May 28, 2008
Brenda Boultwood, the chief risk officer at Constellation Energy, had watched closely the Federal Reserve as it bailed out Bear Stearns by approving a $30 billion credit line to JPMorgan Chase. Prior to its collapse, Boultwood and the credit team at Constellation Energy, based in Baltimore, Md., had gotten reliable information that Bear Stearns was facing liquidity issues and it had therefore restricted its trades.
"We're looking more broadly at who could be next," says Boultwood. "Despite assurances from the head of the Federal Reserve Board that financial firms won't fail, Constellation must conduct due diligence and monitor its exposure to each financial service trader."
Reducing Constellation Energy's trading with Bear Stearns illustrates the many new ways that a chief risk officer must monitor and control risk. Volatility at major commodity traders such as Bear Stearns or Credit Suisse First Boston can trigger losses for energy companies.
At many utilities, the risk environment has intensified in the last year. Rising coal prices, volatile gas prices, more stringent environmental pressures and trading partners with liquidity issues generate a host of problems for utility chiefs.
Stephen Haynes, the chief risk officer at American Electric Power, says he stays up at night out of fear that one of his traders will turn into the next Jerome Kerviel, the trader at Societe Generale whose losses exceeded $7 billion. To minimize risk, AEP has reduced its number of energy traders from 75 to about 25, making it easier to track them. "We're doing more assessments of individual traders and their activities in a timely way that they're not aware of. We want to have a full grasp of what they're doing."
Developing more effective financial models is another way to measure risk, said Haynes, adding that one priority at AEP is developing measures and controls in the market concerning the credit risk of AEP's trading operations. Because AEP owns the largest coal-fired plant in the United States at 1,500 megawatts, he said that he recognizes that a huge swing in volatility could alter its pricing and affect markets nationwide. Ironically, the upheaval in the financial markets has strengthened energy markets by giving financial firms such as hedge funds a reason to inject new money into them.
Because of the massive losses that some financial services companies have suffered, utility traders are stepping up hedging to minimize any potential losses. "If they're not hedged, they could be overexposed to volatile natural gas and oil price changes," said Dilip Daswani, a vice president of corporate development at Triple Point Technology, which is headquartered in Westport, Conn. and which develops software for commodities trading. Historically, smaller utilities didn't employ financial instruments such as swaps, derivatives and options to hedge exposure. "Now they don't have a choice."
Risk Awareness
Daswani said that risk officers have learned that a small exposure can turn out to be a real problem. If natural gas prices spike and the traders aren't hedged, losses can quickly snowball, damaging liquidity. Hence, risk officers are looking at risk more holistically and taking market, credit and operational risks into consideration.
In fact, risk managers at utilities are going beyond examining commodity price risks and are scrutinizing their firms' working capital, noted Sid Jacobson, a managing consultant at PA Consulting Group's global energy practice, who is based in Houston. Risk managers are taking a closer look at receivables and debt service for regulated utilities to get a stronger handle on each firm's own liquidity.
Much of this focus on liquidity is stemming from stepped-up scrutiny by boards of directors. "Boards are more involved in understanding are more involved in understanding what's under the hood. They not only want to know the what's but the how's," Jacobson noted.
But trading and liquidity risks are only two of many faced by most utilities and energy companies. Utilities are concerned about increasing construction costs for building new power plants and whether the regulators will authorize their coal-fired plants or demand more carbon-emission restrictions.
AEP's Haynes suggested that if investment and commercial banks keep tightening credit, utilities would pay more for their construction loans and face a more difficult time obtaining them. After not building plants for several years, AEP, like other major utilities, is exploring building new power generators to meet growing consumer and commercial electricity needs. Since construction and insurance costs are increasing, he investigates what costs can fall into a gap and cause any unforeseen losses.
Meanwhile, the competition for coal on a global basis is spiking prices worldwide and causing an assortment of risk issues, noted Constellation's Boultwood. Since Constellation has hedged much of its coal trading and has long-term contracts, it has weathered the recent price increases. "But if this phenomenon continues around coal, there will be an impact on electricity prices."
"The risk analysis at most utilities is maturing," adds PA Consulting's Jacobson. "I'm seeing risk become part of the DNA of most utilities."
And most utilities are spending more time on risk scenarios to anticipate any potential crisis. What happens if environmental regulations change? What happens if load migrates? What happens if natural gas supplies lessen or prices spike? For most utilities in 2008, those scenarios are keeping chief risk officers quite busy.
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By Gary Stern
