VALUING & MEASURING RISK
than for their financial counterparts. A good definition of enterprise-wide
risk management is “a systematic and disciplined process of identification, measurement, reporting and mitigating risks across all business units and company operations, using a unified and conceptually coherent framework”. Under this definition, for risk measurement to be relevant to a typical energy company, it needs to include the company’s full portfolio – including the asset base of the company, the long term supply and off-take agreements, as well as the hedge book. This definition of risk – encompassing the firm as a whole – is more often than not poorly satisfied by a large number of energy companies. For many, risk management in practice is limited to the calculation of Value-at-Risk (VaR), and in many instances limited to analysis of the trading book alone, ignoring many of the structured trades and assets.
Settling for lower quality risk metrics is a long term losing position
Although the VaR metric brings
the advantage of yielding the risk manager or CEO a relatively quick and easy way of answering the question of “how much risk are we running” (if only for the trading book), VaR models of this kind should not be the end goal. Rather, they should be the starting point for a broader based discussion around risk. If the focus of senior management meetings is typically on the current and forecasted gross margin, earnings, cashflow, or profits, then these should form the basis of the ‘at risk’ measure, and not just value at risk. Firm-wide risk exposure is then more accurately represented by measures such as Gross Margin-at-Risk, Revenue-at-Risk, or Cashflow-at-Risk. Settling for lower quality risk metrics
is a long term losing position. Profits are jeopardized and, as we have seen again recently with JP Morgan, senior management can make incorrect business decisions based on inaccurate information being reported to them.
42 June 2012
Accurate valuations, and comprehensive risk management can afford significant business benefits to market participants. Operations can be better optimised to become more profitable and views into the company’s enterprise risk profile lead to more informed decision making, enabling participants to respond to the greater levels of scrutiny that they now face. So how are valuation and risk assessment addressed in the
majority of energy and commodity companies? We can group the approaches into three main areas outlined below.
Relying on E/CTRM Systems Firstly, many firms that trade energy and commodities look to
the valuation and risk management functionality supplied by their E/CTRM software – ‘risk management’ is, after all, what the RM stands for. Most of the large, broad based, CTRM systems encapsulate three main areas of technological functionality; trading and deal capture; data management; and valuation and risk management. These systems have proved themselves over many years to have core strengths around capturing deals and data, handling the life cycle of trades, executing the interfaces with system operators for the scheduling and nomination of power and gas, as well as handling the physical logistics of other commodities such as oil and LNG. However, there is a large amount of anecdotal evidence that a surprising number of users don’t run their risk calculations, or any complex valuations using their CTRM application, instead choosing to output relevant data to spreadsheets and other ad-hoc applications to perform this analysis.
The need for solutions beyond what a typical CTRM system can provide is driven by two main factors:
• Typical energy portfolios have complex assets and contracts, which can differ widely between similar market participants. One power generator creates revenues by operating a combined cycle gas turbine, whilst another does the same operating three gas turbines feeding a heat recovery steam unit, and a third by dispatching water through a cascading hydro system. Without significant in-house expertise within the ETRM players in these areas, users are typically confined to representing complex assets and structures in simple and naive ways, or choosing to model the assets themselves ‘off system’.
• The complexity of risk factors driving uncertainty in the cashflows of physical assets and structured contracts.
These include power and gas prices, load factors, system demand, wind, temperature, hydrological flows, and snow melt, among others ... and are poorly represented – if at all in the case of non-price factors – in the vast majority of CTRM systems.
In-House Development Faced with these issues, energy players are forced to supplement their existing systems. This leads to the second, and probably largest group of solution providers for valuation and risk management functionality – in house development teams. Often, energy companies employ analysts to evaluate their power plant portfolio, model demand and hydrological flows,
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