Consider the high wire act facing risk managers at power companies these days.
Prices for natural gas and coal--the raw materials needed to fuel their power plants--are soaring and experts are unsure whether commodities prices will continue to skyrocket or if they are headed for a fall because of the weakening economy.
That makes life for risk managers such as Todd Strauss, Pacific Gas & Electric Co.'s senior director energy policy, planning and analysis, more difficult than it already is. As a result, he plans for both contingencies: commodity prices that go up and down.
"It's pretty easy to conjure up these widely different scenarios," Strauss says in a telephone interview from his office at the company's headquarters in San Francisco. "It's immensely challenging to find a strategy that works across them all. That's the holy grail we are seeking."
For Strauss, whose company is part of PG&E Corp., and his colleagues that's a tall order. On July 19, natural gas futures for August delivery prices sold for $10.54 per million British Thermal Units. That's nearly double the $6.94 price the commodity fetched earlier this year.
The story is the same for coal. During mid-July prices for the fuel mined in the northern Appalachian region and elsewhere were about $138 per ton, a more than 60 percent jump from early in the year. Prices moving steadily upward would make life easy for Strauss and his peers. But that's not the case, as coal prices are unusually volatile, heightening pressures on risk managers.
"Price risk is very high on our priority list and is taking a great deal of my time," says Todd Harris, chief risk officer of the Atlanta-based Southern Co., the largest U.S. power producer. "We generally have active hedging programs, very active hedging programs for our natural gas purchases. Coal is a less liquid market so the financial hedging opportunities are not as great."
FIRING UP BUSINESS INTERRUPTION COVERAGE
The run-up in commodity prices has caused many risk managers in the utilities sector to turn to business interruption coverage, says Marshall Nadel, managing director of utilities at AON Natural Resources, as business interruption policies allow risk managers to cover the costs of purchasing replacement power in the event of an unplanned power outage.
Power generators are buying specified replacement limits for longer-term outages on a per-unit basis with daily or monthly limitations on the amount that can be claimed, according to Luke Slemick of Marsh USA Inc. The coverage can also be included within typical business interruption coverage.
"Typically insurers will look for 45 to 60-day waiting periods for most generating equipment," he says, in an e-mail. "Insurers will seek clearly defined indemnity periods for the cover of between 12 months to 24 months, however 36-month periods are available. There is increasing pressure to raise waiting periods due to rising lead times in replacing equipment. Insurers are also seeking to more clearly define scope of coverage offered."
Some clients are buying coverage for 18 months instead of the 12 they had previously because it takes longer to get replacement parts for power plants. Prices for materials needed to build power plants, such as steel and concrete have gone up as well, according to Joel Phipps, a senior vice president with Houston-based Lockton Cos.
"Utilities or independent power producers need to exert much more care in crafting their business interruption coverage," he says, "The individual company has to look at each asset they have? and how their feedstocks costs are hedged."
Risk executives say they are addressing rising commodity prices within their enterprise risk management policies. But convincing midlevel managers to open up about the potential problems that they face is not always easy, according to Stephan Haynes, chief risk officer of American Electric Power Co. of Columbus Ohio.
"Initially, we had some reluctance on the part of business units to report on the details of risk indicators, perhaps fearing that having risk meant that they were not doing an adequate job of managing them," says Haynes. "Now, it is viewed that being proactive at identifying risks and moving quickly to come up with a plan to manage those issues is the critical element. Just having risk is not viewed with a negative stigma."
For Laurie Brooks, chief risk officer of Newark, NJ-based Public Service Enterprise Group, that means there is more emphasis on risk hot spots and less on roll-up numbers.
"Rolling up all risk into one daily value at risk number can cause you to miss obvious risks," she says. "We start by understanding our positions, our profit and loss and how these respond to price and volatility changes."
Many of the reasons why commodity prices rise--unseasonable weather, for example--are beyond the control of power companies. Electricity demand rises in the summer when people crank up their air conditioners and spikes again during the wintertime heating season. Barring any unusual generator failures, power companies can usually meet the needs of customers.
But when demand soars, power companies get hit with the double whammy: higher prices for commodities and additional power supplies, says Krishnan Kasiviswanathan, chief risk officer for NRG Energy Inc., an independent power producer based in Princeton, N.J.
In addition, because of the credit crunch, NRG is keeping a close eye on the creditworthiness of the firms with whom NRG chooses to trade, he says.
Larry Makovich of Cambridge Energy Research Associates points out that there are good reasons for risk managers to be cautious. There have been some defaults on transmission capacity or the amount of space utilities companies need to reserve over transmission lines managed by separate power distribution companies. "There is a lot of arguing about the proper controls needed to make sure that you have got credit worthy counterparties," he says.
Makovich notes that at best volatility can be managed, but the industry can't eliminate the fundamental trends, at least these days, of high commodity prices.
That's why it's critical for companies to hedge their risks to commodity prices correctly. Locking in too much supply through long-term contracts could backfire if commodity prices fall. Conversely, failing to get enough supplies in a long-term contract would force owners of power plants to pay premium prices in the spot market. This makes finding skilled commodities traders a priority for power companies.
"We are in a hiring mode right now," says PSEG's Brooks, whose company is the parent company of New Jersey's largest utility PSE&G. "They are always tough to find, especially traders with energy commodity experience."
FROM PROFITS TO RISK MANAGEMENT
In the years following the collapse of Enron, many power companies scaled back their energy trading operations or sold them to financial institutions. These operations are now viewed as a risk management function rather than as a profit center.
One reason for that strategy change is that commodity prices are so volatile. Natural gas prices have swung 30 cents per million British Thermal Unit over the past calendar year, which would have been "unheard of a few months ago," says Kasiviswanathan.
So far this year NRG has added a "substantial number" of energy hedges to its base load generation that will bring its power and fuel hedges in line with one another through 2013.
Meanwhile, the U.S. Energy Information Administration estimates that total electricity consumption will grow at an average rate of 1.1 percent annually through 2030, and environmental regulations are getting more stringent as the government tries to clamp down on greenhouse gas emissions. This may further pressure commodities prices.
Adding to the utilities' woes are the protracted legal and regulatory battles that power companies fight to build new power plants and power lines in areas where people say they do not want them; and customers large and small are balking at paying for higher electricity bills resulting from the higher commodity costs.
Relief is not going to be immediate. Though gas prices are at historic highs, they have also spurred more interest in drilling and importing gas in liquefied form, according to the CERA's Makovich.
"There is a supply response that should start to put some downward pressure on these prices over the next few years," Makovich says. "There are similar dynamics at work in the coal business. If we get any kind of economic slowdown or recession that will take down demand a bit."
Further clouding the picture for utilities in some states is the policy adopted by regulators of "decoupling" electric rates from the amount of power being sold. This encourages power companies to promote energy efficiency, regulators say.
According to the National Association of Regulatory Utility Commissioners, 10 states including Maryland, Virginia and New Jersey, have adopted the policy at some level and another four, among them New York and Minnesota, are investigating it.
But while it promotes efficiency, the strategy may develop into a particular challenge for risk managers at the utilities since their rates are based on the amount of power they sell and the more they sell, the more revenue a utility generates.
"In the broader sense, since decoupling is a way to introduce energy efficiency, regulators are looking more seriously at efficiency because of high energy prices and have been for a couple years now," says Miles Keogh, NARUC's director of research. "Regulators are looking at it for more than just commodity price reasons--I'd say it's just hard to build new generation and transmission and efficiency can meet that need and is a win-win financially and environmentally if you implement it appropriately."
But the Electricity Consumers Resource Council, an organization of large power users, considers the idea "atrocious" because it enables power producers to maintain their profit margins while at the same time selling less electricity, according to Marc Yacker, the group's vice president for government and regulatory affairs.
JONATHAN BERR has written for national media outlets for more than 15 years
September 1, 2008
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