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Utility Risk Programs: Success or Failure?

State public service commissions are insisting that utilities adopt risk management programs, and are allowing less pass-through for those that don't.
Fortnightly Magazine - May 1 2002

seasons of 1999/2000 and 2001/2002, as expected. But the increase in volatility in the fall and early heating season of 2001/2002 was a surprise.

The large price risk in the fall and early heating season of 2001/2002 can largely be explained by the uncertainty in markets created by the failure of Enron. With traders exiting Enron as a trading partner and seeking new trading partners, there was a reduction in liquidity in the market. Thus, despite robust supplies, each significant movement in temperature between days appeared to be greeted with large up and down movements in price, especially in November when the downward slide of Enron accelerated.

Yet, despite these significant challenges, some utilities and commissions have been successful in steadily addressing utility price risk management practice.

Of course, not too surprisingly, utility price risk management programs vary greatly. In fact, there is an east/west divide, with programs in the east being less ambitious compared to Southern California Gas (SoCal) in the west.

In the West ...

SoCal certainly appears to have continued to have a successful price risk management program during the 2001/2002 heating season. Success for SoCal is measured not only by the ability to effectively hedge or fix its wholesale cost of gas through a derivative instrument, but also by an improved capability to purchase gas.

The hedging program at SoCal is best viewed as a complement to a price incentive program for wholesale gas purchases. Not unsurprisingly, there are risks in this program. Yet, the consumer advocate tracks the incentive program and a report is produced annually. Risks are measured and reported, along with a variety of other information, on a regular basis to commission staff.

SoCal not only uses the New York Mercantile Exchange (NYMEX) futures contract market to hedge price risk, but it also places orders directly onto the exchange floor. The program has been in existence for much of the 1990s, and is manned by professionals who have been engaged in the derivatives market since the inception of the NYMEX natural gas futures market in 1990.

In the East ...

On the other hand, utilities in West Virginia continued with a successful program begun in 1996, several years after the program at SoCal was initiated. The program is a success because the utility, the commission, and the customers generally view it as a success and it is relatively transparent. The approach in West Virginia is much different from the approach in Southern California.

Since 1996, the State Commission and Consumer Advocate staff in West Virginia have tended to set a price target for the utility based on the NYMEX forward strip over several years. The utility then attempts to find a counter-party provider of gas that can at least meet the price. The price is then fixed for all volumes of gas. The utility, in turn, gives up all rights to transportation and storage assets. Thus, utility customers are not faced with any price or volume risk. However, to obtain this, they need to give up any gains associated with having rights to transportation and