Ex Ante or Ex Post? Risk, Hedging and Prudence in the Restructured Power Business

Sat Apr 01 15:24:38 EST 2006
By Dr. Jeff D. Makholm and Eugene Meehan with Professor Julia Sullivan of Georgetown University

The unstable behavior of natural gas prices over the last few years has caused great anxiety for consumers, utilities, and their regulators. Aggravating the effect of high gas prices is the fact that the electric utility industry has become increasingly dependent upon gas-fired generation, which has become the marginal source of power in most regions of the country. Gas-fired generation also has increasingly served baseload demand for electricity, affecting both peak and off-peak electricity prices. Thus, higher gas prices mean not only higher gas bills, but also higher electricity bills.

Under traditional regulatory pricing procedures, the price of retail gas and power corresponds to the utility's cost of service, which means that prudently incurred fuel and purchased power costs are recovered from retail customers. Depending upon a state's interpretation and application of the prudence standard, regulators can and sometimes do deprive utilities of full recovery of their actual costs on the ground that those costs were not reasonable and reflective of prudent management. However, the standard for imposing such a disallowance is high and expenditures that meet the reasonableness standard in good faith should rarely be disallowed.

In the context of prudence reviews, hedging activities have presented a major challenge for state commissions, which have had to address difficult questions involving (1) whether retail customers want price stability, (2) the kind and degree of hedging that should be executed in order to provide the price stability that consumers want, and (3) how much consumers are willing to pay for the price stability that hedging instruments can provide. In this article from The Electricity Journal, NERA Senior Vice Presidents Dr. Jeff D. Makholm and Gene Meehan and Professor Julia Sullivan of Georgetown University suggest a critical need for regulators to establish clear ex ante guidelines for utility hedging in deregulated energy markets. The authors also provide guidance to utilities that, in the absence of clear ex ante guidance, must navigate the treacherous waters ahead.