A Brief Review ofNew Institutions and Structures

in the Electricity Industry

GEMI Power ConferenceHouston, Texas

29 June 2006

Private & Confidential

Agenda

• Overview

• Wholesale Markets

• Retail Markets

• Financial Institutions

• Energy Trading

• Conclusion

Overview

Private & Confidential

• Who will develop an IGCC unit with a positive NPV over a 20-year horizon if investors have only a 5-year horizon?

• Where do you build a new transmission line if costs cannot be recovered through regulated rates?

• What good are smart meters if you still have dumb prices?

• Why do we need new institutions and structures?

Key questions

Private & Confidential

A structure defined

Structure (struk' chər)1. Manner of building, constructing, or organizing

2. Something built or constructed, as a building or dam

3. The arrangement or interrelation of all the parts of a whole

4. Something composed of interrelated parts forming an organism or an organization

Source: New World Dictionary

What buildings are people organizing?What buildings are people organizing?What organizations are people building?What organizations are people building?

Private & Confidential

IGCC financing requires mitigation of uncertainty

Notes:10% Cost of EquityGas Prices can move to $6.8/MMBtu if the cost of sequestration is ~$25/tonWe do not exactly hit $25 ton because IGCC must pay for 10% of CO2 it does not captureChart does not show “grey area” where site-specific factors determine the winnerAssumes no value for the CO2 sequestered

0

1

2

3

4

5

6

7

8

9

10

0 5 10 15 20 25 30 35 40 45 50

Emissions Price ($/ton CO2)

Nat

ura

l G

as P

rice

Bre

akev

en (

$/M

MB

tu)

NGCC Wins

IGCC with sequestration prevails

Point where sequestration becomes economic

IGCC Breakeven

Coal prevails – PC and IGCC are near

parity

Private & Confidential

Merchant Transcos (no rate base) are becoming bolder

Western Interconnect Eastern Interconnect

Private & Confidential

Recent studies support TOU meters/dynamic prices

NGCC Wins

Point where sequestration becomes economic

IGCC Breakeven

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00 1.05 1.10 1.15 1.20 1.25

Peak Period (kWh/hour)

Pe

ak

Pri

ce

($

/kW

h)

Average Critical Price = $0.58

Average Control Price = $0.13

1.18

Average Normal Weekday Price = $0.22

1.22 1.08

Energy Demand Under Variable Pricing

(California pilot program results)

Source: Ahmad Faruqui and Robert Earle, “Demand Response and Advanced Metering,” Regulation, Spring 2006.

Wholesale Markets

Private & Confidential

Growing realization energy-only markets may not suffice

Quantity

Clearing Price

Capped & Mitigated

Price

The “missing money” = lost contributions to fixed

costs for every plant

DPeak

Intermediate

Price set by supply

offer caps

Price set by

demand

Peaker

Baseload

Out-of-Market Actions

Private & Confidential

Resource adequacy solutions

• Proposed / Implemented Capacity Markets– New England– New York– PJM– Spain (structure similar to NE)– Netherlands (structure similar to NE)

• Some type of Resource Adequacy Construct under discussion– Texas– California

• Public Power Authorities– California (proposed, established and retired)– Ontario (proposed, established and operating)– Connecticut (proposed)

• Other Market Designs

Retail Markets

Private & Confidential

State electricity restructuring appears to be stalled

Source: Energy Information Administration

Private & Confidential

Industrial and commercial customers continue to purchase from energy-only providers

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003 2004

Sal

es b

y E

ner

gy-

On

ly P

rovi

der

s(M

illio

n M

egaw

att-

ho

urs

)

Transportation Sector *Other Sector *Commercial SectorIndustrial SectorResidential Sector

Source: EIA http://www.eia.doe.gov/cneaf/electricity/epa/sales_state.xls

Private & Confidential

Utilities offer green products in addition to their standard regulated offerings

Private & Confidential

New distribution channels for energy efficiency services

Financial Institutions

Private & Confidential

Financial services firms provide credit support

“I’d say we spend as much time structuring credit as we do structuring energy”

- Catherine Flax, JP Morgan

"There are investors in this space, principally hedge funds, that will happily take the risk if the spread is attractive enough and if they're convinced that the underlying story is favourable."

- Elad Shraga, Deutsche Bank

Source: Duncan Wood, Risk Magazine, "Putting energy into credit," Dec. 2005 (Volume 18, No. 12).

Private & Confidential

Financial services firms dominate top-rated dealers

Source: www.energyrisk.com, Rankings compiled by Glenn Leihner-Guarin, 2005

Data based on the results of a survey sent to more than 2,000 banks, brokers, energy users and traders worldwide. Voters were asked to nominate their top three counterparty dealers and top two brokers based on criteria that included keen pricing, flexibility, market making, reliability, integrity and speed of transactions.

2005 Rankings of Top Dealers

Private & Confidential

Private equity firms have more than $135 B in capital

Source: CRA Research, best estimates of size as of June 2006

Private Equity

0 5,000 10,000 15,000 20,000 25,000 30,000

Tenaska

Invenergy

KKR

American Securities

Riverstone

ArcLight Capital Partners

First Reserve

One Equity

Fortress Group

Apollo Advisors

Blackstone

Madison Dearborn

Texas Pacific Group

Warburg Pincus

Private Energy Market Fund, L.P.

Com

pan

y

Size ($ Million)

Private Equity

Private & Confidential

More than 300 hedge funds in energy provide liquidity

Source: CRA Research, best estimates of size as of June 2006

Selected Hedge FundsFund Asset Size ($ Million)Appaloosa $4,000Caxton-Iseman $2,000Cerberus $16,000Citadel Investment Group LLC $12,000DE Shaw $20,000MatlinPatterson $4,000Och-Ziff Capital $15,000Vega $12,000

Energy Trading

Private & Confidential

Regulatory oversight focused on market manipulation

Stiffer penalties– Penalties: $1 million per day per violation– Felony vs. misdemeanor– Eliminates Principal/Agent defense

FERC CFTC

New CFTC focus– Proposed legislation

CEA Reauthorization Oil and Gas Traders Oversight

– Natural Gas Price Transparency

– Marketers must keep and provide records, even for exchanges exempt from regulation

FERC compliance

– Prohibition of Market Manipulation refines Market Behavior Rules

– New regulations focused on fraud and scienter

– Must maintain 5-year trading records TRADER

FERC and CFTCMemorandum of Understanding (October 12, 2005) to coordinate requests and share proprietary information

Private & Confidential

Existing trading structures drive compliance strategies

Non-

Discretionary

Discretionary

RationalTraderModel

ProcessModel

RockStar

Model

BenchmarkModel

Ad-Hoc Systematic

Private & Confidential

Current compliance models cannot identify market manipulation very easily

Take appropriate action as dictated

by policy

Review Trading / Marketing results

for evidence of non-compliance

Execute Trades

Define Acceptable Trading / Marketing

activities via Corporate Policy

Typical Mid-Office Compliance Model

• Costly: Tens of millions of dollars

• Questionable: Most traders believe they can stay ahead of the game -- this oversight does nothing to prevent them from executing an improper trade and very little to detect one after the fact

• Incentives: Sets up a contest between highly motivated traders vs. intelligent mid-office staff

• Potential for Failure: Most notable “blow-ups” have occurred in organizations touting “best in class” capabilities in compliance

Private & Confidential

Alternative compliance models create a systematic approach to trading to preclude market manipulation

Define & Analyze possible Trading

Protocols

Execute Trades

Generate Trading

Guidance for Execution

Approve Trading

Protocols for Execution

“Acceptable Basis for Trading”

Guidelines

Execution Discretion Guidelines

Compare Trades to Execution Guidance / Discretion Guidelines

“Systematic” Mid-Office Compliance Model

Capital / Risk Allocation Guidelines

Take appropriate action as dictated by

policy

Private & Confidential

Large industry players are adopting systematic trading

Private & Confidential

Black box trading -- thinking inside the box

Silent dealers set deadly pace in derivatives tradeBy Martin Waller

There is a phenomenon outside the industry called 'black box' trading, carried out by computer programs devised by brilliant mathematic minds

TODAY marks the start of International Derivatives Week, at which participants from exchanges all over the world will gather in London. Yet

traders accounting for more than half those markets’ volume will not be there. They will be at their desks as usual. These are not the overpaid and

overworked dealers in derivatives. They are the algorithmic dealing programs that clinch bargains on exchanges . . . without any human input whatsoever.

Source: Business Time Online, June 2006, http://business.timesonline.co.uk/article/0%2C%2C8210-2231867%2C00.html

Conclusion

Private & Confidential

What’s Hot What’s Not – In Electricity

HOT

• Credit-rating renegades

• LICAPs

• Market Manipulation Tools

• PPAs (Public Power Authorities)

• Smart meters

• Of course we do financing

• MOUs on data exchanges

• IGCCs in regulated rates

NOT

• Price caps

• Market Behavior Rules

• PPAs (Power Purchase Agreements)

• Dumb prices

• Credit-rating downgrades

• You need recourse financing

• Unregulated exchanges

• NGCCs on market rates

Private & Confidential

One Final Caveat

“It must be remembered that there is nothing more difficult to plan, more doubtful of success, nor more dangerous to manage, than the creation of a new system. For the initiator has the enmity of all who would profit by the preservation of the old institutions and merely lukewarm defenders in those who would gain by the new ones.”

– Machiavelli

Tanya Bodell’s consulting practice focuses on various aspects of the energy industry, including the effects of government regulation on profit opportunities, particularly in the areas of competitive markets and environmental policy. Her work in trading and risk management spans all energy-related commodities, including tradebook valuation, portfolio optimization, and regulatory compliance. Her work in electricity includes design and implementation of competitive wholesale and retail markets, as well as strategic advice to the participants in those markets. She has also been extensively involved in the analysis and determination of damages in liability cases pertaining to the energy industry, including breach of contract, product liability, fraudulent conveyance, and bankruptcy proceedings. Ms. Bodell has a B.A. in Mathematical Economics from Pomona College and an M.A. in Public Policy from the University of Chicago.

Tanya Bodell200 Clarendon Street, T-33

Boston, MA617-425-3364

tbodell@crai.com