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Rating the New Risks

How trading hazards affect enterprise risk management at utilities.

Fortnightly Magazine - June 2007

extreme risk scenarios as well, as risks such as terrorist attacks on power generation facilities or environmental disasters such as hurricanes or earthquakes can wipe out a substantial percentage of an energy firm’s capital or even bankrupt it. Of course, insurance is likely to cover a significant portion of this type of extreme exposure.

Credit violations need to be reported to management and remediated immediately. Centralized, automated risk measurement, position monitoring, and trade-limit enforcement enable accountability for visible risks.

Controlling Risk From The Top

Sarbanes-Oxley has rendered essential the authority and accountability of a chief risk officer to senior management and the board. Senior managers need sufficient transparency about the type and magnitude of material risks being taken by their trading desks. After 2001, a few firms began to implement comprehensive risk-management reporting. Other firms upgraded available information about their hedging policies, their risk limits, and their risk-governance structure.

An executive committee should participate in decisions that set monetary loss level limits, position credit exposures, and approve the systems and procedures used to value and mark to market complex structured transactions.

To prevent lapses in risk management, risk control systems need to incorporate internal structures, staffing, procedures, and technical capability, and an effective reporting structure. One prudent strategy could be for a firm’s board to set up separate executive committees for risk management, control, and credit functions. The risk management and control committees can review the risk-management policy and recommend updates and modifications to elements such as VaR methodologies and limits. The credit committee can develop and maintain credit policies (subject to board approval), as well as track and report noncompliance, and oversee counterparty exposure.

Guidelines should exist for trader expertise. Physical separation of the trading floor from the internal credit department as well as the back office avoids any perceived compromise of the floor’s relationship with transaction origination and accounting.

Continual, independent third-party audits, preferably by a major accounting or consulting firm, are advisable. Independent, external risk assessments are advisable as well, as they can raise red flags where the firm’s current practices lag industry best practices. It can also cover various elements of the risk management process and the linkages between them, such as risk discipline, trading performance, economic versus GAAP comparisons, market risk levels, credit risk concentrations, risk transparency, whether the list of risk metrics used is complete and how those metrics are calculated, infrastructure aspects, and industry dynamics.

Firms also need experienced quantitative staffs dedicated to constantly testing and validating valuation models and methods.

Doing all this requires sophisticated and timely knowledge, as well as tools to measure risk, position and exposure reporting systems as close to real time as possible. Review mechanisms must be in place to adjust strategy to changed conditions and communicate those adjustments to stakeholders.

Looking ahead, utilities with trading desks will continue to deal with risks from regulatory and political changes, the ongoing need for environmental compliance, and a constantly, rapidly evolving market with ever more sophisticated derivative instruments to trade and strategies to do so. Fuel prices as well as supplies will