3. The Energy Division Evaluation

Much of the testimony at hearing and many of the terms of the proposed Settlement Agreement centered on the evaluation report prepared by the Commission's Energy Division. The report is a comprehensive 37-page analysis of the history, function and results of the GCIM. It was made part of this record as Tab D of SoCalGas direct testimony (Exhibit 1).

As the report notes, the GCIM is intended to benefit core customers. Core customers are those who lack alternatives to natural gas service, such as residential and small commercial customers. Noncore customers are large businesses capable of switching from natural gas to alternative fuels such as oil and propane. Noncore customers typically are large commercial and industrial firms and utility electric generators.

The Energy Division evaluation notes that the Commission has advocated the use of incentive regulation for energy utilities since the early 1990s. The Commission adopted gas cost incentive mechanisms for San Diego Gas & Electric Company in 1993, SoCalGas in 1994, and PG&E in 1997. The Energy Division states:

"Prior to the implementation of these mechanisms, the Commission conducted annual reasonableness reviews of the utilities' gas procurement costs. Gas utilities had little incentive to take risks to attempt to lower gas procurement costs. Their only incentive to take `reasonable' measures to keep gas costs low was the threat of the annual reasonableness review. Gas costs, if found reasonable, would simply be recovered from ratepayers, with no rewards for utilities doing an exceptional job." (Evaluation, at 4.)

The GCIM establishes a benchmark cost of gas intended to emulate actual market conditions on a monthly basis. For the most part, the benchmark has been based on southwest gas price indices published in the publications Natural Gas Intelligence, Inside FERC Gas Market Report and Natural Gas Week, and these indices in turn reflect a weighted combination of basin or border prices. A tolerance band, or deadband, is placed above and below the benchmark cost to provide flexibility in gas procurement. Savings and losses to shareholders and ratepayers are neither shared nor incurred when they are within the tolerance bands.

The Energy Division concludes that gas purchases made under the GCIM "are definitely far more favorable to ratepayers than those made when reasonableness reviews were in effect." (Evaluation, at 20.) During the first six years of the program, gas was procured at savings of $42 million below the benchmark prices, net of the shareholder incentives. Because SoCalGas receives awards based on these savings, it has had an incentive to expand its Gas Acquisition Department and to engage in cost-saving gas procurement methods. These methods include sales of core gas to other parties, hub transactions that provide parking, loaning and wheeling services for negotiated fees, and financial instrument transactions, including futures contracts and swaps.

The Energy Division analysis concludes that there are other advantages to the GCIM. Among them:

· Under the GCIM, the utility is able to focus on the current gas market rather than trying to justify the reasonableness of decisions in anticipation of hindsight review. SoCalGas also has the flexibility to take reasonable risks, knowing there could be a sharing of financial rewards or penalties associated with these decisions. Because the utility is not primarily concerned about Commission staff discovering information regarding potential disallowances, the Energy Division states that there is better communication between ORA and SoCalGas regarding purchasing and gas accounting practices and operations.

· There has been a significant reduction in the manpower and resources devoted to regulation of gas procurement activities. Previously, the annual reasonableness review consumed thousands of hours of review and extended for years after the costs in question were incurred. Today, SoCalGas presents detailed reports to the ORA and the Energy Division on a monthly basis, and the annual audit generally is completed within a year.

· According to the Energy Division, the GCIM is superior to alternative methods of regulation. A return to reasonableness reviews would eliminate much of the incentive that the company has to reduce gas procurement costs. Eliminating the core procurement function of SoCalGas could lead to higher costs for consumers. Substituting a forecast of gas costs in the base rate instead of relying on the GCIM is undesirable because, according to the Energy Division, "gas forecasting is a notoriously inaccurate business." (Evaluation, at 30.)

In summary, the Energy Division concludes that the GCIM provides a regulatory mechanism superior to reasonableness reviews, has encouraged innovations in procurement practices that have reduced costs for consumers, and there has been no curtailment of service to core customers. With that said, however, the Energy Division also recommends that the Commission consider modifications to the GCIM. These recommendations include the following:

· Reduce the potential size of the shareholder award from its current level of 50% and increase the lower tolerance band from its current level of ½% so that greater savings would be required before the sharing formula takes place.

· Modify the percentages of savings shared by ratepayers and shareholders so that initial gains go primarily to ratepayers while more difficult gains are allocated progressively to shareholders.

· Eliminate the New York Mercantile Exchange (NYMEX) component of the GCIM benchmark, since use of this alternative weighting for gas futures has declined in recent years.

· Consider incentives to encourage purchases from the least-cost basin and to encourage optimal use of storage injections and withdrawals for price advantage.