03.25.10Duncan Sinclair, Director, Redpoint Energy

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The credit crisis that has dominated the international agenda for the last year has been largely driven by systemic shocks to global financial markets, yet one of the biggest shocks to individual financial institutions came from within: the boards and senior management of many companies had failed to understand adequately their portfolio risk exposure and associated capital requirements. Across the financial industry, overreliance on quantitative measures to capture the risk associated with increasingly complex portfolios led to complacency over the source and size of underlying exposures. This left financial institutions vulnerable to extreme events or systemic shocks that had not been adequately accounted for by prevailing risk methodology. Failings in risk measurement also led to a widespread problem of undercapitalisation, a key factor in many company failures.

An energy market systemic shock

Of course, systemic market events are not restricted to the financial sector. The energy sector suffered its own potential meltdown scenario with the dramatic collapse of Enron between October and November 2001. Yet despite the seriousness of the Enron affair, the energy market appears to have been better positioned to cope and to recover. So why did the collapse of Enron not have the same effect as the demise of financial institutions such as Bear Stearns and Lehman Brothers?

Enron was revealed to be hugely undercapitalised and rapidly ceased routine trading operations, setting off a domino effect that brought down the US merchant energy sector, and much of the nascent European sector, which was shown to be similarly undercapitalised. The exposure of undercapitalisation in the merchant energy sector revealed the extent to which complex off-balance-sheet transactions had been used to underpin the huge volume of trade they had conducted.

At the time, there were fears that the UK power market would seize up without substantial regulatory intervention. However despite a drop in market liquidity, other players stepped up to provide market-making services, ensuring continuity of the energy supply chain. Interestingly, banks played a key role as intermediaries in resolving this shock, but it remains to be seen if a weakened financial sector could play a similar role today should the same circumstances occur again.

The energy market appears to be inherently robust

If anything, the Enron affair showed that the energy market was essentially robust in terms of both major individual company failures and systemic failures. Unlike their financial sector peers, energy companies' business models tend to be underpinned by physical underlying assets, providing reassurance that a relatively smooth recovery from a shock could take place without substantial direct government or regulatory intervention. In addition, a strong focus on security of supply has meant that energy portfolios have relatively well established strategies for dealing with extreme risks - driven as much by volume as price risk.

Furthermore, larger energy companies typically have strong balance sheets and cashflow positions with relatively low levels of leverage. This has been backed up by a tendency towards vertical integration and the creation of national champions. Their boards tend to be characterised by a high degree of risk aversion, reflecting the risk profile of shareholders and lenders. It would be a stretch to say the same of the banking sector.

In addition, consumer dependence on gas and electricity is high and therefore core demand is more stable, and whilst exposed to recessionary effects, less susceptible to sudden collapse on the scale of, for example, the demand for mortgage backed securities in the wake of the credit crisis.

A number of lessons can be learned

However the relative robustness of the energy sector should not be a source of complacency. The shortcomings of corporate governance that have been exposed in financial institutions pose similar threats to energy companies. Adequate management understanding of portfolio risk is increasingly difficult given the growing complexity of energy portfolios and the deterioration of counterparty credit quality. Energy companies also face the challenge of ensuring a strong and independent risk management function which is not compromised by commercial objectives.

Strong parallels between trading and risk management practices across financial and energy markets mean there are a number of lessons from the financial crisis that could have implications for the energy sector. For example, many of the risk measurement techniques that failed to capture the impact of major shocks to financial markets are also applied in the energy industry. Specifically most energy companies rely on 'at risk' measurement methodologies to quantify and limit portfolio exposures, although to a lesser extent to define capital requirements than the financial sector.

Measures proposed by the FSA in response to the financial crisis could equally be applied to the energy sector, including closer scrutiny of individual companies in terms of risk governance and measurement, and the capitalisation of trading functions. Further, the energy sector could learn lessons when it comes to increased sector-level regulation in the shape of greater transparency, product regulation, stress testing, and counter-cyclical measures.

While there are parallels between the financial and energy industry, there are also some important differences in the way each industry has managed extreme events in their recent history. The dominance of physical assets in the energy industry supports its ability to withstand systemic shocks. However similar failures in corporate governance and risk measurement to those exposed by the financial crisis could lead to insufficient provisions being made to cover extreme events, in turn leading to under-investment and/or insufficient availability of capital to cover short positions caused by shocks. The latter could result in company failures and insufficient energy supply in emergency situations.

It is still too early to fully grasp the lessons that are emerging from the credit crisis, but with regulators swooping on the energy and finance sectors alike, one thing that's certain is that companies will be expected to pay closer attention than ever before to the way they identify, measure and control risks to their business.

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Reader's Comments

Date	Comment
Ferdinand E. Banks 3.29.10	As Gordon Gekko pointed out in the film Wall Street, greed makes the world go round. The problem is EXCESSIVE greed. I remember reading that one of the bosses of some stone age country, who was already a millionaire, declared that his ambition was to become the first billionaire in his country, and my thinking at the time was that I hoped that I would never live in a country like that. Well, I live in one now, and so do you, and so does just about everybody else, because billionaires are a dime a dozen, and most of them want to move up to the rankings. Even worse, it's thanks to the greed of multi-millionaires who want to be billionaires that we have the kind of mixed-up world in which we are living. About Enron and energy companies. Enron was a brilliant company that was brought down by greed. But their greed was no worse than the greed and stupicity of the officials in California who believed Enron when they claimed that electric deregulation would result in the price of retail electriity falling by twenty or thirty percent- As for the robustness of the energy sector, in my humble opinion a large part of that sector should be accorded the status of a public good - like streetlights and defence. Then we would get the optimal energy structure that we - or at least someof us - deserve. But isn't it true, some people out there might say, that the private sector will give us the energy that we need and deserve. It certainly is, unless they go completely and totally crazy, as Michael Lewis seems to believe has recently happened.
Don Hirschberg 4.5.10	Professor, If there is anything I know less about than movies and economics it is greed. Well, that's not exactly true, I know even less about incomprehensible abstract mathematical mulidimentional physics. My service in W.W.II was too brief to qualify me for the GI Bill yet not long enough to disqualify me for the Korean War draft - after I spent six years in abject poverty becoming a chemical engineer without a dime of help. I was never bitter. In other words I came free. The Army gave me over a year of incredible education (excuse me, training) and paid me! I hadn't eaten so good for many years - and all for free. And I became a 2d Lt. serving in the war. I think that position was the peak of my life. To my men I was a god. How humbling. Many would poo-poo it. Let them. I don't understand the tremendous ratios we now see as measured by money between competence and those getting hundreds of million even billions. Time was when I thought my boss making ten thousand was perfectly justified as I was making 6 thousand. It never occurred to me he was greedy. Even the CEO of my large corp. did not then make close to 100 times my salary. It's all about numbers and numbers change. Ratios can be obscene. Now there are.
Len Gould 4.14.10	Don: Agree totally. Something about greed being (related to) morality, and present elites completely devoid.
Len Gould 4.14.10	The word greed is so last century. These days the CEO collecting a $150 million exit package from the company which went bankrupt under his watch is re-hired somewhere else immediately becuase "Where else could we find such a smart negotiator?".

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