Magazine article Risk Management

Financing the New Utility Risks

Magazine article Risk Management

Financing the New Utility Risks

Article excerpt

Historically, utility firms have not adopted optimal risk management practices. Any losses or gains arising out of the firm's operational or financial risks were simply passed on to the consumers.

The industry is undergoing a radical transformation, however, from a series of regional monopolies to a diverse service industry driven by competition. Deregulation, coupled with other worldwide risks such as terrorism, has exposed utility and energy companies to new security, commodity pricing, distribution and market risks.

Deregulation has also led to the creation of a variety of new business models as companies decide what business they are best suited for. Each type of business model creates a different set of risks. Based upon these changed risk profiles, it is anticipated that utility risk costs will increase at a proportionally greater rate than in the past.

To manage these costs, the utility industry is evolving toward a risk portfolio approach. Companies are utilizing a variety of tools including capital market financial instruments, self-funding and insurance. Their objective is to analyze the current and future risk-return ratios to maxime earnings and shareholder value. The need for more sophisticated risk management tools will increase as companies try to analyze and communicate their strategies to sophisticated investors and consumers.

Facing a Dry Insurance Market

For all industries, including the gas and electric utility industry, it has become increasingly difficult to obtain required risk capital at historical costs. Since all industries are competing for limited capital, insured utilities expect moderately hardening, rates, more limited coverage and increased information requirements. In the reinsurance and treaty markets, which significantly affect gas and electric utility markets, retrocession programs have been difficult to place. Voluntary withdrawals from the market, carrier insolvencies and the inability of investment income to offset underwriting results have significantly drained capital and surplus from the global utility insurance market.

As a result, various industry groups and the organizations themselves are analyzing and developing action plans to address seemingly insurmountable risk costs. Drastic reform of the way the risk capital market operates has been demanded.

Using Hedges

To help alleviate the pressure and to prevent price increases, state regulators are encouraging utilities to use financial hedging instruments to protect against the kind of price increases that sent heating bills skyrocketing during the past two winters. Financial hedges are complex investment instruments that utilities can use to manage wide swings in energy prices. These tools can lock in a rate or soften a drastic price movement in either direction.

These hedges protect against weather-related risks, including temperature, precipitation, wind speed, heat and humidity. The need to hedge against reductions in volume caused by temperature fluctuations, has made temperature the most actively traded of these products.

Until recently, many deals were based on an index of heating degree days and cooling degree days that measured the demand for heating or cooling within a twenty-four-hour period. Now deals are based on a critical day index, where a specific event occurs on a particular day. Other indices, such as the average temperature over a given period are also available for the four common types of products used in the weather risk management market--swaps, collars, puts and calls.

Swaps are contracts where two parties agree to exchange their risk. This produces a more stable cash flow when the weather conditions are volatile. In simple terms, one party agrees to pay the other if the index settles above a certain level, while the other agrees to pay if the index settles below that level. Swaps usually have no premium and provide protection from adverse weather in return for giving up some of the upside value of a milder season. …

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