*
*
* / BEFORE THE
PUBLIC SERVICE COMMISSION
OF MARYLAND
CASE NO. 8897
September 28, 2001
PROPOSED ORDER OF HEARING EXAMINER
Appearances:
Paul S. Buckley, on behalf of Washington Gas Light Company.
Luanne P. McKenna, on behalf of the Maryland Office of People's Counsel.
Sarah Lazarus, on behalf of the Staff of the Public Service Commission of Maryland.
I. BACKGROUND & PROCEDURAL HISTORY
On June 28, 2001 Washington Gas Light Company (“the Company” or “Washington”) filed a revision of its Purchased Gas Charge (“PGC”) tariff with the Public Service Commission of Maryland (“the Commission”). The Company’s filing was designed to permit it to recover from ratepayers prudently incurred costs relating to proposed gas hedging activities. Historically, the Company has not hedged its commodity purchases.[1]
The Commission considered the Company’s hedging cost recovery proposal at a regularly-scheduled Administrative Meeting on August 8, 2001. Because of concerns raised by members of the Commission’s Staff (“Staff”) and by the Maryland Office of People’s Counsel (“People’s Counsel” or “OPC”), Washington’s proposal was, on August 8, 2001, referred to the Hearing Examiner Division for further proceedings.
A prehearing conference was held on August 20, 2001, at which the parties agreed upon a litigation schedule. Following the parties’ further discussions, they submitted an Uncontested Settlement Agreement (“the Settlement”) on September 6, 2001 (appended hereto as Appendix A). A hearing to review and examine the Settlement was held on September 11, 2001. The hearing record was left open and was completed by the parties’ written answers to the Hearing Examiner’s questions and parties’ questions to each other, provided on September 14, 2001. On September 17, 2001 the parties submitted a Joint Motion to Approve Uncontested Settlement Agreement and Request for Expedited Decision (“the Motion”). The Motion summarized the Settlement, and included the parties’ agreement to waive the statutory 30 day appeal period if this Proposed Order accepts the Settlement without substantial
modification.
The Company presented the oral testimony of Mr. Timothy Sherwood, Department Head of Energy Acquisition for Washington Gas Company. People’s Counsel submitted the written Direct Testimony of Mr.Ralph Miller, an independent consultant. Staff submitted comments on the Company’s June 28, 2001 proposed tariff change. Those comments were not made part of the record in Case 8897. Mr.Randy M. Allen, Director of the Commission’s Accounting Division, supplied written answers to the Hearing Examiner’s post-hearing questions regarding accounting review procedures.
II. THE SETTLEMENT
The Company proposes to pursue hedging of the commodity price of a portion of its gas supply purchased for its firm sales (primarily its residential) customers. It also proposes to recover prudently incurred hedging costs from ratepayers through its Purchased Gas Adjustment charge.
Hedging, broadly defined, includes any financial strategy used to offset price risk in taking actual delivery as a result of a purchase of a commodity. Hedging often involves the use of derivative securities, such as options to buy and sell securities and commodities at a specified price. It may include simultaneous buying and selling of the same commodity.[2] More
specifically, Washington’s hedging proposal will attempt to reduce its exposure to gas cost volatility by using a specific and limited number of gas purchasing strategies to buy gas in advance of actual need for the gas thus purchased. Simultaneous buying and selling does not have a place in the Company’s hedging plans at this time. That is, Washington does not plan to be a “hedger” from whom other local distribution gas companies may buy hedged gas products.
The overriding goal of Washington Gas’ hedging plan is to stabilize its gas prices, protecting its firm sales customers from price (and payment) volatility. The Company has specifically justified its hedging plan as an attempt to shield customers from the sudden “spikes” in gas prices that occurred in the winter of 2000-2001. At 24-25. Washington has stressed that its program is not intended to encompass “any level of speculation in gas price.” Id.at 25.
At the September 11, 2001 hearing on its hedging application, the Company adopted, as illustrating its own objectives, the following statement from a report entitled The Use of Hedging by Local Gas Distribution Companies, Basic Considerations and Regulatory Issues, issued by the National Regulatory Research Institute:[3]
Hedging in its purest form does not provide a means to reduce the expected price of gas for a utility. Rather, from the consumer’s perspective, its primary function is to stabilize prices. Generally risk-adverse consumers should be expected to pay extra for shouldering less risks such as exposure to volatile prices.
Tr. at 30.
There are three gas purchasing strategies or “products” contemplated in the Company’s hedging plan. One is a capped price vehicle, essentially an options contract. Under this protocol, Washington will pay a premium for the right to buy gas at a specific price. If the price of gas on the New York Mercantile Exchange Index (NYMEX) falls below the options contract price, the option will not be exercised, and the gas will be purchased by other means. Whether or not the option is exercised, Washington must pay a premium to obtain it. At 53. This strategy corresponds to the Price Cap (“Call”) Product outlined on page two of five of Appendix A to the Settlement.
The second “product” is purchase of gas at a fixed price well ahead of the need for the gas. It is essentially a forward contract, and is a standard gas purchase device. The purchaser, Washington, would assume the risk that, after execution of the purchase contract, the index price would fall below the contract price. This option, however, ensures price stability. There is no separate premium associated with this option. The risk that index prices may be lower than the contract price when the gas is needed is an “opportunity cost” that the Company must bear. This “product” corresponds to the Fixed Price (“NYMEX Strip”) Product, as discussed in Appendix A to the Settlement.
According to Washington “the third [option] is really a floor and a ceiling price arrangement.” If the index price for gas goes above the ceiling price, Washington would be guaranteed not to pay more than the ceiling price. If general market gas prices go below the floor, however, Washington will pay the floor price rather than the lower market price. Guaranteed prices paid for gas thus may float between floor and ceiling, the buyer paying at least the floor price. This option does not include a premium. This is the Price Band (“Call/Put”) Product described in Appendix A to the Settlement. The Company has agreed to employ only the three hedging strategies outlined above as a result of this case.
Washington has traditionally not sought recovery of any hedging costs – any costs of preserving a favorable gas price – that it may have incurred. The Company now seeks assurance that such hedging costs will be treated by the Commission as part of the cost of gas recoverable from ratepayers.
At the Hearing Examiner’s request the Company’s witness explained the steps in a hedging transaction. The Company will first make its gas requirement known, perhaps throughout an RFP. For example, the Company’s witness Sherwood explained that Washington might require “10,000 decatherms a day beginning on 1st of November, ending on the 31st of March 2002, and indicating the pricing parameters that we are interested in reviewing.” Id. at 46. Washington would obtain advance price quotes for each month of the winter. The RFP would be directed to “large gas trader companies that do a lot of trading at the wholesale level; sometimes they are pipeline affiliates who have gotten into marketing gas.” At 48. The marketers may also be producers of natural gas who sell gas “under structured vehicles,” and marketing affiliates of utilities.
Having received replies to its RFP, the Company will then determine which supplier’s offer best meets its objective of limiting volatility. A written recommendation will then go to Washington’s Vice-President of Energy Acquisition-Regulatory Affairs and the Vice-President and CFO of the Company.[4] Upon approval of the purchase, gas covered by the hedging contracts will be available to daily dispatchers to serve gas customers’ supply needs. At 50. Throughout this entire process Washington relies on entities outside itself to provide it with gas at a favorable price. The Company does not perform the hedging mechanics on its own.
Washington’s witness Sherwood described how hedging may result in gas purchases at higher costs than would prevail without hedging. The premium paid to secure a stable, long-term, hedged price would account for at least some of any such discrepancy. Witness Sherwood stated that if the NYMEX price of gas were $5.00, but Washington owned an option to buy hedged gas at $4.95, it would exercise that option. With a hypothetical $.15 premium for the
hedged gas, the total cost of the hedged gas would be $5.10, whereas the gas would have cost $5.00 if purchased at the NYMEX price, without hedging. These facts underscore Washington’s position that its hedging program is focused on price stability rather than price reduction.[5] (Witness Sherwood did state, however, that “if [Washington] had done all fixed price for the volumes that are indicated in the plan prior to last winter the overall reduction in purchased gas cost would have been approximately $40 million of $ 700 million”). At 59.
Washington could accomplish one of its hedging goals-reducing the variability in customers’ monthly payments – through widespread use of budget billing. Budget billing essentially allows customers to receive gas bills for the same amount each month, with recalculation of the bill at least once a year. Washington admits that budget billing could provide stability in customer payments. “Ultimately, though,” witness Sherwood stated “it [budget billing] doesn’t do anything to add to the stability of the Company’s gas costs. Ultimately - the customers will pay the full bill.” At 72. If the company experiences extremely high gas costs in one season, customers will simply pay a higher budget bill later on. Id. The Company therefore characterizes budget billing
as a payment stabilization device, but sees hedging as a cost stabilization device. At 73.
The Company’s witness also testified on the issue of so- called “fixed price forward contracts,” by which Washington would “lock in” the price of gas to be delivered in a future period. As Washington ‘s witness Sherwood explained: “there is a price quoted for each month of the winter right now and an average for the winter that [Washington] can execute a forward contract on … that would limit volatility and stabilize prices at least up to that volume of gas…. bought on a forward basis.” At 73.
While Washington considers forward contracts a likely part of its hedging strategy, at 74, it does not rely on them exclusively. Id. The primary drawback to forward contracts, according to the Company, is incurring opportunity costs – the risk that gas prices will decrease after Washington has made a commitment in a forward contract to buy gas at a higher price. Washington thus explained the disadvantages of budget billing and forward contracts. Because of these disadvantages, Washington seeks to expand its arsenal of gas purchasing strategies to include the hedging techniques described herein.
As for monitoring its hedging program, the Company plans to use industry - typical trading controls. Id. at 102. The Company will monitor its hedging transaction accounts according to the standards of the Derivative Implementations Group, a subgroup of FASB, the Federal Accounting Standard Board.
In addition to Washington’s internal controls, all parties agree that Washington’s gas purchases will be subject to Commission “prudence review” in Washington’s annual PGA hearings, as required in Section 4-402 of the Public Utility Commission Article, as well as in Sections 4-401 (fuel clauses), 4-402 (gas fuel clauses), and 2-115 (Commission right to books and records). The parities contemplate that hedging expenses will be subject to disallowance and/or refund, as are other costs of purchased gas, if they are found to be imprudently incurred.[6]
People’s Counsel’s witness Miller supported Washington’s hedging proposal as detailed in the Settlement. Witness Miller stated that Washington has to date purchased most of its gas at spot market prices. Use of hedging, he concluded, will introduce “pricing diversity” into Washington’s gas portfolio, thus reducing price volatility. Witness Miller therefore stated that the company’s hedging plans would improve Washington’s purchasing practices overall.
II. SUMMARY AND DECISIONS
Washington has proposed to buy about 22 percent of its winter gas requirement on the hedged market. At 92. That is, the Company will purchase gas from different types of gas marketers using the three different hedging protocols described above. In this proceeding the Company seeks assurance that it will have authority to recover the premium costs related to hedging from its customers.
Washington’s purpose in any and all hedging transactions is to stabilize gas costs over the winter months, thus also stabilizing customers’ gas bills in case of price spikes similar to those seen in the winter of 2000-2001. The Company has at its disposal at least two conventional mechanisms to stabilize customer gas costs: budget billing and fixed price forward contracts. Budget billing does nothing to reduce gas costs; fixed price forward contracts dampen price volatility, but may increase price risk. Hedging procedures will increase Washington’s gas purchasing options and should result in reduced price volatility to customers. Whether the benefit is worth the cost may be an issue in a future PGC review. The Company’s hedging decisions will be reviewed by the Commission in Washington’s annual purchased gas adjustment proceedings, and will be subject to any appropriate Commission action, including refund of such costs to customers.