June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 6 of 92 specifically details a framework to address operative risks which is largely based upon the Basle Committees’ “10 Principles for Effective Operational Management”. Effective quantitative modeling of operative risk requires both the probability and severity of a negative operative event. While it is still difficult to measure operative risk in the energy industry, the inroads made from the qualitative standpoint have served to improve the identification and understanding of these risks. This in turn has led to more operative efficiencies and has helped companies position themselves to be better prepared to anticipate and mitigate potential operative risks before these cause significant financial losses. 1.4.3. Market Risk Market risk is broadly defined as the potential loss in value due to adverse movement in market prices, such as energy prices, foreign exchange and interest rates. . Given a distribution of the variables, one way to measure market risk is to calculate the difference between the expected value of the performance measure and the value of the measure at a certain confidence level. The previous CCRO paper addressed various approaches to developing probability distributions of outcomes, along with a discussion of the strengths and weaknesses of each method. 1.4.4. Credit Risk Credit risk is the risk of nonperformance by a counterparty. Economic capital for credit risk is defined as the difference between the expected loss of a portfolio and the maximum loss at a desired confidence level. Economic capital for credit risk is obtained by calculating the amount of capital required to support the unexpected credit loss, using a distribution of credit losses generated by a credit risk model. The previous paper focused on the specific credit models and the selection of these models this paper focuses on a company-wide approach to credit and the required capital to cover a firm’s credit risk and the impact of credit risk mitigation strategies on this capital. 1.4.5. Business Risk & Stress Testing Business risk addresses the risks arising from firm specific events such as, litigation, regulation, and competition. Due to the highly firm specific nature of these risks each company can address or quantify these risks in unique ways that suit their particular situation. This is perhaps the least understood category of risk in terms of quantifying the ways in which the firm’s value distribution is impacted. Many CCRO member firms include an assessment of these risks via specific scenarios and stress tests that incorporate specific business risks situations & valuation outcomes which are perceived to be somewhat plausible in terms of occurrence probability. In addition standard insurance product can be used to manage some of these risks (for example property and liability coverage). Operative Risk Operations Risk Operational Risk Operative Risk Operations Risk Operational Risk