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<p align="left"><font face="Arial"><strong><small>About The Author:</small></strong></font></p>
<font size="3"><p align="left"></font><font size="2">Jeffrey Frost, a PMTC Senior Partner,
has years of experience as a banking treasury executive, trading room technology
innovator, and Internet electronic commerce pioneer. </font></p>
<p align="left"><font size="2">While Jeffrey's prior executive and entrepreneurial roles
have demanded numerous skills, much of his career has revolved around one simple theme:
The use of new computing technologies applied to existing information to create profitable
new business alternatives. </font></p>
<p align="left"><font size="2"><a href="http://www.pmtcweb.com/" target="_blank">The Power
Marketing Technology Consortium</a> is an IT and electronic commerce power marketing
consulting organization which integrates and supports technologies related to energy
trading and marketing.</font></p>
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<p><a href="9902frst.htm#top"><img src="../images/b-t-top.gif" alt="Back To Top" border="0" WIDTH="71" HEIGHT="35"></a></td>
<td width="75%" valign="top"><img src="..\images/techcor2.gif" alt="Technology Corner" align="top" border="0"><p> </p>
<p><b><u>February 1999</u><br>
</b><font size="6"><strong>ENERGY CREDIT RISK SOFTWARE</strong></font></p>
<font size="6"><p></font><font face="Arial" size="3"><strong><a NAME="_Toc442524439">Do
Commercial Systems Provide The Answers Credit Managers Must Have?</a></strong></font></p>
<p><strong>by Jeffrey Frost -- Power Marketing Technology Consortium<br>
</strong><font face="Arial" size="2">(<em>originally published by PMA OnLine Magazine:
99/02</em>)</font></p>
<blockquote>
</blockquote>
<p align="left"><font size="3"><br>
</font></p>
<i><b><font FACE="Arial" SIZE="5"><p></font></b></i><strong><font face="Arial" size="4"><a NAME="_Toc442524440">Background</a></font></strong></p>
<p><font face="Arial">The commercial software systems referred to here are those designed
for Risk Management and Trade Processing (RMTP) for the merchant energy business. These
are the systems used by merchant organizations dealing in physical and financial natural
gas and power plus other energy commodities.</font></p>
<p><font face="Arial">The credit risk management portion of systems is of interest here.
There are over forty vendors offering Risk Management and Trade Processing (RMTP) software
applications in the energy market. Most end users are familiar with some of the vendors.
Names like Altra, ARC IT, Axiom, Energy Imperium, Nucleus, Open Link Financial,
Powertrade, Primo, Riskworks, and Transenergy are well known.</font></p>
<p><font face="Arial">This article starts by identifying what credit managers need from
these systems. After summarizing the capabilities energy credit risk managers need from
their systems, there follows a review of what those needs mean in terms of software
issues. In other words, first about the business issues and then the technology issues are
discussed. The final segment briefly discusses specific vendor applications.</font><b></p>
<p ALIGN="left"><font face="Arial" size="4"><a NAME="_Toc442524441">I) IDENTIFY THE NEED</a></font></p>
</b><p><font face="Arial">Just what does a credit manager need from an energy Risk
Management and Trade Processing (RMTP) system? Let us first look at "Measurement of
Credit Exposure" and then "Credit Exposure Monitoring and Control."</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524442">A) Measurement of Credit Exposure</a></font></b></i></p>
<p><font face="Arial">An RMTP application must allow the user to implement his credit
policy in a quantitative manner. The system must unambiguously allow Counterparty X's
limit to be input as a number, whether $5,000 or $50 million. The system must measure
(calculate) the exposure for any given Counterparty X at all times. Measurement of credit
exposure is a complex and evolving issue.</font></p>
<p><font face="Arial">Historically credit risk exposure measurement has included CURRENT
exposure, but not POTENTIAL exposure. Lets look at each of these in turn.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524443">1) Current Exposure Measurement</a></font></b></p>
<p><font face="Arial">CURRENT exposure is the exposure you face if your counterparty
defaults today. It includes A/R plus open positions marked to market. Marking to market
shows what it will take to replace the transaction with a new counterparty, at today's
market prices, in the event of a default. CURRENT exposure is thus the sum of A/R and MTM.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524444">2) Potential Exposure Measurement</a></font></p>
</b><p><font face="Arial">What about POTENTIAL exposure measurement? It was not considered
by many organizations until quite recently. In fact, Fitch Investors Service wrote the
following in their June of 1997 Special Report titled, Managing Credit Risk in the
Electricity Market: "Fitch predicts that the failure and default of some poorly
capitalized entities will result in the increased sensitivity to counterparty credit in
the electric commodity market."</font></p>
<p><font face="Arial">Well they got that one right! Just one year later, June 1998 proved
them right. The majority of losses suffered in June of 1998 were counterparty default
losses, losses that could have been anticipated to a degree by a good POTENTIAL credit
exposure measurement system. So what is meant by POTENTIAL credit exposure? Potential
exposure refers primarily to the exposure that will result if market prices change.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524445">a) CVAR</a></font></b></p>
<p><font face="Arial">CVAR, or Credit Value At Risk, is the most widely used POTENTIAL
exposure measurement methodology. CVAR as the name CREDIT VALUE AT RISK implies is a
measure of POTENTIAL exposure for credit risk. Credit Value At Risk, CVAR, is perhaps best
understood by looking first at the more familiar regular VAR, regular Value At Risk</font></p>
<p><font face="Arial">VAR measures the exposure that will result if market prices change.
More specifically, it measures the expected change in the value of your energy portfolio
in the face of possible market price changes. VAR, you will recall, is an estimate of the
maximum <u><b>expected</b></u> loss, over a given period, for a given percentage of time.
For example, VAR would allow you to state that you are 95% confident that in the next
month you would not lose more than $3.7 million.</font></p>
<p><font face="Arial">There are three major variants of VAR derivation widely in use in
the energy industry today: One is analytic VAR, a.k.a. the variance/covariance approach;
the second is the Monte Carlo or simulation VAR methodology, and the third is historical
VAR. While the experts do widely debate various energy industry VAR refinements and
limitations for each of these two major methodologies, they are nearly universal in their
agreement that VAR is one of the best risk management tools available.</font></p>
<p><font face="Arial">CVAR or credit value at risk is simply the VAR methodology applied
to counterparties for purposes of credit measurement. Note that CVAR requires a separate
set of calculations since CVAR and VAR ARE NOT identical for a given counterparty. You can
visualize the basic difference between VAR and CVAR for yourself.</font></p>
<p><font face="Arial">EXAMPLE. Think about a fixed price, fixed quantity, open purchase
position, due for future delivery. For example, assume that you enter into a contract to
purchase 100 MW of power on a 5x16 basis for the month of March at a price of $25. Assume
further that you have purchased this power without an offsetting sale. You plan to sell
the power into the market at prevailing prices in March. You are long power.</font></p>
<p><font face="Arial">Entering into this single position results in an increase in both
CVAR and VAR. Your VAR modeling will reveal that DECREASING prices increase your VAR risk.
Think about it: You have purchased power at a fixed price (long) and if prices decrease
you will sell it at a loss. Your VAR calculations will reveal this potential outcome as an
increase in VAR resulting from this transaction. Note also that the measurement is of a
potential actual $ dollar loss.</font></p>
<p><font face="Arial">Your CVAR modeling will reveal, in contrast, that INCREASING prices
increase your CVAR risk. Again, think about it: Your counterparty will be selling you
power at $25. Should they default when market prices have risen, the replacement cost will
be larger. When your counterparty replacement cost is larger, you have an increase in
risk. Your CVAR calculations will reveal this potential outcome as an increase in CVAR
resulting from this transaction.</font></p>
<p><font face="Arial">Note that CVAR measures your potential counterparty credit exposure,
NOT a potential actual $ dollar loss. Although the statistical methodology for calculating
CVAR comes directly from VAR, the use of the term Credit Value At Risk can be misleading
because of this difference.</font></p>
<p><font face="Arial">SUMMARIZE. What are the key points about CVAR?</font><ul>
<li><font face="Arial">CVAR is the most widely used POTENTIAL credit exposure measurement.<br>
</font></li>
<li><font face="Arial">A single transaction can increase both VAR and CVAR.<br>
</font></li>
<li><font face="Arial">VAR and CVAR use the same statistical methodology but one measures a
potential $ dollar loss and the other measures a change in counterparty exposure.<br>
</font></li>
<li><font face="Arial">CVAR and VAR require entirely separate sets of calculations by the
application.</font></li>
</ul>
<b><p><font face="Arial" size="4"><a NAME="_Toc442524446">b) Stress Testing and Scenario
Analysis</a></font></b></p>
<p><font face="Arial">Stress Testing and Scenario Analysis are important alternative
POTENTIAL exposure measurement methodologies. They model the change in a measure (e.g. the
change in CVAR) based upon some random shock to a system or some change in underlying
relationships.</font></p>
<p><font face="Arial">The VAR/CVAR interaction is one use of a scenario analysis
capability. It is important to model the interplay between VAR and CVAR under various
hedged and unhedged scenarios. Sometimes a reduction in VAR (market price risk) is
achieved by effectively transferring the risk to increased credit risk, CVAR.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524447">c) Other Potential Exposures</a></font></p>
</b><p><font face="Arial">POTENTIAL exposure refers primarily to the exposure that will
result if market prices change. But there are other types of POTENTIAL exposure as well.
Examples of these other types include: a change in the legal or regulatory environment or
change in the credit worthiness and/or credit rating of a counterparty.</font><b></p>
<p><font face="Arial"><a NAME="_Toc442524448">3) Combined Measurement</a></font></b></p>
<p><font face="Arial">Now lets write a formula for the Combined Measure of Credit
Exposure. The result is A/R + MTM + CVAR (CURRENT plus POTENTIAL exposure).</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524449">a) A/R + MTM + CVAR</a></font></b></p>
<p><font face="Arial">One should reduce this calculated exposure measure by the amount of
any collateral held, yielding the amended: A/R + MTM + CVAR - Collateral equation.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524450">b) (A/R + MTM + CVAR) - Collateral</a></font></p>
</b><p><font face="Arial">This is a measure of exposure in the event a counterparty does
default. For a full risk assessment, not just a worst case, each counterparty's Combined
Measure of credit exposure should be adjusted for its probability of default, shown as
Default Probability on the next line.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524451">c) ((A/R + MTM + CVAR) -
Collateral) X (Default Probability)</a></font></p>
</b><p><font face="Arial">Similarly, if an organization estimates loss recovery rates that
can be expected in a post default situation, the system must be able to apply a factor and
adjust the credit risk exposure calculations. Loss recovery data in this industry is
little used at this time, but at least one software vendor is ready.</font></p>
<b><p><font face="Arial" size="4"><a NAME="_Toc442524452">d) ((A/R + MTM + CVAR) -
Collateral - Loss Recovery) X (Default Probability)</a></font></b></p>
<p><font face="Arial">That completes the Measurement of Credit Exposure discussion. The
second part of Identifying The Need concerns Monitoring and Control issues and will
require a much briefer description.</font><b><i></p>
<p></i><font face="Arial" size="4"><a NAME="_Toc442524453">B) Credit Exposure Monitoring
and Control</a></font><i></p>
</i></b><p><font face="Arial">Exposure Monitoring and Control will be addressed nly from a
systems standpoint, not from an organizational management standpoint. In software systems
terms, Monitoring and Control, boils down to a few essential issues. For example:</font><ul>
<li><font face="Arial">How often are the measurement calculations made, daily or real-time?<br>
</font></li>
<li><font face="Arial">How is user defined data entered?<br>
</font></li>
<li><font face="Arial">Who is alerted to the results of calculations?<br>
</font></li>
<li><font face="Arial">How are users alerted?<br>
</font></li>
<li><font face="Arial">How do users manually override system limits?</font></li>
</ul>
<p><font face="Arial">These issues are partially policy and implementation issues for
management, but each has systems implications as well. There will be more about these
Monitoring and Control issues within the following section on Idealized Applications.</font><b></p>
<p ALIGN="left"><font face="Arial" size="4"><a NAME="_Toc442524454">II) IDEALIZED
APPLICATION</a></font><i></p>
<p></i><font face="Arial" size="4"><a NAME="_Toc442524455">A) Scope</a></font></p>
</b><p><font face="Arial">The application's scope must cover all of them required energy
commodities. This usually means both physical and financial natural gas and power. It may
mean other energy commodities such as coal, natural gas liquids, emissions credits,
transmission, and weather derivatives.</font></p>
<p><font face="Arial">Another scope issue is the tightness of integration across separate
software modules for separate commodities. The various application modules must be
integrated in a manner that allows a user to measure credit risk across all energy
commodities for a given counterparty. This same integration issue often determines whether
one can use a single client database including integrated management of limits and
collateral tracking.</font></p>
<p><font face="Arial">Another scope issue is the systems breadth of coverage from front to
middle to back office. Some systems e.g. do a poor job of tracking cash flow and
receivables, a back office function. Consequently, their ability to measure the A/R
portion of CURRENT exposure is severely limited. Other systems are weak on tracking
customer documentation and are very clumsy about their handling of contractual issues like
netting, setoffs, and collateral.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524456">B) Measurement</a></font></p>
</b></i><p><font face="Arial">Measurement primarily refers to the ability to calculate all
portions of the Combined Measurement formula shown above. The system should have the
flexibility to calculate, view, and react to both the combined totals <i>as well as</i>
the individual elements of the equation. For example, if a trading manager comes to the
credit manager and requests to do a deal with a counterparty already at its limit, the
credit manager needs to know the total combined measure of exposure <i>and</i> how much is
current exposure and how much is potential exposure. In fact, the system needs to be able
to track separate limits for both types of exposure for each counterparty.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524457">1) Aggregation</a></font></b></p>
<p><font face="Arial">Measurement must also be allowable at differing levels of
aggregation. While credit decisions are usually made at an individual counterparty level,
a risk manager also needs to know the entire portfolio view, a view which is not just the
sum of the individual counterparties due to the mechanics of CVAR calculations.</font></p>
<p><font face="Arial">Similarly, the risk manager very much needs to know which geographic
areas are the sources of the risk. Remember how regional transmission system operating
factors played such a large role in the June 1998 debacle. Other levels of aggregation,
which might be needed, include summaries by trading group or summaries by commodity or
summaries by currency.</font></p>
<p><font face="Arial">Some users define counterparty limits in terms of the volume
measures or even the lessor of separate volume and dollar criteria. This is a good example
of how it is important for the measurement system to be flexibly configurable and highly
customizable.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524459">2) Other Technical Calculations</a></font></p>
</b><p><font face="Arial">The way in which applications provide the myriad technical
details of measurement is also critical for:</font><ul>
<li><font face="Arial">Netting one deal against another in the event of non-performance.<br>
</font></li>
<li><font face="Arial">Setoffs of monies owned in the event of non-performance.<br>
</font></li>
<li><font face="Arial">Collateral tracking and application. Parental guarantees, letters of
credit, cash, and securities are all types of collateral which must be handled.<br>
</font></li>
<li><font face="Arial">Forward price curve maintenance and use.<br>
</font></li>
<li><font face="Arial">Option pricing.<br>
</font></li>
<li><font face="Arial">VAR and CVAR transaction grouping or bucketing.<br>
</font></li>
<li><font face="Arial">Present value discounting techniques.<br>
</font></li>
<li><font face="Arial"><a NAME="_Toc442524464"></a><a NAME="_Toc442524460">Margins and
collateral thresholds need to be calculated and tracked.<br>
</a></font></li>
</ul>
<p><a NAME="_Toc442524460"><font face="Arial">Third party credit ratings from S&P,
Moodys, Duff & Phelps are often tracked as a means to create internally generated
default probabilities.</font></a></p>
<b><a NAME="_Toc442524460"><i><p></i></a><font face="Arial" size="4">C) Monitoring and
Control</font></b></p>
<p><font face="Arial">Once the system has been chosen, installed, customized, and
configured, it must provide the means for users to employ it effectively for Monitoring
and Control of credit risk.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524461">1) Reporting</a></font></p>
</b><p><font face="Arial">Reporting must include a user programmable report writer.
Reporting should have graphic options. Reporting should be both paper based and screen
based. It should provide both regular and ad-hoc report requests. Exception reporting is
mandatory.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524462">2) Event Notification</a></font></p>
</b><p><font face="Arial">The best systems have the ability to notify affected parties
when "user defined events" occur. "User defined events" are based upon
customizable business rules about limits, types of trades, approvals required, price
breaks, etc. Notification can be via email, screen alerts, or database updates.</font></p>
<p><font face="Arial">Event notification is best facilitated via the mechanism of
middleware. Middleware has many flavors, but the type most germane to trading environments
is called Message Oriented Middleware (MOM). Middleware is an essential system
consideration. See the middleware articles within the Technology Corner archives for a
fuller discussion of this issue.</font><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524463">3) Overrides</a></font></p>
</b><p><font face="Arial">A good system should reject trades or transactions that violate
user defined rules such as a counterparty credit limit. It is equally important for there
to be system rules about who may force an override and under what circumstances they may
do so.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524465">D) Non-Credit Issues</a></font></p>
</b></i><p><font face="Arial">The are many other system issues that are not credit
specific. These other issues include many important topics such as the navigability and
configurability of the user interface. Equally important are issues such as system fault
tolerance, stability, and scalability. Of course, pricing and contractual issues always
play a role as well. In addition, in this industry at this time a company's financial
strength, reputation, and personnel are major issues too. The list goes on and on.
Consequently, you must be rigorous.</font></p>
<p><font face="Arial">"Rigorous" means that you should produce your own detailed
list of needs and that you must spend the time immersed in the details. You are best
served by employing a quantitative methodology for decision making. Use a methodology that
allows you to assign both an importance ranking to key needs and assign a separate rating
number to each issue for each vendor. The resulting rank-weighted number calculated for
each vendor is very useful. An interesting discussion always develops around this process
and the process forces a great deal of clarification about decision drivers.</font><b></p>
<p ALIGN="left"><font face="Arial" size="4"><a NAME="_Toc442524466">III) ACTUAL ENERGY
APPLICATIONS</a></font></b></p>
<p><font face="Arial">Systems developers do not have an easy job. The wholesale energy
industry is in a state of rapid change. No two users conduct business in an identical
manner. There are major regional differences emanating from ISO's and regional markets
such as the CA PX and PJM. Market events such as June of 98 change the way users want the
systems to operate. The market and products are immature and in flux. In short, developers
face many demands. The results found while investigating the credit risk capabilities of
eight leading vendors were less than expected. Therefore, in keeping with a policy of only
writing about vendors in a positive vein, just a couple of vendor systems will be
mentioned.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524467">A) Good, Bad, and Ugly</a></font></p>
</b></i><p><font face="Arial">In spite of the difficulties faced by vendors, it was
surprising how inadequately some vendors' treat credit risk measurement and management.
For example, one market leader (not to be mentioned here) still calculates Current Credit
Risk exposure, not Potential; they also still do not aggregate by counterparty across
their power and natural gas modules. Rather than talk about the Ugly, let's talk about the
good.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524468">B) Examples of Good</a></font></p>
</b></i><p><font face="Arial">A couple of vendors, Nucleus and ARC/IT in particular,
seemed to offer a very solid approach to credit risk measurement and management. There are
others such as Open Link, Primo, and Energy Imperium who appear strong although less time
has been spent on credit risk exploration with these vendors.</font></p>
<p><font face="Arial">The most impressive credit risk management system reviewed for this
article is Axiom. If you wanted to set up an institution wide risk management system, no
one has a more refined and more powerful credit risk system. This vendor will do most if
not all of the functions outlined in the Idealized Application. They are not an easy turn
key solution for a smaller merchant energy function, but they are the best of breed found
to date for a larger organization needing a comprehensive approach to credit risk.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524469">C) Building It Yourself</a></font></p>
</b></i><p><font face="Arial">Building your own risk management system is always an
option. Be very cautious about starting down this path. With all of the commercial
alternatives existing today, few organizations have even a ghost of a chance of being able
to promptly and cost effectively create a better in-house alternative. There can be an
incredible naivete about the degree of difficulty in creating a quality Risk Management
and Trade Processing system.</font></p>
<p><font face="Arial">This is a crowded market with some good answers. Unless you have
some highly unusual conditions, your needs will best be met via the buy choice, not the
build choice. Even having chosen to buy and not build, there are still plenty of tough
decisions around the choice between selecting a unified suite or choosing separate best of
breed modules and integrating them in-house.</font><i><b></p>
<p><font face="Arial" size="4"><a NAME="_Toc442524470">D) Improvements In The Works</a></font></p>
</b></i><p><font face="Arial">Most if not all of the vendors are working to rapidly
improve their systems as we speak. Your challenge is to sort through the noise and mine
the nuggets. It is hoped that this article can assist in clarifying the issues you need to
be aware of for purposes of evaluating credit risk management applications.</font></p>
<hr>
<blockquote>
<p><font size="3"><em><strong>Disclaimer</strong></em></font></p>
<blockquote>
<p><font size="3"><a href="http://www.pmtcweb.com/" target="_blank">The Power Marketing
Technology Consortium</a> (PMTC) consults on applications, but has none of its own. Nor
does PMTC have any financial interest in the recommendations it makes to its clients
regarding particular vendors. PMTC funded and performed this research solely as a means to
better serve its target market.</font></p>
</blockquote>
</blockquote>
<hr color="#FFFF00">
<blockquote>
<font size="3"><p>Jeffrey Frost, a PMTC Senior Partner, has years of experience as a
banking treasury executive, trading room technology innovator, and Internet electronic
commerce pioneer. While Jeffrey's prior executive and entrepreneurial roles have demanded
numerous skills, much of his career has revolved around one simple theme: The use of new
computing technologies applied to existing information to create profitable new business
alternatives. </font></p>
<p><a href="http://www.pmtcweb.com/" target="_blank">The Power Marketing Technology
Consortium</a> is an IT and electronic commerce power marketing consulting organization
which integrates and supports technologies related to energy trading and marketing.</p>
<p align="left">Jeffrey C. Frost may be contacted at (802) 864-9903; e-mail: <a href="mailto:[email protected]">[email protected]</a></p>
</blockquote>
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