Financial Simulation via Crystal
Ball Professional Aids Risk Management At Minnesota Power
Part of multi-services company ALLETE, Minnesota Power is a low
cost electric utility engaged in the generation, transmission, and
distribution of electricity in Minnesota and Wisconsin and serving
some of the largest industrial customers in the United States. One
of primary tasks of Minnesota Power's risk group is the estimation,
assessment, and communication of financial risk - defined as the
variability of financial outcomes - and one of the tools they regularly
rely on is Crystal Ball Pro.
Paul Dietz, a Quantitative Analyst with the Risk Management Department,
has used Crystal Ball Pro for almost three years. "I am responsible
for providing quantitative analysis support to the risk management
group," he explained. "This includes developing and implementing
quantitative models for valuing complex wholesale and retail contracts,
tolling agreements, and generation projects. I use Crystal Ball
for analyzing proforma cash flow and income statements and for developing
probabilistic models involving derivatives. Recently, I've used
the program to value real options such as power plant projects,
emission credits, and non-traded embedded options."
Dietz and his colleagues are strong proponents of spreadsheet models
and Monte Carlo simulation. Because analytical models approximate
the real world, the risk group uses them to experiment with the
natural variability within a system. For example, Dietz explained,
the equation Profit = Revenue - Expenses is a very simple analytical
model used by most businesses. In the real world, however, revenue
and expenses are subject to variability, and so simulation is needed
to examine the effects of this variability on profit. The Minnesota
Power risk management group builds and simulates these types of
models to help the company decide whether or not to buy an asset,
how to allocate scarce capital, and whether or not to develop a
new product offering.
Most of the financial models Dietz builds are intended to evaluate
measures of performance or the behavior of financial systems given
a specific set of inputs. He finds the most time-consuming aspect
of model building is determining the variability around the uncertain
inputs, or assumptions, of the model. To ensure that the model is
realistic, the risk management group first consults with the company's
internal experts and takes the time necessary to research the problem.
In one recent project, the risk group developed a financial model
that required advice from more than fifteen experts to help define
assumptions ranging from power plant reliability to environmental
concerns.
Dietz sees many advantages to simulation modeling. First, the discipline
of building a quantitative model forces him to better understand
the data and relationships within the model. Model building also
yields insights into real world problems and helps to reduce the
probability and costs of poor implementation. Finally, and most
importantly, modeling provides management with the valuable information
they need to make less risky and more effective business decisions.
"With our Monte Carlo models, we are able to assess the variability
associated with investing in real options such as combustion turbines
and tolling agreements," said Dietz. "This knowledge provides our
management team with a new tool for ascertaining the risk adjusted
returns associated with a particular project."
Dietz predicts that Crystal Ball Pro will be a solid tool in their
analysis toolbox in the years to come. "This tool allows us to analyze
variability of results, which is essential for making sound business
decisions," he said. "Of course, the need for this analysis will
grow as the level of uncertainty regarding the path of deregulation
grows." The management of Minnesota Power agrees and supports the
use of simulation modeling and Crystal Ball Professional. "This
software has been a primary tool for evaluating and communicating
financial risks throughout the organization, " explained John Janney,
Chief Risk Officer for Minnesota Power.
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