June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 3 of 92 to simultaneously create Economic Value for its stakeholders while maintaining Financial Liquidity to meet maturing obligations1. • Economic value relates to the ability of a company to execute its planned business activities while creating shareholder value. Value is created in an “economic” sense after all operating and financing costs are covered by project revenues. • Financial liquidity relates to a company’s ability to meet demands for cash as they become due. These cash demands arise simultaneously from the company’s physical business activities and from its financial operations and are required to manage the risks inherent in creating economic value. Energy companies of all types face a myriad of risks. An effective capital adequacy framework begins with a proper assessment and measurement of the impact of these risks on both Economic Value and Financial Liquidity. Adequacy for Economic Value is a more balance sheet-driven approach and focuses on measuring these risks in terms of an economic capital requirement, often comparing economic capital to the firm’s equity. Adequacy for Financial Liquidity is a cash flow driven metric, which relates the measurement of uncertainties in cash flow to the firm’s access to capital. Figure 1.1 below highlights the impact of these risks on these two Capital Adequacy measures. It is important to recognize that while economic value and financial liquidity are related, they are two distinct and potentially uncorrelated measures. 1 One can argue that in a perfect market the impact of liquidity would be inframarginal given that a solvent firm can always raise capital to deal with liquidity problems. However, many authors ( Myers ( 1977), Myers and Majluf (1984)) have pointed out that in the presence of information asymmetry, transaction costs can make financing difficult or add significantly to financing costs. Economic Value Economic Value Financial Liquidity Financial Liquidity CAPITAL ADEQUACY CAPITAL ADEQUACY Net Assets Debt Economic Capital Capital Shortfall Cash From Ops Fixed Pay- ments Cash On Hand Credit Lines Risk Aggregation Cash Flow - at - Risk Capital Shortfall 0 0.005 0.01 0.015 0.02 0.025 0.03 $0 $9 $18 $27 $36 $45 $54 $63 $72 $81 $90 $99 $108 $117 $126 $135 0 0.05 0.1 0.15 0.2 0.25 0.3 0 1 2 3 4 5 6 7 8 9 10 11 Loss from Credit Defaults ($MM) Probability -40 -35 -30 -25 -20 -15 -10 -5 0 Internal External Physical Market Risk Assessment Credit Risk Assessment Operative Risk Assessment