ready for energy market risks? · portfolio management and trading help structure and manage risks...

Introduction to risk management approaches

Tokyo, Power Market Seminar METI, June 14th, 2018

Ready for energy market risks?

2METI_energy_markets_seminar_14062018_VF.pptx

Within the past decades, major failures and unusual events have increased the awareness on financial and commodity risks

Source: Press articles, Roland Berger analysis

Illustration – Energy and financial risk eventsFinancial sector

Oil & Gas

Electricity & Others

1995Barings failure

2004China Aviation loses USD 550 m on oil products

2002Enron & US merchants bankruptcies

1998LTCM failureBasel I agreements reviewed

2005Delta & Northwest Airlines go on chapter 11 due to soaring oil prices

2003British Energy quasi bankruptcy

1988Basel I agreements

1980'sFirst oil derivatives

1996First electricity futures (US and Nordpoolin Europe)

2005Basel II agreements

2006British gas prices turn negative for 3 daysAmaranth loses USD 6 bn. on US gas market

2005Opening of European CO2 market

2008SocieteGeneraleloses EUR 5 bn. on trading positions

2008Oil price spikes to USD 147/ barrel25 airlines cease activity in six months due to 2007-2008 oil spike

2007Price of EU CO2 crashes to zero

2010Dodd-Franck Act brings major financial reform in the USBasel III agreements

2011Spot Asian LNG prices increase ~50% following increased post-Fukushima demand

2009Power price spikes to EUR 3000/ MWh in France

2011UBS loses USD 2 bn.on trading positionsMF Global bankruptcy

2012Gas prices reach a 10-year low in the US

2010Market coupling put in place in Continental Europe

1994JP Morgan introduces Risk Metrics

1994Orange County loses USD 1.6 bn. on oil products

2000California CrisisGerman Renewable Energy Act

1993G30 Recom-mendations

1993MGRM loses USD 1.5 bn. on oil products

1998Liberali-zation of German energy market

2014Significantly decreasing oil price

2011Fukushima nuclear disaster, shutdown of 9.7 GWnuclear capacity

2014/15Historically low interest rates

2015Ryanair losses EUR200 mn on failed oil price gamble

2013/14Negative clean dark spread

2016Japan adopted negative interest rate policy

2016Tullow Oil slumps to GBP 1 bn loss as low oil prices bit into revenues

2016Brexit and potential impact of UK leaving EU-ETS

2017Deutsche Bank posted its third consecutive loss in a row

2017/18Small airlines face a brutal reckoning as oil prices surge

2017/18US blames Russia for cyber attacks on energy grid in US and Europe

2018Mifid II and Mifid to apply to all member states in the EU


Commodity prices have been very volatile, creating risks for market participants

Source: Bloomberg, Euromonitor, Roland Berger analysis

SILVER [Spot price, US$/OZ]

COPPER [LME Copper 3 Month Rolling Forward, US$/MT]

COTTON [ESALQ Cotton Spot Price/Brazil, BRl/pound]

CORN [Spot price, US$/MT]

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10000

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Within the commodities world, energy is even more volatile, especially electricity, that cannot be stored (so far)

Source: EIA, Bloomberg, Roland Berger analysis

ELECTRICITY [EPEX Phelix Day-Ahead Electricity Auction Price, EUR/MWh]

CRUDE OIL [WTI Spot Price FOB, US$/BARREL]

EURO/DOLLAR [1€ = x US$]

NATURAL GAS [Henry Hub Spot Price, US$/MMBTU]

00.40.81.21.6

Jan-

00No

v-00

Sep-

01Ju

l-02

May-0

3Ma

r-04

Jan-

05No

v-05

Sep-

06Ju

l-07

May-0

8Ma

r-09

Jan-

10No

v-10

Sep-

11Ju

l-12

May-1

3Ma

r-14

Jan-

15No

v-15

Sep-

16Ju

l-17

May-1

8

1

5

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Volatility only appears in liquid and competitive market – Japan is only at the beginning of this journey – Time to get prepared

121213121212121211

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5

69

6

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64

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65 70

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72 71

Competitive supplierLegacy utility Share of Competitive supplier [%]

1110111112121211

998

02/18

4,514

2,775

11/17

4,075

43910/17

33609/17 12/17

3,4563,085

417334 45001/18

349

4,744

4,2943,107

4,171

3,755

3,111

25504/17

3,082

267

3,084

3,738

2,9422,8162,963

28508/17

3,453

07/17

33406/17

339

3,219

2,751

05/17

3,2823,418

Emerging wholesale market, driven by retail market liberalization > Active retail market with

broad diversity of profiles, yet modest volume

> Still modest wholesale market trading volume –Low liquidity and market depth

> Wholesale market dominated by bilateral/OTC trading - Japan Power Exchange (JEPX) still marginal²

Electricity [TWh]

Natural gas [Mm3]

Source: Japan Electricity and Gas Market Surveillance Commission


For utilities and retailers, the risk management imperative starts with the possibility (the obligation?) to trade energy, physical or financial

Utilities / Retailers

Source: Roland Berger analysis

Clients

> Sales of physical commodity delivery contracts

> Sale of energy services, price visibility

Suppliers / Other utilities

> Purchases of fuels (oil/gas/coal/…)

> Purchase of electricity

Regulator

Other market players (OTC)

Organized markets

> Opening of the possibility to exchange commodity via bilateral wholesale contracts

> Existence of a market place for the commodity, with visible, volatile market prices


In a fully liberalized market, assets and client base are optimized vs. the market – Illiquid market call for gradual optimization

Power generation / Storage

L/T contract (flexibility)

L/T contract (ferm)

Contracted (flexibility)

Contracted(firm)

BOUGHT SOLD

Hypothetical portfolio with volume risk

MARKET

Optimization ina liquid market

> Each position is optimized separately against the market

1 Optimization ina non liquid market

> Portfolio resources and commitments are optimized globally (under retail supply constraints)

> Residual flexibilities are optimized against the market

MARKET

2

Source: Roland Berger Strategy Consultants

Optimization method according to market liquidity


Portfolio Management and Trading help structure and manage risks

PM&T function overviewProcesses/activitiesInput Output

> Asset characteristics– Fuel

procurement contracts

– Generation plants

– Customerloads

> Financial andrisk expectations

> Marketconditions(price, volume, liquidity)

> Power plants dispatch program

> Network scheduling

> Delivery program

> Trading transactions

Portfolio Management (PM)

Trading (T)

> Portfolio structuring– Fuel sourcing (type of fuel, contracts, …)– Influence on generation fleet

(repowering level of flexibility, …)– Orientation of customer portfolio (

contracts, management / interruptions of loads, …)

> Flow Trading (power, gas, coal, oil) buy/sell transactions, for external parties and for the portfolio manager ("window to the market")

> Asset-backed Trading > Proprietary/own account trading

> Portfolio optimization– Fuel contracts utilization

(LT vs. sport, flexibility,…)– Own generation vs.

purchases


Risk monitoring & control


Energy utilities and other commodity-intensive companies are facing significant risk management challenges

Commodityrisk management challenges calling

for a specific framework

Wholesale markets• Increased price volatility• Difficulty to forecast prices• New and evolving market places / market indices• Technical / logistical constraints (transport, storage,…)

Business model• Geographical expansion/acquisitions• Multi-commodity exposure• Sourcing and hedging strategies• Role of "trading"• Organization, P&L responsibilities and transfer price schemes

Scrutiny from financial community• Financial predictability / performance management• Focus on multiple P&L, balance sheet and cash

indicators• Risk governance and control as a must

Volume uncertainties• Supplier / customer consumption uncertainties

(temperature, hydrology, physical failures, ...)• Contract / load modeling challenges• Lack of volume risk experience in financial sector

Complex exposure• Price level and volatility• Volume risk with possible price correlation• Counterparty risk• FX risk linked to commodity prices

Customer needs• Flexibility driven offerings with complex contract structures• Coexistence of tariffs and competitive offers• Difficulty to impose premiums / penalties• Difficulties to pass-through cost increases to customers

(competition, regulated prices, political impact...)

Internal challenges• Multiple parties involved: Strategy, Finance (Controling,

Treasury, Accounting), Operations, R&D• Education of Top Management / Directors


Real-life example: proprietary trading losses close to 9 M€ at a small energy trader due to losses on all commodities

5,1 M€

2,2 M€

8,4 M€

Proprietary Trading loss

Options

0,5 M€

Emissions

0,9 M€ 0,5 M€

GasCrudes Coal

1,2 M€

Power

Cause All Improper marketview / unclear R&R

Cluster risk / improper market

view

No position management / no risk management

Improper marketview / no riskmanagement

- Luck ?

• Several traders with a long position (≈600 GWh) based mostly on chartist analysis

• Power prices decrease

• Long position of 120.000t• Price drop of 20$

• Long position in gas US (10$)and short position in gas EU (22$)

• Spread increase

• Several traders with a long position at oil high prices (102$/b) to speculate on the closure of Strait of Hormuz; but prices went down

• Most of positions switched from long to short the following month, when prices went up

• High cluster risk: no alignment of trade strategies, no cluster risk monitoring• No risk / return policy, monitoring etc.• Lack of Market vision: traders not specialized for PT, lack of strategy

coordination etc.• Risk policy not exhaustive: lack of limits cascading• Lack of safeguards: alerts for large position (overall T&O) etc.

Source: "Trading & PFM Risk Policy" Audit Committee (19th September), Interviews

Breakdown of the Proprietary Trading loss by commodity in a trading year


Failing to assess and manage market risks leads to financial loss –Root causes can be analyzed, and point to risk management policy

Why can trading / retailing activities lose money ?

Risks were too high Risk control was insufficient

Too large positions were taken…

… with too little market view and risk-return preferences

Risk management framework was partly inadequate

Risk framework was not enforced effectively

High cluster risk

(no alignment, specialization of

traders, no cluster risk

monitoring…)

No risk / return policy

(no target, no monitoring…)

Not exhaustive

(relevance and cascading of risk

indicators, missing rules, risk reporting

etc)

No power for enforcement

(too weak riskcontrol, Senior

Management lackof involvement etc.)

Lack of safeguards

(limitation of trader deals, management

alerts etc.)

Not at the right level

(too high limits, lack of limits on certain

topics etc.)

Lack of market view

(market selection, market trader experience…)

Unclear role & respon-sibilities

(positions not managed)

Source: Roland Berger project experience

Generic issue analysis tree on trading losses


Roland Berger energy market risk management framework

1

23

4

INFRASTRUCTUREa) Governanceb) Organizationc) Processesd) IT

5a) Risk indicators & dashboardsb) Control processes

> Risk limit setting> Commitment/contract approval> Deal-entry and valuation> Risk limit compliance> etc.

a) Available management levers b) Portfolio management methodc) Risk attributes in client contracts

RISK CONTROL

PORTFOLIO MANAGEMENT

a) Return/risk preferencesb) Hedging expectations c) Business model and transfersd) Financial predictabilitye) Non-economic accounting effects

a) Characterization of the commodity portfolio risks> Risk factors> Consequences

b) Links and trade-offs between risk categories

BUSINESS OBJECTIVES

RISK IDENTIFICATION

Risk management requires a comprehensive framework, with sophistication level gradually adapted to market realities



Risk is not bad! Not being aware of the risk / return equation can harm profit (P&L) and value (Balance Sheet)

Possible risk management objectives Zoom on return/risk preferences

> Avoid large losses due to market risks

> Ensure consistency with energy return/risk preferences

> Support financial performance management over budget, medium and long-term horizons

> Support operational decisions (hedging, optimization,…)

> Support investment decisions and strategic choices

> Build a competitive advantage through return/risk strategies

> Demonstrate risk management abilities to stakeholders

> Support financial communication

Motivation and objectives

1


Returns(e.g. EBITDA)

Risks (e.g. EBITDA@R)

Ris

k To

lera

nce

Bor

der

Forbidden situation

PROTECT VALUE

Current situation

ENHANCE VALUE

Optimized situation Market

efficiency frontier

BUSINESS OBJECTIVES / Return/risk preferences


Depending on the shareholder structure and market characteristics, many utilities also consider financial predictability as very important

> "We need a stable earnings trajectory with maximum predictability for the budget year"

> "We do not feel comfortable risking more than x% of our yearly earnings on this business"

> "We want to keep our target rating of X"

> We need to capture the average market price

> "For this type of project, corporate requires a hurdle rate of x%"

> "This particular hedge is too expensive for the risk reduction it provides"

Risk adverse company (e.g. municipal utilities, small retailer, ...)

Risk tolerant company (e.g. oil & gas producers, ...)

Financial plan [EUR]

Time

Earningsuncertainty

Financial plan [EUR]

Time

Earningsuncertainty

N N+1 N+2

N N+1 N+2

Reference value

Financial predictability


Objectives Implications on financial predictability

1 BUSINESS OBJECTIVES / Financial predictability


Energy market risks can be characterized by underlying risk factors and expected consequences

Internal factorsExternal factors

Exchange/ interest ratesMarket shocks

Infrastructure failure

Customer behavior/ consumption

Regulation

Human factor

Industrial failures

IT failure

Commodity price/ volatility

WeatherCounterparty/

competitors behavior

Modeling issue

Underlying risk factors

Market> Commodity price risk> Volume uncertainties> Induced FX risk

Counterparty> Impact of client or wholesale

counterparty failures

Business> Impact of competitive

environment factors

Operational> Impact of company internal

factors

Risk categories

Identification


CONSEQUENCES

Reputation

Legal

Security

Financial> P&L> B/S> Cash

Strategic

2 RISK IDENTIFICATION / Characterization of the commodity portfolio risks


> Renewable production forecast is a new challenge that players will need to face:– Network safety problems arise when

renewable production is above 30% of installed capacity

– Renewable producers will be asked to be more and more involved into TSO system services and future capacity markets

> In Spain or Denmark, Direct Marketing players need to give D-1 forecast and have to pay penalties when experiencing forecast errors

> Renewable energy forecast need specific competencies because of its high variability and uncertainty characteristics

Volume risk is emblematic of energy markets – Generation side

Required specific competences

> Meteorology> Advanced statistics


Portfolio management – Case study from a renewable energy generator

Variability of solar power production within a day is dependent on:> Nebulosity> Sunshine> Spatial configuration of solar panels

3500

3000

2500

2000

1500

1000

500

0

00:00

02:00

04:00

06:00

08:00

12:00

14:00

16:00

18:00

20:00

Cloudy dayPaverage real(W)

Paverage forecast (W)



-1,500

-1,000

-500

-

500

1,000

2013/7/16 2013/10/16 2014/1/16 2014/4/16 2014/7/16 2014/10/16

Open positon

0%

200%

400%

600%

800%

1000%

2013/7/16 2013/10/16 2014/1/16 2014/4/16 2014/7/16 2014/10/16

Hedge ratio

Portfolio management – Case study from a European utility


Volume risk is emblematic of energy markets – Supply side

Open positions [hourly, in MWh] Hedge ratios [purchases/ sales, in %]



Portfolio management helps balance and transfer risk to the market through multiple levers – Price hedging only one of them

Wholesale RetailIN THE LONG TERM

> Long-term contract with producers

> Production investment> Financial participation with

off-take contract

> Marketing strategy (customer segments, products…)

> Lobbying strategy

IN THE MEDIUMTERM

> Portfolio flexibilities (storage, contract flexibility…)

> Organized market instruments (forward, options, virtual capacity, financial hedges…)

> OTC market contracts (forward, swaps, structured contracts…)

> Products/ offer pricing> Plant availability> Accurate forecasting

IN THE SHORT TERM

> Portfolio flexibilities (storage, sourcing contract options…)

> Spot buy/ sell

> Customer load management flexibility (interruptibility, load shaving, …)

Other market players

ClientsUtility / Retailer

Organized & OTC marketsRegulator

Suppliers

Transactions and mitigation levers


External risk transfer possibilities Sample risk management levers

3 PORTFOLIO MANAGEMENT


Price position management can rely on four (typical) hedgingstrategies

Hedging strategies

2"Anticipative" hedging

A "campaign price" based on pre-purchases

Sold at

Sourced at

Average cost of anticipated purchases

Market Client

Client Client

First…

…then

2014

3 "Late" hedging

A price which was fixed before the sale to the client, based on market prices at the day of the quoting

Sold at

Sourced at

Combination of forward and spot products to match aggregated client loads

Client Client

Market Client

2014

4For variable prices based on x.y.z. formulas only, hedge "along the formula"

Sales price for the delivery period, being equal to the average forward price for this period during the month before, plus margin

Sold at

Sourced at

Average forward price during the month before (like the sales formula)

Client Client

Market Client2014

Variable price 1.0.1

1/30th everyday during the month before delivery

1 Back-to-back hedging

A price which was fixed during the sale to the client, based on forward price for client specific profile

Sold at

Sourced at

Forward price for delivery period at same time of the sales for client specific profile

Market Client Client

Simultaneous sales and hedging of the client profile

20142014



Hedging, even if feasible, is not always desirable … Depending on risk appetite and limitations

GOODREASONS

DOUBTFULREASONS

WHY TO HEDGE? WHY NOT TO HEDGE?

• Make up for a weak operational performance• Capture "market risk premiums"

• Respect the risk profile expected from investors• Ensure a competitive advantage / avoid a disadvantage

• Support the market guidance• Ensure Management serenity• Avoid cost of financial distress• Enable investments in low cycle periods

• Benefit from upsides• Avoid inefficient or costly hedges• Avoid to hedge unknown / uncertain volumes

• Generate profits from hedges

• Avoid inefficient or costly hedges• Avoid to hedge unknown / uncertain volumes



Specific energy procurement and portfolio management strategies apply to B2C and Industrial & Commercial segments

1) Synthetic load profile 2) Recorded load profile

Procurement of power and gas

DESCRIPTION

CHARACTE-RISTICS

> Households and very small businesses with SLP1)

within own and external grid territory> Small customers with RLP2) in the own grid territory,

which are neither price-sensitive nor fickle

Steady long-term development of the portfolio for the following years

General immediate procurement of the volumes after closing (back-to-back) to secure margins at minimal risk

> (Yet) high inertia of customer base> Volume requirements can be derived from SLP for a

certain time period> Number of customers depends on own price policy in

comparison to competitors

> All RLP customers within external grids as well as larger price-sensitive RLP customers in the own grid

> Massively multi-site small customers, aggregated (e.g., chains of stores)

> Individual contracts with industrial and commercial customers – high range of volumes

> Industry and company-specific volume requirements and load profiles

> High volume risks and low margins

B2B customersB2C customers




In contrast to the B2C segment, B2B offerings may contain multiple flexibility attributes with impact on the company's risk exposureTypical flexibility/ constraint attributes in energy contracts for industrial customers


Before contract signature

Price flexibilities> Fixed price, with or without fixed

component> Total or partial indexation of

contractual price, cap & floor> Different price structures by

predefined periods> Capture of average market price on a

pre-defined period of time

> Total or partial indexation of delivery price, cap & floor– Electricity, gas, oil, coal– Other commodities or indices

> Stop-loss option : Money given to customer if market price goes down

Volume flexibilities> Full supply> Partial supply (especially blocks)

> Take or pay contracts> Volume increase or decrease, with or

without penalties> Interruptibility option at supplier's

hand (peak shaving of customer or aggregated supplier's load curve)

> Consumption forecast to reduce balancing penalties

> For a multi site offer: Addition or withdrawal of sites

Term flexibilities> Flash offers over a defined period> Extension of price validity duration> Long-term commitment (5 years or

more)

> Contract extension option at supplier's hand (against lower price for the prompt period)

> Contract extension option at hand of the customer

> Early termination option at hand of supplier or customer

During contract delivery period



The definition of relevant risk indicators does not require pure mathematics but even more common sense and creativity

FINANCIAL IMPACT

RISK SCOPE

PORTFOLIO SCOPE

OBJECTIVES

Relevant market risks indicators

1

2

3

> Price and/or volume> Single or multiple commodities

> P&L (gross margin, EBITDA, Net Result)> Balance sheet> Cash

> Operational decision support> Risk control> Financial performance management> Financial communication

> Contracted vs. non-contracted positions> Statistical modeling> Timeline

5

4

Definition of risk indicators

DEVIATION TYPE

> Mark to market/ mark to model value> Small deviation (sensitivity)> Statistical deviation (E@R, V@R,

P&Lx%...)> Stress tests and scenarios

4


RISK CONTROL / Risk indicators & dashboards


The proper implementation of risk management involves several mutually reinforcing dimensions

Governance & organization

Risk managementInfrastructure

Skills

Processes &procedures

Risk reporting

IT tools

Risk policy

3

4

1

2

5

6

Overview


5 INFRASTRUCTURE


Risk governance principles come from financial best practices 1) and are fully applicable to Utilities

2 Implication of Senior Management

Rationale: Place risk management close to shareholders risk / return aspirations and avoid making risk control become an experts reserved domain

1 Separation between exposure management and risk control

Rationale: Avoid major losses due to possible human flaw

3 Mark to market valuation of transactions and use of official market price references for risk measurement and investment decisions

Rationale: Account reliably for structural decisions (budgeting and investment)

4

Usage of proper risk indicators to ensure objective, exhaustive, consistent and reliable measurement

Rationale: Capture all the risks to estimate properly decisions and control

5 Promotion of enforceability of risk management through the company

Rationale: Involve all entities within the company (Finance, BU management, operational staff) to create awareness

Risk governance best practices

1) Twenty recommendations of the "Group of Thirty" in 1993

5 INFRASTRUCTURE: Governance

26METI_energy_markets_seminar_14062018_VF.pptx 26

The market risks control framework rely on a steering control entity at corporate level, relayed by entities at operational level

Typical risk control organization

Board of Directors

CEO

CFO CRO

BU #1

BackFrontMiddle

Shareholders

Corporate risk oversight

Business unit risk management

CommitteeDirect reportingFunctional reporting

• A market risks control entity should be set up at corporate level to steer the implementation of the market risks management organization and to look after the correct application of the defined governance principles

• It can either be independent, in charge of market risks control or attached to the internal control entity

• Additional local risk control entities can be created at operational level if needed (e.g. : in case of a specific activity)

• Meanwhile, because of possible conflict of interests, the independence between control and operational activities should always been abided by



The root of all evil: bonuses!

Source: Survey, Roland Berger analysis

Key findings

• Most companies have metric- based bonuses, but with a discretionary component

• Most companies compensations are based on a combination of company and individual performance

• Some companies identify individual behavior as a factor in bonus calculation

• Most companies allocate between 0.5% and 15% of GM as bonus pool

Share of bonus pool in gross margin - Benchmark of energy traders

0%

Player 7

Player 8

5%

5%

Player 5

Player 6

4%

Player 4 5%

Player 3 7%

Player 2 15%

Player 1 30%

Bonus pool policy for energy traders



The energy risk policy sets the framework for market risks management and is shared between organization, management and shareholders

Table of contents of the client market risk policyKey principles for a market risk policy

• A risk policy is:– not a buy / sell strategy document– a normative document that:

- helps integration of risk management into the operations by giving them a qualitative and quantitative framework

- defines the control framework

• Other guidelines documents can be found in the company, such as:– Hedging policy / strategies description– Pricing policy– Offerings / products policy...– ...

• The risk policy is a document that must not be reserved to a specific group (e.g. shareholders or Front Offices…) but must be shared and acknowledged at all levels of the company

1. Risk management objectives, scope & stakes– Financial magnitudes and corresponding risk management goals– Commodities addressed (Gas, electricity, fuel, etc.)– Time horizons– Business Units / subsidiaries concerned

2. Risk identification– Characterization of the portfolio risks– Qualification of these risks

3. Risk governance– Governance principles (segregation of duties, risk committees…)– Organization

4. Risk management principles– General management principles– Discretionary risks vs. minimum exposure (risk profile)

5. Risk measurement & control– Indicators & reporting– Control processes: limits exceeding, etc...

Appendixes: Risk limits, Authorized instruments & products, risk committee composition, risk reporting, control procedures…


5 INFRASTRUCTURE: Policy


Ten questions to challenge your position

6. Do we have a proper risk governance / organization in place?

7. Do we have the proper skills and resources to manage and control our risks?

8. Do we measure and consolidateour risks? with relevant indicatorsand limits?

9. Do we have proper risk policiesthroughout the company?

10. Are our executives on board?

1. What risks are we exposed to? Today and in the future?

2. Which are the ones that can bemanaged? with which levers?

3. Which are the ones that weshould hedge? why?

4. Do we have clarity on P&L responsibilities and transfers?

5. What is our desired level of financial predictibility?

Contact:Denis Depoux, Head of Global Energy Competence [email protected] / + 86 137 88 99 32 72 (Asia)

[email protected] / +81 (3) 358 76-683 (Japan)[email protected] / + 33 6 72 51 32 85 (Europe)

ready for energy market risks? · portfolio management and trading help structure and manage risks...

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