Sacramento utility signs weather derivatives contract

In a first, Sacramento Municipal Utility District (SMUD) has awarded UtiliCorp United Inc. unit Aquila Energy a 5-year hedge contract based on rainfall intended to limit the municipal utility's exposure to purchased power expenses.

The weather derivatives contract which becomes effective Oct. 1 is intended to help offset the potential combined adverse effects on earnings of low rainfall and wide swings in electricity prices, explained Steve Sorey, SMUD senior contract specialist in an interview.

"This will limit our risk during a dry year," Sorey said. He said the district previously purchased a temperature weather hedge through the insurance markets, but this is its first precipitation hedge and its first purchased through the energy markets.

Nearly 700 Mw or 60% of SMUD power is generated from hydroelectric facilities, making its power purchases especially sensitive to annual precipitation.

Under the so-called "collar less contract," which required no upfront payment, Aquila will pay SMUD up to $20 million in dry years, when less water flows through SMUD's hydro plants.

The lower the precipitation, the larger the payment. The payment will also increases as the prevailing market prices for electricity rise. These payments can then be used to offset power purchase costs, Sorey said.

During wet years, when SMUD produces more power, it could pay Aquila up to $20 million under a similar formula. Contract payments for both parties are capped at $50 million over the life of the contract.

Precipitation will be measured on the watershed of the upper American River, the watershed that ultimately drains into the reservoirs feeding SMUD's hydroelectric plants. Electricity prices are based upon the California Power Exchange prices in Northern California, which have been extremely volatile this summer.

``This is a hybrid product, containing elements of power and weather,'' said Jon Cassity, director of power marketing for Aquila Energy.

Cassity said many customers can manage the risks of high power prices or adverse weather, but not both. Currently, an estimated $2-3 billion worth of weather hedges are sold around the globe to companies in a wide variety of industries, Aquila said, including energy companies, agricultural firms and state and city governments that deal regularly with such things as snow removal budgets.