Advancing Best Practices for Companies and their Markets Capital Adequacy Extension June 2007 Committee of Chief Risk Officers THE COMMITTEE OF CHIEF RISK OFFICERS GRANTS USERS A REVOCABLE, LIMITED, NON-EXCLUSIVE, NON-SUBLICENSEABLE, NON-TRANSFERABLE LICENSE TO REPRODUCE THIS DOCUMENT SOLELY FOR INTERNAL, NONCOMMERCIAL AND EDUCATIONAL PURPOSES ALL OTHER RIGHTS ARE RESERVED BY THE CCRO WITHOUT LIMITING THE FOREGOING, THE CCRO DOES NOT CONSENT TO THE REPRODUCTION OF ANY OF ITS DOCUMENTS FOR PURPOSES OF PUBLIC DISTRIBUTION, SALE OR ANY OTHER COMMERCIAL USAGE ATTRIBUTION TO THE CCRO, AS THE COPYRIGHT OWNER, IS REQUIRED IN ALL CASES © Copyright 2005, CCRO All rights reserved June 2007 Capital Adequacy Extension EXECUTIVE SUMMARY 1.1 Objective This paper expands the risk-based capital adequacy framework published in the September, 2003 Committee of Chief Risk Officers (CCRO) “Emerging Practices for Assessing Capital Adequacy” white paper and builds upon that previous paper’s framework to analyze a company’s capital adequacy During the 2002-2003 time frame of the earlier paper, the energy industry, particularly firm’s with significant energy merchant and trading functions, were still feeling the impact of several high profile failures of energy merchant companies One of those effects was to dramatically reduced access to capital to firm’s that were defined to have operations in this space At a time when companies were highly focused on assuring the investors that they would remain a “going concern”, this effect was particularly problematic Without good access to capital, improvements in this area focused on adjustments to remove exposures in the energy portfolio and in the capital structure by reducing debt Many of these actions were undertaken in an effort to manage credit ratings as capital adequacy became a focal point for credit rating agency analysis The current environment is substantially different from the one referenced above as firms in the energy space have access to an abundant supply of capital and are looking to invest in new business opportunities This paper recognizes the improved current environment, and enhances the previous capital adequacy framework In addition, the updated framework is applied to the areas of capital allocation and risk adjusted performance measures relevant for evaluating growth opportunities The major enhancements this paper brings to the 2003 CCRO Capital Adequacy paper are: • • • • • Introducing a new and insightful “Equity at Risk” perspective which is supplemental to the NPV distribution perspective for assessing capital adequacy This methodology reveals potential interim states of capital inadequacy which would go unseen under the NPV distribution approach Expansion of capital adequacy insights to the capital allocation decision Expansion of capital adequacy measures to risk adjusted performance measures Addresses in detail, best practices in the area of operative risk Operative risk was given only cursory coverage in the first paper To aid in understanding capital adequacy modeling and how it can be utilized as a strategic management tool, we have included an Application section 1.2 Revisiting “What is Capital Adequacy” As outlined in our earlier paper, capital adequacy continues to be characterized by two distinct viewpoints; Economic Value and Financial Liquidity A company should seek © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension to simultaneously create Economic Value for its stakeholders while maintaining Financial Liquidity to meet maturing obligations1 • • Economic value relates to the ability of a company to execute its planned business activities while creating shareholder value Value is created in an “economic” sense after all operating and financing costs are covered by project revenues Financial liquidity relates to a company’s ability to meet demands for cash as they become due These cash demands arise simultaneously from the company’s physical business activities and from its financial operations and are required to manage the risks inherent in creating economic value Energy companies of all types face a myriad of risks An effective capital adequacy framework begins with a proper assessment and measurement of the impact of these risks on both Economic Value and Financial Liquidity Adequacy for Economic Value is a more balance sheet-driven approach and focuses on measuring these risks in terms of an economic capital requirement, often comparing economic capital to the firm’s equity Adequacy for Financial Liquidity is a cash flow driven metric, which relates the measurement of uncertainties in cash flow to the firm’s access to capital Figure 1.1 below highlights the impact of these risks on these two Capital Adequacy measures It is important to recognize that while economic value and financial liquidity are related, they are two distinct and potentially uncorrelated measures One can argue that in a perfect market the impact of liquidity would be inframarginal given that a solvent firm can always raise capital to deal with liquidity problems However, many authors ( Myers ( 1977), Myers and Majluf (1984)) have pointed out that in the presence of information asymmetry, transaction costs can make financing difficult or add significantly to financing costs © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension 1.3 Adequacy for Economic Value Measurement of Capital Adequacy requires an assessment of the relative size of the firm’s equity versus its Risk Capital Requirement To the extent that a firm has adequate equity to cover its risks, the firm may enjoy greater confidence in its ability to cover the threats to value creation that it faces from different sources (market, credit, operative, and business risks) 1.3.1 A Word On the Challenge of Accounting Equity Measures Measuring risks within the energy industry is a complex task in itself; measuring a firm’s economic equity, while on the surface fairly straightforward, can prove to be a difficult exercise The use of financial statement data presented under Generally Accepted Accounting Principles (GAAP) may not provide a clear & robust picture of an energy company’s economic equity Fallout from the energy merchant failures of 2000-2002 included a dramatic reduction in the use of fair market value, or mark-tomarket, accounting While this paper does not take a stance on the merits of the current or previous accounting guidelines for energy firms, there is agreement across the industry that GAAP financial data often does not provide a clear picture of the value of energy business operations One result of this recognized mis-match between accounting values and market value is that more energy companies are now supplementing their GAAP financial statements with “economic” financial statements This economic data incorporates fair market valuation for a portion of the firm’s assets and liabilities and may be a more accurate measure of the value of a company’s equity component Firm’s will have to evaluate whether to rely on the GAAP generated traditional balance sheet versus an economic balance sheet in determining equity It is important to note that more stakeholders are demanding economic financial statements in order to get a better understanding of energy companies’ financial health & performance In addition to the above discussion on this issue, a number of CCRO companies have found in the past that the differences between GAAP and internally generated economic balance sheets often provide material for constructive internal debates These debates in turn often lead to a much better understanding by company managers of the issues and risks faced by the company Thus, the capital adequacy frameworks detailed herein often lead to much improved decision making - even if the numbers generated are a cause for internal debate 1.4 Economic Capital and the Four Categories of Risk Capital adequacy assessments require a measure of risk capital – aka the “Economic Capital” created by the business activities conducted by the firm Risks are first © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension assessed and measured from a silo perspective Sometimes called “risk buckets” these silos include market, credit, operative, and business risks2 1.4.1 Economic Capital and Its Components Economic capital is the capital a company needs to hold to financially withstand the risk of an unexpected loss of a predefined magnitude in the value of its portfolio, and still be able to provide collateral and continue operations Economic capital should encompass all risk classes (market, credit, operative, and business) the enterprise faces Economic capital is determined at a desired confidence level in the probability distribution of value for a given business In this paper, we assume that economic capital can be approximated by the unexpected loss in value at some given confidence level Economic capital may be estimated using a range of methods with varying levels of robustness It follows that the greater the robustness of the method, the greater will be the transparency, relevance, and applicability of the economic capital measure For this reason, many energy companies are investing significant resources in developing robust simulation based approaches to assess the distribution of future outcomes for company earnings and cash flow 1.4.2 Operative Risk Since valid and meaningful quantitative data for operative risk is often lacking, we take an in-depth “guiding principles approach” to managing operative risk The extensive coverage of guiding principles for managing operative risk is founded on the assumption that effective management of operative risk is process and controls based We have taken a look at the Basel Committees “10 Principles for Effective Operational Management” and applied them to operative risk management for energy companies The CCRO notes that operative risk in energy is inherently different from banking due to the presence of physical assets in an energy company’s portfolio As a result the CCRO adds an “operations” component to the Operative Risk bucket Operative risk is an integral component of measuring capital adequacy We define “operative risk” as the sum of “operations risk” and “operational risk” Operations risk is the risk associated with delivering, producing, or storing physical energy products including unplanned forced outage rates Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events In recent years, there has been much attention devoted to the area of Operative Risk The previous CCRO paper on Capital Adequacy generally described what an operative risk framework should entail This paper For more information on the different measures of economic capital, we recommend that the reader refer to the previous CCRO paper “Emerging Practices for Measuring Capital Adequacy” Taken from CCRO white paper “Emerging Practices for Measuring Capital Adequacy”, Sep 2003, pp4-5 © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension specifically details a framework to address operative risks which is largely based upon the Basle Committees’ “10 Principles for Effective Operational Management” Effective quantitative modeling of operative risk requires both the probability and severity of a negative operative event While it is still difficult to measure operative risk in the energy industry, the inroads made from the qualitative standpoint have served to improve the identification and understanding of these risks This in turn has led to more operative efficiencies and has helped companies position themselves to be better prepared to anticipate and mitigate potential operative risks before these cause significant financial losses 1.4.3 Market Risk Market risk is broadly defined as the potential loss in value due to adverse movement in market prices, such as energy prices, foreign exchange and interest rates Given a distribution of the variables, one way to measure market risk is to calculate the difference between the expected value of the performance measure and the value of the measure at a certain confidence level The previous CCRO paper addressed various approaches to developing probability distributions of outcomes, along with a discussion of the strengths and weaknesses of each method 1.4.4 Credit Risk Credit risk is the risk of nonperformance by a counterparty Economic capital for credit risk is defined as the difference between the expected loss of a portfolio and the maximum loss at a desired confidence level Economic capital for credit risk is obtained by calculating the amount of capital required to support the unexpected credit loss, using a distribution of credit losses generated by a credit risk model The previous paper focused on the specific credit models and the selection of these models; this paper focuses on a company-wide approach to credit and the required capital to cover a firm’s credit risk and the impact of credit risk mitigation strategies on this capital 1.4.5 Business Risk & Stress Testing Business risk addresses the risks arising from firm specific events such as, litigation, regulation, and competition Due to the highly firm specific nature of these risks each company can address or quantify these risks in unique ways that suit their particular situation This is perhaps the least understood category of risk in terms of quantifying the ways in which the firm’s value distribution is impacted Many CCRO member firms include an assessment of these risks via specific scenarios and stress tests that incorporate specific business risks situations & valuation outcomes which are perceived to be somewhat plausible in terms of occurrence probability In addition standard insurance product can be used to manage some of these risks (for example property and liability coverage) © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension Overall Economic Capital for the Firm Once analyzed and quantified, these risk categories can be aggregated to yield an economic capital metric for the firm This aggregation can be characterized as being within two boundaries; an upper boundary that assumes perfect correlation between the different risk buckets (simple sum of all the risks) and a lower boundary that assumes a zero correlation between the silos These are illustrated in the figure XX: The lower boundary in Figure XX includes a diversification effect of $121MM which is derived from the sum of squares method4 This lowers the risk capital and changes the economic capital requirement from a shortfall to a cushion However, it is likely that the true risk capital number will fall somewhere between these two boundaries due to the fact the true correlation between the risk buckets lies somewhere between zero and one, thus creating some diversification effect Therefore it is important to be careful in estimating correlations and volatilities across the risk silos in order to improve the accuracy of the risk capital estimate We discuss these issues in more detail in the sections that follow 1.5 Revealing Possible Shortfalls at Interim Time Periods We are primarily concerned with risk events that have the potential to reduce the value of the firm’s equity In order to make an assessment of the potential earnings losses, one must have an estimate of the mean path of future economic earnings The various risks can then be modeled as a distribution around the mean path We posit that there is an additional reason for modeling the expected path of economic earnings over time This is because as we move through time there may be expected market downturns that can erode equity The firm’s ability to add stockholder value over this time therefore depends on weathering these downturns To understand the source of the diversification effect when two assets with less than perfect correlation are combined in a single portfolio the reader is referred to any intermediate finance text in investments and portfolio theory A more ambitious reader can read H Markowitz’s text 19590 on Portfolio selection and the efficient diversification of investments © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension For example, this graphic illustrates how earnings may enhance or degrade a company’s equity The earnings expectations for a company are displayed for time periods T+0 through T+7, the lower chart indicates how those earnings affect equity Assume for the moment that T+8 through T+30 have positive earnings expectations, resulting in a significantly positive NPV Relying exclusively on an NPV analysis to determine the economic capital required for market risk, could result in overlooking some time periods where negative equity can result(T+5) These periods represent poor financial condition possibly leading to financial failure, preventing the firm from realizing its full economic value A standard NPV based Monte Carlo simulation approach may not reveal the time periods where the firm can be financially distressed., such as T+3 through T+5 1.6 Adequacy for Financial Liquidity The term financial “liquidity” refers to a company’s ability to create access to liquid capital in the amount and in the timeframe needed to meet all the current cash obligations These include cash demands resulting from the day today operations and financing activities (such as maturing financial liabilities) of the corporation’s business We can assess liquidity adequacy by determining internal funding requirements from all expected internal and external financial resources under normal and adverse market conditions taking into account market, credit, and operative contingencies To the extent possible, the same price modeling process used in market and credit risk assessments can be combined with financial relationships to construct a pro forma financial cash flow statements It is also necessary to account for conditional events such as trigger events that can cause credit rating down grades, probability of counterparty defaults, material adverse changes, adequate assurances, and debt to equity triggers Modeling liquidity is a complex but necessary effort in measuring liquidity adequacy The framework for determining Cash Flow at Risk (CFaR) is comprised of the same elements that made up the framework for assessing Economic © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension Capital, or Risk Capital, outlined in Chapters 3-7, with the difference that in this analysis focuses on sources and uses of cash rather than earnings and equity 1.7 Summary In summary, this paper lays out a risk-based capital adequacy framework that energy companies, industry analysts, and other stakeholders can use to analyze a company’s ability to meet both near-term and long-term obligations The practices described in this document should be viewed as a continuum ranging from an accounting type of implementation to an economic-based capital adequacy calculation The intent is to make the energy industry and its stakeholders aware of emerging practices and to encourage early implementation of a capital adequacy framework With this in mind, the CCRO has endeavored to provide as much guidance in this paper without being prescriptive We expect energy companies and other stakeholders to read this document in the same spirit © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension TABLE OF CONTENTS EXECUTIVE SUMMARY 1.1 Objective 1.2 Revisiting “What is Capital Adequacy” 1.3 Adequacy for Economic Value 1.3.1 A Word On the Challenge of Accounting Equity Measures 1.4 Economic Capital and the Four Categories of Risk 1.4.1 Economic Capital and Its Components 1.4.2 Operative Risk 1.4.3 Market Risk 1.4.4 Credit Risk 1.4.5 Business Risk & Stress Testing Overall Economic Capital for the Firm 1.5 Revealing Possible Shortfalls at Interim Time Periods 1.6 Adequacy for Financial Liquidity 1.7 Summary What is Capital Adequacy? 12 2.1 Capital Adequacy and Credit Ratings 14 2.1.1 Natural Gas Marketing Company Example 16 Economic Capital Adequacy 18 3.1 Determining the Equity Component 19 3.1.1 Total Asset Determination 19 3.1.2 Total Asset Determination: Invested Capital 19 3.1.3 Total Asset Determination: Market Value 20 3.1.4 Total Asset Determination: Invested Capital vs Market Value 20 3.1.5 Total Liabilities Determination 21 3.2 The Risk Capital Requirement 22 3.2.1 Aggregation of Risk Capital 23 3.2.2 The “Cushion” 25 3.2.3 The Time Component 26 3.2.4 Establish Earnings Expectations 27 3.2.5 GAAP Earnings vs Non-GAAP Earnings 28 Operative Risk 31 4.1 Introduction 31 4.2 DEFINITION OF OPERATIVE RISKS 32 4.3 Building the Framework for Assessing Operative Risks 33 4.4 Developing an Appropriate Risk Management Framework 34 4.5 Operative Risk Management: Identification, Measurement, Monitoring and Control 35 4.5.1 Operational: Identification of Internal Risks from People, Processes, and Systems 36 4.5.2 Operations: Identification of Physical Risks of the Production, Delivery, and Storage of Energy Commodities 37 4.5.3 Identification of External Risks from Legal, Regulatory, Political, and Environmental Exposures 38 4.6 Operational: Measurement of Internal Risks from People, Processes, and Systems 39 4.7 Operations: Measurement of Physical Risks and External Risks 40 4.8 Monitoring Operative Risks 42 4.9 Controlling Operative Risks 42 4.10 Role of Supervisors 44 4.11 Role of Disclosure 45 4.12 Conclusion 46 Credit Risk 47 5.1 Introduction 47 5.2 Expected Default Probability (EDP) 49 5.3 Historical Based Approach 50 © Copyright 2007, CCRO All rights reserved Page 10 of 91 June 2007 10 Capital Adequacy Extension 5.4 Bond Based Approach 50 5.5 Equity Based Approach 53 5.6 Default Rate Volatilities and Correlations 56 5.7 Recovery Rate and Recovery Rate Volatility 57 5.8 Rating Migration 57 5.9 Econometric Factors 58 5.10 Current and Potential Future Exposures 59 Market Risk .62 6.1 Introduction 62 6.2 Definition of Market Risks 62 6.3 Elements of the Framework 62 6.4 Exposure Mapping 63 6.4.1 Identify all Market Risks 63 6.4.2 Determine Market Risk Factor Volatilities and Correlations 64 6.4.3 Define How Market Risks Relate to Earnings 65 6.5 Scenario Generation 66 Business Risk, Stress Testing, and the Risk Capital Determination 68 7.1 Introduction 68 7.2 Conclusion 70 Liquidity Adequacy 71 8.1 Introduction 71 8.2 Elements of the Framework 72 8.3 Stress Testing, Trigger Events, and Other Contingencies 75 8.4 Loss or Reduction of Threshold 75 8.5 Adequate Assurance 75 8.6 Debt / Equity Trigger 76 8.7 Credit / Counterparty Terminations / Defaults 76 8.8 Operative Risk 77 8.9 Conclusion 77 Conclusion 78 Appendix A: Practical Application 79 10.1 Utilizing Capital Adequacy Modeling as a Key Management Tool 79 10.2 Application of Capital Adequacy Concepts 80 10.2.1 Overview 80 10.2.2 Modeling Approach 81 10.2.3 Agent Based Modeling Technique 81 10.2.4 EMTCo Parameters for Agent Based Modeling 82 10.2.5 Equity at Risk Methodology 83 10.2.6 Current EMTCo Operations 84 10.2.7 EMTCo New Marketing Opportunities 85 10.2.8 Decomposing EMTCo’s Portfolio 87 10.2.9 Impact of New Marketing Activities on Hedging Strategy 89 10.2.10 Conclusion 90 © Copyright 2007, CCRO All rights reserved Page 11 of 91 ... asymmetry, transaction costs can make financing difficult or add significantly to financing costs © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension 1.3 Adequacy... reader can read H Markowitz’s text 19590 on Portfolio selection and the efficient diversification of investments © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension. .. insurance product can be used to manage some of these risks (for example property and liability coverage) © Copyright 2007, CCRO All rights reserved Page of 91 June 2007 Capital Adequacy Extension Overall