Successfully Managing Risk from the Power Plant to the Boardroom The Art of the Corporate Decision

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Successfully Managing Risk from the Power Plant
to the BoardroomThe Art of the Corporate Decision
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Three Thoughts

• To Be Successful, You Need To Manage Your Risks
  Across The Enterprise
• Risk Management Is Easy
• Uncertainty Can Bankrupt You

When we talk about risk management, we really
mean managing our risk/return dynamics!
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Charting a Path to Corporate Success

• To Be Successful You Must
• At The Enterprise Level!

Your Risk Return
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Risk, What Risk?

• To Be Successful, You Need To Manage Your Risks
  Across The Enterprise
• We got out of trading, we dont have risk
• If you have assets, consume raw materials, employ
  people, etc. ? You have risk!
• Generating units are extremely risky assets
• Market and volumetric risks
• Often operate outside the formal risk structure

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Spectrum of Enterprise Risks

• Market Risk
• Risks associated with changes in market factors
  such as commodity prices, exchange rates, basis,
  liquidity, and interest rates
• Credit Risk
• The risk that a counterparty may default or
  become less able to fulfill their contractual
  obligations (financial and physical)
• Operational Risk
• The breakdown in management controls, information
  technology, processes, and people
• Business Risk
• Risks specific to the industry and markets in
  which a firm operates. For energy firms these may
  include
• Plant outages, weather, customer migration,
  volumetric risk, regulation

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Why Manage Risk at the Enterprise Level?

• Most Energy Firms Manage Their Risk In Silos
• Problems With The Silo Approach
• A firms risks are intertwined
• Risks cannot be neatly divided across business
  processes
• Introduces inefficiencies and inaccuracies
• Diversification benefits may be lost or
  overstated
• Redundant systems and people
• Inconsistent data sources and assumptios
• Actually increases the firms operational risk!

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Enterprise Risk Management

• Address Risk Across Each Of The Firms Business
  Processes

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Enterprise Risk Management

• Enterprise Risk Management Is NOT
• Performing all risk management and risk controls
  from a single corporate office
• Using one super computer
• Enterprise Risk Management IS
• Incorporating risk management into all of a
  firms business processes and decisions
• Training employees to make risk-adjusted
  decisions
• Ensuring consistent risk policies and procedures
• Providing risk controls
• Communicating this with the firms management and
  stakeholders!

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Roadblocks to Managing Enterprise Risk

• If Enterprise Risk Management Is So Important,
  Why Isnt Everyone Doing it?
• Roadblocks To Managing Enterprise Risk
• The science of risk management
• IT and infrastructure

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Roadblock 1 The Science of Risk Management

• Steps To Implementing Enterprise Risk Management
• Define and document risk management policies and
  procedures
• Implement systems to measure risk
• Engage in activities to manage risk
• Risk Versus Uncertainty
• Risks are uncertainties to which we can assign a
  probability
• If you draw a single card from a standard deck of
  cards you can calculate the exact probability of
  it being the ace of spades
• If you bet on the ace of spades, you can asses
  the risk of losing the bet and take action to
  mitigate your risk
• Uncertainty take a thousand decks of cards, mix
  them, and randomly create a deck of fifty-two
• What is the probability of drawing the ace of
  spades?
• You dont know!
• People Often Mistake Uncertainty For Risk!
• Can be a very painful mistake

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Roadblock 1 The Science of Risk Management

• Soft Risks Risks That Are Difficult to
  Quantify
• Most operational risks fall under this category
• What is the probability that one of your
  generating plant operators will encounter a
  situation they are not prepared for and cause the
  plant to trip off-line during the peak period?
• What is the probability that one of your credit
  analysts will type in a number incorrectly and
  expose the firm to significant, but unseen,
  credit risks?
• What is the probability that your most valuable
  employee will leave the firm?
• What type of probability distribution do you use
  to measure these risks?
• How do we develop the statistical parameters
  necessary to model these distributions?
• Lack of liquidity and transparency in power
  markets turn even simple market risks into soft
  risks for power generators!

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Roadblock 2 IT and Infrastructure

• A Simple Example An Energy Firm That Owns A
  Single Electric Generating Plant And Sells The
  Output Into The Market
• What are all of the parameters that affect the
  value of this plant and the risk in monetizing
  this value?
• Plant processes that change second by second and
  affect the component health of the plant and the
  plants availability
• We have financed the plant over a twenty year
  horizon and future economic growth scenarios and
  potential environmental regulations significantly
  affect the risk/return profile of the plant and
  the firm
• Hourly traders need to know the current status of
  the plant (is it up or down, how fast can it
  ramp, how many MW are available, etc.)
• The structuring desk needs to know future
  expected plant availability and market conditions
  to sell the plant forward
• Planners and longer-term analysts need to produce
  risk-adjusted revenue and cash flow, fuel use,
  and plant operation projections that use
  longer-term plant operating characteristics
  combined with forecast market and regulatory
  conditions

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Roadblock 2 IT and Infrastructure

• A Simple Example An Energy Firm That Owns A
  Single Electric Generating Plant And Sells The
  Output Into The Market
• Tremendous amount of raw data and information
  that must be managed across this process
• Multiple business entities within the firm are
  involved each with their own needs and
  operating targets.

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Roadblock 2 IT and Infrastructure

• Efficiently Managing This Process Requires
  State-of-the-art IT And Substantial
  Infrastructure Investment

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Roadblock 2 IT and Infrastructure

• The Most Commonplace Physical Energy Products
  such as generating assets, natural gas storage,
  cross-commodity transactions, and
  weather-sensitive demand Are Extremely Complex
  Compared To Financial Transactions
• Do not lend themselves to closed-form valuation
• Monte Carlo methods are the most widely-used
  technique in valuing these products
• Monte Carlo simulations require significantly
  more computing power than closed-form solutions
• Todays computer hardware provides the tools to
  successfully address complex business analysis
  using Monte Carlo methods
• Still, performing on-the-fly valuations of these
  physical energy products poses a continuing
  challenge

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Removing the Roadblocks

• Implement Enterprise Risk Management Policies And
  Procedures
• Forms the framework around which we identify,
  understand, measure, and manage risk across the
  enterprise
• Should also include initiatives to educate
  employees on considering risks in their
  day-to-day decision making
• Further information
• Committee of Chief Risk Officers Website
  (www.ccro.org)
• Managing Energy Risk A Nontechnical Guide to
  Markets and Trading by John Wengler

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Removing the Roadblocks

• Risk Versus Uncertainty
• Incorporate rigorous stress testing and scenario
  analysis across the decision-making process
  from intra-day trading to long-term strategic
  planning
• Use a blend of analytical approaches to embody
  fundamental and market-centric views and gain
  perspective on the full range of possible
  decision outcomes - fundamental analysis,
  technical analysis, and experience each provide
  different yet complementary insights into how
  future events will effect current business
  decisions
• Dont rely on a single risk metric apply a
  combination of metrics
• Risk-adjusted return on capital (RAROC)
• Economic capital
• At risk metrics VaR, cash flow at risk,
  earnings at risk, volume at risk,
• The Greeks

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Removing the Roadblocks

• IT And Infrastructure
• Open system architecture
• Communicate across applications and platforms
• Intra- or inter-business process
• From real-time to mid-term to long-term for data
  capture and analysis
• New and legacy systems
• Integrate proprietary analytics and valuation
• Capitalize on the firms intellectual capital
• Manage soft risks
• True front-to-back solutions
• Reduce operational risk by enabling consistent
  assumptions valuation methods across the
  enterprise
• Eliminate risk silos with cross-commodity
  capabilities (i.e., managing risk across all
  commodities)

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Removing the Roadblocks

• IT And Infrastructure (continued)
• Distributed processing, including distributed
  Monte Carlo
• Allow for on-the-fly valuation of complex
  energy deals
• Enable intra-day and even real-time portfolio and
  credit risk metrics
• Browser-based, n-tier architecture
• Scalable as the number of users, size of the
  portfolio, and complexity of deals increases
• Easily deployed across the enterprise to reduce
  versioning risk and to lower upgrade and
  maintenance costs

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Parting Thoughts

• Silo Approach Provides Incomplete Potentially
  Inaccurate View Of The Firms Risks may
  actually increase operational risk exposure!
• Firms that Implement Enterprise Risk Management
  Will Achieve Competitive Advantage driving real
  value to the firms bottom line!
• Risk Management Is Easy
• Metallgesellschaft AG (2.4bn, 1993)
• Orange County (1.6bn, 1994)
• Daiwa Bank (1.1bn, 1995)
• Barings Bank (1.3bn, 1995)
• Sumitomo Corporation (1.8bn, 1996)
• Long Term Capital Management (3.6bn, 1998)
• Ashanti Goldfields (100m, 1999)
• Enron (2001)
• Allied Irish Bank (700m, 2002)

Uncertainty can be very painful
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Parting Thoughts

• Rare events exist because they are unexpected.
  - Nassim Taleb (Fooled by Randomness)
• If you give a pilot an altimeter that is
  sometimes defective and he will crash the plane.
  Give him nothing and he will look out the
  window. - Nassim Taleb (interview in Derivatives
  Strategy)
• Any idiot can face a crisis its day to day
  living that wears you out Anton Chekhov

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Questions (hopefully) Answers

• John P.W. Brown VI
• Vice President, Energy Market Asset Analysis
• jbrown_at_newenergyassoc.com