The Effect of Environmental Regulation upon the Electric Power Industry: A Rating Agency Perspective

1. The Effect of Environmental Regulation uponthe Electric Power Industry:A Rating Agency Perspective 23rd February 2005 At the California Public Utility Commission

2. Regulation of Pollutants • Four major pollutants • SO2, NOx, Mercury, CO2 • Regulation is fragmented • Regulation to-date of SO2 and NOx under the Clean Air Act • Clean Air Interstate Rule: Proposed rule for further reductions in SO2 and NOx emissions • SO2: 70% below 2002 levels by 2015 • NOX: 65% below 2002 levels by 2015

3. The Effect on Credit Profiles • Increasing CapEx • Rising allowance credit prices • Leading to • Higher energy costs • Increased leverage and • Lower profit margins

4. Lessons Learned from SO2 • Complying? • Pollution control devises, fuel switching or buying credits. • Best solution was probably a combination. • Buying credits buys time • Fuel switching was feasible because of the abundance of low sulfur coal

5. Lessons Learned from SO2 • Building/switching to gas-fired capacity was not always optimal • Volatile natural gas prices • Limited supply of natural gas • Avoiding the installation of pollution control devises may be costly • The recent run up in prices for SO2 credits has generally caused the building of scrubbers to be more economic than buying allowance credits Compliance Costs Comparission ($ millions) 1 CAIR: Clean Air Interstate Rule; requires a 70% reduction in SO2 emissions by 2015. 2 SO2 emission allowance costs: Jan 2003 = $150/ton, 2005 est = $540/ton. 3Based on a plant with 1,880 MW capacity and scrubber cost of $200/kw. Number represents annual depreciation of total cost based on a useful life of 15 years. Source: EPA, Fitch Ratings.

6. NOx SIP Call • Covers 22 states including DC and affects 35 investor owned electric utilities • The top five NOx emitting utilities include*: AEP, Southern Company, Xcel, Cinergy, First Energy • Seen in the market: NIPSCO, Exelon, CMS, and First Energy. * Ceres. Benchmarking Air Emissions report, April 2004.

7. CO2 Regulation: Not if but when • Fitch believes that there will be a carbon law at the federal level however it may be a number of years off. • Other States currently regulating carbon: Massachusetts, New Hampshire, Oregon, and Washington • RGGI • Law suits from eastern states • Investor requests for additional information • McCain-Lieberman and Carper

8. Anticipation of a Carbon Constrained Environment: Current Industry Response • Participate in the development and/or construction of clean coal technology • Buy Carbon Credits – Chicago Climate Exchange • Estimate and inform Investors as to possible costs (for example studies done by AEP and Cinergy)

9. U.S. CO2 Emissions • Aggregate electric power sector CO2 emissions expected in 2004 = 2,257 million metric tons1 • A 5% reduction could range from $.7 billion to $4.2 billion2 in costs per annum. • Top five CO2 emitting utilities include: AEP, Southern Company, Xcel, Cinergy and Progress Energy • AEP’s costs to reduce CO2 emissions by 2020 range from $0.5 billion to $6.4 billion3 1Source: Energy Information Administration. 2Information Based on prices of CO2 emissions ranging from $6 per metric ton to $37 per metric ton. 3 Cost estimates based upon McCain Leibermann and the Carper proposals.

10. Challenges for CO2 • The Power Industry will need economically feasible CO2 emission control technology • The development of these devises will be challenged by: • A realistic estimate for the price of “carbon” • The time horizon for investors and developers • The time horizon for electric power generators