Frontlines

Deck: 
The Northeast Blackout goes political.
Fortnightly Magazine - September 15 2003

Frontlines

The Northeast Blackout goes political.

Nearly a year ago, cover story announced the rise of the chief risk officer (CRO). "Utility senior management is becoming positively enamored with the office of the CRO," we said. "Fully 40 percent of America's CROs work for utilities and energy companies."

Given the uncertainties and changes in the industry, one might assume that the CRO's position is more important today than ever. Many of the industry's CROs are dealing with an expanding scope of risk issues, from capital adequacy to compliance with the Sarbanes-Oxley Act. "There is much more focus on risk management than there was two years ago," says Richard Osborne, Duke Energy's CRO. Events that have occurred since late 2001 "have created a need for energy companies to have robust risk-management functions," he says.

However, if the CRO's role is defined more narrowly-to oversee trading-oriented risks, for example-then the position becomes more tenuous in today's environment.

"As part of our return to being a seven-state power and gas utility, we eliminated the CRO position," says a spokesperson for Aquila Inc. in Kansas City, Mo. "We no longer have a need for a risk officer now that we are out of the merchant marketing and trading business."

Aquila isn't the only company distancing itself from the wholesale trading markets, or whose former CRO is pursuing other opportunities. El Paso Energy, for example, is liquidating its merchant energy portfolio, and the company eliminated its CRO position earlier this year.

Whether these moves signal an industrywide trend is unclear. Instead, they might represent efforts by a few companies to send Wall Street the message that risks have subsided. But this assertion seems ill-conceived to some in the industry.

"It reflects a somewhat narrow view of what a CRO is," says Mark Randle, CRO of Sempra Energy in San Diego. He explains that the CRO was associated too closely with trading at some companies, and eliminating the CRO upon exiting the merchant markets is largely a cosmetic step. "It was a knee-jerk, near-term reaction that will prove to be a bad decision," he says.

Risks still loom large for the industry, and virtually all companies will face those risks-whether through the office of the CRO or some other executive. Top risk executives will be busy for the foreseeable future, defending their companies in a hostile industry landscape.

Surviving Hell

The current state of the industry might not be hellish, exactly, but utilities and their shareholders are suffering what seems like an eternity of torment.

The current nightmare has three main features easily identified by most industry watchers. Namely:

  1. The withered condition of wholesale power markets has created extreme price volatility, forcing companies to abandon or scale back their trading business. Furthermore, it has made it difficult to hedge forward-price risks. "No one wants to go out on the curve," says Scott Smith, CRO of American Electric Power Co. "The market has stabilized, but it's still in a sorry state. I don't see long-term deals coming back for a couple of years."
  2. Credit-risk concerns have increased the costs and complexities of trading, driving companies even further away from trading markets. "Managing credit-how much you can afford to extend and accept from others-has become more critical," says Laura Brooks, CRO of Public Service Enterprise Group (PSEG) in Newark, N.J.
  3. The capital markets, burned in the meltdown of utility stocks, have demonized unregulated energy businesses. "Capital pretty much dried up immediately post-Enron," says Robert Adams, CFO at Minnesota Power in Duluth. "It has become more available to utilities in the past 12 months, but the days of speculation-building a lot of capacity on the basis of price forecasts-are over."

As a result of these factors, utilities have fled the wholesale exchanges, folded up many deregulated business ventures, and replaced new-economy marketing flak with old-economy fare. "Back to basics" is the industry's new mantra.

However, these moves arguably represent more of a survival reflex than a thoughtful strategic shift. "They aren't voluntarily changing their strategies," says Sempra's Randle. "They did it wrong and they got hammered. They have no choice but to change strategies now."

Changing strategies, unfortunately, cannot guarantee better ratings or glowing analyst reports. "Going to Wall Street and competing for capital, potential shareholders may view the utility industry as being more risky than some others, when in fact it's not," says Patrich Simpkins, CRO at Dallas-based TXU. The industry's exhaustive disclosure requirements might be positioning investor-owned utilities in an unfavorable light, he says, compared to companies in industries with less stringent reporting requirements.

Additionally, analysts and rating agencies seem ready to penalize utilities no matter what they do. For example, Duke Energy announced earlier this year that it would divest itself from the volatile merchant energy business. But Standard & Poor's on July 24 lowered its ratings on concerns about "Duke's ability to effectively terminate the proprietary trading and marketing positions without adversely affecting the consolidated financial profile."

Duke's Osborne says that although the overall industry ratings trend remains bleak, eventually efforts to shore up balance sheets will prevail. "The financial strengthening that is under way should be reflected in the ratios the ratings agencies look at, and we will see credit given for exiting proprietary trading," he says.

In the meantime, the industry's CROs are striving to improve their companies' strategic plans by analyzing the big risk juggernauts-market, financial, and credit. At the same time, they are working to assimilate an expanding variety of less-tangible risks into an enterprise-wide analysis ().

"The CRO role is expanding to include things like capital adequacy risk, business continuity risk, and compliance risk," says Mike Smith, executive director of the Committee of Chief Risk Officers (CCRO). "All of these areas need to be measured and quantified to the extent possible, so the company can gauge the relative strength of the balance sheet."

Indeed, given this widening role, the need for a CRO and an enterprise-risk organization has never been clearer, Smith says. "Everybody is talking about changing strategies and strengthening the balance sheet, but how do you know if you've gotten it right?"

CRO as Portfolio Manager

To answer that question, the CRO is evolving into an enterprise portfolio manager. "The CRO's role has changed from a control framework to a decision-support and optimization framework," Simpkins says. "The mandate used to be 'protect what you have,' and now it's 'protect and optimize what you have, and ensure that the investments you make going forward add value from a risk-reward standpoint.'"

Working at the enterprise level, the CRO/portfolio manager will help the company to establish standards and benchmarks for its risk-reward propositions. Then the CRO's organization will analyze and manage the assets and businesses that the company owns or controls in a way similar to an investment fund manager's approach to managing a portfolio of securities.

Using such a portfolio management approach, a company will weigh value calculations against the pre-defined benchmarks. The CRO and other senior executives will apply this process actively and continuously, seeking to optimize the company's assets and strategic positions on a forward basis.

"We are focusing more on hedging the asset portfolio," says Laura Brooks, CRO of Public Service Enterprise Group in Newark, N.J. "We are having input early and often to ensure risk is understood in the transaction-approval process."

With a CRO/portfolio manager guiding its moves, a company will, in theory, be more likely to acquire assets that serve its goals and to liquidate or reposition those that do not. This is particularly important in the current environment, where companies are jettisoning "non-core" assets and looking for bargains in the depressed market.

"We're taking advantage of this trough to grow our nonregulated business in a controlled way," Randle says. "We are looking to make selective acquisitions, and we are positioning ourselves as a leader in liquefied natural gas."

A strong CRO can help to ensure that such opportunities improve the company's overall value and not just the value of a given business unit. The result is a more competitive company, and one that is less likely to make bad investments.

"We need to get discipline into the [utility investment] process, or we'll fail to see a mismatch in expectations and the range of outcomes possible given today's volatility," Brooks says. For example, an undisciplined company might build assets based on long-term price curves, without any means of hedging short- and mid-term volatility. The effect for the company can be disastrous, as recent business failures so vividly illustrate.

A strong risk-management organization has the respect of the company's board of directors and audit committees, as well as the authority to influence executive decisions. "Risk management can't be viewed as a tactical function, or someone will make an end run around it and decisions will get made without adequate input," Randle says. "These are big risks that can make or break a company."

Future Shock

If it's true that what doesn't kill you will make you stronger, then companies that survive the present adversity should be practically invincible.

"We've taken this industry through a pretty rough ride," says Minnesota Power's Adams. "The shakeout will be good for the industry. Although it will bring gut-wrenching pain for many players, it will sharpen utilities' business acumen and management systems"-qualities they will need for survival in the future.

Simpkins of TXU takes this notion a step further. "This period will prove highly beneficial to the industry going forward. Indeed, without it, the industry would not be able to grow and prosper the way I think it will in the future."

A variety of developments in the next couple of years will probably improve liquidity in wholesale energy markets.

Nevertheless, even as some risks ebb, others will intensify. Specifically:
Environmental Issues: More stringent clean-air policies are lurking on the horizon. Even without new legislation, target dates in existing regulations are set to create new environmental requirements. "Environmental policies are very fragmented, and they change continually," says AEP's Smith. Uncertainties around environmental regulation will command more attention from risk-management organizations.
Security: The Department of Homeland Security is in the process of promulgating new security regulations for critical infrastructure industries. While these regulations should theoretically serve to mitigate some risks, their full scope and effect on utilities remains unknown.
Market Design: Changes in wholesale power market structures will have sweeping effects on utilities' strategies. The efforts of the CCRO and other industry advocates have advanced the debate around key issues such as market-price indices and clearing mechanisms, but many other questions are unanswered. Battles between federal and state regulatory interests continue to delay the process of market restructuring, and multilateral clearing structures have been slow to develop. "There is still a lot of uncertainty over how transmission markets will be working in the next couple of years," Adams says. "That is a dicey proposition if you are trying to manage generation assets or are in the final phases of completing them."
Capital Adequacy: The risk factor that keeps utility executives awake nights is the need to convince ratings agencies and Wall Street that the industry has learned its lesson. "With a continued downward spiral, there would be no capital for investment in infrastructure," says PSEG's Brooks. "Capital allocation decision making could have the most impact on that, but the risk is real that we won't pull out of this slump."

The industry has much work to do in the ongoing struggle to manage its various risk factors. Fortunately, the fundamentals of the industry are solid, and leading players are investing resources toward a more stable future.

"Companies are cutting down on operations expertise and financial management expertise, but they are spending more in the risk management arena," Simpkins says. "As we go forward and develop more liquidity, you will see this industry become more innovative, savvy, and technology-oriented."

As companies develop such skills, their ability to adapt to changing conditions and capitalize on opportunities will improve. And as current events demonstrate, adaptability is the most basic of survival traits.



Monte Carlo Management

As risk-management organizations assume a broader role, the tools of financial risk management are being applied to an increasing range of issues-some of which are notoriously difficult to quantify.

Monte Carlo simulations are one method of forecasting (or "modeling") how various factors might affect the value of a given asset or set of assets. The term "Monte Carlo" comes from the famous city in Monaco-and the many roulette wheels therein. Analysts use computer software-a metaphoric "roulette wheel"-to generate random values for key variables in the model. Those variables change randomly in the real world.

By repeating the process over and over again, analysts can estimate the range of values along which an asset might fluctuate over a given period of time.

Taking this idea a step further, analysts can input values into the model that serve to simulate historic events. In this way, they can learn how a given asset or portfolio might perform in similar situations. For example, one might try to simulate the Midwestern price spikes of 1998, the market disruptions that followed the 9/11 attacks, or the fuel-price impacts of the 2003 Iraq war.

"Two years ago, people would have said operational risks were too complicated and difficult to model with Monte Carlo simulations," says Laura Brooks, CRO of Public Service Enterprise Group in Newark, N.J. "They'd say it's too difficult and nobody understands it. But now it's more accepted."

Increasingly advanced systems and techniques allow CROs to factor the broadest range of risks possible into their models. In addition to operational risks, examples include regulatory and legal risks, exposure to fuel prices in various regions, and, for global players, sovereign risks and currency exposures.

Companies that take such a holistic view will seek to hedge exposures that another company might overlook. In the long term, these players may prove to be more competitive than their less-sophisticated peers. -M.B.


Compliance Quagmire

In the past, utilities have delegated responsibility for compliance and regulatory issues to their legal and regulatory organizations. Risk officers have included regulatory exposures in their periodic roll-up of enterprise risks, but in general they haven't gotten involved in regulatory matters.

That was before the Sarbanes-Oxley Act.

"This is one of the larger risks we are facing," says Scott Smith, chief risk officer at American Electric Power Co. "Some companies might think they have all the controls in place already, but that just means they haven't read all the regulations."

Likewise, Duke Energy's risk-management organization has been involved in managing Sarbanes-Oxley compliance issues. "We've spent more time and resources on Sarbanes-Oxley than I would have envisioned," says Richard Osborne, Duke's CRO.

For some companies, risk-management processes have proved ideally suited to deal with compliance issues. "The whole project integrated with our enterprise-wide risk-management approach. It fit like a hand in a glove," Smith says. "Through these processes you can identify weaknesses in your control environment and determine where you can improve."

In this respect, Smith says compliance requirements are actually proving to be beneficial. And he is not alone.

"Sarbanes-Oxley is an opportunity to improve the business model," says Laura Brooks, CRO at Public Service Enterprise Group in Newark, N.J. "By viewing internal controls as things that reduce the risk of loss and improve the transactional decision-making process, you will improve the bottom line." -M.B.

 

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