Many utilities engage in hedging to protect customers from price spikes. But unless regulators are involved in crafting and monitoring these programs, they can turn into speculative ventures that...
Utility Risk Programs: Success or Failure?
not occur, they must still pay the premium, as they did.
Figure 3 shows this clearly. Most utilities purchased the hedges over the injection season. It can be observed that the price of natural gas for the heating season months was very high initially in early 2001, but it declined significantly over the injection season and stayed low during the heating season. () Thus, the strike price (cap) for most call options likely exceeded $3.50/ MMBtu, as did the price in most fixed price forward contracts and floor prices in swaps and collars.
Since all bid week prices during the heating were less than $3.50/MMBtu (), options were not executed and utilities with other hedging instruments such as fixed price forward contracts paid a price much greater than the market price.
But this is not a problem. It is just the luck of the draw as long as the volumes hedged were no greater than volumes actually required and volumes determined as part of a plan. In some instances, utilities may have hedged more than actually was required, which could be a problem.
Utility price risk management is first of all about volumes. If enough attention is not paid to the volumes to hedge, the company may find itself in the position of not fixing the cost of the gas-which is the purpose of the hedge in the first place.
For example, a company requires only 20,000 MMBtu to be purchased (after account is taken of normal or planned withdrawals from storage) in a heating season month when the cost of gas is $2/MMBtu. But it has an obligation to pay $4/MMBtu for 30,000 MMBtu under a fixed price forward contract. Under these conditions, the company pays $120,000 for the gas. It then sells the 10,000 MMBtu it didn't need at $2/MMBtu. It receives $20,000 for this gas, which leaves it with a net cost of $100,000 for 20,000 MMBtu, or a unit cost of $5/MMBtu. Thus, it neither fixed the price of gas at $4/MMBtu (the purpose of the hedge), nor did it take advantage of the $2/MMBtu gas.
Available evidence suggests that several companies were in a situation where hedged volumes exceeded required volumes during the heating season of 2001/2002. Yet, whether the avoidable economic costs that occurred as a consequence are considered imprudent or simply oversights by the utility because of its inexperience with hedging will not be known until the next hearing cycles at the commissions.
Progress at State Commissions
Commissions are still sorting out the type of hedging program they are likely to support and what type of hedging decisions are considered prudent. In many states, a commission may encourage a utility to provide a price risk management program. But the utility is allowed discretion in making decisions and on choosing a program. The commission then reviews the price risk management program, the decisions made, and the outcomes from the decisions, just like any other program.
In other states, commissions pre-approve plans. The companies' hope is that if they get approval for the plan, they will be