[BETA] Fortnightly

Natural gas distribution utilities have used financial derivative instruments such as futures, options and swaps to hedge gas commodity cost since the 1990s. The primary motivation on the part of utilities and their regulators is price stability to protect consumers against spikes in gas prices. Surveys conducted by the Natural Regulatory Research Institute (NRRI) and the American Gas Association (AGA) in 2008 and 2009 show most state regulatory commissions in the U.S. support or are neutral to local distribution companies (LDC) using financial instruments to hedge gas price movement. However, regulators now are questioning LDC hedging programs in light of large losses some utilities have experienced with them. Also, low price volatility and declining and stable gas prices since 2009 are causing regulators to question the need for hedging programs. Regulatory Commissions in Nevada and British Columbia have suspended hedging activities using financial instruments, and other jurisdictions are targeting financial hedging programs for additional review.

As currently structured, regulators see the costs to consumers of the hedge programs only after the fact when utilities file for cost recovery. But, it’s difficult for regulators to assess the benefits of hedging after the fact, because the benefits can’t always be determined with precision. It’s therefore necessary for regulators to be involved before the fact. Regulators must be actively involved in plan development and in overseeing the use of financial hedge instruments, requiring utilities to submit hedge plans for review and to file periodic reports monitoring the progress of hedge plans.

Upstream Hedging

Moving upstream, you find that FERC-regulated pipelines aren’t in the merchant business of buying and selling natural gas and therefore don’t have a need to hedge gas cost. FERC hasn’t needed to address hedging of commodity cost. However, pipeline companies do trade financial derivative instruments purportedly to hedge other costs, such as debt cost. To the extent this practice is growing, it might be necessary for the FERC to adopt a policy on hedging.

Pipelines, sometimes through their unregulated affiliates acting as agents, use financial derivatives to, in effect, hedge interest rate risk. There’s no FERC stated policy on appropriate financial hedging processes or activities on the part of—or on behalf of—jurisdictional pipelines. For example, special concern might be warranted by apparent hedging activities undertaken at the parent level through the corporate financial office. Is the holding company using financial derivatives to protect the pipeline subsidiary’s customers, or is it trading around interest rate movements for shareholder gain with the understanding that, if the bet is wrong, the losses can be recovered at the regulated subsidiary pipeline level as a claimed debt cost? Without a stated policy, FERC is forced to determine after the fact whether the so-called “hedge” is undertaken to control cost for the benefit of customers or for potential speculative gains.

The recent widely-publicized loss of almost $6.0 billion by JP