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When the Price Is Right

How to measure hedging effectiveness and regulatory policy.

Fortnightly Magazine - October 2007

about the effects on natural-gas rates in other jurisdictions of purchasing such financial instruments. CPUC further notes the absence of an evaluation of what ratepayers would be willing to pay for various levels of protection from price spikes.

“The lack of supporting analysis is of particular concern because the utilities are proposing much higher levels of hedging purchases and spent large sums last year that provided almost no benefit to ratepayers.” 3

California’s Regulatory Policy Initiatives on Hedging

In recent years, efficient natural-gas procurement in California was governed by various shareholder incentive mechanisms. These mechanisms include the gas procurement performance-based ratemaking (PBR) mechanism at San Diego Gas & Electric (SDG&E), the gas cost incentive mechanism (GCIM) at Southern California Gas (SoCalGas), and the gas core procurement incentive mechanism (CPIM) of Pacific Gas and Electric Co. (PG&E). Generally, these mechanisms are very similar.

For example, PG&E’s CPIM establishes procedures for evaluating and reporting gas procurement costs. Among other things, CPIM procedures provide methods for computing a tolerance band around the benchmark. By definition, costs within the band are judged reasonable. Gains or costs may be shared between shareholders and customers if actual costs fall outside the tolerance band.

Recall hedging seeks to manage costs within a tolerance band and would seem to fit naturally within this kind of incentive mechanism.

In 2006, settlements of certain class-action suits arising out of the California energy crisis and price spikes in the period March 2000 through May 2001 included proposals to modify the California incentive mechanisms. Currently before the CPUC for review and approval, these modifications would, among other things, exclude all financial transactions used to hedge natural-gas prices for any portion of the November through March period (winter hedges), and they would establish a long-term hedging program on behalf of core gas procurement customers beginning with winter 2007-2008.

If hedging generally would fit within a procurement incentive mechanism and is generally a good thing to do, why remove it? Well, one answer is that all policies have counterintuitive effects. In addition to greater efficiency, performance incentive mechanisms have been known to create incentives for performance that merely appear profitable. Hedging addresses volatility and not the expected net value of a portfolio. This consideration was a factor in CPUC’s previous decisions to unbundle hedging programs from performance incentive mechanisms.

The CPUC expects to render its decision late in 2007. If the CPUC establishes a long-term hedging program outside the current incentive mechanism, it will bring many practical performance issues into sharp focus and perhaps raise the bar on what constitutes efficient use of risk capital.

What Performance Standard for Hedging Effectiveness?

To begin with, we probably should distinguish between testing the efficacy of derivatives as hedging instruments that can be recognized in financial statements and testing the economic efficiency of hedging.

Financial Accounting Standard No. 133 (FAS 133) provides general guidelines for derivative mark to market and testing hedge effectiveness. FAS 133 tests comprise both historical performance (a retrospective test) and anticipated future performance (a prospective test) of the hedge.

Gains or losses on a derivative