4/20/2020 Understanding Enterprise Risk Management for Utilities © Copyright 2007, CCRO. All rights reserved. 17 Historically, exchange rate risk has typically only been applicable to those utilities with service territories in different countries. This risk was fairly easily managed on its own but could become complicated by both commodity and volumetric risks, where the actual earnings to be hedged can vary significantly. However, with a growing international market for fuels, for instance uranium, or equipment, such as those relating to generating facilities or substations, many utilities are facing exchange rate risk for the first time. Exchange rate risks can become a problem for utilities when the US dollar is weak, increasing the competitive advantage of international purchasers with more buying power, as these commodities are traded in the US dollar. In effect, the price of the commodity increases as the US dollar weakens, thus the relative cost of the commodity is greater for US firms. Hedging this exchange rate risk is also very complicated because it requires forecasts of the requirements for these commodities to enable implementation of hedges, and then the recovery of these hedge costs may not be allowed. Interest rate risk, which is the risk associated with the reduction in the value or cost of a security, good or service resulting from a rise in interest rates, can also have a major impact on utilities for two reasons. First, most utilities are required to set rates in advance of actual expenditures based on expected costs. If there is a change in costs, the company is either required to absorb the incremental cost or, at best, recover the cost at a later date, bearing short-term carrying costs of the expenditure. Second, any utility making capital investments is required to seek financing for funds used during construction and for the actual capital expenditure for an asset. In such an instance, the investor-owned utility faces the market interest rate for its credit level, but then receives an allowed rate of return on that asset. This rate of return is based on a regulatory determination of the fair and equitable value of the asset and associated risk the shareholder is taking on behalf of the ratepayer. These calculations can frequently differ, creating the risk that the investment is less cost effective relative to an industry-allowed weighted cost of capital, thereby lowering the return to the utility. Finally, utilities that are required to maintain, improve or expand infrastructure face the costs of commodities associated with construction. The price of steel and concrete impact the construction of generation facilities as well as gas storage and pipeline infrastructure, while steel and copper costs most dramatically impact transmission assets. As these commodities become more volatile, utilities must manage these expenses because they are obligated to build or maintain their assets at a cost approved in a rate hearing, or face the regulatory burden of proof known as “prudency” to recover actual costs. 2.3.2. Credit Risk Utilities face various credit risks in their daily operation. When a customer’s credit falls into arrears, utilities do not receive the variable cost of the delivered product that stands unpaid or the recovery of fixed costs, which leads to a lower than expected rate of return on rate base. Should utility suppliers realize unexpected changes in their credit, they could also run the risk of default of financial obligations. That is, if utilities hold large positions with credit-challenged suppliers, those suppliers could in turn impact a utility’s credit rating. Further threatening a utility’s financial stability is the credit health of parties in the region or industry. If poor, the availability of qualified suppliers may be limited, which could potentially lead to concentration risk, where too much of a utility’s supply is dependent upon a small number