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HomeMy WebLinkAbout1999-10-18 City Council (10)City of Palo Alto City Manager’s Report TO:HONORABLE CITY COUNCIL FROM:CITY MANAGER DEPARTMENT: UTILITIES DATE:OCTOBER 18, 1999 CMR:387:99 TITLE:PROPOSED ELECTRIC AND NATURAL GAS COMMODITY PRICING POLICY AND METHODOLOGY REPORT IN BRIEF In a competitive environment, the City’s electric and gas utilities face certain risks that were ushered in with the deregulation of the gas and electric supply businesses. These risks, if not properly managed, could lead to revenue shortfalls. Before deregulation, any shortfall in revenues in one year could always be adjusted in rates in subsequent years. Deregulation does not allow for such adjustments. Since the City’s Direct Access program allows eligible customers to choose alternate suppliers, the establishment of a competitive commodity pricing policy is essential if risks are to be properly managed. The method to establish commodity rates under this commodity pricing policy is clear, easily understood, and consistent and compatible with the City’s rate making principles. This report requests the City Council’s approval of the Commodity Pricing Policy, which will guide staff’s actions and decisions as the City faces risks inherent in the new competitive gas and electric utilities environment. The Utilities Advisory Commission (UAC) has reviewed and supports the proposed policy to make prompt and complete energy price proposals to retain customers. CMR:387:99 Page I of 6 .RECOMMENDATIONS Staff recommends that the Council approve the Electric and Natural Gas Commodity Pricing Policy, including its key principles: direct cost recovery, risk management, indirect cost recovery, nondiscrimination, and nonsubsidization. BACKGROUND In a regulated environment, all utility supply and distribution costs are passed on to customers. In that environment, the primary objective of rate setting is cost recovery. The supplier determines both the products available and the prices. In an open competitive market where customers have a choice of commodity supplier, the utility,is not assured that a commodity customer will be retained indefinitely. Therefore, the term of a customer’s commitment to purchase the commodity, the market price, and cost recovery become important considerations in establishing prices. Thus, the competitive environment exposes the City of Palo Alto Utilities (CPAU) to certain risks. These risks include: Market Price Risk CPAU is exposed to this risk when wholesale prices fluctuate but prices to its retail customers are fixed. Since CPAU buys some of its electric supplies and all of its gas supplies on the wholesale market and sets its retail rates only once a year, this risk can be significant. Credit Risk CPAU purchases and sells supplies on the wholesale market from a number of buyers or sellers (counter parties). Credit risk is the failure of a buyer or seller to honor its commitments. CPAU is exposed to credit risk because of the chance that a counter party may default, requiring CPAU to buy (or sell) replacement supplies on the market. CPAU may accommodate such risk in the Supply Rate Stabilization Reserve. Volume Risk Volume risk exists since both supply and demand are unpredictable. For example, the anticipated electricity production from the Calaveras Hydroelectric project may not materialize. Or customer gas consumption may be less than expected. If contracts are in place to purchase or sell a certain amount of energy, but volumes change, there could be a financial loss to CPAU if those surplus (or deficits) must be sold to (or purchased from) the market. CMR:387:99 Page 2 of 6 In addition, energy industry deregulation has led to increased expectations on the part of some customers for new and innovative products and services. To be competitive, CPAU nee~ to offer a range of competitive commodity products that meet the needs of the cust~ .aers while limiting the risks to CPAU. These products may include fixed prices (attractive to those who seek to match their energy costs to budget), prices which vary according to market price indices (attractive to those who are comfortable with market price fluctuations); and other "risk management" products such as those which provide energy at a market price index while guaranteeing that prices will not increase beyond a certain pre-set maximum. Each product would have different costs and benefits for CPAU and its customers. As customers request customized rate contracts, the methods used to price the different commodity products need to be established and followed so that all customers within a customer class are treated equitably using consistent and approved principles. The City Council, at its January 11, 1999 meeting, raised a number of concerns regarding the pricing of supplies to CPAU’s retail customers. At that meeting, the Council directed staff and the City Attorney to respond to a number of issues regarding Council oversight of electric and gas utilities activities in the new competitive business environment. In response, staff prepared an informational report to the Council on July 26, 1999 (CMR:315 :99) which discussed staff’s activities and progress in developing an energy risk management program. At that time, staff indicated it would return to the Council with proposed policies as the first step in the implementation of such a program. The Commodity Pricing Policy is the first major policy that responds to Council’s expressed concern to "submit guidelines for entering onto long-term sales contracts to the UAC and Council for review and approval." DISCUSSION The commodity pricing policy is composed of five key principles. The principles include rate making objectives currently practiced in pricing distribution and commodity services and many of the contract guidelines currently found in CPAU’s Rule and Regulation 5. However, some additional objectives are needed to account for the special nature of commodity service in a deregulated market. These principles will be used both for the development of standardized commodity tariffs and for customer contracts. It is important to emphasize that the commodity pricing principles are listed in priority order such that the first one is the overriding principle. Thus, to the extent that a lower priority principle conflicts with higher priority principles, the higher priority principles will take precedence. 1.Direct Cost Recovery: Direct costs of providing commodity service will be CMR:387:99 Page 3 of 6 recovered in commodity rates. Direct costs include costs of purchasing commodity, electric transmission and gas transportation. It also includes any costs incurred as a result of risks taken to procure the commodity. It does not include indirect costs. Recovery of indirect costs is found in principle #3 below. Risk Management: To the extent CPAU takes a risk to provide commodity products, the customer must pay for that increase in risk. Since the supply of gas and electricity is unpredictable, generation output, market prices, and market demand must be carefully managed. All risks must be insured, to the extent practicable and contract terms must protect CPAU from unanticipated events. Indirect Cost Recovery: To the extent practicable, it is an objective to recover all indirect costs of commodity service from commodity customers. Indirect costs include staff overhead, costs for services from the Northern California Power Agency (NCPA), and other costs allocated to commodity costs. However, recovering these costs may result in a commodity product that is uncompetitive. If this results in a customer choosing another supplier, staff needs the flexibility to provide a discount to that customer. Staff needs this flexibility since it would be better for all customers for CPAU to recover some portion of the indirect costs rather than none at all. If a customer left CPAU, all the indirect costs allocated to that customer would have to be borne by the remaining customers. On the other hand, if the customer agreed to remain a CPAU commodity customer if a discount equal to a portion of the indirect cost was provided, then remaining customers would bear a smaller portion of the lost indirect cost revenue. Additional details regarding how any justified discounts would be offered to customers with a viable threat of leaving commodity service will be covered in aproposed Contract Policy which will come before the Council for approval by the end of the fiscal year. Nondiscrimination: All customers within a customer class shall be treated in a fair and impartial manner. Based on customer classification (i.e. residential, commercial, industrial, institutional) and consumption levels, each customer is assigned to a specific class and each rate schedule is applicable to one customer class. The principle of nondiscrimination requires that all customers in the same class and rate schedule eligibility shall be entitled to acquire energy at the same or substantially similar terms and conditions. Nonsubsidization: To the extent practicable, costs will be allocated to customers and customer classes according to how those costs are incurred. Thus, commodity rates will not be established in a manner which permits one class of customers to be subsidized by another. This will ensure that a choice by one customer or group CMR:387:99 Page 4 of 6 of customers will not adversely affect the choices of other customers. Many of the procedural implications of the policies proposed here involve oversight and control. Implementation of the commodity pricing policy will include the establishment of procedures to address these issues. Guidelines for implementation are shown in Attachment B. The City Manager will be responsible for implementing this policy by overseeing the process of all commodity rate development and ensuring that all procedures are followed consistently and that all calculations are appropriately documented. RESOURCE IMPACT Adoption of the proposed commodity pricing policy will enable the Electric and Gas Utilities to better manage the risks inherent in conducting business, thus mitigating potential negative fiscal impacts. POLICY IMPLICATIONS The policies outlined in this report formalize rate making principles that respond to the new circumstances arising from deregulation of the gas and electric utility supply businesses. TIMELINE If this policy is approved, staff will develop guidelines for implementing the policy. Procedures for calculating each component of commodity rates and appropriate reporting to the City Council and the City Manager will be developed. The development of new rates will follow this policy, if approved. At this time, staff anticipates new rate products to be introduced for implementation on January 1, 2000. ENVIRONMENTAL REVIEW Approval of the proposed policy and procedures does not constitute a project under the California Environmental Quality Act and, therefore, is exempt from the environmental assessment requirement. CMR:387:99 Page 5 of 6 ATTACHMENTS/EXHIBITS A. Commodity Pricing Policy Statement B. Commodity Pricing Policy Implementation Guidelines PREPARED BY: Jane Ratchye, Senior Resource Planner REVIEWED BY: Girish Balachandran, Supply Resources Group Manager DEPARTMENT HEAD APPROVAL: CITY MANAGER APPROVAL: cc: Utilities Advisory Commission CMR:387:99 Page 6 of 6 COMMODITY PRICING POLICY ATTACHMENT A POLICY STATEMENT Prices for energy supplies the City wishes to offer its retail customers will be fair and equitable to all customers and will be developed to recover all costs incurred. The commodity pricing policy will be used both for the development of standardized commodity tariffs and for long-term, or customized, customer contract rates. The City Manager is responsible for implementing this policy by overseeing the process of all commodity rate development and ensuring that all procedures are followed consistently and that all calculations are appropriately documented. The commodity pricing policy is composed of the following five principles with the first principle having priority over the remaining four: 1. Direct Cost Recovery All direct costs of providing commodity service will be recovered in commodity rates. 2.Risk Management Since the supply of gas and electricity is unpredictable, generation output, market prices, and market demand must be carefully managed to match approved risk limits. All risks must be insured, to the extent practicable and contract terms must protect CPAU from unanticipated events. To the extent CPAU takes a risk to provide commodity products, the customer must pay for that increase in risk. 3.Indirect Cost Recovery To the extent practicable, it is an objective to recover all indirect costs of commodity service from commodity customers. 4.Nondiscrimination All customers within a customer class shall be treated in a fair and impartial manner and be entitled to acquire commodities at the same or substantially similar terms and conditions. 5.Nonsubsidization To the extent practicable, costs will be allocated to customers and customer classes according to how those costs are incurred. Thus, commodity rates will not be established in a manner which permits one class of customers to be subsidized by another. ATTACHMENT B COMMODITY PRICING POLICY IMPLEMENTA~ON GUIDELINES Total commodity costs can be broken down into its individual components. Calculating the costs of each of these components of commodity rates is the essential implementation step of the commodity pricing policy. The cost components that make up the cost of supply include the following: Direct Commodity Cost (to Customer Meter): This includes all costs to purchase and transport or transmit the commodity to a customer’s meter. No distribution related costs are part of this component. Generally, this consists of the following elements: a. For Electricity: 1. The fraction of total load met by purchases under the contract with the Western Area Power Administration 2.Market resources comprise the balance of the needs 3.Transmission of the commodity to the city meter and, then, customer meter, including all physical losses incurred during the transmission process. b.For Natural Gas: 1.Market resources are the only available resources to the gas utility 2.Transportation of the commodity from purchase points to the city gate and, then, to the customer meter, including all physical losses incurred during the transportation process. Indirect Costs: This includes administrative costs (overhead) of doing business such as: a. City of Palo Alto overhead includes staff salaries, budget expenses, rent, and allocated charges to the supply business unit from within the Utilities Department and from other City departments. b.The amount transferred to the General Fund from the Utilities Department will be shared between the supply and distribution business units. The charge for commodity will include the share of the transfer allocated to supply. c.For electricity, overhead costs include costs incurred for services received from the Northern California Power Agency. 3.Other Transfers or Non-Operating Income: The Supply Rate Stabilizatio~i Reserves ~SR) eam interest income that is used to offset commodity costs. In addition, transfers of money into and out of the Calaveras Reserve and the Supply RSR are planned to manage rate changes over time. These cash adjustments will be accounted for and included in the establishment of commodity rates. 4.Risk Premium: CPAU is exposed to many risks which arise since costs could be greater than anticipated. CPAU will collect a risk premium for each commodity product based on the risks it assumes. City of Palo Alto Utilities Advisory Commission Utility Policy Advisories 1 September 1999 In August 1999 the Commission re-instituted one-page summaries of key advisories from each meeting. The summary is p~:epared by the Commissioners, not the staff. The full set of approved minutes are usually available 5-6 weeks a,ffer a given UAC meeting. Water Quarterly Report Water source supplements to Hetch Hetchy actively being explored. The UAC was satisfied with the pace of staff work to identify and develop alternative sources to Hetch Hetchy water, both for emergency back-up and for drought-era supplements. Energy Commodity Pricing Poficy UAC supports the proposed policy enabling staff to make prompt, competitive, risk- aware energy price proposals to retain our customers. Staff prepared an excellent draft set of principles for making competitive offers and counteroffers to those utility customers tempted to buy their energy supply and services elsewhere. This first of a series of staff proposals responds to Council’s January 1999 request to rethink and restructure utility operations and governance to thrive in an era of deregulation and competition. The UAC advised that: Priorities and analysis are good. The staff work was very well done. The choice before the City is how to manage the inescapably higher risks posed by deregulation. A new level and kind of self-insurance will be necessary. More examples would help. The staff proposal would be easier for Council to evaluate if it contained examples showing how a typical pricing risk-cost tra~eoff might look and work. Cost definitions need to be clarified. The terms "fixed," "variable," "direct" and "indirect" costs as used in the staff presentations differ somewhat from conventional meanings. The pricing poli~.y and the transfer policy should be linked. Council should examine alternative scenarios showing what happens if transfers are defined as costs to be recovered, or as benefits that vary with overall utility performance. Nimble pricing is impossible if both Council and UAC must approve decisions. Periodic UAC or Council oversight might assure the public that price-risk management works. The new customer information system is critical. Pricing freedom must await delivery and debugging of the new computer information system for managing customer data. New Business Early forums for public comment on utility restructuring. UAC and staff committed to scheduling two extra UAC meetings in October and November for early public comment. ABAG enters the energy business. UAC noted with interest that even ABAG is thinking of becoming an aggregator of energy supplies for member cities, as deregulation unfolds. NEW BUSINESS 2. Commodity Pricing Policy - Electric and Natural Gas Vice Chair Ferquson: We will now take up the Con~nodity Pricing Policy. Jane Ratchye will make the presentation. Ms. Ratchye: (Projecting slides) This is the commodity pricing policy, and it is one of the first things we hope to have completed after council approva! as a risk management program. You may ask, why do we even need a commodity pricing policy? What has changed? The answer is that it is due to competition. At this point, customers can leave us. We no longer can just wait unti! costs are different from what we thousht and take money from the reserves or put money into the reserves. No longer are the customers at risk like that, but the utility is at risk. That is why we need this policy. In the policy, there is a brief description of the different generic risks that we are exposed to. One is Market Price Risk, and that is just when the market price changes, which occurs every minute, and the fact that it--can be MINUTES _UAC:99090hMIN Final Page 7 dramatically different from what you had planned on if you do not take an action to lock in purchasing at that price. Credit risk is where a counter party can default or not perform on-a purchase or sales transaction on the wholesale market. Volume risk is just where there is a difference. Again, it is the uncerhainty, particularly for us, of the production from the Calaveras hydroelectric plant, which is very, very dependent upon what sort of water year we are having. Another reason why we need a policy like this is that it looks like we are going to need to development a lot of different con~modity pricing products that we do not currently have available, because those are available in the m~rket place, and our customers see those that are offered. There is a huge variety of different products being made availabl4 to them, and they see those because they are being contacted directly by power marketers even in Palo Alto. Finally, we need this policy because it is possible that some customers may wish to leave -- and I’l! talk about this more a little later -- we need some flexibility so that we can get at least a part of their fixed cost contribution, so we need some flexibility, and we need to outline what that is in the form of a policy. The policy consists of five principles. The first one is ~Direct Cost Recovery, a pretty straightforward one. Al! of the direct costs of providing commodity service, including the price of the commodity itself plus the transmission and transportation of that are included in the direct cost recovery. The principle there is that we have to recover our direct costs. The second one, Risk Management, is the idea of having a risk premium, of allowing the utility to charge a risk premium for the occasion when the utility is taking a risk and is offering whatever product we have come up with. This is fundamentally the new and different thing about the commodity pricing policy. It is entirely related to what I was talking about before, the switch in who is holding the risk, whicb has gone from the customer to the utility. So we need to be able to collect for that. The third one is Indirect Cost Recovery, which includes all of the overhead and CPU charges, other fixed costs that we may have that we normally would like to spread over all of our commodity customers. The last two, Nondiscrimination and Nonsubsidization, are principles that are in our current rate setting for a bundled product, and distribution also. That just means that we want everyone within a rate class to be eligible to receive the same type of rate, or a substantially similar product. Nonsubsidization - we would like to al!ocate costs according to how those accrue to us. We do not want one class to subsidize another. The next part of this is that those five principles are in priority MhNUTES UAC:990901 :I~IIN Final Page 8 ranked. So the first two are the priority ones. First of all, we do not want to lose money, so we definitely want to have all of our direct costs just in terms of what we had to pay for the commodity plus the transportation to ~hat customer. We do not want to have to price anything that is be!ow that. The second principle is to make sure we can collect that risk premium. The third one is ranked third, and in a dire situation where someone looked like they were ready to leave us ,and they had a very credible alternative and were ready to go, but if we somehow discounted our rate somewhat in order that we received at least some of these indirect costs, maybe not all of them, that would benefit everyone more than if the customer actually left us and the customer was not able to contribute at all to the fixed costs. That also is a critica! item. To the extent that we have to violate this 100% indirect cost recovery, then obviously, we would violate the other two principles, nondiscrimination and nonsubsidization. So the first two are really the priority principles. Obviously, we would like to collect the indirect costs from everyone, too, and we would not want to discount any customer at al! unless we thought they had a very, very credible alternative to it. Just going over it again, what do the direct costs consist of? Just the raw commodity and the transmission and transportation to the customer meter. The indirect costs consist of overhead, which is salaries and benefits of staff, rent which we have to pay, al!ocated charges from services that the utilities receive from genera! fund departments, the General Fund Transfer, whatever part of that is ultimately al!ocated to the supply business, and the NCPA charges that we pay. There is a variety of those that are non-related to dir~tt cor~nodity, such as legislative, regulatory, and just a lot of different charges that we pay NCPA for various services. The third component of commodity rates are other transfers and non- operating income so that when we price to a customer, that we make sure that we account for interest income, for example, or if we had a cost, for example, that was partially a stranded cost and we had income coming into the supply business unit from the Calaveras, the stranded cost~ reserve, that that is accounted for every customer in the development of a rate for a particular one or for a particular class. Finally, the Risk Premium. We want to make sure that any risk that the utility was going to assume, that the customer would end up paying for that. Oversight Control and Reporting is not something that we are asking the Counci! to approve at this time. We are only asking them to approve the principles. The way they will be implemented is that the City Manager would be responsible for policy implementation, so this section is for your information only. Implementation would require the deve!opment of commodity pricing procedures. You do not see those here. You have guidelines that are MINUTES UAC:990901:MIN Final Page 9 attached for your information that go through the components of commodity prices. Much more detailed procedures would need to be developed to declare exactly how these different components would be calculated, because we have complicated factors like a be!ow-market resource to allocate to all of the different customer classes. Those would need to be developed to have it fully implemented. The schedule for this particular policy is that we are planning to take it before the finance committee one day before your next meeting, Tuesday, October 5. A month later, it will go to the City Council, as currently scheduled, for fina! approval.- I want to mention a couple of other related items that are planned to go. There have been no dates set. These are estimated time schedules, and they are Council dates, not when you would see them. We are hoping to get a long-term contract policy approved by the Council in January, and we are hoping that they will also approve some new fixed-term contract rates in January for implementation in February. You will obviously see that before the City Counci!. This slide somewhat goes into items on your next agenda item, which talks about the things coming to the UAC. These dates are not confirmed yet, but give a general idea of when we plan to take various items to the Counci!. That means that a month before, they wil! go to the Finance Cor~mittee, and at least a couple of weeks or a month before that, they will come before the UAC. So the first step is to establish the strategic planning direction for the utilities, and that will also involve some education in the area of risk management for the Council, and prior to that, for the UAC. . In February, we would like to get the Council to sort of buy off on a general approach to risk management, what is their risk philosophy, and then, following that, approval of risk management policies. Following that is guidelines. Those would be guidelines that would be following the policies that were previously approved. It seems like a drawn out schedule, but we cannot ask the Council to approve guidelines or even see guidelines until the policies have been approved. The procedures that we are anticipating at this point are that the City Manager would be approving the procedures, and the procedure level would not go to the Council. Obviously, the UAC would see al! of these different components probably six weeks to a month before the Council does. You will probably see that on the next agenda item. Do you have any questions about the commodity pricing policy? Commissioner Carlson: I want to begin by saying that the writeup on this is one of the clearest writeups of a very complicated subject that I have ever seen. It was a really good job. It is so easy to get lost in this material. I want to jump forward on this to be sure about some of the key implications. What all of this implies is that you start breaking down rates not just by class but by what degree to which the customer -- MINUTES UAC:990901:MLN Final . Page 10 how risk is shared between you and the customer. If the customer wants a firm rate for a certain period of time, that would be one category. If the customer wants to pay some percent indirect cost and just go with you on how the market moves, that is a different rate structure. Is that the direction in which you are moving? Ms. Ratchye: Exactly. If the customer wants to keep the risk and they want essentially an index-base or even a cost-base, we would be happy to accommodate that as long as they really understood what that means in terms of potential volatil~ty.. Or if they are more comfortable with a fixed rate, we can develop-that, or even if it is a fixed rate with a cap. There are lots of things we can do as long as they are willing to pay for that. We can develop different products that have different risks for the utility, and we need to be compensated for that. Commissioner Carlson: .I would think that one of the key parts of this is that you are going to have significant trouble getting the Council to understand that concept. It also applies to customers. I think that one of the questions is, when do you start talking to them about this, even before it is all done, .that this is where we are heading, and you are going to have to start thinking about these kinds of choices which we will be asking you to make a year or so from now. Mr. Balachandran: I recognize what you are saying, and yes, it is going to be a challenge. We have a marketing group, we have a key account program where some of us are in pretty constant touch with our customers. It is through that avenue that we would do it. I guess the message I am getting from you is to not underestimate the difficulty of the task. Commissioner Carlson: I am wondering if they are starting to see material like this? Ms. Ratchye: i think they are seeing it from other marketers already. Some customers are quite sophisticated, and they have said to us, they want to buy at a below-index price. Commissioner Carlson: Yes, I would assume that some of them are very sophisticated, and some will be clueless and wonder what you are talking about. Mr. Ulrich: There ha~ been a lot of progress made in discussions with customers. We do spend quite a bit of. time with each of our key customers. We have people dedicated and focused on that. We believe we are probably quite a bit out in front of many other cities, and even some of the IOUs, in being able to offer -- Con~nissioner Carlson: You are, I have worked with them. Mr. Ulrich: So we are dealing with quite sophisticated customers. You can have this kind of a conversation with them, and they clearly see where it is you are going and what you are trying to do. I think that what is key at this point is that they understand that we are trying to MINUTES UAC:990901:MIN Final Page 11 look at these areas and so, are looking out for their best interest based on what they feed back to us as being what they are looking for. Candidly, we are in a position, particularly with electric in Palo Alto, to be the low-cost provider. When they go out and !ook at alternatives, they see that we are clearly in the forefront of being able to offer them low-cost products. There other things that drive them, as well, so those are the areas we are looking at to improve upon.¯ Coramissioner Gruen: You presented some principles associated with the pricing policy you would like to have. One of them is nondiscrimination within customers of a particular class. Does that mean that if Company A gets a particularly good deal, Company B of similar size, at least as measured by how much of the commodity they use, would be entitled to get the same rate? Ms. Ratchye.: I don’t think it would be the same rate. They would be entitled to a similar product, but our costs are driven by how much heavy-load hours versus light-load hours you have, for example. !f someone has a different load shape, even though they have the same annual kilowatt hours, that would be a different price. Also if they ask for the same product two months hence from the last guy, then they would most definitely get a different price because the market would have moved then. We would have to present the market to them at the time that they were about ready to sign up for that product. Commissioner Gruen: One of the paraxneters would be how sophisticated the customer was, and whether they knew the right questions to ask. Ms. Ratchye: No, I don’t think that is it. We.would try to understand what it is they were after, whether they were afher a fixed price, etc. We could show them that maybe they have things they could adjust, for example, if they wanted a more index-based rate, maybe they could try to flatten their load. There are a number of different things they could do. I don’t think we would hide different alternatives from different people. We want to make sure that everyone within a customer class could have the same type of product, but I could not guarantee that the price would be the same, because I am not sure they are both coming to me on the same day with the same load shape for a single term and for the seme market. If they did, they would have the same price. If you had two customers that came to me on the same day with the same !oad and wanted the same product, then I would say yes, they would get it for the same price. Commissioner Gruen: Let’s see if we can remove some of the variables, at least the theoretical ones. If you had a customer who had not only the same total quantity but who had the same !oad shape (which I feel is a good description) and the time of day they wanted service was the appropriate, if they had the same tolerance for interruption, maybe that is a way of saying they are looking for the same kind of thing, would you actively tell them about other possibilities? Would you expect that the salesman from the Palo Alto Utilities would say, "Here’s the kind of thing we did for someone else. We could do something like this for you." I~IINUT ES UAC:990901: MIN Final Page 12 Ms. Ratchyg: I think we should n6t, because then each product we would develop we would be indifferent to. The risk that each one imposed would be incorporated into the price, so we should not care which product we would be offering to them. Con~missioner Gruen: So some of this depends upon how good the utility salesman is and whether he can recognize which things might be appropriate for this customer. Would you provide the customer with a written description of the kinds of products you have available? Ms. Ratchye: Yes, we have already developed information pieces that describe the different kinds of products, things that would have a cap, fixed prices, index-based, a wide range of different things. Commissioner Gruen: Are those routinely given out when you deal with large companies now? Ms. Ratchy,e: policy. I would say that they will be after the approval of this Commissioner Gruen: But it is not something you are doing now? Ms. Ratchye: We are not actively doing it, and I think the reason we are not is that we need to have approva! of a policy like this that is very, very clear as to how we are doing this and is not different from one customer to another, so the Counci! can have a lot more comfort on what principles we are using to price the different products for different rate-shape customers. Mr. Ulrich: Let me add a little to that. Our current rates are relatively simple. We are moving from a regulated utility environment to unregulated. As you recall, when we opened the access, we are the only City that has open access for electric, and starting today, for gas. We have held meetings with customers, inviting them both to public forums and then visiting with them personal.iy. So they are well aware, or have been made aware, of these options. That would be the same type of philosophy that we would have as we become far. more sophisticated in understanding their needs, and then developing products and services that they will find valuable for their business. So the key to that in having any success and in having any !ong-term relationship with customers is to be honest with them and to provide them with the best source of products and services that would make them successful. That will be the cornerstone of our future development. We wil! try not to develop products that nobody wants. And we will modify those as needed. The key thing is, as pointed out earlier, that we need to keep market share and keep the customers here so that we are not transferring the direct cost from customers that leave over to customers that are staying with us. That has to be factored in all the time. Commissioner Gruen: Are there customers now who have specialized packages developed for them? Mr.Ulrich: Currently, we have two customers that have something MINUTES UAC:990901:MIN Final Page 13 different that were negotiated contracts. looking at those again. We are in the process of Conunissioner Gruen: Do those meet those last two conditions of nondiscrimination and nonsubsidization? Mr. Ulrich: Yes, they do. Commissioner Gruen: Let me ask about some of the precise terms which you are using here. Indirect costs versus direct costs. I have also heard about fixed costs and variable costs. I am not clear which of those you mean when you talk about things. I think of a variable cost as being commodity-related as opposed to the cost of maintaining the pipes, for example. Ms. Ratchye: I misspoke and should not have said fixed costs. I prefer to term it an indirect cost,.~otherwise you run into difficulty if you have, for example, debt service for Calaveras. That is a fixed cost, but through our stranded cost process, we are calling that a marketplace resource. So it is not a fixed cost, but most of these indirect costs are fixed. We mean that they do not change with a change in load. Commissioner Gruen: To me, that sounds more like a variable cost, costs which are associated with how much of the commodity you use, rather than what an accountant might call a direct or indirect cost. Ms. Ratchye: It is probably variable. I don’t know if Girish wants to add to this. We did not want to confuse it by using the words "fixed cost," because I didn’t want to have COTP debt service and Calaveras debt service, which are fixed, to be what people"think of when they say "fixed cost. " Mr. Balachandran: We had a choice of just using all these different words, but using "fixed" and "variable" was limited for the purposes of this discussion. "Direct" and "indirect" seemed to capture what we are trying to say the best. Commissioner Gruen: that the theory? Are salaries included in the indirect costs? Is~ Ms. Ratchye: Yes. Commissioner Gruen: Also, you talk about transmission costs to the customers. In electricity, we have been talking about transmission as being to Palo Alto’s meter, and distribution costs as being within Palo Alto, if you will. Are you thinking differently here? Ms. Ratchye: We are talking about the conunodity price right at the customer meter. So that includes all !osses to the distribution. Those would be part of the supply costs, and the transmission, as you were saying. Yes, more accurately, it would be transmission but does not include any of the distribution system cost components. It is just the losses in the distribution system that are included in the commodity MINUTES UAC:990901:ME’4 Final Page 14 price. Commissioner Gruen: So the commodity price would include leaky water mains and how much water you lost through them. Ms. Ratchye: This is an energy policy. electricity, to confuse things. it is for natural gas and Commissioner Gruen: sure you know. Well, electricity has comparable losses, as I am Ms. Ratchye: Yes, it does include that. Commissioner Gruen: But it does not include the cost of maintaining the wires and the poles, etc. Ms. Ratchye: No. Commissioner Gruen: As I understand it, the payment to the City is based upon the capital whichwe have invested in the utility.Is that correct? Ms. Ratch~.e: Yes. Conumissioner Gruen: So it is primarily distribution-related. Ms. Ratchy~: At this point, there is no allocation of the general fund transfer in the commodity for natural gas and electricity. But we think that might change, so we wanted to make sure tha$.the policy would allow for the collection of that in the indirect costs,’ if that was al!ocated there. There are a lot of questions remaining on the general fund transfer calculation methodology and also the split of it between supply and distribution. So to the extent that in the future, there is some general fund transfer that is allocated in some mechanism to supply, it will be included in the commodity pricing. Commissioner Gruen: There are various kinds of risks that you called out. Have_you some ballpark figure of the percentages that would apply to those risks? Say a dollar’s worth of commodity cost, how many cents’ worth of the various kinds of risks would you expect to see? Ms. Ratchye: I really do not have a figure like that. The credit risk is really a matter of building up some sort of credit reserve. We would nt~nage that risk by having approved counter-parties and having a maximum a~uount where we would, do trading for any particular counter-party. For marketplace risk for gas, that can be significant. For electricity, because we have so much of a fixed c~st W~stern resource, it is not a huge fraction. For volume risk, that is sort of an interesting one, because most prices we would come up with a fixed price is really a free we are selling to customers. We don’t know what their load is going to be, so that could be significant. On the wholesale side, the Calaveras project is not a huge part of our electricity resource. I do not have a number for you on that. MINUTES UAC:99090hMEN Final Pa.ge 15 Vice Chair Ferguson: Let me step in on that to pursue that point. It is a good question, about getting a feel for what these risks are. I made a note here on credit risk. Has the utility ever taken a loss in this category of credit risk, in your experience? Ms. Ratchye: Not yet. Vice Chair Ferguson: So none of us has a feel for it? Cormaissioner Carlson: Rick, there are a number of private utilities that have gotten caught a number of times in recent years. It is kind of like an earthquake. There aren’t any smal! !osses, only rare, gigantic losses when things get really fouled up, and somebody walks away from a contract. Commissioner Gruen: hi. would submit that Palo Alto has seen something like that in the natura! gas area where we were negotiating with someone who was going to provide us with significantly better prices; After a couple or three years, they said they were not going to do it at al!. So we have at least some measure that, yes, this.really happens, and maybe you have a way of quantifying it. In the case of Calaveras, we know that we can see numbers like, a good year is 100%, and we can see bad years where 50% was the right number. So we do have some quantity information we could work from. I think that is the sense in which I was saying, are we looking for a factor of the two differences we see in Calaveras, or are you !ooking for a smaller number than that, or a larger numaber,, or what? Ms. Ratchye: We will look at all of those factors. Actually, we have a very good idea. We have a !ot of hydrologid history, and we know extremes of dry and wet average in Calaveras production. There is actually quite a bit of good data on that. It is n’ot a huge resource mix, so I just cannot tel! you that Calaveras production of a certainty will equal two cents for every dollar. I do not have that number today. Those are the kinds ~f analyses we will be doing. Vice Chair Ferquson: Commissioner Gruen’s question is useful on another point here, that is, that this is well written. But this docLunent is on its way-- we are al! going to try to pitch it to the full Council. Also, in some respects, it would be helped by a couple of scenarios, a couple of hlrpotheticals, talking about rea! electricity, talking about real gas, a made-up company, a made-up product, just to create something closer to a tangible feel for what risk means, what reasonable dollars at stake look like in this policy. This is a great analysis,-a great thinking framework. Making it a bit more tangible, attaching a cguple of pictures in the pitch to the full Council, would be good. I have a couple of questions, as well. You talked about three categories of risk -- market price risk, credit risk and volume risk. Then you have an unnamed category, kind of a customizing risk. Are we getting to a place where you are customizing so much to the peculiar ne~ds or requests of a customer, that we really are way outside of the MINUTES UAC:990901 :MIN Final Page 16 definition of rate making as authorized in the City Charter? Ms. Ratchye: we are not there yet. I think the question of rate making is a separate question from this. This pricing policy is how the process would be developed. It does not specifically say who would set the rates. Randy, you may wa~t to comment on what we may request in the future about who has that authority. Mr. Baldschun: The purpose in coming back later this year to the UAC, and ultimately to the Council, is to address that question, which is, right now we are not doing customized contracts. We are suspending all contracts for this year. As John mentioned, we have two, and the purpose of this commodity pricing policy, to a large extent, is to not only price our full-service rate schedules and provide some fixed term rate options, but also to give a frazaework upon which we can do customized contracts. That is the area that I think is going to be focused upon. So I think that this report gives you a sense of what we are thinking about in terms of how we would approach a customer who convinced us that we needed to do something different than a standard tariff that we have on the books right now. In terms of deviating from traditiona! rate making standards, it is not unusual for utilities to do what we are doing, and even the customized contracts. PG&E, for example, took this approach in the 1980s to keep customers, such as Chevron, from leaving their system. They would offer specia!, confidential contracts. So that is the kind of direction that we see. Frankly, I hope we do not go too far in that direction, but we will not know how far we have to go until we really see some strong interest from our customers to leave us. If they do want to leave us and they convince us that they are going to leave us, than this would be a tool that we would want to have at our disposal to ke~p them, and keep that contribution Vice Chair Ferguson: I agree wholeheartedly with the thrust of this. ~It is the right thing to do to compete. I just paid attention to the December Dick Rosenbaum memo wherein he points out that we have to change some things, perhaps even the City Charter, to give us the flexibility to do that kind of competitive dancing. The definition of rates, at least in my mind, cropped up right there, when we talked about specially customized packages. I have several more questions for Randy. I want to be clear on the nondiscrimination and nonsubsidization provisions. I am sure there are good reasons for them. Are they there because we want them there, or are they there because a statute makes us do it? Are they there because of some type of equa! protection considerations in utility law? Mr. Baldschun: They are formalizing what we have always done. Being an Attorney, you can appreciate what happens to you if you arbitrarily decide to charge undefensibly high rates to one customer. You can get sued and end up in court, so we have never come close to that, but we pay close attention to how we allocate the costs, making sure that customers in similar circumstances are paying the sa~e rates. Typically, the cost differences justify a.departure from one customer to MLNUTES UAC:99090hMLN Final Page 17 the next. Jane talked about load shape, things like that, which help justify it. Regarding subsidization, if you were a sharp economist, you could pick apart any cost service study, and.I don’t care who does it, it can be the most brilliant economist in the world, and he could allege a subsidy somewhere in the rate tariffs. ! have seen it. That-is why the California Manufacturers Association representing residential customers had economists that actually tried to prove that point, and sometimes, they succeeded. It is hard to say that you are never going to have a subsidy. What we try to do in Palo Alto, and what a lot of utilities do, is to do a cost-of-service study. That indicates that one class is paying more than its fair share, so you adjust the rates towards eliminating that subsidy. You may not eliminate it without one rate change. It may.take.~several years, but you move in that direction. You do not move the other way. Vice Chair Ferquson: My last two questions. One is that the number of different facts and figures in customer characteristics and cost categories to juggle are really quite large here, if we are going to be nimble and competitive and adaptive. We talked earlier in the budget season about the new customer information system. Is that still on track, and is that the system that will help us manage all of these kinds of risks? Mr. Baldschun: Regarding that project, we are doubling up on some resources to meet a November 1 go-live date. SET is the contractor that is coming out here. It has been a very difficult project, for a number of reasons, but we want to go live on November I. We wil! go live, but whether or not it is on November ! remains to be seen. But we will eventually go live, and we will have the flexibility to handle all the kinds of commodity prices we have been talking about. Vice Chair Ferguson: So that original promise of the new system makes it the system that will support this kind of slicing and dicing of components of customer risk. Mr. Baldschun: Yes. Vice Chair Ferguson: My last question goes not so much to the role of the UAC in getting this developed and brought before the City Counci!, but the role of the UAC in the periodic quarterly (or whatever it will be) oversight, for discussions with the City Manager about how wel! or how poorly we might have done in our first cut at deve!oping these new risk management products. Do you see that the UAC has a role when you think about oversight? Or do you think the UAC’s role here falls within Councilman Rosenbaum’s connnent about the "...cumbersome procedures and time-consuming processes that are a part of local government handicapping a municipa! utility in a competitive envirornnent..."? Mr. Ulrich: I will try to answer that as directly as I can. I think Councilman Rosenbatun has a finger on the pulse in that it takes a lot of time. It is a public process, as Jane has laid out, and as I am sure we will discuss in our future agenda at that time, which is that the public process takes longer than a company just doing this in a back room MINUTES UAC:990901:MIN Final Page 18 somewhere. We are obviously dedicated to the public process, which owns the utility, and we owe it our ratepayers and to the people who live in Palo Alto to do it that way. I think, though, that on the other side, we also owe it to them to find a process that allows us to stay competitive and be competitive and not lose the business. So we are going to have to find more streamlined ways, as competition heats up, of doing this conununication. My belief is that, as we go through as we are doing now, methodically setting Up the process on how we will treat our customers and how we will act with competition, then all of that public process will take place ahead of time before the competition gets here. Then with those procedures and risk policies in place, we will be ready to go and able to compete. So it is critical that we do al! of that over the next number of months. If it requires, in the judgment of the UAC and the Counci! and the staff, that we go and change procedures and policies, then we should go ahead and do so. But a lot of public process is going to take place before that occurs. We believe it is going to be extremely important to take all of this out and have fortuns where we can talk to people about it, fine-tune it, and end up with staff recommendations on what we should do. Cormuissioner Gruen: I have one final area, and that is the reserves which would implement this sort of policy, i think of our reserves as really being three kinds of things. One is the equipment reserves, and those are calculated based on equipment. If anything, we are not putting enough money into those. There is the stranded cost reserve, which we understand is a transition issue. You used to be able to expect that your bonds would be paid off. Now you have to ensure that you have the money to do that, although I see elements of the kinds of reserves that you are talking about here. Contract rese ~rve, which is what I cal! your Credit reserve, I see some of those creeping into the Calaveras reserve, which is therefore a less purely stranded cost reserve. However, the middle ground, if you will, is what you have been calling rate stabilization, and these are just more elements of rate stabilization. The same rates may be more complicated, and there are more elements to it. By what percentage would you expect the rate stabilization reserves to go up as a result of recognizing these additional risks? Mr. Baldschun: We are not planning to propose any change in the reserve policy, for a couple of reasons. If we are talking about credit risk, my feeling is that we wait and see what happens before we start changing reserve levels. I don’t think we wil! have to. We have reserves at the maximum level right now in the supply rate stabilization reserve. By the way, we are not going to touch Calaveras with this. Calaveras has its own agenda, and it is very specific as to how that can be used. In terms of contract risk or credit risk or commodity price fluctuations, al! of that gets basically netted out in the rate stabilization reserve. We have guidelines for that reserve, a maximum guideline and a minimum guideline. If, for whatever reason, that reserve starts to go down toward the minimum, then we wil! adjust rates. It could be for a credit risk, or it could for any other things that go into it. But I do not see a need right now to go in and increase the MINUTES UAC:990901:MIN Final Page 19 reserves simply because potentially, there could be a new credit risk. If you add up all- the things that could happen, the likelihood of everything happening at once is very.small. So I could not justify in ~y own mind assuming the very worst scenario. When you have to do that, I think you are going to have too big of a reserve surplus. Commissioner Carlson: Part of that is that you are assu/ning that you will self-insure all of these risks. The whole purpose of some of the kinds of contracts you are talking about I would hope is to provide a mechanism for laying off~ the risk on the markets through forward contracts and all of those other things. So there is a very real tradeoff. How much are you self-insuring? How much do you lay off? And how do you lay it off? That is all part of this complex, so I don’t think you can pick out of a hat what you need as a rate stabilization policy. Mr. Balachandran: I think you are right. We will, to the extent that we are offering a customer a certain contract that we can hedge in the market, we are going to go ahead and hedge that. But there are certain things that are the earthquake kind of events, as you said. You try and do the best you can. As a specific example, you prequalify the kinds of people or counter-parties you are going to do deals with. You take some steps like that, so we are not going to expose. There are a number of different ways of hedging those risks. In addition to that, we wil! have reserves, too. Vice Chair Ferguson: You’re right. This is the first product in a series of products that you promised the Council on rethinking and restructuring the utility. It is a good first ~tep and a good thinking framework. Thank you for a job wel! done. ! hop~ these comments can be ref!ecSed, to some extent, in the version that goes to the City Council. NEW BUSINESS 2. Future and Special Meeting Agendas Vice Chair Ferguson: At the last meeting, we talked about scheduling some extra UAC meetings between now and January, for a variety of reasons. One reason is the hundredth anniversary of the utility. That is always a good flag to wave, and it is a nice, positive marker in the history of a wel!-run operation. The second is that I think there were some promises made to Council. Wewill have some new Council members in January, with some promises made to Council to get this question of risk management and restructuring and governance before them in an organized fashion. We have a campaign under way for Council seats. There is an o~portunity h@re for the utility to put its first best foot forward and demonstrate that the utility, as a whole, is on the case, reexamining itself. That there is a game plan, a framework for thinking through these problems. You indicated that in the presentation tonight on how the commodity pricing policy is going to step through the process. So as we think MINUTES UA C:990901: MIN Final Page 20