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On February 2, 1999, the Department of Telecommunications and Energy (the "Department") issued an order (the "Order") resolving certain issues associated with the restructuring of the natural gas industry, including: (1) capacity disposition, both upstream and downstream; (2) contract renewal and supply planning responsibility; and (3) the Portfolio Auction proposal sponsored by the eight local distribution companies filing joint comments.¹

• Department's Goals for a Competitive Natural Gas Industry

The Department stated that it envisions a fully competitive gas industry in which all customers would have the option to purchase both gas commodity and transportation capacity from a wide range of providers operating in a competitive market. The Department further stated that, in this market, the obligations of local distribution companies ("LDCs") would be limited to the transportation and delivery of supplies brought to the city gate by competitive suppliers. According to the Department, as the LDCs transition from the merchant function, their obligation to serve would be met by the competitive market. The Department noted, however, that a workably competitive market must exist in order to ensure that the market would provide reliable and least-cost gas-sales service to distribution customers. Therefore, the Department concluded that the LDCs' obligation to serve cannot be modified or eliminated in the absence of a workably competitive market.

The Department stated that, during the transition period to a workably competitive market, its capacity-allocation program would provide customers and their marketers with access to interstate capacity to meet the customers' requirements without jeopardizing the ability of the LDCs or marketers to provide reliable service to their customers.

• Capacity Assignment

In its Order, the Department analyzed alternative proposals for capacity assignment, including: (1) mandatory assignment; (2) voluntary assignment; and (3) a hybrid proposal submitted by Bay State Gas Company ("Bay State"), that combined elements of the mandatory and voluntary approaches. The Department evaluated these alternatives to ensure that all customers in the Commonwealth will continue to receive reliable service and that customers will be required to pay for only those costs that the LDC incurred to serve them.

The Department found that, until the upstream market is workably competitive, mandatory assignment will ensure that existing levels of reliability will be maintained at reasonable cost. The Department stated that current initiatives of the Federal Energy Regulatory Commission ("FERC"), the introduction of more capacity options and the unbundling of the LDCs' services, will bring the upstream market closer to full competition. The Department further stated that, for the Department to regard the market as fully competitive, the FERC-imposed price controls on interstate pipeline capacity must be lifted and the number of alternative contract holders with firm rights to the capacity must be increased.

The Department determined that, since the upstream capacity market is not sufficiently competitive to allow the removal of traditional regulatory controls, LDCs must continue to plan for and procure sufficient upstream capacity and the capacity assigned to customers and their marketers must be subject to certain restrictions, such as recall rights.

The Department noted that, given proper market conditions, voluntary assignment would be the most expeditious way to achieve the Department's long-range objective of a fully competitive gas market. The Department found, however, that under a voluntary-assignment regimen, LDCs would have a compelling incentive to release unelected capacity either permanently or on a multi-month basis without recall rights in order to mitigate the costs associated with the unelected capacity. The Department stated that such action could result in the diversion of capacity away from the LDCs' traditional customers and have a negative effect on the natural gas market in Massachusetts. According to the Department, at the end of the three-year evaluation period, or at the close of the five-year transition period, market conditions may be ripe for a move to voluntary assignment. The Department concluded that such a judgment can be made only in light of future events.

The Department stated that, although the Bay State proposal is an attempt to bridge the two principal capacity assignment proposals, it does not satisfy the Department's goal to move the gas industry to a competitive market without cost shifting. The Department noted that Bay State's proposal did address, to a certain extent, the Department's reliability concerns.

The Department determined that the recovery of costs associated with unelected capacity from non-migrating customers, which would occur under a voluntary system, is in direct conflict with the Department's well-established policy on cost allocation, which dictates that cost responsibility must follow cost incurrence. The Department noted that the LDCs' supply contracts have been prudently entered into, and therefore, the LDCs are entitled to the non-mitigable stranded costs of prudent contracts in the event that a voluntary-assignment regimen were to be adopted. However, the Department found that the mandatory "slice-of-the system" approach (as opposed to the "path" approach) will allocate capacity costs to all customers on an equitable basis.

The Department found that "virtual" assignment of downstream capacity on a mandatory basis will assist in the development of a competitive market. The Department stated that, because the voluntary assignment of downstream capacity would raise the same issues of cost responsibility and cost shifting, it would not be appropriate to authorize such a program. The Department further stated that it envisions that access to the downstream resources currently held by the LDCs would eventually become available to marketers on a fully competitive basis. According to the Department, downstream storage assets would be developed and managed in a manner similar to the current management of the upstream underground storage facilities.

• Contract Renewal and Supply Planning Responsibility

The Department determined that the level of competition in the upstream capacity market is insufficient to allow the removal of traditional regulatory controls. Accordingly, the Department established a five-year transition period over which it anticipates that a sufficiently competitive market may develop. At the end of the first three years, the Department will evaluate the level of competition in the upstream capacity market and determine whether the market is sufficiently competitive to warrant the removal or modification of the LDCs' service obligation. The Department concluded that, until the Department makes a determination that the market is sufficiently competitive to warrant such a change, the LDCs will continue to plan for and procure capacity resources

Thus, the Department determined that, at least during the first three years of the transition period, the LDCs must continue with their obligation to plan for and procure capacity resources. According to the Department, LDCs may enter into new contracts as necessary to meet existing firm requirements and incremental load growth consistent with established Department planning standards. However, the Department also noted that LDCs should take all necessary and reasonable steps to review and manage existing commitments to avoid incurrence of unnecessary contract costs.

Although the Department found that LDCs may recontract for capacity on an as-needed basis, subject to the approval of the Department, the Department stated that LDCs and marketers should work cooperatively concerning the status of existing and future contracts, and their renewal and termination. The Department requests that the Collaborative propose a mechanism by which LDCs can include other members of the Collaborative or other affected market participants in an LDC's capacity planning process.

The Department also stated that, until it directs otherwise, Default Service is the responsibility of the LDCs and will be provided to firm customers by the LDCs or by designated suppliers approved by the Department.

• Portfolio Auction

The Department's Order also addressed the proposal of eight local distribution companies to transfer, via a competitive bidding process, the management of the LDCs' upstream pipeline, storage and gas supply commodity contracts to competitive wholesale marketers for a fixed time period of three-to-five years. The Portfolio Auction, as proposed by the eight local distribution companies, assumes implementation with mandatory capacity assignment subject to full recall rights at the end of the portfolio management term.

Recognizing that the Portfolio Auction has the potential to provide all customers with efficient administration and use of the LDC's upstream assets, the Department approved of the concept of the Portfolio Auction. Because the Department is not convinced of its "universal applicability," the Department did not mandate the use of a Portfolio Auction. Thus, the Department stated that each LDC must make its own decision whether to outsource the management of its portfolio. According to the Department, if an LDC forgoes the Portfolio Auction, the LDC should be prepared to justify to the Department why it has made that decision. If used, the Portfolio Auction should be fair, open and well-documented to demonstrate that it will provide savings to customers.

With regard to the details, the Department stated that an LDC should not commit to an auction period assuming mandatory assignment, which extends beyond the transition period. The Department made the following determinations with regard to the Portfolio Auction: (1) there should be no limits on the level of customer migration; (2) that fixed prices should not be established (indexed or floating mechanism is preferable); (3) that LDCs must provide terms of any proposed Portfolio Auction to the Department in advance, including the RFP and a description of its proposed outsourced upstream capacity management program; (4) after an auction award, the LDC must file annual progress reports describing the financial and service effect on the company's customers. The Department stated that it will review, for approval, the outsourcing of the LDCs' portfolio prior to implementation. With regard to market power, the Department suggests that the Collaborative develop standards concerning wholesale and retail marketers' participation in the market in connection with the Portfolio Auction and present such standards to the Department for review.
Please contact Bob Keegan or Cheryl Kimball if you have any questions regarding this Regulatory Alert.

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¹The eight LDCs filing joint comments were: The Berkshire Gas Company, Boston Gas Company, Colonial Gas Company, Commonwealth Gas Company, Essex Gas Company, Fall River Gas Company, Fitchburg Gas and Electric Light Company, and North Attleboro Gas Company.