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A Complicated Carrot: LDC Procurement Incentives

It sounds simple: to lower the price consumers pay for natural gas, give the local distribution company (LDC) incentives for saving money when it buys the gas on consumers' behalf.

Not so fast. Designing effective, fair and relatively simple incentive mechanisms that inspire gas procurement frugality by utilities is a challenge that continues to bedevil regulators and the companies they oversee. A new paper from the National Regulatory Research Institute (NRRI), the research arm of the National Association of Regulatory Utility Commissioners (NARUC), attempts to spell out the dos and don'ts of designing gas procurement incentive mechanisms (GPIMs). Authors Ken Costello, senior NRRI researcher; and James Wilson, principal with consulting firm LECG LLC, have found much not to like about existing GPIMs.

"While some GPIMs are well-structured, design characteristics that result in weak or distorted incentives for some gas procurement decisions are quite common," they wrote, "with many GPIMs affording opportunities for the utility to increase its incentive award while not reducing, or even increasing, the customers' gas cost.

"Our review of existing GPIMs indicates that very few are sufficiently broad and well-structured to eliminate the need for regulatory review of procurement decision-making. Yet in most instances, the regulatory reviews of GPIM results and of procurement decisions amount to little more than an audit of the utility's actual costs and incentive award calculations."

The authors say that the limited scope of reviews they've seen suggests that regulators are unaware of the shortcomings that are built in to many incentive mechanism designs. In their paper they say that regulators in at least 15 states have approved GPIMs, and they spell out many of the potential mechanism failings of which regulators and utilities should be aware.

A key failing often found in GPIMs is the use of performance benchmarks that are not exogenous. That is, the standard for utility procurement performance -- above which the utility will be rewarded and below which it will be penalized -- includes parameters that are under the utility's control. When this is the case, the utility can have an incentive to take actions that would move the benchmark rather than those that would actually create gas procurement savings to be shared with customers.

"Any assumptions in the benchmark calculation affected by utility choices result in benchmark that is not exogenous; as a result, some incentives are weakened, eliminated and/or distorted," the authors said. "Such a GPIM may sometimes reward actions that are not in the customers' interest, or fail to reward actions that are in the customers' interest. Unfortunately, our review has found that an exogenous benchmark is the exception rather than the rule..."

Another area where GPIMs can fall down is in the application of incentives only to certain cost components or when very different benefit (cost) sharing percentages are applied to different cost or revenue categories. When this happens, the utility has an incentive to spend more in areas where incentives do not apply, or are weaker, in order to reduce costs where cost reductions will be rewarded under the incentive mechanism.

"For example, some GPIMs assign to the utility a larger percentage of capacity release revenues than of commodity costs savings," the authors write. "When capacity is released, the utility may incur additional cost for short-term transportation or downstream purchases, and it also may lose opportunities for profitable off-system gas sales. The potential revenue from some capacity releases may not justify the incremental supply and transportation cost, but this choice would be distorted by a GPIM that offers the utility a higher percentage of the capacity release revenue than of commodity cost savings."

Among a number of other potential GPIM problems outlined in the paper is one that sounds simple: setting the benchmark too low, making it too easy for a utility to demonstrate exemplary performance worthy of reward when in fact it's just average or worse. "For instance, the benchmark might not reflect optimization of purchase locations, or it might include low expectations (or no expectations) with respect to revenues from release of unneeded capacity, or it might assume the utility must pay full transportation tariffs when discounting is common, to note a few examples."

The 33-page report was prepared by NRRI with funding from NARUC member commissions. For a copy of "A Hard Look at Incentive Mechanisms for Natural Gas Procurement" go to http://www.nrri.ohio-state.edu:9006/dspace/handle/2068/1040.

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