That cost is the underlying reality that VaR management for a short position is the equivalent of a set of institutional stop orders on the fuel or power purchase system. If prices start to run up, the VaR calculations are designed to “force” action by the risk control group. That “forcing action” usually translates into a purchase to reduce price exposure. The problem with that mechanism is that if outside market participants know of those stop orders they can attempt to “run” the market through the stops and force the utility to enter the market. What does “running a stop” mean?
It means purchasing at a lower price in volumes sufficient to cause a significant increase in market price. The expectation is that at some certain point the customer with a buy stop will be forced to purchase the commodity at that higher price. This activity results in the customer with the buy stop entering the market and, lo and behold, the entity that bought at a lower price is ready and able to sell to the utility. This results in a “buy low, sell high” cycle for the person forcing the stop. In addition, if the sell side of the market – the producers – do not have a tendency to sell into the price rise but rather believe “to the moon”, then this cycle creates even more value for the entity forcing the stops.
Because the utility entry in the market offers – potentially – the opportunity to sell more than the original volume necessary to cause the market to rise. Why? Well, the risk tolerance of utilities as a class is relatively uniform (with some outliers). Therefore, one might expect that the VaR limits for most utilities are relatively uniform (let’s face it, many of the utilities use the same consultants and risk management systems – utilizing the same analytics, which create like results). Therefore, there is the potential that driving through the VaR limits for one utility is going to drive through the VaR limits for many utilities. Ah, the economies of scale at work in the market place.
So, what can the utility do? First, look to see if your VaR system has any “early warning” for when market price activity is picking up. If prices are becoming increasingly unstable, it may be a good sign that prices may next make a larger move. So, early detection of market instability not just price movement in one direction is a good idea. The VaR system should be picking that up but not all smaller firms look at the cause of VaR increases or fail to update the price activity frequently enough.
Second, there should be some forward thought about where are prices “stable” at this time. Gas prices seem to hover between $5 and $9 for the most part now. There should be a plan for the company’s response if prices go to $15 in a very short time. Planning that response when prices are screaming up is next to impossible for any firm. A varies response based on price level should be explored and, if acceptable, agreed to ahead of time.
Finally, a utility should examine its VaR system. How many other companies use the same systems? How big are they compared to your company? If their VaR limits are relatively similar to your company’s, is it likely their entry into the market will such all the liquidity out and make your company’s situation worse?
VaR is a useful tool but, like many tools, it can also cause a lot of damage. It may be time to examine the way you are using the tool and whether there is risk in your risk management.