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

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