John J. Stauffacher

1. Energy Markets at Crossroads:Has Deregulation Failed?International Association for Energy Economics John J. Stauffacher

2. Electricity:a Market in Transition • One foot (at least) firmly planted in the past • Much uncertainty from lack of clear direction • The good old days and stranded costs • Part of the political price that had to be paid • Distortion of competitive options • Hidden agenda for many participants decisions

3. Electricity:a Market in Transition • Deregulation or restructuring for a competitive market? • Limbo of neither • Legislative indecision • Jurisdictional turf battles • Market failures or failure to let the market work? • California—leaping the chasm to two bounds • Failure in confidence in markets and participants

4. Electricity Market Structure • New state legislation often mandated or encouraged functional unbundling • Addressed market power concerns • Quantified value of generation assets • Brought in new players and new ideas • Sellers market • Existing assets allowed fast market penetration • Higher prices minimized stranded costs • New facilities faced many barriers

5. Financing new Infrastructure- an evolution of lending philosophy • Rate base assurances—just be Just & Reasonable • New entrant QFs and IPPs—relied on obligation to purchase or LT contract • Merchant plant—non-recourse project debt, high leverage

6. Financing new Infrastructure- an evolution of lending philosophy • Late 1990s shortages and price spikes (signals) brought a wave of investment • Prices for divested generation escalated • Reality of slow demand, over supply and resultant lower electric prices Year Avg Sale Price X Book 2000 $430/kw 1.8 2001 618 1.7 2002(10 mon) 305 1.7

7. Financing the industry- can electricity survive a “boom/bust” cycle ? • Political will to let prices reflect supply/demand • Regulatory certainty in the treatment of purchased power • Maintaining sufficient market number of healthy participants

8. Financing the industry—the Role of the Rating Agencies • Rating Agencies credibility suffered big time from the fall of Enron • Electric Industry paying ever since • Electric industry “taint” and “headline” risk

9. Financing the Industry—Rating Agencies and the Financial Markets • A “credit Armageddon” looms? • Major problems ahead- $90B of refinancing by 2006 (20% non-recourse) • Adverse off shore experience draining many deep pockets • Buyers market but few buyers—is market power the next major problem?

10. Sorting it all out—Can a healthy Electric Infrastructure emerge? • Project debt collateral is the facility itself—an efficient, clean and generally well located facility • Under resourced load pockets exist—despite NERC’s rosy forecasts—24% reserve margin by 2005 • But, investment in Transmission infrastructure seriously lags

11. FERC’s Answer to the Transition: Standard Market Design • Goal to create a seamless transmission market under a single tariff • Addresses congestion through LMP • Tackles key issues including congestion revenue and resource adequacy • Natural gas has shown it can be done

12. FERC’s Answer to the Transition: Standard Market Design Pat Wood- “the status quo is wrong if [it] overrides the Federal Power Act requirement to treat all transmission customers the same” Nora Brownell- “political pressure can not change the reality that significant change is needed to ensure investment to meet both our short terms and long term transmission and generation needs”

13. FERC’s Standard Market Design • Many vocal opponents and proponents • Strange bedfellows—EEI and NARUC, EEI and NRDC • Jurisdictional questions heated • Regional differences touted • Timeline and likely judicial challenge

14. Railroad Standard Gauge- a regional differences analogue • Prior to 1880’s both narrow and wider gauges used • Technical arguments • Regional arguments • Economic interests Eventually a uniform “standard”gauge was accepted—4 foot 8 ½ inches—the uniform width of Roman war chariots wheels

15. Industry Response to Current Crisis • EPSA Code of Ethics • CCRO White Papers on Best Practices • Withdrawal from Power/gas marketing • Deferred or canceled capital additional • Focus on cash flow and balance sheet • Sale of assets

16. EPSA Code of Ethics and Sound Trading Practices for Electric Power Suppliers • Defines and reaffirms the values, principles and internal controls that electric power supply companies must follow • Complements the internal principles and practices of each individual company in supplying power, managing risk, providing market liquidity and reporting financial results • Assures that unethical trading practices are not tolerated and that public disclosures are accurate

17. EPSA Code of Ethics Guiding Principles • Integrity • Sound Trading Practices and Principles • Candid and Complete Disclosure • Comprehensive Corporate Compliance

18. Integrity Business activities should be conducted in an honorable and principled manner consistent with the Code’s ethical standards and sound trading practices • Engage only in transactions with legitimate business purposes, such as managing business risk or that otherwise have economic substance

19. Integrity (cont) • Honor contractual obligations • Maintain risk management activities designed to ensure that power-trading activities are conducted in accordance with this Code • Report financial results so as to fairly present the financial health of the company • Not engage in any transactions intended to boost revenues or volumes artificially, or intended to manipulate market prices

20. Sound Trading Practices • No unlawful withholding • No creation of artificial congestion • No intent to offer and not provide reliability services • No “wash” trades • No misrepresentative trading

21. Candid and Complete Disclosure • Provide accurate and transparent market and transaction information • Adhere to procedures to ensure that all trades are properly and timely documented and that no trades are concealed or misrepresented • Maintain documentation on all transactions • Ensure that any public information is accurate and consistent • Continue to cooperate with regulators in their oversight of market operations

22. Comprehensive Corporate Compliance • Maintain a compliance program that will assure appropriate, timely and ongoing review of power trading activities in compliance with this Code • Personnel training on the provision of this Code and the company’s risk management policies • Encourages employees to disclose to senior management any trading practices that might violate this Code • Establish clear lines of accountability for the company’s power trading practices with appropriate oversight by the Board of Directors or other senior corporate management committee

23. Committee of Chief Risk Officers Best Practices Papers • Governance—separation of functions • Valuation and risk metrics • Credit risk • Disclosure

24. Will the Industry Response be Sufficient? • Self policing a necessary first step • Shrinkage gas/electricity trading volumes a reality but bottom may be near • Deferred and cancelled plants starting to be a concern and gain policy attention • A more conservative approach to economic fundamentals and reporting is here to stay • Less out right sale of assets—more debtor in possession

25. John J. Stauffacher Consultant to the Energy Industry Contact information: Phone- 281-438-1400 Cell- 713-299-5766 e-mail JStauf@AOL.com