Risk-Management Principles for the Utility CEO

Board coordination is the key.
Board coordination is the key.
Fortnightly Magazine - June 2004

Board coordination is the key.

Many utility CEOs are happy to pass off risk-management policy to the CFO and the head of the trading desk. After all, with deregulation and re-regulation, collapsing spark spreads, hypersensitive rating agencies, and nervous investors, there is enough to worry about. So what's the problem? If the financial guys control and report the risks and profits and losses (P&L) within risk tolerances, why should the CEO be concerned about risk management?

The answer, in many cases, is that the board and CEO have not given specific strategic directives to those responsible for risk management. As a result, often they are disappointed when the trading results do not reflect the goals of the organization. On one hand, a trading group may show tremendous profits, while the board complains about the discount the equity analysts have applied to the company as a result of the trading risks. On the other hand, a trading group may appear to lose money on a stand-alone basis, while in fact the group had reduced corporate risk significantly. Many trading shops find themselves in this type of situation: They are urged to turn a profit, but are charged with hedging risk. The only way they win is if their trades both produce profit and reduce risk-an unrealistic expectation for any trading group.

This problem is exacerbated by trading reports that emphasize stand-alone P&L rather than the effect of trading on an integrated risk profile. Therefore, the CEO must set clear directives for trading off profit and risk that are interpreted and executed by the trading groups. A practical process for accomplishing this follows.

Principle #1: All risk management policy follows from the board's agreement with key principles.

Establish a set of key principles upon which the board and senior management agree. The debate about these principles highlights possible inconsistencies, the resolution of which leads to consistent risk-management policy. For example, it is common that companies do not want to supply collateral to a trading operation. However, if they want the trading operation to execute financial hedges, collateral is unavoidable. The company may, of course, decide if it is willing to provide collateral or not. However, the decision not to provide collateral must be accompanied by a prohibition against hedging using financial instruments, which might require posting collateral.

The board frequently hopes to achieve multiple objectives, higher profit, lower risk, fewer headlines, and the like. From a policy point of view, it is inappropriate to charge traders with the responsibility for multiple objectives. One cannot simultaneously, for example, maximize profits and minimize costs, unless revenues are fixed. By the same token, no one can both maximize trading profits and minimize enterprise risk. Yet it is not uncommon to find multiple trading objectives in a typical utility annual report or in a risk management policy document.

Principle #2: Management sets clear definitions, benchmarks, and objectives.

How often have utility CEOs said, "We don't speculate"? The statement is counterfactual in every company with a hedging or trading function. In fact, there is an element of speculation in