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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

in the benchmark through a formula that adapts to relative prices to some extent. 7 However, designing a benchmark formula to better reflect how procurement should adapt to external conditions will tend to increase its complexity, which can render it more costly to audit and increases the potential for misunderstandings or disputes.

While it is important for a GPIM benchmark to reflect external conditions that are outside of utility control, such as load and prices, it is also important that a GPIM benchmark not use parameters that are under utility control or reflect utility choices. It is a fundamental principle of the design of incentive mechanisms that a benchmark should provide an external and independent basis for evaluating company performance. This means that the benchmark must be calculated using only parameters and assumptions that are independent of the utility’s actual purchasing decisions (we call this an exogenous benchmark). If the benchmark is exogenous, the utility can only increase its reward by lowering actual gas cost, not by raising the benchmark, with utility and customer interests aligned.

Any assumptions in the benchmark calculation that are affected by utility choices result in a benchmark that is not exogenous, and some distorted incentives. Such a GPIM sometimes will reward actions that are not in the customers’ interest, or fail to reward actions that are in the customers’ interest.

Common Pitfalls in GPIM Design

The preceding discussion suggests that GPIMs focus on providing incentives for short-term procurement. Their designs should apply a strong incentive—not blunted by caps on rewards or large tolerance bands—equally to all costs and revenues related to short-term procurement. They should use a benchmark that approximates a reasonable procurement strategy, is independent of utility choices (exogenous), and is designed to adjust to external conditions such as market prices and load levels. GPIMs with such designs provide strong incentives to procure gas supplies at least cost.

Our review has found that existing GPIMs generally do not achieve all of these design objectives, and, consequently, they provide weak or distorted incentives for some types of procurement actions, or they expose the utility and customers to some risk of rewards or penalties that may at times be excessive and undeserved.

Of course, utilities will not necessarily act according to the incentives of their GPIM, especially when there is a known conflict with customers’ interests. This does not mean such conflicted incentives are benign. To the extent such conflicts exist, the incentives serve no useful purpose while increasing the risk of actions contrary to customers’ interests and the potential need for more detailed review of purchasing decisions.

One common GPIM design characteristic that can lead to incentive problems is the application of GPIM incentives only to certain cost components. 8 This may allow the utility to increase its GPIM reward by spending relatively more in areas where incentives do not apply, to reduce other costs to which stronger incentives apply. For example, some GPIMs exclude revenues from release of interstate transportation capacity, passing all such revenue through to customers. When such capacity is released, the utility may