Risk swap

Major energy consumers can be forgiven for looking back on the past as a golden era – those halcyon days when energy procurement was about calculating your need for the year, followed by a straightforward tender. When prices stayed relatively stable, and operational budgets were predictable. When carbon emissions, climate change levies and renewable obligations were someone else's problem.

But now, we are definitely living through the interesting times of the famous Chinese proverb. Energy is at the top of everyone's agenda: the media, politicians, consumers, investors. And risk managers.

Energy derivatives

Major industrial and commercial consumers, who two years ago were struggling to balance budgets in the face of rising prices, were facing the possibility of a serious overspend as prices dropped at the beginning of this year. The combination of market volatility and widespread concern about climate change has meant that managing energy risk is a far more complex process than ever before.

This is partly because energy portfolios themselves have become more complex. A number of forward thinking companies who had no previous experience of trading energy other than procuring physical supply for their own needs, are now taking financial positions in the energy markets. Commodity, emissions and climate derivatives are being bought and sold alongside physical power supplies as a mechanism for hedging exposure to the risks inherent in a series of highly volatile markets.

However, unlike the purchase of gas, power or fuel oils, the trade in these financial instruments is highly regulated, and they are subject to the same stringent standards as bonds, equities and other more traditional asset classes. This means those individuals who are responsible for energy portfolios are having to enter the deep waters of financial market regulation, and are having to involve risk managers to keep wider operational risk at a minimum.

If that was not daunting enough, those financial markets themselves are about to undergo a radical change. After much debate and speculation, the new European Market in Financial Instruments Directive (MiFID) is finally with us and will be implemented by all EU member states in November.

MiFID is designed to harmonise the way the financial sector in Europe does its business, and provide a more competitive and efficient European market for financial services. It is also designed to protect the investor from unscrupulous companies and investment houses. It is one of 42 directives that together are known as the EU Financial Services Action Plan, which were introduced alongside the Euro in an effort to provide the impetus to make Europe a financial powerhouse.

Where MiFID applies

Volatility in the energy markets has meant that energy procurement has long been a financial as well as a physical process. With the arrival of MiFID, the relationship between finance and energy has become even closer. The new regulations have several implications for firms who are, or are considering, trading commodity derivatives. More accurately, MiFID has implications for the advisers they choose to assist in this activity.

“Volatility in the energy markets has meant that energy procurement has long been a financial as well as a physical process

First of all, it is important to look at where MiFID does and does not apply. For example, if your firm is simply buying or selling physical supply of gas, power or fuel oils it does not apply. However, financial instruments that are derived from these assets do fall under its remit.

Furthermore, MiFID does not apply when trading of these instruments is incidental to the primary business of your organisation. So a supermarket or pharmaceutical company that trades climate or emissions derivatives need not be concerned by it.

The major concern is when you start taking advice from professional consultants and risk advisers. Firms that offer investment advice are most emphatically covered by the new regulations, as are those that receive or transmit orders in respect of financial instruments, or execute orders for you. And this is where you need to be extremely careful about the energy consultants that you choose.

Although the majority of energy specialists can advise on the purchase of physical supply, it is a criminal offence for them to advise on the trading of regulated assets – such as commodity derivatives – without being regulated themselves by the appropriate body. In the UK that body is the Financial Services Authority (FSA), since these are financial instruments and there is no authority specifically for energy consultants,

Accreditation by the FSA is not just a get out of jail free card for consultants. It also offers reassurance and peace of mind to their clients, for accreditation gives you the means of judging the competence of your advisers, and the knowledge that they have been assessed to be up to the task in hand by one of the world's most rigorous regulatory bodies.

This is important, because taking a financial position in any market – energy, emissions, commodities or futures – is an inherently risky process.

Risk management

An FSA-accredited adviser can work with you to devise risk management processes that apply to your energy portfolio, and dovetail with existing operational risk policies. That ensures that all trading activity happens according to the rule book, and that valuable assets will not be mis-managed. Equally importantly, the individuals who execute trades are prevented from adopting too much responsibility for trading and are protected from the possibility of error. With properly established procedures in place, individuals simply cannot sign off on trades, and then hide the consequences if it all goes wrong – as Nick Leeson, among many others, did.

Instead, effective management structures and carefully delineated and rigorously enforced risk management policies and procedures will prevent unacceptable trades taking place. At the same time a robust system and administrative framework in the back office, where trades are matched and confirmed, exposes any anomalies and ensures that these trades cannot be covered up.

There is no question that adopting a more diverse energy portfolio will minimise a company's exposure to energy price risk. However, only by choosing an FSA-accredited consultant or the national equivalent in other European countries can they ensure that they are not simply swapping energy price risk for potentially catastrophic levels of operational and enterprise risk.