The right strategy for risk management

A Roundtable with Allegro, Navita Systems and SunGard Energy Solutions

Today’s utility companies need a solid strategy in place for risk managemnt. Michael Hinton of Allegro, Mattias Palm of Navita Systems and Sharon Fortmeyer-Selan of SunGard Energy Solutions discuss the way forward.

“The amount and complexity of planning that generation asset owners will need to engage in to make sure that they cover their deficit of allowances and accurately account for any credits can be extensive”
-Michael Hinton, Allegro

P&E. Growing concerns over energy supply and emissions reduction are creating new risks and opportunities for energy and emissions trading. What can companies do to combat these risks and take advantage of the opportunities?
Mattias Palm. Companies that are proactively seeking to take advantage of the new opportunities will at the end of the day be the winners. It will hit bottom line short-term, and it will require investments outside the ordinary. There is a tendency to defend the status quo as much as possible, but this only gives benefits in the short term. It is only four years since the first Kyoto period started and already emission trading has become one of the most important commodity markets in the world. And more importantly, the Kyoto protocol is only the beginning of a new world order in which commodities will become increasingly volatile and the pressure for environmentally friendly alternatives will sharpen over time. Alternatives will emerge, some will stick and some will disappear. Being able to assess the alternatives and to investing in the right one could quickly become a matter of survival for any energy company.

Michael Hinton. As the conflict of demand for energy and lack of “clean” generation and energy sources grows, along with ever-increasing emissions regulations, the developing market for emissions trading will become a key risk management issue for market participants, especially for generators of power and consumers of fossil fuels. Participants in this new generation of energy and emissions trading will require highly developed tools to assist in their trading and risk management of emissions driven transactions. The amount and complexity of planning that generation asset owners will need to engage in to make sure that they cover their deficit of allowances and accurately account for any credits can be extensive.

These allowance limits will fluctuate as demand goes up and down – requiring generation owners to pay careful heed to the emission cost of incremental MW’s. Additionally, as non-asset players enter the market, especially those who are trading speculatively, the market will develop rapidly and concerns about market exposure for all participants will grow. Thus, the single biggest thing companies can do to combat these risks is to ensure transparency into what creates and contributes to these risks through tools that takes into account the total portfolio and interdependencies of all of the commodities impacted.

Sharon Fortmeyer-Selan. Beyond investing in infrastructure and technology for sustainable energy supply and emissions reduction, companies must integrate the information across their multiple operations to help optimize commercial decision-making.  Linking asset management, emissions management, real-time data and trading positions allows trade floors to manage the full commercial implications of the enterprise. 

Taking advantage of the many financial instruments available today is part of the equation.  Companies operating in regions or countries that already have caps and the associated emissions trading schemes can hedge their risk and also take advantage of opportunities to make money by trading in both the primary and secondary markets.  They may go to the market or to the projects directly to buy offset credits directly for their portfolio.  They may buy options on allowances to lock in their cost of emissions compliance or they may employ spreads or swaps across a mix of offset types, vintages, or regions. 

Integrating CO2 and other greenhouse gases into the portfolio is one step companies can take to help combat emissions risk. Taking similar steps with renewable and alternative energy sources, like LNG, can help mitigate the challenges of energy supply security. To manage this holistically, companies need a multi-commodity trading, risk, and reporting platform that aggregates position and operational information to support commercial decision-making.

P&E. Why is a solid risk management strategy crucial in today’s sophisticated and capital intensive commodity markets?
MH. Recent exponential growth in the energy commodity markets has changed the rules and requirements of risk management strategies and systems. With this growing volatility, commodity risk managers are now seeing many of the risk analytics, strategies and solutions already being applied in financial trading circles rapidly migrating into the energy commodity trading space. However, a risk management operation is functionally complex, dependent on many diverse skills, and very data intensive. Compounding the problem is the fast pace of financial innovation which can make many risk management models obsolete, and as a result, enterprises upgrading to next generation risk management systems often lag behind the market trends. Additionally, many risk management systems fail to offer a holistic representation of different risks.

Yet the need to greatly enhance the overall risk management functions of an enterprise, with regards to both the financial and physical aspects of their commodities, is quickly becoming an overarching corporate mandate rather than an optional luxury. This is driving corporate focus on robust, solid risk management solutions.

SFS. Now more than ever companies are constrained by capital, by the cash flow of their operations, financial state of long standing business partners, as well as the liquidity of their franchises. With aging infrastructures, the need to address new demands for energy from rapidly rising economies, and the pressure for sustainability, energy companies are among the top three borrowers of funds (after government and financial institutions) at a time when access to capital is severely constrained by the global financial crisis.

Today’s crisis in credit markets has taught us that we cannot sustain easy paradigms of understanding for complex assets. Not only must companies adopt rigorous risk management practices, and enforce them, but they must adopt methodologies that support the complexity of energy businesses.  Risk management must embrace complexity and be less reliant on simple models that express the world in unrealistic ways.

MP. The answer is really already in the question. Because commodity markets are becoming increasingly sophisticated, it is also becoming more and more complex to ensure proper management of the risks inherent in the business. In fact, a significant factor in the current financial crisis was the lack of transparency due to extensive trading in complex instruments, with limited knowledge about how to deal with the risks.

As commodity markets become increasingly interlinked with each other and to the rest of the financial industry, the need for a proper strategy to handle cross-asset risks becomes increasingly more important. Silo-based risk assessments increasingly create an unmeasured covariance between different business areas. Companies that are able to measure and act on this covariance in a risk managed way will have a significant competitive advantage towards the ones that do not take this into account.

P&E. Risk managers need to be able to quantify positions and exposures in real-time and act quickly on that information. What tools are available to help achieve this?
SFS. Market complexity, price volatility and compliance challenge energy companies to better understand and mitigate risk. In this market environment, timely and easy access to information is more important than ever to enhance the ability of operational managers and traders to manage day-to-day business performance and to sharpen decision-making.  ZaiNet Real Time includes a real-time engine, limits monitoring, real-time dashboards, and a message center to help energy market participants make better decisions in real time. ZaiNet real-time dashboards provide decision makers with powerful visualizations for an accurate, complete picture of the business while letting them instantly drill down to details. Limits are available in real-time cubes for quick analysis of existing exposures. By gaining immediate and streaming updates to forecasts, real-time market data and projected performance metrics, traders can effectively manage their energy positions and maximize reward to risk ratios.

MP. In general, there are plenty of tools in the market to acquire market information in real-time. However, the challenge is to utilise the market information to quantify positions in real-time, particularly when the complexity of traded instruments is increasing. Unfortunately, there is always a trade-off between speed and accuracy. However, this can be solved by combining analytical models for real-time processing with a reasonable level of accuracy with simulation based models for accurate batch mode processing. Ultimately, the risk tool should utilise the output from the simulation model as the baseline for real-time processing, and let the real-time models only provide the changes since the last simulation.

In addition, the development of computer speed has also enabled close to real-time simulations, allowing for a fairly accurate reassessment of the risk in the portfolio as the market moves intra-day. Being able to quickly make risk-managed decisions on how to act will enable a company to make the right decisions early, rather than just following the herd.

MH. Comprehensive commodity trading and risk management solutions exist today that interact with financial and logistical data from a variety of external, real-time sources. These solutions apply a complete set of analytical, simulation and optimization tools to ensure optimal trading scenarios, accurate position keeping, option and asset valuation, and logistical plans for decision making.

An enterprise employing such a solution can use the risk reporting capabilities to quickly view and report on price, market and counterparty risk. The ability to generate various exposure type reports, including market, price, Greeks, and Value at Risk (VaR), is critical, along with the ability to report across a portfolio valuation for Mark to Market, Profit and Loss and P&L Attribution. Such functionality gives an enterprise the ability to benchmark against multiple curves. Additionally, top tier solutions can also provide simulation tools that allow for stressing of various market data parameters to quickly determine overall portfolio sensitivity.
Coupled with the ability to see what is transpiring today, systems such as these are now enabling forward thinking and visualization tools that assist the user in making decisions based upon multiple scenarios.

P&E. What do you see as the future direction  of risk management in energy trading?
MP. The future direction will be significantly more focused on cross-commodity analysis than has previously been the case. More and more energy related commodities are widely traded, and the price of energy is becoming increasingly correlated with non-energy commodities (e.g. metals, agricultural, freight, etc.) This means for many companies, only managing for example the price risk of electricity or natural gas will not allow for efficient decision making; also the related market exposure in for example coal, oil, freight, emissions, metals, etc. has to be taken into account. Companies that rely on silo-based decision making will be at a distinct competitive disadvantage to the companies that can actively pursue a multi-commodity portfolio strategy. And with the increasing need for managing a multi-commodity portfolio also come treasury related risks and how that correlates with the commodity portfolio.

MH. The optimal scenario would be a holistic approach across strategic, operational, regulatory and financial risk functions. To that end, more enterprises are endeavoring to deploy cross-functional integration of risk solutions across the business lifecycle. Thus, deployment of advanced energy trading and risk management systems will require those solutions to be fully interactive with the balance of an enterprise’s risk management functions.

Additionally, companies will continue to broaden their use of analytics to provide for increasingly granular decision support. Advanced analytics will continue to be developed and enhanced to address transaction and asset valuation, risk measures and optimization.

Finally, the ability for an energy trading and risk management system to communicate with any financial exchange, market data provider, logistical entity, or other relevant external resource will become mandatory, rather than optional.

SFS. Several things will play a significant role in future risk management within energy or commodity trading.  One will be a greater emphasis on dealing with complexity as decision makers look beyond simple expressions of risk to gain deeper understanding. Having witnessed a financial market meltdown and its ripple effects on global economies, management at all levels will place more demands on both the discipline and the tools surrounding risk.  Expect to see more use of stress testing, back testing and scenario analysis to try to uncover hidden risks in the portfolio that now are assumed by upper level management.

Linking diverse operational areas to support commercial decision-making on the trading floor will drive further requirements for real-time or intraday risk analytics. Expect increased emphasis on tools to manage cash-flow and earnings risk as well as environmental risks.  This later will drive considerations of weather and emissions risk for trading as well as carbon risks impacting project funding and company valuations. 

Michael Hinton is Chief Marketing Officer of Allegro. He is responsible for increasing market and brand awareness across the industry while leveraging Allegro's marketing resources to increase market share and competitive effectiveness. In addition, he serves as a senior customer spokesman to our market, including the press, industry analysts and partners communities.

Mattias Palm is Executive Vice President and Head of Product Management at Navita Systems AS. Since 1996, Palm has been working with designing commodity trading and risk management solutions for trading organisations across the globe. Before joining Navita in 2002, he was a Principal Consultant at PA Consulting and Cap Gemini. He holds an MSc in Electrical Engineering from the Royal Institute of Technology in Stockholm.

Sharon Fortmeyer-Selan is Senior Vice President of Marketing for SunGard Energy Solutions. She directs the planning and execution of all marketing activities for SunGard across all energy segments globally. She joined SunGard in 2004 and quickly set an agenda for emissions by launching the industries first software solution for carbon trading under the EU-ETS in late 2004.