Rating the New Risks

Deck: 

How trading hazards affect enterprise risk management at utilities.

Fortnightly Magazine - June 2007

Over the past 15 years, trading’s role at utility companies has evolved substantially from ensuring sufficient power and fuel supplies for ratepayers to taking large, open, and speculative positions and maximizing asset value. Along with that evolution come a host of new business and financial risks for utilities.

Fuel and power, of course, must be available, and the potential impact of the financial risks of trading must be controlled and managed, lest they adversely affect the parent firm. And the financial risks, already highly complex, are growing: Today’s very lively market for energy-based commodities and their derivatives has traders at energy desks jockeying with desks at investment banks and hedge funds.

Trading desks are a critical asset for a utility, as they provide the freshest market intelligence. However, they are also charged with being a profitable business undertaking, which faulty intelligence about the weather, the supply chain, or the economy threatens. Faulty intelligence also can damage reputation and result in potential electricity shortfalls in regions served.

New regulatory and competitive information must be integrated fast, which requires speedy and effective technology.

Senior management of utilities with trading desks, from the board and “C suite” down, must be well-versed in the ins and outs of trading, its impact on the firm’s overall financial structure, and, most of all, its risks. As management teams seek to improve how they manage key business and trading risks across an enterprise, they must determine how best to blend financial trading skills with access to energy forecasting, and management and supply knowledge and information.

Processes and procedures must be enhanced, transparency improved, and open enterprise-wide communications about trading activities cultivated and maintained. Individuals knowledgeable and experienced in risk management and mitigation at utilities need to be on board throughout the firm, especially in senior management, and formal risk training programs needs to be in place to ensure that a proper risk-management culture permeates the firm.

Trading Risks

The emergence of trading desks at utilities began in the 1990s with two regulatory events. The 1992 Energy Policy Act let the U.S. Federal Energy Regulatory Commission (FERC) order the unbundling of power transmission from its generation. In 1996, FERC was empowered further to open transmission lines to interstate competition. Deregulation by many states spurred growth in power trading during the 1990s, which introduced competitive power-supply options to the markets and spawned the creation or growth of many energy firms.

Trading activities across all commodities at most utility companies retrenched after Enron’s 2001 bankruptcy. Some firms even shuttered their desks. Since 2003, however, trading in energy commodities and derivatives has emerged as fertile ground for investment banks and hedge funds due to the demand for these products and the very weak credit profile of most of the providers. This has prompted several utilities to launch or relaunch their trading desks.

Since the Enron bankruptcy, management teams at utilities with trading desks have become increasingly aware that a commodity trading desk has impact on risk that is firm-wide, and must be understood all through the firm, from the trading floor all the way up to senior management and the boardroom, and all points along the way.

Several utilities with trading desks have hired chief risk officers, a move that can raise the authority and accountability of the trading risk management function to C suite and board levels. At some firms, chief risk officers even have the authority to change risk positions and, if needed, to close a trading room down.

Many utilities have begun to institute risk-management practices that cover the internal and external risks of physical and financial trading. Such practices include policies and procedures for monitoring, managing and evaluating all structures, activities, and decisions affecting the trading desk, and by extension, the enterprise. It also enables senior management to be constantly aware of the company’s risk position, which risk-mitigating trading and balancing strategies need to be upgraded, or whether new ones need to be implemented.

On the internal side, utilities need to manage the risks associated with ensuring revenue models are well tested and updated; that account reconciliation, credit accounting, and portfolio optimization processes and procedures are tight; that operating performance and liquidity are regularly assessed; and that loss tolerances are effectively set and regularly tested, and communicated throughout the firm. In addition, utility trading desks need strict guidelines in place to govern which commodities and derivatives they can trade, which strategies can be used to trade and hedge them, and to set the risk tolerances and limits, as well as the policies and procedures around counterparty credit.

Utilities also need to manage external risks, such as supply volatility and its impact on demand forecasting, business scandals, competition, regulatory activity, the weather, economic factors, and new business and trading models. These must be transparent both to management and to stakeholders.

EES North America

For many, all of this has shifted the focus for utility senior management teams from profit-centric to risk-centric. Silos must be crossed to provide enterprise risk management that integrates risk analysis with customer, geographic, and product analysis.

But even with all these changes, most utilities with trading desks are still far from an optimum maturity level. Standard & Poor’s thus far has reviewed the policies, infrastructure, and methodologies for trading risk management at 10 U.S. energy companies. In this initial sampling, we found significant divergence in risk-mitigation structures, a less robust infrastructure for asset-based trading than for pure trading, a relatively new structure for risk management, dominance of senior management over the risk processes in some cases, and poor external reporting on the firm’s risk position.

Capital, Counterparties, and Credit Risk Management

Credit risk management is how a trading firm evaluates its credit makeup and the current dollar exposure of its counterparties. Systems should be in place to monitor all risk positions to ensure a firm stays within its exposure limits.

Critical to improving trading risk management at utilities is the implementation of methodologies that can improve risk identification, quantification, and mitigation, especially in liquidity, credit operations, and technology. On the liquidity side, sufficient collateral is necessary to sustain physical and financial trading, as high consumption can drive up spot market prices for fuel and power, which can leach cash. To mitigate this risk, most energy trading desks run price and volatility stress tests constantly to quantify their potential exposure. In addition, the trading operation should have access to sufficient liquidity to weather price fluctuations.

A principal ongoing risk for trading desks is the long and short positions left open, or unhedged, at the end of each trading day. Since 1998, the average number of open contracts at the end of each month has soared. A firm’s willingness to hold open positions, especially in illiquid markets, makes it critical that its traders and senior management be accountable for their own market, credit, or operational risks.

Obviously, credit departments should also conduct credit analyses on all counterparties. Counterparties incur more risk in commodity transactions because credit is implicitly extended between physical delivery and financial settlement. Each counterparty’s credit profile should be scrutinized for regional concentrations, which can make portfolios vulnerable to local market conditions. Appropriate credit exposure limits should be established for each counterparty, including dollar trading limits and commodity volume limits. These limits should also be checked frequently—optimally, after each trade. In addition, firms should ensure they maintain access to as many counterparties as possible, in as many regions as possible, to supplement physical liquidity and mitigate some counterparty risk.

The capital structure is a major component of financial risk and performance. Risks associated with counterparty exposure, portfolio exposure, operations and general capital needs must be quantified. Actual and potential exposures by counterparty, region, and commodity need to be monitored daily. Potential exposure by counterparty should be assessed to limit the potential loss to an energy firm stemming from default risk. Market volatility can spark large price increases, which can push a counterparty’s account over its credit limit, especially if it is running sizable receivable balances.

For good risk management, energy firms need a portfolio of methodologies that can measure and value the risks inherent in the contracts and derivatives energy desks trade. VaR (value at risk), which measures the cost of liquidating a position at unfavorable market conditions, has become a standard measure. Various other metrics, such as EVA (economic value added), SVA (shareholder value added), and RAROC (risk adjusted return on capital) may provide value in capital-allocation decisions. These valuation models should be assessed constantly, and senior management should ensure that the assumptions behind the models are appropriately validated by the risk-management function.

While Standard & Poor’s has not completed analysis and implementation of its own capital allocation model in the utility sector, it nevertheless appears reasonably clear that management should also use stress tests and scenario analyses as they can proactively identify and evaluate important scenarios and feed that information to capital allocation decisions. Standard & Poor’s expects it may incorporate extreme risk scenarios as well, as risks such as terrorist attacks on power generation facilities or environmental disasters such as hurricanes or earthquakes can wipe out a substantial percentage of an energy firm’s capital or even bankrupt it. Of course, insurance is likely to cover a significant portion of this type of extreme exposure.

Credit violations need to be reported to management and remediated immediately. Centralized, automated risk measurement, position monitoring, and trade-limit enforcement enable accountability for visible risks.

Controlling Risk From The Top

Sarbanes-Oxley has rendered essential the authority and accountability of a chief risk officer to senior management and the board. Senior managers need sufficient transparency about the type and magnitude of material risks being taken by their trading desks. After 2001, a few firms began to implement comprehensive risk-management reporting. Other firms upgraded available information about their hedging policies, their risk limits, and their risk-governance structure.

An executive committee should participate in decisions that set monetary loss level limits, position credit exposures, and approve the systems and procedures used to value and mark to market complex structured transactions.

To prevent lapses in risk management, risk control systems need to incorporate internal structures, staffing, procedures, and technical capability, and an effective reporting structure. One prudent strategy could be for a firm’s board to set up separate executive committees for risk management, control, and credit functions. The risk management and control committees can review the risk-management policy and recommend updates and modifications to elements such as VaR methodologies and limits. The credit committee can develop and maintain credit policies (subject to board approval), as well as track and report noncompliance, and oversee counterparty exposure.

Guidelines should exist for trader expertise. Physical separation of the trading floor from the internal credit department as well as the back office avoids any perceived compromise of the floor’s relationship with transaction origination and accounting.

Continual, independent third-party audits, preferably by a major accounting or consulting firm, are advisable. Independent, external risk assessments are advisable as well, as they can raise red flags where the firm’s current practices lag industry best practices. It can also cover various elements of the risk management process and the linkages between them, such as risk discipline, trading performance, economic versus GAAP comparisons, market risk levels, credit risk concentrations, risk transparency, whether the list of risk metrics used is complete and how those metrics are calculated, infrastructure aspects, and industry dynamics.

Firms also need experienced quantitative staffs dedicated to constantly testing and validating valuation models and methods.

Doing all this requires sophisticated and timely knowledge, as well as tools to measure risk, position and exposure reporting systems as close to real time as possible. Review mechanisms must be in place to adjust strategy to changed conditions and communicate those adjustments to stakeholders.

Looking ahead, utilities with trading desks will continue to deal with risks from regulatory and political changes, the ongoing need for environmental compliance, and a constantly, rapidly evolving market with ever more sophisticated derivative instruments to trade and strategies to do so. Fuel prices as well as supplies will most likely remain volatile.

Most risk models and managers seek to measure and manage expected events, but more emphasis should go to protecting from surprises. Risk managers should have tools in place to respond quickly to predictable surprises with the magnitude of the fall of Enron and Amaranth and the Katrina floods. Management that fails to take action to prevent predictable surprises could experience rating downgrades.

Keeping risk across the enterprise at manageable levels can be done if a company institutes a strong risk-management infrastructure, maintains a stable management structure, long-term goals, risk tolerance levels commensurate with its ability to manage those risks, strong internal policies, procedures, and controls, transparency, and strong corporate governance.

However, no risk model is perfect. How good a company’s risk management is depends a great deal on the commitment of senior management, and whether sufficient budget and resources are allocated, to create and implement good firm-wide systems, improve technology, and hire and retain the right people.