A no-holds-barred interview with the electric industry’s chief architect of wholesale electric market design.
A New World of Risks
A new set of skills and expertise will be necessary to deal with the risks created by new government mandates, new market developments, and new energy technologies.
So, I have to be able to look at potential investments on a risk-adjusted basis, which means I have to be able to identify those risks.”
For example, if a utility has to spend “X” and understands the risks of five potential projects, and can further identify the risks of each project and compare the risk-adjusted returns of those five projects and allocate X in the most cost-effective manner, England says that maximizes the utility’s risk-adjusted returns.
“The investment could be a new generating plant, building new transmission or gas transportation, gas storage facilities, or even putting a scrubber on a coal plant. As markets get more competitive, we believe that utilities [that] are able to evaluate investments on a risk-adjusted basis, they are going to have a real advantage.”
Meanwhile, Vincent J. Kaminski, professor of executive education at Rice University, in a panel discussion during the CERAweek 2007 conference earlier this year, cautioned that many companies shouldn’t engage in hedging unless they have a very strong risk-management culture and understand the consequences of the hedging.
“Putting on the wrong hedges or not understanding fully [the risks] are potential dangers,” Kaminski said.
Differing Outlooks on Risk
“How utilities are focused on risk management depends on the type of utility,” says Mike Muse, New Energy Associates’ head of Energy Trading Risk Management.
“Non-competitive utilities which are not in an RTO and not facing any type of competition, they are not really worried about market risk or their exposure. They are focused on volumetric risk.”
Muse says regulated utilities are concerned with the risk of being brought before the commission and explaining why the lights went off.
Of course, that is not to say they are not interested in risk management. In terms of their systems, they have been focusing on reducing the number of older systems.
“They do want to show that they are doing their part [on risk management]. Some of the systems that they have make that process slower and more expensive. I think what we see in that niche is primarily driven around cost and making sure they can get information to regulators rather than actively managing exposure,” he says.
Utilities that are facing competition are “clearly worried about hedging their risk to prices just like everybody else playing in the wholesale market.”
Muse sees one trend among competitive utilities—their move to new metrics from value-at-risk (VaR) to an earnings-at-risk (EaR) model.
VaR is a measure of how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period (usually over 1 day or 10 days) under usual conditions.
EaR, unlike VaR, is used as a longer-term risk measurement to estimate and manage earnings volatility. And unlike VaR, which measures a period no more than days, EaR measures earnings volatility over monthly, quarterly, semi-annual, and annual time periods.
According to analysts, EaR is versatile, as it can be used to focus closely on the cost side (price and volume of the input fuel) as well as on the revenue side