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The Trouble with Risk Measures

Companies should adopt a far more robust metric.

Fortnightly Magazine - October 2006

the overall cash position change within the organization.

For the purposes of this article, we will focus on the elements of earnings and cash flow that are similar. The following sections use an example of a simple gas and power portfolio to better define EaR and contrast it with VaR.

Consider a 1,000-MW tolling contract on a natural-gas-fired generation plant in ERCOT that covers the plant’s operations from February 2006 through the end of June 2006. For each hour in the period, net earnings are determined by the following formula:

Net Earnings = Plant Capacity * Max(0,P ee – (Heat Rate * P ng ) – VOM)

To generate a range of possible power and gas price scenarios, Monte Carlo simulation is used to generate 1,000 different time series of daily forward curves and hourly spot prices across the entire measurement period. These prices are then used in the net earnings equation above to generate a distribution of possible net earnings. These results also are conditional on various operational events (random plant break downs) and constraints (start up, shut down, ramp rates, etc.). The distribution of results, set out in Figure 1, is used to generate an expected net earnings amount of $14.63 million and an EaR of $10.75 million. In other words, the toll expects to generate $14.63 million in net operating income. However, there is a 5 percent probability that net earnings could be less than $3.88 million ($14.63 million - $3.88 million = $10.75 million).

Suppose the organization that holds the toll believes $10.75 million of EaR exceeds its risk appetite. The group could reduce this risk using a set of power and natural-gas swaps. Table 2 summarizes the expected output from the plant, the fuel consumed and a set of hedge volumes used in this example. Note that the hedge is only designed to cover the volatile months of May and June, and that the amounts hedged are considerably less than the total volume expected. These volumes reflect the fact that there is a band of uncertainty around these volume expectations. The optimal hedge volume considers this uncertainty and optimizes the amount of market risk reduction possible using the available hedge instruments.

Table 3 illustrates the importance of using the appropriate market-risk metric. The hedge contracts reduce the market risk of the combined portfolio by $4.4 million using EaR. Under the traditional VaR metric, these contracts eliminate only $0.4 million in risk. The difference in these amounts is attributed to the assumed holding period for VaR (1 day) vs. EaR (6 months). In addition, gas plants can take advantage of spikes in hourly spot prices. Some of the risk embedded in this tolling contract is generated from these hourly prices. EaR captures this risk. VaR captures only the risk in the monthly forwards.

The risk metric used depends on the merchant’s primary activities and its portfolio of assets and positions. In some cases, both VaR and EaR should be used. Table 4 contrasts the two standard metrics and provides some insight into the benefits that EaR offers. As