Reprinted with permission of the publisher
 
 
 
 

Missouri PSC Plans to Terminate MGE's Purchasing Incentives
 

Many utilities across the country have gained new freedoms from regulation, including new incentives to save ratepayer dollars while making a few extra for shareholders. But those that have linked their incentive mechanisms to the volatile spot market may not fare so well. Some don't seem to realize that tying ratepayers to the spot market can be similar to tying your neck to a hop-happy kangaroo.
 

A lesson can be learned from Missouri Gas Energy. It returned millions of dollars to shareholders and customers last winter under its spot market index-based incentive mechanism because it beat the index consistently by several percentage points. But it now is facing a probe by the Missouri Public Service Commission for passing through near- record high gas costs.
 

Missouri PSC staff last week recommended the immediate termination of MGE's gas procurement incentive mechanism following a review of the first year of operations under its use. Staff said, "Since the incentive mechanism contains such pervasive weakness, the commission [should] return to full prudence reviews through the PGA/ACA process." And because the incentive mechanism is "embedded in current tariffs, and will increasingly produce unintended behavior and unwarranted 'savings,'" staff also recommends an early pre-hearing conference be set to schedule a process to remove the incentive plan from tariffs.

Like most gas procurement incentive mechanisms, MGE's is designed so utility shareholders and ratepayers split "savings" if the utility can beat a given benchmark price for gas - in this case the benchmark is four percent higher than a combination of two Inside FERC's Gas Market Report Midcontinent region indexes, Williams Natural Gas (30%) and Panhandle Eastern Pipe Line (70%). Savings are measured by comparing the benchmark to the lower, actually achieved gas costs.
 

All savings go to customers if actual costs drop below 94% of the benchmark. But if purchase costs are between 94% of the benchmark and the actual benchmark price, MGE receives 50% of the savings. Last winter, purchase costs came out at 94.6% of the benchmark.
 

At first glance, the procurement incentive seemed to have worked well. MGE saved a total of $8.5 million, $4.3 million of which was returned to customers. It achieved the savings by increasing its purchases from the lower-priced Rocky Mountain region through contract renegotiations and incremental agreements. But the savings achieved are relative to the benchmark only, which rocketed to new heights last winter. While MGE was returning savings to ratepayers, it also was passing through huge increases in gas costs and facing a large number of complaints from customers.
 

Meanwhile, despite the high prices-which the "incentive" was by definition designed to guard against-MGE's shareholders were earning big bucks by beating the fluctuating benchmark by a small margin, staff explained. "[T]he index could rise to astronomical levels and MGE could still be rewarded. Assuming the benchmark went to $7/MMBtu, if MGE procured gas at $6.90, savings would result," staff said. "Defining savings in this manner does not help much in minimizing the overall cost of gas to the customers." If MGE decided to cap procurement costs through a long-term supply deal it could be penalized if the market benchmark fell below its cap.
 

The mechanism also doesn't appear to create an incentive for MGE to achieve costs that are less than 94% of the benchmark because at that level MGE shareholders would receive nothing. "Why would there be an incentive to not share benefits to our customers? There's no penalty to the company for going below 94%," MGE spokesman Darrek Porter noted. "There is an incentive to [go below 94%] because particularly with the experience of last year our uncollectibles have nearly tripled because of the increased gas costs and the inability of our customers to pay their bills. Our company is interested in low gas costs and low gas bills regardless of an incentive mechanism." Porter said since Southern Union purchased MGE in 1994 it has "cut the premium" the utility was paying for its gas supply contracts "to almost zero" from nearly 12% "and that was before the incentive mechanism was in place."
 

Despite the improvements, however, purchase prices soared last winter. The Missouri PSC also made the mistake during the winter of giving MGE the freedom pass through costs to ratepayers every month. For a two-week period in the beginning of February, the company passed through that actual high cost of purchased gas and large correction factors to previous cost estimates resulting in a $5.81/Mcf purchased gas adjustment rate. Later, the passed through cost plummeted to $1.77/Mcf. "It's hard to justify these volatile price swings to customers," staff said in its report.
 

Taming Spot Prices
 

Changes, however, already are being made to the PGA mechanism to prevent that from happening again. Rather than a monthly purchased gas adjustment (PGA), the utility now will change the PGA only twice a year, once going into the heating season and once coming out. "That will reduce the volatility that people saw last year," said Porter. A prorationing method also is going to be used so the rates charged at the beginning of the month do not change during the month. The PSC also is allowing MGE to hedge by using $3 million to purchase price caps on a number of its contracts.
 

"We have taken the steps we think are necessary to resolve the volatility issue that impacted our customers last year and also to buy some insurance against wild price increases from the market through hedging," said Porter. He said the utility plans to fight in court any effort to terminate its incentive mechanism on purchased supply.
 

MGE is expecting even bigger returns under its incentive mechanism next winter. Strangely enough, the incentives on gas procurement do not include the cost of transportation. Transportation costs are separated and passed through the PGA. That has inspired the utility to purchase a large amount of capacity on KN Energy's new Pony Express pipeline. MGE can buy cheaper Rocky Mountain production, and as long as it's below the Midcontinent index, shareholders and customers make money. It doesn't seem to matter that MGE still has to pay KN to bring the gas to Kansas City from Wyoming. Those costs are passed through the PGA. MGE could buy LNG from Indonesia and pay millions for shipping. As long as the purchased price is below the benchmark by a few percentage points it would make money.
 

"Well I suppose, but if we were to do that the transportation costs would add to the cost that customers pay and it would undoubtedly affect our uncollectibles. At the end of the day, it's not in the company's interest to do that," Porter said.
 

A PSC attorney said the commission will take a closer look at transportation costs. "The Pony Express project was the major reason we decided to recommend termination of the [incentive] plan," said the PSC's Tim Schwarz, deputy general counsel. "They're assured of beating the benchmark every time with Pony Express." He added because of its flawed design, the incentive mechanism could become a real cash cow for MGE.
 

"[It] creates an opportunity to increase capacity charges through the old PGA process while maximizing profit in the incentive mechanism," staff said in its report. The commission is expected to take up the report within the next 60 days. The PSC attorney said if a new incentive plan is developed it likely will be designed to achieve low gas procurement costs rather than "lower-than-the-spot-market" prices.
 

Rocco Canonica