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When the Price Is Right

How to measure hedging effectiveness and regulatory policy.

Fortnightly Magazine - October 2007

Hedging programs promise protection against energy-market price spikes, and they can be important to the regulatory goal of sustainable, lowest long-term service cost. But how much price protection is enough in natural-gas markets? When is too much protection, well, too much? What is the most efficient utilization of risk capital when hedging energy supplies?

Questions of efficiency immediately beg questions of measurement and process control. Many CFOs will say utilities really need better guidance designing and adjusting their energy portfolios (both electric and natural gas). What metrics best characterize the dual goals of lowest service cost and optimal hedging performance? How much accuracy, sensitivity and metric reliability should be expected?

These questions are not rhetorical. The internal control structure and procedures established under Sarbanes-Oxley have improved financial report quality. These structures and procedures do not easily accommodate spreadsheet or ad hoc applications that often are used to structure hedges. CFOs need to have confidence that processes perform to a specified standard, are auditable, and produce reliable results.

Service at the Lowest Reasonable Long-Term Cost

Electrical distribution companies (EDCs) and local natural-gas distribution companies (LDCs) are tasked by regulation to provide reliable service at the lowest reasonable long-term cost and with minimal volatility. EDCs and LDCs have a legitimate concern that their operational and market decisions may be subjected to after-the-fact prudence reviews that could seem like a bureaucratic game of “hide the peanut.” Service providers need unambiguous performance standards. It’s tough running a process when the goalposts can move at any time.

Procurement auctions promise low cost. But as with any optimization problem, there’s a bit of “needle threading” involved. A local optimum is not necessarily global in nature. Small perturbations around the optimal can have surprisingly uneconomic effects. Optimization is not like horseshoes. A near-miss can be very non-optimal.

Regulators increasingly recognize that seeking optimal, integrated solutions can be counterproductive. Rather than relying solely on procurement auctions, a growing number of regulators have adopted the “portfolio approach” policy that may include procurement auctions for a portion of the secured supply along with a hedging program aimed at stabilizing prices and volatility. In many cases, the portfolio approach may operate within an incentive mechanism prescribing a general operating band, and some formula for allocating unanticipated costs or the benefits of exceptional performance between shareholders and customers.

A hedging strategy employs various physical and financial strategies with the goal of offsetting the risk of unfavorable price swings when purchasing energy. While comprising mostly options and swaps, financial hedging instruments can include futures, basis swaps, and fixed-price swaps involving natural gas and possibly other commodities whose price movements are known to be related to energy price movements.

In addition to financial instruments, weather derivatives and natural-gas storage provide important vehicles for mitigating price volatility through physical hedges against shortages and disruptions to pipeline operations.

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