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Resource Planning After the Crash

How to update yesterday's IRP model to account for tomorrow's risk profile.
Fortnightly Magazine - September 15 2003

implied in option prices. In its more comprehensive applications, VaR may serve as a foundational element in assessing earnings risk or the risk of customer bill increases. For the operational horizon, VaR and its offshoots are metrics that allow utilities to make short-term hedging decisions.

When assessing alternative resource plans, the analytical underpinnings of VaR may be extended to assess risks for longer horizons. This may be done with a Monte Carlo analysis where the objective is to assess states of the market that might exist as potential outliers in a future probability distribution. To do so requires quantitative observations of market characteristics and related uncertainties; necessary inputs include today's forward market prices for power and fuel, price volatilities, and the characteristic variability of observed volatilities, correlations, mean reversion characteristics, etc. A typical result of this step might conclude with a table of potential market environments as seen in Table 1.

This stochastic representation of market values, which may include further assumptions regarding regulatory outcomes or other items, is then used to drive generation dispatch simulations for the range of market environments.

Other factors such as credit risk should also be integrated. Note, for example, that abrogation risk might be considerable if long-term contracts are signed with a single counterparty that ultimately may be counted on to deliver $5 fixed-price gas in an $8 market.

In the RIRP™ process (), we do not weigh the outcomes by their probabilities. A 2 percent probability of incurring a $300 million problem is not just $6 million on a weighted basis; it is dealt with as a discrete issue because the $300 million problem could bankrupt the company.

On reviewing results, management is faced with metrics that are very similar to those deployed in managing risks for the shorter operating horizon. Benchmarks for evaluation are similar as well; some typical questions and objectives might be: 1) What is a tolerable range for earnings or rate variability for Earnings at Risk (EaR), and Rates at Risk (RaR)? 2) What long-term exposures need to be protected so that the economics of investment decisions are looked after?

Finally, the resource plan that is selected will narrow the range of unfavorable outcomes that management might have to deal with in the future. The RIRP™ process begins with a risk management perspective to better optimize planning decisions, and then comes full circle in that the firm's ongoing risk management program will deal with the residual risks that could not be mitigated through the RIRP TM.

Verify Program Objectives and Acceptable Risk Boundaries

The consolidated risk profile generates an expression of the utility's risk tolerance and forms tolerances of commodity risk exposure that the utility may want to manage. The primary considerations with respect to forming either short- or long-term risk boundaries include the following factors:

  • Net rate impact associated with uncovered commitments;
  • Net revenue risk of significant contingencies; and
  • Risk of appearing imprudent due to unfavorable current fixed positions.

It is important to clearly articulate objectives consistent with constraining risk exposures using the same metrics contained in the initial