The Role of Risk Management in the Trading Transaction Lifecycle

The evolution of energy trading, while relatively brief in duration, has been dramatic. As part of electricity and natural gas pipeline industry deregulation, companies embarked upon opportunities to trade and transact around energy commodities. While different companies employed varying approaches through speculative trading and “trading around their assets,” the rewards–and the risks–were significant. Now, even after some well-documented trading-related challenges in the late 1990s and early 2000s, energy trading is alive and well, thanks in large part to effective risk management practices.

For power and utility companies with trading operations, Sarbanes-Oxley established platforms to transform the way their businesses trade commodities, manage risk and communicate, especially between front, middle and back offices. Since the implementation of SOX 404 in 2002, the industry has shifted its focus to enterprise-wide compliance and risk management. By understanding the impact of trading operations at every level, senior management, financial teams, traders and, importantly, the company’s stakeholders and investors, can all have full confidence in energy trading activities and the risk management strategies that are in place. Consider the following current best practices of the trading transaction lifecycle.

Tone from the top

In the past, risk management played a part in the trading process, but it was focused primarily on the business unit or trading desk. Today, many power and utility companies with trading operations are devoting entire teams to aggregating, monitoring, advising and recording the potential risks associated with all daily transactions across the corporation. A risk strategy team, typically consisting of a chief risk officer, a policy committee and a risk management committee, establishes an overall risk strategy for the company, evaluates risk limits for each business unit and develops clearly stated policies to reflect risk limits.

For the trading floor, leaders should first define the goal of the company’s trading activities and then strategize what types of trades are best suited for the overall risk management strategy. Once the strategy is in place, they should regularly read and interpret risk reports from the trading organization. Above all else, it is imperative that company leaders understand the importance of risk management, especially in the trading transaction lifecycle, and communicate with traders to understand the extent of their activities.

Changing corporate functional areas

Old practices are giving way to new, comprehensive approaches as key functional areas–namely credit risk, market risk, product control and operational risk–shift their roles and responsibilities. As these functional areas oversee trading and operations, they are working more closely with senior management in both the day-to-day and overall monitoring, enabling senior company leaders to take a more active role in risk management. While all four groups are independently important, communication among company leadership and these functional areas has become key to understanding corporate-wide risks and to developing a consistent vision and approach to risk management. Each individual area can contribute to the company’s overall risk management strategy.

Transitions in the trading organization

In the past several years, the trading market mindset has become more holistic, with traders forced to understand both how to make a profit as well as how their transactions impact overall company performance. Like all areas of a company, senior leadership should provide its traders with an understanding of the overall corporate objectives and work with traders to ensure that trading activities achieve these objectives. To assist other risk management operations, traders should learn to accurately enter trades into the system, be sure volumes are balanced and help resolve discrepancies. However, additional responsibilities for traders should not include reporting; ultimately, trading is their primary role.

As companies aim to utilize personnel effectively, cross-functional responsibilities allow organizations to move away from the structured front, middle and back offices. While traditional middle offices slowly diminish, oversight monitoring will become a separate and distinct function and will remain a vital part of the organization structure. Whether the individuals responsible are in the back office or an independent group, their duties will include daily confirmations, effectiveness calculations and regressions.

Communication ties objectives together

Financial teams at power and utility companies will be critical to connecting the front and back offices and raising awareness of compliance and risk management issues across the company. The finance and accounting organization must understand what is going on within the trading organization through daily interaction and communication with traders. Open lines of communication will allow accountants and traders to discuss the effect of trades on the overall business objectives and strategize the most effective approach for the company.

Author

Michael D. Barrett is a senior manager in Ernst & Young’s energy risk management practice. He focuses on risk management infrastructure, controls and analytics in the energy, utility, refined products and natural gas liquids industries. You may contact him at m.barrett@ey.com.

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