Standard & Poor's Ratings Services has completed its initial PIM (policies, infrastructure and methodologies) risk-management review of 10 selected U.S. energy companies, primarily merchant-energy firms, pure financial trading companies and unregulated utilities.

Among the selected companies were Dynegy Inc, Mirant Corp., NRG Energy Inc., Reliant Energy Inc., Sempra Inc. and TXU Corp.

The PIM review represents an expansion of the credit-rating agency's analytical approach to assessing the trading-risk management practices of those energy companies that have significant trading and marketing operations-that trade in the market daily, have open commodity positions, and use financial and/or physical transactions to hedge those positions.

Previously, in assessing a company's trading-risk position, "we relied on our well-established liquidity survey, which focuses on liquidity adequacy given certain market stress, and on our capital-adequacy methodology, which measures the discrete risks of market, credit and operational events and estimates the capital needed for these exposures," says Terry A. Pratt, an S&P director in the utility and project-finance group in New York.

The PIM analysis, a more qualitative tool the firm plans to incorporate more formally into its energy-sector credit ratings in the future, takes the added step of scrutinizing three specific aspects of an energy company's risk-management practices-policies, infrastructure and methodologies.

"In the case of [company] policies, we focus on four key items: the stature of risk management in a company, an assessment of its risk appetite, its risk-control process and how risk information is disclosed internally and externally," says Pratt.

With respect to risk-management infrastructure within a company, the PIM tool analyses how risk data is captured and managed, as well as assessing a firm's back-office functions. The methodologies component of the PIM analysis assesses the quality and variety of a company's valuation techniques and the way in which models are vetted and updated.

"Through it, we examine how a company determines its pricing models, how it captures the asset-operating risk that differentiates it from financial institutions, and what methods the company uses to assess counterparty risk in trading activities."

In summary, the PIM analysis structure "allows us to identify a company's risk appetite, understand its risk-management infrastructure, assess the contribution of its trading and marketing risks to the firm's overall credit risk, then factor that information into the company's credit rating, he says.

"Put another way, it allows us to perform a very deep evaluation of a company's ability to identify and monitor significant risks, limit the losses from those risks, and operate within very well-defined risk tolerances."

The findings of the PIM review of the selected 10 energy companies? First, it showed that there was a large variation in the risk-management infrastructures these companies use.

Second, the analysis found that the risk appetite of an energy company may not necessarily be matched or supported by the risk-management structures and modeling resources of that company. In those cases, a company might be more exposed to risk, which could affect its credit worthiness, says Pratt.

Third, the PIM review showed that the risk-management policies of most of the energy companies have only been in place for a few years; comparatively, in other industries like banking and insurance, such policies have been in place for a very long period and are much more robust.

Fourth, the analysis revealed that the dominance of senior management in risk control can be a key concern if there isn't present within that organization a separate, independent risk-management group that has the ability to monitor, quantify and limit the overall company's risk exposure.

Fifth, the review found that while the internal reporting of the risk-management structure within the energy companies was generally very good, almost all the companies didn't report in any great depth externally on their risk-management positions.

Adds Pratt, "Looking ahead, the likely next logical step within the energy sector would be to refine and apply all three of these risk-management analysis tools... to the E&P sector."

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