Electricity price risk management: understanding the basic tools.

• Author: Baker, Hugh D., Jr.

RISK IN A COMPETITIVE ENVIRONMENT

There are two basic risk management tools: forwards and options.

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, in 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 in 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 risk management program in place, the cooperative is exposed to the risk 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 in Figure 1.

How can the cooperative's exposure to price risk 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 "forward agreement" 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 in the future. Note the features of a forward agreement: (i) the transaction price is agreed upon in 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 risk...