Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 74 Operations risk - The risk associated with delivering or producing physical energy. Operational risk- The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events. Operative risk – Term used in this paper to refer to operations and operational risk collectively. People / relationship risk – Variation of portfolio market value intentionally or unintentionally caused by an employee or involving employees, or losses caused through the relationship or contact that a company has with its clients, shareholders, third parties, or regulators. Price risk - Potential fluctuations in prices of the underlying energy commodity. Probability of event - The probability of loss due to an event. Process risk - Variation of portfolio market value due to failed transactions, client accounts, settlements, and everyday business processes. Risk-adjusted return on capital (RAROC) - A system that adjusts profits for capital at risk, defined as the amount of capital required to protect against 99% of potential economic losses over a year holding period, or investment horizon on an after-tax basis. In more developed RAROC systems, the same one-year horizon is used for all RAROC computations, regardless of the actual holding period, to allow meaningful comparisons across asset classes. [Bankers’ Trust] Risk capital – Funds at risk in an enterprise, entity, or trading organization. See economic capital. Risk neutral – A valuation approach that takes advantage of a theoretical construct in which investors do not require compensation for taking risk Sharpe ratio – A measure of the ratio of average return in excess of the risk free rate to the volatility of returns (estimated as the portfolio’s standard deviation). During business performance reviews, the Sharpe ratio is a risk-adjusted measure of return. For instance, in the market risk analysis, the risk-adjusted return on a proprietary trading business can be defined as annualized earnings divided by the annualized standard deviation of earnings. Simple cycle - A plant where the combustion of fuel, usually in a combustion turbine, drives a shaft that operates a generator to generate electricity. Solvency confidence level – The confidence level at which to estimate the economic capital. This method assumes that the company wants to hold sufficient capital to prevent a default at this level of confidence and maintain the associated credit rating. It is defined as one minus the default probability for the company’s target credit rating. Solvency standard – Confidence level associated with the credit rating that a company wishes to maintain unexpected loss – the difference between the credit loss at a given solvency standard and expected loss. Systems risk - Variation of portfolio market value due to disruption of business or system failure due to unavailability of IT infrastructure or personnel. Target credit rating – The credit rating for the purpose of determining the default probability that is used to establish the solvency confidence level. The target credit rating may differ from the current rating of the company. By setting its capital requirements to a higher level of solvency, the company can position itself for a credit upgrade. Unexpected loss – The difference between the estimated loss at a given confidence level and expected loss.