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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

used in the benchmark. For example, a utility buyer can receive a discounted price on a deal by offering a seller valuable flexibility, such as rights to recall the supply or terminate the contract at any time during the month. However, such recall rights could lead to costly replacement purchases when the supply is recalled under tight market conditions. If the utility is able to arrange the replacement purchases so that they are priced at benchmark (perhaps by initially relying on storage, to defer replacement to a later month when the gas can be purchased at index), it will have an incentive to enter into such contracts to increase its GPIM reward, even if total customer gas cost is raised as a result. 12

These examples suggest just a few of the ways compromises to the GPIM design principles can lead to distorted incentives and opportunities for the utility to increase its GPIM reward through actions that are contrary to the interests of customers. How frequently these opportunities arise, and the strength of the distorted incentive when they do arise, will depend upon other GPIM characteristics and the particular utility circumstances. A more detailed treatment of GPIM incentives and incentive problems is included in the authors’ longer paper on this topic.

GPIM Review and Assessment Procedures

In principle, strong, well-aligned incentives provided by a GPIM obviate the need for detailed regulatory review of the reasonableness of a utility’s performance of the gas procurement function. To the extent a GPIM provides distorted incentives, the need for regulatory review of some aspects of utility decision-making actually is greater than in the absence of direct incentives, such as when there is no GPIM.

Our review of multiple GPIMs, of documents representing reviews of GPIM results, and of regulatory commission orders approving the associated rewards, suggests that in a number of instances, the regulatory staff reviewing the GPIM filing may be unaware of the extent of a GPIM’s shortcomings and the areas where it can provide weak or distorted incentives. In these instances, staff and the commissions may be unaware of the full scope of opportunities to increase the utility reward at the cost of customers, and, consequently, may not be adequately reviewing utility actions to ensure that such gaming has not taken place to a significant extent. In some instances, staff reviews and commission orders on GPIMs apparently assume that if actual costs are below the benchmark, customers have benefited, and there is little need for a detailed review.

This brings us to another common problem with the GPIM review process—misinterpretation of the difference between the benchmark gas cost and actual gas cost. A utility operating under a GPIM often will interpret this difference as “savings” for customers, suggesting that it reflects superior utility performance under the GPIM. Such claims are echoed by the regulatory commission staff or consumer advocate staff responsible for reviewing the GPIM filing, 13 and reflected in the commission order approving the incentive reward. 14 However, this claim is true only if the benchmark formula accurately estimates the costs that would