Energy Trading Oversight: 10 Questions you Need to Ask

1. EnergyTrading Oversight: 10 Questions you Need to Ask Applying Rigorous Curiosity and Responsible Observation

2. ENERGY TRADING OVERSIGHT • Co-author of the guide: • Energy Trading Oversight:10 Questions you Need to Ask • Purpose of the guide: • Provide a practical business understanding of energy trading and marketing • Offer recommended practices • Help increase one’s understanding of complexities Rigorous Curiosity and Responsible Observation

3. OVERVIEW • Introduction • Background and Track Record • Nature of Energy Trading and Marketing Business • Question 1 to 10: • Overview • Recommended Practice • Discussion

4. BACKGROUND AND TRACK RECORD • Trading and Marketing is necessary to: • Optimize assets, • Mitigate/Manage exposures, and • Provide cash flow certainty • Track Record of business failures: • Enron USA (Fall 2001) • Amaranth (Fall 2006) • Global Financial Crisis (Fall 2008) • Failures due to lack of: • Oversight, • Understanding, • Risk Management

5. NATURE OF THE BUSINESS • Trading & Marketing = Unique & High Risk: • Delegation of authority • Dynamic/real-time markets • High transaction volumes & deal complexity • Involves speculation (open positions) • Uncertainty of measurement (mark-to-market and mark-to-model)

6. 10 QUESTIONS YOU NEED TO ASK • HOW DO WE GENERATE PROFITS? • HOW MUCH RISK ARE WE TAKING? • WHAT IS OUR CREDIT EXPOSURE AND HOW DO WE MITIGATE IT? • DO WE HAVE THE APPROPRIATE ORGANIZATIONAL STRUCTURE? • DO WE HAVE THE APPROPRIATE INTERNAL CONTROLS? • DO WE HAVE A ROBUST RISK MANAGEMENT POLICY? • DO OUR PROCESSES MITIGATE OPERATIONAL RISK AND HOW DO WE KNOW? • WHY SHOULD WE USE MARK-TO-MARKET AND WHAT IS THE IMPACT TO THE FINANCIAL STATEMENTS? • HOW SHOULD OUR RISK MANAGEMENT COMMITTEE RESPONSIBLY OVERSEE OPPORTUNITIES AND RISK? • WHAT ARE THE SIGNALS THAT A TMO MAY BE IN, OR HEADED TOWARD, FINANCIAL JEOPARDY?

7. QUESTION 2 HOW MUCH RISK ARE WE TAKING?

8. QUESTION 3 WHAT IS OUR CREDIT EXPOSURE AND HOW DO WE MITIGATE IT?

9. CREDIT EXPOSURE Securitization = Capital Commitment

10. RECOMMENDED PRACTICE • To mitigate Credit Exposure need to: • I. Establish contracts, • II. Establish credit limits, • III. Monitor credit exposures, & • IV. Manage cost of credit.

11. PHYSICAL & DERIVATIVE CONTRACTS • Bilateral Physical commodity : • Gas EDI Base Contract for Sale and Purchase of Natural Gas (Canada) • NAESB Base Contract for Sale and Purchase of Natural Gas (USA) • Power Purchase Agreements (PPA’s) • Crude Oil Contracts (LEAPs) • Derivatives: • International Swaps and Derivatives Association Master Agreement (ISDA).

12. I. ESTABLISH CONTRACTS • Standard contracts contain terms and conditions to mitigate credit risk. • Settlement • Payment netting • Financial responsibility • Termination

13. II. ESTABLISH CREDIT LIMITS • Establish credit limits based on assessment of the counterparty’s creditworthiness. • Rated: Rating (Standard and Poor’s, Moody’s) provides an indication of creditworthiness(probability of default). Establish credit limit. • Unrated: If counterparty is unrated, request adequate security (cash, LC).

14. III. MONITOR CREDIT EXPOSURE • Credit exposure should be proactively monitored and managed: • By individual counterparty • By counterparty group (grouping based on credit rating) • By industry • Using key economic indicators or a general outlook

15. III. CREDIT EXPOSURE REPORT: EXAMPLE

16. EXERCISE • EnerFactor has decided to sell its Gas and Power Book. • PurchaseCo has hired you to analyze the Gas and Power Book. • How does this additional credit information impact the purchase price? • What questions would you ask Enerfactor about its P&L?

17. III. CREDIT EXPOSURE REPORT • Management should ask: • How much credit exposure do we have? • What is our concentration risk? (by counterparty, industry, product) • How frequently do we review and revise established credit limits? • Do we proactively request additional security?

18. REMEDIES • Counterparty exceeds its credit limit and fails to post:  • Provide notice and suspend delivery of commodity • Counterparty defaults: • Realize on the security posted • Terminate, and liquidate all transactions

19. IV. MANAGE COST OF CREDIT • Cost of credit is dependent upon the type of securitization. Most to least expensive: • Cash, • Letters of credit, & • Parental guarantees. • Exchange traded transactions have onerous securitization requirements: • initial margin, & • variation margin.

20. QUESTION 5 DO WE HAVE THE APPROPRIATE INTERNAL CONTROLS?

21. CONTROL ACTIVITIES • Control activities: prevent, detect, and correct, material misstatements. • Reconciliations are Key Controls: • Ensure errors/irregularities are detected and corrected. • Enhanced by data obtained from independent sources. Validation of Balance Sheet = Confidence in the Income Statement

22. CONTROL ACTIVITIES Independent sources are as follows:

23. RECOMMENDED PRACTICE: RECONCILIATIONS • Implement a month-end review process to reconcile the following accounts: • Accounts receivable and payable • Storage • Margin account(s) • MtM Assets and Liabilities (physical and financial) • Other

24. RECONCILIATIONS

25. QUESTION 7 DO OUR PROCESSES MITIGATE OPERATIONAL RISK AND HOW DO WE KNOW?

26. OPERATIONAL RISK • Operational Risk = Risk of loss due to failed process, people, systems, and legal. • Losses due to failed processes: • Financial losses • Eroded reputation, share price, brand • Customer dissatisfaction Trading & Marketing = High Operational Risk Profiles. 

27. OPERATIONAL RISK • To minimize operational risk & losses ensure: • Efficient processes: • Consume no more resources than necessary • Effective processes: • Provide adequate internal controls to prevent and detect loss • Optimize business performance

28. OPERATIONAL RISK ASSESSMENTS • To ensure processes are efficient & effective...... Perform Operational Risk Assessments 1) Identification and measurement of operational risk: • Identify critical processes. Critical processes have a high likelihood/high impact. .

29. TYPICAL BUSINESS MODEL (PROCESSES) FRONT OFFICE MIDDLE OFFICE BACK OFFICE Settlement and Collections Margin Settlement Price Actualization Volume Balancing Reconciliation (Operations to Invoices) Invoice preparation/checkout (trader sign off, pricing actualization) Derivative Settlement Check-Out Billing and Accounts Receivable Interface Tracking overdue accounts/Collections Trading/Marketing Trade Origination Deal Capture Deal Pricing Deal Structuring Commercial Analysis Deal Validation Deal Summary review and Approval Deal Validation Inter-book Transfers Risk Management Daily Book Management including Limits, Hedging, Measurement, Control Reporting including daily position reports, exposure, MtM Risk Control: reconciling P&L price curve validation, VaR, Reconcile Broker Transactions, Stress testing, Credit Risk Management Collateral/Margining Approval process Credit approval process (Account Debtor Limits) Security Tracking Credit monitoring/reporting Financial and Management Reporting Monthly/Qrtly Financial Statement prep/review Accounting policies, GAAP Compliance Accrual 2 Actual Budget, cash forecast Operations Tracking Sheet development Nominations (monthly & daily) Transport Optimization Tariff Management Manage Imbalances Pipeline Balancing (Pipeline Statements) Volumetric Actualization Contract Management/Administration Creation of contracts and renewals Legal Review (Combined Special Provisions) Storage of physical contracts Confirmation Management, Admin. Deal approval by Trader Matching of confirmations Receiving and tracking confirms Logging and Aged listing of confirmations Correction/Revision process Taxation, GST, Cross Border Transactions Treasury Banking Arrangement and authorities Bank reporting requirements (covenants) Daily/Monthly cash forecasting Margin account controls Manage FX Exposure Regulatory Establish Permits Reporting requirements for EUB, NEB, DOE

30. EFFECTIVENESS & EFFICIENCY 2) Detailed operational risk assessment:

31. OPERATIONAL RISK ASSESSMENTS 3) Identify & implement process improvements • Implement process improvements/internal controls • Develop metrics for processes • Streamline, benchmark, and automate 4) Monitoring and reporting • Document and report learning's • Circulate to management & RMC

32. OPERATIONAL RISK ASSESSMENTS • Management should ask: • Is there an operational risk framework in place? • Have Operational Risk Assessments been performed? Have the recommendations been implemented? • Are Management and RMC are informed?

33. EXAMPLE: CONFIRMATION PROCESS • Confirmation Signed & Matched • Complete • Accurate • Meaningful • Timely What are the potential impacts? • Stuck with a deal or terms not intended • Unauthorized Deal • Invoicing Errors • Loss of cash GOAL MET • Upload prices • Prepare Confirmation • Match PROCEDURES INPUTS OUTPUTS NEXT STAGE • Salaries • System licensing and maintenance costs RESOURCES • Contract term • Contract price • Contract volume Outgoing confirmation GOAL NOT MET What could go wrong? What is likelihood? • Deal entered incorrectly or not entered • Deal information not approved by Trader • Confirmation deadline missed • Previous/next stage wrong • Deal revision not made

34. EXERCISE • EnerFactor has decided to sell its Gas and Power Book. • PurchaseCo has hired you to analyze the Gas and Power Book. • You have reviewed the Operational Risk Assessment performed during 2009: • Financial Settlement Process ORA: Significant internal control weaknesses identified including 5 invoices contained pricing errors, 10 invoices were sent out late, and tax was not correctly calculated on invoice.

35. EXERCISE • How does this additional internal control information impact the purchase price? • What questions would you ask Enerfactor about its Settlement Process?

36. QUESTION 8 WHY SHOULD WE USE MARK-TO-MARKET AND WHAT IS THE IMPACT TO THE FINANCIAL STATEMENTS?

37. MARK-TO-MARKET • Initial Measurement: MtM includes gains and losses on “Day One” measured at fair value. • Subsequent Measurement: MtM recognizes subsequent changes in the fair value in P&L daily. • Best Measurement: MtM reflects the fair value (market prices)

38. MARK-TO-MARKET • MtM has two applications: • Risk Management: MtM is fundamental in the monitoring and management of price risk. • Financial Reporting: MtM is required for financial reporting in Canada & United States

39. EXAMPLE 1: INITIAL MEASUREMENT • A TMO enters into a Natural Gas contract for one year (November 1 to October 31) for 120 gigajoules at $10 (market price) per gigajoule. 1.The transaction will be recorded on day one as follows: Debit: MtM Assets (Balance Sheet) $1,200 Credit: Unrealized Income (Income Statement) $1,200 To record MtM income from one year gas contract at a market price of $10 per gigajoule (120GJ X $10)

40. EXAMPLE 1: INITIAL MEASUREMENT 2. At the end of the first month the entries are as follows: Debit: Accounts Receivable (balance sheet) $100 Credit: MtM Assets (balance sheet) $100 To record accounts receivable for one month of gas delivered (10GJ X $10) Debit: Unrealized Income (Income statement) $100 Credit: Realized Income (Income statement)$100 To reclassify unrealized income to realized income related to delivered and invoiced gas

41. FINANCIAL STATEMENT IMPACT Sample Balance Sheet at November 30, 2XXX Current Assets Accounts Receivable $100 Mark-to-Market Assets $1,100 Total Current Assets $1,200 Equity Retained Earnings $1,200 Sample Income Statement at November 30, 2XXX Realized Income $100 Unrealized Income $1,100 Total Income $1,200

42. EXAMPLE 2: SUBSEQUENT MEASUREMENT A TMO enters into a Gas EDI purchase and sale of natural gas contract for one year (November 1 to October 31) for 120 gigajoules at $10 (market price) per gigajoule. At the beginning of the second month the natural gas prices increases by $3 per gigajoule and the November accounts receivable has been collected. 1. At the time of the price increase the entries are as follows: Debit: MtM Assets (balance sheet) $330 Credit: Unrealized Income (income statement) $330 To record MtM income from gas price increase (110 gigajoules x $3)

43. EXAMPLE 2: SUBSEQUENT MEASUREMENT 2. At the end of the second month the entries are as follows: Debit: Accounts Receivable (balance sheet) $130 Credit: MtM Assets (balance sheet) $130 To record accounts receivable for one month of gas delivered (10 gigajoules x $13) 3. At the end of the second month the entries are as follows: Debit: Unrealized Income (income statement) $130 Credit: Realized Income (income statement) $130 To reclassify unrealized income to realized income related to delivered and invoiced gas

44. FINANCIAL STATEMENT IMPACT Sample Balance Sheet at December 31, 2XXX Current Assets Cash $100 Accounts Receivable $130 Mark-to-Market Assets $1,300 Total Current Assets $1,530 Equity Retained Earnings $1,530 Sample Income Statement at December 31, 2XXX Realized Income $230 Unrealized Income $1,300 Total Income $1,530

45. RELATIONSHIP BETWEEN MtM & CASH • MtM accounting has come under scrutiny. • Financial results can be manipulated and/or errors can occur. • Results in poor commercial decisions resulting in losses and deterioration of investor confidence. Relationship between MtM & cash is key

46. QUESTION 10 WHAT ARE THE SIGNALS THAT A TMO MAY BE IN, OR HEADED TOWARD, FINANCIAL JEOPARDY?

47. SIGNIFICANT SWINGS IN MTM INCOME • Signal: • Significant swings in MtM income (positive or negative)  • Potential problem: • Traders engaging in speculative activities  • Investigation and follow up: • Review the MtM and Exposure reports: determine the root cause price/volume

48. SIGNIFICANT AND FREQUENT MARGIN CALLS   • Signal: • Significant and frequent margin calls   • Potential problem: • Out-of-the-money positions • Investigation and follow up: • To the extent there are no offsetting in-the-money-positions then these are trading losses.

49. FRICTION BETWEEN FO, MO, BO • Signal: • Friction between the FO, MO, BO due to inability to reconcile financial results  • Potential problem: • There is a lack of internal controls.  • Investigation and follow up • Review reconciliations including: confirmation, volume balancing, roll-off to settlement

50. BACK-UP SLIDES • BACK-UP SLIDES