THE ALL IMPORTANT CREDIT TERMS: EEI CREDIT AND COLLATERAL REQUIREMENTS AND EEI COLLATERAL ANNEX

1. 1 THE ALL IMPORTANT CREDIT TERMS: EEI CREDIT AND COLLATERAL REQUIREMENTS AND EEI COLLATERAL ANNEX Presentation by Elizabeth Sager (JPMorgan) and Randy Osteen (Constellation) 2008 Master Agreement Training Session November 20, 2008- Houston, Texas

2. 2 Topics of Discussion UNDERSTANDING ARTICLE 8 OF THE EEI UNDERSTANDING THE EEI COLLATERAL ANNEX COMMON NEGOTIATION ISSUES Q&A

3. 3 Understanding Article 8 of the EEI 8.1 (Party A) and 8.2 (Party B) (a) Financial Information options (b) Credit Assurances (c) Collateral Threshold (d) Downgrade Event 8.3 Grant of Security Interest/Remedies

4. 4 Preparing the contract for a change in credit quality Downgrade Events Adequate assurance Objective Criteria For non-rated counterparties Co-ops, often unrated with capital structure vastly different from investor-owned companies Hedge funds, generally unrated, foreign and domestic, may reference NAV change. Consider collateralization rather than termination

5. 5 Understanding the EEI Collateral Annex Why post margin? Why use the Collateral Annex? How do parties use the Collateral Annex?

6. 6 Why post margin? Posting Margin is: Most effective way to manage credit risk to acceptable levels Part of cost of doing business in physical energy market since credit crisis of 2001/2002 Physical power agreements have been morphing; to more closely resemble financial trading agreements

7. 7 Potential Issues with Posting Margin Liquidity risk that may result when contracts are not matched for credit and collateral terms Potential imbalance when selling or hedging an asset in the market Imbalance when buying from a counterparty and selling to a customer

8. 8 Why was Collateral Annex developed? When the EEI Master was first introduced (1999), margining relationships were generally the exception, not the rule. Post 2001, the demand for robust margining relationships became greater.

9. 9 Why use Collateral Annex? EEI Master Agreement includes its own collateral provisions (see Secs. 8.1(c)/8.2(c)), but: A good, thorough margining relationship cannot be addressed adequately in 23 lines! Management of potentially millions in collateral requires more detail

10. 10 Advantages of Using EEI Collateral Annex Provides for payment of interest on and use of cash collateral Addresses eligibility to hold collateral and custodians Contains Letter of Credit terms (valuation principles, when draws are permitted) Clarifies application of “Independent Amounts”

11. 11 Advantages of Using EEI Collateral Annex (cont’d) Identifies conditions precedent to delivery/return of collateral Addresses required timing of collateral transfers (i.e., “Notification Time”, timing of deliveries and returns) Establishes mechanism for resolving disputes over amounts of collateral calls

12. 12 How do parties use the EEI Collateral Annex? Like EEI Master: Base document with general terms drafted by group consensus Starting point for negotiations: parties may make any elections/changes that are important to them In “Paragraph 10”, parties make various elections, amend base annex if desired If elections not made, then elections will be as set forth in Section VIII of Para. 10

13. 13 How do parties use the EEI Collateral Annex? (cont’d) In EEI Master Cover Sheet, elect that “Collateral Threshold” is applicable, but add: “If applicable, the provisions of Section 8.1(c)/8.2(c) of the Agreement shall be replaced by the provisions of the Collateral Annex attached hereto.” On Collateral Annex Cover Sheet, if elections not made, then elections will be as set forth in Section VIII

14. 14 Determination of Collateral Requirement Net Exposure LESS: Pledging Party’s Collateral Threshold Cash already posted by Pledging Party Value of Letter of Credit, other collateral posted by Pledging Party

15. 15 Sample Collateral Requirement Calculation Net Exposure of Party A: 70 Party B's Collateral Threshold (10) Party B Cash Held by A ( 5) $55 Letter of Credit held by A  but less that 20 days until expire - 0 - Party B’s Collateral Requirement $ 55

16. 16 Setting Collateral Thresholds Standard choices: Fixed amount Matrix approach tied to Credit Ratings Guaranty amount Threshold goes to zero upon Event of Default /Potential Event of Default If Potential Event of Default cured, return from zero to stated level

17. 17 Other Key Elections to Make Eligible Collateral Valuation Percentages Minimum Transfer Amount Rounding Amount Eligibility to Hold Cash Collateral May need to amend for unrated counterparties Interest Rate Payable on Cash

18. 18 Other Key Elections to Make -Independent Amount Fixed: Stated dollar amount must be maintained for so long as there are any obligations between the parties Full Floating: Stated dollar amount shall always be added to exposure calculation,as if Party B had such dollar exposure Partial Floating: Stated dollar amount is posted only if Party for whom it is selected would owe the other Party $1 or more (i.e., other Party has a Net Exposure) Full Floating Example: No trades; $5 million Party B Full Floating Independent Amount; Party A would have $5 million dollar exposure Party B would be required to post $5 million As trades went in the money to Party B, Party B could ask for a return of collateral (e.g., trades in the money to Party B by $6 million, Party A would post $1 million (6-5) Partial Floating Example: (1) Party A has a Partial Floating Independent Amount of $5 million; Party B has a Net Exposure of $1 million; Party A would post $6 million(2) Party A has a Net Exposure to Party B; Party B posts and Party A does not have to post any of the $5 million Full Floating Example: No trades; $5 million Party B Full Floating Independent Amount; Party A would have $5 million dollar exposure Party B would be required to post $5 million As trades went in the money to Party B, Party B could ask for a return of collateral (e.g., trades in the money to Party B by $6 million, Party A would post $1 million (6-5) Partial Floating Example: (1) Party A has a Partial Floating Independent Amount of $5 million; Party B has a Net Exposure of $1 million; Party A would post $6 million(2) Party A has a Net Exposure to Party B; Party B posts and Party A does not have to post any of the $5 million

19. 19 Resolution of Disputes Disputing Party must notify by Notification Time on Business Day following demand Pending dispute, post undisputed amount If no agreement within 1 Business Day, each party selects a Reference Market- Maker to calculate MTM for disputed trades Mark = average of prices obtained Same procedures for requests to return collateral

20. 20 EEI vs. ISDA Collateral Annex Performance Assurance vs. Eligible Collateral EEI: Cash & Letters of Credit If securities can be posted, need to add valuation, substitution, DR & security interest terms. ISDA: Cash & Securities If letters of credit can be posted, need to add relevant L/C terms Payment of Interest “Specified Conditions” Failures to Transfer Collateral

21. 21 EEI vs. ISDA Collateral Annex (cont’d) Payment of Interest EEI Paragraph 6(a)(iii) Monthly invoicing by Pledging Party to Secured Party Payment Schedule – later of: 3rd Local Business Day of following month 3rd Local Business Day after the day the invoice is received ISDA CSA Paragraph 6(d)(ii) No invoicing Last Business Day of Month and any Local Business Day where Cash is transferred to the Pledgor

22. 22 Common Points of Negotiation Credit Assurances vs. Collateral Thresholds Master netting arrangements Implications of using EEI Gas Supplement Collateral Lessons reinforced by Lehman Other issues …