In June of 1998, an Ohio utility experienced forced outages as a result of the failure of a step up transformer at a large fossil fuel plant and tornado damage at a nuclear power station. Concurrently, the supply of available megawatts had dried up, largely due to surge in demand as a result of a heat wave. The situation was aggravated by transmission failures. Other regions were unable to dispatch megawatts to this utility and more than one broker defaulted on contracts to deliver power.
The absolute high price during this three-day period of market turmoil was $7,000/MWh. This investor-owned utility reportedly lost $50 million.
Throughout the summer of 1999, many of the North American Electric Reliability Council ("NERC") regions experienced heat wave-induced price volatility. Once again, generation and transmission outages flamed the fires. In the mid-west, MegawattDaily reported that an absolute high price of $3,000/megawatt hour was paid by one utility in late July.
Benefits of Forced Outage Insurance
Utility risk managers have four basic risk management techniques at their disposal.
- Increase generating capacity and either buy or build power stations. Many utilities are building peaking plants that burn more expensive natural gas, but turn on only when needed to meet peak demand. Either way, It takes time to build and acquire power plants – this technique involves the investment of hundreds of millions of dollars.
- Long-term supply contracts where utilities contract with merchant power plants and brokers to supply them the megawatts they need to meet their native demand. There is, however, a counterparty credit risk associated with this technique.
- Multiple-trigger derivatives have been developed to treat forced outage risk. In a derivative transaction, there are two triggers: First, the utility must experience a forced outage. Second, the spot price must exceed an agreed upon strike price per megawatt hour. If both of these events occur at together, the derivative contract will pay an amount specified in the contract. In the experience of The Risk & Insurance Advisors, derivatives are very costly.
- Forced outage insurance is an attractive risk treatment technique, mainly because it is a fixed and tax-deductible expense. In other words, it is not an investment whose value can change. In the experience of The Risk & Insurance Advisors, a forced outage insurance policy is less costly than a derivative contract. A third advantage of insurance is that there is no counterparty credit risk. True, insurance companies can become insolvent -- but the buyer can manage this by de-selecting insurers that do not have acceptable A.M. Best Ratings. Lastly, only licensed insurance companies can issue insurance policies -- and for multiple years.
