Collateral Risk Analytics for Energy Trading and Portfolio Risk Management
Summary of report by PA Consulting Group for the Energy Power Research Institute (EPRI).
Energy firms are required to post collateral for various types of trading or contracting activities. Accurate calculation of the amount of collateral, whether it is the amount one firm expects to post, or expects to require a counter-party to post, can become complex. For example, taking into account market conditions, such as forward pricing, anticipated market volatility, correlation behavior and situation-specific aspects, such as netting across obligations with a given counter-party.
Contracts often contain clauses requiring that additional collateral be posted mid-stream depending on market conditions and the financial conditions of the counter-party. Energy firms need to calculate the likelihood of such events and either be prepared to comply with the additional posting or find a way to hedge that risk in advance.
Trading activities often require material amounts of cash for collateral. The recent economic crisis was rife with examples of companies caught short on cash and with no other option but to liquidate hedges. Many companies enter into trades that require collateral, but front office staff often lack an understanding of the expected and potential collateral required for those trades. Weak collateral and risk management controls can capsize company balance sheets with alarming consequences, resulting in a rapid reduction of available cash and credit reserves. Bankruptcy, even business failure, could ensue. Compounding matters are the over-the-counter (OTC) derivatives regulation, the rules for which the CFTC and the SEC are in the process of drafting. Depending on their final form, these rules could significantly increase the cash collateral required to engage in energy hedging and trading.
This report describes the need for a strong collateral risk management function as an integral part of an energy company’s risk management programme. It reviews the basics of margining and collateral both in over-the-counter markets and on exchanges.