One of the most striking changes in the power industry over the past couple of decades is the outright proliferation of short-term contracts—the patchwork of hedges, financial instruments and commodity trades that is now part and parcel of moving energy across the grid. Veterans of the business can remember a time when predictable demand, simplified buyer-seller relationships and relatively stable prices for coal and natural gas led quite naturally to long-term contracts—and long-term thinking.
Today, however, the electric power business is so fast-paced, with such rapid and dramatic fluctuations in both energy demand and fuel costs, that utilities can easily lose sight of their long-term strategic goals as they try to cope with all of that flux. Indeed, the day-to-day challenge of using short-term transactions to hedge risk and maximize reward can be enough to monopolize the attention of even the most conscientious and forward-thinking executive.
Consider how the commoditization of fuel costs has affected the industry. On a recent trading day, natural gas closed on the New York Mercantile Exchange at $3.70 per MMBtu. The locked-in prices for 2015 contracts, by contrast, were 30 percent higher. The market clearly believes that increased demand around the world, combined with tougher U.S. regulations on coal (some of which will take effect in 2015), will drive up the price of natural gas for years to come.
Evolving infrastructure requirements are a contributing factor here as well. Let’s say ACME Power responds to heavier regulations by repowering a coal-fired plant with a new gas-fired boiler. If there is no existing distribution line to ACME’s plant, the line will need to be installed, thus further increasing demand on both the interstate and distribution infrastructure—and driving up prices.
What does this have to do with short-term power issues? Today’s price variability gives power companies considerable motivation to buy-forward on gas as much as possible. Fuel, after all, is their biggest variable cost. Finding and negotiating five- and 10-year deals (although these latter contracts will contain reopener clauses) is a top priority for many utilities. But such efforts still amount to a gamble. If ACME Power finances its fixed infrastructure costs with a 30-year facility, but can only fuel that plant with a five-year, variable-cost contract, what happens if the market is rocked by wild swings in price? ACME will want to guard against this risk by hedging on that fuel contract. It will buy an “insurance policy” geared toward stabilizing that price as much as possible. This can help ACME ensure delivery, stabilize rates and project an aura of confidence for its customers and stockholders.
But of course, such hedges can apply, not only to fuel purchases, but also to power sales or delivery. For example, ACME might say to a customer, “If we cannot deliver on our promise of power, we will give you a financial instrument so that you can go buy it somewhere else.” Or a supplier might say to ACME, “If we fail to meet our obligations, this fiscal contract guarantees that so-and-so will step in to make good on our promise.”
Hedges, then, can involve either commodity-for-commodity guarantees or financial instruments that open doors to alternative sourcing. And yet the complexity of this marketplace does not end here. Fluctuations in load profile are yet another uncertainty driving the proliferation of short-term transactions. Simply put, companies can make predictions, but they never really know how many customers they will lose or gain, or how much or how little power those customers will need. These factors determine how much power utilities will need to generate, and how much fuel they will need to buy. If ACME has under-purchased fuel, it may be forced to go to the marketplace and buy short-term fuel at a higher price. If it has over-purchased fuel, it will need to find buyers for that excess supply, or perhaps renegotiate the contract. Load fluctuations, too, drive more short-term transactions.
Meanwhile, the uncertain impacts of our ever-evolving regulatory climate are another complicating factor. With the growing emphasis on renewable energy, odds are higher that utilities will face situations where, for instance, they run the risk of failing on a contract because, thanks to renewable portfolio standards, their coal-fired power plant must sit on the sidelines amid the preferential grid access granted to energy from renewable sources. With more and tighter regulations, in other words, the already difficult game of predicting and preventing grid overload/delivery failures is bound to get even trickier.
So what is a utility to do? At the big-picture level, it can be helpful simply to be aware of the danger posed by a myopic focus on short-term exigencies. Understanding this risk, the C-suite can then be sure to allocate time and energy to longer-term planning, and to brainstorming sessions in which the primary objective is to ask broad, strategic questions.
When it comes to short-term planning, meanwhile, a strategic approach is equally helpful. New software can help utilities plan for and even predict grid breakdowns. And while staying abreast of regulations is certainly important, even here it is possible to be myopic—namely, by focusing only on the implications of regulations that directly affect the power industry itself. Whenever power industry executives read about new regulations, even those outside the industry, it can be helpful to ask whether any ripple effects could necessitate changes in company operations. In some cases, it might even be appropriate to start laying the groundwork for a preemptive response.
In the age of “big data,” it is also imperative to keep the utility’s internal systems modern. Data-gathering is a huge part of the power business today, but some companies fail to assimilate that data and to put it to good use from a strategic, longer-term standpoint. The latest tools and techniques in pattern-analysis and modeling can and should be applied to fuel purchases, transmission access and other risks.
Hedges, however, are more than numbers on a spreadsheet. Prior to its meltdown in 2001, Enron was widely considered one of the power industry’s most reliable transaction partners, with $100bn in revenues. This highlights one of the biggest, and perhaps most overlooked, challenges in today’s transmission marketplace: Doing proper due diligence on hedging partners to make sure they can back up their claims. What company had a nicer corporate brochure or better name-recognition than Enron? The onus is on utilities to investigate thoroughly any counterparty to a hedge. How financially strong is that counterparty? What is its history? What is the experience level of its employees? Is its infrastructure such that this counterparty can actually deliver as it says it can? This kind of detective work can be difficult (and admittedly, it will not always lead to a smoking gun that exposes the Enrons of the world), but it is clearly a worthwhile best practice for risk-management. The key is to invest time and effort proportionate to the risk involved.
The field, after all, is risk-management, not risk-elimination. The good news about today’s proliferation of short-term transactions is that, for all of the risks involved, the ramped-up activity translates into more and greater opportunities for the industry overall. Like a sharp machete, a well-honed, long-term strategy can help utilities cut through the day-to-day weeds and make the most of these opportunities for years to come.
Roy M. Palk, Esq. is the former President and CEO of East Kentucky Power Cooperative, and is Senior Energy Advisor for the national law firm LeClairRyan.