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Residential Risk Management Plan

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Residential Risk Management Plan Powered By Docstoc
					Hedging and Price Risk Management:
      A California Perspective


                       Todd Strauss
      Senior Director, Energy Policy, Planning, and Analysis
                Pacific Gas and Electric Company


  NARUC – Staff Subcommittee on Accounting and Finance
                   Spring 2008 Meeting
                           1 April 2008
Contents

 Introduction to energy procurement at PG&E
 How PG&E’s hedging programs work
 Learning and insights from PG&E experience
  in hedging




                                               1
Pacific Gas and Electric

 Combined gas and electric utility in northern and
  central California

 Gas
   • 4 million customer accounts
   • $4 billion annual revenue
   • 850 bcf (30% bundled)
 Electric
   •   5 million customer accounts
   •   $9 billion annual revenue
   •   86,000 GWh (92% bundled)
   •   20,000 MW peak load



                                                      2
PG&E Energy Procurement

 Costs heavily tied to gas commodity prices
  • Electric: 45% of energy tied to natural gas
    commodity prices
 Combined utility; separate portfolios
  • Wholesale portfolios for bundled electric customers
    and core gas customers are managed separately
 Decoupling
  • Balancing account treatment provides no incentive
    for utility to earn more dollars by selling more
    energy


                                                          3
PG&E Energy Procurement: Objectives

 Reliability
  • Meet obligation to serve
 Environment
 Customer cost
  • Reasonable level
  • Stable
 Cost recovery
 Cost allocation
 Shareholder earnings (core gas incentive
  mechanism)

                                             4
PG&E Energy Procurement: Regulatory Regimes

 Bundled electric portfolio
   • Procurement plan review and approval
      □ Procurement plan includes products, processes, strategies
      □ Includes hedging plans
   • Compliance review of activities
      □ Were utility’s actions consistent with plan?
   • Procurement Review Group (PRG)
      □ Consumer advocates, California PUC staff, and other non-market
        participants representing stakeholder interests in electric procurement
      □ Advisory role to PG&E
 Core gas portfolio
   • Incentive mechanism
      □ Based on basket of monthly indices
      □ Short-term oriented


                                                                                  5
Contents

   Introduction to energy procurement at PG&E
   How PG&E’s hedging programs work
    • Policies and principles
    A. Bundled electric portfolio
    B. Core gas portfolio
   Learning and insights from PG&E experience
    in hedging




                                                 6
A. Bundled Electric Portfolio: PUC’s Risk Policy

Risk policy established by California PUC in 2003
   1. Cost variability measure
      □ To-expiration Value-at-Risk (TeVaR)
   2. Customer Risk Tolerance (CRT)
      □ 1 cent per kWh
   3. Risk management policy
      □ Compare TeVaR with CRT
      □ If TeVaR > 1.25  CRT, then meet and confer with
        Procurement Review Group




                                                           7
Portfolio Cost Variability

 Bundled electric portfolio consists of
   • Load obligations
   • Resources (supply-side and demand-side)
 Sources of portfolio cost variability
   • Resource cost (natural gas price)
   • Resource quantity (forced outages, hydro generation)
   • Load uncertainty: heat rate of marginal resource in supply
     stack
 Probability distribution of portfolio cost
   • Each source of variability can be described probabilistically
   • Result is probability distribution of portfolio cost



                                                                     8
1. Cost Variability Measure

TeVaR is a measure of the width of the probability distribution of
  portfolio cost
   • Cost distribution (and therefore TeVaR) is modeled, not observed
       □ Inputs include market data (forward curves, volatilities, and correlations) and
         portfolio resources/instruments
       □ See next slide for comparison between TeVaR and Value-at-Risk (VaR)




                                                                                           9
SIDEBAR
Risk Measurement: VaR and TeVaR

 Value-at-Risk (VaR)
  • Answers the question of how large the deviation
    could be between portfolio value in the future and
    portfolio value today
  • This deviation is in the context of a particular time
    horizon (1 to 5 days in the future) and confidence
    interval (e.g., 95th percentile)
  • Time horizon is typically short: 1 to 5 days
 To-Expiration Value-at-Risk (TeVaR) is VaR
  with liquidation horizon carried to delivery
  • Load obligation cannot be unwound like
    instruments in a trading book
                                                            10
Reducing Cost Variability

Activities that narrow the cost distribution:
   • Adding fixed-price resources to the portfolio
   • Hedging
      If it doesn’t narrow the cost distribution, it isn’t hedging, it’s speculation!




                                                                                        11
Hedging Strategy Changes Cost Distribution

 Candidate strategies differ by amounts and product mix
 Cost distribution is narrowed by
   • Greater hedging quantities
   • More swaps/forwards/futures and fewer options




                                                           12
Hedging and Cost Distributions: A Numerical Look

Some analysts like tables of numbers, others like graphs
   Table has additional information (lines 18-27)




                                                           13
Hedging Strategies and Cost Distributions

 The question Which hedging strategy is best?
                  is transformed into the question
       Which cost distribution do bundled electric customers prefer?
 Extensively discussed with PRG




                                                     strategies differ by
                                                   amounts and product mix




                                                                             14
2. Customer Risk Tolerance

How much of an increase in cost can customers
 tolerate?

  is operationalized as the question


How wide should the probability distribution of
 portfolio cost be?




                                                  15
Customer Risk Tolerance (CRT)

 How wide should the probability distribution of
  portfolio cost be?
  • This is a risk preference
  • This is a policy issue
  • Current policy set by California PUC is 1 cent per
    kWh
     □ For PG&E bundled electric portfolio, this corresponds to
       incremental portfolio cost of about $800 million
  • Customer survey was/is intended to inform
    policymaking



                                                                  16
3. California PUC’s Risk Management Policy

 Compare TeVaR with CRT
  • In words: compare estimated width of probability
    distribution of portfolio cost with the stated 1 cent
    per kWh target for the width
 If TeVaR > 1.25  CRT, then meet and confer
  with Procurement Review Group
  • Stakeholder discussion of the situation is required
  • No particular portfolio action is required
  • 1.25  CRT is referred to as the ―notification level‖
     □ This is very different from a trading limit



                                                            17
B. Core Gas Portfolio

   Regulatory regime is short-term incentive mechanism
    •   Based on basket of monthly indices
   Misalignment of interests: hedging for customers
    looks like speculating from shareholder perspective
    •   Longer-term hedges deviate from monthly spot price index
    •   Hedging narrows probability distribution of customer cost
    •   Hedging increases probability distribution of shareholder
        gain/loss
   Disconnect identified: significant hedging for bundled
    electric customers, and no hedging for core gas
    customers
    •   Bundled electric customers and core gas customers are
        largely the same residential households and small
        commercial customers, with the same risk preferences for
        gas service costs as for electric service costs


                                                                    18
Core Gas Portfolio: History of Hedging

   In 2005 PG&E initiated PUC filing regarding hedging
    for core gas customers
   PG&E requested that all benefits and costs related to
    hedging go to customers, and be outside of incentive
    mechanism
   Hedging has been performed for past 3 winter
    seasons, with hedges outside of incentive
    mechanism
   Advisory group process analogous to bundled
    electric PRG has been established
   Customer risk tolerance survey is underway
   PUC about to begin a broad proceeding looking at
    hedging in context of existing incentive mechanism
    structure

                                                            19
Contents

 Introduction to energy procurement at PG&E
 How PG&E’s hedging programs work
 Learning and insights from PG&E experience
  in hedging
  • Hedging vs. speculating
  • Hedging: costs vs. cash flows
  • Risk vs. regret




                                               20
Hedging vs. Speculating: Behaviors

   Market view
    • Hedging takes the market as is: the market (i.e., what is
      currently transactable) is not right or wrong, it just plain
      exists
    • Speculating takes a view on where the market is headed
      and acts on that view
   Market timing
    •  Hedging executes transactions relatively evenly over
      time, to diversify timing risk, perhaps using dollar cost
      averaging
    • Speculating uses event-driven trading to time the
      market, perhaps trading in and out of positions



                                                                     21
Hedging vs. Speculating: Objectives

   Hedging objectives
    • Manage TeVaR
    • Protect against price blowout scenarios
    • Flatten positions that arise from physical
      assets and obligation to serve


   Speculating objective
    • Earn an outsized return on risk capital




                                                   22
Hedging: Costs vs. Cash Flows

  Q: What is the cost of hedging?
  A: Transaction costs.
    • Broker fees
    • Financing margin and collateral
    • Bid-ask spreads
  A: Option premiums are cash outflows, not
    costs.

  Hedging has little impact on expected
   portfolio cost.

                                              23
Cash Flows vs. Net Costs: Forwards

  Q: At the time a forward (swap/forward/future) contract is executed,
     how much money trades hands?
  A: Zero.

  Q: At settlement, does money trade hands?
  A: Yes.

  Q: At time of execution, how much money is expected to trade hands
     at settlement?
  A: Zero.

  Q: Therefore, at execution, expected net cost of forward is zero?
  A: Yes.

  Q: But what about cost at settlement?
  A: See ―regret.‖



                                                                         24
Cash Flows vs. Costs: Options

  Q: At the time an option contract is executed, how much money
     trades hands?
  A: Buyer of option pays seller of option the option ―premium.‖

  Q: At settlement (option expiry), does money trade hands?
  A: If option is in the money, seller of option pays buyer of option the
      difference between market price and option strike price.

  Q: At time of execution, how much money is expected to trade hands
     at settlement?
  A: The option premium plus the interest associated with the time
     value of money.

  Q: Therefore, at execution, expected net cost of option is zero?
  A: Yes.

  Q: But what about cost at settlement?
  A: See ―regret.‖

                                                                            25
Risk vs. Regret

 Risk is ―potential negative impact that may arise from
  a future event‖
 Regret is ―distress of mind for what has been done or
  failed to be done‖
   • Hedging example: quantity hedged is always wrong in
     hindsight—too little or too much
   • Hedging example: buying options
      □ Most of the time, these options won’t pay back the option premium,
        and will regret buying them
      □ When these options do pay out, will regret not having swaps instead
   • Hedging example: whether to hedge or not to hedge
      □ Hedging seems to have more regret than not hedging
 Risk is prospective, regret is retrospective


                                                                              26
Conclusion: Overcoming Regret

 Ask yourself: Is the hedging strategy designed to
  reduce risk or to avoid regret?
 Focus on the total portfolio—physical and financial—
  not just the hedge book
 Focus on the exposure ($) of a potential event
  separately from the probability of that event occurring
 Establish risk benchmarks and measure the portfolio
  against those benchmarks
 Include as a hedging objective: Manage option
  premium expenses



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