The overall control framework

We have not discussed the most important piece a risk manager needs – the overall
risk framework. With a highly volatile commodity like power this needs to be multilayered,
with a strong linkage down to a variety of control points.

Figure 18.10 sets out some of the most important quantifiable limits that can be
set and how they relate to each other. This control structure links many parts of the
organization. As well as monitoring for trade input error, significant emphasis needs
to be placed on verifying counterparty and broker confirmations to the trade capture
systems. Conformations can often be slow and inconsistent depending on the
counterparty, which combined with the potential volatility in the market makes for
a dangerous mix. We have seen players lose several million dollars based on trading
input errors that never got picked up by the confirmation process.
Summary
Energy markets are probably the most challenging commodity markets a risk manager
will face in terms of level of complexity, volatility and quantification. Many of
the issues raised and approaches outlined in this chapter are a reflection of the
developing nature of the markets. In addition, some fundamental risk management
issues still need to be adequately addressed.
As the developing energy markets continue to evolve, the tools used by risk
managers to measure, monitor and control market, credit and operational risk will
also continue to develop. These developments will impact energy markets on a
worldwide basis. I suspect many of today’s models will be rendered obsolete in the
very near future.20
However, the establishment of VaR, CVaR and associated quantitative processes
being modified and developed for the energy market provides a strong framework to
effectively communicate and control risk as well as providing a useful process to
isolate the component risks within the overall company. The use of these quantitative
approaches needs to be complemented by an appropriate stress testing and model
testing environment that challenges both the assumptions made by traders and the
risk management department itself.
One of the most useful aspects of the quantitative approach is that it can be easily
encompassed within an overall risk framework for setting risk/reward ratios, internal
capital allocation, liquidity and reserve requirements. This puts the role of risk
management as a key element in any business organization, truly bridging the gap
between the financial accounting and ‘commercial’ departments.
The risk management strategy, allocating risk and investing in control and analytical
systems needs to be an integral part of the overall business and enterprise risk
framework. This chapter has not sought to recommend how such allocations should
be made since they are a function of individual business environments. Rather, we
would stress that as risk managers are faced with such decisions and organizations
are being restructured it important for the risk manager not to lose sight of the fact
that there is no substitute for common sense.