Proposed Approach To An Energy Industry Risk Management Benchmarking Study

1. Proposed Approach To An Energy Industry Risk Management Benchmarking Study Draft For Discussion June 25, 2001

2. Introduction Based on recent conversations with senior risk management executives of several major energy firms, we identified a high level of interest to understand risk management best practices within the industry. These professionals indicated that a benchmarking survey would be an effective way to gain such insight, and participants in such a survey could yield significant benefits: • Create a confidential comparison of their practices against a cross section of their peers • Increase the awareness of industry-wide risk management best practices • Create transparency among industry players that should reduce systemic risk (e.g., pricing for credit risk) • Provide greater awareness of expected levels of risk adjusted performance for energy trading and asset based businesses We have prepared this document to outline our approach for conducting such a benchmarking survey

3. Contents • Objectives and Benefits to Participants • Approach • Sample Output • Targeted Participants • Expected Resource Requirements

4. The benchmarking survey has six principle objectives • Provide participants with a fact base of industry-wide capabilities in risk measurement and management • Create an understanding of the trade-offs, e.g., accuracy vs.timeliness, made by industry peers as they have developed their risk management systems • Develop a common understanding of platforms, methodologies, processes and support capabilities • Determine levels of risk adjusted trading performance within the energy markets, and provide comparisons with financial markets • Identify industry-wide methodological and data aggregation capabilities • Provide a confidential basis of comparison for how each firm stacks up against its peers

5. Contents • Objectives and Benefits to Participants • Approach • Sample Output • Cost and Expected Resource Requirements

6. The survey will address risk based performance and risk management infrastructure Proposed Risk Management Survey Framework Risk Infrastructure Evaluation Risk Performance Assessment • Scope: • Breakout by specific business line: E&P, Generation, Transmission, Trading, etc. • Trading will focus on market making activities, not hedging • Market risk focus • Commodities: Gas, Power, Crude, NG Liquids, Petroleum products • Other: Weather, Bandwidth, Hybrids (multiple risks) • Scope: • Market risk • Credit risk • Operational risk

7. The performance assessment will focus on risk capital usage and return for energy based market making activities Proposed Risk Management Survey Framework Risk Infrastructure Evaluation Risk Performance Assessment • What levels of capital are allocated to business activity, e.g., VaR, economic capital limits? • How does business risk capital relate to overall corporate risk capital? • What is the return relative to the risk capital allocated and utilized? • What is the average, high and low risk based performance? • How has risk performance historically trended?

8. Process, Policies and Controls Reporting and Information Organization, Roles, and Responsibilities Methodologies The infrastructure survey will assess the current state of risk management process, organization, methodology and reporting Proposed Risk Management Survey Framework Risk Infrastructure Evaluation Risk Performance Assessment • What is the structure of the risk organization? • What functions are business aligned? • Where does responsibility lie for key activities, e.g., set limit take positions, etc.? • How is independence between risk takers and oversight ensured? • What risk measures are utilized, e.g., VaR, economic capital? • What approaches are used, e.g., parametric, simulation, etc.? • How is performance assessed? • Is risk measured for new projects? • Is risk based investment analysis consistent with methods for ongoing monitoring? • How is stress testing conducted? • What risk reports are produced? • Do formal risk discussions take place? • What information is presented in the reports? • How is risk information and transactions maintained? • What technology supports the risk calculation process? Is it centralized? • What data shortfalls exist? • How is risk externally disclosed to shareholders, rating agencies, analysts? • What management processes involve risk measurement input? • Are risk management objectives clearly defined? • What limits are set? • How are limits determined? • What is the frequency of monitoring? • Do formal risk policies exist? What do they address? • Do risk based compensation policies exist?

9. Solicit survey participants Discuss preliminary findings Conduct fact gathering Finalize survey results We envision the final results to be available in approximately 5 months, although preliminary findings will be available sooner Overall Survey Approach and Estimated Timeline Participants will see first results within 3 to 4 months 1 month 1 month 2 - 3 months 2 weeks • Identify target participants • Solicit involvement in survey • Adapt survey questions to interest of foundation participants • Identify required interviews at each participating company • Distribute survey questions prior to interview • Conduct interviews • Gather appropriate supporting documents • Conduct follow-up to clarify answers, or other supporting materials • Provide written summaries of company-specific findings and confirm • Prepare preliminary summary report • Integrate performance information with financial markets data • Review preliminary report with participants • Identify required revisions • Prepare final report with key findings, conclusions and trends • Distribute report to participants

10. To make the results most meaningful, we are targeting major U.S. based energy firms. We will look to the initial survey sponsors to identify additional firms of interest Summary of Target Companies • AES • Andarko • Aquilla • BP • Calpine • Duke • Dynegy • El Paso • Enron • Entergy • Koch • NiSource • Pan Canadian • PG&E • Pinnacle West • Reliant • Southern Company • Williams

11. Our survey will address issues that have been identified as of particular interest by survey participants • Relationship between risk management objectives/strategy and approach • Managing risk against “normal” or expected market events, and stress situations

12. Risk Management Objective Loss Avoidance Risk/Reward Optimization • Central Risk Control • Corporate focus on controlling organizational risk taking • Central definition of policies/procedures • Little or no delegation of responsibilities • Deep drill-down capabilities for monitoring and limit setting • Granular and frequent risk reporting • Typically IT intensive - data warehouses and central risk engines • C) Performance Manager • Corporate focus on granular (i.e., trade) level risk/reward optimization • Little or no delegation of responsibilities • Deep drill-down capabilities that focus on risk-adjusted performance measurement • Continuous monitoring and management of portfolio risk profile at a granular level • Reliance on central data warehouses and risk engines Centralized Management Approach • B) Delegated Risk Control • Corporate focus on controlling risk taking at a high level • Central steering of policies and processes • Significant delegation of responsibilities (e.g., limits, methodology, calculations) • Light drill-down capabilities that focus on aggregate limit setting and monitoring • Regular risk reporting • Decentralized IT and data management • D) Portfolio Manager • Corporate focus on business unit risk/reward optimization • Delegation to business unit managers • Light drill-down capabilities that focus on risk adjusted performance measurement • Management of portfolio risk profile at an aggregate level Decentralized We will identify various risk management strategies being pursued, and infrastructure adaptations to achieve these objectives

13. Primary Objective: Manage earnings/risk to target levels Frequency: High Reflects normal markets of product demand, market supply, operations and competition Impact: Low Similarly, our approach will evaluate how participants quantify the differences between normal and stress conditions, and the strategies used to control losses in each situation Stress conditions: Normal conditions: Primary Objective: Protect against catastrophic loss Frequency: Low Reflects infrequent occurrences which have a dramatic effect of product supply, commodity prices, or ability to produce and deliver product or service to consumers Impact: High Tail risk 95% area

14. Contents • Objectives and Benefits to Participants • Approach • Sample Output • Cost and Expected Resource Requirements

15. The output will be summarized based on the performance and infrastructure components of the survey • Performance Assessment • Infrastructure Evaluation

16. One key insight gained from the performance assessment will be the relative performances achieved between competing uses of capital Illustrative Transmission E&P Market Making Company A’s Raroc: 59% • The survey will identify distributions of performance across lines of business, and within specific markets, when appropriate • To ensure anonymity, only distributions will be available to survey participants, although each company will be informed as to their relative position in each of the distributions RAROC 100% 50% 0% -20% 90th % 75th % Median 25th % 10th % Distribution Crude Gas Power RAROC RAROC RAROC 100% 100% 100% 50% 50% 50% 0% 0% 0% -20% -20% -20% 90th % 75th % Median 25th % 10th % 90th % 75th % Median 25th % 10th % 90th % 75th % Median 25th % 10th % Distribution Distribution Distribution

17. Another objective will be to see how performance varies over time Summary of Risk Performance of Market Making Activity vs. Time Illustrative RAROC 80% 60% Company A 40% Top 10% 20% Median Bottom 10% 0% -20% 1995 1996 1997 1998 1999 2000

18. Henry Hub Price RAROC Hurdle Rate Business line performance and its ability to create value can be determined. Additionally, comparisons with relevant market factors can be assessed Summary of Business Performance vs. Market Prices $/mmbtu 9.00 35% 8.00 RAROC 30% 7.00 25% 6.00 20% 5.00 4.00 15% 3.00 10% 2.00 5% 1.00 0.00 0% 1996 1997 1998 1999 2000 2001

19. The output will be summarized based on the performance and infrastructure components of the survey • Performance Assessment • Infrastructure Evaluation

20. Companies: B, C, H CEO CRO/ Business Head Policy Committee Market RM Credit RM Dealing Room RM We will identify various risk management organizational approaches firms within the survey have taken Organization, Roles and Responsibilities. . . 1. RISK MANAGEMENT SPLIT BETWEEN CENTRAL RISK MANAGEMENT AND BUSINESS 2. RISK MANAGEMENT INDEPENDENT OF BUSINESS MANAGEMENT Companies: A, E, F, G Companies: D CEO CEO CRO/ Business Head CRO/ Business Head Policy Committee Policy Committee Corporate Market RM Credit RM Corporate Market RM Credit RM Dealing Room RM Dealing Room RM 3. INDEPENDENT CORPORATE RISK MANAGEMENT, DEPENDENT DEALING ROOM RISK MANAGEMENT

21. Increasing sophistication Increasing sophistication We will identify various approaches used to quantify risk, and indicate where various survey participants are positioned Risk Measurement Methodologies. . . Illustrative MARKET RISK CAPITAL B, C, D, F A E, G, H None VaR DynamicModeling Business Analogs INTEGRATED CAPITAL B, C, D, F, G A, E None SimpleAggregation CorrelatedAggregation CREDIT RISK CAPITAL B, D, G, H C A, E, F None Historical Based From portfolio model

22. Transaction Business Unit Company-wide Both limit types and their utilization will be analyzed Policies, Process and Controls: Limits Used. . . Illustrative A A A B A C C B B Institutions That Use These Limit Types D D C A C E B E E B D A F E E F F C D A E E F G F G G A F E E D E F F F G H H E E G F H H H F F F G G C H G EaR or Economic Capital Sensitivity Limits Notional Loss Limits VaR Stress Limit Limit Type

23. DISTRIBUTED AUTHORITY SENIOR CONTROL HYBRID We will also compare limit allocation approaches across surveyed companies Policies, Process and Controls: Limit Allocation. . . Illustrative THREE MODELS FOR LIMIT ALLOCATIONS Allocator Limit Level Allocator Limit Level Allocator Limit Level Senior Management Senior Management Senior Management Firmwide Firmwide Firmwide Risk Management Risk Management Risk Management LOB LOB LOB LOB Desk LOB Desk LOB Desk Trader Trader Trader (D) (E, F) (A, B, C, G, H)

24. We will evaluate various approaches used to gather and maintain risk related information and transactions Reporting and Information: Information warehousing and aggregation …. Illustrative

25. Contents • Objectives and Benefits to Participants • Approach • Sample Output • Cost and Expected Resource Requirements

26. We have structured the survey to minimize the time commitment of the participants and priced it accordingly • Personnel requirement: Our approach will focus on gathering results through a series of short (i.e., hour-long) interviews. We will attempt to schedule these interviews to minimize the number of visits to the benchmark company. The interviews will be conducted with persons responsible for: • Overall risk management (e.g., CRO, CFO, Treasurer) • Credit Risk, Market Risk and Operational Risk In addition to the interviews, we will prepare a detailed request for information, which identifies specific financial and risk calculations required to complete the performance assessment part of the survey • Cost for the study: We proposed a tiered pricing structure to encourage early adoption: • Charter participant: $75,000 • Second round participant: $100,000.