System Gas as a Source of Supply for Larger Consumers

October 2011

• The price for system supply from Enbridge and Union has been relatively low and stable for the last while, leading larger consumers who have traditionally arranged their own supply to ask whether system supply is a viable alternative for them.
• Price risk management is the key differentiation between system supply and a direct purchase of supply.
• In Aegent's experience, institutional, commercial and many industrial buyers have a need to be able to tailor their pricing strategy to their own requirements. Managing their own supply enables them to apply price risk management techniques, whereas the system gas price is smoothed, but not managed.

Enbridge Gas Distribution and Union Gas offer a gas supply option to consumers in their franchise areas. This supply is commonly referred to as "system supply" or "system gas". The price for system supply from Enbridge and Union has been relatively low and stable for the last while, leading some users who have traditionally arranged their own supply to ask whether system supply is a viable alternative for them. To consider this question, it is important to understand how system supply is priced, and the implication of that pricing for system gas buyers.

For each utility, the price for its system supply option is regulated by the Ontario Energy Board with the gas supply charge changing every quarter according to an OEB-approved methodology. The prices for system supply that result from the quarterly adjustment mechanisms are intended to be transparent benchmarks that reflect market prices, but also provide a degree of price stability.

How the gas utility quarterly adjustments to system supply charges work

The quarterly adjustment mechanisms for Enbridge and Union are not precisely the same in every detail, but they are consistent in their major components. The OEB reviewed the mechanisms back in 2008/09 with the goal of standardizing the methodologies to the extent it made sense. The methodologies are designed to be formulaic and mechanical so that the regulatory review process is straightforward and can be completed quickly in order to have the new gas supply charges take effect at the start of each quarter.

The starting point for the quarterly adjustment is a gas supply reference price. The reference price is based on forward market pricing data for the 12-month period that begins with the quarter in question. So for example, the October 1, 2011 adjustment was based on forward prices for the October 2011 to September 2012 strip. The two utilities are required to collect the pricing data for the 12-month strip on each day of a 21-day period that ends 31 calendar days before the effective date of the new supply charge. (The 21-day period for the October 1, 2011 adjustments by Enbridge and Union was made up of the trading days between August 3 and August 31.) The purpose of this requirement is to ensure that the market price to be incorporated into the utilities' gas supply charges are as current as possible, allowing time for the necessary regulatory review.

The reference price is essentially a rolling 12-month average price that is updated quarterly. The 12-month average price is intended to smooth seasonal prices so that system supply consumers see a more stable rate on their bills. The purpose of the quarterly updates is to ensure that the reference price adequately reflects any changing market dynamics.

The pricing points for which the forward market prices are collected vary between Enbridge and Union, but the end result is the same; the gas supply reference price serves as the basis for establishing the new gas supply charge that consumers who buy their supply from the utility will pay for the upcoming quarter. The determination of the gas supply charge starts with the forward price at Empress that is inherent in the gas supply reference price. The cost of compressor fuel for transporting the gas to the utility's delivery area and other commodity-related charges such as each utility's gas supply administration fee are then added to the Empress price to arrive at the gas supply charge that consumers see on their bills. But the quarterly update does not stop there.

Enbridge and Union are required to pass through the actual cost of the system supply option to their customers, and they are not permitted to include a mark-up on the price of the commodity. The gas supply charge reflects the utility's forecast cost of system supply, and its actual costs will likely be different. Therefore, Enbridge and Union both have a "Purchase Gas Variance Account" (PGVA) in which the difference between their actual supply costs and the forecast supply costs are captured. The utilities are allowed to recover the balances in their PGVA on an ongoing basis and the mechanism for doing this is part of the quarterly adjustment process.

Each quarter, the utilities identify the debits or credits that have accumulated in the PGVA during the previous quarter and calculate commodity price adjustments that recover or refund the accumulated balance prospectively, over the next 12 months. The adjustments also include any variances between the actual and forecast amounts recovered or refunded from the previous quarter as a result of actual consumption being different from planned consumption over the 3-month period. These adjustments then are gas cost-related riders to the gas supply charge. Enbridge calls the rider a "Cost Adjustment" and Union refers to it as a "Gas Commodity Price Adjustment". In either case, the total cost of the system supply option in any quarter is the sum of the gas supply charge and the rider.

The utilities do not operate any price risk management programs, which is to say they do no gas price hedging. Since they do no hedging, and since they are required to pass through their cost of gas with no mark-up, it is clear that in the long run, the cost of system gas will be essentially the average market price of gas over the period. However, the smoothing effect of the quarterly rate adjustment mechanism means that in any given quarter or two, particularly in a period where market prices are changing quickly, the system gas price may lag the market.

As an aside, it is for this reason that the advertising campaigns of retail gas marketers become more intense when the wholesale price of gas drops. The marketers are able to buy lower priced gas and offer it to system gas consumers whose price has not yet reflected the price drop. This enhances the apparent attractiveness of the retail price offer, at least until the next quarterly adjustment of the system price reflects the market drop.

Is system gas a viable source of supply for larger consumers?

In Aegent's experience, institutional, commercial and many industrial buyers have a need to be able to control gas price risk. Managing their own supply enables them to apply price risk management techniques, whereas the system gas price is smoothed, but not managed. As prices have gone through a period of decline in recent years, the system gas price moved down as it passed through the declining market price. Buyers managing their own supply who likely had some price hedges in place may not have seen their average price fall quite as quickly, and may have looked enviously on the system price. However, when prices rise again, buyers who have some degree of hedging in place will see their prices rise less quickly and perhaps stay below the price of system gas during the upswing. Price risk management is the key differentiation between system supply and a direct purchase of supply.

For that reason, most large consumers will continue to choose to take on the management of their own supply, to be able to tailor their pricing strategy to their own needs.

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