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June 20, 2016

Risk Management Policy: An Elusive Target for Energy Companies

by Miki Kolobara, Esq.

Energy market participants face an uphill battle in developing, maintaining, and implementing a set of consistent and current risk management or trading policies and procedures (together referred to as a “risk management policy” herein).  Since most physical energy market participants are primarily focused on producing, transporting, distributing, or consuming energy commodities, their policy emphasis traditionally has been focused on operational reliability and safety.   However, with the introduction of the Dodd-Frank Act (“DFA”), the majority of physical energy market participants, at least those that intend to hedge any of their positions, are required to create and maintain “…written policies and procedures that are reasonably designed to ensure that the persons responsible for evaluating all swap recommendations and making trading decisions…” on behalf of a company are capable of doing so. In addition to energy regulators, many exchanges also require that market participants include some specific exchange-related requirements in their policies and procedures such as position limits, block trades, prohibitions on wash trades, anti-disruptive trading practices, and other prohibited conduct.

The accelerated emphasis on corporate policies and procedures, in the energy arena, was initially triggered by the alleged misconduct and resulting exposures surrounding the Western energy crisis of 2000 – 2001.  The rampant price volatility, unpredictable commodity exposure fluctuations, lack of adequate hedging, and regulatory uncertainty surrounding the Western energy crisis resulted in significant market dislocation, at least on the physical side.  The speed of trading and associated defaults had been unprecedented, and many market participants were unprepared to quickly react to rapidly deteriorating market conditions.  Subsequent investigations and reviews uncovered a significant breakdown of basic internal controls and corporate oversight, combined with improper compensation packages for some traders which incentivized and encouraged irresponsible trading practices.  With that in mind, the Energy Policy Act of 2005, and subsequent policy statements by energy regulators, recommended that market participants develop and implement policies and procedures outlining the framework within which trading and risk management activities should take place while creating and maintaining a culture of compliance.  However, the DFA is the first federal statute that specifically provides what must be included in a risk policy.

The main reason the DFA mandates a risk policy for energy companies and other “end users”, is to ensure that less-sophisticated (from the trading standpoint) market participants have the necessary skill set to properly understand and manage the risks associated with energy trading or hedging.  In other words, the more market participants elevate their risk management skills, the more market fundamentals will remain stable and consistent.  A risk policy allows every market participant to adequately outline the scope of its activities, approved trading/hedging strategies, approved products and markets, acceptable VaR and exposure limits, and the relevant corporate responsibility and accountability, from the board down to senior management.   Also, it is critical for every market participant to properly outline the prohibited trading practices so the commercial personnel can stay away from any trading practice that could be deemed a market manipulation.  A trader that is not properly trained and informed about what constitutes a market manipulation, disruptive trading practices, or similar trading misconduct, is much more likely to violate those rules.  If a market participant is subject to a regulatory inquiry, its risk policy would probably be one of the documents that a regulator would want to review because that is the document that should reflect how seriously the company’s senior management, including its board, is committed to regulatory compliance.   The tone is set at the top when it comes to regulatory compliance and the way that tone is manifested is in the risk policy.

While the overall reasons for creating and maintaining a robust risk policy seem obvious, many energy companies are struggling to adequately formulate their risk policy.  There are several reasons for this.  Energy utilities traditionally did not develop a robust marketing or risk management infrastructure, especially since their wholesale marketing or hedging activity was mostly incidental to their core business of managing the load for their residential or commercial customers.  Also, many energy utilities’ senior executives and board members were suspicious of any significant wholesale marketing or hedging activities, mainly due to their lack of familiarity with these types of activities.  Consequently, many energy utilities were behind the curve when it came to creating or maintaining a robust risk management skill set.  This, in turn, made it more difficult to attract and retain adequate personnel, and utilities were often forced to reassign their employees, mainly engineers, to various marketing roles.  This history of not focusing on a robust risk management infrastructure is now creating significant regulatory and financial exposure for many energy utilities, for several reasons.

First, gas and electric utilities cannot properly evaluate and manage the lowest wholesale supply costs for their customers without having the relevant risk management skill set.  At the same time, participation in wholesale markets is becoming increasingly risky due to increased and vague market regulations.  Consequently, many utilities trying to lower the wholesale supply costs to their customers could expose those same customers to significant risk if those utilities are authorized to pass any regulatory fines onto their customers.  To manage this apparent dichotomy, it is imperative for utilities to create, implement, and continuously update their comprehensive risk policy in order that all relevant employees have clear understanding of their company’s risk framework and procedures for identifying, quantifying, and managing the commodity risk.

As a matter of course, gas and electric utilities emphasize their mission to keep their ratepayers’ rates as low as possible.  Often they are required by their state utility commission to utilize certain risk management practices, such as hedging, to keep their rates as low as possible.  This commitment to the ratepayers or state regulatory commissions is becoming increasingly difficult and risky to implement.  For example, for a gas or electric utility to demonstrate that it has properly evaluated and executed the necessary risk management due diligence to keep the wholesale supply of commodity at the lowest possible price, including any hedging activity, it must have a risk policy that sufficiently outlines the risk management framework while ensuring that the utility’s core business mission is not overshadowed by the appearance of wholesale trading or hedging activities.  Additionally, many utilities have to walk a fine line between their ratepayers’ need for low rates and their shareholders preference for a steady, fee based, cash flow, devoid of any volatility associated with wholesale marketing and trading activities.  In order to properly demonstrate that they have ensured their ratepayers’ low rates by monitoring and reacting to changing wholesale market fundamentals, utilities must have a risk policy that adequately outlines a sequence of events for various marketing or hedging activities including price curves and models, position limits, authorized trading/hedging products, margin and collateral management, and prohibited trading practices.  This, in turn, requires resources to hire and maintain personnel sufficiently trained and knowledgeable about marketing and hedging.

Another reason energy companies are now faced with increased exposure is the numerous layers of vague, often contradicting, and ever-expanding energy regulations make it increasingly difficult to formulate and implement a robust risk policy even for the most sophisticated market participants, let alone for physical energy companies such as gas and electric utilities.  As energy commodities regulation became collateral damage to the sweeping Dodd-Frank regulation, it became evident that all market participants needed to elevate their risk management prowess, no matter how infrequently they participated in the wholesale market.  Consequently, those market participants that only occasionally participated in the wholesale trading or hedging activities, such as energy utilities, faced a much steeper learning curve in creating and implementing adequate risk management framework.  In addition to Dodd-Frank, many CFTC and FERC regulatory enforcement policy statements, recent enforcement cases and orders, various exchanges’ rules, and even U.S. Sentencing Guidelines reiterate the need for relevant risk management policies and procedures.  At the same time, market participants face significant (civil and criminal) penalties for violating energy trading regulation.  For example, a market participant can face up to $1 million per day, for market manipulation.

Every market participant should have a risk policy informing the relevant personnel to never engage in any prohibited marketing practices such as manipulation, wash trades, prohibited pre-arranged trades, noncompetitive trades, accommodation trades, fictitious trades, impermissible sleeves, prohibited trading in constrained markets, trading at off-market prices, trading at the close, pegging or supporting existing prices, uneconomic trading, misleading, false, or inaccurate reporting, recordkeeping requirements (including company, regulatory exchange, and all other requirements), false price reports, false statements, and anti-disruptive trading practices.  Unfortunately, a prohibited conduct is often a matter of interpretation based on the “totality of circumstances.”  For example, in a recent enforcement case, the CFTC fined a market participant for attempting to benefit its financial positions by uneconomic trading of fixed-price physical contracts, and pointed out that the market participant’s risk management department never questioned or disciplined traders for having a high market share at any particular hub location.  While this statement was made by the CFTC in a particular context, the question remains how can any market participant identify a particular market share limitation for its traders, especially in light of real-time trading information?  In particular, recent pullback in commodity prices has seen a significant decrease in liquidity at many trading points.  Consequently, market participants that comprise a relatively small percentage of trading activity at those delivery points could suddenly gain a significant market share just by virtue of many other market participants dropping out.  It may be impossible for the remaining market participants to measure their market share at those delivery points, especially if they have physical delivery obligations to meet.  Thus, framing this issue in terms of a proactive risk policy could be very difficult.

Finally, another factor creating regulatory and financial exposure is the fact that the costs associated with establishing and maintaining a robust risk management program, including a risk policy, combined with the severity of potential fines and penalties for violating the regulation, may be cost-prohibitive to many energy utilities.  In particular, any savings realized to the ratepayers by utilities’ hedging programs could be significantly smaller than the costs of creating and maintaining the risk management aspects of the utilities’ business.  Also, the utilities ratepayers could end-up having to pay for any significant regulatory violations.  Therefore, gas and electric utilities are facing a difficult choice of having to minimize the costs to their ratepayers’ and ever-increasing risk management regulatory risk.  To the extent that they decide to participate in the wholesale market place, no matter infrequently, they are required to have the necessary risk policies and procedures in place.

In addition to utilities, other physical energy companies face similar challenges in balancing their core business activities with burdensome regulatory requirements.  For example, a merchant generator trying to optimize a generation asset must carefully outline its risk management and trading/hedging activities to ensure that its marketing personnel do not engage in any marketing activity that could raise a regulatory red flag.  Unfortunately, many prohibited marketing activities fall into a gray area where a market participant may face regulatory scrutiny and great cost just to prove that it did not do anything wrong.  The increasing sentiment among energy market participants–that they are deemed guilty of a regulatory violation until they are proven innocent–is creating a difficult choice for many: either curtail business activities due to regulatory uncertainty or allocate significant resources to establishing a significant risk management infrastructure.  This is a tough choice in any business environment but, it is especially tough in the time of depressed commodity prices and margins.  Similar to merchant generators, a natural gas gathering company or pipeline is facing a similar dilemma.  What makes their circumstances even more complicated, many natural gas gathering companies, pipelines, or storage providers are subject to either federal or state regulators, limiting their rates of recovery and mandating their market behavior.  On top of that extensive operational and regulatory mandate, they also have to carefully navigate the wholesale marketing and risk management aspects of their business, no matter how infrequent it may be.  For example, a natural gas gathering company must move the natural gas it receives from a producer, no matter what the market conditions may be.  The flow of gas must continue in order for producers to meet their contractual obligations to royalty owners and other market participants.  However, even a traditional natural gas service company such as gathering company, pipeline, or a gas processing facility is now required to comply with a plethora of risk management or trading regulation, no matter how infrequently they may participate in the wholesale market.  In other words, they are expected to meet the extensive requirement regarding risk management prowess that can only be memorialized in a risk policy.  Again, this can be a very expensive proposition in any market environment but, it is especially expensive in the depressed markets.

Considering the recent regulatory guidance and enforcement cases, it is clear that every market participant is expected to allocate sufficient resources to ensure that risk management systems allow to properly identify, quantify, and manage wholesale trading or hedging risk, no matter how frequently such market participant transact in a wholesale market.  In addition, all market participants should continuously reiterate that all personnel at the company need to be committed to regulatory compliance to ensure the company’s conduct conforms to the relevant regulatory requirements including FERC, CFTC, and exchanges. This means communicating to all trading/marketing/hedging employees that they must comply, at all times, with the company’s risk policies regarding: authorized transactions, parameters and controls, restricted and prohibited activities, prohibitions against concealing trades, possible disciplinary actions, and required employees acknowledgements of compliance.  These compliance goals should be memorialized in a proper risk policy, drafted to adequately balance the necessary compliance without unnecessarily constraining the day-to-day business objectives.

To be clear, having a robust risk policy is not, in itself, a guaranty of regulatory compliance.  Many recent enforcement cases and orders have been issued against sophisticated market participants that, arguably, had some of the strongest risk management policies and procedures.  A risk policy is only good if the relevant employees are directed, incentivized, and accountable to comply with it.  The effectiveness of a risk policy must be measured by, among other things, making clear to management its responsibility to report to the board any “red flags” or other signs of improper conduct or questionable risk; overseeing management’s involvement in and commitment to a risk policy; scrupulously adhering to the policy; and considering an employee’s compliance with policy and relevant regulations in that employee’s compensation, promotion, and disciplinary action.

There should be no doubt that any energy company that participates in energy trading activity, however small, must have a robust risk policy.  Recent regulatory enforcement cases have imposed significant monetary fines on companies and individuals involved in violations of energy regulations.  The increased regulatory scrutiny on individual responsibility of traders and senior management makes it clear that every market participant must create the necessary risk management infrastructure, including a robust risk policy, to adequately protect the company, its employees, senior executives, ratepayers and shareholders from unnecessary regulatory and financial exposure.

 

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