8 minute read 29 Aug 2018
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How to ride the waves of P&U financial risk

By

Matt Chambers

EY Global and Americas Power & Utilities Risk Leader

Risk management leader in power and utilities. Solving complex problems with pragmatic solutions. Avid snow skier. Sports lover. Father.

8 minute read 29 Aug 2018

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The power and utilities (P&U) sector is transforming, making finding ways to secure financial success a significant challenge.

Investing in new infrastructure. Improving operational efficiency . Reassessing business strategies. Seeking new merger and acquisition opportunities. These are some of the actions taken by P&U organizations to improve or protect their financial position.

The EY Global Power & Utilities Risk Pulse Survey revealed that across the industry, organizations are aware of the disruptive forces that could transform the sector. Yet, in an era of stagnating revenues and margin erosion in many markets, a number of financial challenges remain as they continue to navigate a volatile regulatory and policy landscape .

To better understand the concerns of the sector, we asked P&U executives to rank their top five financial risks.

Power and Utilities. Current most critical financial risks for the industry
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Chapter 1

The top five financial risks facing P&U organizations

From traditional concerns about compliance and regulatory changes to emerging worries about price volatility, finance tops the agenda.

No. 5: Accuracy of financial reporting

While the P&U industry continues its transformation, governments and regulators are persisting in their demands to keep prices stable — even as they push for greater supply certainty, increased investment in renewables and reductions in greenhouse gas emissions. All of these competing factors, in addition to the more traditional reporting issues, increase the burden of financial reporting.

No. 4: Volatility in interest and foreign exchange rates

Political and economic uncertainty across countries can impact the value of a P&U organization’s assets and liabilities alike. Fluctuations in foreign exchange rates, in particular, can negatively affect operating profits, something the sector can ill afford given stagnating revenues and declining margins in many markets.
As we transition to the future energy and utility world, where many P&U organizations will be seeking to expand supply chains, networks and assets beyond traditional borders, the industry will be increasingly exposed to interest and exchange rate volatility. This is why 44% of respondents ranked this in their top three risks.

No. 3: Volatility in prices of commodities and industrial inputs

It’s not just exchange rates and interest rates that can become volatile — the underlying valuation of key commodities can also fluctuate significantly. Geopolitical changes can impact oil prices, as can the rise of new sources, such as shale gas, while major catastrophes can create supply shocks, as seen in the aftermath of Fukushima. All this and more can increase P&U organizations’ risk exposure to commodity price volatility, which can be fundamental to the long-term success of their business models.
However, as Talib Dhanji, US Commodities Markets Lead, Ernst & Young LLP, warns, “Few utilities have invested in the talent or resources to manage commodity risk. For the most part, regulatory requirements do not provide the right incentives for them to do so. To me, this is a lost opportunity.”
Despite this lack of action, there is strong awareness of the need to do more, with 60% of respondents ranking this in their top three financial risks.

No. 2: Credit ratings and financing

The International Energy Agency estimates that, worldwide, over US$19 trillion will be invested in the power sector alone between 2016 and 2040. This means that managing large capital investment programs will become a critical success factor for utilities as they compete to deliver capital projects on time, within budget and to the expected standards.
As we continue to see an increase in energy demand and infrastructure expansion in emerging markets and consolidation in mature markets, it will be essential for utilities to find effective ways to finance their ambitions to address new competitive challenges and create fresh value.
But without a solid credit rating, P&U organizations may limit their liquidity and access to capital markets, putting all this at risk. Little wonder this was listed in the top three financial risks by 78% of respondents.

No. 1: Regulatory or rate changes impacting cost recovery of assets

While there are certainly threats to traditional P&U organizations from the rise of new technologies, there are also numerous opportunities to diversify power generation portfolios presented by both renewables and distributed generation. At the same time, operations could be transformed and long-term costs significantly reduced by robotics, automation and artificial intelligence.
However, regulatory frameworks often provide little incentive to invest where costs cannot be recovered under traditional rate-based models. And in mature markets, capital infrastructure investments that rely on cost of service rate strategies have been even harder to justify with regulators.

There will be a tipping point at which traditional cost-based regulators will disappear. The regulatory models that worked in the past won’t work in the future.
Susan Bell,
P&U Assurance, EY

In fact, risks associated with the regulatory compact are perhaps the most far-reaching of all. Not only do they impact the financial bottom line, but they also extend into operations , compliance and, of course, overall strategy — which is why 86% of respondents ranked this in their top three financial risks, as well as coming out as the number two risk overall .

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Chapter 2

How P&U can chart a course for a more financially secure future

A combination of traditional methods and new technologies can help mitigate financial risk for P&U firms.

Over half (53%) of respondents anticipate that the current number one financial risk and second highest-ranked overall risk — regulatory or rate changes impacting cost recovery of assets — will become more or much more important in a new energy world. So, it is important that P&U organizations don’t look at financial risk in isolation, but rather as a critical part of their broader risk management strategy.
This may include hiring resources with the capabilities to conduct sophisticated scenario planning around different regulatory frameworks and assumptions, commodity pricing environments and customer expectations that may define a future energy and utility world.
To help address the financial risks threatening the sector, utilities should:

  • Strengthen their relationships with regulators by:
    • Promoting an open dialogue, seeking to educate them more fully on today’s challenges
    • Assessing the impact that the accelerating pace of change is having on financial reporting and conducting a gap analysis to identify any new standards and process requirements, including who is responsible for addressing them
  • Reduce exposure to volatility, such as:
    • Developing hedging strategies to limit the risk of interest and foreign exchange rate fluctuations
    • Properly funding the talent, resources and technologies to manage commodity price volatility, even where regulatory incentives for such investment may be lacking
    • Ensuring clarity on the level of risk the organization is willing to assume — for example, are you positioning to be a conservative price fixer or an opportunistic hedger?
  • Introduce the use of innovative technologies to:
    • Improve reporting responsiveness and accuracy – for example, robotic process automation can streamline and automate repetitive business and financial processes, improving quality, security and execution time
    • Improve trading and hedging capabilities via enabling technologies such as blockchain , which have the potential to lower transaction costs by replacing the need for brokers, intermediaries or even an exchange

In some cases, such as regulatory and rate changes or volatility in commodities, P&U organizations don’t have to wait for regulators to provide incentives for change. Instead, they can invest in the talent, resources and technology that can turn this risk into a significant advantage.
Finally, organizations should also ensure that they understand their level of risk tolerance and develop a robust strategy that balances exposure with opportunity to take advantage of commodity or interest rate volatility. This may require them to develop relationships and form partnerships with organizations that have the skills the utilities may lack in house.

With financial risks continuing to pose critical challenges, what questions should utilities be asking?

  • How should they respond to regulatory changes that have significant cost recovery impacts?
  • How much exposure are they willing to accept in turning commodity volatility from a risk to an opportunity?
  • How are capital projects being managed to successfully maintain and strengthen credit ratings?
  • How is the organization connecting the dots between financial risks and other risk categories across the enterprise?
  • Is the right financial risk talent at the table? Is the right labor force in place to address the pace of change?
  • Is the organization doing enough scenario planning and avoiding unconscious bias in ways that will help it plan more effectively for the future?

Take the risk pulse of your own organization

Read our other survey results and deep-dive articles to learn what your peers are saying about key risks in the strategic , operational and compliance categories, or find out more about how our risk and cybersecurity professionals can help .

Summary

Regulatory changes, financing and price volatility top the list of financial risks P&U leaders are most concerned by. With the right combination of traditional approaches and the leveraging of new technologies, mitigating these risks is certainly possible.

About this article

By

Matt Chambers

EY Global and Americas Power & Utilities Risk Leader

Risk management leader in power and utilities. Solving complex problems with pragmatic solutions. Avid snow skier. Sports lover. Father.