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The Trouble with Risk Measures

Companies should adopt a far more robust metric.

Fortnightly Magazine - October 2006

Market risk remains one of the most significant issues for gas and power merchants. The SEC requires disclosure of market risks in a company’s annual filings. However, the allowable metrics fail to communicate the type of information an investor actually can use to gain an understanding of the market risk embedded in a company’s business.

An “earnings-based” market-risk metric is an alternative to the existing “value-based” risk metric. This article provides a simple example that demonstrates how the metric works for an energy merchant that controls generation and wants to hedge that exposure using gas and power swaps.

One common “value-based” risk metric is value at risk, or VaR, which is well defined and reasonably understood in the power and gas sector. In fact most investor-owned utilities use VaR to satisfy the SEC’s market-risk disclosure rules. VaR is defined as the maximum reduction of value that could be experienced from the impact of a set of market risks for a specfic holding period given a selected confidence level. Generally, holding periods are one to five days, while the confidence level is 95 to 99 percent.

VaR generally is considered an effective market risk measure for financial institutions that primarily follow mark-to-market (MtM) accounting and trade in liquid equity, fixed-income, and foreign exchange rate markets. On the other hand, energy companies have a more complicated business and financial reporting model. VaR is a much less effective metric for them.

While most energy merchants have some type of trading and risk-management activity that requires mark-to-market accounting, the core of their business includes signficant asset and customer-driven, load-serving activities that require accrual-based earnings recognition. While these activities often are more risky than the trading and risk-management acitivity, they usually are not included in the VaR metric.

Energy companies should adopt a far more robust market-risk metric that captures both the impact from trading and risk management, and the earnings from their accrual-based business. Earnings at risk (EaR), profit at risk, and cash flow at risk are all references often quoted in public disclosures and the press. However, there does not seem to be a common standard around which these metrics are based.

One definition asserts that EaR is the maximum shortfall of earnings, relative to a specific target, that could be experienced because of the impact of a set of risks for a specific period given a selected confidence level.

• Earnings are forecasted using business rules that are consistent with the organization’s financial or management reporting model. Accrual and MtM processes are incorporated on the appropriate positions so that forecasted earnings are consistent with what is reported ultimately in the financial statements.

• Specific targets vary. Some use the expected outcome from a large number of potential scenarios. Others used the forecast from a business plan or required earnings targets stated in debt covenants.

• Risks typically include forward and spot price risks as well

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