Hedging 360: The Case for Improved Perspectives Among Risk Management Participants in the Regulated Energy Utility Industry
By Leigh Parkinson
Four years after the wholesale marketing and trading sector meltdown, utility hedging is once again seen as a vital tool for the management of financial and commodity risks. Many utility companies have attempted to compete in the marketplace by enhancing corporate performance through the creation of unregulated subsidiaries to capitalize on perceived opportunities. These unregulated trading activities inevitably lead to areas of conflict or perceived conflict between these subsidiaries and the core regulated utility business. To a large degree it would now appear that utilities have abandoned these initiatives and that hedging activities are relegated to managing rate volatility on behalf of companies’ constituent customers.
Our research indicates that the industry is more comfortable with the use of hedging in this capacity today. Indeed, across the entire spectrum of industry influencers – utility companies, regulators and consumer advocates – all seem to be assigning and assuming roles and responsibilities to employ common-sense hedging strategies. The industry is in broad agreement that practical uses of hedging techniques can help to create price stability for consumers, manage the balance sheet and avoid speculation. Our research would further indicate that there is evidence of increased cooperation and collaboration between those previously adversarial groups. This spirit of cooperation should provide significant cost reductions in the regulatory process and ultimately benefit consumers, if this trend continues.
This rosy picture is very likely influenced by the current high commodity price environment where almost any magnitude of hedging that was undertaken early in 2005 would have validated this new spirit of collaboration to all the parties who recommend, approve and manage policies for risk management decision making in the utility world. In the realm of utility public opinion right now, hedging is a good thing. Our research indicates that, at this juncture, hedging is widely regarded as an efficient tool, and that perceptions have grown more favorable this year relative to results from research we conducted a year ago. Last year’s hedging looks smart, protecting consumers from historically high volatility and prices for energy fuel supplies and, not surprisingly, the degree of acrimony between regulators, utilities and consumer groups has diminished where common sense hedging was employed.
But the true test for the longevity of this collaborative spirit is still ahead. Commodity prices have cyclical up and down trends. Mathematical theory would suggest that even at these high fuel price levels there still exists an even possibility – like a flip of the coin – that prices could continue higher or reverse the current rising trend. It will become increasingly difficult to enter into new hedging strategies if price s continue ever higher with the risk being, of course, that the collaborators decide that hedging should be constrained and prices continue to rise leaving ratepayers exposed with fewer hedges in place. The larger risk to the current state of calm is a cyclical price decline if significant hedges are still in place. Such a decline would prevent consumers from participating in a lower price environment. In the past this has ignited ominous second-guessing: regulators and consumer advocates become Monday morning quarterbacks, suggesting that utility management should have foreseen the drop and allowed customers to participate in the downward movement. Essentially this viewpoint asks the impossible: Why could mainstream utility management not do what only a handful of traders were able to do; beat the market? It’s almost the same as saying: Why didn’t everyone win on their trip to Vegas?
Our supposition is simple: the utility industry now has a historic opportunity to use the current environment to correct some serious inefficiencies of the past, especially with regards to setting expectations in a rate-setting process that begins with – and sets the structure for – future hedging decisions. The utility industry can demonstrate both responsibility and innovation in this historic moment by changing the backward-looking nature of the rate-setting process, embracing techniques of mechanistic hedging and minding the details of its business through comprehensive monitoring of market positions and measuring and managing the risk and credit exposures endemic to commodity volatility.
Impossible, you say? Au contraire. The willingness to better the rate setting process exists among all participants, today. Research and development advancements in powerful new software indicate that all this is possible and within the industry’s grasp.
Times are Changing
In the past, when utilities have wrongly divined the price, it has been easy for regulatory bodies to look backwards and point the finger at the utility, charging that management should have known better. A utility’s primary role should be to ensure a secure supply of energy and delivery to its constituents. Utilities do not have the ability and compensation incentives to foster an environment to employ trading personnel that are capable of picking market direction correctly and are never compensated for attempting to do so. To a large degree, utilities have put themselves in this uncomfortable regulatory position by sticking their necks out on behalf of the consumers andassuming the role of price forecaster. If a utility does occasionally make the correct call on price direction, all the financial benefit for that decision will flow through to the ratepayers and if the utility gets it wrong they run the risk of material regulatory disallowances. The rate-setting process practically institutionalizes a structure that fosters animosity and contentiousness. The net effect of this acrimonious relationship between a utility and its regulator has caused tremendous wastes of time and money at lengthy rate hearings with escalating emotion and tension on all sides.
For the last two years, RiskAdvisory has administered spot polls of attendees at the Utility Risk Management Summit Conferences we host in Chicago. The results are inevitably skewed toward the utilities’ point of view because more of their representatives attend than do people from regulatory or consumer advocate groups. Nonetheless, the accumulation of data in 2004 and 2005 enables both year-over-year comparisons and initial trend analysis. References to industry sentiment also are derived from these surveys. The full results are available on www.RiskAdvisory.com.
The 2005 survey revealed some interesting changes from the prior year and they have most likely been caused by the rapidly escalating price environment. First, there’s a definite desire for more collaborative approaches for managing ratepayer risk among all the groups involved in the rate-setting process. Of course, sharp natural gas price increases in 2005 and 2006 will likely represent seminal years because of the sheer number of North American rate cases convened. Those cases are mostly reactive, with utilities needing to hike prices in response to commodity volatility and upward cost pressures and every utility feels pain when there are the inevitable disallowances.
But in 2005, research indicates that survey respondents believe utilities, regulators and consumer advocacy groups can employ more productive methods for coming to a consensus on rates. The landscape seems to be shifting, however gradually, because there is a growing realization that there is a better way. Nearly 70 percent of respondents to our 2005 survey believed that regulators, consumer advocates, direct marketers and utilities can come to terms on hedging programs before they are implemented. They can work through some negotiation processes to agree on a percentage of a portfolio that should be fixed on the consumers’ behalf, based on a perception of ratepayers’ appetite for volatility in their utility bills. The theory is that, by using this upfront approach, the utility’s sole responsibility beyond its involvement and input into the collaborative process is the implementation of the agreed upon risk management program.
If future pass-through adjustments are needed because actual costs exceeded forecasts, then everyone shares some responsibility for the “decisions,” on behalf of ratepayers and allowances are made because a measure of consensus was achieved on guidelines at the beginning of the process. Assuming a utility implements the program according to the consensus plan, it should be absolved from any responsibility of forecasting which way prices are headed and then trying to hedge appropriately. Animosity and contention should, in this approach, be reduced or removed from the regulatory risk equation. Consequently the industry’s current – and correct – sense that rate hearings are costly and ineffective could be reversed.
Meanwhile many rate case hearings linger on in their traditionally acrimonious mode, in large part because utilities have continued to put themselves in the impossible position of predicting price direction on behalf of the ratepayer and as often as not, getting it wrong. We contend that this is precisely the area where the utilities can make life easier for themselves, the regulators and consumer advocacy groups. Utilities should consider adopting a mechanistic hedging program that eliminates the quasi-speculative aura that sometimes surrounds hedging decisions. When the utility systematically fixes the agreed percentage of the portfolio – at a pre-ordained time, without consideration for market and price activity – then they are implementing a mechanistic program that reduces the perception of opportunism and speculation. Even if all utilities cannot get comfortable with immediately adopting and implementing a mechanistic hedging approach, the utilities in our survey overwhelmingly indicated that they want regulators’ blessing for the design of their hedging programs. While utilities aren’t always convinced of the regulators’ ability to comprehend and distinguish the nitty-gritty details of a hedging program, they still welcome the concept of an ex ante agreement on the parameters and guidelines of such a program. Mechanistic programs can incorporate industry knowledge, financial best practices and balance constituent interests that are agreeable to all parties and represent the best interests of the ratepayer.
If mechanistic hedging is being considered, the difficulty then becomes the determination of the ratepayers’ appetite for risk. Consumers are not homogenous and risk appetites will be very diverse. How much price exposure are consumers willing to absorb if a utility is fully exposed, in exchange for participation in a possible downward move in prices? How much of a premium over market prices would consumers pay to ensure they were not exposed to prices above a predetermined level? The questions are many and there is no easy solution. More and more utilities are engaging market research firms to define how much volatility various ratepayer classes – commercial, industrial and retail – are willing to tolerate in a fluctuating commodity environment. Focus groups are polled to get a sense of the risk profile of this diverse customer base. This research – and a commitment to educating the public about hedging and its impact on utility bills – creates a more collaborative foundation for rate-setting hearings. Theoretically, the hearings should become less contentious and even more productive for the participating groups because they are giving the public what it wants: increased transparency, predictability and cooperation. The utility no longer has to stick out their neck … as much.
Minding the Store
As we’ve discussed above, regulatory risk could be more manageable than has been the case in the past. There is evidence of a willing spirit now in the industry to change the way that risk responsibility is assigned and rates set.
Yet even while energy market participants face the challenges posed by the need to manage their exposures to commodity prices, other risks remain. Companies face a number of internal risks in a volatile commodity environment. Interest rates, foreign exchange rates, shifting volumetric profiles, supply disruptions and credit risks all pose their challenges. Failure to properly manage these exposures can result in financial losses, credit downgrades, regulatory disallowances and the erosion of shareholder value and investor confidence. Ignoring these challenges puts the utility at risk of abrogating its end of the operational agreements that rate payers and regulators expect, in turn creating a return to the contentious rate-setting environment the utility seeks to avoid.
Utility companies can mitigate this pervasive uncertainty by having at their fingertips accurate and timely information available on all relevant risks. Companies can control and optimize the complex risk profiles associated with their involvement in energy markets, but they can only do so through robust information technology and software systems. Deciding what those systems should do will determine whether the utility operates at its absolute best when facing these challenges.
The software solutions required by today’s energy market participants must be evaluated for their ability to measure the value and risk in the portfolio of commodity exposures, ensure data integrity, reduce the risk of error in portfolio-tracking models, account for real options in the asset portfolio and help companies model the volumetric risk in their commodity positions. Other considerations include capabilities for multi-commodity support (electricity, fuels and natural gas); deal capture on web-enabled software; multiple financial transaction types (physical spot, forward contracts, futures, options and swaps); multiple energy market transactions (transmission/transportation, power generators, power load, FX swaps and inter-book transactions); and, graphical presentation of earnings distribution. Most importantly, all of this information must be accessed and presented in a way that allows both information and analysis to be delivered to senior management in a timely and instructive manner.
In addition to accounting for all the financial products listed above, options have become a large part of energy firms’ portfolio management strategy. Any trading/risk management system needs to properly value and assess the non-linear risk of a portfolio that contains options or more complex agreements that have embedded optionality within them. Equally important is the ability to run multiple scenarios quickly while capturing this non-linearity so firms can properly understand how its policies may affect both financial and physical exposures. In combination with an environment that can quantify credit risk, utilizing the same underlying data, the user will be fully empowered to understand how any market event will impact the firm, with regards to price, volumetric and credit risks.
In conclusion, RiskAdvisory believes that today’s utilities have the means and the momentum to change for the better both the way they manage external political risks and the manner in which they monitor the operations of their internal financial transactions. The question today is whether there is the will to change. The events that triggered change in 2001, and the prevailing outlook for continuing volatility, indicate that change will be a necessity in the utility industry going forward and it’s comforting to know that managing the shape of future change is at the fingertips of industry executives.
This article will be featured in the soon to be published "Utilipoint Trading and Risk Management Book". A compilation of information pieces written by experts in the area of energy trading and risk management, the book will be available for purchase soon. For more information regarding how to obtain a copy, contact gvasey@utilipoint.com