Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies (2012)

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54 Program Implementation Fuel price hedging programs are the most effective way for a public transit agency to manage fuel price volatility. Starting a hedging program can be a long and involved process depending on the type of strategy and instrument and the types of financial activity that the agency is authorized to participate in. This section of the guidebook is designed to provide an overview of the major steps required to implement a fuel price hedging program. These steps are presented in the general order in which they should be undertaken, although work on many of these steps can run concurrently. General timeframes are provided for each step based on interviews with several transit agencies and consultants, but these timeframes can vary significantly from agency to agency. A hedging program can be implemented in a couple of months or several years depending on a number of factors including the complexity of the program and the legal prerequisites. 8.1 Evaluate Impact of Fuel Price Volatility on Budget Variance Timeframe: 1 month The first question that a transit agency should ask before it begins the process of developing and implementing a hedging program is “should we hedge?” This task, best performed by the agency’s finance department, involves an evaluation of the agency’s budget variability and the degree to which fuel price fluctuations contribute to this variability. This evaluation may involve an historical analysis of budget data as well as a forward-looking analysis of the budget’s sensitivity to fuel price changes under a range of hypothetical price changes. This forward-looking analysis should include a study of value-at-risk as well as worst-case scenarios in which the price increases by at least two standard deviations from the mean. Once the agency has determined how much of its budget is at risk due to fuel price volatility, it must assess what the consequences of this risk are for the organization. If the worst-case fuel price volatility has only a small impact on the overall budget, or the agency has cash or other funds available to absorb losses in the event of a worst-case scenario, then a hedging program may not be a necessity. Transit agencies should also consider their ability to manage fuel price costs in other ways, such as passing along fuel costs through fuel surcharges or reducing service on less popular routes. Often, raising prices and cutting service is not possible for public transit agen- cies, but an evaluation of alternative methods of managing budget variability should be performed before deciding to hedge. 8.2 Educate Staff About Hedging Timeframe: 1 to 3 months Once a transit agency has determined that hedging would be advantageous to the orga- nization, it must educate its staff about the different hedging instruments and strategies S e c t i o n 8

Program implementation 55 available. This process involves reviewing informational resources (such as this guidebook), contact ing neighboring transit agencies or companies that have experience with fuel price hedging, and contacting hedging consultants. A hedging consultant may be an employee from the transit agency’s bank or may be an independent adviser. At this stage in the program, hedging consultants and advisers will often work with the transit agency free of charge and will make presentations to the agency explaining the need for hedging, describing the options available, and marketing the consultant’s experience and capabilities. If possible, it may be advantageous to bring in two or more hedging consultants to explain their risk man- agement philosophies and approaches. The agency then has an opportunity to evaluate the consultants’ qualifications and decide which one would be a good fit for the organization. Hedging can be a complex activity that requires careful management, and it is important that the transit agency understand and trust the consultant’s approach to hedging. At this stage, the transit agency should also identify the financial products and strategies that might be effective at hedging its fuel consumption and should consider an optimal duration of the hedge. 8.3 Obtain Authorization to Hedge Timeframe: 0 months to several years This step will vary considerably from agency to agency. Some transit agencies may already have legal authorization to hedge. Often, however, public transit agencies are explicitly prohibited from investment activity, including the use of financial hedging instruments. In other cases, hedging is neither authorized nor prohibited. Regardless of the agency’s legal situation, management should consult the agency’s lawyers to confirm the agency’s legal position and outline how to implement a hedging program within the existing authorization or identify the steps needed to obtain legal authorization. These steps will vary depending on specific state and local laws, budgetary practices, agency bylaws, management structures, and oversight. Obtaining authorization for hedging might be as simple as a receiving approval from the board of directors or as complex as enacting a change in state or municipal law. As a result, obtaining approval for hedging could take from a few days to a few years. Convincing lawmakers or board members to authorize the development and implementa- tion of a hedging program requires transit agency management to convince those in power of the value of hedging. Transit agencies that have successfully obtained hedging authorization recommend using an organized, data-driven approach. Management must present charts and statistics to explain the transit agency’s financial position and explain the potential risk of increases in fuel prices. Often, hedging consultants are asked to explain the finer points of hedging to help engender confidence in the program. Transit agencies that have success- fully obtained authorization to hedge note that it is important to emphasize that hedging is a conservative practice and not a speculative investment activity. One transit agency official interviewed for this guidebook reported using the term forward-pricing instead of hedging when presenting his agency’s risk management strategy to the board of directors because hedging had a negative connotation for some board members, particularly in the wake of news about scandals involving Wall Street hedge funds. (It is important to note that fuel price hedging has nothing to do with hedge funds.) In cases where obtaining authorization to hedge involved a change to state law, some transit agencies reported that banks that wished to act as counterparties to the transit agency in the hedging program helped to lobby lawmakers. In some cases, the hedging program may be autho- rized as a pilot program, and the decision to continue the program on a permanent basis may be made only after an evaluation of the effectiveness of the pilot program.

56 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies 8.4 Develop Hedging Policy Timeframe: 1 month Once authorization for the hedging program has been obtained, the transit agency must begin developing its hedging policy. This policy can be developed before authorization has been obtained or while the agency is in the process of obtaining authorization. The transit agency will often work closely with a hedging consultant to develop its strategy and the agency may not be allowed to compensate this consultant for development of the strategy until it has received autho- rization to spend money on a hedging program. Alternatively, an in-house financial expert can be hired to develop the strategy and manage the program or an existing employee can be trained to do this task. The need for specific expertise (either in-house or outsourced) will depend on the complexity of the hedging instruments selected. Managing fuel price risk with firm, fixed-price contracts can often be handled by the transit agency’s existing fuel procurement officials, and employing user-friendly, web-based price protection programs can be effectively handled by the agency’s existing finance or procurement departments. However, when using financial derivative products, such as futures, swaps, and options, it is highly recommended to develop the agency’s hedging policy with the help of an experienced professional. A hedging policy is a document that outlines the transit agency’s strategy for managing fuel price risk. The document identifies the hedging instruments that the strategy will employ, the maximum hedge level (as a percentage of total projected fuel consumption), the maximum hedge duration (i.e., the farthest-out month that can be hedged), and the strategy for timing purchases. The four components of a hedging strategy were described and compared in Sec- tion 2 of this guidebook. Often, the hedging policy will also outline the process for authoriza- tion and approval of all hedging transactions. In some cases, the hedging consultant may have full authorization to manage the program (including entering and exiting hedge positions) on the transit agency’s behalf. More often, however, transactions must be executed by a designated transit agency official who receives advice and recommendations from the hedging consultant. Under some strategies, particularly those that involve single-point decisions, each hedging trans- action may need to be approved by senior management. The policy will also outline the hedging program’s reporting practices, which might include periodic program reports to management and annual program evaluations. A hedging policy usually will need to be approved by upper management and by the board of directors before it is adopted. Subsequent amendments to the hedging policy, such as extending the hedge duration or using a different hedge instrument, will often also require management and board approval. As a result, it is advantageous to include sufficient flexibility in the hedging policy. For instance, a transit agency may want to include the use of options in its hedging policy even if it initially intends to use swaps as the primary hedging instrument. This will give the tran- sit agency authority to adjust its strategy in the future without obtaining new approval from the board. While broadly worded hedging policies are advantageous from a flexibility standpoint, it is important that the hedging policy provide enough detail and direction to present a clear conception of the agency’s hedging strategy. 8.5 Identify Qualified Derivative Brokers or Counterparties Timeframe: 1 to 3 months When hedging with financial derivatives (futures, swaps, or options), public transit agencies must establish a relationship with qualified brokers or counterparties in order to execute hedging transactions. This step is usually only started once the hedging program has been fully authorized

Program implementation 57 and the hedging policy has been approved. Hedging with exchange-traded futures or options requires a relationship with a broker with a seat on the NYMEX and is an easier process than eval- uating counterparties for over-the-counter transactions. NYMEX brokers execute hedge transac- tions, such as entering futures contracts or buying options, on the transit agency’s behalf while charging the agency fees based on the number and size of transactions. NYMEX brokers do not take on any basis risk and require clients to meet collateral requirements and pay premiums asso- ciated with their NYMEX transactions. The brokerage business is generally competitive in terms of fee structures and brokerage contracts are typically standard agreements. As a result, shopping for the broker with the lowest fees may not yield significant savings. Often, the brokerage firm used for NYMEX transactions is recommended by the agency’s hedging consultant. Establishing counterparty relationships with OTC swaps and options requires a more involved evaluation process. The fees and premiums associated with OTC hedging are less transparent than with exchange-traded products. As a result, fees and premiums may vary from counterparty to counterparty, and it is advantageous to have at least two counterparties compete with each other to provide hedging services with the lowest markup. This means that the transit agency may need to identify and qualify several counterparties before the hedging program can be launched. This process will typically require that the transit agency issue an RFP for interested counterparties, such as banks, financial institutions, and the trading desks of major energy companies. If the tran- sit agency’s hedging adviser is an employee of the transit agency’s bank, then this bank should be prohibited from participating in the RFP in order to prevent a conflict of interest. When evaluating potential counterparties for OTC hedging services, transit agencies should consider a number of factors. One of the most important factors is counterparty risk—the risk that the counterparty will owe money to the transit agency through its OTC contracts, but be unable or unwilling to pay it. In order to minimize counterparty risk, transit agencies will typi- cally select counterparties with investment grade credit ratings. Conversely, providers of OTC hedging services may require the public transit agency to have an investment grade credit rating. (Public transit agencies often do not have credit ratings and may have to have one issued before attempting to enter hedging agreements.) Other factors that transit agencies should consider when evaluating counterparties are the products they offer, limits in terms of volumes and dura- tions, and collateral requirements. 8.6 Negotiate Counterparty Agreements Timeframe: 1 to 3 months Contract negotiation is an important part of any form of fuel price hedging, except when using web-based price protection programs that have standard usage agreements. Hedging with firm, fixed-price contracts involves negotiation on volume, price, delivery dates, and other components. Hedging with futures contracts involves a contract with the futures broker and although this is typ- ically a standard contract, the transit agency may have some leeway on negotiated fees. OTC hedg- ing with swaps and options involves the most time and resource intensive contract negotiations because OTC agreements are often arranged with multiple counterparties and each counterparty may have a different expectation about the agreement. OTC products are fully customizable in terms of the reference price index, methods of calculation, basis risk exposure, settlement dates, and collateral requirements, which results in a large number of negotiable items. As a result, it is not uncommon for a counterparty agreement to be passed back and forth several times between the transit agency, the counterparty, and the lawyers of both parties. Several transit agencies interviewed for this guidebook noted that the negotiation of OTC agreements was one of the most time-consuming steps in implementing their fuel hedging programs. OTC agreements are

58 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies reviewed by upper management, and sometimes the board of directors, before being signed by the transit agency. A full overview of the myriad of negotiable clauses in an OTC hedging agreement is beyond the scope of this guidebook. However, it is important to highlight some of the issues with negotiating collateral. For smaller clients with weaker credit, OTC swap and options providers often require cash collateral to be posted to mark-to-market accounts. This is similar to the margin accounts (performance bonds) required by the NYMEX. Public transit agencies, however, typically have strong balance sheets and can obtain high credit ratings because they have fairly reliable income sources (taxes and farebox receipts) and are often implicitly backed by state and local governments with considerable funding power. As a result, public transit agencies have significant bargaining power when it comes to negotiating collateral requirements. One large Midwestern transit agency reported that it was able to receive one-way cash collateral from its swap counterparties. One-way cash collateral is when one party posts collateral, but the other doesn’t. The Midwestern transit agency was able to achieve this deal because its hedge positions were secured by stable farebox and tax revenues. Other transit agencies reported being able to use buses and physical assets in addition to or instead of cash collateral. 8.7 Begin Hedging Timeframe: not applicable Once the requisite legal authorization, hedging policy, and brokerage or OTC counterparty agreements are in place, the transit agency can begin hedging following the strategy and process outlined in the hedging policy. Several other items that are needed prior to hedging are: a system of tracking profits and losses on hedge positions on a daily basis; a system for ensuring that the targets outlined in the hedging strategy are being met; a system for tracking the performance of the hedging strategy against the program’s goals and benchmarks (i.e., staying within the fuel budget for the year); a system for reporting hedging results to management and the board of directors on a periodic basis; and a system for reporting hedging activity and profits and losses in annual reports and financial statements. Samples of some of these reports and systems are included in the Appendix A: Case Studies.