A capital adequacy primer

As part of its drive to introduce standardised best practices across the energy industry, the Committee of Chief Risk Officers (CCRO) is introducing a set of emerging practices that energy firms can use to measure capital adequacy.

Capital adequacy has been a topic of debate for many years. By its simplest definition, capital adequacy is the availability of funds necessary for a company to meet its foreseen and unforeseen obligations – both short- and long-term. Capital should be large enough to allow a company to operate as a going concern through expected and unexpected business and economic cycles, without disrupting operations and while continuing to create shareholder value.

The energy industry can benefit from the lessons learned by the financial sector regarding the design of a framework for the measurement of capital adequacy. The energy industry has been slow to adopt many of the capital adequacy concepts used by banks, mainly because of the complexities particular to the energy sector.

Energy companies typically have long-lived physical and financial assets and liabilities, which pose significant market, credit and operational risks. Further, since the energy market is not always sufficiently liquid to help measure and mitigate these risk exposures, it is very difficult to determine the appropriate level of capital required to carry these risks. Moreover, companies involved in activities outside non-regulated energy supply and marketing activities also need to incorporate the impact of regulatory rules into their capital adequacy assessment.

Emerging guidelines

Hence, the CCRO’s emphasis is on understanding how companies can adopt a capital adequacy framework for their asset-based merchant activities, starting with the principles used for measuring the risks and exposures of their energy supply and marketing activities.

The CCRO emphasises that these are “emerging” and not “best” practices in the energy industry, as some elements of capital adequacy measurement are relatively embryonic at this stage.

Company management can use a capital adequacy framework to:

  • assess the long-term viability of a company’s business model;
  • make decisions regarding capital allocation by bringing risks implicit in a proposed project or business plan to the forefront;
  • help evaluate the effects of specific corrective actions if a company is facing a capital shortfall; and
  • help promote transparency throughout the industry by providing more insight into factors that drive uncertainties and their influence on short- and long-term financial results.

Economic value v. financial liquidity
A robust assessment of capital adequacy requires an analysis of – and balance between – economic value in the long term and financial liquidity in the short term (see figure 1).

For a company to have adequate capital, it must simultaneously possess both the capacity to create sufficient economic value for its customers and shareholders under unfavourable conditions and the sources of liquidity to meet maturing obligations under adverse conditions. Organisations must address these measurements concurrently.

In addition, the capital adequacy framework measures adequacy under stressed or unforeseen environments – that is, the company must have sufficient capital to withstand expected outcomes and unexpected (unfavourable) outcomes.

Assessing results
How a company approaches its assessment of capital adequacy is strongly dependent on the complexity of its portfolio and the availability and commitment of resources. The CCRO framework for capital adequacy focuses on how a company measures available capital against the amount it “should have”, leaving a resultant “excess” or “shortage”. The Committee recommends two methods for calculating available capital in measuring capital adequacy for economic value – invested capital and market value – and each has its own strengths and weaknesses.

Invested capital is the more straightforward approach, but has a significant drawback in that values on the balance sheet may not reflect the market value of assets, especially for regulated companies. Estimated market value is a preferred approach, albeit a more difficult one, since it is likely to require the use of sophisticated models.

Quantifying risks
The framework for determining capital adequacy for economic value requires an estimation of economic capital – the capital a company is required to hold to support the risk of unexpected loss in the value of its portfolio (see figure 2). This economic capital should cover the most significant quantifiable risks a merchant energy business faces: market risk, credit risk and operational risk.

The CCRO’s white paper, due for release by September, addresses alternative approaches to measuring economic capital for market risk. To quantify market risk, the white paper outlines processes for determining price movements and applies them to an exposure map to produce a probability distribution of financial performance. Firms measure market risk by taking the difference between the expected value of the performance measure and the value of the measure at a certain confidence level on the distribution.

Economic capital for credit risk is derived by calculating the amount of capital required to support an unexpected credit loss, using a distribution of credit losses generated by a credit risk model. Note the focus on ‘unexpected’ loss – the measurement of uncertainty around the expected loss.

The CCRO’s main recommendation for measuring operational risk is to create a “risk taxonomy” as the first step towards applying operational risk to economic capital. A risk taxonomy is a system for organising types of operational risks via a ‘family tree’ – that is, classing risks by various characteristics. In the current embryonic state of operational risk measurement, the CCRO prefers a combination of quantitative and qualitative measures, with emphasis placed on qualitative differentiation between companies.

Operational risk in the energy sector is inherently different from that in banking, due to the presence of physical assets in a company’s portfolio. It is important to note that how companies are going about this measurement is as important as the results they are calculating, because of the qualitative importance of strong processes and controls. An assessment of operational risk controls must include a review of control process flows – for example, the checks and balances a company has implemented. Firms should also review mitigation techniques for controlling operational risk.

Aggregating risks
The CCRO recommends three methods for combining market, credit and operational risk to calculate total economic capital. The first two methods involve a two-step process. First, a company calculates components of economic capital for each class of risk. Second, the firm aggregates them in an analytical form. While these approaches may seem simplistic, they are easy to implement and are viewed as a practical necessity.

The second methodology takes into account the correlation between classes of risk . However, estimating correlation at this level is difficult, due to the limited availability of data.

The third methodology aims to produce a joint probability distribution for the three risk classes through simulation. This methodology is the most comprehensive and consistent, but also the most costly and difficult to implement.

Financial liquidity
The CCRO recommends a framework for calculating liquidity adequacy by measuring internal funding requirements from all expected internal and external financial resources in meeting cashflow obligations or demands. They should be measured under normal and adverse market conditions, taking into account market, credit and operational contingencies (see figure 3). Liquidity modelling should as far as possible use a price propagation process consistent with that used in market and credit risk assessments, combined with financial relationships used in the construction of forward-looking financial cashflow statements.

The Committee recommends that firms use both an expected and extreme stress scenario in modelling liquidity requirements and be explicit about the assumptions made. The CCRO also suggests implementing liquidity limits for contingent capital requirements as a means to monitor and report on liquidity risk. Finally, the importance of liquidity dictates measuring liquidity over several different time horizons. The CCRO suggests calculating both over a short-term (say, 30- or 90-day) horizon and a longer period (say, a year).

By the numbers…
The methods of determining capital adequacy should be viewed in terms of a continuum ranging from an accounting-type implementation to an economics-based capital adequacy calculation. The intention is to make the energy industry and its participants aware of emerging practices and to encourage early implementation of a capital adequacy framework. Experienced firms outside the energy sector – notably in the banking and insurance industries – are well aware that the process generated from a capital adequacy framework is just as important as the numbers that are generated.

Antonio Ligeralde is general manager, research & analytics at Cinergy in Cincinnati, Ohio.
Kenneth Robinson is vice-president, risk management at El Paso Merchant Energy in Houston.
Michael Smith
is executive director of the Committee of Chief Risk Officers, which operates mainly out of Washington, DC.
email: [email protected]

Energy & Power Risk Management
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