By Executive Decision

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Energy Trading & Risk Management: A better framework for making decisions is required to ensure earnings stability and shareholder value in the utilities industry.

Fortnightly Magazine - October 2005

Despite the fact that companies are refocusing attention on their traditional utility businesses, the current utility environment has become both complex and risky. Electric utility restructuring has resulted in the inextricable integration of the regulated and competitive models, which has created greater exposure to emerging and volatile fuel and energy markets; more stringent environmental requirements; more focused standards for reliability and customer service; and major requirements for capital spending to support generation and transmission infrastructure.

At the same time, in response to corporate scandals such as Enron and WorldCom, there has been a substantial increase in external scrutiny from regulators, rating agencies, investors, and shareholders reinforced by the formalized accountabilities defined in the Sarbanes-Oxley legislation. Rating agencies have imposed stricter standards—both quantitative and qualitative—for companies to maintain investment-grade credit ratings. Shareholders have successfully introduced resolutions to ensure transparency and, in some cases, to restrict management discretion. Boards of directors also are being held more accountable for their fiduciary responsibilities.

Though investors were satisfied with the era of stability and predictability prior to the Enron bankruptcy, today investors are looking for growth, while demanding both price stability and predictability. Companies with understandable growth strategies are trading at higher P/E multiples than companies that appear to have limited opportunities or do not have a well-articulated plan. In addition, companies with higher perceived risk profiles have been penalized in the market. These differences in shareholder value become increasingly important as M&A activity in the industry increases and companies with higher P/E multiples are able to use their strong stock values as currency to complete acquisitions.

Against this backdrop of uncertainty, volatility, intense external scrutiny, and intolerance for unattained goals, utility executives are required to make both tactical and strategic decisions to ensure growth in shareholder value. Although utilities are refocusing attention on their traditional utility businesses, it is clear that the traditional utility decision-making framework is not sufficiently robust to meet the needs of today's utility executive.

Why Historical Decision Frameworks Failed

Traditional utility decision systems were designed to optimize outcomes in a far more stable and forgiving environment. Most rely on financial analyses based on single-point "most-likely" forecasts, supplemented by sensitivity analyses. Although the financial forecast often is used to determine broad corporate budgets, the rigor underlying the forecast and the sensitivity analyses can be forgotten when specific decisions are made throughout the year. For many companies, the result is a compartmentalized and inconsistent decision process. A common view might be developed in support of the formal forecast process, only to have different groups then formulate their own assumptions to support specific proposals, often ignoring or basing evaluation of risks on an individual and parochial view of the future. It is equally damaging when individual decisions are made without consideration of regulatory, investor, and customer impacts.

Historically, traditional utility decision frameworks failed in several key instances: (1) the merchant glut scenario; (2) the regulatory risk in international strategies; (3) the earnings risk in retail competition; and (4) the nuclear cost overruns in the 1970s.

The saturation in the merchant market over the past several years can be attributed to decisions made by independent power producers (IPPs) on the basis of "best guess" forecasts of future market conditions that largely ignored market price and demand volatility. Nearly all plants constructed by IPPs were of the gas-fired, combined-cycle variety with economics driven by gas prices that were expected to be $2.50-$3.50/MMBtu. If short-term price volatility had been considered, then IPPs and their banks would have had to consider the possibility that gas prices eventually would hit $6-$9/MMBtu, meaning, at such prices, gas-fired plants would not dispatch enough to cover bank covenants, which would have affected the viability of a number of proposed projects.

Many utilities opted to heavily invest in international projects. In addition to market price risk, such investments face exchange rate, political, and regulatory risks. If, for instance, Brazilian investors had examined the political situation that resulted in rampant inflation, or Chinese investors recognized the nationalization risks, or Canadian investors in Ontario had considered the possibilities of regulations banning coal-fired generation, would these investment decisions have been approved? Any decision process that does not explicitly consider these factors must be flawed.

In theory, retail competition presented a new and unique opportunity, but in reality it resulted in failure for many. Although all of the new suppliers were convinced that they could provide energy at costs lower than the incumbent utilities, many participants failed to understand, or simply did not consider, the regulatory framework or consumer behavior that they would be facing. Regulators were intent on insuring lower-cost energy coupled with consumer protection, which offered little headroom for new entrants. Although consumers often were dissatisfied with their utility suppliers, the perceived risk of leaving far outweighed the modest benefit they thought they could obtain. The impact of price inelasticity readily was apparent but largely ignored in business planning when these decisions were developed.

The nuclear cost overruns of the 1970s and 1980s resulted from several factors: stagflation, increased regulatory redundancy requirements after Chernobyl and Three Mile Island, design flaws, and poor management. But many plants were completed well after these factors were known. Plants were completed based on revised estimates of completion dates and updated cost estimates, but the potential variation in completion schedules and costs to complete largely were ignored.

In each of these cases, the evaluation criteria were based on either "best-guess" forecasts, expected values, or "risk-adjusted" expected values of earnings or revenue requirements. In none of those cases were objectives that considered risks explicitly identified and made a part of the decision process. Inevitably, these outdated measures either ignore or mask short-term volatility. Perhaps more important, these outdated measures ignore those "unexpected" events that can doom a project or an entire company—even though these virtually are certain to occur once or possibly even several times during the course of a 25-year planning horizon.

Also, uncertainty usually is far greater in one direction than another. In the above examples, the likelihood of gas prices being far above ($9-$12) the long-term expectation of $5-$6/MMBtu is much greater than of it falling below $3. The likelihood of a huge nuclear cost overrun was far greater and had a much larger impact than the possibility of a cost under-run. The impact of a combined-cycle plant not dispatching is devastating to an IPP relative to the windfall that might have occurred with lower gas prices. Any decision process that ignores these realities is likely to lead to major disappointments.

What Is an Effective Executive Decision Framework?

EES North America

Some companies have introduced concepts like "balanced scorecards," linking them to incentive compensation plans in an attempt to ensure decisions are consistent with diverse corporate objectives. Although possibly effective in defining corporate goals and evaluating and rewarding performance, these approaches do not provide a consistent framework for decision-making. More important, they do not address the risk implicit in today's environment.

An effective executive decision framework is one that ensures all decisions are evaluated with the full range of corporate goals in mind, measured in the context of a risk-cognizant view of the future, and broadly embraced by the executive team. For some areas, that approach may be highly quantitative; in other areas, a qualitative analysis may be all that is available.

To be effective, the decision framework must have three key characteristics:

1) a manageable design and application;

    2) functional information; and

      3) transparency.

        This framework goes well beyond the employment of a risk management program, which is designed primarily to protect the downside. It embeds an explicit risk perspective in the corporate culture that can be applied uniformly to create shareholder value. An effective framework will ensure that decisions are aligned with corporate goals and consistent with the company's tolerance for risk.

        In short, an effective decision framework creates value throughout the organization because:

        • It supports proper resource allocation to meet high-risk needs and to achieve corporate goals by defining consistent and transparent decision-making across all organizational functions. A risk/reward relationship is defined for all options. All corporate groups are required to evaluate options in the context of a common set of assumptions and a common view of the probable range of future states.
        • It integrates short- and long-term decisions across corporate functions by standardizing the backdrop for prioritizing choices.
        • It keeps focus on high-risk areas and issues by embedding risk awareness into the corporate culture.
        • It creates shareholder value by ensuring that risks are maintained within prescribed limits and that high risk areas are addressed. An effective framework allows management to establish credibility with investors, rating agencies, and regulators, illustrating that the company is well-managed. At the same time, it supports the pursuit of high-reward opportunities where significant risks can be managed.

        What Are the Requirements?

        An effective executive decision framework can be sustained only if its objectives are clearly defined and understood; if decisions regarding resource commitments are consistently based on the framework; and if determination of success is based on that same framework.

        Management first must define and prioritize the corporate objectives, including the level of risk that ultimately is tolerable. The goal of this step is to create a template against which the rest of the organization can test proposals. This activity will define the metrics that will be used to evaluate decisions.

        The second, equally important requirement to initiate an effective executive decision framework is development of a consensus management view of the realm of possibilities for the future. This step is intended to define not only the major assumptions and their range of outcomes, but also to identify the contingent event risks, or "shocks," that should be considered. Management must evaluate all decisions such as capital spending, acquisitions & divestitures, resource planning, energy sales, and purchases, using a transparent decision framework that defines the extent to which corporate objectives are achieved and risks are incurred or mitigated.

        Once consensus is achieved, all alternatives can be evaluated against that common view, the range of identified impacts, the intolerable outcomes, and the mitigation strategies that have been developed. Based on that information, alternatives can be compared and the options that provide the best value for the firm can be selected.

        In its ideal form, the executive decision framework cuts across the organization and is embedded in the corporate culture. Development of the framework, however, more typically is done in stages, applied to those functions or decisions where the greatest near-term value can be achieved.

        Planning activities often are the most effective and valuable area to introduce this framework. In particular, integrated resource planning, fuel procurement, and energy procurement are obvious choices, since such decisions are so heavily affected by the volatile competitive commodity markets. Decisions around mergers and acquisitions tend to be more discrete and offer the unique opportunity to develop a broader framework outside the day-to-day activity of the firm. These decisions require evaluations against the market, as well as broad-based review around compatibility with corporate goals, as well as with investor, shareholder, customer, and regulator impacts.

        The framework, however, is not limited to activity related to commodity markets. Rather it is intended to deal with operational and financial performance as well alignment with other corporate objectives. For example, the framework can evaluate alternatives in the context of reliability, safety, or financial parameters as well as in the context of diversity, staffing or environmental compliance.

        The science of this framework is not particularly new. Portfolio theory shows us that rational investment decisions are best made when a risk-reward trade-off is presented and risk tolerances are evaluated explicitly. This leads to diversified portfolios, a concept well understood by investors. The framework is a very straightforward extension of the same principle to a broad array of decisions. Enterprise risk management is an application of the principle, as is risk-integrated resource planning.

        To ensure its effectiveness throughout the organization, senior management must initiate and continuously champion the new decision framework. The requirement that all investment decisions must explicitly identify and evaluate the risks, as well as returns, across a broad range of outcomes (a confidence interval) may significantly change how different parts of an organization interact. The challenge will be how to make that change and incorporate that approach into the corporate culture. Therefore, it is best to show the advantages in one part of the organization, probably either the corporate planning group or the risk management group, and then use that group to spread to other parts of the organization.

        Bottom Line

        The bottom line is that an effective executive decision framework provides better answers in the complex utility environment that exists today. With hindsight, we can all agree that there was a significant overbuild of gas-fired, combined cycle generation in 2001. Gas prices were low and were expected to remain low; with its low emissions, gas was the fuel of choice. However, gas price volatility was always greater than coal. A fully evaluated analysis including the price and volume risks of both technologies would have significantly reduced the number of gas-fired plants being built. Today the same decision-making approach that resulted in a glut of combined-cycles could result in a wave of new coal fired generation. But is that the right answer given environmental and other uncertainties?

        By explicitly considering the range of risks to which utilities are exposed, some companies have been able to reduce costs and allocate resources more effectively. It is not unusual for the resources to go to the project with the greatest net present value or to the project first requested. But resources are limited and, in large organizations, there are numerous projects of relatively equal "value" competing for them. Often, by explicitly evaluating how each of the projects supports corporate goals and affects the corporate risk profile more value-creating activity can be performed.

        As we look to the future and consider the complex issues associated with evolving environmental compliance; the price volatility of fuel, energy, and emission credits; and the choices related to allocating resources to generation or transmission infrastructure, reliance on tradition single-point financial estimates is likely to result in significant adverse results. A robust executive decision framework that considers various outcomes for numerous variables is bound to permit more informed and higher value decisions.