t

TB0191
March 3, 1999

os
British Columbia Hydro

rP
“Treasury cannot be seen as a passive activity,” Bell says. “Once we isolated treasury as a
separate subset of our business and set some goals for it, it helped our people view problems in
a fresh way. If you think of it in terms of opportunities, it may be the biggest profit centre you
have got in your company, particularly if you are capital intensive.”
Larry Bell, CEO, British Columbia Hydro
Intermarket, September 1989.

yo
British Columbia Hydroelectric and Power Authority (BC Hydro) is a Provincial Crown
Corporation, a wholly owned subsidiary of the Province of British Columbia. BC Hydro is
the fifth largest Canadian utility, generating, transmitting, and distributing electricity to
more than one million customers in British Columbia. The fact that it is a government-
owned utility does not change its need to manage treasury operations against financial
risks.
op
BC Hydro has substantial exposure to financial risk. Larry Bell, as Chairman of BC
Hydro, was determined to do something about the financial price risks—the movements of
exchange rates, interest rates, and commodity prices—facing the firm. It was now March
1988, and the time for discussion had ended and the time for decisions had come.

Financial Exposures
tC

Upon taking over as Chairman of BC Hydro in late 1987, Larry Bell started at the ground
up in his analysis of the firm’s financial exposures. Bell was formerly British Columbia’s
Deputy Minister of Finance, and therefore not a newcomer to issues in financial manage-
ment. His first step was to isolate those major business and financial forces driving net
income (revenues and operating costs) and the balance sheet (asset and liability component
No

values).

BC Hydro was—at least by financial standards—relatively simple in financial struc-

ture. The firm’s revenues came from power sales. Power sales were in turn divisible into
residential and small business (60%), and transmission sales (40%). Residential power use
was extremely stable, so that 60% of all revenues of BC Hydro were easily predictable.
However, the same could not be said of transmission sales. This was power sold to large
industrial users, user’s who numbered only 80 at that time. The power use of these 80
Do

industrial users was determined by their business needs, and needs were highly cyclical. BC
Copyright © 1999 Thunderbird, The American Graduate School of International Management. All rights reserved.
This is a revised version of a case originally prepared by Professor Michael H. Moffett, University of Michigan, 1992.
This case was prepared for the purpose of classroom discussion only, and not to indicate either effective or ineffective
management.

This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
Hydro’s sales were predominantly domestic, with only about 5% of all revenues generated
from power sales to utilities across the border in the United States.

os
The cost structure of BC Hydro was also relatively simple—debt service. Debt service
dominated operating expenses, averaging 55% of operating expenses over the mid-1980s.
(Debt service rarely constitutes more than 15% of operating expenses in typical corporate
financial structures.) Power generation, however, is extremely capital intensive. The require-

rP
ments for capital are met primarily by debt.
In 1987 BC Hydro had approximately C$8 billion in debt outstanding. Unfortu-
nately, BC Hydro was a victim of its own attractiveness. It had been a direct beneficiary of
the need for U.S.-based investors to diversity their exposures in the late 1970s and early
1980s. It had tapped the U.S. dollar debt markets at extremely attractive rates for the time.
But now it was faced with the servicing of this U.S. dollar-denominated debt, a full-half of

yo
its total debt portfolio. Much of the U.S. dollar debt had been acquired when the U.S.
dollar was weaker (approximately C$1/US$) and both U.S. and Canadian interest rates
were higher. As shown in Exhibit 1, the appreciation of the U.S. dollar had resulted in an
increase in the Canadian dollar debt equivalent of C$750 million. Equity amounted to
approximately C$540 million. BC Hydro was highly leveraged to say the least.
Exhibit 1 Currency Composition and Exchange Rate Impacts on British Columbia Hydro’s Liabilities and Net Worth
op
Initial Values March 1988
Debt and Equity by Currency of Denomination (Canadian Dollars) (Canadian Dollars)
Debt Canadian dollar-denominated 4,000,000,000 4,000,000,000
U.S. dollar-denominated 3,250,000,000 4,000,000,000
Equity 540,000,000 540,000,000
Total liabilities and net worth 7,790,000,000 8,540,000,000
tC

Exchange rate related gains (losses) (750,000,000)

Source: BC Hydro and Moodys Canada. Initial values debt are Canadian dollar equivalents, regardless of
original currency of denomination, on original date of issuance.

BC Hydro had followed the general principles of conservative capital structure man-
agement. It had financed long-term assets with long-term debt. The match of asset and
No

liability maturities was quite good, but the currency of denomination was not. This cur-
rency mismatch constituted an enormous potential exposure to the financial viability of the
firm.

Isolating the Issues

In early 1988 Chairman Larry Bell called in Bridgewater Associates, a Connecticut finan-
cial consulting firm, for help. Bob Prince and Ray Dalio (president) of Bridgewater, along
Do

with senior management of BC Hydro and representatives of the BC Ministry of Finance

met at Whistler Mountain, British Columbia. The purpose of the retreat was to first iden-
tify the primary financial risk issues facing BC Hydro, and secondly purpose preliminary
solutions. Chairman Bell encouraged an open exchange of ideas.1
1
Intermarket, September 1989, p. 26.

2 TB0191
This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 We have to do what makes sense economically. We’ll deal with the accounting and regulatory

t
hurdles after they’ve been resolved. If someone wanted to point out that our legislation

os
wouldn’t allow us to trade in futures, that’s fine. The legislature sits every year.

Bell felt that consideration of institutional or legal constraints would prevent the analysis
from getting to the core issues. The group proceeded to isolate two basic questions that had
to be addressed prior to moving forward:

rP
1. Does BC Hydro want to eliminate all financial risk, or only manage it?

2. BC Hydro is in the business of providing power. Is it also in the business of trading or

speculating in the financial markets?

Discussion was heated on these points and ended with no clear agreement initially.

yo
Ray Dalio of Bridgewater pushed the discussion by arguing that the interest rate and for-
eign exchange problems the firm was saddled with were the direct result of a simple basic
problem: the lack of a plan.

BC Hydro hadn’t thought through its financial activities strategically. They were thinking
about running their business, not asset-liability management. You can’t take that approach
in a volatile economic environment.
op
The participants agreed to move on to a detailed discussion and analysis of the BC
Hydro’s financial exposures without resolving these first two issues.

Financial Price Risks

tC

Financial risk management focuses on how the movement of financial prices (interest rates,
exchange rates, and commodity prices) affect the value of the firm. Isolating these impacts
on any individual firm requires the evaluation of how revenues and costs, both operational
and financial, change with movements in these prices. Bridgewater Associates and BC Hydro’s
staff conducted a number of statistical studies to find what economic forces were at work in
the costs and revenues of the firm.
No

Revenues. The results were quite clear. The 60% of power sales going to the 1.25 million
small business and residential consumers was extremely stable, and was therefore insensitive
to movements in interest rates, or other business cycle indicators such as unemployment or
inflation. In fact residential power use was sensitive primarily to population size. The 40%
of power sales to the large industrial users was, however, very cyclical. Closer analysis of the
industrial users indicated that these users were sensitive to basic commodity prices (pulp,
paper, chemicals mining, etc.). Statistically speaking, transmission sales were found to be
Do

heavily dependent on movements in commodity prices (positively related) and industrial

production (positively related).

Costs. A closer look at the cost structure of BC Hydro also revealed a number of clear
economic forces at work. Operating expenses were dominated by debt service, over 55% of
the total. The remaining 45% of operating costs possessed little variable content. Although

TB0191 3
This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
business conditions for industrial users could decline, the nature of the utility industry still
required that operations continue with little change in operating expenses achievable.

os
Secondly, since 55% of operating expenses were debt service, costs could potentially
move directly with interest rates. But BC Hydro’s practice over the past decade had been to
finance long-term assets with long-term debt, and long-term debt at fixed rates obviously
did not move with shorter-cycle interest rate movements. Long-term interest rates were

rP
locked in. And interest rates (short-term and long-term rates) had in general been falling in
both the United States and Canada since the early 1980s.

Short-term interest rates move with commodity prices. Because increases in commod-
ity prices frequently lead to more inflation, and interest rates and bond yields must in turn
move with changes in inflation, significant commodity price increases translated directly
into rising interest rates.

yo
Exhibit 2 British Columbia Hydro’s Revenue and Cost Sensitivity to Commodity Price Changes
Value (C$)
Power Sales
op
Short-Term I/Rs

Long-Term I/Rs
tC

% Change in
Commodity Prices

It was now clear that if BC Hydro’s revenues and cost structures were to be managed
No

against underlying economic or financial forces, protection would be needed against com-
modity prices. Exhibit 2 illustrates how power sales moved positively with commodity
price changes. At the same time, it also shows how short-term interest rates moved with
commodity price changes, but long-term interest rates did not. Since BC Hydro was fi-
nanced nearly exclusively with long-term debt, its present debt structure was not enjoying
the fruits of these correlated movements (lower commodity prices and interest rates).

Currency Exposure. BC Hydro was facing an enormous foreign currency exposure. The
Do

fact that revenues were 95% Canadian dollar-denominated, while C$4 billion of total long-
term debt was a U.S. dollar-denominated, meant that debt-service was completely exposed
to currency risk. The firm earned only 5% of its revenues in U.S. dollars, and therefore had
no “natural way” of obtaining the foreign currency it needed to service debt. As Exhibit 3
illustrates, although the U.S. dollar had risen versus the Canadian dollar steadily between
1980 and 1986, the Canadian dollar had regained some ground in the past two years.

4 TB0191
This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
Exhibit 3 The Canadian Dollar/U.S. Dollar Exchange Rate, 1980-1987 (C$/US$)

os
1.40

1.35

rP
1.30

1.25

1.20

yo
1.15
80.1 81.1 82.1 83.1 84.1 85.1 86.1 87.1

By 1988 Larry Bell estimated that BC Hydro had realized C$350 million in foreign
currency losses on its U.S. dollar debt, all of which passed through current income. The
remaining exposure still approached C$400 million depending on the direction of the ex-
op
change rate movement. Something had to be done quickly. The urgency of the issue was
particularly acute given that the total equity of BC Hydro amounted to only C$540 mil-
lion!

The outstanding U.S. dollar debt was to be repaid in single “balloon” payments upon
tC

maturity. BC Hydro therefore had an enormous amount of cash flowing into a sinking
fund for debt principal repayment. The funds were presently being reinvested in Canadian
bonds, yielding short-term current rates on Canadian debt instruments.

Proposed Risk Management Strategies

Several alternative solutions were put forward for both the revenue-cost risks and the for-
No

eign currency risks. It seemed the solutions would have to be independently constructed.

The basic revenue-cost mismatch, the fact that BC Hydro held little short-term debt
which would parallel the movement of revenues with commodity prices, was attacked first.
The obvious solution was to increase the proportion of short-term debt. Although this
approach would clearly increase the matching of commodity price cycles, it would do the
opposite with regard to asset-liability maturity matching. It was argued that 60% of all
power revenues were still very stable, and that the debt structure of the entire utility should
Do

not be reworked in order to pursue risk management goals. The critics of the short-term
debt approach also emphasized that historical correlations might not hold up in the future.
Movements of revenues and short-term interest rates correlated with commodity price
movements may not hold true. The debate was heated.

TB0191 5
This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
 t
The foreign currency exposure problem was at first glance, simple. The easiest and
most risk-averse approach would simply be to buy U.S. dollars forward. There was little risk

os
in that the debt-service schedule was known exactly in terms of amounts and timing, and
the resulting forward cover would eliminate the currently risk.

Several senior finance ministry officials suggested a currency-interest rate swap in-
stead. All agreed that both would work equally well. However, they were not certain that as

rP
a Crown Corporation they would be allowed to enter into a swap agreement. Late in the
afternoon of the weekend retreat an additional detail was also recognized, that the signing
of a forward contact (or series of forward contracts) to cover the U.S. dollar debt-service
would require BC Hydro to recognize and realize (pass through the income statement) the
total currency loss remaining, approximately C$500 million. This was obviously unaccept-
able.

yo
A second alternative put forward by Ray Dalio of Bridgewater Associates was to move
all sinking-fund capital out of Canadian dollar bonds into a similar risk category of U.S.
dollar-denominated securities. This would result in the security values moving in the oppo-
site direction of the U.S. dollar debt, thus offsetting adverse (or favorable) exchange rate
changes; a natural hedge. But, this also meant that BC Hydro, a Crown Corporation, would
be intentionally constructing an enormous uncovered foreign currency position. This met
op
with considerable opposition by representatives of the British Columbia Ministry of Fi-
nance.

The participants returned from the quiet wilderness setting of Whistler Mountain to
the hustle and bustle of Vancouver. It was now March 1988; Larry Bell needed a decision
soon.
tC

“When I came to BC Hydro, because half our costs are associated with debt servicing, there
were significant opportunities that could be shaken loose in a proactive treasury operation,”
he recalls. “As a manager, I shouldn’t run this company unless I exploited all of those oppor-
tunities.”
No
Do

6 TB0191
This document is authorized for educator review use only by Joseny Guevarra, Other (University not listed) until Sep 2023. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860