Discussing Energy Economics on the Internet

Regulating Capital Adequacy

Posted in Regulation,Risk Management by Cheryl Morgan on the September 9th, 2008

Over at the EU Energy Policy blog Bert Willems and Emmanuel De Corte of Tilburg University suggest that the EU should regulate market power in the generation sector by setting limits on capital adequacy as well as looking at market concentration. Being aware of capital adequacy issues is generally a good thing for regulators, if only because most of the major disasters in energy markets have been caused by melt-downs in trading. Also such an awareness might dissuade them from encouraging very small companies to enter retail markets, with predictable results. On the other hand, getting a reliable measure of capital adequacy is not easy. The authors say:

we would allow firms to use their own risk analysis, and base the regulation on a general ‘Value at Risk’- measure, similarly to what is used in the banking sector

While VaR is a well known and commonly accepted methodology, its implementation is very complex. That’s particularly the case in the energy industry where price distributions have such extreme kurtosis. Consequently such a regulation could easily lead to endless disputes about whether the VaR numbers coming out of companies were in any way comparable; and indeed whether the regulation provided an incentive for companies to distort their risk reporting, thereby putting their financial security in danger. Possibly the authors have addressed these issues in their paper, but it is behind a pay wall.

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