White Papers

Effective Energy Risk Management
The Effect of FERC Rulings 888 and 889





Effective Energy Risk Management:
The Essentials of a High-Level Process Structure And The Successful Management of an Energy Portfolio.

A White Paper for Electric Power Producers

Integrated Energy Services LC

Copyright ©1998 Integrated Energy Services LC
www.ieslc.com
P. O. Box 14008
Research Triangle Park, NC 27709
Tel. 919-549-0801, FAX 919-549-0713
ies@ieslc.com

Introduction

This paper discusses the key concepts associated with structuring an effective risk management organization, including the more specific challenges associated with physical and financial portfolio management. The first section of this paper covers the essentials of a high-level process structure. The second section discusses the most important elements of effective energy portfolio management.

This paper also discusses some fundamental issues and concerns associated with selecting risk measurement and reporting software. The process of choosing risk measurement and reporting software should be preceded by the creation of (at a minimum) a high-level blueprint of the company's risk management process structure and a slightly lower-level blueprint of the company's portfolio management approach. These blueprints should accurately describe the approach the firm intends to take to 1) the integration of financial and physical transactions, 2) the distillation of the financial book into physical delivery, and 3) the time windows associated with this distillation.

Section I: Building an Effective Commodity Risk Management Operation

Give Management Full Control

Management must control the price risk that will be incurred in the emerging competitive marketplace. Even though measuring and reporting risk in a complex portfolio is a comprehensive and time-consuming job, monitoring that risk does not have to be.

Management can fully control the emerging risk management operation through a high-level working knowledge of the risk measurement procedure and through a process of risk reporting that fully unites the operation vertically. The result is a simple and meaningful risk report that instantly provides management with a complete understanding of the firm's current exposure, without trivializing the importance of the risks the company faces. As long as the risk exposure is within management's pre-set tolerance, management need not act. If the exposure exceeds the pre-set tolerance, management can invoke predefined Management Action Triggers to bring risk back within tolerance.

The Three Tiers of Success

History has proven that three primary business groups must exist to achieve reliable commodity risk management. In this report, these groups are called Management, Front/Middle Office and Back Office. But their names are not as important as their functions, nor are their names as important as the firewalls that must exist between them in order to ensure prudent portfolio and risk management.

These three groups provide a structure in which the practice of risk measurement and risk reporting becomes meaningful for all levels of the organization. When associated with clear guidelines, this triple-tiered structure provides the degrees of freedom necessary for effective daily operation, while empowering management with Management Action Triggers (MATs) that keep management firmly in control without imposing a substantial daily time commitment.

Of all the many rules associated with prudent commodity risk management, one stands out as supreme: a group that is completely independent of the trading operation must do risk reporting. It is absolutely crucial that the group exposing the company to risk not be responsible for measuring and reporting that risk. Virtually every major debacle in recent financial history has arisen because the risk reporting function was not separated by a firewall from the trading and hedging group.

By creating a clear and well-defined process structure, the evolution to a competitive environment will proceed in a prudent and organic manner. Influences that impact risk, and therefore earnings, become obvious when the high-level process structure is well defined. Changes in either organizational structure or in organizational responsibilities follow naturally as the functions necessary to protect the company from adversity find a home in the new process structure.

Education is Important

Through education, everyone in the organization learns to speak the same risk language. Management also learns what assumptions underlie the risk report. This makes the daily report of a single aggregated dollar value at risk in the portfolio meaningful, without trivializing the risk.

Risk Tolerance Subordination and Aggregation

The key to successful price risk management in the triple-tiered risk management structure is the subordination and aggregation of risk tolerance. After a thorough education process, management approves an aggregated risk tolerance. This tolerance is a threshold that is not to be exceeded.

Once management has approved a risk tolerance, the front and middle office groups subordinate pieces of this tolerance to various hedging and trading functions. Through the use of sophisticated software programs, the front and middle office group can optimize the use of the company's capital through a variety of channels, continually redistributing the company's risk profile into the most optimal configuration. The front and middle office group works closely with the back office to ensure that these subordinations do not aggregate into an actual risk in the portfolio that exceeds the risk tolerance threshold approved by management.

On a daily basis, the back office measures individual risk in the subordinated pieces and then aggregates these risks into a single dollar figure. This aggregate single dollar figure is then reported daily to management and the front and middle office groups. The result is an efficient and meaningful monitoring process that provides clear guidelines, immediate knowledge, firm controls, and benchmarks for success.

Creating a Company-Wide, Centralized Risk Management Operation

Risk has mass, almost like a rock. This mass can be broken into pieces and redistributed. Often, in hedging risk, mitigating risk in one sector creates risk in another sector. For example, if a future price obligation is hedged, it can shift risk from price risk to counterparty risk. Even more complex is the risk and opportunity associated with the relative values of the system lambda — the relative values of dollars (or another currency), input fuels and the electric power products generated and sold, as well as the relative values of these components in various locations and time windows.

It is essential to create a company-wide risk management operation, to reduce the chance that risk might be unintentionally increased through the use of isolated hedging and analysis practices.

Creating the Optimal Risk Management Structure

Within each business function are an infinite variety of possible process and organizational structures (refer to Section II of this document for a more detailed explanation of portfolio management). Creating the most optimal internal structures is an organic outcome of education and internal business exploration. For a variety of reasons, no two companies develop the same internal structures. Some of the issues that affect the creation and makeup of these structures include:

  • the firm's relationship to current regulatory restrictions and benefits
  • the firm's future view of the deregulation process
  • the blend of the firm's generation mix
  • the relationship of the firm's existing regulated and non-regulated business entities
  • the structure of the firm's existing portfolio
  • the nature and extent of communication between the firm's upper and middle management.

Regardless of the internal process and organizational structures that are formed within each group, prudent risk management requires specific inputs from the three primary groups into the larger risk tolerance subordination and reporting process.

Management Functions

The functions of the Management group are primarily development, approval, implementation and oversight of policies and procedures. As previously discussed, this includes the critical approval of the company's aggregated risk tolerance. It also includes the vital determination of the company's hedging and trading philosophy. This philosophy becomes a guide for all risk management practices, basically becoming the heart and soul of the risk management operation.

Upper management is often represented by a Risk Management Committee, which may be chaired by the CFO and comprised of an odd number of members to facilitate decision-making.

Front/Middle Office Functions

The primary function of the Front and Middle Office is to optimally shape the company's price risk profile. This is accomplished within the guidelines of the policies and procedures developed and approved by management. The process of optimally shaping a risk profile is complex. It relies on two basic functions: 1) determining future probabilities, 2) pricing vehicles to shape a risk profile that is in accord with these probabilities and with the firm's risk/reward perspective and hedging/trading philosophy.

The process of determining future probabilities includes market analysis that should be derived from more than one of the following types of analysis:

  • Fundamental analysis - uses economic data (e.g. production, consumption, heat rates, etc.) to forecast prices. This analysis of the known fundamentals that underlie the process of determining future price is an important function. It combines many of the analysis procedures currently existing in the utility, although those procedures are rarely utilized for the purpose of predicting price. Fundamental analysis also uses information from the trading desk and publications. The value of the firm's current fundamental analysis activities should not be underestimated. There is vital information in the firm's existing structure. Often these activities need to be expanded and redirected, but they are vital for determining value in various future time windows.

  • Technical analysis - determines future probabilities directly and exclusively from historic prices. Historic behavior patterns are the guide to the future in technical analysis. This form of analysis provides benefit because the price of a security or commodity can often move for reasons other than fundamental reasons. For example, the movement of spot market electricity price to $10,000 per MWh in the summer of 1998 occurred due to speculative interest that burdened an illiquid market, and was further amplified by counterparty defaults. Because technical analysis looks only at price and because price contains the beliefs and preferences of all market participants, technical analysis is capable of providing a unique package of information that is very useful in determining future price probabilities, both in price and time.

  • Quantitative analysis - the use of sophisticated mathematics to determine future price or to determine anomalies in pricing structures. Quantitative analysis is a hybrid of both fundamental and technical analysis in that it often quantifies fundamental information into strictly numeric terms and then often analyzes this numeric information in technical ways. Due to the use of sophisticated calculus and other advanced mathematical practices, quantitative analysis provides a unique and vital perspective in defining future probabilities. Of more importance is the benefit that quantitative analysis provides in shaping the risk profile. It provides insurance vehicles with payout schedules that can be tailored to meet any specific market environment.

(Note: because the existing portfolios of all electric power producers were developed in an environment where reliability and optimization of generation assets were the prime objectives, electric power portfolios are complex portfolios with derivative options embedded in them. Because utilities never faced price risk in the past, utility management commonly believes that they do not use financial derivative products. Nothing could be farther from the truth. The current portfolios of every utility are the most complex derivative portfolios of any portfolio in any industry. For this reason, it is imperative that a utility develops a fully functioning quantitative analysis group.)

Portfolio structuring is also accomplished in the Front/Middle Office group. This is a process of constant adjustment. In this model, Middle Office decision-makers provide instructions to the Front Office. The Front Office executes transactions and captures these transactions into the larger deal system.

Back Office Functions

The Back Office is responsible for all clerical activity related to the hedging/trading operation. Once a transaction has been captured by the Front Office, the Back Office confirms the transaction's terms and conditions. On at least a daily basis, perhaps more often, the Back Office takes a measurement of risk in the portfolio components. These risk measurements are aggregated into a single dollar figure and are reported to Management and the Front/Middle Office groups.

Other reports generated by the Back Office can include:

  • Exception log (Daily);
  • Report of Significant Change (as significant levels are breached);
  • Portfolio Stress Tests (Monthly);
  • Counterparty Credit Analysis (Weekly);
  • Management Summaries (Monthly).

The Back Office reports on and exposes risk in all of the four primary risk categories. Price risk and liquidity risk are exposed in the daily risk report. This report includes a component of analysis that takes into account the potential dollar loss effect of liquidity risk on the portfolio. When management sees this daily report it knows that the risk measurement provided includes an amplification of potential danger that is directly related to embedded liquidity risk. This information reflects the effect of not being able to conduct business at a reasonable price, making it easy for management to instantly keep track of both price risk and liquidity risk.

Counterparty or credit risk is monitored daily and reported monthly. No counterparty is accepted without prior approval. All counterparties either have worthy credit or put up an irrevocable letter of credit signed by a first-class bank that is acceptable to the company.

Financial operational risks are managed in the Back Office where they most often occur. These are managed by strict adherence to policy and redundant systems. A common mistake made in a developing organization is to understaff this critical group. This is the primary cause of loss of earnings due to clerical errors.

The Back Office also performs the critical function of ex-post validation. This process overlays actual returns on top of expected returns to validate the assumptions of the risk measurement models. This is a critical step in ensuring that the firm is not misleading management by under-reporting risk. It also is a vital tool in optimizing the use of the firm's assets. Over time it becomes an invaluable tool for building an understanding of how the various assets in the portfolio behave under various conditions, such as seasonal time windows or various interest rate structures.

Section II: Portfolio Management and Financial-to-Physical Convergence

Successful energy risk management and successful hedging require management of the company's underlying physical transactions and management of the financial transactions that overlay the physical business. The management objective for both of these portfolios, or "books," is to prudently enhance earnings and minimize risk. Effective management of these two different books requires the management of three distinctive portfolio "time buckets," along with a working knowledge of shifts in the forward curves of the assets that make up each portfolio's components.

Forward curves are the prices being traded today for sequential future delivery of input fuels, electric power products, or any other liquid asset whose prices fluctuate enough to represent potential measurable loss to the portfolio. Because the prices of a forward curve are traded, they generate themselves. A portfolio manager simply discovers these curves by looking at the market. Managers do not construct a forward curve based on any cost of generation. Forward curves generate themselves through market activity.

Portfolio managers shape the company's risk profile in relationship to the prices being traded, i.e., in relationship to the forward curve. Since forward curves twist and flex under the weight and pressure of buyers and sellers, portfolio managers must adjust their portfolios to be in line with the peaks and valleys of the forward curve. These peaks and valleys shift as the perceived fundamental supply and demand equation for the underlying assets shift. These shifts in the peaks and valleys of the forward curve create demands on the software used for portfolio management, risk measurement and risk reporting.

For electricity, and to a lesser degree for other commodities, the actual physical delivery window and the forward curve immediately attached to it represent the most volatile window of risk. Prices in this physical window fluctuate more dramatically than prices in future time windows. These fluctuations are further exacerbated by seasonal idiosyncrasies. Therefore, this important forward curve (the time frame between next hour and two weeks out) must be managed well.

The need to manage this important front-end forward curve means that the software purchased for risk measurement and reporting must be capable of at least two important functions:

  1. Providing continued service after the critical handoff from a financial portfolio to a physical portfolio. This brings up several important issues regarding the software's capabilities in communicating with the company's EMS system.

  2. Accurately approximate volatility in the potentially highly-volatile physical delivery market.

The next most important time bucket for portfolio management is the hedge window. The hedge window is the time (generally, between 1 week and 3 months from the current delivery window) during which hedgers accomplish the convergence of the financial portfolio into the physical portfolio. This is also the time when most speculators enter the market. The combination of hedgers distilling their portfolios and speculators trying to profit on their behavior causes an increase in energy market transaction volume.

In the hedge window, risk management software must be able to hand off the financial portfolio into the physical portfolio 1) in a manner that makes the accountant's job as simple as possible, and 2) in a manner that optimizes the portfolio's earnings capabilities without compromising the company's risk management thresholds.

The third portfolio management window is one month and beyond from the current delivery window. This third window is traded when the long-term forward curve shows signs of restructuring, or when the need to serve customers requires entry into forward obligations. Management of this window is perhaps most important for a manager guiding a large portfolio. Fortunately, there are no specific risk measurement and reporting software requirements that create much concern in this window. The portfolio is considered completely financial in this window and, relatively speaking, the volatility in this window is not a problem for energy traders.

The Role of Beliefs and Preferences in Portfolio Management

Beliefs and preferences combine with corporate guidelines or requirements to help the portfolio manager shape the portfolio's risk profile. Beliefs are the manager's view of the future. Preferences are the manager's method of expressing his or her beliefs. Corporate objectives or guidelines dictate how much flexibility the portfolio manager has in expressing his or her beliefs. The result is quantified. Analysis of this quantification is reviewed to reshape and refine the manager's beliefs and preferences.

Conclusion

The end result of building a properly-structured energy risk management operation and an effective energy portfolio management program will be a streamlined, efficient energy trading operation. Such an operation will prudently enhance corporate earnings while mitigating and minimizing the risks inherent in holding an energy portfolio. This provides power producers and energy traders with critical components for success in the increasingly competitive energy markets.





The Effect of FERC Rulings 888 and 889 On the Emerging Competitive Marketplace.


Lessons from the Summer of 1998

A White Paper for Electric Power Producers

Integrated Energy Services LC

Copyright ©1998 Integrated Energy Services LC
www.ieslc.com
P. O. Box 14008
Research Triangle Park, NC 27709
Tel. 919-549-0801, FAX 919-549-0713
ies@ieslc.com

A Fundamental Change: FERC rulings 888 and 889

FERC rulings 888 and 889 have dramatically changed the electric power marketplace. This change is forcing power producers to transform their business practices. FERC rulings 888 and 889 have created a partially developed competitive environment that now has lasted through a business cycle. As a result, we have vital new information about the nature of electric power markets. We also have a clear picture of the challenges that power producers must address if they are to survive and prosper in the emerging competitive environment.

Case Study - Louisville Gas & Electric

Louisville Gas and Electric (LG&E), an early leader in developing an aggressive power marketing operation, terminated its power marketing operation after taking severe losses during the summer season of 1998. The forces acting both in and upon LG&E are a perfect example of the results that inevitably follow when traditional risk management rules are not respected.

LG&E failed to:

  • Create effective risk measurement and reporting practices
  • Recognize the impact of liquidity and counterparty risk on market prices
  • Recognize that customers do not equal earnings in freely traded markets, and that it is possible to have a large customer base and still suffer a substantial loss

LG&E chose not to build a risk measurement and reporting organization. A risk measurement and reporting organization would have reported the likelihood of price risk in the company's portfolio. Price risk is the ultimate risk because it is measured in dollars. Risk measurement and reporting is designed to calculate the likelihood of loss due to price risk over a specific future period of time. If LG&E had built a price risk measurement and reporting function, LG&E would not have continued to make fixed-priced forward sales that had unmitigated price risk exposure. Without a risk measurement and reporting function, LG&E was unable to see the influence of liquidity risk and counterparty risk on price risk. In the end, LG&E management was unable to monitor the risk inside their portfolio and therefore was unable to keep their losses within acceptable tolerances.

The LG&E case shows that even though the supply and demand equation for electric power as a commodity is unique, respect for the basic laws of risk management is still required to ensure portfolio stability. Risk must be managed in all aspects of the business and across all risk categories.

Having Customers Does Not Guarantee Earnings

Utilities are conditioned to believe that owning generating assets and having customers ensures earnings. This is only true when customers are forced by regulation to pay a premium for electric power products. What LG&E and others have failed to realize is that fixed priced sales outside the rate base do not ensure earnings. To remain competitive in the emerging environment, an electric power producer must realize that not only must they have prudent management practices, they must learn that selling product at a profit is what ensures earnings. Without a guaranteed rate base, poorly managed long-term sales can be disastrous. They certainly were for LG&E.

Even after the LG&E debacle, most utilities still are instructing their unregulated subsidiaries, such as their energy services group, to carry out a sales campaign to bring in more customers. These utilities are not considering that, for the most part, the power products sold by these campaigns will be 1) in highly illiquid markets, and 2) not secured by a specific guaranteed capacity stream. What if the utility must purchase power from the spot market during times of peak demand, when the utility's capacity is most often exceeded? If the market is burdened with speculative interest at such a time, the utility could suffer the same fate as LG&E.

Disappearing Rate Base, Emerging Shareholder Risk

It is most likely that the price protection offered by the regulated rate base will disappear for all utilities in coming years. This should be reason enough for a utility to consider building a risk management organization. However, most utilities do not understand that, even if they do have the protection of a rate base, they may still have a complex risk profile. Such a risk profile might represent direct risk to shareholders.

The Unseen Hazards of Off-System Sales

Most often, utilities have made off-system sales designed to optimize the firm's generation assets. These off-system sales are made in the "wholesale" market. The cash flows of these contracts usually are outside the utility's rate base. Being outside the rate base, losses in off-system sales should be carried directly to the shareholder—but this is rarely done. Utilities mistakenly believe that, because a regulated generation stack most often serves the off-system sale, the profit or loss from the off-system business can be folded into the regulated business. This practice may not meet with regulatory approval.

Many utilities historically have supplemented their own capacity with spot electricity purchases as an alternative to building new generation facilities. This was a sound business practice in localized markets where capacity exceeded demand most of the time, and where base load is a large part of the area's capacity. However, since the implementation of FERC 888 and 889, the dynamics of localized markets have changed dramatically. In the upper third of the United States, for example, hydroelectric power from Canada traditionally has been used to supplement local generation. But that low-cost hydroelectric power now flows to other, higher priced markets. The result is a higher-priced peak-demand spot market in these regions.

When utilities make off-system sales with a generation stack that includes spot purchases, they are betting on the future of the spot market. If such a bet loses money and the loss is folded back into the regulated business, the regulated customer suffers. Depending on where the company is in relationship to its rate base and/or fuel clause threshold, the customer may end up paying for the utility's speculation. It is clear that these off-system sales should be entirely booked to the shareholder account. As such, these sales are speculation.

Capacity Sales—an Unsuspected Source of Potential Loss

Capacity is the right to call on energy. Therefore, capacity is an option. It provides the right but not the obligation to make or take delivery of energy. Options have a very specific pricing structure. However, electric power capacity sales have never been priced using standard option pricing methodology. Utilities with off-system contracts often have substantial capacity sales in their portfolios. Many times, these are sales to other utilities who use this capacity to fulfill URGE requirements. In such sales, the capacity most often won't be exercised, even if the market price of the capacity has dramatically increased—a practice that is contrary to financial common sense. In the coming years, as the actual market value of these capacity sales is recognized, the market for capacity will change. This change could very well cause a substantial loss for utilities that fail to manage the risks associated with their capacity sales.

Protecting the Revenue Base and Finding New Opportunities In the Competitive Marketplace

The changing electric power marketplace offers opportunities for enhanced profits as well as for taking losses. Utilities with prudent risk management policies, procedures and structures can protect themselves and their shareholders. At the same time, a sound risk-management structure offers a power producer the opportunity for new, low-risk sources of revenue and enhanced value for shareholders.

Risk for Power Producers: How to Define It, How to Approach It

Traditionally, risk is identified as residing in one of four categories:

  1. Price risk: the risk of dollar loss due to fluctuations in market price
  2. Counterparty risk: the risk of loss associated with lack of performance by a trading partner
  3. Liquidity risk: the risk of loss arising from an inability to transact business at a reasonable price due to a limited number of potential counterparties
  4. Operational risk: the risk of loss due to incorrect instruction of payments and other clerical errors.

Utilities can address risk using either of two basic approaches: Build or acquire in-house risk management expertise, or enter into a partnership with an outside firm that can provide risk management services for the utility.

Partnership with an Outside Risk Management Firm

Partnership with an existing risk management firm has both benefits and drawbacks. The benefit is that the utility immediately has a risk-management program with no up-front development cost. The drawbacks are that risk-management skills are not developed in-house, critical and proprietary supply-and-demand information is given to outsiders, and the arrangement is detrimental to the utility's long-term profitability.

Risk management partners do not share the benefits of prudent risk management with a utility. A risk management partner will never tell a utility that risk management, using the utility's considerable asset base as leverage, can actually generate substantial profits. This usually means that the risk management firm is leveraging the utility's generation assets for their own benefit, without sharing the profits.

The worst part about a partnership arrangement is that the utility does not receive the necessary education to understand the risk management process. When full deregulation is ushered in, the utility that handed risk management off to a partner may suddenly find themselves in a very vulnerable position: the utility will be left with much lower margins and a much higher risk profile. Such a utility will then see the desirability of having the additional profits generated by prudent risk management—but the utility won't be able to have those profits, because the risk management partner will continue to keep them. Such a utility will not be in a position to terminate the relationship and begin to enjoy these additional profits, because the utility will not have the knowledge or internal infrastructure needed to perform its own risk management.

Building an In-House Risk Management Operation (the Best Approach)

Creating an internal risk reporting function in preparation for the future is the best approach for any utility that wants to survive and prosper in the competitive marketplace. The benefits are many:

  1. The utility develops risk management skills that meet the utility's specific needs
  2. The developed risk-management skills remain the proprietary property of the utility
  3. Management takes the time and receives the education needed to become comfortable with risk management, hedging and trading concepts.
  4. The utility creates a stable base from which they can explore various earnings enhancement strategies
  5. The utility has a strategic and precise gauge that can be used to measure, report on and prudently manage earnings enhancement strategies
  6. The risk management structure provides MATs (Management Action Triggers) that place management firmly in control
  7. The entire risk-management structure can be developed in predetermined stages at a reasonable, clearly-defined cost

Over time, the education and achievement processes used to build an in-house risk management organization redefine the company's understanding of risk, financial markets and the role of the electric power producer in these markets. The result is a unification of previously separated business functions, both vertically and horizontally, making the utility a much more effective and efficient organization.

The process of building a risk management organization in a utility requires a concerted multi-level educational program that addresses the massive internal cultural change associated with each of the following developmental phases:

  1. Design. The creation of a high-level 5 year business plan and a detailed one year operational plan
  2. Approval. This phase provides the necessary human resources and budget, as well as necessary management participation
  3. Implementation. Executing the plan.
  4. Review. An assessment of progress, leading to a revision of the high level five-year plan if necessary and the design of a second, detailed one-year operational plan for management approval

Building a Risk Management Organization

Developing Process Structures

Successful risk management in a competitive environment requires certain basic process structures. In general, these process structures are divided into two basics categories: Back Office and Front Office (front office is sometimes further divided organizationally into front office and middle office). The basic activities performed under each category are:

Back OfficeFront / Middle Office
Accounting
Risk Measurement
Risk Reporting
Counterparty Credit Assessment
Instruction of payment
Data management
Market Analysis
Hedge/Trade Decision-making
Deal Execution & Capture

Effective back office and front office functions are always divided by a "firewall." Even though there is a connection between the functions of these two office structures, there should be no overlap between personnel or practices. Risk measurement and reporting is a serious business that is designed to police the activities of the front office. The back office functions, therefore, require complete autonomy.

Building a Back Office - What Exists, What Doesn't, What Must Change

In an ideal world, no analysis, decision-making or execution would take place prior to a fully functioning back office. Therefore, a utility is well advised to focus first on building its back office structure to provide accurate and timely risk management information. Entering into competitive trading or hedging activities without a fully functioning risk measurement and reporting function can lead to substantial losses.

Building a back office is a perfect first step for a utility that is developing an in-house risk management organization. The entire goal of the process is to reduce risk. Management likes this, and can easily accept and support the project. In addition, the process can be achieved with a reasonable first-year budget. The process, filled with education, empowers management and unites the company vertically.

Very few of the back office functions that now exist in a utility can be transferred directly into a newly developing competitive organization. Four of the necessary back office functions that should be developed simultaneously from the start of the risk management development process are: 1) accounting, 2) risk measurement, 3) risk reporting, and 4) counterparty credit assessment.

Accounting - accounting procedures in the back office of a commodity operation are different than those historically used in the utility industry. Historic practices use accrual accounting. The back office uses "mark-to-market" accounting. Accrual accounting holds assets on the ledger book, analyzing these assets only periodically, either at the end of longer-term accounting periods or when the asset is sold. Mark to market accounting analyzes the value change of each asset daily. The practice of mark to market accounting by the back office does not replace more traditional accounting practices. It supplements them. Mark to market accounting is essential for useful risk measurement and reporting.

Risk Measurement - measuring risk in an electric power portfolio requires skill sets not commonly found in a utility. The practice uses advanced probabilistic mathematics to predict the likelihood of capital loss over a specific future time window.

Risk Reporting - reporting risk should unite the organization from top to bottom. Risk reports are designed to provide a single dollar evaluation of the likelihood of loss, derived from the risk measurement practices described above, in an easily understood format for management. This practice empowers management, providing them with not-to-be-exceeded thresholds and management action triggers (MATs) to maintain control. The practice usually involves high-level management (usually as high as the CEO and the CFO) who receives daily summary reports. It also demands the creation of a new process structure that eventually becomes the organizational structure around which the company solidifies.

Counterparty Credit Assessment - the creditworthiness of even traditional trading partners will change in the coming years. Many new trading entities will arise, some with questionable credit. The utility must build an effective credit analysis group to set standards for offering credit, as well as to monitor the daily extension of credit to any single counterparty, ensuring daily that this offer does not exceed the limit set by the credit group. Often, the initial stages of credit analysis can be developed within the cash and banking group. This approach makes sense if the company's CFO is participating in the risk management project. If not, a separate credit group must be developed.

Developing Risk Measurement and Reporting

The practice of risk measurement and reporting has been developed over the last thirty years. A major breakthrough occurred in 1994 with the introduction of Value at Risk, a methodology developed by JP Morgan Bank. Value at Risk is designed to deliver a single dollar figure that represents, with a certain confidence factor, how much gain or loss can be expected in a portfolio over a specific future time period.

Though the general concept of Value at Risk is valid for all markets, the JP Morgan method was designed for interest rates and other associated markets. Therefore, the JP Morgan model is not immediately and practically applicable for electric power markets. In fact, no firm participating in the electric power markets has yet produced an accurate Value at Risk statement. However, firms that are working on the problem of refining the Value at Risk methodology were among those who did not suffer in the summer 1998 price spikes, even though many of these firms were actively speculating in the market at that time.

The important point is that it is well worth a utility's time and effort to develop risk measurement and reporting tools that address the company's needs.

Defining Risk Tolerance

A utility must define its risk tolerance before it can develop effective risk management policies and procedures. For most utilities, their stated risk tolerance, prior to understanding the Value at Risk concept, is zero. However, at the same time, these same utilities often make unhedged off-system sales using the most complex derivative financial vehicles in use in any industry. The result is direct and unmitigated shareholder risk.

Fully Integrating a Utility's Various Business Units

The disparity between a seemingly well-defined risk tolerance and the execution of risky business is often the result of a lack of integration between a utility's business units. This lack of integration is a natural development in an industry where, essentially, the only substantial loss the regulated company could suffer was a failure of the physical generation and distribution system. As long as the company had customers who were forced to pay a guaranteed premium for the utility's product, the business did not need to measure or control financial risk.

Essentially, such a company had no price risk. It also did not have to limit the types and complexities of the financial vehicles used to ensure optimum operation of the firm's generation assets.

Understanding and Managing Derivative Financial Products

Most utilities have one of the most complex financial derivative portfolios of any business in any industry, but very few utilities understand this. One of the reasons that the wholesale financial vehicles used by every major utility are so complex is that these vehicles were never priced on a market basis. These vehicles were always priced with the idea of optimizing the electric power generating and distribution system—they were always priced on a "cost plus" basis. The result is that, over time, utilities have built comprehensive portfolios of very complex derivative financial vehicles. This complexity often extends to off-system sales. A portfolio of these derivative financial vehicles is nothing to fear—in fact, it can be a source of additional revenues with very little risk—as long as the utility has a fully developed, integrated risk management organization in place.

Managing Off-System Sales Prudently

An immediate benefit of in-house risk management is prudent management of off-system sales. If off-system sales are concluded at a fixed price, then the price risk associated with these off-system fixed priced sales is fully mitigated if, and only if, the utility has met one of two requirements:

  1. the utility has the capacity to generate enough electric power at all times to meet both its absolute peak customer load demand and its off-system sales volume without any spot market purchase, or
  2. the utility makes a specific purchase with a credible counterparty to offset the specific off-system risk.

Due to the price volatility of electric power, simply meeting a probability or approximation of future demand is not enough. Any off-system sales with a window of potential coverage that requires purchases from the spot market represents a potential risk of loss that should be unacceptable to any electric power producer. A fully functional risk management organization will ensure that the utility's current risk is mitigated and that the utility is always properly protected when engaging in such transactions.

Risk Transfer Markets and Speculators - Allies, not Adversaries

The ability to wheel power between regions has been the catalyst for the transformation of the energy price structure. The main reason for this transformation has been the introduction of speculative interest in the marketplace. The presence of speculators has led to higher price volatility in electricity, a commodity that already has the highest price volatility of any commodity. Even though this volatility places a utility at more risk, power producers should not bemoan the presence of speculators.

Speculators serve a vital function in risk transfer. Companies that face price risk associated with their underlying business, like most electric power producers, most often choose to hedge this risk. Hedging risk means to transfer this risk. A hedger gives up risk for a fixed and known price, and a speculator accepts risk for a potential gain. Without speculators hedgers would not be able to actually hedge. Therefore, speculators are vital to the interest of the power producer.

Utility management often confuses using risk transfer markets, in which speculators participate, with speculation itself. It is vital that a utility's management understands risk transfer forums. These forums, like futures exchanges, offer an unparalleled arena for an electric power producer to reduce its risk by transferring this risk to speculators. Without these forums, hedgers and speculators can not interact. The bad press associated with major losses by speculators never provides the full story. When a firm, like LG&E suffers a substantial financial loss due to unmitigated speculation, it is rarely reported that, at the same time, other firms received a fixed price that gave them a stable balance sheet.

The conclusion on the part of electric power management should be that competitive markets are to be respected, not ignored. Fires can either protect or they can destroy. The same thing is true of risk transfer forums, whether these forums are regulated futures exchanges or the forwards markets in which utilities now conduct the bulk of their business. LG&E, for example, took its losses in these forwards markets. It was not the use of complex derivative vehicles that caused LG&E's failure. It was a lack of risk management discipline. The utility with a fully developed risk management organization will find themselves positioned to avoid the pitfalls and exploit the opportunities provided by financial derivatives, risk transfer markets, and the emerging competitive marketplace.

Education—a Crucial Ingredient of Successful Risk Management

Building a risk management organization represents perhaps the largest cultural change ever attempted in any industry. Constant and frequent education is required at every step in the process. This education must be administered at every level of management.

The importance of education in this process can not be overstated. For example, a fully functioning risk measurement and reporting organization is worthless if management won't approve the necessary tolerance policies that make the risk report meaningful.

Ideally, the utility will conduct an ongoing education campaign that will be an integral part of building an effective risk management infrastructure.

Building the Back Office - Year 1

Creating the necessary fundamental elements of a Back Office is a reasonable and prudent first step in building the larger organization needed to address competitive market issues. The cost of creating a Back Office directly depends upon how much time and human resource is required to sell management on the idea. Assuming management approval, the basic milestones of the first year are divided into two major categories: Risk measurement, reporting and accounting, and counterparty credit assessment.

Risk measurement, reporting and accounting

Marked-to-market accounting is a basic tenet of back office functions in prudent risk management organizations. Therefore, the process of building a risk measurement and reporting function will automatically facilitate the acceptance and use of this accounting style.

Milestones to be achieved during the first year of building the risk measurement and reporting function are:

  1. Write and post a job description for a risk technician
  2. Interview and hire the risk technician
  3. Select a software vendor & purchase software
  4. Educate the risk technician in the functions of risk reporting software
  5. Define a subset of the firm's portfolio for test measurement
  6. Decompose the cash flows of the selected portfolio subset
  7. Populate the risk reporting software with data from the decomposed portfolio
  8. Produce the first risk report
  9. Review the first risk report and adjust the underlying functions
  10. Optimize risk reporting
  11. Produce daily, ongoing risk reports

Counterparty Credit Assessment

Working with cash and banking or another finance group, create a schema of acceptable credit standards. Establish a first year review and monitoring procedure. Other considerations in the process include authority of credit extension and a limit exception process. A simple credit policy can be written and approved within a few weeks. Implementation of the policy requires at least two periodic researchers and one full-time compliance monitor.

Creating and Educating an Advisory Committee

Most utilities prefer to monitor their risk management organization with a risk advisory committee. A risk advisory committee is usually comprised of:

  • upper-level policymakers (usually an odd number, like five or seven, to facilitate decision-making)
  • a project manager or someone else who will be involved in future hedging and trading decisions
  • the risk technician

The members of the risk advisory committee are the primary recipients of education campaign material. This committee should meet at least once a month for the first year.

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