owners are not unlawful rebates in violation of the Elkins Act 25 if they do not exceed 7 percent of the ICC's valuation figure. The wisdom and efficacy of this agreement have been the subject of considerable congressional scrutiny.27 Much of the criticism is justifiable, for it is clear the decree has, for a long time, failed to operate as the Department intended it should. Since stockholders are ordinarily paid dividends only after debtholders are paid interest, the decree has been interpreted to permit expensing of interest prior to an allowance of dividends, while permitting 7 percent dividends based upon an overall valuation that is independent of the overall debtequity capital structure of the pipeline.2

30

28

In response to this situation, debt financing in the industry has risen sharply since 1941. Prior to 1941 pipelines were funded almost entirely from equity funds provided by their shipper-owners, and investments in oil pipelines from outside sources were rare. Oil pipelines had capital stock outstanding of over $264 million in 1940, while total debt of pipeline companies reporting to the ICC that year was under $21 million, and that amount was attributable to only eight companies. Today, heavy debt financing with minial equity contribution is commonplace, with debt-equity ratios of 90:10 or higher.31 This leveraging greatly increases the return to total capital. To take a somewhat simplified example, if a pipeline were 90 percent debt-financed with an eight percent interest rate on its debt securities, the total return (7 percent of valuation in dividends plus interest charges) would be more than double the total return (7 percent in dividends only) to the pipeline if it had no debt.

In the pipeline regulatory proceedings we have been participating in recently, it has become increasingly clear that the pipeline industry generally-even those lines not covered by the consent decree-has attempted to parlay the consent decree dividend loophole into an ICC rate regulation loophole. For example, in the TAPS case,32 each of the eight carriers involved ignored the ICC's forties 8 percent rate of return standard and filed initial rates based on consent decree methodology; 7 percent dividends plus actual interest expense, all highly leveraged at 80 percent debt and greater. The approach, and the applicability of consent decree standards to rate regulations, was squarely rejected by the ICC last summer, when, in response to protests by the Department and others, it suspended the initial rates filed by the TAPS carriers.33 However, this action came only after 35 years of silence dur

25 United States v. Atlantic Refining Co., Civil Action No. 14060 (D.D.C. 1941). 20 Elkins Act, 32 Stat. 847 (1903), as amended, 34 Stat. 587 (1906), 49 U.S.C. §§ 41-43. 27 See, e.g., Hearing Before the Subcomm. on Special Small Business Problems of the House Select Comm. on Small Business, 92d Cong., 2d Sess. (1972); Hearings on the Consent Decree Program of the Department of Justice Before the Antitrust Subcomm. of the House Comm. on the Judiciary, 85th Cong., Ist Sess.. V. 9, pt. 1 (1957).

28 United States v. Atlantic Refining Co., 360 U.S. 19 (1959).

20 Jones at 17-19.

30 Id. at 17; House Comm. on the Judiciary, Antitrust Subcomm., Consent Decree Program of the Department of Justice, 86th Cong., 1st sess. 176 (1959).

31 Jones at 18-20.

32 Trans-Alaska Pipeline System, FERC Dkt. No. OR 78–1.

33 Order of the Interstate Commerce Commission in Investigation and Suspension Dkt. No. 9164, Trans Alaska Pipeline System (Rate Filings) and No. 36611, Trans Alaska Pipeline System (Rules and Regulations), June 28, 1977.

ing which most vertically integrated pipelines took advantage of regulatory laxity and "double counted" interest to produce returns far in excess of the ICC's published standards. The Supreme Court recently upheld the ICC's suspension of the TAPS carriers' proposed initial rates in a unanimous opinion.34

The future status of the ICC fair value rate base methodology and rate of return standards is uncertain, but the signs are hopeful, owing largely to the fresh airing these questions are receiving at FERC in both the TAPS rate proceeding and the general rulemaking I alluded to, entitled Valuation of Common Carrier Pipelines. We have argued in both proceedings that the FERC may and should (1) abandon outmoded and cumbersome fair value rate base concepts in favor of depreciated original cost rate regulation modeled after the natural gas pipeline industry, and (2) set rate of return standards that allow a fair and reasonable return (reflecting the realities of current debt markets and equity capital attraction needs), but do not compensate twice for debt, i.e., interest expenses.35 These proceedings are vitally important from a competitive perspective. To the extent rate regulation has been ineffective, the results can be likened to those that would occur if all domestic pipelines had engaged in an industrywide price-fixing conspiracy. Showing how regulation may have duplicated those effects should thus be, in our view, a major antitrust objective.

The other method by which regulation curbs the potential monopoly power of vertically integrated pipelines is through common carrier regulation. Under the Interstate Commerce Act; it is unlawful to provide any undue preference to one shipper (such as the pipeline company's parent) over another (such as an independent).36 But the true scope of the common carrier obligation as applied to pipelines has never been made very clear. For example, there are no regulatory decisions on the obligation of a pipeline, if any, to provide storage or terminal facilities that would make the line more generally useful to nonowner-shippers. In fact, one of the few-if not the only operating practices addressed directly by the ICC in all its years of common carrier regulation were early claims of excessive minimum tenders.37

The ICC's long periods of regulatory passivity on both common carrier and rate matters appear to have been premised on a "HearNo-Evil, See-No-Evil" approach to regulation. According to the theory, if complaints are few, the system must be working well and the public interest being served. But the interests of the shipping public are not necessarily coincident with those of the public at large, especially where, as is often the case with oil pipelines, the shipper and the carrier share a strong commonality of interest. Not unexpectedly at hearings such as this, the industry points to the absence of complaints as proof of nondiscriminatory service to the shipping public. În weighing that record, however, Congress should also consider

34 Trans Alaska Pipeline Cases,

U.S.

46 U.S.L.W. 4587 (June 6, 1978). 35 See Memorandum Defining and Stating the Position of the United States Department of Justice on Policy Issues raised by This Proceeding and Statement of Suggested Procedures to Be Employed for Bringing the Proceeding to a Conclusion, at 38-54 and 66-84 (April 3, 1978) (DOJ 4/3/78 Memo).

Interstate Commerce Act. Sections 1(4), 2 and 3(1), 49 U.S.C. §§1(4), 2, and 3(1). See Brundred Bross. v. Prairie Pipe Line Co., 68 I.C.C. 458 (1922); Reduced Pipe Line Rates, supra n. 21; Petroleum Rail Shippers' Ass'n, supra n. 22.

the fact that the nonowner-shipper has in the past been faced with a climate of regulatory indifference in an industry dominated by carrier-affiliated shipments. This is an additional burden to any reluctance that may exist in the nonowner-shipper to disturb a customer-supplier relationship by resort to litigation.

In reality, where shippers and carriers are truly different entities, interests cannot fail to frequently clash, and the adversary fallout provides the regulator with insight into the workings of, and the dynamic tensions within, the regulated system, as well as the basis for enlightened compromise. The absence of true adverseness then, is a substantial disadvantage: if the regulator does not take affirmative steps to regulate effectively, it is unlikely to have the opportunities to develop the expertise ever to do so. Indeed, as I have noted, it was not until there were complaints regarding the rates of independent pipeline companies that the ICC, after nearly 70 years, began to awaken to its affirmative responsibilities respecting rate regulation.

To conclude this overview, I would stress that if the pipeline problems were no more than what I have already described, I could end the discussion here. Our expectation might reasonably be that efforts at rate reform will ultimately prove successful, and that common carrier regulation can be substantially improved if the FERC avoids the trap of regulatory passivity to which the ICC fell victim, or if there were some minor adjustments to the Interstate Commerce Act, or perhaps both. But the pipeline problem is unfortunately not so simple. We have taken a much closer look at the consequences of vertical integration for the pipeline's regulated environment, and concluded that to a great extent industry structure predetermines the failure of regulation.

II. CIRCUMVENTION OF RATE REGULATION

I will try to describe, as simply as I can, how vertical integration creates the incentives and opportunities for noncompetitive behavior in the regulated context. To do this requires discussion of how and when rate regulation may be circumvented, the ineffectiveness of regulatory restraints on circumvention, manifestations of this behavior, and how such conduct can be perpetuated.

A. How and when circumvention occurs

To understand how and when rate regulation may be circumvented, three questions must be addressed: 1) When does a pipeline have market power?

2) Is rate regulation at all effective in curbing that power?

3) When does vertical integration enable a pipeline company to circumvent the constraints of rate regulation?

1. Market Power in Pipelines.-In analyzing the first question, we have formulated some general conclusions about market power in pipelines that apply across the board to independents and integrated pipelines alike. To some degree, all pipelines have the incentive to circumvent existing regulatory constraints, but only those pipelines with market power can succeed. Market power, as I have already suggested, is something more than the mere fact that pipelines possess economies of scale or inherent cost advantages. Market power is the

amount of a pipeline's monopoly advantage over its competitors, measured either at the upstream or the downstream end of the pipeline, or both.

Focusing for the moment on the downstream market, the factors affecting the level of market power include: (1) The size of the pipeline's share of the downstream petroleum market; (2) The level of effective transportation competition either from other pipelines or from other modes of transportation; (3) Elasticity of demand in the downstream petroleum market; and (4) The ability of other suppliers to the downstream petroleum market to expand output.

In applying these tests, the prices and outputs must be at or near those that would obtain under competition.

Thus, in general, a pipeline will have market power downstream when (a) its throughput comprises a significant share of the downstream market, (b) it can supply the downstream market with less expensive petroleum than can other suppliers, either because of lower transportation costs than alternative modes of transportation (including other pipelines) or because local producers (or refiners) cannot expand output without increasing costs, and (c) consumers in the downstream market are willing to pay a higher price to obtain petroleum if the supply is reduced.

A good example of a pipeline-type facility that will have downstream market power when it is built is LOOP. Its input of crude oil into Gulf Coast and Midwest crude markets will be substantial: it will have significant cost efficiencies over other modes transporting much-needed imported crude into that market (such as lightering, transshipment and small tankers); 38 and downstream refiners would very likely be willing to pay more for imported oil if supply_were reduced. On the other hand, the proposed Sohio Pipeline from Long Beach to Midland, Texas, would not have market power in the Gulf Coast/Midwest crude market, because its input of crude into that market would not be substantial and the delivered cost via that pipeline of oil in that market is comparable to that for foreign sources of supply. I invite the Committee's attention to our recent Sohio Pipeline report 3 for a fuller analysis of the somewhat unusual Sohio situation.

39

Likewise, a pipeline will generally have market power upstream when (a) its throughput comprises a significant share of the upstream market, (b) increased supplies of petroleum can be absorbed upstream only at a lower price, and (c) suppliers upstream will be willing to accept lower prices to sell their crude or products, either because of a lack of transportation alternatives at costs as low as the pipeline's, or because contraction of output would be difficult or unprofitable. This type of market power is ordinarily termed "monopsony" power.

Our study of pipeline returns in connection with our rate reform efforts has produced what we consider to be strong empirical evidence that many pipelines have substantial market power-power which rate regulation has failed to curb. For example, in an evaluation of pipeline profitability conducted by our Economic Policy Office last

38 Deepwater Port Rep. at 51-53.

Report of the Antitrust Division. Department of Justice, on the Competitive Implications of the Ownership and Operation by Standard Oil Company of Ohio of a Long Beach. California-Midland, Texas Crude Oil Pipeline, June 1978 (Sohio Rep.).

44-579 0 79 - 2

year, our economists concluded that the rates of return for many oil pipelines are significantly above what is encountered in the most profitable electric utility and natural gas pipeline companies.40 This bears out our historical impression that pipelines have exhibited monopoly power all through the years of ineffective regulation.

2. Effectiveness of Rate Regulation. These observations lead to a second question, whether rate regulation is at all effective in curbing monopoly power. This question is significant because with completely ineffectual rate regulation there would be no need to use vertical integration to reap the pipeline's monopoly profits. Such profits could be obtained directly with excessive tariffs. As is suggested by my earlier remarks, however, the ICC rate standards of 8 percent and 10 percent on valuation set in the forties, along with the consent decree, did finally provide some practical bounds on the rates of return pipelines have earned.

These bounds have acted as a partial curb on pipeline monopoly power. In suggesting that rate regulation has had some effectiveness, however, I mean only that rate constraints have been sufficient to create incentives in the regulated enterprise to circumvent those limitations. It is, if anything, clear that rate regulation has not been truly effective.

3. Means of circumvention.-There remains the question of how the vertically integrated structure of a pipeline permits circumvention of rate regulation in a manner foreclosed to an independent. The first step in this analysis requires identification of incentives. An independent pipeline company is in the transportation business and no other. Its natural incentive would be to maximize transportation profits. If it has monopoly power, it can be expected to exercise it; if it does not, it can be expected to accommodate itself to the needs of the widest possible variety and number of potential customers, earning a fair return on each barrel of oil shipped. In general, the greater the pipeline's throughput, the greater its profitability.

On the other hand, a vertically integrated pipeline company is not a pure transportation company, in theory or in fact. The incentive of the integrated firm as a whole is to maximize overall profits, not just transportation profits. Our study of this industry, therefore, focuses on whether those differing incentives result in a distortion of the independent's transportation-profit-maximizing calculus when the pipeline is vertically integrated. The critical question that has emerged is whether, given at least some partially effective regulatory constraint, the vertically integrated structure permits circumvention of that constraint.

We have concluded that if a vertically integrated pipeline has market power, it ordinarily possesses the ability to use its vertically integrated structure to circumvent rate regulation. Our analysis of this point should come as no surprise to this Committee; it first emerged in the publication of the Attorney General's Deepwater Port Report in November 1976, and has been repeated on numerous occasions since, including appearances here.

41

As we see it, the ability to avoid regulation is rooted in the ability of the shipper-owner to limit pipeline throughput below the level an

40 Statement of George A. Hay, Ex Parte No. 308, at 6-7 (May 27, 1977). "Deepwater Port Rep. at 3-5 and 103-09.