REGULATORY GUIDANCE FOR GAS HEDGING: WHY AND HOW MUCH

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REGULATORY GUIDANCE FOR GAS HEDGING WHY AND HOW
MUCH?

• Ken Costello
• Senior Institute Economist
• The National Regulatory Research Institute
• The NARUC Subcommittee on Accounting and Finance
• Columbus, Ohio
• September 16, 2003

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The Increased Importance of Hedging in the
Natural Gas Industry

• The high volatility of gas prices, especially in
  recent years, has become an inherent feature of
  the gas commodity market
• Increased price volatility implies increased
  probability of price spikes
• Recent events and prospects for the future
  warrant serious consideration of hedging by gas
  utilities, including with financial instruments
  (which may have lower costs and more liquidity
  than physical hedges)

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The Increased Importance of Hedging -- continued

• Hedging has been recognized as an essential
  activity by both gas utilities and regulators
• For example, state PUCs have increasingly
  indicated that buying gas at the market or spot
  price may no longer be acceptable (i.e., may be
  imprudent)
• PUCs and gas utilities have other options, in
  addition to physical and financial hedges, to
  help protect consumers from high gas prices

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NARUC/NRRI Survey of 2001

• Most PUCs allow hedging, including with financial
  instruments, and some are even encouraging it
• PUCs seem more comfortable with physical hedges
  than with financial hedges
• Hedging costs are generally recovered through
  PGAs, as they are considered part of purchased
  gas costs
• State PUCs vary in how much upfront guidance they
  are willing to give gas utilities

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NARUC/NRRI Survey of 2001 -- continued

• In my opinion, too many PUCs are giving utilities
  inadequate guidance
• Some PUCs are willing to pre-approve a utilitys
  hedging plan fewer are willing to pre-approve
  the associated costs
• A typical position is go ahead and hedge, we
  wont stop you, but well evaluate the plan and
  the associated activities and costs later by way
  of a prudence review
• Overall, most state PUCs are reluctant to sign
  off upfront to a utilitys hedging strategy

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General Commission Positions on Hedging with
Financial Instruments

• Absolutely no hedging, and surely no speculating
• Hedging may be okay, but, sorry, cant offer any
  guidance
• Hedging requires our (commission) approval of a
  strategy or plan, or compliance with regulatory
  guidelines
• Hedge as much as you like since an incentive
  mechanism (e.g., cost-sharing) will provide you
  with the right incentive to hedge
• You must hedge or else

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Sample of States Having Addressed Hedging

• Arkansas
• Illinois
• Iowa
• Massachusetts
• Missouri
• Nevada
• North Carolina

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Policy Options for State PUCs

• Full commitment (e.g., pre-approval of a hedging
  plan and all of its costs)
• Partial commitment (e.g., pre-approval of a
  hedging plan but not its costs upfront
  guidelines)
• No commitment (e.g., no guidance but
  after-the-fact prudence review)

Which is preferred?
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Why Regulatory Guidance?

• How much to hedge and how to hedge are more
  complicated and subjective than traditional
  gas-procurement decision-making
• Thus, hedging is highly susceptible to
  second-guessing
• Narrows the scope and incidence of prudence
  reviews
• Reduces opportunism by regulators

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Why Regulatory Guidance? --continued

• Avoids placing the gas utility in a dilemma -- no
  hedging versus hedging without regulatory
  guidance in either case, much uncertainty over
  cost recovery by the gas utility (Hobbesian
  choice backing the utility into a corner)
• The overriding concern Disincentives for hedging
  when it would advance the public interest -- LDCs
  have probably been excessively conservative in
  their hedging activities, especially with
  financial instruments, because of the absence of
  regulatory guidance

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Kinds of Regulatory Guidance

• General policy and guiding principles (the volume
  or range of volume of gas to be hedged, the total
  budget for hedging, cost-recovery criteria, the
  mix of hedging instruments that would be
  acceptable, and discretionary actions that are
  allowable during the time horizon of the hedging
  plan, and so forth)
• Guiding principles, for example, could include
  the objectives and general features of an
  acceptable hedging plan, and cost criteria for
  cost recovery
• Pre-approval of hedging plan or strategy (partial
  commitment by the regulator)
• Pre-approval of all costs (full commitment by the
  regulator)

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Basic Questions in Evaluating a Hedging Strategy

• Did the utility take into account the preferences
  of consumers for more stable prices?
• Does the utilitys proposed strategy seem to be
  least-cost in nature, accounting for the various
  hedging options available to the utility?
• Does the proposed strategy allow the utility
  adequate flexibility in responding optimally to
  changed market conditions and other updated
  information?

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A Proposal

• Pre-approval of a hedging strategy but not the
  associated costs
• After-the-fact review of costs related to the
  strategy Did the utility reasonably implement
  the strategy? Did the utility comply with the
  pre-approved strategy? Did the utility adequately
  adapt its strategy to changed market conditions
  and other updated information?
• No micromanaging (e.g., day-to-day oversight) of
  hedging activities

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Rationale for Pre-Approval of a Hedging Plan

• Hedging is susceptible to 20-20 hindsight, more
  so than for traditional gas procurement
  activities (Why?)
• Pre-approval of a plan or strategy would greatly
  narrow the scope of a prudence review, which
  would otherwise be difficult for a utility who
  has the burden of demonstrating prudence or for
  other parties demonstrating imprudence
• Hedging should be viewed as a value-added
  activity distinct from traditional gas
  procurement activities

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Rationale for Pre-Approval of a Hedging Plan --
continued

• A commission should not micromanage the
  day-to-day activities of a utility carrying out
  its hedging plan or strategy
• Pre-approval, by and in itself, reduces
  uncertainty to the utility
• Pre-approval would make it much easier for a PUC
  to determine afterwards whether an outcome fell
  within the bounds of prudent decision-making by
  the utility
• Pre-approval of costs, however, could give a
  utility bad incentives (moral hazard and
  adverse selection problems) for carrying out a
  hedging strategy

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Arguments Against Pre-Approval

• The utility alone should decide its
  gas-procurement and hedging strategies
  commissions dont have the expertise to do this
• The utility might be reluctant to modify its
  strategy and tactics when warranted by new
  information and changes in market conditions
• The utility has the right incentive to know when
  to hedge and how it should hedge
• The utility benefits from hedging, so sufficient
  incentives exist in the absence of pre-approval
• Excessive risks are shifted to consumers

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A Case Study Arkansas PSC Natural Gas
Procurement Plan Rules

• The LDC is expected to take all reasonable and
  prudent steps to develop a diversified gas supply
  portfolio
• The LDC has to submit its gas supply portfolio
  plan (by May 15), along with its contracting
  and/or hedging objectives, for Commission staff
  review and determination as to whether or not it
  appears to be consistent with policy objectives
• Hedging costs, including fee-based costs, can be
  flowed through the PGA or GSR

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Arkansas PSC Rules -- continued

• The LDC has to maintain records for its hedging
  program
• The LDC has to educate consumers on gas prices
  for the upcoming winter heating season and on
  available options to respond to those prices
• The LDC has to offer small consumers a levelized
  billing plan
• LDCs are encouraged to explore and, if
  appropriate, offer fixed-commodity gas supply
  options to consumers

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Observations on the Arkansas PSC Rules

• Both an incentive and information problem in
  achieving the optimal balance of
  gas-procurement objectives dont know or
  difficult to know
• How much hedging core consumers want the utility
  to do
• The least-cost strategy for hedging
• From the utilitys perspective, the incentive of
  hedging versus not hedging

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Observations on the Arkansas PSC Rules --
continued

• Conflicting objectives in that hedging would
  generally be expected to drive up the average
  cost of purchased gas over time
• Rules are premised on the belief that consumers
  value hedging by the gas utility what evidence
  is there to show this?
• The rules require the LDC to submit to the
  Commission its gas-supply portfolio plan, which
  includes its proposed hedging strategy, in
  advance for review and evaluation (eliminates
  some uncertainty to the utility and opportunism
  by the Commission)

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Observations on the Arkansas PSC Rules --
continued

• This advance signal from the Commission should
  reduce the scope and complexities of a prudence
  review, which would otherwise be difficult for a
  utility if it has the burden of demonstrating
  prudence also, difficult for other parties to
  demonstrate imprudence
• The rules exclude pre-approval of all the costs
  pre-approval of costs which could give a utility
  bad incentives for executing a hedging or gas
  procurement strategy the Commission and others
  should have the opportunity to question whether
  the utility actions complied with the strategy
  considered reasonable beforehand by the Commission

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Observations on the Arkansas PSC Rules --
continued

• The wording of the Policy Principles relating to
  Staff review and determination as to whether or
  not it the proposed plan appears to be
  consistent withpolicy objectives. Is the
  intent outright pre-approval of the plan, or
  something less committal? To what extent can the
  Commission and other parties go back and question
  the plan after the fact? What are the parties
  interpretations of the word appears?
• Under the Rules, the utility has the
  responsibility to provide complete and
  analytically-sound information in advance for
  Commission review, which is a sort of quid pro
  quo for some degree of upfront Commission
  commitment this seems to be a reasonable
  trade-off

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Observations on the Arkansas PSC Rules --
continued

• The Rules also rightly define prudence, and the
  scope of a prudence review, in the traditional
  legal sense rather than in accordance with
  second-guessing or 20/20-hindsight practices
  (this is both in reference to the plan itself and
  the activities associated with carrying out the
  plan)
• Requiring utility recordkeeping of its hedging
  plan is also a good idea
• Incidentally, consumer education regarding what
  to expect in terms of future natural gas prices
  is rather obvious and fundamental I would guess
  most consumers do not closely follow natural gas
  prices, like they do for gasoline prices, which
  are so visible and transparent if consumers are
  informed beforehand of future prices, they might
  be more likely to take pre-emptive actions such
  as investing in energy conservation or other
  actions that would mitigate the impact of higher
  prices

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Final Comments

• PUCs should be pro-active, rather than reactive
  waiting after the fact to evaluate what happened
  becomes a difficult task, especially in the
  absence of regulatory guidelines
• At the minimum, PUCs should establish guidelines
  on hedging rules of the road
• PUCs need expertise in hedging
• Gas utilities or other parties should educate
  commissioners and their staffs on hedging with
  financial instruments