Gary Dorris and Andy Dunn, e-Acumen Inc.
Energy risk management was born during the deregulation of natural gas and power over the last decade. At the same time, there was a general mismanagement of the balance between the asset base that provides all types of energy and an ever-growing demand for this energy. These factors have resulted in market volatility never before seen in any market, which in turn has created a need for widespread adoption of sophisticated financial risk management systems by commodity trading companies.
The new millennium marks a period of significant advancement for energy risk management capabilities. Risk managers are beginning to focus on the necessary evil of avoiding hazards as well as the need to create shareholder value out of the capital invested in risk management infrastructure. Shareholders, analysts and ratings agencies have begun to focus on each organization’s ability to leverage the risk management tools and methods used to strategically maintain earnings and maximize capital initiatives.
The affirmative role of risk management will be most profound for corporations that own physical assets or retail obligations (e.g., electric generators, power and gas distributors, and oil refiners). These companies have large physical risk and spot price risk exposure that can be effectively managed and optimized using sophisticated risk management analytics. The evolution of risk management as an affirmative tool to address the crossover between physical asset characteristics and spot price risks requires a fundamental shift in how risk is measured. If the future of risk is maintaining or enhancing shareholder value, then risk management needs to evolve to more holistically encapsulate the elements affecting future earnings.
As equity markets and credit rating agencies demand stable earnings, risk management of the 21st century will focus on systems to balance derivative positions against asset positions. This is a major transformation from current methodologies under a Value at Risk, or VaR, framework. VaR requires the risk manager to value assets that have useful lives well in excess of 20 years and contain enormous levels of operational risk. Half-baked attempts to trivialize operational risk, treat assets as spread options and estimate forward prices out 20 plus years fail because these factors have significant effect on an asset’s economic performance. Risk management must consider all relevant factors that drive an asset’s performance, including ancillary services, unexpected forced outages, regulatory factors, environmental factors and the behavior of retail customers along the entire energy value chain. The difference in risk estimates can be startling.
Assets in the balance
It is essential that the energy risk management method used captures all of these significant operational factors in conjunction with the market factors that are typically modeled. This should be done so that any of the natural interrelationships between business units effectively offset the risk, and the enterprise is modeled in aggregate using a financial metric that is in line with its standard business model.
In most instances, an energy company that owns assets should capture these risks from an earnings perspective rather than a value perspective.
Earnings at Risk, or EaR, can be effectively measured if one follows a simple earnings framework for a reasonable measurement period.
Net Revenues =
Spot sales revenues – costs of operating assets +
Retail sales revenues – spot energy costs +
Financial instrument payoffs prior to delivery +
Financial instrument payoffs during delivery
Each of the terms in this equation has a level of variability due to changes in market prices and operational uncertainties in each asset/business unit. Joint simulations of these factors create a revenue distribution that can then be used to estimate EaR.
The analysis of VaR, on the other hand, only addresses a single factor of the net revenue equation:
Value at Risk =
Financial instrument payoffs prior to delivery
Although simulation of VaR incorporates a single line of the earnings equation, it often does not result in a smaller value.
The value produced by a VaR measure is inconsistent with assets and financial positions with spot price exposure. VaR’s focus on financial instrument payoff is appropriate for “spec books” and other non-asset-backed transactions that are not carried through to delivery. The delivery of commodities with volatility in spot prices poses significant risks. If spot price risk is compounded by other delivery or volumetric risk, VaR has a difficult time of capturing these elements of risk.
In addition, VaR’s focus is on trading liquid financial instruments, and the time horizon of the VaR calculation tends to be less than a month. For operations involving physical delivery, a monthly analysis for even long-dated instruments does not provide adequate temporal vision or resolution of the market and non-market components of risk to make risk management an affirmative tool. A proactive risk management strategy requires joint simulation of markets and operations several months to several years into the future.
In order to turn risk management into an affirmative tool, risk managers need tools that have adequate modeling resolution and breadth to proactively address physical and financial risk exposures in an integrated framework. This is the future of energy risk management. The sooner the industry adopts this approach, the better the industry can navigate volatile markets with some degree of control.
Dorris is CEO and Dunn is vice president of risk management at e-Acumen Inc., a technology company focusing on risk management, trading, weather and asset valuation solutions and advisory services for the energy industry. e-Acumen’s product AcuRisk models Earnings at Risk with full integration of physical assets. Contact Dorris at firstname.lastname@example.org, and Dunn at email@example.com.