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Merchant Power: When Hedging and Profits Collide

Does too much risk management mean leaving money on the table?

Fortnightly Magazine - June 2006

Consider the 2006 portion of the forecast: Figure 4 (see p. 34) illustrates the CDF for EBITDA without the contracts (bottom line) and the EBITDA with the contracts (middle line). In almost all of the scenarios, EBITDA falls well short of the interest expense. In addition, the business plan that includes the contracts generates superior EBITDA in all but the most positive market conditions. The key message here is that business is bad no matter what contracts are in place, but the contracts do help in a significant way.

A similar examination of 2007 through 2010 begins to paint a different picture. There exists a clear tradeoff between the probability of Calpine falling short of the interest requirements versus the amount of upside Calpine has traded away through risk management.

These concepts can be broken down into a tabular comparison to improve the clarity of a stakeholder’s choice. Table 3 lists the probability of EBITDA falling short of interest costs and the 95 percent best-case EBITDA (representing the potential above-market return opportunities) for both the uncontracted business and the business with contracts.

Using 2008 as an example, there is a 63 percent chance that the business without the contracts will fall short of interest costs. This probability drops to 46 percent (17 percent lower) with the contracts in place. One can balance that against a forecasted upside of $4.5 billion from an uncontracted business to an EBITDA of $4 billion when the contracts are in place. In other words, all stakeholders, whether they own equity or debt, should be asking themselves, “Is the 17 percent improvement in the probability of meeting interest payments worth a $504 million reduction in upside earnings?”

The answer differs depending on whether one is management or an investor in equity, secured debt, second lien debt, or unsecured debt. How will the bankruptcy process address this balance?

This article raises some interesting inconsistencies in investing in electricity merchants compared with other resource industries. It attempts to show that risk-management activities can have a material impact on the native business model currently in place. Deregulation continues to move forward in fits and starts. Over time, energy merchants should become less constrained from existing regulation and oversight. When this happens, both investors and company managers will need to understand the risk management choices available to them. Most likely, the key will be aligning the company’s chosen strategy with the predominant stakeholders, whether those stakeholders are management, debt holders, or equity holders.

Regardless of these trends, avoidance of financial distress always will be an important baseline requirement. The above analysis should provide some insight into avoiding such disasters in the future.



1. Figure 2 is generated using a Monte Carlo simulation engine that simulates market prices for power and gas at an hourly level of granularity. These prices then are input into a generation dispatch model that considers the plant’s heat rate, capacity, start-up and shut-down constraints, probability of forced outage, and various operation costs. This model generates a large number of operating scenarios based on the simulated market