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By Executive Decision
Energy Trading & Risk Management: A better framework for making decisions is required to ensure earnings stability and shareholder value in the utilities industry.
evaluation of risks on an individual and parochial view of the future. It is equally damaging when individual decisions are made without consideration of regulatory, investor, and customer impacts.
Historically, traditional utility decision frameworks failed in several key instances: (1) the merchant glut scenario; (2) the regulatory risk in international strategies; (3) the earnings risk in retail competition; and (4) the nuclear cost overruns in the 1970s.
The saturation in the merchant market over the past several years can be attributed to decisions made by independent power producers (IPPs) on the basis of "best guess" forecasts of future market conditions that largely ignored market price and demand volatility. Nearly all plants constructed by IPPs were of the gas-fired, combined-cycle variety with economics driven by gas prices that were expected to be $2.50-$3.50/MMBtu. If short-term price volatility had been considered, then IPPs and their banks would have had to consider the possibility that gas prices eventually would hit $6-$9/MMBtu, meaning, at such prices, gas-fired plants would not dispatch enough to cover bank covenants, which would have affected the viability of a number of proposed projects.
Many utilities opted to heavily invest in international projects. In addition to market price risk, such investments face exchange rate, political, and regulatory risks. If, for instance, Brazilian investors had examined the political situation that resulted in rampant inflation, or Chinese investors recognized the nationalization risks, or Canadian investors in Ontario had considered the possibilities of regulations banning coal-fired generation, would these investment decisions have been approved? Any decision process that does not explicitly consider these factors must be flawed.
In theory, retail competition presented a new and unique opportunity, but in reality it resulted in failure for many. Although all of the new suppliers were convinced that they could provide energy at costs lower than the incumbent utilities, many participants failed to understand, or simply did not consider, the regulatory framework or consumer behavior that they would be facing. Regulators were intent on insuring lower-cost energy coupled with consumer protection, which offered little headroom for new entrants. Although consumers often were dissatisfied with their utility suppliers, the perceived risk of leaving far outweighed the modest benefit they thought they could obtain. The impact of price inelasticity readily was apparent but largely ignored in business planning when these decisions were developed.
The nuclear cost overruns of the 1970s and 1980s resulted from several factors: stagflation, increased regulatory redundancy requirements after Chernobyl and Three Mile Island, design flaws, and poor management. But many plants were completed well after these factors were known. Plants were completed based on revised estimates of completion dates and updated cost estimates, but the potential variation in completion schedules and costs to complete largely were ignored.
In each of these cases, the evaluation criteria were based on either "best-guess" forecasts, expected values, or "risk-adjusted" expected values of earnings or revenue requirements. In none of those cases were objectives that considered risks explicitly identified and made a part of the decision process. Inevitably, these outdated measures either ignore or mask short-term volatility. Perhaps more important, these