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Measuring and Managing Utility Credit Risk: Taking a Page from Wall Street

Adopting a portfolio approach to credit risk is the answer.
Fortnightly Magazine - October 15 2002

counterparties or business activities within the portfolio. A framework that is capable of doing this facilitates several useful credit risk management applications. These applications are highlighted in the next section.

Useful Applications

A framework for quantifying credit risk is useful in and of itself, but is enhanced greatly by the applications it supports. The EC framework, with its single metric for quantifying credit risk, stands out as particularly useful due to its ease of application in various risk management situations. These include:

  • Capital adequacy-One of the first useful questions that a quantitative credit risk measurement framework addresses is whether or not the firm has sufficient resources (i.e., equity) to be able to cover credit losses resulting from its operations. Comparing the actual amount of capital (i.e., shareholders equity) to the calculated amount of EC provides an analysis of capital adequacy.
  • Credit approval and limit monitoring-A credit measurement framework that is capable of attributing EC back to an individual counterparty or business opportunity facilitates limit management. Unlike a limit management system that is based on exposures, an EC framework focuses on the risk from a given counterparty.
  • Business opportunity analysis-For asset deals that generate credit risk (e.g., acquiring a generation asset with a long-term PPA from a customer that may default), building in a quantification of credit risk from the transaction may decide the financial attractiveness of the deal.
  • Prudence reserve management-A quantitative method for measuring credit risk can assist in setting the appropriate amount of prudence reserves. The reserves are often set at some level above EL, but well below EC, depending on corporate policy.
  • Portfolio management-A versatile credit portfolio model assists in the management of counterparty exposures by highlighting diversification opportunities, and preventing excessive concentrations of exposures to a single counterparty or industry.

Striking a Balance

In addition to the many useful applications of an economic capital framework for quantifying credit risk, one of its strongest attributes is its ability to resonate with two key stakeholder groups: shareholders and debtholders. Figure 5 provides a representation of the conflicting interests of both groups, and highlights how economic capital "bridges the gap" as the common metric to serve the differing interests of the two groups.

In the case of shareholders, whose interest is that of maximizing return on invested capital, economic capital provides the framework to evaluate business opportunities on a common footing. Likewise in the case of debtholders, who are more interested in making sure the company pays its bills; EC provides a measure of the appropriate capitalization of the organization. Economic capital provides the single measure that allows the competing views to strike an appropriate balance between profits and prudence.

While economic capital will not solve all the problems currently gripping the energy industry, it certainly provides credit managers with a powerful tool for measuring credit risk and facilitates several credit risk management applications. In addition, it gives corporate managers a communication device that resonates well with the competing interests of shareholders and debtholders.


  1. For a more complete discussion of PFE, see our recent article, "Potential Exposure: The Long View On