Fraud remains a serious risk for companies in the energy industry. This publication, which is derived from the June 18, 2009 Webcast "Fraud Risk Management," will highlight the national and industry results from KPMG Forensic’s Integrity Survey 2008-2009 and address fraud and misconduct in the energy sector.

KPMG Integrity Survey 2008-2009: Background and Methodology

The KPMG Integrity Survey was initially undertaken to help clients measure risks, strengths, and weaknesses associated with their ethics and compliance programs. These challenges include the kind of ethics and compliance risks that they perceived occurring in their organization, how well they view their ethics and compliance programs working in terms of actually having an influence on the behaviors and decisions of employees, and where they see some of the root causes of any shortcomings. The survey is not only a way to understand what is happening nationally and across different industries, but it is also a tool that organizations can use to compare their results against these external benchmarks.

The key findings in the survey are that the prevalence of fraud and misconduct within organizations remains high and the nature of the misconduct remains serious. Pressures, incentives, inadequate resources, and job uncertainty are major drivers of misconduct. Whistleblower mechanisms are gaining traction, but risks of silence remain. Finally, ethics and compliance programs continue to have a favorable impact on employee perceptions and behaviors. The report on the results of the KPMG Integrity Survey as well as the Integrity Survey – Energy and Natural Resources Results are available on the Global Energy Institute Website at http://www.kpmgglobalenergyinstitute.com/.

Specific Risks to the Energy Industry

Energy companies face specific risks, as the perceived changes in the current economic environment have heightened the focus on the regulatory environment. This includes an increased focus on market manipulation, violations of the Foreign Corrupt Practices Act (FCPA), conflicts of interest, oil, and gas reserve valuations, revenue recognition, misappropriation of costs between regulated and nonregulated businesses, valuation of derivative instruments, environmental compliance regulations, and royalty payments.

Market Manipulation

Market manipulation is an intentional act to manipulate commodity prices through the forces of supply and demand. This may include wash trades, manipulation of prices between affiliates, false index reporting, transactions predicated on false information, collusion for the purpose of manipulating the market, withholding generating capacity, and cornering the market.

Market manipulation has always been the purview of the Federal Energy Regulatory Commission (FERC) and the Commodity Futures Trading Commission (CFTC). The Securities and Exchange Commission (SEC) and the Federal Trade Commission (FTC) are additional governing bodies with recent authority over market manipulation.

Over the past few years, there has been a heightened awareness of market manipulation and there have been more fines and enforcement actions. Companies in the energy industry should be aware of the penalties associated with this misconduct, they should ensure that they have a compliance program in place, and they should also ensure that they have a process in place to test that program. Companies should be able to show a regulatory body that they are monitoring the program.

Violation of the FCPA

Energy companies with international business activities should be aware of potential bribery and corruption actions that could violate the FCPA. Companies should ensure that they have a compliance program as well as processes in place to test those programs. Companies should also consider potential mitigation activities that could lead to a reduction in the occurrence of these violations, and they should strengthen reaction mechanisms for detected violations.

Conflicts of Interest

New Contracts and new vendors may open energy companies to new conflicts of interests between company decision makers and potential new vendors. An example of a potential conflict of interest may be a kickback or payment made to an insider with the intent to coerce a decision regarding a specific vendor and/or contract. Conflicts of interest may pose new risks, in particular with the stimulus package and federal funds. Companies should take prevention steps to help ensure that conflicts of interests do no interfere with the normal procurement process.

Oil and Gas Reserve Valuations

Companies should consider reserve valuations an ongoing risk. Oil and gas reserve valuations are estimates derived from reserve engineering reports, but they are often difficult to estimate given the fact that the reserves are not easily measured. Despite the presence of strong expertise, valuing reserves still proves to be subjective and open to potential misstatement. In addition, industry analysts often place higher values on reserves, increasing the pressure to misstate reserves in a down economy. The SEC has looked at oil and gas reserve valuations given that they are significant estimates for some companies, and effective prevention steps should be taken to help ensure reserves are valued appropriately.

Revenue Recognition

Revenue growth is important to increasing shareholder value, but a difficult economy could increase the pressure to recognize revenue improperly. Special attention should be considered in the areas of meter reading and unbilled revenue calculations for the utilities sector. Improperly recorded gains can also come from the sham sales, when companies sell assets with the intent to repurchase them. A strong corporate governance strategy can help ensure revenue recognition issues are minimized.

Misappropriation of Costs between Regulated and Nonregulated Businesses

Misappropriating costs of a nonregulated business with a regulated business can be used to increase the regulated affiliate’s revenue, as the regulated affiliate can pass costs through to customers. This could involve action from state and federal regulators. It is critical to financial reporting that companies appropriately classify these costs.

Valuation of Derivative Instruments

There is a heightened focus on the valuation of derivative instruments. Energy and commodity derivative contracts must be recorded at fair value. This creates a level of subjectivity in the valuation of these contracts, which can increase the company’s risk of inappropriately overstating gains and understating losses. Derivative contracts for energy or commodity contracts could be deliberately manipulated within the financial statements. Prevention programs can assist the company in effectively valuing these instruments. The SEC and the CFTC are looking at changing the regulations to require a derivative contract to be traded via an exchange. Customized instruments unsuited to such treatment would be subjected to more record-keeping under the proposed changes.

Environmental Compliance Regulations

Complying with the environmental regulations is becoming a routine aspect of the regulatory profile energy companies. Environmental regulations are extremely costly, even for regulated entities with cost recovery, and there may be pressure in a down economy to allow some noncompliance with these regulations. False reporting of environmental compliance may also be a consideration when requirements have no be fully satisfied. Environmental liabilities can involve subjective estimates open to manipulation, and companies need to ensure that the reporting is accurate. They need to look at their estimates and the changes and ensure that their methodology is documented. Companies also need to ensure that there is some clear direction or communication of why any changes have been made. Prevention programs can assist the company in managing these regulations effectively.

Royalty Payments

There is an increase in the number of claims related to royalty disputes, as royalty calculations can sometimes be vague and misinterpreted. Management may calculate royalty payments in an inappropriate manner as commodity prices fluctuate. Companies should have prevention programs in place to assist the company in the managing these obligations effectively.

Conclusion

Fraud remains a serious risk for companies in the energy industry, and there is a heightened focus on the regulatory environment. Surveys allow companies to gather diverse viewpoints and compare results internally and over time, and they are also an early warning mechanism and identification of areas of concern. Companies can use the KPMG Integrity Survey as a tool to compare their internal survey results against these external benchmarks.

About the Author

Ginger Menown is a Partner in KPMG LLP’s Forensic Services Practice in the Houston office and the Forensic National Energy Leader.