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Natural-Gas Procurement: A Hard Look at Incentive Mechanisms

Better designs are needed to realize the goal of lower-cost gas.

Fortnightly Magazine - February 2006

incur additional cost for short-term transportation or downstream purchases, and it also may lose opportunities for profitable off-system gas sales. The potential revenue from a capacity release may be much greater than the incremental supply and transportation cost, lowering total cost, but the capacity release would be discouraged by a GPIM that includes the supply and transportation costs but ignores the capacity release revenue. In this example, the LDC’s incentive under the GPIM can be contrary to the interests of its customers.

Another very common design compromise is the use of actual utility purchase volumes in the benchmark calculation. 9 The motivation for doing this is clear—it is a simple approach to creating a benchmark that adapts to a broad range of external circumstances, such as changing relative prices and overall load levels. However, when a GPIM benchmark uses actual utility purchase or net purchase volumes (or weights reflecting them), it means that the utility’s actions affect the benchmark, and it is no longer exogenous. The result is that incentives are distorted to a surprising extent.

As a simple example, consider a utility that can purchase supply from either of two basins, A or B. Figure 2 illustrates that when actual purchases are used in the benchmark, each purchase is essentially benchmarked to a price index at its location. As a result, the GPIM incentive is not to purchase the least-cost supply, but to make the deal that allows beating the respective locational price index by the largest amount, earning the largest incremental reward. By contrast, if the volumes used in the benchmark are independent of utility choices (for instance, set by a rule that is a function of actual loads and market prices, which the utility does not control), the utility always has the proper incentive to purchase the lower cost supply.

Use of actual net-purchase volumes in the benchmark creates similar incentive problems with respect to use of storage and the timing of purchases, as it reflects actual storage choices in the benchmark. As an illustration, suppose a utility chooses to delay storage injections during spring and early summer, planning to catch up later in the summer. An exogenous benchmark would include a specific storage injection schedule, or one based on parameters independent of the utility’s actual choices, placing the utility at risk for a share of the cost impact of deviations from the benchmark schedule. With a benchmark that uses actual net purchases reflecting storage, the utility would be at no risk for whether its choice turned out well or poorly, as the benchmark would reflect the choice. The consequences, however, could be costly for customers. 10

Use of net-purchase quantities (reflecting storage) in the benchmark can create more serious and frequent incentive problems depending upon other benchmark characteristics, such as use of first-of-month prices in the benchmark that apply to incremental sales or purchases on the daily market. 11

Use of actual purchase volumes in the benchmark also distorts incentives with respect to additional contract provisions that change the value of a contract relative to the price indexes