by BRIAN HODGE

A power hedging program can reduce price risk and create budget certainty. (Graph provided)

The cost of electricity can materially impact the “bottom line” and the budget process for many public funds issuers including local governments and tax-exempt 501(c)(3) organizations. The U.S. Energy Information Administration expects electricity prices to remain volatile and to continue to increase from 12.98 to 13.41 cents per kWh by 2018. Tax-exempt organizations rarely have room in their budgets to allow for price volatility commonly seen in power and other energy products.

To make matters worse, recent budget cuts proposed by many state and local governments make it more difficult than ever for municipalities to maintain balanced budgets. An unexpected price swing in the power market could force tax-exempt organizations with already strained budgets to make more cuts or risk disruption of essential services.

What can you do?

Over the past 10 years, electricity has been
one of the more volatile energy commodities.
(Source: Bloomberg Finance)

To assist in the budget process, tax-exempt organizations might consider implementing a power hedging program that creates a “price lock” on the cost of power. Power hedging involves stabilizing the price that a consumer pays for electricity over a specific time period. Financial professionals can develop a power hedging program to provide some budget certainty around the volatility in the power market.

A hedge can reduce the effect of price movements on an organization’s electricity bill, and it can provide a tax-exempt organization with more confidence in its electricity budget. While a tax-exempt organization may realize savings through the implementation of a power cost management program, there is no guarantee of savings; rather the purpose of a power cost management program is to provide budget certainty around volatility in the power market. When establishing a power hedging program, tax-exempt organizations should decide which hedging method best suits their needs.

What tools are available?

Under a producer price agreement, an organization negotiates directly with the provider to establish a fixed price for power (Graph provided)

Producer Price Agreements: Many businesses and individuals already participate in producer price agreements with their electricity providers. By entering into a producer price agreement, a tax-exempt organization negotiates directly with the power provider to establish a fixed price for a specific time period. Producer price agreements are easy to implement. However, it should be noted that the carrying costs, delivery expenses and hedging charges incurred by the provider will all be passed on to the consumer. Furthermore, producer price agreements are proprietary. Data on producer price agreements is not publicly available, and it can be difficult to determine if a fair market price was achieved.

Exchange-traded futures contracts are highly liquid and generally have short maturity dates. (Graph provided)

Exchange-Traded Futures: An exchange-traded futures contract allows buyers to lock-in the price of power, by purchasing a contract over an exchange. The price is determined by market participation (hedgers and speculators), and it reflects the spot price of power and future market projections. Since futures are traded on an exchange, they are highly liquid and generally have short maturity dates. While counter-party risk is limited by trading through a centralized clearing house, buyers and sellers of futures contracts are subject to daily variation margin which may require a tax-exempt organization to post cash to cover the daily change in the price of the futures contract.

Over-the-counter swaps can be tailored to
meet precise power consumption needs.
(Graph provided)

Over-The-Counter Swaps: An over-the-counter swap is a contractual obligation between a swap dealer and a power consumer in which each agrees to exchange a series of payments based on the movement of a particular power index over a predetermined period of time. A swap dealer is typically a large financial institution like a bank or securities dealer. A tax-exempt organization pays fixed amounts to the swap dealer and in return receives variable amounts based on the movement of a market index. Swaps can be tailored to meet precise power consumption needs, and they can be structured to extend over much longer maturities than futures or producer price agreements.

Summary

In the face of a volatile power market, a power cost management program can provide a tax-exempt organization with budget certainty. For years, it has been common practice for investors to hedge the price risk in everything from gold to the S&P 500 even though each of those is much less volatile than power. Maybe the time is right for you to use power cost management tools to protect yourself from price volatility in the power market.

Reprinted with permission from HilltopSecurities.