Hedging Your Megawatts

lectric utility deregulation introduces new risks for businesses that consume a lot of electricity. CPAs can help clients avoid a shock by steering them toward an energy risk management program. To limit the risk of spiking electric power prices, companies can employ strategies similar to those used to tame the price volatility of energy commodities such as oil or natural gas. CFOs, CPAs and other financial managers can hedge, using new exchange-based electricity derivatives, private forward contracts, or insurance to keep costs even. (See glossary for definitions of italicized terms.)

END USERS, GREAT AND SMALL

Any company buying electricity directly from an unregulated power supplier may be vulnerable to price surges. According to David A. Lifson, CPA, one of six partners with the firm Hays & Co. in New York City, companies whose pricing structure prevents passing costs on to customers should consider hedging. Because hedging takes considerable effort, a company should hedge against only significant price fluctuations likely to cause major problems.

Called retail wheeling by the power industry, deregulation is intended to reduce the price of electricity by introducing competitive market forces. However, the supply of power is relatively stable, while demand is subject to large swings. A company’s sensitivity to electricity prices depends on the quantity of power it consumes. A company that buys a lot of electricity but can’t pass along changes in those costs should prepare to transfer the economic risks posed by that volatility to professional risk takers.

As states deregulate their electric utilities, most are decoupling power production from distribution, with the result that distributors are becoming mega-purchasers of power and are more exposed to power price risk than any other industry. In states where deregulation is well along utilities have already witnessed their vulnerability to power price spikes.

Take Illinois, which was one of the first states to deregulate: In 1998 some power distributors there got walloped when very hot summer weather drove up consumer demand. Chicago’s Commonwealth Edison had to supply power to consumers, whatever the market cost. One day during a killer heat wave the spot market price peaked at an astounding $7,000 per megawatt hour, more than 175 times the normal price. This year Commonwealth is actively hedging.

Although the power distribution industry has the greatest exposure, other companies may have a lot at risk, too. For example, a networking company dependent on computers may need to power heavy-duty air conditioning to keep them cool and functioning smoothly. A research lab may use a lot of electricity to protect components and maintain sterile conditions. An ice cream factory may need a lot of power to keep its products frozen. Or a radio station might consume a lot of electricity to power its signal.

THE LONG AND SHORT OF HOW HEDGES WORK

When a company takes an offsetting financial position designed to protect itself against fluctuations in a commodity price, it is called a hedge. For example, it could buy a standardized electricity futures contract on an organized exchange, entitling it to buy a specified amount of electricity at an agreed-on price on a particular date. The value of that contract is dependent on—or derived from—the price of the underlying commodity, in this case electricity. (That’s why it’s called a derivative.)

As an alternative to a futures contract, one could buy a forward contract. Similar to futures contracts, forwards are negotiated privately between parties without going through an organized exchange, and they are customized rather than standard. The advantage of going through an organized exchange is that the exchange limits the credit risk on a futures contract.

Exchange-traded contracts are regulated by both the exchange itself and, in the United States, the Commodity Futures Exchange Commission. In the more mature energy markets, such as oil and natural gas, the standardized contracts traded on exchanges are much more liquid than privately negotiated contracts. If a company wants to change its hedges before a contract matures, it is much more difficult to trade a customized contract than a standardized one. However, exchange-based trading in electricity futures is still fairly light, essentially eliminating any liquidity advantage for exchange-traded electricity contracts.

Some risk management programs make use of call options, which are also derivatives. In this context, a call option is an option to buy a futures contract. Options require less initial cash outlay than buying the underlying futures contract would, but they can be much more volatile.

When a company hedges its position by purchasing a derivative, whether that derivative is a futures contract, an option or a forward contract, it buys a contract to protect itself against the possibility of a devastating price change. When a company hedges against a price increase, it buys a long contract or a call option. If a company is selling electricity rather than buying it, it can hedge its position by purchasing a short contract or put option.

Usually, a company continues to purchase power at the market price through its ordinary supplier even if that price goes way up. It uses the profits on the derivative financial instrument to offset the price increase. Of course, the offset is never perfect. And if there’s a sudden drop in the price of electricity, rather than an increase, the company hedged long ends up paying less for electricity, but it loses money on its financial hedge. That’s the cost of protection against risk.

HOW FAR TO GO?

Many companies prefer to limit their trading in the relatively new electricity markets because those markets are still thin. The exhibit shows how little trading actually takes place on the New York Mercantile Exchange (NYMEX), the most active exchange for electricity derivatives. Companies that have such concerns may hedge only against the greatest risks. Some utilities hedge only at specific times of the year. A utility might choose to hedge against summer price spikes but leave itself open during the rest of the year, when it is better able to find alternate supplies.

Jim Miller, a senior vice-president in charge of regulated networks for electricity and gas at Utilicorp, a utility with 4.5 million customers around the world, explains: “We do a hedge or a swap with regard to summer and winter.” That swap is keyed to above- or below-normal temperatures. Of course, his company, which is based in Kansas City, Missouri, and had $12.6 billion of revenues last year, has a partial natural hedge because of its geographic and fuel mix, which includes customers in the southern hemisphere—Australia and New Zealand—as well as others closer to home.

Some utilities are so active in financial markets for electricity derivatives that they have hired full-time traders. American Electric Power Co. (AEP) of Columbus, Ohio, started trading megawatts in 1997. The first year it traded 11 million megawatts, and in 1998 it traded 202 million megawatts, making it the second largest trader in the market. (By volume, Enron is the largest.)

Why would a utility get into the trading business? “We started because of deregulation,” says Eric van der Walde, senior vice-president of energy trading at AEP Energy Services, which facilitates its parent’s trading activities. Retail wheeling gave AEP a profit opportunity, more detailed market knowledge and a chance to defend itself against increased price volatility. Overall, AEP Energy has 200 traders, dealing in contracts on the NYMEX as well as over-the-counter transactions.

HOW COMPANIES HEDGE OTHER ENERGY RISKS

Although electricity price hedges may be relatively new, many different companies have routinely hedged other energy products for more than a decade. These range from companies that need energy products as raw materials—power generators, refineries and chemical manufacturers (see Case Study), to companies that consume a lot of fuel—airlines, large office buildings and limousine services. Many companies have used the derivatives markets for natural gas and oil, which are already well developed. Experienced companies have devised other hedging strategies—some simple, some sophisticated—for the same products.

A hedge doesn’t have to be complicated; it can be as simple as a long-term contract with a supplier or a change in product mix. For example, Lifson suggests that a dairy that uses heat to process milk could enter a long-term contract for fuel.

However, a bigger company facing greater risks often can use a derivatives trading program to great advantage. United Parcel Service, the delivery company, has been hedging its energy risk for a decade. In 1998 fuel accounted for 2.8% percent of the carrier’s operating expenses. The company has an extensive jet fleet as well as the familiar brown trucks, which consume large amounts of diesel, jet fuel and gasoline.

To hedge, UPS uses forward contracts, futures and options, working both on and off exchanges. The company has several people dedicated to hedging full time in its Treasury group. Bob Clanin, UPS’s chief financial officer, reviews any policy change. They look at the price of energy daily and decide how much of their total needs they want to hedge. In general, the company tries to hedge as much of its energy costs as possible.

WHERE TO BUY A DERIVATIVE

Like UPS, some businesses devise their own derivatives trading strategy; others use a brokerage firm, bank or insurance company to develop and manage a program for them. CPAs in business and industry exploring derivatives for the first time probably will want to get help from an expert with a core competency in risk management.

Businesses buying electricity derivatives should make sure that advice comes from an intermediary with experience in this relatively new market, which is somewhat different from other energy derivative markets, and quite different from interest-rate and commodity derivatives.

The important differences between electricity derivatives and other energy derivatives include

• A relatively illiquid marketplace for electricity derivatives.
• The regulated status of many potential customers for the contracts.
• Different regulations in every state.
• The fact that electricity cannot be stored for later use like gas or oil.

Electricity derivatives markets are illiquid both because they are new and because deregulation is incomplete. Some states are much further along with deregulation than others are. Since electricity cannot be stored, only large consumers of electricity are potential customers for the contracts. (Anyone can speculate in oil or gas, store the underlying commodity and sell it at a more auspicious time. Electricity that isn’t used is perishable.)

Some, though not all, brokers competent to manage electricity risk will have their own seat on an exchange. Companies can purchase electricity derivative contracts through brokers with a seat on one of several exchanges, but the most active one in the United States is NYMEX. A few utilities have their own seat on an exchange trading electricity, but most companies are content to execute their trades through a broker.

“With deregulation, the utility industry needs our help,” says Keith Jacobson, managing director for debt markets and global debt derivatives at Merrill Lynch & Co. in New York City. Smaller businesses, with only a very limited need to hedge, may want to trade through a broker they use for other transactions whether or not that broker has a seat on the exchange. It can execute trades through a second broker that does.

The NYMEX has five contracts, and it also offers options on four of those. They are:

• California/Oregon border.
• Palo Verde, Arizona.
• Cinergy (a utility in Cincinnati).
• Entergy (a utility in Louisiana).
• PJM (Pennsylvania, New Jersey and Maryland; no options yet).

Robert Heller, chief risk officer for Commonwealth Edison in Chicago, is waiting to see how fluidly the PJM contract will trade. The NYMEX first offered the contract last March. Very few PJM contracts have changed hands so far (see exhibit).

The Electricity Markets Are Still Thinly Traded

Skirting the exchanges, customized forward contracts are negotiated privately, directly between a net electricity buyer and a net seller. Such contracts are usually negotiated with the help of a third party—many investment banks, commercial banks and insurers offer such services, as do a few specialized commodity trading companies, some associated with energy companies. In most circumstances, such over-the-counter or off-the-market contracts are not regulated, but that has been a controversial matter in Washington and could change. Although the derivatives themselves are not regulated, the Federal Energy Regulatory Commission monitors underlying transactions that involve actual power delivery, such as those traded on the California Power Exchange (CalPx) a market California devised for trading electricity in-state when it began deregulating.

OTHER WAYS TO KEEP CURRENT

Financial managers also can manage electricity price risk without derivatives. Some, particularly smaller companies, may want to buy straightforward insurance. “This can be a cost-effective means to reduce a company’s exposure,” says Marty Scherzer, managing director of Marsh, the world’s largest insurance broker and risk adviser.

A small company would pay a premium to get a fixed amount—say, $100 million—of insurance coverage over a specific time period—say, the summer. Various triggers are possible, the price of a megawatt hour of electricity being one, weather conditions another. Marsh is working on insurance structures for utilities that would cover the costs in excess of $100 per megawatt hour.

For the past couple years, insurers have been offering products that manage a company’s combined risks. (See “Two for the Money.”) Marsh calls this a “fusion” policy, but other insurers offer similar products. The idea is to calculate all of a company’s risks—natural disaster, interest rates, international political risks—together in one computer model, rather than calculate each one independently. Because the portfolio of risks is diversified the insurer can sell the fusion policy for a lower premium than it would have to charge if the risks in the portfolio were insured separately. The policy pays if any of the risks cross a well-defined threshold written into the policy. For instance, if electricity goes over the named price, the policy pays. It would also pay if a fire destroyed a power plant.

WEATHER DERIVATIVES

Although the electric power contracts are the obvious derivatives to offset changes in electricity prices, some companies use other derivatives as proxies. Weather derivatives are so new that the Emerging Issues Task Force is still discussing accounting standards for them as Issue no. 99-2. Weather derivatives may be appropriate for electricity hedges because most power supply and demand problems are weather-driven—heat taxes the grid with air-conditioning demands; storms can disrupt supply. Weather derivatives have been available for only a year or so and don’t have a real track record yet.

A weather derivative can be a customized contract written to pay under specified weather conditions—less than ten inches of rain in June, July and August, or more than 30 days with a low temperature below 30 degrees Fahrenheit, for instance. In addition, the Chicago Mercantile Exchange began offering standardized weather derivatives in late September. Initially, these are heating degree day index futures for four U.S. cities.

DERIVATIVES ADDICTION—JUST SAY NO

Derivatives trades can be very profitable, but they are risky. Companies are better off not trying to make such trading into a profit center. “If the hedge goes in the money and the underlying commodity [goes] dear, you look great,” Lifson says. He warns financial managers not to think they’re experts after one lucky transaction though, even if it is very remunerative. “Hedging can be to some like a painkiller after surgery—too much can be habit forming,” says Lifson. A company that hedges amounts that “far exceed the volume of the underlying commodity at risk” can become very vulnerable very quickly. Without a hedge, a company is naked. Too much hedging, it may go broke.