Mark to market tensions

It is now a decade since the collapse of Enron and the rapid demise of its US marketing and trading company peers. One of the key developments from the fall out of the Enron crisis has been the evolution of a more rigorous approach to energy company risk management. Recognition of ‘modelled’ as opposed to ‘market’ value is a practice that is now much more closely scrutinised by risk managers. However issues remain today around how to effectively mark to market more complex and illiquid structured energy exposures such as those of power tolling contracts and flexible gas supply agreements.

April 2, 2012

It is now a decade since the collapse of Enron and the rapid demise of its US marketing and trading company peers.  One of the key developments from the fall out of the Enron crisis has been the evolution of a more rigorous approach to energy company risk management.    Recognition of ‘modelled’ as opposed to ‘market’ value is a practice that is now much more closely scrutinised by risk managers.   However issues remain today around how to effectively mark to market (MtM) more complex and illiquid structured energy exposures such as those of power tolling contracts and flexible gas supply agreements.

MtM challenges

Liquidity in European power and gas markets has progressed to the point that marking flat commodity exposures to market within the forward curve horizon is a relatively straightforward and universally accepted task.  But life is more complicated with flexible and longer term exposures.  Traditionally the value of these contracts has been dealt with on an accrual rather than a MtM basis (i.e. not recognising value until it is realised).  While more complex to implement, focusing on fair market value via a MtM approach is much more informative for managing risk.

The simplest approach for MtM of complex exposures is to focus on a strict definition of the intrinsic value that can be hedged against forward prices.  But this is likely to significantly underestimate the value of a flexible contract.   For example, in the current weak spark spread environment, a tolling contract on a CCGT plant has a similar exposure to a strip of ‘at the money’ options on the forward spark spread.  There is very little intrinsic value that can be hedged in the market but the tolling contract has significant value from a flexibility to respond to increases in the spark spread (extrinsic value).  The key driver of this flexibility (extrinsic) value is forward spark spread volatility, a parameter which is not easily observable in the market.  But ignoring extrinsic value in the MtM calculation will significantly underestimate the value and risk associated with the tolling contract.

The fact that MtM of extrinsic value is difficult is not a reason to walk away from it.  Market benchmarks for volatility and the value of flexibility are available and increasingly transparent. For example in the gas market the liquidity of traded options has increased significantly in the last year, increasing the validity of volatility implied from traded options prices (as we explore in next week’s article). 

Value drivers such as spread correlations and power volatility are more difficult to observe in the market.  However as long as a transparent valuation methodology is adopted to calculate these parameters, based on as much market information as is available, it is likely to be more effective than ignoring their impact on contract value.

A healthy tension

There is an inherent tension in energy companies between market facing commercial functions (traders and originators) and the risk and middle office functions tasked with reporting an independent assessment of value and risk.  Traders and originators are often frustrated by conservative valuations, slow validation of methodologies and a less acute commercial acumen.  Risk and middle office managers on the other hand can be hampered by a lack of transparency around market pricing and clear incentives for traders to inflate value.

The challenges in implementing MtM on more complex exposures is a common flashpoint for this tension between commercial and control functions.  A risk manager is likely to be justifiably cautious in recognising value that is complex and not easily valued against market prices.  But a simplistic approach to MtM which is conservative from a risk control perspective, is likely to destroy the incentives for traders and originators to innovate in creating value from more complex contracts.

As long as it is managed effectively, the tension between commercial and control functions can make a very constructive contribution to the evolution of a company’s understanding of market value and risk.  The table below sets out a few key principles behind the successful management of the trading/risk relationship with respect to MtM:

Table 1: Principles behind a healthy tension over MtM

Principles

Description

 

Balance

Strong and balanced relationship between function heads (e.g. Chief Risk Officer vs Trading Director)

Authority

Clarity around delegation of authority (e.g. MtM parameter sign off, dispute resolution)

Onus of proof

An onus of proof on the trading desk to demonstrate ‘bankable’ market value

Skills/resources

A risk control function with the skills/resources to efficiently challenge and validate market value

Dispute process

An effective dispute escalation process with arbitration driven by the senior management of both functions

Resolution forum

Empowered forum for senior management resolution of complex issues (e.g. a Risk Management Committee with ‘C level’ representation)

Effective incentives

Minimising the incentives for traders to distort market value (specifically in relation to performance measurement and remuneration)

 

As a result of the catastrophic risk management failings of the financial crisis, investment banks are taking some interesting steps to increase the effectiveness of the relationship between traders and risk managers.  One important change is that a stint in a risk management role is increasingly seen as a pre-requisite for promotion to senior management (e.g. Deutsche, Goldmans).  This cross seeding of skills, experience and perspective is likely to be equally valuable in effectively managing the trading/ risk tension within energy companies.  If a company’s traders scoff at the idea of spending some time in a risk management role, it is probably a good sign that some work is required to restore the balance between these functions.

Relevant Articles:

Energy risk management: the demise of Value at Risk?

Robust analysis of energy asset value and risk