Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 20 4.5 Measurement of Market Risk – Simulation Approach Determining the market risk component of economic capital requires the ability to re-value the company’s portfolio under multiple scenarios over a specified time horizon. One of the most important factors that can influence the value of an energy asset is the price of the underlying commodity. Thus, generating a distribution of portfolio values requires the ability to simulate future prices at different points in the future. 7 In this paper, we focus our discussion on simulating forward prices. 8 Note that the discussion is intended to illustrate how a simulation approach can be used in the calculation of economic capital as opposed to analyzing the merits of a specific simulation methodology. Before describing the simulation approach, it helps to clarify the following aspects of the modeling exercise. • Time Horizon – The maximum time horizon over which prices need to be simulated depends on the time horizon over which capital adequacy is to be assessed. For example, if capital adequacy is being assessed over the next 12 months, each relevant forward price needs to be simulated only over the next 12 months. In the event that delivery occurs before 12 months, the forward price needs to be simulated only to delivery. Time horizons are discussed in further detail in Section 4.6. • Relevant Forward Prices – Each forward price that is required to value the asset needs to be explicitly considered for simulation. For example, if the asset were a July 2005 forward contract for on-peak power, then the relevant forward price would be today’s July 2005 forward price. On the other hand, if the asset is a power plant, one needs to consider all the forward prices required to value the output of the power plant over its life. This might include, for instance, a July 2020 forward price. To the extent that a July 2020 contract does not actually trade today, a July 2020 “forward-type” price would first need to be estimated.9 • Volatility – In order to simulate the evolution of the relevant forward price over a given time horizon, one needs to estimate price volatility. This can either be implied from market transactions when available or modeled. • Correlations – The price simulations must also account for various types of correlations. Depending on the specific price propagation model used, these could include correlations across time and/or locations, across commodities, and across other risk factors. Having defined the above elements, the price simulation process essentially involves generating the different paths that a particular forward price can take over the chosen time horizon. There are a variety of ways to generate such price paths. For example, some models use reduced-form equations while others are based on engineering economic types of models. 7 Other factors include volume, weather, and other fundamental drivers. Ideally, the simulation model used to value the portfolio under multiple scenarios should capture the correlation between price and these other factors in a consistent manner. Modelling the correlation of price and load is especially important if one defines market risk to include not just price risk but also volumetric risk. 8 In the discussion, it is assumed that valuations are carried out using a risk-neutral framework. 9 Estimating the July 2020 forward price is not to be confused with simulating the July 2020 forward price. The estimate sets the current forward price level. The simulation describes how the estimated price level might evolve over the chosen time horizon.