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Risk-Management Principles for the Utility CEO

Board coordination is the key.
Fortnightly Magazine - June 2004

incentive to insist on collateral and mitigate counterparty risk where possible.

These charges have to be carefully thought out to prevent gamesmanship by traders. For example, a flat counterparty credit charge will cause traders to migrate toward counterparties with higher average risk than the fixed charge would indicate. Different games can be played with value-at-risk and other market risk statistics. For example, traders will search for positions, like spreads among very similar commodities, which have no VAR impact but nevertheless carry great risk.

Principle #7: The chief risk officer must be empowered and independent.

If you don't have a chief risk officer (CRO), stop stalling! Appoint someone at a high level of the executive hierarchy to this function, even if it is not full-time. The stakes are high, and the cost of failure is great.

The CRO must have complete reports both for himself or herself, and for presentation to management and the board. These include P&L reports, position reports (delta-equivalent and options separately), value-at-risk reports, liquidation value reports, stress testing results, counterparty risk reports, collateral usage forecast reports, working capital forecast reports, policy exception reports, and error reports. If one of your books is a hedge book, then the reports must integrate the underlying assets with the hedges and report on that basis.

Management sets the rules of the game through the policy/procedures documents. The control function referees the game, but the traders will optimize within those guidelines. Unfortunately, the CRO often is asked to be both the head referee and the coach of the game. 2 Poor coaching results from poorly specified and communicated policies. Both poor coaching and poor refereeing can lead to unexpected and unwanted trading performance.

Principle #8: Most things are possible in risk management, except the recovery of past losses. Act now.

This is the saddest moment in a risk consultant's life. They always get the phone call after the big loss occurs, as if they knew how to get it back. Almost anything is possible in risk management policy. Setting policies and controls in line with corporate objectives, measuring results, and rewarding performance appropriately-these are stock in trade for the risk management consulting profession. But recovery of past losses is not possible.

The utility industry has seen disaster after disaster, but many CEOs have not yet focused on trading risk management as a strategic objective. The 1998 power spikes in the U.S. Midwest, the collapse of Enron and coincident disappearance of market liquidity, the agency loss of faith, debt-holder pullback, and re-regulation-if you have been fortunate enough to survive these calamities, are you bracing for the next one, or will you plan to set up your organization to better withstand these disasters in the future?

Perhaps uncharacteristically, the responsibility for integrated risk management now lies squarely on the shoulders of the utility CEO. Fortunately, for a small investment of time, the CEO can establish agreed risk management principles at the board level to ensure that the trading activities of the firm best reflect its overall strategy and corporate direction.

Endnotes

  1. RAROC = Risk-adjusted return on