Skip to main content
SpringerLink
Log in

Futures trading and fuel adjustment clauses

  • Published:
Journal of Regulatory Economics Aims and scope Submit manuscript

Abstract

Despite many criticisms and potential problems, wide-spread and, in many cases, long-standing use of fuel adjustment clauses (FACs) continues. This paper proposes replacing use of the FAC mechanism with permission to allow the utility to hedge its fuel price risk(s) in the futures markets. By pursuing a hedging strategy, the utility can achieve higher welfare, while shifting price change risk to speculators in the futures market, provided certain conditions are met. By efficiently transferring risk to speculators, the utility can improve the welfare levels of ratepayers. Thus, the use of futures trading may provide a Pareto improvement over the use of an FAC.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Anderson, R.W., and J.P. Danthine. 1980. “Hedging and Joint Production: Theory and Illustrations.” Journal of Finance 35: 487–497.

    Google Scholar 

  • Arkinson, S.E., and R. Halvorsen. 1980. “A Test of Relative and Absolute Price Efficiency in Regulated Utilities.” Review of Economics and Statistics 62: 81–88.

    Google Scholar 

  • Baron, D.P., and R.R. De Bondt. 1979. “Fuel Adjustment Mechanisms and Economic Efficiency.” Journal of Industrial Economics 27: 243–61.

    Google Scholar 

  • Baron, D.P., and R.R. De Bondt. 1981. “On the Design of Regulatory Price Adjustment Mechanisms.” Journal of Economic Theory 24: 70–94.

    Google Scholar 

  • Bohrnstedt, G.W., and A.S. Goldberger. 1969. “On the Exact Covariance of Products of Random Variables.” Journal of American Statistical Association 64: 1439–1442.

    Google Scholar 

  • Burns, R.E., M. Eifert, and P.A. Nagler. 1991. “Current PGA and FAC Practices: Implications for Ratemaking in Competitive Markets” NRRI 91-13

  • Clarke, R.G. 1978. “The Impact of a Fuel Adjustment Clause on the Regulatory Firm's Value and the Cost of Capital.” Journal of Financial and Quantitative Analysis 13:745–57.

    Google Scholar 

  • Clarke, R.G. 1980. “The Effect of Fuel Adjustment Clauses on the Systematic Risk and Market Values of Electric Utilities.” Journal of Finance 35: 347–58.

    Google Scholar 

  • DeMarzo, P.M., and D. Duffie. 1991. “Corporate Financial Hedging with Proprietary Information.” Journal of Economic Theory 53: 261–286.

    Google Scholar 

  • Epstein, L.G. 1985. “Decreasing Risk Aversion and Mean-Variance Analysis.” Econometrica 53: 945–961.

    Google Scholar 

  • Francis, J., and J. Stephan. 1993. “Characteristics of Hedging Firms: An Empirical Examination,” in Swartz, R., and C.W. Smith (eds.), Advanced Strategies in Financial Risk Management, New York Institute of Finance, New York.

    Google Scholar 

  • Froot, K.A., D.S. Scharfstein, and J.C. Stein. 1993. “Risk Management: Coordinating Corporate Investment and Financing Policies.” Journal of Finance 48: 1629–1658.

    Google Scholar 

  • Gollop, F.M., and S.H. Karlson. 1978. “The Impact of the Fuel Adjustment Mechanism on Economic Efficiency.” Review of Economics and Statistics 60: 574–84.

    Google Scholar 

  • Golec, J. 1990. “The Financial Effects of Fuel Adjustment Clauses on Electric Utilities.” Journal of Business 63: 165–86.

    Google Scholar 

  • Ho, T.S.Y., and A. Saunders. 1983. “Fixed Rate Loan Commitments, Take-Down Risk, and the Dynamics of Hedging with Futures.” Journal of Financial and Quantitative Analysis 18: 499–516.

    Google Scholar 

  • Isaac, R.M. 1982. “Fuel Cost Adjustment Mechanisms and the Regulated Utility Facing Uncertain Fuel Prices.” Bell Journal of Economics 13: 158–69.

    Google Scholar 

  • Kaserman, D.L., and R.C. Tepel. 1982. “The Impact of the Automatic Adjustment Clause on Fuel Purchase and Utilization Practices in the U.S. Electric Utility Industry.” Southern Economic Journal 48: 687–700.

    Google Scholar 

  • Nance, D.R., C.W. Smith, and C.W. Smithson. 1993. “On the Determinants of Corporate Hedging.” Journal of Finance 48: 267–284.

    Google Scholar 

  • Pirrong, C. 1995. “The Welfare Costs of Arkansas Best: The Inefficiency of Asymmetric Taxation of Hedging Gains and Losses.” Journal of Futures Markets 15: 111–129.

    Google Scholar 

  • Scott, F. A. 1985. “The Effect of a Fuel Adjustment Clause on a Regulated Firm's Selection of Inputs.” The Energy Journal 6, No.2, 117–26.

    Google Scholar 

  • Smith, C.W., and R.M. Stulz. 1985. “The Determinants of Firms' Hedging Policies.” Journal of Financial and Quantitative Analysis 20: 391–405.

    Google Scholar 

  • Tiemann, T.K. 1978. “Pass Through Fuel Prices, Not Fuel Costs.” Quarterly Review of Economics and Business 18: 91–94.

    Google Scholar 

  • Watts, R., and J. Zimmerman. 1978. “Towards a Positive Theory of the Determination of Accounting Standards.” Accounting Review 53: 112–134.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Department of Economics, University of Kansas, 66045, Lawrence, KS, USA

    Donald Lien & Lihong Liu

Authors
  1. Donald Lien
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Lihong Liu
    View author publications

    You can also search for this author in PubMed Google Scholar

Additional information

The research benefits from helpful discussion with John Cita of the Kansas Corporation Commission. Gautum Bhattacharyya, Keith Chauvin, Thomas Lyon, Joseph Sicilian, and two anonymous referees provide many useful comments and suggestions. Of course, the authors are solely responsible for any remaining errors. Financial support from the General Research Fund at the University of Kansas is greatly acknowledged.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Lien, D., Liu, L. Futures trading and fuel adjustment clauses. J Regul Econ 9, 157–178 (1996). https://doi.org/10.1007/BF00240368

Download citation

  • Issue Date:

  • DOI: https://doi.org/10.1007/BF00240368

Keywords

Search

Navigation