Energy Risk Management: Still a Work in Progress?

Assessment and hedging must always reflect all substantial sources of power, operational behavior and consumer behavior, or else the provider will find themselves at greater risk of substantial, negative surprises.

Wednesday, June 03, 2009
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Electricity, a complex and dynamic commodity, presents difficult financial risk management problems due to (a) lack of cost-effective storage mechanisms, and (b) customers that expect unlimited supply, on demand, at a firm and modest cost. The resulting wholesale price volatility, in combination with the natural volatility in pricing of fuels such as gas and coal, present a formidable challenge for risk management staff at electric utilities.

Are there 'Holes' in Existing Procedures?

Researchers at the Electric Power Research Institute (EPRI) in Palo Alto, Calif. and Électricité de France (EDF) found that they share similar concerns: that existing and accepted practices of energy risk management do not address a number of important questions, forcing risk managers to develop company-specific solutions for problems of widespread concern. For example, education in energy risk management includes alternative methodologies for calculating a variety of risk measures. But how does one decide which method to use, or how large must a risk measure grow before triggering concern? How should one respond to a risk measure that exceeds the limit -- immediate hedge? Selloff? Deliberate action over a period of time? Observation? Suppose that a risk measure increases due to a market price move rather than an explicit change in the portfolio. Does this alter the nature of the response?

Are risk managers making assumptions about market behavior that may fail them in crucial moments, such as the availability of trades ("market liquidity"), clarity about asset values ("price transparency"), or the likely pace of price changes ("market volatility")? And even if these procedures are effective in the narrow sense of managing risk, are they coordinated with other aspects of the business? Are risk managers involved in identifying and taking advantage of market opportunities, or are they fulfilling overall corporate preferences for cash flow stability over growth in margin? Should they be?

Survey and Action

EPRI and EDF have completed a study funded by a group of EPRI research supporters. The survey was carried out via intensive interviews among 10 diverse electric utilities, large and small, relying on a variety of fuels. Risk managers, traders and planners were interviewed in detail to determine what they thought were the most substantial and unaddressed procedural concerns and what solutions they had developed.

Researchers and practitioners have developed specialized methods for dealing with energy risk management. Enormous progress has been made, but is it sufficient? Electric utilities need to deal with a wide variety of risks, including:

• Wholesale price risk for power and fuels
• Volumetric risk (i.e., having enough power available when needed)
• Delivery risk (having sufficient "transmission rights" to fulfill delivery obligations)
• Credit risk (Will counter-parties fulfill their contractual obligations?)
• Operational risk (Ability to fulfill obligations during periods of mechanical; breakdowns), and
• Unusual yet highly impactful events, such as terrorist attack or earthquake (sometimes called "black swans")

Energy Risk Management: Opportunities for Improvement

The findings of this study are reassuring in many respects, and also show a work in progress. There is potential for improvement, and some cause for concern. Highlights of findings and implications include:

• Focus on Compliance: Energy risk managers largely are focused on developing risk measures and assuring compliance. This is extremely important of course, but it seems that the same analyses could contribute to optimization of asset deployment and/or utilization. Is this a missed opportunity, or would it represent a conflict of interest?
• Term of Study: Risk managers tend to focus on the medium term, from one month to several years into the future, coinciding with typical availability of market price quotes for forward contracts. By contrast, long-term utility planners use entirely different techniques to, in effect, perform long-term risk management. Failure to ensure that these groups are working closely with each other may lead to inconsistent asset acquisition and deployment strategies for medium and long terms.
• Simple Models: Risk managers show a bias to use relatively simple models. There are several good reasons for this -- risk management is a cost-constrained activity and implementing simpler models is easier; commercial models are limited in their complexity, it is expensive to build custom versions of such models, and perhaps most importantly, the audiences for risk measures include upper management and public utility commissions, who will be more likely to trust decisions based on measures they can understand. Nonetheless, an overly simplistic model also can potentially be misleading; we found that mathematical models of physical assets such as generation were particularly simplified, to a point of concern.
• Lack of Integration in Modeling Risk: The study found that commodity price risk modeling was well-integrated with volumetric risk modeling, and given careful treatment. Credit risk was dealt with entirely separately, typically via limits by counterparty. But hedging price risk with forward contracts transforms price risk into credit risk. How can one effectively balance such trade-offs in the absence of coordination? Similar potential concerns may arise, such as coordination of maintenance-expense allocation with modeling the financial implications of operational risk.
• Efforts Inconsistent with Degree of Concern: For some types of risks, such as price of power and fuels, the level of attention seemed consistent with the level of concern. Other risks, such as liquidity/cash flow risk, or operational risk, seemed under-represented in actual risk assessment and hedging relative to the level of concern.
• Subjectivity in Hedging: Risk limits almost exclusively were used to trigger root-cause analysis and reporting to higher management. Decisions were heavily exposed to subjective judgment. Similarly, hedging policies, such as how far into the future should risks be hedged, appeared arbitrary rather than the result of analysis and testing via simulation. Several risk managers cited the rule "We hedge one-third of the risk 3 years out, two-thirds 2 years out, and 100% one year out." None could cite a mathematical justification. Is this optimal?
• Volumetric Risk: Markets offer limited options for transferring volumetric risks (load, hydro inflows, outages), and the options that were available (weather derivatives, correlation hedges) tended to be ineffective or overpriced.

Addressing a Future of Growing Complexity and Risk

Recently a number of concerns have developed or are achieving critical mass. These will form the basis of our next round of study. They add yet more complexity to the responsibilities of the energy risk manager, but in some cases provide creative opportunities to hedge risk. They include:

• How do you determine acceptable levels of collateral among trading counterparties, particularly during periods of extreme financial uncertainty?
• How do you risk-manage portfolios heavily dependent on stochastic power generation sources that will vary -- literally -- with the strength of the wind or position of the clouds?
• Will "plug-in" hybrid cars sell in large enough numbers to expand "off-peak" demand for power? Will they provide a means of power storage that providers can use to fulfill peak demand?
• Will consumers respond to energy efficiency pleas aggressively or with a yawn? Will they respond to offers to buy back power during load peaks ("price demand response") in predictable and sufficient numbers?
• Will power transmission -- which takes many years to site and build -- be available when and where it is needed? Or do we face a future of dangerous and expensive transmission congestion?
• Will carbon restrictions trigger huge price increases, rapidly altering the geographic distribution of the most cost-effective generation of power?
• Will distributed resources, such as photovoltaic solar, undercut and render worthless huge, existing long-term investments in energy infrastructure?
• Nassim Taleb, a former trader who is now an author and lecturer at NYU, has raised the concern that corporate decision-makers in many industries are overly reliant on simple mathematical risk measures, and that they are paying insufficient attention to the impact of unexpected events ("black swans"). Recent economic events appear to support this concern. What are the implications for energy risk management?

Finally, we are quite curious to know how well the established means of commodity and enterprise risk management have helped energy firms survive and thrive during the sharp recession of 2008-2009. Our next round of study will help address these concerns.

The energy industry is rapidly incorporating renewable generation, demand response, PHEVs and smart grid technology. Energy risk assessment and hedging must always reflect all substantial sources of power, operational behavior and consumer behavior, or else the provider will find themselves at greater risk of substantial, negative surprises.

Art Altman is a Senior Project Manager at the Electric Power Research Institute. The Electric Power Research Institute, Inc. conducts research and development relating to the generation, delivery and use of electricity for the benefit of the public. An independent, nonprofit organization, EPRI brings together its scientists and engineers as well as experts from academia and industry to help address challenges in electricity, including reliability, efficiency, health, safety and the environment. my.epri.com

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