Volume 3 — Valuation and Risk Metrics © Copyright 2002, CCRO. All rights reserved. 2 Note that the best practices herein are offered as a resource. Their use is voluntary, and no company has agreed to or is required to use them. In addition, they may be modified as appropriate by individual companies, and they do not relieve any company from the need to comply with their legal and professional requirements. For further information on the aims and the objectives of the CCRO (including appropriate use of best practices), please refer to Volume 1 of this set of white papers. The Committee of Chief Risk Officers has endeavored to identify, define, and provide guidance on risk management and valuation techniques and metrics that provide information on the various levels of risk encountered by a company engaged in energy trading and hedging activities. Quantifying the risks implicit in a set of physical or financial commodity contracts requires the use of probabilistic techniques to measure the effect of market changes deemed likely based on either historical observations or forward implied volatilities. These include techniques that measure daily earnings at risk and value at risk over varying time periods, as well as capital drawdown scenario analyses, “Greek” analyses, and operational risk assessments. Risk metrics provide management with the ability to gain insight into a company’s performance measures such as gain/loss ratios and efficiency-of-earnings ratios. In addition, we have defined the use of stress tests and scenario analyses to supplement the risk metrics. By developing standard risk management techniques and metrics, the CCRO’s objective is to provide companies engaged in energy trading and hedging and stakeholders with consistent metrics for quantifying and evaluating risk. This white paper sets forth best practices for risk management for companies engaged in energy merchant and trading activities, focusing primarily on the trading and asset management segments rather than on the entire company’s operation. It discusses the metrics most commonly used to assess the risk of the business, as well as best practices for risk management. We have also defined the terminology pertinent to the merchant energy sector, with particular emphasis on trading and marketing (see Glossary). The objectives of this white paper are to: • Disseminate risk management metrics and practices that energy companies can use to quantify and assess the risk within their energy trading and hedging activities • Provide a common platform for stakeholders to use to better understand risk management and compare companies • Enhance business capabilities by − Disseminating knowledge of best practices − Providing guidance for training employees in valuation methodologies − Fostering communication internal and external to the corporation by creating a common vocabulary and understanding of valuation methodologies This white paper does not cover the operation or optimization of a physical asset (e.g., how to run a power plant/pipeline), the technical accounting directives and implications, or how a