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  1. 1. Successfully Managing Risk from the Power Plant to the Boardroom The Art of the Corporate Decision
  2. 2. Three Thoughts… <ul><li>To Be Successful, You Need To Manage Your Risks Across The Enterprise </li></ul><ul><li>Risk Management Is Easy </li></ul><ul><li>Uncertainty Can Bankrupt You </li></ul>When we talk about risk management, we really mean managing our risk/return dynamics!
  3. 3. Charting a Path to Corporate Success <ul><li>To Be Successful You Must: </li></ul><ul><li>At The Enterprise Level! </li></ul>Your Risk & Return Understand Identify Measure Manage
  4. 4. Risk, What Risk? <ul><li>To Be Successful, You Need To Manage Your Risks Across The Enterprise </li></ul><ul><ul><li>“ We got out of trading, we don’t have risk” </li></ul></ul><ul><ul><ul><li>If you have assets, consume raw materials, employ people, etc.  You have risk! </li></ul></ul></ul><ul><ul><ul><li>Generating units are extremely risky assets </li></ul></ul></ul><ul><ul><ul><ul><li>Market and volumetric risks </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Often operate outside the formal risk structure </li></ul></ul></ul></ul>
  5. 5. Spectrum of Enterprise Risks <ul><li>Market Risk </li></ul><ul><ul><li>Risks associated with changes in market factors such as commodity prices, exchange rates, basis, liquidity, and interest rates </li></ul></ul><ul><li>Credit Risk </li></ul><ul><ul><li>The risk that a counterparty may default or become less able to fulfill their contractual obligations (financial and physical) </li></ul></ul><ul><li>Operational Risk </li></ul><ul><ul><li>The breakdown in management controls, information technology, processes, and people </li></ul></ul><ul><li>Business Risk </li></ul><ul><ul><li>Risks specific to the industry and markets in which a firm operates. For energy firms these may include </li></ul></ul><ul><ul><ul><li>Plant outages, weather, customer migration, volumetric risk, regulation </li></ul></ul></ul>Understand Identify
  6. 6. <ul><li>Most Energy Firms Manage Their Risk In “Silos” </li></ul><ul><li>Problems With The Silo Approach </li></ul><ul><ul><li>A firm’s risks are intertwined </li></ul></ul><ul><ul><ul><li>Risks cannot be neatly divided across business processes </li></ul></ul></ul><ul><ul><li>Introduces inefficiencies and inaccuracies </li></ul></ul><ul><ul><ul><li>Diversification benefits may be lost or overstated </li></ul></ul></ul><ul><ul><ul><li>Redundant systems and people </li></ul></ul></ul><ul><ul><ul><li>Inconsistent data sources and assumptios </li></ul></ul></ul><ul><ul><li>Actually increases the firm’s operational risk! </li></ul></ul>Why Manage Risk at the Enterprise Level? Physical Nat Gas Power Planning Financial
  7. 7. Enterprise Risk Management <ul><li>Address Risk Across Each Of The Firm’s Business Processes: </li></ul>IT & Infrastructure Physical Assets Engineering Operations & Production Asset Management Trading & Risk Management Fuel Procurement Strategic Planning Corporate Strategy Credit Management
  8. 8. Enterprise Risk Management <ul><li>Enterprise Risk Management Is NOT: </li></ul><ul><ul><li>Performing all risk management and risk controls from a single corporate office </li></ul></ul><ul><ul><li>Using one super computer </li></ul></ul><ul><li>Enterprise Risk Management IS: </li></ul><ul><ul><li>Incorporating risk management into all of a firm’s business processes and decisions </li></ul></ul><ul><ul><li>Training employees to make risk-adjusted decisions </li></ul></ul><ul><ul><li>Ensuring consistent risk policies and procedures </li></ul></ul><ul><ul><li>Providing risk controls </li></ul></ul><ul><ul><li>Communicating this with the firm’s management and stakeholders! </li></ul></ul>
  9. 9. Roadblocks to Managing Enterprise Risk <ul><li>If Enterprise Risk Management Is So Important, Why Isn’t Everyone Doing it? </li></ul><ul><li>Roadblocks To Managing Enterprise Risk </li></ul><ul><ul><li>The “science” of risk management </li></ul></ul><ul><ul><li>IT and infrastructure </li></ul></ul>
  10. 10. Roadblock 1: The “Science” of Risk Management <ul><li>Steps To Implementing Enterprise Risk Management </li></ul><ul><ul><li>Define and document risk management policies and procedures </li></ul></ul><ul><ul><li>Implement systems to measure risk </li></ul></ul><ul><ul><li>Engage in activities to manage risk </li></ul></ul><ul><li>Risk Versus Uncertainty </li></ul><ul><ul><li>Risks are uncertainties to which we can assign a probability </li></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul><ul><ul><ul><li>If you bet on the ace of spades, you can asses the risk of losing the bet and take action to mitigate your risk </li></ul></ul></ul><ul><ul><li>Uncertainty – take a thousand decks of cards, mix them, and randomly create a deck of fifty-two </li></ul></ul><ul><ul><ul><li>What is the probability of drawing the ace of spades? </li></ul></ul></ul><ul><ul><ul><li>You don’t know! </li></ul></ul></ul><ul><ul><li>People Often Mistake Uncertainty For Risk! </li></ul></ul><ul><ul><ul><li>Can be a very painful mistake… </li></ul></ul></ul>
  11. 11. Roadblock 1: The “Science” of Risk Management <ul><li>“ Soft” Risks – Risks That Are Difficult to Quantify </li></ul><ul><ul><li>Most operational risks fall under this category </li></ul></ul><ul><ul><ul><li>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? </li></ul></ul></ul><ul><ul><ul><li>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? </li></ul></ul></ul><ul><ul><ul><li>What is the probability that your most valuable employee will leave the firm? </li></ul></ul></ul><ul><ul><li>What type of probability distribution do you use to measure these risks? </li></ul></ul><ul><ul><ul><li>How do we develop the statistical parameters necessary to model these distributions? </li></ul></ul></ul><ul><ul><li>Lack of liquidity and transparency in power markets turn even simple market risks into “soft” risks for power generators! </li></ul></ul>
  12. 12. Roadblock 2: IT and Infrastructure <ul><li>A Simple Example: An Energy Firm That Owns A Single Electric Generating Plant And Sells The Output Into The Market </li></ul><ul><ul><li>What are all of the parameters that affect the value of this plant and the risk in monetizing this value? </li></ul></ul><ul><ul><ul><li>Plant processes that change second by second and affect the component health of the plant and the plant’s availability </li></ul></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul><ul><ul><ul><li>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.) </li></ul></ul></ul><ul><ul><ul><li>The structuring desk needs to know future expected plant availability and market conditions to sell the plant forward </li></ul></ul></ul><ul><ul><ul><li>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 </li></ul></ul></ul>
  13. 13. Roadblock 2: IT and Infrastructure <ul><li>A Simple Example: An Energy Firm That Owns A Single Electric Generating Plant And Sells The Output Into The Market </li></ul><ul><ul><li>Tremendous amount of raw data and information that must be managed across this process </li></ul></ul><ul><ul><li>Multiple business entities within the firm are involved – each with their own needs and operating targets. </li></ul></ul>
  14. 14. Roadblock 2: IT and Infrastructure <ul><li>Efficiently Managing This Process Requires State-of-the-art IT And Substantial Infrastructure Investment </li></ul>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. 15. Roadblock 2: IT and Infrastructure <ul><li>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 </li></ul><ul><ul><li>Do not lend themselves to closed-form valuation </li></ul></ul><ul><ul><li>Monte Carlo methods are the most widely-used technique in valuing these products </li></ul></ul><ul><ul><li>Monte Carlo simulations require significantly more computing power than closed-form solutions </li></ul></ul><ul><ul><li>Today’s computer hardware provides the tools to successfully address complex business analysis using Monte Carlo methods </li></ul></ul><ul><ul><li>Still, performing on-the-fly valuations of these physical energy products poses a continuing challenge </li></ul></ul>
  16. 16. Removing the Roadblocks <ul><li>Implement Enterprise Risk Management Policies And Procedures </li></ul><ul><ul><li>Forms the framework around which we identify, understand, measure, and manage risk across the enterprise </li></ul></ul><ul><ul><li>Should also include initiatives to educate employees on considering risks in their day-to-day decision making </li></ul></ul><ul><ul><li>Further information: </li></ul></ul><ul><ul><ul><li>Committee of Chief Risk Officers Website ( www.ccro.org ) </li></ul></ul></ul><ul><ul><ul><li>“ Managing Energy Risk: A Nontechnical Guide to Markets and Trading” by John Wengler </li></ul></ul></ul>
  17. 17. Removing the Roadblocks <ul><li>Risk Versus Uncertainty </li></ul><ul><ul><li>Incorporate rigorous stress testing and scenario analysis across the decision-making process – from intra-day trading to long-term strategic planning </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Don’t rely on a single risk metric – apply a combination of metrics </li></ul></ul><ul><ul><ul><li>Risk-adjusted return on capital (RAROC) </li></ul></ul></ul><ul><ul><ul><li>Economic capital </li></ul></ul></ul><ul><ul><ul><li>“ At risk” metrics: VaR, cash flow at risk, earnings at risk, volume at risk, </li></ul></ul></ul><ul><ul><ul><li>The “Greeks” </li></ul></ul></ul>
  18. 18. Removing the Roadblocks <ul><li>IT And Infrastructure </li></ul><ul><ul><li>Open system architecture </li></ul></ul><ul><ul><ul><li>Communicate across applications and platforms </li></ul></ul></ul><ul><ul><ul><ul><li>Intra- or inter-business process </li></ul></ul></ul></ul><ul><ul><ul><ul><li>From real-time to mid-term to long-term for data capture and analysis </li></ul></ul></ul></ul><ul><ul><ul><ul><li>New and legacy systems </li></ul></ul></ul></ul><ul><ul><ul><li>Integrate proprietary analytics and valuation </li></ul></ul></ul><ul><ul><ul><ul><li>Capitalize on the firms intellectual capital </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Manage “soft” risks </li></ul></ul></ul></ul><ul><ul><li>True front-to-back solutions </li></ul></ul><ul><ul><ul><li>Reduce operational risk by enabling consistent assumptions & valuation methods across the enterprise </li></ul></ul></ul><ul><ul><ul><li>Eliminate risk silos with cross-commodity capabilities (i.e., managing risk across all commodities) </li></ul></ul></ul>
  19. 19. Removing the Roadblocks <ul><li>IT And Infrastructure (continued) </li></ul><ul><ul><li>Distributed processing, including distributed Monte Carlo </li></ul></ul><ul><ul><ul><li>Allow for “on-the-fly” valuation of complex energy deals </li></ul></ul></ul><ul><ul><ul><li>Enable intra-day and even real-time portfolio and credit risk metrics </li></ul></ul></ul><ul><ul><li>Browser-based, n-tier architecture </li></ul></ul><ul><ul><ul><li>Scalable as the number of users, size of the portfolio, and complexity of deals increases </li></ul></ul></ul><ul><ul><ul><li>Easily deployed across the enterprise to reduce versioning risk and to lower upgrade and maintenance costs </li></ul></ul></ul>
  20. 20. Parting Thoughts <ul><li>Silo Approach Provides Incomplete & Potentially Inaccurate View Of The Firm’s Risks – may actually increase operational risk exposure! </li></ul><ul><li>Firms that Implement Enterprise Risk Management Will Achieve Competitive Advantage – driving real value to the firm’s bottom line! </li></ul><ul><li>Risk Management Is Easy… </li></ul><ul><ul><li>Metallgesellschaft AG ($2.4bn, 1993) </li></ul></ul><ul><ul><li>Orange County ($1.6bn, 1994) </li></ul></ul><ul><ul><li>Daiwa Bank ($1.1bn, 1995) </li></ul></ul><ul><ul><li>Barings Bank ($1.3bn, 1995) </li></ul></ul><ul><ul><li>Sumitomo Corporation ($1.8bn, 1996) </li></ul></ul><ul><ul><li>Long Term Capital Management ($3.6bn, 1998) </li></ul></ul><ul><ul><li>Ashanti Goldfields ($100m, 1999) </li></ul></ul><ul><ul><li>Enron (2001) </li></ul></ul><ul><ul><li>Allied Irish Bank ($700m, 2002) </li></ul></ul>Uncertainty can be very painful…
  21. 21. Parting Thoughts <ul><li>“ Rare events exist because they are unexpected.” - Nassim Taleb (Fooled by Randomness) </li></ul><ul><li>“ 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) </li></ul><ul><li>“ Any idiot can face a crisis – it’s day to day living that wears you out” – Anton Chekhov </li></ul>
  22. 22. Questions & (hopefully) Answers <ul><li>John P.W. Brown VI </li></ul><ul><li>Vice President, Energy Market & Asset Analysis </li></ul><ul><li>[email_address] </li></ul>
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