Power Pointers: Primer on energy risk management

By John Wengler

July 1, 2002 — In turbulent markets, energy risk management (ERM) provides management executives with the tools necessary to control trading activities.

While first imported from banks to electricity markets in the mid-1990s, risk management is needed now more than ever to make sense of the headlines regarding such firms as Enron, Dynegy, Reliant and many others.

EL&P invited John Wengler of R. W. Beck to provide this month’s expert answers to commonly asked questions about ERM.

What is energy risk management?
“Risk” consists of any event or condition that could potentially cause actual outcomes to differ from expected outcomes, either negatively or positively. Energy risk management is the professional practice of measuring, hedging and communicating the risk posed by commodity markets (such as electricity and natural gas) and controlling the personnel (such as traders) who transact in those markets.

What is the difference between energy risk management and what utilities traditionally call “risk management?”
Many utilities and other types of businesses say “risk management” to describe efforts to improve worker safety and reduce the impact issues related to insurance. With the rise of unregulated wholesale power markets, many of these same utilities hired traders to buy and sell energy with “energy risk managers” hired to understand the market risks being taken and ensure that the traders were following corporate policy.
Simply put, “insurance” risk management looks to historical data for “actuarial” modeling while energy risk management also looks at forward-looking traded markets. Unlike insurance folks, energy risk managers utilize models based more on random (also known as “stochastic”) price behavior. Additionally, energy contracts tend to be continuously traded whereas insurance policies may only be sold for re-insurance purposes.

What is the difference between speculation and hedging?
Speculative traders believe that they know the market better than the market itself. With each trade they assume risk in the hopes of market prices changing in a profitable direction. Hedgers, on the other hand, accept market prices and simply “pay” to reduce the impact of market prices changing in an adverse direction. There is nothing inherently wrong with speculation. Speculation and hedging are equally valid trading strategies so long as they are consistent with organizational policies. In fact, markets desperately need speculators to “assume the risk” from the hedgers willing to pay for such service.

Likewise, the financial contracts called “derivatives” are not inherently dangerous. These are simply contracts that “derive” their value from some underlying market or index. The same derivative contract could be entered into for speculative or hedging purposes, all depending on the organization’s original position and its policies.

How has energy risk management evolved over the past 30 years?
The electricity industry has always managed its financial risk. Historically, the regulatory compact of “reliability-for-fixed-return” can be seen as the perfect hedge against market risk. Early examples of power trading include swaps for reliability purposes and the traditional “seasonal exchanges” between summer-peaking California and the winter-peaking Pacific Northwest. In power markets, “modern” energy risk management emerged in response to wholesale electricity trading in the early 1990s. At first, the tools were directly transplanted from money markets, but electricity-specific models and software systems appeared in the late 1990s. The “California Crisis” and Enron’s bankruptcy have boosted awareness of the discipline, particularly among shareholders. Some organizations have gone so far as to appoint a chief risk officer (CRO) to provide executive level authority.

What are the benefits of energy risk management?
Energy risk management provides three general benefits to an organization:
* Proactive Mission Control: Like coaching in sports, management can clearly state and enforce its game plan using energy risk management policies and procedures.
* Better Decision Making: Markets can offer multiple solutions to the same problem. Energy risk management helps map the risk-and-return so that management can make informed decisions.
* Improved Corporate Health: Like a radar system, energy risk management helps identify potential problems to be controlled or hedged. Good energy risk management helps managers sleep at night.

What are the key features of an energy risk management program?
Regardless of why or how an organization trades electricity, each energy risk management program typically contains three basic elements:

* Risk Policies: The heart of the program would be some sort of “risk management policies and procedures,” which state organizational objectives and detail how to achieve them. This control document can range in length from three to 300 pages.
* Portfolio Management System: The organization needs a computer-based system for warehousing and updating their portfolio. These systems typically track financial trades, but the industry increasingly also includes generation assets and load curves.
* People: On a day-to-day basis, the traders and risk managers work together to achieve corporate objectives in the market place, supported by the portfolio management system and the entire risk infrastructure.

What’s ahead for energy risk management?
The combined impact of the California Crisis and energy company devaluations should be a clarion call for enhanced risk management efforts at American utilities. Proactive organizations will take this opportunity to ask such important questions as “Do we have a risk policy?” and “How can we use energy risk management to avoid being the next headline story?”

Ironically, some organizations will react not by enhancing risk management, but by reducing trading activity. While this response may be valid for an organization where trading is out of control, these same organizations could still be faced by exposure to spot price volatility. A healthy energy risk management program needs traders in the forward market to help manage spot price exposure to both ensure reliability and price (or earnings) stability.

Perhaps the bigger issue, however, is the viability of electricity markets in general. The market could continue to provide solutions to organizations seeking to “buy and sell” their risks and trading volumes will resume their growth started in the mid-1990s. On the other hand, public reaction to recent events could scare potential traders from the market and incite politicians to re-regulate.

We would certainly need some kind of “random walk” or stochastic model to help predict which of these scenarios will occur, but the general consensus is that the “genie is out of the bottle” and open markets are here to stay. If so, energy risk management will continue its role in providing management control, better decision-making and improved financial health to electric and gas utilities.

The Manager’s Bookshelf

The following books represent “must haves” about energy risk management on your office bookshelf.

Bernstein, Peter, Against the Gods: The Remarkable Story of Risk, John Wiley & Sons, 1996.
The perfect holiday or birthday present for your manager. Fun-to-read introduction to how humans feel about risk. No equations! An audio version is even available.

Hull, John C., Options, Futures, and Other Derivative Securities, Prentice-Hall, Inc., Englewood Cliffs, NJ, 1993.
The “Blue Book” that is now golden. The Basic Text. A well-written text for those wanting to understand derivatives theory by looking under the hood.

Jarrow, Robert and Turnbull, Stuart, Derivative Securities, South-Western College Publishing, 1996.
Written for MBA students, this encyclopedia of futures and options is a great reference for the generalist.

Pilipovic, Dragana, Energy Risk: Valuing and Managing Energy Derivatives, McGraw-Hill, 1998.
A leading book in the energy market. This book details how energy markets differ from money markets and provides new tools to handle these differences.

Wengler, John, Managing Energy Risk: A Nontechnical Guide to Markets and Trading, PennWell, 2001.
Written for the business generalist with a focus on risk management policies and procedures. Very few equations; great overview of topic.

Wilmott, Paul, Derivatives: The Theory and Practice of Financial Engineering, John Wiley & Sons, 1998.
A comprehensive reference for generalists wanting to become specialists.
Source: Wengler, John, Managing Energy Risk, PennWell Books, April 2001, Table 1-2.

Wengler, an executive consultant with R. W. Beck Inc, a risk management educator and the author of “Managing Energy Risk: A Nontechnical Guide to Markets and Trading” (PennWell, 2001) provided this month’s Power Pointers. Wengler may be contacted at 303-299-5200, or jwengler@rwbeck.com.

This article is scheduled to appear in Electric Light & Power Magazine, July 2002. To read more, visit http://elp.pennnet.com/Articles/Print_TOC.cfm?Section=Articles&SubSection=CurrentIssue.

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