Lessons learned from Cinergy's losses in commodity markets.
After a second summer of extreme weather, contract defaults and consequent financial losses to energy companies, the financial community and shareholders are holding utilities ever more accountable when it comes to managing risk, say analysts. Moreover, they're showing zero tolerance for failure.
On Aug. 10, Cinergy announced cash losses of $73 million after taxes, reflecting increased costs due to hot weather in late July and anticipated liquidated damage claims for failure to meet delivery obligations to several power marketers. The announcement drew criticism from stock analysts.
"We expect recent events will frustrate investors and create a stock overhang [for Cinergy], potentially for an extended time despite current discount valuation," according to a report from a stock analyst at Merrill Lynch & Co.
Cinergy held a meeting with analysts Aug. 11 in New York City, where the company insisted that planning couldn't and shouldn't revolve around a potential event with a 1 percent probability. But Wall Street did not seem to buy this explanation completely.
"We agree [to ignore low probabilities], but there are plenty of other players in this business (e.g., Enron) who have managed to navigate a number of price crises. ¼ Enron prides itself on being able to deliver electricity or gas anywhere in the U.S. on two hours' notice. Cinergy can't do that today, and we doubt they ever will be able to," says the Merrill Lynch & Co. stock analyst report.
Investors: Not Ready for Risk
Analysts say utilities that take on greater amounts of commodity risk must improve their risk management practices to the level achieved by investment banks. At the same time, however, they don't believe that investors in utilities have come to grips with this changing risk profile.
Cal Payne, vice president and risk control officer at UtiliCorp United, explains that even as utilities take on more risk as part of deregulation, electric utility shareholders continue to expect the dependable earnings they enjoyed from utilities under regulation.
But Payne says nothing is stopping utilities from successfully adopting the type of strict risk management practices investment banks are known for.
"If there is something that differentiates UtiliCorp, it could be something as simple as that we are not a utility that just decided to get into trading because the big boys were in it. Risk management has been part of our culture for many years. We have a very robust trading organization at Aquila that has been associated with UtiliCorp for many years," he says. Payne adds that UtiliCorp's risk management culture has been successful because the company's top management initiated the effort.
Meanwhile, it is still difficult for shareholders to regain confidence after they see utilities suffer a trading financial loss, as compared with when investment banks lose money, say financial experts.
Consider the investment bank J.P. Morgan. With the global financial crisis in 1998, Morgan posted a drop in earnings to $237 million for first-quarter 1998, which included earnings with one-time charges, though operating income was $366 million. But by first-quarter 1999, the investment bank showed operating income of $600 million, a 64 percent increase. Furthermore, in one year's time, J.P. Morgan's stock price jumped from around $97 in 1998 to near $129 in early September, a show of shareholder confidence, analysts say.
"For our core activities, the crisis was one of the most stringent market tests ever. We learned many tactical lessons, but fundamentally our risk management processes and operational support areas performed well," says Douglas A. Warner III, chairman and chief executive officer of J.P. Morgan, in annual report materials.
Could a utility like Cinergy make such a fast turnaround?
Merrill Lynch thinks not. "We are able to conclude that Cinergy remains at risk for another heat-driven supply and price spike, that mitigation measures will be taken and those will cost money. How much risk and how much cost are hard to quantify," according to the analyst report.
At least some bond analysts disagree with the stock analysts. "Moody's believes Cinergy's July failures and losses to be a legacy of Cinergy's previous power trading strategy and not reflective of Cinergy's supply and power marketing strategy going forward. ¼ Moody's expects Cinergy to be able to meet its obligations during high-demand periods in future years," says Andy Jacobyansky of Moody's Investors Service. Moody's did not change Cinergy's "stable" ratings outlook and has removed the company from review, he added. A "stable" ratings outlook, as opposed to a "negative" or "positive" outlook, indicates Moody's determination that barring unforeseen events, the ratings will remain stable for 18 to 24 months.
Nevertheless, bond rating agency Standard & Poor's on Sept. 16 was not swayed by Moody's confidence, assigning Cinergy a "negative" outlook. According to S&P press materials, "Standard & Poor's is concerned by Cinergy's decision at the beginning of 1999 to cover its potential exposure of 5 percent on full requirement contracts with hourly sales rather than purchase options. This indicates that Cinergy's risk appetite may be greater than previously judged and is not fully captured in the consolidated business profile."
However, a bond analyst says the business community does not recognize as significant a difference of one notch or level among ratings agencies. In the case of Cinergy, he says, the S&P review is not viewed as significantly different from the Moody's review of the company because the ratings outlook is only one level of difference.
UtiliCorp's Payne explains why Wall Street and Main Street view utilities and investment banks differently when it comes to risk.
"Investment banks are seen as the professionals when it comes to managing risk. Those who invest in investment banks know what they are getting into. The person who invests in Cinergy does not want earnings volatility. Shareholders still see electric utilities as the stable, low-risk investment for widows and orphans."
Blinded by the Duty to Serve
Some executives say that utilities like Cinergy will be at risk of default no matter how much risk management is practiced because of their adherence to the traditional utility "obligation to serve." That view is growing among financial experts.
"Between its core utility requirements [obligation to serve] and its long-term sales contracts to a number of municipals, Cinergy had effectively burned through its reserve margin, thereby creating a short position that was to be covered by hourly purchases in the highly active, liquid and relatively cheap Midwest power market. This strategy, however, anticipated some things that just didn't happen: 1) deregulation didn't relieve Cinergy of its native load customers as fast as expected, and 2) hot weather drove price through the roof," says the Merrill Lynch stock analyst report.
Steve Brash, Cinergy's manager of external communications, says that full requirements contracts were primarily with municipal electric systems and rural electric cooperatives.
"We consider those contracts to be very similar in nature to our native load. These are human needs. These organizations are full requirements providers. We are their single source of power and they serve, in most instances, residential population," says Brash.
"Certainly if we look at today's circumstances in relation to the full requirements contracts, you don't see anybody writing full requirements fixed-price contracts," he says. "We have had a period of time while these contracts are still in force where we have to fulfill the requirement of these contracts acting to limit their impact on earnings."
Brash would not say if risk management products could have averted the company's financial losses, as the company was still conducting an internal review of the matter. Furthermore, by November Cinergy was to decide whether to retain its supply/trading/marketing business.
Nevertheless, UtiliCorp United's Payne says there are a lot of people that successfully play in regulated and non-regulated markets where there are fixed-price full requirements contracts.
"It does offer a set of risks that must be properly managed," he says.
"If you think about the characteristics of a full requirements contract, what you have is fixed-price risk with a variability of take. Essentially you have granted an option to your customer and that option is to take more and take less. What drives that variability is typically weather," he says.
For example, if it is hotter than normal and you have electricity load, people are going to turn up their air conditioning because they want to cool down - not because they are in-the-money or out-of-the-money on a contract, Payne says. (When a contract is out-of-the-money it has no intrinsic value.)
"To the extent that incremental load exposes you to fixed-price risk, you have to recognize that is price risk and need to price your product in a way that mitigates price risk," he says.
Nevertheless, Brash says he does not believe there is much that other utilities can learn from his company's experience this summer.
"It used to be in the utility industry that there was a total pack mentality. Nobody did anything until someone else did it first, and then everybody watched to see it happen. The circumstances in the market are altered now that each company's circumstance is very much individualized. It is very hard to draw conclusions on one set of occurrences and say this is the direction that a specific company ought to take," Cinergy's Brash says.
But at least one risk manager says what can be learned from Cinergy's experience is that you have to adequately prepare for even a 1 percent event.
"If you don't prepare for the consequences, you take a huge profit and loss hit, you jeopardize a corporate strategy and wipe out hundreds of millions of dollars of market capitalization," the risk manager says.
Moreover, what happened to Cinergy was not an isolated or wholly unexpected event, as Cinergy contends, but partly a result of having deregulation at the wholesale level and not on the retail level. That's the opinion of Shannon Burchett, president and chief executive officer of Risk Limited Corp. in Dallas and former president of Ameren Energy.
"With retail prices still fixed by regulation, you don't get any demand-side price signal to reduce consumption during peak periods, and utilities can end up paying $7,500 per megawatt-hour in the wholesale market if they haven't effectively hedged. It is no longer fixed prices; it's floating prices. It is an unregulated wholesale business where it's the free market and the price is whatever it is," he says.
In a fully deregulated retail market, commercial and industrial customers will have the choice to buy on the spot market or do their own price hedge, he says. The current state of partial deregulation, coupled with the transmission and generation constraints that exist in some regions, create an environment where such price spikes may well occur, and that price risk must be managed.
Burchett explains what would have happened this summer if price spikes had occurred and a more fully deregulated wholesale and retail market were in effect. "[In a fully deregulated market], the price would get passed through to the large industrial and commercial customers. They would reduce their consumption and get the supply and demand more in balance; it's free market economics. When that occurs, the price is going to decline. The end result is a reduction in demand because of the higher price. The price then declines to lower levels," he explains. "Even then electricity price volatility is not going to be low, but ultimately we need both sides in the market - the supply side as well as the user side."
Burchett does not believe there will be 200 highly expert risk management and trading operations in the future. "It is going to become a highly complex and sophisticated business," he predicts.
Furthermore, he says, utilities wanting to develop risk management skills will not have the luxury of time that the investment banks had. Big exposure, big volatility and lack of risk management expertise are a brew for disaster, he says.
"Generally, in this market, one has a short window of time to acquire risk management capabilities. Speed is everything. That is what makes it altogether more difficult. It is hard to make that transition in regulated markets," Burchett says. "It comes down to management expertise and management philosophy."
Markets: Volume Too Thin?
Even as experts preach the benefits of adopting tougher risk management standards, utility executives complain of the lack of liquidity and transparency in the futures markets.
"The New York Mercantile Exchange has not been a big provider of risk management to the industry," says the managing director of an investment bank. "I don't think anyone is looking at NYMEX as a viable risk management source, but the over-the-counter market is sufficiently liquid to manage their risk," he says.
David Shimko, a principal at Deutsche Bank's risk management advisory group, says liquidity is a classic problem in futures that the industry has been unable to solve.
Regions characterized by severe weather and frequent transmission interruptions abhor standardization, he says. Shimko explains that utilities fear that a futures contract will not adequately match the risks of their particular region, causing basis risk. Basis risk is the risk that the value of a futures contract (or an OTC hedge) will not move in line with that of the underlying exposure.
According to Bob Levin, senior vice president of planning and development at NYMEX, "a deregulated subsidiary is more likely where [futures trading] will take place." (See figures.) Furthermore, he adds, the low usage of futures contracts by utilities has more to do with regulatory issues than with geography. If a utility is buying and selling in the wholesale market, Levin says, basis risk is no longer an issue because the utility is no longer saddled with the obligation to serve and thus benefits from hedging risk with futures.
Regulated utility activity is still subject to a lot of scrutiny, especially with a new risk management tool, whereas a deregulated subsidiary is free of that scrutiny, he adds. Usage of risk management tools by regulated utilities would have to be motivated by state regulators, he says.
"We don't see at this time distribution companies that are highly scrutinized to be jumping to use these [futures]. We could see some experimental programs, but what we are really expecting eventually is that side of the business will become very limited and that suppliers to end-users will want to use these [futures] when the market is genuinely freed up," he says.
In addition, Levin says, in time, affiliates or subsidiaries of utilities that are actively competing in the downstream and between upstream and downstream parts of this business and in wholesale trading will use NYMEX futures.
"What we think we are seeing, but this may be a slow process [is] the fading out of traditional regulated distribution with the obligation to serve by utilities. It will not disappear tomorrow, but we will see the obligation to serve reduced more and more over time. Thus, we don't expect as much emphasis on futures in a part of the business we think most utilities believe is going to fade out in time. That is why they are not concentrating their efforts there," Levin says. "Why would utilities go through all the burden of the regulatory process to trade futures if they do not see it as a future business?"
Moreover, Levin says that the price spikes were completely avoidable. "Last year when it happened in late June, they had tornadoes knocking out generation. They had a big cut in available generation at a same time as a spike in demand. This year they had a spike in demand but they did not lose the same amount of generation. Notwithstanding [that fact], we had perhaps higher demand when the price spikes hit," he says. "This was just bad transmission policy."
Levin says the price spikes will continue to get worse. To manage the risks, market participants need to have access to forward markets, which means forward market commercially usable firm transmission is necessary, he says.
Levin says that forward market commercially usable firm transmission has not been offered attractively in the market to date. Lack of commercially viable firm transmission policy does not support greater participation in more forward markets with physical delivery obligations because people don't have confidence that the markets can perform and they know they will be scrambling in the spot market.
With regard to NYMEX's most successful power futures hub, named after Cinergy, Levin cannot assess the impact of Cinergy's financial loss to the market itself. He says that Cinergy has done well in maintaining its counterparts after its financial losses. "At the moment, it has not impacted the Cinergy futures contract," he says.
Fred Cohen, a partner with PricewaterhouseCoopers responsible for the firm's energy risk management practice, says with the adoption of Financial Accounting Standard 133, Accounting for Derivative Instruments and Hedging Activities, there will be clearer visibility to risk management activities in the financial statements of utility companies. Cohen says that FAS 133 specifically defines many of these methods for determining what is a derivative and the accounting treatment for hedging transactions. More detailed disclosure for risk management activities is required as part of the new accounting. The new accounting and disclosure will result in better visibility to derivative activity at these various companies.
For calendar year-end utilities, required implementation of the standard begins Jan. 1, 2001. Cohen says that this is more than an accounting standard and given the magnitude of the changes, utilities need to aggressively reassess their strategies and practices to develop their plans for implementing the standard. The biggest concern for his utility clients is defining their risk management strategy and how much risk and expected return on that risk they should take in their target markets, he says.
When thinking about this summer's price spikes and contract defaults, Cohen takes a forward-looking view.
"Five years from now we could see a reversal of the last couple of years. Potentially, we could see a need to manage low prices, slim margins and excess generation in certain markets. Utilities will need to develop their skills to manage in dynamic and complex markets," says Cohen. "That is the challenge of this industry. How do you create shareholder value and sustainable profitability while taking acceptable risks in a changing and complex industry?"
Richard Stavros is the senior editor at Public Utilities Fortnightly.
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