challenges in capital adequacy uh-gemi 3rd annual energy trading  marketing conference: rebuilding the business houston,

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2. Capital Adequacy and Capital Allocation Connected?. Capital Adequacy How much capital is required to achieve the company's stated goals and objectives?Capital AllocationHow should corporations allocate capital between competing demands?. 3. Capital Adequacy for Energy Transactors . .

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1. Challenges in Capital AdequacyUH-GEMI 3rd Annual Energy Trading & Marketing Conference: Rebuilding the BusinessHouston, TexasJanuary 20, 2005 Laurie Brooks VP Risk Management and Chief Risk Officer Public Service Enterprise Group The Committee of Chief Risk Officers (CCRO) is a diverse coalition of energy companies developing tools to strengthen risk management and disclosure practices in the physical and financial trading and marketing of electricity and associated fuels. Member companies represent a variety of business models, sizes, and scopes from many regions of the United States. The CCRO has released the following white papers to date: Governance and Controls Valuation and Risk Metrics Credit Risk Management Disclosures Energy Price Indices Emerging Practices in Assessing Capital Adequacy The Committee of Chief Risk Officers (CCRO) is a diverse coalition of energy companies developing tools to strengthen risk management and disclosure practices in the physical and financial trading and marketing of electricity and associated fuels. Member companies represent a variety of business models, sizes, and scopes from many regions of the United States. The CCRO has released the following white papers to date: Governance and Controls Valuation and Risk Metrics Credit Risk Management Disclosures Energy Price Indices Emerging Practices in Assessing Capital Adequacy

2. 2 The information required to generate capital adequacy and liquidity requirements can also be used by management to make decisions regarding capital allocation by bringing risks implicit in a proposed project or business plan to the forefront.The information required to generate capital adequacy and liquidity requirements can also be used by management to make decisions regarding capital allocation by bringing risks implicit in a proposed project or business plan to the forefront.

3. 3 Capital Adequacy for Energy Transactors

4. 4 Capital Use by Activity

5. 5 Market Risk – Trading vs. Non-Trading Activities

6. 6 Key Concepts of Capital Adequacy: Three Risk Types Market Risk - Variation of portfolio market value due to a change in a market price or rate, as well as a change in energy demand Credit Risk - Variation of portfolio market value due to default or a credit downgrade of an issuer or counterparty Operative Risk (term to address Operations and Operational risk collectively) Operations - The risk associated with delivering or producing physical energy Operational - The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events

7. 7 Key Concepts of Economic Capital Adequacy: Market Risk

8. 8 Key Concepts of Economic Capital Adequacy: Credit Risk

9. 9 Scorecard Approach Can be used for operations and operational risk to identify risks, determine frequency and range of costs, and assesses the effectiveness of controls and mitigation techniques in place. It is subjective, but now that the SEC has mandated the COSO framework for Sarbanes Oxley 404 compliance, standards will be set. In particular, the Capability Maturity Model can be adapted to set standards for a scorecard approach and is already used by many audit firms. Additionally, a company may want to use CCRO Best Practices from earlier white papers as a qualitative assessment of where companies stand with regard to CCRO recommendations. Regardless of the scorecard criteria used, a scorecard approach can form the basis for continuous improvement processes for internal controls to mitigate operative risk. It can also reflect improvement in the risk-control environment in reducing the severity and frequency of future losses. Key Concepts of Economic Capital Adequacy: Operative Risk – Scorecard

10. 10 The risk taxonomy is a system for organizing types of operative risks by serving as a family tree, aggregating risks by various characteristics. The level of aggregation at which each characteristic presents itself may be determined individually. There is no standardized risk taxonomy, but certain characteristics should be used to create the groupings: Risk classes (people, processes, systems, asset damages) – the broadest classes of risks Subcategories – could include whether the risk is internal or external, a type of fraud, or a natural disaster Risk activity examples – specific activities or events that could cause a loss, such as rogue trading, hurricane, model risk, or pipeline rupture. Key Concepts of Economic Capital Adequacy:Operative Risk – Risk Taxonomy

11. 11 Key Concepts of Liquidity Adequacy Fixed Payments - This would include, but is not limited to; fixed charges such as debt service, dividends, debt/equity retirement and current portion of committed, maintenance and non-discretionary capital expenditures. Contingent Liquidity – Contingent liquidity is synonymous with unexpected change or variation in liquidity. While economic capital protects against losses in the company’s economic value, contingent liquidity is held to support the risk of unexpected reduction in cash. Includes: Cash Flow at Risk Trigger events: Downgrade event Loss of threshold Adequate assurance Debt/equity trigger Contingency events: Operational/Operations Risk Credit/counterparty termination default

12. 12 Key Concepts – Combined Capital

13. 13 Key Concepts – Correlation Math Refresher In a two asset portfolio with equal investment in assets A and B, the VaR of the portfolio (at 95% confidence) VaRA+B = 1.65 * ?AB where ?AB is the standard deviation of returns of the portfolio: where ?AB is the correlation between A&B (do the returns move together?) Remember (a+b)2 =a2+2ab+b2 and Then if ?AB =1 So Portfolio VaR = VaRA + VaRB! If ?AB=0, (Square root sum of squares) The truth 0 < ?AB < 1 lies somewhere in between and: < ?AB < ?A+?B Square root sum of squares Simple Sum

14. 14 The Risk Management team at PSEG demonstrated the CCRO’s framework using a sample asset portfolio. This example illustrates how the CCRO framework can be used in practice We will walk you through the following implementation steps: Portfolio setup Methodology Pre-simulation Simulation Results We will also discuss some of the firm and systems resources required

15. 15 We modeled market, credit and operative risks jointly in one simulation versus separately Felt there was better intuition and that we could better justify a choice of the assumptions Calculation process seemed clear based on this approach Used a 1-year holding period and ran 5,000 trials with a 95% CI We modeled a five-year time horizon, with price changes modeled as follows: Year 1: spot Year 2-5: forward prices We chose a variety of assets and parameters. Three different generating assets and fuel types Assets are in three different pools We chose to model the asset-level impacts over a year of different risks on a company over time.

16. 16 Market Risk Calculations Unhedged market risk Minimum [(realized generation over 12 months) + (Expected generation value of the remaining term)] – (Initial expected value of the generation) Hedged market risk (Unhedged market risk) + (Realized and unrealized trading profit or loss)

17. 17 Credit Risk Calculations Calculated as the sum of credit loss across the twelve months of simulations, as a function of counterparty risk and power pool risk The company has three counterparties Counterparty A is used for fuel procurement Counterparty B is used for power sales Counterparty C is used for speculative trading. The recovery rate is assumed to be 10%. Each power pool has collateral requirements that are a function of the company’s credit rating, tangible net worth and activity in the pool Value is calculated under two potential ratings, BBB (credit limit $80,000,000) and BB (credit limit $4,000,000)

18. 18 Operative Risk Calculations Operations loss Sum of lost profit from plants not running at full capacity Operational loss (if applicable) Hidden trade on the books whose value is set to the largest negative value of all the trading positions on the book.

19. 19 Liquidity calculations Prior month realized P/L (retained earnings) Current month generation P/L Collateral posted Accounts receivable Accounts payable Full margin on mark-to-market Credit loss Operations loss Operational loss

20. 20 Hedging affects liquidity in offsetting ways.

21. 21 Three key methodology choices drive our model

22. 22 Pre-Simulation: prior to running our simulations, we calculated a number of initial values. Initial expected value of the assets Calculated based on the current forward prices for fuels and power Expected fuel purchases and expected output to be sold to counterparties Calculated based on current forward prices Randomly-generated positions in power and fuels Constrained to be a quarter of the size of outright positions Used to simulate a speculative trading operation

23. 23 Simulation: we generated the inputs to credit and operational performance.

24. 24 Results – Unhedged vs. Hedged Assets

25. 25 Results – Portfolio Effect

26. 26 Why Emerging Practices? These are recommendations for internal use and experimentation for companies to better understand and quantify the capital and cash requirements of the merchant energy business; these are not recommendations for external communication or new disclosure. No one is going to implement all of these recommendations over night. Most of us have some capability to begin looking at the components of Capital Adequacy and liquidity requirements through the use of tools that we already have in place but which require extension and modification to achieve the more sophisticated views that result from the white paper recommendations. This should be a controlled evolutionary process - in most cases, the less sophisticated tools that we already have in place generate more conservative answers than the sophisticated approaches do. Why we will implement these ideas over time: Better than what we have now Emphasize need to look both long term and short and to look at cash flow as well as earnings and value Ideas and methodologies useful in decision making  

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