Empirical Analysis of Hedging Policies Among Norwegian Hydropower Producers

1. Empirical Analysis of Hedging Policies Among Norwegian Hydropower Producers Gaute Egeland Sanda Eirik Tandberg Olsen Stein-Erik Fleten • Department of Industrial Economics and Technology Management, • Norwegian University of Science and Technology

2. Summary • We gather unique data from a representative sample Norwegian electricity companies and study hedging practices in a commodity market • Hedging gives reduced Cashflow at Risk across the sample • Limited evidence of CF volatility reduction is surprising • Companies’ policies and quantitative analyses reveal that companies incorporate market view in hedging policies

3. Agenda Nordic power market is well suited for study of commodity hedging Incorporation of market view in hedging policies among 12 commodity producers Trend in industry is a dynamic approach to hedging

4. Norwegian Electricty Market well equiped for risk management • Hydro dominated market • Liberalized in 1991 • Price risk transferred from the customers to the producers • Nordic Power Exchange – Nord Pool (1996) • Largest both in terms of spot volume and power derivatives • Swaps, European options, swing contracts Sources: EuroPEX, Nord Pool price data

5. Participating rate high after extensive data gathering process Extensive use of hedging Data gathering successful Direct inquires to 33 companies Data collected under confidentiality Sample geographic representative 3 years of data is analyzed on monthly basis Sources: Norwegian Water Resources and Energy Directorate • 90% of electricity producers have hedging policies • Hedging practices never been studied in the Nordic market TWh/a (# companies)

6. Added value from risk premium and increased predictability Risk premium up for catch Hedging value descends from enhanced predictability Increased predictability can give increased debt capacity, lower taxes, reduced default risk and relaxed risk aversion for stakeholders 91% of sample in Wharton survey cite reduced CF volatility as most important hedging objective Brown (2001) finds evidence of reduced CF volatility in case study Sources: Adam and Fernando (2006), Botterud et.al. (2009, Bodnar et.al. (1996), Brown (2001), Smith and Stulz (1985) • Adam and Fernando (2006) • Positive risk premium (Futures price – Spot price) yields positive return from hedging • Zero expected value from selective hedging (incorporation of market view in hedging decisions) • Botterud et.al. (2009) find positive risk premium in Nordic power derivatives

7. Inspiration and motivation from empirical papers on gold and currency How is hedging performed and motivated? • Are there industrial trends? • Howcan hedging add value? Sources: Brown (2001), Petersen amd Thiagarajan (2000), Adam and Fernando (2006)

8. Agenda Nordic power market is well suited for study of commodity hedging Incorporation of market view in hedging policies among 12 commodity producers Trend in industry is a dynamic approach to hedging

9. Companies allow for selective hedging Stulz (1996): “the management will found its trading strategies on a belief that they are able to predict market movements ” Company 9: “ it is possible to exploit our market competence ” Company 6: “ a portfolio for extraordinary hedging transactions based on expectations for future electricity prices ” Company 2:“ does not have authorization to engage in speculative trading ” Sources: Stulz (1996), participating companyies’ hedging policies

10. Added value measured by profit and income smoothing • Previously applied by • Quantity Company 12:“[hedging shall contribute to] maximize the profit in the long term ” Derivative cashflow • Adam and Fernando (2006) • Brown et.al. (2006) Company 6:“ the goal of the hedging activity is to secure a profit or margin ” Company 7:“control the risks associated with periods of […] large fluctuations in the result ” CF and price volatility • Ederington (1979) • Brown (2001) Company 10:“ reduce the fluctuations in profit and cash flow on the long term ” Cashflow at Risk (C-FaR) Company 3: “ secure an acceptable income and hedge as little as possible to retain as much of the upside potential as possible ” • Stein et.al. (2001) Sources: Participating companyies’ hedging policies, Adam and Fernando (2006), Brown et.al. (2006 ), Ederington (1979), Brown (2001), Stein et.al. (2001)

11. Derivative cashflow Considerable profit contributionfrom hedging transactions • Surprising that hedging produce cash flows of this scale • Larger payoffs when prices are lower than average • During the analyzed period the spot price had a slight positive trend Does high derivative cash flows indicate selective hedging? Sources: Participating companyies’ data sets

12. CF and price volatility Surprisingly low effect on volatility reduction • Two companies reduce cash flow volatility • Five companies reduce price volatility • Derivatives only hedge price, but surprising that there are minor effects on CF Cash flow w/ and w/o hedging company 1 • One company achieves reduction in both volatility measures w/o having a written strategy Do companies value volatility reduction? Sources: Participating companyies’ data sets

13. Cashflow at Risk (C-FaR) Hedging results in C-FaR decreaseacross the board • 10 companies decrease 5.6% C-FaR compared to spot exposure • Stulz (1996): ”fundamental goal of hedging […] to eradicate extreme lower outcomes of […] earnings function Cash flows distribution w/ and w/o hedging company 3 Clear increase in cash flows for the 5.6% worst months Is Cashflow at Risk a correct indicator of success? Sources: Stulz (1996), Participating companyies’ data sets

14. Agenda Nordic power market is well suited for study of commodity hedging Incorporation of market view in hedging policies among 12 commodity producers Trend in industry is a dynamic and selective approach to hedging

15. Analyses reveal a dynamic hedging approach within policy restrictions Does high derivative cash flows indicate selective hedging? • The companies apply a dynamic approach to hedging • Focus on additional profit rather than income smoothing • Policies allows for selective hedging inside boundaries Is Cashflow at Risk a correct indicator of success? Do companies value volatility reduction? Hedge ratio boundaries Company 5 Sources: Participatingcompanyies’ data sets

16. Selective hedging findings corresponds with other commodities Hedging practices in electricity companies Hedging practices for other commodities 74% for currency (Brown (2001) ), 34% for gold ( Brown et.al. (2006) ) Brown (2001) find that his case study use hedging as “smoke screen for speculative trading” Average 10% of cash flow among gold-hedgers originate from hedging activity (Adam and Fernando (2006) ) Sources: Brown (2001), Brown et.al. (2006), Adam and Fernando (2006) • Electricity companies hedge close to 90% of production on average • Extensive selective hedging practice and incorporation of market view • Significant cash flow contribution from hedging transactions

17. Key findings • Incorporation of market view in hedging policies indicates dynamic hedging trend among companies • Hedgers succeed in limiting the worst-case cash flows through hedging without reducing cash flow volatility • Findings for electricity companies similar to studies performed on other commodities (gold, jet-fuel) and currency

18. Questions and comments are very welcome 