IX. Risk Management

5. Timing Risks - Exercising Caution and Allowing the Market to Develop

We expect each utility to utilize a procurement strategy that fulfills its procurement needs over time (rather than signing contracts for its entire residual net short energy needs in a short condensed time-frame). Each utility shall modify its procurement plan on November 12^th to include details of how the utility plans on procuring over a period of time.

6. Supply Risks - Diversifying the Supplier Portfolio

The utilities shall seek to secure diversity in counterparty representation within its contract portfolio; not all contracts should be with one supplier or limited set of suppliers. Modified procurement plans filed on November 12^th shall discuss how the utility will ensure that if contracts with a variety of counterparties. In addition, utilities should not rely on generation based on only one fuel source. We encourage the utilities to devise a strategy for procuring generation from a variety of fuel resources. Utilities should also address on November 12^th their use of demand reduction products.

7. Price Risks - Establishing Consumer Risk Tolerance Level For Overall Portfolio

PG&E and SDG&E state in their testimony that their risk management policy would be dependant upon an unspecified level of acceptable cost for protection against price spikes. Edison discusses its current risk management policy, but does not provide its target level of risk tolerance (described as acceptable costs to avoid price spikes). In their filed procurement plans, the utilities decline to recommend or quantify a level of price risk tolerance.¹⁶ Determining consumer risk tolerance for the overall portfolio is critical for the utilities.

Our objective is to create a procurement policy that ensures low and stable rates.

The utilities have not filed any real details for the level of consumer risk risk tolerance that should be considered acceptable.

It is clear that in order to develop coherent procurement strategies, the utilities must be able to evaluate potential transactions in terms of the costs of the transaction against the elimination of potential price risk. Given the lack of record, we require the utilities to provide a level of consumer risk tolerance, along with a justification for the level they propose in their modified procurement plans on November 12th. In reviewing the modified utility procurement plans, we will accept or modify their proposed consumer risk level. The utilities shall use the approved consumer risk tolerance level in preparing their updated procurement plan for the following quarter.

On a parallel track, the Energy Division shall retain a consultant to gather additional information regarding appropriate consumer risk tolerance levels. We expect that the consultant's final report will be incorporated into our review process for 2004.

We note that we have moved significantly from the situation of recent years where the majority of the consumers' energy needs were procured on the spot market, subject to extreme price volatility. Utilities are now required to retain their remaining generation and use it to serve customers on a cost of service basis as specified in AB 6X. DWR has entered into over 10,000 MW of long term contracts that further reduce the reliance on spot purchases, and reduce potential price volatility. In D.02-08-071, we granted utilities the authority to enter into additional contracts that will further reduce any reliance on spot purchases and reduce consumers' risks of price volatility. Thus, we have moved from a situation with near total exposure to volatile market prices to one where, depending on the level of utility transitional contracting, essentially none of consumers' needs will be subject to market volatility.

Whether we return in the future to having any significant reliance on spot markets will depend in part on developments in the markets themselves and FERC regulations. Future consideration by the Commission of other alternatives to meeting consumers' needs, including demand response and energy efficiency programs, transmission infrastructure additions, and other options such as utility ownership of generation facilities, will also impact the extent to which utilities are to rely on short-term procurement options.

8. Reliability Risks

Closely related to the concept of determining the appropriate level of price risk in each utility's procurement strategy is determining the appropriate degree of reliability risk. Reliability risk is concerned with the availability of sufficient energy to meet expected demands, particularly during peak periods. At its extreme condition, reliability risk recognizes the possibility of there being insufficient energy, at any price, available to meet demand.

In their previous filings where the utilities performed calculations of their residual net short, the utilities had to develop forecasts of a number of key inputs. These included such factors as what type of weather year, forecasts of demand, and the expected availability of utility retained generation, DWR and other contracts, and the availability of additional energy in the Western market. While many of these calculations were sufficient to develop the residual net short and to start developing procurement strategies, they may not have been as useful as they should have been in determining the reliability of their procurement strategies, particularly under stressed system conditions (such as abnormally hot weather or above normal plant outages).

Therefore, we will direct the utilities, as part of their November 12^th filings, to address the underlying reliability risks inherent in their procurement strategies under varying degrees of stressed system conditions.