The industry is going down the mark-to-market route, creating significant opportunities for earnings swings and distortions.
John Bampfylde and David Shimko are partners at Risk Capital, an independent risk management consultancy based in New York.
Model risk is no longer the purview of quants and analysis groups hidden deep within the organization. With mark-to-market (MTM) accounting, the quants' MTM pricing models now drive earnings, and, as we all know, earnings drive CEOs. Model risk was dragged into the spotlight with the 2002 and 2003 restatement of earnings by many energy-trading concerns, due in large part to over-optimistic model valuations, which removed billions of dollars from the industry's balance sheet. These losses were far in excess of any value-at-risk (VAR) limits, causing stock prices and investor confidence to plummet. Given that many utilities as a matter of necessity must trade in energy markets and new financial traders also are playing this market, the issue of model risk is again a cause for concern.
Furthermore, the triple-whammy of MTM accounting, market illiquidity, and substantial legal liability for auditors massively increases model risk in the electricity industry. Many participants focus on market and credit risk, which is a perfectly reasonable approach, but in some cases it is to the exclusion of model risk management. This exclusion may cause undue risk to future earnings.