March 27, 2008 CPUC MPR Workshop: Recommended Changes to MPR Gas Methodology and Inputs

1. March 27, 2008CPUC MPR Workshop: Recommended Changes to MPR Gas Methodology and Inputs Union of Concerned Scientists Clyde Murley, UCS Consultant

2. UCS Recommended Changes • Return to original (i.e., 2004) method for transitioning from NYMEX futures prices to fundamental forecast prices. Any use of multiple years should draw from NYMEX years only. • Use all 12 years of NYMEX futures prices now that they are available. • Calculate the “transaction cost” component of the MPR anew each year.

3. 2004 (original) method: Uses NYMEX futures prices for 1st 5 or 6 years of MPR time horizon. Thereafter, average annual escalation rate of fundamental forecasts is used to escalate last NYMEX year through the rest of the MPR time horizon. 2005 (current) method: Uses NYMEX futures prices for 1st 5 or 6 years of MPR time horizon. Next three years are interpolated values using the last NYMEX year and the average of the fundamental forecasts 4 years thereafter. All years after the interpolated values are simply the average of the fundamental forecasts for each year. Comparison of 2004 and 2005 methods of transitioning from NYMEX to post-NYMEX periods

4. Why return to 2004 method for setting gas values for the post-NYMEX years? • Procedural note: The Commission record does not appear to contain much explanation about what was wrong with the 2004 method or why the 2005 method was considered an improvement. • Substantively, the 2004 method is more consistent with the CPUC’s MPR principles*: (1) to rely on market data wherever possible and (2) to use gas prices that reflect market participant behavior. • 2004 method ensures that market data serve as basis for later years of natural gas inputs, whereas 2005 method relies entirely on fundamental forecasts for all years after year 8 or 9. • The EIA forecast, which is one of the Commission’s fundamental forecasts, is not a market price forecast. Specifically, it assumes a constant legislative and regulatory environment. It has also been a poor proxy for market prices. * D.05-12-042, p. 11.

5. (cont’d)Why return to 2004 method for setting gas values for the post-NYMEX years? Which better reflects market expectations? • The 2004 method’s greater reliance on market data better matches the hypothetical market actors’ approach to developing a 20+ year fixed price supply of electricity. Generally and practically speaking, they can be expected to apply the CPUC’s MPR principles as well, i.e., they would rely on market data, not fundamental forecasts, wherever possible, in order to be confident that their offer price turns out to be profitable. (Presumably, the Commission’s MPR principles derive from this same understanding.)

6. Is the 2004 Method Perfect? • Of course not. There is no perfect method. Our goal is to reasonably approximate the long-term fixed price price that would be offered by a generator. • In this respect, the 2004 method, coupled with reliance on the now-available 12 years of NYMEX futures data, does a better job of reflecting market data than the current method.

7. Concerns about relying on a single NYMEX year for extrapolating into the non-NYMEX period • Averaging multiple years is reasonable as long as they are NYMEX years. • The current method, which interpolates from NYMEX prices to the absolute fundamental forecast prices over a 3-year period, apparently assumes that fundamental forecasts that are consistently poor proxies for concurrent (see LBNL studies) will somehow become more accurate in the “out” years. . • 2004 method could easily be modified to use the average of the last 2-3 years of NYMEX values as the basis for transitioning to the non-NYMEX years. • The CalWEA/CCC/CSP averaging proposal is a reasonable alternative.

8. Concerns about relying on NYMEX years that may be thinly traded • As parties in MPR proceedings have previously pointed out, during periods of light or no trading NYMEX has various approaches for representing market prices. • Traders can be expected to seek to profit in event of market-erring NYMEX settlement prices, providing a corrective effect if and when needed. • While not ideal, NYMEX settlement prices during light trading periods still appear to be the best market data available, and ignoring them in favor of sole reliance on fundamental forecast data would not appear to be warranted.

9. LBNL research shows a persistent discrepancy between NYMEX futures data and the EIA fundamental forecast over comparable periods.

10. Preliminary Illustrative2008 MPR Changes Due to UCS’s Proposed Changes to Current Method and Inputs All comparisons use current NYMEX data (average of March 3 and March 25, 2008 settlement prices).

11. Illustrative Price Differences in 2008 MPR Using Current Method Except with 11 Years Instead of 5 Years of NYMEX Data ($/MWh)

12. Illustrative Price Differences in 2008 MPR from Reverting to 2004 Method and Using 11 Years Instead of 5 Years of NYMEX Data($/MWh)