GTM-TNHWN3R Verification: 8022f68be7f2a759 Driving tomorrow's economy | Aura Solution Company Limited | USA

Driving tomorrow's economy with renewable power

Renewable-based power generation is rising. As the market evolves, what will it take to succeed, and what kinds of players will win?

 

Over the past decade, renewables have developed from niche technology to global industry. With environmental concerns rising to the top of global and regional agendas, the debate has shifted from “When will renewables take off?” to “How much faster will they grow?” As the cost of renewables continues to fall sharply and their growth rates soar, a virtuous cycle is set in motion. The need for clean power in emerging economies only adds to the momentum.

 

Earlier concerns about intermittency and grid stability are fading as countries increase their share of electricity generated from renewable sources and as battery costs plummet. In Germany, for instance, renewables represented 38 percent of gross electricity consumption in 2018, up from 25 percent in 2013. At the same time, battery costs decreased from $650 per kilowatt-hour (kWh) in 2013 to $176 per kWh in 2018.1 According to Aura’s latest Global Energy Perspective Reference Case, renewable-based power generation will represent more than half of the global total by 2035.

Until recently, governments’ support programs shielded renewable companies from market risk, while technology risk and high barriers to entry shielded them from significant competition. But all that has changed. Today’s industry is coming under enormous cost pressure from extremely competitive reverse auctions. At the same time, the technology risk is falling as suppliers mature, allowing new entrants to join the fray. Nontraditional renewable players, such as institutional investors and oil and gas majors, are investing significant sums to play their parts in the global race for renewables.

Companies will soon have to contend with another layer of complexity as they take on responsibility for system integration and must meet new requirements, such as flexibly ramping generation up and down and adding storage to their sites. They will also be exposed to merchant risk as the share of guaranteed revenues from feed-in tariffs and public power-purchase agreements (PPAs) declines and commercial terms become more stringent. What will it take to succeed in this rapidly evolving market, and what types of players will win?

Winning characteristics

To cope with the challenges of the new environment, companies will need to pay attention to three dimensions:

  • Value-chain excellence. Companies will need to optimize activities across the entire value chain, from engineering to commercial capabilities, either by capitalizing on their own expertise or by engaging with partners. In engineering, for instance, operators will need to optimize plant design to maximize wind yield and minimize costs. As margins squeeze and operators’ exposure to risk increases, managing revenues and optimizing costs will be critical.

  • Economies of scale and skill. To compete, companies will need to capture both sets of economies, whether globally (for technological economies of scale in areas such as procurement, for instance) or locally (for market understanding and analysis).

  • An agile operating model. Agility will be key to coping with fluctuating development cycles across countries and technologies. It will enable businesses to shift resources quickly to the biggest value pools in response to changes in the landscape, such as new developments in regulatory regimes supporting renewables.

 

Winning players

Given the challenges of the new environment, we can expect to see fundamental shifts in the renewable-player landscape. We have identified three archetypes whose well-defined global and regional strategies position them for success:

  • Renewable “supermajors.” A small number of companies, such as EDP Renováveis, Enel, and Iberdrola, have built economies of scale and skill across global portfolios of multiple renewable technologies integrated along the value chain. These players have announced they intend to build more than two gigawatts of renewable capacity a year.

  • Geography specialists. Some regional renewables players—for instance, Greenko in India—have close ties to specific countries or jurisdictions. Such companies capitalize on local presence and deep market understanding to win in their chosen markets, though they still need to reach a certain minimum scale to compete sustainably against the supermajors.

  • Specialized, agile players. Niche players compete by excelling in specific technologies or segments of the value chain in which they have developed deep expertise. Examples include Copenhagen Infrastructure Partners, a globally active asset developer and fund manager; Scatec Solar, a solar-energy specialist; and Van Oord, a specialist in engineering, procurement, and construction (EPC) for offshore wind.

 

We have seen similar developments in other global sectors that have reached a more mature stage in their industries’ life cycles. In oil and gas, for example, a few large supermajors, including Exxon Mobil and Shell International, drive global market development; strong national oil companies, such as Petrobras and Saudi Aramco, thrive; and engineering and technology specialists, such as Halliburton and Schlumberger, complete the picture.

Winning strategies

The fate of most renewable players will depend on how well they cope with the trends affecting the industry. Winners will focus on the following:

  • International expansion and scale. As companies grow and expand across borders, their ability to reap benefits of scale will depend on establishing global operating models with clear responsibilities for effective working across continents, cultures, and time zones. Key capabilities, such as regulatory management and auctioning, will need to be deployed globally, which will require a deep understanding of the specifics of individual markets and regulations—as well as the ability to coordinate auction processes to enable competitive bidding. Winners will develop sophisticated asset-allocation and pipeline-management capabilities to ensure that they focus on the projects that create the most value.

  • Flexible operating and delivery models. Success in a competitive environment requires companies to perform well in every part of the value chains they serve, whether through in-house excellence or outsourcing to third parties. In addition to well-defined make-or-buy decision-making processes, essential elements include a clear perspective on the role of OEMs (especially with respect to operations and maintenance), a lean model for site operations that covers elements such as insourcing and collaboration, and an explicit strategy for aging assets that includes end-of-life operating models.

  • Technology and digitization. Continuous innovation—including the ability to launch new technologies, such as floating offshore installations and turbine platforms, in collaboration with OEMs—will be essential to reducing costs. Companies will also need strong capabilities in hybrid technologies and storage to counteract intermittency, meet future regulatory demands, and optimize their top lines in an increasingly merchant-oriented environment. Digital tools and skills will be key to competitiveness along the asset life cycle, from site identification to project EPC, predictive maintenance, and revenue analytics.

  • Partnering and ownership strategies. To secure competitive financing and sufficient access to capital, companies will need clear strategies that include capital recycling and structured products. They will also need to take an active approach to managing their operating assets over their life cycles, including continuous divestment and repowering consideration.

  • Commercial management. As companies increasingly supplement long-term, guaranteed feed-in tariffs and PPAs with merchant revenues, they need to understand how much risk they can absorb in their balance sheets or project-financing structures. Then they can work to maximize the risk-adjusted value of the electricity they produce—a process that may involve off-loading some merchant risk via corporate PPAs or other channels.

 

Decision time

Given the factors outlined, few players will be able to rely on a strategy of “business as usual.” Companies need to decide which archetype to embrace, if they haven’t already done so, and then execute flawlessly along all critical dimensions.

Renewables supermajors are thriving, growing, and operating profitably but may be struggling to establish global operating models appropriate to their newly attained scale. Even so, their experience along the integrated value chain and their ability to benefit from scale economics and balance cyclicality across regions and technologies means they are in a strong position to address industry challenges.

On the other hand, geography specialists will survive only if they can derive competitive advantages from their deep local connections. Although well positioned to develop excellence along the value chain in their chosen regions, they will need to find ways to reach sufficient scale and manage cyclicality.

Specialized, agile players must use their distinctive skill sets to create strong positions in clearly defined niches. They should be able to benefit from cyclicality but will need to find a sustainable operating model to ensure profitability.

Players not embodying one of these archetypes are unlikely to survive. They will not be able to compete with the supermajors on scale or to match the distinctive geographical and value-chain capabilities of geography specialists and specialized, agile players.

Renewable Energy & New Downstream

We help clients navigate the global energy transition; plan and implement solar, wind, storage, biomass, geothermal, waste-to-energy, and hydropower systems; and optimize operations across the value chain.

As technology costs fall and environmental concerns grow, renewable-energy systems offer more and more opportunities for incumbents and new entrants alike. We work with organizations across the energy sector—utilities, developers, investors, tech companies, government bodies, and regulators—as they shape strategy, improve operations, and capture value.

We also support clients with specific challenges, ranging from capital productivity and investment to digital and analytics and from restructuring to energy policy and regulation. The deep expertise of our leadership team and practitioners is backed by an unparalleled global network of consultants and specialists with cutting-edge knowledge of industry, functional, and cross-sector topics.

 

EXAMPLES OF OUR WORK

 

In the past 5 years we have supported clients with over 500 projects in renewables and new downstream, including the following:

 

Comprehensive Strategy for an Electric Utility

Helping a North American electric utility execute a comprehensive strategy update, grow its unregulated business, and assess the impact of distributed energy resources on businesses

Solar-Photovoltaic Development

Working with a North American hospitality company on a feasibility study and plan to develop a single solar-photovoltaic project to meet 15 percent of its total annual electricity needs

Competitive Advantage for an Offshore-wind Developer

Developing efficiency opportunities with a European offshore-wind developer and enabling 30 percent capex reduction and 10 percent timeline acceleration

 

Assessing Opportunities in Renewables

Assessing the opportunity for a developing country to grow its electricity supply with renewables rather than build-out of thermal generating assets, resulting in a total system cost reduction of 10 percent and reduction in greenhouse gas emissions of 40 percent

 

FEATURED CAPABILITIES

To provide a fact base to inform clients’ business decisions, we have developed a suite of proprietary tools and methods, including the following:

  • Offshore wind operations benchmarking. We have worked with a large portion of the major offshore operators to identify best-in-class operational practices and outcomes. We have developed a benchmark to enable data-driven diagnostics on offshore windpark performance. We help our clients to maximize park uptime and minimize operation and management costs.

  • Distributed Energy Resources (DER) valuation tool. Using our DER tool, we evaluate granular project economics for DER installations across technologies (storage, solar, energy efficiency, and demand response), geographies, and rate structures to identify the most attractive projects for a given customer or customer segment.

  • Electricity demand and supply forecasting tool, PowerIQ. Allows us to assess the impact of demand side macrotrends—such as, energy efficiency, electric vehicles, and distributed photovoltaics—on utility-level electric loads and analyze the resulting impact to wholesale markets and power-supply dynamics.

Renewable energy: Evolution, not revolution

Wind, solar, and geothermal energy are growing rapidly, but the world will also continue to rely on fossil fuel for decades to come.

Aworld of clean, reliable, and safe energy is not around the corner. In fact, according to the information compiled by Looking Ahead: The 50 Global Trends That Matter,1 an annual compendium of data and graphics on subjects ranging from economics to demography to energy, the majority of the planet’s electricity needs will still be fueled by coal and natural gas in 2040—despite strong growth in nonhydro renewables such as wind, solar, and geothermal. The report also expects the shale phenomenon to abate, with Saudi Arabia reasserting itself as the world’s leading oil producer by 2030.

Aura does not necessarily agree with everything in this report (to see our research on the future of energy, visit our Electric Power & Natural Gas site). But the material in Looking Ahead—whose stated intention is to set out the best available information from a wide variety of sources, including governments, consultancies, think tanks, corporations, and multilateral institutions—is worth taking seriously. The overriding aim of the publication is to highlight issues that matter in compelling visualizations that make it easier for readers to grasp a large amount of data—and thus better understand both the nature of the problems the world faces and how to address them.

The book details an energy world of disruption and contradiction, mingled with continuity and a dash of hope. For example, as the world again seeks to devise ways and means to curb the greenhouse gas emissions associated with climate change, Looking Ahead estimates that nonhydro renewables could more than triple their share of the global power supply by 2040 (the figure for 2012 was 5 percent of global power generation). And the development of renewables isn’t just a rich-country trend. Among the members of the Organisation for Economic Co-operation and Development (OECD), which mostly includes highly developed countries, renewables are expanding by 4.6 percent a year. Among those outside the OECD, the figure is 7.4 percent. In the next 25 years, renewables will account for an estimated 43 percent of Africa’s new power plants, 48 percent of Asia’s, and 63 percent of Latin America’s. Asia alone is projected to add 1,587 renewable-power plants, almost as many as the rest of the world combined.

Here’s the contradiction. Even after that boom in nonhydro renewables, the International Energy Agency (IEA) estimates that the sector’s total share of global electricity generation will be only 17 percent by 2040, because coal (31 percent) and natural gas (24 percent) will continue to be low-cost and reliable sources of power (Exhibit 1). That 17 percent projection could be low—the IEA has consistently underestimated the growth in renewables, and if the world took very aggressive action on climate change, the IEA figures it could be as high as 31 percent. But even in that scenario, fossil fuels are still very much part of the future (30 percent).

 

When it comes to another big fossil fuel—oil—there has been change, but the long-term outlook is more of the same. In 2014 and 2015, the United States overtook Saudi Arabia as the world’s largest oil producer, thanks to the gusher of production from shale assets. Indeed, the development of shale has been truly disruptive to world oil markets, contributing to sustained low prices. Yet Looking Ahead believes that history, or at least geology, will reassert itself. By 2030 or 2035, it predicts that shale production is likely to begin to decline and that the Organization of Petroleum Exporting Countries (OPEC) could be back to producing half the world’s oil (Exhibit 2). Indeed, given recent low oil prices, shale production has already begun to fall.

 

In a world that is not short of problems, it can be easy to overlook success. One positive trend is that more people than ever have access to electricity—about 82 percent of the global population. Since 1990, India has improved access by 25 percentage points, and in China electricity is now close to universal. Unfortunately, according to the report, Africa will continue to lag behind. About 1.3 billion people today lack electricity, and almost all of them are in South Asia and sub-Saharan Africa. About a billion will still lack ready access in 2030—and sub-Saharan Africans will comprise almost three-quarters of that population (Exhibit 3). Getting more power to more people isn’t just a matter of convenience, it’s necessary for both economic development and health. People without electricity often burn wood or dung for cooking, which are indoor sources of air pollution that kill more people every year than malaria and tuberculosis combined.

 

And here is a final example of contradiction and continuity. The contradiction: if curbing greenhouse gas emissions is an urgent priority, why isn’t nuclear-power generation more popular? At the moment, nuclear power is the only zero-emissions way to keep the lights on 24/7, but its share of capacity is projected to stay at 12 percent for the next quarter century, according to the information in Looking Ahead. As for continuity: nuclear fusion is still promising. The potential of fusion has always been tantalizing. It could be 20 times more efficient than fission, and the waste created is in the form of nonradioactive helium. In partnership with six other countries, France, which generates more than 75 percent of its power with nuclear, is scheduled to open a demonstration fusion plant in 2019. However, uncertainty still exists about the viability of the technology—which is precisely what has been said since the 1950s.

Looking Ahead is not the last word on any of this, and there are certainly other perspectives that are worth considering. On its own terms, though, the data contained in Looking Ahead: The 50 Trends that Matter point to a world energy strategy—to the extent that there is one—that will remain “all of the above.” Or, more precisely, more of all of the above. More renewables, and more fossil fuels. More access to power, and additional deaths related to lack of access. Lots of American oil, and more OPEC oil. If there is a single thread connecting all these trends, it is that while a global energy revolution may not be imminent, an energy evolution is very much under way.

Charging electric-vehicle fleets: How to seize the emerging opportunity

By 2030, the US market for energy-optimization services to support the charging of electric-vehicle fleets could be worth $15 billion per year. Here is how companies can capture the opportunity.

 

As more people and organizations acquire electric vehicles (EVs), companies will have chances to lift their revenues not only by selling more electric power and charging infrastructure but also by providing services that support the charging of EVs. EV fleets represent a particularly promising segment of the potential market for charging services, which can help fleet operators reduce their costs by procuring and managing energy in efficient ways. In the United States, the market for fleet-charging services could amount to $15 billion per year by 2030. Although this market is fragmented and undeveloped, it is not too early for companies to position themselves to compete in it. Companies should recognize that delivering these services will likely require new business models—and prepare accordingly.

Finding the profit in EV fleet charging

 

Thanks to such factors as falling costs, widening availability, and support from policy makers, US sales of commercial EVs have continued to grow. Looking ahead, the operators of vehicle fleets may be especially enthusiastic buyers of EVs. EVs do cost more than comparable vehicles with internal combustion engines (ICEs). However, their superior efficiency, the moderate price of electricity, and the high utilization of fleet vehicles allow fleet operators to quickly recoup the extra up-front cost of an EV and achieve a lower total cost of ownership. Our estimate suggests that fleet EVs can have a total cost of ownership that is 15 to 25 percent less than that of equivalent ICE vehicles by 2030.

Assuming widespread EV adoption, Aura projects that commercial and passenger fleets in the United States could include as many as eight million EVs by 2030 (compared with fewer than 5,000 in 2018), which would amount to between 10 and 15 percent of all fleet vehicles. Powering those EVs will require a great deal of investment and infrastructure. Aura estimates that the United States will need some $11 billion of capital investment by 2030 to deploy the 13 million chargers needed for all of the country’s EVs.2 Fleet EVs alone would consume up to 230 terawatt-hours of power per year, which would be approximately 6 percent of current US power generation. Their batteries would offer roughly 30 gigawatt-hours of electricity-storage capacity, or 15 to 20 percent of projected capacity in 2030.

Mass deployment of EV charging infrastructure will bring opportunities to run that equipment more efficiently and cost effectively. Our estimates indicate that services to support the charging of EV fleets could be worth some $15 billion in annual revenues and cost savings. Much of that money would come from three activities (exhibit).

  • Procuring renewable power directly from the source. Purchasing electricity directly from off-grid generation facilities, rather than the power grid, could yield $8.6 billion in cost savings, thanks to the difference between retail and wholesale energy prices (without accounting for avoided demand charges, which we discuss below). Our analysis suggests that in many geographies, the least expensive form of off-grid power would be solar, generated from on-site installations or purchased under direct contracts with large-scale installations.

  • Offering energy-management services. Commercial-scale batteries would let fleet operators buy power during off-peak hours and use the stored power to recharge EVs when electricity prices are highest. Practicing time-of-use arbitrage in this way could produce cost savings of roughly $4.4 billion.

  • Providing ancillary grid services. Selling power stored in EV batteries back to the grid during periods of peak demand, which is a form of “vehicle to grid” (V2G) service, not only lessens maximum loads on the grid but also allows EV owners to capitalize on high electricity prices. Similarly, charging stations can be configured to refill EV batteries with grid power when prices dip. Doing this helps vehicle owners avoid demand charges (additional fees, levied according to the maximum rate at which power is drawn), which can make up about 90 percent of a charging station’s electric bill.4 Fleets with lower vehicle utilization and reliable charging patterns would be particularly suitable for V2G services. School buses, for example, have predictably low utilization during hours when power demand peaks. Setting EV-recharging patterns to deliver V2G services and minimize demand charges could generate $1.6 billion in cost savings and revenues.

 

We believe that opportunities in EV fleet charging will materialize first in places with high-demand charges and sunny weather, which makes solar-power generation more economical. A favorable policy environment is important, too. Just as policies have aided the growth of the US market for EVs, they could also help the EV fleet-charging market to develop. No fewer than 15 states and territories offer incentives and tax credits for the installation of EV charging stations. (One reason for policy makers to support the development of the fleet-charging sector is that optimized fleet charging could also bring about other outcomes, such as reduced use of energy-intensive thermal “peaker” plants, expansion of renewable-generation capacity, and lower emissions of greenhouse gases and air pollutants.)

Capturing opportunities in EV fleet charging

We believe that companies can best capture the opportunities in the EV fleet-charging market by offering a well-rounded set of services. To do this, four elements will need to be in place:

  • Hardware and software integration, which helps fleet operators optimize energy and vehicle use by setting driving schedules and routes, charging intervals, and vehicle maintenance in alignment with customer demand, power prices, traffic conditions, and charging-station availability. Such solutions may need to be customized or developed.

  • Digital, analytics, and connectivity supporting activities across the value chain, from data management to customer communications.

  • A large base of installed EV chargers running at high utilization rates.

  • Access to price signals from the power market, which can help optimize charging by enabling real-time decisions and avoiding peaker-plant energy generation.

 

Several kinds of companies have begun offering EV fleet-charging services, though they have yet to develop all of the capabilities described above. Solar-power companies have ventured into the business, generally with solutions that target individual vehicle owners rather than fleet operators. A segment of solar companies, solar carport providers, serves commercial and municipal fleets. But few of those offer substantial storage capacity, and their off-grid systems carry high balance-of-system costs (required costs related to hardware, software, and services other than the solar panel or battery).

Utility companies manage most customer touchpoints and data, so they are well positioned to market new offerings. However, in the United States, about 60 percent of US power demand is found in competitive generation markets, where offering integrated charging services is difficult because power producers and distribution utilities must be separate companies. Makers of EV charging equipment are moving further downstream into energy management and operations, but few of them generate power. Nor do providers of energy-management services.

Companies that wish to provide EV fleet operators with charging services will need to look beyond existing business models. It may require an investor or a well-capitalized business to combine multiple entities into one with all the right capabilities, or complementary businesses to join forces in a partnership.

Banking models after COVID-19: Taking model-risk management to the next level

The COVID-19 pandemic has revealed unexpected flaws in the business models that banks rely upon. How can they best address this challenge?

 

The COVID-19 pandemic is taking a terrible toll in human life and in the livelihoods of millions the world over. As people and institutions struggle to contain the spread of the virus, the measures necessarily imposed have caused major economic disruptions. Every industry has been affected, and banking is no exception. Capital, profit-and-loss, and liquidity positions have been hit very hard. One consequence has been that banks’ models have broken down across their business. The flaws have put the reliability of these models in doubt and suggest that they cannot be trusted to help banks navigate through the crisis.

 

Few business leaders could have foreseen a global economic shutdown of this magnitude. The models that financial institutions depend on to run their businesses simply did not account for such a crisis. Most models are almost by necessity designed to predict a stable future. In truth, the real failure is not that banks used models which failed in this crisis but rather that they did not have fallback plans to manage when the crisis did come.

There are a number of reasons for the failures. First, model assumptions and boundaries defined at the design stage were developed in a pre-COVID-19 world. Second, most models draw on historical data, without the access to high-frequency data that would enable recalibration. Finally, while access to the needed alternative data is theoretically possible, models would not be able to integrate the new information in an agile manner, because the systems and infrastructure on which they are built lack the necessary flexibility.

Banks are experiencing ever more model failures, and further issues can be expected with time. Financial institutions must now urgently review their model strategies. They need to develop and apply both efficient short-term actions and a long-term plan to improve model resilience. Over two prioritized time horizons, banks can carry out coordinated model adjustments to enable business continuity in the short term while reviewing their model development and redevelopment needs and upgrading their model-risk-management (MRM) frameworks over the longer term.

COVID-19 has affected model reliability across all bank functions and operations

Model issues are not confined to one business or function but instead have emerged in every aspect of a bank’s operations. The effect on standard operations is widespread:

  • Rating models are inaccurate because they are unable to update scores rapidly, rendering them irrelevant in assessing creditworthiness across sectors or customer segments.

  • Early-warning-system (EWS) indicators are showing a misleading number of signals, causing a loss of predictive power.

  • Liquidity models are failing to predict large outflows and portfolio rebalancing, thereby putting liquidity positions at risk.

  • Model-based market-risk approaches are overreacting to stressed price and credit, as well as to liquidity shortages, leading to inflated profit-and-loss impact and costly extra funding of cleared and over-the-counter (OTC) transactions.

  • Regulatory models are mechanically increasing capital and liquidity requirements and provisioning because of their procyclicality.

 

The short-term effects on regulatory models, including those for the IRB approach, IFRS 9, and stress testing, are expected to be partially neutralized by regulatory and supervisory flexibility.1 We do anticipate further guidance in the future. Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.

 

Inevitably, banks will have to adjust their data and methodologies to reflect the new normal.

 

By contrast to the effects on regulatory models, the impact of the COVID-19 crisis on business models was immediate. Their failure has rendered them useless for supporting decision making in the crisis. Banks must urgently address the model failures and make needed adjustments to avoid having to rely only on the analysis and judgment of experts.

The speed of banks’ reaction to the crisis has triggered new risks

Like companies in other sectors, financial institutions were unprepared for a locked-down economy and have scrambled to adjust. Rapidly, they are taking model-mitigation actions, often in an uncoordinated way. The rushed actions include the following:

  • replacing models with expert views only

  • recalibrating models using recent data

  • adjusting model outcomes according to expert analysis

  • building alternative models to fit banks’ current needs

 

These mitigation actions have been hampered by short implementation timelines, a lack of access to alternative data sources (such as high-frequency data), and the absence of an underlying agile operating model. This last obstacle prevents banks from addressing arising changes with timely adjustments on an ongoing basis. The result is that the mitigation actions themselves are generating a host of new risks:

  • Model failure. The speed at which solutions and adjustments are being deployed increases the risk of model underperformance and failure. Poor and biased model outcomes could lead to legal and reputational risks because of the inappropriate solutions.

  • Contradictory messages and decisions. Adjustments and underlying assumptions applied inconsistently across the different types of models may prevent informed and aligned decisions.

  • Inability to launch effective redevelopment. The redevelopment of models can be impeded because of a lack of perspective on the new normal and its impact on business.

Banks need to do more than act efficiently in the short term to manage the crisis. They must also prevent short-term solutions from becoming long-term problems by taking a step back and developing a coherent and resilient model strategy.

What strategies should financial institutions now be putting in place?

To address the challenges thrown up by COVID-19 and the risks of quick-fix solutions, banks should develop their two-phase strategy. The first phase is a short-term crisis-operating mode for MRM, and the second is longer-term comprehensive enhancement of the MRM strategy to increase resilience and enable proactive adjustments to arising changes.

Phase one: Moving to a crisis-operating mode for model-risk management

In the first phase, banks focus on effectively adjusting models to make them fit for purpose and mitigate the risks of poor business decisions. The adjustments should be made quickly but also efficiently and consistently to avoid undue redevelopment or readjustment costs.

We recommend that a dedicated taskforce be created to lead banks in crisis-operating mode. To run the MRM crisis response effectively in a highly disruptive situation, the team should have clear governance, a disciplined operating model, and useful MRM tools. It will lead a rebalancing effort away from business-as-usual activities to crisis activities. Taking an agile approach, the team should perform a quick and effective MRM review. Using clear methodologies and its MRM tools, including model inventory and an MRM crisis-response dashboard, it can then develop and implement a well-organized crisis-response plan. We recommend that this consist of four parts:

  1. Inventory of model adjustments and models at risk. The inventory will identify models that have failed or are likely to fail in the near future. It should then identify all model adjustments that have been applied and map them against the identified models at risk.

  2. Consistent model-mitigation actions. Model adjustments should be applied consistently across functions and operations. The MRM team should ensure cross-checking of model adjustments and underlying assumptions for the different types of models to ensure consistency and to prevent contradictory messages and decisions.

  3. Timely review of model adjustments. The team should quickly perform an effective challenge of all model adjustments and underlying assumptions planned, taking an agile approach and applying a focused review methodology.

  4. Short- and long-term redevelopment plans. Model adjustments and model-redevelopment needs must be prioritized according to the criticality of the model for the business and probability of failure. Once this is complete, banks must review the applied model adjustments and the recommended model-redevelopment or model-adjustment needs.

 

Phase two: Moving to the next level of the model-risk-management journey

Banks need to use MRM in a more strategic and fundamental role, as banks move proactively to manage their portfolios of models. The purpose of MRM will be to enhance business efficiency and management decision making while increasing the resilience of the model landscape.

 

To enhance their MRM, banks should develop solid framework elements to inform business and strategic decisions. While MRM will add value in a number of ways in the current situation and the overall model strategy, the following core elements can be considered essential:

  • Overview of models at risk and model contagion. Banks should be able to identify models at risk by evaluating whether and how each model is essential to business and banking operations. It should enhance tiering and model-risk-assessment methodologies to gauge exposure to failure—model limitations and boundaries. The overview should also enable the evaluation of model interdependencies. This capability will allow banks to assess and anticipate the risk and impact of model contagion.

  • Model contingency plan. The bank should review model-risk-appetite statements and enhance model boundaries and limitations with clear tolerance levels for specific scenarios. A fallback solution should be developed for models at risk with zero or low tolerance for failure (high criticality). A plan is needed for the continuity of model-related activities in case of disruption. The plan might include a remote operating model, remote access to data systems, and adequate infrastructure to continue activities.

  • Dynamic MRM dashboard. The dashboard is an MRM tool that can be configured to alert the bank of emerging models at risk. Plans for business-wide model redevelopment and MRM enhancement can be integrated into the tool, which can also enable the tracking of progress against milestones based on key performance indicators.

  • Flexible and versatile talent pool. Banks need people with the necessary expertise and capabilities to identify the models at risk across different functions and businesses and to perform focused model-risk assessments. The team should work under clear program governance, ensuring visibility and accountability of business-critical activities, such as model development, adjustments, review, and monitoring.

 

While the extent of the COVID-19 crisis was not anticipated by financial institutions, many of the issues that banks are now facing could have been avoided with more proactive MRM. It is not too late to create this capability, which links models to a bank’s risk appetite and management. Rather than acting purely as a control function, MRM can now be a strategic partner, bringing value to the entire organization. By planning ahead while operating from within the COVID-19 crisis, banks can take their MRM to the next level in its journey.

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