Utilities Respond To Competition
As electric utilities prepare for open competition, many have recognized the need to develop
substantially stronger marketing and risk management skills so they can effectively compete with
the new power marketers and brokers who will be entering the marketplace.
In the past, the regulators established elaborate rules to effectively set electricity prices. In the new world of open competition, prices will be unbundled with tremendous variability in the pricing options available to customers. These developments have created a requirement for substantial additional resources in the area of new product development, pricing and competitive intelligence. It is not possible to predict exactly when this future state will exist in Canada, however it is evident that many utilities are paying greater attention to these key processes.
Risk and Risk Management
When thinking about risk management, it is important to establish common definitions and terms
of reference. First, what is risk? For the purposes of this discussion risk will be defined as
earnings uncertainty. Secondly, why is risk management important in an open competitive
environment? Most firms which compete in an open competitive environment have shareholders.
Shareholders like the comfort of knowing that the earnings stream from their company is steady
and reliable. Companies who do not manage the risks they face and consequently do not have a
reliable earnings outlook may be viewed less favorably in the capital markets. Equally important
is the fact that many firms entering the open market competitively are trading and selling
electricity in new and different ways from anything they have previously experienced. With new
operating methods and environments, it is important to know what new risks these firms now
face, and how to deal with those risks.
The ultimate goal of any risk management program is to minimize earnings uncertainty, thereby increasing the value of a business entity. This happens either by making risk management an integral part of the development of new marketing tools and products, or by eliminating input price or revenue volatility.
A company's risk management goals would typically incorporate the following 'wish list':
Learning From The 'Open Access' Experience In the U.K.
The U.K. experience with open competition energy markets can provide a glimpse of how
contract prices might soon be set in Canada. Open market competition in the U.K. brought with
it price volatility. This source of price risk was managed through the use of over-the-counter
derivatives. In the initial stages of open market competition, Contracts for Differences (CFD)
were created. CFDs are essentially large long term tailored swaps between generators and the
large regional electric companies (REC). They initially covered 75 per cent of the electricity
consumed in the UK and were long term contractual buying agreements.
Shortly after the emergence of contracts for differences the RECs determined that these contracts merely passed fuel risk and operating risk of marginal electricity plants from generators to the RECs.
The RECs developed customer demand curves to more accurately gauge the demand for electricity over shorter timelines. The RECs needed to better manage the risk of volatile spot electricity prices vs. the costs of establishing long term contracts which covered periods of high and low demand, but locked the RECs into periodically purchasing electricity quantities above their requirements. They used these improved demand curves to create shorter term Electricity Forward Agreements (EFA) with the generators.
When financial traders and marketers of electricity provided liquidity to the forward markets and competition to the generators on pricing and contract structure, the EFA marketplace grew rapidly. At present, the EFA market covers some 75 per cent of electricity consumed in the UK. A real "spot" market is not yet in place, but is expected some time in 1998.
It is important to note that the market evolved over time. It did not spring forth fully developed. It could reasonably be expected that financial traders will enter the Canadian market at the outset, based on the UK and to a lesser extent, the US experience, and that the evolution of this market will be rapid. Those companies who are not prepared will be left behind by the better prepared.
Consumer and Product Behaviour Under Open Competition
It is also important to consider what Canadian power consumers will demand of sellers in the new
open competition environment. Otherwise, it is difficult to understand the skills that must be
acquired and fine-tuned before open competition arrives.
Power consumers generally want reliability of supply and protection against price increases. This does not necessarily mean consumers want the lowest possible rate. Reliability of supply is critical, and consumers are generally willing to pay a little more if the supplier can demonstrate that the increased cost delivers additional value. If consumers perceive however, that by buying in a spot market or with short term contracts they can get a lower cost with little or no additional risk of price shocks, then some will likely do so.
Model of End User/Consumer Behaviour in Commodity Markets
Modeling of consumer behavior helps the generators and marketers of electricity to more
accurately forecast demand in the various market segments and thus manage the risks of
over/under production and buying/selling into unfavorable market conditions. Ernst & Young has
developed a concentric ring model of end user/consumer behaviour in commodity markets.
At the centre of the rings is the spot market, characterized by extreme price volatility. The spot market is driven by power generation outages, excess demand due to unforeseen severe weather development, and similar occurrences.
The next ring is the mid term or 'on the margin' market. This market is populated by consumers and producers who are not engaged in long term market activity, perhaps because they expect short term price declines. The market also includes those producers who seek to cover a planned outage by purchasing for resale the quantity of electricity to fulfill long term or medium term contracts.
The outer ring is the long term market. Generally this area is populated by customers who wish to purchase a consistently priced, reliable supply of power , as well as by producers who need the long term contracts to arrange financing in the debt or capital markets.
Importance of Pricing Models and Risk Management
All 'marketers' of electricity, if they hope to survive in the new retail environment, are
well-advised to develop a strong knowledge base of the tools and techniques of risk management
and derivatives trading before open competition arrives.
Pricing models allow power providers to decide when to enter into mid term, long term or spot pricing deals. Without a model, these suppliers may become passive price takers and may be unable to compete with sophisticated trading/dealing market makers.
Many bulk marketers have already begun the process of developing marketing strategies which use sophisticated derivative products, along with simultaneous development of risk management strategies to reduce or eliminate the risk exposure these products bring. Some of these products include over-the-counter derivatives, customized to meet the requirements of not only the bulk marketer as a buyer, but also the large users which the bulk marketers may wish to serve.
Derivatives: The Ticket To Price & Supply Stability
Many customers will demand a pricing mechanism sufficiently robust to ensure protection against
price increases, but sufficiently generous to pass on the benefits of significant declines in price. It
is likely that bulk marketers and financial traders will use the derivatives market to deliver this
kind of price arrangement.
Electricity derivatives will add greater credibility, but can be highly complex, and require implementation of a detailed risk management strategy. Power suppliers and marketers must therefore acquire and develop the capability to defend market share by utilizing these marketing and risk management tools.
As we enter this new open competition market, those firms who are prepared to identify, measure and control risks through the use of well developed risk management policies will be in a better position to beat the competition, regardless of their size or experience in a regulated environment. Companies using the debt or capital markets cannot afford earnings uncertainty. Risk management and new innovative marketing programs may mean the difference between mere existence and creating real shareholder value.
Ian Doidge is Senior Consultant, International Capital Markets Group and Ron Buckle is Partner, Utilities Group, Ernst & Young Management Consultants.