Background

Risk management has always been at the forefront of those within the energy industry
and indeed those within government and other regulatory bodies setting energy
policy. From OPEC to nationalized generation and distribution companies, the risks
associated with movements in energy prices have been keenly debated by both
politicians and industry observers. As such, assessing the risks associated with the
energy markets is not a new phenomenon. However, the recent global trend to shift
the risk management of the gas and power markets from regulated to open markets
is radically changing the approach and tools necessary to operate in these markets.
Energy price hedging in oil can be traced back to the introduction of the first
heating oil contracts on NYMEX in 1978 and the development of oil derivative
products in the mid-1980s, in particular with the introduction of the ‘Wall Street
Refiners’ including the likes of J. Aron and Morgan Stanley who developed derivative
products such as ‘crack’ spreads which reflected the underlying economics of refineries.
While the traditional risk management techniques of oil companies changed
radically in the 1970s and 1980s the traditional model for managing gas and power
risk remained one of pass through to a captive customer group well into the 1990s.
In gas and electricity, regionalized regulated utility monopolies have traditionally
bought long-term contracts from producers and passed the costs onto their retail
base. The focus was on what the correct costs to pass through were and what
‘regulatory pact’ should be struck between regulators and the utilities. Starting with
a politically driven trend away from government ownership in the 1980s and early
1990s, this traditional model is now changing rapidly in the USA, Europe, Australia,
Japan and many other parts of the world.
Apart from the underlying shift in economic philosophy, the primary driver behind
the change in approach has been the dramatic price uncertainty in the energy
markets. Large price movements in the only unregulated major energy market, oil,
left utilities with increasing uncertainty in their planning and thus an increasing
financial cost of making incorrect decisions. For instance, the worldwide move by
utilities towards nuclear power investments as a means to diversify away from the
high oil prices in the 1970s led to significant ‘above market’ or stranded costs for
many utilities.