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

Fortnightly Magazine - October 15 1999

of liquidity and transparency in the futures markets.

"The New York Mercantile Exchange has not been a big provider of risk management to the industry," says the managing director of an investment bank. "I don't think anyone is looking at NYMEX as a viable risk management source, but the over-the-counter market is sufficiently liquid to manage their risk," he says.

David Shimko, a principal at Deutsche Bank's risk management advisory group, says liquidity is a classic problem in futures that the industry has been unable to solve.

Regions characterized by severe weather and frequent transmission interruptions abhor standardization, he says. Shimko explains that utilities fear that a futures contract will not adequately match the risks of their particular region, causing basis risk. Basis risk is the risk that the value of a futures contract (or an OTC hedge) will not move in line with that of the underlying exposure.

According to Bob Levin, senior vice president of planning and development at NYMEX, "a deregulated subsidiary is more likely where [futures trading] will take place." (See figures.) Furthermore, he adds, the low usage of futures contracts by utilities has more to do with regulatory issues than with geography. If a utility is buying and selling in the wholesale market, Levin says, basis risk is no longer an issue because the utility is no longer saddled with the obligation to serve and thus benefits from hedging risk with futures.

Regulated utility activity is still subject to a lot of scrutiny, especially with a new risk management tool, whereas a deregulated subsidiary is free of that scrutiny, he adds. Usage of risk management tools by regulated utilities would have to be motivated by state regulators, he says.

"We don't see at this time distribution companies that are highly scrutinized to be jumping to use these [futures]. We could see some experimental programs, but what we are really expecting eventually is that side of the business will become very limited and that suppliers to end-users will want to use these [futures] when the market is genuinely freed up," he says.

In addition, Levin says, in time, affiliates or subsidiaries of utilities that are actively competing in the downstream and between upstream and downstream parts of this business and in wholesale trading will use NYMEX futures.

"What we think we are seeing, but this may be a slow process [is] the fading out of traditional regulated distribution with the obligation to serve by utilities. It will not disappear tomorrow, but we will see the obligation to serve reduced more and more over time. Thus, we don't expect as much emphasis on futures in a part of the business we think most utilities believe is going to fade out in time. That is why they are not concentrating their efforts there," Levin says. "Why would utilities go through all the burden of the regulatory process to trade futures if they do not see it as a future business?"

Moreover, Levin says that the price spikes were completely avoidable. "Last year when it happened in late June, they had