Given energy markets’ newfound volatility and the range of exposures that global energy firms must deal with, the reactive, reporting-oriented nature of transaction management practices is in need...
Strong CROs: More Important Than Ever
How important is the risk function at your company?
or even blows up, the impact could cause far-reaching and sizable disruptions in the market. Although the CRO function might have been important once because of wholesale markets and trading, the function is even more important now because the risk-creating factors affecting even traditional utilities (particularly price volatility and regulatory risks) are extreme and deeply embedded within a utility’s core business.
Arlene Spangler at Standard and Poor’s recently prepared a detailed report, Taking the “PIM” Approach When Assessing U.S. Energy Companies’ Risk Management, which describes in exquisite detail how S&P analysts intend to examine an energy company’s risk-management program on the basis of close attention to policies, infrastructure and methodologies. The very first item discussed under “Infrastructure” is “the quality of the risk-management organization.” The risk-management staff’s “seniority, career path, and compensation” will be examined, along with their educational backgrounds and the quality of their training. The analysts also will examine the budget for the risk-management function.
Four Crucial Areas
Clearly, utility executives need to look at risk management again—particularly the all-important position of CRO. A CRO must look after at least four highly diverse yet interconnected risks: market risk, credit risk, operational risk, and regulatory risk. The most obvious of these is the market risk—the cost of fuel and the price of electricity.
Credit risk involves the creditworthiness of people buying and selling large amounts of fuel or electricity. Simply put, when the utility sells energy to another market participant, the company needs to get paid. Likewise, fuel and power sellers want to do business with utilities that have a strong credit rating and a good balance sheet.
Operational risk involves the risk in the company’s day-to-day asset operations, be it power generation, or natural gas/coal procurement and transportation. The regulatory risk, of course, entails anticipation of, and preparation for, unforeseen new regulations or modifications to regulations. One example of this latter concern would be the often discussed and debated “carbon tax” on emissions.
The risk-management staff, under the CRO’s supervision, constantly models and stress-tests the market and credit risks, creating scenarios that illuminate potential problems in operational risk. For example, what happens if one of our plants unexpectedly goes off line and we have to buy power on the open market? How will this affect our credit and exposure?
A major issue pertaining to the regulatory environment is the utility’s rate structure—whether unexpected costs can be passed through to the consumer, and if so, how quickly. One of our clients recently approached $1 billion in unexpected, unrecovered fuel costs, but because of the regulatory environment in his state, his ability to pass these unexpected expenses through to consumers in a timely manner was impeded. The company therefore had to implement aggressive strategies to deal with liquidity issues associated with the unrecovered fuel costs.
The CRO must anticipate these types of market-driven regulatory risk issues, track them through the legislative or regulatory process, and prepare strategies to deal with the direct and indirect issues associated with them. The risk-management staff has to be well qualified to perform these functions effectively, and