As the debate over restructuring the U.S. electricity industry moves forward, there comes a host of new theoretical models. Two proposals in particular serve well to frame the debate.
Gas Price Prudence: From Hedge-and-Hope to Best Practice
- the trading organization.
- Issue Reports. Make those reports physically available to-and intellectually accessible by-senior managers and regulatory staff.
- Maintain Accountability. Enforce accountability. Be ruthless, for both individuals and groups.
These practices and metrics are derived from a set of twenty risk control "best practices" enunciated by the Group of 30, a special-purpose committee of economists and financial analysts who joined together in the early 1990s. They are as applicable and fair to LDCs (and fuel-purchasing utilities) wishing to shield their customers from price volatility-and PUCs wanting to monitor and enforce prudent behavior-as they are to the largest commodity trading houses. Any transaction must meet a standard test that looks at the decision-not the subsequent "rightness" or "wrongness" of that decision-in the context of portfolio objectives, risk policy parameters, current portfolio composition and current market activity and information. Follow the rules and you'll be prudent, and not far wrong.
Portfolio objectives and the overall risk/reward profiles must reflect the specific circumstances of the LDC. A provider of last resort may value price and pass-through certainty, and aim to fully hedge its forward positions. A regulated, full-service retail merchant with unregulated competitors may wish to maintain a larger speculative position, especially if it comes to hold a strongly contrarian viewpoint about market direction. Performance-based rates make more sense under these circumstances, as there is clearly a risk/reward balance that must be recognized and accommodated by the regulator.
The design and implementation of these management and reporting systems need not be elaborate or prolonged, either at the commission or individual LDC level. It must be done in a credible and transparent manner, however, clearly enunciating the guidelines for performance evaluation and setting in place and in motion the reporting systems and practices to afford fair and comprehensive review by all involved parties. Risk management reports need not be mysterious to the non-trader; those that remain so after a brief explanation should be treated with suspicion or sent back to the drawing board.
Portfolio risk management can be done by design and governed by process. It can be done in a manner that affords utilities the freedom to make timely business decisions. It can be done in a manner that also affords regulators the opportunity to review these decisions within a preestablished framework of prudence review that addresses the context in, and procedures by which, these decisions are made, not the outcome at a given moment in an uncertain future market environment. It can be done in a manner that allows the measured assumption of risk in pursuit of reward in a conscious, transparent and equitable process. And, it can begin today.
- For an introduction to basic risk management concepts and practices for the uninitiated, and the arguments for and against LDC hedging programs, I highly recommend a recent report by The National Regulatory Research Institute, (May 2001, 65 pp.).
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