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Energy Trading: Down But Not Out

The speculative electricity trading industry has a bad case of rigor mortis, but current efforts might breathe new life into the practice.

Fortnightly Magazine - January 15 2003

for physical asset-based trading because they don’t assume that all assets can be liquidated overnight, but they offer the ability to measure the effect of a given contract on the income statement.

“This paradigm will drive new types of valuation and Monte Carlo approaches,” Janardhan says. A significant advantage of EaR and CFaR metrics is that they can be expressed in terms of how they affect the profit-and-loss statement.

“The trend is moving away from VaR, even though the CRO committee has mentioned it extensively,” says Bell of SAS. “CROs and other folks want to see things in terms of profits, earnings before taxes and cash flow. We’re working to break down risk, demystify it, and present it in terms of how it affects the balance sheet.”

Other systemic changes are occurring at the same time. Namely, companies are carefully analyzing the way their systems handle credit-risk management and are investing to enhance them where necessary.

WPS Energy Services is one example. To improve its credit due diligence, the company implemented a system called Corporate Credit Manager, which is produced by Credit & Management Systems Inc.

“The system hooks in with Dun & Bradstreet and some of the agencies that provide financial information, so we can get credit scores quicker and better,” Verbanac says. “We also tightened our policies and our collateral thresholds for counterparties. We put more resources in place to watch the credit of our counterparties more closely.”

Rising From the Ashes

In addition to system changes to account for changing market and credit conditions, companies are preparing to implement standards suggested by the CCRO.

“For most risk systems or end-to-end transaction-management systems, the CCRO is recommending things that we have always supported,” says Gordon Allott, vice president of business development with risk-management system vendor KWI. “It’s just a matter of doing them in a little more organized fashion.”

Until the CCRO recommendations reach a more final stage, it’s impossible to tell exactly what the standards will be. However, in general, the CCRO recommendations will affect trading and risk-management processes in three ways.

First, the CCRO recommends a set of credit-risk management practices that make clear a company’s credit-risk exposures in terms of a single transaction or counterparty, or the net exposure across the portfolio. Some of these steps seem fairly standard in the context of modern credit-risk management approaches, but the details might require significant system changes.

“In terms of modeling credit risk, how do you predict when another Enron will happen?” asks Walker of SunGard. “You can think about credit in the sense of what the real risks are. You can estimate how much you might lose and set aside capital reserves to cover it. But some of the credit-risk modeling recommendations require things that don’t exist right now.” Given the multi-faceted and uncertain nature of credit-risk, adequate credit-risk models will take some time to develop.

Second, the CCRO calls for standardized, transparent accounting methods that separate transactions into three types—proprietary trades (i.e., speculative deals); structured contracts that are not associated with assets; and asset-based contracts. This segregated