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Risk Management Starts at the Top

How to sort out strategies and weather the storm.

Fortnightly Magazine - October 2006

trading energy for profit is no different than trading common stocks, soybeans, or tulip bulbs. A market exists. It is volatile. The trader hopes to earn a profit by selling a product on the market at a higher price than the purchase price. The trading business is a high-risk, volatile enterprise that requires strict trading rules and supervision to prevent the kind of rogue trading that can bring down the firm. 6 It requires a capitalization befitting the risk profile, and a keen awareness of the risks on the part of management and directors.

Hedging: Energy buyers or sellers may have a prosaic use for risk management. They do not intend to make a killing in the energy markets. They just want some assurance of the price at which they will buy or sell energy, or to shift some of the risk that they might contract to buy or sell at too high or low a price. Hedging costs money, but it also lowers risk, which lessens the cost of capital. Businesses or consumers who do not view their primary activity as speculation on energy prices should hedge. Those who hedge should regard the activity as a way to lower risk rather than as a money maker. Risk managers of hedgers have to keep the policy focused on cutting risk, and not allow any eager prognosticator to turn the policy toward speculation, “just this one time.”

2. Using trading to build other businesses: Often called “trading around the assets,” this strategy views energy trading as a means to build up an associated business. For instance, the firm owns power plants and views operation of those plants as its real business. But the power plants have to sell the electricity that they produce. A trading operation might help to market the output from the power plants, and might find ways to reduce the price risks involved in selling that electricity on the markets. This type of trading has a specific goal, to enhance the value of the generating assets. It should operate within risk guidelines that prevent it from engaging in other activities, or it will develop other purposes, and probably, raise the level of risk.

In effect, the organization must align risk management with the priorities of the organization, and then stick to the priorities set. Aligning risk management with priorities does not mean something like looser risk management for speculative ventures in order to let them speculate. It means setting procedures that control the activities undertaken. Changing the priorities leaves the firm operating with risk management procedures designed for the previous priority. In addition, the risk managers must apply their standards throughout the organization, else risk activities shift from risk intolerant to risk tolerant divisions within the enterprise.

Role of Risk Managers

The risk manager does not establish the firm’s risk policy. The board of directors does (or should do) that. The risk manager (or the chief risk officer) implements board policy. That means that the board of directors must, consciously, decide the level of risk it wishes the corporation to