[BETA] Fortnightly

Lessons learned from Cinergy's losses in commodity markets.

After a second summer of extreme weather, contract defaults and consequent financial losses to energy companies, the financial community and shareholders are holding utilities ever more accountable when it comes to managing risk, say analysts. Moreover, they're showing zero tolerance for failure.

On Aug. 10, Cinergy announced cash losses of $73 million after taxes, reflecting increased costs due to hot weather in late July and anticipated liquidated damage claims for failure to meet delivery obligations to several power marketers. The announcement drew criticism from stock analysts.

"We expect recent events will frustrate investors and create a stock overhang [for Cinergy], potentially for an extended time despite current discount valuation," according to a report from a stock analyst at Merrill Lynch & Co.

Cinergy held a meeting with analysts Aug. 11 in New York City, where the company insisted that planning couldn't and shouldn't revolve around a potential event with a 1 percent probability. But Wall Street did not seem to buy this explanation completely.

"We agree [to ignore low probabilities], but there are plenty of other players in this business (e.g., Enron) who have managed to navigate a number of price crises. ¼ Enron prides itself on being able to deliver electricity or gas anywhere in the U.S. on two hours' notice. Cinergy can't do that today, and we doubt they ever will be able to," says the Merrill Lynch & Co. stock analyst report.

Investors: Not Ready for Risk

Analysts say utilities that take on greater amounts of commodity risk must improve their risk management practices to the level achieved by investment banks. At the same time, however, they don't believe that investors in utilities have come to grips with this changing risk profile.

Cal Payne, vice president and risk control officer at UtiliCorp United, explains that even as utilities take on more risk as part of deregulation, electric utility shareholders continue to expect the dependable earnings they enjoyed from utilities under regulation.

But Payne says nothing is stopping utilities from successfully adopting the type of strict risk management practices investment banks are known for.

"If there is something that differentiates UtiliCorp, it could be something as simple as that we are not a utility that just decided to get into trading because the big boys were in it. Risk management has been part of our culture for many years. We have a very robust trading organization at Aquila that has been associated with UtiliCorp for many years," he says. Payne adds that UtiliCorp's risk management culture has been successful because the company's top management initiated the effort.

Meanwhile, it is still difficult for shareholders to regain confidence after they see utilities suffer a trading financial loss, as compared with when investment banks lose money, say financial experts.

Consider the investment bank J.P. Morgan. With the global financial crisis in 1998, Morgan posted a drop in earnings to $237 million for first-quarter 1998, which included earnings with one-time charges, though operating income was $366 million. But by first-quarter 1999, the investment bank showed