Entry Capacity Substitution Workshop 5 – 5 th December 2008

1. Entry Capacity Substitution Workshop 5 – 5th December 2008 Review and Options for Development

2. Agenda • Recap of substitution benefits and impacts • Impact on entry capacity charges • Reserve prices • Incremental step prices • Potential options for substitution

3. Substitution Benefits • Maximise use of existing Transmission network assets for the benefit of consumers. • Avoid both capacity sterilisation and unnecessary infrastructure investment while accommodating changing flow patterns.

4. Substitution Impacts • Substituting capacity to recipient ASEPs to meet incremental capacity requirements will impact on prices paid for capacity at those recipient ASEPs in exactly the same way as if requirements are satisfied through investment (i.e. in the absence of substitution). • Substituting capacity away from donor ASEPs will reduce the reserve price at the donor ASEP (all other things being equal).

5. Substitution Impacts • To trigger incremental capacity at an ASEP where capacity has been substituted away will have minimal impact on the prices that would have to be paid. Therefore the main impacts are: • For long term capacity projects that are economically able to trigger incremental capacity, the potential default lead time of 42 months and the need to provide the necessary User Commitment. • For short term players there may be a greater reliance on the 10% of baseline capacity that is held back to the shorter term. However, this is supplemented by availability of additional capacity through Transfer and Trades and discretionary release. • For marginal gas fields, there may also be a greater reliance on the 10% of baseline capacity.

6. Substitution Example – Prices Reserve Prices (and step prices for incremental entry capacity) are a function of the obligated capacity level. Hence, substitution will generally decrease the P0 price at donor ASEPs; and Release of incremental entry capacity will generally increase the P0 price at recipient ASEPs. Revised obligated levels / prices apply from the applicable quarter/month, i.e. from month 42. The assessment undertaken is highly simplistic and ignores all other effects, e.g. • substitution may impact supply / demand scenarios which could in turn affect prices, • other, non-substitution, issues may cancel out the effects shown, • similar substitutions at different ASEPs may have different outcomes. At Substitution Workshop 3 on 11th June 2008 National Grid gave an example of the possible impact of substitution on entry capacity reserve and incremental step prices. An update of these prices is provided in the following slides. In this example 10mscmd of incremental capacity is allocated at Easington. This is achieved by substituting capacity from other ASEPs: • All available capacity from Hornsea, Hatfield Moor and Theddlethorpe; • Some of the available capacity from Bacton.

7. Substitution Example – Prices (Sept 2008 basis) NB – P10 and P20 step prices relate to an incremental capacity of 25% and 50% of the obligated level. Hence, with the exception of Easington, the “new” prices relate to a smaller incremental quantity.

8. Substitution Example – Prices • Where capacity has been substituted away from a donor ASEP, such that the obligated capacity level is reduced, Users can only be allocated capacity to the initial obligated level by triggering, in a subsequent QSEC auction, the release of incremental entry capacity. This may be subject to a 42 month lead-time. • In general the step price is driven by the obligated level. Hence, following substitution we would expect the prices at equivalent capacity levels to be the same pre and post substitution for any particular ASEP. • However, the IECR methodology requires a minimum increment at each step so the step price required to return to the initial obligated value may, for some ASEPs, be above the initial P0 price as in the given example.

9. Substitution Example – Prices In the example the obligated capacities at Theddlethorpe and Bacton are reduced significantly. The step price to return to the initial level is slightly higher than the initial P0 level.

10. Substitution Example – Prices • In order to return to the original obligated capacity level Shippers will need to place capacity bids at the next QSEC auction at a level that passes the NPV test, i.e. • Bids must have an NPV of at least 50% project value • Earliest “incremental” bid placed at Q15 (42 month lead time) at the relevant step price. • The bidding strategy was designed to maximise the quantity of [capacity * Days] having triggered the incremental quantity. • Ignores cost of capacity up to the initial (post-substitution) obligated level. • No profiling (winter / summer variations) of bids.

11. Substitution Analysis Timeline Incremental Obligated Entry Capacity proposal submitted to Ofgem QSEC auction closes Allocations to be made Substitution analysis Challenge & Review. Audit of results Ofgem governance 28 day veto period defined in Licence National Grid governance Analysis of alternative investment option Value of projects can be several £100m. Sanctioning at senior level required. Ofgem response may impact proposals requiring further analysis / governance Indicative Timeline 2 months – as defined in UNC section B2.6.7

12. High Level Choices – Substitution Decision • In the draft Methodology Statement, shipper bids are the only determinant of shipper interest. • Constraints could be applied to the draft MS e.g. an economic test or exchange rate cap. • Non-market information could be used to determine how much should be reserved at each donor ASEP, this opens up the party making the decisions to challenge and lobbying – it also begins to challenge the value of the User commitment process other than as a mechanism for providing funding. • New mechanisms could be developed to enable shippers to prevent capacity from being substituted away from a donor ASEP, probably by requiring payment of a nominal fee.

13. Option Assessment Criteria • Each option has its advantages and problems; so how do we assess the most appropriate methodology? • National Grid considers the following criteria are key: • Does the option maximise the potential substitution benefits? • Does the option provide sufficient risk mitigation against unintended consequences? • How easy is the option to implement • Is the process transparent and predictable with minimal scope for challenge? • Can processes be undertaken within allowed timescales? • Impact on systems, Licence, UNC etc • Each option to be rated on a scale of 1-5, where: • “5” fully satisfies the criteria and • “1” does not satisfy the criteria

14. Evaluation of each Option against Criteria

15. Option 1: Literal Interpretation of Substitution Obligation – as discussion draft • All obligated entry capacity remaining unsold after the QSEC auction allocations will be available for substitution. • No restriction on substitutions e.g. exchange rates / zones.

16. Option 2: Limits on Quantity Available for Substitution • As Option 1 but with additional capacity withheld from substitution. • Could be based on % of baseline / obligated or historic flows or TBE forecasts. • Additional withheld capacity to be agreed with Ofgem in advance of the auction.

17. Option 3: National Grid Discretion • This option can be developed in several ways; based on • Option 1 but with National Grid rejecting certain potential substitutions. • A loosely defined methodology allowing National Grid discretion to apply/vary exchange rates or limit substitutable capacity from donor ASEPs.

18. Option 4: Ofgem Discretion • Based on Option 1. National Grid will submit incremental capacity release proposals to the Authority identifying proposed substitutions. Ofgem may reject certain potential substitutions even if the published methodology has been followed.

19. Option 5: Simple Economic Test • As Option 1 but with each substitution confirmed subject to an economic assessment. • This assessment could be applied to restrict substitution in several ways; e.g. if • Recipient ASEP bids < Donor ASEP reserve price * exchange rate • Donor ASEP value (to the pre-auction obligated level) > [50%] Recipient ASEP value. • Based on incremental capacity project values from the Transportation Charging Model • Based on revenue drivers • Donor ASEP value (to the TBE level (or other criteria used in option 2)) > [50%] Recipient ASEP value These tests are intended to measure and compare the value of capacity substituted from the donor ASEP and released at the recipient ASEP and preventing substitution where the value at the donor ASEP is higher.

20. Option 5: Simple Economic Test (2)

21. Option 6: Exchange Rate Cap / Economic Test Combination • As Option 1 but with each substitution confirmed subject to: • Exchange rate cap: close 1:1 • Economic assessment: project value at donor ASEP to recover TBE peak forecast capacity must be less than the project value for the incremental capacity at the recipient ASEP.

22. Option 7: Option to Buy • A Shipper can place a value on non-incremental capacity at an ASEP for an option price. • To comply with the Licence fees need to be cost reflective.

23. Option 7: Option to Buy – Issues for Consideration • What does the Option provide? • Does the Option prevent capacity from being substituted?...or • Does the Option put the capacity to the back of the queue for substitution? • What is the Option price (i.e. the price paid to create the Option)? • Subject to question above. • Same for all ASEPs or linked to ASEP specific reserve price? • Is there an Exercise for the Option? If so, how is it effected? • Automatic if ASEP identified as a donor ASEP for substitution? • Only if Shipper gives consent at the time that the ASEP is identified for substitution? • What is the Exercise price (i.e. the price paid to be allocated the capacity)? • Reserve price at the relevant ASEPs? • What duration does the Option cover? • Default lead time plus 1 year? • What is the life-time of the Option? • For one year from one annual QSEC auction to the next?

24. Option 8: Sub Reserve Prices • Donor ASEP shippers can reserve capacity through capacity bids at below reserve price. In effect a variant on the Option to Buy model. • Where substitution is identified, capacity will not be substituted if the donor ASEP bid value exceeds the recipient ASEP bid value (bid price * quantity * duration).

25. Option 9: Early Warning System • Based on Option 1 but publication of TBE data on new projects ahead of auction • Shippers will be able to bid for capacity at “vulnerable” ASEPs.

26. Option 10: Two Stage Auction • Based on Option 1. Several variations where QSEC is run in two parts. • Baseline and incremental capacity can be obtained in the first phase. • Only baseline capacity can be obtained in the second stage. This allows donor ASEP Shippers to respond in the second stage if they feel that capacity at their ASEP is vulnerable.

27. Options 11: Previous BGT Proposal • Based on Option 1 but Shippers at donor ASEPs can recover substituted capacity at the next QSEC auction at reserve price. • Essentially this is Option 10 (two stage auction) with an extended period between stages.

28. Other Options?

29. Option Shortlist • …………….

30. Next Steps • By 12th December - Industry options to be put forward • Forward to Joint Office • cc andrew.fox@uk.ngrid.com • 7th January - Workshop 6 • Location to be confirmed • Review industry options; narrow down for further development. • Detailed assessment of preferred options.