In light of the ongoing oil spill disaster in the Gulf of Mexico and the mushrooming whipping BP is taking, I did some hunting around for films on the oil industry. With so much bad-mouthing of the industry giant, I’ve got reputation risk on my mind. Aside the fact that eleven men were killed in the platform explosion, and an unprecedented environmental disaster is unfolding, BP is going to have a lot of scrubbing to do in order to remove the tarnish from their name.
Of course, BP’s not the only oil giant who’s gone through this. Exxon famously had to clean up in more than one way after the Valdez oil spill in 1989. AndChevron’s fighting a class action lawsuit in Ecuador, where 30,000 citizens allege Chevron has been polluting the Amazon basin for decades.
This risk management stuff doesn’t always have to be so heady though. Sure we can ruminate on the latest data from the EIA, and we are sure to check the latest news over on Bloomberg and CNBC. But learning can be entertaining as well. Savvy energy risk managers enjoy a good film now and again. Here, then, are some films on the oil industry that are sure to raise some questions and eyebrows, as well as inform. For your weekend, check out some of these films.
Crude (2009) Chevron is not too happy with this film. Indeed, today it was announced that a court order has been issued to the filmmaker, Joseph Berlinger, to handover 600 hours of unreleased, raw footage to the oil giant. Here’s the official site for the film.
Here’s a small, independent film on a tiny corner of the world (Stanley, South Dakota), where oil plays a big part in the lives of the people who live on top of the reserve. What happens when your town get hits with an oil boom?
Tuesday afternoon of EIA’s annual conference found me in a standing-room-only panel discussion on “Short-Term Energy Prices: What Drivers Matter Most?” The massive, global audience that reads this blog will no doubt be familiar with my recent series on “what makes energies different?”—the last post of which focused on the pricing impacts of storage and convenience yield. Well, I thought I’d tap into the minds of some experts to see which energy price drivers they deem important, to see if our thinking is lining up.
On the panel: Howard K. Gruenspecht, EIA (moderating); David M. Arseneau, Federal Reserve Board; Guy F. Caruso, Center for Strategic and International Studies; Christopher Ellsworth, FERC; and Edward L. Morse, Credit Suisse.
By the way, massive global audience, I heard that all the presentations from EIA’s 2010 conference will be put on their website, so check there in the near future if you want to learn the details of all presentations.
So, what’s driving short-term energy prices these days? Well, I’ll give you a hint: it ain’t necessarily the fundamentals anymore.
Here are some highlights:
Arseneau went to bat first: Speaking on drivers for short-term energy prices, the man from the Fed wants to remind us that volatility, for them, has an impact on inflation and policy making. Arseneau is looking at a basic (stress: basic) framework consisting of two parts, fundamentals versus speculation.
There’s uncertainty in commodity markets, Arseneau states without irony [this coming from a regulatory body!]. Specifically in three areas: modeling, parameters, and understandings of the true state of the market. His solution? Research. Comprehensive research, in his view, will help reduce volatility ex ante (before) volatility strikes (versus conduct research ex post—after—volatility cycles). It is time to push “research frontiers.”
Morse was up next. For him, there are two clear factors leading to volatility: supply constraints/shortages (lead to price spikes) and algorithmic traders. Hmmm…
Morse also points to investment cycles, and the problems they create. For instance, refineries take time to build, a five-year lead time in general. By the time infrastructure can catch up with demand, the latter may fall (by, say, 10-12%), which then leads to a glut of capacity, which effects pricing, and on and on…
Caruso says that despite excess spare capacity, reduced demand and increased OPEC production volumes, high prices persist. Why? All of the following are contributive drivers:
• Insufficient data (from China, non-OECD countries) • Misplaced confidence in OPEC quota compliance • Premature, bullish market predictions • Fears of long-term capacity constraints • Investor moves back to commodities • The declining dollar • The adjustments made for “real” replacement prices for oil
In other words, are there new fundamentals at work?
Batting cleanup, Ellsworth of FERC, who, in referring to the 2008 State of the Market Report, discussed natural gas price-drivers. Ellsworth traditionally takes a look at physical elements, such as weather, storage, and pipeline flows, and also the effects of shale gas drilling. In 2008, however, non-physical fundamentals seemed to drive prices. For instance, during 2008 supply and use of natural gas grew at four percent each, yet prices in July skyrocketed to $13 mmBtu, with attendant physical events apparent as a driving force behind the increase. Why?
Well, Ellsworth says, financials were driving fundamentals. An influx of institutional investors (e.g. pension funds), for example, contributed to the jump. Likewise, the natural gas prices seemed to follow NYMEX futures.
*
That’s that for the Drivers session. Food for thought: are there new fundamentals at work in energy markets? And if so, have they moved from the physical side (e.g. storage capacity) to the financial side (e.g. institutional investing)? Discuss…
Lawrence Summers, Director of the National Economic Council, provided the luncheon keynote for EIA's 2010 conference. To my left at the lunch table (delicious, by the way), a planning director for a Minnesota energy cooperative; to my right, a U.S. Navy commander charged with improving energy efficiency in nuclear submarines. Over a delectable chocolate cake, Summers delivered his address. Here are some highlights:
The current economic recession, Summers says, will not be remembered as a decade-defining moment (like the Great Depression defined the 1930s). Instead, it will be remembered as a disturbing economic fluctuation. This is with thanks to the leadership and initiatives promulgated by the Obama administration, by the way. With 162,000 job-growth this past month, the economy is on the right track.
Dependence on foreign oil “represents a serious national security concern,” Summers says (echoing similar statements made by Energy Secretary Steven Chu earlier that morning). Debates on a national energy policy need to move from an either/or paradigm into a both/and mode of thinking. In other words, we can no longer discuss exploration or renewables, or environmental preservation or economic growth—we need to discuss exploration AND renewable, environmental preservation AND economic growth. An eclectic approach is needed.
This approach (which rather mirrors Chu’s call for a new industrial revolution) for economic security will come in the form of comprehensive energy legislation, which will accomplish five things:
1. Raise demand for and create new jobs (especially through capital intensive projects) 2. Reduce uncertainty and increase confidence 3. Reduce reliance on regulation and increase reliance on market forces 4. Support leadership and innovation 5. Strengthen the country’s international competitive position
Taken together, the five elements will mitigate systemic risks [pick you system, I suppose].
Summers then continued to hammer home some points made by Chu a couple hours earlier. The United States led the 20th century with innovations and transitive technologies, such as with nuclear technology, silicon chips, and the internet (Chu also had on his list satellite and GPS technology).
This was the gist of Summers’ speech, here are a couple of responses to questions from the audience:
*
The military has been at the nexus of technological innovation and development. Think of the internet and jets—neither would have been possible without the support of a government entity willing to shell out immense amounts of investment dollars and resources to give the technologies necessary boosts. Much like the transcontinental railroad [yup, he brought history into the discussion, and even did an impression of J.P. Morgan…], market forces alone would not have supported these kinds of projects because they were not economically viable or profitable in the near-term. It takes government heft to get beyond this hesitancy toward the unknown.
To abdicate the responsibility of project development where prospects and benefits are unknown is, Summers says, blinkered and shortsighted. Indeed, harkening to Chu’s theme earlier, it is a matter of economic and national security to support such projects and innovations.
Philip Sharp, President of Resources for the Future, followed Steven Chu’s keynote at EIA’s 2010 conference. (Why was Chu a warm-up act for Sharp?) (Note also that Steve Bolze of GE Energy followed Sharp, but I ducked out to wrestle with the press gaggle pelting Chu with follow-up questions.)
In any case, Sharp’s remarks on shale gas exploration and production were the most interesting in his presentation. Shale gas’s emergence into the markets has had a number of impacts that are certainly worth considering in the risk management world, including:
• A re-thinking of LNG markets • Will it cause the U.S. to become a gas exporter? • Pipeline and gas plant construction • Effects on gulf drilling operations • Government and regulatory policy
Sharp also notes, with a tone of quasi-foreboding, that the emergence of shale gas will delay nuclear and renewable energy developments. On the bright side, Sharp thinks the emergence of shale gas will make the transition to a low-carbon future easier.
Readers take note: the shale gas debate is REALLY heating up in the United States, especially in Texas and now, New York. The lines of the triangular debate are being drawn by gas developers on one side, NIMBY and citizen groups on another side, and government and the need for tax revenue making up the third angle. (Look here, here, and here for an argument from each of these sides.) The risks in shale gas exploration and production go well beyond market forces!
In the press gaggle following his address, Steven Chu remarked on “hydro-fracking,” the method of shale gas removal sparking so much debate (as well as bringing so much new natural gas onto the market). The Energy Secretary said that as long as it is practiced in an environmentally friendly way, hydro-fracking would be “part and parcel” of American energy development.
*
Up next, Lawrence Summers, Director of the National Economic Council...
Hundreds of eager energy, thirsty conventioneers braved the gorgeous weather of Washington, DC and the flurries of cherry blossoms to attend the Energy Information Administration’s annual energy conference. This year’s theme: Short-Term Stresses, Long-Term Change.
Keynote addresses frontloaded the conference. Headliners included Secretary of Energy Steven Chu, and Director of the National Economic Council, Lawrence Summers. Let’s begin!
Steven Chu came into the event under a heavy cloud: a coal mining disaster in West Virginia had left, at the time, 25 dead and four missing. His presentation avoided discussing the issue, however. Instead, Chu made bold calls for a “new industrial revolution,” one that ensures competitiveness (of the U.S. in the world), weans this country from oil dependence, and mitigates climate change.
“We can and must be a global leader” in the clean energy economy, Chu stated. Already this is being accomplished in mandating standards in appliance energy usage and home energy efficiency.
For those not sold on the market incentives or who are not tickled by technological innovations, Chu stated that smarter energy-resource use enhances the U.S.’s national security. These can be accomplished in a myriad of sectors, like:
• Transportation, especially through increased transition to electric cars • Responsible expansion of offshore oil and natural gas exploration and production • Development of clean coal technology • Nuclear energy development, especially small modular reactors
All of these elements cannot happen, Chu told the audience, without large-scale, rapid deployment of private-sector investment into new technologies. Likewise carbon caps will be important policy initiatives that will spur innovation amongst the private sector.
This new industrial revolution must occur. Indeed, it will occur, for as Chu points out, oil prices will continue to rise, and the risks of climate change are becoming increasingly apparent.
Likewise, the European Union and China are moving ahead with their new energy revolutions; the United States must catch up—“we can still lead” the world in innovation and energy usage, Chu declares.
See “Shale Gas Snippets” for a quick note on Chu’s position on shale gas exploration.
In continuing the series on what makes energies different, here I take a bird’s eye view on two related price drivers: storage and convenience yield. (Incidentally, next week I will be attending the 2010 EIA-SAIS Energy Conference in Washington, where one of the sessions is on price drivers—let’s see which the panel considers most important.)
First, it is important to understand the concepts of “storage” and “convenience yield.” Storage is the physical holdings of a commodity; maintaining an inventory allows for holders to meet unexpected demand with little disruption to production processes. Convenience yield is the benefit of holding an underlying product (versus holding, say, a contract). Thus, storage and convenience yield are intricately linked.
When storage reserves are down, commodity prices increase (this holds for non-energy commodities too, like aluminum). And if inventories are low, and there is a sudden shock in demand, prices can skyrocket. Commodity prices and volatility are positively correlated because both are negatively related to inventory levels.
Convenience yield, according to Helyette Geman, can be “defined as the difference between the positive gain attached to the physical commodity minus the cost of storage.” Depending on the commodity, the length of time, and inventory levels, the convenience yield can be positive or negative.
Storage also affects the shape of short- and long-term forward curves, and for different reasons. As noted, storage may have an effect on short-term pricing, but long-term pricing is reflective of potential new energy to be discovered and captured. Imagine, then, the short-term curve of natural gas when a series of freak weather patterns comes through a region. In comparison, the long-term curve would remain fairly steady and predictable.
Moreover, the effects of storage and convenience yield across energy commodities vary widely. Take crude oil, for instance: because it is traded on a nearly “just-in-time” basis, actual storage of crude oil is minimized. Crude generally takes 30 days (85 days for long trips) to get from well-head to end-user, which does not allow for long-term physical holding. Moreover, with crude, rather than being held for a length of time at the point of export or import, it often changes owners en route (by ship and pipeline), giving little time to actually store the commodity. Natural gas, on the other hand, is traditionally associated with seasonal needs. Thus, natural gas can be stored for months at a time until it is actually needed (indeed, natural gas can be stored indefinitely). And electricity is a whole different beast, since it is not storable at all!
Knowing the connections between storage and convenience yield can help one model the benefits of the latter to the commodity owners. As such, the convenience yield is a feature unique to energy and commodity markets. It is not necessarily easy to determine its value, but to dismiss it entirely is risky business in the energy sector.
For more, see the excellent discussion on the subject peppering Helyette Geman’s Commodities and Commodity Derivatives: Modeling and Pricing for Agriculturals, Metals and Energy (Hoboken, NJ: John Wiley & Sons, 2005).
So, what makes energies unique? The complexity underlying this question is the reason GARP was inspired to create the Energy Risk Professional (ERP) certification program in the first place. Energies are unique from their traditionally traded counterparts. The differences are what make energies so absorbing and worthy of study. Learning about their underlying characteristics is fascinating, trading in them is a thrill, and managing their risks is maddening.
“Energies” is a generic term I use to indicate financially traded instruments in the energy sector (and all the risk management that’s entailed). Of course, there are many similarities across money and energy markets. Credit and counterparty risk, for example, is a real concern for those in both arenas. Likewise, uncertainties in the political (read: regulatory) realm are shared by actors in both traditional and energy markets—regulators even often cross-over these fields (think CFTC, SEC, for example).
There are probably as many differences as there are similarities between money and energy markets. This post quickly highlights some of the diversity between the two.* (For those who are inspired to learn more, and for the daring, I suggest you examine the ERP section of the GARP website and consider joining the vanguard of those with the mark of specialization in this exciting field.) In this post I seek only to introduce the topic of traditional vs. energy market differentials. Subsequent posts will very quickly examine some of the elements in (somewhat) greater detail.
But for now…
The Fundamentals
Those dealing with energy instruments quickly come to understand that the value of their holdings is affected by more than what happens in OTC markets, on the floors of the NYSE, or by interest rates. Weather, political happenings, wear and tear, and human error can wreak havoc on the value of energies. When a hurricane whips through the Gulf of Mexico, for example, refineries along the coast and oil drilling platforms shut down until the storm passes, causing a back-up in delivery and processing of crude products, which in turn affects pricing down the line. A quick shutdown is easy to deal with though; imagine the hair-pulling that happens when a platform is knocked off its pilings or a refinery gets smacked with a tidal wave—physical damage can take weeks or months to repair, causing even further disruptions in projected prices and values.
All kinds of things happening on the ground—out there in the “real” world—can upset the value of an energy holding. A pipeline shuts down in Alaska because corrosion demands repair. Or, a pipeline in Colombia is bombed by disgruntled rebels. Oil tankers run aground or get hijacked by pirates. Refineries explode. Wells come up dry. Residents fight new exploration and production (the NIMBY—not in my backyard—factor). Earthquakes shut down mines (see: Chile). Oil and natural gas companies are nationalized (see: Latin America). Wars break out. Shipbuilding is delayed, highway infrastructure gets clogged, storage tanks leak, blackouts occur, power lines go down, the wind dies, and on and on.
You get the picture. A trader holding an energy instrument needs to be aware of not just what is happening on the trading floor, but also of what’s happening in the entire upstream-to-downstream train. To do otherwise is poor risk management and invites negative returns on value.
Price Drivers
Compared to money markets, the number of and complexity of price drivers for energies are dazzling. Pilopovic (see citation below) does a remarkable job of laying these out as an introduction to the complexity of energies. Here I replicate her table in order to give a bird’s eye view of the difference between the two markets. I recommend picking up Pilopovic's book (much of which is used for the ERP exam) to get better acquainted with the subject.
Issue
In Money Markets
In Energy Markets
Maturity of market
Several decades
Relatively new
Fundamental price drives
Few, simple
Many, complex
Impact of economic cycles
High
Low
Frequency of events
Low
High
Impact of storage/delivery; convenience yield
None
Significant
Correlation between shot- and long-term pricing
High
Lower, “split personality”
Seasonality
None
Key to natural gas and electricity
Regulation
Little
Varies from little to very high
Market activity (liquidity)
High
Lower
Market centralization
Centralized
Decentralized
Complexity of derivative contracts
Majority of contracts are relatively simple
Majority of contracts are relatively complex
As Pilopovic notes, "Energies respond to the dynamic interplay between producing and using, transferring and storing, buying and selling, and ultimately 'burning' actual physical products." Remember that statement each time you make a move in the energy market - it should give pause to ensure the right trade / hedge / model / measurement ' move is being made.
A quick look at the actual physical environment energy commodities must navigate to make it to market, and a brief overview of the differences between money and energy markets (above) reveals the complexity of energies, and why the variations are worth further examination. I hope to tackle many of these elements in future entries. In the next post I will take a quick look at the impact of storage and convenience yield on energies. Stay tuned...
*Many of the concepts in this post were inspired by: Dragana Pilopovic. Energy Risk: Valuing and Managing Energy Derivatives (McGraw Hill, 2007).
Following quickly on the heels of the executive risk manager panel was a discussion on "Enterprise Risk Management: Integrating Risk and Performance Management - A Multidisciplinary View on Risk."
And might I say, I am amazed at the size of the crowd still in attendance. Hundreds! Snowstorm? What snowstorm? Bah!
Readers will forgive me if I am short on names and titles appearing on this panel. I showed up a few minutes late and there were some switches made. I caught the names of a few of them, but only the first name and company of the last. Appearing, then: Kevin Buehler, Director, McKinsey (and moderator); Jonathan Stein, VP and CRO, Hess Corporation; Kanwardeep Ahluwalia, Head of Financial Risk Management, Swiss Re; Glenn Labhart, President of Labhart Risk Advisors, and Rodney, from Vanguard. Here are some of the highlights:
Buehler: How does risk management work in your company?
Ahluwalia: Swiss Re uses a three signature process to increase accountability and ensure that multiple parties are involved in decision making processes.
Stein: At Hess, the key is to be transparent. One needs to be consistent too, and this is accomplished with formal, standardized processes (be it in determining metrics, governance, etc).
Labhart: Mr. Labhart looks at the energy value chain as a model - production, processing, and storage are elements along this chain that must be considered. The point is to identify and define what physical risks you have to better understand exposure, and the best way to hedge/mitigate the risks.
Buehler: On risk and return trade-offs: How do you make sure people take it seriously when executives are most interested in just looking at returns?
Stein: Change is coming through increased transparency and how to promulgate the risk structure. Qualitative and quantitative methods are being combined, the latter providing a basis for discussion for the former.
Strategists make assumptions five to ten years out, whereas risk managers get bogged down in, for example, correlations. Risk managers need to do better in making more strategic assumptions.
Labhart: Business units and risk units need to communicate more effectively so there is one view everyone shares, and there are no misunderstandings.
Question from audience: During annual budget and strategic reviews, is enterprise risk management considered?
Roger: One problem to consider is how to collate all the information coming from below to convey to executives.
Labhart: The reviews are the best time to capitalize on the relationships created throughout the year. Leverage these connections so that all voices can be heard and understood for moving forward.
Question from the audience: How long can CEOs hold out and listen to risk managers when the sky seems to be so blue? When things look golden in the market, for how long can the CEO take the advice of risk managers and keep his foot off the pedal?
Ahluwalia: It's a very good question. Even in good times, though, what are the signals for bad turns? Bringing this to the fore is difficult too. Personalities of CEOs differ, but the imporant thing is to make decisions. Good or bad, decision making provides practice and allows for the ability to self-correct when the time comes.
Stein: How do you turn risk analysis into action? When risk appetites are too great, how do you implement measures (triggers) that mitigate doomsday events?
Rodney: Guiding principles, values, ethics keep you on the right path. For example, when internet stocks were soaring and looked great, Vanguard did not bite because they did not fit into our core focus. We avoided them and did not get burned when the bubble burst.
And that... my friends... is it for my reporting from GARP's 11th annual convention! I hope you all enjoyed my notes, and I look forward to seeing you at upcoming events.
Following the keynote address by Susan Schmidt Bries, a panel of experts convened to ruminate on the concept, "Executive Risk Managers - The CRO Perpsective."
Panelists included moderator Aaron Brown , CRO at AQR Capital Management; Ken Abbott, Managing Director at Morgan Stanley; Lawrence Prybylski, Partner at Ernst & Young; Dan Rodriguez, CRO at Credit Suisse; and Ken Winston, CRO at Western Asset Management.
Here are some of the highlights:
Aaron Brown: Which risk management tools proved their worth over the past couple of years? Which did not?
Winston: VaR is a normal market tool, and for commodity markets VaR did its job - a 99% success rate. In other arenas, however, it fell short. What is the optimal time window, to examine, for example? VaR proved problematic because of the uncertainty of the answer.
Also, stress testing fell short because of unanticipated shocks. Winston likes of idea stress-testing/VaR calculations in Monte Carlo frameworks.
Rodriguez: VaR keeps you distracted from tails. You need to focus on tail risks. Be dynamic in your view to see where you can get hit.
Winston: VaR = worthless and pernicious. Large operations waste time with VaR and they distract from real risks. VaR does not encourage diversification, rather it encourages tail risk. Co-variances from one period cannot be used in another period. Scenario analysis is too variant to account for fat tail risk. Risk managers need deep knowledge of markets and quantitative tools.
Brown: Are risk managers worthless because they did not predict the crisis?
Winston: The question has the premise that the job of risk managers is to predict unforseen hazards. This is very difficult, and predictions could have been better. There was a failure in managing rather than predicting risks. Types of qualitative measures should be used as well.
Rodriguez: Risk managers use a dynamic, evolving view. They must synthesize information, have an awareness of uncertaintity (e.g. regulatory). Across the industry, risk managers could have performed better. Agrees that qualitative information and analysis should also be incorporated.
Prybylski: Risk managers did not have a seat at the table in strategic thinking and planning. Moving forward, risk managers will not be isolated from Boards, product design, long term strategies, etc.
Brown: On regulations, which are good and which should we watch?
Prybylski: Positive elements coming from regulators and supervisors include FSB Publications of best practices. Also, pushing Boards to get more pro-active and forcing conversations with risk managers.
Unfortunately, firms are struggling with how to deal with liquidity risks. Risk managers are aware of regulatory uncertaintity and the implications for organizations. Companies are in states of impasse - resolution of this is important.
Brown: On the appointment of a systemic risk regulator, is this positive or negative idea?
Rodriguez: He likes the potential of reinforcing the Federal Reserve with potential system risk regulators. It's too early to tell, near-term effectiveness is a fantasy. He is not hopeful that regulation will pass anytime soon.
Winston: Systemic risk is being created by uncertainty across the industry over what will happen. A great deal of risk still exists.
The threat of blizzard has had little deterrent on GARP conventioneers. Hundreds filled the room this morning to listen to a keynote address by a cheerfulSusan Schmidt Bies, consultant and former Federal Reserve Board Governor. Here are some highlights from her speech (paraphrased, of course, don't quote her!).
Ms. Schmidt Bies wanted to tie the theme of GARP's conference (Transforming Risk in a New World Order) to emphasize some risk management failures in the recent economic crisis. Specifically she aimed at mortgage and commercial real estate lending. She likened the crisis to the movie Groundhog Day, in which the main character is doomed to re-live the same day everyday until he learns his lesson. For our purposes, a real estate crisis grips some part of this country on average every ten years. It appears our Groundhog Day schedule runs in ten year cycles.
For Ms. Schmidt Bies, the problem did not rest on hedge funds or in derivatives or in private equity. The crisis landed squarely on the shoulders of mortgage and real estate lending. Let's looks at some of the facts:
Between 2004-2006, new home sales were over one million, well above the growth in number of households--thus, a surplus in houses came about.
Investor demand normally occupies 1/12 of the sales of new homes. During the bubble, investor demand ranged from 40-60%--hence, speculation abounded.
That said, what is the main lesson to take away from the crisis? That nobody was paying attention to the markets. Big mistake. What was happening instead?
Banks were reaching outside their traditional, market footprints. For example, North Dakota banks were making loans in Florida, well outside their footprint.
Banks lost sight of what lending should be: they were based on asset-priced lending versus being based on the ability to repay.
Credit models were inappropriate for lending. FICO, for example, worked in the 1990s when there was no bubble. FICO measures a willingness to pay rather than an ability to pay, thus no good for the housing bubble. Loan types changed as well: no dock loans and complex loans came into vogue, and they were peddled to those with lesser levels of financial literacy. 228 loans, with their automatic, periodic payment jumps, were passed on too easily.
One real problem with the recent crisis is that banks and financial services moved from customer-based to transaction-based mentalities. Mortgage lending provides a prime example; but when bankers' bonueses are tied to the closing of a deal, the problem is bound to be exacerbated. With the transaction-based mentality, value and risk are overlooked.
In short, Ms. Schmidt Bies says when you have a market failure you cannot rely on market mechanisms to correct the mistakes.
On Fannie Mae and Freddie Mac: the entities were pressured to buy the junk mortgages and to push the American dream of home ownership (not good things).
On Basel II and risk-based capital: how does one measure liquidity risk? More liquidity should equal more capital. When systemic risk is addressed lack of liquidity is often overlooked.
Leading up to the crisis, Ms. Schmidt Bries says there was too much reliance on VaR models. The lookback periods were way too short, often just 100-200 days. This short attention fueled a downward spiral of bad risk measurement and its consequent investments. Tails, not variances, need more attention. One only goes to capital for unusual and unforseen events - stress testing will assist in correcting these oversights.
Ms. Schmidt Bries says leverage ratios are not good as well. She is concerned over Basel discussions about this because capital held is supposed to be based on assets. But, a) every asset is not equally risky, and b) when based on assets, one often ignores risks off the books (see Bear Sterns).
There are also accounting issues that need tackled, especially for marked-to-market non-trading assets and liabilities. These were highly leveraged during the bubble and needed to be drastically de-leveraged when the bubble burst. Fair value accounting is needed.
In closing, Ms. Schmidt Bries wants to know: what are risk managers going to do to make sure Groundhog Day in the financial world is not going to be re-lived again? Historic precedence should sound alarm bells. Currently too much risk is siloed; CROs need to open risk management to other business units.
Jon Spector, CEO of The Conference Board, led a conversation with Michael Fallon, Member of Parliament for Sevenoaks and Member of Treasury Select Committee.
Ladies and gentlemen of the Risk Exchange audience, let me caution you: this conversation was rapid fire!!! I took as many notes as possible and tried to keep up with all of the points brought up, but I must say: what follows below is merely a paraphrased conversation. Neither Mr. Spector nor Mr. Fallon should be quoted! Information presented below is merely to give those not in attendance the gist of the positively interesting (and fast!) conversation between these two experienced and thoughtful men.
With that said…
Mr. Spector led the discussion, but threw the floor open to the audience from time to time. It made for a dynamic conversation, much appreciated after a long day. To wit:
JS. Are there steps companies should be taking to limit executive pay? Is executive compensation an issue? MF. Yes. Governments need to determine, for example, proportionality of compensation.
JS. How do you determine proportionality? MF. Profits, revenues, relationships to previous years, remuneration generally across the company – all of these elements must be taken into consideration. One cannot tackle it in isolation. If there is no relationship, it becomes unbelievable to the public.
JS. Are there companies we think that are fully ignoring these points? MF. Governance has improved, especially in terms of transparency. Non public companies, however, are able to get away with more.
JS. It’s a complicated process you describe. MF. [here MF responded with questions of his own]: Is there accountability to the compensation committees? Are they answerable to shareholders? Was there shareholder activism, or was there opportunity for it?
JS. Now for the role of government. What have you done in the UK? MF. Requiring annual vote on compensation report, compensation committee chairman, annually. Regulators should have authority to issue mandatory guidance at below board levels, such as pay ratios from highest to lowest pay rates.
JS. Most CEOs are nervous about impending scope of regulatory changes. What do risk managers think of these looming changes? Relief? Concern? Does it make your job more difficult? Audience: Quite bluntly it’s a waste of time. Compensation has little to do with the riskiness of a company’s situation. MF. It was not the level of compensation that brought banks down, but some might have encouraged shorter term thinking and strategies. Second, lots of public money has been put to boost the banking system, indeed upwards of 74% of UK GDP. Given high levels of compensation, and huge cost of bailout, the government and people deserve a say in pay structure.
JS. Will new regulations hinder ability to compete? MF. It’s a strong argument deployed by European banks. Nevertheless, it’s a real and serious issue in UK that must be dealt with. It’s one reason the one-time windfall tax has been introduced in UK. MF is not a fan of windfall taxes, but tax money must be recouped and banks have actually benefited from receiving cheap money to turn into extraordinary large profits. The taxpayer is deserving of a share of that.
UK banking sector is 4 times size of UK’s economy(!!)
JS. On the societal aspects of executive pay: is it a populist issue? If it is, how do companies respond? Is the populist outrage over compensation at a dangerous level? Is there too much scrutiny? Is the populism falling? What are the implications? Audience: Society definitely has an issue in Nigeria. Corporate remuneration is definitely an issue, including executive tenure. Audience: Yes, we have a societal issue. Not just in finance, but in other sectors like energy. …There has to be accountability, that there are consequences for irresponsible behavior.
JS. Are we at a societal breaking point? MF. There is an enormous backlash. And now there is a realization that banks and financial institutions are different kinds of companies than mainstream companies, and now the trust put into these institutions has been fractured.
When people see it is their money at stake, they take a proprietary interest in the fairness of corporate actions.
Audience: Analogy – movie stars get paid almost as much as traders on Wall Street, but there is no outcry for expensive films or actors. The reason is: they are not too big to fail. If they fail, so be it. With banks, that’s different: too big to fail has massive consequences on societal fabric. Maybe we need to make sure banks are not too big to fail. MF. You don’t have to go to the movies, but you do have to have an institution to deposit and handle money transactions. But what makes bank execs so special that they cannot get out of bed without tremendous bonuses?
Think of General McChrystal in Afghanistan. He is protecting the security of an entire country, yet he does not demand the same kind of compensations.
…
MF. UK does not have nearly as much competition between banks as in the U.S. In UK, why aren’t new banks, such as in retail sector, coming online? How do we stimulate competition in UK?
On shareholder activism – shareholders need to be more involved in the compensation process.
Audience: There is a history of director linkngs, a I-scratch-your-back, you-scratch-my-back mentality. MF. Not anymore. Banks are losing the rationale for this behavior. If they don’t get out and explain their behavior, regulators will come after them. Transparency is a must that should increase rational behavior.
Audience: Regarding competition: there is an argument that competition increased market uncertainty that forced banks to create more attractive packages for new customers, that may not have been in the best interest of the public. MF. To an extent, that was true. But the top 5 banks maintain control over 75% of certain banking sectors in the UK. The point MF wants to make is that there may be too many barriers to new entrances into the banking industry.
JS. Prediction: This issue will ebb and flow, but it will come back again, because of one law – law of unintended consequences. We need to invest into the science of executive compensation.
***
With that, the discussion ended. A large group swarmed the stage to further pick the brains of Mr. Spector and Mr. Fallon. Another large goup headed for the cocktail hour... all in all, a very full and productive day!
It's impossible to cover all the multiple, simultaneous tracks. I've stuck my head into every single one of them--and you know what? Wow! Full crowds in each one! The energetic attendance for all of these nuanced break-outs is a true measure of the excitement surrounding the many facets of risk management in these trying economic times.
So, I thought I'd take a walk around the exhibition hall, peek at a few nametags, talk to a few people, and get a general feeling for the mood of those in attendance. Here's what I heard in just a quick, 15 minute stroll during the afternoon break:
- Someone said to me: "Ken Abbott! Ever get a chance to hear him, go out of your way--a very refreshing talk." Mr. Abbott is a Managing Director at Morgan Stanley. He spoke about Basel implementation.
- A gentelman on the phone to his colleague stuck in his office: "It's great! I can't stop taking notes!"
- I picked up conversation in French, Hindi, Chinese and Russian.
- Robert Jackson must have made quite an impression with his keynote address on executive compensation. I heard a duo and a trio discussing this, while an energetic foursome in between animatedly discussed the merits of - or lack thereof - of Basel II.
Up next: panel discussion on executive pay - starting now!
Following the keynote address was a panel discussion: The New Role of the CRO: Empowered, Equipped and Engaged.
I had to duck out for a meeting, so I could only catch the gist of two of the panelists' remarks. Here are some quick notes:
Three panelists participated in the discussion:
Anthony Santomero – Senior Advisor to McKinsey, Board of Citigroup and Citibank NA Jacob Rosengarten – Executive VP, Prez and Chief Enterprise Risk Officer at XL Capital William Martin – Chief Risk Officer of Commonfund, Chairman of GARP Board of Trustees
Santomero: from Board member’s perspective, he has been watching the evolution of the role of the CRO with interest. At McKinsey, 4 different roles are ascribed to CROs:
Risk organization; the CRO is organizer of a decentralized risk system (an orchestrator, if you will).
CRO is aggregator of risk (reporting function with standards, metrics).
Empowered advisor – sets risk appetites and policies.
Clearinghouse of risks, and thereby an owner of risk, that also reports to the Board.
The above are not four choices. They are roles of active participation within a company.
Rosengarten: The role of the CRO is not to just say No, but also to elaborate as to why the businesses you are involved in make sense. And of course, if they don’t make sense, why not? The roles of risk managers at successful organizations involve constructing debate and encouraging discussion. Risk managers should be involved in strategic planning and mitigation schemes, directly involved with the Board. Boards are more fluent in financial matters than risk managers, which is ironic because “risk produces returns.”
In short, risk planning, budgeting, and monitoring processes must be brought to the Board by the CRO.
*
Apologies for the brevity here, but just in these couple of paragraphs some interesting perspectives on the relationship of the CRO to the Board come to light.
Coming on the heels of the 2009 Risk Manager of the Year Award is today's Keynote Address, delivered by Robert Jackson of the U.S. Treasury Department. More specifically, Mr. Jackson is with the Office of the Special Master for TARP Executive Compensation.
As a measure of how fascinating Mr. Jackson's presentation was, let me just say that I never once saw someone take out their Blackberry to check email or surf the web. Mr. Jackson delivered some heavy food for thought, and the hundreds in dark suits were all his. Here, then, are some highlights (we'll see if we can't get a copy of the presentation too, but don't hold your breath):
Overview:
Compensation packages played a contributing factor to the recent financial crisis. Restoring trust by changing compensation practices will help us get on the right course. A number of elements will play a key role in this re-alignment, as discussed:
Administration Principles on Compensation Reform
FSB Implementations Standards
Proposed Federal Reserve Guidance
TARP Compensation Regulations and Special Master Rulings
Summary of Considerations
1. What do we mean by compensation structures contributing to risk management? Performance metrics should take into account risk taking. For example, compensation structures should provide a space for risk managers to have a say. What elements and principles are being considered in the executive pay structure? These should be made know to the public as well.
2. In September 2009, all G-20 countries agreed to tough new implementation standards that will guide compensation decisions at financial institutions worldwide. See the Financial Stability Board standards here.
Balanced risk taking (e.g. lower sensitivity of pay settings)
Effective controls and sound risk management (e.g. do risk managers have the independence they need?)
Strong corporate governance (e.g. compensation committees should be set up, and they should communicate pay rates and reasons to the public)
4. Consistent with these principles, the Special Master's rulings require "exceptional assistance" firms to adopt pay structures that link to long-term performance.
Special assistance firms like AIG and GMAC, for example, but these principles should be promoted beyond special assistance companies. There is a fundamental gulf of understanding of compensation between what executives understand and public understand.
5. Summary of considerations: Taken together, these reforms identify four key considerations for directors and risk managers to take into this year's board room discussions:
Analysis of the relationship between compensation and risk taking
Structural governance protections
Substantive guidance on pay structures
Disclosure and accountability to shareholders and the public
Mr. Jackson says that we need to better communicate complex risk management practices and policies to the public. Whether or not this is a rule for the SEC matters not, executives would be remiss not to explain this information to the public, especially given the lessons learned in the past couple of years.
Early empirical evidence of reform: Goldman Sachs, Morgan Stanley rewards payouts will take into account fundamental risk management measures. If risk management does not work, compensation is reeled in.
***
There were just a couple of questions from the audience:
Q. Relating to the market: How will firms retain the talent? Also, a dollar now is worth more than a dollar in the future, which might actually increase compensation packages.
A. Employees hedging compensation is absolutely critical. Stock sold short does not help the principle of the matter very much, if they were supposed to hold onto it for a few years.
Q. Final date for release of rules? Who will regulate?
A. Finalized by end of this year, early next. But the Federal Reserve is operating in face of regulatory uncertainty. U.S. Treasury wishes to be ahead of the analysis before new rules/guidance are promulgated. A new law is not needed, Boards want to get this compensation structure right.
***
Up next, some very brief notes from a panel discussion on emerging CRO roles.
GARP's 11th annual risk management convention and exhibition is well underway at the Mariott Hotel in Times Square, New York. The theme this year: Transforming Risk in a New World Order. With this blog, we'll try and highlight some of the happenings here to keep informed those worldwide who could not attend.
Up first, GARP President Richard Apostolik greeted the crowd and provided some general background for the hundreds in attendance this morning. By the end of the day, Mr. Apostolik expects to see some 800 conventioneers stream through. The stage was set for the presentation for the 2009 Risk Manager of the Year Award.
This year's recipient is Liu Mingkang, Chairmanof the China Banking Regulatory Commission. A few words about this esteeemed gentleman, from the introductory remarks of Mr. Apostolik:
The roots of China's success can be traced back to the 2003 formation of the China Banking Regulatory Commission (CBRC) and appointment of its current Chairman, Liu Mingkang. Under Mr. Liu's leadership the CBRC orchestrated the recapitalization of China's largest state-owned banks and has implemented a variety of disciplined risk management practices, regulatory oversight policies and corporate governance initiatives. All influenced by Mr. Liu's strong belief in the importance of prudential banking regulation.
In a June 2009 interview with the Financial Times, Mr. Liu summarizes what he believes to be the five major causes of the financial crisis:
Lack of proper firewalls between commercial and investment banking activities.
Neglect of macro-prudential regulation.
Excess financial leverage and lack of transparency
Short-term profit incentives versus long-term growth perspective
Government bailouts provided short-term liquidity without solving underlying structural issues - primarily bank balance sheets.
... Since Mr. Liu's appointment in 2003, the capital adequacy of Chinese banks has increased dramatically. In 2003, eight Chinese institutions met minimum capital adequacy requirements. By the end of August 2009, 219 banks were in compliance. Furthermore, over this same six year period the ratio of non-performing loans (NPL) as a percent of total banking assets decreased from close to 18% to less than 2%. Given the performance, it's no surprise bank profitability has mproved dramatically at a time when many global banks have struggled to remain solvent in the face of losses on lending portfolios and illiquid investments. Average return-on-assets for five on China's largest commercial banks has almost doubled over the past three years while retuns-on-equity have increased more than 7%.
...Mr. Liu and the CBRC have been instrumental in guiding China's banking system through the recent financial crisis and have it well positioned for future success.
***
Unfortunately, Mr. Liu could not be in person to accept the award. But he did pass along a note to be read, part of which said: Regulators and supervisors share the common least thankful job, and we share the most risks. For better or for worse we will work together with you.
On his behalf, then, a Director General of CBRC, Liau Min, accepted the award and gave a presentation. Some highlights from this (you will forgive some of the choppy language I use, but the essence is still the same):
Being a regulator is the greatest job, except it is a thankless job. Being awarded the Risk Manager of the Year Award is vindication for their unsung, hard work.
CBRC provides a model for behavior for the rest of Chinese banking system.
CBRC established in 2003 – rolled out banking reform in 2004, including re-capitalization and restructuring and internal controls. Outsiders were brought in to lead and advise, international procedures were adopted. Banks experienced tremendous growth over the following eight years, but…
Can they be sustained? After all, rapid economic growth does not equal soundness of an economic system.
CBRC has six principles to keep in mind in for successful risk mitigation and supervisory practices:
I. Supervisors play a role: “We have been sticking to a set of simple, useful, and effective ratios and targets and limits and always kept a close eye on the key indicators for prudential regulation.” As such, they have 1 trillion RMB to offset any unforeseen upsets in the banking system and to hedge liquidity risk. Remember: “better safer than sorry.”
II. Don’t see trees for the forest. Stopped banks lending to speculative shares, training and monitoring carefully monitored the value of stocks held as collateral, for example.
III. Banking and capital markets – Glass Steagall Act principles held fast to keep risks divided, acts as a firewall. Friends agree most at a distance. Innovation is encouraged, but proper pricing is evaluated, social risk is taking into account.
IV. The quality of bank governance matters.
V. Emphasize risk oversight and transparency.
VI. Learn by doing: International advisors brought in for advice. Set high standards for success. Combat self-assessment. Basel is used as benchmark for supervisory practices. Gaps are identified in the supervisory system, and plans are drawn for future trajectories.
Challenges ahead: credit risk: next 5 years and beyond – transform from growth-driven, export-driven to quality and customer-driven. Potential risks in this sector must be accounted for.
“Creating a culture of risk awareness is GARP’s goal and it is CBRC’s goal as well.” The best time to do this is when times are good, not when they’ve already turned sour.
***
And that's that from the Risk Manager of the Year Award presentation and remarks. Up next, notes from the keynote address of Robert Jackson of the U.S. Treasury Department.
When it comes to oil price spikes, those in oil trading have a sixth sense for picking out the vulnerabilities of assets and products tied to those prices. All kinds of things happen when oil prices jump: gold looks more attractive, demand for natural gas increases, political instability increases, the dollar drops in value, food costs increase, and on and on. We see the consequences on exchanges and feel the results in our wallets, but we don’t often see the effects of oil price spikes. Enter risk mapping, or risk visualization.
But the risk map above is dull—we live in a Web 2.0 world, we like dynamics in our visualizations. Kudos, then, to the World Economic Forum for taking a stab at enhancing the risk visualization experience with a tool that highlights “risk networks.” Although the information is incomplete (if not downright tantalizing) for our purposes, it is still a fun little gadget (here) to use to determine—from a bird’s eye view—the quality of relationships between risk factors, or nodes. In WEF’s risk network, choosing a node allows one to view details (on the “risk landscape”) of its probability (given as a percentage), severity (in costs of USD billions) and, in an added dimension to the traditional risk map, the interconnectedness to other risks (by strength). The map is colorful, connections are clearly delineated, and severity and significance are clearly indicated with circles and bold lines: the thicker the lines, the larger the circles, the bigger the risks.
For example, choosing “Iran” tells us that there are very risky connections to “asset price collapse,” “Afghanistan instability,” “financial crises,” and more. But what the WEF means by “Iran” or “financial crises” and the other nodes is only vaguely defined (the tantalizing part of the tool). “Iran” is defined simply as: “Iran’s nuclear programme and its role in the Middle East increases instability and tensions regionally and internationally.” The riskiest node connected to “Iran,” in terms of severity and likelihood, is “asset price collapse.”
Five categories, or domains, of risk opportunities make up WEF’s risk network: economics, geopolitics, environment, society, and technology. Nodes within these domains include “Iraq,” “Migration,” “Major fall in the US $,” and “Data fraud/loss,” to name just four.
For fun, I chose to examine the effects of “Oil price spikes.” The WEF explains the node “oil price spikes” as “sharp and/or sustained oil prices increases/places further economic pressures on highly oil dependent industries and consumers, as well as raising geopolitical tensions.” So, according to WEF, where are the associated risks when this phenomenon is in play? Would you have surmised that oil price spikes correlate strongly with an increase in “Underinvestment in infrastructure”? What are the reasons for this? Likewise, the factor has an intense effect on “Major fall in the US $,” “Iran,” and “CII breakdown.”
Conversely, oil price spikes have weaker correlative effects on other phenomena, like “air pollution,” (higher oil price = less travel), “migration” (because people can’t afford the oil to power their transportation?), and “nuclear proliferation” (seems odd, seeing as how high oil prices might increase a country’s desire to build nuclear plants…).
World Economic Forum
The fun part of the map is being able to click through the risk networks. Thus, with “Oil price spikes” in the center (above), we can see a semi-strong correlation with “Underinvestment in infrastructure.” Click on the latter, the circles wiz around, and voila! A new visualization appears and we see that “coastal flooding” becomes a very serious concern. Click on “coastal flooding,” and… you get the picture.
Back to the oil price spikes. We can see from the risk network that many risk elements correlate strongly with oil price spikes: fiscal crises, major fall in the US dollar, Iran, Iraq, underinvestment in infrastructure, slowing Chinese economy, food price volatility, and a few more.
Take, for example, “Asset price collapse.” WEF defines it as: “A collapse of real and financial assets in advanced and emerging market economies leads to the destruction of wealth, deleveraging, reduced household spending and demand.” Much of this appears obvious. When consumers must spend more of their income filling up the gas tank, they’re going to have less money to shop at Wal-Mart. Take that thinking up a level and you have the same problem with companies: when companies have to spend more to transport their goods, they have less capital to re-invest in expanding business and infrastructure. Ironically, deleveraging can work to minimize a firm’s risk by paying off debts, but what are the specific dots connecting oil price spikes to deleveraging? There’s some homework for you.
And what about another consequence of oil price spikes, “Retrenchment from globalization (emerging)”? Again, the WEF: “Multiple emerging economies adopt policies that create barriers to flows of goods, capital and labour and fail to engage with multilateral governance structures to address global challenges.” Ah, yes. The higher the price of oil, which comes from just a handful of countries, forces many without the fuel source to put up their defenses, to look out for number one. In extreme cases, an emerging economy may even choose to nationalize oil companies doing business within its borders in order to get a grip on pricing and distribution, among a myriad of other possible economic strategies. But again, the steps between these causes and effects are decidedly lacking in WEF’s risk network. More homework!
Food for thought Clearly the WEF’s risk network is insufficient for risk managers to use in everyday situations. They don’t even delve into the nuances of financial trading instruments, hedging scenarios and so forth. But that’s not the purpose of bringing it to light. The point of this post is to get risk managers thinking about various ways to map risks, to better see the various risks and measure their correlation to other risks.
It’s a project that has been on the back of my mind for a few months now. How do we in energy risk management visually convey various risk exposures? Is it with a simple X-Y axis graph, like the one above? Or are energy risk managers utilizing innovative methods from outside the traditional risk management network to get a better grip on vulnerabilities? And in doing so, do they create a-HA! moments?
What did WEF get right with this matrix? What risk elements associated with oil price spikes are missing? As noted, the financial side of this is clearly absent. But so are some physical operations, like pipeline risk. What else? Credit freezes, which lead to underinvestment in infrastructure? Precious metals pricing perhaps? Increases in the price of gold often correlate with the price of oil. Higher oil prices means more investment in precious metals which means mining ventures continue to operate, sometimes in marginal, risky countries, which may also have adverse environmental and political effects, and on and on and on.
Can we map that?
What elements would you add? (The possibilities are endless.) Could an energy risk manager effectively (and visually) network physical risk (e.g. pipeline operations) AND financial risk (e.g. volatility)?
Is it helpful to be able to visualize risks? Does doing so add a measure of risk awareness?
Is the WEF model helpful? What other risk visualization models are helpful?
Debate about the root cause of the financial crisis has raged for over a year. With blame to go around everywhere, there is no clear winner and many losers. Ill conceived government policies to stimulate single family home ownership, overly accommodative monetary policy, and explosive growth of a loosely regulated and poorly managed shadow banking system designed to disburse risk ….all helped fuel the crisis. Now that bank taxpayer bailout funds are being repaid and fears of a nationalized banking industry allayed (at least until the next “too big to fail” runs into trouble), what is an appropriate level of government involvement in the banking system?
Recent history suggests the key to creating a successful and healthy banking model lies in finding the optimal balance between free-market economics and government regulation. As this is more or less a zero-sum game, let us focus on the regulatory side of the equation. Two recent legislative initiatives could greatly re-shape the banking and financial services industry.
Consolidation of bank regulatory activities under one empowered organization,
Significant reduction in FDIC and the Federal Reserve’s role in banking oversight,
Government intervention to soften the market impact of “too big to fail” firms gone bad and
Separately, Senators Maria Cantwell and John McCain introduced bi-partisan legislation to effectively resurrect Glass-Steagall a decade after it was abolished. The Cantwell-McCain Legislation would generally:
Prohibit commercial and investment banks from affiliating in any manner
Require legal separation of officers, directors and employees
Prevent commercial banks from engaging in insurance activities
Create a one year transition period for compliance
If forced to choose (which of course we aren’t) the Cantwell-McCain proposal represents a good alternative. There are many who criticize the idea of creating a 21st Century Glass-Steagall Act on the grounds that it is outdated, and simply does not satisfy the needs of the modern financial system. The fundamental premise is that large global corporate clients have sophisticated financing needs that only a fully integrated (‘integrated’ meaning the full menu of commercial banking, investment banking and sales and trading products is offered under one umbrella) global financial organization can provide. Looking over the wreckage left behind from the recent financial crisis, it’s hard to see the wisdom in that argument. It seems the separation of federally insured bank deposits from risky trading and investment banking activities would strike the requisite balance between free-market capitalism and the heavy hand of government (the Dodd bill calls for the bail-out of “too big to fail” firms, up to a $4B ceiling). If the Cantwell-McCain legislation is passed, independent commercial and investment banks would be free (short of mandated max leverage ratios and/or higher risk based capital requirements) to individually pursue profit maximizing strategies, without the risk of robbing Peter to pay Paul.
So what is an appropriate level of government involvement in the banking industry? Surprisingly it may not need to be much more, or extremely complex. Simply separating those businesses with an implicit government backstop (and I am certainly not talking about any “too big to fail”) from capital raising and trading activities might be just enough.
A little better balance between the profit motive and public accountability might help as well. Greed is good. Opacity is unacceptable. Suicide is always to be prevented.
An overflowing, standing-room-only crowd filled the room on the top floor of the Reuters building in Manhattan last night to hear a panel discussion on energy risk management. More specifically, the topic du jour focused on electricity generation and trading. Art Altman of the Electric Power Research Institute (EPRI) presided over a panel of experts, including Alexander Eydeland (Morgan Stanley), Steven Oster (PSE&G) and Glen Swindle (Credit Suisse).
Chris Donohue, Managing Director at GARP, kicked off the evening with a presentation about GARP’s newest certification, the Energy Risk Professional (ERP) program (learn more about that here). A number of ERP Holders representing the first class of the certification were in attendance as well, and were recognized with a genial round of applause. Congratulations to them for their spirited effort at tackling a tough exam!
(By the way, Alexander Eydeland should be a familiar name to those who have taken the ERP or are pouring over the ERP Course Pack now: chapters from his co-authored book, Energy and Power Risk Management are in the study guide).
GARP hosted last night’s event, as part of an international series of forums on the future of energy risk management. The crowd, approaching 250, listened intently to the panelists’ views on a number of topics, ranging from the complexity of hedging energy to utilization of VaR to smart grid hang-ups, and more. Panelists mused on a few thoughts before turning to the crowd for questions.
Here are some of the highlights:
* Altman led off by asking what makes trading and risk management of electricity and related fuels (gas, coal, etc) so much more challenging than financial risk management of bonds, stocks, currencies, etc? Or, at least what are the salient differences? (Note: this is a dandy of a question, one I hope to take on in future blog posts, stay tuned). Swindle took the lead, bluntly stating that electricity is more volatile. He says power and commodities are “special all the time,” meaning there are a lot of risks with few hedging strategies. In short, he’s “haunted” by the number of risk variables with such few mitigation techniques. How does one handle a commodity that has hundreds of forward curves?
Oster echoed Swindle’s sentiments, then added that electricity is not storable, which is problematic. Also, constraints on physical infrastructure and delivery methods make dealing with electricity unique. Eydeland too shook his head, thinking of the number of variables involved in managing a beast like electricity. Theories and models that work with traditional financial trading instruments just don’t work in energy, he says. On paper, everything looks fine, but engineering and environmental aspects (i.e., the physical world of energy) can change at a given moment, thus adding a measure of complexity to the fundamental issues at hand. On top of all this, the illiquid nature of energies is problematic for risk managers.
* Altman: what are your biggest headaches these days? Eydeland pointed to regulatory uncertainty. Regulations, he said, could change overnight. They are impossible to hedge and forecast. Credit problems are an issue right now too. Money’s not moving fast enough to the right places at the moment, causing headaches in the energy field. Oster’s headache revolves around valuation. How does one value a 30-year old power plant, for instance? Traditional VaR methods don’t work in this instance. Further, he applauded the efforts of the ERP program, because in the energy risk management world, there are no common metrics or models being applied across the board. In short, energy risk managers often aren’t “speaking the same language,” and this needs to be fixed.
At this point, the microphones in the audience came to life. Here are a few highlights:
* One audience member was curious as to how the panelists were dealing with the smart grid factor. Oster noted that once smart grids are used effectively, the dynamics of power usage would certainly be altered. Swindle, however, is holding back on the smart grid factor for now because he is unsure of the rapidity with which the idea will develop. As of now, there are no analytics with which to conjecture. He agreed with Oster though: once up and running, smart grids could refine and smooth the operating market. Altman deftly handled the smart grid line of questioning, noting that in a flip of the status quo, power companies could turn to consumers to purchase energy to fulfill peak demand requirements. In so doing, the risk mitigation technique of turning to consumers could alter hedging strategies. Smart grids will also dramatically decrease peaks in pricing markets. (Clearly smart grids are Altman’s bag. Check him out in the November and December issues of Energy Risk too).
* On taking into consideration the financial health of suppliers in the energy chain, Eydeland says one must worry about this factor “a lot.” And it’s not just credit worthiness—cash flow management has become a concern for risk managers. How funds are allocated within a company (smartly, to the right projects, etc), is something to keep an eye on. * How does one hedge in electricity knowing that weather is volatile? Put it in the contract! So says Eydeland anyway. But Eydeland and Oster spun the audience member’s question, lamenting on the inability to hedge against economic growth—or lack thereof. Oster, for one, noted that load growth predictions did not live up to their expectations, which can be traced to the economic downturn. This is a real risk management concern.
* How does one choose the kind of power generation to purchase? Choices like picking gas generation over renewable generation are not always easy to make. Well, Oster says, generation and purchase of it varies from state to state. So that’s one problem to deal with. Secondly, the bidding process for power is extremely dynamic. Bids, for example, can go in at 4pm for a set amount of time the following day—but the plant can be called on a moment’s notice to supply power at an unexpected time at a price named for them. In short, there are a lot of variables, known and unknown, that complicate the process. * On whether or not one should use WTI pricing for hedging purposes. Eydeland says that liquidity is increasing “forever and ever,” and doesn’t see the use of WTI going anywhere.
* An audience member asked if the use of a given commodity VaR gives a false sense of security. Or, conversely, what leniency does it give? Again, Eydeland: no single number should be used as a metric in energy risk management. Use many numbers and metrics, plain and simple. * To wrap it up, someone wanted to know who “the next kid on the block” is? Who’s the next Apple for the energy sector? Oster, with humor and verve, answered: “Is anyone the leader? No. Is there a lot of money being spent? Yes.” (Note: My eyes are on Google. They just created a utility to buy and sell energy, see more here).
And on that note the discussion ended. 250 people made great use of the open bar and munched on finger foods. The crowd didn’t go anywhere—lots of mingling and further discussion of the night’s topic took place over glasses of chardonnay. I meandered to the panelists’ table where a crowd had gathered and pinned all the speakers back with enthusiastic questions and comments. Swindle fielded questions on load volatility while Altman mused on transitions to green technology, and Eydeland signed a copy of his book for one smiling admirer. All and all, a great night.
Learn more about energy risk management GARP’s previous energy forum was on December 8 in Houston, TX. On January 28, Glenn Labhart, chair of GARP’s Energy Oversight Committee, will host a webcast on the need for standardized energy risk education and certification. This webinar will be hosted by EPRI (register here). And on February 2, the Zurich chapter will host a meeting on investment opportunities in the global carbon markets. Keep an eye on the GARP website for more events and opportunities to learn about energy risk management.
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