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ELECTRIC PRICE RISK MANAGEMENT USING RATE SWAPS, PRICE INDICES AND MARKET MAKERS

by Scott Spiewak
(originally published by PMA OnLine Magazine: 04/98)

The electric industry is rapidly transforming from a regulated industry in which "ratepayers" receive "tariffs" based upon "cost-of-service," to a commoditized business in which "customers" demand "contracts" based upon the best "price."

Price risk management is a key to this transformation. It is accomplished largely by using four tools: forward contracts, options, swaps and the futures contracts.

Just as transmission access provides liquidity in the physical market, price indices provide liquidity in financial markets. To understand the critical role of price indices, consider the plain vanilla swap, a swap of fixed for fluctuating rates, done without price indices.

Electric Rate Swaps

Electric rate swaps are financial transactions in which an electric customer has its electric bill paid for by a "counterparty," and in turn pays the counterparty a fee. The electric customer finds this type of transaction to be attractive in circumstances in which the originating utility’s cost-based product does not suit its risk management needs.

For example, a customer which is served by a utility with rates which include a large fuel cost adjustment mechanism, due to overdependence upon oil or natural gas, may desire to avoid the inherent exposure to fuel price fluctuations. The customer has a "fluctuating" rate which it wishes to exchange for a "fixed" rate—e.g., a rate which is more stable.

Rate swaps are best understood using tables and diagrams. Here is the diagram for a possible swap between Customers 1 & 2 (Direction of arrows designates direction of money):

Below is a table which shows the result of a rate swap.

Table 1

Swapping Fixed for Fluctuating Rates

Customer 1 (C1) has as its goal obtaining a fixed rate, and avoiding the vagaries of its utility’s fuel procurement practices. It accomplishes this by getting Customer 2 (C2) to agree to pay its bill for it. In return, C1 pays C2 three cents per kWh. The ultimate result is that the 2.5 payment to Utility 1 is cancelled out by C2’s payment, leaving C1 with a 3/kWh fixed payment to C2. C1 has accomplished its goal of rate stabilization.

Customer 2 has the goal of getting an immediate rate reduction, with the possibility of future rate reductions should the cost of generating power fall. It accomplishes this by enticing C1 to pay it a premium rate in return for rate certainty— C1 pays 3, reducing C2’s fixed costs to only 1.5/kWh.

Of course, C2 has to pay C1’s variable-rate electric bill, but that is only 2.5 currently. Add the 1.5 fixed payment and the 2.5 variable payment and C2 is still only subject to a current charge of 4/kWh. C2 has an immediate savings of .5/kWh, and the possibility of additional savings should the cost of production for Utility 1 fall in the future.

In order to accomplish this transaction, the counterparties had to not only be made comfortable with each other’, but also with the fluctuating measure (Utility 1’s cost of production). Documenting and making the customer familiar with that fluctuating measure has taken months. Even then, there may be disputes regarding the measure, and it is subject to the vagaries of a single company’s operations. Finally, it is almost impossible to find customers who are perfect matches—who are willing to trade a customized fluctuating measure in the exact same quantities during the same time frame. In practice, many "nubs" are left on the deal.

Price indices create the conditions for solving most of these problems. By standardizing the fluctuating measure, price indices permit there to be created a market in price swaps. Rather than identifying a counterparty for each transaction, familiarizing each with the vagaries of the custom price measure, and dealing with transaction nubs, customers can deal with market-makers. Market makers establish prices for swapping the index, and handle many transactions, quickly and cheaply.

Liquidity in Financial Markets

With the DJ-COB index in place, the electric price swap market is beginning to look like this:

Freedom to Focus on Core Competencies

Rather than the one-on-one transactions we have had to do in the past several years, market-makers make it possible to do many transactions without perfect matches among customers.This vast increase in liquidity is permitting new rate products to be created which allow companies to focus on their core competencies, such as running powerplants well.

Example: Coal priced to electricity

For example, many utilities are moving away from long-term fixed price coal supply contracts. These contracts have often resulted in power costs which are "out-of-the-market," even though the powerplant is running well.

An ideal solution to this problem is a coal supply contract which is priced indexed to electricity. That way, if electric prices fall, coal prices fall. If electric prices rise, coal prices rise. In either case, so long as the plant is run well, the power company will continue to make a profit.

Without electric price indices, it is very difficult (and expensive) for a coal company to offer coal at prices marked to electricity. One has to establish what the measure is and gain confidence that it can’t be manipulated. With an electric price index in place, it is a relatively simple matter to offer coal at electricity-based prices. The transaction looks like this (arrows show direction of money):

The Utility pays the Coal Supplier a rate which fluctuates with electric rates. The Coal Supplier "swaps" that "fluctuating" payment stream for a "fixed" payment stream through a price market-maker. The market maker is continually swapping fixed for fluctuating based upon the index, and so can readily name a price for doing the swap. It is the broad use of the index by a variety of customers which makes it possible to be a market maker.

Example: Selling electricity at "market rates" without risk

Increasingly, electric power customers will be seeking electric suppliers which are willing sell at the "market price." Indices provide not only the basis for determining that market price, but a means of hedging the risk associated with such an offer. The customer wants market-based rates. The power company needs to cover the fixed costs associated with power production. These wants and needs can be reconciled through the use of price indices:

In this case the Utility receives a "fluctuating" payment stream from the customer, based upon the "market price" of electricity. But because that market price is based on an index, it can be easily "swapped" for a fixed rate with a market-maker.

Conclusion

The establishment of reliable indices is not a trivial matter. In the natural gas industry, for every dollar spent on natural gas product, there are ten dollars worth financial transactions based upon natural gas. Presuming the same ration holds with electricity, we can expect financial transactions with a notional value in excess of a trillion dollars each year in support of electric price risk management. The efficiency and viability of this market depends in large measure on the reliability of the price indices established by such firms as Dow Jones.

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