Energy Risk Management and Credit Ratings

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Energy Risk Managementand Credit Ratings

• CMCAS
• 26 April 2007
• New York

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Risk ManagementMain Analytical Objectives

• Identifying a companys risk appetite
• Understanding the risk management infrastructure
• Assessing the contribution of trading and
  marketing risk to the overall credit risk.
• Factoring the results into the companys credit
  rating

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Risk Management Three-Part Analysis

• Risk management practices PIM
• Evaluation of a companys ability to identify and
  monitor significant risks, limit losses and
  operate within well-communicated risk tolerances
• Capital adequacy
• Measures discrete risks of market, credit and
  operational risks
• Liquidity
• Measures exposure to collateral calls under
  stress scenarios

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Risk Management Part 1 PIM

• Policies
• Risk Culture and Structure
• Infrastructure
• Processes and Technology
• Methodology
• Measurement and Reporting

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Risk Management Part 1 PIM
INFRASTRUCTURE
Risk Technology
Operations
Valuation Methods
Risk Training
Risk Culture
Risk Appetite Strategy
Risk Control Monitoring
Disclosure and Awareness
Model Vetting Back-Testing
POLICIES
Capital Allocation
METHODOLOGY
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Risk Management PIM - Policies

• Business Strategy
• What is the business model? What risks are
  included in the business strategy?
• Risk Tolerance
• Is the risk tolerance consistent with the
  business strategy?
• Policies
• Are authorities effectively defined?
• Disclosure
• Is the risk and its effect on cash flow disclosed
  externally and internally?

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Risk Management PIM - Infrastructure

• Technology
• Is sophisticated software and effective
  hardware in place?
• Operation
• What is the quality of the operational
  processes?
• Data
• What is the level of data integrity?
• People
• Are the appropriate people employed and are the
  proper
• incentive programs in place?

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Risk Management PIM - Methodologies

• VaR, stress testing and other measures
• Are the models and stress tests appropriate for
  the business?
• Model vetting
• Are the models properly vetted?
• Valuation
• How are the positions valued?
• Performance
• Are the methodologies tied into performance?
• Management understanding
• Does senior management understand the model risks?

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Risk Management PIM - Efforts to Date

• Completed PIM reviews for 10 U.S. energy
  companies
• Utility and energy merchants
• Pure trading
• Oil and gas EP
• Big and small
• Report findings
• Large divergence in risk mitigation structures
• Asset-based trading tends to have less robust
• infrastructure than pure trading
• Much of the infrastructure is relatively new
  only a
• few years old
• Dominance of senior management a key concern
• External reporting is poor

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Risk Management Part 2 Capital Adequacy-
Imputed Debt

• Addresses the potential economic loss of a
  trading operation due to
• market risk
• credit risk
• operational risk
• Estimate amount of risk capital and add to debt
• Offset with true equity at risk
• Current model imputes debt
• 6x trading VaR 4x probability adjusted credit
  
• exposure
• Looking beyond VaR measures to improve model

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Risk Management Part 3 Liquidity

• Basic liquidity adequacy is quantified with two
  primary measures for which SP requires periodic
  reporting
• Credit event liquidity adequacy (CELA)
• Is liquidity sufficient to withstand a credit
  downgrade?
• Market and credit event liquidity adequacy
  (MCELA)
• Is liquidity sufficient to withstand a change in
  market commodity prices and a credit event?

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Risk Management CELA and MCELA
Primary liquidity unrestricted cash committed
credit lines
Investment grade companies should maintain an
MCELA of at least 1.0x
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Risk Management Looking Ahead Next Steps

• Further refine risk management assessment
  framework
• Formalize analytical treatment of results into
  ratings
• Complete PIM reviews on larger set of diverse
• companies
• Move towards full ERM analysis

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Terry A. Pratt Director Utilities, Energy and
Project Finance Standard Poors 55 Water
Street New York, NY 10041 Phone
212-438-2080 terry_pratt_at_sandp.com www.standardand
poors.com/ratings