0. Hedging and Price Risk Management: A California Perspective
Todd Strauss
Senior Director, Energy Policy, Planning, and Analysis Pacific Gas and Electric Company
NARUC – Staff Subcommittee on Accounting and Finance Spring 2008 Meeting 1 April 2008

1. Contents Introduction to energy procurement at PG&E
How PG&E’s hedging programs work
Learning and insights from PG&E experience in hedging

2. Pacific Gas and Electric
Combined gas and electric utility in northern and central California
Gas
4 million customer accounts
$4 billion annual revenue
850 bcf (30% bundled)
Electric
5 million customer accounts
$9 billion annual revenue
86,000 GWh (92% bundled)
20,000 MW peak load

3. PG&E Energy Procurement
Costs heavily tied to gas commodity prices
Electric: 45% of energy tied to natural gas commodity prices
Combined utility; separate portfolios
Wholesale portfolios for bundled electric customers and core gas customers are managed separately
Decoupling
Balancing account treatment provides no incentive for utility to earn more dollars by selling more energy

4. PG&E Energy Procurement: Objectives
Reliability
Meet obligation to serve
Environment
Customer cost
Reasonable level
Stable
Cost recovery
Cost allocation
Shareholder earnings (core gas incentive mechanism)

5. PG&E Energy Procurement: Regulatory Regimes
Bundled electric portfolio
Procurement plan review and approval
Procurement plan includes products, processes, strategies
Includes hedging plans
Compliance review of activities
Were utility’s actions consistent with plan?
Procurement Review Group (PRG)
Consumer advocates, California PUC staff, and other non-market participants representing stakeholder interests in electric procurement
Advisory role to PG&E
Core gas portfolio
Incentive mechanism
Based on basket of monthly indices
Short-term oriented

6. Contents Introduction to energy procurement at PG&E
How PG&E’s hedging programs work
Policies and principles
Bundled electric portfolio
Core gas portfolio
Learning and insights from PG&E experience in hedging

7. A. Bundled Electric Portfolio: PUC’s Risk Policy
Risk policy established by California PUC in 2003
Cost variability measure
To-expiration Value-at-Risk (TeVaR)
Customer Risk Tolerance (CRT)
1 cent per kWh
Risk management policy
Compare TeVaR with CRT
If TeVaR >  CRT, then meet and confer with Procurement Review Group

8. Portfolio Cost Variability
Bundled electric portfolio consists of
Load obligations
Resources (supply-side and demand-side)
Sources of portfolio cost variability
Resource cost (natural gas price)
Resource quantity (forced outages, hydro generation)
Load uncertainty: heat rate of marginal resource in supply stack
Probability distribution of portfolio cost
Each source of variability can be described probabilistically
Result is probability distribution of portfolio cost

9. 1. Cost Variability Measure
TeVaR is a measure of the width of the probability distribution of portfolio cost
Cost distribution (and therefore TeVaR) is modeled, not observed
Inputs include market data (forward curves, volatilities, and correlations) and portfolio resources/instruments
See next slide for comparison between TeVaR and Value-at-Risk (VaR)

10. SIDEBAR Risk Measurement: VaR and TeVaR
Value-at-Risk (VaR)
Answers the question of how large the deviation could be between portfolio value in the future and portfolio value today
This deviation is in the context of a particular time horizon (1 to 5 days in the future) and confidence interval (e.g., 95th percentile)
Time horizon is typically short: 1 to 5 days
To-Expiration Value-at-Risk (TeVaR) is VaR with liquidation horizon carried to delivery
Load obligation cannot be unwound like instruments in a trading book

11. Reducing Cost Variability
Activities that narrow the cost distribution:
Adding fixed-price resources to the portfolio
Hedging
If it doesn’t narrow the cost distribution, it isn’t hedging, it’s speculation!

12. Hedging Strategy Changes Cost Distribution
Candidate strategies differ by amounts and product mix
Cost distribution is narrowed by
Greater hedging quantities
More swaps/forwards/futures and fewer options

13. Hedging and Cost Distributions: A Numerical Look
Some analysts like tables of numbers, others like graphs
Table has additional information (lines 18-27)

14. Hedging Strategies and Cost Distributions
The question Which hedging strategy is best?
is transformed into the question
Which cost distribution do bundled electric customers prefer?
Extensively discussed with PRG
strategies differ by
amounts and product mix

15. 2. Customer Risk Tolerance
How much of an increase in cost can customers tolerate?
is operationalized as the question
How wide should the probability distribution of portfolio cost be?

16. Customer Risk Tolerance (CRT)
How wide should the probability distribution of portfolio cost be?
This is a risk preference
This is a policy issue
Current policy set by California PUC is 1 cent per kWh
For PG&E bundled electric portfolio, this corresponds to incremental portfolio cost of about $800 million
Customer survey was/is intended to inform policymaking

17. 3. California PUC’s Risk Management Policy
Compare TeVaR with CRT
In words: compare estimated width of probability distribution of portfolio cost with the stated 1 cent per kWh target for the width
If TeVaR >  CRT, then meet and confer with Procurement Review Group
Stakeholder discussion of the situation is required
No particular portfolio action is required
1.25  CRT is referred to as the “notification level”
This is very different from a trading limit

18. B. Core Gas Portfolio
Regulatory regime is short-term incentive mechanism
Based on basket of monthly indices
Misalignment of interests: hedging for customers looks like speculating from shareholder perspective
Longer-term hedges deviate from monthly spot price index
Hedging narrows probability distribution of customer cost
Hedging increases probability distribution of shareholder gain/loss
Disconnect identified: significant hedging for bundled electric customers, and no hedging for core gas customers
Bundled electric customers and core gas customers are largely the same residential households and small commercial customers, with the same risk preferences for gas service costs as for electric service costs

19. Core Gas Portfolio: History of Hedging
In 2005 PG&E initiated PUC filing regarding hedging for core gas customers
PG&E requested that all benefits and costs related to hedging go to customers, and be outside of incentive mechanism
Hedging has been performed for past 3 winter seasons, with hedges outside of incentive mechanism
Advisory group process analogous to bundled electric PRG has been established
Customer risk tolerance survey is underway
PUC about to begin a broad proceeding looking at hedging in context of existing incentive mechanism structure

20. Contents Introduction to energy procurement at PG&E
How PG&E’s hedging programs work
Learning and insights from PG&E experience in hedging
Hedging vs. speculating
Hedging: costs vs. cash flows
Risk vs. regret

21. Hedging vs. Speculating: Behaviors
Market view
Hedging takes the market as is: the market (i.e., what is currently transactable) is not right or wrong, it just plain exists
Speculating takes a view on where the market is headed and acts on that view
Market timing
Hedging executes transactions relatively evenly over time, to diversify timing risk, perhaps using dollar cost averaging
Speculating uses event-driven trading to time the market, perhaps trading in and out of positions

22. Hedging vs. Speculating: Objectives
Hedging objectives
Manage TeVaR
Protect against price blowout scenarios
Flatten positions that arise from physical assets and obligation to serve
Speculating objective
Earn an outsized return on risk capital

23. Hedging: Costs vs. Cash Flows
Q: What is the cost of hedging?
A: Transaction costs.
Broker fees
Financing margin and collateral
Bid-ask spreads
A: Option premiums are cash outflows, not costs.
Hedging has little impact on expected portfolio cost.

24. Cash Flows vs. Net Costs: Forwards
Q: At the time a forward (swap/forward/future) contract is executed, how much money trades hands?
A: Zero.
Q: At settlement, does money trade hands?
A: Yes.
Q: At time of execution, how much money is expected to trade hands at settlement?
Q: Therefore, at execution, expected net cost of forward is zero?
Q: But what about cost at settlement?
A: See “regret.”

25. Cash Flows vs. Costs: Options
Q: At the time an option contract is executed, how much money trades hands?
A: Buyer of option pays seller of option the option “premium.”
Q: At settlement (option expiry), does money trade hands?
A: If option is in the money, seller of option pays buyer of option the difference between market price and option strike price.
Q: At time of execution, how much money is expected to trade hands at settlement?
A: The option premium plus the interest associated with the time value of money.
Q: Therefore, at execution, expected net cost of option is zero?
A: Yes.
Q: But what about cost at settlement?
A: See “regret.”

26. Risk vs. Regret
Risk is “potential negative impact that may arise from a future event”
Regret is “distress of mind for what has been done or failed to be done”
Hedging example: quantity hedged is always wrong in hindsight—too little or too much
Hedging example: buying options
Most of the time, these options won’t pay back the option premium, and will regret buying them
When these options do pay out, will regret not having swaps instead
Hedging example: whether to hedge or not to hedge
Hedging seems to have more regret than not hedging
Risk is prospective, regret is retrospective

27. Conclusion: Overcoming Regret
Ask yourself: Is the hedging strategy designed to reduce risk or to avoid regret?
Focus on the total portfolio—physical and financial—not just the hedge book
Focus on the exposure ($) of a potential event separately from the probability of that event occurring
Establish risk benchmarks and measure the portfolio against those benchmarks
Include as a hedging objective: Manage option premium expenses