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Betting Against the Gods

In search of the Holy Grail of utility risk management.

Fortnightly Magazine - October 2006

Many analysts in the industry say the search for the Holy Grail of risk management is on.

Since their early beginnings, utilities have learned to be exceptionally prepared for the unknown hurricane, storm, or catastrophe that could instantly disrupt delivery of their essential services to customers. On balance, utilities emergency preparedness for the unimaginable natural disaster has been exceptional throughout the years; one only need recall Southern Co.’s or Entergy’s response to Hurricane Katrina.

But where some utilities have excelled at managing the physical risks of their business, those very same utilities have often been ill prepared to manage the various operational, financial, and other business calamaties.

How often have utilities filed quarterly reports to the Securities and Exchange Commission explaining the utility lost millions due to unexpected weather, unexpected changes in demand, unexpected changes in the price of a commodity, or due to the unexpected outage of a base-load power plant? Furthermore, how often have regulators had to consider a rate increase to cover losses from the utility who failed to anticipate an increase in commodity prices or other risk?

Of course, for a long time utilities were not held responsible by regulators or investors for managing these risks (and there are some jurisdictions where utilities are still not held responsible). In the past, the prudent way to manage these so called unpredictable and some believed unmanageable events was to pass it through to the ratepayer or the investor. “Call it an act of God or force majeure,” a utility executive might say, which in contractual terms excuses a party only if the failure to perform could not be avoided by the exercise of due care by that party. And in most cases, regulators would have agreed. But that has changed.

In the new environment following the Enron collapse, the California crisis, and the recent run up in commodity prices, utilities have a much greater burden in proving that they are prudent.

“Since deregulation there seems to be a lot more pressure from stakeholders, and interest on the parts of utilities to do a much better job forecasting. In the traditional utility environment everything was a cost passed through to ratepayers. So, what you paid for fuel and how much fuel you needed based on the variability around your demand, you just went out and did it and you passed that on to the customer. That’s not as easy to do today,” says Leigh Parkinson, a founding principal of RiskAdvisory, a division of SAS.

Parkinson explains, a climate of high natural-gas prices mean that these pass-throughs are not going to be approved or rubber stamped by regulators anymore. In fact, his utility clients have been asking him how, on a quantitative level, they have been prudent in their risk management.

But the pressure to adopt more sophisticated risk management techniques hasn’t been coming only from the regulators. Ratings agencies, such as Standard and Poor’s, rate utilities’ risk management for

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