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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

there are substantial differences in the detailed structures that are not readily apparent from a general description, and these details can have a large impact on their incentive properties and the regulatory outcomes for the utility and customers. Most utilities across the country operating under GPIMs have regularly beat their benchmarks and earned incentive rewards. However, many GPIMs have been criticized and frequently modified, and some have led to disputes or allegations of utility misconduct. 1 Some GPIMs have been terminated, either by the initiative of the regulatory commission or the utility itself. 2

GPIM Objectives, Scope, and Structure

The objective of most GPIMs is to provide incentives for achievement of lower short-term procurement costs. As such, they are generally not designed to incent or reward provision of reliability or price stability, which are different and competing objectives for which it would be difficult or impossible to provide effective incentives within a single incentive mechanism. Nor do GPIMs attempt to provide incentives with respect to decisions concerning long-term firm pipeline and storage reservations, which usually are reviewed and approved separate from a GPIM. However, management of such assets in the short term, including revenues from gas sales or capacity release, generally is within the scope of a GPIM’s incentives.

Many current GPIMs were designed in the mid-1990s when gas prices were relatively low and stable, and few if any utility commissions were encouraging utilities to hedge gas costs. So it is not surprising that many GPIM benchmarks assume only short-term gas purchases (with monthly and daily pricing), and little or no hedging other than through storage. 3

However, as natural-gas prices have increased and become more volatile in recent years, interest has grown in providing customers with greater price stability, which can be achieved through physical forward purchases or financial hedging. When a GPIM benchmark includes only short-term purchases, it places the utility at risk through the GPIM for the costs and outcomes of any substantial amount of forward physical purchases or financial hedges. This discourages hedging.

To accommodate an approved level of hedging, a GPIM can include a target schedule and quantity of hedging in the benchmark. 4 The utility is permitted to hedge more or less, or sooner or later, than the benchmark schedule (perhaps limited to some range), and is at risk for whether its adjustments to the schedule ultimately result in higher or lower gas cost. Another approach to accommodating hedging is to exclude both the costs and impacts of hedges from a GPIM.

With respect to short-term procurement-related costs, many GPIMs are designed to provide incentives for all or nearly all such costs and associated revenues, including supply, transportation, and storage. 5 (Note that a GPIM provides an incentive for a particular cost or revenue category if it establishes a separate benchmark value for it; if instead the cost category is excluded from the calculation of benchmark and actual costs, or if the actual cost value is included in the benchmark, no incentive is created.) GPIMs that encompass as broad a scope of interdependent procurement-related costs and