Fuel Risk Management at American Electric Power

• DOI: http://doi.org/10.1111/j.1540-6296.2011.01207.x
• Author: Bill Rives,Laura Thomas,Dwayne Elliott,Douglas Buck,Greg Niehaus
• Date: 01 March 2012
• Published date: 01 March 2012

Risk Management and Insurance Review

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Risk Management and Insurance Review, 2012, Vol.15, No. 1, 1-22

DOI: 10.1111/j.1540-6296.2011.01207.x

FOCUS ON ENTERPRISE RISK MANAGEMENT

FUEL RISK MANAGEMENT AT AMERICAN ELECTRIC POWER

Douglas Buck

Dwayne Elliott

Greg Niehaus

Bill Rives

Laura Thomas

ABSTRACT

The senior management team and board of directors at American Electric Power

(AEP) have emphasized the importance of an Enterprise Risk Management ap-

proach for dealing with the wide array of risk exposures that the firm faces.

Senior management has put in place a risk governance structure that facilitates

the identification of major risk exposures, assesses their impact on the firm’s

overall risk profile, and interacts the risk management process with the strategic

planning process. Central to this structure is the firm’s Risk Executive Commit-

tee, which includes the senior leadership of the firm and the Enterprise Risk

Oversight staff. Members of the AEP Enterprise Risk Oversight group have just

returned from a meeting of the Risk Executive Committee. The discussion at

the meeting focused on an event that recently came to the firm’s attention—an

unexpected disruption in the firm’s coal supply over the coming year due to

necessary repairs in railroad facilities near the coal source. By the end of the

week, the Enterprise Risk Oversight group needs to communicate with the rel-

evant teams within the organization as part of its effort to identify the potential

repercussions of the event for the enterprise. In addition, the Risk Executive

Committee would like the groups to identify other possible adverse events that

could occur and steps that should be taken now in preparation.

INDUSTRY BACKGROUND

A Brief History

The history of the electric utility industry in the United States is driven by two important

trends—the spread of new uses for electricity in homes and businesses and the evolution

of federal and state regulation of electric power.

Following construction of the first working power station by Thomas Edison in 1882,

electric companies began to appear in the nation’s larger metropolitan areas during the

Douglas Buck, Dwayne Elliott, and Laura Thomas are at American Electric Power.Greg Niehaus

is a Professor of Insurance and Finance, Moore School of Business, University of South Carolina;

e-mail: gregn@moore.sc.edu. Bill Rives is in the Department of Finance, The Ohio State Uni-

versity. For more information, including teaching notes, contact: The Griffith Insurance Educa-

tion Foundation, info@griffithfoundation.org,614-880-9870, Enterprise Risk Management at AEP.

This article was subject to double-blind peer review.

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2RISK MANAGEMENT AND INSURANCE REVIEW

1890s, where economies of scale made their operation feasible. In 1907, two states, New

York and Wisconsin, became the first to pass laws regulating electric utilities. By 1920,

state regulation had spread to two of every three states. During the 1920s, as electric

power became more widely available to both homes and businesses in many urban

areas, a new regulatory framework emerged—the dedicated corporate franchise with

an obligation to serve all the customers in a certain geographic area (service area), along

with regulation of rates (electricity prices).

As the use of electricity spread, so did the sale of electricity across state boundaries,

which in turn led to federal regulation. In 1935, President Franklin Roosevelt signed two

key pieces of legislation. The Federal Power Act regulated the interstate sale of electricity

by investor-owned companies, and the Public Utility Holding Company Act (PUHCA)

regulated their corporate organization. These two laws would remain on the books for

the balance of the twentieth century.

Through the early 1970s, rate regulation in the electric utility industry was based on

the notion that the electricity business was a natural monopoly; that is, the efficient

production and distribution of electricity argued for only one provider in a geographic

area. Electric power had become vital to communities and construction of the capacity

to produce power required a substantial investment of capital.

In the mid 1970s, Congress became concerned with the lack of competition in the electric

utility business. The natural-monopoly model had created large holding companies,

effectively closing the door to smaller competitors and innovators at a time when issues

like energy efficiency and dependence on foreign energy resources were just beginning

to grab the public’s attention. In 1978, to promote greater competition in the electric

utility industry, Congress passed the Public Utility Regulatory Policies Act. This statute

expanded the role of the federal government in the pricing of electricity and, for the first

time, required utilities to purchase power from smaller producers, effectively opening

the “regulatory” door to a whole new group of industry players.

More recently, Congress passed the Energy Policy Act of 1992, further opening the door

to competition by recognizing a new category of wholesale power generators that can

generate and sell electricity to companies (e.g., utilities) serving retail customers. The

1992 Act also pioneered the role of the federal government in promoting energy effi-

ciency by creating standards for electric appliances and buildings, expanding clean coal

programs, and encouraging the development of alternative fuels and renewable energy.

Congress acted again in 2005 with the Energy Policy Act of 2005, and also in 2007 with

the Energy Independence and Security Act of 2007. Both were designed to strengthen

and further expand key provisions of the 1992 Act. The 2005 Act is notable because it

repealed the 1935 PUHCA, which had sought to control the organization of investor-

owned electric utilities, and imposed mandatory standards for the reliability of the U.S.

“power grid” (the complex national network linking power producers with users). These

standards reflect one of the first times Congress had expressed concern for the safety and

reliability of domestic power production and delivery. Table 1 summarizes the major

federal legislation affecting electric utilities.

Today, the U.S. electric power industry consists of a complex confederation of investor-

owned, cooperative, municipal, state, and federal utilities, along with power-generating

companies (sometimes called merchant generation companies) that are not classified