Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. ii EXECUTIVE SUMMARY Objective This paper lays out a risk-based capital adequacy framework that energy companies, industry analysts, and other stakeholders can use to analyze a company’s ability to meet both near-term and long-term obligations, with a particular focus on merchant energy activities. Why and How to Assess Capital Adequacy Capital adequacy is a potentially vital financial metric designed to assess a company’s short- and long-term outlook for financial health. It measures the availability of capital necessary for a company to meet both its foreseen and unforeseen obligations in the short and long term. The main notion is that existing capital should be sufficient to enable a company to operate as a going concern through expected and unexpected business and economic cycles without disrupting operations and while continuing to support shareholder value creation. The intent of the CCRO through this white paper is to introduce a set of emerging practices that energy companies can explore and use to measure capital adequacy. The CCRO’s emphasis is on understanding how energy companies can adopt a capital adequacy framework for their asset- based merchant activities, beginning with the principles used for measuring risks and exposures of their energy supply and marketing activities. The CCRO emphasizes that these are “emerging” practices, as some elements of the science of capital adequacy measurement are relatively embryonic at this stage. This paper offers an alternative to a capital adequacy assessment that imputes VaR (value at risk) multiples as debt to a firm’s capital structure. Instead, it encourages the fundamental quantification of market, credit, operations, and operational risks and makes a clear distinction between debt obligations, which represent expected demands on net assets, and the capital cushion required to absorb unexpected losses due to market, credit, operations, and operational risks. Although the capital adequacy framework applies principles used primarily to measure energy supply and marketing activities, energy companies have long-lived physical assets that must be analyzed as well, as they pose significant market, credit, operations, and operational risks. The Four Principal Benefits of a Capital Adequacy Framework The CCRO believes companies should embrace a “capital adequacy framework” in the course of performing their regular planning and analysis activities for the following reasons: • First, management can use the framework to assess the long-run viability of a company’s business model. The capital adequacy framework is consistent with and supports the concept of a “going concern” and also shows support for anticipated growth rates. Management’s assessment brings forth valuable information that can be used to bolster stakeholder confidence.