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Rating the New Risks

How trading hazards affect enterprise risk management at utilities.

Fortnightly Magazine - June 2007

several utilities to launch or relaunch their trading desks.

Since the Enron bankruptcy, management teams at utilities with trading desks have become increasingly aware that a commodity trading desk has impact on risk that is firm-wide, and must be understood all through the firm, from the trading floor all the way up to senior management and the boardroom, and all points along the way.

Several utilities with trading desks have hired chief risk officers, a move that can raise the authority and accountability of the trading risk management function to C suite and board levels. At some firms, chief risk officers even have the authority to change risk positions and, if needed, to close a trading room down.

Many utilities have begun to institute risk-management practices that cover the internal and external risks of physical and financial trading. Such practices include policies and procedures for monitoring, managing and evaluating all structures, activities, and decisions affecting the trading desk, and by extension, the enterprise. It also enables senior management to be constantly aware of the company’s risk position, which risk-mitigating trading and balancing strategies need to be upgraded, or whether new ones need to be implemented.

On the internal side, utilities need to manage the risks associated with ensuring revenue models are well tested and updated; that account reconciliation, credit accounting, and portfolio optimization processes and procedures are tight; that operating performance and liquidity are regularly assessed; and that loss tolerances are effectively set and regularly tested, and communicated throughout the firm. In addition, utility trading desks need strict guidelines in place to govern which commodities and derivatives they can trade, which strategies can be used to trade and hedge them, and to set the risk tolerances and limits, as well as the policies and procedures around counterparty credit.

Utilities also need to manage external risks, such as supply volatility and its impact on demand forecasting, business scandals, competition, regulatory activity, the weather, economic factors, and new business and trading models. These must be transparent both to management and to stakeholders.

For many, all of this has shifted the focus for utility senior management teams from profit-centric to risk-centric. Silos must be crossed to provide enterprise risk management that integrates risk analysis with customer, geographic, and product analysis.

But even with all these changes, most utilities with trading desks are still far from an optimum maturity level. Standard & Poor’s thus far has reviewed the policies, infrastructure, and methodologies for trading risk management at 10 U.S. energy companies. In this initial sampling, we found significant divergence in risk-mitigation structures, a less robust infrastructure for asset-based trading than for pure trading, a relatively new structure for risk management, dominance of senior management over the risk processes in some cases, and poor external reporting on the firm’s risk position.

Capital, Counterparties, and Credit Risk Management

Credit risk management is how a trading firm evaluates its credit makeup and the current dollar exposure of its counterparties. Systems should be in place to monitor all risk positions to ensure a firm stays within its exposure limits.

Critical