ERAC Energy Risk Management Principles 5 — Questions and Answers
Question 1: A risk manager notices that electricity price volatility spikes every summer afternoon. This pattern is best described as:
- Stochastic price drift
- Seasonal and intraday volatility clustering in power markets (Correct answer)
- Mean reversion in commodity prices
- Counterparty concentration risk
Correct answer: Seasonal and intraday volatility clustering in power markets
Power markets exhibit pronounced volatility clustering tied to seasonal demand cycles and intraday peak load periods, requiring time-varying risk models.
Question 2: Which of the following is an example of reputational risk in the energy sector?
- A pipeline rupture causing environmental damage that triggers public backlash (Correct answer)
- A sudden drop in natural gas futures prices reducing hedging profits
- An unexpected increase in state property taxes on generation assets
- Counterparty insolvency resulting in undelivered fuel supplies
Correct answer: A pipeline rupture causing environmental damage that triggers public backlash
Environmental incidents that attract negative public attention and media coverage directly damage an energy company's reputation, affecting customer trust and regulatory relations.
Question 3: An energy firm sets a 'risk limit' for its trading desk. Breaching this limit should trigger which immediate action according to best practice?
- Automatic termination of all open positions
- Escalation to senior management and review of the position causing the breach (Correct answer)
- Transfer of the position to another desk without reporting
- Adjustment of the limit upward to accommodate the position
Correct answer: Escalation to senior management and review of the position causing the breach
Risk limit breaches require immediate escalation so that senior management can assess the situation and decide on corrective action transparently.
Question 4: The concept of 'risk aggregation' across an energy portfolio is important because it:
- Ensures each desk's risk is measured independently without netting effects
- Identifies diversification benefits and concentration risks that are not visible at the individual position level (Correct answer)
- Eliminates the need for position-level risk reporting
- Reduces the computational burden of mark-to-market calculations
Correct answer: Identifies diversification benefits and concentration risks that are not visible at the individual position level
Aggregating risk across the portfolio reveals correlations, concentration risks, and diversification offsets that cannot be identified by looking at individual positions in isolation.
Question 5: A gas marketing company uses a heat rate call option to manage which specific risk in power generation?
- Transmission congestion between generation node and load center
- The conversion economics between natural gas fuel cost and electricity output value (Correct answer)
- Physical pipeline capacity constraints during peak demand
- Regulatory approval timelines for new generation facilities
Correct answer: The conversion economics between natural gas fuel cost and electricity output value
A heat rate call option gives the holder the right to buy gas and sell power at a fixed heat rate, directly hedging the spark spread or gas-to-power conversion margin.
Question 6: Under the Dodd-Frank Act, which requirement was introduced for most standardized OTC energy derivatives to reduce systemic risk?
- Mandatory physical delivery of all energy contracts
- Central clearing through a CFTC-registered derivatives clearing organization (DCO) (Correct answer)
- Prohibition on energy firms using derivatives for speculation
- Public auction of all bilateral energy contracts
Correct answer: Central clearing through a CFTC-registered derivatives clearing organization (DCO)
Dodd-Frank Title VII mandated central clearing of standardized swaps to reduce bilateral counterparty risk and improve market transparency.
Question 7: A risk auditor reviewing an energy company's hedging program identifies that hedge ratios have not been updated after a significant change in physical exposure. This finding indicates a failure in:
- Initial hedge designation and documentation
- Ongoing hedge effectiveness monitoring and rebalancing controls (Correct answer)
- Counterparty credit assessment procedures
- Market data sourcing for daily mark-to-market
Correct answer: Ongoing hedge effectiveness monitoring and rebalancing controls
Hedge ratios must be periodically reviewed and rebalanced to match current physical exposure; failing to do so represents a breakdown in hedge monitoring controls.
ERAC Energy Risk Management Principles 5
A risk manager notices that electricity price volatility spikes every summer afternoon.
This pattern is best described as: