Severe upward pressure on electric rates after a decade of stability has regulators, legislators, utility executives, consumer advocates, and myriad other stakeholders searching for solutions....
Are They Betting The Company?
Eleven questions to ask senior managers about their risk-management objectives.
hedge program, did the business perform well enough to at least cover those losses? If the answer is no, then the hedge probably was poorly structured from the beginning. In cases where market conditions deteriorated and the hedges made money, did the firm make sufficient money to cover the business losses they were designed to protect against? Again, if the answer is no, the hedge probably was not well structured and should be judged to have performed poorly despite the fact that it made money.
6) What is the role and definition of speculation?
Even in companies with small, asset-based trading operations, this question receives a disproportionate amount of attention from senior management and the board. Even the exact definition of speculation can be unclear. Is it speculation to adjust power or fuel hedges once in place? What about building or buying power assets without corresponding fuel supply and offtake agreements? The former is usually considered speculation; the latter sometimes not. In any case, the amount of risk resulting from these activities must be clearly quantified to separate perception from reality.
7) What is the relationship between budgetary targets and hedging strategy and execution?
Budgets are static; markets are not. Hedging should not be curtailed because a certain budgetary target based on out-of-date curves is unachievable. Similarly, hedging should not be accelerated simply because there is an opportunity to lock in budgeted levels of profitability forecast several months ago.
To see such an approach in action, consider the abbreviated example below based on a utility that owns a fleet of generation assets and is financed with a mixture of unsecured debt and equity.
8) What are the financial goals and objectives of the firm?
Our firm in the example could have several goals, depending on who is asked. The most obvious would be maximizing shareholder value, which is typically measured by EPS.
9) What are the constraints on the most important financial objective?
The most likely constraint on this firm’s financial goals would be the maintenance of its current credit rating. If the company took extreme amounts of risk, its credit rating could be affected adversely, its cost of capital increased, and shareholder value eroded because the company would be forced to reject potentially profitable investment opportunities. In this case it would be in the shareholders’ best interests for the company to maintain an investment-grade credit rating.
10) How do the company’s financial objectives link to the risk policy?
Ratings agencies rely heavily on cash-flow metrics to assess financial health. While this is in some ways not entirely consistent with maximizing shareholder value, it directly addresses the most significant constraint on the firm’s ability to sustain growth. As such, in this case a cash-flow-based risk metric would be most appropriate, since debt cannot always be serviced by monetizing future earnings.
11) How to think about hedging?
Since the constraint on the firm’s financial objective is maintaining solvency and a cash-flow-based metric is most appropriate, the expected hedge performance must be measured relative to debt-service targets. In this case, the company may have