Electricity Generator "Losses" In NSW  

Another day, another stupid energy news story in the local media - maybe I should rename this column "Energy Media Watch".

The SMH has a breathless article about enormous "potential" losses in the local power generation sector - "$3.7b loss warning generates alarm".

If I was a cynic I'd wonder if this was just part of some byzantine PR campaign to generate bad press for the parties involved in order to help build a case for their privatisation (which both the state opposition and Premier Iemma seems to do be in favour of).

A less cynical explanation would be that the journalist and the politician breaking the story don't have any understanding about how derivatives in general and forward sales in particular work for owners of the "commodity" underlying the derivative.

THE State Government's plans to sell its power generators may have been thrown into disarray by the disclosure of potential losses of $3.7 billion due to rising wholesale power prices.

The Government, which is finalising its plans to sell the state-owned power industry, is continuing talks with the unions in the hope of holding special cabinet and caucus meetings today to discuss the privatisation.

Meanwhile, the administrative committee of the ALP will tomorrow consider calls to hold a special meeting of the party to block the sale proposal.

Asked in Parliament yesterday about the potential losses from the the power companies' hedging contracts, which lock in electricity wholesale prices as an attempted insurance against volatility, the NSW Minister for Finance, John Watkins, sidestepped the question. "I refer the member to the appropriate minister," he said.

He and the NSW Treasurer, Michael Costa, signed the annual reports of the power companies disclosing the potential losses.

The Opposition's finance spokesman, Mike Baird, said the issue was not the size of the potential losses but the risk to which the taxpayer would be exposed. "Who is authorised to make these hedging decisions? What procedures are in place to protect the taxpayer from these losses and why are [the power companies] making these long-term hedging decisions locking in positions at lower electricity prices, when all the indications are that electricity prices will be rising?" he asked. "The Iemma Government needs to assure the people of NSW it understands the risk and [it needs to] provide confidence in the way it is being managed."

The hedging contracts allow the power generators to agree to a future electricity price.

The contracts are to protect them from volatile power prices, although they can result in heavy losses if wholesale electricity prices rise, as they have over the past 12 months due to the drought.

The way forward sales (usually in the form of swaps) for an electricity generator in NSW work is pretty simple.

The companies have a number of relatively "fixed" costs like labour costs for operations and maintenance of the plant and overhead at central office that grow broadly in line with inflation, and some more variable costs - mostly for coal, the price of which can itself be hedged via forward purchase contracts with the coal mining companies. Water costs could also potentially be an issue, but I suspect that these are either fixed or (most likely) non-existant. The other primary cash outflow is dividends to the state government.

The company can ensure that its costs are covered over time by forward selling the power it generates. Electricity consumers (electricity retailers and large industrial power users like aluminium and steel smelters, or paper mills) are happy to buy these contracts, as it allows them in turn to fix a lot of their operating costs.

As long as the contract price for the forward sales is set at or above the cost of generation, the power company can be reasonably confident that it will operate profitably, and avoid the risk associated with selling power on the spot market, where the price achieved may fall below the cost of generating.

There are some pitfalls with this approach of course - if the company has forward sold more power than it can generate, then it runs the risk of having to pay spot market price for the amount of power sold above what it has actually generated.

As the spot price can rise much higher than the forward price (forward prices would traditionally be somewhere in the region of $25 - $50 per MWhr, while the spot price can rise as high as $10,000 per MWhr in times of high demand), this can result in substantial losses.

The scenarios under which this tends to occur is when a large proportion of generation capacity is not in service - usually because of some accident such as an equipment malfunction or operator error shutting down a plant, or transmission lines between the plant and the grid being damaged (due to bushfires, for example).

Generators can mitigate this risk by one of 2 methods (preferably both). First, they avoid forward selling all of their generation capacity - they set policies to limit the amount of forward sales to a safe percentage of the total available - say 70%. Second, they buy options from other generators to cover any shortfalls they may encounter between their contracted capacity and their generation capacity. As all parties tend to operate the same way, they can net out the risk by exchanging options with one another.

As long as generators follow these basic precautions, the "possibility" of enormous losses from forward sales is pretty low (two generators who had hedged one another on spot market shortfalls would need to both lose more 30% of their generation capacity at the same time).

Of course, you could successfully argue that by hedging in this way, generators are missing out on much of the upside when spot prices exceed the forward sales prices - but that is rather different to a "loss" (and you can be sure that forward sales prices rise when the generators think the spot market will be tight too).