Growth
Risky business
How Neal Schmale evaluates risk to help guide Sempra Energy through volatile markets
By Leslie Stevens-Huffman
Smart Business San Diego | November 2007
Neal Schmale joined newly formed Sempra Energy in 1998 just
as the company was about to embark on a voyage of expansion
into the new era of energy deregulation.
Unfortunately, energy deregulation didn’t turn out the way everyone thought it would.
As the firm’s chief financial officer at the time, Schmale had to
help the company navigate through the California energy crisis of
2000.
Sempra was originally formed by the merger of the parent companies of two of Southern California’s oldest and largest utility
companies, San Diego Gas & Electric and the Southern California
Gas Co. At the time of its inception, there was every reason to
believe that deregulation would spawn huge growth opportunities
for the newly created $300 million firm. When the energy crisis of
2000 began, California’s deregulation opportunity started to look
like a wolf in sheep’s clothing, but thanks to Schmale’s conservative strategies, the company survived.
“Sempra was one of the three major investor-owned California utility companies to survive the energy crisis of 2000,” Schmale says. “We
have always had a conservative financial structure and a keen awareness that the commodity markets can be extremely volatile. We’ve
grown our business in this unregulated market during a time period
when most of our competitors have been stumbling. The plan has
always been to expand the company given the unregulated business
platform. My job was to make sure we had enough money to do it and
to exercise prudent risk management and the appropriate corporate
governance along the way.”
Since assuming his present role as president and chief operating officer in February 2006, Schmale has continued to rely on
his thorough risk-evaluation style to help grow Sempra Energy to
$11.8 billion in operating revenue, compared to $9.2 billion in
2004.
Here’s how he’s conquered some of the challenges of growth
along the way.
Understand risk
Taking risks is part of growing a company. The difference
between high-growth companies and no-growth companies often
comes down to an understanding of risk.
“The first thing you have to ask yourself when you’re evaluating
risk is: Based on the assumptions, if this opportunity fails, will this
hurt the company a little bit or a great deal?” Schmale says.
He says that it’s important for executives to understand how the risk
they are evaluating can potentially affect the entire company’s financial stature. Make no mistake about it, Schmale has taken risk — and
lots of it during his 18-month tenure as president of the firm. But he
says that it’s easier to undertake expansion opportunities when he
knows that if the investment happens to fail, that it won’t serve as the
fatal blow to the company.
“The next step in evaluating risk is to thoroughly review the economic models, and to do that effectively, you really have to scrub the
assumptions,” Schmale says. “You have to understand that all of the
numbers presented in the model have some sensitivity to variation,
and you have to know what those variations are to understand how
the projections may change.
“I recommend digging at the model until you understand what all
of the key drivers are that went into the model and where the pitfalls might be. For example, one of the assumptions might be that
the model builder may have assumed that prices will grow at a certain rate every year. Well, that’s unrealistic, but it’s a common mistake. Somewhere along the timeline, you are likely to hit a year
where prices don’t increase and you have to know how that will
affect your projections.”
Schmale also points out that he believes every situation and every
risk is unique. So he doesn’t use a cookie-cutter evaluation methodology for every deal. Rather, he relies on obtaining a thorough understanding of the situation behind every aspect of every deal before he
agrees to move forward.
“You can’t look at everything, so look at the big things that are
supposed to drive the economics of the deal to make sure you’re
comfortable with how those have been represented,” Schmale
says.
Test your assumptions
“We’ve always had a tendency here at Sempra to express risk in
terms of probability and consequences,” Schmale says. “If you’re
wrong 1 percent of the time, you only cause the company a small
amount of financial distress. The more frequently it happens, the
harder it is to overcome the consequences.”
Schmale says that he requires his staff to run numerous tests of the
financial assumptions to understand the best-case and worst-case
scenarios surrounding each investment opportunity. His review of
various financial what-if scenarios is conducted with members of
his senior leadership team. The composition of the review team
varies according to the opportunity, but all team members must
demonstrate a thorough understanding of the numbers and present
possible alternatives for downsizing or exit strategies should it
become necessary to do so.
“I ask the senior leaders who have been involved in evaluating the
risk why they think certain things are going to happen before I reach
judgment over a range of likely scenarios that they present to me
about how they think the investment is going to play out,” Schmale
says. “I like those scenarios to include some worst-case alternatives,
such as, ‘What happens if we invest in a new production plant and
then we find we have overcapacity? Can we sell a portion of the
plant off?’ I like to get everybody on the team on board with the
strategy and the thinking behind it, and I can be pretty contrarian
and pretty skeptical sometimes.”
Once you’ve evaluated all the possibilities, it’s time to make the
decision.
“Finally, if it feels right, then go ahead and do it,” Schmale says.
“You can never be 100 percent assured that the investment will be a
good one, but I think if you’ve played out everything that can go
wrong and are comfortable that you know what can happen and
you’ve knowingly decided to assume those risks, you’re ready to
move forward. Most risk can be managed effectively, you just have to
know where the risks lie.”
As an example, Schmale says that prices in the commodities
business can be very volatile. To manage those uncertain costs, he
enters into long-term contracts whenever possible that allow him
to purchase or sell energy at set prices.
By precontracting energy sales at set prices prior to a new power
plant expansion, Schmale locks in most of the deal’s variables and
hedges his risk by guaranteeing a set return before new plant construction begins.
He says that he leaves the door slightly ajar to sell some of the energy at higher prices on the open market by precontracting for only
about 70 to 75 percent of the plant’s total output capacity. Under his
philosophy, he says the firm initially might make a slightly smaller
profit, but it takes on less risk, and then when the contracts expire,
he has the ability to raise rates and increase profits if the market is
conducive to it.
“We certainly haven’t built things on spec, but nonetheless, in the
early days, the investors were brutal when we were taking a lot of
risk through expansion moves,” Schmale says. “We had to earn
their respect by demonstrating results for our expansion decisions.”
Create the right environment for growth
Given the scrutiny that he employs when reviewing assumption
models, Schmale naturally says that he favors team members who
are self-confident and have a great deal of strength in their convictions. In addition, he says that having the right internal environment
is vital to achieving growth.
“I think that to foster growth, you have to have an environment that
fosters diversity of opinion, openness and one where people aren’t
afraid to be innovative,” Schmale says.
He relies on his listening abilities to work through detailed risk-evaluation meetings with his senior leadership team, getting the
information that he needs to evaluate the risk while still encouraging the team members to express their diverse opinions.
“First of all, you have to listen to everyone and try to hold back
your comments as the team presents their opinions on the topic or
opportunity,” Schmale says. “It’s hard to do sometimes. But even the
smallest comment by the leader can cause the meeting participants
to read into what you’ve said as some indication that that’s the direction for the decision, and they may withhold their comments.
Everybody has their own style, and you have to appreciate that and
listen in order to bring out the variety of opinions.
“I favor using the Socratic method to elicit a dialogue within the
group, and I find that people with strong personalities will stick to
their guns and take a stand on the issue. Of course, if new information comes to light through the process, you have to be prepared as the leader to change your mind. I always try to live by the
advice of John Maynard Keynes who said, ‘When the facts change,
I change my mind.’”
He says that as the leader, you want to surround yourself with
people who are strong and have diverse opinions.
“The notion that one person in the organization should make all
of the decisions is usually the person that ends up running the ship
aground,” Schmale says.
With close to 14,000 employees, Sempra Energy has a great deal
of diversity in its ranks, which Schmale says is also one of the company’s key strengths. He favors diversity within the executive leadership team as another way to benefit from a variety of opinions
and backgrounds because he says that each team member may
view expansion opportunities differently based upon his or her
previous experiences.
“It’s important for the leader to set the tone,” Schmale says. “We’re
a large organization, but periodically, I’ll go out and spend time talking to a drilling foreman because they have valuable opinions and
insights that I can learn from. The company’s environment is really
heterogeneous, and I think you’re a more effective leader when you
have that type of diversity in your ranks.
“Business executives really play the role of coach and general
manager, not the quarterback. You can’t run the team when you’re
out on the field driving the offense. Leaders should set the tone,
establish the strategy and then get the right people in place to execute it.”
HOW TO REACH: Sempra Energy, www.sempra.com
