A Brief Review of New Institutions and Structures in the Electricity Industry

1. A Brief Review ofNew Institutions and Structuresin the Electricity Industry GEMI Power Conference Houston, Texas 29 June 2006

2. Agenda • Overview • Wholesale Markets • Retail Markets • Financial Institutions • Energy Trading • Conclusion Private & Confidential

3. Overview

4. Key questions • Who will develop an IGCC unit with a positive NPV over a 20-year horizon if investors have only a 5-year horizon? • Where do you build a new transmission line if costs cannot be recovered through regulated rates? • What good are smart meters if you still have dumb prices? • Why do we need new institutions and structures? Private & Confidential

5. A structure defined Structure (struk' chər) • Manner of building, constructing, or organizing • Something built or constructed, as a building or dam • The arrangement or interrelation of all the parts of a whole • Something composed of interrelated parts forming an organism or an organization Source: New World Dictionary What buildings are people organizing? What organizations are people building? Private & Confidential

6. IGCC financing requires mitigation of uncertainty Coal prevails – PC and IGCC are near parity IGCC with sequestration prevails Point where sequestration becomes economic IGCC Breakeven NGCC Wins Notes: 10% Cost of Equity Gas Prices can move to $6.8/MMBtu if the cost of sequestration is ~$25/ton We do not exactly hit $25 ton because IGCC must pay for 10% of CO2 it does not capture Chart does not show “grey area” where site-specific factors determine the winner Assumes no value for the CO2 sequestered Private & Confidential

7. Merchant Transcos (no rate base) are becoming bolder Western Interconnect Eastern Interconnect Private & Confidential

8. Recent studies support TOU meters/dynamic prices Energy Demand Under Variable Pricing (California pilot program results) Point where sequestration becomes economic IGCC Breakeven NGCC Wins Source: Ahmad Faruqui and Robert Earle, “Demand Response and Advanced Metering,” Regulation, Spring 2006. Private & Confidential

9. Wholesale Markets

10. Out-of-Market Actions Growing realization energy-only markets may not suffice DPeak Clearing Price Price set by demand The “missing money” = lost contributions to fixed costs for every plant Capped & Mitigated Price Price set by supply offer caps Peaker Intermediate Baseload Quantity Private & Confidential

11. Resource adequacy solutions • Proposed / Implemented Capacity Markets • New England • New York • PJM • Spain (structure similar to NE) • Netherlands (structure similar to NE) • Some type of Resource Adequacy Construct under discussion • Texas • California • Public Power Authorities • California (proposed, established and retired) • Ontario (proposed, established and operating) • Connecticut (proposed) • Other Market Designs Private & Confidential

12. Retail Markets

13. State electricity restructuring appears to be stalled Source: Energy Information Administration Private & Confidential

14. Industrial and commercial customers continue to purchase from energy-only providers Private & Confidential

15. Utilities offer green products in addition to their standard regulated offerings Private & Confidential

16. New distribution channels for energy efficiency services Private & Confidential

17. Financial Institutions

18. Financial services firms provide credit support “I’d say we spend as much time structuring credit as we do structuring energy” • Catherine Flax, JP Morgan "There are investors in this space, principally hedge funds, that will happily take the risk if the spread is attractive enough and if they're convinced that the underlying story is favourable." - Elad Shraga, Deutsche Bank Source: Duncan Wood, Risk Magazine, "Putting energy into credit," Dec. 2005 (Volume 18, No. 12). Private & Confidential

19. Financial services firms dominate top-rated dealers 2005 Rankings of Top Dealers Source: www.energyrisk.com, Rankings compiled by Glenn Leihner-Guarin, 2005 Data based on the results of a survey sent to more than 2,000 banks, brokers, energy users and traders worldwide. Voters were asked to nominate their top three counterparty dealers and top two brokers based on criteria that included keen pricing, flexibility, market making, reliability, integrity and speed of transactions. Private & Confidential

20. Private equity firms have more than $135 B in capital Private Equity Source: CRA Research, best estimates of size as of June 2006 Private & Confidential

21. More than 300 hedge funds in energy provide liquidity Source: CRA Research, best estimates of size as of June 2006 Private & Confidential

22. Energy Trading

23. Regulatory oversight focused on market manipulation FERC and CFTC Memorandum of Understanding (October 12, 2005) to coordinate requests and share proprietary information Stiffer penalties • Penalties: $1 million per day per violation • Felony vs. misdemeanor • Eliminates Principal/Agent defense New CFTC focus • Proposed legislation • CEA Reauthorization • Oil and Gas Traders Oversight • Natural Gas Price Transparency • Marketers must keep and provide records, even for exchanges exempt from regulation FERC compliance • Prohibition of Market Manipulation refines Market Behavior Rules • New regulations focused on fraud and scienter • Must maintain 5-year trading records FERC CFTC TRADER Private & Confidential

24. Existing trading structures drive compliance strategies Non- Discretionary Discretionary Rational Trader Model Process Model Rock Star Model Benchmark Model Ad-Hoc Systematic Private & Confidential

25. Current compliance models cannot identify market manipulation very easily Typical Mid-Office Compliance Model Execute Trades Review Trading / Marketing results for evidence of non-compliance Take appropriate action as dictated by policy Define Acceptable Trading / Marketing activities via Corporate Policy • Costly: Tens of millions of dollars • Questionable: Most traders believe they can stay ahead of the game -- this oversight does nothing to prevent them from executing an improper trade and very little to detect one after the fact • Incentives: Sets up a contest between highly motivated traders vs. intelligent mid-office staff • Potential for Failure: Most notable “blow-ups” have occurred in organizations touting “best in class” capabilities in compliance Private & Confidential

26. Alternative compliance models create a systematic approach to trading to preclude market manipulation “Systematic” Mid-Office Compliance Model “Acceptable Basis for Trading” Guidelines Capital / Risk Allocation Guidelines Execution Discretion Guidelines Compare Trades to Execution Guidance / Discretion Guidelines Define & Analyze possible Trading Protocols Execute Trades Approve Trading Protocols for Execution Generate Trading Guidance for Execution Take appropriate action as dictated by policy Private & Confidential

27. Large industry players are adopting systematic trading Private & Confidential

28. Black box trading -- thinking inside the box Silent dealers set deadly pace in derivatives trade By Martin Waller There is a phenomenon outside the industry called 'black box' trading, carried out by computer programs devised by brilliant mathematic minds TODAY marks the start of International Derivatives Week, at which participants from exchanges all over the world will gather in London. Yet traders accounting for more than half those markets’ volume will not be there. They will be at their desks as usual. These are not the overpaid and overworked dealers in derivatives. They are the algorithmic dealing programs that clinch bargains on exchanges . . . without any human input whatsoever. Source: Business Time Online, June 2006, http://business.timesonline.co.uk/article/0%2C%2C8210-2231867%2C00.html Private & Confidential

29. Conclusion

30. What’s Hot What’s Not – In Electricity HOT NOT • IGCCs in regulated rates • NGCCs on market rates • Smart meters • Dumb prices • PPAs • (Public Power Authorities) • PPAs • (Power Purchase Agreements) • LICAPs • Price caps • Of course we do financing • You need recourse financing • Credit-rating renegades • Credit-rating downgrades • MOUs on data exchanges • Unregulated exchanges • Market Manipulation Tools • Market Behavior Rules Private & Confidential

31. One Final Caveat “It must be remembered that there is nothing more difficult to plan, more doubtful of success, nor more dangerous to manage, than the creation of a new system. For the initiator has the enmity of all who would profit by the preservation of the old institutions and merely lukewarm defenders in those who would gain by the new ones.” • Machiavelli Private & Confidential

32. Tanya Bodell’s consulting practice focuses on various aspects of the energy industry, including the effects of government regulation on profit opportunities, particularly in the areas of competitive markets and environmental policy. Her work in trading and risk management spans all energy-related commodities, including tradebook valuation, portfolio optimization, and regulatory compliance. Her work in electricity includes design and implementation of competitive wholesale and retail markets, as well as strategic advice to the participants in those markets. She has also been extensively involved in the analysis and determination of damages in liability cases pertaining to the energy industry, including breach of contract, product liability, fraudulent conveyance, and bankruptcy proceedings. Ms. Bodell has a B.A. in Mathematical Economics from Pomona College and an M.A. in Public Policy from the University of Chicago. Tanya Bodell 200 Clarendon Street, T-33 Boston, MA 617-425-3364 tbodell@crai.com