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Donald F. Santa, Jr.
Executive Vice President
Interstate Natural Gas Association of America

Energy in the North American Market Conference
June 12, 2003

Thank you for the opportunity to deliver one of the keynotes for this important and timely conference on energy trade in North America.

In thinking about how the role of Canadian energy supply in the U.S. market is perceived, I recall my initial exposure to U.S./Canada energy issues while I was a member of the staff of the Senate Energy and Natural Resources Committee in the early 1990s.

At that time, the U.S. Congress was considering the Energy Policy Act of 1992. One of the most divisive parts of that legislation was an amendment to the Senate bill that would have required FERC to adjust pipeline tariffs to account for the allegation by some U.S. producers that Canadian gas had a competitive advantage due to the difference in U.S. and Canadian pipeline rate design. That amendment, along with an amendment in the House bill that would have restricted the producing states' ability to regulate production, caused the Senate and House conferees to jettison almost all of the natural gas title in the comprehensive energy bill.

An Integrated Energy Market.

Today, as Congress once again is considering comprehensive energy legislation, that controversy is a distant memory. The intervening decade has seen the dramatic growth of the integrated North American energy market. Commerce in this broad, regional market annually has exceeded $50 billion in recent years.

The lion's share of the North American energy market is represented by US-Canada energy trade. Canada's natural gas exports to the U.S. have more than quintupled since 1986 and now account for nearly 60 percent of Canadian production and 16 percent of U.S. domestic consumption. Canada's crude oil exports to the U.S. account for 65 percent of Canadian production and 8 percent of U.S. crude oil consumption. In addition, Canada's refined products exports to the U.S. are destined to grow as U.S. refining capacity is increasingly constrained.

While the numbers for electricity trade are not of the same magnitude (Canada exports less than 10 percent of its electricity production to the U.S. where it accounts for less than 1 percent of domestic consumption), cross border commerce in electricity is significant and complex. For example, the Canadian Provinces of Alberta and Saskatchewan are routinely net importers of U.S. electricity and nearly all Canadian provinces count on U.S. electricity at times during the year. Also, NEB statistics reveal that in recent years Canada has traded more electricity with the U.S. than across its own provincial borders.

Our nations' energy markets are joined at the hip, and these market ties will continue notwithstanding occasional trade and political irritants between our countries. U.S. Ambassador Paul Celucci delivered this message unmistakably in his remarks to the Canadian Energy Pipeline Association last month. The message also was emphasized by FERC Commissioner Pat Wood when he visited Alberta for the meeting of the Canadian Association of Members of Public Utility Tribunals (and I thought that NARUC was a mouthful!).

The trade press quoted Chairman Wood as saying: "You look at a pipeline map of North America, and it's just no boundaries." He's right; the natural gas pipeline grid is a very concrete and dramatic example of what has occurred in U.S./Canada energy trade over the past decade. According to the Energy Information Administration, both pipeline capacity and the average flow of gas from Canada to the U.S. more than doubled between 1990 and 2000.

In fact INGAA symbolizes that effectively there are no boundaries within the interstate and inteprovincial natural gas pipeline grid in North America. TransCanada Pipelines, Enbridge and Alliance are among our members, and beginning this October, TransCanada's CEO, Hal Kvisle, will become the first Canadian chairman of INGAA. And, as you know from this morning's first panel, Ron Turner of TransCanada is the current chairman of the Canadian Energy Pipeline Association.

This integrated energy market has not occurred by accident. The U.S. and Canadian governments have pursued largely parallel energy policies and have engaged in intergovernmental cooperation on key energy commerce issues. Beginning in the 1980s, both countries moved away from pervasive economic regulation of the energy industry to the market-based pricing of energy commodities, open access for energy transmission and the unbundling of energy services. NAFTA has been instrumental in the emergence of the integrated continental energy market, with its recognition of electricity and gas as commodities and its limits on the use of import restrictions and national security exemptions.

Intergovernmental coordination on energy continues today, with the establishment in 2001 of the North American Energy Working Group and, most recently, last month's summit of U.S., Canadian and Mexican energy regulators in Alberta. Looking forward, intergovernmental cooperation in harmonizing the approval and permitting process for cross border pipelines, such as the proposed Alaska natural gas pipeline, could greatly increase the efficiency and reduce the cost of constructing such critical infrastructure.

Lessons Learned.

Parallels in the issues facing the industry and policy makers in our integrated continental energy market create opportunities to benefit from the "lessons learned" across our borders:

For example, a decade ago FERC followed the NEB's lead in introducing straight fixed variable rate design for interstate pipelines (that is, a rate design in which all of a pipeline's fixed costs are allocated to the demand charge). This mooted the alleged rate tilt toward Canadian gas supply and set the stage for positive financial performance by the U.S. pipeline industry following the Order No. 636 restructuring.

Conversely, FERC has greater experience with the issues arising in connection with competition between regulated pipelines, such as bypass, decontracting, and the greater business risk for pipeline companies created by such competition. This is an issue of growing importance for the Canadian pipeline industry.

There also are many examples of natural gas industry technologies and best practices that are transferable across the border. The Canadian pipeline industry pioneered the use of automatic welding for pipeline construction, the development of smart pigs, risk-based approaches for pipeline integrity management, and using high-strength steel for pipeline construction. All of these advances can be transferred to the U.S. pipeline industry, and can be especially beneficial when combined on a large, greenfield pipeline. Think of the difference these innovations could make when applied to the Alaska natural gas pipeline.

Going the other way, the U.S. producing sector and environmental and land use regulators have greater experience with coal bed methane production, which has not yet occurred to a significant extent in Canada. This expertise can be applied when Canada develops its CBM resources.

Capital Investment Knows No Borders.

Capital investment in energy resources and infrastructure also is affected by our integrated energy markets — and by the greater integration of continental and global financial markets. This is particularly important where regulation and public policy affect the attractiveness of capital investment in energy resources and infrastructure. In the regulated segments of the energy industry, regulators must strike a balance between consumer protection and a return on investment that is sufficient to attract the capital needed for maintaining and expanding the infrastructure needed to serve the public.

Private capital — whether it is dollars or loonies or euros or yen — is not captive; it is mobile, and it will seek the highest risk weighted return, whether that is in another regulated company or in an entirely different sector of the economy. Thus, in balancing between consumers and investors, regulators must be mindful of the long-term consequences of their actions. Excessive zeal in short-term consumer protection — or rigid adherence to historic cost of capital methodologies — may leave the same consumers with inadequate, and higher priced, energy supply in the long term.

New Challenges — Gas Supply.

Our governments and our energy industry have much to be proud of in creating this highly successful, integrated North American energy market. Still, we cannot rest on our laurels, because there are significant challenges emerging for our governments and our industry. The first, and most immediate, of these challenges is the emerging shortfall in natural gas supply and its effect on natural gas prices.

The inclusion of natural gas supply and price within Federal Reserve Board Chairman Alan Greenspan's May 21st testimony before the Joint Economic Committee of the Congress signaled that this is much more than just an issue for the natural gas industry; it is a significant issue for the larger economy. As you know, this past Tuesday Chairman Greenspan elaborated on this message in his extraordinary testimony before the House Energy and Commerce Committee. In his prepared statements, Chairman Greenspan succinctly summarized the current situation: sharply increased prices in response to tight supplies; low levels of working gas in storage and a lag in rebuilding inventories; the inability of heightened drilling to augment supplies significantly; Canada's inability to expand exports significantly in the near term; and increased demand for natural gas over the past two decades due to growing consumption by industrial and particularly electric generation users.

It is not difficult to see how the natural gas supply situation has the potential to ripple through the larger economy. Natural gas prices affect the cost of heating our homes and businesses, the cost of electricity (especially as an increasing portion of generating units, and especially those at the margin, are gas-fired), the competitiveness of a wide range of industries where natural gas is a feedstock or a significant input to industrial processes, and the derivative effects on the consumers of the output produced by such industries. And, as if this were not enough, there will be upward pressure on diesel and fuel oil prices as dual fuel customers migrate from natural gas to refined oil products.

Chairman Greenspan warned of the consequences of failing to address the inconsistencies in our national policies affecting natural gas: "[I]t is essential that our policies be consistent. For example, we cannot, on the one hand, encourage the use of environmentally desirable natural gas in this country while being conflicted on larger imports of LNG. Such contradictions are resolved only by debilitating spikes in prices." As has been widely reported, Chairman Greenspan's testimony placed great emphasis on the role that significant expansion of U.S. LNG import capacity could play as a safety valve for natural gas supply and price pressures.

As Chairman Greenspan suggested, the natural gas price and supply situation exposes real tensions in U.S. energy policy. Environmental laws and regulations and the market dynamic created by electric restructuring make natural gas the fuel of choice for electric generation, by default. Yet, environmental and land management laws and regulations restrict access to supply, federal and state and local laws create impediments to infrastructure development, and industrial and electric generating facilities that one would think should have dual fuel capability often cannot operate on alternative fuels (i.e., oil) due to environmental restrictions.

This energy policy schizophrenia is evident in the debate over the pending energy legislation. For example, the sizable opposition to the inventory of Outer Continental Shelf resources that is part of the legislation reported by the Senate Energy and Natural Resources Committee is a microcosm of the failure to reconcile the effects of energy and environmental policies that work at cross purposes.

There is a direct correlation between "not-in-my backyard" and "nowhere-off-my-beach" and energy price and supply. Is there anywhere that would not, by definition, be someone's "backyard" or off someone's "beach"? The cumulative effect of acquiescing to such parochial vetoes greatly handicaps our nation's ability to produce energy at reasonable cost and to maintain our energy security. Of course, there will be places that are so sensitive or where the energy development prospects are so minimal, that energy resource and infrastructure development make no sense. Still, the public and our policymakers must be made more aware of the real costs of so readily making this trade off in favor of no development.

There is an interesting parallel between the current natural gas supply situation and the supply crisis a quarter century ago. The natural gas "shortages" in U.S. interstate markets during the 1970s were the product of flawed policy — that policy being the bifurcation between interstate and intrastate natural gas markets and wellhead price controls that failed to reflect the balance of supply and demand. While wellhead prices are no longer regulated, the restrictions on access to resources and on infrastructure development that are embodied in current federal policy clearly affect supply and, in a supply-constrained market, also affect price. So, at least at the margin, today's supply/demand imbalance has been exacerbated by the lack of coherent U.S. energy policy. Excess deliverability masked these flaws for many years; now these flaws are being exposed.

Rationalizing the Natural Gas Marketplace.

One of the responses to the natural gas shortages of the 1970s following partial wellhead decontrol under the Natural Gas Policy Act was that interstate pipelines, in their role as supply aggregators and bundled merchants, entered long-term gas purchase contracts that underpinned the development of new gas resources. This later proved to be the pipelines' undoing when demand and price collapsed and the pipelines were left with crippling take-or-pay exposure. Still, the supply response facilitated by such long-term gas purchase contracts nonetheless made possible the abundant natural gas supplies and moderate consumer prices that we have enjoyed for much of the past two decades.

As we know, pipelines have restructured and no longer are in the role of supply aggregator and bundled merchant. This begs the question of who will fill this role within the current structure of the energy industry, especially in developing new reserves and infrastructure in frontier areas, where the capital cost is high and the lead time is long?

The marketing and trading sector is greatly weakened and, for a variety of reasons, LDCs now rely much more on the short-term market. Understandably, LDCs want to minimize the risk that state regulators will second guess, and possibly disallow, gas purchases that exceed the clearing price in short-term spot markets. Also, the efforts to implement retail competition in some states have discouraged LDCs from making long-term commitments for upstream pipeline capacity that might be stranded should new entrants make significant inroads.

Because the twin shock absorbers of excess productive capacity and a vibrant market maker segment have disappeared, we must reexamine the allocation of risk in the natural gas industry. And, because gas procurement for a significant portion of the downstream market is in the hands of local distribution companies, the answer to this question will depend in large part on state regulators. Regulatory policies that may have provided consumer protection during a period of oversupply will not necessarily work in the new market environment for natural gas. I would suggest that state regulators can do a better job protecting consumers from the brunt of supply constraints, higher prices and greater price volatility by signaling that LDCs may make commitments supporting the development of new resources and infrastructure.

Alaska Natural Gas Pipeline Authorization.

These changes in the structure of the natural gas industry also are relevant to the debate over whether a government backstop is needed to ensure that the Alaska natural gas pipeline is constructed in a timely fashion. The structure of the industry was very different when the Congress first authorized the project 25 years ago. It likely was assumed the long-term pipeline gas purchase contracts would underpin the production and pipeline infrastructure. That simply is not the case today.

As this audience knows well, the question of whether the U.S. government backstops the Alaska pipeline is politically sensitive in the dealings between our two governments. In his remarks to CEPA last month, Ambassador Celluci recognized the very practical side of this diplomatic issue. The ambassador said that he frequently reminds Washington that significant parts of the Alaska pipeline will cross Canada and will be subject to permitting under Canadian law by Canadian regulators. In other words, the success of the Alaska project will depend heavily on how it is received in Canada.

A Challenge for the Natural Gas Industry.

How will the natural gas industry respond to the supply and price situation? It is worth noting here that, in contrast to the oil industry or the traditional electric power industry structure, this is not a vertically integrated industry — rather it is disaggregated with multiple segments or sectors. In fact, the various segments of the natural gas industry often have battled one another in various regulatory and legislative forums.

This creates challenges in crafting a substantive response and in managing the various constituencies — that is, the policymakers, regulators, financial markets and customers — that affect the industry's future. Fortunately, the industry segments are working better together. We largely are on the same page with respect to issues in the pending energy legislation and with respect to the need to enhance confidence in competitive wholesale natural gas markets by upgrading the rigor of the market indices.

Cooperation and speaking with a unified, constructive voice are critically important at this juncture. If not, we risk much of what has been accomplished over the past two decades in establishing natural gas as a clean, reliable and affordable energy source that can meet the needs of expanding markets.

More particularly, the natural gas industry faces twin challenges in addressing the natural gas supply crunch.

First, how will we manage the near-term? Supply will be tight for the next three or so years and prices will remain high compared to what the market is familiar with. How can the industry manage the political and regulatory response to prevent counterproductive results?

At the regulators' summit in Banff, NEB Chairman Ken Vollman warned against a consumer backlash against energy free trade. In fact, the NEB already has fended off the first wave of this reaction last year when it rejected an appeal from the New Brunswick government to reserve offshore production for Atlantic Canada.

As former House Speaker Tip O'Neill was fond of saying, all politics is local. It can be anticipated that the representatives of energy consumers of all stripes will make the case for protecting their constituents from the brunt of high natural gas prices. Still, it is important that the short-term response not distort the incentives for developing the new resources and new energy infrastructure that represent the constructive, long-term answer to the supply and price situation.

Second, how can we capitalize on the current situation as a "wake up call" that educates the public, opinion leaders and policy makers at all levels of government about the inherent contradictions in our environmental and energy policies? Can we use this situation as an impetus for creating public policy that, first, supports the development of resources and the construction of infrastructure in an efficient and environmentally responsible manner and, second, that enables the market to make rational choices on the highest and best use of energy resources, whether those resources are natural gas, other conventional fuels, alternative fuels or investments in energy efficiency?

New Challenges — The Environment.

Now let me turn briefly to the environmental challenges in connection with our integrated North American energy market. As I've already noted, there frequently is a confluence between environmental and energy issues at all levels. Markets will develop most efficiently when these policies are coordinated.

Both countries face dilemmas in connection with global climate change and the Kyoto Protocol. Canada ratified the treaty over the strong opposition of some regions and industries in Canada. Still, it is unclear how Canada will implement its compliance and what this will cost. For example, methane is a greenhouse gas and, in order to implement Kyoto, fugitive emissions from production, processing and transportation either must be controlled or else offsets must be purchased. How will this affect the cost of expanding Canada's natural gas production and the infrastructure for transporting such production to domestic and export markets?

The U.S. government rejected the treaty. The pressures in our country to take constructive steps to address climate change remain, however, and are growing. There are an increasing number of initiatives at the state and local level, some within industry are calling for greater U.S. engagement on climate change, and major energy producing and consuming companies are facing increasing shareholder pressure to take a more pro-active role.

Is this an area where, as opposed to the fruitless "Kyoto yes/Kyoto no" debate, we would be better to devote our energies to fashioning a North American approach to climate change? Could we fashion a continental policy that recognized the unique economic and cultural demographics of North America and yet still made a contribution to addressing this global issue? It's worth thinking about.

Conclusion.

In conclusion, let me return to Ambassador Celluci's remarks about the diplomatic sensitivities associated with how the Congress chooses to support the Alaska natural gas pipeline. As you will recall, the Ambassador noted that he frequently reminds Washington that, no matter what the Congress does, the fate of significant parts of the pipeline will be in the hands of Canadian policymakers and regulators.

The Ambassador's remarks highlight an essential point in our cross-border energy relationship: The United States and Canada are each a sovereign nation; neither can dictate to the other; and each will have the energy policy that it believes best strengthens its economy and serves its citizens. At the same time, it is equally inescapable that our two nations operate in a common energy market, and that it should be a goal that our policies, laws and regulations support strengthening this common market.

The integrated North American energy market is a true success story. The energy industry and our nations' governments have much to be proud of in this accomplishment. It has been mutually beneficial to the U.S. and Canadian economies and consumers. We are much better positioned as an industry and as nations to address new challenges because of this integrated market and because of the intergovernmental cooperation that has fostered this market.

INGAA represents the owners and operators of much of the critical energy infrastructure that integrates the U.S. and Canadian energy markets. Our association leadership is indicative of the fact that we do business in a North American energy market. We are ready to work with other segments of the energy industry and with governments on both sides of the border in strengthening our integrated energy market and addressing the pressing challenges that I have highlighted today.

I commend the Canadian Embassy for sponsoring this program to explore how we can build on our successes and constructively meet the challenges in our integrated North American energy market.