RiskAdvisory Summit Aims to Improve the Lines of Communication between Utilities, Regulators and Ratepayers with Respect to Managing Commodity Cost Exposures
By Tim Simard
Picture the regulatory hearing battleground where the regulated gas or electric utility's actions to control gas or fuel cost volatility are under review. Armed with piercing hindsight abilities, regulators and intervenors work diligently to uncover errors in judgment and potentially imprudent management decisions, with the aim of avoiding rate increases or disallowing the utility shareholders' ability to clear burgeoning deferral accounts. The utility, who is so often portrayed as Goliath in our daily newspapers, is placed in the role of David, trying to fend off its combatants and avoid not only the risk of direct financial loss, but also the peril of negative publicity.
After a rise in fuel costs (which many assume could be foreseen), the utility must be in a position to explain why it didn't hedge more, why it didn't hedge earlier, and why it employed option strategies which did not provide ratepayers with as much protection as a fixed price purchase strategy. Yet if prices fall, the warriors representing the ratepayers will want to know why the utility hedged so much, why it didn't hedge later, and why option strategies were not used to allow customers greater participation in a falling price environment as opposed to the fixed price purchases selected by management.
And no matter which direction prices move, retail marketers will want to know why the utility feels it should be managing the commodity costs at all. Shouldn't the ability to provide alternative pricing structures rest with the direct marketing community, where the expertise, competitiveness and entrepreneurial spirit can serve to provide customers with more choice and lower costs? Doesn't the utility hedging activity dampen the development of the competitive retail market?
All of these issues surrounding utility risk management programs are complex, with different stakeholder groups having very strong opinions about the desired actions of the utility when it comes to the management of commodity price volatility. There are some real risks for each of the groups when the forum for the discussion of these issues takes place in the middle of a rate case. All stakeholders should look to engage in more informal discussions of these issues on an ex ante basis, allowing for the upfront analysis of the various viewpoints and a chance to review what types of commodity cost control mechanisms have been employed in other regulatory jurisdictions.
One such initiative that promotes the open discussion of these issues in an informal environment is the RiskAdvisory Regulatory Summit 2004. By bringing together representatives from many of the gas and electric utilities across North America, along with regulatory staff from a range of public utility commissions, customer representatives and members of the direct marketing community, the stage is set for a productive exchange of ideas and methodologies in an informal setting. Take away the stressful environment of the regulatory hearing and all parties can work rationally toward a better solution that recognizes the needs of all stakeholders. Build upon the experiences of others without trying to re-invent the wheel. Clearly circumstances will differ from one region to the next in North America, requiring some customization of commodity cost volatility management strategies, but most participants in this market will still be able to apply lessons learned from other jurisdictions to their marketplace.
Tim Simard is a Principal Consultant with energy risk management consulting firm RiskAdvisory. The consulting practice has provided advisory services to more than 50 regulated gas and electric utilities across North America since its inception in 1995, and its consultants have served as expert witnesses in a number of regulatory proceedings pertaining to utility risk management programs. From our experience it is clear that there is still no standardization around the design and implementation of utility hedging programs from region to region. In many instances, regulators and the regulated do not have a thorough understanding of the experiences of other utilities in other jurisdictions. We felt there was a real niche for a conference that brings together a broad range of experts from all stakeholder groups to have open discussions about the management of commodity risk in the regulated utility environment.
Some regulators and ratepayer groups may feel that they are best served by a hindsight review that allows for a critique of the risk management actions taken by the utility's management team. Leave the upfront decision-making entirely in the hands of the utility and then analyze the impact of these decisions after the fact when all the pricing information is available. However, there is a concern that the 20/20 hindsight capability may turn out to be myopic in the long-run.
In this type of situation, the utility is burdened with significant regulatory risk. It is impossible to employ the perfect hedge strategy that on an ex post basis will result in the lowest cost to the ratepayer some alternative strategy can always be found that would have outperformed the strategy selected by the utility. With the high levels of volatility impacting all energy markets these days, the variance between actual costs and the costs that could have been incurred on the perfect hindsight strategy can and have been material. Burdening the utility with this uncertainty endangers the viability of the regulated entity, increases the cost of capital and motivates utilities to get out of any risk management responsibility to their customers.
There is also no basis for the assumption that the utility is in the best position to select the optimal risk management strategy. In many instances, any hedging that is undertaken by the utility is done on behalf of ratepayers it is an attempt to design an energy supply portfolio that matches the risk appetite of its customers. And who is in the best position to opine on the customers' risk appetite? The utility? The regulator who serves to protect the interests of the customers? Customers themselves?
It is the responsibility of all stakeholders to settle on the appropriate guidelines for the risk management strategy, says Simard. Risk tolerances should be established upfront with agreement between customer groups, the regulator and the utility. Part of this process would involve workshop sessions where these issues can be discussed and the impact of alternative strategies reviewed. The utility has an obligation at this stage to provide stakeholders with comprehensive information around the nature and magnitude of risk in its energy procurement portfolio. It should also be in a position to examine the effects of proposed hedging strategies on the energy cost risk profile.
Once the general guidelines have been established in concert with all stakeholders, there remains the important issue of how much discretion is granted to the utility with respect to the implementation of the hedging program.
Often, both the utility and stakeholder groups feel that the utility should retain some discretion around the timing of any hedge implementation, the magnitude of the hedge, and the selection of hedging instrument. However, it is debatable if the utility should be granted any discretion if the foundation for that discretion rests on market views. It should not be assumed that utilities have some kind of competitive informational advantage to out-forecast the market, says Simard. Utilities are in the best position to conduct the appropriate risk analysis and share necessary parts of this information with stakeholders. However, their core business is not commodity trading. Beating the market' consistently is extremely difficult even for the best (and very expensive) traders, and this does not come without risk. These are not typically the risks that either utility shareholders or ratepayers want to incur.
If the utility maintains an element of implementation discretion, it legitimately opens itself to the risk of disallowances through a hindsight review. Let's examine a situation where under the hedging guidelines developed for a gas utility, 25% of the exposure to gas prices during the upcoming winter must be hedged during the third quarter. The utility is given discretion to establish the hedge at any time through the third quarter. Early in July, a powerful hurricane moves through the Gulf of Mexico, forcing up both spot and forward prices for natural gas. The utility decides that this price move is likely only temporary, and defers any execution of hedge positions. But prices continue to climb, with other supply and demand concerns taking over as the hurricane fears subside. By the end of the quarter, hedges now must be implemented, and they are established at price levels well above those available early in July. Regulators and ratepayers in hindsight could well question if this decision to delay hedge implementation was prudent, creating the possibility of a material disallowance for the utility. By removing the discretion granted the utility and narrowing the execution window, ratepayers are assured of a supply portfolio that matches their original guidelines, and utilities avoid the incremental risk tied to a prudence review. Some management discretion may be required for operational reasons, or if there are liquidity constraints in the forward market, says Simard. However, discretion associated with the exercise of a price view typically does not serve the interests of ratepayers or the utility.
These issues should be solved through a consensus-building exercise with all parties. Instead of waiting for the David and Goliath showdown in the regulatory arena over hedging programs, all stakeholder groups should embrace a healthy discussion of these topics in more informal surroundings, whether they be workshops hosted by the utility or technical conferences hosted by the regulator. The RiskAdvisory Regulatory Summit 2004 provides another effective forum to build consensus around these risk management issues and learn from the experiences of participants in other regulatory jurisdictions.
For more information about regulatory issues, or the RiskAdvisory Regulatory Summit 2004, contact Tim Simard at tsimard@riskadvisory.com