Valuing & Measuring Risk in Portfolios
Accurate valuations and comprehensive risk management can afford significant business benefits to market participants. Operations can be better optimized to become more profitable and views into the company’s enterprise risk profile lead to more informed decision making, enabling market participants to respond to the greater levels of scrutiny that they now face. This article highlights how operations are driven by accurate valuations and risk management, and analyses the three main ways in which these are approached by energy companies.
By Dr. Chris Strickland
THE PRODUCTION, DISTRIBUTION, trading and hedging of commodities has long been a complex business. The larger companies that operate in this space do so in multiple physical markets, across multiple geographies and currencies, own and dispatch multiple physical assets, trade in multiple types of complex commodity contracts (power purchase agreements, tolling agreements, transportation contracts, virtual storage contracts etc.) as well as in standard hedge contracts. In addition, energy and commodity companies are increasingly driven by economic circumstances and outside oversight to accurately value and measure the risk of these portfolios.
Valuation of Energy Contracts Like their financial market counterparts, the valuation of
contracts by commodity companies is typically attempted on a daily basis – whether by mark-to-market or mark-to- model. However, trading by financial institutions is generally characterised by operating in purely financial markets (stocks, indexes, bonds, foreign exchange, etc.) and in standardised, liquid contracts. Many energy companies trade paper contracts that ‘back-to-back’ the physical assets in their portfolio, for instance tolling agreements that sell the power produced by a particular station, long term gas supply contracts such as take-or- pay, or virtual storage contracts. The contracts often inherit many characteristics of the physical asset and this makes the financial contracts traded by energy organisations typically more complex than their banking counterparts, often requiring advanced optimization techniques simply to accurately derive their value.
Valuation of Asset Portfolios Although not normally attempted on a daily
operation of the asset requires complex optimisation, and hence the derivation of the costs and revenues that feed in to any asset valuation are made more complex by their physical characteristics (for example, minimum up and down times, ramp rates, minimum stable generation and start up costs for power plants, or capacities, injection and withdrawal rates for gas storage facilities).
Measurement & Management: Risk in the Spotlight In addition to accurate valuations, risk measurement and management of energy portfolios is increasingly the focus of external as well as internal attention. In part this is driven by regulatory oversight, but perhaps a bigger driver is oversight by credit rating agencies, as well as from banks that are being asked to extend credit. Without demonstrably strong risk policy frameworks and evaluation tools, companies are threatened with being ‘marked down’ and refused credit.
Without demonstrably strong risk
policy frameworks and evaluation tools, companies are threatened with being ‘marked down’ and refused credit
basis, the accurate valuation of physical asset positions is critical to commodity players. Whether or not a transaction, merger, acquisition or dispute has a successful outcome is often based on the value reached. Asset valuation is not straightforward and advanced valuation techniques are required to properly assess assets such as thermal, hydro, and wind power plants, gas pipelines, gas storage facilities, oil refineries, or LNG ships. Further complicating the analysis, these assets are often viewed over the long term (often 15 years or more) where it is difficult to obtain forward curve or volatility information. The physical
Furthermore, there is increased shareholder pressure for companies to make more of their portfolios. This is driving the requirement to make better informed decisions, to structure more appropriate hedges, absorb market volatilities and price shocks, and to optimise operations to improve profitability. Similar to the valuation of assets and
contracts, measuring the risk profile of energy companies is also more complex
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