VIII. Price Benchmarking and the Development of an Incentive Mechanism

A. TURN's Proposed Price Benchmark Strategy

TURN's testimony regarding price benchmarks highlighted several important issues facing this Commission regarding how to reasonably measure what constitutes fair prices. As history has all-to-painfully taught us, the energy markets serving California can be manipulated, so the going rate for energy may not necessarily be the price that would be prevalent in a truly competitive market.

TURN proposed a system for evaluating the reasonableness of utility transactions based upon benchmarks created to approximate actual costs for generation. TURN suggested such a proposal to minimize the effects of potential gaming by producers, as well protect against any gaming that might develop under incentive regulation.

The TURN proposal is based upon the calculations used by the FERC and ISO to determine costs for providing generations services. The FERC uses a measure of short-term utility procurement costs using a Short-Run Marginal Cost (SRMC) approach. The California ISO uses the incremental heat rate of the plant that is on the margin, multiplied by the going price for gas to find the Estimated Competitive Price (ECP) for energy.

As proposed, a SRMC or ECP would be used as a benchmark for evaluating the reasonableness of contracts of up to five years in duration. All contracts that come in at or below 110% of the benchmark price (on average for a one year period) would automatically be deemed reasonable; those above the 110% limit would trigger a reasonableness review. In a reasonableness review, the utility would be required to demonstrate that it gave every reasonable effort to procure at or below the benchmark price.

B. ORA's Proposed Benchmark Strategy for Portfolio Management

ORA provided a detailed discussion of what it called a "rule-based system for utility procurement" that would guide how the utilities managed their portfolio to minimize risk. ORA's recommended portfolio management system would require the utilities to continuously adjust its portfolio based upon periodic updates of price forecasts and risk analysis.

ORA's rule-based system can be split into two major analytical tasks:
(1) forecasts and stress testing of forward prices, and (2) risk analysis based upon the forecasting. The outcome of the risk analysis would guide how the utility would manage its portfolio. ORA recommended that each utility undertake its own forecasting effort, and evaluate the price exposure of its portfolio using low-probability scenarios (i.e., extreme system conditions). The final portfolio would be adjusted frequently to minimize price risks.

C. Discussion

While we do not adopt the TURN methodology for utility procurement in this decision because it would necessitate after-the-fact reasonableness reviews, we agree with TURN that cost-based benchmarks are a useful tool in determining the health of California's energy markets.

We also do not adopt ORA's rule-based system in this decision. We appreciate ORA's robust methodology for calculating forward prices, and agree with ORA that the utilities should focus on a portfolio management strategy that minimizes price risk to ratepayers. We do not adopt the ORA proposal because we find it is in the ratepayers' interest to allow utilities more flexibility in managing its portfolios than a formulaic approach would provide.

Though we adopt neither the TURN nor the ORA approach to price benchmarking, we believe both proposals point to the necessity both of determining what "just and reasonable" prices are in this market and of measuring utility procurement performance in light of the reality of the market.

We find that the TURN proposal could be modified to trigger, rather than after-the-fact reasonableness review (which AB57 steers us away from undertaking), an incentive mechanism that rewards the utilities for beating the benchmark and penalizes them for exceeding it, within certain limits. We seek further input from parties on the proper design of such an incentive mechanism, for purposes of the utilities' long-term procurement plan. To facilitate this input, we direct SDG&E, in cooperation with the other utilities, to sponsor an all-party workshop to develop a consensus proposal for an incentive mechanism. To the extent that consensus is reached, the proposal should be filed as part of the utilities' long-term procurement plans. If consensus is not reached, SDG&E should file a separate workshop report by February 15, 2003, detailing areas of agreement and disagreement among parties for our further consideration.