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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

outdated measures ignore those "unexpected" events that can doom a project or an entire company—even though these virtually are certain to occur once or possibly even several times during the course of a 25-year planning horizon.

Also, uncertainty usually is far greater in one direction than another. In the above examples, the likelihood of gas prices being far above ($9-$12) the long-term expectation of $5-$6/MMBtu is much greater than of it falling below $3. The likelihood of a huge nuclear cost overrun was far greater and had a much larger impact than the possibility of a cost under-run. The impact of a combined-cycle plant not dispatching is devastating to an IPP relative to the windfall that might have occurred with lower gas prices. Any decision process that ignores these realities is likely to lead to major disappointments.

What Is an Effective Executive Decision Framework?

Some companies have introduced concepts like "balanced scorecards," linking them to incentive compensation plans in an attempt to ensure decisions are consistent with diverse corporate objectives. Although possibly effective in defining corporate goals and evaluating and rewarding performance, these approaches do not provide a consistent framework for decision-making. More important, they do not address the risk implicit in today's environment.

An effective executive decision framework is one that ensures all decisions are evaluated with the full range of corporate goals in mind, measured in the context of a risk-cognizant view of the future, and broadly embraced by the executive team. For some areas, that approach may be highly quantitative; in other areas, a qualitative analysis may be all that is available.

To be effective, the decision framework must have three key characteristics:

1) a manageable design and application;

    2) functional information; and

      3) transparency.

        This framework goes well beyond the employment of a risk management program, which is designed primarily to protect the downside. It embeds an explicit risk perspective in the corporate culture that can be applied uniformly to create shareholder value. An effective framework will ensure that decisions are aligned with corporate goals and consistent with the company's tolerance for risk.

        In short, an effective decision framework creates value throughout the organization because:

        • It supports proper resource allocation to meet high-risk needs and to achieve corporate goals by defining consistent and transparent decision-making across all organizational functions. A risk/reward relationship is defined for all options. All corporate groups are required to evaluate options in the context of a common set of assumptions and a common view of the probable range of future states.
        • It integrates short- and long-term decisions across corporate functions by standardizing the backdrop for prioritizing choices.
        • It keeps focus on high-risk areas and issues by embedding risk awareness into the corporate culture.
        • It creates shareholder value by ensuring that risks are maintained within prescribed limits and that high risk areas are addressed. An effective framework allows management to establish credibility with investors, rating agencies, and regulators, illustrating that the company is well-managed. At the same time, it supports the pursuit of high-reward opportunities where significant risks can be managed.

        What Are the Requirements?