June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 37 of 92 In the identification of these risks, it is prudent to work closely with Internal Audit to ensure a complete review of all areas for potential risk due to failures within people, processes, and systems. In conjunction with the Internal Audit, this area will require coordination with the Human Resources, Information Technology, and Corporate Compliance departments to identify material risks with their respective areas, as well as other business line mangers that have responsibility over people, processes, and/or systems. 4.5.2. Operations: Identification of Physical Risks of the Production, Delivery, and Storage of Energy Commodities The Operations Risks in this category deal with the delivery, production, and/or storing of physical energy products. The purpose of capital in this instance is to maintain liquidity and service obligations in the face of delivery, production, and storage disruptions. It is important to identify all material risks in this category and measure their potential impact on earnings (measurement will be discussed later in this chapter) in order to ascertain what mitigation steps can be taken. These are generally operative risks that can affect your liquidity position that are beyond direct control though oversight or internal controls. In the case of assessing day-to-day operations risks to production, storage, and delivery, identifying these risks will entail working with the engineers and other personnel along the entire route of the commodity who have familiarity with the risks involved in the physical operations. Many companies have very solid physical operational risk control processes and procedures for the production, delivery and storage of energy commodities however the risks should be translated into a potential financial impact for the determination of adequate capital. The interaction between the Risk Function and the engineers and others will facilitate the identification of material production, delivery and storage risks and translate those risks into potential financial impact on earnings. That assessment will be a major factor in determining capital requirements for the various business units based on their operative risk assessment. This interaction should be regular and on-going as an integral part of the Operations Risk assessment. Beyond the day-to-day risks to production, delivery and storage, there exists the ‘High Impact / Low Frequency’ event. These are risks that are keenly felt within the energy industry. As recent events such as hurricanes Rita and Katrina have shown they can have a lasting and material impact on the operations and finances of energy companies. Other recent events that have occurred in this category are explosions at a refinery, or generating unit, or a massive regional black out due to downed power lines. The impact of these events is so high that any capital reserve used to mitigate their effects would result in capital requirements that would be too much for any company to bear.10 More appropriate would be the purchasing of insurance products 10 ISDA. A New Capital Adequacy Framework: Comments on a Consultative Paper Issued by the Basel Committee on Banking Supervision in June 1999. February 2000.