Hedging Strategy and Electricity Contract Engineering - IFOR

46 Risk management
risk management is briefly introduced in Chapter 3.6. Valuation models in general
and electricity valuation models in particular are discussed in Chapter 3.7.
3.2. Motivation of and introduction to risk management
It is an established fact that in the financial markets there are no excess
returns without risk, why a zero risk tolerance would result in zero excess
returns [GL98]. To deliver on shareholders demand on return, risk must
be taken, implying that some losses cannot be prevented. The goal of risk
management is to monitor those risks and to contain those losses within
pre-specified tolerances.
The numerous examples of firms that have suffered because of lacking risk
management skills, like Barings, Metallgesellschaft and Orange to mention a
few, show how costly it can be when risk management is not taken seriously.
A firm that does not have its risks under control will have a greater probability
to default. If the firm would default it would cause problems for all parties that
have connections with the firm, the so-called stakeholders. The bondholders
could lose a substantial part of their lent money, the firm’s counterparties could
potentially lose built-up profits and the customers could suffer a lot of problems
if their electricity supplier defaulted. In all cases the stakeholders will demand
something for this uncertainty, a so-called risk premium. The bondholder will
demand a higher interest rate, the counterparties will demand bigger spreads
and better collateral of securities, and the customers better prices. Banks
and other financial institutions are enforced by regulation to carry a certain
amount of capital, depending on the risk level, to decrease the probability to
default. Well functioning risk management procedures within the firm can
avoid or decrease this costly risk premium 1 and hence improve the profitability.
Players in the deregulated electricity market are facing substantial risks. In
such markets in Europe and in the US extremely volatile prices have been
observed. This in combination with the complex contracts and the relatively
1 Either in terms of the stake holder’s demand for a risk premium or in terms of the low
yielding regulatory capital.