Regarding the Practice of Financial Hedging among Distribution Utilities in the Philippines
Amicus Brief
Prepared for industry review by Green Tiger Markets
Authors
Carlos Korten
John Knorring
Oliver Pearson
Abstract
Financial Hedging, such as Contracts For Difference (CFD), is an established business practice in the Philippines electricity industry among generators and retail electricity suppliers (RESs). CFDs improve the efficiency of the electricity market by allowing participants to adjust hedging ratios that reflect their expectations of future supply and demand conditions.
However, the nation’s Distribution Utilities (DUs) have not embraced CFDs as a price risk management tool to date. Following discussions with industry leaders, we understand that DUs have refrained from this practice due to ambiguity in the interpretation of regulatory guidelines as stipulated by the Energy Regulatory Commission (ERC).
The principal concern is whether occasional losses incurred by the DUs in CFD transactions would be included within the scope of the “principle of full recovery of prudent and reasonable economic costs” that may form part of the retail rate, as described in Section 25 of the Electric Power Industry Reform Act (EPIRA).
In this brief, we propose that the ERC should…
advance the use of financial hedging as a business practice among DUs;
provide specific guidance and clarity regarding the application of existing regulation to the practice of financial hedging;
stipulate suitable operating parameters for this practice, and specify the context in which DUs may responsibly participate in financial hedging
…in order to stabilize retail electricity prices and realize lower long-term retail electricity prices for the public interest.
We draw on lessons from other free markets to motivate a regulatory framework for reasonable and responsible financial hedging by regulated DUs.
Prudent and Reasonable Business Practice
During the first half of 2021, at the height of the COVID pandemic, the spot price of Luzon electricity as reported by WESM moved between 2,000 and 18,000 Php per MWh over a six month period. A 900% variance in price over such a short period of time is destructive to the shared interest of the country and the electricity industry as a whole.
Commercial participants in the electricity industry continue to carry significant risk to their business operations from fluctuations in the price of overseas coal, natural gas, and foreign exchange rates, such as the shocks that impacted the Philippines economy in 2022 following the outbreak of war in the Ukraine.
For the purpose of domestic policy and commercial planning, exogenous shocks are practical realities that need to be handled. Responsible power generators, which are natural sellers, fear a massive collapse in energy demand, such as experienced during the pandemic lockdown. Responsible distribution utilities, which are natural buyers, fear supply-side disruption which may cause massive spikes in cost, such as the loss of access to Indonesian coal in 2022, or an interruption of contracted service.
It is prudent and reasonable for all electricity market participants to mitigate these risks by entering into hedging contracts.
Financial forward hedging is a proven mechanism for informed commercial interests with different financial-risk exposure to mitigate their respective risks, negotiate a middle path, and set a strike price which satisfies the economics of both parties, to smooth the impact of any shocks that may occur in the future.
These agreements are the shock absorbers that allow resilient economies to function even in times of crisis. These agreements smooth final retail prices because parties throughout the supply chain can agree ahead of time on price for a fixed term, insulating the full system from the idiosyncrasies of the spot market and substantially reducing long term uncertainty.
Market Driven Efficiency
The opportunity for DUs to enter into financially settled CFDs on an open marketplace will promote efficiency and resiliency in the Philippines electricity market through a number of factors, including:
Rapid and Competitive Price Discovery: By participating in a forwards market where all transacted prices are published, all DUs benefit from market information that would otherwise be unavailable to them. Information transparency via a multi-party marketplace provides context for rapid and competitive price discovery, characterized by a more rigorous, timely and like-for-like negotiation than is possible through peer-to-peer physical contracting.
Operationally Efficient Contracting: A standards-based, competitive marketplace reduces the operational costs associated with search, negotiation and execution of well priced contracts. The ease and convenience of this approach is an order of magnitude faster than the time required to enter into a PSA.
Risk Management: Forward markets allow participants to hedge against price fluctuations in the electricity market by exchanging financial risk with another party that carries the opposite risk. The result is improved operating efficiency for both parties and improved energy security for the nation.
Market Liquidity: Standardized contracts improve market liquidity by expanding the universe of eligible counterparties and encouraging more qualified participants to engage in price discovery: the larger the community of active participants (including institutions which could not participate in a PSA) the more productive and competitive the facility of market pricing.
Solving Price Volatility: Allowing a DU to efficiently secure a forward contract to fix a competitive and fair price at which it will buy its electricity, and mechanisms to easily unwind and recalibrate those contracts as market conditions change, allows them to insulate their customers from the impact of dramatic short term price fluctuations.
True Cost of Risk: Forward price signals create mechanisms for existing and new market participants to evaluate the true cost of managing risk. The margins applied to retail electricity to account for commercial risk can be compressed by allowing participants to hedge efficiently. This cost saving can be passed on to consumers, resulting in lower long-term retail prices.
Stimulating Investment: By insulating all market participants from extreme price volatility, and thereby lowering the real cost of financial risk, organized forward markets unlock new sources of capital investment. Energy markets around the world with well constructed forward markets have realized increases in capital investment that would not have been viable otherwise.
The most efficient markets in the world – Rates, FX and Credit – have all made a substantial move towards standardization and information transparency as a concerted international effort in response to the Global Financial Crisis (GFC) of 2007 - 2009. A financially settled forwards market using standardized terms enables the entire Philippines electricity industry to benefit from the lessons learned by global regulators following the GFC.
Risk Management Guidelines
We urge the ERC to adopt guidelines under which a DU may enter into contracts to hedge their financial exposure and protect their end consumers from price volatility. We suggest that such guidelines include reasonable stipulations and controls to protect the public interest, such as:
Competitive Market Pricing: the DU should enter into a competitive bidding process for financial hedging with transparency for all market participants, to mitigate any price information asymmetry. A multi-party platform with open access by qualified commercial participants, in which bids and offers may be communicated simultaneously to the whole market, should be understood to satisfy those competitive requirements.
Counterparty Agnostic: the DU should be operationally prepared to enter into a hedging contract with any qualified and suitably capitalized counterparty to promote the best possible pricing, including counterparties which may not bid for PSA.
Risk Management Policy Framework: the DU should adopt a written statement of their risk management operating framework to govern the methods and process of managing their forward price risk. This framework should be provided in advance to the ERC.
Internal Risk Committee: ERC may consider requiring that DU’s establish an internal risk committee, to include representatives from the DU’s business personnel, internal market risk, credit, legal and compliance departments (or analogous departments within each DU), tasked with setting limits to manage risk in a dynamic manner, responsive to shifts and changes to market conditions. We have observed regulators in other jurisdictions prescribing similar requirements.
Risk Monitoring: ERC may wish to stipulate a regular retrospective review of such risk committees’ decision-making practices. By way of example, regulators in other jurisdictions have opted for such a review on an annual basis.
Authority to Enter into Agreement: the DU should assign privileges to named individuals, who are authorized to enter into financial hedging agreements in real time on behalf of the DU, in accordance with their risk management policy framework.
The ERC may contemplate further controls to satisfy their obligation to protect the public interest. We recommend adopting policies that deliver oversight and accountability without inhibiting the DUs ability to take regular and timely market action, as needed, to promote market stability.
Cost Recovery
On balance and over time, well constructed financial hedges are expected to realize offsetting losses and gains, resulting in a moderate and smooth long term price trajectory. A well-hedged DU will trade-off occasional windfall financial gains to protect against occasional catastrophic losses. The expected benefit to the end consumer and the nation is better assurance and certainty in long term retail pricing.
To realize this form of market-driven price stability, for any DU which has satisfied the risk management guidelines, we urge the ERC to endorse the practice of financial hedging.
EPIRA provides guidance regarding the management of flow-through costs which may be passed on to end consumers (emphasis added):
“SEC 25 - Retail Rate. The retail rates charged by distribution utilities for the supply of electricity in their captive market shall be subject to regulation by the ERC based on the principle of full recovery of prudent and reasonable economic costs incurred, or such other principles that will promote efficiency as may be determined by the ERC.”
To advance the practice of financial hedging among DUs, we urge the ERC to expressly characterize occasional financial losses incurred by the DU through the performance of well executed financial hedges as “prudent and reasonable economic costs,” capable of being recovered in full via the retail rate pursuant to Section 25 of EPIRA.
We believe the ERC can reasonably expect this characterization to advance many points of urgent public interest: reduced retail price volatility, improved market efficiency and resiliency, and lower long-term prices.
