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A Primer on the PIM Framework

How enterprise risk management practices impact the Standard & Poor’s rating process.

Fortnightly Magazine - June 2007

is particularly important for good risk management, as the physical component of an energy firm’s trading renders its operational risks considerably different from those financial commodities traders face. PIM’s methodology component assesses how effectively an energy trading firm’s risk management tools test and capture its specific market, credit, and operational risks.

The process determines whether risks are correctly identified, risk factors evaluated periodically, and the metrics used to quantify risk and manage limits well-identified and understood. We look to see if and how companies value at risk (VaR) calculations and stress-testing measures, and how those are harmonized to define risk appetite and set limits. It also assesses how an energy trading firm measures its credit and operational risk by examining which measurement tools are used and why the company believes those tools are good indicators of risk-exposure levels. We also test a firm’s methodologies for worst-case scenario assumptions, to determine if sufficient information is being captured to permit proper risk and exposure mitigation. Models need to be periodically vetted, and the vetting process’ quality assessed. This vetting should include model back-testing.

We also assess whether specific measurement tools are tied to performance. Management must understand and appreciate the risk associated with the models. Good practice would require all model vetting and back-testing to be independent of the profit center. It would also capture the unique risks inherent in energy trading.

We examine an energy trading firm’s ability to attribute economic capital appropriately to the trading operation as well as measure risk-adjusted performance. We also examine how the performance metrics are used to manage the portfolio. Finally, we look for a steady record of compliance with the risk policies.

Down The Road

Like anything else, PIM is a tool. As we ask companies to do with their risk policies, we are constantly vetting and assessing this tool to make sure it provides us with results we can trust, so that the rating we arrive at correctly reflects the trading desk’s level of risk management and reveals how it fits into the rest of the firm.

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