Hedging Against Wholesale Power Market Risk: Practical Application from a Utility Perspective. John P. Carr Vice President Generation

Transcription

1 Hedging Against Wholesale Power Market Risk: Practical Application from a Utility Perspective John P. Carr Vice President Generation

2 Topics Independent System Operator (ISO)/Regional Transmission Organization (RTO) and Midcontinent Independent System Operator (MISO) Overview Hedging and Risk Management Dairyland and the Wholesale Market Comparison to Other Commodity Markets 2

3 Overview ISO/RTO - MISO 3

4 MISO Overview Created as a result of FERC Orders 888 and 889 First priority Bulk transmission system reliability Secondary role Operate wholesale market Wholesale market components: Energy locational marginal pricing (LMP) Auction revenue rights (ARR)/financial transmission rights (FTR) Ancillary services (frequency regulation, spinning reserves) Capacity Serves a critical role in the reliable and efficient operation of the bulk electric system 4

5 ISO/RTO System 5

6 Control Centers MISO Carmel, IN NASA Houston, TX Mission Control 6

7 Most Common View (of ISO/RTO Markets) Transmission Generation Auction Revenue Rights Financial Transmission Rights Congestion Capacity LMP Day Ahead Spinning Reserves Load Supplemental Reserves Real Time Virtual Supply and Demand Demand Response Transmission Losses CONFUSING! 7 Frequency Regulation Reactive Power (VARs)

8 MISO Energy Market Basics All power produced is sold through MISO Paid at the LMP All power consumed is purchased through MISO Charged at the LMP Marginal resource sets energy price for all LMP price differences due to transmission losses and/or congestion FTR holder paid or charged congestion price difference between source and sink Day Ahead and Real Time markets Majority of transactions are in the Day Ahead market Real Time market applies to any variation from the Day Ahead commitment 8

9 Overview Hedging and Risk Management 9

10 Hedging and Risk Management Hedging A risk management strategy used to limit or minimize negative impacts of price volatility Provides more future cost certainty Does not guarantee the lowest cost Typically carries a cost (risk premium) The more distant the future cost certainty.the higher the risk premium 10

11 Hedging and Price Certainty Purpose is to provide cost certainty LMP price is volatile and unpredictable especially in the long run The LMP margins earned by generators can be misleading on its own LMP price impact limited to net position (generation vs. load) 11

12 Spot vs. Forward Prices Spot price Price today for delivery and cash settlement today (or very near term) Minimal risk premium due to short term until delivery Purchasing a predefined portion of requirements in the spot market is part of a reasonable hedging program Amount depends on organization s tolerance for risk/long term goals Forward price Price today for delivery and cash settlement at some point in the future Can include a significant risk premium depending on how far forward the transaction will deliver/settle typically not a good predictor of the future spot price! A hedge typically involves taking a position in the forward market! How well can we predict future spot prices? 12

13 Spot vs. Forward Price Forward price is not a good predictor of future spot price! 13

14 How to Measure Hedge Effectiveness Tempting to compare the hedge to the spot market Genius when in the money! Shouldn t they have seen this coming? when out of the money NOTE: Result could have been identical in each case. Only difference was where spot market ended up One way to never be out of the money Buy 100% in the spot market! Acceptable risk/reward? How confident are we in predicting the future? What is the risk if we are wrong? 14

15 Hedge Effectiveness Instead of comparing hedges to the spot market Effectiveness should be assessed on: How effective has the risk management plan been in helping the business meet stated goals and objectives Competitive and relatively stable electric rates? Predictable cash flows? Satisfied customers, owners/investors/lenders, regulators? 15

16 Some Misconceptions In low LMP markets generators do not make money and this will hurt operating margins In high LMP markets generators are making money and this will help operating margins 16

17 Some Facts Generation production costs and forward fuel prices are generally more stable, certain and predictable than LMP prices Production cost certainty helps provide rate certainty Cost certainty provides benefit during high priced periods, but also limits opportunity during lower price periods By definition, increasing the opportunity to benefit from lower priced periods means accepting the risk of higher costs as well 17

18 Hedging Energy (MWh) Hedged v. Obligation MWh Forecast Demand Hedged Energy Positions 800, ,000 ACTUAL 600, , , ,000 Open Positions 200, ,000 Hedged Positions 0 18

19 Misconceptions Addressed Low/high LMP prices do not impact a utility as much as individual plant margin reports might seem to imply Margins earned by generation are largely offset by the cost to purchase load obligations Load serving entities that also operate generation: Benefit in low LMP periods limited to net purchases from market Benefit in high LMP periods limited to net sales to the market 19

20 Overview Dairyland and the MISO Market 20

21 Dairyland and the MISO Market Conservative approach Hedging objectives Stable and competitive rates Predictable cash flows Opportunistic use of the markets Avoiding speculation or over reliance DPC blessed with very skilled and knowledgeable staff in this highly specialized field 21

22 What Risks Are We Hedging? Obligation to provide wholesale power Reliability/availability and cost Capacity (ability to meet peak demand) Energy and ancillary services (actual energy use) Congestion (locational price differences) Renewable portfolio targets? ISO/RTO market design standardizes capacity and energy Consumers and state regulators may not take the same approach Not all electricity is created equally Dispatchability/intermittency Renewable attributes Significant differences in capacity costs, variable operating costs and the role different sources have in meeting consumer needs 22

23 Primary Hedge Instruments Generation Accredited capacity (MW) Availability (MW and MWh) Fuel inventory (BTU to MWh) Forward fuel commitments (MWh) Coal Natural gas Fuel transportation agreements Rail Pipeline Bilateral contracts Capacity (MW) Energy (MWh) Fuel (BTU to MWh) Financial transmission rights Congestion prices (LMP price difference) Generation (source) to load (sink) 23

24 MISO Generation Margins Misleading if looking at generation-only results Dairyland is a load serving entity We must evaluate the combined impact of the LMP on generation, load and our financial transmission rights Evaluating the LMP impacts on any one of these separately can potentially be misleading Generation resources Pre-MISO they provided physical energy to DPC members at equal to DPC s variable production costs In MISO, the generation resource serves the exact same purpose, but is now a financial hedge (vs. physical hedge pre-miso) 24

25 MISO Market Operations Summary Complex, volatile and unpredictable LMP prices Dairyland s strategy is to hedge the volatility/uncertainty Primary hedge mechanisms Generation availability and fuel inventory Fuel and transportation commitments Purchased power contracts (bilateral/non-miso) Offer generation resources at short run marginal cost (fuel) If LMP is higher than our costs, we maximize use of our generation to meet member needs If LMP is below our costs, we serve less of our needs from generation and maximize use of lower cost market purchases (through MISO) 25

26 General Rules of Thumb Low LMP prices benefit DPC when we are a net buyer High LMP prices benefit DPC when we are a net seller DPC s future load obligations are hedged via the fuel and transportation commitments in place Load obligations largely insulated from the impacts of high/low LMP prices Load obligations are hedged at equal to generator variable production costs 26

27 Benefit from Low LMP Dairyland in MISO (Off-Peak Hours) Off-Peak Power Demand & Generation Benefit from High LMP LMP (off peak) 27

28 Dairyland in MISO (On-Peak Hours) Gen / Load (on peak) Benefit from High LMP Benefit from Low LMP LMP (on peak) 28

29 Hedge Example High vs. Low Prices Generation Load DPC s Cost Sell 1 MW Buy 1 MW Supply 1 MW Generator Cost $28/MWh LMP Revenue $50/MWh LMP Charge $50/MWh Net: $22/MWh ($28/MWh) Generation Load DPC s Cost Sell 1 MW Buy 1 MW Supply 1 MW Generator Cost $28/MWh LMP Revenue $26/MWh LMP Charge $26/MWh Net: ($2/MWh) ($28/MWh) 29

30 Examples: Assume a 300 MW generator $30/MWh variable production costs LMP prices $20/MWh Margin = ($10/MWh) $100/MWh Margin = $70/MWh Terrible!!! GREAT!!! Much better results in the high priced market---right? WRONG! (If generator is owned by a load serving entity) 30

31 Generation and Load Very High LMP (Big Generator Margins!!) Production Cost = 300 MW = ($9,000) Generator Revenue = 300 MW = $30,000 Load Purchase = 300 MW = ($30,000) TOTAL Power Supply Costs = $9,000 Very Low LMP (Negative Generator Margins!!) Production Cost = 300 MW = ($9,000) Generator Revenue = 300 MW = $6,000 Load Purchase = 300 MW = ($6,000) TOTAL Power Supply Costs = $9,000 SAME RESULTS!!! 31

32 Overview ISO/RTO Compared to Other Commodity Markets 32

33 The U.S. Wheat Market Analogy The U.S. is a major producer/consumer of wheat A robust market allows market participants to: Buy/sell and deliver wheat (physical trade) Hedge risk (financial trade) Speculate on price of wheat (risk transfer) Spot and futures markets Financial markets also allow for physical delivery Spot and forward markets eventually converge 33

34 Not All Wheat is Created Equally! Hard Red Winter Wheat Great Plains Region Breads, buns, rolls Soft Red Winter Wheat Eastern US Cakes and pastries Dark Northern Spring Wheat Northern Great Plains Breads, hard rolls, flour blends Durum Wheat Northern Great Plains Semolina flour and pasta Soft White Wheat Interior Pacific Northwest Noodles and pancake flour It is all wheat..but with very different uses and value to consumers 34

35 U.S. Wheat Futures Markets (Closing Prices as of April 27, 2018) Soft Red Winter - July 2019 Chicago Mercantile Exchange Hard Red Winter - July 2019 Kansas City Board of Trade Dark Northern Spring - July 2019 Minneapolis Grain Exchange $5.66/Bu $5.91/Bu $6.46/Bu It is all wheat but the market differentiates the value of each 35

36 ISO/RTO vs. Wheat Market Question: Why doesn t the ISO/RTO market provide for a futures market that allows market participants to differentiate the value of various kinds of capacity and energy? Baseload Dispatchable Intermittent Renewable Answer (?): The ISO/RTO also has responsibility to schedule and control actual transportation of the energy in real time and it is done through a spot only market If the U.S. wheat market performed like an ISO/RTO, they would schedule and monitor real time flow of wheat on the rail, waterway and highway systems and calculate LMP prices for wheat at each delivery or consumption point on the system; they would not provide for forward price discovery of wheat, and instead let the market use other means to determine the future cost or value Wheat can be stored electric power generally can not! 36

37 ISO/RTO Markets The need to instantaneously balance supply and demand creates unique challenges Results in an imperfect market Very short term (spot market) Does not differentiate the value of different energy resources Intermittent vs. dispatchable? Renewable vs. non-renewable? Marginal resource sets price for all ISO/RTO valuation may be not same as consumers Lack of a forward market 37

38 Last Note If cost and rate certainty/stability are organizational objectives, this means tolerating hedges that might be both in, or out, of the money It is tempting to question the value of a hedging program when hedges fall out of the money The risk of abandoning a hedging program is typically the highest at the same point in time when the need for hedging appears to be the lowest. Anonymous former colleague Attempting to precisely predict the future is speculation! 38

39 Questions? 39