Energy Risk Management: More Than Just A Risk System

Nathaniel Sheik | Mar 26, 2003

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To manage risk effectively, an energy company needs to insure that it has a transaction management infrastructure that captures accurate and timely information regarding the entire set of business activities performed. Without this, a risk system is likely to produce misleading results.

Given the ongoing volatility of the energy business, it is not surprising that buyers of software continue to be focused on managing risk and in procuring energy risk management systems. Usually these systems are focused on measuring and managing the price and credit risks associated with a portfolio, with an emphasis on Value-at-Risk (VaR), mark-to-market reporting and other risk calculations.

But to be truly effective, risk management must go beyond simply implementing risk management software; it must be a set of processes or methodologies that includes internal controls, well-understood documented policies and procedures, and the right corporate culture. Everyone involved with the business has to be trained, equipped, and motivated to support the overall risk management process or methodology in order to gain the benefits of improved visibility, better-informed decisions, and ultimately a better bottom line.

The implementation of a comprehensive end-to-end risk management strategy involves a number of key elements. These include defining the business processes to be utilized and understanding ownership and accountability with respect to those processes and their decision points. The business processes must then be turned into comprehensive documented procedures and plans to implement these processes, complete with backup plans and workarounds if the defined processes fail for some reason.

An underrated component of implementing the risk practices and procedures is the creation of a risk-aware culture to support them. The company must define its risk appetite and create processes, controls and metrics to measure, report and monitor to ensure that it stays within its risk tolerance. This must be demonstrated through the leadership and vision of the executives within the company and promoted through on-going training and behavior reinforcement.

A further consideration is the implementation of a scalable and flexible transaction management infrastructure that enforces rigor with respect to the application of the business processes. The capture and processing of the transactions must be performed in a manner that ensures accurate, timely and complete data capture since it is this transaction data that forms the basis for the deployment of the risk management software. The cornerstone of a good risk management strategy is to ensure integrity of critical system information, and this is the role of the Transaction Management Infrastructure (TMI).

In a complex business that processes hundreds, thousands, or more transactions per day, capturing, valuing and reporting every aspect of those transactions, including their impact on the organization’s relationships and changing contractual obligations with its counterparties (for example, the liquidity issues caused by downgrades), is critical to success. Data processing that relies on having each group enter information into its own systems, manually transfer the information between groups, and then try to make sense of the chaos at the end of the day will not stand up to the increased demand for accountability, accurate timely reporting and quick decision-making required in today’s marketplace. The risk is not just limited to lost opportunities; it also includes unknown exposures to credit and market risks and operational penalties when trying to make decisions without good visibility into critical business information.

In order to control financial and physical exposures, the TMI must support straight-through processing in its trade capture, deal valuation, risk measurement, reporting, scheduling, metering, and settlement capabilities, and these must be robust enough to handle all activity from long-term structured transactions through day-ahead and next-hour markets. A properly implemented automated TMI captures information from across all business units into a single repository that feeds the entire enterprise to ensure that the right amount of power is moved to the right place for the right price. This single source of transaction information imposes rigor and discipline on the information, managing it from cradle to grave and allowing the individuals, groups, and departments within the organization to function as an integrated enterprise rather than isolated islands. As the organization scales up, the TMI can and must scale with it, to provide the basis for growing the business without sacrificing the decision making support that made it possible to grow in the first place.

Through the provision of comprehensive ongoing visibility into the process and information, the TMI helps users optimize positions and accurately assess delivery obligations, so that companies can hedge more effectively and manage the associated risks. Even with the best mathematical tools, the most advanced algorithms and the brightest minds, inaccurate data will lead to inaccurate analysis and ultimately to incorrect and costly decisions.

When the TMI works in unison with a suite of risk management tools, physical assets can be optimized, contracts can be better leveraged, and exposures can be minimized. The risk manager can see immediately where they stand with a given counterparty at any given time, and quickly turn business over to settlement. This is not limited to end-of-day or end-of-month reporting; the TMI needs to constantly evaluate and proactively inform its users in real time – where real time is two to ten seconds.

All industry participants – independent power producers, trading and marketing companies, load-serving entities, municipalities, industrial users, etc. – will benefit from implementation of risk management strategies. Be careful, though, not to let the software applications force your business processes – define your business processes and procedures first, select vendors with a business process focus rather than a software tools focus, pay less attention to how many systems they have implemented, and more to how well they understand your business, and make use of a solid, reliable TMI to guarantee that your critical information gets the care and protection it deserves – this will ensure good return on your investment.

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