[BETA] Fortnightly

A pseudonymous executive tells why the CCRO's recommendations don't pass muster.

The latest splash from the Committee of Chief Risk Officers ¹ (CCRO)-a new white paper regarding capital adequacy for energy companies ²-makes barely a ripple. While an improvement over the CCRO's previous efforts, ³ the capital adequacy recommendations do not provide adequate standards that can be implemented consistently by energy companies. The CCRO recommendations in their current form are silent on many critical questions and will do little to increase the confidence of investors and credit analysts in the sector. They also provide an inadequate foundation for revival of the energy industry and fall far short of what has been achieved by the banking and insurance industries, each of which has collaborated on voluntary stakeholder development and review to create detailed capital adequacy standards.

Perhaps more importantly, the CCRO recommendations do not address or incorporate the de facto framework currently being used by credit analysts for the energy sector. Considering the devastating effect credit downgrades played in the sector's recent troubles, this omission requires reconsideration.

Even with these substantial gaps, the CCRO's capital adequacy paper does provide a useful launching point for discussing what capital adequacy is for energy companies. The paper develops a framework for analysis, as well as consolidation of the conventional risk management approaches related to methods of quantifying the primary components covered by capital reserves: market, credit, and operational risk.

The High Points

This article sets forth a framework for comparing a firm's available capital resources and liquidity against unexpected draws on each due to adverse market movements and other events. The primary goal of this framework is to allow energy companies to better manage and communicate their risks of insolvency and liquidity crisis. This is fundamentally different from traditional enterprise-risk evaluation, which relies heavily on accounting ratio analysis and is either backward looking or uses expected future values.

The CCRO addresses capital adequacy by two different aspects-economic value and financial liquidity (see Table 1).

The white paper does a good job of describing methods for the quantification of an energy company's overall risk to measure against its available capital. Calculation approaches are offered for market, credit, and operational risk-key first steps in implementing a capital-adequacy program.

But while these first efforts are marginally beneficial, many important questions are not addressed, and the energy industry is left wanting for specific recommendations.

Missed Opportunities and Unanswered Questions

The CCRO seems unwilling to take a stand by issuing specific recommendations around the open critical questions. Much like the last round of its white papers, the capital adequacy white paper generally provides only high-level recommendations without associated implementation methodology, due either to conscious avoidance or the ills of committee authorship.

Specifically, the paper fails to answer the following critical questions:

1. How much surplus capital is enough?
2. What are the appropriate parameters to calculate total risk (e.g., confidence level, time horizon, tenor of deals)?
3. What source data is appropriate?
4. What is the role of stress testing and scenario analysis?

How Much Capital Is Enough?

The capital adequacy paper's biggest shortcoming