Energy Risk Management Credit Rating Perspective

1. Energy Risk Management Credit Rating Perspective

2. Energy Trading & Marketing Credit Rating Methodology • Our Objective: • Understand an energy companies’ risks and how well those risks are managed • Both quantitative and qualitative analysis tools are used to evaluate risks • Findings are incorporated into credit ratings

3. Analysis Tools Three pronged approach Risk Management Practices • Evaluation of a company’s 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

4. Risk Management Practices • Qualitative assessment of risk management practices • Analysis will be tailored for specific business model • For a company that has good financial flexibility and capital or takes few unusual or complex risks, risk management practices will be less important • For a company that has weak financial flexibility and capital or takes unusually high or complex risks, risk management practices will be very important

5. Risk Management Practices Framework • Policies – Risk Culture and Structure II. Infrastructure – Process and Technology III. Methodology – Measurement and Reporting

6. 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? Authorities • Do authorities reflect a desired tolerance for risk? Disclosure • Is the risk and its effect on cash flow disclosed externally and internally?

7. Policies Evaluation In the policy dimension, Standard & Poor’s will look for: • Corporate commitment to risk management • Communication with board on risk positions and risk management programs • Clearly defined and communicated risk management policies • Corporate governance structure that supports risk management • Independent risk management function • Consistency between business strategy and risk • Senior management’s involvement in the risk process • Risk limits that reflect risk tolerance and capital deployed • Compensation is tied to achievement of risk management objectives

8. 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?

9. Infrastructure Evaluation In the Infrastructure dimension, Standard & Poor’s will look for: • Qualified risk management staff • Adequate training and budget available to risk management staff • Compensation linked to achievement of risk management objectives • Proper infrastructure exists to support risk management • Data quality – data is validated and timely • Controls are in place with respect to data usage • Technology used is consistent with risk tolerance and business strategy

10. Methodology 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? Methodology questions will be tailored for business model

11. Methodology Evaluation In the methodology dimension, Standard & Poor’s will look for: • Identification of metrics used to quantify risks and manage limits • Understand how metrics influence decision making • Metrics are commensurate with business strategy • Independent validation of models • Models that are validated against actual market outcomes • Risk factors that are evaluated periodically • Assumptions that are reasonable • Reports that are in place to support compliance with risk management policies • Reports effectively control business activities and disclose risks on a timely basis • Appropriate risk management documentation is in place

12. Capital Adequacy Model Addresses the potential economic loss due to market, credit and operational risk of a trading operation Estimate the amount of risk capital and impute it as debt Current Model imputes debt = 6x trading VaR + 4x probability adjusted credit exposure

13. Market • For trading positions, Standard & Poor’s primarily relies on VaR calculation • Use a 10 day holding period with 99% confidence interval • Multiple is used depending on credit rating, e.g. 4x that number is necessary for a “BBB” rating

14. Credit • Credit risk is measured by taking the one year default probability times the unsecured credit line for each counterparty • That number is multiplied by a factor depending on credit rating, e.g. 4x for investment grade

15. Operational • Operational risk should incorporate both financial and physical operational risk • Currently using 50% of the market risk capital

16. Liquidity Analysis • Standard & Poor’s Objective: • To measure the sufficiency of liquidity under stress scenarios • Credit Event • Downgrade to non-investment grade • Market Event • Stress test movement in commodity prices

17. Liquidity Analysis Tools • CELA measures a company’s exposure to a credit event • MCELA measures a company’s exposure to a simultaneous credit event and market event

18. Liquidity Analysis Tools Credit Event Liquidity Adequacy Primary liquidity . CELA = Neg MTM without price stress Market and Credit Event Liquidity Adequacy MCELA = Primary liquidity . Neg MTM with price stress Primary liquidity = unrestricted cash + committed credit lines

19. Ratings Implications

20. Ratings Implications Investment Grade companies should maintain an MCELA ratio of 1.0x

21. Mitigating Factors • Discretionary inventory • Reserves • Discretionary business • Capital spending • Debt maturity profile

22. Arleen Spangler Director, Utilities, Energy and Project Finance Standard & Poor’s 55 Water Street New York, NY 10041 P 212-438-2098 F 212-438-2154 arleen_spangler@sandp.com