Financing the New Utility Risks

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 maximize 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. For example, an apparel manufacturer buys a swap to protect against the average temperature over a summer period being cool, in return for sacrificing some of the extra revenue earned during a hot summer.

A collar is similar to a swap in that protection against adverse weather is provided in return for giving up some of the returns generated in more predictable conditions. The difference is that the payments between parties take place outside an upper and lower level. This allows revenues to fluctuate within a normal range of weather conditions, but protects either party against extreme weather. Collars will often include a premium for one of the parties. Utilities use this form of risk management to smooth the peaks and valleys of price variations.

Put options, or floors, are contracts that compensate a buyer if a weather variable falls below a predetermined level. They protect against adverse weather while allowing profits to be retained in a historically predictable season. An agricultural cooperative might buy a put on the level of rainfall over a growing season. This contract would compensate the organization if the level of rainfall were lower than normal, therefore diminishing the product yield and resultant revenue. If the level of rainfall is normal, the cooperative only loses the premium it paid.

Call options, or caps, are similar to puts except that buyers are compensated if a weather variable rises above a predetermined level. A commercial real estate company might buy a call option from an energy supplier on the number of days that the average cooling days exceed a certain level. This would compensate the company for the extra expense during days when they had to continue cooling their premises. Once again, the only downside that the company faces is the loss of the premium during a predictable period.

Another financial hedge is a double trigger insurance policy, which is utilized to mitigate risk costs associated with two events of coverage. In order for the insurance to become effective, both events have to occur at the same time. Specific examples include:

• A Mid-Atlantic utility used this coverage when a windstorm above a certain mile per hour occurred within a certain radius of the energy company’s gas platform and the price of natural gas exceeded a specified amount. 

• A Midwest utility used the coverage when there was an unscheduled outage at a nuclear power plant causing it to shut down and an increase in the price of spot energy rates above a certain amount.

• A Northeast utility used the coverage when there was a power outage resulting in more than 600 megawatt hours (MWh) of lost power and the spot market price of power exceeded $74 per MWh.

Modeling the Unknown Risks
The common thread of all utility companies is that they are pursuing enterprise risk strategies in a deregulated business environment where it is absolutely essential to quantify the risks undertaken.

For example, Niagara Mohawk has identified over sixty different risks that could affect earnings and shareholder equity including various forms of security, hazard, financial, political, regulatory and technology risks. By managing and integrating disparate risks into one portfolio, the overall cost of risk is reduced.

To calculate these risks, a proliferation of data for risk investigation, decision making and public policy is needed. To get it, risk managers at utilities are collaborating with computer scientists to create database design, artificial intelligence and graphics that use complex models and new methods of statistical analysis.

The basic research in this area is in evolving stochastic models to capture and help interpret characteristics of the risks under study, such as terrorism associated with known vulnerabilities. These models are mathematical techniques, which assist the risk practitioner in predicting probable future outcomes from a set of random variables. 

In insurance, the models are utilized in a wide variety of settings to determine premiums and reserves. In actuarial science, interest centers on the management of complex, interdependent insurance portfolios. In finance, research arises from evaluating complex new financial instruments and schemes in rapidly changing markets. Stochastic models in a risk portfolio approach require common computing platforms and clear recognition of the various organizational risk profiles.

The premier example of this in the utilities industry is a proprietary engineering economy model developed by LCG Consulting over the last two decades. The model is a rigorous and comprehensive representation of the commercial and technical operations of a modern, deregulated electric power system. On an hourly basis, it simulates generator and load bidding behavior in forward and real-time markets for energy and ancillary services, in the context of specific power market protocols.

On a nodal basis, it reflects individual lines and bulk power flows through its detailed AC model of the transmission system. In short, the model can calculate market prices of all energy commodities and transmission congestion costs in each hour and node in an electric power network.

Moreover, the model facilitates the calculation of the real option value of a generating unit for a distribution of market outcomes. It performs a systematic analysis of price volatility caused by uncertainty in fundamental market drivers, such as fuel prices, hydro conditions, demand fluctuations, generation and transmission outages, entry and other key business and engineering variables. The model has been used in asset valuation, the formulation of bid and hedging strategies, and the analysis of deregulation and industry restructuring. Thus, it can perform an exhaustive assessment of risk faced by a utility at any business level and for any planning horizon.

Risks and Rewards
By using these techniques, not only will these organizations outperform their competitors in the industry, providing above average returns to their investors, the utility company customers will be served with a safe, reliable source of energy. 

Other capital-intensive industries, such as aviation and real estate, could utilize many of the methodologies, tools and concepts that are currently being employed in the utility industry. By analyzing the sources of risk, then reducing the total risk costs with advanced management, econometric and stochastic techniques, organizations will create additional shareholder value and customer loyalty in an increasingly complex world.

The Price-Anderson Act For electric production, liability for damages to the general public from nuclear accidents is controlled by the Price-Anderson Act, an important system that is the basic financial responsibility funding mechanism for all U.S.-based nuclear reactors.  Under Price-Anderson, the owners of commercial reactors must assume all liability for accident damages to the public. To pay any such damages, each licensed reactor must carry the maximum liability insurance available, currently $200 million. Any damages exceeding that amount are assessed equally against all operating commercial reactors, up to $83.9 million per reactor. Those assessments, or retrospective premiums, would be paid at an annual rate of no more than $10 million per reactor to limit the potential financial burden on owners following a major accident.  Including three that are not operating, 106 commercial reactors are currently covered by Price-Anderson. Without this legislation, the worldwide insurance markets would be under further pressure for scarce capital, therefore further increasing insurance premium pressures.

Robert Blackburn, a twenty-five-year veteran of the specialty risk business, is the managing principal of Penfield, New York-based Blackburn Group, Inc., a company he founded in 1991 to provide general consulting services and high technology products for the risk management and insurance industries.