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  • 1. Successfully Managing Risk from the Power Plant to the Boardroom The Art of the Corporate Decision
  • 2. 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!
  • 3. Charting a Path to Corporate Success
    • To Be Successful You Must:
    • At The Enterprise Level!
    Your Risk & Return Understand Identify Measure Manage
  • 4. Risk, What Risk?
    • To Be Successful, You Need To Manage Your Risks Across The Enterprise
      • “ We got out of trading, we don’t 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
  • 5. 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
    Understand Identify
  • 6.
    • Most Energy Firms Manage Their Risk In “Silos”
    • Problems With The Silo Approach
      • A firm’s 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 firm’s operational risk!
    Why Manage Risk at the Enterprise Level? Physical Nat Gas Power Planning Financial
  • 7. Enterprise Risk Management
    • Address Risk Across Each Of The Firm’s Business Processes:
    IT & Infrastructure Physical Assets Engineering Operations & Production Asset Management Trading & Risk Management Fuel Procurement Strategic Planning Corporate Strategy Credit Management
  • 8. 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 firm’s business processes and decisions
      • Training employees to make risk-adjusted decisions
      • Ensuring consistent risk policies and procedures
      • Providing risk controls
      • Communicating this with the firm’s management and stakeholders!
  • 9. Roadblocks to Managing Enterprise Risk
    • If Enterprise Risk Management Is So Important, Why Isn’t Everyone Doing it?
    • Roadblocks To Managing Enterprise Risk
      • The “science” of risk management
      • IT and infrastructure
  • 10. 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 don’t know!
      • People Often Mistake Uncertainty For Risk!
        • Can be a very painful mistake…
  • 11. 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!
  • 12. 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 plant’s 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
  • 13. 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.
  • 14. Roadblock 2: IT and Infrastructure
    • Efficiently Managing This Process Requires State-of-the-art IT And Substantial Infrastructure Investment
    Generation Asset Information Flow Scheduling & Dispatch Fuel & Emissions Volumes & Rates Plant Status Instrument & Controls Trading Asset Optimization Market Interface Financial Planning Structuring Resource Planning
  • 15. 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
      • Today’s 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
  • 16. 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
  • 17. 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
      • Don’t 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”
  • 18. 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)
  • 19. 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
  • 20. Parting Thoughts
    • Silo Approach Provides Incomplete & Potentially Inaccurate View Of The Firm’s Risks – may actually increase operational risk exposure!
    • Firms that Implement Enterprise Risk Management Will Achieve Competitive Advantage – driving real value to the firm’s 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…
  • 21. 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 – it’s day to day living that wears you out” – Anton Chekhov
  • 22. Questions & (hopefully) Answers
    • John P.W. Brown VI
    • Vice President, Energy Market & Asset Analysis
    • [email_address]