AEIC Load Research Workshop

Why Normal Matters Why Normal Matters

By Tim Hennessy

RLW Analytics, Inc.

April 12, 2005

Normal MattersNormal Matters

Normalizing energy and demand is a routine matter.

It allows plans to be developed under the “most likely scenario”

It allows the comparison of loads without on a consistent basis

The choice of what is “normal” has an economic value.

Normal’s economic impactNormal’s economic impact

Simplistic Rate Making: Forecast models are developed using history. Normal weather is applied to the models to determine

sales. Costs are divided by the sales to get prices per unit.

Three possible points of contention: Models, Normal Weather Costs.

Were going to focus on the weather

An exampleAn example

A Utility develops a forecast, using degree days as a independent variable.

The utility chooses a 10 year basis for the Normal degree days.

The PUC says a 20 year basis is more appropriate

The utility determines that the different basis results in over $1M difference in revenue.

The issue: Which basis is better?The issue: Which basis is better? Since 1972 there has been a

general and consistent decline in DD.

Over the span, 59% of the periods the normal DD based on the previous 10 years are less that the normal DD based on the previous 20 years.

Since 1990, the 10 year normal DD is less than the 20 year normal DD in 87% of the periods.

Comparion of Normal HDD

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Month Ending

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Approaches to determine the more Approaches to determine the more accurate degree day basisaccurate degree day basis

Analytical Approach: Forecasting approach based on historical pattern.

Market based approach What does the market place expect?

Analytical approachAnalytical approach

Compares how well a chosen normal DD basis predicts a future period.

The forecast horizon was defined as three years.

The three year average annual DD over starting in month m was compared to the normal DD use a 10 and 20 year basis, ending in month m-1.

Comparison of Normal Degree Days Vs Comparison of Normal Degree Days Vs Forecast Period degree Days Forecast Period degree Days

10 year Normal vs. 3 year Forecast Period

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Normal HDD

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20 year Normal vs 3 year Forecast Period

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Comparison of Error between NDD and Comparison of Error between NDD and Forecast Period DDForecast Period DD

Using a simple comparisonUsing a simple comparison

10 years 20 yearsn 998 998Average 50 69 Std Dev 334 339 Range 1,861 1,834 Max 1,139 1,109 Min (721) (725)

NHDD Basis10 years 20 years

n 158 158Average 123 205 Std Dev 412 362 Range 1,697 1,533 Max 1,139 1,109 Min (558) (423)

NHDD Basis

Since 1920 Since 1990

ConclusionConclusion

In comparing normal DD based on 10 years to those based on 20 years, the 10 year basis has the minimum amount of error.

However, the relationship between historical normal DD and forecast period DD can be used to determine a more accurate DD basis.

Simple ForecastSimple Forecast

The relationship can be quantified by using autoregression techniques that would use normal DD to predict the actual DD during a forecast period.

FPHDD=β*NHDD+ε Where:

FPHDD=The annualized degree days during the forecast period. The forecast period is the 36 months starting in month m.

NHDD= The annualized degree days during the normal basis period. For the 10 year analysis, the normal basis period is the 120 months preceding month m. For the 20 year forecast period the normal basis period is the 240 months preceding month m.

Regression ResultsRegression Results

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Actual HDD Forecast

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Comparison of Error Comparison of Error Predicted Forecast Period DD and Predicted Forecast Period DD and

Forecast Period DDForecast Period DD

The variability, the ranges, and the extremes are virtually identical

The variability of the prediction was substantially reduced by using the model.

10 years 20 yearsn 998 998Average (1) (2) Std Dev 50 48 Range 367 378 Max 190 171 Min (177) (206)

NHDD Basis

Comparison to Chicago Mercantile Comparison to Chicago Mercantile ExchangeExchange

The model generated forecasted DD based on 10 years is within 0.5% of the CME futures.

The modeled generated DD based on 20 years is with 1% of the CME futures.

it does not materially matter if a 20 year or a 10 year basis is used if these bases are adjusted for historical patterns.

Forecast Period HDD Basis

CME HDD Futures 6,995 10 Year Normal 6,957 Based on MSP, ending January 200620 Year Normal 7,059 Based on MSP, ending January 200610 Year Normal Predicted 6,957 Based on January 2006 Prediction20 year Normal Predicted 7,068 Based on January 2006 Prediction

ConclusionsConclusions

DD have generally declined since the early 1970s. The use normal DD to estimate average temperatures during a

forecast period will, on average, overestimate the DD observed during that period.

If normal DD are to be used as an expected value during a forecast period, normal DD based a 10 year average will have an average smaller error, or less bias, than normal DD based a 20 year average.

If expected forecast period DD are estimated using autoregression techniques, the difference in estimated average annual forecast period degree days using normal DD based 10 year or 20 year averages are minimal.

Market Value Of Degree DaysMarket Value Of Degree Days

Weather Derivatives-A type of insurance Most are private contracts, but are traded on

the publicly Chicago Mercantile Exchange Can use to determine the put a value on

degree day basis.

ExampleExample

If the PUC is correct, the Company would meet its revenue requirements when the NDD were 7,060.

However, the Company believes that NDD would only be 6,960.

If the Company’s NDD assumption is correct, it will lose $1M, or $10K/DD.

What value does the market put on DD between 6,960 and 7,060?

ExampleExample

We can design a derivate that would pay $10K/DD, with a limit of $1M, for each DD over 6,960.

If the market values this derivative at $1M, that means it would expect that the NDD to be 7,060.

ComparisonComparison

-$1.1

-$0.9

-$0.7

-$0.5

-$0.3

-$0.1

$0.1

$0.3

6950697069907010703070507070

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ions

Degree Days

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Rates Derivative

Market values DD at $6.3K/DD

Comparison of last 10 years Using eachComparison of last 10 years Using each

Using 7060 Using 6960

Year Actual DDChange in Revenue

Change in Revenue

97 1996 8223 -$ 1,000,000$ 98 1997 7453 -$ 1,000,000$ 99 1998 6273 (1,000,000)$ -$

100 1999 6461 (1,000,000)$ -$ 101 2000 7004 (560,000)$ 440,000$ 102 2001 6730 (1,000,000)$ -$ 103 2002 6945 (1,000,000)$ -$ 104 2003 7098 -$ 1,000,000$ 105 2004 6835 (1,000,000)$ -$ 106 2005 6670 (1,000,000)$ -$

(656,000)$ 344,000$

ConclusionsConclusions

In our example, 6,960 may be a little to low, and 7,060 is too high.

If 7,060 is used, RR should be increased to make up for the projected shortfall. Alternatively, if 6990 is used, RR could be lowered a little.

The choice of Normal can have significant economic impacts.

The market can be used to put a value degree days.