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The Hidden Costs of Sarbanes-Oxley

Can they be reduced?

Fortnightly Magazine - July 2007

assets more effectively as a result.

Better Method

There is a better way. Instead of excluding trader forecasts altogether, organizations simply should evaluate these forecasts analytically and identify and correct for systematic trends of over or under forecasting across time. Consider an example.

Suppose a risk-control function is in place that generates MtM values based on curves derived from external sources only. This risk function also generates value, earnings, and cash flow at risk metrics derived from these external curves. Part of this process includes the simulation of spot prices into the future. These spot-price scenarios are key inputs into all of the risk metrics. For example, Figure 1 illustrates a set of simulated spot-price paths for Henry Hub (HH) natural gas. This figure includes each individual price path (the thin multicolored lines) and the daily percentiles for 5, 50, and 95 percent (the bold red lines).

Sarbanes-Oxley created the incentive to put in processes that would generate this information. It is invaluable for MtM accounting and risk reporting. However, it explicitly excludes the trader’s perceptions of market prices in the future. Any organization that is integrated in the market, owning assets across the value chain, could have a better view of the direction of the market based on supply and demand fundamentals that they contribute to through operating their own assets. This information often is available to the traders, which gives them a competitive advantage when trading against banks and hedge funds. However, for this information to flow back to the organization, it needs to be integrated into the price forecasting, forward-curve building, and risk-measurement infrastructure. If Sarbanes-Oxley has created a process that explicitly prohibits the trader’s participation, the entire organization will pay through decreased efficiency in operations.

Suppose the traders in this organization have a specific view of the average price in July 2007 that is different from what the market is telling risk control? Figure 2 provides the histogram of average prices in July 2007 derived from the information provided to Risk Control. The vertical blue line represents the expected price of $8.09/MMBtu that is also the executable forward price in the market. However, in this instance, the trader has a view that this price is higher than expected given knowledge of the production, pipelines, and storage assets that affect the market. The trader’s view of the market leads to an expectation of an average price for July 2007 of $6.92/MMBtu as seen by the vertical green line in Figure 2. As a trader, one would expect to sell forward contracts at $8.09 and then expect to settle those commitments at the expected price, netting $1.17/MMBtu.

In the pre-Sarbanes-Oxley era, this trader could have executed the trade at $8.09 and then reported the expected price of $6.92 and generated an MtM gain and the end of the next reporting period. Furthermore, the price forecast would have fed into the planning infrastructure throughout the organization, and the asset operators would have optimized their operations based on that forecast. However, now that the trader’s insight is excluded from the process, one