A pseudonymous executive tells why the CCRO's recommendations don't pass muster.
The latest splash from the Committee of Chief Risk Officers1 (CCRO)-a new white paper regarding capital adequacy for energy companies2-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:
- How much surplus capital is enough?
- What are the appropriate parameters to calculate total risk (e.g., confidence level, time horizon, tenor of deals)?
- What source data is appropriate?
- What is the role of stress testing and scenario analysis?
How Much Capital Is Enough?
The capital adequacy paper's biggest shortcoming is that it does not make any recommendation about the level of capital required for safety. The CCRO paper openly admits that it will not address the "amount" (of capital) a company should have.
This stands in stark contrast to the committees and working groups in the banking and insurance industries that have defined parameters for capital adequacy. Through the Basel Accords, banking industry stakeholders developed capital adequacy standards that are now internationally accepted. Basel provisions require that banks keep capital reserves greater than 8 percent of the sum of market, credit, and operational risk.
Guidance for the calculation of the specific risk components is also defined:
- Market Risk: Max(Previous day's Value at Risk (VaR), 3 * last 60 days' VaR);4
- Operational Risk: 17 percent to 20 percent of gross income, or 99.9 percent one year VaR; and
- Credit Risk: Defined risk weight by credit rating.5
The insurance industry serves as another data point for comparison. The National Association of Insurance Commissioners' task force on risk-based capital works with industry participants and stakeholders to develop and maintain capital adequacy standards for life, property, and health insurers. Currently, these standards stipulate calculation of the ratio of "total adjusted capital" to "risk weighted liabilities," with a sliding scale of corrective action, from voluntary correction to regulatory response.
Most importantly and immediately relevant are the credit rating agencies' views on this matter. Standard and Poor's issued its own methodology for capital adequacy for energy companies in March 2003.6 S&P's methodology calculates capital adequacy as a multiple of VaR. Specifically, four times market, credit, and operational risk is treated as debt equivalent.7 The CCRO indicated that it was not interested in addressing the appropriateness of S&P's methodology when it states "(our) paper offers an alternative to a capital adequacy assessment that imputes VaR multiples as debt to a firm's capital structure"8-even though these methodologies (Fitch and Moody's each have developed similar methodologies) have a direct impact on energy companies' credit ratings.
Considering the amount of pain the credit rating agencies have dealt recently to the energy sector, it is surprising that the CCRO did not collaborate with the rating agencies on developing its capital adequacy standards, or, at the very least, address the appropriateness of the credit rating agencies' methodologies within the context of proposing its own guidelines.
What Source Data Is Appropriate?
The CCRO also is silent on the criteria for the data used in the capital adequacy calculation. This is a significant hole in the CCRO's capital adequacy standards, since an energy company in debt hypothetically could claim surplus economic capital under the CCRO's framework by selectively choosing the source data used for risk calculations.
In comparison, the Basel Accords stipulate that banks' source data be based on an observation period of at least one year of historical data and updated at least once a quarter.9 Again, the point is not to adopt banking standards for the energy industry but rather to provide the appropriate parallel criteria. Defined criteria for the underlying data will have the effect of increasing the transparency of risk reporting and a positive influence on the energy sector's credit ratings.
What Is the Role of Stress and Scenario Testing?
The CCRO's capital adequacy is heavily VaR focused. VaR generally is not considered entirely suitable to the energy industry given the structural presence of leptokurtic returns, or "fat tails." The presence of "fat tails" indicates that energy price returns do not follow a normal distribution, that extreme price spikes occur with greater frequency than a value-at-risk analysis would indicate (e.g., California power price spike in 2001, December 2003 natural gas price spike). Therefore, using only a VaR-based approach to capital adequacy without stress testing or scenario analysis will fundamentally underestimate the levels of capital required.10
But few energy companies rely solely on VaR for this reason in structuring their risk management limits, so the CCRO is deficient in not discussing the role of stress and scenario testing in evaluating capital adequacy. A survey of financial institutions by Capital Market Risk Advisors in 2001 revealed that approximately 36 percent of financial institutions use scenario analysis testing and/or a combination of VaR with scenario analysis to set capital adequacy levels.
An IRB bank must have in place sound stress testing processes for use in the assessment of capital adequacy. Stress testing must involve identifying possible events or future changes in economic conditions that could have unfavorable effects on a bank's credit exposures and assessment of the bank's ability to withstand such changes.11
The insurance industry also widely uses scenarios to test capital adequacy. Insurance compaines must consider the effect of at least seven interest-rate scenarios in performing asset adequacy analysis.12
It has been almost two years since the energy industry's liquidity and credit crisis started to produce tangible capital adequacy recommendations, but the CCRO has not come forward with any definitive recommendations. With the devastation visited upon shareholders, employees, and the public good by laissez faire risk standards in the energy sector, it is reasonable to expect more.
It is difficult to believe that investors, credit analysts, and regulators will view the CCRO's effort as credible given the vacuousness of the capital adequacy recommendations and the fact that the participating CCRO companies make no commitment to implementation. The CCRO seems more interested in writing tepid papers than making the tough choices required to facilitate structural change in the energy merchant and trading sector-changes that are necessary to return vitality and stakeholder confidence.
- The CCRO was formed in the spring of 2002 as a reaction to the massive upheaval in the merchant energy sector.
- Issued in September 2003 at www.ccro.org.
- "Where the CCRO Fell Short," Public Utilities Fortnightly, January 2003.
- 99-percent confidence level, 10 day time horizon
- Jorion, Financial Risk Manager Handbook, Second Edition, Chapter 31.
- Standard and Poor's, Debt Treatment of Contingent Capital for Energy Marketing and Trading, March 20, 2003.
- Market Risk: 99-percent confidence level, 10-day holding period. Operational Risk: 50 percent of Market Risk. Credit Risk: exposure times default probability.
- CCRO Capital Adequacy Whitepaper, "Executive Summary," p. 2.
- Jorion, p. 673.
- According to insiders, the $80 million loss in February 2003 that caused Reliant Resources to shutter its speculative trading operations was caused by greater than a seven standard deviation price movement. Also, "Reliant Resources to Join Trading Market Exodus," Houston Business Journal, March 10, 2003.
- The New Basel Capital Accord, Section 396.
- NAIC Model Actuarial Opinion and Memorandum Regulation and New York Regulation 126.
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