Confronting the Risks - The New Utility Organization

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Deregulation and other worldwide risks such as terrorism, have exposed utility and energy companies to new risks including security risks, commodity price risks, throughput volume risks, and market risks.  Deregulation has also created diverse business models as companies decide what business they are best suited for.  Some companies are concentrating on building generating capacity where others are becoming transmission and distribution organizations.  Each type of business model creates a different set of risks.  

The common thread of all utility companies is that they are pursuing enterprise risk strategies in a deregulated business environment.  In this environment, it is absolutely essential to quantify the risks undertaken.  In the case of one client, the company has identified over 60 different risks that could affect earnings and shareholder equity including various forms of security, hazard, financial, political, regulatory, and technology risks.  By managing and integrating disparate risks into one portfolio, the overall cost of risk is reduced.  

The utility industry will evolve toward a more risk portfolio approach in the future.  The companies will utilize a variety of tools including capital market financial instruments and insurance.  The objective will be to analyze the current and future risk-return ratio to maximize earnings and shareholder value in the company. The need for more sophisticated risk management software tracking tools will increase as companies try to analyze and communicate their strategies to sophisticated investors and consumers.

Utility Industry Background

To succeed in the deregulated global economy with significant treats such as terrorism, utility companies have recognized that they need to be more security conscious, consumer-responsive, and service-oriented. This strategy demands an evolution in their business system environment. Specifically, existing lines-of-business transaction systems have to be transformed into integrated, enterprise wide, information-oriented systems. In turn, these retooled systems can help companies achieve a variety of key business goals including:

·          Increased security.

·          Maximizing profitability.

·          Creating a client-focused orientation.

·          Integration across business lines to achieve economies of scale and maximize customer service capabilities.

·          Lower technology development and maintenance costs.

·          Greater flexibility for easy entry into new business lines to address emerging growth opportunities.

The utility industry is adopting new risk management strategies on an enterprise wide basis.  For example, energy companies have adopted many new forms of risk mitigation and transfer including biometric imaging, double trigger insurance policies, weather hedges, etc.

Biometric and Other Technology Applications  

Organizations are integrating biometrics and other technologies into applications related to security risk management.  Biometrics is defined as measurable physiological and/or behavioral characteristics that can be utilized to verify the identity of an individual. They include fingerprints, retinal and iris scanning, hand geometry, voice patterns, facial recognition and other techniques. They are of interest in any area where it is important to verify the true identity of an individual, such as highly secure areas in nuclear energy generation or energy distribution. Initially, these techniques were employed primarily in specialist high security applications, however we are now seeing their use, and proposed use, in a much broader range of situations including management of security in the utility and energy industries.  In the future, it is anticipated that they will become an integral part of any risk management application related to security.  

Hedges  

Regulators in a growing number of states are allowing and encouraging utilities to use financial hedging instruments to protect against the kind of price increases that have sent heating bills skyrocketing.  Most state regulators had previously rejected hedging as too risky.  However, many states are now allowing the techniques because they believe it will lead to more stable prices.  Financial hedges are complex investment instruments that utilities can use to manage wide swings in gas prices.  Utilities can purchase a wide variety of instruments to cover a range of price scenarios.  The tools can have the effect of locking in a rate or softening a drastic price movement in either direction.  Utilities are managing their risk by transferring some of the price volatility to the investors who buy and sell hedging instruments. 

Weather “collars”  

This tool is essentially a purchase of insurance where the upside benefit in revenue generated by a very cold winter is swapped with the downside risk caused by a warmer than expected winter.  Utilities are increasingly using these forms of risk management to smooth the peaks and valleys of price variations.  

“Double trigger” insurance policies  

Two events of coverage occur for the insurance to become effective. Examples are:  

1.       An energy conglomerate used this coverage when a windstorm above a certain miles per hour occurred within a certain radius of the company’s gas platform and the price of natural gas exceeded a specified amount. 

2.       Another corporation used the coverage when there was an unscheduled outage at a nuclear power plant causing it to shut down and there was an increase in the price of spot energy rates above a certain amount.

3.       Yet another company used the coverage when there was a power outage resulting in more than 600 MWh of lost power and the spot market price of power exceeded $74 per MWh occurring in tandem.  

Weather “puts”  

Weather “puts” are contracts that protect the purchaser from some risk event.  An example may be a retail distributor purchasing a weather “put” from an energy supplier that protects them from the impact of a warmer than usual winter. 

Theft of Electric Service 

As power shortages and rate increases spread across the United States, utilities are escalating their efforts to find and prosecute electric power thieves.  Power theft amounts to approximately $6 Billion per year in the United States according to the Edison Institute’s 2000 estimates.  Since deregulation of the utility industry, energy companies have started to focus on eliminating this cost of business.  

Until recently, utility companies in the United States had minimal incentive to pursue power thefts. Electricity was cheap and companies routinely obtained pay hikes to cover their costs, burying theft in catch all categories like “line losses” or non-technical losses. With soaring energy generation costs, regulators and consumer watchdogs are expected to take a harder look at these expenses.  However, many public utilities can’t pass the cost along to their customers due to rate caps.  The cost therefore comes out of their bottom line.  

Most large utility companies have departments that are dedicated to investigating and prosecuting theft of electric service.  For example, Rochester Gas and Electric Company (a unit of Energy East) employed one of our solutions in 1998.  It is estimated that the company recovers over several millions of dollars per year in total risk costs including theft of electric service. 

Theft of power is a serious issue across the world. In the UK, the losses due to theft are estimated at ₤350 million every year.  In Australia, the losses are estimated to be $120 million every year.  In India these losses are estimated to be $4 billion where power companies believe that 20% of all power produced is stolen.  Organizations with international operations require sophisticated tools that include currency conversion and other valuable tools in analyzing and managing risk on a global basis.

Pipeline Damage Cost Reclamation 

Oil, Gas, and Hazardous Liquid production and distribution companies have serious problems with maintaining the integrity of their pipelines.  With modifications to their lines occurring every day, their lines are under continuous risk of being compromised or damaged.  If the lines are damaged in some way, the more sophisticated companies have engineered methods to recover the lost gas product and other associated costs of the damage.  Many of the accidents go unreported and recovering costs of these obscure pipeline accidents is difficult as these insurance claims are strongly refuted by insurance companies and the probability of recovering these costs is low.  National Fuel Gas Company employed one of solutions for this type of risk and save millions of dollars annually of lost product and business interruption costs.  

According to a recent Office of Pipeline Safety report, property damage to the 200,000-mile gas pipeline network in the United States is over $25 million per year.  It is generally believed that the losses were significantly more than reported based upon discussions with several key industry executives.

Utilities and Risk Management  

The utility industry is undergoing a radical transformation from a series of regional monopolies to a diverse service industry driven by competition.  The end of regulated franchises exposes these utility firms to a complex set of risks.  Historically, these firms have not adopted optimal risk management practices.  Any losses or gains arising out of the firm’s operational or financial risks were passed on to the consumers.

Summary  

Sophisticated risk management tools allow companies to capture the information necessary to measure and manage these business and operational risks.  The rewards to the investors and ratepayers are potentially significant. Not only will the organizations outperform their competitors in the industry, providing above average returns to their investors, the utility and energy company customers will be served with a safe, reliable source of energy to meet the demands of a complex world. 

   

Blackburn Group, Inc.
Penfield, NY 14526-0052
(585) 586-4530,  (585) 586-7479 fax,  Email: sales@blackburngroup.com
  

RiskPro is a registered trademark of Blackburn Group, Inc.

Copyright 2006 Blackburn Group, Inc. All rights reserved.