It is useful to think of risk as “the impact of uncertainty on your objectives”. Nothing in our future is certain, but we need to identify when the degree of uncertainty and the potential consequences of uncertain events are big enough to really matter. If so, then we need to do something to manage that risk. Otherwise, we can just go about our business.
Whether the risk is big enough to worry about is really a matter of context. Each person or organization will have their own specific ability to deal with events, which means each will have a unique risk tolerance. And even for one person or organization, the tolerance for a specific risk may vary over time as their own circumstances change.
There’s no doubt that effective risk management has to start with a determination of what the organization’s risk tolerance is, including the understanding that this ability to absorb risk can change from time to time.
Effective risk management also depends on recognizing that the environment is always changing too. The likelihood of some impactful event might be low much of the time but become high some of the time. All to say, the potential impact of uncertainty on your objectives – your risk level – is constantly changing as circumstances within and without your organization change.
Efficient Risk Management
Risk management costs money. Whether it is fixed mortgage rates versus floating, or fixed natural gas prices versus index, studies have shown that more risk management (a higher proportion of fixed prices) increases the buyer’s average costs in the long run. It makes sense then to use only as much risk management as needed. Use more when risk is high, but use less when risk is low, to avoid paying for risk management that isn’t needed.
This sounds complicated!
Actually, it is pretty intuitive, and all of us manage our own lives this way without thinking too much about it. Consider, for example, the risk of being caught in stormy weather.
Managing Stormy Weather
When it comes to rain, a risk management tool is an umbrella. From Monday to Friday, you travel to work and you really don’t want to get wet. Your business attire could get ruined, or at the very least you’ll look bedraggled all day at the office. You are pretty much carefree on weekends, but you are risk averse when it comes to weekday wet weather.
Taking an umbrella every day seems far too conservative. While you really want to avoid the impact of getting wet, having to lug an umbrella on a sunny day is burdensome (and maybe embarrassing) and may add the cost of a few lost or forgotten umbrellas.
Realizing you can’t tolerate zero risk management, but 100% risk management is overdoing it, you choose a compromise. You’ll take your umbrella every Monday, Wednesday and Friday and you’ll have hedged 60% of your wet weather risk!
Does this make sense?
Well, just by random chance there will be some rainy Mondays, Wednesdays and Fridays and you will have your umbrella, so you’ve reduced the risk of getting wet. And you are not carrying an umbrella every sunny day, so that’s good.
But it is plain to see that there will also be some Tuesdays and Thursdays when it rains, and you’ll get wet on those days. And there will be sunny Mondays, Wednesdays and Fridays when you still have an umbrella you don’t need or want. On balance, the compromise is not very satisfying -- because it is not very efficient.
For a risk management program to be efficient, it needs to be risk-responsive. Instead of applying a pre-determined amount of risk management all the time, the program needs to apply more risk management when risk is high and less when risk is low.
Instead of taking an umbrella 60% of the time, I will take my umbrella on any workday when the weather report gives a probability of precipitation of 60% or more. That means I could take it on any day of the week, or for several days in a row, if the risk as measured by the weather office is high.
But it also means I am accepting up to a 60% chance I’ll get rained on when I don’t have an umbrella. If that is too high a risk, I should reduce my decision threshold. I can set the level to match my personal risk tolerance. Maybe a probability of precipitation as low as 30% will prompt me to take an umbrella if I am all dressed up for a special occasion. I will take less chance, because the impact of getting wet would be higher and less acceptable.
On weekends, I will take an umbrella only when the probability of precipitation exceeds 70%. This is not because there is less chance of rain on weekends, but because the rain has less impact on me on those days.
The level of risk I face from time-to-time depends on changes in my specific circumstances and objectives, as well as changes in the environment. The level of risk management I deploy is responsive to these changes in risk. That’s the thinking we use any time we decide whether to take an umbrella.
Applying a Risk-Responsive Approach
How can this intuitive risk-responsiveness be applied to energy price risk management for your organization?
As we said before, the first step is an assessment of your organization’s tolerance for energy price risk, including an understanding of how and why that may change from time-to-time.
The second step involves assessing market conditions through a risk lens. This is not about price forecasts, or the absolute level of prices, or even the price trend. It is about the degree of uncertainty in prices. The market goes through periods of high price uncertainty and low. Astute analysts use proven techniques to measure price risk on a continuous basis, quantifying the probability or confidence level of certain price events – like the daily probability of precipitation quantifies the chance of rain – to inform an efficient risk management program.
A risk-responsive approach is the efficient, least-cost way to manage energy price risk so you can be well prepared, rain or shine.
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