Previously, we described our view of the fundamental principles for commodity risk management. This framework was developed from observing risk-related problems and failures over time. Sadly, the underlying causes of trading-related failures are often repeated. Our framework is a progressive approach that begins with a thoughtful view of an enterprise’s risk appetite that then drives the development of risk policy, risk limits, and reporting—all set within a proper organizational design. This organizational design features a clear front-, mid- and back-office separation, and the designation of a risk control function to provide oversight.
Apart from establishing the essential elements for effective commodity risk management, we now focus on the importance and process for aligning different parts of a risk management environment and, more importantly, keeping them aligned. Changes in an enterprise’s internal strategy, as well as external changes out of an enterprise’s control such as market price fluctuations, regulation, or other factors, can create a perfect storm of an otherwise ineffective risk control environment.
Consider the following example:
An integrated utility established an unregulated trading and marketing group and properly established risk policies, limits, and oversight at that time. As the utility’s strategic focus reverted to emphasize the core regulated earnings of the enterprise, the previously established trading limits and the exposure implied from such limits became out of sync. Most telling, in outlining the potential volatility implied in the existing trading policy to the enterprise’s head of investor relations, it was clear that investors were unprepared for potential outcomes that were fully sanctioned by the existing trading policy.
Aligning Commodity Risk Appetite Starts At The Top
In simplest terms, aligning the organization for commodity risk starts and stops with a Board-directed view of risk appetite. Board members may or may not be deeply knowledgeable in commodity risk. However, a Board-level forum for determining risk appetite is a sound place to start a dialog to ensure that all parts of an organization hear and are being heard in discussing the risk. Linking the reporting of risk with commercial performance reporting is another technique to raise awareness and align interests.
For companies with existing risk management activities, and an existing risk management/trading policy, one approach could be to include terms in the policy that requires ongoing discussion with the Board. This discussion would encompass:
- Embedded commodity risk in the company’s operations without risk management efforts.
- Qualitative outline of how the existing commercial strategies and trading limits act to address such embedded risk taking into account the recent and expected volatility of the markets.
- Assessment of potential effects on operating results if the existing embedded risks, commercial strategies, trading limits, and market conditions work as expected—that is, the development of a reasonable scenario for the Board’s consideration.
Laying The Foundation For An Assessment Of Embedded Commodity Risk
For risk management functions in the process of being established, a comprehensive assessment of embedded commodity risk in the enterprise is foundational. Management and the Board must conclude whether the embedded commodity risk is acceptable or not—the development of commercial strategies, policies, and limits flow from the conclusion that embedded risk is NOT acceptable.
Translating embedded risk and acceptable risk into terms understood across the entire organization is essential to thwarting commodity risk “surprises” over time. Changes in corporate strategy, changes in markets, and actual risk management results provide a strong case for an intentional effort to examine a company’s commodity risk management on a periodic, ongoing basis.
Finally, for lenders, we believe understanding how counterparties assess the alignment of their risk appetite, corporate strategy, commercial strategies, and limits (or don’t) can be an important element in knowing your customer.