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Energy Risk Management: Rise of the Chief Risk Officer

The new CROs are bringing back much-needed discipline to restore investor confidence.
Fortnightly Magazine - October 1 2002

of weather, seasonality, and the interrelation of different commodities. This has made it difficult for companies to identify and track their risk exposures.

Nevertheless, the industry has made progress toward more sophisticated approaches to managing risks. One of the first steps was to include gas and coal prices in their electricity trading analyses. While such efforts obviously improved companies' trading operations, they left out major factors affecting overall performance. "For example, a trading-centered viewpoint does not recognize that a power-plant development group represents an enormous commodity position," says Dunham Cobb, a senior manager with Cap Gemini Ernst & Young (CGEY). "The decision to build a power plant is a decision to buy a long-term coal option."

An even more troublesome problem involves credit risks. Trading systems have become robust at clearing counterparties and measuring credit exposure on the trading floor. However, credit risks don't stop there-a fact underscored by the Enron meltdown.

"When Enron filed for bankruptcy, all the analysts asked, 'what was your exposure to Enron?'" says Phil Kassin, a consultant with PwC Consulting. For many companies, the CFO was unable to answer that question because the company's risk-management infrastructure did not cover large parts of its operations.

"Even the banks couldn't get a handle on their exposure," Kassin says. "Now boards [of directors] are asking, 'do you have the necessary systems in place to manage all this data?' Suddenly risk management is back in vogue."

Combined with the recent California market disaster, the Enron meltdown opened utilities' eyes-and those of regulators, investors and analysts-to a multitude of risk exposures that were not being captured in companies' risk analyses. "Even major utilities have been managed on a reactive basis," Kassin says. "With competition and volatility in prices, they have no choice but to learn to manage these risks or perish."

In practical terms, this means companies need a systematic way to ensure that all their significant exposures are included in their decision-making processes. This is frequently termed "enterprise risk management" or "global risk management," and is defined as a holistic way of viewing and analyzing risks.

Whatever the terminology, companies are striving to develop high-level risk-management competencies and weave them into the fabric of their cultures. This trend is coming none too soon, because better risk management is needed to help the industry restore its credibility and earnings performance.

"The more we can do to support risk management in the industry, the better off we will all be," says Patrich Simpkins, CRO of TXU. "It's important to make executive managers understand that risk-management is not some line function that drains resources. It's an integral part of making money consistently."

Simpkins explains that companies with the highest price/earnings (P/E) multiples have the most consistent revenue performance, and accomplishing consistent revenue in today's energy and utility industry requires world-class risk-management competency. "Many companies fail to understand that, and it creates a huge credit burden on the trading and retail side. Seventy-five percent of the credit capacity is held by fewer than 15 counterparties," he says. "We need more people who can hold up