HomeMy WebLinkAboutINS-14-014 - Natural Gas Purchase Policy Review Staff Rep►�►r
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REPORT TO: Finance and Corporate Services Committee
DATE OF MEETING: June 9, 2014
SUBMITTED BY: Wally Malcolm, Director Utilities, 519-741-2600 ext.4538
PREPARED BY: Wally Malcolm, Director Utilities, 519-741-2600 ext.4538
WARD(S) INVOLVED: All
DATE OF REPORT: May 29, 2014
REPORT NO.: INS-14-014
SUBJECT: NATURAL GAS PURCHASE POLICY REVIEW
RECOMMENDATION:
Whereas the results of a comprehensive customer survey indicate a customer preference
for the blending of fixed prices and variable market prices to provide stable rates for
system natural gas customers of Kitchener Utilities, that the natural gas purchase policy
be modified as follows:
1. Stable Portfolio Policy — reduce purchase timeframe from five years to three years
and maintain the current minimum and maximum "rails" as set out in the revised
policy criteria (Appendix A),
OR
2. Market Responsive Portfolio Policy — reduce purchase timeframe from five years
to three years and reduce the current minimum and maximum "rails" as set out in
the revised policy criteria (Appendix B).
BACKGROUND:
At the April 28, 2014 Finance and Corporate Services Committee Meeting, the following motion
was resolved on a recorded vote:
"That staff be directed to update the natural gas purchasing policy to reflect the Modify
Current Hedging Approach option, outlined in Infrastructure Services Department report
INS-14-013, for a timeframe of 1 year, 3 years and 5 years, with specific policy details
and recommendations be provided at the May 12, 2014 Finance & Corporate Services
Committee meeting."
At its May 5, 2014 regular meeting, Council agreed to amend the date for staff to provide
specific policy details and recommendations to the June 9, 2014 meeting of the Finance and
Corporate Services Committee.
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REPORT:
Current Purchase Policy& Natural Gas Portfolio Price Management
In order to provide rate stability, the current purchase policy (Appendix C) permits a blended
approach to buying natural gas supply for Kitchener Utilities system customers. Fixed price
contracts are purchased for requirements up to five years into the future. Natural gas, at
variable market prices, is purchased along with fixed price gas. The cost of these supplies is
blended into a portfolio that is diversified by price, term and supplier. The projected average
supply cost, including administration, is recovered in the supply rate without any mark-up or
discount. Natural gas rates typically change annually.
The projected price of the natural gas portfolio is managed using a "rails approach". This
approach guides the minimum and maximum amounts of fixed price natural gas supply to be
purchased for each year of the five year purchase horizon. The following table illustrates the
current rail limits:
TABLE 1
Current Natural Gas Purchase Policy— "Rail Limits"
Current Limits Year 1 Year 2 Year 3 Year 4 Year 5
Maximum 90% 70% 50% 30% 20%
Minimum 40% 30% 20% 10% 10%
In addition to the rails approach, the management of the forecast portfolio price risk and its
potential impact on the supply rate are guided by a quantitative model and advice provided by
external consultants to Kitchener Utilities. In use since 2011, this added approach focuses on
mitigating the risk of exceeding a target or budget price for the supply portfolio. Entering into
fixed price contracts, known as "hedging", is done only to protect the price target with a high
degree of confidence. In other words, hedging is only done when deemed necessary. If not, the
portfolio is subject to market conditions and can benefit from falling prices.
Modified Purchase Policy Options
Subsequent to its review and discussion of the results of the recent customer survey and
engagement process on natural gas rate preference, as set out in Report INS-14-013, dated
April 10, 2014, Council directed staff to update the current purchase policy under one, three and
five year timeframes, and reflecting a modified hedging approach.
The recent customer survey found that, "While there is appetite in the community for both types
of rate-setting policies (variable or stable), a majority selected a "stable"rate policy."While this
is instructive, it remains open to interpretation as to what exactly is a "stable" rate policy? In
other words, at what point do natural gas rates either become "too stable" or "not stable enough"
to satisfy the majority of Kitchener Utilities customers?
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"Rate stability" is somewhat in the eye of the beholder. It is difficult to precisely define what it is
as a policy objective. However, one can recognize stability where it exists and where it clearly
doesn't exist, for example, in the natural gas rates comparison charts provided in prior reports.
The extent of rate stability or variability under a more market-responsive price approach is a
decision for Council.
The policy question for Council is, "How much natural gas should be bought at fixed prices
and for how Ion_g into the future?" Different answers to this question will achieve a different
balance of interests between customers that value rate stability and customers that value
market-based pricing and will impact their natural gas bills accordingly — both the amount
included for natural gas supply and the change needed from year to year to recover costs.
Rate stability comes from buying greater proportions of fixed price natural gas for longer periods
of time relative to variable market-based natural gas. A more market-based price comes from
buying less fixed price natural gas for longer periods of time relative to variable market-based
gas. Natural gas is an energy commodity which is subject to longer-term cyclical price swings
and shorter-term weather-driven price swings. Over time, the two purchase approaches can
result in very different rates for customers, with a wide range of possible rate outcomes
depending on the variability of market prices and the amount and timing of fixed price natural
gas purchased to "smooth out" the variability. This is precisely why the natural gas purchase
policy is currently under review.
Based on the direction from Council and the over-arching policy question noted above, staff has
identified three options that could be applied to each of the three purchase timeframes:
1. Maintain Current Rails
2. Reduce Minimum Rail Only
3. Reduce Minimum and Maximum Rails
At a high level, this framework results in nine possible policy options with varying implications
for the relative stability of future system supply natural gas rates as summarized below.
TABLE 2
Purchase Policy Options — Rate Stability Matrix
Option One Year Three Years Five Years
Maintain Current Rails Somewhat Stable Stable Most Stable
Reduce Minimum Rail Less Stable Somewhat Stable Stable
Reduce Min / Max Rails Least Stable Less Stable Somewhat Stable
The greatest risk of rates that are "too stable" (not sufficiently market responsive) to suit the
majority of customers is found in the options under a five year purchase timeframe, particularly
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where the current rails are maintained. The greatest risk of rates that are "not stable enough" to
suit the majority of customers is found in the options under a one year purchase timeframe,
particularly where the current rails are reduced. The options under a three year purchase
timeframe represent a compromise between the desire of customers that value rate stability to
avoid unpleasant rate shocks and the desire of customers to pay lower prices when benign
market conditions occur.
The following table illustrates modified rail limits:
TABLE 3
Modified Natural Gas Purchase Policies— Reduced "Rail Limits"
Reduced Limits Year 1 Year 2 Year 3 Year 4 Year 5
Maximum 60% 40% 20% 20% 20%
Minimum 20% 20% 0% 0% 0%
III inge (20%) (1(.N ( 0%( (1(N (1(.)%)
The modified rails are reduced to achieve a more market-responsive rate for customers — but
they still provide some stability to the supply portfolio. The range between the maximum and
minimum rail limits is broader in the near-term (Year 1) to recognize the higher risk of sharp
price swings due to shorter-term weather impacts. This type of increased price volatility was
experienced this past winter season (and the current rails offered a greater degree of protection
against the resulting price spikes).
Three Year Timeframe Recommended
Given the results of the recent customer survey / engagement process and the ensuing public
discussion and debate, a modified purchase policy under a three year timeframe could achieve
the balance which Council seeks to achieve at this time. Should Council prefer to emphasize
rate stability, then the current rail limits as set out in Table 1 can be maintained. Should Council
prefer a more market-responsive approach, then the minimum and maximum rail limits as set
out in Table 3 can be implemented.
Potential Rate Impacts Under Three Year Timeframe
Staff recommends that Council make a choice at this time between two Portfolio Policy
approaches — Stable or Market-Responsive. To help guide this choice, illustrative portfolio
performance charts for the two modified policy approaches as compared to market-based
pricing and the current policy since 2002 are provided in Attachment 1.
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These charts are not predictions of market prices or the future natural gas portfolio price for
Kitchener Utilities. Actual market data over the historical period is used to "back test" the two
approaches to determine the maximum year over year bill impacts for customers if those
approaches had been in place— in percentage and dollar terms for increases and decreases.
While past performance is not necessarily an indication of future performance, these portfolio
performance charts are instructive for Council and ratepayers because the period tested
includes times when market prices rose sharply, remained relatively constant or fell sharply —
exhibiting cyclical commodity price behavior with underlying trends. The relative performance of
the two policy approaches is measured over an extensive period of time, covering episodes of
very strong and very weak pricing to give a more complete and representative picture.
Both of the recommended approaches yield a more market-responsive rate outcome than the
current policy. The Market-Responsive approach tracks the market price more closely than the
Stable approach, with greater year over year bill impacts — both for increases and decreases.
The difference between the two policy approaches is in the extent of rate stability provided by
the rail limits.
Meeting Expectations
Natural gas is a commodity and its price can go up or down or remain relatively constant— often
moving sharply and unpredictably. Council is aware of the volatile behavior of market prices
since Kitchener Utilities began its natural gas supply program in 1998. Neither staff nor its
consultants (nor anyone else for that matter — amateur or expert) can be expected or tasked to
accurately and consistently predict natural gas prices to "perfectly time the market" and lock in
prices before a spike occurs or float prices before a collapse occurs.
Given the unpredictable nature of natural gas prices, there is no assurance that pursuing any
specific purchase option will provide "savings" or result in ratepayers paving a "premium"
relative to other purchase options (or a fully market-based approach) over time. This can only
be seen in hindsight. Effective risk management is forward-looking and accepts the premise that
the future is uncertain and may unfold in ways that are very different from the past and from
current expectations. Taking some action to mitigate the negative consequences of this
uncertainty is preferable to inaction in the hope or belief that the risk does not arise.
The use of maximum rails to limit the purchases of fixed price natural gas will result in higher
rates for customers in a rising market than if no constraints on hedging were in place.
Conversely, the use of minimum rails to purchase some fixed price natural gas for price stability
will result in higher rates for customers in a falling market than if no constraints on variable
market-priced natural gas were in place. The rails are an imperfect compromise but can achieve
the desired effect of providing rate stability.
It is important for Council to recognize, and for system natural gas ratepayers to accept, that
any hedging to achieve price stability will act as a "brake" on the natural gas rate going forward.
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A hedged price will lag the market price trend as it rises and falls. This "braking" effect on rates
does not appear to cause any concern with ratepayers in a rising market for natural gas where
the hedged price is lower than the market price. From recent public debate, it only appears to be
a problem with some ratepayers and Members of Council in a falling market for natural gas
where the hedged price is above the market price for prolonged periods of time.
In other words, customers' reaction to the extent and duration of a disconnection between a
hedged price and the market price is skewed. Less joy is felt when the stable rate is below the
market rate than the pain from a lost opportunity when the stable rate is above the market price.
The modifications to the purchase policy to provide an appropriate degree of rate stability as
determined by Council should recognize this behavioral reality.
To keep the purchase policy reasonably aligned with customer expectations over time, it is
advisable to include periodic performance reporting and review in a modified policy. Both of the
recommended modified policies include this criterion (attached as Appendix A& B—#4.)
ALIGNMENT WITH CITY OF KITCHENER STRATEGIC PLAN:
The policy review process aligns with the strategic foundation of effective and efficient
government — communication and customer service. Good customer service, within the
corporation, responds to the changing needs and expectations of stakeholders.
FINANCIAL IMPLICATIONS
Adopting either of the modified natural gas purchase policies recommended in this Report will
not impact the natural gas rate change currently expected for September 1, 2014, subject to
pending review and approval by Council. However, the frequency of future natural gas supply
rate changes may be impacted by the modified purchase policy adopted by Council. A greater
degree of price stability in the Kitchener Utilities purchase portfolio should allow for the natural
gas rate to change annually. To the extent that a greater degree of market-priced natural gas is
purchased, and the cost of this natural gas varies significantly due to market conditions, then
the rate may need to change more frequently so that revenues keep pace with costs and
stabilization reserves are prudently managed and not abruptly depleted or limits exceeded.
COMMUNITY ENGAGEMENT:
This Report relates to the consult theme of the Community Engagement Strategy. Kitchener
Utilities consulted with customers in both qualitative and quantitative formats this past winter
regarding their natural gas rate preference. The modified Purchasing Policy will be
communicated in a media release and on the Kitchener Utilities website.
Acknowledged by: Pauline Houston, DCAO, Infrastructure Services
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Appendix A
MODIFIED NATURAL GAS PURCHASE POLICY
CRITERIA -STABLE
1) Utilities' Staff, with assistance from external parties, as appropriate and subject to
periodic tendering for consulting services, shall monitor market and economic
forces to develop a prudent purchase strategy.
2) The purchase strategy shall reflect a three year timeframe and use a disciplined
approach to acquire a blended portfolio of natural gas contracts which varies the
pricing and terms of the contracts to provide rate stability while remaining
responsive to market pricing.
3) Given the long-term nature of getting natural gas to the City, acquiring
transportation or storage contracts should include a longer term view with contract
terms of up to twenty (20) years.
4) The ongoing performance of the purchase portfolio in meeting its strategic
objectives and customers' rate expectations shall be periodically reviewed, not less
than every three years and not more than annually, and revised as needed and
approved by Council.
5) To ensure market competition is used and balanced with contracting costs, the
City's expected natural gas supply needs will be placed with no less than four (4)
primary suppliers. At no time should more than 50% of the City's annual
supply be placed with one supplier.
6) The natural 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 (Investment Grade).
7) The natural gas supply contracts will provide the City with the flexibility to swap
between indexed and fixed prices at market based transaction 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 natural gas purchase transactions will be authorized by the Deputy CAO & City
Treasurer, Finance and Corporate 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.
10) Separate accounting for the supply, transportation and delivery programs should be
maintained, audited and reported to Council on a regular basis with other City
financial statements.
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Appendix B
MODIFIED NATURAL GAS PURCHASE POLICY
CRITERIA— MARKET RESPONSIVE
1) Utilities' Staff, with assistance from external parties, as appropriate and subject to
periodic tendering for consulting services, shall monitor market and economic
forces to develop a prudent purchase strategy.
2) The purchase strategy shall reflect a three year timeframe and use a disciplined
approach to acquire a blended portfolio of natural gas contracts which varies the
pricing and terms of the contracts to provide some rate stability while remaining
more responsive to market pricing.
3) Given the long-term nature of getting natural gas to the City, acquiring
transportation or storage contracts should include a longer term view with contract
terms of up to twenty (20) years.
4) The ongoing performance of the purchase portfolio in meeting its strategic
objectives and customers' rate expectations shall be periodically reviewed, not less
than every three years and not more than annually, and revised as needed and
approved by Council.
5) To ensure market competition is used and balanced with contracting costs, the
City's expected natural gas supply needs will be placed with no less than four (4)
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 (Investment Grade).
7) The natural gas supply contracts will provide the City with the flexibility to swap
between indexed and fixed prices at market based transaction 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 natural gas purchase transactions will be authorized by the Deputy CAO & City
Treasurer, Finance and Corporate 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. .
10) Separate accounting for the supply, transportation and delivery programs should be
maintained, audited and reported to Council on a regular basis with other City
financial statements.
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