Electricity Price Risk Management: Understanding the Basic Tools

RISK IN A COMPETITIVE ENVIRONMENT There are two basic management tools: and In a regulated environment, the price at which electricity is bought and sold is relatively stable. Electric cooperatives have generally been able to pass through the prudently incurred cost of generating plants, off-system purchases and fuel costs(1) to their member/customers. However, a competitive market, cooperatives will be exposed to price risk. In other words, the price that a member/customer is willing to pay (which is determined by the level of competition at the retail level) may not match the cost the cooperative incurs to produce or purchase the power (which, at the margin, will be determined by the level of competition wholesale power and fuel markets). Thus, the cooperative's ability to earn a predictable and reasonable margin (and maintain an acceptable TIER) is at risk. Consider the following hypothetical example: 1. A cooperative has entered into a contract with a retail member/customer to provide a specific amount of electricity at a fixed price; 2. The cooperative purchases off-system power from the competitive market to meet the contractual obligation. The cooperative's margin is determined as follows: Cooperative Margin = Revenue from Member/Customer less Purchased Power Cost Since the cooperative's revenue from the member/customer is fixed, the cooperative's margin will increase if the wholesale market price of electricity decreases. Conversely, the cooperative's margin will decrease if the wholesale market price of electricity increases. With no management program place, the cooperative is exposed to the of wholesale market price changes. The cooperative cannot manage margins to meet TIER requirements or even be assured that margins will be positive. The relationship between margin changes and wholesale price changes for the cooperative (also know as the cooperative's risk profile) is shown Figure 1. How can the cooperative's exposure to price be managed? There are two basic tools for hedging or managing price risk: forwards and options. Let's take a look at the two products. THE FORWARD AGREEMENT A is an agreement entered into by two parties where one party (the Seller) promises to sell a commodity to the other party (the Buyer) at an agreed upon price and at a specified date the future. Note the features of a forward agreement: (i) the transaction price is agreed upon advance (i.e. at the time the agreement is made), (ii) a specific future date is set for the transaction to occur, and (iii) both parties are obligated to consummate the transaction on that date. Consider the profile of the forward agreement depicted Figure 2. The buyer a forward agreement will profit from increases the market price; decreases the market price will decrease the buyer's margin. This profile is exactly the opposite of the cooperative's unhedged profile shown Figure 1. By combining the forward agreement with the cooperative's profile, the cooperative's exposure to wholesale market price changes is completely eliminated as shown Figure 3. A forward agreement can be used to in the price at some point the future. This is the essence of management, i.e. can be managed by taking a exposure that is the opposite of the original exposure. Risk management involves taking a exposure that is opposite the inherent being managed. Using a forward agreement, the cooperative our example now has a way to effectively fix the price at which it purchases electricity at a future point time. The fixed price of the sale to the member/customer and the (presumably lower) fixed price agreed to the forward contract allow the cooperative to lock a given margin on the sale to its member/customer. …