5. Preliminary Scoping Memo

In this Preliminary Scoping Memo, we describe in broad terms the issues to be considered in this proceeding regarding prospective changes to the gas utilities' incentive mechanisms and the treatment of hedging under those incentive mechanisms.

This Rulemaking will examine:

· the guidelines and policies each utility uses to operate its hedging plan;

· whether the Commission should establish statewide hedging guidelines and policies for all California gas utilities;

· whether hedging costs should be re-integrated into the existing incentive mechanisms, and if so, how;

· alternatively,if a separate incentive mechanism can be designed to compare the cost of a hedging program with market benchmarks thus creating an incentive to manage costs, but that would not penalize a utility for the profit or loss of the hedging program;

· the process under which the utilities' will request authority for implementation of their hedging plan;

· Whether the removal of hedging cost recovery from the incentive mechanisms results in reduced risk borne by shareholders. If so, whether (and how) the incentive mechanisms should be revised to maintain an appropriate sharing of risks/rewards between shareholders and ratepayers; and

· What timetable should apply for purposes of transitioning from currently adopted rules and processes to any revised arrangements adopted through this proceeding.

Depending on the timetable adopted in this OIR for implementing any modifications to existing rules and processes, modifications to the utilities' currently adopted long-term hedging plans may be required.  Accordingly, we hereby place parties on notice that the treatment of long-term hedging plans adopted for PG&E and SoCalGas in D.07-06-013 and D.07-12-019, respectively, may be subject to modification as a result of reforms adopted through this rulemaking

In reviewing the existing incentive designs and hedging practices among the utilities, we recognize that differences between utilities may be attributable to operational variations. We also, however, remain mindful of the benefits of applying conceptual consistency in formulating future regulatory standards and policies applicable to the respondent utilities. While there may be reasons for different designs in incentive mechanisms and treatment of hedging costs, we intend to consider whether, or in what manner, incentive guidelines and hedging policies should apply across the board to all utilities in order to ensure appropriate risk mitigation at reasonable cost.

Currently, it seems that each utility operates under different policies with varying effects on ratepayers. For example, SWG does not engage in financial hedges at all, but does have a Volatility Mitigation Program which includes fixed price contracts entered into for price mitigation. PG&E and SoCalGas, our two largest gas utilities, both utilize hedging, but each seem to be operating under different guidelines or strategies. PG&E has spent almost three times more than SoCalGas, yet PG&E has fewer core customers to protect.¹⁷ We recognize that one possible explanation for at least some of PG&E's relatively higher level of expenditures may be that PG&E's core customers consume more gas in the winter due to a colder climate relative to that of Southern California.

In this proceeding, we seek to gain a better understanding of the reasons for differences in how incentives and hedging policies are applied among the utilities, while protecting the confidentiality of the utilities' hedging plans. As stated in past decisions, the hedging plan is to remain confidential as there is presumably highly sensitive market information involved which, if released, could work toward the detriment of ratepayers. It should, however, be noted that many hedging instruments can be purchased in a liquid and transparent market, and DRA publishes an after-the-fact review of the utilities' performance.

We must first decide at a policy level what the appropriate level of wholesale natural gas price volatility is for core customers. If PG&E is spending three times more for price hedging than does SoCalGas, which has more core customers to protect, then it seems that one utility defines the appropriate level of gas price volatility differently from the other. Alternatively, one utility may have a larger physical hedge (e.g., with storage), thereby allowing them to use a reduced amount of financial hedges. The huge discrepancy begs the question of whether and how the utilities are actively managing their hedging programs. The Commission needs to understand the impact on ratepayers of the different utility hedging plans and vehicles to allocate risks between shareholders and ratepayers. It is also instructive to understand how and the degree to which financial hedging is being utilized to protect against rate volatility and/or extreme price increases. Bill volatility can be stabilized via level pay plan programs currently in place for each utility. This rulemaking should address whether it makes sense to establish a consistent policy across the board that determines when winter hedging should begin, what the acceptable level of gas price volatility is, and what level of risk should be undertaken in order to ensure reasonable expenditures of ratepayer dollars.

We shall also consider how incentives should be provided for effectively managing the hedging programs. The profit/loss of a hedging program is mainly determined by market fluctuations, and only marginally impacted by utility performance. The utilities have argued that they should not be at risk for the profit/loss of a hedging program. As stated previously, beginning with winter 2005/2006, PG&E, SoCalGas, and SDG&E were granted authority to hedge outside of their respective mechanisms, based on their respective hedging plans. Furthermore, these utilities requested and were granted a modification to their incentive mechanisms so that all costs and benefits of their winter hedge programs are allocated directly to core customers without risk to shareholders.

On the other hand, we seek to explore whether the structure of the gas cost incentive mechanisms for each of the utilities is flexible enough to adequately insulate shareholders from significant risk. In addition, if hedging instruments are purchased in a liquid and transparent market, we could examine whether it is possible to design a program that compares the cost of a hedging program itself with market benchmarks, and puts the utility at some risk for variations from the benchmarks.

Each utility has a slightly different incentive mechanism based on their respective compilation of core assets. Each year the respective utility files an application or report with the Commission summarizing their results from the prior year with either a shareholder gain or loss. After the utility makes its filing, DRA conducts a full audit of each incentive mechanism and files its monitoring and evaluation report. The Commission then issues its decision or approval depending on the type of filing made by the utility. Each year since the inception of these incentive mechanisms, the Commission has found that it is in the best interest of ratepayers that these GCIMs and CPIMs continue.

This rulemaking is not intended to be a broad reexamination of the utilities' gas incentive mechanisms.  Each year these incentive mechanisms go through an application process where there is an opportunity to propose modifications.  In this rulemaking, we will focus more narrowly on whether hedging costs should be re-integrated into the existing incentive mechanisms, and if so, how.  For example, we will examine whether the risks and benefits of hedging should continue to be allocated 100% to core customers and whether the incentive mechanism design should be modified in some manner to recognize a decrease in shareholder risk. 

We invite parties to provide comments if they feel that ratepayers could benefit from a certain type of modification to the existing structure of the incentive mechanisms. The Commission invites parties to provide comments on whether a separate hedging incentive mechanism is beneficial. Such an incentive program would concentrate on the cost of running an effective hedging program, not the whether the hedge resulted in a gain or loss.

¹⁷ According to PG&E's website there are 4.2 million customers while SoCalGas has 5.1 million customers.