Float with Market Price Spikes Unfavorable Regulatory Unpredictable Cash Flow Not Trained Lack of Infrastructure No Controls Hedging the Spark Spread by 2E612M

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									Hedging Energy
    in the
New Marketplace


                  Scott E. Thompson
      Portfolio Director SPP/ERCOT
  To Regulate?
        or
 Not to Regulate?

That is the Question!
    Regulated Market Characteristics

•   Cost of Service Studies
•   Rate of Return Regulation
•   Guaranteed Margin
•   Annual Fuel Adjustment Clause
•   Long-term Contracts (20+ years)
•   Stable Rates
•   Limited Concern of Counterparty Contracts & Credit
•   Suppressed Volatility
                     VERY LITTLE RISK
 Transition to un-Regulated Markets


• Federal Deregulation is moving at a faster
  pace than State Deregulation, which limits the
  tools available to many Utility Energy Risk
  Managers compared to un-regulated
  marketing companies.
    Energy Market Evolution
• Un-Regulated or Competitive Markets
  do not behave like Regulated Markets.




• Buyers & Sellers Beware!
Un-Regulated Market Characteristics

•   Market Pricing vs. Cost of Service Pricing
•   Uncertain Margins vs. Guaranteed Margins
•   Competition vs. Guaranteed Margin
•   Monthly - Fuel Adjustment Clauses
•   Shorter Term (< 5 year) Contracts
•   Less Predicable Rates
•   Significant Contracts & Credit
•   Severe Price Volatility
•   Specialized Risk Management and Trading Skills
              VERY RISKY BUSINESS
         To Hedge or Not to Hedge?
• Most Utility Managers would like to hedge to reduce
  some of the risks on the previous slide.
• Many Utility Managers are not familiar enough with the
  hedging alternatives to fully explain them to the
  regulators or management, causing state regulators to
  move more slowly.
• Many of the hedging tools require infrastructure
  upgrades or education (contracts, credit, accounting
  and analytical)

        Will current regulation allow the utility to effectively
               hedge and is there a defined process?
    To Hedge or Not to Hedge? (cont.)
• Can the LDC or Power Company pass the net effect
  of the hedge through to their rates?
      • PGA, GCR, PCA …….Sometimes
• Some state regulators do not allow any hedge losses
  to be passed through to customers.
      • no incentive to implement a hedging program
• Some states allow physical losses to be passed
  through but not financial losses.
      • Incentive to hedge physically only
• Financial Hedging in some cases is much more
  efficient than Physical Hedging (example)
                 Hedging Example
• 200 MW Natural Gas Fired Peaking Plant (CT) is
  expected to run 1000 hours this summer to produce
  electricity for a utility.
      • 200 MW x (1000 hours) x 10 heat rate
      • 2,000,000 DTH or 2 BCF of Natural Gas
• Should you Purchase Fixed Price Physical Gas from
  a producer who will to deliver the gas to the plant or
  Purchase NYMEX Financial Contracts as Hedge?

   Can you pass through Financial Gains/Losses
      through the Fuel Cost Adjustment (FCA)?
            Hedging Example (cont.)
• Purchasing Physical Gas:
     •   Removes Delivery Risk
     •   Removes Price Risk (Reduces Volatility)
     •   Adds Credit & Contract Risk
     •   Limits Ability to change Positions (Liquidity Risk)
     •   Requires un used gas to be sold (non-ratable)
• Purchasing NYMEX Financial Gas:
     • Removes Price Risk (Reduces Volatility)
     • Cash Margining to NYMEX
     • Allows for Purchasing Physical gas only on days unit
       runs, rather than baseload (everyday), as gas units are
       not usually run around the clock baseload.
             Hedging Example (cont.)
• For those that can’t pass through Financial Hedge results, they
  are forced to hedge with Physical gas via a marketing company
  with a structured product that includes a NYMEX derivative for
  (Fixed Price) and a physical delivery component with a “Buy
  Back Premium” for unused volumes.

• This “Buy Back Premium” causes a Financial Hedge to usually
  be more efficient and a better hedge.

• The marketing companies thrive on providing these types
  services that bridge the gap between regulation and de-
  regulation.
           Hedging Example Summary
• Some hedge transactions are restricted from selling
   – Coops are subject to the 85/15 tax laws
• Liquidity for physical gas at the plant may be limited and
  therefore utility may have to pay a “buy-back premium”
• Hedging with NYMEX Futures contracts can be more efficient
   – If one can pass derivative gains/losses thru on the fuel clause?
• Typically gas fired generation is not a baseload plant and is
  dispatched non-uniformly which could add costs to hedging with
  physical gas.
   – Gas Fired CTs usually don’t run on weekends or off-peak periods
     resulting in volumetric risks
          To Hedge or Not to Hedge….
              What is your Goal?
            YES                            NO
•   Reduce Volatility          •   Achieve Lowest Price
•   Predictable Price          •   Float with Market
•   Avoid Price Spikes         •   Price Spikes
•   Favorable Regulatory       •   Unfavorable Regulatory
•   Predictable Cash Flow      •   Unpredictable Cash Flow
•   Trained Management         •   Not Trained
•   Developed Infrastructure   •   Lack of Infrastructure
•   Proper Controls            •   No Controls
        Hedging the Spark-Spread….
                 Example?
• Hedge Natural Gas for July 2005
• Plant Characteristics:
  –   Purchase 225,000 Dt @ $7.00/Dt
  –   Combined cycle gas
  –   On-peak hours (5x16)
  –   Heart Rate 7.0 Dt/MWh 32,000 MWh


• Power is $53/MWh
        Hedging the Spark-Spread….
             Example? (cont.)
•   Cost to run plant for July ($7 x 7) = $49/MWh
•   Cost to Purchase Power                $53/MWh
•   Savings by running gas-unit           $ 4/MWh
•   Total Saving (32,000 x 4 = $128,000)

             POSITIVE Spark Spread
              BUY Gas, not Power
        Hedging the Spark-Spread….
             Example? (cont.)
    Gas Price $8.00,          Power Price $53

•   Cost to run plant for July ($8 x 7) = $56/MWh
•   Cost to Purchase Power                $53/MWh
•   Loss by running gas-unit              $ 3/MWh
•   Total Loss (32,000 x 3 = $96,000)
              NEGATIVE Spark Spread
                BUY Power, not Gas
      Hedging the Spark-Spread….
           Example? (cont.)
  Gas Price $8.00,      Power Price $53
• Sell Gas ($8 - $7) x 225,000 Dt = $225,000
• Buy Power ($53 - $49) x 32,000 = <$128,000>
• Savings                          = $ 97,000

       Gas Unit now becomes available for
       additional transaction opportunities
                Summary
         To Hedge or Not to Hedge?
•   A decision NOT to hedge will place the buyer with much more
    risk in the new marketplace
•   A decision to hedge must be made carefully so one fully
    understands what risks are going away and what new risks
    they are obtaining.
•   Develop a hedge plan which includes identifying and
    measuring risk within an appropriate infrastructure of
    contracts, credit, accounting & regulatory constraints.
•   Educate management, staff, board and regulatory staff of
    goals of the hedge plan in detailed format (prior to
    implementation).
New Market Design

“A Transmission Example”
   So Why Change from the Traditional
     Transmission Market Structure?
• Fair & Open Access to a constrained transmission
  system
   – Eliminate manipulation & abuse of transmission use
   – Effective FERC oversight & regulation
• More efficient use of generation & transmission
  resources
• Create a structure that yields delivered power prices
  based on actual flow versus contract path
• Create broader access to competitive power markets
Example:Where Do you Buy?
       Example: Where Do you Buy?

1. $20/MWh + 2+3+2+2 = $29.0/MWh
2. $25/MWh + 2.5 + 2 = $29.5/MWh
3. $28/MWh + 2       = $30.0/MWh

Which alternative should the Buyer Purchase and why?
         Example: Where Do you Buy?

$20/MWh + 2+3+2+2                        = $29.0/MWh
Least expensive but far away, transmission may get a TLR


$25/MWh + 2.5 + 2                        = $29.5/MWh
Closer, only 2 transmission paths but $0.50/MWh more.


$28/MWh + 2                              = $30.0/MWh
Purchase from neighbor utility with only one transmission tag.
Natural Gas Market Update

   To be added if necessary?

								
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