Observing the Risk
A Brief Look at Energy Risk Management
I recently had the good fortune to work on an especially challenging and interesting client engagement in the field of Energy Risk Management. Our client was an electricity retailer, not the largest in the state, but not the smallest either. The challenges that this client faced appear to be shared amongst the majority, if not all, of the energy retailers in New South Wales. With Full Retail Contestability (FRC) now in place, and the Enron memories (and lawsuits) still fresh in everyone’s mind, Energy Risk Management is increasingly being placed in the spotlight. With such a high political profile and large financial stakes, electricity supply and sales must be insulated from disasters arising from poor risk management. Any problems with systems, methodologies and/or procedures had to be identified and plans put in place to address such problems.
The first thing that some electricity industry people will tell you about is the volatility of the pool price. Prices that are a steady $40 that jump to $4000 in less than half and hour and lose (or make) institutions tens of millions of dollars in a day or two. If you get it very wrong in the financial markets you can generally say good-bye to bonuses and perhaps even the desk head. If you get power markets very wrong it can be time to switch off the lights and hire the lawyers.
Listening to some of the anecdotal evidence, it all sounds a bit like the ‘wild west’. A bunch of refugee traders from the financial markets turning their hand to speculating with energy derivatives, risk managers who can’t accurately price the derivatives because the models aren’t there, governments changing the rules every so often while freak bushfires send prices screaming into the stratosphere. Saddle up and enjoy the ride! Fortunately, it is not nearly as gung-ho as some people would have you believe.
While it is true that many traders were not long ago in the employ of banks or brokers, there are also some very seasoned energy people calling the shots. Also, there is very little speculation in electricity trading. In fact, the word ‘trading’ is a bit of a misnomer. ‘Hedging’ would be a far better word to describe what these people do. Alas, if the energy trading desks were renamed as hedging desks, it would probably become more difficult to attract new talent.
The trading environment of energy derivatives is also very different to that of the financial markets. Probably the biggest difference is the extraordinary lack of liquidity in the market. Energy retailers need to negotiate and document an International Swaps and Derivatives Association agreement (an ‘ISDA’) with each counterparty before they can trade with them.
This can be an involved process, taking months. Further to this restriction, there are only a handful of potential counterparties out there. If this is not limiting enough, each counterparty will only be interested in doing deals that fit in with their business. In the financial markets, you have plenty of brokers who will offer you a price on almost anything – the price may vary with the brokers focus and position in any particular market, but a price will be offered. In energy markets, your potential counterparties are disparate organisations – generators, retailers and the ‘pool’ itself. A generator will happily offer you a swap agreement on electricity, as they are a producer. A retailer on the other hand will be less likely to do this, as they would be exposed to the pool price on the variable side of the swap. With the huge potential price spikes, any margin made generally will not cover the risk.
There are also some difficulties in obtaining a fair price for the derivative instrument that an energy retailer would like to trade. When trading swaps, as is in the case with interest rate swaps, the forward curve is critical. Aside from the structure of the deal itself, the curve is solely responsible for implying fair value. In electricity markets, there is a forward curve, but this curve is regarded as rather dubious by many in the industry.
Even more challenges exist for pricing option-based products such as caps and floors. This time there are three points of influence: the forward curve, volatility and the pricing model itself. In a very liquid market, volatility can be implied from the prices trading at any one moment. This can’t be done in electricity markets as it is a very illiquid market. Historical volatility is one option, but while historical volatility is generally unreliable for pricing in most markets, it is even worse in power markets due to periodic regulation changes. The upcoming introduction of FRC will no doubt affect future pool price volatility, and given that instruments with a three year maturity are commonly dealt, it will no doubt affect the pricing.
Which leads us to the pricing model itself, a very interesting topic with many points of view available. In most markets, including equities, foreign exchange and interest rate derivatives, there is a benchmark. While many models exist and each have their supporters, the Black-Scholes pricing model, or slight derivatives thereof, is regarded as benchmark pricing. Of course, this model is of little use for more complex derivatives such as ‘path dependent’ and ‘multi-factor’ instruments, but such markets have had the benefits of many great minds working on them for many years, and in general traders can rely on the models as accurate.
As a stark contrast, the electricity industry has as yet failed to adopt a standard pricing model. While price spikes can be huge and unpredictable, this isn’t really the problem. The problem is more about what factors are influencing these pricing movements, and the fact is that there are many. Electricity is a highly ’seasonal’ market, with different price and volatility behaviour in summer as to winter (and different to ‘neither’, which is energy-speak for the combination of spring and autumn). There is also an interesting daily profile, with a much smaller amount of power being used before 6am and after 8pm than in the middle of the day.
The problem can be looked at as three-fold:
Firstly, there are financial constraints. While a large bank can make a great deal of ‘fee’ income from the margins on correctly priced derivatives, electricity retailers are operating with far tighter margins. Because of this, the retailers have not had their own teams of PhDs working on this for the last five years to come up with a solution. Up until now, the work done has largely come from academically-based projects.
Secondly, this is a far newer market than equities and foreign exchange. Even the relatively new interest rate derivative market has had a good twenty-five years to mature.
Thirdly, many of the trading and risk professionals working in energy markets started their careers in the financial markets. Energy market derivatives pose a different set of issues requiring a ‘back-to-basics’ approach, and it is often difficult to ‘forget what you know’.
So without a benchmark pricing model, it becomes difficult to asses ‘fair value’. Add to this the extraordinary lack of liquidity, and fair value itself becomes a rather academic point. What does this then mean for a Value at Risk (VaR) calculation, which essentially relies on a portfolio being priced at fair value?
As the Energy Market matures and grows, and as more work comes to fruition within the industry and academic groups, the current difficulties will be replaced by new challenges. An increase in liquidity will no doubt give rise to an increase in competition. More consistent pricing models may reduce margins and lead to a more commoditised market (as happens with all OTC markets eventually). Until such time however, there is a lot of work to be done and it is an exciting place to be.
