Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era by CTRM Center

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RISK AND COMPLIANCE LESSONS LEARNED AND LOOKING BEYOND THE COVID-19 ERA

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Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

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INTRODUCTION While it is commonly believed that the pandemic was a black swan event, according to most risk experts it wasn’t. As they point out, the COVID Pandemic was an event that was foreseeable in its occurrence, though perhaps not in its timing. Despite being (thankfully) rare, these types of events do occur and bring with them an increased awareness of the importance of proper and holistic risk management practices, not only as it applies to external risks (as the pandemic was), but also commercial and internal risks as well. When looking back at the events of 2020, the impacts of the pandemic, both direct and those catalyzed by it, rippled throughout virtually every industry and commodity group. Supply chain disruptions throughout the year increased operational risks and forced often forced companies to seek alternative sources for their critical supplies. Initially these disruptions were caused by international border closures, and later caused temporary closure of facilities due to infection and quarantine creating shortages in the workforce. These disruptions impacted the production and distribution of a number of consumer goods such as paper products, proteins and cleaning supplies. Lockdowns also changed a mix in the types of commodities and quantities being consumed, notoriously toilet paper (as demand moved from industrial/ commercial packaging to retail). Energy commodities were also heavily impacted,

notably oil and refined products due to Russia and OPEC failing to agree a production level extension and flooding the market with crude oil at the very time demand collapsed due to lockdowns. After falling below zero dollars per barrel, prices have recovered, but volatility is remains high and is expected to continue so for the foreseeable future. Power demand also fell significantly during the pandemic, as industrial facilities shut down and load shifted to less intensive residential needs as workers moved to their dining room tables from the offices and factories. Work from home has increased the emphasis on business continuity issues and on collaboration. The pandemic exposed weakness in many companies’ contingency and continuity plans, particularly in the areas of collaboration due to limited access to critical systems. These issues have and will continue to force organizations to

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

move more quickly to become more digitalized. The events of 2020 provided a view of risk that has never been seen in a truly globalized marketplace and no industry was left unscathed

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by its impacts. But, if there are silver lining in the events of 2020, it is that companies that have survived the year are more likely to be aware of, and better equipped, to address similar risks in the future.

ENTERPRISE RISK The breadth of risks faced by commodity-centric firms can be broken into 3 broad categories: 1) market risks, 2) external risks (including environmental) and 3) internal risks. Market risks are primarily those that manifest themselves in the prices paid for commodities within a given market; and are primarily driven by abnormal (non-seasonal) changes in supply and demand, or the perception that supply and demand may change rapidly in the short-term. Market risks can include credit risk, as rapid price swings can degrade the financial position of companies, impacting both the firms themselves and their counterparties. At various times during the last year, the markets became oversensitive to news developments and rumors. Prices for all commodities, particularly energy products and metals become highly unstable as demand forecasts swung rapidly as COVID surged in the 2nd quarter of the year. The metals markets did recover relatively quickly from a drop of about 20% in the third quarter. However, energy prices and particularly oil have struggled to recover to their pre-COVID levels. The resultant loss of value to energy producers has had a devastating impact, particularly in the US shale market, where bankruptcies have been numerous and credit risk has risen for many trading organizations.

External risks can result in increased market risk if the external events are of sufficient scale to impact more than a single company or small region. These risks can range from another COVID-like pandemic creating havoc in global markets, to unusual weather events that damage producing assets or result in closure of trade routes. Other large scale and destabilizing external events can include earthquakes, tidal waves, or even crop diseased or insect infestations. Internal risks are usually related to the breakdown of internal processes. These can include equipment failures due to improper maintenance, trading exposures due to breaches of trader or aggregate desk position limits, improper regulatory reporting, and many others. Though many of the most high-profile failures of internal controls disasters that had been caused by rogue traders (with billions of dollars in losses) have occurred in the not-too-distant past, recent scandals in the Singapore fuels markets (exposed, in part, by events related to the COVID pandemic) have again shown a spotlight of the importance of adequate

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

internal controls and financial reporting. While many of these risks, such a price volatility, can be ameliorated, at least in part, through existing financial products such as hedges; and others, like weather damage or earthquakes can be addressed with insurance products, the impacts and timing of events such as the recent global pandemic can only be addressed reactively. The ability to effectively manage

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any of these risks requires a complete view of not only external market conditions, but also of the operational risks and any optionality and/or alternative strategies embedded in the assets of your company. The ability to visualize and quantify risks, optionality and alternative strategies requires a comprehensive technology infrastructure in which the CTRM/CM system is central component.

RISKS REMAIN BEYOND THE COVID-19 ERA Even after the pandemic has fully receded, risks of all kinds will continue as before, and many are likely to grow in breadth and intensity. Among those: • Environmental Risks - Western governments’ movement to a low carbon future has an impact on all fossil fuels, renewables, and even other commodities like proteins and animal feeds. Questions remain as to the timing of legislation across the various participating countries, how resilient these regulations will be should there be a significant global economic downturn, and how willing will consumers be to continue to support their countries’ politicians should these initiatives result in much higher prices? Additionally, many governments are looking to phase out hydrocarbon fuels, with the initial push focused on coal. This move to decarbonize has been supported by subsidies, including tax breaks

and direct payments, helping accelerate endconsumer adoption of ‘green’ energy and products like electric vehicles. However, should some or all these types of subsidies end, what impact will that have on investment in new renewables projects and consumer goods? With the growing adoption of renewable energy sources, market volatility in power markets is likely to increase without a massive development effort in energy storage. The power crisis in the California markets in the summer of 2020 was a clear indicator that without a comprehensive strategy that embraces not only new investments in renewables, but also battery and other storage technologies, grid instability and market volatility

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

will ensue, especially in markets that are isolated from other sources of conventional generation. Aside from green products and green power, western consumers have also been moving toward products that can demonstrate socially responsible supply chains and products, such as non-GMO produce and proteins, and commodities produced without child labor or deforestation. Certifying these types of commodities and products requires traceable supply chains, from producer to consumer and continuing investments in such capabilities will be required. And should there be a high-profile failure related to that tracing (food borne illness, GMO controversy, etc.), the subsequent loss of consumer confidence could cause significant damage to market reputations across the affected industries. • Regulation/Oversight – In the same vein as environmental risks, increasing regulation and oversight globally in the form of a myriad of rules and regulations (often regional and/or local in extent) have impacted all aspects of commodity supply chains and trade, such as IMO2020 for marine fuels sulfur content which has required increased investments by ship operators, refineries, and bunker operators. These types regulations will likely increase in intensity as governments and industry consortiums seek to limit any number of “bad” actions or by-products related to commodities and the products produced from them. Rules governing child labor practices and

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commodities produced in areas of conflict have also gained increasing attention in recent years. These regulations, usually bound by treaties, require that any company that transacts in the affected commodities track their origin, movements, transformation, and finally delivery to consumers via traceability applications, as with the previously mentioned environmental risks. Some regulators have instituted, and others are proposing market rules that essentially limit positions in some commodities, such as energy derivatives. These rules will impact trade volumes and market liquidity, and almost certainly leading to increased volatility in those markets. Stakeholders, including company boards, shareholders and banks are also increasing the intensity of oversight are they seek assurances that those companies in which they are involved are maintaining and practicing sound risk management policies to limit downside risks and potential legal exposures. • Trade and Project Financing - The entirety of the various trends previously discussed, in combination with massive losses by several trading firms (including accusations of fraud such as in Singapore) have led to a near crises in global trade financing as banks continue to exit the commodity trade financing market. In late August 2020, ABN Amro announced it will exit the trade and commodity finance business, joining BNP Paribas, Société Générale, Natixis, and others that have

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

either entirely left the market or have declined to take on new exposures in the commodity space. The loss of structured, bank-backed financing will undoubtedly increase trading costs across all commodities, reducing liquidity and limiting market growth - though the effects will almost certainly be most pronounced in the Asia-Pac region where alternative financing (funds, etc.) is limited. Government-backed investments and private investors have recently been limiting, or eliminating, funding for various oil, gas, or other hydrocarbon focused projects. In late 2020, the European Union indicated they would limit their funding of natural

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gas projects because of the “risk” they pose to the group’s ambitious climate goals. Activist investors may also pose problems in these markets as they invest in various funds and then seek to prevent those funds from engaging in what they view as socially unacceptable investing, including hydrocarbon energies, protein production and some metals. However, despite these activists’ efforts to date, widescale disruptions in those markets has yet to occur outside of a few local markets, but there is little question their efforts will continue.

RISK AND CTRM/CM The COVID-19 pandemic has again pushed risk management, in all its forms, the top-of-mind status for all companies, even those that exist outside of what is commonly termed “commodity trading”. Any firm that produces, consumes, trades, or sells commodities or commodity derived products has had some level of disruption in 2020, and those disruptions have impacted bottomline performance, up to and including some companies that have failed entirely. Of course, the end of the pandemic does not mark the end of a myriad of internal, external or environments risks, and firms need to increase their focus on addressing these through a combination of increased vigilance, strengthened balance sheets, improved processes, and investments in critical technologies. These steps will be required to improve those companies’ ability to identify and ameliorate financially erosive, or even catastrophic, risks.

For most of these commodity-centric firms, their CTRM/CM applications are at the technology center of their risk management efforts. And though some of the previously discussed external risks may not be directly addressable by the scope of a CTRM/CM system, such as extreme weather events, earthquakes, or even increasing regulatory pressures, these types of external risks will all have direct and sometimes massive impact on commodity supplies and prices, in turn increasing market & credit risks.

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

Internal risks are a critical CTRM/CM consideration as these systems not only capture and value commodity transactions, but also serve as a central point of control for policies, procedures, and compliance for many companies. This can include the tracking of trading limits, valuing and ensuring compliance with financing covenants (including VAR limits and stress testing), tracking trading activities across any number of dimensions (from individual traders to global commodity positions) and providing a complete audit trail of all trading and marketing activities. Risk analytics and supply management applications, when properly integrated with CTRM/CM applications can further assist in developing a proactive approach to risk management. AI-powered analytics have proven their worth during the pandemic in forecasting rapidly changing demand patterns that have affected numerous commodities, including energy and agricultural commodities. Unfortunately, there is no singular approach to developing a truly comprehensive solution for managing all risks, as the exposures any company faces will be dependent on the markets in which they operate, the assets deployed, and the length and breadth of their supply chains. Developing such a system may require any number of specific components to monitor market conditions, communicate with suppliers, monitor supply chains to identify constraints, etc.

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The increasing awareness of enterprise risk is driving a changing focus in software procurement – not just of CTRM/CM and risk analytics, but of surrounding solutions like contract management, document management, workflow, supply chain solutions and others. As these new components/systems are implemented, many will need to integrate with and into the CTRM/CM system. This requirement to tightly couple these critical systems has driven increased interest into “platform approaches” in which the CTRM/CM retains its central importance, but it exists within a more modular architecture on which these other components reside. When such a platform, one that incorporates not just CTRM but also the other critical components of CM and supply chain management, is available from a single vendor (like that from EKA), users are able to quickly add new capabilities as the need arises, without costly and lengthy implementation projects. With either generalized components (such as VAR or Credit Risk) or commodity specific components (such those that assist in identifying crop diseases or insect infestations), platforms like EKA’s can accelerate information across the enterprise and ensure their users have “first mover” capabilities in the event of erosive or catastrophic risk events.

Risk and Compliance – Lessons learned and looking beyond the COVID-19 Era

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SUMMARY The COVID pandemic has taught the world any number of very painful lessons and has exacted a terrible toll in lives and livelihoods lost. Though the effects on the commodities industry may pale in comparison to the personal losses suffered by many, it is important that the lessons of 2020 are not forgotten and that companies better prepare themselves not only for the next catastrophic event, but also what now seem more mundane (but no less threatening) events that may be looming on the horizon.

Early identification of these threats, along with proper risk controls and procedures, will be key to ameliorating risks and helping to reduce the likelihood of internal failures. For commodity-centric companies, continuing to invest in the latest solutions that leverage new technology to gain a holistic view of all enterprise risks, from production to delivery to consumers, will be one of the most critical success factors going forward.

ABOUT EKA Are your ready to find the best CTRM/CM solution for your organization? An extensible cloud platform can help you create an agile, digital business – automating processes and delivering the depth of insight you need to make better decisions for trading and risk, supply chain and financial management. Eka empowers you to prioritize and scale a solution that meets your unique business. Customize and develop the best-fit solution for your: • Scope of functionality: Unlock the value of your data from sourcing to trading and risk, supply chain and financial management. • Commodity and market versatility: Manage a broad set of asset classes across geographies by selecting the best solutions from our library of 50+ applications. Our solutions serve the entire trading value chain across agriculture, energy, metals and mining and manufacturing markets. • Functional requirements: Perform on-demand analysis using trusted data with custom dashboards, drill downs, visualizations, and embedded machine learning algorithms for anomaly detection. • System integrations: 20+ built-in connectors and open APIs enable you to easily bring exter-

nal data from ERP systems and other sources including market, weather, compliance, and your database. Eka’s Cloud Platform provides advanced analytics, one source of data and an automation engine, providing maximum flexibility and investment protection as business needs and market requirements change. With our fully mobile platform enables insight and analytics on the go, Eka is committed to ensuring our 100+ clients can work from anywhere and collaborate across ecosystems within a secure and trusted environment. If you’re ready to find a solution that can address your specific business requirements, learn more about at www.eka1.com

ABOUT Commodity Technology Advisory LLC Commodity Technology Advisory is the leading analyst organization covering the ETRM and CTRM markets. We provide the invaluable insights into the issues and trends affecting the users and providers of the technologies that are crucial for success in the constantly evolving global commodities markets. Patrick Reames and Gary Vasey head our team, whose combined 60-plus years in the energy and commodities markets, provides depth of understanding of the market and its issues that is unmatched and unrivaled by any analyst group. For more information, please visit:

www.comtechadvisory.com ComTech Advisory also hosts the CTRMCenter, your online portal with news and views about commodity markets and technology as well as a comprehensive online directory of software and services providers. Please visit the CTRMCenter at:

www.ctrmcenter.com

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