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Hedging Under Scrutiny

Planning ahead in a low-cost gas market.

Fortnightly Magazine - February 2012

The new world of gas supply, brought about by shale development, the economic downturn, and expanded gas infrastructure, has caused regulatory stakeholders to challenge utility gas supply hedging programs.

Hedging, a common feature of utility risk management practices, serves as a tool to stabilize prices, protect customers from market volatility, and insure against unexpected price spikes. However, regulatory commissions and intervenors are challenging the merits of their utilities’ hedging programs with increasing frequency, questioning whether the risk mitigation benefits of hedging have justified the associated costs, and whether customers are paying for insurance to manage a risk that might no longer exist.

Concerns raised by commission staff or other stakeholders relating to the cost of utility hedging programs has led to an emerging trend of greater commission and stakeholder involvement in assessing such programs’ efficacy. Regulatory commissions are asking utilities to provide written justification of their hedging practices, applying pressure on utilities to work with stakeholders to resolve hedging differences through collaborative processes and to find common ground on the risk-reward spectrum. In some cases, risk management hedging programs have been suspended until there are visible increases in volatility and market prices.

Utilities that engage stakeholders in a dialogue now about their risk-management practices can ensure hedging remains a viable tool for limiting exposure to future price volatility.

Costs Incurred and Avoided

This shift toward re-assessing hedging practices is relatively recent. In 2008, a survey conducted by the National Regulatory Research Institute (NRRI) indicated that most commissions in the U.S. either supported or were neutral to hedging. 1 This was reinforced in a follow-up survey the AGA conducted in 2009. 2 Among more than 100 respondents, over 90 percent said their commissions allowed financial hedging of commodity price risk. However, only a very small number of commissions required utilities to engage in financial hedging.

Push-back on utility hedging typically begins with intervenors. Ultimately, however, most administrative law judges and commissions generally support hedging. While intervenors often recommend disallowance of hedging costs, commissions generally accept that the goal of hedging is price stability and not “to beat the market.” As a result, cost disallowance decisions by commissions have been rare. 3 But, in an environment where utility customers are experiencing across-the-board rate increases, it isn’t surprising that commissions would encourage utilities to evaluate changes to their hedging programs.

Intervenors have tended to take a retrospective view when evaluating the efficacy of hedging programs. While it’s tempting to look at historical hedging based on current information and perfect hindsight, the regulatory standard for what is reasonable and prudent must consider the availability of information and what was known at the time hedging decisions were made. This is the standard commissions have adopted when reviewing historical hedging costs.

Many stakeholders have focused on costs associated with hedging, but there has been less focus by