A study released yesterday by the American Clean Skies Foundation (ACSF) and the Bipartisan Policy Center (BPC) on how to encourage more effective use of natural gas included two reports authored by economists at The Brattle Group. One report analyzed the wide range of methods used by natural gas market participants to manage price volatility, and the other provided an overview of the implications of Financial Accounting Standards Board (FASB) accounting rules for natural gas purchase contracts. In the report “Managing Natural Gas Price Volatility: Principles and Practices Across the Industry,” Brattle principals Frank Graves and Steve Levine surveyed different sectors of the natural gas industry and identified variations in the use of risk management instruments. They found that while all participants essentially face the same commodity volatility, the hedging needs and approaches of market participants vary depending on their specific circumstances. For instance, some large, diversified gas producers forego the use of hedging instruments altogether because their financial strength makes hedging unnecessary, while mid-size gas producers make significant use of hedging instruments to manage cash flow for operations and expansion and to ensure debt-service coverage. Many electric and most gas utilities have adopted hedging programs to manage price volatility on behalf of their customers for at least the baseload portion of their needs and to avoid the risk of disallowances that might be imposed without hedging. Despite the widespread use of hedged procurement in the utility sector, many firms are not directing these practices with risk management analytical tools. The Brattle report recommends enhancements to electric and gas utility hedging programs, including:
- Less adherence on procurement rules that dictate the type and timing of hedges based on what they perceive other utilities are doing.
- Increased use of simulation models to forecast the cost uncertainty faced by customers and identification of shifts in circumstances that would justify alternative hedging tactics.
- Combining the tracking of gas and power supply risks, given their close relationship and tendency to substitute for each other in short- to mid-term operations.
Graves and Levine stress the importance of engaging senior managers and regulators in the design of the programs in order to achieve clarity on what is feasible to accomplish with risk management. They also recommend engaging regulators to discuss when changes to utility hedging programs in the face of shifting market conditions may make sense for customers. The second report, “FASB Accounting Rules and Implications for Natural Gas Purchase Agreements,” was authored by Brattle principal Bente Villadsen and associate Fiona Wang. The report reviews the current accounting treatment for gas purchase contracts, with a focus on whether an end-user of natural gas must use fair value accounting or can rely on the end-user exemption, where gas costs are expensed as incurred. The analysis finds that most gas utilities rely on the exemption for some contracts, but that the treatment is far from uniform across the industry. Based on their review of accounting guidelines and practices, the authors conclude that the decision regarding contract type is not and should not be chosen based on the accounting treatment. Thus, Villadsen and Wang find it unlikely that the accounting treatment drives the contract length or type in natural gas markets. Further, companies may prefer different accounting methods based on their unique facts and circumstances. Both reports were prepared for the Task Force on Ensuring Stable Natural Gas Markets, which was convened by the ACSF and the BPC. The Task Force, which includes major energy producers, energy consumers, environmental organizations, and public interest groups, has been exploring new options for reducing and managing future price swings for natural gas, while considering the potential for major supply increases from U.S. shale gas production. The Brattle Group reports are available for download below. The final study published by the Task Force is available at www.cleanskies.org/pricestabilitytaskforce.