U.S. District Court Judge Joseph Farnan, Jr. on October 16 approved a $36.5-million settlement resolving class action lawsuits alleging securities laws violations against the bankrupt Columbia Gas...
Risk-Management Principles for the Utility CEO
ambiguous. Should the trader be measured on risk reduction, or P&L? Either way, management will be disappointed if both goals are not reached.
The second directive, offering a range of hedges, may be achievable, but introduces tremendous ambiguity and is therefore always inappropriate. Should the trading group be compared to a 25 percent hedge to see if they made money, or a 50 percent hedge at year-end? The "better of" benchmark is unachievable by definition. No money manager would agree to such a benchmark. The trading group is guaranteed to fail relative to at least one of these hedging endpoints, unless they trade their positions actively. Even if they trade actively and beat both benchmarks, they are starting from an underwater position. It is possible that they could be fantastic traders, but this benchmark could rate their value-added as negative.
Also, how does management deal with the possible illiquidity of the markets where they sell power? If a 25-percent hedge is achievable only at a significant cost, should the traders execute the hedge regardless of the price? Of course not. We need some pricing discipline in addition to a risk-management discipline. In this case, the benchmark is not specific and probably not achievable. Traders may be compared to an impossible alternative as a result. The board may be disappointed regardless of the outcome.
Principle #4: Each trading book is allowed only one benchmark and one objective.
Multiple objectives from trading must be separated into different trading books. For example, if you both want to hedge and to profit from speculation, you probably should have a hedging book and a spec book. Recognizing that the agencies hate terms like "spec book," you might want to call this by another name.
Notwithstanding the books' designations, each book may have only one benchmark. The hedge book, for example, should take as a benchmark the unhedged asset position, perhaps net of any marketing contracts. This is specific and achievable by hedging nothing financially. The goal of the hedge book should be either to reduce risk by a certain amount or percentage relative to the native asset position, or to reduce risk only when the expected cost of doing so does not exceed, say, 25 percent.
The first criterion is weak because it allows traders to execute any trade in the name of hedging, regardless of the price. Nevertheless, it is defensible if the alternative is a costly bankruptcy. The second criterion suggests that at year-end, one compares the native position to the combined position (native position plus hedges). The resulting portfolio performance is measured as its incremental P&L together with a risk rebate for reduction of risk. This allows the hedge to underperform the unhedged position, but only by a predetermined amount. One cannot ever look at the hedge book in isolation, since it shows results without reference to the underlying asset position. The proposed benchmark is specific and achievable, and sets a clear performance metric. It compares hedging performance to the alternative of doing nothing, and rewards traders for both profitability and risk reduction.