Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. iv availability and commitment of resources, both of which affect the level of complexity used to calculate capital adequacy. Understanding how companies measure risk is as important as the results they are calculating. This includes how one looks at the individual components of each calculation, how the components are summed once they are determined, and how relationships among various factors are accounted for. The CCRO framework for capital adequacy focuses on how we measure net assets as opposed to the amount a company “should have,” with a resultant “excess” or “shortage.” The paper outlines two methods for calculation of net assets in measuring capital adequacy for economic value – invested capital and market value – and outlines the strengths and weaknesses of both measurements. Invested capital is a more straightforward approach but has a significant drawback in that values on the balance sheet may not reflect the market value of assets, especially for regulated companies. Estimated market value is the preferred, albeit more difficult, approach because of the reliance on assumptions about several key factors. Economic capital is the capital a company is required to hold to support the risk of unexpected loss in the value of its portfolio. Economic capital should encompass all risk factors the enterprise faces – market, credit, operational, and operations. In this paper, the term “operative” is used to denote both operational and operations risk. Financial liquidity adequacy is the assessment of the sufficiency of all expected internal and external financial resources that are readily available to meet scheduled cash flow obligations, net of a measurement of the uncertainties resulting from cash flow risk factors. Liquidity adequacy should exist without substantial disposition of assets outside the ordinary course of business, restructuring of debt, or similar actions. The risk components (market, credit, and operative) that affect economic capital are the same as those that affect financial liquidity before applying contract rules and other cash flow risk factors. Therefore, this white paper is structured so that the risk factors used in calculating economic capital are discussed first, and the discussion of financial liquidity follows a comprehensive review of concepts and emerging practices. This structure is not meant to imply that economic value is more important to a company than liquidity, but rather is meant to reduce redundancy in discussion of concepts. Capital adequacy implies an analysis and balance of both perspectives. Depending on a company’s specific situation or capital structure, the focus may be on one or the other (or both) in an effort to balance requirements. Economic Value Involves Quantifying Market Risk, Credit Risk, and Operative Risk The framework for determining capital adequacy for economic value requires an estimation of economic capital. This economic capital should cover the most significant quantifiable risks that a merchant energy business faces: market risk, credit risk, and operative (operational/operations) risk. This paper assesses each of these sources of risk. It also introduces methodologies for combining separate assessments of each of these risk components into a single representation of a company’s economic capital.