Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 61 CAPITAL ADEQUACY EXAMPLE Purpose Presented here is a structured example of economic capital and liquidity valuations for a small merchant energy portfolio. The goal is to demonstrate how capital needs change based on risk management activities for a single asset as well as a portfolio of assets. The net effect of risk management activities across market, credit, and operative risk and the portfolio is shown. This example strives to reflect a general framework for all components of economic value and liquidity discussed in this paper. The example focuses not on exactly how the calculations assessing required capital are performed, but rather on the effect that specific activities might have. Furthermore, the example may not reflect all concepts or alternatives in this white paper, nor is it intended to be prescriptive on how companies would implement the framework calculation results for a particular company may vary based on a wide range of factors, including portfolio composition, sophistication of trading organization, size of company, business model, and counterparties. Structure In this example, we examine three risk management activities. 1. We assess the capital requirements of the assets in the portfolio, comprising a gas-fired combined-cycle plant, a coal-fired base load plant and a peaking facility. The portfolio owner is long in power in multiple power pools and short in the fuels used to generate the power but has no direct credit risk. The portfolio owner has indirect credit exposure by selling its output to the pool, since power pools allocate credit losses to pool participants. 2. The capital requirements for the same portfolio of assets are assessed with hedges in place, demonstrating the tradeoffs between managing market and credit risk. 3. The requirements associated with market, credit, and operative risks are viewed for the portfolio of operating assets and for each asset independently to demonstrate the diversification benefits of owning a portfolio. The interplay between the three risks is revealed by looking at alternative ways of summing the risks to arrive at a total capital requirement. In addition, the effects on a company’s liquidity are reviewed, with particular attention given to understanding the impacts on collateral requirements of a downgrade event, under the assumption that marginable contracts are put in place to govern risk management hedging activities.