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Collaring the Risk of Real-Time Prices: A Merchant Strategy for Utilities

Fortnightly Magazine - October 15 1999

approach is likely to be superior in all situations. Some investigators claim that options alone will be sufficient and that there is no need for separate examination of insurance or price collars because they are equivalent to options. Were these claims correct, then any price collar or insurance policy could be priced using the Black-Scholes model applied to an equivalent option.[fn.3]

There are, however, at least two fundamental differences between collars and options. As mentioned, options are for fixed contractual quantities while price collars allow unlimited consumption at the ceiling price. The price of a contract that allows unlimited consumption is not the price that would be given by an option pricing formula.[fn.4] In this respect, a price collar would entail more risk for the merchant and consequently cost more than an option.

Second, options have upside potential. Mike O'Sheasy demonstrated that as spot prices exceed the option strike price, holders could decide to exercise the option prior to expiration. ("Real-Time Pricing - Supplanted by Price-Risk Derivatives?" Public Utilities Fortnightly, March 1, 1997, pp. 31-35.) In this respect, because options entail more risk for the merchant, price collars should be priced lower than options. Naturally, there are other differences. Options require greater customer knowledge and a willingness to trade financial derivatives. Price collars have no explicit premium costs, they do not require knowledge of financial derivative markets and they are simpler.

Insurance also has its place in the market. Insurance protects against downside risk by indemnifying against unfavorable states of nature. Enron offers temperature derivatives, should prices rise with extreme temperatures. The customer negotiates a "strike" temperature and corresponding price. At temperatures above the "strike," Enron pays the difference, if any, between the market price and the "strike" price. CIGNA Property & Casualty offers PowerBackersm, a product that insures against generation outages. If a generator goes offline and the generating company buys replacement generation in the market, the insurer will indemnify the customer, provided the market price exceeds a level agreed to by the customer and insurer.

While insurance protects against downside risk, it does not offer upside potential. The risk to the merchant is lower and, therefore, the cost of insurance is lower than a corresponding call option. [fn.5]

There is an important concern about the economic efficiency of price collars. Because ceiling and floor prices are not necessarily equal to marginal cost, the cap would appear to cause too much electric use at high-priced times, and the floor would cause too little consumption at low-priced hours. The usual criticism is in the context of a risk-less world. Just as farmers sell in a forward market to avoid risk, customers choose a price cap to limit upside risk. Efficiency depends upon the consumer's tolerance of risk. Even flat rates may be efficient if a customer is willing to pay to avoid all risk.

Table 1 summarizes the key characteristics of the three risk management alternatives.

There is a role for price collars to reduce risk. In addition to offering simplicity and protection with unlimited consumption, they are an extension of a