Hedging and Price Risk Management: A California Perspective

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Hedging and Price Risk ManagementA California
Perspective

• Todd Strauss
• Senior Director, Energy Policy, Planning, and
  AnalysisPacific Gas and Electric Company
• NARUC Staff Subcommittee on Accounting and
  FinanceSpring 2008 Meeting1 April 2008

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Contents

• Introduction to energy procurement at PGE
• How PGEs hedging programs work
• Learning and insights from PGE experience in
  hedging

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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

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PGE 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

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PGE Energy Procurement Objectives

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

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PGE 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 utilitys 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 PGE
• Core gas portfolio
• Incentive mechanism
• Based on basket of monthly indices
• Short-term oriented

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Contents

• Introduction to energy procurement at PGE
• How PGEs hedging programs work
• Policies and principles
• Bundled electric portfolio
• Core gas portfolio
• Learning and insights from PGE experience in
  hedging

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A. Bundled Electric Portfolio PUCs Risk Policy

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

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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

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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)

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SIDEBARRisk 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

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Reducing Cost Variability

• Activities that narrow the cost distribution
• Adding fixed-price resources to the portfolio
• Hedging
• If it doesnt narrow the cost distribution, it
  isnt hedging, its speculation!

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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

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Hedging and Cost Distributions A Numerical Look

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

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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
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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?

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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 PGE bundled electric portfolio, this
  corresponds to incremental portfolio cost of
  about 800 million
• Customer survey was/is intended to inform
  policymaking

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3. California PUCs 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 gt 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

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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

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Core Gas Portfolio History of Hedging

• In 2005 PGE initiated PUC filing regarding
  hedging for core gas customers
• PGE 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

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Contents

• Introduction to energy procurement at PGE
• How PGEs hedging programs work
• Learning and insights from PGE experience in
  hedging
• Hedging vs. speculating
• Hedging costs vs. cash flows
• Risk vs. regret

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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

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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

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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.

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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.

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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.

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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 hindsighttoo little or too much
• Hedging example buying options
• Most of the time, these options wont 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

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Conclusion Overcoming Regret

• Ask yourself Is the hedging strategy designed to
  reduce risk or to avoid regret?
• Focus on the total portfoliophysical and
  financialnot 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