Hedging your megawatts.

EXECUTIVE SUMMARY

* ELECTRIC UTILITY DEREGULATION introduces new price risks for companies that consume large quantities of power. Several electric utilities have been surprised by sudden dramatic electricity price moves. Hedges can reduce that risk.

* A HEDGING STRATEGY CAN BE as simple as a long-term fixed-rate contract or as complicated as setting up a fully staffed trading desk.

* ELECTRICITY DERIVATIVES DIFFER from other energy derivatives. They are less liquid; electricity markets and electric utilities must follow different rules in every state; and the underlying commodity, electricity, cannot be stored.

* THREE KINDS OF ELECTRICITY DERIVATIVES are readily available for hedging: privately negotiated, customized forward contracts; standardized futures contracts traded on an exchange; and options.

* SMALL COMPANIES SHOULD CONSIDER insurance policies to manage their power price risk, or get advice on a comprehensive risk management program from a bank, broker or insurer.

* ELECTRICITY HEDGING SHOULD NOT BE a profit center for most companies outside the utility industry. Hedges should only offset exposures created by core businesses.

When power prices might whipsaw, derivatives can help.

Electric utility deregulation introduces new risks for businesses that consume a lot of electricity. CPAs can help clients avoid a shock by steering them toward an energy risk management program. To limit the risk of spiking electric power prices, companies can employ strategies similar to those used to tame the price volatility of energy commodities such as oil or natural gas. CFOs, CPAs and other financial managers can hedge, using new exchange-based electricity derivatives, private forward contracts, or insurance to keep costs even. (See glossary, page 49, for definitions of italicized terms.)

END USERS, GREAT AND SMALL

Any company buying electricity directly from an unregulated power supplier may be vulnerable to price surges. According to David A. Lifson, CPA, one of six partners with the firm Hays & Co. in New York City, companies whose pricing structure prevents passing costs on to customers should consider hedging. Because hedging takes considerable effort, a company should hedge against only significant price fluctuations likely to cause major problems.

Called retail wheeling by the power industry, deregulation is intended to reduce the price of electricity by introducing competitive market forces. However, the supply of power is relatively stable, while demand is subject to large swings. A company's sensitivity to electricity prices depends on the quantity of power it consumes. A company that buys a lot of electricity but can't pass along changes in those costs should prepare to transfer the economic risks posed by that volatility to professional risk takers.

As states deregulate their electric utilities, most are decoupling power production from distribution, with the result that distributors are becoming mega-purchasers of power and are more exposed to power price risk than any other industry. In states where deregulation is well along utilities have already witnessed their vulnerability to power price spikes.

Take Illinois, which was one of the first states to deregulate: In 1998 some power distributors there got walloped when very hot summer weather drove up consumer demand. Chicago's Commonwealth Edison had to supply power to consumers, whatever the market cost. One day during a killer heat wave the spot market price peaked at an astounding $7,000 per megawatt hour, more than 175 times the normal price. This year Commonwealth is actively hedging.

Although the power distribution industry has the greatest exposure, other companies may have a lot at risk, too. For example, a networking company dependent on computers may need to power heavy-duty air conditioning to keep them cool and functioning smoothly. A research lab may use a lot of electricity to protect components and maintain sterile conditions. An ice cream factory may need a lot of power to keep its products frozen. Or a radio station might consume a lot of electricity to power its signal.

THE LONG AND SHORT OF HOW HEDGES WORK

When a company takes an offsetting financial position designed to protect itself against fluctuations in a commodity price, it is called a hedge. For example, it could buy a standardized electricity futures contract on an organized exchange, entitling it to buy a specified amount of electricity at an agreed-on price on a particular date. The value of that contract is dependent on--or derived from--the price of the underlying commodity, in this case electricity. (That's why it's called a derivative.)

As an alternative to a futures contract, one could buy a forward contract. Similar to futures contracts, forwards are negotiated privately between parties without going through an organized exchange, and they are customized rather than standard. The advantage of going through an organized exchange is that the exchange limits the credit risk on a futures contract.

Exchange-traded contracts are regulated by both the exchange itself and, in the United States, the Commodity Futures Exchange Commission. In the more mature energy markets, such as oil and natural gas, the standardized contracts traded on exchanges are much more liquid than privately negotiated contracts. If a company wants to change its hedges before a contract matures, it is much more difficult to trade a customized contract than a standardized one. However, exchange-based trading in electricity futures is still fairly light, essentially eliminating any liquidity advantage for exchange-traded electricity contracts.

Some risk management programs make use of call options, which are also derivatives. In this context, a call option is an option to buy a futures contract. Options require less initial cash outlay than buying the underlying futures contract would, but they can be much more volatile.

When a company hedges its position by purchasing a derivative, whether that derivative is a futures contract, an option or a forward contract, it buys a contract to protect itself against the possibility of a devastating price change. When a company hedges against a price increase, it buys a long contract or a call option. If a company is selling electricity rather than buying it, it can hedge its position by purchasing a short contract or put option.

Usually, a company continues to purchase power at the market price through its ordinary supplier even if that price goes way up. It uses the profits on the derivative financial instrument to offset the price increase. Of course, the offset is never perfect. And if there's a sudden drop in the price of electricity, rather than an increase, the company hedged long ends up paying less for electricity, but it loses money on its financial hedge. That's the cost of protection against risk.

HOW FAR TO GO?

Many companies prefer to limit their trading in the relatively new electricity markets because those markets are still thin. The exhibit on page 50, shows how little trading actually takes place on the New York Mercantile Exchange (NYMEX), the most active exchange for electricity derivatives. Companies that have such concerns may hedge only against the greatest risks. Some utilities hedge only at specific times of the year. A utility might choose to hedge against summer price spikes but leave itself open during the rest of the year, when it is better able to find alternate supplies.

Jim Miller, a senior vice-president in charge of regulated networks for electricity and gas at Utilicorp, a utility with 4.5 million customers around the world, explains: "We do a hedge or a swap with regard to summer and winter." That swap is keyed to above- or below-normal temperatures. Of course, his company, which is based in Kansas City, Missouri, and had $12.6 billion of revenues last year, has a partial natural hedge because of its geographic and fuel mix, which includes customers in the southern hemisphere--Australia and New Zealand--as well as others closer to home.

Some utilities are so active in financial markets for electricity derivatives that they have hired full-time traders. American Electric Power Co. (AEP) of Columbus, Ohio, started trading megawatts in 1997. The first year it traded 11 million megawatts, and in 1998 it traded 202 million megawatts, making it the second largest trader in the market. (By volume, Enron is the largest.)

Why would a utility get into the trading business? "We started because of deregulation," says Eric van der Walde, senior vice-president of energy trading at AEP Energy Services, which facilitates its parent's trading activities. Retail wheeling gave AEP a profit opportunity, more detailed market knowledge and a chance to defend itself against increased price volatility. Overall, AEP Energy has 200 traders, dealing in contracts on the NYMEX as well as over-the-counter transactions.

HOW COMPANIES HEDGE OTHER ENERGY RISKS

Although electricity price hedges may be relatively new, many different companies have routinely hedged other energy products for more than a decade. These range from companies that need energy products as raw materials--power generators, refineries and chemical manufacturers (see Case Study, page 52), to companies that consume a lot of fuel--airlines, large office buildings and limousine services. Many companies have used the derivatives markets for natural gas and oil, which are already well developed. Experienced companies have devised other hedging strategies--some simple, some sophisticated--for the same products.

A hedge doesn't have to be complicated; it can be as simple as a long-term contract with a supplier or a change in product mix. For example, Lifson suggests that a dairy that uses heat to process milk could enter a long-term contract for fuel.

However, a bigger company facing greater risks often can use a derivatives trading program to great advantage. United Parcel Service, the delivery company, has been hedging its energy risk for a decade. In 1998 fuel accounted for 2.8% percent of the carrier's operating expenses. The company has an extensive jet fleet as well as the familiar brown trucks, which consume large amounts of diesel, jet fuel and gasoline.

To hedge, UPS uses forward contracts, futures and options, working both on and off exchanges. The company has several people dedicated to hedging full time in its Treasury group. Bob Clanin, UPS's chief financial officer, reviews any policy change. They look at the price of energy daily and decide how much of their total needs they want to hedge. In general, the company tries to hedge as much of its energy costs as possible.

WHERE TO BUY A DERIVATIVE

Like UPS, some businesses devise their own derivatives trading strategy; others use a brokerage firm, bank or insurance company to develop and manage a program for them. CPAs in business and industry exploring derivatives for the first time probably will want to get help from an expert with a core competency in risk management.

Businesses buying electricity derivatives should make sure that advice comes from an intermediary with experience in this relatively new market, which is somewhat different from other energy derivative markets, and quite different from interest-rate and commodity derivatives.

The important differences between electricity derivatives and other energy derivatives include

* A relatively illiquid marketplace for electricity derivatives.

* The regulated status of many potential customers for the contracts.

* Different regulations in every state.

* The fact that electricity cannot be stored for later use like gas or oil.

Electricity derivatives markets are illiquid both because they are new and because deregulation is incomplete. Some states are much further along with deregulation than others are. Since electricity cannot be stored, only large consumers of electricity are potential customers for the contracts. (Anyone can speculate in oil or gas, store the underlying commodity and sell it at a more auspicious time. Electricity that isn't used is perishable.)

Some, though not all, brokers competent to manage electricity risk will have their own seat on an exchange. Companies can purchase electricity derivative contracts through brokers with a seat on one of several exchanges, but the most active one in the United States is NYMEX.

A few utilities have their own seat on an exchange trading electricity, but most companies are content to execute their trades through a broker.

"With deregulation, the utility industry needs our help," says Keith Jacobson, managing director for debt markets and global debt derivatives at Merrill Lynch & Co. in New York City. Smaller businesses, with only a very limited need to hedge, may want to trade through a broker they use for other transactions whether or not that broker has a seat on the exchange. It can execute trades through a second broker that does.

The NYMEX has five contracts, and it also offers options on four of those. They are:

* California/Oregon border.

* Palo Verde, Arizona.

* Cinergy (a utility in Cincinnati).

* Entergy (a utility in Louisiana).

* PJM (Pennsylvania, New Jersey and Maryland; no options yet).

Robert Heller, chief risk officer for Commonwealth Edison in Chicago, is waiting to see how fluidly the PJM contract will trade. The NYMEX first offered the contract last March. Very few PJM contracts have changed hands so far (see exhibit, page 50).

Skirting the exchanges, customized forward contracts are negotiated privately, directly between a net electricity buyer and a net seller. Such contracts are usually negotiated with the help of a third party--many investment banks, commercial banks and insurers offer such services, as do a few specialized commodity trading companies, some associated with energy companies. In most circumstances, such over-the-counter or off-the-market contracts are not regulated, but that has been a controversial matter in Washington and could change. Although the derivatives themselves are not regulated, the Federal Energy Regulatory Commission monitors underlying transactions that involve actual power delivery, such as those traded on the California Power Exchange (CalPx) a market California devised for trading electricity in-state when it began deregulating.

OTHER WAYS TO KEEP CURRENT

Financial managers also can manage electricity price risk without derivatives. Some, particularly smaller companies, may want to buy straightforward insurance. "This can be a cost-effective means to reduce a company's exposure," says Marty Scherzer, managing director of Marsh, the world's largest insurance broker and risk adviser.

A small company would pay a premium to get a fixed amount--say, $100 million--of insurance coverage over a specific time period--say, the summer. Various triggers are possible, the price of a megawatt hour of electricity being one, weather conditions another. Marsh is working on insurance structures for utilities that would cover the costs in excess or $100 per megawatt hour.

For the past couple years, insurers have been offering products that manage a company's combined risks. (See "Two for the Money," page 41.) Marsh calls this a "fusion" policy, but other insurers offer similar products. The idea is to calculate all or a company's risks--natural disaster, interest rates, international political risks--together in one computer model, rather than calculate each one independently. Because the portfolio of risks is diversified the insurer can sell the fusion policy for a lower premium than it would have to charge if the risks in the portfolio were insured separately. The policy pays if any of the risks cross a well-defined threshold written into the policy. For instance, if electricity goes over the named price, the policy pays. It would also pay if a fire destroyed a power plant.

WEATHER DERIVATIVES 

Although the electric power contracts are the obvious derivatives to offset changes in electricity prices, some companies use other derivatives as proxies. Weather derivatives are so new that the Emerging Issues Task Force is still discussing accounting standards for them as Issue no. 99-2. Weather derivatives may be appropriate for electricity hedges because most power supply and demand problems are weather-driven--heat taxes the grid with air-conditioning demands; storms can disrupt supply. Weather derivatives have been available for only a year or so and don't have a real track record yet.

A weather derivative can be a customized contract written to pay under specified weather conditions--less than ten inches of rain in June, July and August, or more than 30 days with a low temperature below 30 degrees Fahrenheit, for instance. In addition, the Chicago Mercantile Exchange began offering standardized weather derivatives in late September. Initially, these are heating degree day index futures for four U.S. cities.

DERIVATIVES ADDICTION--JUST SAY NO

Derivatives trades can be very profitable, but they are risky. Companies are better off not trying to make such trading into a profit center. "If the hedge goes in the money and the underlying commodity [goes] dear, you look great," Lifson says. He warns financial managers not to think they're experts after one lucky transaction though, even if it is very remunerative. "Hedging can be to some like a painkiller after surgery--too much can be habit forming," says Lifson. A company that hedges amounts that "far exceed the volume of the underlying commodity at risk" can become very vulnerable very quickly. Without a hedge, a company is naked. Too much hedging, it may go broke.

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CASE STUDY

Dow Chemical Consumes Gas, Trades Gas Derivatives

Dow Chemical's Gulf Coast chemical production facilities consume 1,500 megawatts of electricity every hour, 365 days a year, 24 hours a day. Dow generates most of that power itself.

Dow purchases natural gas to produce electricity and steam used in its chemical processes. The company burns about 500 million cubic feet of natural gas daily, making it one of the nation's largest nonutility consumers of natural gas--accounting for just under 1% of U.S. gas consumption. Last summer, when the average natural gas price was $2.41 per thousand cubic feet, Dow was spending $1.2 million per day on natural gas.

Although Dow's exposure to the price of power is negligible, it needs to hedge its exposure to the price of natural gas. Pedro Reinhard, the company's chief financial officer, is an ardent believer in active risk management. Dow hedges all its risks--in interest rates, commodities and energy. The company's energy hedges are managed by an eight-person group based in Houston, Dow Hydrocarbons and Resources Inc.

The company uses NYMEX futures and over-the-counter swaps, collars and options. "We don't have any particular rule as to how much of each type of hedge to use," says a Dow hedge strategist, although the company almost always goes long, hedging against a rise in the price of gas--it doesn't worry about a potential price drop.

For swaps, Dow uses an investment bank, a commercial bank or an energy trading company, such as Enron, Koch Industries or Williams, as a trading partner. That agent, known as a counterparty or calculating agent, is almost always a member of the International Swap Dealers Association, and, even if it weren't, is expected to abide by the association's rules.

Why swaps? "You can custom design transactions and have different volumes in different months," the Dow trader says. In part to save on transaction costs, one counterparty (the bank or trading company) arranges a series of contracts for several months ahead as one hedge with many parts.

The swaps are settled once a month. At the end of the contract, Dow pays a fixed price, which is negotiated beforehand. The counterparty pays the average of the last three days' settlement price of natural gas on the NYMEX.

With a swap, Dow has a fixed price. If it uses an option instead or a swap, the price is not fixed--the company's exposure is merely limited instead. When the company can get a swap at a fixed price of, say, $2.40, but it is willing to eat a price increase up to $2.60, it uses an option, paying less than it would for a swap. Call options can be purchased on the NYMEX or through the same over-the-counter companies Dow uses for swaps.

What's a Derivative?

What FASB Statement no. 133 Says

In June 1998, after seven years and 140 public meetings, the FASB issued Statement no. 133, Accounting for Derivative Instruments and Hedging Activities. It establishes that all derivatives must be reported at fair value--rather than book value---and defines "derivative" Some companies began reporting by this standard in the third quarter of 1999. Firms that use the calendar fiscal year must adopt the new standard as of June 15, 2000.

Statement no. 133 defines a derivative as a financial instrument or contract:

* Having all three of the following characteristics: 1) one or more underlyings; 2) one or more notional amounts or payment provisions; or 3) both.

* Requiring no initial investment or an initial net investment that is smaller than would be required for other types of contracts driven by the same markets.

* Having terms that require or permit net settlement.

A sufficient condition: If a company hedges its risk on an exchange, it's a derivative. If the company hedges its risk over the counter, it may not be a derivative for the purposes of Statement no. 133.

Derivatives are contracts or statements that create rights and obligations meeting the definitions of assets and liabilities. All derivatives must be reported at fair value on the balance sheet. Changes in the value of hedges need not be recorded in earnings. Changes in value for all other derivatives must flow to earnings whether or not they have been realized.

Beware embedded derivatives. These are implicit or explicit terms that affect the cash flows or value of other exchanges required by a contract in a manner similar to a derivative. They would include a call option embedded in a debt instrument and an equity-index return feature embedded in a debt instrument.

Why the added complexities? Pascal Desroches, professional accounting fellow at the SEC, says, "From 1989 to 1995, derivatives volume grew 10-fold, but the accounting didn't change. We want to be sure that investors see what's going on."

GLOSSARY

call (option) A call allows an investor to buy a futures contract or other underlying commodity at a specific price for a limited time. The investor is not required to make the purchase. A call option is one kind of derivative.

collar An option that limits the holder's exposure to a price band. The owner essentially has a call above the cap of that band, and a put below its floor.

credit risk The chance that a trading partner will default on a contract.

derivative A financial instrument that is contingent on the price of an underlying commodity, in this context, electricity.

embedded derivative A derivative implied by a contract such as a bond, insurance policy or lease that is contingent on an underlying commodity but is not itself a derivative.

forward contract A privately negotiated contract to buy or sell a commodity for an agreed-on price on a certain future date. Unlike a futures contract, it is not standardized and is not traded on an organized exchange. A forward contract is a type of derivative.

futures contract A contract to buy or sell a standard quantity of a commodity on an established exchange for an agreed-on price on a specified date in the future. A futures contract is a kind of derivative.

hedge (noun) A financial position geared to counteracting fluctuations in the price of a commodity.

hedge (verb) To take a financial position intended to offset fluctuations in the price or a commodity.

long An investment is long if the investor makes money when its price or the price of an underlying commodity rises. See short.

off-the-market contract An over-the-counter contract, negotiated without the assurance of an exchange.

option An option creates the chance, but not a requirement, for the holder to buy a commodity at a set price for a limited time. See call (option); put (option).

over-the-counter market A decentralized market (as opposed to an exchange-based market) where geographically dispersed dealers are linked together by telephone and real time computer connections.

put (option) In this context, an agreement allowing an investor to sell a futures contract or other underlying commodity at a specific price for a limited time. The investor is not obligated to sell. A put option is a type of derivative.

retail wheeling Power industry jargon for deregulation of retail electricity prices.

short An investment is short if the investor makes money when its price or the price of the underlying commodity drops. See long.

swap A binding agreement between two parties to exchange contracts with each other.

ALAN GERSTEN is a freelance business and finance writer based in Brooklyn, New York. He regularly contributes to the Reuters and Bridge news services. His e-mail address is [e-mail].