Hedging Your Megawatts
EXECUTIVE SUMMARY * ELECTRIC UTILITY DEREGULATION introduces new price risks for companies that consume large quantities of power. Several electric utilities have been surprised by sudden dramatic electricity price moves. Hedges can reduce that risk. * A HEDGING STRATEGY CAN BE as simple as a long-term fixed-rate contract or as complicated as setting up a fully staffed trading desk. * ELECTRICITY DERIVATIVES DIFFER from other energy derivatives. They are less liquid; electricity markets and electric utilities must follow different rules in every state; and the underlying commodity, electricity, cannot be stored. * THREE KINDS OF ELECTRICITY DERIVATIVES are readily available for hedging: privately negotiated, customized forward contracts; standardized futures contracts traded on an exchange; and options. * SMALL COMPANIES SHOULD CONSIDER insurance policies to manage their power price risk, or get advice on a comprehensive risk management program from a bank, broker or insurer. * ELECTRICITY HEDGING SHOULD NOT BE a profit center for most companies outside the utility industry. Hedges should only offset exposures created by core businesses. When power prices might whipsaw, derivatives can help. Electric utility deregulation introduces new risks for businesses that consume a lot of electricity. CPAs can help clients avoid a shock by steering them toward an energy risk management program. To limit the risk of spiking electric power prices, companies can employ strategies similar to those used to tame the price volatility of energy commodities such as oil or natural gas. CFOs, CPAs and other financial managers can hedge, using new exchange-based electricity derivatives, private forward contracts, or insurance to keep costs even. (See glossary, page 49, for definitions of italicized terms.) END USERS, GREAT AND SMALL Any company buying electricity directly from an unregulated power supplier may be vulnerable to price surges. According to David A. Lifson, CPA, one of six partners with the firm Hays & Co. in New York City, companies whose pricing structure prevents passing costs on to customers should consider hedging. Because hedging takes considerable effort, a company should hedge against only significant price fluctuations likely to cause major problems. Called retail wheeling by the power industry, deregulation is intended to reduce the price of electricity by introducing competitive market forces. However, the supply of power is relatively stable, while demand is subject to large swings. A company's sensitivity to electricity prices depends on the quantity of power it consumes. A company that buys a lot of electricity but can't pass along changes in those costs should prepare to transfer the economic risks posed by that volatility to professional risk takers. As states deregulate their electric utilities, most are decoupling power production from distribution, with the result that distributors are becoming mega-purchasers of power and are more exposed to power price risk than any other industry. In states where deregulation is well along utilities have already witnessed their vulnerability to power price spikes. Take Illinois, which was one of the first states to deregulate: In 1998 some power distributors there got walloped when very hot summer weather drove up consumer demand. Chicago's Commonwealth Edison had to supply power to consumers, whatever the market cost. One day during a killer heat wave the spot market price peaked at an astounding $7,000 per megawatt hour, more than 175 times the normal price. This year Commonwealth is actively hedging. Although the power distribution industry has the greatest exposure, other companies may have a lot at risk, too. For example, a networking company dependent on computers may need to power heavy-duty air conditioning to keep them cool and functioning smoothly. …