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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

revenues as is feasible, within a single incentive calculation applicable to all costs, provide the best incentives.

The actual utility reward or penalty under a GPIM is determined in a periodic (usually 12-month) GPIM accounting, in which the GPIM’s sharing rules are applied to the difference between benchmark and actual costs. Typically, 50, 25, or 10 percent of the difference may be assigned to the utility. A higher percentage provides a stronger incentive, but also imposes more risk and could lead to more risk-averse, cautious actions; the utility might tend to forgo opportunities that are attractive in expectation but somewhat risky, raising gas costs. A larger percentage assigned to the utility may also lead to very large rewards because of external conditions that cause a greater difference between benchmark and actual gas costs. In general, a GPIM’s sharing parameters are set to provide strong incentives while also balancing these other concerns and objectives under particular utility circumstances.

Tolerance bands, within which there is no reward, are common, as are caps on rewards or penalties, and sharing percentages that vary by the size of the reward. These features tend to reduce incentives, and they also can lead to some distortion of incentives.

Design of the Benchmark

The central element of GPIM design is the benchmark formula, which affects the relative likelihood of reward or penalty, the strength and nature of incentives, and the extent to which the utility is exposed to external risks as a result of the GPIM.

The simplest possible GPIM would entail a benchmark gas cost that is a fixed dollar figure set in advance, representing a forecast of gas cost. However, this simple approach would expose the utility to substantial risk due to factors that it cannot control, such as the weather-induced variability of gas loads or large movements in natural gas market prices. To remove these risks from the mechanism and focus incentives on factors under utility control, benchmark formulas typically take into account load levels and market-price indexes.

The overriding objective of a GPIM is to provide incentives for performance surpassing that which would be reasonable and expected under traditional regulation. Under a GPIM, there is no incentive reward or penalty if actual costs equal (or are within a tolerance band around) the benchmark, and the utility receives an incentive reward if it beats the benchmark. This suggests that, in principle, the benchmark should be designed to reflect the gas cost that would result from a reasonable procurement strategy reflecting acceptable, but not superior, performance deserving of no reward or penalty. However, in practice, benchmark formulas are kept simple, and, as a result, benchmarks often reflect implied purchasing rules that can be easy to beat.

For example, under some GPIMs, the benchmark assumes purchases from available supply basins in fixed proportions, based on historical averages, a gas supply forecast, or firm pipeline reservation quantities. 6 The resulting benchmark is easy to beat if relative prices change and the utility is able to optimize purchase locations accordingly. Other GPIMs determine the purchase locations and timing to be assumed