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Temperature, Price and Profit: Managing Weather Risk

Fortnightly Magazine - September 1 1998

success is not assured.

GRI's Cochener advises caution: "Weather hedging may become more important in a deregulated market, but not as important as the promoters of hedging tools would lead you to believe. Seven or eight years ago, there were no natural gas futures, and we got along fine without it. But now people seem to be convinced that they need to hedge. Look at the winter of 1995-96, when basis differentials collapsed; hedging is not a sure thing. People tend to speculate in the name of hedging. They're tempted to chase a market."

A recent example of "speculating in the name of hedging," Cochener says, comes from Centra Gas Manitoba, a Canadian natural gas distribution company. Centra asked the Manitoba Public Utilities Board for permission to recover $31.4 million in trading losses last year, but the PUC ruled that the losses came from speculative gas trading, not hedging, and forced the utility's shareholders, not gas buyers, to bear the brunt of the losses.

Restructuring:

From Ratemaking to

Consumer Product

Utility deregulation promises an end to weather-driven ratemaking adjustments and perhaps the beginning of weather-related consumer products.

Under cost-of-service rate regulation, state utility regulators commonly approved revenue normalization adjustments to take account of unusual weather. Such adjustments did not directly affect the price the utility charged for energy. Instead, in the typical case, the commission would adjust the overall revenue requirement by modifying test-year income to reflect the level of expenses and revenues (including derivative items such as taxes and reserves for uncollectibles) that would have been earned had temperatures fallen with a "confidence interval" or a statistical range surrounding an arithmetic mean.

Depending upon how soon the utility would file its next rate case to allow it to adjust its tariffs, the typical weather normalization adjustment would tend to increase rates overall after a period of abnormally mild weather and reduce rates after a period of severe weather. A survey published in 1987 identified more than 20 states in which utility regulators had approved such adjustments during the 1970s and '80s, though some states, such as Ohio, Missouri and South Carolina had rejected the idea outright.

In a 1989 rate case, the Georgia Public Service Commission had approved a weather normalization adjustment for Atlanta Gas Light Co. that followed the typical pattern - it tended to raise or lower rates, respectively, after an abnormally mild or severe winter. That adjustment led to a higher authorized revenue requirement for the company in 1991 in its next rate case.

In June 1998, however, with the enactment in Georgia of the new legislation to deregulate natural gas (The Natural Gas Competition and Deregulation Act of 1997), the PSC told the company that beginning July 1, 1998, it could no longer factor in the weather adjustment.

"Now our rates are no longer based on how many times the wheel turns around on the meter, but how many noses [customers] we have," says an AGLC representative.

This loss of ratemaking guarantees by Atlanta Gas Light and other utilities, coupled with the onset of consumer choice, quite