June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 2 of 92 1. EXECUTIVE SUMMARY 1.1. Objective This paper expands the risk-based capital adequacy framework published in the September, 2003 Committee of Chief Risk Officers (CCRO) “Emerging Practices for Assessing Capital Adequacy” white paper and builds upon that previous paper’s framework to analyze a company’s capital adequacy. During the 2002-2003 time frame of the earlier paper, the energy industry, particularly firm’s with significant energy merchant and trading functions, were still feeling the impact of several high profile failures of energy merchant companies. One of those effects was to dramatically reduced access to capital to firm’s that were defined to have operations in this space. At a time when companies were highly focused on assuring the investors that they would remain a “going concern”, this effect was particularly problematic. Without good access to capital, improvements in this area focused on adjustments to remove exposures in the energy portfolio and in the capital structure by reducing debt. Many of these actions were undertaken in an effort to manage credit ratings as capital adequacy became a focal point for credit rating agency analysis. The current environment is substantially different from the one referenced above as firms in the energy space have access to an abundant supply of capital and are looking to invest in new business opportunities. This paper recognizes the improved current environment, and enhances the previous capital adequacy framework. In addition, the updated framework is applied to the areas of capital allocation and risk adjusted performance measures relevant for evaluating growth opportunities. The major enhancements this paper brings to the 2003 CCRO Capital Adequacy paper are: • Introducing a new and insightful “Equity at Risk” perspective which is supplemental to the NPV distribution perspective for assessing capital adequacy. This methodology reveals potential interim states of capital inadequacy which would go unseen under the NPV distribution approach. • Expansion of capital adequacy insights to the capital allocation decision. • Expansion of capital adequacy measures to risk adjusted performance measures • Addresses in detail, best practices in the area of operative risk. Operative risk was given only cursory coverage in the first paper • To aid in understanding capital adequacy modeling and how it can be utilized as a strategic management tool, we have included an Application section. 1.2. Revisiting “What is Capital Adequacy” As outlined in our earlier paper, capital adequacy continues to be characterized by two distinct viewpoints Economic Value and Financial Liquidity. A company should seek