What Is the Role of Stress and Scenario Testing?
The CCRO’s capital adequacy is heavily VaR focused. VaR generally is not considered entirely suitable to the energy industry given the structural presence of leptokurtic returns, or “fat tails.” The presence of “fat tails” indicates that energy price returns do not follow a normal distribution, that extreme price spikes occur with greater frequency than a value-at-risk analysis would indicate (e.g., California power price spike in 2001, December 2003 natural gas price spike). Therefore, using only a VaR-based approach to capital adequacy without stress testing or scenario analysis will fundamentally underestimate the levels of capital required.10 But few energy companies rely solely on VaR for this reason in structuring their risk management limits, so the CCRO is deficient in not discussing the role of stress and scenario testing in evaluating capital adequacy. A survey of financial institutions by Capital Market Risk Advisors in 2001 revealed that approximately 36 percent of financia
