June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 80 of 92 10.2. Application of Capital Adequacy Concepts 10.2.1. Overview This application demonstration is for a hypothetical energy marketing and trading company called EMTCo. EMTCo focuses on buying and selling power in the wholesale marketplace. Traditionally, the company has leveraged its strong relationships with the industrial sector to provide cost effective and reliable electricity to this group as the power industry has deregulated. Various characteristics of the company are as follows: • Current sales volume is 5000 MW • $750 million in debt with a $200 million line of credit • Transact with 50 different counter parties all with individual credit limits, contract rules and credit rates • $50 million letter of credit threshold • 40% dividend payout policy • BBB- credit rating EMTCo is primarily customer driven fixed priced electricity sales are normally entered into and a percentage of the supply is then purchased to back the customer’s requirement. This percentage is dictated by the company’s hedging program which requires at least 90% of the exposures 1 year out be hedged, 60% 2 years out, and 30% 3 years out. The company has the opportunity to enter a new market area where certain rules and regulations have recently changed allowing industrial customers to more easily purchase their electricity from competitive suppliers. This new area has the potential to increase the company’s sales revenues by 15% annually for the next 5 years. Faced with this opportunity, EMTCo is concerned with the following issues: • Does the firm have the necessary equity commensurate with its credit rating for its existing operations as well as if it decides to enter this new market area? • If additional equity is required for the new market area, how much is needed and will the new marketing activities provide a favorable return on this additional equity? • Will the firm’s hedging policy need to be altered given these increased sales?