An effective risk-management strategy depends on knowing your shareholder’s idea of value.
David Shimko is founder and president of Risk Capital.
How do shareholder relations link to risk-management policy? The answer: Utilities have to communicate to shareholders a particular set of operating strategies that will attain certain financial results. Risky activities both enhance and threaten those financial results. Therefore, policies must define how risky strategies are formulated, approved, controlled, and measured.
Consider an example. Prior to declaring bankruptcy in 2003, Mirant was seen by many as an energy trading company that held assets in order to improve its trading prospects. The theory was that the connection between physical and financial trading of energy commodities provided unique profit opportunities. This particular strategy also is common to J.Aron and Morgan Stanley, both financial trading shops that acquired physical commodity capabilities in order to capitalize on this sweet spot in commodity trading.
Yet Mirant also could have been seen as a company that managed generation assets and traded to the extent it found opportunity around those assets. In other words, the assets and the activity of a company do not define its strategy. The company defines its strategy. Several different strategies might by coincidence lead to similar portfolios.
We would expect that a trading firm with assets would have a different risk-management policy than an asset firm that trades. These are suggested in Table 1.
The trading firm with assets is really a hedge fund with some illiquid trades (i.e., assets) in its portfolio. There is nothing wrong with this model; in fact, many companies have earned billions from following it. The alternative model is a company driven by its asset strategy. Trading may balance out the strategy or capitalize on some value of the assets (e.g., information about day-ahead production and grid characteristics), but it does not drive the asset selection.
While both business models are valid, different disclosure strategies are required for investors in each case. Traders with assets should disclose like hedge funds or banks. Asset managers with trades should disclose like industrial companies. Unfortunately, some utilities better seen as asset companies wind up disclosing their risks as if they were trading companies, causing confusion and fear.
Why do investors focus so much on trading, when in many cases, it is such a small contributor to earnings? The answer is that trading holds hidden risks; it is a black box that utility investors don't always understand. When management lets on that it also does not understand these risks fully, investors run scared. The consistency principle has been violated. Trading cannot be seen as being consistent with an overall financial strategy if management cannot explain how it both enhances and threatens the strategy.
Most utilities fall into the category of asset managers with trading. For these utilities, we suggest a "straw man" strategic model.
Straw-man Strategy for Asset Utilities With Trading
1. Communicate to investors that the goal is to preserve assets, and that trading around assets is necessary to capture part of the asset's intrinsic value. However, trading will be tightly controlled and monitored to ensure that the profits from the trading activities are commensurate with their risks.
2. Use separate trading books to hedge the assets and trade around the assets. Apply different goals and performance measures for each trading book.
3. Measure your risks in an integrated manner, (i.e., how future earnings will be affected by changes in power and fuel prices), and by how much trading activities may cause those forecasts to vary from predictions.
4. Never make point forecasts for earnings guidance. Always indicate a range based on possible price outcomes, and be clear about what factors will cause earnings to lie in the upper or lower points in the range. If possible, allow analysts to input their own forecasts for power and gas prices to obtain their own earnings forecast.
5. Make a complete listing of material risks that face the corporation, and explain to shareholders how they will be either deliberately unmanaged, hedged, insured, or minimized through operational controls. This list should include not only market risks, but credit-exposure concentrations, operational risks, and legal/regulatory risks. In general, risks should be quantified, except when quantification may limit the strategy with respect to managing those risks.
6. Institute a policy of continuous updates and management commentary-perhaps through a Web site and automated e-mails by request-of beneficial and adverse changes in the risk profile. Quarterly reports are highly inadequate for communicating dynamic risk profiles.
7. Introduce and stick to a small number of risk and performance reports that can be updated on demand, perhaps through the Web site as well.
You will no doubt want to make changes to this straw man (and, of course, we immediately disclaim any liability for those who attempt to follow it blindly). Circumstances will differ across firms. However, the straw-man strategy provides a way for utilities to use their disclosure in a proactive way to increase trust with their investors and attract new investors. Risk management need not be seen as a defensive strategy, or a compliance strategy. Good risk management is the definition, execution, and communication of trading strategies that are consistent with shareholders' overall financial strategies.
There are two answers to the question, "What do my investors want?" One is found by going to the investors and asking them, but we expect you will get the kind of answers summarized in the sidebar. The other is found by asking yourself what you want. Your consistent formulation and execution of business strategy begins explanations to shareholders of how you intend to add value. Follow through, and they will be yours to keep. Investors expect bumps in the road, but they also expect to be forewarned.
What Investors Want: Six C's of Shareholder Relations
Although each of these terms may, at first glance, appear simplistic, there is a level of complexity and subtlety to the relationship between risk and reward for shareholders.
It is tempting to think of investors as passive souls, interested only in maximization of shareholder value, and not concerned with how a utility increases its value. Shareholders often fail to provide a clear and unified message to management, leaving management to decide what is best. But if any message has emerged from the capital markets' reactions to events in the energy industry in the last two years, it is that shareholder perceptions of risk can be critical. Indeed, nervous shareholders have marked down equity values to the point where energy trading groups were perceived to have negative value. Anything that smelled the least bit like the-company-that-must-not-be-named was rapidly sold off.
The resulting impact, aided by skittish rating agencies, has hobbled the industry. What can we do to improve this capital shortage? Can we better address what shareholders actually want? In a survey of utility equity analysts, we attempted to address this question. We found that contrary to our expectations, there were several consistent principles that shareholders adhered to. These "Six C's of Shareholder Relations" determine risk-management policy for a utility.
Consistency implies a direct logical line-from shareholders to board members, senior management, policy, action, and the interpretation and communication of operating results. The financial objectives of shareholders may be, for example, (a) diversification within the utility; (b) a high return/risk ratio; or (c) placement to benefit from changes in a particular region's economics. Of course, each of these financial objectives leads to a different set of operating policies-for example, the risk-management policy. Therefore, those who formulate a risk-management policy without reference to consistent financial objectives break this chain. The profit or loss resulting from trading activities may therefore disrupt the balance between what shareholders want to see and what they end up seeing. It is extremely important to note that consistency within the utility's execution and disclosure strategy does not imply that disclosures should be consistent across firms, contrary to the recommendations of the Committee of Chief Risk Officers (CCRO). Rather, a utility's risk disclosures should be consistent with its own strategy, and should inform analysts as to the ability of the firm to execute against that strategy.
One should always be clear in delivering a message, of course. Clarity in this context implies linking difficult concepts to a central shared vision. It also means speaking in a language that analysts understand. Analysts do not generally have Ph.D.s in statistics. They feel nervous about any single number, especially value-at-risk, because they don't necessarily understand how it was computed, and they don't believe it communicates key information. Risks must be expressed in terms consistent with the execution of shareholder strategy. If the stated goal for shareholders is to maximize earnings per share (EPS), then the risk measure should be expressed as a possible threat to EPS. If the stated goal is diversification, then the risk measure should reflect the degree of concentration within a region or to any particular exposure that would threaten diversification.
Communication also seems obvious. Yet, how many utilities would hide exposures and bad news from their investing public? True, a negative disclosure will affect share price. But withholding the information will hurt share prices more if investors find that their trust has been violated, and they sell their shares in a panic when the information is finally disclosed. Some will sell because of the negative information, others will sell because of the loss of trust. Over the long run, it is better to release negative information as it is received, putting it in the context of how it affects the overall utility strategy and prospects. Through the rapid and clear dissemination of negative information, management builds trust with its investor and analyst community.
Conditioning can be thought of as pre-communication. Investors in every company all over the world uniformly hate one thing: Negative surprises. If they buy a U.S. utility stock and then get hit with a nine-figure loss on foreign exchange translation, this is a negative surprise, because investors found out they had an exposure they did not expect. On the flip side, had there been a nine-figure gain on foreign exchange, investors would not capitalize that part of EPS into shareholder value; it would be seen as transient. Therefore, taking an undisclosed foreign-exchange risk hurts shareholder value. The upside is limited to the amount of the gain, and the downside is disproportionately penalized by reduction in shareholder value. So on average, the value is negative. When a utility finds itself in this position, being exposed to a risk previously unknown, it must condition shareholders to understand the size of that risk and how it is being managed. In doing so, if there is a loss in the future, it will not be a surprise to shareholders that causes a selling cascade.
Utilities frequently assume analysts want more information. But that ain't necessarily so. Analysts are responsible for all the information you give them, because the failure to use that information in their recommendations is tantamount to neglect. Therefore, unnecessarily long government disclosures and analyst reports put a great burden on analysts. Most analysts we met felt they were understaffed. On the margin, if a utility provides too much information, the analysts' choice boils down to whether to do overtime to cover the stock, or to stop covering the stock.
Confidence is the result of the previous five C's. If a utility is able to effectively deliver consistency of strategy, clarity in communication, and good pre-conditioning to possible negative surprises in a concise manner, it will earn the respect and confidence of the analyst community. When CEOs ask, "How do I build trust in the analyst community," the only possible answer is to be trustworthy. I recall a CEO conference for one of the major investment houses, where 4 out of 5 CEOs said, "We do not take risks." Some said they "traded around their assets," or "optimized their marketing activity." Statements like these undermine confidence, for no business is run without risk. A CEO inspires investor confidence when he says, "Yes, we run a risk of losing $X per share as a result of our marketing and trading activities, but this is offset historically by average incremental earnings of $Y per share from that activity. We will therefore continue pursuing this activity as long as expected incremental earnings exceed $Z per share." A statement like this shows that the CEO understands the risk of his business and has taken the time to measure it, judge it, and manage it. This is what analysts want-inspired and confident management that demonstrates judgment and investment-worthiness.