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Risk Experts Speak Out: Where the CCRO Fell Short

A surprisingly timid effort for an industry on the brink.

Fortnightly Magazine - January 15 2003

pricing can be used to price credit risk but makes no mention of the fact that it can also be used to calculate default probability.

Inexplicably, there also is no mention in the credit section of the importance of integrating credit risk with market risk frameworks. 14As is well known, market and credit risk are positively correlated in the energy industry. Thus the evaluation of each independently (or as if they had a correlation of zero) will always overstate a merchant energy company's total risk.

The disclosure section is little more than a set of template forms that can be filled out for internal and/or financial reporting. As discussed above in the valuation section, the composition of VaR under current practices is extremely malleable based on intent. Knowing VaR without an understanding of the underlying market values (e.g. forward price curves, volatilities, and correlations) can be misleading. These reported values can be shifted significantly depending on which VaR model is employed, which forward curves are used, and how volatilities and correlations are calculated. While the CCRO does suggest that the type of VaR model used be divulged, this is not sufficient disclosure. At a minimum, disclosure should include:

  • Underlying forward curves, volatilities, and correlations comprising VaR and MTM calculations; and
  • Volumetric positions by commodity (as mutual funds are required to do).

If the industry believes that releasing this information is detrimental to its competitive advantage, then a set of common forward curves and associated market data can be developed and used for reporting purposes, as is done in Australia. 15 Either way, investors and regulators require an understanding of the underlying data and assumptions that comprise VaR to be able to use this information fully.

Additionally, the CCRO did not go far enough. By focusing only on the disclosure of VaR and mark-to-market values, investors and regulators should also receive:

  • Results from a standard set of stress and scenario tests (as insurance companies are required to do); and
  • Metrics measuring the recognition of mark-to-market values to realized cash.

[Editor’s Note: To mark-to-market is to calculate the value of a financial instrument (or portfolio of such instruments) at current market rates or prices of the underlying.]

Real Reforms Are Needed

Eight of the top 10 energy traders have either gone out of business, left the business, or are seriously cutting back. Liquidity is down 50 percent to 75 percent, 16 and the last six months have seen bankruptcies and 78 debt downgrades. 17 Thousands have been laid off, and retirements have been destroyed. The existing norms, practices, and regulations for the merchant energy industry need to be reformed. By limiting its recommendations to the most basic and uncontroversial, the CCRO dodged the critical issues that desperately needed to be addressed.

The CCRO had a unique opportunity and impetus to develop and commit to a set of strong recommendations that moved beyond old mindsets, drawing upon the considerable amount of work done in the financial services industries to address these same issues . 18 But apparently the process of getting all 31 participants