Issue 1: Were the Actions of Southwest Prudent?

The central issue before us is whether the gas procurement decisions of Southwest meet the Commission's standard for reasonableness. As one might expect, the positions of the parties to this proceeding are radically different - Southwest claims its actions were reasonable, while ORA and the County argue that Southwest's failure to store gas in advance of the Winter of 2000-01 was unreasonable.

Southwest: Gas Procurement was Reasonable

To show the reasonableness of its gas procurement and storage policies, Southwest states that it maintained a "measured decision-making process, under which it has revised its procurement and storage decisions as market conditions changed, in order to procure gas for its customers at the lowest possible overall cost."¹⁰ As evidence of the reasonableness of its policies, Southwest points out that it has procured gas for its customers "at lower per-unit costs than two of California's large LDCs [local distribution companies] during the review period, with the exception of the six-month period of December, 2000 through May, 2001."¹¹

Southwest describes its decision-making process as consisting of evaluating 1) historical price data; 2) current market information; and 3) forecasts of what gas prices are expected. To show the past effectiveness of these principles, Southwest details a series of actions that it took between 1993 and 1998 to demonstrate its responsiveness to changing conditions in the natural gas market. These include Southwest's ending of its wholesale customer relationship with PG&E and its negotiation of a comprehensive wholesale agreement with SoCalGas. Southwest contends that these decisions, along with previous decisions to avoid holding long-term firm capacity on interstate gas pipelines, enabled Southwest's customers to avoid an estimated $3.9 million in Interstate Transition Cost Surcharges. Both PG&E's and SoCalGas's customers paid such transition charges.

Southwest claims that its decision not to use storage extensively was consistent with Commission policies that direct gas companies to use forecasts of gas prices to guide their use of storage. Southwest notes that between 1993 and 2001, "gas prices were higher in winter only 5 of those 9 years."¹² Southwest states that D.93-02-013 admonishes utilities to make gas storage decisions on a forecast basis, and that Southwest makes "storage decisions on the basis of historic conditions, current market conditions, and forecast future conditions, rather than simplistically doing the same thing every year without regard to market conditions."¹³

To justify its decision to store only modest amounts of gas in advance of the 2000-2001 heating season, Southwest notes that the historic range for gas prices was no greater than $2.00-$5.00/MMBtu, and that "Never in California's history had gas prices exceeded $5.00/MMBtu."¹⁴ During the Summer of 2000, gas prices reached a record high of $7.00/MMBtu, and Southwest anticipated that they would drop during the fall and winter. Since Southwest could meet its gas demands from flowing gas supplies without using storage and both futures prices and forecasts "universally predicted prices dropping the coming winter,"¹⁵ it declined to fill its gas storage.

Southwest also defends the reasonableness of its managerial actions by examining the results of its gas procurement decisions. Southwest states that its procurement costs "(1) beat the market by approximately 12.4%, or $10.8 million in total gas costs; (2) were lower on average than the gas procurement costs of both PG&E and SDG&E and were only approximately 6 cents/MMcfd higher than SoCalGas; and (3) would have earned a shareholder reward of approximately $5.4 million dollars if Southwest had been operating under a GCIM [gas cost incentive mechanism] identical to SDG&E's."¹⁶

Southwest further argues that its gas procurement actions are consistent with Commission adopted gas policies. In particular, Southwest claims that the Commission has established policies favoring cost minimization over price stability, and disfavoring the use of long-term fixed-price procurement contracts. Southwest cites D.89-04-080:

"We expect utilities to demonstrate least cost purchasing practices, given the need for supply security. We reiterate our view that a well-managed portfolio will balance supply and cost considerations, and will provide a menu of supply arrangements with differing price, contract length, and other terms."¹⁷

And:

"We have discussed our view that price stability should not be a primary goal for core and core-elect customers in order to promote lower cost supplies."¹⁸

Further, Southwest quotes a Commission 1994 decision that while imposing a disallowance on PG&E states:

"Subsequently, in D.89-04-080, we relegated the goal of price stability to a secondary priority behind supply security and cost minimization."¹⁹

Similarly, Southwest discusses Commission decisions that discourage the purchase of gas through long-term contracts and concludes that despite these contracts' ability to provide price stability, the Commission disfavors such contracts. As a result, Southwest concludes that Commission policy is one of placing the highest priority on low prices, not stable prices. Southwest views its actions as consistent with these policies.

Southwest further asserts that not only its procurement actions, but also its utilization of storage was consistent with Commission policy. In particular, Southwest argues that the "two criteria the Commission imposes are (1) certainty of gas supply; and (2) lowest possible overall cost."²⁰ Southwest notes that certainty of gas supply is not an issue for Southwest because it can meet peak winter needs from flowing gas without taking gas from storage. Concerning the criteria of lowest possible cost, Southwest argues that it "used its reasoned decision-making process to analyze historical gas prices, current market prices, and forecasts of future prices, in order to make gas procurement and storage decisions based on all available information."²¹ Southwest states that applying the same storage criteria as it had used in the past led to storage amounts of "0.17 Bcf [11%] (2000), 1.4 Bcf [93%] (1999), 1.4 Bcf [93%] (1998), 1.1 Bcf [73%] (1997) and .75 Bcf [50%] (1996)."²² Finally, Southwest notes:

"Neither historical gas prices, current prices during the Summer of 2000, nor any gas price forecasts would have put a reasonable gas purchaser on notice that gas prices would jump more than tenfold by the end of Winter 2000/2001."²³

Southwest concludes that the evidence of this record demonstrates the reasonableness of Southwest's procurement costs.

ORA: Southwest's Failure to Store Gas was Imprudent

ORA contends that Southwest's procurement actions were imprudent. First, ORA states the Commission's storage policy "directed gas utilities to use storage to benefit core customer in terms of both reliability and price."²⁴ ORA argues that an application of this policy is readily seen by examining the actions of SoCalGas, SDG&E, and PG&E. ORA notes that each has a Commission-authorized storage target for its core customers and that each utility "sets monthly storage targets and winter month-end minimums to ensure that the storage is being utilized for the benefit of the core."²⁵ ORA contrasts this practice with that of Southwest, stating, ". . . from May through September 2000, traditional injection months, Southwest injected no gas at all into storage."²⁶ Thus, ORA views the actions of Southwest as inconsistent with Commission gas storage policies, particularly as applied by other gas utilities.

ORA argues that Southwest's storage of so little gas in 2000 necessitated that it "rely almost entirely on flowing supply to meet winter demand, procuring gas primarily on the monthly and daily spot market."²⁷ In particular, ORA argues that since Southwest was relying so heavily on gas future prices as a predictor of winter gas prices, Southwest should have reduced exposure to potential price volatility either by putting gas in storage or buying a contract for the future delivery of gas. Moreover, ORA notes that the savings from not storing gas versus the prices predicted on the futures market were "minor at best."²⁸

ORA, citing D.94-03-050, notes that Southwest's "purported reliance on its interpretation of Commission decisions or policies is not dispositive of the reasonableness of its actions."²⁹ In particular, ORA argues that reliance on Commission policies does not relieve Southwest from the responsibility to justify specific decisions. Moreover, ORA notes that the Commission policy concerning gas storage is nuanced, seeking to provide both reliability and price stability for customers, while giving the overarching direction to utilities to use the storage for the benefit of core customers.

Finally, ORA states that Southwest's failure to use financial instruments to hedge the price volatility of its gas portfolio during the review period demonstrates that Southwest lacks "appropriate risk management policies."³⁰ ORA notes that SoCalGas, PG&E, and SDG&E use financial tools to hedge their gas supply costs. ORA concludes that by failing to use financial instruments to hedge, by failing to utilize storage, and by failing to hold interstate transmission capacity, Southwest was "ill prepared to mitigate gas price increases experienced during the second year of the review period."³¹

County: Failure to Store Gas was Imprudent and Risky

The County also concludes that Southwest's gas procurement policies were unreasonable, and not mandated by Commission policies. The County argues that Commission policy does not require that gas utilities rely exclusively on the spot market. In particular, the County notes that Commission policy "has also encouraged utilities to consider hedging strategies to protect against episodes of high prices."³² The County further states that the record in this proceeding shows that other California gas utilities have used hedging strategies successfully.³³ Finally, the County states that the Commission has supported "a geographic diversity in the utilities' core purchases."³⁴ Thus, the County does not believe that Southwest's actions were consistent with Commission policy, but that they were inconsistent with a Commission policy that "encouraged the California utilities to purchase a diversified portfolio of supplies for their core customers."³⁵

The County also contends that the Commission's gas storage policies seek to provide the certainty of gas supplies and to do so at the lowest possible overall costs. The County notes the Commission's directives that set gas storage targets for SoCalGas, SDG&E and PG&E, and argues that Southwest should have known these policies and followed similar storage practices. The County notes that the "Commission applies these storage policies to all other gas utilities and even to small third-party marketers: core storage had to be filled prior to winter in order to provide supply certainty."³⁶ In particular, the County argues that under current gas policy, any utility or marketer, regardless of size, should store gas to insure certainty of supply for its customers and to contribute to the peak period reliability of the system.

The County further contends that Southwest's actions prior to the Winter of 2000-2001 were not required by Commission policy and clearly unreasonable for several reasons. First, the County states that Southwest failed to start the winter with adequate gas in storage or under forward contracts. The County argues that this action was inconsistent with Commission policy that encouraged the use of storage and was a departure from Southwest's past practices.

Second, the County states that Southwest "ignored the price function of storage."³⁷ The County analyzes the data presented by Southwest and finds that winter prices are on average "significantly higher in the winter than in the summer"³⁸ and concludes that failing to store gas was imprudent.

Further, the County argues that Southwest failed to inject gas into storage even when it was economic to do so. The County states that the "record shows that in April and June 2000, Southwest decided not to inject, even though its monthly analyses calculated that the expected savings from not storing gas were less than $0.05 per Dth."³⁹ The County additionally states that the future prices for December and January gas were high enough to support injecting gas in May. The County therefore concludes "In these three months [April, May and June], Southwest could have injected about 1.1 Bcf of gas."⁴⁰

The County also notes with disapproval Southwest's failure to purchase future contracts to offset the risks that arose from the decision to forego injection during the spring. The County states:

"Once Southwest decided not to store gas in a particular month, the utility should have purchased winter supplies equal to the foregone injections at the lower prices that prevailed when it made the decision not to inject gas into storage. . . . By doing nothing, Southwest abrogated its responsibility to ensure certainty of supply for its core customers, and essentially lost any ability to mitigate the risk of high prices during the coming winter, as Southwest's Mr. Hester conceded."⁴¹

The County also contends that the Commission should disregard Southwest's discussion of the Commission's policies concerning the storage of natural gas. The County points out that the Commission has not recently examined Southwest's storage policies. Moreover, the County points out that in a recent Commission examination of gas storage practices, "All of the other wholesale customers in the state (SDG&E and the Cities of Palo Alto and Long Beach) filed reply comments indicating that they had either filled their contracted storage, or took other steps to assure the adequacy of their core supplies to meet peak winter needs."⁴² The County concludes "Southwest is a large and sophisticated company - among the ten largest gas distribution companies in the U.S. - and they do not need to be micro-managed by the Commission" and therefore should "apply a little common sense in interpreting the Commission's decisions."⁴³

The County also makes several arguments to rebut Southwest's defense of the reasonableness of its gas procurement decisions through comparisons with the prices charged by other utilities. The County points out "SoCalGas' tariffed core gas costs were almost 50% lower than Southwest's during the energy crisis months of December 2000 through May 2001."⁴⁴ The County also points out "During the year ending May 2001, Southwest's gas costs in southern California were 155% and 84% higher than its cost of gas in Nevada and Arizona, respectively."⁴⁵ The County also argues that the Commission should discount comparisons with SDG&E, the gas utility with core gas costs closest to those of Southwest. The County notes that because of greater heating needs, the per capita bills in the Big Bear District and Victorville were much higher than those in San Diego.

Finally, the County takes issue with Southwest's claim that its tariffed gas costs were lower than SDG&E's in 17 of 24 months during the record period. The County argues: "These comparisons are virtually meaningless, due to the fact that for 18 out of the 24 months in the review period, Southwest operated under a completely different scheme for recovering its gas costs than the other gas utilities to whom it is comparing itself."⁴⁶ In particular, the County notes that from June 1999 through November 2000, Southwest's tariffed gas costs was fixed at 22.932 cents per therm, while SDG&E's prices were changed monthly to more closely track actual costs.

Discussion - Flaws in Southwest's Gas Purchasing Policy Constitute Imprudent Action

We conclude that Southwest's gas procurement and storage policy constitute imprudent managerial action. Southwest's failure to either use more of its storage capacity or to secure stable prices through futures contracts left its customers exposed to a highly volatile gas market in the months with the greatest heating demand. The County rightly notes that the Commission has encouraged gas utilities to use hedging strategies to protect against high prices and price spikes. The failure of Southwest to forego use of its storage capabilities and simultaneously to refrain from the purchase of a futures contract led to an unjustifiable failure to protect its customers with a hedge against high gas prices.

Southwest misinterprets Commission gas procurement pronouncements when it concludes that the Commission's heavy emphasis on least-cost purchasing practices, as opposed to price stability, provides support for its actions. First, we note that the Commission decisions cited by Southwest and noted above do not eliminate price stability as a goal of Commission policy. Consider, for example:

"Subsequently, in D.89-04-080, we relegated the goal of price stability to a secondary priority behind supply security and cost minimization."⁴⁷

Although price stability is secondary to cost minimization, the Commission determined that it remained a priority. Despite Southwest's contentions, this statement provides no support for a policy that either blindly fills storage or blindly relies on spot markets.

Second, it is clear retrospectively, and should have been clear prospectively, that the use of storage not only provides price stability, but also enables a utility to refrain from purchasing gas in a spiking gas market, thereby helping it to manage gas costs. Southwest's low supply of stored gas as it entered the Winter of 2000-2001 - only 11 percent of its contracted storage capacity - necessitated that Southwest secure gas supplies extensively in gas markets of Winter 2000-2001 even when prices were soaring. Historically, the use of storage has provided not only a hedge against price fluctuations, but also absolutely lower prices. In particular, storage can earn an economic return, not only by delaying investments in pipelines and other transmission facilities needed to meet the winter transmission peak, but also by enabling those holding gas in storage to decline to purchase high-priced gas. Our record indicates that Southwest appeared to view storage as a method for meeting operational needs and providing price stability, but failed to see the necessity of having a cushion of gas to reduce its purchases of gas on the days and weeks when gas prices were peaking.

Third, it is also clear that Southwest's decision to forego the use of storage departed from the practice of other gas utilities operating in California. As the County noted, all of the other major wholesale customers in California - SDG&E, the City of Palo Alto and the City of Long Beach - either filled their contracted storage or took other steps to secure stable supplies. Southwest's departure from the practice of the managers of these other utilities is difficult to understand. All faced the same gas market.

In addition to Southwest's claim that its gas procurement and storage policies were consistent with Commission policy, Southwest also defends the reasonableness of its actions with a detailed explanation of the economic rationale that it used to guide its procurement and storage decisions. Southwest's efforts to explain the economic reasoning that led it to forego the use of storage, however, do not present clear and convincing evidence concerning the reasonableness of its actions.

For example, Southwest examines the price history of the recent past and observes that in 4 of 9 years winter prices were below summer prices. Southwest further notes that prices were unusually high in the Summer of 2000. These facts demonstrate that a policy of filling storage every year is not reasonable. Nevertheless, in the Summer of 2000, future markets were indicating that the Winter of 2000-01 would likely face high prices. In the face of this market indicator, i.e., that winter prices would be about the same as those in summer, it is difficult to understand how economic reasoning caused Southwest to forgo summer injections. Further, the County points out that in the injection months of April, May, and June, there was virtually no difference between the cost of injecting gas for winter retrieval and the price of a contract for future delivery. Thus, there is no clear and convincing evidence that Southwest pursued a reasonable strategy.

In the face of the unprecedented high prices of the spring and summer, it would be reasonable for a manager to conclude that winter could also show unprecedented prices. In this situation, gas storage is not just a way of securing price stability, but is an important component in a strategy that leads to the lowest possible overall cost. Although on any particular day it may be easy to understand how Southwest's reasoning led to a decision not to inject gas when future prices were more economic than the purchase, injection, and future withdrawal of gas, it is not possible to conclude that it was reasonable for Southwest to let the entire summer pass without either injecting substantial quantities of gas or purchasing attractive contracts for the future delivery of gas.

Southwest's defense that it was following an established gas procurement and storage strategy that had worked in the past is not adequate. Clearly, the procurement and storage strategy contained flaws, and the adverse conditions of Winter 2000-2001 exposed these flaws. The fact that the strategy had worked well in the past only shows that the strategy was equal to the set of circumstances encountered. It does not provide clear and convincing proof that the strategy was reasonable and prudent.

Our consideration of the reasonableness of managerial action depends on the supporting rationale based on the facts known at the time of the decision. With this criterion in mind, the question becomes one of what should the managers have done in the spring of 2000 with the facts then available?

The County and ORA both argue that Southwest should have filled its contracted storage. In retrospect, it is clear that completely filling storage would have been an excellent strategy for the conditions of the Winter 2000-2001. Southwest, however, effectively points out that in the previous four years, it had never filled its contracted storage, and that even if the year 2000 is excluded, the 1996-1999 average of storage was only 77%. In 1996, a year without any pricing crisis, only 50% of the storage was filled. Moreover, the pricing analysis that Southwest conducted showed that the prices of gas in the Summer of 2000 were at unprecedented high levels and that forecasts suggested that they would be no higher and possibly lower in winter. In the face of this information, completely filling the contracted storage would be unreasonable.

Nevertheless, entering winter with only 11% of the storage filled is also unreasonable. The unprecedented high prices of the summer, in combination with futures prices that showed little change in gas prices, indicated that gas markets were entering a period unlike the past. We conclude that a more prudent managerial approach would be for Southwest to fill the contracted storage to 50% - the lowest level in the recent past - or, alternatively, to secure contracts for future delivery of an equivalent amount of gas.

Finally, although Southwest's evidence comparing its gas tariff prices with those of other utilities is important in our evaluation of its performance, the evidence presented is not dispositive. For example, Southwest notes that for "21 months of the 24-month review period, Southwest's tariff gas costs were lower than SDG&E."⁴⁸ Although accurate, this statement constitutes an "apples to oranges" comparison, for during 18 of the 24 months in the review period, Southwest's gas tariffs were fixed and not subject to adjustments to reflect the costs of purchased gas. Similarly, the County's comparison of Southwest's California gas costs with those of its Nevada and Arizona divisions is also an "apples to oranges" comparison. In particular, the Nevada and Arizona gas did not pass through congested California gas transmission hubs.

Although the comparisons with SDG&E, PG&E, and SoCalGas are relevant, the reasonableness of a utility's actions depends on its own costs and assets. Southwest differs from both SDG&E and SoCalGas, and the reasonableness of Southwest's decision depends on the circumstances and opportunities that Southwest confronted.

Southwest's argument that under SDG&E's gas cost incentive mechanism it would have generated $10.8 million in shared savings does not provide evidence that its purchasing decisions were reasonable. Indeed, we note that SDG&E, operating under its incentive mechanism, extensively used storage as part of its overall procurement strategy. Thus, SDG&E's managerial actions and its performance under the incentive program do not provide clear and convincing evidence that Southwest has acted reasonably concerning its gas procurement activities in the period under review.

In summary, the Commission has articulated three steps it has used in determining the reasonableness of a utility's decisions. ⁴⁹ In the first step, we examine the goals that the utility hopes to achieve and evaluate whether that goal was reasonable. On this point, the record indicates that Southwest focused so exclusively on providing low-cost gas, that it failed to attach importance to the goal of price stability that was consistent with Commission policy.

In the second step, we compare the actual outcome with the goal. Here, we find that Southwest filled only 11% of its contracted storage and purchased no futures contracts for gas in the Summer of 2000. These actions undervalued the role of storage and futures contracts in both reducing the costs of gas and providing price stability. The result was that the actual outcome - high and volatile prices - failed to meet either the goal of low-cost gas or the goal of price stability.

In the third step, we consider whether a reasonable and prudent utility would have taken other steps to come close to achieving the goal. Here, we find that SDG&E, the City of Long Beach, and the City of Palo Alto - also wholesale customers of larger gas utilities - each made extensive use of storage in the Summer of 2000. Thus, we conclude that in facing the market costs and futures prices of gas, it was unreasonable for Southwest to proceed through the Summer of 2000 without either filling 50% of its contracted storage or securing an equivalent amount of gas through futures contracts for delivery during the Winter of 2000-2001. In conclusion, Southwest has failed to show by clear and convincing evidence that its gas procurement and storage actions in the Summer of 2000 were reasonable.