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Retail Wizardry: How To Make Money in Today's Power Market

Fortnightly Magazine - February 15 1999

A hedging strategy to protect gross margins in a fixed-price mass market.

The retail electricity markets in the United States are set to bloom. Retail power marketers presently must navigate various hurdles, raised by incumbent utilities, before they are able to establish a foothold. Some states, however, including Pennsylvania and Massachusetts, have established a fixed schedule for the recovery of stranded costs, resulting in profit opportunities for new entrants. In addition, alliances of utilities and municipal-owned electric utilities with local brand recognition have further opened the commercial, industrial and residential customers to enterprising power marketers.

A retail business strategy that focuses only on customer acquisition is destined to the red ink. The strategy must be complemented by a judicious management of the risks inherent to servicing electric loads. Power marketing is vastly different from selling electronic microchips where gross margin is clear-cut and inventory control helps manage production flow. Electricity cannot be stored cheaply. Power marketers must, therefore, balance their supply and demand requirements at every point in time or incur heavy energy imbalance penalties. A few hours of $1,000 per megawatt-hour spot prices will, in an instant, wipe out an entire year's worth of profit margins.

While the price and volume risks of retail power marketing are significant, they can be managed with financial and physical instruments already available in the wholesale market. An effective hedging strategy not only reduces risk exposure for the retail power business, but also provides a clearer indication of value.

Risk: The Short and Long of It

A retail energy service provider faces two types of risks: (1) in the short term, risks associated with servicing the load profiles of customers who have already signed up; and (2) in the long term, risks associated with anticipated demand growth. This distinction between short- and long-term risks is critical particularly if the power marketer is offering fixed-price, full-requirements packages to retail customers. A "full-requirements" contract stipulates that during any time period, the customer has the right to consume any quantity at the previously determined fixed price.

All retail market participants face short-term risks since their customers' energy demands depend primarily on weather conditions. Recall this past June when temperatures in the U.S. Midwest rose to unseasonably high levels and, unfortunately for some, coincided with a series of power plant outages. Several utilities and power marketers "playing" the region got singed by energy costs of $5,000 to $7,000 per MWh - as much as 200 times the usual prices. Trading losses for several entities reached hundreds of millions of dollars. Long-term risks are not trivial either, because the aggregate volume is much greater. A marketing oversight may result in a much lower customer acquisition rate than planned. Therefore, long-term power supply contracts signed previously now represent an "exposed" position, leading to a very high value-at-risk for the supply portfolio.

Risk-Hedging Strategies

The hedging strategy, or "supply" strategy, for these two classifications of risks will be different; however, the general framework used to analyze the problem is most comparable.

Short-term hedging tactics lean more heavily toward temperature-based load projections. The