Market, credit, and liquidity risk – the report card is in for energy trading and risk management

 "PA has played a critical role in the integration of our electricity and gas businesses. They have developed a new business model which creates a strong platform for continued growth across the European commodity markets." 
Kurt Bligaard Petersen, Executive Vice President, Commercial Division of Dong Energy

Summary of results from PA Consulting Group's (PA)2009/2010 European Energy Trading and Risk Management Survey.

About the survey

Our 2009/2010 survey focused on key European energy players and in particular the adaptations they have made to their credit risk management practices in response to the credit crisis. We also wanted to establish some 
benchmarks for current best practice in market and credit risk management and take a view on the overall trading outlook in light of the current economic conditions.

The survey respondents were major European energy players from continental Europe and Scandinavia. Many have transitioned from being production-oriented businesses (in which risk management was confined to hedging production) to integrated utilities (operating across the value chain, in multiple commodities and geographies). In addition several have assumed the task of proprietary trading.

The surveys were conducted as detailed interviews by consultants specialised in risk management with CROs or Risk Managers.

Overview of survey results

Results from the survey and insights from our work with clients suggest that experiences over the past 18 - 24 months have been both positive and negative.

Survey respondents were overall comfortable with their current market risk management practices. They also indicated that risk management systems in place at large energy trading companies proved capable of handling unprecedented market price volatility, the financial crisis and the ensuing economic downturn.

However, as defaults increased across multiple sectors, confidence in external rating agencies fell. As a result, the spotlight turned on credit risk management, which up until the recent economic crisis had been comparatively under-resourced. Results from the survey demonstrated an evolving and increasingly important relationship between market and credit risk, especially when coping with the overarching issues of price volatility and credit worthiness.

The survey highlights that energy trading companies would benefit from a more holistic approach to risk management; one that paints a complete picture and that more accurately details the interrelationships between market, credit and liquidity risks. To gain a better understanding of the risk environment that energy trading companies now face, companies should use an enterprise-level, consolidated risk measure.

Market risk - key findings

1. According to our survey respondents, the key areas of risk are:

• commodity price volatility

• trading market liquidity, both OTC and via exchanges.

2. Most companies feel overall comfortable with their market risk management expertise and concepts in place:

• survey respondents consistently ranked Daily VaR reporting as the most important measure within market monitoring

• all respondents stressed the need to employ a set of monitoring and reporting tools to support market risk management

• stress testing is the least developed tool – often not implemented as a standard routine or limited to certain exposures.

3. New challenges currently faced by utilities across Europe include:

• coping with increased levels of market price volatility

• moving from VaR to PaR measures for a better reflection of real market conditions

• coping with a changing picture in market liquidity

• the need to adjust hedging strategies to the new market environment (to account for volatility and liquidity) an issue that could become more important should mandatory clearing be introduced by regulators

• changes in the market landscape given consolidation as a result of a number of mergers, take-overs and the financial sector reducing its stake in energy trading.

Credit risk - key findings

Handling counterparty credit risk exposure has often been under-resourced compared to market risk. However the banking crisis followed by the credit crunch triggered a wave of new activity in credit risk management.

1. Energy companies have become more aware of credit risk management functions, key developments include:

• an expansion of internal analytical capabilities and review of practices currently employed

• external scoring still used as important benchmark, although cross-checked with other analyses

• sophistication and standardisation in assessing credit worthiness and risk exposure, including efforts to implement CVaR to account for potential exposures and outstanding actuals

• to reduce risk exposure, energy utilities also reviewed ratings and cut down on credit line limits, with many restrictions lifted again following the peak of the crisis end of 2008

2. Further changes in the market environment seem inevitable, presenting energy companies with new credit risk management challenges:

• European energy markets are showing signs of becoming two-tiered, for example:

  • there has been a rise in smaller market entrants to benefit from structured portfolios and hedging opportunities. These players tend to carry out simple, low volume, exchange-cleared deals

  • by contrast, there has been a rise in larger players with a growing demand for more complex, structured deals, as used by generation asset-strong energy companies

• though many restrictions on credit limits have been lifted and price levels have come down, many companies are keeping a close watch on credit lines

• expanding credit risk is moving up the Board Room agenda

• measures taken to mitigate credit risk, such as the use of margining and clearing as well as increased requirements on collateral, has increased risks in other areas

• should compulsory clearing become a reality, cash requirements and the need for liquidity management could increase substantially, along with the need to manage liquidity risk exposure.

Conclusions

Our survey suggests that Major European Energy Companies have managed the recent credit crisis well and as a result, have made improvements in the focus and sophistication of credit risk management practices. Market risk practices are generally well-established and sophisticated, although we would warn against complacency given the extreme price volatility that has been seen in commodity markets in recent years and the ongoing market developments.

The area we would highlight for greater focus is liquidity risk management. Cashflow management has been the key to navigating the current troubled economic waters, especially given absolute commodity price levels and price volatility. We suggest, companies need to take account of the links between market, liquidity and credit risk and work towards an integrated risk measure across all three categories.

In our view, firms gain a competitive advantage when liquidity risk is managed using a holistic and coordinated risk management framework. Capital adequacy set in accordance with the overall corporate strategy on desired risk profile can then also monitor and fine-tune from the bottom-up using comprehensive limit systems. Using this robust approach will give ratings agencies confidence and translate to easier and cheaper access to finance. This gives a competitive advantage for the organisation in any economic environment but especially within the context of an economic downturn or crisis when access to liquidity is challenging.