KPMG has published the results of a survey on risk management in the power sector.
Widespread modernization is planned in Russia's electricity sector, which will require power companies to raise significant amounts of finance. The stability of the regulatory and legal framework, realistic forecasting of the development of the sector and competent management of market risks are key to attracting private investors and credit institutions to the sector.
Andrew Korn, Head of Power & Utilities, KPMG in Russia and the CIS, noted: “In connection with the reform of Russia’s power sector and the strategic course of electricity deregulation, consistency in financial performance and consequently the management of market risks are playing an increasingly important role for companies. The modeling and forecasting of electricity and fuel markets, synchronization of work on wholesale and retail electricity and capacity markets, the hedging of pricing, foreign exchange and interest risks and other state-of-the-art practical risk management methods will enable Russian electricity companies to increase the consistency of performance and the level of trust in the sector among investors and creditors, and will also enable them to avoid the errors made by Western companies during the liberalization of national electricity markets in Northern America and Western Europe”.
Russian power companies recognize the importance of risk management. The majority of the respondents believe that risk management plays an important (46%) or material (50% of the respondents) function in the overall managing process.
However, today Russian organizations are only embarking on this path. This is the reason why they pay the most attention to the development of a risk management strategy (42% of the respondents) and the construction or optimization of the risk management system (58% of the respondents). Our survey demonstrated that only 22% of the company respondents have a risk management strategy approved by management and specified in a separate document. Only 17% of the company respondents have no plans to develop a risk management function over the next two years.
Scenario analysis is the most popular method used to perform qualitative risk assessment – this method is applied by an absolute majority of the companies. The Value at Risk (VaR) method ranks second at Russian electricity companies – this method assesses the maximum possible loss in a company's value based on a specified probability.
As a rule, Russian companies submit reporting on risks within the framework of the annual budgeting process, and also during major transactions or further to a management request. In most cases qualitative risk assessment is performed once a quarter. Only 6–19% of the respondent companies submit such reporting to management on a weekly basis. In foreign companies a week and a month are considered optimal periods for monitoring the risk positions of the company, while reporting is submitted on a daily basis at the trading divisions of Western power companies.
The conclusion of long-term fixed price contracts is the most popular risk management tool used to counter price changes on electricity and capacity markets – it is actively used by a third of respondents. Futures contracts rank second. Options contracts are practically never used. In all 45% of the respondents believe that a month is the optimal time period when concluding exchange contracts based on the electricity price. Following an increase in the effective timeframe of the agreement, interest falls: in contracts where this time interval was a quarter, 35% of respondents were interested, while interest fell to only 20% for contracts where the time interval came to a year.
The conclusion of long-term fixed price contracts is the only risk management tool used by Russian electricity companies to counter price changes on fuel markets - it was cited by a third of the respondents. In Russia, exchange methods for managing fuel procurement prices (futures, options, swaps) are not used, while a market for financial derivatives for fuel prices has still not been developed. At the same time, Western companies actively use both exchange and off-exchange (financial instruments (natural gas, fuel oil and coal).
The results of the survey show that Russian electricity companies are only now starting to focus on the management of market risks. At the same time, however, respondents highlight significant exposure to market risks and perceive the importance of a corresponding risk management function. In view of these factors, and also the history of the development of the risk management function at American and European electricity companies, we expect that companies will soon start building market risk management functions in a similar fashion to the best practice models used at major Western energy concerns.