Ratemaking Special Report
Return on Equity:
Fixing an appropriate rate of return on equity (ROE) for electric utility investors marks a fundamental...
Potential Exposure: The Long View on Credit Risk
Tools for measuring credit risk.
For some time, managers and directors of energy companies have known that their company's risk management programs must do more than simply monitor exposure to market risk within some value-at-risk limit. While market risk remains the largest risk faced by energy companies (particularly for power and gas marketers), credit risk brings up a strong second and looms large enough to create company-killer situations. In just this past year three widely discussed industry-wide credit events (the California crisis, the PG&E bankruptcy, and the Enron bankruptcy) have once again opened the eyes of managers to the need for improved credit risk management practices.
The most recent such event, the Enron bankruptcy, highlights the destructive potential of credit events. At the time of Enron's bankruptcy filing, the aggregate exposure to Enron of all its counterparties was estimated at $6.3 billion. 1 Energy companies held $900 million 2 of that exposure, and the "Top 10" most exposed publicly traded energy counterparties among this unfortunate group held a combined total of $685 million 3 or 76 percent of all energy company exposure. ()
While it is too early to predict how much of this exposure will translate into credit losses, the effect on the market capitalization of our Top 10 was immediately quantifiable. The day after Enron's filing, the market capitalization of these firms was down a total of $4.2 billion (or an average of 10 percent) from the equivalent figure at the end of September; one month later, their share prices had still not recovered and were showing a $2.6 billion total decline 5 (or an average decline of 12 percent). Each of the companies on this Top 10 list has scaled back growth plans to some degree. Four of the companies on the list, prompted by pressure from the credit ratings agencies, have raised a combined total of $3.3 billion in additional (and expensive) equity capital and convertible debt since the Enron bankruptcy. 6 Worse, some of these companies must continue to guard against the danger of a sudden loss of investor confidence, as credit analysts and investors remain wary of "the next Enron."
Clearly, the stakes are high. The frequency of occurrence and the size of losses place credit risk management squarely in the "must-act" category. Unfortunately, while risk managers at energy firms acknowledge that they must improve their firm's credit risk management capabilities, most remain focused on current exposure measurement (i.e., current mark-to-market exposure, plus outstanding receivables) and collateral management. The problem with this focus is that it places excessive emphasis on the present and fails to provide an acceptable indication of credit risk at some point in the future. Because losses from credit risk take a relatively long time to evolve, a more useful measure of exposure is .
Unlike current exposure, potential exposure exists in the future and therefore represents a range or distribution of outcomes rather than a single point estimate. Two useful measures of potential exposure are best described by the questions they answer and the applications they support. The first measure, average or