For Utilities, Derivatives Is Not a Dirty Word

The electricity industry applauds the current efforts by Congress to reform the nation’s financial markets. But we don’t believe these reforms should include new regulations aimed at some already-transparent and financially sound transactions conducted on a regular basis by electric companies—namely over-the-counter (OTC) derivatives.

OTC derivatives are financial products that electric utilities and a variety of other U.S. businesses use to manage various financial risks and protect their customers from price volatility. These products enable utilities to insulate their businesses and their customers from the volatile nature of fuel and electricity markets, fluctuating currency exchanges and interest rates.

Trading derivatives “over-the-counter”—in other words, directly between two parties instead of through centralized clearinghouses or exchanges—keeps prices lower and makes it possible for trades to be customized for the parties involved.

By reducing a company’s exposure to substantial or severe swings in fuel prices—the natural gas used to generate electricity, to name a prime example—OTC derivative trading helps to insulate electricity customers from price volatility. Derivatives also help provide utilities access to lower-cost capital, which in turn promotes new infrastructure investments and business growth, both of which create jobs in this recovering economy.

Put simply, these useful financial instruments help to reduce various costs for electric utilities, including those for fuels and wholesale electricity trades. Those savings are passed directly to our customers in their electric bills.

But some of the related proposals now in Congress, though well-intended, would eliminate this vital option for electric companies and other end users of OTC derivatives. Under such proposals, derivatives would have to be centrally cleared, executed on exchanges and cash-collateralized, with end users possibly subject to higher capital charges.

Any of these measures would place an extraordinary financial burden on utilities and other industries that use derivatives. For electric utilities, the increased costs of making such trades on exchanges would be astronomical—in the neighborhood of $200 million a year for an average-sized utility.

Eliminating the use of derivatives as tools of financial risk management, meanwhile, would increase our customers’ exposure to the vicissitudes of the marketplace. Electric bills across the United States most certainly would increase.

The point of Congress’s financial reform efforts is to address what has been called “systemic risk”—the kind of risk that allowed malfeasance by some market participants and contributed to our current economic downturn. The markets in which electric companies presently utilize OTC derivatives have proven to be durable and robust, even during times of turmoil and uncertainty.

Meanwhile, there are other, less onerous ways to ensure sufficient oversight of OTC derivatives than requiring centrally cleared exchanges. For example, the Federal Energy Regulatory Commission’s Electric Quarterly Reporting program could be expanded to include OTC derivatives markets. A centralized data repository wherein all trading could be reported and examined also would provide for regulatory oversight without hindering the effective use of OTC derivatives by electric companies.

Proven regulatory tools such as speculative positions limits also could be used to address potential excessive speculation, as could the clearing of standardized derivatives transactions between large dealers where appropriate through regulated central counterparties. That would reduce systemic risk and bring additional transparency through information reporting regarding pricing, volume and risk.

Promoting clear delineation of regulatory authorities and functions among the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Federal Energy Regulatory Commission and other agencies to ensure similar products are governed by similar standards also would go a long way toward addressing these issues while minimizing the burden and cost of compliance with regulatory oversight.

Whatever available solutions are utilized, it is vitally important that electric companies be able to insulate their customers and businesses from market volatility by effectively managing risk in a cost-effective way. Preserving their access to the OTC derivatives markets is the best way to ensure this happens.

—Thomas Kuhn is president of the Edison Electric Institute, which represents the nation’s investor-owned electric companies. This commentary is based on his testimony last October to the House Financial Services Committee and originally appeared in MANAGING POWER’s sister publication, The Energy Daily.