The evolution of risk capital allocation in energy companies

11 Jun, 2012

The following article was published in the May 2012 edition of Energy Risk magazine.

The fallout from the financial crisis has seen a fundamental shift in the attitude of energy companies to their balance sheets.  Investment and expansion has given way to capital constraints, asset divestment and a refocusing on core business as the harsh realities of an ongoing balance sheet recession have set in. 

This environment is also driving a renewed focus on the approach that energy companies take to defining and allocating the capital required to support their risk exposures.  Concern about risk capital allocation is being driven internally by pressure on company balance sheets, but also increasingly by the scrutiny of shareholders, lenders and regulators. 

The key principle behind risk capital allocation is to ensure that risk exposure incurred by a company is backed by capital to support ‘worst case’ losses.  As with many areas of energy risk management, the principles behind risk capital allocation have been derived from financial markets.  But extending the banking approach to energy companies can be difficult, given complexity around structural physical asset exposures such as those from power stations, gas production assets and retail customers.

An energy company’s approach to risk capital allocation is specific to its business model and portfolio of assets.  But the key challenge common to all companies is the translation of risk appetite and capital allocation at a Board level into a cohesive framework that empowers individuals across the company to take on risk within clearly defined constraints.  Effective risk capital allocation can be a pillar of a company’s risk management system as well as a powerful tool for measuring risk adjusted performance and allocating resources across its business activities.

Risk capital allocation must come from the top

The keystone of a company’s risk management strategy is a clear signal of risk appetite from the Board.  In defining risk appetite, the Board is constrained both by company balance sheet capacity and shareholder tolerance for earnings volatility.  Risk capital allocation is a mechanism for ensuring that the Board’s management of capital constraints is reflected in a company’s risk taking activity.  It is about making balance sheet management the problem of individual decision makers across the company.

Effective implementation of Board level risk appetite relies on a consistent methodology for the quantification of risk exposures and a cohesive limits structure to govern risk taking activity.  The allocation of risk capital ensures that a company’s risk limit structure is supported by adequate balance sheet capacity to withstand a ‘worst case’ outcome.  Although capital should be allocated to support all risk exposures, market risk and credit risk are particularly important, given the potential for more extreme market driven fluctuations in these risk categories. 

Energy companies typically use their existing limit structure and risk measurement methodology to drive risk capital allocation.  While this is sensible in principle, limit structures within business units have often evolved organically rather than being implemented consistently from a Board level down.  So mechanistically overlaying risk capital allocation on an existing limit structure can lead to a disconnection between the higher level portfolio allocation of risk capacity (e.g. via portfolio level risk limits) and allocation at a working level (e.g. via limits on individual trading book exposures).

The key to success is ensuring that a clear signal of risk appetite from the Board is reflected in a consistent framework of risk limits which is backed by the allocation of risk capital.  This should in turn drive a flow of information from within the business on utilisation of risk capacity and the performance of allocated capital as illustrated in Diagram 1.  This approach can be cloned to drive the cascading allocation of risk capacity at a sub business unit level. 

Diagram 1: Risk capital allocation cycle

Portfolio level allocation

There are specific challenges with risk capital allocation that relate to the structure of energy company portfolios.  Energy portfolios typically consist of two types of risk exposure:

(i)            Structural physical asset exposures (e.g. production assets, retail customers)

(ii)          More liquid trading exposures which usually relate to the hedging and optimisation of structural assets.

For most energy companies, structural asset exposures dominate trading exposures.  So portfolio risk tends to be best governed using a measurement focused on potential earnings deviation over a forecast horizon, for example ‘Earnings at Risk’ (EaR).

Risk around trading exposures may be small in comparison to structural exposures, but these exposures can inflict substantial losses over a short period of time as a result of volatile market prices.  This means trading exposures are particularly important from a capital allocation perspective.

Risk capital allocation to support trading exposures is focused on ensuring that there is liquid capital set aside to back worst case losses.  Risk around trading exposures is typically governed using ‘Value at Risk’ (VaR) as a measure of the ‘worst case’ loss that could be incurred before exposures can be closed out within a specified holding period (e.g. 5 days).  So VaR is also commonly used to drive risk capital allocation, although there are some key issues to consider when using VaR which are summarised in Table 1.  

Capital also needs to be managed to support the risk around structural asset exposures, although this tends to be done in the context of decisions around asset investment and portfolio diversification.  The balance sheet threat from structural asset exposures is typically driven by portfolio earnings deviation rather than losses over a short holding period.  As a result structural exposures can be backed by a broader range of capital based on a measurement of potential earnings deviation over a forecast horizon (e.g. using EaR).

Table 1: 5 considerations when using VaR to drive business unit risk capital allocation:

 

  1. Short term focus: The use of VaR is limited to allocating risk capital against losses from trading exposures over a short term holding period horizon. It is not well suited to understanding longer term capital requirements around structural asset exposures.
  2. Clean exposure definition: VaR focuses on the risk of loss before exposures can be closed out in the market.  For this to be meaningful it relies on a clean market based mechanism for the transfer of exposures from Asset business units to Trading.
  3. Liquidity: Use of VaR assumes exposure liquidity over a specified holding period.  Energy portfolios are often rich with complex illiquid exposures that can compromise this liquidity assumption.
  4. Worst case loss: VaR can be a poor measure of worst case loss, particularly given the behaviour of energy prices.  It is prudent to use a buffer (e.g. a multiple of VaR) and alternative metrics (e.g. stress tests) to challenge or complement VaR.
  5. Subdivision: Subdivision of VaR capacity facilitates cascading risk capital allocation.  But this needs to be done carefully, e.g. appropriately accounting for correlations that may break down under conditions of market stress.

 

 Allocation down into business units

Some key challenges with risk capital allocation arise when it comes to the allocation of portfolio level risk capacity down into business units.  Issues are specific to a company’s business model, but an effective risk measurement and limit structure are key conditions for success. 

Since the quantification of risk capital is tied to the metric used to measure and limit risk (e.g. VaR), risk capital allocation needs to be supported by a transparent risk limit structure that subdivides portfolio level risk capacity and cascades it down into company business units. 

Equally important is the clear definition of ownership of risk exposures across business units.  Energy company business models typically consist of a single market facing ‘Trading’ business unit and a number of ‘Asset’ based business units (e.g. retail, generation, production).  Exposures within the liquid forward curve horizon are transferred from the Assets to Trading for hedging and optimisation in the market.  What is critical for effective risk capital allocation is a market based exposure transfer mechanism that cleanly separates trading exposures from the underlying structural asset exposures.

For example power exposures from a Retail business unit can be transferred to the Trading business unit using a rolling profile based on seasonal forward contracts.  To the extent that the Trading function does not close out the transferred exposure in the forward market, it requires risk capital to support potential losses.  The risk capital requirement can be quantified based on the worst case loss (e.g. VaR) of the net of the transferred Retail exposure and any hedging contracts entered into by Trading. In parallel, risk around structural exposures in the Retail business unit can be measured using EaR.

Charging for risk capital

There is a cost in allocating balance sheet capacity for risk capital purposes, given that capital set aside in liquid assets could be invested to earn a higher return elsewhere.  Explicitly recognising the cost of risk capital facilitates the efficient allocation of company resources.

Once the cost of risk capital has been quantified it seems like a natural step to charge business areas for their risk capital requirements.  This approach is common in banks and has been extended to some energy companies with a trading focus.

However charging for risk capital is not a precondition for an effective allocation framework. What is important is that the cost of risk capital is reflected in business decision making, performance measurement and incentivisation.  Often in energy companies it makes more sense to use implicit drivers such as KPIs focused on risk adjusted performance measures.

Charging for risk capital can work well in incentivising behaviour around speculative trading of liquid exposures. But there are some key issues with implementing an effective charging structure for the more complex structural asset exposures in energy portfolios.

Take for example a Trading function that manages the hedging and optimisation of an integrated power portfolio covering retail load and generation.  There are a number of risk exposures in this portfolio, such as those from customer load variability and generation outages, that the Trading function may be best placed to manage, but that it cannot easily close out in the market.  While it is appropriate that these exposures are backed by risk capital, charging for that risk capital can introduce perverse incentives.

Risk adjusted performance

Understanding the capital implications of risk taking activity at a business unit level enables a powerful insight into a company’s performance on a risk adjusted basis.  Traditional measures of capital return such as Return on Equity (RoE) can only be applied at a company-wide level.   But the allocation of risk capital to specific activities facilitates a more meaningful understanding of risk adjusted performance at a sub business unit level.

A metric such as Return on Risk Adjusted Capital (RORAC) can be used to measure the return on a trading book adjusted for the amount and cost of risk capital incurred.  For example, RORAC enables a comparison of the performance across a retail hedging book, a structured gas trading book and a multi-asset proprietary trading book, despite variations in exposure complexity and risk.  This provides a powerful lens through which to focus strategic decisions on allocation of a company’s resources.

The financial crisis is driving an increasing awareness of constraints around balance sheet capacity.  An effective risk capital allocation framework connects a company’s risk governance structure with the balance sheet capacity required to support it.  It also drives a stronger understanding of risk adjusted performance, which in a capital constrained environment can be a clear competitive advantage.  Balance sheet management is ultimately the responsibility of the Board.  But the surest sign of success is the transformation of capital allocation from a Boardroom topic to a factor driving everyday business decision making.

Relevant articles:

Preparing your business for a eurozone breakup?

The credit risk implications of a eurozone breakup

Structured energy contracts and VaR

Energy risk management: the demise of VaR?