A risky world requires a robust framework
The challenge
Severn Trent Water Limited is exposed to a combination of financial risks – principally liquidity risk, market risk and inflation risk. Changes in interest and inflation rates can have a significant impact on the organisation’s profit and loss statement, balance sheet and cash flows. It is therefore essential for management to have a good understanding of interest rate and inflation risk, and the impact of these on the financial statements.
In addition, changes in interest and inflation rates can impact the company’s financial metrics. The close monitoring of key ratios and financial indicators is crucial when it comes to determining the strength of the business, as well as highlighting areas to focus on in the future.
As a result, Severn Trent needed a robust risk management tool that could assess the potential impact of changing interest and inflation rates on the organisation’s profitability and financial metrics.
The solution
Severn Trent, in partnership with Zanders Treasury and Finance Solutions, developed a purpose-built best in class quantitative risk decision support model. Its main objectives include:
- Understanding Severn Trent’s sensitivity to interest rate and inflation risk.
- Quantifying how these risks impact Severn Trent’s financial statements and key financial metrics.
- Aiding strategic decision-making on activities such as hedging, raising new debt and liquidity management.
Best practice and innovation
The resulting treasury risk management tool supports decision-making for areas such as hedging, financing and liquidity management by providing insights into interest and inflation risk. The balance sheet, profit and loss and cash flow statements are recalculated based on (stressed) interest rate and inflation shocks.
The data-driven simulation uses an econometric model to simulate future interest and inflation rates based on historical data and a statistical distribution, while keeping the historical correlation between metrics intact. As well as simulating all risk factors, the tool can also simulate interest risk or inflation risk only, while keeping the other factors at projected levels. Furthermore, the model can simulate a flat ‘wedge’ – in other words, the difference between RPI and CPI rates – for inflation rates. Based on multiple scenarios, at-risk metrics are calculated and shown in a detailed report.
Using the tool, Severn Trent’s treasury team can also use interest and inflation rate scenarios based on expert judgement to perform stress testing. Based on various stress tests, the risk management tool assesses the impact of certain economic scenarios on future cash flows and credit metrics.
Both methodologies allow management to evaluate the impact of different financing strategies, debt mix combinations (fixed, floating or inflation linked) and hedging via derivatives, thereby managing interest rate and inflation risk.
Key benefits
The treasury risk management tool quantifies inflation and interest rate risk, enabling Severn Trent to make better strategic decisions regarding funding and hedging. To ensure the company stays within its risk limits, the financial statements and key financial metrics are measured and monitored.
The financial statements and financial metrics are calculated from the current period until the end of the forecast period for each simulation. Based on multiple simulations, a best estimate of the future financial statements and key financial metrics is calculated, as well as at-risk figures that represent worst case scenarios.
The tool also provides insight into stress scenarios, providing crucial insight into how shocks could impact the viability of the business.
Listen to podcast
