While the energy and commodity markets have always been volatile, over the last 18 months, there has been a surge in volatility, due to geopolitical events such as the Russian invasion of Ukraine and all the knock-on impacts, including gas supply issues and higher gas prices among others. Heightened levels of default risk, performance risk and even liquidity risk have made for a wild ride for traders and risk managers alike, who may have traditionally underinvested in managing counterparty credit risk.
Unique Aspects of Energy Markets
Energy markets differ significantly from traditional financial markets due to the physical delivery aspect of commodities. They involve a wide range of products, each with their own unique attributes. The granularity of the energy market's life cycles, seasonality and intricate analytics make risk management highly complex. Additionally, factors like supply chain disruptions, geopolitical risks and natural disasters affect performance risk, adding another layer of complexity.
Investments in RiskTech
Despite having been a major focal point during the Enron era and then being deprioritized in recent years, counterparty credit risk is now experiencing renewed attention.
Firms are beginning to invest extensively in areas of counterparty risk, spanning from basic management to advanced analytics like Potential Future Exposures (PFE) and Credit Valuation Adjustments (CVA). Stress testing and predictive analytics are also gaining traction, particularly in cash management.
On one side, there are the large global players that have invested over the years in sophisticated legacy systems. But various factors like mergers and acquisitions in the industry mean that these systems are typically quite siloed. Often these firms are looking to replace the old technology and implement truly enterprise solutions that enable them to obtain a full view of risk and to be more proactive about risk management. On the other side, there are the smaller players that are coming to market for improved technology and analytics because they've realized that relying on spreadsheets is not a sustainable or competitive approach.
Small and large-sized firms alike are motivated by getting a better view of risk across their portfolios and improving their overall risk management function. Greater automation instilled by modernized systems is also key to coping with high trading volumes and analyzing risks efficiently.
Risk-adjusted pricing is a methodology that seeks to align the price of derivatives with the inherent risks they carry. This approach acknowledges that not all risks are created equal, allowing market players a more nuanced assessment. By factoring in volatility, creditworthiness and market conditions, risk-adjusted pricing ensures that derivative contracts accurately reflect the risk profile. In doing so, stability and transparency are fostered, safeguarding financial institutions and investors alike.
Today, risk-adjusted pricing is a growing trend in the energy markets, albeit not universally adopted yet. Some regions are hesitant to embrace risk-adjusted pricing due to concerns over short-term competitiveness. Nevertheless, it is an evolving trend that is expected to result in more nuanced approaches to counterparty credit risk management as time goes on.
Key Trend to Watch…
2023 has been a record year for investing in technology for managing counterparty credit risk, which is likely to continue and even accelerate in 2024 and beyond, given current market conditions and the fact that these are typically multi-year projects.
Firms investing in upgraded risk systems are entering a new era of commercial-based trading in energy markets. The cost of capital, credit and other financial factors will play a significant role in shaping the industry's future, ultimately determining winners and losers based on how they manage these dynamics.
Navigating the energy markets in the face of heightened volatility and counterparty risk is far from easy. However, prioritizing advanced analytics and technology adoption to streamline operations and make informed decisions will enable firms to gain a competitive advantage in this ever-evolving sector.
Want a deeper dive into this topic?
For further insight into the multifaceted world of energy markets amidst heightened volatility and the vital role of risk management, listen to our podcast: "Navigating Volatility and Counterparty Risk in Energy Markets.” Hosted by Jim Jockle, an expert in capital market risk management technology, this informative podcast features Karl Sees, the global head of product strategy and pre-sales for Cube Logic.