Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. iii • Second, management can use this framework for decision-making regarding capital allocation by bringing to the forefront risks implicit in a proposed project or business plan. The capital adequacy framework may be used as a starting point for eventually assessing a “charge” for the utilization of capital. • Third, if a company is facing a capital shortfall, a capital adequacy framework will help management evaluate the effects of specific corrective actions. Management may consider changing the company’s capital structure (e.g., reducing debt by adding equity) or reducing economic capital requirements by changing the makeup of the business portfolio’s risk profile. • Fourth, the capital adequacy framework may help promote transparency throughout the industry, as management’s use of the principles of this framework allows for a more complete assessment of the business and financial risks the company faces. It provides more insight into factors that drive uncertainties and their influence on short- and long-term financial results, which may be communicated with stakeholders. Issues for Regulated Utilities and Public Power It is important to note that companies involved in activities outside of non-regulated energy supply and marketing may, for regulatory reasons or otherwise, approach the concept of capital adequacy in a significantly different way. For instance, it is important that (1) a portfolio containing a significant portion of regulated positions or (2) public power companies and cooperative entities consider whether they are contractually or otherwise afforded cost recovery through regulation as a result of events that create a mismatch when costs exceed their rates. These types of companies may include subsidiaries and affiliates of an energy merchant company, and such unique circumstances must be factored into the development of a consolidated capital adequacy framework. Further discussion on the topic of regulated utilities and public power is contained in Appendix A. Two Key Measurements: Economic Value and Financial Liquidity A robust assessment of capital adequacy requires an analysis of – and balance between – economic value in the long run and financial liquidity in the short run. For a company to have adequate capital, it must simultaneously possess the capacity to create sufficient economic value for its customers and shareholders under unfavorable conditions and the sources of liquidity to meet maturing obligations under adverse conditions. These measurements must be addressed separately and are not additive requirements. Economic value relates to the ability of a company to execute its planned business activities while creating or enhancing shareholder value, and financial liquidity is a company’s ability to meet demands for cash as obligations become due. When measuring capital adequacy, a company must ensure that the amount calculated satisfies conditions in the short and long run. The capital adequacy framework measures adequacy under stressed or unforeseen environments – i.e., the company must have sufficient capital to withstand not only expected outcomes, but also unexpected (unfavorable) outcomes. Assessing Capital Adequacy Results in an Excess or a Shortage The focus of this paper is how a company can measure economic capital and financial liquidity. The vigor with which a particular company approaches its assessment of economic capital and financial liquidity adequacy depends, to a large extent, on (1) the complexity of its portfolio and (2) the