Steven Rideout, When the futures contract for bulk power begins trading on the New York Mercantile Exchange in early 1996, the nature of corporate risk management for electric utilities will change drastically. These changes will not be limited to a simple exposure of capital loss due to fluctuations in the price of electricity—an exposure which, in and of itself, could create financial havoc if left unattended—but the floating price of electricity will bring with it changes in the marketplace which are much more subtle and insidious.
Procrastinators will lose
Lost outlets
To compete in the commercial market place, an electrical producer must offer its clients hedging packages comparable to those offered by investment banks, as well as stress to the end-user the security of purchasing power directly from the source. A producer who starts now will be prepared to profit when the market is freely traded. On the other hand, the producer with a wait-and-see attitude will not be prepared. The unprepared producer will lose clients to those investment banks and aggressive producers who do offer these sophisticated hedging packages. In addition, in a rush to catch up, the wait-and-see producer could very easily overlook important risk management considerations associated with selling these sophisticated hedging programs. This over sight could result in financial losses.
However, an electrical producer which creates a sophisticated sales department now will not only gamer a larger market share, but will also profit, like Wall Street does, from the activity of building a risk management book. Each time the producer sells a sophisticated hedging package to an end-user, profit will be factored into the price. The producer further enhances this profit through strategies which transfer remaining risk into opportunities. Therefore, the activity of creating a sophisticated sales approach not only aids in ensuring the producer's client base, but it also becomes a profit center unto itself.
Great Wall Street seduction
Most producers, even those not currently taking the wait-and-see approach to deregulation, very likely will be seduced by these sophisticated offers which not only provide a stable bottom line for the producer, but also an egoic sense of sophistication. These two byproducts of the great Wall Street seduction are both detriments to the electrical producer. The stable bottom line actually represents a loss of profit, which the producer could realize without any addition al risk. And, the sense of sophistication the electrical producer's ego feels by simply being involved in using sophisticated vehicles does not make a producer sophisticated. In fact, quite the opposite. An investment bank can only make money if it sells a sophisticated vehicle to a counterparty which is unsophisticated. The feeling of sophistication is the liquor the investment banks use to inebriate the producer, so that at the end of the transaction, the producer feels like it has hedged risk in a sophisticated manner. Nothing could be further from the truth. Investment banks are a producer's adversary, not its ally. It is incumbent upon an electrical producer to understand how an investment bank can continually profit in commodity markets, like electricity, without ever generating, refining or producing a physical product. And further, a producer must understand the ramifications to profitability associated with using investment banks as a counter party in sophisticated hedging vehicles. Investment banks profit by charging more for the sophisticated hedging products they sell than the products are worth. Because these products are complex and because most refiners and producers are unskilled in the processes of calculating the value of these products, the investment bank can continue to extract profit from a variety of markets with little or no risk exposure. Investment banks make their money by standing between the efficient and inefficient price curves in any market. In other words, they make their money by knowing the real price of a trading or hedging vehicle and selling that vehicle at an inflated price to a counterparty that does not know the vehicle's real value. For an electrical producer to be on the efficient side of the price curve, it must learn to evaluate and construct sophisticated hedging programs without the assistance of an investment bank. Until it is able to calculate these values, the producer will be the inefficient half of the price structure that investment banks seduce and exploit. For a sophisticated producer, investment banks must become a counterparty of last resort. Simply using a sophisticated hedging or trading vehicle does not make an electrical producer a sophisticated risk manager. In fact, quite the opposite. In general, if the sophisticated transaction is performed with an investment bank as the counterparty, it only proves that the producer is involved in a transaction it does not understand. In the initial stages of the producer's sophistication transformation, the techniques investment banks offer will be very attractive. This attraction will diminish if the producer learns to price these vehicles for itself. Sophisticated trading vehicles are designed to most efficiently price a commodity. Investment banks know how to price these vehicles so that it appears to be accepting the risk the producer is trying to hedge. In reality, however, the investment bank never accepts risk. It is only common sense that a company cannot continually accept risk as a business practice and continue to survive, let alone flourish. Investment banks have a built-in profit in each transaction. That profit can only exist if the investment bank's counterparty does not know the value of the product it is purchasing. To ensure profitability, an electrical producer must learn to construct its own sophisticated hedging products. Only then will the producer know the actual value of the products it is buying and selling. To ensure profitability, the producer must be the efficient half of the price structure. This will happen when the producer raises capital protection to a primary objective, creates its own hedge vehicles and makes investment banks a counterparty of last resort.
Out of the equation
Common hedging vehicles offered by Wall Street involve trigger mechanisms. Trigger mechanisms allow the purchaser, whether an end-user or a producer, to declare a variety of contract terms at its option in the future. If both the end-user and the producer park their hedges with investment banks using trigger mechanisms, then whenever these participants decide to actually hedge their availabilities or requirements, they pick up the phone to the investment bank and announce their intentions. Essentially, these trigger mechanisms transfer vital supply and-demand market information directly to the investment bank. In this common scenario, the investment bank is the only market participant with the complete picture of the supply and-demand equation. The producer is in the dark, having given even its own production information to its adversary, the investment bank. To remain profitable after deregulation, the producer must maintain its direct relationship to the end-user by providing the end-user with trigger mechanisms. When the producer has sold electricity directly to the end-user through trigger mechanisms, then every time the end-user decides to buy electricity, it will call the producer to declare its future requirement for the product. This cuts the investment bank out of the supply-and-demand information loop, while ensuring that the producer has the vital, fundamental information necessary to be sensitive to price fluctuations in the future that affect the producer's profitability. In summary, there are at least five beneficial outcomes when an electrical producer creates and sells sophisticated hedging packages to commercial end-users:
Wealth of opportunity exists
Any producer taking the wait-and-see approach will not only find it difficult to compete in the new marketplace, but will also find it loses valuable ground which will be difficult to retake. For those who are prepared, the exciting new bulk power market will provide a wealth of opportunities. As in all things, time!y knowledge is the difference between those who are prepared and those who are not.
For more information about risk management, contact Steven Rideout, who is president of Integrated Energy Services Inc., a professional risk management consulting firm, at (515) 472-7280, 52 North Third St., Fairfield, IA 52556.
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