Big power cost pass-throughs deepen hedging controversy

Ann de Rouffignac
OGJ Online

This summer's sharp rise in natural gas and purchased electricity costs caught many US utilities off guard and sharpened interest in hedging strategies that could be used to protect consumers from price hikes.

Just a few years ago, utilities rarely bought power on the spot market. But power shortages in some regions of the US, voracious demand, and deregulation have forced many companies into that market.

It's been a rough ride.

Customers of San Diego Gas & Electric Co., a unit of Sempra Energy, experienced a 12�/kw-hr increase in their bills this summer. In the Northwest, Avista Corp.�s regulated utility took a $62 million hit in the second quarter on purchased power costs. Nevada Power Co., a unit of Sierra Pacific Resources Corp., nearly had to swallow $48 million in unexpected purchased power costs, until regulators allowed the company to pass the charges through to consumers.

This summer's experience suggests many did not have strategies in place to cope with big price swings and are paying the price or forcing their customers to pick up the tab. In the wake of debacles in California, Florida, and the Northwest, hedging, the ability to buy or sell electricity in the forward market as protection against volatility, has emerged as one of the hottest topics in the industry.

�Many suppliers offered San Diego Gas & Electric the opportunity to purchase power at fixed, predictable rates of 4-5 years at costs below this summer�s prices,� testified Steven Kean, Enron Corp. chief of staff, testified during a San Diego congressional hearing. �Unfortunately, SDG&E�s ability to consider those offers is restricted. Customers not only see the effects of higher prices, they are left exposed to price volatility."

In the East and Midwest, a mild summer allowed utilities to squeak by without any big surprises from the power market. Despite tight supply and projected shortages New York, Ohio, and New England, utilities got by without hedging or shocking consumers with big price hikes for purchased power. Consumers in Florida, Nevada, and Texas, however, will be paying more once regulators approve. Most of these utilities didn�t hedge their summer power supply.

Under regulation, most states permitted utilities to pass their purchased gas and power costs through to consumers. But as states move towards deregulated markets, the picture is changing. Now, who takes the risk�the utility or its customers�varies from state to state and almost utility by utility.

High gas, oil, and purchased power costs stung Florida Power & Light Co., a unit of FPL Group Inc. �Nobody could have guessed what happened with oil much less gas,� says Bill Swank, spokesman for the utility. �We got hit on both accounts.�

The utility is asking the Florida Public Service Commission to approve about $518 million in oil, gas, and purchased power expenses. Swank would not say how much of that sum represented purchased power. After accounting for an offsetting refund, residential electric rates could increase by about 13 %/ kw-hr. If regulators approve, FPL will pass through the additional costs to customers.

A spokesman said the company engaged in "a limited amount of short-term hedging�less than a month." While there are no state prohibitions against hedging, the commission said if a utility guesses wrong it can't pass the costs of the hedge on to customers.

Ditto Texas
Central Power & Light Co., a unit of American Electric Power Co. Inc., and HL&P Reliant, a unit of Reliant Energy Inc., have filed with the Public Utility Commission of Texas to pass unhedged fuel and purchased power expenses through to customers.

�All the penalties are ours if we hedge and we are wrong," says Larry Jones, spokesman at American Electric Power. "And there is no benefit when we are right. As a result, we go with the spot market.�

In Georgia, Alabama, Mississippi, and Florida where Southern Co. operates five utilities, purchased power is passed through to customers along with fuel costs. But with a comfortable reserve margin of about 13.5%, the huge holding company doesn�t have to go to the spot market often. Its customers have not been exposed to the sort of volatile bills that are plaguing other regions.

�We can pass through the spot market costs to customers,� says Mike Tyndal, Southern spokesman. �The only time we do go to the next-hour market is when the lights are about to go out.�

High power costs and whether San Diego Gas & Electric could or could not hedge is under dispute and part of an ongoing federal and state investigations. But this much is known. San Diego Gas &Electric didn�t have the ability to hedge forward all its summer power purchases. Because it had to buy power for customers on the spot market, the utility was completely subject to the volatility of the California power market.

If San Diego Gas &Electric had hedged just 10% of its power purchases, it could have saved customers $30 million, according to the Independent Energy Producers, a trade association in Washington, DC.

In Indiana, consumers will ultimately pay the purchased power bill. But regulators have instituted a new program that will give utilities incentives to hedge against future volatility.

�We just got approval for a purchase power �tracker�,� says Angeline Protegere, spokesperson for Cinergy Corp. �Before there was no incentive to get these contracts.�

Consolidated Edison Co. of New York (ConEd) has the best of both worlds: it can hedge and pass through to customers spot market purchases of power.

The New York utility buys a significant amount of power from the New York Independent System Operator (ISO) in the day-ahead or spot market, says Gerry Dunbar, section manager, energy trading for ConEd. Purchases from the ISO can be passed through to customers.

This summer ConEd didn�t hedge forward or lock up most of its supply. The mild summer was kind to New York damping volatility on the spot market.

�There was quite a dilemma going into summer. We had to assess what the price would be like,� says Dunbar. �We had to think hard about leaving significant amounts (power supply) on the market.�

ConEd guessed right.

�If I had been wrong, I wouldn�t be talking to you today,� he says. �As it is retail prices still increased on average about 25% because of higher fuel and power costs.� If ConEd had bought forward, Dunbar says, retail prices for power would have gone even higher.

Excluding 'armed robbery'
GPU Inc., based in Morristown, NJ, sold all its generating units under a settlement with Pennsylvania state regulators when that market opened for competition in 1999. GPU intended to become a transmission and distribution company and expected its native load customers to switch to other electric providers.

The retail competitive market never materialized and GPU was left with 95% of its customers, even though it had no generation. As the �provider of last resort,� GPU was forced to buy electricity on the open market and sell it to customers under frozen rates.

�We have to be very smart in buying power,� says Ned Raynolds, spokesman for GPU. �We do anything to get power short of armed robbery.�

GPU is a firm believer in hedging to keep operations within a certain risk profile.

�The worst thing we could have done was not hedge and leave us exposed to the spot market,� says GPU�s Kevin Wright, director supply portfolio management. �We don�t want to be in the market and risk paying $1,000/Mw for power.�

As it turned out, Pennsylvania�s summer was mild and the prices GPU paid for power under the hedging arrangement were higher than prevailing prices.

PECO Energy Co., GPU�s utility neighbor to the north in Pennsylvania, also hedged some of its power purchases for the summer. But PECO doesn�t have to buy as much power to supply its customers. PECO kept all of its generation under a settlement with state regulators. It, too, operates under a price freeze that expires in 2005.

�We buy power only when we can�t produce it as cheaply as we can buy it,� says Bill Jones, spokesman for PECO. �We�re not forced out into the spot market very much.�

No pass through
In Missouri, utilities cannot pass through fuel and purchased power expenses to customers without a major rate case.

�The commission allows hedging. But UtiliCorp [United Inc.] just doesn�t do it because we can�t recover the costs of the hedge,� says John Browning, vice-president of regulated power marketing. The Kansas City-based utility's coal-fired generation has saved it from being too exposed to increasing natural gas prices and the spot power market.

Arizona also doesn�t allow utilities to pass through its fuel and purchased power costs, unless there is a major rate case, says Heather Murphy, spokesperson for the Arizona Corporate Commission.

In fact, purchased power costs at Citizens Utilities, a small utility serving communities near the southern border of Arizona and the Northwest corner, tripled this summer. A contract with Arizona Public Service was structured to allow the price of power to be passed through to the small utility. But higher costs cannot be passed directly through to customers.

�They will have to come up with a way to recover that and the commission will have to consider the request,� says Murphy.

�Rates are set,� says Damon Gross, spokesman for Arizona Public Service. �That�s where good planning comes into play.�

Arizona has predictable weather patterns. Hot summers are no surprise, he says. Hedging forward as well as selling excess power to power hungry California was routine for the utility.

�We came out pretty good for the summer,� he says.

In Colorado, purchased power costs are tallied and revised annually by the Colorado Public Service Commission. In one of the most novel arrangements in the US, the costs are then divided 50-50 between consumers and shareholders.