[BETA] Fortnightly

MODEL RISK MANAGEMENT:

The industry is going down the mark-to-market route, creating significant opportunities for earnings swings and distortions.

Model risk is no longer the purview of quants and analysis groups hidden deep within the organization. With mark-to-market (MTM) accounting, the quants' MTM pricing models now drive earnings, and, as we all know, earnings drive CEOs. Model risk was dragged into the spotlight with the 2002 and 2003 restatement of earnings by many energy-trading concerns, due in large part to over-optimistic model valuations, which removed billions of dollars from the industry's balance sheet. These losses were far in excess of any value-at-risk (VAR) limits, causing stock prices and investor confidence to plummet. Given that many utilities as a matter of necessity must trade in energy markets and new financial traders also are playing this market, the issue of model risk is again a cause for concern.

Furthermore, the triple-whammy of MTM accounting, market illiquidity, and substantial legal liability for auditors massively increases model risk in the electricity industry. Many participants focus on market and credit risk, which is a perfectly reasonable approach, but in some cases it is to the exclusion of model risk management. This exclusion may cause undue risk to future earnings.

Model Risk, MTM, and Mark-to-Model

What is model risk? A model can be defined as a mathematical representation of price relationships in the marketplace. Model risk occurs when either the model does not represent the market accurately or when it may not appear to do so; both present big risks. If the model does not represent the market accurately, the contract will be misvalued and earnings will be misstated. If the model appears to be inaccurate, auditors and investors may apply a higher uncertainty premium to those claimed earnings.

Model risk exists when a model stands between a market price and the valuation of a financial product. Common market indexes include exchanges (, NYMEX and ICE), various broker quotes, and index-reporting organizations.

Most traded products do not fit exactly into the index categories, however. Experience shows that "plain vanilla" hedge contracts, as priced in the market indexes, often are relatively ineffective hedges for a generator or retailer (in particular). Thus, utilities seek out non-standard, or exotic, products that may be more effective hedges and perhaps better value. Examples include monthly contracts, structured transactions, options, non-firm contracts, and combinations thereof.

Energy traders model these exotic contracts as part of their core business and buy and sell based on the model's values; this is the business of trading. The problem arises when MTM accounting is applied. Most companies keep the exotic contract either until delivery or for a long period of time, since they are non-standard and therefore difficult to on-sell. Under MTM though, these contracts have to be frequently valued to get the current liquidation value. The previously applied valuation model is the most obvious way to calculate this MTM.

This is "mark-to-market-through-a-model," or mark-to-model, where the model's output is taken almost directly to the profit and loss (P&L). This is a risk because even if the model