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					Pipeline April 2000

Games Markets Play
risk analysis for energy markets
Edward Sankey reviews risk and offers some relevant analysis.
“I cannot believe God plays dice” Einstein said when presented with the idea of quantum mechanics. Clearly he did not work on a trading desk, or indeed very near to business! The nature of commerce is to place bets. It is not expressed like that: businessmen prefer to say that plans are carefully made, experienced executives use their best judgement, facilities are well run by trained staff, traders follow developments in supply, demand and prices closely. These are all ways to remove some, but certainly not all, of the unpredictability out of business activities.

The need for risk analysis
The importance of risk analysis in preventing major accidents or physical loss is well recognised. Engineering projects are taken through detailed risk appraisals to find the possibilities for under-performance or failure. In the oil industry, the Piper Alpha disaster led to appraisals becoming even more rigorous. Without systematic approaches to risk analysis, immense bridges could not be built nor, for example, could new medicines be introduced. “The scientist who developed the Saturn 5 rocket that launched the first Apollo mission to the moon put it this way: you want a valve that doesn’t leak and you try everything possible to develop one. But the real world provides you with a leaky valve. You have to determine how much leaking you can tolerate”, quoted by Peter L Bernstein in his book Against The Gods. A business and its operating environment are even more complex and uncertain. For example, some banks suffered massive losses because the Russian economy collapsed but businesses rarely receive the same level of risk management as engineering projects. Exceptional events, of course, are not the only justification for business risk analysis. Every business activity is undertaken, day by day, against a profile of its risks, and prospective rewards. A car component supplier working a “just in time” supply system with a UK car assembler suffered heavy penalties because one of its trucks was involved in a traffic jam caused by somebody else’s breakdown, and the assembly line had to stop. Consumer interest in the newly launched banking service Egg was too great for the number of telephone agents, and Egg probably lost potential customers.

The upside of uncertainty and the range of business risks
The aim of risk analysis is to improve the balance of risk and reward in the daily commerce and development of the business. Whilst cost advantages and superior products are certainly two ways to achieve above average financial performance, so is a better risk/reward balance than that of competitors. In much of business, and not least in trading activities, risk is two-sided and factors can become better than expected. The challenge is to protect the business against the downsides, without limiting the upsides to the same degree. Managers and traders are sometimes surprised to realise the wide range of sources of uncertainty to which their businesses are exposed. The figure below illustrates some of these sources.

The particular risks arising in any source can come from a number of causes, technical problems, political developments, commercial or transactional difficulties. Risks can have an immediate impact or one that emerges gradually. Clearly, the significance of each risk is different for each business. A particular gas trader may be vulnerable to unplanned production cutbacks from a platform. This would be unimportant to most oil traders but they would be exposed to unexpected action by Opec members.

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Managers might focus on a smaller set of risks because of pressure of time. Unfamiliarity with the area of risk can lead to executives subconsciously putting it to one side, or saying to themselves “there’s nothing we can do about that”. This needs to be recognised as convenient thinking. There is usually something that can be done using a systematic approach. Experience has shown that the most damaging risks have been the totally unexpected. Ratners might still be a high street name if its jewellery products had not been publicly attacked by its own most senior executive. Good risk analysis would have made clear that the products’ image was important but fragile.

Risk controls
The value of this systematic approach is to develop the means to control the likelihood of the impact of the risks on the business. “Likelihood” and “impact” are particularly important. High impact/high probability events clearly are a priority for attention. Low impact/low probability events can be ignored, at least for now. A key challenge is prioritising frequent events with low consequences against highly unlikely events with catastrophic consequences. For example, the business’s risks may include repetitive small transaction errors by staff and the extended loss of information technology systems by fire or flood. In the long run these two may cause similar levels of average annual loss. A systematic approach provides a priority list of the uncertainties to control. The development of cost-effective controls is the goal of risk management.

Risk management as a system
This is not a once-off activity and it must be embedded in the management of the business, to use the phrase of the Turnbull Report on Internal Controls, part of the corporate governance guidelines of the Stock Exchange.

The overview of a risk management system can be illustrated as follows: A business has a certain strategy and, for example, for a trading unit it may be a trading policy. This influences the uncertainties to which it is exposed and their impact. Identifying these is the risk assessment. Unfortunately, this is often where risk analysis stops: file the assessment and put a tick in the procedures checklist box! Risk controls must be implemented. The success, and costs, of these controls need to be monitored so the policy can be reviewed. Provable success in risk control may allow a trading unit to expand its activities, prompting a new risk profile and assessment. Trading desks might ask themselves whether they are a risk control measure for their company, or a business in its own right! Oil, gas and electricity companies may find it an interesting question in respect of their inhouse trading operations. Controls entail cost, or foregone opportunities for profit. Improvement in the risk/reward balance needs to be compared to the costs of achieving the improvement. Apparently, because Barings Bank preferred to “reward” its star trader by having him double up as the back office manager rather than pay for a separate manager, the bank was lost. Proper control would have been very cheap at the price. However, too many layers of authorisation for each trade would make a trading operation uneconomic. Improvements in information flows for traders and managers can be very cost-effective. These may be about operational or market conditions, or trading performance and positions. Adequate relevant and timely information greatly enhances the assessments of potential impacts, putting trading desks in a better position to take corrective or preventative action.

Master the uncertainties - don’t be their victim
Risk is unavoidable and doing nothing carries risks. All that can be avoided, at one’s peril, is tackling risk. The good news is that the risks, the rewards, and the control costs can be changed. In his book on business risk, Kit Sadgrove reports a sign in a New York dealing room “Hide from risk and you hide from its rewards”.

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