The purpose for the Committee of Chief Risk Officers (CCRO) recommendations, as stated in the introduction to their 198-page opus, is "to provide guidance on new methods and tools to establish a...
Risk Experts Speak Out: Where the CCRO Fell Short
A surprisingly timid effort for an industry on the brink.
The purpose for the Committee of Chief Risk Officers (CCRO) recommendations, as stated in the introduction to their 198-page opus, is "to provide guidance on new methods and tools to establish a strong foundation for future growth in this (merchant energy) industry." But the reality is that the recommendations, almost without exception, fail to provide strong leadership in the areas of past and potential future abuse.
Even a cursory walk through the CCRO's four areas of recommendations-governance, valuation, credit, and disclosure-makes this clear.
Inadequate governance, perhaps more than any other issue, has been cited for the excesses and financial chicanery perpetuated by some in the energy merchant industry. The CCRO states that its governance recommendations are "patterned after that of the banking industry." 1 The major points of the CCRO's governance recommendations are:
- The separation of roles among front, mid and back offices;
- The formation of a Risk Oversight Committee headed by the CRO;
- The direct reporting of a CRO to the CEO and board of directors; and
- The independence of mid-office compensation from trading profits.
These are all reasonable and fair recommendations. But are they enough? The application of the first three recommendations did little if anything to stop bogus trades and fraudulent deals at Enron and Dynegy (point of note: Dynegy's CRO was named 2001 CRO of the year by the Global Association of Risk Professionals, at the same time Dynegy's cash-flow-inflating Project Alpha was active), 2 and El Paso Energy. The industry widely viewed these three companies as having best-practice risk policies and top-notch talent.
The implementation of the forth principle, making mid-office compensation independent of trading results, would be a departure from current norms. 3 Unfortunately, this recommendation is naïve, proposed without any recognition as to the likelihood of the success of its implementation, and is destined to fail.
In the past, top risk managers have been able to make 30 to 50 percent of their salary as variable pay based on merchant energy results. While not quite on par with the compensation of top front-office employees, these levels have ensured a talent pool sophisticated enough to keep up with products developed by the front office. If mid-office compensation is moved away from merchant energy results, which alternative might maintain the same level of talent?
Most logically, the alternative should be linked directly to the mid-office's output-the accuracy of its risk models and the reporting of risk. But it is culturally untenable for energy merchants to consider rewarding mid-office employees high variable pay for having accurate risk models if the overall division wallows in losses. More likely the mid-office can expect flat salaries and job cuts if the merchant energy division fares poorly.
Promised earnings from merchant energy activities have been (and, for companies expanding their operations in this area, continue to be) 4 relied upon to beat Wall Street earnings per share (EPS) expectations, thus protecting equity valuations. The front