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When the Price Is Right

How to measure hedging effectiveness and regulatory policy.

Fortnightly Magazine - October 2007

prices, it has been argued companies simply could have traded the spot market. In other words, hedging according to set formulas may not always result in efficient procurement. In light of these considerations, hedging programs are coming under closer scrutiny.

Regulator Views of Utility Hedging Programs

The California energy crisis put hedging programs on the regulatory radar screen. In a speech before the American Gas Association (AGA) in early 2001, then FERC Commissioner Linda Breathitt urged state regulators to investigate the benefits of permitting energy companies to hedge gas purchases to decrease volatility. The previous December, FERC recommended California utilities put 95 percent of their load in forward markets to minimize exposure to price volatility on the spot market.

An ever larger number of utilities are now hedging their supply requirements. AGA reports 88 percent of natural-gas utilities surveyed incorporate financial instruments as a hedge against market price volatility, compared to six years prior, when 55 percent of the survey sample reported using financial instruments as a hedge. AGA says 29 companies use options, 36 companies use fixed-price contracts, 26 companies use swaps, 19 companies use futures contracts, and 5 companies use weather derivatives. Companies that employed hedging programs generally saw positive impacts on their bottom lines and on their customers over the years. For example, FPL’s April 2004 8-K reported its hedging program contributed to the better-than-average performance in the northeast. Baltimore Gas & Electric reportedly hedges 10 to 20 percent of its winter gas requirements.

It’s difficult to dispute the benefits of hedging a sizable portion of indicated requirements when prices are trending up and volatility is high. It’s a simple matter of averting obvious hazards. It’s apple pie.

But risk aversion is not risk management. When the ramp-up slows and volatility settles, simple models and policies can lead to significant overhedging and unnecessary costs.

For example, Keyspan Energy Delivery New England bought two-thirds of the gas needed for the 2006-2007 winter in advance, at prices that turned out to be generally higher than they were as the winter season began. Massachusetts ratepayers paid markedly higher rates last winter to enjoy the benefits of more certainty in monthly bills.

This is not simply complaining about paying an insurance premium without filing a claim. Economic use of risk capital demands insurance premium purchases accurately reflect the risk. When the capital return from insurance falls below the cost of capital, self-insurance becomes attractive.

Similarly, the $2 monthly increase in residential bills would seem a bargain in a Katrina winter season. But should utilities routinely enter the winter season running 75 to 80 percent hedges with little regard to market fundamentals?

The California Public Utilities Commission (CPUC) thinks not. In rejecting the initial utility proposals for a long-term hedging program, the CPUC acknowledges the risks in natural-gas market instability. Nevertheless, the CPUC observes such risks do not implicitly justify spending enormous sums on hedging substantial portions of the utilities' gas portfolios.

The CPUC also cites the absence of evidence that the hedging programs were consistent with best practices, prevailing financial theory or statistics