FERC Filings
COMMENTS OF THE ELECTRIC POWER SUPPLY ASSOCIATION ON METHOD FOR DETERMINING NATURAL GAS PRICES FOR PURPOSES OF CALCULATING REFUNDS
COMMENTS
A. Lack of Evidentiary Findings by the Commission and Historical Reliance on Published Prices Provide No Basis for Changing Pricing Methodology for Refunds
During the refund period in question and at all other times over the past fifteen years, both the Commission and market participants have relied on published spot prices at California border delivery points. Hence, the prices utilized by sellers and buyers in the market during the refund period should remain the source of the natural gas component of the refund calculations. In the Staff’s proposed alternative, published price data for the producing basins would be used, but not California delivered prices from the same trade sources. There is no explanation as to why border prices, but not producing basin prices, have been subject to manipulation. In the Initial Report, Staff states, “the natural gas and electricity industries rely on the prices published by the reporting firms as the actual forward prices for contract settlements, and many contracts are indexed to the published prices.” This situation is the case now and was also the case during the refund period. Clearly published gas price data are referenced in a wide range of bilateral contracts, and even FERC-approved tariffs, and have been for several years. The daily spot delivered price best reflects the fuel costs incurred by market participants without utilizing the time-consuming process of litigating the actual fuel costs of every supplier, hour by hour, in the California market. The Commission may be hard-pressed to find a more representative indicator of actual market conditions than the published indices.
Further, the Staff’s findings that published prices were manipulated by any party are tenuous at best. While the Initial Report states that there “may have been manipulation” and that EnronOnline, as a primary source for reported prices and price discovery, was “potentially susceptible to manipulation,” there are no findings based on substantive or verifiable evidence detailed in the report. On the basis of mere suppositions by Staff, the Commission does not have an adequate record to institute an entirely new reference fuel price for calculating the mitigated market clearing price (MMCP) for power in the ongoing, two-year-old California refund proceedings. This is an untenable and inadequate basis on which to introduce yet another layer of regulatory uncertainty into an already complex proceeding that has enormous financial stakes.
The reason to continue to rely on the published daily spot gas prices is similar to the reasoning included in the Commission’s “Order Establishing Evidentiary Hearing Procedures, Granting Rehearing in Part, and Denying Rehearing in Part” issued July 25, 2001. In that order the Commission stated,
…[I]t is unreasonable to re-create the markets to apply such requirements for the period…The end result of using an assumed economic dispatch (prices lower than the actual marginal costs of the last generator dispatched) unfairly punishes the very generators that helped keep the lights on in California….We note that spot purchases have traditionally been used to calculate the replacement cost of fuel.
The imposition of a cost-based fuel price based on production basin spot prices plus transportation cost rather than delivered border prices imposes the same type of artificial and inaccurate pricing mechanism and market “re-creation.” Without substantive evidence that prices were based on incorrect data, or that the data was flawed to the degree that there was a material impact on the relevant prices, there are no grounds to substitute one for the other. This is especially true at this stage of an arduous proceeding which has been in progress for over two years, and is expensive, extremely complex and highly sensitive for both the marketplace and individual market participants.
In the Initial Report, there is a glaring lack of substantive evidence or data to support the supposition that manipulation occurred or had a measurable adverse affect on California prices. Published reports that one or more parties have provided imprecise data add no stronger basis for this conclusion, given the absence of any empirical analysis of the effect of these responses, or even specific evidence that such responses were limited to gas price surveys of California border prices. Further, previous findings by the Commission have attested to the particular volatility of natural gas prices in California. In the July 25, 2001, “Order Imposing Reporting Requirement on Natural Gas Sales to California Market,” the Commission stated “the price of natural gas sold in the California market…has exceeded the increase in other markets…including those markets that are supplied by the same producing areas.” This merely underscores that prices in California are impacted by multiple forces that caused more volatility than occured in other regional markets. Further, this order instituted a major fact-gathering effort begun by FERC on August 1, 2001, through the present, which has obviously yielded no proof or price information to indicate that natural gas sellers and transporters serving the California market have manipulated prices into that marketplace.
Within the Initial Report the FERC Staff found no specific errors in the published price data, but “incentives for market participants to manipulate prices reported to the reporting firms, including incentives specific to California due to its regulatory structure.” Similarly, the Report states, “undetected errors may exist” in the published price data, “wash trading may have had an adverse impact on reported prices date” and “EOL was…potentially susceptible to manipulation by market participants [emphasis added in each quoted phrase].” Based on these possibilities, the Initial Report concludes that the published delivery-point spot prices are not “sufficiently reliable to be used in the California refund proceeding” and that “the Commission cannot rule out the possibility that market participants deliberately report inaccurate prices to the reporting firms in order to manipulate the reported prices data.”
The circular logic underlying Staff’s suppositions and those unanswered questions have been explored in an Industry Commentary Report released by Prudential Financial entitled, “California Energy Crisis: What Did it Really Cost?” (Prudential Report). The Prudential Report attempts to quantify the Commission’s alternative power refund proposal and finds “the FERC Staff’s approach falls short in that it does not fully consider external factors such as supply constraints.” To understand the natural gas prices during the refund period, Prudential utilizes a comparable market approach that statistically compares the California gas market during the refund period to gas markets in other regions of the country, especially New York Zone 6 which is a large, heavily transacted area that has experienced volatility and limited pipeline capacity, similar to California. According to the Prudential analysis,
the California gas prices were not entirely out of sync with market prices in the rest of the country, and an analysis of the New York market during the same time period showed an example of a better-supplied, more competitive market that also experienced price shocks….Our comparable market analysis concludes that scarcity rather than manipulation caused the gas price spikes in both California and New York during the proposed refund period.
The Prudential Report further finds that the California energy price spikes were caused by “a severe supply and demand imbalance exacerbated by an inefficient deregulated electricity market” and not by market manipulation. Price spikes in both California and New York appear to be based on pipeline bottlenecks and scarcity of natural gas supply and, in fact, “[t]he severity of the California price shocks during the refund period is lessened even further when normalized by the New York market’s price action during the same period.”
B. Supply/Demand Imbalance and Infrastructure Inadequacy Produce Scarcity, Reflected in Basis Differential Pricing
The findings in the Prudential Report underscore an important flaw in the FERC Staff’s conclusions in the Initial Report. Because Henry Hub is the most liquid natural gas market in the country, Staff looks to make comparisons between the California border spot prices and Henry Hub prices, but it ignores any external impacts to the delivered price of natural gas, such as supply and demand imbalances or inadequate pipeline capacity. These regionally specific issues are factored into the delivered price of natural gas through basis differential pricing. The very nature of basis prices will include some degree of volatility because they reflect situational influences on the deliverability of gas, including, for example, extremely high power prices that impact the demand for natural gas in an area without adequate self-supply or intrastate capacity.
The way that basis differential pricing performs, and has performed in California, is precisely the goal of recent Commission initiatives to ensure a robust, competitive natural gas market. The Commission stated two years ago in Order 637,
the fact that prices for transportation rise during peak periods is not evidence of the exercise of market power, but may be the appropriate market response to an increase in demand for capacity. During peak periods when there is insufficient capacity to satisfy all the demand for short-term capacity, an increase in market price would be the competitive response to a situation in which the quantity of transportation demanded increases relative to the quantity that can be supplied.
The Commission also explains,
Particularly during peak periods, the value of transportation will rise because the transportation quantity demanded begins to exceed the quantity of capacity supplied. As a result, a higher price is needed to efficiently allocate transportation to those who most need to obtain it and are willing to pay the highest price for the bundled commodity. Such price increases would occur in any competitive market when supply becomes constrained relative to demand. This situation must be distinguished from the exercise of market power when a pipeline has power to raise prices by withholding capacity, creating greater scarcity than would occur in a competitive market. Indeed, all commenters recognize that the bundled sales market operates independently of the regulated rate governing straight-forward (unbundled) capacity transactions, but none suggest that the Commission should attempt to impose more stringent regulation on the bundled sales market.
Order 637 is based on the premise that the appropriate way to allocate scarce capacity to those who value it most is through peak prices which reflect that scarcity. A 1997 FERC discussion paper which examined certain extreme winter demand periods concluded that “the unbundled gas market has responded to severe demand conditions better than the traditional regulated electric market.” This was the case during the extreme winters of 1994 and 1996, and was also the case during the electricity crisis in California during 2000 and 2001.
In the Initial Report, Commission Staff implicitly acknowledged the underlying structure of basis differentials as the driver of price for natural gas deliveries. In the discussion of the El Paso pipeline rupture, there is an explanation that the rupture results in the curtailment of capacity to California, which may affect price. There should also be an acknowledgement, then, that at the time of the curtailment there will be a non-correlative price spike in California that may not be experienced in the producing basins or at the Henry Hub. While in Order 637 the possibility of regionally non-correlative prices is a natural function of the supply and demand dynamic of basis differential pricing, it is utilized in the Initial Report as a sign of dysfunction and “possible” manipulation. The natural gas market has been workably competitive for quite some time, and it is this very volatility that has inspired the hedging and risk management tools that have been successful in the natural gas market. These are, in fact, the workably competitive aspects of the gas industry that the Commission is attempting to bring to the power marketplace through Standard Market Design and competitive regional wholesale transmission organizations.
In testimony before the U.S. Senate Committee on Energy and Natural Resources in June 2001, Bruce Henning of Energy and Environmental Analysis, Inc., presented analysis on the natural gas market in California. Explaining the pricing volatility experienced in California, Mr. Henning stated,
California prices were also affected by a significant increase in the transportation basis… [which] is the market “value” of transportation capacity available to move natural gas from one market to another….[I]n a capacity-constrained market, the “value” of transportation can significantly exceed the maximum regulated rate. This happened in California, but it has happened for shorter periods of time in other markets, such as New York and the Northeast last December [2000].
Mr. Henning states that there is more capacity available to bring gas to the California border than to move gas within the state itself, resulting in a major capacity bottleneck not experienced in other regions of the country. Because of these issues,
Power generation customers bid against each other for the scarce supply. Moreover, because of the extreme conditions…generators who are usually extremely sensitive to fuel prices were willing to pay dearly for any supply available. The result was the extremely high basis value. The prices being reported at the border reflected the “value” of the scarce intrastate capacity minus the state regulated cost of distribution.
Again, this is an element of the natural gas prices in California that is not reflected in producing basin or Henry Hub spot prices. These elements that cause basis differential prices to vary based on deliverability emerge in the scarcity of capacity of natural gas, which is a pricing component missing completely in the FERC Staff alternative methodology. While the Commission asks questions on how scarcity should be accounted for, that “value” is already reflected in the California border prices, which is the daily spot price for natural gas to reach the California market.
In competitive markets, such as natural gas, the commodity is allocated where supplies are needed most, and high prices send signals to the market. These signals were heard in California and there has been a rush to develop both interstate pipeline capacity to the border and intrastate capacity within the state. The Commission heeded these signals as well, and has required market participants to present regular updates to the Commission on the improvements and additions to the California energy infrastructure. In June 2001, FERC Chairman Curt Hebert sent a letter to Commissioner Michael C. Moore of the California Public Utility Commission, which included an attachment of FERC Staff’s comments on the California Energy Commission Draft Staff Report on Natural Gas Infrastructure Issues. In that attachment FERC Staff stated,
The [CEC’s] draft report’s conclusion (at p. 9) that an inadequate intrastate natural gas transportation infrastructure is a major contributor to high natural gas prices in California appears quite likely. Commission Staff believes that there may be other contributing factors…such as the inability of some electric generators being served by the California utilities to obtain firm capacity rights to the utilities “backbone” systems or firm/flexible rights to the utilities’ receipt points…
Because the natural gas price spikes at issue in this Investigation have been followed by numerous major physical pipeline capacity developments and projects, the underlying cause of the price spikes appears to have a basis in market realities, not artificial market manipulations. The price signals have worked. The very energy companies that delivered natural gas to California during the relevant period are currently investing millions of their scarce dollars to expand the pipeline infrastructure to and within the state of California.
The high natural gas prices in California during 2000 and 2001, and the market reasons for them, have been well documented in many proceedings before FERC, the CPUC and Congress. There is a plethora of discussion on the supply/demand imbalance caused by the electricity markets, the lack of adequate intrastate infrastructure and increasing demand and consumption in markets east of California. While the FERC Staff infers that a dysfunctional natural gas market is the result of a dysfunctional electricity market, that is not the case. The natural gas industry is competitive and reacted in a rational, market-driven manner to the situation presented in California. No evidence has been offered that the natural gas market was dysfunctional or failed in any way.
C. Producing Basin Prices and Henry Hub Correlation Do Not Reflect Conditions Experienced in California
It has been roundly acknowledged by market participants and the Commission that there has been and remains a serious and damaging lack of pipeline infrastructure in the state of California. The Commission has also acknowledged that generators, like industrials, are likely to purchase a bundled natural gas product at the city gate which reflects market clearing prices, not regulated cost-of-service rates. While pipeline transportation remains a regulated component of the price of natural gas, no other aspect of the delivered price is regulated; therefore, the delivered price cannot be broken out into “cost components” to reflect actual costs. In a marketplace in which capacity is scarce, actual costs reflect that capacity squeeze and the delivered prices necessarily include scarcity value. In fact, it is clear that a substantial amount of the natural gas available to power generators during the period in question was delivered via released capacity – where rates were not capped at the time – rather than through regulated interruptible capacity purchased from the pipelines.
Further, to utilize spot prices at producing areas because they can be, according to FERC Staff, “independently validated by correlation analysis to Henry Hub prices” is nonsensical, because although Henry Hub is a liquid market, and the natural gas produced at these producing basin areas is actually delivered to California, those spot prices do not reflect that value for the gas inside the state of California. The Initial Report states that, absent the factor of scarcity, the California natural gas market prices should have closely tracked those producing area spot prices. Scarcity, however, is exactly why the delivered California prices do not correlate to the producing area spot prices. Scarcity is reflected in the basis differential pricing experienced at the California border.
The Staff’s proposed methodology is substituting a market-driven and competitive component of the price of power with a proxy price that bears no resemblance to actual prices. While the individual cost components of the Staff’s proposal allegedly are “verifiable and statistically valid,” they do not reflect the price of gas during the relevant period. The further the prices calculated in this refund proceeding veer from reality, the greater the short-term and long-term damage to the market participants in particular and energy market as a whole. The artificially constructed natural gas prices proposed by Staff are not based on any logical basis of costs that reflect the functional market circumstances of the relevant period. This methodology is the imposition of a regulatory solution onto a viable, working competitive natural gas market.
D. Staff’s Proposal Unfairly Harms Marketers
Another troubling aspect of the proposed approach is its impact on power marketers. Power marketers buy and resell energy in the market without regard to the underlying price components of that power. The Staff does not even acknowledge that marketers will be adversely impacted by this proposal. Power marketers play an important role in providing liquidity and assuring efficient allocation of resources. Revising the gas component of the power price as proposed by Staff will unfairly subject marketers to additional refund risk since gas supply costs are a key component of the Commission’s refund methodology, but changes to that component will have no relationship to what marketers actually paid for the power they sold during the refund period. This will simply compound the fundamental unfairness that already exists in the refund methodology vis a vis marketers. There are no findings that power marketers contributed to the problems alleged by Staff or that marketers could do anything – then or now – to protect themselves from this unfair result. This unfairly discriminates against a marketer’s ability to capture any form of scarcity rent and threatens the vital role of marketers in the energy industry.
E. Negative Impact on Refund Cases
Overriding all these other problems with the Staff’s proposal, there is the concern that the imposition of a new reference fuel price in this proceeding at this time will cause irreparable harm to the progress of the cases. This case has dragged on for two years, infusing the industry with regulatory uncertainty that has resulted in crippling capital losses and financial deterioration. It is likely that, in the midst of many ongoing issues and initiatives in the energy industry, this California refund proceeding and the other numerous counter-party refund proceedings filed this year are also playing a role in the degradation of the financial health of numerous energy companies. A major change in the largest refund case at this stage will certainly add to the time it takes to resolve these matters. Clearly, published reports have suggested that the value to opposing parties in this docket would be revised materially in the context of the Staff paper. Disrupting the proceeding in this manner, based largely on appearances and the possibility of improper behavior rather than hard empirical data, adds considerable uncertainty as to the timely resolution of this docket, including the outcome of various ongoing agreements in principle to settle. The risk is increased that the proposed alternative pricing method could result in California sellers fully litigating their cases in order to achieve a natural gas price component that meaningfully reflects their actual costs. This interference so late in the game is not only unnecessary but improper. The methodology for calculating the MMCP has been vetted through the Commission’s proceedings, and must stand as it is today.