Discussion

The CPIM, most recently modified and approved in D.04-01-047, guides and provides financial incentive to PG&E's Core Procurement Department in its gas procurement practices. The CPIM provides PG&E the incentive to procure natural gas at the lowest possible cost as compared to monthly gas price benchmarks. Its structure establishes evaluation criteria for PG&E's annual gas procurement costs. In applying the mechanism, the Commission adds up the allowed monthly benchmark dollars over the CPIM period and compares that sum to PG&E's actual costs for the year to determine PG&E's performance. A tolerance band around the benchmark defines the range of costs that is considered reasonable and these costs are recovered entirely from ratepayers. If PG&E's actual gas costs, as measured against the CPIM benchmark, are outside the upper (+2%) and lower (-1%) limits, PG&E shares with ratepayers the savings or losses as compared to the costs outside the tolerance band. Ratepayers and shareholders share penalties for gas costs that are above 2% on a 50/50 basis, and share savings attributed to gas costs lower than 1% of the benchmark on a 75/25 basis.

PG&E asserts that "there is limited flexibility under its CPIM to fix the prices of natural gas for an extended period of time, or to expend dollars to hedge a significant portion of the Company's natural gas purchases on behalf of core gas customers." (Emergency Petition, p. 4.) PG&E also alleges that the company's risk of a major financial penalty for hedging large portions of the portfolio can be significant under the current CPIM. Therefore, PG&E is recommending that its hedging plan be excluded altogether from the CPIM, i.e. all costs and potential gains or losses would flow entirely to ratepayers.

At issue in this instance is whether we should encourage PG&E and other core-serving gas utilities to increase the use of gas price hedges for the coming winter, and if so, how we should express that encouragement. There is little dispute that current natural gas prices are volatile, and that prices have climbed, in recent weeks, to extremely high levels. Properly applied hedges will protect consumers against the highest prices. At the same time, because price hedges add cost, their use virtually ensures that consumers will not experience the lowest possible cost for gas service.

Utilities should always strive to reduce gas cost, but should not expose consumers to great risk in pursuit of the lowest price. Every utility should serve its core customers through a mixture of flowing gas and gas hedges. The latter can be physical hedges in the form of storage and supply contracts, or they can be financial hedges that do not lead directly to more consumable gas, but insure against extreme price spikes.

Utilities need storage to meet winter demand. They must inject throughout the injection time period from spring through fall. As SPURR-ABAG points out, current gas costs are much greater than they were just three years ago. While it is as important as ever to continually replenish core storage supplies, this form of physical hedge may no longer be enough. When supplies are tight, and there is every reason to assume that they will continue to be for some period of time, it makes sense to look for opportunities when the forecast of future prices somewhat lower and then to lock in those lower prices for a portion of the projected load through long-term contracts or price hedges.

Deciding when and how utilities should acquire specific additional hedges is not a call that regulators are well equipped to make, particularly in an expedited time frame. The regulatory process lacks the flexibility, and regulatory staffs often lack the expertise and access to information necessary to make a skillful determination related to fleeting gas purchase opportunities. This is one of the strongest reasons for establishing gas procurement incentive mechanisms and allowing utilities to apply expert judgment in making these marketplace decisions.

How is the Commission to know whether or not PG&E has offered a good hedging plan, let alone the right hedging plan? TURN argues that it does not really matter whether the plan is either good or right:

"TURN believes that PG&E's proposal represents a rational approach to the situation, although not necessarily the only rational response. We are faced with difficult choices, none of which are especially appealing. Rather than wasting precious time debating among the various unpleasant options, TURN believes that the best approach is to act quickly to authorize the utilities to pursue whatever approaches appear best suited to their individual situations. With winter fast approaching and market volatility likely to continue for some time, there is simply no time to wait." (TURN's Response, pp.1-2.)

What is missing from this suggestion is an explanation of whose judgment of the "best suited" approach should apply. TURN does not offer (nor does PG&E, for that matter) facts or argument to support a conclusion by this Commission that PG&E's proposed hedging plan is the best one, or even a particularly good one. The Commission would be left to approve the proposed plan simply because it is one that PG&E proposed. Presumably, if the utility proposed a vastly different plan, we would be compelled to approve that one, as well.

ORA states the problem well:

"Under the PG&E application, the regulator is placed in the unenviable and inappropriate position of dealing with an application in which it has the least amount of market information to make the ultimate decision. This approach also implicitly relegates PG&E to an advisory role on matters related to its hedging plan. If advice on the hedging plan is ultimately what the Commission seeks, then the Commission may wish to contact Wall Street investment banks for second and third opinions before taking on the accountability for PG&E's hedging plan and exposing ratepayers to 100% of the risk. The PG&E application ultimately represents a very unfortunate turn of events given the structure and intent of the CPIM, especially given that PG&E can make (and could have already made) the decisions concerning the additional hedging request within the CPIM structure." (Opening Comments pp. 6-7.)

This must not be what TURN had in mind. More likely, TURN is suggesting that it is PG&E that must identify and implement the hedging plan best suited to its situation. This is a proposition with which we agree. The question is how to motivate PG&E to pursue the best approach on behalf of its customers. Rubber-stamping whatever PG&E brings to the door of the Commission is not likely to produce that result. Taking the time to collect the expert opinion necessary to critique the merits of PG&E's proposal is unworkable given the time constraints and issues of confidentiality.

As several parties point out, there is nothing about the CPIM in its current form that would prohibit PG&E from using hedges to the extent it feels it needs to, in order to protect core customers.⁸ PG&E's petition is premised on the assumption that its shareholders have no reason to use hedges to protect core customers from high prices when those shareholders face a CPIM penalty if the eventual gas price is not high enough to cover the cost of the hedges. ORA wonders, and PG&E does not adequately explain, why after ten years of operation under the CPIM, including the high gas price years of 2002 and 2001 when prices at the California border at times exceeded the levels expected this winter, the inclusion of financial instruments in the CPIM now is considered to carry the risk of unacceptable penalties.

ORA agrees that the CPIM, given its nature as an annual mechanism, exposes PG&E to risk to the extent that PG&E acquires multi-year hedges due to the volatility of the natural gas market. Nonetheless, the mechanism does allow PG&E to undertake significant hedging. ORA argues that the CPIM "tolerance" band around the benchmark provides PG&E the ability to rely on it to a significant extent for purposes of shareholder risk protection for potential hedging transactions and losses. The tolerance band or "reasonableness range" of 2% is significant. For example, in the most recently ended CPIM Year 11 (covering the period November 1, 2003 through October 31, 2004), the upper end of the tolerance band, based on 2% of the annual benchmark procurement costs, was approximately $30 million.⁹ The prior CPIM Year 10 (covering the period November 1, 2002 through October 31, 2003) had an upper tolerance of approximately $27.5 million. Given the recent prices of natural gas and the current NYMEX forward prices, the current expectation would be for the tolerance band in the next CPIM period (November 1, 2005 to October 31, 2006) to greatly exceed these past levels or even the current CPIM tolerance band.

In its Petition, PG&E alleges that "the Company's risk of a major financial penalty for hedging large portions of the portfolio can be significant under the current CPIM" and "if PG&E's spending on hedges (option premiums) exceeds the upper level of the deadband, then PG&E shareholders face the risk of large financial penalties." (Emergency Petition, p. 4.) However, as ORA points out, in the Emergency Petition, PG&E fails to provide any factual evidence to support the specific allegation regarding the actual level of risk of a major financial penalty and what level of penalty it would consider significant under the current CPIM. While the tolerance band amount fluctuates based on the cost of gas in the market, it nonetheless provides a significant "cushion" that can be used to cover hedge costs.

As gas costs rise, so does the value of the tolerance band within the CPIM. The hedging costs anticipated by PG&E to protect customers in the coming winter would normally be reflected in the 2005-2006 CPIM calculation. PG&E has not demonstrated why the tolerance band, swollen by the expected high gas costs during that period, would not adequately protect PG&E for its hedge investments.

Although we want to encourage PG&E to make hedge investments, we want the company to be tempered in its approach. It should not purchase hedges that are unlikely to be of value because they cost too much or provide too little protection. It should also realize an appropriate mix between a reliance on hedges and a reliance on the price of flowing gas. In at least the short term, we expect that a need to respect the limits of the tolerance band should push PG&E in the direction of that appropriate mix. It remains for use to determine in future proceedings whether there may be a more effective way to promote appropriate hedging activity.

The approaching winter brings with it significant uncertainty and the threat of higher prices. It is important to acknowledge these conditions in light of PG&E's specific hedging concerns. ORA offers an alternative approach.

ORA recommends that the Commission widen the tolerance band by increasing it equally to +3% on the penalty side (from the existing +2%) and -2% (from -1%) on the savings side, giving PG&E additional flexibility or "hedge room" to make any additional hedging decisions it deems appropriate for this upcoming winter. This would constitute a 50% increase to the current upside tolerance band and in the current environment would provide substantial additional protection. From an equity standpoint, given the additional risk protection, the ability to generate a reward would also be adjusted. This would be implemented for the upcoming CPIM period commencing November 1, 2005 for the 2005/2006 cycle. Any longer-term proposals or major structural changes regarding the CPIM and multi-year hedging plans can be evaluated in the context of PG&E's upcoming application.

This is a constructive proposal that responds to PG&E's fundamental concern. A widening of the tolerance band would give PG&E a safety net for shareholder risk, yet would preserve the integrity of the CPIM which has worked well over the years to align ratepayer and shareholder interests in making appropriate decisions, without shifting the entire risk to ratepayers. The CPIM can continue to provide the appropriate incentives for PG&E to procure gas for core ratepayers in a manner that is in the best interest of both core customers and shareholders, while significantly reducing the possibility of unreasonably high risks or reward.

PG&E does not oppose ORA's alternative, but continues to believe that the best approach here is to remove the additional hedges from the CPIM altogether. The utility points out that the purpose of the CPIM is to align customer and shareholder risks and interests, and thereby to provide an incentive to PG&E to manage its gas purchases and storage and transportation assets to reduce total gas costs for customers and that its hedging program is a form of price insurance for core customers. PG&E argues that continuing to track hedging costs through the CPIM would create a disincentive for PG&E to acquire this "insurance," since the absolute size of the tolerance band could decrease if market prices were to drop, causing customer and shareholder risks and interest to become misaligned. In addition, by including the hedging costs in CPIM, PG&E states it would have little incentive to attempt to lower costs, since the cost of the insurance is likely to outweigh any savings achieved through the day-to-day trading of gas and management of transportation and storage assets.

The expansion of the tolerance band resolves PG&E's primary concern, by giving the company significantly greater protection against losses resulting from additional hedges. To use PG&E's words, it is a means for realigning ratepayer and shareholder interests by protecting shareholders as the company acts to protect its customers. We are willing to take this additional step because of the exceptional uncertainty we are all facing in the next few months. We are not persuaded that this change would significantly reduce PG&E's incentive to achieve cost savings through day-to-day gas trades and asset management. The company has not explained why it would not do all it can to reduce costs in order to protect itself against a CPIM penalty, to maximize its opportunity to achieve an award, or simply to ensure that its customers face the lowest feasible charges.

For all the reasons discussed above, we will adopt the revised tolerance band as proposed by ORA. We do this because we encourage PG&E to acquire the price hedges it feels best serve ratepayer interests.

This petition, and the response that it has generated, underscore the importance of re-examining the incentive mechanisms in light of current conditions and the potential for high gas prices over the next few years. PG&E has indicated its intention to file an application addressing hedging over the next four years.

The Other Utilities

We thank Southwest, SDG&E and SoCalGas for offering their responses to the PG&E petition and for reflecting on hedging issues as they affect their own procurement plans for this winter. None of these utilities has asked for a modification of its incentive mechanism, although each expressed a willingness to expand its hedging activities, if that was the Commission's desire.

Southwest states that it has recently begun operating under its first GCIM cycle and that it has already implemented its hedging program for the upcoming 2005-2006 period, and thus does not recommend suspension of its existing program. Southwest's GCIM contains a "Volatility Mitigation Program" (VMP) which Southwest is recommending be increased to 50% from the adopted 25%.¹⁰ ORA notes that in recognition of the reduced risk associated with the current VMP treatment, Southwest's GCIM contains a wider tolerance band than that of the other utility incentive mechanisms. In this context, and based on the extremely limited new information available for Commission review in the context of this expedited petition, it is not clear that there is a need to increase the scope of the VMP. Southwest already has significant shareholder protection, which should give it the encouragement it needs to pursue appropriate hedges.

SDG&E and SoCalGas filed comments together, but have different stories to tell. SDG&E has been acquiring price hedges within the confines of its Performance-Based Ratemaking mechanism. SoCalGas has not been buying hedges, as it functions within its GCIM. Neither asks for changes to its current core procurement practices. However, both companies support a pre-approval process for natural gas hedging activities, stating:

"In such a process the Commission can provide guidance on fundamental issues related to hedging. What does the Commission value more, low cost gas or price stability? If the answer is low cost gas, then limited hedging may be the most reasonable course of action. A portfolio of call options can be an effective way to insure customers against extreme prices. In most years, however, the vast majority of such call options will expire worthless, and the cost of hedges will simply increase the delivered cost of gas. If price stability is more important, a more robust hedging program will be called for, even if it tends to increase the overall average delivered cost of gas..."(Comments, p. 4.)

As stated above, we do not see the merit of pre-approving a specific hedging plan, especially in the expedited timeframe for this winter. We encourage all of the utilities to hedge as it appears most appropriate to protect core customers. SDG&E and SoCalGas have not proposed any specific modifications to their incentive mechanism, and we will adopt none.

⁸ As ORA points out in its comments, The Post-1997 CPIM Agreement provides the most comprehensive description of the general CPIM structure. It specifically includes a Risk Management Clause which states:

PG&E will be allowed to trade futures, options, swaps, and other financial instruments to manage price and currency risks. These gains and losses resulting from these positions, as well as any transaction costs associated with them, will be included as a cost of gas under the CPIM, but will not be reflected in the benchmark. (PG&E/ORA Post-1997 CPIM Agreement, IV.B., p. 13.)