By Paul Wielgus, Managing Director, GDS Associates, Inc.
(originally published by PMA OnLine Magazine: May 21, 2006)
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Buyers, sellers, and others in the energy business need to understand the risks in this very uncertain environment in order to maintain their responsibility to their stakeholders and to protect their bottom line. Organizations can achieve their goals and objectives in this uncertain business environment by developing a comprehensive risk management program. At GDS, we understand that risk management is more than energy price management, more than regulatory compliance, and that each client faces a unique set of challenges and risks. To fully understand and mitigate the risks that can affect your business and your cost structure, your leadership team must have a complete view of these exposures.
With a great deal of attention being paid to the area of risk management, it is easy to become overwhelmed or confused about what it really means. A lot us focus that attention to managing or fixing the price of our power and or fuel, kind of the trading model definition. So, what exactly is Risk Management? A simple way to define risk management is: The process of identifying, evaluating, and mitigating the risks that threaten the strategic and financial goals of your business.
Every business is vulnerable to a wide array of risks that
may or may not be specific to its particular industry, although only some
choose to actively acknowledge and address those risks in an attempt to
reduce exposure to them. Since the power industry is an inherently risky
one, the focus on risk management will only continue to increase as a
response. In our business, risks can be identified in virtually all
segments of the power supply industry, not just that risk associated with
the price of our power or fuels. These segments and can be divided more
simply into the three general categories: 1) supply side; 2) demand
side; and 3) business-related.
As with any construction project, the biggest risk is the project's schedule being delayed or extended. In most cases, a delayed schedule results in an increase of interest-duringconstruction, and most likely further increases in the capital costs. If the schedule is delayed too long and the expected commercial operational date or COD is missed, the delay could force an owner to go to the market and purchase replacement power, most likely at a price different than what was planned. And if higher than planned, the costs can be very unfavorable.
Delays during the construction phase of a project can arise from any number of potential problems. Some major ones include; unforeseen environmental issues related to permitting and siting, problems with the interconnection and supply of fuel, transmission service and interconnection, water, performance issues related to the contractor, and operating problems with the plant itself during commissioning. The adage,“Time is money," is especially true during the construction phase of a power project, and virtually all of these risks are inherent to the construction phase of any generation resource. However, with proper management and well thought out contingency plans, these risks can be properly measured and mitigated, thereby reducing the likelihood of unforeseen and especially unfavorable consequences.
Once the unit is operational, the owner must contend with unscheduled outages, the risk of day-to-day operations, unforeseen capital expenditures, and possible accidents. There is also the risk of technological obsolescence of an owned generating plant resulting in lost opportunity for cheaper alternatives. Long-term water and fuel supply arrangements are typically settled prior to the operational start date, but there is always the risk of the supply being temporarily interrupted due to pipeline or other transportation problems, or even force majeure. Here again, with proper management and well thought out contingency plans, these risks can be properly measured and mitigated.
Diversifying your generation portfolio with various fuel types, suppliers, and geographic locations are natural hedges to fuel and power market risks. Other tools to mitigate your risk exposure, or hedge your position, include a wide array of financial products that are available in the marketplace. The use of futures and forwards can lock in a set price of fuel or power for several years if you desire. Additionally, many financial counterparties are willing to provide you with collars or swaps that also provide more certainty about the cost you will pay for fuel or power in the future. The fundamental idea is to adopt a longterm resource planning and evaluation process that will lead you to a well thought out, more diversified and secure power supply portfolio in the long run.
Transmission & Market Design
Transmission issues are huge in today's transmission-constrained power supply environment. In many markets today, it is difficult if not impossible, to obtain long term firm transmission service. Transmission access and pricing may be the most unfamiliar area to many in the industry, almost viewed as a “black box” by some, so it can pose a serious risk to your ability to provide reliable low cost power. Without a way to deliver the power to the load, your issues can begin to compound.
During the planning and construction phase of a power project, most transmission issues such as routing and siting, environmental regulations, or landowner and citizen opposition, are identified and need addressing. However, it is during the operational phase that a fair number of risks can become apparent. For example, there are risks associated with the variable rates and penalties associated with ancillary services and transmission scheduling.
Congestion costs may be the driver for many problems and concerns in the future as new market designs attempt to more directly assign costs. New transmission lines can be built, but the process is a long and costly one. Ultimately, taking an active role in this challenging activity, understanding where the risks may be that could affect your supply, and planning on contingencies can help mitigate a large portion of the risk.
The accuracy of a peak demand and/or energy sales forecast
generally depends upon two primary factors: 1) the ability to quantify the
impacts of influential variables on power requirements, and 2) the skill
to project changes in these key influential variables (e.g. economic
outlook, weather conditions) over the forecast horizon. A base case
forecast typically presents the load and energy projections corresponding
to the expected, or most probable, outcomes of the key influential
variables. Of course, it is inevitable that future changes in the factors
that influence power requirements will deviate to some degree from what
was assumed when the load forecast was prepared. Therefore, it can be best
to develop forecast ranges that address high and low range scenarios.
In order to mitigate the risk of abnormal loads, it is important to try to better understand the forces that can cause high variability. These drivers may include competition, catastrophic events, industrial activity, or technological issues. Some of these areas can be very difficult to predict, making it tougher but not impossible to mitigate such risks in a cost effective manner. Although not always easy, being up to speed in this area is part of risk management planning, including catastrophe plans. You may also be able to exploit the savings from an interruptible product or other demand-side management program where appropriate. For market participants that are subject to weather extremes, there are opportunities available to hedge weather risk through the use of financial hedges that are designed to help protest against this risk.
At Risk…Fundamental Business Risks
Once the decision to obtain financing has been made, it is important to conduct "what if" scenarios to study what the impact of unexpected events could have on your business, as well as to understand if your business has the potential for financial distress. Ultimately, maintaining strong financials through proper rate structure and strong liquidity and equity levels are essential to ensuring the availability of low-cost financing for your organization in the future.
Risk Management Framework
1.Determine risk profile
• Risk exposures and tolerance
• Identify • Evaluate • Mitigate
2.Define program of clear goals and objectives
3.Develop comprehensive risk management strategy and tools
4.Implement appropriate controls and support systems
It is easy to feel overwhelmed by the variety and magnitude of risks that affect the supply of reliable and economic power. These risks may not all apply to you and your situation directly, but these risks are faced by some entity in the supply chain of power. While completely protecting yourself is virtually impossible, relying on a risk management framework is certainly the next best thing. Without it, you don't really know how much you don't know. This proactive stance is carried out by first determining your risk profile and then by developing and implementing a comprehensive risk management plan. By utilizing a risk management framework, you will be best positioned to reliably serve your needs or your customers’ needs at a lower cost of service and greatly reduced price volatility.
The GDS approach to designing risk management programs incorporates quantitative and qualitative techniques to capture, assess, measure, and mitigate the risks that can impact a business's strategic and financial objectives, along with its operations, and ultimately the bottom line. For more information about GDS and its Risk Management Services, contact Paul Wielgus, Managing Director at the numbers below and visit www.gdsassociates.com.
Paul Wielgus - Managing Director