Integration of Physical and Financial risk in Australia’s National Electricity Market

1. Integration of Physical and Financial riskin Australia’s National Electricity Market Les Hosking Managing Director and CEO NEMMCO

2. Presentation – Overview • NEM design- gross pool and contract market • Settlement inefficiencies • Risk management processes • Reallocation- offset spot with • contract payments • Futures payments • Central clearing- Objectives/Issues

3. NEM Design – Gross Pool • All prices via pool • Compulsory • Competing generators • Energy only • Marginal price setting • Volatile $-1k to $10k • Competing retail G G G G Pool R R

4. NEM Design – Contract Market • Risk management for Retailers requires • Contracting around compulsory gross pool spot market • Direct generation investment (vertical integration - gentailer) • Demand side control • Contracts can take the form of contracts for differences, hedges, swaps or futures • Via bilateral, brokers and exchange traded futures • Concerns over financial market liquidity • Vertical integration (gentailers) • Beyond Q2 2010 climate change uncertainty • Futures contracts strong but not in all locations

5. Energy $10,000 Energy $10,000 Gross Pool / Contract Market- Settlements NEMMCO Retailer buys 100MWh Generator supplies 100MWh Spot price determined as $100/MWh Settlement = $100x100 =$10,000 per hour via NEMMCO NEMMCO Retailer Generator $6,000 Contract at $40/MWh = ($100 – $40) x 100MW = $6,000 per hour Banking System

6. Energy $10,000 Energy $10,000 Gross Pool – financial inefficiencies NEMMCO • Circular cash flows • Volatile cash flows • 33 day settlement • High prudential requirements • Credit default risks • One retailer has failed NEMMCO Generator Retailer $6,000 Banking System

7. Prudential Management • Risks from large volatility in price • Risks from rapid payment obligations • Largest retailer (20% of NEM) with spot price at $10,000/MWh will increase exposure to NEMMCO at $1Million per minute • Risk of non payment covered by bank guarantees with NEMMCO • NEMMCO typically holds $1.5Billion to $3.5Billion in bank guarantees • Level of guarantee (Max Credit Limit) driven by energy traded, average price and price volatility • Daily review of participant exposures • Rapid payment requirements when near limits • Default then suspend if obligation not met • Rapid retailer of last resort required

8. NEM Outstandings History

9. Reallocation- Offset spot with contract payments • Option to offset the credit from one party (generator) in MW or $ against the debit from another (Retailer) - in line with their financial contract position • Slow to be taken up by participants • Confidentially concerns • Counterparty credit issues

10. Energy $10,000 Energy $10,000 $4,000 Mechanics of Reallocation Reallocation of 100MW between Generator and Retailer which is valued at $10,000 Retailer buys 100MWh Generator supplies 100MWh Spot price determined as $100/MWh Settlement = $100x100 =$10,000 per hour via NEMMCO NEMMCO NEMMCO Reallocate $10,000 Reallocate $10,000 Retailer Generator Banking System Contract at $40/MWh Strike value paid direct = $4,000 per hour

11. Growth in Reallocations - MWh

12. Reallocation by Formula • NEMMCO is moving towards reallocation by formula • Effectively allows parties to settle derivatives via NEMMCO and net against physical spot settlement • Requires licence/exemption from Securities Regulator ASIC

13. Energy $10,000 Energy $10,000 Reallocation by Formula Retailer buys 100MWh Generator supplies 100MWh Spot price determined as $100/MWh Settlement = $100x100 =$10,000 per hour via NEMMCO Reallocation of 100MW swap between Generator and Retailer which is valued at $6,000 NEMMCO Reallocate $6,000 Reallocate $6,000 Retailer Generator Contract at $40/MWh = ($100 – $40) x 100MW = $6,000 per hour

14. Futures Offset Arrangement • Investigations into using positive margins from futures contracts flowing to NEMMCO • Has strong upside price stablising effect for retailers • Risks need to be understood • Complex under insolvency • Complex in segregation of accounts in clearing participant and potentially clearing house

15. Energy $4,000 Energy $10,000 Futures Offset Arrangement Positive margins Futures Exchange NEMMCO Clearing Participant $6,000 Futures Contract Generator Retailer

16. Central Clearing – Objectives/Issues • Shorten settlement cycle in the NEM • Align settlement times of all products • Data on amounts owing and to be paid fed to Central Clearer • A single party takes responsibility to clear all products • All payments made to Central Clearer • Prudential regime managed by Central Clearer • Central Clearer to be responsible to address defaults and “remove” defaulting parties • Synergy with market operation functions • Acceptance of compulsory central clearer by participants

17. Conclusion ISSUES • Gross Pool Challenges • vertical integration • liquid Financial markets • Settlement Inefficiencies • offset spot/forward difficulties • protracted settlement cycle • credit squeeze • Central Clearing • outsourcing issues