Price volatility in the California power market promptedSouthern California Edison to take the very unusual hedgingapproach of buying over-the-counter options on 740 Bcf of naturalgas earlier this month. Although the huge deal is not likely to bereplicated, Edison officials say the concept is spreading withcompetition in the retail power market.

California regulators had earlier given Edison permission totake this risk management route. Edison, like other Californiautilities, is barred from using the power futures market because bylaw it has to buy all of its power from the Power Exchange for thenext four years. If for some reason Edison could not get out of aNymex futures position, it may have to take delivery to theCalifornia-Oregon Border or Palo Verde. But Edison’s John Butler,manager of capital markets, said the utility probably wouldn’t useNymex anyway because volume is still too low on its western powerfutures contracts.

The terms and conditions of Edison’s gas options deal, which wasput together by Houston-based Coral Financial Products andServices, were filed earlier this month with the California PublicUtilities Commission. They are being kept confidential forcompetitive reasons.

Butler would not say how long the options are good for, althoughhe did indicate it was for a multi-year period.

“We’re required to buy all of our power out of the state PX, andthe problem is that price is subject to market fluctuations, so theintent of this program is to try to put a cap on the highest pricewe would have to pay for electricity,” Butler said. “It is not aperfect cap because these are natural gas options and not optionson electricity itself. But for a portion of our electric load weare protected.

“These options are exercised in cash, so if it turns out gasprices are high, which would be likely to drive up electricityprices, then rather than receive gas for exercising the options, wereceive cash. That helps to offset the cost of having to buy higherpriced power out of the PX. It’s an insurance policy basically.”

Butler indicated that this type of hedge by an electric utilityis still somewhat new. Longer term, he said it is “entirelypossible” for use of gas options to spread to other states aselectricity markets open up and regulation changes. In places wherethere’s an abundance of gas-fired generation, the gas market canoffer a great deal of flexibility to power purchasers, he noted.

The options are not based on any particular supply area; theyare linked to a published natural gas price index. The Edison dealinvolves what Coral calls an “innovative type of natural gasoption,” specifically to mitigate against price spikes in the PX.

“…Edison faced a completely new type of risk with apotentially high, yet difficult-to-predict, exposure,” said LeeBarba, Coral Financial’s CEO. “Numerous factors could drive theprice of wholesale electricity, and the complexity of thestructuring came in analyzing and modeling the potential risk.

“We then used our market knowledge to develop a viable hedgeportfolio and execution strategy which successfully assembled therequired quantity of instruments in an efficient and orderlyprogram.”

Barba noted that similar risks will arise in other states suchas New York and Pennsylvania, but different risk managementapproaches will have to be employed in each situation.

“There will not be a cookie cutter solution…for other utilitycompanies,” he said.

Coral Financial Products and Services is a unit of NorthAmerican energy marketer, Coral Energy LP, also based in Houston.

Richard Nemec, Los Angeles

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