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Rating the New Risks

How trading hazards affect enterprise risk management at utilities.

Fortnightly Magazine - June 2007

Over the past 15 years, trading’s role at utility companies has evolved substantially from ensuring sufficient power and fuel supplies for ratepayers to taking large, open, and speculative positions and maximizing asset value. Along with that evolution come a host of new business and financial risks for utilities.

Fuel and power, of course, must be available, and the potential impact of the financial risks of trading must be controlled and managed, lest they adversely affect the parent firm. And the financial risks, already highly complex, are growing: Today’s very lively market for energy-based commodities and their derivatives has traders at energy desks jockeying with desks at investment banks and hedge funds.

Trading desks are a critical asset for a utility, as they provide the freshest market intelligence. However, they are also charged with being a profitable business undertaking, which faulty intelligence about the weather, the supply chain, or the economy threatens. Faulty intelligence also can damage reputation and result in potential electricity shortfalls in regions served.

New regulatory and competitive information must be integrated fast, which requires speedy and effective technology.

Senior management of utilities with trading desks, from the board and “C suite” down, must be well-versed in the ins and outs of trading, its impact on the firm’s overall financial structure, and, most of all, its risks. As management teams seek to improve how they manage key business and trading risks across an enterprise, they must determine how best to blend financial trading skills with access to energy forecasting, and management and supply knowledge and information.

Processes and procedures must be enhanced, transparency improved, and open enterprise-wide communications about trading activities cultivated and maintained. Individuals knowledgeable and experienced in risk management and mitigation at utilities need to be on board throughout the firm, especially in senior management, and formal risk training programs needs to be in place to ensure that a proper risk-management culture permeates the firm.

Trading Risks

The emergence of trading desks at utilities began in the 1990s with two regulatory events. The 1992 Energy Policy Act let the U.S. Federal Energy Regulatory Commission (FERC) order the unbundling of power transmission from its generation. In 1996, FERC was empowered further to open transmission lines to interstate competition. Deregulation by many states spurred growth in power trading during the 1990s, which introduced competitive power-supply options to the markets and spawned the creation or growth of many energy firms.

Trading activities across all commodities at most utility companies retrenched after Enron’s 2001 bankruptcy. Some firms even shuttered their desks. Since 2003, however, trading in energy commodities and derivatives has emerged as fertile ground for investment banks and hedge funds due to the demand for these products and the very weak credit profile of most of the providers. This has prompted

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