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Price Spike Roulette: Can Utilities Play By Wall Street's Rules?

Fortnightly Magazine - October 15 1999

Brash says.

But at least one risk manager says what can be learned from Cinergy's experience is that you have to adequately prepare for even a 1 percent event.

"If you don't prepare for the consequences, you take a huge profit and loss hit, you jeopardize a corporate strategy and wipe out hundreds of millions of dollars of market capitalization," the risk manager says.

Moreover, what happened to Cinergy was not an isolated or wholly unexpected event, as Cinergy contends, but partly a result of having deregulation at the wholesale level and not on the retail level. That's the opinion of Shannon Burchett, president and chief executive officer of Risk Limited Corp. in Dallas and former president of Ameren Energy.

"With retail prices still fixed by regulation, you don't get any demand-side price signal to reduce consumption during peak periods, and utilities can end up paying $7,500 per megawatt-hour in the wholesale market if they haven't effectively hedged. It is no longer fixed prices; it's floating prices. It is an unregulated wholesale business where it's the free market and the price is whatever it is," he says.

In a fully deregulated retail market, commercial and industrial customers will have the choice to buy on the spot market or do their own price hedge, he says. The current state of partial deregulation, coupled with the transmission and generation constraints that exist in some regions, create an environment where such price spikes may well occur, and that price risk must be managed.

Burchett explains what would have happened this summer if price spikes had occurred and a more fully deregulated wholesale and retail market were in effect. "[In a fully deregulated market], the price would get passed through to the large industrial and commercial customers. They would reduce their consumption and get the supply and demand more in balance; it's free market economics. When that occurs, the price is going to decline. The end result is a reduction in demand because of the higher price. The price then declines to lower levels," he explains. "Even then electricity price volatility is not going to be low, but ultimately we need both sides in the market - the supply side as well as the user side."

Burchett does not believe there will be 200 highly expert risk management and trading operations in the future. "It is going to become a highly complex and sophisticated business," he predicts.

Furthermore, he says, utilities wanting to develop risk management skills will not have the luxury of time that the investment banks had. Big exposure, big volatility and lack of risk management expertise are a brew for disaster, he says.

"Generally, in this market, one has a short window of time to acquire risk management capabilities. Speed is everything. That is what makes it altogether more difficult. It is hard to make that transition in regulated markets," Burchett says. "It comes down to management expertise and management philosophy."

Markets: Volume Too Thin?

Even as experts preach the benefits of adopting tougher risk management standards, utility executives complain of the lack