By some measures, merchant power assets look like a bargain, selling for well below their replacement cost. But whether low prices signal a buying opportunity or a value trap depends on the...
Rating the New Risks
How trading hazards affect enterprise risk management at utilities.
to improving trading risk management at utilities is the implementation of methodologies that can improve risk identification, quantification, and mitigation, especially in liquidity, credit operations, and technology. On the liquidity side, sufficient collateral is necessary to sustain physical and financial trading, as high consumption can drive up spot market prices for fuel and power, which can leach cash. To mitigate this risk, most energy trading desks run price and volatility stress tests constantly to quantify their potential exposure. In addition, the trading operation should have access to sufficient liquidity to weather price fluctuations.
A principal ongoing risk for trading desks is the long and short positions left open, or unhedged, at the end of each trading day. Since 1998, the average number of open contracts at the end of each month has soared. A firm’s willingness to hold open positions, especially in illiquid markets, makes it critical that its traders and senior management be accountable for their own market, credit, or operational risks.
Obviously, credit departments should also conduct credit analyses on all counterparties. Counterparties incur more risk in commodity transactions because credit is implicitly extended between physical delivery and financial settlement. Each counterparty’s credit profile should be scrutinized for regional concentrations, which can make portfolios vulnerable to local market conditions. Appropriate credit exposure limits should be established for each counterparty, including dollar trading limits and commodity volume limits. These limits should also be checked frequently—optimally, after each trade. In addition, firms should ensure they maintain access to as many counterparties as possible, in as many regions as possible, to supplement physical liquidity and mitigate some counterparty risk.
The capital structure is a major component of financial risk and performance. Risks associated with counterparty exposure, portfolio exposure, operations and general capital needs must be quantified. Actual and potential exposures by counterparty, region, and commodity need to be monitored daily. Potential exposure by counterparty should be assessed to limit the potential loss to an energy firm stemming from default risk. Market volatility can spark large price increases, which can push a counterparty’s account over its credit limit, especially if it is running sizable receivable balances.
For good risk management, energy firms need a portfolio of methodologies that can measure and value the risks inherent in the contracts and derivatives energy desks trade. VaR (value at risk), which measures the cost of liquidating a position at unfavorable market conditions, has become a standard measure. Various other metrics, such as EVA (economic value added), SVA (shareholder value added), and RAROC (risk adjusted return on capital) may provide value in capital-allocation decisions. These valuation models should be assessed constantly, and senior management should ensure that the assumptions behind the models are appropriately validated by the risk-management function.
While Standard & Poor’s has not completed analysis and implementation of its own capital allocation model in the utility sector, it nevertheless appears reasonably clear that management should also use stress tests and scenario analyses as they can proactively identify and evaluate important scenarios and feed that information to capital allocation decisions. Standard & Poor’s expects it may incorporate