Managing Interest Rate Risk

Mike Zaccardi, CFA, CMT

Those who work in utility operations tend to focus on operational risk – imagine that. Financial risk is also huge. So what the difference between operational and financial risk? Operations consist of running a power plant, and overall utility functions, effectively and efficiently. Activities such as routine maintenance of generators, servicing load customers, even hedging commodity risk such as natural gas, power, transmission and other items that can drive up costs.

Financial risk for utilities comes primarily from what is going on in the interest rate market. Utilities can be some of the more financial leveraged firms in the business world. Financial leverage, having a high total debt to total equity ratio, is often shunned by investors as it indicates a potentially higher risk firm. It can be the best way to run a utility, however.

Why is that? A utility’s operations tend to be quite stable. Think about it – customers (you & me) pay our electric bill each month as a routine expense. It is non-discretionary. Sure, recessions can cause residents to be late or even miss a payment or two to their local utility, but that tends to be transitory. The dependable and consistent nature of the business allows for high leverage as cash flows will be fairly stable relative to other industries. Also, generators are not cheap to build, so they are often financed with debt.

But there is a downside to high financial leverage even if a utility has the most reliable customer base. What if interest rates go up, and a utility has to re-finance at a higher cost? Interest expense can shoot through the roof if not properly hedged. This is financial risk.

Something these firms can do to manage financial risk (i.e. interest rate risk) is using interest rate derivatives, namely call options. Interest rate call options give the holder the right to lock-in a known interest rate today for purchase in the future. A utility can purchase an interest rate call option with a strike of 2% now, and if market rates shoot to 5%, they can make a profit on that spread. It’s not really a profit through when looking at it from a portfolio perspective since the interest rate expense line item on the income statement will go up. There is a cost to this hedge, like there often is when managing risk.

The cost is the premium to purchase the option – the seller of the option will require a little kicker to do the deal since the holder’s potential gain is infinite while the most a buyer can lose is the amount paid; so it’s not a free lunch.

Here’s the point – managing utility risk is complex. It is important for these firms to monitor how they hedge interest rate exposure. Getting fixated on operational risk can happen, particularly for those in charge who want to stay in their circle of competence.