Portfolio Strategy Optimization

1. Portfolio Strategy Optimization OES Committee January 18, 2008 Draft 6 - Revised 1/11/08 – 5:00

2. Alternative Scenario Worlds – General Description • June Re-adjusted – Current world and where we are today • Energy Independence – The US sets a priority on reducing its dependence on non-North American fuel sources. No additional air emission or carbon regulations occur. Energy conservation and renewables are encouraged to reduce use of foreign fuels. Natural gas prices are high. Medium-low load forecast. • Booming Economy – Strong economic growth leads to high peak and energy demand. Some increases in environmental requirements occur and renewables requirements and mild carbon taxes are implemented. Natural gas prices are low. Medium-high load forecast. • Green is Good – Public and political support for more stringent environmental regulation. Tougher CAIR Phase II standards result in SCRs and FGDs on all fossil plants by 2018. Carbon taxes start at $10/ton in 2013 and escalate to $43/ton by 2030. 50% of allowances are auctioned. By 2025, 15% of electricity sales to customers with demand > 4000 GWH must be from renewables. Medium natural gas prices. Medium load forecast. • Greener Than Green – Even stronger support for environmental regulations. Command and control requirements of NSR and mercury MACT require SCRs and FGDs on all fossil units by 2015. Carbon taxes start at $40/ton in 2013 and increase with inflation. By 2022, 20% of all energy sales must be from renewables. Natural gas prices are very high. Low load forecast.

4. Illustrative Portfolio Strategies in These Scenario Worlds • Current Planning Case (Readjusted June) • No additional nuclear units beyond Bellefonte 3&4. New coal would be supercritical pulverized coal but would not be included until 2022. Natural gas CT and CC built as needed to economically meet growth. DSM ramps to 520 MW in 2012 and to 1200 in 2025. No additional renewables generation. Placeholder retirement of Johnsonville 1-10 in 2022 is assumed as input assumption. • Energy Independence • No additional clean air investments; least-cost compliance with RPS. New build focus is on coal and nuclear. No coal retirements assumed. • Booming Economy • No clean air investment on Johnsonville 1-10 but add controls to other fossil plants as needed for compliance; consider increased purchases from market; least-cost compliance with RPS. New build focus is on gas. Assumed retirement of Johnsonville 1-10 by 2022. • Green is Good • No clean air investments on Johnsonville 1-10 and Widow’s Creek 1-6 ; Add SCRs and FGD (or equivalent) to all other fossil units by 2018; acquire cost-effective renewables and buy credits for remainder of compliance; increase DSM to maximum 2000mw level. New build focus is on gas and nuclear. Assumed retirement of Johnsonville 1-10 and Widow’s Creek 1-6 by 2018 as input assumption. • Greener Than Green • No clean air investments on Widows Creek 1-6, John Sevier1-4, Colbert 1-5, Shawnee 1-10, and Johnsonville 1-10; add SCRs and FGDs (or equivalent) to all other fossil units by 2015; acquire as much in-Valley renewables as feasible and buy credits for remainder of compliance; increase DSM to maximum 3000mw level. New build focus is on nuclear or coal options with CCS. Assumed retirement of Widows Creek 1-6, John Sevier1-4, Colbert 1-5, Shawnee 1-10, and Johnsonville 1-10 by 2015 as input assumption.

7. Current Portfolio Strategy (Re-adjusted June) • Continue to purchase existing lower costing gas capacity given cash flow and rate increase restrictions • Continue with gas expansion for near-term capacity needs • Planned nuclear expansion limited to WB2 and Bellefonte 3&4 • Existing coal fleet is assumed to run over planning horizon with exception of placeholder retirement of one coal plant in 2022 • DSM and energy efficiency programs provide up to 1256 MW by 2027 (520 MW by 2012) • CO2 assumed at relatively low price and no caps • Balance supply/load to roughly 5% level

8. Peaking CT DSM (direct load control) Summer only market purchases Intermediate CC new build/acquisitions CC PPAs DSM (energy efficiency programs) Baseload Nuclear SCPC IGCC SCPC w/ CCS IGCC w/ CCS New Generation Options • Observations

9. Major Observations and Insights - 1 Demand and DSM • All new capital expenditures will increase the levelized cost of electricity due to higher capital costs -- the more additional capacity needed, the greater the impact. • Demand uncertainty has the largest impact on portfolio financial results -- high demand is bad • Optimum portfolio is very different under low and medium-low growth assumptions and is favorable financially compared to higher demand assumptions • DSM growth affects peaking/intermediate capital expenditures more than base generation • If we are able to project the need and timing of additional capacity, then average cost per unit can be reduced, but it is difficult to accumulate enough savings to fund new capacity Capacity Additions - Gas • Combined cycle (CC) gas-fired generation remains viable as intermediate capacity even with high gas prices ($12) • CCs dispatch reasonably well in various future worlds and can mitigate capacity factor and construction risks • CTs remain viable for peaking needs and are needed primarily for capacity

10. Major Observations and Insights - 2 Capacity Additions - Baseload • New coal without CCS looks economic (given limits to nuclear generation) in most worlds (if no CCS is required), and supercritical pulverized coal (SCPC) is preferred over integrated gasification combined cycle (IGCC) in all worlds • SCPC with CCS is never selected even in the extreme green world • Nuclear is not economical at $3500/kw, even if we retire fossil plants -- CC and SCPC are better investments at that construction cost • Nuclear builds are associated with more debt and lower average free cash flows through the study period, but higher residual value of the expansion portfolio at end of 2025 • Reliance on existing coal goes with lower debt and higher average free cash flow, given performance assumptions through 2025 • In most worlds, allowing more nuclear will reduce SCPC expansion --- nuclear picked except in low ($5) sustained gas prices CO2 • Green worlds (with high CO2 & renewable portfolio standards) increase effective rates significantly based on RPS cost, CO2 cost and % allocation. The main impact of CO2 prices is to increase wholesale power prices, resulting in load reduction. Net revenues for TVA’s non-emitting generation increase and remain positive for coal assets though declining with increased CO2 stringency. • A high price on CO2 provides a strong incentive to add non-emitting generation • TVA CO2 emissions are primarily reduced through coal plant retirement, and to a much lesser degree by the addition of low (gas) or non-emitting (nuclear) generation

11. Major Observations and Insights - 3 Existing Assets • Net revenues for existing coal remain positive across the range of assumptions • Assuming that three coal plant retirements are required as an input assumption (in certain worlds) indicates a need for 2-4 more nuclear and/or new SCPC units depending on load growth and CO2 assumptions • Forced retirements in today’s world is financially negative due to additional expansion costs ($10B range impact on TFO or 7% additional base rate increase needed) • In greener worlds, residual value of the expansion portfolio is much higher than in current world – with or without assumed coal retirements – driven by existing fleet dispatch against a much higher market price • Generator net revenues are more sensitive to natural gas prices than to CO2 prices (i.e. unit net revenues increase with higher gas prices and in turn market prices)

12. Risks • Load growth projections • Cost and timing of new construction • Future CO2 and environmental legislation • Gas prices • DSM and energy efficiency program MW impacts • Continued performance of existing asset fleet • Commitment to a single rate increase

13. Conclusions Over the next few years: • Continue with gas expansion for near-term capacity needs and pursue acquiring lower costing existing assets where financially feasible • Relative to capacity expansion, continue to maintain as much flexibility as possible --- keep options open with minimum expenditures (siting/permitting, DSM program exploration, Bellefonte licensing) • Increase emphasis around efficiency, conservation and TOU pricing that can impact demand and load growth rate • Delay decision and expenditures as much as possible for baseload expansion until load growth amounts and DSM contribution are better recognized • Continue operating existing coal assets and continue with the clean air control retrofit plan, including JSF and other projects as their implementation date approaches. • Continue to maintain or improve fuel diversity mix in TVA’s system portfolio to decrease risks • Continue to obtain the best estimates possible for determining cost of future construction

14. Portfolio Strategy Optimization Process • Develop framework for incorporating portfolio strategy optimization results into decision making process • Incorporate portfolio strategy optimization process as an ongoing part of the annual long term power supply planning process currently under review