4/20/2020 Understanding Enterprise Risk Management for Utilities © Copyright 2007, CCRO. All rights reserved. 9 ERM is a key tool in understanding risk exposure from a portfolio viewpoint and assessing the financial strength of the company. Financial strength is determined by the company’s ability to create economic value for its stakeholders while meeting its financial liquidity demands. This concept is known as capital adequacy. From an economic value perspective capital adequacy is measured by assessing the company’s equity against their risk exposure to determine the level of equity surplus or shortfall. From a financial liquidity perspective, capital adequacy is measured by the company’s ability to meet demands for cash as they become due. Both economic value and financial liquidity determinations involve quantifying risk exposure where feasible. This enhanced understanding allows for an improved financial management process that focuses not only on the individual risk exposures and the ability of the company’s equity structure and forecasted cash flows to cover such exposures, but also on the overall diversification effect of the portfolio of the company creating natural hedges to offset exposure. A risk-based approach to capital adequacy is becoming paramount for utilities as rating agencies are reviewing and considering a company’s ERM practices in the determination of a company’s credit rating. 3 Finally, an ERM framework conveys a certain level of risk management sophistication to external parties such as rating agencies and regulators. Communication of the types and extent of risks taken on in the normal course of business provides evidence that the critical risks impacting earnings or cash flow are being addressed and can improve the reputation of the management team and the company. These internal enhancements then lead to increased stakeholder confidence as they recognize that the risk culture permeates through every decision made by the executives, and counterparties, investors and lenders understand the total risk of the portfolio, lowering costs related to credit. Specifically, ERM builds stakeholder confidence by establishing processes to stabilize earnings and costs, and demonstrating proactive risk stewardship. In summary, an ERM framework: • Improves understanding of the risks that impact the enterprise and how these may be manifested • Encourages employees to integrate risk management into their normal activities • Demonstrates risk management performance to stakeholders • Enhances confidence that the risk profile is understood and being monitored in accordance with the enterprise’s risk management plan and • Focuses management attention on key risks. 2.2. Appreciating the Value of Best Practice Risk Categorizations Every Utility, Merchant, Producer – any firm for that matter - is subject to the same multitude of specific risks. However, depending on the specifics of its business, each firm is affected by each of these risks to a different degree. Thus, each firm is said to have a unique “risk profile”. The firm’s risk function must at some point consider how to best group or categorize this multitude 3 For more information on capital adequacy, please see the CCRO’s previously released paper Emerging Practices for Assessing Capital Adequacy, September 17, 2003 and the current release Capital Adequacy Extension, May 2007.