Risk Scenario

Fumble

Failure to arrange the proper cover for regulatory penalties in the energy sector adds up to big losses.
By: | September 14, 2015 • 8 min read
Risk Scenarios are created by Risk & Insurance editors along with leading industry partners. The hypothetical, yet realistic stories, showcase emerging risks that can result in significant losses if not properly addressed.

Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.

Buckets of Money

Maxine DaGuerre, the risk manager for the Middle Atlantic power generation company Corsair Corp. was decidedly uncomfortable.

Scenario_Fumble

Along with the rest of the Corsair Corp. management team, she was waiting to hear the latest decision from PJM, the regional electricity wholesale market. Under guidance from federal regulators, PJM was establishing incentives and penalties for power generators willing to guarantee delivery of electricity to the grid at times of crisis or peak demand, otherwise known as Emergency Load Response events.

The Northeast saw a near blackout in the frigid winter of 2014. Demand during several days of intensely cold weather almost knocked off the grid and generators reported a number of problems trying to feed the beast.

The regulators did not want to risk that scenario again.

The incentives were lucrative, game changers, and despite the protests of large buyers of electricity, the incentive plan was moving forward. Now, in mid-August of 2015, Corsair executives were awaiting word from PJM on what the incentives would be for the energy auctions for June 2018 to May 2019. Word was that they were going to be even more than they had been for the corresponding period for 2017-2018.

The questions included what to do with the increased revenues? Plow them into plant upgrades, purchase insurance to cover the cost of any penalties for non-delivery, lock in natural gas delivery for the year to guarantee price and supply?

It was a complicated set of questions. DaGuerre knew which way she was leaning.

The incentives were one thing, but the penalties were staggering. The regulators were ready to fine power generators that failed to deliver electricity on emergency demand at more than $3,000 per megawatt hour in some cases.

For a 1,000 megawatt plant that was a penalty that could run into millions of dollars per hour.

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“Where was the backstop against that?” she thought to herself.

DaGuerre’s internal monologue was interrupted by the ringing of her desk phone. It was the company CFO, Eric Petruzzi. He sounded excited.

“Hey Maxine, can you join us upstairs? The announcement from the market is just in for the 2018-2019 incentives and we want to look at our options.”

“Sure thing, I’ll be right up,” DaGuerre told Petruzzi.

The exuberance in Petruzzi’s voice was off-putting.

In DaGuerre’s mind this was not a time for celebration, it was a time for careful consideration.

When she got upstairs there were three men at the table, Petruzzi, the operations chief Ben Ochstein and the CEO, Bill “Red” Miller.

“It’s what we thought Maxine,” Petruzzi began.

“PJM raised the incentive for 2018-2019.” He glanced briefly at the electronic pad in front of him.

“It’s raised the incentive by almost one third,” Petruzzi said with enthusiasm in his eyes. DaGuerre could swear she saw dollar signs there.

From $120 Mw-Day the incentive had been raised to almost $160 Mw-Day for 2018-2019. One 1,000 Mw plant could bring in more than $60 million in annual revenue.

Margaret watched as Ochstein and Miller exchanged glances. It seemed like some key decisions had already been made.

“We know how you feel about the penalties, Maxine,” Miller said.

“But you also know the importance of risk mitigation,” Ochstein said.

“We’re thinking we’ve got a real good opportunity here to upgrade some of the facilities, particularly Peachtree and Susquehanna,” Ochstein said.

DaGuerre cleared her throat and tried to steady herself.

“I’m all for risk mitigation, as you know. And I think we should upgrade some of the plants, particularly Susquehanna,” she said, giving Ben Ochstein a look that she hoped communicated solidarity with his idea.

“But I can’t help thinking that some risk transfer is in order here,” she said.

Petruzzi started to say something but DaGuerre felt compelled to just plow ahead.

“One, this is the first time we’ve been in this situation. The incentives are compelling, but the penalties are severe if we have a breakdown. Four of our plants are coal-fired and let’s face it, could really use some upgrades. It’s not just Peachtree and Susquehanna,” she said, giving Ochstein a meaningful look.

“I’m not asking for a lot but I think 5 percent of the three years’ auction revenue should be invested in some sort of risk transfer,” she said.

“That’s too much Maxine,” Miller said. From his tone, DaGuerre knew she’d be lucky to get a fraction of that.

The meeting ended with DaGuerre making her own odds that the company would be investing 2 percent of any emergency load auction funds into risk transfer mechanisms.

She flat-out doubted that was enough.

More Misgivings

While she did her best to partner with Ben Ochstein and the company’s engineering team to make the best use of the company’s capital in plant upgrades, Maxine DaGuerre couldn’t stop doing the numbers in her head.

Scenario_Fumble

For power generators that had agreed to supply electricity to the grid during Emergency Load Response events, the penalties from PJM and the regulators could be staggering. They were looking at $3,000 per megawatt hour. For a 1,000 MW plant, that was $3 million per hour.

The variables were driving DaGuerre crazy. She’d only been able to purchase $15 million in coverage for any fines Corsair might face. That might seem like a lot of coverage but she’d have been much happier with five times that.

She studied the preventative maintenance plans and upgrades for Corsair’s 18 power generation plants until her eyes hurt. Ben Ochstein and the company’s engineering team weren’t slouches. They were top-notch professionals. But nobody was perfect.

As fall moved to winter, the upgrades at the Corsair plants, at Susquehanna, Peachtree and others carried on apace. Ochstein and Petruzzi were also congratulating themselves that they had locked in reasonably priced natural gas supplies for the company’s plants that relied on natural gas to produce electricity.

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DaGuerre struggled to share their enthusiasm.

DaGuerre hated to be a stick-in-the-mud. She wanted the company to thrive. She certainly wasn’t hoping for a blackout in the Northeast or anything like it.

Then the cold came, just like it did in the winter of 2014, only this time much earlier. Three days of intense cold in the week between Christmas and New Year’s provoked the region’s first Emergency Load Response event, on Dec. 28.

Corsair didn’t miss a beat, while the word got out that one of its competitors had failed to deliver for three hours due to a natural gas pipeline problem near Philadelphia and been fined.

2016 broke with reasonable temperatures, but a polar vortex gripped the Northeast in the second week of January. This time Corsair wasn’t so lucky. Boiler problems at the coal-fired Susquehanna plant caused the 1,200 megawatt plant to go offline for five hours during an Emergency Load Response event. The fine was $15 million.

The formerly sanguine Eric Petruzzi went into full panic mode.

“Can you get us more coverage?” he asked DaGuerre during a late-night phone call on Dec. 29.

DaGuerre could hear laughter and clinking glasses in the background.

“Where are you?” she asked him.

“I’m … at a party. At my mother’s place in Annapolis,” he said somewhat sheepishly.

“I’ll … see what I can do,” DaGuerre said.

She didn’t bother calling her United Kingdom-based broker until very early the following morning.

An Endless Slog

Sorry, the carriers said.

“Not at this point,” DaGuerre’s broker Martin Rule told her the following morning.

Scenario_Fumble

“Your best bet for the remainder of the winter is to go full bore on plant inspections and preventative maintenance and hope you can ride it out,” he told her.

“Ride it out.” Those were words that Maxine DaGuerre hated. That wasn’t risk management, it was like playing roulette.

Sleep-deprived from meetings with Corsair Corp. engineers and operations personnel throughout the Atlantic seaboard through January, DaGuerre was trying to catch a nap in a drafty hotel in Wilmington, Del., on Feb. 10 when her phone buzzed.

It was Ochstein. He was a humbled man.

“We were out six hours at Leedsville from 6 a.m. to about an hour ago,” he told her. It almost sounded like his voice was cracking. He sounded exhausted.

An $18 million fine. No cover. Not for this.

“Another boiler problem?” DaGuerre asked him.

“Boiler-related.”

As Ochstein droned on, dispirited, with the technical details, DaGuerre started tuning him out.

She rolled over and stared at the framed print in her room as Ochstein’s words seeped in. She didn’t even feel sick, she felt numb.

She knew what Miller and Petruzzi would tell her and maybe they were right. Corsair had the resources to keep its plants up-to-speed and perhaps even profit greatly from the incentives it could earn from this Emergency Load Response arrangement with PJM.

But she knew one thing for sure.

She never again wanted to feel what she felt that early afternoon in that drafty hotel room in Wilmington.

These multimillion dollar hits had to stop. They couldn’t afford to fumble again.

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Risk & Insurance® partnered with Swiss Re Corporate Solutions to produce this scenario. Below are Swiss Re Corporate Solutions’ recommendations on how to prevent the losses presented in the scenario. This perspective is not an editorial opinion of Risk & Insurance®.

The cold snap during the Polar Vortex of January 2014 brought the northeast United States dangerously close to blackout conditions. As temperatures plunged, many of the region’s key power plants performed poorly, and the region came dangerously close to rotating blackouts and a loss of electric heat. Had the power gone out, a large segment of the population would have been exposed to the severe cold with dire consequences.

Recently, the PJM Interconnection, which manages the electric grid for 13 states (plus Washington DC) and nearly 61 million people, implemented a new electric generator incentive scheme that aims to prevent a repeat of the poor generator performance during January 2014. The new program, called PJM Capacity Performance, will provide increased revenue for power generation companies that participated in capacity auctions. However, while generation companies will receive additional revenues for offering firm capacity, there is also considerable risk for non-performance. An unplanned outage or derate at a power plant during an emergency event could have significant financial costs (a million dollars an hour or more, depending on plant size).

Swiss Re Corporate Solutions understands the risks facing your business. Our electricity price and power plant outage solutions are designed to help you take advantage of the new capacity incentives, and offer protection for unseen mechanical issues impacting power generation.

Power producers can manage that risk through Swiss Re Corporate Solutions’ Electricity Price & Outage (ELPRO) and Capacity Performance coverages, which compensates generators for output lost from unplanned outages based on market conditions at the time of loss. We also offer weather and commodity price risk solutions to help you manage risk. To learn more, visit http://www.swissre.com/corporate_solutions/solutions/weather/




Dan Reynolds is editor-in-chief of Risk & Insurance. He can be reached at [email protected]

More from Risk & Insurance

More from Risk & Insurance

Exclusive | Hank Greenberg on China Trade, Starr’s Rapid Growth and 100th, Spitzer, Schneiderman and More

In a robust and frank conversation, the insurance legend provides unique insights into global trade, his past battles and what the future holds for the industry and his company.
By: | October 12, 2018 • 12 min read

In 1960, Maurice “Hank” Greenberg was hired as a vice president of C.V. Starr & Co. At age 35, he had already accomplished a great deal.

He served his country as part of the Allied Forces that stormed the beaches at Normandy and liberated the Nazi death camps. He fought again during the Korean War, earning a Bronze Star. He held a law degree from New York Law School.

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Now he was ready to make his mark on the business world.

Even C.V. Starr himself — who hired Mr. Greenberg and later hand-picked him as the successor to the company he founded in Shanghai in 1919 — could not have imagined what a mark it would be.

Mr. Greenberg began to build AIG as a Starr subsidiary, then in 1969, he took it public. The company would, at its peak, achieve a market cap of some $180 billion and cement its place as the largest insurance and financial services company in history.

This month, Mr. Greenberg travels to China to celebrate the 100th anniversary of C.V. Starr & Co. That visit occurs at a prickly time in U.S.-Sino relations, as the Trump administration levies tariffs on hundreds of billions of dollars in Chinese goods and China retaliates.

In September, Risk & Insurance® sat down with Mr. Greenberg in his Park Avenue office to hear his thoughts on the centennial of C.V. Starr, the dynamics of U.S. trade relationships with China and the future of the U.S. insurance industry as it faces the challenges of technology development and talent recruitment and retention, among many others. What follows is an edited transcript of that discussion.


R&I: One hundred years is quite an impressive milestone for any company. Celebrating the anniversary in China signifies the importance and longevity of that relationship. Can you tell us more about C.V. Starr’s history with China?

Hank Greenberg: We have a long history in China. I first went there in 1975. There was little there, but I had business throughout Asia, and I stopped there all the time. I’d stop there a couple of times a year and build relationships.

When I first started visiting China, there was only one state-owned insurance company there, PICC (the People’s Insurance Company of China); it was tiny at the time. We helped them to grow.

I also received the first foreign life insurance license in China, for AIA (The American International Assurance Co.). To date, there has been no other foreign life insurance company in China. It took me 20 years of hard work to get that license.

We also introduced an agency system in China. They had none. Their life company employees would get a salary whether they sold something or not. With the agency system of course you get paid a commission if you sell something. Once that agency system was installed, it went on to create more than a million jobs.

R&I: So Starr’s success has meant success for the Chinese insurance industry as well.

Hank Greenberg: That’s partly why we’re going to be celebrating that anniversary there next month. That celebration will occur alongside that of IBLAC (International Business Leaders’ Advisory Council), an international business advisory group that was put together when Zhu Rongji was the mayor of Shanghai [Zhu is since retired from public life]. He asked me to start that to attract foreign companies to invest in Shanghai.

“It turns out that it is harder [for China] to change, because they have one leader. My guess is that we’ll work it out sooner or later. Trump and Xi have to meet. That will result in some agreement that will get to them and they will have to finish the rest of the negotiations. I believe that will happen.” — Maurice “Hank” Greenberg, chairman and CEO, C.V. Starr & Co. Inc.

Shanghai and China in general were just coming out of the doldrums then; there was a lack of foreign investment. Zhu asked me to chair IBLAC and to help get it started, which I did. I served as chairman of that group for a couple of terms. I am still a part of that board, and it will be celebrating its 30th anniversary along with our 100th anniversary.

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We have a good relationship with China, and we’re candid as you can tell from the op-ed I published in the Wall Street Journal. I’m told that my op-ed was received quite well in China, by both Chinese companies and foreign companies doing business there.

On August 29, Mr. Greenberg published an opinion piece in the WSJ reminding Chinese leaders of the productive history of U.S.-Sino relations and suggesting that Chinese leaders take pragmatic steps to ease trade tensions with the U.S.

R&I: What’s your outlook on current trade relations between the U.S. and China?

Hank Greenberg: As to the current environment, when you are in negotiations, every leader negotiates differently.

President Trump is negotiating based on his well-known approach. What’s different now is that President Xi (Jinping, General Secretary of the Communist Party of China) made himself the emperor. All the past presidents in China before the revolution had two terms. He’s there for life, which makes things much more difficult.

R&I: Sure does. You’ve got a one- or two-term president talking to somebody who can wait it out. It’s definitely unique.

Hank Greenberg: So, clearly a lot of change is going on in China. Some of it is good. But as I said in the op-ed, China needs to be treated like the second largest economy in the world, which it is. And it will be the number one economy in the world in not too many years. That means that you can’t use the same terms of trade that you did 25 or 30 years ago.

They want to have access to our market and other markets. Fine, but you have to have reciprocity, and they have not been very good at that.

R&I: What stands in the way of that happening?

Hank Greenberg: I think there are several substantial challenges. One, their structure makes it very difficult. They have a senior official, a regulator, who runs a division within the government for insurance. He keeps that job as long as he does what leadership wants him to do. He may not be sure what they want him to do.

For example, the president made a speech many months ago saying they are going to open up banking, insurance and a couple of additional sectors to foreign investment; nothing happened.

The reason was that the head of that division got changed. A new administrator came in who was not sure what the president wanted so he did nothing. Time went on and the international community said, “Wait a minute, you promised that you were going to do that and you didn’t do that.”

So the structure is such that it is very difficult. China can’t react as fast as it should. That will change, but it is going to take time.

R&I: That’s interesting, because during the financial crisis in 2008 there was talk that China, given their more centralized authority, could react more quickly, not less quickly.

Hank Greenberg: It turns out that it is harder to change, because they have one leader. My guess is that we’ll work it out sooner or later. Trump and Xi have to meet. That will result in some agreement that will get to them and they will have to finish the rest of the negotiations. I believe that will happen.

R&I: Obviously, you have a very unique perspective and experience in China. For American companies coming to China, what are some of the current challenges?

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Hank Greenberg: Well, they very much want to do business in China. That’s due to the sheer size of the country, at 1.4 billion people. It’s a very big market and not just for insurance companies. It’s a whole range of companies that would like to have access to China as easily as Chinese companies have access to the United States. As I said previously, that has to be resolved.

It’s not going to be easy, because China has a history of not being treated well by other countries. The U.S. has been pretty good in that way. We haven’t taken advantage of China.

R&I: Your op-ed was very enlightening on that topic.

Hank Greenberg: President Xi wants to rebuild the “middle kingdom,” to what China was, a great country. Part of that was his takeover of the South China Sea rock islands during the Obama Administration; we did nothing. It’s a little late now to try and do something. They promised they would never militarize those islands. Then they did. That’s a real problem in Southern Asia. The other countries in that region are not happy about that.

R&I: One thing that has differentiated your company is that it is not a public company, and it is not a mutual company. We think you’re the only large insurance company with that structure at that scale. What advantages does that give you?

Hank Greenberg: Two things. First of all, we’re more than an insurance company. We have the traditional investment unit with the insurance company. Then we have a separate investment unit that we started, which is very successful. So we have a source of income that is diverse. We don’t have to underwrite business that is going to lose a lot of money. Not knowingly anyway.

R&I: And that’s because you are a private company?

Hank Greenberg: Yes. We attract a different type of person in a private company.

R&I: Do you think that enables you to react more quickly?

Hank Greenberg: Absolutely. When we left AIG there were three of us. Myself, Howie Smith and Ed Matthews. Howie used to run the internal financials and Ed Matthews was the investment guy coming out of Morgan Stanley when I was putting AIG together. We started with three people and now we have 3,500 and growing.

“I think technology can play a role in reducing operating expenses. In the last 70 years, you have seen the expense ratio of the industry rise, and I’m not sure the industry can afford a 35 percent expense ratio. But while technology can help, some additional fundamental changes will also be required.” — Maurice “Hank” Greenberg, chairman and CEO, C.V. Starr & Co. Inc.

R&I:  You being forced to leave AIG in 2005 really was an injustice, by the way. AIG wouldn’t have been in the position it was in 2008 if you had still been there.

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Hank Greenberg: Absolutely not. We had all the right things in place. We met with the financial services division once a day every day to make sure they stuck to what they were supposed to do. Even Hank Paulson, the Secretary of Treasury, sat on the stand during my trial and said that if I’d been at the company, it would not have imploded the way it did.

R&I: And that fateful decision the AIG board made really affected the course of the country.

Hank Greenberg: So many people lost all of their net worth. The new management was taking on billions of dollars’ worth of risk with no collateral. They had decimated the internal risk management controls. And the government takeover of the company when the financial crisis blew up was grossly unfair.

From the time it went public, AIG’s value had increased from $300 million to $180 billion. Thanks to Eliot Spitzer, it’s now worth a fraction of that. His was a gross misuse of the Martin Act. It gives the Attorney General the power to investigate without probable cause and bring fraud charges without having to prove intent. Only in New York does the law grant the AG that much power.

R&I: It’s especially frustrating when you consider the quality of his own character, and the scandal he was involved in.

In early 2008, Spitzer was caught on a federal wiretap arranging a meeting with a prostitute at a Washington Hotel and resigned shortly thereafter.

Hank Greenberg: Yes. And it’s been successive. Look at Eric Schneiderman. He resigned earlier this year when it came out that he had abused several women. And this was after he came out so strongly against other men accused of the same thing. To me it demonstrates hypocrisy and abuse of power.

Schneiderman followed in Spitzer’s footsteps in leveraging the Martin Act against numerous corporations to generate multi-billion dollar settlements.

R&I: Starr, however, continues to thrive. You said you’re at 3,500 people and still growing. As you continue to expand, how do you deal with the challenge of attracting talent?

Hank Greenberg: We did something last week.

On September 16th, St. John’s University announced the largest gift in its 148-year history. The Starr Foundation donated $15 million to the school, establishing the Maurice R. Greenberg Leadership Initiative at St. John’s School of Risk Management, Insurance and Actuarial Science.

Hank Greenberg: We have recruited from St. John’s for many, many years. These are young people who want to be in the insurance industry. They don’t get into it by accident. They study to become proficient in this and we have recruited some very qualified individuals from that school. But we also recruit from many other universities. On the investment side, outside of the insurance industry, we also recruit from Wall Street.

R&I: We’re very interested in how you and other leaders in this industry view technology and how they’re going to use it.

Hank Greenberg: I think technology can play a role in reducing operating expenses. In the last 70 years, you have seen the expense ratio of the industry rise, and I’m not sure the industry can afford a 35 percent expense ratio. But while technology can help, some additional fundamental changes will also be required.

R&I: So as the pre-eminent leader of the insurance industry, what do you see in terms of where insurance is now and where it’s going?

Hank Greenberg: The country and the world will always need insurance. That doesn’t mean that what we have today is what we’re going to have 25 years from now.

How quickly the change comes and how far it will go will depend on individual companies and individual countries. Some will be more brave than others. But change will take place, there is no doubt about it.

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More will go on in space, there is no question about that. We’re involved in it right now as an insurance company, and it will get broader.

One of the things you have to worry about is it’s now a nuclear world. It’s a more dangerous world. And again, we have to find some way to deal with that.

So, change is inevitable. You need people who can deal with change.

R&I:  Is there anything else, Mr. Greenberg, you want to comment on?

Hank Greenberg: I think I’ve covered it. &

The R&I Editorial Team can be reached at [email protected]