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Risk-Management Principles for the Utility CEO

Board coordination is the key.
Fortnightly Magazine - June 2004

spec book, unlike the hedge book, must be evaluated on a standalone basis. In this case, positive P&L alone is not enough to justify this business activity. The P&L must exceed risk and capital charges to justify continuing or expanding the activity. There are separate controls required to protect against a multitude of risks on this book, but these largely can be considered implementation details subject to an overall tolerance to bear speculative risk that does not disrupt the firm's capital plan.

Principle #5: Risk management objectives are linked to corporate financial objectives.

Many utilities link their trading risk limits to risk tolerance and choose their counterparty limits according to their credit ratings. This offers the appearance of trading risk control, but at the expense of missing an overall corporate objective. For example, if the corporate objective is to conserve enough internal cash to get through the planned capital expenditure cycle, then the trading controls should be chosen in concert with this corporate goal.

If the corporate goal is to maximize expected earnings before interest, taxes, depreciation, and amortization (EBITDA), subject to a minimum level of EBITDA, then the trading group should be measured on its contribution to expected EBITDA and worst-case EBITDA. If the corporate goal is to minimize the probability of insufficient cash to make fixed payments, then the trading goals should be expressed in terms of worst-case working capital requirements. In both cases, the link between corporate goals and the trading measures of risk causes the trading group to align with the rest of the corporation in achieving a common goal.

Principle #6: Scarce resources, like risk capital, credit capacity, collateral, and working capital, must come at a cost.

Many firms are short on personnel relative to their opportunities and can logically conclude that other things being equal, their allocation of people to an activity should correspond with the highest profitability per person. In fact, every scarce resource of the firm should be allocated to its best possible use. Furthermore, scarce resources should come with a price to ensure that managers use these resources wisely.

So why is risk capacity any different? If the company has a limited capacity to bear risk, then to induce traders not to squander this scarce resource, management must put a cost on it. Almost all banks now include risk charges for traders using a RAROC 1 adjustment, along with many energy companies. Risk charges ensure that traders take risk efficiently. For example, if a trader goes long on gas by purchasing forwards or calls, if he is otherwise indifferent, he will choose calls to minimize his cost of risk capital, because they minimize risk to the downside.

Similarly, if the company is concerned about working capital usage, it can put a cost on it to induce traders to make trades with lower cash requirements or to seek cash funding of trading mark-to-market outside the firm's balance sheet. If the company is concerned about counterparty credit-risk capacity-not an unreasonable concern in today's markets-there should be a charge on counterparty risk to give traders the