Primer on Electricity Futures and Other Derivatives

Increased competition in bulk power and retail electricity markets is likely to lower electricity prices, but will also result in greater price volatility as the industry moves away from administratively determined, cost-based rates and encourages market-driven prices. Price volatility introduces new risks for generators, consumers, and marketers. Electricity futures and other derivatives can help each of these market participants manage, or hedge, price risks in a competitive electricity market. Futures contracts are legally binding and negotiable contracts that call for the future delivery of a commodity. In most cases, physical delivery does not take place, and the futures contract is closed by buying or selling a futures contract on or near the delivery date. Other electric rate derivatives include options, price swaps, basis swaps, and forward contracts. This report is intended as a primer for public utility commissioners and their staff on futures and other financial instruments used to manage price risks. The report also explores some of the difficult choices facing regulators as they attempt to develop policies in this area. Key findings include:

1. Hedging decisions are often made using sophisticated, proprietary computer models, and new hedging strategies and instruments are developed frequently. It is doubtful that state PUCs will have the time and expertise to reconstruct and dissect hedging decisions made by distribution utilities and others. As such, a performance target approach appears to be a much better policy than a reasonableness review.
2. PUCs should guard against speculation on the part of distribution utilities, even though it can be difficult to establish simple rules that can prevent speculative transactions. One possibility, however, is for regulators to require utilities to identify the obligations being hedged and report both the correlation between the obligation and the future contract, and the size of the hedge as a percentage of the purchased commodity being hedged.
3. Some PUCs have established program limitations and other protective measures for hedging instruments used by utilities and telecommunications companies to manage interest and exchange rate fluctuations. These measures, which may provide a guide to regulating utility involvement in electricity derivatives, have included: 1) requirements that utilities only enter into hedging agreement with entities with a credit rating equal to or better than the utility itself; 2) limitations on the amounts that can be hedged; 3) reporting requirements, including both income effects and expenses and the filing of agreement terms and contracts.