ERAC Audit Procedures & Risk Mitigation 5 — Questions and Answers
Question 1: A power plant operator wants to reduce exposure to unplanned outage costs. Which risk mitigation strategy directly addresses this operational risk?
- Purchasing put options on electricity
- Implementing a preventive maintenance program with reliability performance tracking (Correct answer)
- Entering into a basis swap agreement
- Extending credit terms with fuel suppliers
Correct answer: Implementing a preventive maintenance program with reliability performance tracking
A preventive maintenance program with performance tracking reduces unplanned outage frequency and duration, directly mitigating the operational risk of unexpected downtime costs.
Question 2: During an audit, an auditor finds that a company's risk appetite statement has not been approved by the board of directors. What is the primary concern?
- Trading limits may be miscalibrated to market conditions
- Risk-taking is not aligned with governance oversight and lacks board accountability (Correct answer)
- The company cannot file regulatory disclosures
- Market risk models will produce inaccurate results
Correct answer: Risk-taking is not aligned with governance oversight and lacks board accountability
The board of directors is responsible for setting and approving risk appetite; without board approval, the risk appetite lacks proper governance oversight and accountability.
Question 3: Which document typically defines the maximum allowable position size, stop-loss thresholds, and escalation procedures for an energy trading desk?
- Annual report
- Trading risk policy and limits framework (Correct answer)
- Financial statements
- Counterparty master agreement
Correct answer: Trading risk policy and limits framework
A trading risk policy and limits framework formally establishes position limits, loss thresholds, and escalation procedures that govern risk-taking activity on the trading desk.
Question 4: An auditor identifies that an energy company uses a single risk model for all commodities including electricity, natural gas, and crude oil. What limitation should the auditor flag?
- The model likely violates SEC reporting requirements
- Commodity-specific dynamics such as seasonality and delivery constraints may not be adequately captured by a generic model (Correct answer)
- Using one model reduces computational efficiency
- Single models are prohibited under CFTC regulations
Correct answer: Commodity-specific dynamics such as seasonality and delivery constraints may not be adequately captured by a generic model
Each energy commodity has unique price dynamics, seasonality, and physical delivery characteristics that a generic single model may fail to capture accurately, leading to mispriced risk.
Question 5: What is the purpose of a heat rate contract in electricity risk management?
- To guarantee fuel delivery to a power plant at fixed volume
- To convert between natural gas and electricity prices using a plant's conversion efficiency ratio (Correct answer)
- To set a fixed carbon offset price for emissions compliance
- To establish interconnection agreements with grid operators
Correct answer: To convert between natural gas and electricity prices using a plant's conversion efficiency ratio
A heat rate contract links natural gas and electricity prices using a plant's heat rate (BTU per kWh), allowing generators to hedge the spark spread between fuel cost and power revenue.
Question 6: When an energy risk auditor reviews a company's business continuity plan (BCP), which scenario is most critical to test for a trading operation?
- Extended office renovation
- Loss of access to trading systems and market data during peak market hours (Correct answer)
- Annual staff turnover exceeding 10%
- Delayed publication of quarterly earnings
Correct answer: Loss of access to trading systems and market data during peak market hours
For a trading operation, loss of trading systems and market data access during active market hours represents the highest-impact disruption scenario and must be a BCP testing priority.
Question 7: An energy company audit reveals that counterparty credit exposure is monitored monthly rather than daily. For an active trading portfolio, what risk does this create?
- Regulatory reporting delays only
- Undetected credit limit breaches and accumulation of significant credit exposure between monitoring cycles (Correct answer)
- Higher operational costs from over-collateralization
- Reduced market risk sensitivity
Correct answer: Undetected credit limit breaches and accumulation of significant credit exposure between monitoring cycles
Monthly monitoring of an active portfolio means that credit limit breaches can go undetected for weeks, allowing credit exposure to build to dangerous levels before corrective action is taken.
ERAC Audit Procedures & Risk Mitigation 5
A power plant operator wants to reduce exposure to unplanned outage costs.
Which risk mitigation strategy directly addresses this operational risk?