EME 801
Energy Markets, Policy, and Regulation

Risk Mitigation Measures

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One can mitigate risks through a number of different measures:

  1. Contracting (for physical commodities or services)
  2. Buying or selling futures contracts
  3. Buying or selling options

It is always important to understand that as the developer or operator moves to reduce risk in certain areas, they may be taking on unidentified risk in another area. Please keep this in mind as you work to de-risk your projects in this class and in your career. As Stephen Covey has said, “When you pick up one end of the stick, you pick up the other.”

Contracting (for physical commodities or services)

One of the simplest ways to remove price and performance risk is to enter into a contract for services or a commodity. These types of arrangements take on many forms and can be very simple and also very complex. Natural gas and power purchase arrangements can be 50-100 pages in length, as many different terms and conditions need to be agreed upon. Typical terms that are covered in energy contracts include:

  1. Term (how long?)
  2. Quantity (how many?)
  3. Price (how much does it cost?)
  4. Credit (how much do I trust you will perform?)
  5. Termination (how do we end the deal?)
  6. Payment terms
  7. Force Majeure (when can the parties be excused from performance?)
  8. Liability
  9. Confidentiality
  10. Governing Law

Contracts for services can include many other provisions as well, such as:

  1. Non-discrimination (who to hire)
  2. Prevailing wage (how much to pay people working on the job)
  3. Safety
  4. Limitations on performance
  5. Project Timelines

The general idea of a commodity or performance contract is to remove certain risks that one counterparty has to another counterparty who is better able to mitigate that risk. For instance, I would probably hire a plumber if my garbage disposal were clogged. This would allow me to remove the risk of flooding my kitchen and/or injuring my hand. The plumber gets paid to take on that risk, which he or she is much better at mitigating because he or she is a trained professional. These types of arrangements occur all the time even though we may not be aware that they are risk management measures. It is important, though, to make sure that when one mitigates risk with a contract that one is confident in the performance of the counterparty. The best contract doesn’t mitigate any risk if the party on the other side can’t or won’t perform.

Buying or Selling Futures Contracts

A futures contract is an agreement traded on an organized exchange to buy or sell assets, especially commodities or shares, at a fixed price but to be delivered and paid for later. The most relevant futures contract that the North American energy market deals with is the NYMEX Natural Gas Futures Contract. One can trade natural gas on the New York Mercantile Exchange in contracts of 10,000 MMBtu per month on a fairly liquid basis out about 3 years and in less liquid manner about 10 years beyond that. Buying a futures contract obligates one to take delivery of that gas in the month specified for the price agreed to. Selling a futures contract obligates one to deliver gas in the month specified for the price agreed to.

Buying or Selling Forward Contracts and Options

A forward contract is an informal agreement traded through a broker-dealer network to buy and sell specified assets or commodities.

There are two basic options (and many other options) in the energy markets. The put and the call. The put allows but does not obligate the owner to deliver energy in a certain quantity at a certain price for a certain period. This type of contract is very helpful to a generator or producer because they can lay off the risk of prices falling below a certain level and not having enough revenue for the project.

The call allows but does not obligate the owner to receive energy in a certain quantity at a certain price for a certain period. This type of contract is very helpful to a consumer because they can lay off the risk of prices rising above a certain level and not having enough revenue for the project.

When one sells a put and buys a call, they are then a buyer in a forward contract. When one sells a call and buys a put, they are then a seller in a forward contract.