NRRI 01-08 USE OF HEDGING BY LOCAL GAS DISTRIBUTION COMPANIES: BASIC CONSIDERATIONS AND REGULATORY ISSUES


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By Kenneth W. Costello
Senior Institute Economist

And John Cita, Ph. D.
Chief, Economic Policy and Planning Kansas State Corporation Commission

May 2001

An unexpected price spike of staggering proportions pushed the
average price of natural gas for the winter of 2000-2001 to a new plateau,
more than double the average price of the previous winter. Largely
because of low storage levels and extreme weather conditions, spot gas
prices rose to the $9-10 per MMBtu range in December and January.
Needless to say, the volatile nature of natural gas prices has had a
discomforting effect on consumers and utilities alike.
State public utility commissions (PUCs) and other public officials
are concerned that high gas prices can cause financial hardship for retail
customers, especially low-income households. In the vast majority of
cases, high gas prices get passed along to consumers. Depending upon
the jurisdiction, cost recovery by utilities in many states occurs within a
few months. As an aggravation, gas-price volatility can make it difficult for
residential consumers to accurately plan their budgeting of gas costs.
Aggravated further by the uncertainty of weather, the budgeting problem
becomes even more severe. While price spikes combined with
abnormally cold weather imply that some consumers will be faced with
unaffordable bills, more generally it means consumers will face bills they
simply did not plan for.
As part of gas contracting responsibilities, utilities are not only
concerned with procuring physical gas supplies to meet their required
obligation to serve, but they are also concerned about pricing terms. Of
course, the price level matters, but so do provisions that specify whether
the price is fixed or variable over time. Clearly, depending on whether the
utility enters, say, an annual contract that provides for a fixed price or a
price that varies with a specific monthly index, consumers will be exposed
to different price paths. Buying exclusively gas at index, 'for example, a
gas utility would expose its customers to a "roller coaster" of prices over
different time periods.
As an alternative to entering fixed-price gas contracts, the utility
can conduct its gas purchasing business on an "at index basis" and then use risk-management tools to smooth out the market-price path.1 In fact,
by using financial derivatives the utility can manage or tailor its price risk
by various degrees, ranging from nearly complete elimination of all market
volatility to an elimination of just the most extreme price spikes. When it
comes to risk management through the use of financial derivatives, the
utility has an infinite number of available alternatives to consider. Risk
management alternatives can be evaluated in terms of the degree of
volatility removed, cost, and susceptibility to regulatory scrutiny. Some
risk-management strategies, such as options, can be relatively costly, requiring an up-front payment that is analogous to an insurance premium.2
Just as homeowners buy fire, insurance to avoid large losses of wealth in
the event of a fire, risk-averse consumers may be willing to pay a premium to avoid paying highly variable gas prices. Of course, some
consumers may not be willing to pay anything extra for increased price
stability. It is difficult to know what the average utility customer is willing
and able to pay for a particular risk-management strategy. Lastly, utilities
that use risk management to lock in a gas price may be criticized by
customers if the locked-in price turns out to be greater than the actual
market price.

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