Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. v Market Risk Market risk is broadly defined as the potential loss in value from adverse movement of market price variables, such as energy prices, foreign exchange, and interest rates, over a defined time horizon. Market risk is measured by taking the difference between the expected value of the performance measure and the value of the measure at a certain confidence level on the distribution. This paper addresses the various approaches to developing probability distributions of outcomes, along with the strengths and weaknesses of each. Key to the measurement of market risk is the estimation of price movements over time. Both analytical (“closed-form”) and simulation approaches are detailed. Simulation offers flexibility in handling several features of energy price behavior that make analytical solutions difficult. Simulation does have its drawbacks, however, primarily because of the sheer number of iterative simulations and need for proper treatment of multidimensional correlations. This paper advocates that users constantly evaluate the need to model such complexities for their respective businesses in order to determine the appropriate solution for quantifying market risk. Credit Risk Credit risk is the risk of nonperformance by a counterparty. Economic capital for credit risk is defined as the difference between the expected loss of a portfolio and the maximum tolerable loss implied by a desired confidence level. Economic capital for credit risk is derived by calculating the amount of capital required to support the unexpected credit loss of an organization, using a distribution of credit losses generated by a credit risk model. Note the focus on “unexpected” loss – the measurement of uncertainty around the expected loss. This paper describes the various approaches and modeling techniques for measuring credit risk and also discusses an “interim” solution that approximates unexpected loss. It is provided for those companies that may not otherwise be able to calculate economic capital. Operative Risk Operative risk is an integral component of measuring capital adequacy. However, the method is not as well established as the other components of economic capital. Therefore, the CCRO recommends a wide range of methodologies for managing these risks. We define “operative risk” as the sum of operations and operational risk. Operations risk is the risk associated with delivering, producing, or storing physical energy products including unplanned forced outage rates. Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events. The CCRO notes that operative risk in energy is inherently different from banking due to the presence of physical assets in a company’s portfolio. Principally, the CCRO’s recommendation for measuring operative risk is to create a “risk taxonomy” as a long-term solution, coupled with the development of an internal rating-based scorecard as the first step toward including operative risk as part of economic capital. The scorecard approach assesses the effectiveness of the controls and mitigation techniques in place. The risk taxonomy is a system for organizing types of operative risks via a family tree, aggregating risks by various characteristics. This paper gives examples of taxonomies and covers both qualitative and quantitative methods for measuring these risks. Given the current embryonic state of measuring operational risk, we prefer a combination of measures, with emphasis on qualitative differentiation