Economic Capital as an effective tool for enhancing trust and confidence of shareholders

Georg Ohm GmbH ("Company") is a German power utility from which 50% of the shares belong to London based Newton & Watt PLC and another 50% are owned by a Chicago based hedge fund More Bang for a Buck Inc.

Company’s business is supplying electricity to small and medium size customers as well as developing PV's on roof tops of the warehouses and selling green power through PPAs. The company is solely equity financed, as such all profit and losses have a direct impact on its shareholders through dividend payments in good years or equity injections in bad years. However, over the last 10 years, the Company’s actual financial results have deviated significantly from the budgeted Key Performance Indicators (KPIs), with the previous financial year 2023 falling way below expectations.

For the upcoming Shareholder Meeting scheduled in January 2023 the Company was asked to prepare answers on the following questions:

A)????? What are the Company’s financial risks for 2024?

B)????? What is the amount of the risk reserve that Newton & Watt should budget?

The CFO has following information readily available:

Balance Sheet as of 31/12/2023: Total Assets amount for mEUR 1, there are no Liabilities and Intangible Assets.

Market risk / EBITDA at Risk 12 months @ 99.9% conf level: mEUR 2

Credit risk 12 months @ 99.9% conf level: mEUR 0.5

Gross Margins over the last 3 years in mEUR: 0.01 (2021), 3.2 (2022), -0.6 (2023)

Credit rating of Newton & Watt: ‘B‘ (S&P)

1-year default probability of a B-rated corporate is around 3.6%.

First step is the aggregation of different risk categories into Economic Capital. Root-Sum-Square (RSS) Aggregation is one widely common method of aggregating risk categories, especially in portfolio management, where the volatility of individual positions and their potential interactions should be considered.

Let’s start evaluating this formula by first looking at the Operational Risk.

Operational Risk - risk of failures of system or processes* - can be calculated in dozens of ways. Ideally (what I would personally prefer), the Company has collected a history of operational incidents along the impacts. Then using these historical observations one would model a distribution which can then be used to derive required risk metric. Since it is not a focus of this article, let us use Basel’s Standardised Approach to calculate Operational Risk: average non-negative Gross Margin over the last three years multiplied by a factor of 18%, where 18% is multiplier recommended by Basel for "Sales" type of business. So, using Standardised Approach and Gross Margins 2020-2023 Operational risk over the 12 months would then be EUR 0.29m = ((0.01+3.2)/2)*18%.

Next - Market and Credit Risks. These risks can be used as stated with 99.9% confidence level, however since shareholder Newton & Watt has only a B rating it would be better to calculate Economic Capital not at 99.9% but at 96.4% confidence level which is 1 - 3.6% (statistical probability of default for a B-rated corporate bond*). This would imply that both Market and Credit Risk metrics must be translated to 96.4% confidence interval. In ideal case CFO would ask both teams to recalculate their numbers at a lower confidence level. Since no further information is available we would approximate required confidence levels using normal distribution: Market risk @96.4% = (2m/z-value 99.9%)*z-value 96.4% = 1.16m and similar for Credit risk we obtain EUR 0.29m.

So the Economic Capital at 96.4% can be calculated as:

The answer to the first question of the shareholder is: "The total risk of the Georg Ohm GmbH over the next 12 months will not exceed 1.23m with a probability of 96.4% under normal market conditions". Disclaimer "under normal market conditions" is an important one: it allows Economic Capital to exceed by far the calculated number,e.g. if market conditions are extraordinary: a war, or a global desease like Corona or similar which occur one in 50 years or even less and normally cannot be considered in modelling any of the risk categories properly.

To answer next question of the shareholder we need to evaluate or compare Economic Capital against something. Is it high or low? Similar to a stock trading at an exchange we normally would relate riskiness (volatility) of the stock to its price. Similar in this case the riskiness of the Company should be compared with its value or Tangible Net Worth. The TNW serves as a baseline valuation for a company. It represents the minimum value that a company would be purchased for by an acquiring entity in the event of liquidation.

Tangible Net Worth = Total Assets – Liabilities – Intangible Assets

Given the last available balance sheet figures we calculate TNW to be EUR 1m (value of assets since there are no liabilities and intangibles).

The ratio of Economic Capital to TNW is termed "Economic Capital Utilisation", it indicates how efficient TNW is allocated. If TNW is substantially higher than Economic Capital then it would mean the Company can take substantially more risk, i.e. increase risk capital.

In our case Georg Ohm GmbH Economic Capital utilisation is 1.23/1 = 123%. In this case it would be a good risk management practice to inquire from the management a risk reduction plan to bring Economic Capital down to 1m or alternatively shareholders agree to provide to the Company a risk reserve of at least 0.23m. Such a reserve would not imply any cash transfer but a transfer of risk from the Company to its shareholders (eventually increasing shareholders own EC utilisation).

Most probable solution in this case would be that shareholders provide sufficient risk reserve (take this risk in their books – each 50%, i.e. Newton & Watt would take an additional risk of ~EUR 0.115m.) At the same time they may require the Company to reduce its Economic Capital to later remove these reserves if necessary to free up risk capital for other projects.