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<span style="text-transform: uppercase"><font size="6"><b><br>
So what exactly is risk management?</b></font></span></p>
<font FACE="Arial-ItalicMT" SIZE="3"><i>
<p ALIGN="LEFT">By Paul Wielgus, Managing Director, GDS Associates, Inc.</i></font><span style="color: black"><font size="2"><br>
</font></span><font size="2">(<em>originally published by PMA OnLine Magazine:
May 21, 2006</em>)<br>
<br>
<a href="So%20What%20Exactly%20is%20Risk%20Mgmt.pdf">Download Article in
Adobe PDF</a></font><br>
</p>
<font SIZE="3">
<p ALIGN="LEFT">Buyers, sellers, and others in the energy business need to
understand the risks in this very uncertain environment in order to
maintain their responsibility to their stakeholders and to protect their
bottom line. Organizations can achieve their goals and objectives in this
uncertain business environment by developing a comprehensive risk
management program. At GDS, we understand that risk management is more
than energy price management, more than regulatory compliance, and that
each client faces a unique set of challenges and risks. To fully
understand and mitigate the risks that can affect your business and your
cost structure, your leadership team must have a complete view of
these exposures.</p>
</font><font SIZE="4">
<p ALIGN="LEFT">At Risk<b><i><br>
</i></b></font><font SIZE="3">One does not have to wait long during a
conversation with others involved in the power industry to hear the word
<b>"risk" </b>or the phrase <b>"risk management</b>.<b>" </b>Many of us
have a general idea of what the words risk management mean, but how they
can impact your organization may not be so obvious. </p>
<p ALIGN="LEFT">With a great deal of attention being paid to the area of
risk management, it is easy to become overwhelmed or confused about what
it really means. A lot us focus that attention to managing or fixing the
price of our power and or fuel, kind of the trading model definition. <i>
So, what exactly is Risk Management? </i>A simple way to define risk
management is: <i><b>The process of identifying, evaluating, and
mitigating the risks that threaten the strategic and financial goals of
your business.</p>
</b></i>
<p ALIGN="LEFT">Every business is vulnerable to a wide array of risks that
may or may not be specific to its particular industry, although only some
choose to actively acknowledge and address those risks in an attempt to
reduce exposure to them. Since the power industry is an inherently risky
one, the focus on risk management will only continue to increase as a
response. In our business, risks can be identified in virtually all
segments of the power supply industry, not just that risk associated with
the price of our power or fuels. These segments and can be divided more
simply into the three general categories: <b>1) supply side; 2) demand
side; </b>and <b>3) business-related. <br>
<br>
</b>Effective risk management encourages decision-makers to examine their
business process across the board to identify the various risks that can
affect it, and to begin thinking about how the exposure to these risks can
be best mitigated or minimized.</p>
</font><font SIZE="4"><i>
<p ALIGN="LEFT">At Risk...</i>Supply-Side<br>
</font><font SIZE="3" COLOR="#202020">Supply-side risks generally fall
under one of the following four categories: 1) generation; 2) market; 3)
transmission; and 4) counterparty.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Generation<br>
</b></font><font SIZE="3" COLOR="#202020">You may be an owner in a power
plant or you may buy power under a unit purchase agreement tied to a
particular resource. Regardless, you could be confronted with several
potentially costly risks. These risks and associated potential costs can
arise during the construction phase of a project if you are involved
during that time, or during the operational period.</p>
<p ALIGN="LEFT">As with any construction project, the biggest risk is the
project's schedule being delayed or extended. In most cases, a delayed
schedule results in an increase of interest-duringconstruction, and most
likely further increases in the capital costs. If the schedule is delayed
too long and the expected commercial operational date or COD is missed,
the delay could force an owner to go to the market and purchase
replacement power, most likely at a price different than what was planned.
And if higher than planned, the costs can be very unfavorable.</p>
<p ALIGN="LEFT">Delays during the construction phase of a project can
arise from any number of potential problems. Some major ones include;
unforeseen environmental issues related to permitting and siting, problems
with the interconnection and supply of fuel, transmission service and
interconnection, water, performance issues related to the contractor, and
operating problems with the plant itself during commissioning<b>. </b>The
adage, </font><i><font SIZE="3" COLOR="#202020">�Time is money," </font>
</i><font SIZE="3" COLOR="#202020">is especially true during the
construction phase of a power project, and virtually all of these risks
are inherent to the construction phase of any generation resource.
However, with proper management and well thought out contingency plans,
these risks can be properly measured and mitigated, thereby reducing the
likelihood of unforeseen and especially unfavorable consequences.</p>
<p ALIGN="LEFT">Once the unit is operational, the owner must contend with
unscheduled outages, the risk of day-to-day operations, unforeseen capital
expenditures, and possible accidents. There is also the risk of
technological obsolescence of an owned generating plant resulting in lost
opportunity for cheaper alternatives. Long-term water and fuel supply
arrangements are typically settled prior to the operational start date,
but there is always the risk of the supply being temporarily interrupted
due to pipeline or other transportation problems, or even force majeure.
Here again, with proper management and well thought out contingency plans,
these risks can be properly measured and mitigated.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Market Prices<br>
</b></font><font SIZE="3" COLOR="#202020">There are aspects of buying or
generating power that are always in a state of change. The market prices
of fuel and power are good examples of this. The exposure to fuel and
power price volatility is the most significant supply-side risk faced by
most participants in this market. In the past few years, we have seen
tremendous increases in the cost of natural gas, and we�ve seen almost the
same in increases in the cost of coal, not to mention the issues of coal
transported by rail. The price of fuel is driven by many factors: the
balance of supply and demand, industry production capacity, storage
levels, market dynamics, as well as others. These factors all contribute
to the risk associated with supplying fuel for power plants. Market prices
for power are similarly driven by supply and demand, the cost of fuel both
today and in the future, and transmission and congestion issues.</p>
<p ALIGN="LEFT">Diversifying your generation portfolio with various fuel
types, suppliers, and geographic locations are natural hedges to fuel and
power market risks. Other tools to mitigate your risk exposure, or hedge
your position, include a wide array of financial products that are
available in the marketplace. The use of futures and forwards can lock in
a set price of fuel or power for several years if you desire.
Additionally, many financial counterparties are willing to provide you
with collars or swaps that also provide more certainty about the cost you
will pay for fuel or power in the future. The fundamental idea is to adopt
a longterm resource planning and evaluation process that will lead you to
a well thought out, more diversified and secure power supply portfolio in
the long run.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Transmission & Market Design</b></font><font SIZE="3" COLOR="#202020"><br>
Transmission issues are huge in today's transmission-constrained power
supply environment. In many markets today, it is difficult if not
impossible, to obtain long term firm transmission service. Transmission
access and pricing may be the most unfamiliar area to many in the
industry, almost viewed as a �black box� by some, so it can pose a serious
risk to your ability to provide reliable low cost power. Without a way to
deliver the power to the load, your issues can begin to compound.</p>
<p ALIGN="LEFT">During the planning and construction phase of a power
project, most transmission issues such as routing and siting,
environmental regulations, or landowner and citizen opposition, are
identified and need addressing. However, it is during the operational
phase that a fair number of risks can become apparent. For example, there
are risks associated with the variable rates and penalties associated with
ancillary services and transmission scheduling. </p>
<p ALIGN="LEFT">Congestion costs may be the driver for many problems and
concerns in the future as new market designs attempt to more directly
assign costs. New transmission lines can be built, but the process is a
long and costly one. Ultimately, taking an active role in this challenging
activity, understanding where the risks may be that could affect your
supply, and planning on contingencies can help mitigate a large portion of
the risk.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Counterparty<br>
</b></font><font SIZE="3" COLOR="#202020">The question of counterparty
reliability and accountability has become a major issue since Enron�s
collapse in late 2001. The importance of dealing with strong, creditworthy
counterparties is critical when you are involved in a shared ownership
position of a plant, or when you are a party to a power purchase agreement
with a supplier. By conducting credit analyses and factoring such analyses
into your decision criteria when choosing a counterparty, you may not
entirely eliminate, but can significantly reduce your exposure to
counterparty risks. It is fundamental to understand exactly who your
counterparty is and the long-term viability of that counterparty before
entering into any power supply arrangement�<b>no matter how good the price
may seem</b>. Proper financial analysis of a counterparty can be an
involved and detailed step in the process of supplying/buying power, but a
necessary one when you are trying to ensure low-cost and reliable power to
your customers. Not only should this be looked at prior to entering a
deal, but should be monitored during the deal.</p>
</font><font SIZE="4">
<p ALIGN="LEFT">At Risk�Demand-Side<br>
</font><font SIZE="3" COLOR="#202020">Demand-side risks can fall under one
of two categories: 1) Forecasting; or 2) Load.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Forecasting<br>
</b></font><font SIZE="3" COLOR="#202020">One of the first tasks of power
supply planning is determining how much energy and capacity will be
required in future years. After all, you need to have a very good idea of
your power supply needs to effectively search for a way to meet them. This
is why a load forecast can be so critical to both the administration of a
well-balanced portfolio of power supply resources and the creation of a
comprehensive risk management strategy. There is the risk of being long or
short in physical energy.</p>
<p ALIGN="LEFT">The accuracy of a peak demand and/or energy sales forecast
generally depends upon two primary factors: 1) the ability to quantify the
impacts of influential variables on power requirements, and 2) the skill
to project changes in these key influential variables (e.g. economic
outlook, weather conditions) over the forecast horizon. A base case
forecast typically presents the load and energy projections corresponding
to the expected, or most probable, outcomes of the key influential
variables. Of course, it is inevitable that future changes in the factors
that influence power requirements will deviate to some degree from what
was assumed when the load forecast was prepared. Therefore, it can be best
to develop forecast ranges that address high and low range scenarios. <br>
<br>
Range forecasts are useful for providing power requirement estimates for
extreme or specific market influences. However, range forecasts do not
necessarily provide probabilities for a range of projected power
requirements outcomes. Software tools available today provide the means
for developing probabilistic forecasts, where probabilities can be
assigned to a distribution of projected load and energy values. The power
supply planning is enhanced tremendously when the load forecast can be
presented as a probability distribution rather than as a series of
single-point projections for each time period in the forecast horizon. The
use of probability analysis is highly recommended and a key tool in the
risk management process.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Load<br>
</b></font><font SIZE="3" COLOR="#202020">Managing the uncertainty of your
load is difficult at best, but that does not mean it is impossible. This
can be a critical aspect of your business and it is important in helping
to achieve your strategic and financial goals.</p>
<p ALIGN="LEFT">In order to mitigate the risk of abnormal loads, it is
important to try to better understand the forces that can cause high
variability. These drivers may include competition, catastrophic events,
industrial activity, or technological issues. Some of these areas can be
very difficult to predict, making it tougher but not impossible to
mitigate such risks in a cost effective manner. Although not always easy,
being up to speed in this area is part of risk management planning,
including catastrophe plans. You may also be able to exploit the savings
from an interruptible product or other demand-side management program
where appropriate. For market participants that are subject to weather
extremes, there are opportunities available to hedge weather risk through
the use of financial hedges that are designed to help protest against this
risk.</p>
</font><b><font SIZE="4">
<p ALIGN="LEFT">At Risk�Fundamental Business Risks<br>
</font></b><font SIZE="3" COLOR="#202020">Fundamental business risks fall
under one of the following categories: 1) Regulation; 2) Financing; or 3)
Management.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Regulation<br>
</b></font><font SIZE="3" COLOR="#202020">As seen over the last several
years, the structure of the utility business and the regulation that
governs it is one of constant change. Regulation ranges from the Federal
Energy Regulatory Committee (FERC) or the Rural Utilities Service (RUS) at
the federal level, to the EPA of �05, to Independent System Operators like
ERCOT, Security Coordinators, Regional Transmission Organizations, Public
Utilities Commissions at the state level, and even city and county
governments at the local level. The sheer number of regulatory agencies,
coupled with the uncertainty and magnitude of potential requirements that
may be placed upon your business by these agencies, only increases the
need to understand the regulatory risks faced by our industry today.
Changes in the authority level of regulatory agencies, the time and
resources required for litigation, new environmental and nuclear
regulations, and market design and restructuring are only a few of the
major regulatory risks that should be of concern. Staying abreast of the
legislation and proceedings and getting involved with these agencies can
be expensive and time consuming, not to mention seemingly fruitless at
times as proposed changes come and go. Involvement with working groups or
panels can be an effective way in ensuring your position is well
represented, as well as gaining as much advance notice of potential
regulatory risks that may affect your business.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Financing<br>
</b></font><font SIZE="3" COLOR="#202020">Every business needs to borrow
money at some point in time, especially if you are on the supply side of
this business. Regardless of the purpose, you will desire to obtain
financing under the most favorable terms and conditions possible. This is
often hard to ensure, particularly because of the fluctuation in interest
rates and the demands on the market for money. It is impossible to know
whether rates will get better or worse in the future, so a balanced,
diversified portfolio of borrowing instruments often produces the most
favorable results over time. Furthermore, due to the recent uncertainty in
the energy industry, lending institutions are becoming more selective of
which entities they lend money. Lenders are now performing more rigorous
risk analyses on a borrower's financial condition to determine the
long-term viability of the borrower or project and the ability to meet
debt service payments. Equity requirements and debt covenants are also
becoming far more stringent than they have been in years past. Basically,
they�re doing their own risk management.</p>
<p ALIGN="LEFT">Once the decision to obtain financing has been made, it is
important to conduct "what if" scenarios to study what the impact of
unexpected events could have on your business, as well as to understand if
your business has the potential for financial distress. Ultimately,
maintaining strong financials through proper rate structure and strong
liquidity and equity levels are essential to ensuring the availability of
low-cost financing for your organization in the future.</p>
</font><font SIZE="3"><b>
<p ALIGN="LEFT">Management<br>
</b></font><font SIZE="3" COLOR="#202020">The makeup of an organization
can arguably be the most important factor in successfully operating a
business. Integrating and processing all of the various operational inputs
from your business to formulate a reliable and cost-effective power supply
portfolio is more than a challenge. Human capital and the aging of the
experienced work force is a topic much discussed today. By taking a
systematic approach to your business operations through better
understanding the drivers that cause change in your business, and through
the corresponding implementation of a comprehensive risk management
strategy, managers can take fundamental actions that can help mitigate
more effectively the risks associated with their business and have less
exposure to management and people issues. Turn in the human capital can be
offset by having a well developed process that can be somewhat immune from
having to rely on institutional knowledge of seasoned managers.
Additionally, creating management policies and controls that administer
and measure your organization's performance can be advantageous to the
ongoing success of your business.</p>
</font><font SIZE="4"><b>
<p ALIGN="LEFT">Conclusion<br>
</b></font><font SIZE="3" COLOR="#202020">It is clear that we are facing
challenges and uncertainty like never before. With that said, there is no
one "right way" to apply risk management principals to a business, or
silver bullet solution that will protect any of us from uncertainty.
Entity risk management is rather a methodology or approach that helps
identify risks to your business, evaluate the potential negative impact
those risks may have on your business, and create solutions to mitigate
the potential damage. With new challenges, often new tools can be
extremely helpful. We've summarized this suggested new approach below:</p>
</font><b>
<p ALIGN="LEFT">Risk Management Framework</p>
<font SIZE="3">
<p ALIGN="LEFT">1. </font><font SIZE="3" COLOR="#202020">Determine risk
profile<br>
</font><font SIZE="3">� Risk exposures and tolerance<br>
</font></b><font SIZE="3">� Identify � Evaluate � Mitigate</p>
</font><b><font SIZE="3">
<p ALIGN="LEFT">2. </font><font SIZE="3" COLOR="#202020">Define program of
clear goals and objectives<br>
</font><font SIZE="3">� Strategic<br>
� Financial</p>
<p ALIGN="LEFT">3. </font><font SIZE="3" COLOR="#202020">Develop
comprehensive risk management strategy and tools</p>
</font><font SIZE="3">
<p ALIGN="LEFT">4. </font><font SIZE="3" COLOR="#202020">Implement
appropriate controls and support systems<br>
</font></b><font SIZE="3" COLOR="#202020">It is easy to feel overwhelmed
by the variety and magnitude of risks that affect the supply of reliable
and economic power. These risks may not all apply to you and your
situation directly, but these risks are faced by some entity in the supply
chain of power. While completely protecting yourself is virtually
impossible, relying on a risk management framework is certainly the next
best thing. </font><b><font SIZE="3" COLOR="#202020">Without it, you don't
really know how much you don't know. </font></b>
<font SIZE="3" COLOR="#202020">This proactive stance is carried out by
first determining your risk profile and then by developing and
implementing a comprehensive risk management plan. </font><b>
<font SIZE="3" COLOR="#202020">By utilizing a risk management framework,
you will be best positioned to reliably serve your needs or your
customers� needs at a lower cost of service and greatly reduced price
volatility.</p>
</font></b><font SIZE="3">
<p ALIGN="LEFT">The GDS approach to designing risk management programs
incorporates quantitative and qualitative techniques to capture, assess,
measure, and mitigate the risks that can impact a business's strategic and
financial objectives, along with its operations, and ultimately the bottom
line. For more information about GDS and its Risk Management Services,
contact Paul Wielgus, Managing Director at the numbers below and visit <b>
<a href="http://www.gdsassociates.com">www.gdsassociates.com</a></b>.</p>
</font><font SIZE="2"><b>
<p ALIGN="LEFT">Paul Wielgus </b>- Managing Director<br>
<b>GDS Associates, Inc.<br>
</b>1850 Parkway Place, Suite 800<br>
Marietta, GA 30067<br>
phone 770.425.8100 | fax 770.426.0303 | cell 281-797-8799<br>
</font><font SIZE="2" COLOR="#1b1b1b">
<a href="mailto:[email protected]">
[email protected]</a></p>
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