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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

This had all the appearance of a conflict of interest-the company appeared to be serving other agents at the expense of the consumer.

Subsequently, the commission found the company's "failure to utilize traditional storage, to develop a diversified gas supply portfolio plan, to implement a price mitigation plan or to take any significant action to mitigate price volatility on behalf of its ratepayers, compels the Commission to find the company imprudent."

The total impact of the program was $46 million. However, the final ruling only disallowed recovery of the $34.6 million remaining balance in gas costs not recovered for the 2000/2001 heating season.

Measuring Achievements

Achievement cannot be completely measured by cataloguing what particular utility commissions and utility companies have been doing. Benefits from price risk management will be well measured, and successful programs identified when utilities follow through on planned programs and adjust programs based on customer requirements being met or not. Moreover, benefits will only grow if going forward utilities and commissions and their staff and consumer advocates are towing the same lines.

Nonetheless, some achievements are worth mentioning:

  • More utilities are using the regulated futures options market directly to hedge price risk. They are gaining commercial and other skills from this experience.
  • More commissions are ruling on what are prudent price risk management decisions and what are imprudent.
  • More commissions are ruling that failure to follow a price risk management plan or failure to make price risk management decisions is imprudent.
  • Simply passing all commodity costs onto consumers is no longer considered acceptable as it was in the past. This naturally is good for consumers since it will stabilize their bills over time. 11 It is good for stockholders since it will increase or tend to sustain the credit rating of the utility and thus reduce its cost of capital.

Thus, going forward several things may happen from the more active involvement of state commissions. The utility will be better able to satisfy customer needs. Utilities will become better informed, more aggressive buyers of gas. They will be better able to measure the value of their assets, and they will be more likely to capture risk free or arbitrage returns. 12 Finally, as they better understand the gas wholesale market, 13 with the collapse of Enron, and the increased importance of a credit rating, utilities will be better able to negotiate and purchase gas directly from producers and avoid the problems and costs of dealing with a middleman.

  1. The better the producing company is at assessing its expected future production and its expected future marginal cost and the greater the debt on its books the greater the incentive to hedge.
  2. This was the great success of Enron. The weakness was that the consistent current cash returns were highly leveraged to investments that didn't yield much of any current income and the marking to market of forward supplies was corrupted to consistently inflate expected paper forward revenues which, in turn, were used to inflate current booked profits. Enron's failure was not about a hedging program but about hedging being used