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Your power supply portfolio and the role of hedging.

Last quarter I wrote about "What is Energy Risk Management and Who Needs It?" Now I will address the largest risk of a cooperative power supplier-managing the power supply portfolio. If you are responsible for securing any part of your power supply today or in the future, then you are a power supplier.

Similar to your personal investment portfolio, a power supply portfolio is a collection of transactions designed to meet a specific objective.

Your personal investment portfolio may include cash, bonds, stocks, mutual funds, and real estate. Hopefully, your personal investment plan is based on your personal tolerance towards risk (high risk or low risk investments) and is managed to meet your long-term financial objectives (family needs, college for kids, retirement!).

A power supply portfolio may include purchase power agreements, transmission, generation plants, and fuel to run the plants. Your power supply plan should be based on your cooperative's tolerance towards risk and should be managed to meet its short and long-term power supply objectives.

A power supply portfolio Should be designed to balance the hourly supply needs of a cooperatives load obligations. It's a matter of matching hourly supply with hourly demand. This can be done in ways that are very risky or in ways that carry less risk.

Matching supply with demand for a load serving entity is challenging and requires much more effort than the typical commodity trading firm can provide.

Hold that thought! It becomes very relevant when we talk about where you can get help with your energy portfolio and hedging.

Each individual supply component (purchased power, generation plant, fuel, etc.) made to meet a portion of the cooperative's hourly demand (load obligation) can be considered a hedge. Hedging significantly decreases uncertainty in the overall cost of power to serve the end use consumer. Hedging usually involves both long-term decisions (e.g. power plants, 10 year purchased power) and short-term decisions (e.g. purchase power for the next hour, day, week, month, or year).

So what constitutes the right hedging decisions for your power supply portfolio? Just like there is no one "right" way to invest your money, there is no one "right" way to hedge your power supply portfolio. However, it must start with defining your cooperative's long-term power supply objective and its risk tolerance.

A cooperative's long-term power supply objective determines if the cooperative is more concerned with "long term cost stability" or in its cost "being at market". Many cooperatives make the mistake of establishing a power supply objective of the "least possible cost". While that may have worked in the cost-based regulated wholesale market of the past, it is not feasible in today's deregulated wholesale energy market. No load serving entity can be at or below market 100% of the time. In other words, it's not possible to buy at the bottom of every swing in the market, regardless of whether it's energy supply, or your personal investments.

Similar to establishing a personal investment strategy, a cooperative's risk tolerance is an overall strategy to guide hedging decisions based on a typical risk-reward trade off. In the case of a cooperative power supplier, its risk tolerance is the acceptable swing in price variability that it's willing to chance in order to achieve potentially favorable outcomes in lowering its costs. In other words, how much variability in the annual budget price to its members is too much? Once again, there is no "right" or "wrong" answer to this question. As with a personal investment portfolio, the answer depends upon the stakeholders risk tolerance.

Combining the long-term power supply objective with the cooperative's risk tolerance defines how much risk the organization is willing to accept in achieving its power supply goals.

This is a critical first step in developing the power supply portfolio for your cooperative. Other important factors include your location and staff expertise in risk management and trading. All of these impact the type of power supply portfolio you will manage and how much help you may need.

Typical power supply portfolios range from buying everything from the short term power market, to entering fixed price full requirements contracts, to building generating units and securing long term fixed price fuel. Certainly, riding the power market for all your supply is like riding the stock market, up and down with no certainty in results. This strategy in the power supply market contains significant risk and is much more volatile, up and down, than the stock market.

So now lets take the example of the cooperative that wants to pursue long-term stability but wants to try and "time" the market (wait for low, long term market prices) in securing its long-term power. Taking that risk may produce better results, but if prices go up, not down, then power costs will not be favorable.

Defining the objective and risk tolerance requires consensus building between senior management and the Board of Directors. Analytical and tactical support must come from skilled staff or be outsourced to experts, and it requires significant market data and intelligence.

More hedging of long-term power supply, results in more certainty in your power supply cost. Less hedging equals less certainty. The hedging strategy creates tough questions that senior management and Board members must address and upon which consensus must be built. Failure to systematically address these tough questions leads to mistrust between the Board and Management.

* How much certainty in power supply cost do you want?

* How far into the future do you want to plan for certainty?

* What is the effect of cost certainty on your rates?

* Do you have the right staff expertise or outsource assistance to help you in these matters?

So where can you get help? There are many power marketers and consultants that claim they can help. However, many of them DO NOT understand:

* Cooperative governance and its challenges

* Power supply portfolio needs for load serving entities

* How to develop complete risk management solutions

* How to build a risk management program that is grounded upon consensus building between staff, senior management, and the Board of Directors.

Interview potential outsource companies diligently. Be careful because many will claim they can provide complete risk management solutions when in fact they are very narrow in their capabilities and approach, in addition, many of these entities are your competitors in the market. They will often use your information to their personal advantage, negating much of the perceived benefit of using them.

Establishing your cooperative's power supply objective and risk tolerance will allow your cooperative to be successful. Waiting for the market to come to your pricing objectives usually is fatal.

David J. Tudor is the President and Chief Executive Officer of ACES Power Marketing (APM), headquartered in Indianapolis, Indiana. Mr. Tudor joined APM in May of 1999 and has helped guide the organization into a national energy risk management and transaction execution company. APM has grown from 4 generation and transmission cooperative (G&T) owners to 14 and provides services to 15 additional companies located in various regions across the U.S.

Mr. Tudor has been in the energy business throughout his career and has experience in both the management of energy assets and trading. Prior to joining ACES Power Marketing, Mr. Tudor, as President of Risk Advisors, LLC, provided risk management advice to several large, investor owned utilities in the development and implementation of their risk management software systems and trading control policies.

Prior to forming Risk Advisors, LLC, Mr. Tudor was the Executive Vice President & Chief Operating Officer of PG&E Energy Trading, where he managed commercial operations in the United States and Canada.

Mr. Tudor is a graduate of David Lipscomb University in Nashville, Tennessee, and he and his family live in the Indianapolis area.

David Tudor, President and Chief Executive Officer, ACES Power Marketing
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Author:Tudor, David
Publication:Management Quarterly
Date:Mar 22, 2004
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