Scenario analysis

As stated at the beginning of this chapter, many observers have been assessing energy
market risk for a significant time. In addition, large numbers of consultantcy firms
who specialize in the forecasting of energy prices to aid companies make investment
or other business planning decisions. In addition, large energy companies will spend
significant amounts of time and money determining their own views of the world.
Most will provide a range of possible scenarios recognizing the difficulty of providing
an accurate forecast and a business can estimate the impact of both positive and not
so positive scenarios. In other words a risk assessment of adverse price movements is
made on a heuristic ‘scenario’-based approach using some form of economic model.
Where no discernible forward curves can be established this is still the most common
form of market risk assessment. One advantage of this approach is that it can link
into known market indicators. For instance, it can take a gas and oil forward curve
and help ‘translate’ it into a power curve. As such, the models can be used as tools
to provide a number of different types of forecasts, and to estimate:
Ω A pure arbitrage model
Ω A new entrant model (assuming ‘potential’ new entrants set forward prices)
Ω A macro model incorporating political, environmental, regulatory and economic
model (e.g. a ‘game theory’ model)
Ω A micro ‘dispatch’ optimization model
The advantage of such an approach is that it can incorporate the important
regulatory or market power issues that can dominate many regional energy markets.
For instance, models that allow for the gradual deregulation of the local distribution
companies and the transition away from cost plus pricing can provide useful insights
into future price movements.
The important aspect of scenario analysis is consistency in the ‘story’ being told
and ‘buy-in’ from senior management early in the process. As such, you need to
establish that the scenarios are plausible, cover the key market risks to the business
and then go through the painstaking process to ensure internal consistency.