Behavioral pitfalls to managing utility risk

Mike Zaccardi, CFA, CMT

I come from a trading background, so I see the utilities world from this perspective. Having gone through the CFA & CMT programs only reinforced by trader mindset. I also teach finance at my local university, and I focus part of the course on behavioral finance and our biases.

Base-rate neglect is an important behavioral bias and a potential pitfall for utility managers with regards to reducing risk during planned generator outages. Base-rate neglect as it pertains to covering a power plant outage means this – the base case is that the utility is hedged to the market – meaning their power generation covers how much power they must procure from the market for their residents.

The base-rate in this case is being fully hedged. When there is a power plant outage, the utility will be forced to buy from the market. Today’s organized power markets make that very easy, but also very risky. Utilities are likely better off reducing this risk my purchasing in the forward market. Like futures markets in other commodity arenas, a bilateral forward market is available to utilities.

The bias though lies in the notion that it takes action to put on the hedge by purchasing forward. Managers may be averse to making this call. Think about it – you put on a hedge and then market prices will swing around the mark-to-market value of that hedge, so it is tempting to view the hedge as a ‘trade’. It is really not a trade, rather part of an overall position coupled with the utilities load/resource balance.

We are prone to view the hedge as a P&L which also leads to our natural loss aversion mind set. Human feel losses about two and a half times that of a gain. So if a market participant sees a negative mark-to-market on the hedge, he or she may panic and unwind the hedge at the wrong time. That is another bias called ‘decision risk’. So there’s lots of behavioral pitfalls in this arena. Utilities must be keenly aware of these perils and ensure good decisions are made.

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Chart used with permission from Tradingview.com