Special Series (Part 1)
Energy Risk & Markets
An effective risk-management strategy depends on knowing your...
Risk Experts Speak Out: Where the CCRO Fell Short
A surprisingly timid effort for an industry on the brink.
office is responsible for meeting these often highly aggressive growth targets, which can have direct significant impact on the wealth of senior corporate and divisional executives.
In recognition of the importance and pressure of meeting earnings, the front office almost always exercises an inordinate amount of de facto organizational power over the mid and back office. As noted above, even in shops with strong independent CROs, the mid-office can be pressured to contribute to earnings 5 or turn a blind eye to liberal valuation interpretations.
The CCRO governance recommendations are ineffectual given recent history, the issue of executive compensation, the problematic nature of mid-office independence, and the proposed structure that continues to rely on internal risk groups to be the sole policeman of merchant energy risk. Although the CCRO notes that this structure has worked successfully in the banking sector 6, it fails to note that the independence of a bank's risk-management group is augmented by the scrutiny and threat of audit by banking regulators. By ignoring the importance of an independent third party to guard the autonomy of the risk function, the CCRO governance recommendations do not come close to its objective of providing guidelines that will instill the integrity in merchant energy risk practices on par with the banking industry. 7
While the issue of flawed governance has received the most press and legislative response , 8 the favorite weapon for earnings manipulation has been the loose standards governing energy instrument valuation. Unfortunately, the CCRO did not rise to the challenge of recommending actionable industry standards but instead issued rather general guidelines that propose little that's new. The CCRO recommendations are to:
- Use the appropriate value-at-risk model;
- Back test value-at-risk model, and suggested metrics;
- Stress scenario and sensitivity test portfolios; and
- Use risk-adjusted performance metrics.
Like the governance recommendations, these recommendations are valid and should be employed, but they break no new ground; the majority of companies are already complying. These recommendations are unsatisfactory in that they do not endorse a VaR methodology.
While the CCRO describes the characteristics of the three primary VaR models, it stops short of endorsing a Monte Carlo as the preferred model. Of the three, only Monte Carlo can take into account forward market information and account for the non-linear risk from options.
[Editor’s Note: Monte Carlo simulation is a method of pricing derivatives by simulating the evolution of the underlying variable (or variables) many times over. Monte Carlo is useful in the valuation of complex derivatives for which the exact analytical solutions have not been found, but it can be computationally intensive. Monte Carlo simulation can also be applied to a portfolio of instruments, rather than a single instrument, to estimate the value-at-risk of that portfolio.]
In addition, the CCRO provides no guidance on how to set appropriate VaR limits. The banking rules on which the CCRO modeled its efforts speak at length to risk capital adequacy and how to set VaR limits. The CCRO provides a description of "risk capital" but fails to go to the next level and state recommendations