So, what makes energies unique? The complexity underlying this question is the reason GARP was inspired to create the Energy Risk Professional (ERP) certification program in the first place. Energies are unique from their traditionally traded counterparts. The differences are what make energies so absorbing and worthy of study. Learning about their underlying characteristics is fascinating, trading in them is a thrill, and managing their risks is maddening.

“Energies” is a generic term I use to indicate financially traded instruments in the energy sector (and all the risk management that’s entailed). Of course, there are many similarities across money and energy markets. Credit and counterparty risk, for example, is a real concern for those in both arenas. Likewise, uncertainties in the political (read: regulatory) realm are shared by actors in both traditional and energy markets—regulators even often cross-over these fields (think CFTC, SEC, for example).

There are probably as many differences as there are similarities between money and energy markets. This post quickly highlights some of the diversity between the two.* (For those who are inspired to learn more, and for the daring, I suggest you examine the ERP section of the GARP website and consider joining the vanguard of those with the mark of specialization in this exciting field.) In this post I seek only to introduce the topic of traditional vs. energy market differentials. Subsequent posts will very quickly examine some of the elements in (somewhat) greater detail.

But for now…


The Fundamentals

Those dealing with energy instruments quickly come to understand that the value of their holdings is affected by more than what happens in OTC markets, on the floors of the NYSE, or by interest rates. Weather, political happenings, wear and tear, and human error can wreak havoc on the value of energies. When a hurricane whips through the Gulf of Mexico, for example, refineries along the coast and oil drilling platforms shut down until the storm passes, causing a back-up in delivery and processing of crude products, which in turn affects pricing down the line. A quick shutdown is easy to deal with though; imagine the hair-pulling that happens when a platform is knocked off its pilings or a refinery gets smacked with a tidal wave—physical damage can take weeks or months to repair, causing even further disruptions in projected prices and values.

All kinds of things happening on the ground—out there in the “real” world—can upset the value of an energy holding. A pipeline shuts down in Alaska because corrosion demands repair. Or, a pipeline in Colombia is bombed by disgruntled rebels. Oil tankers run aground or get hijacked by pirates. Refineries explode. Wells come up dry. Residents fight new exploration and production (the NIMBY—not in my backyard—factor). Earthquakes shut down mines (see: Chile). Oil and natural gas companies are nationalized (see: Latin America). Wars break out. Shipbuilding is delayed, highway infrastructure gets clogged, storage tanks leak, blackouts occur, power lines go down, the wind dies, and on and on.

You get the picture. A trader holding an energy instrument needs to be aware of not just what is happening on the trading floor, but also of what’s happening in the entire upstream-to-downstream train. To do otherwise is poor risk management and invites negative returns on value.


Price Drivers

Compared to money markets, the number of and complexity of price drivers for energies are dazzling. Pilopovic (see citation below) does a remarkable job of laying these out as an introduction to the complexity of energies. Here I replicate her table in order to give a bird’s eye view of the difference between the two markets. I recommend picking up Pilopovic's book (much of which is used for the ERP exam) to get better acquainted with the subject.

Issue	In Money Markets	In Energy Markets
Maturity of market	Several decades	Relatively new
Fundamental price drives	Few, simple	Many, complex
Impact of economic cycles	High	Low
Frequency of events	Low	High
Impact of storage/delivery; convenience yield	None	Significant
Correlation between shot- and long-term pricing	High	Lower, “split personality”
Seasonality	None	Key to natural gas and electricity
Regulation	Little	Varies from little to very high
Market activity (liquidity)	High	Lower
Market centralization	Centralized	Decentralized
Complexity of derivative contracts	Majority of contracts are relatively simple	Majority of contracts are relatively complex

As Pilopovic notes, "Energies respond to the dynamic interplay between producing and using, transferring and storing, buying and selling, and ultimately 'burning' actual physical products." Remember that statement each time you make a move in the energy market - it should give pause to ensure the right trade / hedge / model / measurement ' move is being made.

A quick look at the actual physical environment energy commodities must navigate to make it to market, and a brief overview of the differences between money and energy markets (above) reveals the complexity of energies, and why the variations are worth further examination. I hope to tackle many of these elements in future entries. In the next post I will take a quick look at the impact of storage and convenience yield on energies. Stay tuned...

*Many of the concepts in this post were inspired by: Dragana Pilopovic. Energy Risk: Valuing and Managing Energy Derivatives (McGraw Hill, 2007).

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Posted by Shaun Randol at 4:08 PM 0 comments

Following quickly on the heels of the executive risk manager panel was a discussion on "Enterprise Risk Management: Integrating Risk and Performance Management - A Multidisciplinary View on Risk."

And might I say, I am amazed at the size of the crowd still in attendance. Hundreds! Snowstorm? What snowstorm? Bah!

Readers will forgive me if I am short on names and titles appearing on this panel. I showed up a few minutes late and there were some switches made. I caught the names of a few of them, but only the first name and company of the last. Appearing, then: Kevin Buehler, Director, McKinsey (and moderator); Jonathan Stein, VP and CRO, Hess Corporation; Kanwardeep Ahluwalia, Head of Financial Risk Management, Swiss Re; Glenn Labhart, President of Labhart Risk Advisors, and Rodney, from Vanguard.

Here are some of the highlights:

Buehler: How does risk management work in your company?

Ahluwalia: Swiss Re uses a three signature process to increase accountability and ensure that multiple parties are involved in decision making processes.

Stein: At Hess, the key is to be transparent. One needs to be consistent too, and this is accomplished with formal, standardized processes (be it in determining metrics, governance, etc).

Labhart: Mr. Labhart looks at the energy value chain as a model - production, processing, and storage are elements along this chain that must be considered. The point is to identify and define what physical risks you have to better understand exposure, and the best way to hedge/mitigate the risks.


Buehler: On risk and return trade-offs: How do you make sure people take it seriously when executives are most interested in just looking at returns?

Stein: Change is coming through increased transparency and how to promulgate the risk structure. Qualitative and quantitative methods are being combined, the latter providing a basis for discussion for the former.

Strategists make assumptions five to ten years out, whereas risk managers get bogged down in, for example, correlations. Risk managers need to do better in making more strategic assumptions.

Labhart: Business units and risk units need to communicate more effectively so there is one view everyone shares, and there are no misunderstandings.


Question from audience: During annual budget and strategic reviews, is enterprise risk management considered?

Roger: One problem to consider is how to collate all the information coming from below to convey to executives.

Labhart: The reviews are the best time to capitalize on the relationships created throughout the year. Leverage these connections so that all voices can be heard and understood for moving forward.


Question from the audience: How long can CEOs hold out and listen to risk managers when the sky seems to be so blue? When things look golden in the market, for how long can the CEO take the advice of risk managers and keep his foot off the pedal?

Ahluwalia: It's a very good question. Even in good times, though, what are the signals for bad turns? Bringing this to the fore is difficult too. Personalities of CEOs differ, but the imporant thing is to make decisions. Good or bad, decision making provides practice and allows for the ability to self-correct when the time comes.

Stein: How do you turn risk analysis into action? When risk appetites are too great, how do you implement measures (triggers) that mitigate doomsday events?

Rodney: Guiding principles, values, ethics keep you on the right path. For example, when internet stocks were soaring and looked great, Vanguard did not bite because they did not fit into our core focus. We avoided them and did not get burned when the bubble burst.



And that... my friends... is it for my reporting from GARP's 11th annual convention! I hope you all enjoyed my notes, and I look forward to seeing you at upcoming events.

Until then, let it snow...

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Posted by Shaun Randol at 3:49 PM 0 comments

Following the keynote address by Susan Schmidt Bries, a panel of experts convened to ruminate on the concept, "Executive Risk Managers - The CRO Perpsective."

Panelists included moderator Aaron Brown , CRO at AQR Capital Management; Ken Abbott, Managing Director at Morgan Stanley; Lawrence Prybylski, Partner at Ernst & Young; Dan Rodriguez, CRO at Credit Suisse; and Ken Winston, CRO at Western Asset Management.

Here are some of the highlights:

Aaron Brown: Which risk management tools proved their worth over the past couple of years? Which did not?

Winston: VaR is a normal market tool, and for commodity markets VaR did its job - a 99% success rate. In other arenas, however, it fell short. What is the optimal time window, to examine, for example? VaR proved problematic because of the uncertainty of the answer.

Also, stress testing fell short because of unanticipated shocks. Winston likes of idea stress-testing/VaR calculations in Monte Carlo frameworks.

Rodriguez: VaR keeps you distracted from tails. You need to focus on tail risks. Be dynamic in your view to see where you can get hit.

Winston: VaR = worthless and pernicious. Large operations waste time with VaR and they distract from real risks. VaR does not encourage diversification, rather it encourages tail risk. Co-variances from one period cannot be used in another period. Scenario analysis is too variant to account for fat tail risk. Risk managers need deep knowledge of markets and quantitative tools.


Brown: Are risk managers worthless because they did not predict the crisis?

Winston: The question has the premise that the job of risk managers is to predict unforseen hazards. This is very difficult, and predictions could have been better. There was a failure in managing rather than predicting risks. Types of qualitative measures should be used as well.

Rodriguez: Risk managers use a dynamic, evolving view. They must synthesize information, have an awareness of uncertaintity (e.g. regulatory). Across the industry, risk managers could have performed better. Agrees that qualitative information and analysis should also be incorporated.

Prybylski: Risk managers did not have a seat at the table in strategic thinking and planning. Moving forward, risk managers will not be isolated from Boards, product design, long term strategies, etc.


Brown: On regulations, which are good and which should we watch?

Prybylski: Positive elements coming from regulators and supervisors include FSB Publications of best practices. Also, pushing Boards to get more pro-active and forcing conversations with risk managers.

Unfortunately, firms are struggling with how to deal with liquidity risks. Risk managers are aware of regulatory uncertaintity and the implications for organizations. Companies are in states of impasse - resolution of this is important.


Brown: On the appointment of a systemic risk regulator, is this positive or negative idea?

Rodriguez: He likes the potential of reinforcing the Federal Reserve with potential system risk regulators. It's too early to tell, near-term effectiveness is a fantasy. He is not hopeful that regulation will pass anytime soon.

Winston: Systemic risk is being created by uncertainty across the industry over what will happen. A great deal of risk still exists.


And that's that!

Up next: enterprise risk management

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Posted by Shaun Randol at 3:13 PM 0 comments

The threat of blizzard has had little deterrent on GARP conventioneers. Hundreds filled the room this morning to listen to a keynote address by a cheerful Susan Schmidt Bies, consultant and former Federal Reserve Board Governor. Here are some highlights from her speech (paraphrased, of course, don't quote her!).

Ms. Schmidt Bies wanted to tie the theme of GARP's conference (Transforming Risk in a New World Order) to emphasize some risk management failures in the recent economic crisis. Specifically she aimed at mortgage and commercial real estate lending. She likened the crisis to the movie Groundhog Day, in which the main character is doomed to re-live the same day everyday until he learns his lesson. For our purposes, a real estate crisis grips some part of this country on average every ten years. It appears our Groundhog Day schedule runs in ten year cycles.

For Ms. Schmidt Bies, the problem did not rest on hedge funds or in derivatives or in private equity. The crisis landed squarely on the shoulders of mortgage and real estate lending. Let's looks at some of the facts:

• Between 2004-2006, new home sales were over one million, well above the growth in number of households--thus, a surplus in houses came about.
• Investor demand normally occupies 1/12 of the sales of new homes. During the bubble, investor demand ranged from 40-60%--hence, speculation abounded.

That said, what is the main lesson to take away from the crisis? That nobody was paying attention to the markets. Big mistake. What was happening instead?

1. Banks were reaching outside their traditional, market footprints. For example, North Dakota banks were making loans in Florida, well outside their footprint.
2. Banks lost sight of what lending should be: they were based on asset-priced lending versus being based on the ability to repay.
3. Credit models were inappropriate for lending. FICO, for example, worked in the 1990s when there was no bubble. FICO measures a willingness to pay rather than an ability to pay, thus no good for the housing bubble. Loan types changed as well: no dock loans and complex loans came into vogue, and they were peddled to those with lesser levels of financial literacy. 228 loans, with their automatic, periodic payment jumps, were passed on too easily.

One real problem with the recent crisis is that banks and financial services moved from customer-based to transaction-based mentalities. Mortgage lending provides a prime example; but when bankers' bonueses are tied to the closing of a deal, the problem is bound to be exacerbated. With the transaction-based mentality, value and risk are overlooked.

In short, Ms. Schmidt Bies says when you have a market failure you cannot rely on market mechanisms to correct the mistakes.

On Fannie Mae and Freddie Mac: the entities were pressured to buy the junk mortgages and to push the American dream of home ownership (not good things).

On Basel II and risk-based capital: how does one measure liquidity risk? More liquidity should equal more capital. When systemic risk is addressed lack of liquidity is often overlooked.

Leading up to the crisis, Ms. Schmidt Bries says there was too much reliance on VaR models. The lookback periods were way too short, often just 100-200 days. This short attention fueled a downward spiral of bad risk measurement and its consequent investments. Tails, not variances, need more attention. One only goes to capital for unusual and unforseen events - stress testing will assist in correcting these oversights.

Ms. Schmidt Bries says leverage ratios are not good as well. She is concerned over Basel discussions about this because capital held is supposed to be based on assets. But, a) every asset is not equally risky, and b) when based on assets, one often ignores risks off the books (see Bear Sterns).

There are also accounting issues that need tackled, especially for marked-to-market non-trading assets and liabilities. These were highly leveraged during the bubble and needed to be drastically de-leveraged when the bubble burst. Fair value accounting is needed.

In closing, Ms. Schmidt Bries wants to know: what are risk managers going to do to make sure Groundhog Day in the financial world is not going to be re-lived again? Historic precedence should sound alarm bells. Currently too much risk is siloed; CROs need to open risk management to other business units.

Up next: panel on executive risk managers

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Posted by Shaun Randol at 11:46 AM 0 comments

Jon Spector, CEO of The Conference Board, led a conversation with Michael Fallon, Member of Parliament for Sevenoaks and Member of Treasury Select Committee.

Ladies and gentlemen of the Risk Exchange audience, let me caution you: this conversation was rapid fire!!! I took as many notes as possible and tried to keep up with all of the points brought up, but I must say: what follows below is merely a paraphrased conversation. Neither Mr. Spector nor Mr. Fallon should be quoted! Information presented below is merely to give those not in attendance the gist of the positively interesting (and fast!) conversation between these two experienced and thoughtful men.

With that said…

Mr. Spector led the discussion, but threw the floor open to the audience from time to time. It made for a dynamic conversation, much appreciated after a long day. To wit:

JS. Are there steps companies should be taking to limit executive pay? Is executive compensation an issue?
MF. Yes. Governments need to determine, for example, proportionality of compensation.

JS. How do you determine proportionality?
MF. Profits, revenues, relationships to previous years, remuneration generally across the company – all of these elements must be taken into consideration. One cannot tackle it in isolation. If there is no relationship, it becomes unbelievable to the public.

JS. Are there companies we think that are fully ignoring these points?
MF. Governance has improved, especially in terms of transparency. Non public companies, however, are able to get away with more.

JS. It’s a complicated process you describe.
MF. [here MF responded with questions of his own]: Is there accountability to the compensation committees? Are they answerable to shareholders? Was there shareholder activism, or was there opportunity for it?

JS. Now for the role of government. What have you done in the UK?
MF. Requiring annual vote on compensation report, compensation committee chairman, annually. Regulators should have authority to issue mandatory guidance at below board levels, such as pay ratios from highest to lowest pay rates.

JS. Most CEOs are nervous about impending scope of regulatory changes. What do risk managers think of these looming changes? Relief? Concern? Does it make your job more difficult?
Audience: Quite bluntly it’s a waste of time. Compensation has little to do with the riskiness of a company’s situation.
MF. It was not the level of compensation that brought banks down, but some might have encouraged shorter term thinking and strategies. Second, lots of public money has been put to boost the banking system, indeed upwards of 74% of UK GDP. Given high levels of compensation, and huge cost of bailout, the government and people deserve a say in pay structure.

JS. Will new regulations hinder ability to compete?
MF. It’s a strong argument deployed by European banks. Nevertheless, it’s a real and serious issue in UK that must be dealt with. It’s one reason the one-time windfall tax has been introduced in UK. MF is not a fan of windfall taxes, but tax money must be recouped and banks have actually benefited from receiving cheap money to turn into extraordinary large profits. The taxpayer is deserving of a share of that.

UK banking sector is 4 times size of UK’s economy(!!)


JS. On the societal aspects of executive pay: is it a populist issue? If it is, how do companies respond? Is the populist outrage over compensation at a dangerous level? Is there too much scrutiny? Is the populism falling? What are the implications?
Audience: Society definitely has an issue in Nigeria. Corporate remuneration is definitely an issue, including executive tenure.
Audience: Yes, we have a societal issue. Not just in finance, but in other sectors like energy. …There has to be accountability, that there are consequences for irresponsible behavior.

JS. Are we at a societal breaking point?
MF. There is an enormous backlash. And now there is a realization that banks and financial institutions are different kinds of companies than mainstream companies, and now the trust put into these institutions has been fractured.

When people see it is their money at stake, they take a proprietary interest in the fairness of corporate actions.

Audience: Analogy – movie stars get paid almost as much as traders on Wall Street, but there is no outcry for expensive films or actors. The reason is: they are not too big to fail. If they fail, so be it. With banks, that’s different: too big to fail has massive consequences on societal fabric. Maybe we need to make sure banks are not too big to fail.
MF. You don’t have to go to the movies, but you do have to have an institution to deposit and handle money transactions. But what makes bank execs so special that they cannot get out of bed without tremendous bonuses?

Think of General McChrystal in Afghanistan. He is protecting the security of an entire country, yet he does not demand the same kind of compensations.

…

MF. UK does not have nearly as much competition between banks as in the U.S. In UK, why aren’t new banks, such as in retail sector, coming online? How do we stimulate competition in UK?

On shareholder activism – shareholders need to be more involved in the compensation process.

Audience: There is a history of director linkngs, a I-scratch-your-back, you-scratch-my-back mentality.
MF. Not anymore. Banks are losing the rationale for this behavior. If they don’t get out and explain their behavior, regulators will come after them. Transparency is a must that should increase rational behavior.

Audience: Regarding competition: there is an argument that competition increased market uncertainty that forced banks to create more attractive packages for new customers, that may not have been in the best interest of the public.
MF. To an extent, that was true. But the top 5 banks maintain control over 75% of certain banking sectors in the UK. The point MF wants to make is that there may be too many barriers to new entrances into the banking industry.


JS. Prediction: This issue will ebb and flow, but it will come back again, because of one law – law of unintended consequences. We need to invest into the science of executive compensation.

***

With that, the discussion ended. A large group swarmed the stage to further pick the brains of Mr. Spector and Mr. Fallon. Another large goup headed for the cocktail hour... all in all, a very full and productive day!

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Posted by Shaun Randol at 4:57 PM 0 comments

It's impossible to cover all the multiple, simultaneous tracks. I've stuck my head into every single one of them--and you know what? Wow! Full crowds in each one! The energetic attendance for all of these nuanced break-outs is a true measure of the excitement surrounding the many facets of risk management in these trying economic times.

Here's a full rundown of the program. There were 9 today, there'll be 10 tomorrow. Too many too cover!

So, I thought I'd take a walk around the exhibition hall, peek at a few nametags, talk to a few people, and get a general feeling for the mood of those in attendance. Here's what I heard in just a quick, 15 minute stroll during the afternoon break:

- Someone said to me: "Ken Abbott! Ever get a chance to hear him, go out of your way--a very refreshing talk." Mr. Abbott is a Managing Director at Morgan Stanley. He spoke about Basel implementation.

- A gentelman on the phone to his colleague stuck in his office: "It's great! I can't stop taking notes!"

- I picked up conversation in French, Hindi, Chinese and Russian.

- Robert Jackson must have made quite an impression with his keynote address on executive compensation. I heard a duo and a trio discussing this, while an energetic foursome in between animatedly discussed the merits of - or lack thereof - of Basel II.


Up next: panel discussion on executive pay - starting now!

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Posted by Shaun Randol at 3:27 PM 0 comments

Following the keynote address was a panel discussion: The New Role of the CRO: Empowered, Equipped and Engaged.

I had to duck out for a meeting, so I could only catch the gist of two of the panelists' remarks. Here are some quick notes:

Three panelists participated in the discussion:

Anthony Santomero – Senior Advisor to McKinsey, Board of Citigroup and Citibank NA
Jacob Rosengarten – Executive VP, Prez and Chief Enterprise Risk Officer at XL Capital
William Martin – Chief Risk Officer of Commonfund, Chairman of GARP Board of Trustees

Santomero: from Board member’s perspective, he has been watching the evolution of the role of the CRO with interest. At McKinsey, 4 different roles are ascribed to CROs:

1. Risk organization; the CRO is organizer of a decentralized risk system (an orchestrator, if you will).
   
2. CRO is aggregator of risk (reporting function with standards, metrics).
   
3. Empowered advisor – sets risk appetites and policies.
   
4. Clearinghouse of risks, and thereby an owner of risk, that also reports to the Board.

The above are not four choices. They are roles of active participation within a company.

Rosengarten: The role of the CRO is not to just say No, but also to elaborate as to why the businesses you are involved in make sense. And of course, if they don’t make sense, why not? The roles of risk managers at successful organizations involve constructing debate and encouraging discussion. Risk managers should be involved in strategic planning and mitigation schemes, directly involved with the Board. Boards are more fluent in financial matters than risk managers, which is ironic because “risk produces returns.”

In short, risk planning, budgeting, and monitoring processes must be brought to the Board by the CRO.

*

Apologies for the brevity here, but just in these couple of paragraphs some interesting perspectives on the relationship of the CRO to the Board come to light.

Up next: lunch!

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Posted by Shaun Randol at 10:14 AM 0 comments

Coming on the heels of the 2009 Risk Manager of the Year Award is today's Keynote Address, delivered by Robert Jackson of the U.S. Treasury Department. More specifically, Mr. Jackson is with the Office of the Special Master for TARP Executive Compensation.

As a measure of how fascinating Mr. Jackson's presentation was, let me just say that I never once saw someone take out their Blackberry to check email or surf the web. Mr. Jackson delivered some heavy food for thought, and the hundreds in dark suits were all his. Here, then, are some highlights (we'll see if we can't get a copy of the presentation too, but don't hold your breath):

Overview:

Compensation packages played a contributing factor to the recent financial crisis. Restoring trust by changing compensation practices will help us get on the right course. A number of elements will play a key role in this re-alignment, as discussed:

1. Administration Principles on Compensation Reform
2. FSB Implementations Standards
3. Proposed Federal Reserve Guidance
4. TARP Compensation Regulations and Special Master Rulings
5. Summary of Considerations

1. What do we mean by compensation structures contributing to risk management? Performance metrics should take into account risk taking. For example, compensation structures should provide a space for risk managers to have a say. What elements and principles are being considered in the executive pay structure? These should be made know to the public as well.

2. In September 2009, all G-20 countries agreed to tough new implementation standards that will guide compensation decisions at financial institutions worldwide. See the Financial Stability Board standards here.

3. The Federal Reserve has issued proposed guidance identifying three key principles on the relationship between pay and risk, including:

• Balanced risk taking (e.g. lower sensitivity of pay settings)
• Effective controls and sound risk management (e.g. do risk managers have the independence they need?)
• Strong corporate governance (e.g. compensation committees should be set up, and they should communicate pay rates and reasons to the public)

4. Consistent with these principles, the Special Master's rulings require "exceptional assistance" firms to adopt pay structures that link to long-term performance.

• Special assistance firms like AIG and GMAC, for example, but these principles should be promoted beyond special assistance companies. There is a fundamental gulf of understanding of compensation between what executives understand and public understand.

5. Summary of considerations: Taken together, these reforms identify four key considerations for directors and risk managers to take into this year's board room discussions:

1. Analysis of the relationship between compensation and risk taking
2. Structural governance protections
3. Substantive guidance on pay structures
4. Disclosure and accountability to shareholders and the public

Mr. Jackson says that we need to better communicate complex risk management practices and policies to the public. Whether or not this is a rule for the SEC matters not, executives would be remiss not to explain this information to the public, especially given the lessons learned in the past couple of years.

Early empirical evidence of reform: Goldman Sachs, Morgan Stanley rewards payouts will take into account fundamental risk management measures. If risk management does not work, compensation is reeled in.

***

There were just a couple of questions from the audience:

Q. Relating to the market: How will firms retain the talent? Also, a dollar now is worth more than a dollar in the future, which might actually increase compensation packages.

A. Employees hedging compensation is absolutely critical. Stock sold short does not help the principle of the matter very much, if they were supposed to hold onto it for a few years.

Q. Final date for release of rules? Who will regulate?

A. Finalized by end of this year, early next. But the Federal Reserve is operating in face of regulatory uncertainty. U.S. Treasury wishes to be ahead of the analysis before new rules/guidance are promulgated. A new law is not needed, Boards want to get this compensation structure right.

***

Up next, some very brief notes from a panel discussion on emerging CRO roles.

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Posted by Shaun Randol at 10:13 AM 0 comments

GARP's 11th annual risk management convention and exhibition is well underway at the Mariott Hotel in Times Square, New York. The theme this year: Transforming Risk in a New World Order. With this blog, we'll try and highlight some of the happenings here to keep informed those worldwide who could not attend.

Up first, GARP President Richard Apostolik greeted the crowd and provided some general background for the hundreds in attendance this morning. By the end of the day, Mr. Apostolik expects to see some 800 conventioneers stream through. The stage was set for the presentation for the 2009 Risk Manager of the Year Award.

This year's recipient is Liu Mingkang, Chairman of the China Banking Regulatory Commission. A few words about this esteeemed gentleman, from the introductory remarks of Mr. Apostolik:

The roots of China's success can be traced back to the 2003 formation of the China Banking Regulatory Commission (CBRC) and appointment of its current Chairman, Liu Mingkang. Under Mr. Liu's leadership the CBRC orchestrated the recapitalization of China's largest state-owned banks and has implemented a variety of disciplined risk management practices, regulatory oversight policies and corporate governance initiatives. All influenced by Mr. Liu's strong belief in the importance of prudential banking regulation.

In a June 2009 interview with the Financial Times, Mr. Liu summarizes what he believes to be the five major causes of the financial crisis:

• Lack of proper firewalls between commercial and investment banking activities.
• Neglect of macro-prudential regulation.
• Excess financial leverage and lack of transparency
• Short-term profit incentives versus long-term growth perspective
• Government bailouts provided short-term liquidity without solving underlying structural issues - primarily bank balance sheets.

... Since Mr. Liu's appointment in 2003, the capital adequacy of Chinese banks has increased dramatically. In 2003, eight Chinese institutions met minimum capital adequacy requirements. By the end of August 2009, 219 banks were in compliance. Furthermore, over this same six year period the ratio of non-performing loans (NPL) as a percent of total banking assets decreased from close to 18% to less than 2%. Given the performance, it's no surprise bank profitability has mproved dramatically at a time when many global banks have struggled to remain solvent in the face of losses on lending portfolios and illiquid investments. Average return-on-assets for five on China's largest commercial banks has almost doubled over the past three years while retuns-on-equity have increased more than 7%.

...Mr. Liu and the CBRC have been instrumental in guiding China's banking system through the recent financial crisis and have it well positioned for future success.

***

Unfortunately, Mr. Liu could not be in person to accept the award. But he did pass along a note to be read, part of which said: Regulators and supervisors share the common least thankful job, and we share the most risks. For better or for worse we will work together with you.

On his behalf, then, a Director General of CBRC, Liau Min, accepted the award and gave a presentation. Some highlights from this (you will forgive some of the choppy language I use, but the essence is still the same):

Being a regulator is the greatest job, except it is a thankless job. Being awarded the Risk Manager of the Year Award is vindication for their unsung, hard work.

CBRC provides a model for behavior for the rest of Chinese banking system.

CBRC established in 2003 – rolled out banking reform in 2004, including re-capitalization and restructuring and internal controls. Outsiders were brought in to lead and advise, international procedures were adopted. Banks experienced tremendous growth over the following eight years, but…

Can they be sustained? After all, rapid economic growth does not equal soundness of an economic system.

CBRC has six principles to keep in mind in for successful risk mitigation and supervisory practices:

I. Supervisors play a role: “We have been sticking to a set of simple, useful, and effective ratios and targets and limits and always kept a close eye on the key indicators for prudential regulation.” As such, they have 1 trillion RMB to offset any unforeseen upsets in the banking system and to hedge liquidity risk. Remember: “better safer than sorry.”

II. Don’t see trees for the forest. Stopped banks lending to speculative shares, training and monitoring carefully monitored the value of stocks held as collateral, for example.

III. Banking and capital markets – Glass Steagall Act principles held fast to keep risks divided, acts as a firewall. Friends agree most at a distance. Innovation is encouraged, but proper pricing is evaluated, social risk is taking into account.

IV. The quality of bank governance matters.

V. Emphasize risk oversight and transparency.

VI. Learn by doing: International advisors brought in for advice. Set high standards for success. Combat self-assessment. Basel is used as benchmark for supervisory practices. Gaps are identified in the supervisory system, and plans are drawn for future trajectories.


Challenges ahead: credit risk: next 5 years and beyond – transform from growth-driven, export-driven to quality and customer-driven. Potential risks in this sector must be accounted for.

“Creating a culture of risk awareness is GARP’s goal and it is CBRC’s goal as well.” The best time to do this is when times are good, not when they’ve already turned sour.

***

And that's that from the Risk Manager of the Year Award presentation and remarks. Up next, notes from the keynote address of Robert Jackson of the U.S. Treasury Department.

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Posted by Shaun Randol at 10:09 AM 0 comments

When it comes to oil price spikes, those in oil trading have a sixth sense for picking out the vulnerabilities of assets and products tied to those prices. All kinds of things happen when oil prices jump: gold looks more attractive, demand for natural gas increases, political instability increases, the dollar drops in value, food costs increase, and on and on. We see the consequences on exchanges and feel the results in our wallets, but we don’t often see the effects of oil price spikes. Enter risk mapping, or risk visualization.

Here’s a basic, self-explanatory risk map:

http://www.wku.edu/Dept/Support/FinAdmin/RISK%20MAPPING.pdf

But the risk map above is dull—we live in a Web 2.0 world, we like dynamics in our visualizations. Kudos, then, to the World Economic Forum for taking a stab at enhancing the risk visualization experience with a tool that highlights “risk networks.” Although the information is incomplete (if not downright tantalizing) for our purposes, it is still a fun little gadget (here) to use to determine—from a bird’s eye view—the quality of relationships between risk factors, or nodes. In WEF’s risk network, choosing a node allows one to view details (on the “risk landscape”) of its probability (given as a percentage), severity (in costs of USD billions) and, in an added dimension to the traditional risk map, the interconnectedness to other risks (by strength). The map is colorful, connections are clearly delineated, and severity and significance are clearly indicated with circles and bold lines: the thicker the lines, the larger the circles, the bigger the risks.

For example, choosing “Iran” tells us that there are very risky connections to “asset price collapse,” “Afghanistan instability,” “financial crises,” and more. But what the WEF means by “Iran” or “financial crises” and the other nodes is only vaguely defined (the tantalizing part of the tool). “Iran” is defined simply as: “Iran’s nuclear programme and its role in the Middle East increases instability and tensions regionally and internationally.” The riskiest node connected to “Iran,” in terms of severity and likelihood, is “asset price collapse.”

Five categories, or domains, of risk opportunities make up WEF’s risk network: economics, geopolitics, environment, society, and technology. Nodes within these domains include “Iraq,” “Migration,” “Major fall in the US $,” and “Data fraud/loss,” to name just four.

For fun, I chose to examine the effects of “Oil price spikes.” The WEF explains the node “oil price spikes” as “sharp and/or sustained oil prices increases/places further economic pressures on highly oil dependent industries and consumers, as well as raising geopolitical tensions.” So, according to WEF, where are the associated risks when this phenomenon is in play? Would you have surmised that oil price spikes correlate strongly with an increase in “Underinvestment in infrastructure”? What are the reasons for this? Likewise, the factor has an intense effect on “Major fall in the US $,” “Iran,” and “CII breakdown.”

Conversely, oil price spikes have weaker correlative effects on other phenomena, like “air pollution,” (higher oil price = less travel), “migration” (because people can’t afford the oil to power their transportation?), and “nuclear proliferation” (seems odd, seeing as how high oil prices might increase a country’s desire to build nuclear plants…).

World Economic Forum

The fun part of the map is being able to click through the risk networks. Thus, with “Oil price spikes” in the center (above), we can see a semi-strong correlation with “Underinvestment in infrastructure.” Click on the latter, the circles wiz around, and voila! A new visualization appears and we see that “coastal flooding” becomes a very serious concern. Click on “coastal flooding,” and… you get the picture.

Back to the oil price spikes. We can see from the risk network that many risk elements correlate strongly with oil price spikes: fiscal crises, major fall in the US dollar, Iran, Iraq, underinvestment in infrastructure, slowing Chinese economy, food price volatility, and a few more.

Take, for example, “Asset price collapse.” WEF defines it as: “A collapse of real and financial assets in advanced and emerging market economies leads to the destruction of wealth, deleveraging, reduced household spending and demand.” Much of this appears obvious. When consumers must spend more of their income filling up the gas tank, they’re going to have less money to shop at Wal-Mart. Take that thinking up a level and you have the same problem with companies: when companies have to spend more to transport their goods, they have less capital to re-invest in expanding business and infrastructure. Ironically, deleveraging can work to minimize a firm’s risk by paying off debts, but what are the specific dots connecting oil price spikes to deleveraging? There’s some homework for you.

And what about another consequence of oil price spikes, “Retrenchment from globalization (emerging)”? Again, the WEF: “Multiple emerging economies adopt policies that create barriers to flows of goods, capital and labour and fail to engage with multilateral governance structures to address global challenges.” Ah, yes. The higher the price of oil, which comes from just a handful of countries, forces many without the fuel source to put up their defenses, to look out for number one. In extreme cases, an emerging economy may even choose to nationalize oil companies doing business within its borders in order to get a grip on pricing and distribution, among a myriad of other possible economic strategies. But again, the steps between these causes and effects are decidedly lacking in WEF’s risk network. More homework!


Food for thought
Clearly the WEF’s risk network is insufficient for risk managers to use in everyday situations. They don’t even delve into the nuances of financial trading instruments, hedging scenarios and so forth. But that’s not the purpose of bringing it to light. The point of this post is to get risk managers thinking about various ways to map risks, to better see the various risks and measure their correlation to other risks.

It’s a project that has been on the back of my mind for a few months now. How do we in energy risk management visually convey various risk exposures? Is it with a simple X-Y axis graph, like the one above? Or are energy risk managers utilizing innovative methods from outside the traditional risk management network to get a better grip on vulnerabilities? And in doing so, do they create a-HA! moments?

What did WEF get right with this matrix? What risk elements associated with oil price spikes are missing? As noted, the financial side of this is clearly absent. But so are some physical operations, like pipeline risk. What else? Credit freezes, which lead to underinvestment in infrastructure? Precious metals pricing perhaps? Increases in the price of gold often correlate with the price of oil. Higher oil prices means more investment in precious metals which means mining ventures continue to operate, sometimes in marginal, risky countries, which may also have adverse environmental and political effects, and on and on and on.

Can we map that?

What elements would you add? (The possibilities are endless.) Could an energy risk manager effectively (and visually) network physical risk (e.g. pipeline operations) AND financial risk (e.g. volatility)?

Is it helpful to be able to visualize risks? Does doing so add a measure of risk awareness?

Is the WEF model helpful? What other risk visualization models are helpful?

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Posted by Shaun Randol at 3:45 PM 4 comments

Debate about the root cause of the financial crisis has raged for over a year. With blame to go around everywhere, there is no clear winner and many losers. Ill conceived government policies to stimulate single family home ownership, overly accommodative monetary policy, and explosive growth of a loosely regulated and poorly managed shadow banking system designed to disburse risk ….all helped fuel the crisis. Now that bank taxpayer bailout funds are being repaid and fears of a nationalized banking industry allayed (at least until the next “too big to fail” runs into trouble), what is an appropriate level of government involvement in the banking system?

Recent history suggests the key to creating a successful and healthy banking model lies in finding the optimal balance between free-market economics and government regulation. As this is more or less a zero-sum game, let us focus on the regulatory side of the equation. Two recent legislative initiatives could greatly re-shape the banking and financial services industry.

The Restoring American Financial Stability Act of 2009 proposed by Senator Christopher Dodd offers a number of alternatives to Barney Frank’s financial reform legislative agenda including:

• Consolidation of bank regulatory activities under one empowered organization,
• Significant reduction in FDIC and the Federal Reserve’s role in banking oversight,
• Government intervention to soften the market impact of “too big to fail” firms gone bad and
  

Separately, Senators Maria Cantwell and John McCain introduced bi-partisan legislation to effectively resurrect Glass-Steagall a decade after it was abolished. The Cantwell-McCain Legislation would generally:

• Prohibit commercial and investment banks from affiliating in any manner
• Require legal separation of officers, directors and employees
• Prevent commercial banks from engaging in insurance activities
• Create a one year transition period for compliance
  

If forced to choose (which of course we aren’t) the Cantwell-McCain proposal represents a good alternative. There are many who criticize the idea of creating a 21st Century Glass-Steagall Act on the grounds that it is outdated, and simply does not satisfy the needs of the modern financial system. The fundamental premise is that large global corporate clients have sophisticated financing needs that only a fully integrated (‘integrated’ meaning the full menu of commercial banking, investment banking and sales and trading products is offered under one umbrella) global financial organization can provide. Looking over the wreckage left behind from the recent financial crisis, it’s hard to see the wisdom in that argument. It seems the separation of federally insured bank deposits from risky trading and investment banking activities would strike the requisite balance between free-market capitalism and the heavy hand of government (the Dodd bill calls for the bail-out of “too big to fail” firms, up to a $4B ceiling). If the Cantwell-McCain legislation is passed, independent commercial and investment banks would be free (short of mandated max leverage ratios and/or higher risk based capital requirements) to individually pursue profit maximizing strategies, without the risk of robbing Peter to pay Paul.

So what is an appropriate level of government involvement in the banking industry? Surprisingly it may not need to be much more, or extremely complex. Simply separating those businesses with an implicit government backstop (and I am certainly not talking about any “too big to fail”) from capital raising and trading activities might be just enough.

A little better balance between the profit motive and public accountability might help as well. Greed is good. Opacity is unacceptable. Suicide is always to be prevented.

What do you think……..?

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Posted by Jaidev Iyer, MD, GARP at 11:54 AM 4 comments

An overflowing, standing-room-only crowd filled the room on the top floor of the Reuters building in Manhattan last night to hear a panel discussion on energy risk management. More specifically, the topic du jour focused on electricity generation and trading. Art Altman of the Electric Power Research Institute (EPRI) presided over a panel of experts, including Alexander Eydeland (Morgan Stanley), Steven Oster (PSE&G) and Glen Swindle (Credit Suisse).

Chris Donohue, Managing Director at GARP, kicked off the evening with a presentation about GARP’s newest certification, the Energy Risk Professional (ERP) program (learn more about that here). A number of ERP Holders representing the first class of the certification were in attendance as well, and were recognized with a genial round of applause. Congratulations to them for their spirited effort at tackling a tough exam!

(By the way, Alexander Eydeland should be a familiar name to those who have taken the ERP or are pouring over the ERP Course Pack now: chapters from his co-authored book, Energy and Power Risk Management are in the study guide).

GARP hosted last night’s event, as part of an international series of forums on the future of energy risk management. The crowd, approaching 250, listened intently to the panelists’ views on a number of topics, ranging from the complexity of hedging energy to utilization of VaR to smart grid hang-ups, and more. Panelists mused on a few thoughts before turning to the crowd for questions.

Here are some of the highlights:

* Altman led off by asking what makes trading and risk management of electricity and related fuels (gas, coal, etc) so much more challenging than financial risk management of bonds, stocks, currencies, etc? Or, at least what are the salient differences? (Note: this is a dandy of a question, one I hope to take on in future blog posts, stay tuned). Swindle took the lead, bluntly stating that electricity is more volatile. He says power and commodities are “special all the time,” meaning there are a lot of risks with few hedging strategies. In short, he’s “haunted” by the number of risk variables with such few mitigation techniques. How does one handle a commodity that has hundreds of forward curves?

Oster echoed Swindle’s sentiments, then added that electricity is not storable, which is problematic. Also, constraints on physical infrastructure and delivery methods make dealing with electricity unique. Eydeland too shook his head, thinking of the number of variables involved in managing a beast like electricity. Theories and models that work with traditional financial trading instruments just don’t work in energy, he says. On paper, everything looks fine, but engineering and environmental aspects (i.e., the physical world of energy) can change at a given moment, thus adding a measure of complexity to the fundamental issues at hand. On top of all this, the illiquid nature of energies is problematic for risk managers.

* Altman: what are your biggest headaches these days? Eydeland pointed to regulatory uncertainty. Regulations, he said, could change overnight. They are impossible to hedge and forecast. Credit problems are an issue right now too. Money’s not moving fast enough to the right places at the moment, causing headaches in the energy field. Oster’s headache revolves around valuation. How does one value a 30-year old power plant, for instance? Traditional VaR methods don’t work in this instance. Further, he applauded the efforts of the ERP program, because in the energy risk management world, there are no common metrics or models being applied across the board. In short, energy risk managers often aren’t “speaking the same language,” and this needs to be fixed.

At this point, the microphones in the audience came to life. Here are a few highlights:

* One audience member was curious as to how the panelists were dealing with the smart grid factor. Oster noted that once smart grids are used effectively, the dynamics of power usage would certainly be altered. Swindle, however, is holding back on the smart grid factor for now because he is unsure of the rapidity with which the idea will develop. As of now, there are no analytics with which to conjecture. He agreed with Oster though: once up and running, smart grids could refine and smooth the operating market. Altman deftly handled the smart grid line of questioning, noting that in a flip of the status quo, power companies could turn to consumers to purchase energy to fulfill peak demand requirements. In so doing, the risk mitigation technique of turning to consumers could alter hedging strategies. Smart grids will also dramatically decrease peaks in pricing markets. (Clearly smart grids are Altman’s bag. Check him out in the November and December issues of Energy Risk too).

* On taking into consideration the financial health of suppliers in the energy chain, Eydeland says one must worry about this factor “a lot.” And it’s not just credit worthiness—cash flow management has become a concern for risk managers. How funds are allocated within a company (smartly, to the right projects, etc), is something to keep an eye on.

* How does one hedge in electricity knowing that weather is volatile? Put it in the contract! So says Eydeland anyway. But Eydeland and Oster spun the audience member’s question, lamenting on the inability to hedge against economic growth—or lack thereof. Oster, for one, noted that load growth predictions did not live up to their expectations, which can be traced to the economic downturn. This is a real risk management concern.

* How does one choose the kind of power generation to purchase? Choices like picking gas generation over renewable generation are not always easy to make. Well, Oster says, generation and purchase of it varies from state to state. So that’s one problem to deal with. Secondly, the bidding process for power is extremely dynamic. Bids, for example, can go in at 4pm for a set amount of time the following day—but the plant can be called on a moment’s notice to supply power at an unexpected time at a price named for them. In short, there are a lot of variables, known and unknown, that complicate the process.

* On whether or not one should use WTI pricing for hedging purposes. Eydeland says that liquidity is increasing “forever and ever,” and doesn’t see the use of WTI going anywhere.

* An audience member asked if the use of a given commodity VaR gives a false sense of security. Or, conversely, what leniency does it give? Again, Eydeland: no single number should be used as a metric in energy risk management. Use many numbers and metrics, plain and simple.

* To wrap it up, someone wanted to know who “the next kid on the block” is? Who’s the next Apple for the energy sector? Oster, with humor and verve, answered: “Is anyone the leader? No. Is there a lot of money being spent? Yes.” (Note: My eyes are on Google. They just created a utility to buy and sell energy, see more here).

And on that note the discussion ended. 250 people made great use of the open bar and munched on finger foods. The crowd didn’t go anywhere—lots of mingling and further discussion of the night’s topic took place over glasses of chardonnay. I meandered to the panelists’ table where a crowd had gathered and pinned all the speakers back with enthusiastic questions and comments. Swindle fielded questions on load volatility while Altman mused on transitions to green technology, and Eydeland signed a copy of his book for one smiling admirer. All and all, a great night.

Learn more about energy risk management
GARP’s previous energy forum was on December 8 in Houston, TX. On January 28, Glenn Labhart, chair of GARP’s Energy Oversight Committee, will host a webcast on the need for standardized energy risk education and certification. This webinar will be hosted by EPRI (register here). And on February 2, the Zurich chapter will host a meeting on investment opportunities in the global carbon markets. Keep an eye on the GARP website for more events and opportunities to learn about energy risk management.

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Posted by Shaun Randol at 1:49 PM 1 comments

Well here’s a bit of interesting news in the energy trading world. Google Energy LLC, a recently formed subsidiary at Google, has applied for approval from the Federal Energy Regulatory Commission (FERC) to “act as a power marketer, purchasing electricity and reselling it to wholesale customers.”

Yes, that’s right. Google wants to get into the business of energy trading.

Enron anyone…?

As noted in the San Francisco Chronicle, Google spokeswoman Niki Fenwick denies any similarity to the Houston based, now defunct, energy company. "We want to be able to procure more renewable energy as part of our carbon neutrality commitment," she said. Apparently securing “market-based rate authority” from FERC could allow the company to purchase power from alternative sources like wind, geothermal and solar.

(By the way, this is not an unprecedented move. Wal-Mart owns Texas Retail Energy, an electricity provider it helped create in 2004, to provide power to its stores. It has yet to sell electricity).

Google is not new to the energy sector. It already consumes massive amounts of energy to power its data centers. It is also no stranger to funding alternative and green energy initiatives through its philanthropic arm, Google.org. Many of Google’s facilities are also topped with solar panels. In a way, then, getting into the energy business seems like a logical step for a company used to venturing and investing in places it holds technological (or at least psychological) dominance, like books, video (YouTube), mobile phones (Nexus One), and more.

So if Google wants to get into the energy business in order to achieve a carbon neutral position, more power to them (so to speak). The red flag in this story, however, is in the trading capacity of Google Energy’s positioning. Again, from the Chronicle: “The company doesn't have any specific plans to actually trade or sell energy, but it wanted to ensure it had all the flexibility it needed to reach its goals, Fenwick said. For instance, she described one scenario in which the company could buy solar or wind power directly, strip off the renewable energy credits to offset the company's carbon footprint and then resell the energy.” Google says it has “no concrete plans” to sell energy… but that doesn’t mean it couldn’t.

Where are the potential pitfalls and risks in Google’s move? There will be trading issues, no doubt. How Google intends to buy and sell renewable energy on the open market comes with its own hazards. Same goes for buying and selling green credits and carbon offsets, a trading area still trying to get its legs. Moreover, as a utility, Google Energy will be falling under a new umbrella of state(s) and federal government regulation and compliance.

Further, is there a conflict of interest if the utility Google Energy purchases renewable power generated by companies funded by the philanthropic arm, Google.org?

Google always seems to be one step ahead of the curve, this one is worth keeping an eye on.

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Posted by Shaun Randol at 11:28 AM 2 comments

Systemic risk has been defined many ways, in most cases explained in ways that best align with the interest of specific constituents ranging from bankers, economists, regulators and politicians. Regardless of the agenda, systemic risk is probably best summarized as that of an economic shock or event triggering market dislocation, illiquidity and the potential for failure of a group of institutions that jeopardizes the integrity of the local or global financial system.

Assessing systemic risk (especially in the “So What” rather than the What” sense) can be challenging or virtually impossible. Consider the following examples where, without sufficient warning (at least of the even-I-understand-that variety), market events triggered the failure of these entities and immediately threatened the financial system.

• LTCM, a hedge fund run by “the best of the best” saw its fortunes turn when an unexpected failure on Russian debt triggered a global flight to quality causing LTCM bets to go awry while creating disproportionately large margin calls due to excess leverage.
• Fannie Mae and Freddie Mac, two GSEs thought to be “default-proof” but whose use of excessive leverage and a hedge fund like operating strategy brought each firm to the brink of collapse costing taxpayers hundreds of billions in bailout funding.
• Bear Stearns and Lehman Brothers, a pair of iconic financial institutions whose lack of proper risk management and investment in an undiversified, illiquid, highly leveraged portfolio of mortgage backed securities led to the demise of each.

Assuming systemic risk can be measured in some meaningful way, what are the options for mitigation that would help with the So-What ??

• Creation of a systemic risk regulator is being discussed and on the surface sounds like a nifty idea. The problem is nobody really understands what any ex-ante actions can be taken or catalyzed by such an entity. The other problem is that it reeks strongly of a “lender of last resort” which brings us back to a moral hazard problem.
• Implementation of higher bank capital thresholds would provide a larger margin for error in the event a “systemic financial shock” permeates markets and causes an extensive drawdown in system-wide capital. But “higher” than what, and how high is enough?
• Regulation of leverage has in many cases been self imposed by financial institutions since the financial crisis (the question is does all this last beyond the immediate memory of the 2007-2009 brouhaha). Creating formal regulatory requirements around maximum leverage ratios for regulated financial institutions could go a long way toward mitigating systemic risk, ensuring we do not see a repeat of the crisis.
• Development of a market based systemic risk index used to account for and value a number of independent variables that, when combined, may signal a build-up in system wide risk. This I think is something definitely worth pursuing in the world of risk.
• Adoption of 21st century Glass-Stegal Act as been discussed in Washington recently and may be gaining support among legislators. The original Glass-Stegal Act was created during the Great Depression era to address many of the same questions and concerns we face today. While the complete separation of commercial banking and investment banking activities would certainly help alleviate systemic risk, it is unclear how this might be practically accomplished in today’s highly integrated financial system. More to come on this…..

My armchair view meanwhile is a convenient one now that I am not in a commercial enterprise: simply eliminate leverage altogether. There goes your systemic risk too !!

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Posted by Jaidev Iyer, MD, GARP at 10:40 AM 10 comments

Despite all the hot air coming out of Washington on the need to bolster the renewable energy sector, much of the recent investment in American wind technology and wind farms stems from places like Japan, China, and Europe. New wind energy projects, it seems, are having difficulty locating funding and gaining traction in the U.S. With an unemployment rate hovering at ten percent, it’s a wonder that a sector with such promise for growth and job creation has to go overseas to get a helping hand. What gives? Three elements stand out: frozen credit lines, regulatory and legislative uncertainty, and risk aversion to new projects.


Illiquidity
It’s no secret that small and medium businesses, which make up half of the nation’s workforce and create the most new jobs, are having difficulty getting loans from banks to invest in new infrastructure, more labor, and new research and technology. Banks are holding their cards close for now, but it’s not as if the finance sector is holding out on the energy sector specifically; the same holds true no matter which industry these mid-size companies work within.

Nevertheless, according to the Union of Concerned Scientists (UCS), hundreds of billions of dollars in new capital investment and 300,000 new jobs could be created with the enforcement of a Renewable Energy Standard (RES). UCS reports that in 2007 and 2008, “more wind power was installed in the United States than in the previous 20 years combined, representing a $27 billion investment. More than 70 wind turbine component manufacturing facilities opened, expanded, or were announced. Moreover, according to their respective trade associations, the U.S. wind industry employed 85,000 people in 2008, up 35,000 from 2007.” Despite these arguments, strong winds behind this sector in the U.S. are coming from foreign rather than from Washington or American banks.

Billions of investment dollars are floating around, yet someone like Tom Carnahan of Missouri could not get a single American bank to invest in his $240 million, 150-megawatt wind farm project. Instead, European and Japanese banks stepped up to the plate. In October, Renewable Energy Group and Cielo Wind Power announced a joint venture agreement with the Chinese Shenyang Power Group to construct a 600 megawatt wind farm in Texas. On November 6th, AES Corporation announced that China Investment Corporation (CIC) was purchasing a fifteen percent stake in the company for $1.58 billion. Moreover, a recent report by the Investigative Reporting Workshop finds that 84 percent of $1.05 billion ($849 million) in energy grants have gone to foreign wind companies, with Spanish firm Iberdrola S.A. receiving the bulk of the funds. (Iberdrola employs about 800 people in the U.S.).

(Investigative Reporting Workshop)

The Obama Administration allocated about $80 billion of its economic recovery act to stimulate the renewable energy sector. According to the Department of Energy, as of November nearly $17 billion has been authorized for allocation to companies in the renewable energy sector. Of that, $10.6 billion has been awarded, and of this amount, a mere $348 million has been spent. According to the DOE, of the over 130 projects awarded funds, only three relate directly to wind energy, and even then these projects focus on research and technology rather than manufacturing.

Wind power, one part of a multifaceted energy generation future, shows no sign of slowing down—indeed the sector is growing rapidly. Illiquidity, unfortunately, is putting the brakes on its promising future. Despite the known risks (below), banks should ease up and start doling out cash for these hungry wind projects.


Regulatory Uncertainty
Uncertainty in Washington toward climate and energy policy has put the brakes on any major investments in renewable and new energy technologies. Investors are waiting to hear from Congress which way tax breaks will lean, which industries will be saddled with more stringent regulations, and so forth. “The process of passing climate change legislation that would explicitly encourage investment in low-carbon and alternative energy production has stalled in the Senate, amid opposition from Republicans as well as Democrats from coal and agricultural states,” says the Financial Times. The ball is very much in Obama’s court.

Or is it? Barron’s reports that three sectors of the economy look promising for the next six to twelve months: technology, health and energy. The hullabaloo surrounding potential health care reform at the federal level does not appear to dissuade investors in that industry. Yet debate in Washington, Brussels and Copenhagen about climate change legislation at domestic and international levels seems to instill a sense of “wait and see” amongst alternative energy investors. Considering the broad diversity of the energy sector, however, such stall tactics are possible. Oil, natural gas and coal markets are rather more predictable than untested carbon trading schemes and alternative energy investment sectors, thus providing an outlet for energy investment funds that might otherwise sit idle.

Meanwhile, local governments like those of Maryland, Virginia, and Delaware aren’t waiting on Washington, choosing instead to team-up to incentivize investment in offshore wind development in the Mid-Atlantic. For now, though, state and regional efforts appear to have a minimal effect on overall wind project investment patterns.


Risk Aversion
Perhaps the biggest obstacle—or obstacles—to getting wind projects up and running lie in the difficulty of surmounting and mitigating the myriad of risks associated with this wind energy. A number of financial, social and political risks immediately spring to mind:

• windmills are unsightly;
  
• windmills maim and kill birds while underwater transmission lines disrupt sea life;
• wind is not cost-effective when compared to other energy sources (e.g., natural gas);
• wind farm construction is cost-prohibitive (esp. when it comes to constructing transmission lines);
• wind farms lower nearby property values;
• wind energy is inconsistent (i.e., dependent on the weather);
• regulatory permits are difficult to obtain

Yet these are not insurmountable hurdles. Many claim, for instance, that offshore windmills will be unsightly and will ruin pristine ocean views. But of the proposed offshore wind farm in Maryland, “on the clearest of all days ... [the windmills] may appear as a slight toothpick on the horizon”—hardly a landscaping disaster. And in regards to avian mortality rates, it appears that more birds are killed by cars, birds running into windows, transmission lines, feral cats and a whole host of other sources than are slain by wind turbines. And a new study by Lawrence Berkeley National Laboratory finds that “proximity to wind energy facilities does not have a pervasive or widespread adverse effect on the property values of nearby homes.” And while wind energy is not a constant force, intermittency problems can be mitigated by mixing other energy resources into the grid to compensate for non-breezy days. Nearby hydropower turbines could be opened up, for instance, when the wind dies down.

Yes, it is true billionaire T. Boone Pickens abandoned a plan to build the world’s largest wind farm in Texas when natural gas prices dropped. Likewise the lack of transmission infrastructure was problematic (in the U.S., the wind blows hardest in the most remote places, including offshore). But it’s also true that Pickens didn’t abandon investing in wind altogether, and big companies like GE Energy and Iberdrola continue to invest in wind energy technology and infrastructure in the U.S. and worldwide. The joint Texas-Chinese venture mentioned above also lends to the idea that funding wind projects is an investment that is sure to pay off.

So, yes, there are many risks, but none seem to be particularly or individually dissuasive to wind energy investing. Taken as a whole, however, the list of risks is formidable. (But is this a sentiment based more in psychology than reality?)


For now…
For now though, it appears we will have to wait for legislative initiatives coming post-Copenhagen before a surge in wind energy investment materializes in the U.S. Yet even the slightest breezes off the mid-Atlantic coast, in California, Missouri and Texas indicate the winds are a-changin’. Senator Charles Schumer, for one, has called for a halt to the deal between REG, Cielo and Shenyang, claiming the money received from the government’s stimulus plan for manufacturing wind turbines should stay in the U.S. This could be a shot over the bow that Washington is getting ready to throw its weight behind this burgeoning power sector.

Readers: what other reasons and risks are there for a slow embrace of wind energy investment?

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Posted by Shaun Randol at 10:59 AM 0 comments