Risk Management in the Energy Industry

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Risk Management in the Energy Industry

• Troy Stansberry
• Finance 340
• December 2, 2001

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Electric Energy Companies Under Regulation

• Obligation to serve public with electricity
• Allowed to earn a reasonable rate of return on
  investment
• Minimal risk
• Buying and selling power was based on
  relationship with neighboring utility

3
Electric Energy Companies Under Deregulation

• Deregulation is being phased-in, in various parts
  of the United States
• Still have obligation to serve public with
  electricity

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What's Changed with Deregulation?

• Consumers have a choice
• Increased competition for buying and selling
  power
• Increased risk due to power marketing and trading
  
• Energy prices can be extremely volatile

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Risk Management in the Energy Industry

• New awareness to risk and how it is managed
• Companies now have Chief Risk Officers and Risk
  Management Committees
• Committees develop strategies for managing risks
• Provide energy trading polices and procedures for
  managing commodity transactions
• Provide controls for financial risks

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Quantifying Market Risk with Models

• Companies are using the Value at Risk (VaR) model
  (or variations of)
• VaR indicates how much money the company could
  lose if the market prices change drastically
  before the company can change its position
• VaR measures the worst case scenario for expected
  loss (in a portfolio) to a specified confidence
  level (usually 95) 

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Three Main Methodologies for Calculating VaR

• Variance-Covariance
• Monte Carlo Simulation
• Historical Simulation
• Correlate and complement each other

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Variance-Covariance (2 Steps )

• Find set of market risk factors measure price
  levels,volatilities, correlations
• Use a cash flow mapping to analyze risk
  factors-convert portfolio to a collection of cash
  flows to derive synthetic portfolio of assets
• Being able to define and capture all risks is
  most difficult part
• Once cash flow map is complete-calculate VaR of
  portfolio

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Monte Carlo Simulation

• Used to develop random pricing scenarios
• Simulated gains and losses of a portfolio is
  translated into a histogram of gains and losses
• Computationally intensive
• Must have pricing models for all of the
  instruments in a portfolio

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Historical Simulation

• Calculates hypothetical gains and losses based on
  past scenarios
• Advantage is that it does not use estimated
  variances and covariances
• Difficult to use for energy markets because
  histories are hard to find
• Disadvantage is that it makes predictions based
  on past

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Variations of VaR

• Cash Flow at Risk (C-far)
• Earnings at Risk (EaR)
• Profit at Risk (PaR)

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Cash Flow at Risk (C-far)

• C-far is an analytical model that is used to
  predict volatility of earnings for one quarter to
  one year
• C-far is a bottom up approach used to quantify
  the risk caused by individual financial assets

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Earnings at Risk (EaR)

• Earnings at risk is calculated by the formula
• Profit Spot prices (cost of Prod)
• Hedge prior to delivery
• Hedge during delivery
• EaR is used by utilities because they are unable
  to liquidate and acquire assets like other
  companies

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Profit at Risk (PaR)

• Some energy companies feel that Profit at Risk is
  a more accurate and a powerful tool
• PaR measures volume risk which is extremely
  important
• Volume risks occur whenever a power plant has an
  unplanned outage,or when customers exceed
  expected usage, or when there is a failure in
  transmission lines

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Conclusion

• By using measures based on variations of the
  Value at Risk model, energy companies are
  quantifying risks and making better decisions
  about how to deal with them. New risks and more
  complex risks need to be managed in different
  ways. Even risks that were present before
  deregulation such as political, regulatory and
  technology risks, are taking on new meaning and
  awareness. Companies are taking a comprehensive
  approach in identifying all risks. They are
  moving in the direction of developing ways to
  assess and measure risks. They are searching for
  risks that may offset or cancel each other out.
  They are deciding which risks they are willing to
  keep and which ones can be transferred to third
  parties. The landscape of risk has forever been
  changed, and will require constant attention to
  the risk-return relationship going forward.