Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 64 Scenarios representative of these positions are: • Long power position in different power pools • Short fuel positions Unhedged Case Results Available vs. Required Capital ($ millions) BBB Rated BB Rated Available Capital 571 571 Debt 286 286 Required Economical Capital Market Risk 23 23 Credit Risk 0 0 Operative Risk 22 22 Diversification Effect - Across Risks -11 -11 Total Required Economic Capital 35 35 Economic Capital Adequacy 251 251 Sources of Liquidity 600 400 Fixed Payments 200 200 Contingent Liquidity 27 27 Liquidity Capital Adequacy 373 173 As shown in the table above, there is no direct credit risk (spot market settlement risk during price spike events was not modeled as all power was sold into pools where, at worst, Example Company might be allocated a portion of a pool loss due to a default). Contingent liquidity is required to meet the cash requirements of buying and selling in the spot market, but not for credit margin payments. Because there are no counterparties – and thus no margin requirements – there is no change in the liquidity contingency with the downgrade to BB. However, we assume that Example Company’s funding agreement contains a material adverse change clause, which states that the bank might refuse funding as a result of deterioration of financial condition. Therefore, the company’s sources of liquidity are assumed to be reduced through the loss of a credit facility.20 Level 2 – Middle of Pyramid: The Effect of Hedging To demonstrate the effect of hedging, the required capital for the same portfolio is assessed taking into account the effect of hedging the fuel inputs and power output. Our intent is to illustrate how market risk can be reduced through hedging but at the expense of assuming credit risk. A 5-year time horizon was chosen for the Example because it is a realistic hedging horizon for a generation portfolio in the chosen markets. The portfolio owner at the outset sells all expected output from the power plant to an A-rated counterparty, purchases all expected fuel consumption from a CCC- 20 Please refer to section 8.2.3 for a further discussion of backup credit facilities.