[BETA] Fortnightly

A Risky Business Utilities wrestle with how much to charge for their product.

The trading model has many good points, including the imposition of market discipline upon both transfer prices and prices to external third parties. Trading also encourages the use of resources and capital at their market value and the cultivation of specialized skills within different business units. But applying the model, particularly to the risks of power pricing, continues to be a challenge.

In fact, the challenge of how pricing is applied may be the difference between success and a long-term strategic decline. Competing against a firm using a return-to-asset model (e.g., one which transfers or internally prices to downstream activities to meet the financial objectives of upstream assets), may place an entity using a trading model at a decided disadvantage if risk valuation is implemented incorrectly. While the return-to-asset player, through internal transfer prices, may engage in predatory pricing in the most competitive portion of the market, the entity using the trading model but implementing risk valuation incorrectly will be at a strong disadvantage. What's wrong? If the trading entity, instead of using pricing based upon the marginal cost of risk to the enterprise, uses a purely theoretical price, it will be unlikely to be competitive with the return-to-asset player. ¹ The marginal costs of taking risks should be quantified dynamically using appropriate enterprise-wide methods. Critically, risk taking has a cost, but unless a firm can bear such costs at the margin for less than a purely abstract theoretical cost, it will not create value for shareholders. ² Accepting greater risk for greater reward is at best value-neutral, and may even be value-destroying as it distracts from other more beneficial efforts. Conversely, ignoring the marginal cost of risk taking can be perilous.

At one time, risks inherent to the production and marketing of gas and power were subsumed in larger cost structures or paid for through surplus capacity and sub-optimal operation. No longer. In the last 10 years many unregulated and regulated utilities have adopted the so-called trading model to better deal with shortages and surpluses in their supply mix. The trading model places trading at the center of a vertically integrated firm comprising generation and asset management all the way through to distribution and sales.

Although it is accepted that arm's-length transfer pricing (that is, internally pricing at market valuations) in energy trading helps ensure that resources are optimally used and that returns to various activities are not artificially subsidized, critical issues remain regarding how such market transfer pricing is obtained.

In this regard, the ascendancy of certain disciplines has led to the oversight of larger and more basic issues on how businesses should set prices in often imperfectly competitive markets. Knowing the purely theoretical price of a complex, non-linear energy market exposure is critical. But it defies business logic to use such prices unadjusted for what the actual and empirical cost of risk taking is at the margin for a given energy utility. Only through empirical analysis, using a risk-metric simulation, can energy utilities discover what the