The Proposal

PG&E seeks support from the Commission for the company to increase its investments in hedges for gas needed this winter and in following years. PG&E points out that the CPIM covers only a 12 month period, and does not provide a mechanism for tracking multi-year hedges. Nonetheless PG&E asks the Commission to retain the CPIM, partially because its enactment led to the elimination of reasonableness reviews. However, to accommodate the need for additional hedging, PG&E is requesting that the following new Ordering Paragraphs be added to D.04-01-047:

(1) To provide much-needed supplemental protection from possible dramatic natural gas price increases in the wake of Hurricane Katrina, PG&E is hereby authorized to purchase hedges in 2005. The level of the hedges and the expiration dates thereof are specified in the Gas Hedging Plan attached as a confidential Addendum to PG&E's Petition for Modification dated September 13, 2005.

(2) The costs associated with these approved hedges shall be paid by core customers. PG&E shall establish a specific core subaccount in the PGA to track these costs.

(3) All payouts associated with these hedges shall flow directly to PG&E's core gas customers in the year which the payout occurs. PG&E shall establish a specific core subaccount in the PGA to track the payouts.

(4) Neither the costs nor the payouts associated with these hedges will be shared by PG&E's shareholders.

As part of its petition, PG&E submitted a confidential hedging plan for expedited review and approval by the Commission. PG&E asked that the Commission approve the hedging plan as part of its decision granting the requested modification of D.04-01-047. Approval of the plan would authorize PG&E to spend up to a specified limit on option premiums to protect core customers from additional increases in natural gas prices over the next five winters, commencing with the coming winter of 2005-2006.²

PG&E proposed that the costs and benefits of these hedges be excluded altogether from CPIM calculations. Both costs and benefits would flow entirely to PG&E's core gas customers, outside the CPIM. The confidential hedging plan attached to the petition describes the hedging products and the annual volumes to be hedged.

PG&E specifically requested that the expanded hedging authority be extended to include, not just the coming winter of 2005-2006, but also the subsequent four winters, and that this expansion of PG&E's hedging authority over the next five years is warranted by the exigent circumstances in the wake of Hurricane Katrina. PG&E states that it also intends to propose, via a separate application to be filed within the next several weeks, a more comprehensive, long-term hedging plan for the winters after 2005-2006.

PG&E argues that adoption of the current hedging proposal would require only one relatively minor, one-time modification. PG&E seeks authority to change the CPIM accounting procedures to allow PG&E to exclude option premiums and any other related hedging costs associated with the supplemental hedging plan from the CPIM. PG&E would establish separate Core Sub Accounts in the PGA to track the costs and payouts associated with the purchase of hedging instruments under this plan. All costs and payouts from the hedges authorized in the supplemental hedging plan would accrue directly and entirely to core customers. In contrast to the treatment of hedges under the CPIM, shareholders would bear no costs and receive no benefits associated with the hedges. PG&E shareholders also would forego any reward for the 2004-2005 CPIM year (Year 12). All other aspects of the CPIM would remain unchanged.

The Exigent Circumstances

There is no disputing PG&E's assertion that since it hit the U.S. mainland on August 29, 2005, Hurricane Katrina has had a major adverse impact on natural gas markets, contributing to significant increases in the price of natural gas throughout the United States. Although production levels in the supply basins serving PG&E in the Southwest and in Western Canada have not been affected, natural gas supplies and futures have experienced significant price increases in the wake of Hurricane Katrina.

Hurricane Katrina struck the heart of the natural gas and oil producing region of the Gulf of Mexico and caused a major disruption in energy markets. A large proportion of offshore gas and oil production initially was shut in, and there was significant damage to the onshore infrastructure as well.³ The upward effects on prices were immediate and significant. Gas prices for the coming winter rose above $12.00 per MMBtu (or per Dth) on the New York Mercantile Exchange (NYMEX), and created the substantial possibility of further multi-dollar per MMBtu increases due to the resulting loss of gas production.

PG&E reports that Hurricane Katrina disrupted sixteen percent of the gas production for the United States, and about seven percent remains shut in as of the date of this document. It is not yet known when and to what degree this gas production will resume.

The problems caused by Hurricane Katrina have come on the heels of several years of sustained high gas prices. Prices for natural gas already had been on an upward trajectory since early 2002. The pace of growth in demand has exceeded supply during that time, and is forecast to continue to do so for the next several years.

After the approach of Hurricane Katrina, winter natural gas prices on NYMEX rose literally overnight by twenty percent, from around $10.00 to $12.00 per MMBtu. The prices for gas in the supply areas accessed by PG&E (the U.S. Southwest and Western Canada) rose in similar proportion.

A further basis for concern arises from the fact that September is the peak month for hurricane activity. The hurricane season does not end until November 30. Already this year to date, there have been more named tropical storms in the Atlantic Ocean as of September 9 than as of the same date in any year in recorded history. Another hurricane in the Gulf of Mexico that affected gas supply could have a devastating upward effect on prices. Also, PG&E predicts that the current supply outage caused by Hurricane Katrina will reduce pre-winter storage inventories nationally from the previously-forecasted 3,300 billion cubic feet (Bcf), which is generally considered to be adequate for normal winter weather, to levels approaching 3,100 Bcf, or perhaps lower. This lower level of storage inventories would make it very difficult for natural gas markets to meet expected demand should there be a colder than normal winter.

Other externalities - most notably a forecast of (or the actual appearance of) below-normal winter temperatures, even in other parts of North America, as well as increases in the price of other energy commodities, such as heating oil - are also major risks that may drive natural gas prices higher.

According to recent information released by the Energy Information Administration in the U.S. Department of Energy (EIA), Hurricane Katrina also reduced natural gas production on the Gulf Coast, and slightly less than four Bcf per day of the normal 10 Bcf per day remains offline. To date, 92 Bcf of gas production has been lost. The EIA reports that several major processing plants in Louisiana are out of service due to the hurricane, and may remain out of service for as long as six months.⁴

The Administrative Law Judge (ALJ) Ruling

On September 14, 2005, the presiding ALJ issued a ruling setting an expedited schedule for review of the petition. He concluded that, since a rapid decision was needed to inform PG&E's hedging efforts this month, there was insufficient time to provide adequate consideration of PG&E's proposal for multi-year hedging. Accordingly, he directed parties to prepare comments on PG&E's secondary proposal to approve its hedging strategy only for the winter of 2005-2006. We concur with this approach. We understand PG&E's desire to begin hedging for future years, and encourage the company to do so, to the extent that, in its judgment, it is the best thing to do for core customers. However, for the Commission to fully consider and approve a multi-year approach would require an understanding of the facts supporting such a plan, as well as a review of long-term options.⁵

The ALJ also asked parties to comment on a further alternative, under which the CPIM would be suspended during this winter, and all costs would be tracked through a balancing for eventual recovery from ratepayers. All of those commenting on this proposal opposed it, largely due to the assumption that suspension of the incentive mechanism would lead, sooner or later, to the re-imposition of reasonableness reviews, a practice that was, for the most part, suspended with the initial introduction of procurement incentives.⁶ The ruling did not propose a return to reasonableness reviews. Parties only feared that it might.

What Other Utilities Plan to Do

As part of the expedited consideration of PG&E's proposal, the ALJ directed the San Diego Gas and Electric Company (SDG&E), the Southern California Gas Company (SoCalGas) and the Southwest Gas Company (Southwest) to file comments reflecting whether or not the Commission should act to change either their procurement practices or their incentive mechanisms for the winter of 2005-2006.

SDG&E and SoCalGas, responding jointly, support PG&E's proposal to remove the costs and benefits of hedging from the CPIM, and have ratepayers fund hedges pre-approved by the Commission. These utilities stated that they do not see a need for any changes to their current procurement practices. However, these utilities state that if the Commission wants them to acquire hedge instruments, they are willing to do so, and offer to submit detailed hedging plans for pre-approval by the Commission.

Southwest reports that it is just now gaining experience with its relatively new Gas Cost Incentive Mechanism (GCIM). The first full GCIM year begins November 1, 2005. When designing its GCIM, Southwest incorporated a Volatility Mitigation Program under which the Commission has authorized it to hedge up to 25 percent of its core gas needs. Southwest states that it had originally proposed a 50 percent limit, which it had reduced after negotiations with the Office of Ratepayer Advocates (ORA). The utility reports that in light of recent events, it supports the Commission authorizing Southwest to increase the percentage of hedging for its portfolio up to 50 percent.

Reactions From Other Parties

TURN, ORA, Lodi Gas Storage, Coral Energy, The School Project for Utility Rate Reduction and the Association of Bay Area Governments (SPURR/ABAG), and Accent Energy Group (Accent) all filed comments on the proposal.⁷ Only TURN expresses general enthusiasm for PG&E's proposal.

ORA opposes PG&E's proposal. However, ORA recommends that if the Commission finds additional shareholder protection is warranted, the Commission should widenthe tolerance band in the CPIM, instead of moving hedging outside of the mechanism. If the Commission is inclined to grant PG&E's request to remove the costs and potential benefits of its alternative hedging plan proposal from CPIM calculations, ORA recommends that the CPIM rewards be suspended for the next CPIM period commencing November 1, 2005, in addition to the current 2004-2005 CPIM period as proposed by PG&E.

SPURR/ABAG vigorously oppose the PG&E proposal, claiming that PG&E is merely looking for a way to shift all of its procurement risk to its core customers. However, if the Commission were to grant the petition at least in part, SPURR/ABAG advocates that we impose the following restrictions:

A. Any hedging plan approved as an exception to the CPIM should cover not more than 30% of overall monthly usage during the period from November 2005 through March 2006. Since, according to PG&E's September 14, 2005 press release, PG&E already has 20% of Nov05-Mar06 usage in storage, that would result in a hedging level not to exceed 50% overall.

B. Any hedging plan approved should be limited to Nov05-Mar06 usage.

C. Any application by PG&E with regard to hedging in subsequent periods (1) must not become effective during the time period covered by the Gas Accord III Decision, and (2) must take as its scope the question of allowing and assisting core customers to manage price spike risk, including the role of core aggregators, rather than simply a narrow review of CPIM in isolation.

D. Prior to the start of each month in the Nov05-Mar06 period, PG&E must announce publicly both the level of hedging employed for that month and the weighted average hedging level. For example, PG&E could announce that "we have hedged 30% of projected commodity usage with a weighted average capped price of $1.40/therm, plus we anticipate pulling 15% to 20% of projected usage from storage."

Accent also opposes the petition, arguing that the Core Aggregation, under which core customers can elect to buy gas from providers other that the utilities, allows customers to manage price volatility. Lodi does not oppose the proposal to hedge for this winter, but recommends that the Commission reserve action on PG&E's request for authority to enter financial hedges beyond this winter until PG&E files its separate application, so as to permit the Commission to fully evaluate all of the hedging options PG&E enjoys, including physical hedges.

Coral expresses concern that PG&E proposal may not represent the most appropriate means by which to stabilize gas costs for PG&E's core procurement customers. Coral urges the Commission to encourage PG&E and the other gas utilities to enter into long-term, fixed price contracts as a part of a portfolio strategy in order to provide greater price certainty and stability for the utilities' core gas sales customers. Coral argues that this can be accomplished under the utilities' existing incentive mechanisms or through carefully considered adjustments to the incentive mechanisms.

TURN offers its "general" support for the PG&E proposal, and despite the admonition to limit comments to consideration of hedging for only the coming winter, proposes that PG&E be allowed to implement its hedging strategy for the following two years (not the four additional years proposed by PG&E). TURN is concerned that it might take too long to process a separate application for future-year hedging, but that conditions may change sufficiently by 2008 to make current hedges for years beyond that point unwise.