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TAC Update Credit Aspects of Mass Transition March 9, 2006

Gain insights into recent protocol changes aiming to enhance the market's credit profile. Evaluate risk scenarios, timelines, credit quality data, collateral requirements & potential losses. Consider options to manage credit risk in the interim period.

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TAC Update Credit Aspects of Mass Transition March 9, 2006

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  1. TAC UpdateCredit Aspects of Mass TransitionMarch 9, 2006

  2. TAC has approved a number of Protocol changes to improve the credit profile of the market. Credit Working Group met on Feb 3 to review the changes made to date and evaluate residual risk Reviewed the impacts of the various PRRs that have been implemented Considered two scenarios A QSE dropping an LSE A QSE stand alone General

  3. Received an update on Mass Transition timeline from C Reed and C Bratton Short term - Mass Transition timeline not expected to change Long term – goal is to reduce Mass Transition timeline to 3-4 business days Long term solution not expected to be effective for 12 to 18 months Requires Protocol changes, system changes, etc. CWG continues to be concerned about credit risk In the interim until a long term solution is implemented Residual credit risk once a solution is in place General

  4. QSEs representing their own load Approx 80% of LSEs represent themselves as QSEs Supported by collateral Approx 20% of LSEs are represented by others Supported by notice period from QSEs of intent to drop Credit quality of QSEs representing load 23% of load meets credit standards 41% of load does not meet credit standards and posts a guaranty 36% of load does not meet credit standards and posts cash or LCs Primary area of concern

  5. Identify problem and make collateral call BDay 0 Notice periods (4 BDays, down from 6) Collateral due BDay 2 Notice of default given BDay 2 2 BDays to cure default BDay 4 Mass transition (9-11 BDays) Conference call to begin Mass Transition BDay 5 POLRs initiate switches (5 BDays allowed, switches to date have taken, on avg 3 BDays) BDay 8 Time until switch complete by TDSP BDay 14 (Note: 14 business days + 6 weekend days = 20 days of liability) Revised Timeline to Remove a Troubled QSE (approx)

  6. Potential loss (simplified – w / 3 weeks of collateral) Collateral held 1,000 MWh/day x $100/MWh x 10% x 21 days = $ 210,000 At default 1,000 MWh/day x $100/MWh x 100% x 21 days = $ 2,100,000 Potential loss to the market $ 1,890,000 For 100 MWh/day $ 189,000 For 10,000 MWh/day $ 18,900,000 Open question: Is 20 days a reasonable estimate if the MP is a larger entity? Revised potential loss in exit scenario

  7. Potential loss range – w/ 3 weeks of collateral (assume MCPE = $100/MWh) Collateralized based onBES 10%BES 100% At Default BES 100% BES 100% For 100 MWh/day $ 189,000 $ 0 For 1,000 MWh/day $ 1,890,000 $ 0 For 10,000 MWh/day $ 18,900,000 $ 0 Revisedpotential loss in exit scenario

  8. Potential loss range – w/ 2 weeks of collateral (assume MCPE = $100/MWh) Collateralized based onBES 10%BES 100% At Default BES 100% BES 100% For 100 MWh/day $ 196,000 $ 70,000 For 1,000 MWh/day $ 1,960,000 $ 700,000 For 10,000 MWh/day $ 19,600,000 $ 7,000,000 Original potential loss in exit scenario

  9. Consistent calculation Inconsistent results in terms of protection in the market Collateral calculation concern

  10. # of LSEs by average daily MWh for August 2005 Potential MWh/dayCRNOIE Tot%Loss by cat < 200 23 25 48 31% $ 200k ea 200-2,000 21 41 62 40% $ 2,000k ea 2,000-20,000 24 12 36 23% $20,000k ea > 20,000 7 3 10 6% Total 75 81 156 100% Market Statistics

  11. Entity Est MWh/day Est ESIDs Tot Est Exposure LSE 1 350 3,000 $ 400,000 QSE 1 50 500 $ 30,000 QSE 2 65 550 $ 220,000 LSE 2 3,500 12,250 $ 5,500,000 LSE 3 1,500 10,000 $ 200,000 QSE 3 125 2,500 $ 100,000 Total $ 6,450,000 Credit Exposure – Mass Transitions 2005/2006

  12. CWG has been meeting over the past month to consider options to “fill the gap” until the long term solution can be implemented. While no formal votes have yet been taken, generally, the discussions have indicated that: Preferred solution – one that reduces (rather than mitigates) credit risk Alternate solutions currently being considered Credit insurance Increased collateral requirements Supplier certification/guarantee of bilateral arrangements (to be used in conjunction with increased collateral requirements) Possible Solutions

  13. Credit insurance Talking with a broker about options and cost Need to consider how to pay for coverage Market participants must give written permission to disclose proprietary information Historically this has been a stumbling block Would cover some but not all risk Credit insurance

  14. “Right size” collateral for the risk faced by the market See example Very costly to entities required to post Potential to constrain competition in the market See example Increased collateral requirements

  15. Example of increase to collateral (simplified)

  16. Example of increase to collateral (simplified)

  17. Cost Example For the 36% of QSEs that must post cash or LC At 1 MM MWh/day of load X $50/MWh X 7 days X 36% = $126 MM in additional collateral to post At 15% cost of capital = Approx. $19 MM per year or 17.4 cents/MWh ($19MM /300,000 MWh/d /365) For the 41% of QSEs that post a guaranty At 1 mm MWh/day of load x $50/MWh X 7 days x 41% = Approx. $144 MM in additional guaranty support At 4% imputed cost = Approx. $6 MM Cost to Market –Increased Collateral

  18. Generally – certify weekly (say Monday) for the two weeks forward (Friday to Thursday) Potential way to get credit for committed bilaterals Provide as addition option to meet collateral requirements Must have “teeth” – supplier must be responsible for requirements certified Potential problem – how to ensure that QSE benefiting from a certification doesn’t “resell” or “flip” the commitment Would suppliers be willing to do this? Devil is in the detail…haven’t worked through all issues Note: To be used in conjunction with increased collateral requirements Supplier certification/guarantee

  19. Substantial credit risk remains in the market related to Mass Transition events Long term solutions are 12 – 18 months away from implementation Long term solutions will not fully mitigate credit exposure CWG is reviewing possible ways to mitigate credit exposure Preferred solution is one that reduces credit exposure Alternatives are being considered Summary

  20. Want to provide an environment that will support a strong market Currently, goal is not to eliminate All credit exposure Want to ensure financial viability of market Summary

  21. CWG will continue to identify and work through potential solutions BOD has an ongoing concern around the credit situation in the ERCOT market CWG has been asked to update F&A in March on ideas for reducing credit exposure in the market Next Steps

  22. Credit WG met on Monday, April 10 and will meet again over the next three weeks (April 13, 20, 27) to determine what steps should be taken to mitigate credit exposure. Questions asked and being discussed at Credit WG How will ERCOT deal with credit exposure NOW? Five of the six failures experienced in 2005/2006 occurred from July 2005 to January 2006, during a period of significant price volatility Can we shorten the Mass Transition process NOW (other than collateral) to mitigate the risk until the long term solution is in place? Lessons learned from prior defaults (before Mass Transition process was finalized) April Update

  23. Questions asked and being discussed at Credit WG (Cont) Can the Long Term Solution become effective earlier? (by December 31?) What will be in place at December 31 – the 3 business day solution? Or a subset of that? Is there consensus among all key players that must implement that December 31 is attainable. If attainable, does December 31, 2006 meet the need? In either the Long Term or Short Term solution, how do ensure that established rules are followed? What incentives / penalties are built in? April Update

  24. Questions ?

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