Managing Risks with Electricity Futures

By Crowson, Martin R. | Management Quarterly, Winter 1995 | Go to article overview

Managing Risks with Electricity Futures


Crowson, Martin R., Management Quarterly


A NEW EXPERTISE RACE

For the time being, there are no real "experts" in the use or dangers of electricity futures contracts. Until exchange trading volume develops, no one will know how closely futures market prices and real-world energy prices, in any particular region, fluctuate together. The potentially bad news is that the competitors and large customers of both distribution and power supply cooperatives are likely to have that expertise as soon as anyone else. That probability obligates cooperative board members and staff to start learning about this complex subject, with its awkward jargon and occasionally roller-coaster financial impacts.

Electricity futures are expected to be more than just another technical development like demand-side management or time-of-day metering or quality-of-power assurance that must be mastered by a cooperative's professional staff in order to control costs and keep consumers happy. With their potential to lose lots of money fast, if not prudently structured, futures hedges demand top-level guidance, authorization and control. Realizing the benefits of this risk management technique while mitigating its hazards ahead of their competition pushes electric cooperatives into a new expertise race.

NEXT-HOUR UNCERTAINTY

Technological and regulatory developments are pushing electric utilities toward medium-term reliance on very short-term supplies of electric power and energy. The following sequence of factors increasingly allows large industrial and electric distribution customers to demand low prices and high service reliability:

* Commercial application of military gas turbine technology to electric generation, combined with fuel gas availability, make power supply a declining cost industry.

* Tougher international competition intensifies cost pressures on manufacturing customers and communities.

* The Federal Energy Regulatory Commission requires transmission-owning utilities to provide open access at firm or non-firm wheeling rates and state regulatory agencies increasingly promote non-regulated power generation and marketing.

* Expanding computer bulletin board and real-time information networks replace "dialing for deals" for hourly communications between energy buyers and sellers.

* Power marketers proliferate as surplus natural gas supplies and storage capacity push gas companies into the electric generation business while traditional electric utilities scramble to avoid the stranding of older generating plant costs.

* The availability of on-premises standby generation and expectation of retail wheeling encourages large customers to bargain more assertively for power supply.

Consequently, many electric cooperatives will be increasingly dependent on next-hour priced energy and other short-term sources, either purchased directly over a real-time information network or through their bulk power supplier.

RISKS OF MARKET-CLEARING PRICES

If customers had complete freedom of supplier choice, the unregulated price of electricity would, in theory, decline to equal the variable kWh production cost of the least efficient generating unit needed to come on-line to meet demand in its market area. In June 1994 Moody's Investors Services estimated that "market clearing price" at 17.41 mills per kWh for the Michigan market. Most consumers do not have that much freedom, but large commercial and industrial users frequently do have the option of moving their facilities to another utility's service area, and residential consumers may opt to sell-out their cooperative.

That market clearing price might be expected to rise as noncompetitive generators were put out of business and supply declined relative to demand. However, all this suggests that to successfully serve their consumers electric cooperatives must strive to either be the most efficient suppliers or buy from them, and that may require taking new risks. …

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