Financial players bring credit depth to energy markets, but will they play by the rules?
The center of gravity for energy marketing and trading activity is moving from...
The utility industry is in financial transition, both in the United States and abroad. In such times, it is often difficult to pinpoint the catalyst that carries an organization through a period of change. Successful analysis of efficient market models in the past can offer an excellent indication of how "restructuring" will affect utility industries in the United States and the world. Current efforts have come about because of the growing, and projected, need for power. Technological advancements in information systems and automation, as well as migrating and growing populations in developed countries, have emerged as the largest factors driving this need.
History teaches us that these periodic metamorphoses are cyclical. Paul Kennedy's 1989 book, The Rise and Fall of the Great Powers, analyzes the repetitive nature of the world's economies. Kennedy attributes the development of economies of scale to the great wars that nurtured production, which, in turn, advanced technology. In the current era of "peace," this cycle continues. Although today's battles are more economic than military, the victims remain the same: people. In the case of utilities, these people could be investors, customers with limited service options, or employees. Projecting the likely financial effect of change is probably the most important element in surviving it.
Investors and companies use market risk as their primary gauge in making investment decisions and determining liability if their investments should go sour. Regulators must avoid the urge to overprotect institutional investors or risk undermining the cardinal principle of financial markets: caveat emptor. Creating a "safe" environment for companies and institutional investors (em allowing them to appeal to regulators (or the courts) if they incur losses on a deal (em creates a disincentive to fully consider the risks involved in their transactions. Such an environment fosters even greater losses. The predicament of the newly bankrupt Orange County, CA, is a sad but excellent example.
The once fourth-wealthiest county in the country allowed treasurer Robert Citron complete control over its $20-billion portfolio. Orange County had an A- bond rating from Standard & Poor's until just before it filed for bankruptcy. Citron chose to borrow more than $12.5 billion in bonds from Merrill Lynch to increase the value, and concurrent leverage, of the county's investments ($7.5 billion originally). As bond values moved in the opposite direction of interest rates, Citron's move raked in annual returns of more than 9 percent as interest rates declined. The rise of interest rates in 1994, however, suddenly weakened the county's portfolio. To make matters worse, Citron invested $8.5 billion in high-risk derivatives (called inverse floaters), which have a value relationship similar to that of interest rates and bonds, although much more sensitive. As interest rates rose, their values plunged. Losses have been gauged at $1.6 billion and are still climbing. Needed repairs (earthquake damage) for schools and county and city buildings will not be made, and economic development initiatives such as expanding Anaheim stadium (to keep the Rams from leaving area) will not be completed.
And what will happen to Orange County's municipal water system, which needs upgrading? Will the federal