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Corporate Risk: What Does Management Really Know?

A short list of questions that every board member and senior manager should be able to answer.

Fortnightly Magazine - February 2005

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Spark-spread risks, retail risks, equity risks, operational/reliability risks, credit risks, catastrophe risks, legal risks, regulatory risks. … With all of the risks facing today's utility, how is senior management supposed to know which risks to self-insure and which risks to shed? The task can seem daunting, but the leader of a well-run risk management program will clearly identify the organization's core competencies and then decide which risks he is better capable of managing than outsiders. For example, a utility's knowledge of the physical demand characteristics of its customer base and the physical constraints surrounding its fleet and its region typically give that utility a competitive advantage over potential outsiders in managing physical supply risks. Alternatively, the credit risk inherent in a 10-year power purchase agreement with an energy merchant may be something that a financial institution is better prepared to manage.

Reaching the desired risk profile by reducing these unwanted risks comes at a cost (think insurance premium), but the criteria used to evaluate the decision should be the comparison of the opportunity cost of self-insuring to the cost of insuring the risk through a third party and freeing up the firm's capacity to take more risk in other areas.

4. Does the commercial staff have the proper incentives to reach our desired risk profile?

The answer to the question depends on the company's ability to measure and assess the firm's allocation and use of risk capital (capacity to take risk). This process already has been developed in the banking and insurance industries and is mandated by international banking regulations. The process is more challenging for utilities but valuable nonetheless. Implemented correctly, the process introduces a framework for quantifying the risk-taking capacity of the firm by comparing it to established metrics such as rating agency and capital market financial ratios, and comparing the effect of different risk mitigation alternatives (, insurance vs. hedging vs. credit default swaps).

The backbone of this approach relies on the firm charging for the use of its risk capital just as it charges for the use of cash capital or credit capacity. Risk charges and hurdle rates provide a concrete comparison of risk to return and form the basis of the firm's risk-management strategy. Consider a simple example where management is considering purchasing insurance against an unplanned outage. At the same time, they are considering entering into a credit default swap with a major bank to protect one or more of their credit exposures. By assigning a charge for risk, 25 percent for example, staff can use a simple formula to compare the two. Both transactions have a risk reduction benefit (25 percent multiplied by the risk reduced) and a cost (premium). The alternative with the largest risk adjusted value (Risk Reduction x 25 percent - Premium) offers the most efficient use of the firm's risk capital. If the insurance purchase resulted in a risk reduction of $75 and cost $10, and the credit default swap resulted in a risk reduction of $50 for a cost of $5, then this approach would yield the