Global Adjustment: Change in Behaviour Has Implications for Hedging

August 2009

• The Global Adjustment (and the previous OPG Rebate) provides a natural hedge against fluctuations in electricity spot market prices.
• Previous behaviour of the Global Adjustment and OPG Rebate was predictable and linear, leading to straightforward hedge quantity decisions.
• Recent and future behaviour has and will be unpredictable and non-linear, greatly increasing the complexity of hedge quantity decisions.
• Over-hedging, a big risk management no-no, is now a bigger risk than ever.

Global Adjustment Overview

The Global Adjustment, also known as the Provincial Benefit, is one of two Ontario electricity market mechanisms used to transfer costs between the market at large and customers. The other mechanism is the Ontario Power Generation Non-Prescribed Asset Rebate, known more simply as the OPG Rebate. The rebate ended April 30, 2009. The Global Adjustment is not well understood by consumers, and yet this mechanism has a large and growing impact on the true cost of electricity and hedging decisions.

The Global Adjustment reflects the net financial impact of three main types of costs: contracts with OPG, contracts with private generators, and conservation and demand management expenditures made by the Ontario Power Authority.

Previous Behaviour - Global Adjustment and OPG Rebate, Net Un-hedged Price

Previously, careful analysis of the relationships between the Global Adjustment and the OPG Rebate and electricity spot market prices showed that the two mechanisms in combination provided a natural hedge against fluctuations in spot prices. This relationship was fairly predictable, as evidenced by its straight-line nature shown in the first chart below. This meant that customers wanting to reduce their exposure to fluctuations in spot prices could "hedge"; that is, enter into a fixed-price arrangement for electricity, with the quantity being some percentage of their total consumption. The hedge would have an effect similar to the two mechanisms, by reducing the slope of or flattening the Net Un-hedged Price line.

Recent and Future Behaviour - Global Adjustment, Net Un-hedged Price

The nature of the contracts underlying the Global Adjustment is changing, particularly agreements with private generators. The result is a change in the relationship between the Global Adjustment and spot prices. The recent and expected future relationship is and will be distinctly non-linear, as shown in the second chart.

Why Care - Implications for Hedging

The earlier behaviour of the Global Adjustment and OPG Rebate, relative to fluctuations in spot market prices, was predictable and linear, so choosing a hedge percentage or quantity was relatively straightforward. With recent and future Global Adjustment behaviour becoming unpredictable and non-linear, decisions about hedge percentages and quantities will be much more complicated.

The major risks then are hedging much less or much more than is required. The latter, also referred to as over-hedging, amounts to speculation -- a big risk management no-no. A consumer not only ends up paying unnecessary energy marketer margins and risk premiums, but may also end up over-hedged. A sure-fire sign of over-hedging is a rise in the consumer's hedge-inclusive net price when spot prices fall. The rise occurs as a result of the additional cost incurred during periods of lower-than-contracted spot prices, when the consumer has to sell the over-hedge quantity at a loss.

Going forward, Ontario electricity consumers wishing to understand their exposure to spot price fluctuations and manage their risk by hedging need to understand the behaviour of the Global Adjustment and how it affects potential hedging decisions.

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