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By Executive Decision

Energy Trading & Risk Management: A better framework for making decisions is required to ensure earnings stability and shareholder value in the utilities industry.

Fortnightly Magazine - October 2005

An effective executive decision framework can be sustained only if its objectives are clearly defined and understood; if decisions regarding resource commitments are consistently based on the framework; and if determination of success is based on that same framework.

Management first must define and prioritize the corporate objectives, including the level of risk that ultimately is tolerable. The goal of this step is to create a template against which the rest of the organization can test proposals. This activity will define the metrics that will be used to evaluate decisions.

The second, equally important requirement to initiate an effective executive decision framework is development of a consensus management view of the realm of possibilities for the future. This step is intended to define not only the major assumptions and their range of outcomes, but also to identify the contingent event risks, or "shocks," that should be considered. Management must evaluate all decisions such as capital spending, acquisitions & divestitures, resource planning, energy sales, and purchases, using a transparent decision framework that defines the extent to which corporate objectives are achieved and risks are incurred or mitigated.

Once consensus is achieved, all alternatives can be evaluated against that common view, the range of identified impacts, the intolerable outcomes, and the mitigation strategies that have been developed. Based on that information, alternatives can be compared and the options that provide the best value for the firm can be selected.

In its ideal form, the executive decision framework cuts across the organization and is embedded in the corporate culture. Development of the framework, however, more typically is done in stages, applied to those functions or decisions where the greatest near-term value can be achieved.

Planning activities often are the most effective and valuable area to introduce this framework. In particular, integrated resource planning, fuel procurement, and energy procurement are obvious choices, since such decisions are so heavily affected by the volatile competitive commodity markets. Decisions around mergers and acquisitions tend to be more discrete and offer the unique opportunity to develop a broader framework outside the day-to-day activity of the firm. These decisions require evaluations against the market, as well as broad-based review around compatibility with corporate goals, as well as with investor, shareholder, customer, and regulator impacts.

The framework, however, is not limited to activity related to commodity markets. Rather it is intended to deal with operational and financial performance as well alignment with other corporate objectives. For example, the framework can evaluate alternatives in the context of reliability, safety, or financial parameters as well as in the context of diversity, staffing or environmental compliance.

The science of this framework is not particularly new. Portfolio theory shows us that rational investment decisions are best made when a risk-reward trade-off is presented and risk tolerances are evaluated explicitly. This leads to diversified portfolios, a concept well understood by investors. The framework is a very straightforward extension of the same principle to a broad array of decisions. Enterprise risk management is an application of the principle, as is risk-integrated resource planning.

To ensure its effectiveness throughout