Guarding against a repeat of the financial troubles that have devastated the merchant energy sector, the Committee of Chief Risk Officers (CCRO) Wednesday published proposed guidelines for assessing capital adequacy in a stressed environment, both for a company’s long-term viability and its short term liquidity.

“Emerging Practices for Assessing Capital Adequacy” outlines a framework of different ways to value assets and assess risk and balance the two in making decisions on capital allocation. The practices are “emerging,” said Laurie Brooks, vice president and chief risk officer of PSEG Corp., because they include some elements that are relatively new or embryonic.

Companies can use the calculations offered and test them in the marketplace. This will not happen overnight, Brooks said, since the processes are fairly sophisticated and there currently is no pre-packaged computer software that can make the computations and integrate with a company’s accounting systems. Some of the principles come from the regulated financial community, which has developed a framework, but these must be adapted to the energy sector.

Developing this new framework will require a “culture change,” Brooks said, and changes in who is included in the decision-making for new acquisitions. It offers a way to achieve a much better understanding of how to combine quantifiable, justifiable reasons for doing something. “In the past there has been an underestimation of capital needed to support businesses.”

This latest effort by the CCRO addresses how to measure risk dealing with uncertainties and stressed environments and things that occur in fairly illiquid periods. These are calculations that should be made when a company is considering allocating capital to new acquisitions or businesses.

It “offers an alternative to a capital adequacy assessment that imputes VaR (value at risk) multiples as debt to a firm’s capital structure. Instead, it encourages the fundamental quantification of market, credit, operations and operational risks and makes a clear distinction between debt obligations, which represent expected demands on net assets, and the capital cushion required to absorb unexpected losses due to market credit, operations and operational risks.”

There are four primary reasons for a capital adequacy framework: (1) to assess the long-term viability of a company’s business model; (2) to make decisions on capital allocation; (3) to make decisions on corrective actions in the event of a capital shortfall; and (4) promote transparency throughout the industry.

The highly complex 86-page report includes sections on determining net assets for economic value; defining and measuring market risk; defining and measuring credit and operational risk; liquidity adequacy, and balancing the demands on capital. CCRO plans to hold a workshop to discuss how companies can use the report, which is available at

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