Winning Hedges
This article first appeared in the March issue of EnergyRisk and is reprinted with permission.
Utility hedging gains wider acceptance, but companies still need to work harder to eliminate pure price-view hedging, writes Leigh Parkinson of RiskAdvisory.
While more utilities are adopting hedging practices, there is little agreement in the industry about how hedging should be implemented and who should decide the programme’s shape and ultimate objectives. Ask someone in the utility industry about their views on hedging and you are likely to get a wide range of answers and opinions, especially in the current environment of wildly fluctuating commodity prices and new, non-traditional energy speculators (Hedge Funds) in the markets. Akin to bringing up politics or religion at the dinner table, the topic can make staid industry types blow fuses.
Despite the differences of opinion, it does appear that mechanistic hedging is gaining momentum as an implementation programme of choice. A mechanistic hedging approach involves the execution of predetermined/pre-approved hedges at some consistent time interval without regard to the underlying price. The mechanistic approach takes the guesswork out of hedging, eliminating the speculative qualities that regulators assign to certain types of hedging – at times after they have tacitly approved the hedges in the first place.
The move toward mechanistic hedging seems in large part due to the industry’s wider acceptance of hedging as a legitimate risk-management practice. Recent surveys of utilities, marketers, consumer advocate groups, regulators and financial institutions conducted by RiskAdvisory reveal that hedging is not viewed as speculation – at least when utilities do it – but more as a standard operating procedure.
Are they correct in hedging in the current high price environment? If a utility has adopted a mechanistic hedging programme, then the answer is yes. Even with spiking prices, hedging now is appropriate. Commodity price spikes can be temporary situations but mathematical theory would still suggest that prices have a 50% chance of moving higher and a 50% chance of moving lower. Locking in now to ensure that a company’s financial forecasts are more predictable is an appropriate approach, no matter what the short term underlying price view. Utilities, regulators and consumer advocates increasingly seem to be accepting this type of hedging because it removes the speculative element from the activity.
Hedging is holding its own as a means to manage the severe volatility of natural gas and fuel prices in today’s markets. Ninety percent of the survey respondents indicated that utilities should hedge and nearly all said that hedging is either “very effective” or “somewhat effective”.
Regulators and rate hearings
In fact, hedging seems to be a topic that is changing the way that consumer advocate groups and regulators are interacting with utility companies. One RiskAdvisory survey indicated that more than two-thirds think that regulators, advocate groups and utilities can work together in advance of rate-hearing cases to develop equitable and effective hedging programmes that are not speculative or risky in nature.
While there is still some skepticism over regulators’ abilities to set policies for utility hedging programmes, utilities still ideally want the regulator’s upfront input on hedging to reduce the risk of a negative hindsight review. As a protector of consumer interests, the regulator has a responsibility to provide input into the appropriateness of certain hedging strategies, given that the hedging strategy is based on estimating the ratepayers’ risk appetite. Regulators as well as consumer advocates are in as good a position as utilities to provide input into this decision.
Interestingly, in the same survey the year before, most utility representatives thought regulators to be categorically unqualified to provide this kind of input. There is now, then, a glimmer of hope for less acrimonious hearings as there seems to be more trust in each other’s abilities to determine ratepayer risk appetites and mitigate excessive exposure.
The poll also indicated that utilities are looking to lock-in long-term hedges right now. Fully one-fifth are now able to hedge out three years or more, which is an increase in term from the more typical historical hedging term of the current or next fiscal year. Another quarter of respondents could hedge two to three years, while 30% had a maximum term of six to 12 months.
The survey results indicate a few trends that are to be expected and somewhat predictable in a time of volatile commodity prices. Companies are looking to employ all the appropriate tools available to stabilize their forecast predictability. Similar to the changes in term, the choices of hedging instruments has expanded. The most popular hedging instruments are still fixed-price natural gas fuel purchases and fixed-price financial swaps but the acceptance of zero-premium collars structures and outright call options is more prevalent.
Surprisingly, even though rising energy prices are a factor in nearly everyone’s day-to-day decision-making, it is not dominating utilities’ thinking on hedging. Half the survey respondents were not letting high energy prices affect their hedging strategy, while 21 percent had changed the type of hedging instrument they employ in this higher price environment. Most respondents think their company will be more actively engaged in hedging in 2006.
While more companies, regulators and consumer advocate groups see hedging as a valuable tool, they still have differing opinions about how to implement a programme and need to come to the bargaining table at the start of the rate-setting process to avoid future acrimony if energy prices continue skyward. They should work harder to eliminate price-view hedging. Even the acceptance of extending hedging terms could be interpreted as a symptom of a price-view outlook and may backfire – not in terms of the effects of the programme, but in terms of the adverse reaction that regulators and consumer groups may have should prices fall.
Collaborative trends are moving in the right direction, there is still a need in the industry for more understanding of the mechanistic hedging techniques that eliminate the regulatory risks of hindsight reviews.