Once upon a time, a real estate developer dreamed of building a planned community. The developer, Syd Kitson, envisioned a “city of tomorrow™” in southwestern Florida, designed for efficiency,...
given asset or set of assets. The term "Monte Carlo" comes from the famous city in Monaco-and the many roulette wheels therein. Analysts use computer software-a metaphoric "roulette wheel"-to generate random values for key variables in the model. Those variables change randomly in the real world.
By repeating the process over and over again, analysts can estimate the range of values along which an asset might fluctuate over a given period of time.
Taking this idea a step further, analysts can input values into the model that serve to simulate historic events. In this way, they can learn how a given asset or portfolio might perform in similar situations. For example, one might try to simulate the Midwestern price spikes of 1998, the market disruptions that followed the 9/11 attacks, or the fuel-price impacts of the 2003 Iraq war.
"Two years ago, people would have said operational risks were too complicated and difficult to model with Monte Carlo simulations," says Laura Brooks, CRO of Public Service Enterprise Group in Newark, N.J. "They'd say it's too difficult and nobody understands it. But now it's more accepted."
Increasingly advanced systems and techniques allow CROs to factor the broadest range of risks possible into their models. In addition to operational risks, examples include regulatory and legal risks, exposure to fuel prices in various regions, and, for global players, sovereign risks and currency exposures.
Companies that take such a holistic view will seek to hedge exposures that another company might overlook. In the long term, these players may prove to be more competitive than their less-sophisticated peers. -M.B.
In the past, utilities have delegated responsibility for compliance and regulatory issues to their legal and regulatory organizations. Risk officers have included regulatory exposures in their periodic roll-up of enterprise risks, but in general they haven't gotten involved in regulatory matters.
That was before the Sarbanes-Oxley Act.
"This is one of the larger risks we are facing," says Scott Smith, chief risk officer at American Electric Power Co. "Some companies might think they have all the controls in place already, but that just means they haven't read all the regulations."
Likewise, Duke Energy's risk-management organization has been involved in managing Sarbanes-Oxley compliance issues. "We've spent more time and resources on Sarbanes-Oxley than I would have envisioned," says Richard Osborne, Duke's CRO.
For some companies, risk-management processes have proved ideally suited to deal with compliance issues. "The whole project integrated with our enterprise-wide risk-management approach. It fit like a hand in a glove," Smith says. "Through these processes you can identify weaknesses in your control environment and determine where you can improve."
In this respect, Smith says compliance requirements are actually proving to be beneficial. And he is not alone.
"Sarbanes-Oxley is an opportunity to improve the business model," says Laura Brooks, CRO at Public Service Enterprise Group in Newark, N.J. "By viewing internal controls as things that reduce the risk of loss and improve the transactional decision-making process, you will improve the bottom line." -M.B.
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