NOTICE: this is the author's version of a work that was accepted for publication in The Electricity Journal.

Changes resulting from the publishing process, such as peer review, editing,
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publication. A definitive version was published in The Electricity Journal [VOL 14, ISSUE 6, (July, 2001), pages 11 - 22; http://dx.doi.org/10.1016/S1040-6190(01)00211-1]

Vesting Contracts:
A Tool for Electricity Market
Edward D. Kee is a Vice President at
CRA International, Inc. He is a
Transition
specialist in the electricity industry, Vesting contracts can manage the transition to full competition
with a focus on nuclear power, in electricity, manage the financial risk of market participants
industry restructuring, and electricity
and help achieve other deregulation objectives. Vesting
markets.
contracts could have prevented the financial problems in
At the time this article was published, California.
Mr. Kee was a partner at PA
Consulting Group in Washington, Edward D. Kee
DC, and the head of PA’s Energy
Economics practice. He was a Senior
Vice President at PHB Hagler Bailly
when PA acquired that firm in late The California electricity customers (or the retailers
2000. Between 1997 and 2000, Mr. crisis is not proof that serving the customers) from
Kee was the leader of the Australian electricity deregulation can only spot market prices even in
practice of Putnam, Hayes & Bartlett, work if there is an excess of capacity-tight markets, kick-
with a range of client engagements capacity and low spot prices. start the hedge contract
Instead, this crisis market, maintain a viable spot
related to the electricity industry
demonstrates that a market, provide incentives for
restructuring and privatization. new entry, and facilitate other
deregulation plan based on a
belief in low spot prices, aspects of a transition to
The insights and observations in this electricity markets.
without hedging, is very risky.
article are derived from the author’s
The California deregulation Without adequate hedging of
experience as a consultant and
plan was a bet-the-state spot market purchases,
participant in the electricity industry. electricity trade that could California has focused on spot
The author thanks colleagues and succeed only if spot prices were price caps to control losses –
friends who provided comments on low. removing important market
drafts of this article. Vesting contracts, hedge price signals. Deregulation
contracts put in place prior to plans that recognize the
Mr. Kee is based in Washington, DC the divestiture of generators, potential for high spot market
and can be contacted at could have locked in utility prices and incorporate
ekee@crai.com. power costs and largely appropriate hedging strategies
prevented the California will be viable regardless of spot
financial crisis. Vesting prices and without the need for
contracts can protect price caps.

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 1
 The California crisis does the Governor of California, electricity industry reform
not mean that deregulation who stated that: and deregulation. The
and electricity markets are “Deregulation can only work experience in PJM, New York,
unworkable. Instead it if there is an excess of New England, England &
should remind us that spot capacity” 1 Wales, Australia, and other
market prices can be Underlying this statement places show that electricity
unpredictable and sometimes are three assumptions, only markets can work.
very high; demonstrate that the first of which is valid. 3. Deregulation is only
deregulation plans without 1. Spot market prices possible when prices in the
appropriate hedging will be lower when there is spot market are low (i.e.,
strategies are risky; and an excess of capacity. because there is an excess
show that being wrong on a Most industry observers of capacity). I also disagree
bet-the-state electricity trade would generally agree with with this assumption.
can be very expensive. Governor Davis may be
This article looks briefly at reflecting the political reality
the California crisis from a that electricity consumers
risk management point of
One mistaken and voters will favor a shift to
view, discusses risk assumption: markets when they get
management and the use of immediate benefits. Other
hedge contracts in electricity California tried jurisdictions have
markets; and then provides deregulation successfully implemented a
an overview of vesting shift to electricity spot
contracts. and it did markets without an
not work. oversupply of capacity. 2
I. Did High Spot Market While excess capacity and
Prices Cause California’s low spot prices would have
this assumption. Market averted the financial crisis in
Problems? design, concentration of California, excess capacity
ownership, the nature of and low spot market prices
Some believe that the
existing infrastructure, and are not prerequisites for
California electricity crisis
other factors will determine electricity deregulation.
was caused by high
the level of competition in a Another view of the California
electricity spot prices. Those
market and the level of spot crisis that high spot prices
holding this view may
market prices. All these exposed a deeply flawed and
advocate the use of price
factors being equal, an risky deregulation plan.
caps to control spot prices
excess of supply will
and try to find a scapegoat
generally lead to lower spot
on which to blame high spot II. California
market prices compared to
prices. The most common Deregulation: A Recipe
the prices in a market with a
scapegoats are in-state for Risk
shortage of supply.
generators, with out-of-state
utilities, traders and even 2. California tried California built significant
Federal Power agencies also deregulation and it did not risk into its deregulation
being named as culprits. work. If the Governor had scheme by setting objectives
said that “California-style that could only be achieved
Others hold a slightly
deregulation can only work if in total when spot market
more enlightened view and
there is an excess of prices were low:
blame high prices on the lack
capacity,” most would agree.
of new capacity additions in • End-use customer rates
Electricity deregulation and
California over the last
markets can and do work. at stipulated levels (i.e.,
decade. Some then conclude
The failure of the particular no spot market pass-
that California proves
deregulation plan adopted by through);
electricity deregulation is
California should not be
only possible when spot
viewed as a general failure of
prices are low. An example is

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 2
 • Utilities that were to divestiture, referred to as real problems with adequacy
recover stranded costs; vesting contracts, could have of supply and potential
supported the original rate blackouts should be ignored.
• Utilities that were freeze regardless of spot price These capacity supply
restrained from hedging levels. 3 problems must be examined
spot market exposure; Instead, high spot prices and resolved on a regional
and in California have destroyed basis. The financial crisis
the credit of the investor- and the supply shortage are
• Utilities that were not unrelated, but the two
owned utilities and threaten
financially solvent. to burden the State for problems should be
California utilities were decades. Without adequate considered separately.
obligated to supply end-use hedging of spot market A focus on price caps to
customers at fixed prices purchases, California has ease the financial problem is
while required to purchase in focused on spot price caps to likely to exacerbate the
the spot market, largely control these losses – supply shortage problem.
without hedging. It is now removing important market Viewing the California crisis
painfully obvious that only price signals. Many parties as a risk management
low spot market prices would are calling for even more problem may allow solutions
have kept these utilities that both ease the financial
financially solvent without exposure to spot prices and
the need for rate increases. help solve the supply
Small commercial and With California’s shortage problem (e.g., new
residential customers were enormous unhedged entrants signing up for hedge
given an initial 10% contracts).
reduction in rates, but could financial position, Before discussing risk
only obtain additional deregulation became the management and vesting
benefits at end of the rate contracts, it is useful to
freeze period if spot prices equivalent of a bet-the- examine another feature of
remained low. the California deregulation
state electricity trade.
California’s approach plan – the notion that
established an enormous customers should see
unhedged financial position stringent and widespread wholesale spot prices.
in the electricity market, so spot market price caps to
that deregulation became the ease the financial problem, III. Should Customers be
equivalent of a bet-the-state even while the state (and the
electricity trade. If spot
Forced to Buy at
region) is in great need of
prices were low, deregulation new entry. Wholesale Spot Prices?
would work; if spot prices New generation plants in The California
were high, a lot of money California already face deregulation plan called for
would be lost. significant environmental customers, after the end of
The financial crisis and siting hurdles and price the rate freeze, to buy energy
demonstrates that a caps will further reduce the at the wholesale spot market
deregulation plan based on a attractiveness of power plant price. Retailers were to be
belief in low spot prices, investments. Also, retailers conduits to pass on the
without hedging, is very and customers are unlikely wholesale market price. This
risky. Hedge contracts to hedge spot market probably looked like a nice
signed before spot prices exposure when frozen retail idea when spot prices were
were high could have locked rates and spot market price relatively low compared to
in utility power costs, largely caps are in place. the rate freeze levels. There
preventing the current Viewing California’s is disagreement among the
financial crisis. Even better, problems in the context of industry experts on this
hedge contracts assigned to hedging and financial risk issue, with some arguing that
generators prior to does not mean that the very the California chose the

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 3
 correct path and others be especially true in the early • Generators hold a
arguing that customers will stages of a market (the portfolio of hedge
seek fixed price California market is far from contracts that provide a
arrangements and retailers settled, even after several significant part of their
serve a useful function in years), when spot prices are income;
providing risk management.
California was unique in • New entrants in
deciding that there was to be generation compete with
little hedging in the market incumbents for hedge
and to have most customers The San Diego contracts; and
provided with electricity experience suggests
service after the end of the • The spot market
rate freeze that passed that customers provides appropriate
through spot market prices. 4 may not desire a price signals at the
Some have asserted that this margin to unhedged
aversion to hedge contracts pass-through of generation and load.
was a reaction to decades of spot market prices. Retailers in this model are
overpriced contracts with primarily involved in
cogeneration and renewable packaging electricity bought
generators. in the wholesale market for
Some have expressed the resale at a profit to
view that customers should likely to be more volatile and customers at fixed prices (or
be provided with a pass- new entry may still be under at other pricing
through of wholesale spot development. arrangements that customers
prices. 5 While this approach More likely, retailers will seek).
may produce clear and offer a set of packages that This sounds like California
efficient price signals to include bundled service at utilities over the last several
consumers, there is little fixed rates for some period years, doesn’t it? The major
reason to believe that (e.g., a year). The experience difference is that the
electricity markets will evolve in England and Wales, California utilities remained
in this manner. Norway, Australia, and now regulated. They were
While wholesale electricity in San Diego, suggests that prohibited from managing
spot markets may be a useful customers will the risk inherent in
way to achieve the efficient overwhelmingly choose some supplying customers at rate
dispatch of resources, both sort of fixed price package, freeze tariffs (hence the
generators and consumers largely ignoring rates linked financial crisis).
are exposed to the risks of to wholesale spot prices. 7 The California utilities
highly volatile and The natural end state of may also have thought that
unpredictable spot market electricity markets is likely to regulation made them
prices. This problem of risk be one where: immune from the risk of
can be solved with bilateral such losses. While the
contracts that allow • A majority of customers
California utilities risked not
generators and consumers to take electricity service at
fully recovering stranded
deal with one another fixed rates from
costs if spot prices were high,
directly or through retailers; they probably believed that
intermediaries without costs of purchasing power to
• Retailers enter into a
distorting the dispatch-based supply regulated customers
spot market. 6 variety of hedging
arrangements to would be recovered. This
The experience in San issue is the heart of the
Diego in the summer of 2000 manage the risk of these
California financial crisis and
suggests that customers may fixed rate sales; is in the courts now,
not desire a pass-through of including the PG&E
spot market prices. This may bankruptcy case. 8

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 4
 It would have been a very develop hedging strategies to Risk Management
different world if the control the risk arising from
California utilities had been volatile spot prices. A contract for differences (CfD) is a
told, prior to 1998, that their Electricity spot markets, with financial agreement that is linked to
retail functions (including extremely volatile spot prices, the level of spot prices and used for
sales to customers at rate are no exception. Generators risk management. The concept of risk
freeze levels) were to be will seek to limit their price management can be illustrated by
explaining how a CfD works.
separated from the regulated risk by entering into hedges
wires business and removed with buyers. Retailers, if Assume that a buyer (e.g., a
from regulation. unregulated, will also seek to retailer) and the seller (e.g., a
limit price risk exposure. generator) make actual purchases
Risk management would and sales in the spot market,
have been a very high priority Market participants will receiving revenues and incurring
for these companies. develop a risk management costs at the spot price. Both parties
approach that determines the are exposed to risk due to volatile
IV. Risk Management level and type of hedge spot prices.
arrangements they hold and The parties, in order to manage
One large and painful is dependent on the other risk, enter into a simple 2-way CfD.
lesson from California is that mechanisms in the market This contract calls for side payments
the shift from regulated (see insert 1). between buyer and seller based on
utilities to markets brings the level of spot prices compared to
Price caps in the wholesale the CfD strike price.
risk. This is a hard lesson market or large and
after decades of experience in persistent amounts of excess When the spot price is above the
an industry where cost-based capacity (with resulting low
strike price, the seller pays the buyer
transactions and full an amount equal to the difference
prices) will tend to reduce the between the spot price and the strike
recovery of costs in rates appetite of buyers for hedge price. When the spot price is below
were the norm. arrangements. Likewise, the strike price, the buyer pays the
The California experience sellers will have a lower seller an amount equal to the
over the last year can be appetite for hedge difference between the strike price
compared to earlier financial and the spot price. Thus, both parties
agreements if there are large have hedged their exposure to the
hedging disasters such as and persistent supply spot price.
those at MG 9 , Barings shortages in the market
Bank 10 , and LTCM 11 . The (perhaps due to some Other types of CfD contracts are
MG, Barings Bank, and used in risk management, including
constraints on new entry) cap contracts, floor contracts, and
LTCM disasters each involved that result in expectations of collar contracts (the 2-way CfD
experienced and high spot prices. described above is a collar contract
sophisticated trading entities In the early stages of an with the cap and floor at the same
and arose from a complicated electricity market, existing strike price).
series of events interacting infrastructure and Depending on the contract terms
with complex hedging incumbent participant and conditions, a bilateral physical
strategies. While the behavior influence spot contract may be used to achieve
magnitude of the California prices. Later, after similar outcomes as CfD contracts.
financial crisis, at more than participants experience Other financial instruments
$15 billion to date, is much periods of low spot prices and including futures contracts, the
larger than these earlier high spot prices, they will ownership of physical production
hedging disasters combined, develop appropriate risk
facilities (e.g., a retailer owning a
the California crisis was not peaking plant) and other things may
management strategies. be part of an overall risk management
a complicated failure by Vesting contracts can be arrangement.
sophisticated traders. In useful to facilitate the early
California, there was a simple Some companies use complex
development of a contract analyses (e.g., real options) to
failure to hedge. market and to achieve other develop a portfolio of assets,
Companies that operate in deregulation objectives. contractual agreements and financial
spot markets, especially instruments to maximize profits in the
those that sell at fixed prices, V. Vesting Contracts face of risk.

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 5
 Vesting contracts (used the parties to the contracts will come at a
mostly outside the US) are contracts before price.
hedge contracts assigned to deregulation or Market-based contracts
incumbent retailers and privatization, rather negotiated after retailers and
generators at the time of than freely negotiated in generators are in private
electricity industry the market; hands will be have prices
disaggregation, prior to asset that reflect the market, not
divestiture or privatization. • Vesting contracts may necessarily the prices needed
Vesting contracts are usually require approval from to hedge regulated customer
a set of related hedge anti-trust regulators; rates. When spot prices are
contracts between incumbent and low, retailers are unlikely to
retailers 12 and generators 13 . offer above-market prices to
In the vertically integrated • Vesting contracts may generators without
structure of regulated or be used to meet a compensation. When spot
government-owned utilities, broader set of policy prices are expected to be
risk management is primarily objectives as compared high, generators are unlikely
accomplished through to bilateral negotiated to sign a contract at below-
ownership of generating and contracts. market prices without
perhaps transmission assets compensation.
and through long-term power A. Imposed, not As vesting contracts
purchase agreements (often expire, the parties will
negotiated
the equivalent of owning a negotiate market-based
share of a power plant). The Vesting contracts are follow-on contracts. These
introduction of electricity typically put into place in the market-based replacement
markets is usually early stages of deregulation, contracts will have as
accompanied by the de- during the disaggregation of counterparties, in addition to
integration of these a vertically integrated utility. the incumbents, new
companies, separating Properly structured vesting retailers and new generators.
generation assets and long- contracts can provide The contract market will
term power purchase retailers and generators with become more liquid as the
agreements from retail sales portions of the natural hedge vesting contracts expire. As
companies. The implicit inherent in vertical vesting contracts expire over
hedge of retail sale integration. 14 The time, the parties begin with
obligations may be gone. disaggregated entities, with only vesting contracts, move
Vesting contracts provide manageable risk positions, to a mix of vesting and
a mechanism to recreate all can then be sold on a stand- market-based contracts, and
or part of the natural hedge alone basis. Vesting eventually to a portfolio
in the vertically integrated contracts must be done consisting entirely of market-
utility in the form of before the privatization of based contracts.
contracts. This allows the government-owned systems
de-integrated parts of the or before generator sales in B. Regulatory
industry to function in the investor-owned systems. Approvals
market without an abrupt After retailers and generators
change in risk position and are sold, it is spot market Vesting contracts are
allow gradual transition to a prices and expectations of used, among other things, to
contract market. future spot market prices control spot market prices
Vesting contracts are that will determine the price and the power contract
different from commercially and terms of hedging market. Because of this,
negotiated hedge contracts in contracts between these these contracts may require
several important ways: retailers and generators. Any approvals from antitrust or
non-standard terms or trade practices regulators.
• Vesting contracts are conditions in market The use of vesting
typically imposed upon contracts to control market

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 6
 power may involve high levels • Achieve other 2. Behavior
of contracting for some deregulation objectives. Modification. Hedge
generators, especially where 1. Financial Hedges. A contracts can provide most, if
there is a shortage of primary function of vesting not all of the market control
capacity in the market. contracts is to provide features now sought for the
Highly contracted generators participants with financial California market, including
may require a set of hedges that ensure the price caps and control of
“insurance” contracts financial viability of the participant behavior. 17
between generators, reducing participants during the Hedge contracts, and
financial risk of the highly- transition to full especially imposed vesting
contracted generator and deregulation. This might contracts, have the potential
reflecting the natural include hedging the financial to modify the behavior of
portfolio in a vertically exposure of retailers to high market participants. 18 When
integrated utility. 15 These spot prices or providing a a generator is highly
insurance contracts, as hedge to back obligations of contracted, the ability to
agreements between retailers to supply retail profit from market power is
competitors, may also need customers at stipulated or largely removed and the
regulatory approvals. regulated prices (i.e., the rate generator’s bidding behavior
The Australian freeze in California). This is may be modified. The
Competition and Consumer the feature that would have incentive to drive market
Commission (ACCC) has largely prevented the prices up is reduced because
reviewed and approved California financial crisis. profits from higher spot
several applications for A feature that has not prices are removed by the
vesting contract been discussed in the context hedging contracts and
arrangements. The reviews of California is hedging the because high prices in the
by the ACCC have weighed financial exposure of spot market create risk for
any anti-competitive effects generators to low spot prices. highly contracted generators.
of vesting contracts against In markets where there is an Vesting contracts can also
the public benefits arising excess of capacity in the start influence the behavior of
from the deregulation policy of the market, this feature retailers and provide much-
objectives provided by the can ensure the financial needed demand response to
vesting contracts. 16 viability of generators and high spot prices.
prevent bankruptcies and a. Retailers. The
C. Features of shutdowns of power plants. California situation has been
Vesting Contracts Even in markets with more exacerbated by lack of
robust spot prices, such response by customers to
In general, vesting contracts can increase the high spot prices. This lack of
arrangements provide a certainty of generator response is not surprising,
means to manage the revenue and facilitate given the rate freeze. While
transition to full financing, enhancing the some demand response
deregulation. Typically, value of assets to be sold. would occur if spot prices
vesting contracts might: were simply passed through
A vesting contract package
• Provide participants could replicate the portfolio in monthly bills today, this
with financial hedges; of contracts that the would imply a significant
participants might develop degree of rate shock. There
• Aim to modify after many years of market are ways to maintain
participant behavior; experience. This will provide customer tariffs while
the basis for a mature stimulating effective demand-
• Minimize interference side activity in the market.
bilateral hedging contract
with the spot market, market, as market-based As discussed above, in the
the contract market, contracts replacing vesting fully deregulated retail
and the retail market; contracts over the transition market, it is unlikely that
and period. each customer would

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 7
 Hedge Contract Incentives
participate directly in the Unregulated retailers have
wholesale spot market, just Assume a two-way contract for
powerful incentives under
as all consumers do not differences (CfD) between a generator this arrangement (i.e., fixed
participate directly in the and a retailer with a simple all-hours tariffs to customers backed
spot markets for oil, gold, strike price of $50 per MWh and a firm by vesting contracts) to
coffee beans, or other all-hours volume of 100 MW. This manage demand. The
commodities they consume. contract fixes the revenue of the retailer can make significant
generator and the cost of the retailer at
Rather, retailers or other $50 per MWh for the contract volume.
profits by reducing actual
middlemen will package load below the amount
wholesale power purchased Retailer Demand Reduction covered by vesting contracts,
in the spot and contract Incentives and can face losses if actual
markets for resale to If the retailer had 110 MW of load, load rises above the amount
consumers. Retailers will the additional 10 MW above the CfD covered by vesting contracts
prosper by reaching level is purchased at unhedged spot (see insert 2).
prices, providing an incentive to pay
profitable arrangements that b. Generators. Properly-
customers to reduce load so long as
appeal to end-use customers. customer payments are less than the written vesting contracts can
This could include such potential losses from unhedged provide powerful incentives
products as on-peak and off- purchases at spot prices. for generators to make their
peak power, controllable If the retailer had 90 MW of load and power plants available at
appliances, non-interruptible spot market prices were $500 per times of high prices and high
power, and curtailment MWh, the difference between the strike demand, to bid at reasonable
agreements. price and the spot market price ($450 prices, and to coordinate
Because incumbent per MWh) is paid to the retailer (10 MW outages.
times $450 per MWh, or $4,500 per
retailers are regulated under hour) and represents profits. The Availability of power plants
cost-of-service regulation, retailer can make arrangements to is seen as a critical factor in
they will have minimal share these profits with large California. If power plants in
incentive to participate in customers that have the ability to California had appropriate
such activities. Therefore, curtail load. Even if the large customer hedge contracts in place for a
the first step is to deregulate is on a fixed tariff (generally thought to
be immune from price signals), the
significant amount of their
the retailers, so that they capacity, the incentives to
retailer can provide the signals for
keep profits and suffer demand response to high prices. keep that capacity online and
losses. The development of in the market would have
risk management strategies, These incentives only arise if the
retailer is unregulated and allowed to
been significantly enhanced.
and the hedge contracts that suffer losses and keep profits. Similarly, such a contract
implement those strategies, can contain provisions for
will be driven by the risk Generator Reliability and Bidding
annual maintenance that are
preferences of the owners Incentives
at times agreeable to the
and managers of the If spot market price is $500 per MWh retailer (off-peak hours in off-
retailers. When deregulated and the generator is only producing 50
peak seasons). The
incumbent retail companies MW, the generator must purchase 50
MW of power at $500 per MWh and generator will accomplish
are obligated to serve resell it to the retailer at $50 per MWh. maintenance outages in
customers at regulated fixed This cash loss of $450 per MWh will other times only after
prices during the transition provide a powerful incentive to the securing their own outage-
period, they would be generator to keep the power plant specific hedge contract or
provided with a portfolio of operating and available. Further, the
backup source of generation.
vesting contracts to manage generator has a strong incentive to bid
at or neat the contract strike price to High spot market prices
the risk of these fixed sale
ensure plant dispatch and resulting alone will provide an
prices. Additional risk spot price revenues when spot prices incentive for generators to be
management activities, to exceed the strike price. available, but there is a
fine-tune the inherited
Additionally, the generators have difference in the behavior
vesting portfolio, would be incentives to increase capacity above modification of a lost
undertaken by the the CfD contract volume in order to opportunity to make profits
companies. maximize sales when spot prices are and a cash payment to a
high.

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 8
 counterparty. Lost sufficient incentive to build reflect the infrastructure
opportunities to sell at spot peaking units based on already in place. The
prices can remove some portable aero-derivative gas influence of existing
profits from an otherwise turbines that would have infrastructure will decline as
profitable year, while the been in operation before the new entry, new contractual
hedge payments can wipe out summer of 2001. These relationships, and new
a year’s profits in a few days units might have provided participant behaviors arise in
of high spot prices. (See reasonable returns on the market. Vesting
insert 2) investment in a short period contracts can provide a
3. Avoid Price Caps and while helping to avoid useful transition to a more
Distorted Markets. Vesting blackouts. With the current mature electricity market.
contracts can be used to price caps and the Australia provides two
control the market as an expectation that even more examples of the transition to
alternative to other means onerous caps and refunds markets using vesting
such as price caps. might apply, generators are contracts:
Importantly, vesting likely to be shy about
investing in California. • Victoria. The electricity
contracts can be used to
markets in the Australian
focus only on incumbent 4. Other Objectives.
generators. Vesting contracts can be State of Victoria were
structures to help achieve deregulated in the mid-
Imposing price caps on the
spot market when supply is other objectives in a 1990s. One of the drivers of
scarce provides the wrong deregulation plan. Phased deregulation was the high
incentives to new entry. Spot expiration of the vesting cost of installed over-capacity
prices and the expectation of contracts can facilitate a in electricity generation, as
future spot prices drive the gradual shift to market- Government-owned utilities
market for new entry. While based contracts. Vesting had invested heavily in large
it is too soon to determine contracts that are associated base-load coal stations.
the precise impact of price with customer demand and When markets opened, there
caps in California in reducing made portable (i.e., able to was a potential for over-
or delaying new entry, there move to a new retailer, supply, exacerbated when
is almost certainly some should the customer decide
new owners of the privatized
effect. Also, price caps have to leave the incumbent
retailer) can facilitate power plants improved
the effect of removing price
customer choice and the new capacity factor and
spikes and corresponding
incentives for the entry of retailers before the availability. The resulting
development of infrequently expiry of the vesting spot market prices hovered
operated peaking units. contracts. at or just above the marginal
Some have sought to Vesting contract packages fuel cost for much of 1996
define a level of price caps can include contracts that and 1997. Vesting contracts
that would be low enough to cover the first few years of acted to shield the newly
help out the utilities with new entrants to facilitate fast privatized generators from
unhedged spot market start projects. Also, vesting severe financial losses.
exposure and high enough to contracts that are aimed at
avoid deterring new entry. controlling market power can • South Australia. In
Better to use vesting have expiration dates linked contrast to Victoria, the
contracts to hedge utility to events such as new entry Australian State of South
exposure and have no price online dates. Australia entered the
caps. The long-term price cap Australian National
in a competitive market is the VI. Vesting Contract Electricity market in late
new entry price. 19 Examples 1998 with a potential
Indeed, were California shortage of generating
spot prices uncapped, When an electricity market capacity and a high reliance
developers might have had is initiated, spot prices will on imported power from

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 9
 other States, similar to VII. What Can be Done in • Threat of significant new
California. Spot prices were California Now? government-owned or
very high. 20 government-facilitated
Vesting contracts in South Now, the most prudent generation in the
Australia insulated end-use course of action is to state 22 ; and
customers from price shock, negotiate hedge contracts
meeting a Government that will remove the utilities • Price caps, both now
promise that tariffs would from the spot market. From and in the future.
increase at no more than reports in the press, this is These issues may have
inflation for the initial years. being done, although the some impact on the prices
Vesting contracts also terms, conditions and prices negotiated with incumbent
controlled the large potential in these negotiated contracts generators. However, the
market power held by the are not generally available. issues are likely to have a
newly privatized generating Further, the April 26 FERC much larger negative impact
stations. Order requires utilities to on new entry. Power plant
have 95% of their load under developers, investors and
The spot market was bilateral contract or face
allowed to work without lenders will include these
penalties for non-compliance. issues in their analysis of the
interference and significant
new entry was committed It is possible to obtain profit and risk of a new
early, only a month after the some of the beneficial effects power plant investment,
opening of the spot market. 21 of vesting contracts in reducing the attractiveness of
Opportunistic generating negotiated contracts. projects in California. New
companies built small However, it may not be generation plant investments
peaking stations in record possible to negotiate in California already face
time in order to profit from contracts at prices that are significant environmental
summer peak prices. consistent with rate freeze and siting hurdles. Adding
Likewise, the incumbent levels. additional uncertainties to
retailer arranged demand- High contract market future cash flow will further
side deals (e.g., interruption) prices and having to pay for reduce the attractiveness of
with customers in order to contract features that might California as an investment
profit from high spot prices have been easy to obtain in opportunity.
while helping control peak vesting contracts are the Just as the threat of
demand. detrimental result of waiting intervention will dampen new
California seems to be until high spot market prices power plant investments, it
between these two examples, occurred in California to will encourage customers to
but moving toward a arrange hedging for retailers. avoid participating in the
shortage condition similar to California and other contract market. Customer
that of South Australia, but parties (such as the ISO) incentives to enter into
without vesting contracts or appear to be trying to “talk hedging contracts have also
market-based hedge down” the prices of the been removed. Why would a
arrangements. As in South negotiated contracts by customer negotiate a market-
Australia, vesting contracts raising issues that put future based contract to limit
could have helped ease the profits of incumbent exposure to spot market
transition and ensured that generators in doubt. These prices when a combination of
California’s policy objectives issues include: regulated retail rates and
(e.g., stable rates to wholesale spot market price
• Assertions that illegal caps will do this for free?
consumers, stranded cost
acts by generators led to When sufficient hedge
recovery, and security of
supply) were met. high spot prices; contracts have been signed
• Threats of criminal in California, the focus
actions against the should turn to new entry.
owners of generators; For California’s sake, the
State should embrace an

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 10
 unfettered spot market and have a role in
“talk up” the prospects for deregulation; and
much needed new entry soon ers/MSCDEC01; pdf or
after contract negotiations • Show that being wrong http://www.caiso.
are complete. on a bet-the-state co,/docs/2000/12/01/2000120
electricity trade can be 116120227219.pdf (July 6,
very expensive.■ 2001).
VIII. Conclusions and
Lessons learned 5. Paul L. Joskow, Why do we
Endnotes:
Valuable lessons can be need Electricity retailers? Or can
you get it cheaper wholesale?,
learned from California, 1. Davis Haggles for
MIT Center for Energy and
where there were no vesting Transmission Systems, but
Federal Approval is Far from Environmental Policy Research,
contracts, and from other
Certain, Elec. Util. Week, March Feb. 13, 2000,
areas like Australia, where
5, 2001, at 4. http://web.mit.edu/pjoskow/re
vesting contracts were used
tailv2.pdf (July 6, 2001)
extensively. Vesting
contracts are a powerful tool 2. South Australia entered the
Australian National Electricity 6.. Larry E. Ruff, Competitive
to allow the existing Electricity Markets: The Theory and
electricity industry to Market in late 1998 with very
low reserve margins, much of its Application, in FROM REGULATION
transition to open and TO COMPETITION: NEW FRONTIERS IN
functional markets. which came from aging and
ELECTRICITY MARKETS (Michael
inefficient power plants. The
Jurisdictions developing Einhorn, ed., Kluwer, 1994), at 11.
Government limited retail rate
deregulation plans can, and
increases to the consumer price
should, use vesting contracts 7. Stephen C. Littlechild, Why
index (CPI) even though spot
to prevent the financial crises we need electricity retailers: A
prices were much higher than
seen in California. Vesting reply to Joskow on wholesale
those in California. Vesting
contracts can not only contracts managed the risks of
spot price pass-through, WP
protect incumbent customers this arrangement, kept the
21/2000, Research Papers in
from spot market prices and retailer financially viable, and
Management Studies, Judge
retailers from bankruptcy, even made it possible to
Institute of Management
but can do so without the Studies, University of
privatize the retail company.
deleterious effects of price Cambridge, Cambridge, U.K.,
caps. Aug. 22, 2000.
3. It is not clear that vesting
The California crisis contracts could have totally
should not be viewed as a 8. U.S. Bankruptcy Court,
eliminated the problems in
sign that deregulation and Northern District of California,
California. Load and peak
electricity markets are San Francisco Division, Case
demand growth that exceeded
unworkable. Instead it No. 01-30923 SFM, Chapter 11;
expectations and adverse hydro
in re Pacific Gas and Electric
should: conditions might have remained
Company, a California
as problems on the margin.
• Remind us that spot Corporation.
market prices can be 4. Frank A. Wolak, Robert
unpredictable and 9 . MG (Metallgesellschaft AG) is
Nordhaus, and Carl Shapiro of
sometimes very high; a major German metal trading
the Market Surveillance
company. In 1991 MG, through
Committee of the California
• Demonstrate that Independent System Operator,
a US subsidiary, entered the US
deregulation plans heating oil and gasoline markets
Analysis of “Order Proposing
without appropriate by offering 5 and 10 year fixed
Remedies for California
hedging strategies are price contracts to retailers. MG
Wholesale Electric Markets
hedged its exposure through the
risky; (Issued November 1, 2000),”
purchase of futures and OTC
Dec. 1, 2000,
• Provide a demonstration ftp://zia.stanford.edu/pub/pap
energy swaps and by buying an
that vesting contracts

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 11
 interest in an oil exploration
firm. By late 1993, MG was
long in energy derivatives by
about 160 million barrels and
faced falling oil prices. MG
liquidated its hedge positions in
December 1993 for an amount
reported to be more than $1.3
billion.
10. Barings Bank was a
traditional British merchant
bank that collapsed in early
1995. The Singapore office of
Barings Bank accumulated a
very large long position in
Nikkei stock index futures and
Japanese government bonds.
When the Japanese equity
markets collapsed in January
and February of 1995, the
resulting margin calls
exhausted the Barings Bank
reserves.
11. LTCM (Long Term Capital
Management) is a hedge fund.
In December 1997, LTCM
managed about $7 billion of
client money by a complex
strategy of statistical arbitrage,
with leverage bringing the gross
position of the firm up to about
$100 billion. LTCM’s statistical
arbitrage strategy worked well
from 1994 to 1996. However, in
mid-1998, defaults of Russian
bonds led to a cascade of events
that forced LTCM to liquidate it
positions in a declining market
to meet margin calls. LTCM was
reported to have lost about $4.5
billion.
12. The term “retailer” is used
here to refer to the retail
function of the incumbent
vertically integrated utility,
whether or not the retail
function is in a separate entity.
Most regulated distribution
Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001
companies in the US market are
also retailers because they
retain some customers or have
provider of last resort
obligations. A very important
lesson from California is that
the retail function is risky,
whether it is embedded in a
larger company (i.e., a regulated
utility that also has generation,
transmission, and distribution
businesses) or it is formed into a
single-purpose retail company.
13. The term “generator” is used
here to refer to the supply side
of the market. This may include
unregulated generators,
regulated utilities with
generation, holders of contracts
with generators, or other parties
that participate in the supply
side of the wholesale market.
14. The natural hedge in a
vertically integrated utility may
consist of a mix of power plants,
power purchase agreements,
power sales agreements, and
other things. All these can be a
part of a vesting arrangement.
While vesting contracts may be
able to preserve portions of the
natural electricity price hedge
inherent in a vertically
integrated company,
transferring the obligations and
rights of the parties into
bilateral contracts will certainly
add new risks and more sharply
define other risks for both
parties.
15. A base load generator with a
4-unit power plant might
normally seek to fully contract
only 3 units, leaving the fourth
unit in reserve for self-insurance
against performance risk. If the
generator is subject to vesting
contracts that cover all four
units, other insurance contracts
(e.g., with a peaking generator)
may be included in the vesting
package to reduce the financial
risks held by the base load
generator. See the Vesting
Contract final determination for
South Australian Treasury at
www.ACCC.gov.au (under
Electricity, Authorisations,
Other Applications) for an
example of a vesting contract
package with high contracting
levels and concomitant
insurance contracts.
16. See www.ACCC.gov.au
(under Electricity,
Authorisations, Other
Applications) for examples.
17. Memo on 2001 Market
Stabilization Plan from ISO staff
(including Ziad Alaywan,
managing director, engineering
and training; and Lorenzo
Kristov, manger, market design),
to the ISO Board of Governors,
March 12, 2001; and Order
establishing Prospective
mitigation and monitoring plan
for the California wholesale
electric markets and
establishing an investigation of
public utility rates in the
wholesale Western energy
markets, 95 FERC ¶ 61,115,
April 26, 2001.
18. For a more detailed
explanation, see Scott M.
Harvey and William W. Hogan,
“California Electricity Markets
and Forward Market Hedging,”
October 17, 2000; Severin
Borenstein, “The Trouble with
Electricity Markets (and some
solutions),” POWER Working
Paper number 081, January
2001; and Frank A. Wolak, “An
Empirical Analysis of the Impact
12
 of Hedge Contracts on Bidding I mean at least 50%.” Gov. Davis
Behavior in a Competitive Explains What Went Wrong in
Electricity Market,” Fourth Calif. Market, Restructuring
Annual POWER Research Today, March 7, 2001.
Conference, March 5, 1999
(Berkeley, CA: University of
California Energy Institute).

19. Ironically, the situation in

California may provide an
exception to this. If spot market
prices are capped and viewed as
uncertain due to potential re-
regulation or continued price
caps, new entry may be delayed.
This would lead to continued
shortages, an increased reliance
on price caps and other
intrusive measures that further
stifle incentives for new entry,
and so on.

20. While price caps are in place

in Australia, these caps are at
high levels. The price cap is
now at AUS$5,000 per MWh,
with prices occasionally hitting
the cap in South Australia. The
price caps will be increased to
AUS$20,000 per MWh over the
next several years.

21. International Power’s Pelican

Point combined-cycle power
plant was developed on a very
fast schedule, beginning with
the purchase of a Government-
owned site that had received
preliminary permits and
approvals and a short-term
hedge contract that formed part
of the incumbent retailer’s
vesting contract package.

22. It was reported that Gov.

Davis has a preference for “an
active role by a public power
authority to make sure that we
build enough power plants…”
“…until we have a clear surplus
of power over demand – by that

Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001 13