HomeMy WebLinkAboutINS-13-096 - Natural Gas Purchase Policy Overview Staff Rep►�►r
I r Infrastruc�ture5ervrresDepartment wvwuukitchenerra
REPORT TO: Finance and Corporate Services Committee
DATE OF MEETING: December 2, 2013
SUBMITTED BY: Walter J. Malcolm, Director of Utilities,
519 741 2600 ext 4538
PREPARED BY: Loraine Baillargeon, Manager Asset Optimization,
519 741 2600 ext 4532
Jim Gruenbauer, Manager Regulatory Affairs & Supply,
519 741 2600 ext 4255
WARD(S) INVOLVED: All
DATE OF REPORT: November 26, 2013
REPORT NO.: INS-13-096
SUBJECT: NATURAL GAS PURCHASE POLICY— OVERVIEW
RECOMMENDATION: For Information Only
EXECUTIVE SUMMARY:
The City's Natural Gas Purchase Policy for Kitchener Utilities (KU) was initially approved by
Council in 1998 and last revised and approved in October 2006. The guiding principle of the
Policy is to achieve the minimum cost of gas for the minimum risk. The Policy criteria are
similar to other gas utilities and are sound. Natural gas is an energy commodity impacted by the
weather, economy and geopolitical events. Its price fluctuates and cannot be consistently
predicted with accuracy.
KU's gas supply program is not for profit and serves most of Kitchener's residential and
smaller commercial customers. KU buys gas supplies for these customers using a combination
of fixed and spot prices. Due to the "rapid fire" nature of gas trading in the market, the tendering
process is quite different from other City requirements for products and services. The staff
responsible for gas supply purchasing has more than 60 years of experience and is supported
by two qualified Ontario-based consulting firms.
KU gas rates typically change on an annual basis. This is consistent with a preference for stable
rates by the majority of customers. Rate-setting must include the reserve requirements for the
prudent management of municipal finances. If the gas purchasing strategy is changed to rely
solely on spot market prices, then it will be necessary to change the supply rate on a quarterly
basis, similar to Union Gas.
There are risks, benefits and trade-offs between these two approaches to buying gas. They are
fundamentally different and designed to achieve different goals. Their performance must be
fairly measured against those goals over the longer-term, recognizing the unpredictable nature
of gas prices. The OEB's order in late 2008 for Union Gas to buy gas solely on a spot basis was
a lucky coincidence for Union's customers. More than luck and hindsight are needed for Council
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to fairly assess if it should direct KU to change its gas purchase policy. KU is not impacted as
the program is not for profit; however, the impact of such a change would fall on customers and
the management of their gas bill along with their remaining household budget.
From a rate perspective, Council could adopt Union's spot purchasing approach and quarterly
rate-setting policy. In staff's view, it is not necessary to change the current policy to do so; only
a change in its implementation and the active price management of supply is needed. While this
approach is counter to the historical preference for stable gas rates in Kitchener, this approach
will be thoroughly canvassed in a substantial customer engagement process in 2014.
BACKGROUND:
Report INS-13-022 on Natural Gas Rates was presented at the May 27, 2013 meeting of the
FCS. INS-13-022 included a review of the gas supply program of KU. Report INS-13-077 on
Natural Gas Rates Follow-up Report— Gas Supply Options was presented at the September 30,
2013 meeting of the FCS. At the October 7, 2013 meeting of Council, staff undertook to provide
an overview of the City's current gas purchasing policy.
REPORT:
Introduction
As a natural gas distributor in Ontario, KU is required to provide a default "system supply" option
to its customers at cost, without cross-subsidization by other utility programs. Natural gas is an
energy commodity (similar to crude oil) whose supply and demand is impacted by uncontrollable
and unpredictable factors such as the weather, economy and geopolitical events. Its price
cannot be consistently predicted with accuracy.
Gas supply is purchased and managed to meet planned customer requirements, assuming
normal weather conditions. KU contracts for supply with credible and credit-worthy third party
suppliers under an industry standard form of contract with negotiated special provisions. Gas
supplies are closely managed under Natural Gas Purchase Criteria as approved by Council.
As shown in Figure 1 on the following page, KU's system gas customers currently number about
65,000 or about 97% of total customers and about 77% of total annual volume of gas delivered
(about 200 million m3 out of 260 million m3). Total annual gas supply purchased at current
market and contract prices is in the order of $ 32 million (pre-2008 financial crisis, the value of
annual purchases was closer to $ 60 million.)
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Figure 1-Number of KU System Gas Customers
Industrial
350
1 Commercial
4153
6%
Residential
60678
93
KU -Total System Gas Volume -in millions of m3
Industrial
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21%
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Residential
128
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32
16%
Gas supply is purchased in advance and scheduled daily and invoiced monthly. Purchases are
higher during the winter season to meet higher customer demand. Changes in weather-related
demand occur often and require seasonal adjustments in gas supply and close management of
gas storage balances to economically balance supply with demand and ensure that KU remains
within its contractual limits. Management of gas supply and storage involves dozens of high-
value transactions on an annual basis.
1. Current Gas Purchase Policy
The City's current gas purchasing policy was approved by Council in October 2006 (attached as
Appendix A). The revisions to the policy as approved at that time by Council extended the future
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period for gas purchases from three years to five years. This provided flexibility to KU to mitigate
cyclical price risk for ratepayers during periods of increased market volatility amid consensus
expectations of higher prices. In the mid 2000's, domestic supplies of natural gas were stagnant
or falling while the demand for gas for power generation and other uses was growing. This put
significant upward pressure on spot and future gas prices at that time which were already at
elevated levels relative to historic prices.
Given these price uncertainties, the flexibility to purchase gas at fixed prices up to five years in
the future, as approved by Council, shields ratepayers to some extent from higher prices. It also
stabilizes the rate in accordance with the preference of the majority of KU system gas
ratepayers as supported by continuous customer survey.
The City's current gas purchasing policy has been reviewed in comparison to other utilities,
such as Union Gas, as described below.
2. Gas Purchase Management
KU's supply program is not for profit and serves the majority of Kitchener's residential and
smaller commercial gas customers. KU buys gas supplies for future consumption by its system
customers using a combination of fixed and spot (floating) prices. Staff closely monitors and
actively manages the portfolio of supply contracts and its average price for planned purchases
(based on normal weather) up to five years into the future in accordance with the approved
purchase policy. Importantly, KU's managed supply program does not try to "time the market"
and attempt to predict the future price to "buy at the bottom" and avoid "buying at the top".
—"Rails" Approach to Future Purchases
Since the inception of KU's managed supply program in the late 1990's, it has taken a
disciplined approach to buying gas supplies for future consumption, consistent with the
approved gas purchase criteria. Attempts to predict prices and "time the market" are inherently
risky and to be avoided, particularly as the factors which impact gas prices are complex and
unpredictable. Market timing risks magnify in the longer-term. KU's disciplined approach to
buying gas recognizes these risks and acts to mitigate them in a practical way that also provides
the rate stability historically preferred by the majority of customers.
Figure 2 on the following page is a "snapshot" of the current gas supply portfolio for the next five
years. The amount of gas to be purchased for future years is guided by the minimum and
maximum limits or "rails" as illustrated. The maximum limits are tied to expectations of higher
prices, while the minimum limits are tied to expectations of lower prices. The limits diminish and
narrow over the five year purchase horizon. This provides discipline and flexibility, while
explicitly recognizing the magnified risk that actual prices in the longer-term may be very
different from current expectations.
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Figure 2
KU - Gas Supply Portfolio at Nov 12, 2013
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A disciplined commitment to the rails approach, in conjunction with the risk sensor approach
described below, should result in the average rate for KU gas supply to be comparable over
time to the market price and Union's rate. As market prices for gas rise and fall in a cyclical
pattern and with underlying trends towards higher or lower prices in future cycles, the disciplined
rails approach will result in a smoothed rate. The price "peaks" and "valleys" will tend to be
avoided, resulting in less volatility and a more stable and predictable rate from year to year.
Figure 3 on the following page is the current gas supply portfolio over the next five years. It
illustrates the application of the "rails approach" (declining amounts of fixed price gas over the
term) and the corresponding convergence of the blended average price of the portfolio with the
prevailing market price.
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Figure 3 - KU Current Natural Gas Supply Portfolio
100% 20
90% not 18
80% - _. 16
70% 14
60% 12
Fixed Price 50% - 10
Percent of Total Price-Cents per M3
40
30% — — — — — — — — 6
20% - 4
10% — — — — — — - °°.°.°.
2 L
0%
2013 2014 2015 2016 2017 2018
Fixed% Fixed Portfolio-cents/m3 °A',I- Market Price-cents/m3 ••••Blended Portfolio-cents/m3
—Tendering of Gas Purchases
The approved gas purchase criteria provide for competitive tendering of requirements by KU's
approved suppliers. This tendering is executed by KU's consultants with close oversight and
approval by staff. Due to the very liquid and "rapid fire" nature of natural gas trading in the
market, the gas tendering process is quite different from the process used for other City
requirements for products or services. Offers for natural gas supply at fixed prices cannot be
held open for acceptance for more than several minutes. Accordingly, it isn't possible or
practical for Council to approve each purchase like other City tenders.
The volume and dollar value of gas supply transactions are significant, as noted above (dozens
of transactions on an annual basis with a total value of about $ 32 million). For similar reasons,
the approach to tendering for gas purchases is similar to the approach taken for treasury
management and investment policy where Council doesn't approve each investment. However,
in both cases, Council does provide meaningful direction to staff to manage the gas and
investment portfolios under detailed policies with defined criteria and limits within which
decisions are made.
— Expertise of KU staff and consultants
Council is keenly aware that the natural gas utility business, in general, and the procurement
and management of gas supply, in particular, are complex. This complexity demands the
retention of utility staff and consultants with specialized knowledge and experience. The current
full-time and contract staff at KU with primary responsibility for the strategic and day-to-day
management of gas supply have more than 60 years of combined applicable experience;
including time spent at KU (23 years) and at other utilities, including Union Gas and Consumers
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Gas, and energy marketing and consulting companies (37 years). This experience included
appearances as an expert witness before the OEB on numerous occasions.
In addition to in-house staff, KU is supported under retainer agreements by two Ontario-based
consulting firms (ECNG Energy LP and Aegent Energy Advisors) with extensive experience in
assisting large energy buyers. The primary consultant contacts for KU at these firms each have
more than 25 years of applicable experience and are supported by their own complement of
experienced staff and back office resources.
3. Changes to Price Risk Management
A risk assessment of factors impacting utility operations was conducted by staff in 2010. This
included the gas supply and risk management program. A best practices review was undertaken
of the Gas Procurement and Risk Management Policy and Procedures for System Gas used by
Union Gas. It was felt that Union's policy and procedures could serve as a replicable model for
KU, with adjustments to allow for differences in scale, scope and resources.
The following objectives were the foundation of activities under Union's policy:
1. Provide reasonable value through a diversified portfolio.
2. Reduce price volatility.
3. Minimize exposure to counterparty credit risk.
4. Insure in all gas supply transactions, fairness to customers and all counterparties.
5. Corporate governance and controls.
Each of these Union Gas purchase policy objectives can be matched to the ten criteria of the
current Gas Purchase Criteria as approved by Council. This matching of policy principles
reassured staff that the City's Gas Purchase Criteria were—and continue to be—sound.
Recommendations to improve KU's management of price risk, arising from the best practices
review, were implemented in the past several years. These improvements include enhanced
oversight and governance through the establishment of the Commodity Risk Committee (CRC)
comprised of senior management and operating personnel in the Finance and Infrastructure
Services Departments'. The CRC has a formal working process, including quarterly meetings.
The retention of Aegent Energy Advisors in 2011, as approved by Council under a competitive
Expression of Interest (El 0-101) for consulting services, added a more rigorous and quantitative
approach to price risk management. Aegent's proprietary risk sensor model provides guidance
to staff to hedge (fix prices) only when necessary to protect the stable price. This added tool to
quantify and manage price risk guides the CRC to better align the trade-offs between stable and
variable rates in both rising and falling markets and meet customer expectations without
engaging in risky attempts to time the market. Over time, this approach should improve the
responsiveness of KU's gas rate to declining market prices while protecting against price spikes.
4. Setting the Rate to be Charged to Customers
KU gas rates typically change on an annual basis. This is consistent with a preference for stable
rates by the majority of customers. The "Gas Supply rate" is the charge for the natural gas
' The mandate of the CRC is: Provide oversight of gas procurement and risk management activity;
Review and approve gas supply and transportation strategies; Initiate review of purchase policy if and as
required.
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commodity, fuel and administration. The Gas Supply rate is determined based on KU's
committed and planned purchases, forecast consumption, overhead and inventory carryover.
The total dollar value is divided by the forecast consumption to determine the rate needed to
recover the costs. Factors that affect the rate changes include lower or higher than forecast
consumption and "spot" price changes due to market conditions.
Rate-setting for KU as a City enterprise must include the reserve requirements for the
management of municipal finances. The periodic projection of annual supply program revenues
and expenses must include a positive year-end reserve of 10% to 15% of annual revenues. If a
change in purchasing strategy is adopted to rely solely on "spot" market prices, then it will be
necessary to change the supply rate on a quarterly basis, similar to Union Gas. This is due to
the volatility of market prices for gas and is necessary to mitigate the risks of accumulating large
financial imbalances between the revenues collected in rates and the actual costs incurred. The
potential accumulation of a large under-recovery of costs in a sharply rising market is of
particular concern to the City and its ratepayers from a prudency perspective.
Figure 4 below is a comparison of the gas supply rates of KU, Union Gas and LAS / AMO with
market prices since 2002. This graph illustrates the greater variability in the Union Gas rate as
compared to KU and LAS/AMID and the more recent convergence among these rates.
Figure 4
NG Market Price vs KU Gas Rate vs Union Gas Rate vs
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Monthly Market Price 7A—cents per m3 +KU Gas Rate-cents per m3
Union Gas Rate-cents per m3 LAS Gas Rate-cents per m3
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5. Are Changes in the Purchase Policy Required?
Some Kitchener residents have raised concerns with Council about the gap between the gas
supply rates of Union Gas and KU — suggesting that changes to the current purchase policy are
needed. These concerns have only arisen in the past several years as Union's rate has fallen
faster and farther than KU's rate due to market conditions2. The lower gas supply rate in
adjacent municipalities such as Waterloo has raised questions about the performance and value
of KU's managed supply program relative to Union's passive supply program.
There are risks, benefits and trade-offs between these two approaches to buying the natural gas
commodity. The approaches are fundamentally different and designed to achieve different
goals. Their performance must be fairly measured against those goals and not against goals
which they were never intended to — and could not possibly — achieve. Performance must also
be fairly measured over the longer-term; recognizing the fluctuating and unpredictable nature of
gas commodity prices.
As mandated by the OEB in late 2008, Union Gas passively manages its supply program and
relies solely on spot and short-term purchases of gas. This approach results in its customers
paying the going market price for gas over time —whatever that price turns out to be. As a direct
consequence of this approach, its system customers are fully and promptly exposed to price
volatility — benefiting during falling markets but paying more in rising markets. Rates change
quarterly to mitigate the amounts and lag in collecting or refunding the financial difference
between the costs recovered in rates, as billed, and the actual costs incurred under market
prices, as purchased and flowed through storage.
KU actively manages its supply program to provide stable rates as historically preferred by the
majority of its system gas customers. It achieves this goal by buying gas supplies for their future
consumption using a combination of fixed and spot prices. The supply program was not and is
not managed to achieve the lowest price or market prices over time. Neither staff nor its
consultants attempt to predict gas prices in order to "time the market". Some critics of KU's
current active approach to price risk management are using the benefit of hindsight to unfairly
judge the results of the supply program against a goal it was never intended to achieve.
By way of analogy, a homeowner does not know if interest rates will rise or fall when fixing their
mortgage interest rate. The entire point of fixing the interest rate is to remove uncertainty around
the future rate to be paid. The household mortgage budget can be managed and met over the
term of the fixed interest rate. Whether mortgage interest rates subsequently fall or rise does not
impact the achievement of that goal — had the homeowner preferred a floating interest rate, then
they would have enjoyed the savings of a lower rate or suffered the harm from a higher rate.
But, the homeowner cannot have it both ways, i.e. the certainty and savings from a fixed rate in
a rising market and the savings from a variable rate in a falling market.
Similar common sense logic applies to gas rates. Customers who want rate stability when
market prices are rising yet unrealistically expect their rates to decrease in lock step under a
falling market either misunderstand or unfairly ignore the basic trade-off between stable and
variable rates. This trade-off necessarily means giving up the chance to pay lower prices in
future in exchange for avoiding the risk of paying higher prices.
2 While some delegations before Council over the past year have been vocal in expressing their concerns,
the number of similar inbound calls or complaints by customers has been minimal to date. The extent of
these concerns will be assessed in the comprehensive public engagement process in Q1 of 2014.
3 - 9
The OEB's order in late 2008 for Union Gas to cease its managed program and instead to buy
gas supply solely on a spot and short-term basis was a lucky coincidence for Union's
customers. More than luck and the benefit of hindsight are needed for Council to fairly assess if
it should direct KU to adopt a change in its gas purchase policy or the management of
commodity price risk. The price management of the supply program should align with customer
preference. That preference must be obtained in an unbiased fashion from a representative and
statistically significant sample of informed customers who are aware in a balanced and factual
way of the relative risks and benefits of the "stable rate" and "market rate" approaches.
It is important to reiterate that the system gas supply program is not-for-profit — regardless of
whether or not KU buys any fixed price gas on behalf of customers. KU is not impacted as the
program is not for profit; however, the impact of a change in purchasing approach would fall on
customers and the management of their gas bill along with their remaining household or
business budget.
If a basic change is made from an actively managed approach designed to provide rate stability
and predictability to a passive spot approach that provides fluctuating and unpredictable market
prices, then it is essential that customers be informed about the potential rate implications of
that change, particularly if the cyclically benign period of low gas prices that buyers currently
enjoy comes to an end. In other words, "Be careful what you wish for (market prices), because
you just might get it— not only the lows, but more importantly, the highs."
Figure 5 below is a graph of historic and forecast commodity prices for natural gas in the U.S.
by ICF International, an independent forecasting and consulting firm retained by Union Gas.
Canadian gas prices are significantly influenced by prices in the U.S. This outlook on gas prices
was prepared by ICF in the summer of 2013 and is representative of the consensus view of
forecasters and energy experts on the key drivers of gas prices and their likely future direction.
Figure 5
Gas Prices Reirnain Relatively I, in he Near 1CF
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3 - 10
ALIGNMENT WITH CITY OF KITCHENER STRATEGIC PLAN:
Theme: Financial Management
Strategic Direction: - Invest and manage assets strategically;
- Ensure responsible use of public funds within a supportive policy framework;
- Maximize value through cost effective service delivery
FINANCIAL IMPLICATIONS:
None
COMMUNITY ENGAGEMENT:
Quantitative customer research and focus groups to be explored in Q1 of 2014 prior to finalizing
proposed gas rates for July 2014.
CONCLUSION:
From a rate perspective, Council could adopt Union's spot purchasing approach and quarterly
rate-setting policy. In staff's view, it is not necessary to change the current gas purchasing
policy to do so; only a change in its implementation and the active price management of supply
is needed. While this approach is counter to the historical preference for stable gas rates in
Kitchener, this approach will be thoroughly canvassed in a substantial customer engagement
process in 2014.
ACKNOWLEDGED BY: Pauline Houston, Deputy CAO, 519 741 2600 ext 4646
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APPENDIX A
Krl
c REPORT
Finn'ncdal Services
Report To: Finance & Corporate Services Committee
Date of Meeting: October 2, 2006
Submitted By: Pauline Houston, General Manager of Financial Services
& City Treasurer
Prepared By: Dwayne Quinn, 2538
Ward(s) Involved: All
Date of Report: September 25, 2006
Report No.: FIN-06-030
Subject: NATURAL GAS PURCHASE POLICY
RECOMMENDATION:
That the Gas Purchase Policy Criteria for continuation of the Utilities Division provision
of Gas Supply services as attached to Report FIN-06-030 be approved.
BACKGROUND:
As deregulation advanced during the 1990's, Kitchener Utilities determined that the best way to
balance the interests of its customers and owners in a changing market would be to purchase its
own supply of natural gas. In 1998, after consecutive years of significant retroactive billing by the
City's previous supplier, Kitchener Council approved the development of a Kitchener Utilities
supply program. This program undertook responsibility for the purchase of natural gas for all
customers that chose not to contract for their gas supply on their own.
The gas industry has evolved since 1998. The most notable impact was the collapse of Enron and
the subsequent consolidation of the market, followed by a moderate expansion. The resulting
environment provides the Utilities Division with the opportunity to expand its portfolio of suppliers in
an effort to achieve on-going value for the customers. In the same period, Kitchener's
administration has reorganized resulting in the elimination of the former Public Works roles.
REPORT:
In its first eight years, the Utilities Division's natural gas purchase strategy has resulted in savings
in excess of$30 million compared to the City's previous supply arrangements. While the program
has been successful by any measure from a customer point of view, much has changed in the gas
market and the City's organization since 1998. The attached recommended policy addresses those
changes and provides opportunities of continued success of the Gas Supply program.
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In the years since the initiation of the program, Kitchener Council has implemented a
reorganization that evolved the departments eliminating the General Manager of Public Works
position that was integral to the authorized Gas Purchase Criteria. While staff has managed the
Gas Purchase criteria to the intent of the original criteria, this recommendation provides the
opportunity to align the criteria to the current organization of the City.
Further, with the continued evolution of the market, the Utilities Division recommends that this is
also the time to adjust some aspects of the criteria to ensure ongoing value for the Community's
customers and owners. The development of the market enhances the opportunity for multiple
suppliers to provide value to the portfolio while mitigating counter-party risk. Additionally, the
proposed criteria differentiates the on-going nature of our responsibilities as a utility in allowing
longer term contracting for transportation and storage upstream of the City.
FINANCIAL IMPLICATIONS:
While unquantifiable, the benefits of supply source expansion yield further opportunities to enhance
the value of the program to end use customers.
COMMUNICATIONS:
None required.
Dwayne Quinn, P Eng., MBA Pauline Houston, CA
Director of Utilities General Manager of Financial Services
& City Treasurer
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GAS PURCHASE POLICY
CRITERIA
1) The basic principle of minimum cost of gas for the minimum risk should be at the
forefront. This should be accomplished by monitoring and projecting economic
market forces to develop a prudent purchase strategy.
2) The purchase strategy should review a five year horizon and develop a disciplined
approach to acquiring a portfolio of natural gas contracts which varies the pricing
and terms of the contracts to minimize risk.
3) Given the long-term nature of getting gas to the City, acquiring transportation or
storage contracts should include a longer term view with contract terms of up to 20
years.
4) The purchase strategy should be monitored continuously and adapted to changing
markets conditions.
5) To ensure market competition is used and balanced with contracting costs, the
City's expected gas supply needs will be placed with no less than 3 but no more
than 7 primary suppliers. At no time should more than 50% of the City's annual
supply be placed with one supplier.
6) The gas supply contracts will only be placed with large, financially secure suppliers
with a proven industry track record. Before supply contracts are placed, the
City must ensure that the supplier has a strong financial rating as evaluated
by an independent evaluator. The minimum rating with be Standard & Poors
BBB or equivalent Moody's rating Baa.
7) The gas supply contracts will provide the City with the flexibility to swap between
indexed and fixed prices at market based transactions fees.
8) The financial exposure of the City will be minimized by seeking financial
assurances in the event of supplier default. These assurances will be maintained
commensurate with exposure of the contracts to an individual supplier. When
dealing with a marketing entity for supply, assurances will be sought from the
corporate parent.
9) All gas purchase transactions will be authorized by the General Manager, Financial
Services Department or in his/her absence one of the City's signing officers and the
Director of Utilities or in his/her absence, Utilities' Manager, Regulatory Affairs and
Supply or Utilities' Manager, Asset Optimization.
10)Separate accounting for the supply and delivery programs should be maintained,
audited and reported to Council on a regular basis with other City financial
statements.
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