J Regul Econ (2007) 32:209–223 DOI 10.1007/s11149-007-9037-9 ORIGINAL ARTICLE The role of excess capacity in determining market power in natural gas transportation markets R. Preston McAfee · Philip J. Reny Published online: 14 July 2007 © Springer Science+Business Media, LLC 2007 Abstract The approval by FERC of a regulated natural gas pipeline’s market-based rate application depends upon the availability of substitute pipelines with sufficient capacity to maintain the current transport price. But how much alternate capacity is enough? Clearly, the price will not increase when alternate pipelines have unsubscribed capacity equal to the capacity of the applicant pipeline, since the applicant’s capacity is then perfectly substitutable. And indeed, FERC has approved market-based rates when this “complete-replacement” criterion has been met. However, complete-replacement is too stringent a condition and we determine precisely how much alternate capacity suffices to keep the price from rising. Keywords Market-based rate application · Natural gas regulation JEL Classifications D21 · D43 · L51 · L95 1 Introduction Regulation of natural gas pipeline rates in US began with the Natural Gas Act of 1938. For almost five decades, pipelines offered a bundled service that combined the purchase and delivery of natural gas, principally to local distribution companies and R. P. McAfee Department of Humanities and Social Sciences, California Institute of Technology, Pasadena, CA 91125, USA e-mail: preston@mcafee.cc P. J. Reny (B) Department of Economics, University of Chicago, Chicago, IL 60637, USA e-mail: p-reny@uchicago.edu 123