Corporate risk management: a new world opportunity after Enron

Greg Keers, Chief Strategy Officer
KWI

With the advent of deregulation, energy utilities have had to transform themselves from cost-plus dinosaurs into high performance enterprises in order to stay competitive. This year, utilities will find an additional requirement placed on their businesses, in light of the Enron collapse. External pressure from investors, analysts and credit ratings agencies will force utilities to show higher levels of transparency in financial reporting. Also under scrutiny will be how these energy companies manage their risk exposure, not only at the trading desk, but also over the entire enterprise.

While outside parties are demanding this elevated level of financial reporting and corporate risk management, energy companies would be short-sighted to view this as some kind of compliance duty. It actually presents them with an opportunity to introduce much more rigorous financial controls, which can be proactively used to improve their overall business performance and bring about a rapid culture change. In order to achieve a fluid level of transparency across the enterprise, a central technology system, from which every point of the business can be managed, must be deployed.

Depending on the structure of the energy company, the process of adopting a technology platform to manage corporate-wide risk will vary. For pure trading organizations that already use mark-to-market, VaR and credit risk techniques in their operations, it is not a giant leap to extend these upward to corporate level analysis. From a technology standpoint, these companies will most likely have an existing set of systems to trade various commodities across multiple geographic locations that is poorly integrated. The choice they face is one of system integration. Existing programs can be patched together at the cost of complex system integration, or a new platform can be deployed that is completely integrated, but that may have weaknesses in one area or the other. Whatever path is chosen, even the most complex trading system integration challenge can be met.

For diversified energy utilities that have assets and other business activities in addition to trading operations, a different set of risks and opportunities exist. The ability to assess activities and precise risk position across the enterprise is critical in a volatile commodity market with large volume risks, (e.g. unplanned generation plant outages or changing demand forecasts), uncertain transportation and storage challenges.

If a company wishes to actively trade its entire trading, generation, storage and retail portfolio, traders must have visibility to accurate position and information. They must be able to determine exactly where the trading opportunities are, and that can only be done if generation, storage and retail information is combined with that of the trading book. Also, this information needs to be updated in real-time fashion across a common technology platform. Such capabilities are not the reserve of aggressive, risk-seeking players since, from a defensive perspective, exactly the same capabilities are needed to react quickly and accurately to threats caused by unexpected market and portfolio events.

From the corporate level, visibility to the productivity and performance of the entire organization can be gained, which in turn can drive key business decisions. For instance, more accurate budgets and targets for business units can be set using up-to-date market and portfolio data. Projected and actual fiscal year earnings by business unit can be more accurately measured on an ongoing basis. Risk scenarios that illustrate the potential effect of missed targets and budget results by business unit can also be played out.

In addition, a corporate-level approach can assess the risks and corresponding capital involved with new projects, investments and divestments in relation to the entire organization. Simply drawing up the projected financial impact of these projects is not enough when dealing with a diversified business model with inherent commodity risk. A project considered in isolation without reference to other parts of the enterprise may reveal an erroneous corporate risk position-one that is either more positive or more negative to the bottom line. Only through analysis of projects in the context of the overall enterprise can a holistic effect on the corporate risk profile be assessed.

For instance, senior management may identify a business unit that, although profitable, has a disproportionate negative effect on the corporate risk profile. By divesting that business operation, capital would be freed up to invest in other projects that are a better corporate fit. This sort of proactive corporate risk management is much more desirable than the reactive and limited scope of risk management available from the trading department.

Another benefit that is gained through elevating risk management to the corporate level is a paradigm mind shift in corporate culture. A company that has traditionally been risk-averse will embrace smart risk management principles, a more rapid pace of change and greater diversification of business operations. Employees across the enterprise will be empowered to seek out greater profit potential within a controlled risk framework, if they have the right knowledge and tools.

What is required for diversified energy companies is a comprehensive corporate-level technology platform that integrates key trading data as well as asset/generation activities and other corporate information so that there is a fluid exchange of information throughout the enterprise. Business decisions based on the right organization, processes and systems will improve the risk/return profile of the whole enterprise.

External pressures from the investment community will undoubtedly force more changes in 2002 for utility companies. Much of this change will be through advanced risk management extending beyond the trading department: horizontally through to other business operations such as generation and retailing; and vertically up to the corporate level. Those companies that proactively tackle the issue of transparent financial reporting and articulation of their risk profile will improve not only their overall financial results, but also their standing with Wall Street.

Greg Keers is chief strategy officer for KWI, the global energy trading and risk management software specialists. KWI products manage over 1.5 billion MWh worldwide and are installed at more than 70 utility companies. Visit www.kwi.com for more information.

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