VI. Discussion

A. Emergency Nature of Petitions

We first address whether in fact the petitions make the case for emergency action by the Commission, as the utilities propose. We find that they do not. Last year, the Commission took emergency action on related utility petitions following an extraordinary event, namely, the devastation by Hurricane Katrina to the Gulf Coast, an area that produces and refines a substantial portion of the country's petroleum supplies. D.05-10-015 and D.05-10-043 found that Hurricane Katrina "had a major adverse impact on natural gas markets," disrupting 16 percent of the natural gas production for the United States and resulting in a dramatic rise in gas prices. On this basis, we took emergency action to relieve the utilities of liabilities associated with hedging and to encourage their purchase of hedging instruments to protect ratepayers. No events have occurred this year that would create an emergency circumstance and none is anticipated except to the extent there is always some probability of events that could disrupt gas supplies or affect market prices. Although PG&E states that it needs expedited action on its petition because of the impending hurricane season, the onset of the hurricane season is not news and is certainly not unforeseen.

By seeking Commission decisions only weeks after the filing of their petitions, the utilities seek extraordinary treatment of their petitions with little justification. The utilities themselves waited to file their petitions for seven months following last year's decisions. Moreover, the utilities already have authority to purchase hedging instruments within their respective incentive mechanisms, and, in the case of PG&E, to purchase hedging instruments outside their respective incentive mechanisms for this year and next. These petitions merely seek authority to spend additional ratepayer funds on hedging instruments outside existing regulatory mechanisms. Although we appreciate the need for the utilities to purchase hedging instruments now if they are going to purchase them at all, a request for additional ratepayer funds to spend on hedging instruments hardly constitutes an emergency under the circumstances.

B. The Need for Hedging Instruments for Natural Gas Supplies

The utilities have developed plans for purchasing hedging instruments on behalf of their respective core ratepayers, believing that hedging is a type of insurance against the price impacts of catastrophic events such as Hurricane Katrina and market volatility generally. The utility petitions explain why existing incentive mechanisms do not provide motivation for them to purchase what they believe are optimal investments in hedging instruments, namely, that hedging instruments generally present shareholders with too much risk. Each utility has purchased hedging instruments over the years as part of its natural gas portfolios and subject to its incentive mechanism. Each utility intends to continue to purchase some hedging instruments within its incentive mechanisms.

In October 2005, the Commission approved the utilities' emergency requests for authority to purchase hedging instruments outside of their incentive mechanisms following a devastating hurricane that affected national prices for natural gas. During that extraordinary period, the ratepayers of two of the utilities received no benefit from utility investments in hedges. The ratepayers of the third received almost no benefit. This year, the utilities want to spend considerably more on hedging instruments and plan to hedge much larger proportions of their total portfolios. Unlike last year, the market for natural gas is relatively stable and there is no expectation of natural catastrophe. On the other hand, the utilities did demonstrate that natural gas markets are more volatile than they have been for many years.

Although market conditions are in recent years less stable than they have been historically, market conditions alone do not justify spending enormous sums on insurance for substantial portions of the utilities' gas portfolios. The utilities did not support their proposals by demonstrating that they were consistent with best practices, prevailing financial theory or statistics about the effects of purchasing such financial instruments on natural gas rates in other jurisdictions. Neither did the utilities provide an evaluation of what ratepayers would be willing to pay for various levels of protection from price spikes. The only justification the utilities provide is their wish to reduce the risk of price spikes and higher rates. The lack of supporting analysis is of particular concern because the utilities are proposing much higher levels of hedging purchases and spent large sums last year that provided almost no benefit to ratepayers. Moreover, the utilities are proposing that ratepayers assume all of the risk for these investments absent any regulatory incentive mechanism and without any reasonableness review.

In effect, the utilities seek authority to spend hundreds of millions of dollars of ratepayer funds at their discretion on financial products they themselves describe as expensive and in financial markets they describe as highly volatile. Viewed from this perspective, our approval of the utilities' proposals as they are presented to us would be irresponsible.

On the other hand, we understand the utilities' concerns, which we share, that ratepayers be protected from price spikes in gas markets. Hedging is a form of insurance. Most individuals in the state's economy purchase insurance as a way to protect themselves from loss associated with fire, catastrophe, accidents or illness. Whether they are willing to purchase insurance against higher natural gas costs and how much they would be willing to spend are open questions. With the appropriate ratepayer protections, the utilities should be able to make those decisions on behalf of ratepayers, just as they must decide when and where to purchase gas, and when to inject gas into storage and use it. The question, therefore, is how to motivate strategies for the purchase of hedging instruments that are cost-effective and provide appropriate incentives for the utilities to make wise decisions on behalf of ratepayers. We discuss the utilities' common proposal for how the Commission would oversee their purchases below.

C. Pre-Approval of Utility Hedging Plans

Each utility petition provides an outline of a hedging plan. Each plan provides some information about the types of instruments the utilities might purchase, the dollars they might spend, strike prices, the amount and type of gas they would hedge and the impact on utility rates. Each utility presented highly qualified and credible experts at the Commission hearing who explained each program element in response to questions and described the various hedging instruments they might purchase.

The utilities seek Commission approval of these hedging plans and propose that this approval would represent adequate regulatory protection for ratepayers in the utilities' use of ratepayer funds. The utilities ask us to forego any retrospective review of the purchasing decisions of utility managers, although they state their intent to provide ongoing program information to Energy Division, DRA and TURN.

The information provided by the plans and the expert witnesses, however, is not adequate for the Commission to approve the plans. That is, the plans could permit the utilities to use very poor judgment about the instruments they might purchase and there would be no recourse for ratepayers who fund those purchases. Although the utilities' state the Commission could monitor the purchases for problems, they propose to be excused from retroactive reasonableness reviews. In responses to related questions, the utilities' witnesses refer to a "compliance" process, which they distinguish from a "reasonableness review." The utilities suggest at least inferentially that they would not be held accountable to ratepayers even if the Commission uncovered evidence of fraud or abuse.

The utility plans are broad outlines of the utilities' hedging programs, providing almost no detail about purchasing strategies. The plans do not provide any assurance as to how the utility's purchasing strategy would be optimal for ratepayers as time passes and market circumstances change. Making a decision about whether to buy a hedging instrument requires judgment not implied in purchasing utility equipment. Unlike a contract for a utility product or service, purchasing hedging instruments requires knowledge of future purchasing decisions that we cannot evaluate in advance. Thus, our approval of these plans in advance is not comparable to our advance review and pre-approval of pipeline capacity contracts, advanced metering equipment or incremental gas storage service. We could not regard our approval of these plans as adequate regulatory oversight in light of the costs involved and the fact that specific hedging decisions are determined after we render our opinion.

Moreover, our responsibility is not to supervise day-to-day utility operations but to provide appropriate incentives for efficient and effective utility management. For the same reason, we would not delegate to Commission staff or any intervenor responsibility to oversee utility investments in financial instruments as a substitute for enforceable regulatory protections for ratepayers.

We therefore decline to pre-approve any utility hedging plans and proceed to determine other options for regulatory oversight of utility hedging strategies.

D. Appropriate Ratemaking for Hedging Programs

The utilities claim their existing incentive mechanisms do not provide adequate motivation for them to invest in hedging mechanisms at a level that might be optimal to protect ratepayer interests. Their witnesses explained that hedging has become increasingly risky and expensive. They also state that the incentive mechanisms do not align ratepayer interests with shareholder interests; that is, shareholders may be in a position of "winning" when market prices go up.

The utilities have the authority to implement their hedging plans within existing incentive mechanisms. In fact, they have considerable experience hedging within the parameters of existing hedging mechanisms. SoCalGas in particular has used hedging very effectively and benefited substantially in recent years. PG&E in particular argues that under the incentive mechanisms, utility and ratepayer interests are misaligned with regard to the effects of hedging because hedging rewards shareholders when market prices go up. SPURR makes a reasonable argument that when a utility realizes returns on hedging within the incentive mechanism, ratepayers in fact also "win" because they are not saddled with higher gas prices. Moreover, if there were a potential "misalignment of interests" that would present a substantive conflict for shareholders, we would prohibit the utilities from purchasing hedging instruments through their incentive mechanisms. This is a restriction the utilities explicitly do not propose and, given SoCalGas' favorable investments with hedging instruments, would probably not be wise.

Overall, we find that existing incentive mechanisms may not be designed to accommodate hedging activities that might be reasonable given changing market conditions. On the other hand, those mechanisms provide essential protections for ratepayers. We are not willing to abandon those protections on the basis of the record we have before us and considering the costs to ratepayers of last year's hedging strategies.

We have stated our view that hedging may represent one element of a good procurement strategy and also that this Commission is not in a position to judge the details of day-to-day financial transactions. These two important elements of our thinking motivate us to provide the utilities with some freedom to purchase hedging instruments. On the other hand, we are not willing to give the utilities what is tantamount to a blank check to purchase high risk financial instruments, while taking no risk for the management of their purchasing strategies and absent any meaningful regulatory oversight of those strategies.

The utilities make a reasonable case that they may not be able to justify the shareholder risk that could be implicated if they were to engage in an optimal amount of hedging within their respective incentive mechanisms. The utilities have generally opposed increasing the tolerance bands for their incentive mechanisms on the basis that the change could reduce their prospects for shareholder awards. The record here provides little analysis of the potential impacts of increasing the tolerance bands under different scenarios and, because this aspect of the incentive mechanisms is complex, we are not prepared to increase the tolerance bands at this juncture, as DRA proposes. This and other ratemaking alternatives may deserve additional consideration in the utilities' applications for a permanent hedging ratemaking mechanism.

The option that has considerable appeal for us at this point is DRA's compromise suggestion that some portion of the costs and benefits of hedging positions be included in the incentive mechanisms, with the remainder allocated directly to ratepayers. This option limits shareholder exposure to risk but creates enough risk that the utility will be motivated to purchase only those instruments that appear most likely to provide some ratepayer benefit. Because the utilities state that all hedging instruments have an expected value of zero - and that the utilities cannot affect or game the market - this modification to our ratemaking policy for hedging is fair and will promote conservative, thoughtful purchasing strategies.

We will direct the utilities to account for all hedging purchases the same. That is, each utility may choose to allocate either 100% or a 25% share of the costs to their respective incentive mechanisms. They may not allocate 100% of some purchases to the incentive mechanisms and 25% of others to the incentive mechanism. This restriction will eliminate any concerns that the utilities might treat high risk investments differently from lower risk investments in ways that skew risk toward ratepayers and potential reward toward shareholders.

We do not adopt the utilities' proposed dollar caps on spending for hedging instruments at this time, partially because the record is unclear as to what amounts the utilities are proposing and the associated liabilities ratepayers would assume. Instead, we limit increases to each utility's rates for hedging in winter 2006-07 to $14 per customer if the utility chooses to allocate 75% of hedging costs outside of its incentive mechanism. The amount would not include instruments commonly known as "swaps," which do not have pre-paid premiums. This amount provides adequate funding for hedging and is reasonable until and unless we have information about utility customers' willingness to pay for gas hedging. If a utility chooses to account for 100% of hedging purchases in its incentive mechanism, this limit on rate increases would not apply. We also have no objection to the utilities' plans to engage in "swaps." However, we adopt DRA's suggestion that the utilities limit their hedging to the winter period for 2006-07. If the goal is to limit risk of price spikes, this limitation is reasonable. The utilities may address how year-round hedging purchases are compatible with a sound procurement strategy in applications for permanent hedging programs.

The authority provided in this order to each utility to account for 75% of hedging purchases outside its incentive mechanism applies to all hedging purchases made for the 2006-07 winter season. Each utility must inform the Commission's Executive Director in writing no later than 15 days from the effective date of this order whether or not it intends to take advantage of this option, rather than accounting for all hedging within its incentive mechanism. Once this notice has been provided, the utility's option shall not be revocable.

E. Utility Reporting

We agree with DRA that each utility should be directed to provide a report of the results of its hedging programs. The reports will provide some evidence to evaluate the merits of the programs and may be useful in guiding future ratemaking and policy in this area. The utilities have not made a compelling case for retaining the confidentiality of past hedging activities in light of our commitment to an open and transparent ratemaking process. The utilities' reports should therefore be made public and provided to any interested party who requests a copy. The reports should provide the following information:

· Total funds spent on hedging instruments;

· Total losses and gains for each category of hedging instrument;

· Amount of natural gas supplies hedged monthly; and

· Impact of hedging program on utility rates.

The utilities should be prepared to provide more detailed information to DRA and the Commission's Energy Division upon request and the reports should be filed by April 1, 2007. The utilities should notify parties to these proceedings of the availability of the reports and provide paper copies to the ALJ and the Commission's Energy Division.