Unveiling the cost of capital

In the fast-evolving business of energy and commodity trading, understanding the cost related to trading is paramount. Economic capital safeguards companies from risks related to trading activities and enables commercial functions to fulfil value creation objectives and seize profitable opportunities. Yet, the true impact of cost structures often remains hidden beneath the surface. In this article, we'll explore why cost awareness and transparency are important and provide some thoughts on cost of capital allocation.

Understanding the cost structures in trading activities

Commodity trading is an expensive business and significant amounts of capital are required to finance physical and financial transactions. The capital required is often sourced externally (against a cost) and deploying the capital (borrowed or not) always carries an opportunity cost ; the same amount of money might have been deployed for profitable activities elsewhere. Transactions that generate less PnL than the cost of sourcing and deploying that capital therefore are not economically feasible and should be avoided. Bringing the cost of capital into the traders/dealmakers PnL should therefore lead to more selective risk-taking and an optimisation of the return on capital.

It could be argued that the capital required for trading activities is not limited to the financing costs. There is the cost of the organisation supporting the trading environment (systems and people) the cost and complexity of which scale with the magnitude of trading activities. Additionally there is also a requirement for a financial buffer. Trading organisations are complex and at times unpredictable, and a buffer is required not only to absorb unexpected market events, but also potential losses stemming from counterparty default, inadequate strategic planning, system outages, force majeure and other internal and external events. This buffer typically exists in the form of a reservation of liquid assets or the right to utilise credit lines.

Understanding the true cost of business activities is the first step in cost optimisation and informed decision making. It is important to know which costs/capital requirements are incurred by which business activities (including supportive functions) and the actual rates these costs should be charged at. Working out the true cost of capital and subsequently allocating it to the various business elements is a complex assignment that requires careful consideration of the impact on the business and its people.

Key challenges

There are a wide range of issue and challenges that we see working with energy and commodity firms on cost allocation topics. Below, we have listed a number of experiences, observations, insights and anecdotes to illustrate some key considerations:

Pre-trade or post-trade cost allocation

Due to the existence of portfolio effects the only way to accurately calculate the real cost of associated capital is on a post-deal basis at the end of the deal lifecycle. However, this creates the undesirable situation of traders and dealmakers being confronted with a PnL-hit after the fact; one that is unmanageable and unhedgeable but could easily swing deal economics away from an acceptable risk/reward threshold. The alternative of pre-trade cost allocation has the inherent drawbacks that (1) accuracy is impacted by the underlying assumptions and (2) the resulting charge is likely to be in excess of actual costs as the (future) portfolio effect is to be ignored.

Basis for cost of capital charges

When the associated capital required for a certain activity or deal has been identified, the next hurdle is to decide on a model to calculate the cost of the required capital. Typical options are the Weighted Average Cost of Capital (WACC), the actual cost of the capital or the replacement cost of capital. While WACC is a relatively straightforward metric, it works best on either pre-defined pools of capital or on an after-the-fact basis. The averaging nature of the WACC can be contentious as it invariably leads to certain deals and strategies being over- and under- charged. The issue of over/under-charging can be addressed by charging on an actual cost basis, however this has fairness and behavioural implications if the accessible capital is not uniformly priced. Neither the WACC or the Actual Cost approach take the cost to the business of replenishing the capital pool into account. In a rising interest rate environment, this could affect the attractiveness of funding lower risk/reward deals and strategies. Charging capital at a replacement cost basis can be a way of addressing this however the same drawbacks apply as for the Actual Cost basis. On top of which, one could invite a discussion on the necessity of replenishing all the consumed capital on a short-term basis, and the fairness of charging for capital that is not replenished on a back-to-back basis.

Incentive alignment

More significantly, deal economics are not just subjected to the merits of the deal anymore; the positioning of the entire portfolio can be a key element for the overall attractiveness of a deal, trade or strategy. This interplay and dependence can give rise to serious issues with the alignment of incentives between the various commercial teams and trading desks and could negatively impact risk and performance management.

Self-financing through PnL

As cost of capital charges become more significant, it’s a fair challenge that traders could self-finance through generated trading PnL, or at the very least offset capital charges against PnL. After all, it seems reasonable that a positive PnL should carry a negative cost of capital.

Holistic considerations (cost of credit, cost of liquidity)

When reviewing the entire value and activity chain of a trading operation it becomes clear that the organisation provides a broad range of activities and services to their traders and dealmakers. From a finance perspective the contribution exceeds the simple cost of financing transactions. The organisation often provides credit to customers and third parties and is required to keep a sufficient state of liquidity. Introducing a cost of credit and cost of liquidity could therefore be a logical step, taking into account the associated cost of capital as well as the risk shouldered by the organisation on behalf of its traders (credit risk). Apart from the expected challenges regarding measuring and allocating these cost components, there is also the discussion between charging for the cost of capital versus charging for risk mitigation. The cost of credit for example involves a capital component (the opportunity cost of not receiving the cash at the current time), but also a risk component (the likelihood of not recovering the money owed). The latter could be solved with an internal insurance-like approach to pricing credit risk. Whilst this is straightforward as a concept, it is likely to lead to further debate and discussion: has this turned the credit risk function into a PnL centre? Should traders be kept whole in case of a counterparty default (after all they have been charged an insurance-like premium)?

Technology and capabilities

This article would not be complete without a reference to the implementation of a cost of capital allocation set-up. Once all the hard work is done in terms of analysis, design and safeguarding the journey has a step change into delivering the new functionalities. A large number of the implementation challenges can be handled by having the right people mix, both in quality and quantity. A lot of those people will need to be focussed on the technical part of the implementation. The requirements for new systems and capabilities to support the allocation of costs is significant. Systems and activities need to be mapped and developed to capture the entire activity chain. This enables the capital requirements to be worked out, although further connectivity with the finance department is required to calculate the actual cost of capital. More advanced systems are required to calculate the price of incremental risk assumed and liquidity required. While none of these challenges are insurmountable, it pays to plan ahead and break the process down into multiple stages. This will reduce overall complexity and increase the likelihood of delivering on time, on spec and on budget.

Business considerations – staying competitive when pricing the risk

The exercise of identifying the true costs of trading activities will undoubtedly reveal cost and risk elements that had so far remained under the radar and therefore have not been sufficiently charged. The upside of this is a more risk-aware organisation, enhanced risk management, and an increase in average bottom-line profitability when executed well. The downside of charging for previously unpriced risk and cost elements is a down-adjustment to trade/deal margins and by extension a negative effect on the ability to compete on price compared to peers that have not adopted a holistic view of cost and capital allocation. The costs are still there mind you, and from a bottom line perspective there is no tangible difference, however instead of the costs being packaged with each individual deal or trade, they are realised through a series of ‘one-off’ PnL hits and adjustments that are attributed to unexpected internal and external events.

This is by no means a plea against cost of capital allocation models. As explained, the upside potential is real and significant. It might however lead to a rethink of the business model and strategy, potentially a move towards competition based on quality and service instead of price only, a shift to higher margin business with a better risk/reward profile or a revamp of the firm’s risk profile and appetite. Even a decision to not charge for all capital and risk components for the sake of retaining price competitiveness could be a credible outcome (which technically is a change in risk profile/appetite) as long as that decision is made for the right reasons and with a solid understanding of the underlying risks and rewards.

What about the banks?

Financial Institutions and banks have taken the concept of cost allocation to the limit and often operate an XVA Desk to ensure proper valuations, credit reserves (legally mandated) and portfolio level hedges and risk adjustments. One of the most impactful practices in navigating these intricacies involves establishing a dedicated optimization function within the XVA desk. This function effectively positions itself against market dynamics, mitigating risk and offsetting various risk types, thus alleviating the burden of capital costs.

We are not arguing for commodity and energy traders to set up a fully-fledged XVA-function, but some cherry-picking of banking practices may be beneficial. However implementing an element of cost of capital allocation to commodity trading organisations is far from straightforward. There are many design, policy and technical considerations to take into account, all of which are further complicated by typical trader challenges such as the alignment of incentives and behavioural patterns.

Closing thoughts

Despite its complexities, the understanding and allocation of costs of capital are undervalued and underutilised in the world of energy and commodity trading. The potential for optimising an organisation’s bottom line is real and significant. By embracing cost-awareness, transparency and risk capital frameworks, trading companies can effectively monitor and improve their net performance.

Baringa has engaged with major industry participants on these topics. With experience in both the energy and commodities field as well as banking (hello XVA), we can help you improve your bottom line through a cost of capital allocation set-up.

We invite you to connect with us for more insights and expertise. Your journey towards cost-conscious trading starts here.