Enterprise-wide risk management in energy and utilities sector

Introduction

Risks are not new to businesses. Every transaction and every decision made by an organization is exposed to risks, and in turn might generate more risks. However, the key to sustained business performance and success is to rigorously monitor and efficiently manage these risks. This applies, in particular, to the energy and utilities industry, which functions in a highly volatile and price-sensitive global market. Organizations in this sector, which have long-term investment horizons, require a risk-intelligent approach to survive the challenges posed by the economic and geo-political fluctuations.
 

Risks can be quantified, and volumes of risk data can be aggregated into valuable business insights.

Enterprise-wide Risk Management (ERM) holds the answer to pressing questions on identifying, evaluating and mitigating a multitude of risks faced by the energy and utilities organizations.

The broad risk areas include the stringent compliance and regulatory landscape, price instability, availability of energy and fuel reserves, weather and environment, trading, extended supplier networks, and operations. Add to these the growing emerging risks, and the need for a comprehensive and enterprise-wide risk strategy increases manifold. 

 

THE ROADMAP TO AN EFFECTIVE ERM PROGRAM

ERM is a comprehensive process that enables an organization to efficiently manage the impact of risks on its total return, so that it can achieve its’ stated business goals and objectives without any major disruptions. It helps to efficiently manage enterprise risks in terms of the right business context.

One of the core exercises that facilitates the implementation of a meaningful ERM program is defining the key building blocks of a business such as its economics, the business context, the functional applications, the organizational capabilities, as well as technology infrastructure. Identifying these key components of a business environment and their interplay, offers the required flexibility to develop and execute a strategic risk plan.

An energy and utilities organization must clearly identify the business context in which it operates. It must be able to gauge how well its individual functional units are integrated with the overall organizational outlook. Organizations in this sector must also have a thorough understanding of their capabilities and economics, which highly influence strategic decision-making on risks. In addition, technology infrastructure requirements must be factored in to help an organization streamline and automate risk management processes.

Another critical decision involves the controls necessary to mitigate risks. While too little operational control might result in ineffective risk management, too much of the same can stifle an organization’s progress. What is ideal is a centralized risk management program with a flexible operational control, which helps manage unacceptable risks at a reduced cost.

 

SALIENT FEATURES OF ENERGY RISK MANAGEMENT 

Energy companies follow varying approaches to ERM, depending upon their scale of operations, existing energy reserves, and the revenue margins they decide to maintain. While a few companies with more energy reserves to explore, might strive to function on a greater scale, look for bigger profit margins and are ready to take on more risks, other energy plants facing over exploitation of their energy reserves might want to secure their future and handle less risks, rather than generate revenue margins. A few might also be worried about their fragile energy infrastructure operating under extreme conditions.

However, one common approach to managing energy risks is to identify the broad risk areas under various functional units such as production, transportation and storage, refining and processing, and distribution, for various energy commodities including crude oil, refined products, Liquefied Natural Gas (LNG), Liquefied Petroleum Gas (LPG), and electricity. 
 

A good risk strategy is a fine synthesis of: Views and opinions of the Board of Directors Optimal risk limits determined by the Executive Risk Management Committee Important risk inputs from the business management Organization’s risk history Corporate strategic plan Market conditions

 

 

Managing Volatility

Widely prevalent methods such as hedging and commodity trading are employed by energy organizations to offset price risks, and the negative impact of adverse market conditions. Commodity price volatility has always been the single biggest variable in forecasting EBIT (Earnings before interest and taxes) for energy organizations.

Organizations, therefore, hedge to tactfully manage this price risk and exposure. Hedging is also utilized to assure returns on equity in volatile market situations often witnessed in this sector.
 

Mitigating Underlying Risks 

Energy organizations also have to monitor and manage their underlying risks, which include credit risks, market risks, operational risks and legal risks. The process involves studying specific elements in the energy value chain, identifying the existing patterns of supply and demand, and evaluating the acceptable levels of risk. A core element here is data mapping which allows organizations to integrate available risk data and establish the appropriate relationships to calculate and measure risk.

The right techniques and models for risk evaluation, as well as the appropriate accounting methodologies must be given the highest priority. It is also mandatory to have adequate policies and controls that govern various compliance requirements of a business. These policies should be guided by relevant laws and regulations, and industry standards. 
 

RISK MANAGEMENT GOVERNANCE

A fine combination of top-down and bottom-up approach best suits an organization’s risk management governance. The Board of Directors and the audit committee occupy the top position in the governance structure, and play a primary role in charting an organization’s risk management plans that is led and managed by the Chief Risk Officer. Below them is the Executive Risk Management Committee, chaired by the Chief Risk Officer, followed by the key business and functional units.

An ideal risk management structure in an energy organization is one in which the business management, comprising the senior managers of various business units, identify the critical risks, and provide a comprehensive risk inventory. They also set the broad risk metrics to monitor continuous business performance.

Whereas, the senior management provides the overall strategic leadership and guidance on risks, and determines the risk policies and processes that control the decision-making throughout the organization.

This structure helps to develop a robust risk management culture across the organization.

 

RISK METHODOLOGY

In order to execute and control their risk strategy, energy and utilities organizations must adopt a sound risk methodology, with the necessary flexibility to enable them to generate more profits. The critical tasks in a well-thought out risk methodology are as follows:

 

• A strategic risk plan must be drafted based on important elements such as a dynamic network to leverage energy assets, the scope of asset control, the physical commodity presence, as well as a focus on the market trends. This core strategy must be used as the cornerstone to derive the organizational risk tolerance, the risk control limits, and the risk capital.
• The various financial, operational, market and environmental risk components in each operations unit in the energy value chain have to be clearly identified.
• Standard techniques of risk measurement such as earnings and Cash Flows at risk (CFR), the maximum potential loss, Value at Risk (VAR), Credit Value at Risk (CVAR) are then applied to the financial results, which are presented in terms of Earnings Per Share (EPS), cash flow, Return on Equity (ROE), balance sheet, and shareholder value.

The above three steps will help in arriving at the systems, processes, the strategic models and the risk platform that are required for risk management. Another critical exercise in the overall risk management program is a comprehensive risk assessment. From this the risk appetite can be clearly identified.

Following this, the organization has to finalize the policies, the systems and procedures, the valuation methods, the performance measurement criteria, and the capital allocation, for risk management.

All these revolve around the key concept of establishing a corporate risk tolerance for the risk appetite as well as market conditions.

A market-focused enterprise-wide risk management program can steer an organization in the direction of sustained progress. Also, by replacing obsolete manual systems with advanced technology-based solutions, energy companies can eliminate organizational silos, and become risk efficient. 

ENHANCE ERM BY LEVERAGING TECHNOLOGY

Workflow-based technology solutions play an enabling role in simplifying and streamlining the risk management processes, and helps organizations drive an analytic decision-making culture. It allows seamless incorporation of risk information into management decisions and strategic plans. Multiple manual and paper-based systems and spreadsheets can be replaced with a single, automated and integrated solution on a centralized platform. 

Being prepared is the singular way for energy and utilities organizations to secure themselves from the cascading negative effects of energy risks. Technology solutions allow these organizations to conduct various scenario analyses to get a comprehensive understanding of potential risks and their possible outcomes. A federated information data model which comprises standard libraries of risks, controls processes and policies, ensures a consistent risk methodology, and eliminates information silos.

Risk management tools help organizations clearly define and institute relevant qualitative and quantitative risk metrics such as Key Risk Indicators (KRIs). A unified rating methodology can also be employed to measure the probability and severity of risk exposures. These tools also facilitate the streamlining of the process of determining the organization’s risk appetite. Other advantages include improved risk identification, and better evaluation of control effectiveness. It is also possible to aggregate risks across business units, as well as the enterprise. 

Once the risks are identified, risk heat maps can help in weighing and prioritizing the risks, and deciding the right risk response. Interactive dashboards, which are effective visualizations with advanced user-interactivity, along with flexible reports, can provide detailed statistics and exhaustive risk data. Relevant tools are also available to capture and predict losses and incidents. 
 

An effective ERM program, driven by technology and a farsighted strategy, with a heightened emphasis on the evolving market conditions, can enable organizations to be better prepared for the future. Thus they can effortlessly enhance their operational efficiencies, and survive the changing dynamics of investments, competition, regulations and compliance.