Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 1 I. INTRODUCTION By participating in energy commodities markets throughout the world, companies are exposed to a variety of risks. However, each company has developed its own financial reporting practices, risk management techniques, and infrastructure to manage its business. The Committee of Chief Risk Officers (CCRO or the Committee) has been formed in an effort to compile risk management practices surrounding these activities. The Committee is composed of Chief Risk Officers from leading companies that are active in both physical and financial energy trading and marketing. They are committed to opening channels of communication and establishing best practices for risk management in the industry. The concept of capital adequacy has been a topic of interest and debate for many years. In its simplest definition, capital adequacy is the availability of funds necessary for a company to meet its foreseen and unforeseen obligations ― both short term and long term. Capital should be sufficient to allow a company to operate as a going concern through expected and unexpected business and economic cycles without disrupting operations and while continuing to support the process of shareholder value creation. The energy industry can benefit and borrow from the lessons “learned” in the financial sector regarding the design of a framework for measuring capital adequacy. Through regulation, banks are required to hold sufficient capital to reduce the risk of insolvency and the potential cost of a bank’s failure to depositors. In 1988, the Basel Committee on Banking Supervision published the Capital Accord. Since then, a more risk-sensitive framework has been debated. The banks, through the New Basel Capital Accord, refined their framework for capital to incorporate a menu of approaches to assess risk factors (market, credit, and operational). The energy industry has been slow to adopt many of the capital adequacy concepts the banks use primarily because of the complexities specific to the energy sector. Energy companies typically have long-lived physical and financial assets and liabilities, which pose significant market, credit, operations, and operational risks. Further, since the energy market is not always sufficiently liquid to help measure and mitigate these risk exposures, it is very difficult to determine the appropriate level of required capital to carry these risks. In addition, the industry itself has been changing radically, and deregulation has enabled many companies to expand their business interests into unregulated operations that have introduced new market, credit, operational, and operations risks. The Committee of Chief Risk Officers (CCRO) has developed a capital adequacy framework for application in the energy industry. To date, there have been fragmented efforts within the industry to address capital adequacy, primarily through the use of a “one size fits all” approach to calculating capital adequacy. This white paper is a primer on capital adequacy, addressing many of the complexities in the energy industry. The CCRO’s intent is to introduce a set of emerging practices that energy companies can explore and use.