Peter Fusaro Global Change Associates New York, New York 212-333-4979 global-change

1. State of Energy Trading & Markets After EnronEIM Conference Tarpon Springs, FloridaFebruary 24, 2003 Peter Fusaro Global Change Associates New York, New York 212-333-4979 www.global-change.com

2. GCA Products & Services • Books: • New York Times bestseller What Went Wrong at Enron (John Wiley, July 2002) • Energy Convergence (John Wiley, May 2002) • Energy Derivatives:Trading Emerging Markets (2000) • Energy Risk Management (McGraw-Hill, 1998) • Customized consulting for energy & financial service companies in energy & environmental risk management advisory, competitive intelligence and business strategy

3. Energy Market Changes • Evolution of Energy Trading: • Overview of energy trading • Energy futures and OTC trading • New market developments and instruments such as weather and emissions • The Enron disaster’s impact on markets • What’s to come

4. Evolution of Energy Trading • Historically high price volatilities for oil, gas and electricity • More volatility coming • Risk shifting not elimination: no silver bullet • More futures contracts failing • OTC markets in crisis • Electronic trading & price discovery

5. Historical Overview of Energy Trading • Need for viable cash markets: • crude oil • heating oil • gasoline • propane • fuel oil and bunkers • natural gas • coal • electricity

6. Historical Overview of Energy Trading • Exchange-traded Futures Contacts: • Transparency, clearing, and performance • Crude oil (Headline contracts) • Gasoline • Propane • Home heating oil • Natural gas (Benchmarks created) • Electricity • Coal

7. Historical Overview of Energy Trading • The Over-the-Counter Markets: • Flexibility & customization • Longer-term • No regulation, more risk • Forward Contracts • Price Swaps • OTC options • Current market collapse

8. Historical Overview of Energy Trading • Multicommodity Trading Takes Off: • Oil & Petroleum Products • Natural Gas • Electric Power • Emissions • Weather • Shipping • LNG • Coal

9. Energy is a Risky Business • The Risks: • Price • Fuel • Operational • Regulatory • Liquidity • Credit

10. Why These Tools Emerged • Oil, gas, power and emissions are now commoditized • Unprecedented price volatility • Coal becoming a commodity • Securitizes future sales and receivables • Energy price risk management becomes a fiduciary responsibility of energy companies

11. Why These Tools are Emerging • Deregulation, privatization and risk of competitive markets • Conservative industry on the brink of fundamental change • Financial leverage is now more important • More risk endemic in a market economy but more risk mitigation techniques now exist

12. Evolution of Power Trading • Energy Policy Act of 1992 • Long-term contracts die (10 to 20 years) • No building except IPP • Spot markets are created • Price discovery commences • NYMEX & others fail at creating futures • Financial instruments for power fail • Market breaks down in 2002

13. Evolution of Power Trading • Advantages of Merchant Power • Wholesale trading essential in deregulated markets • No retail load nor obligation to serve • Act like a trader • Greater arbitrage opportunities • Can turn off equipment • More flexibility • Cash flow becomes king

14. Evolution of Power Trading • Disadvantages of Merchant Power • No retail load (i.e. no cash flow) • Incumbent retail clients can be served and maintain cash flow • Market collapse: oversupply • Weather still the key variable • Too much financial leverage (debt)

15. Why is this Happening Now? • Greed and incompetence have to lead to market failure • Wrong incentives in place for traders • Quarterly profits and quarterly bonuses • Senior management knew: no rogue traders • Need for oversight both internally and externally • Replication of financial template throughout the energy complex: not just Enron

16. Why is This Happening Now? • Financial leverage became paramount • Hiding debt became the game • Lying became endemic • Perversion of financial engineering • The energy companies, banks, accountants, lawyers and regulators are all to blame • Government asleep at the wheel

17. Not Just Enron • Major energy market makers in gas, electric and bandwidth failed • More off balance sheet financing schemes to be further exposed • Arthur Andersen auditors replaced with rigorous scrutiny of MTM and other deals • More red ink to be disclosed in next 2 quarters • Market bottom coming

18. Rebuilding the Market • May take rest of the decade • NYMEX wins by doing nothing: oil and gas futures work, are regulated, and business as usual. OTC Clearing is a great success! • ICE in trouble, salvation is IPE • Liquidity crisis brewing: $90+ billion needed to shore up balance sheets • Potential power shortages in some areas of the US in the future

19. Rebuilding the Market • New gas-fired combined cycle turbines are not dual fuel capable (a new risk) • Loss of generation build out • Environmental compliance could be overridden by power shortages • Load growth still going up • Guess what: the digital economy uses power

20. State of Electricity Markets • The dispatch queue: nuclear, hydro & coal with gas for peaking • Microturbines as peakers • Distributed gen can’t get off the ground • Reserve margins are not a bad thing i.e. peak vs. off peak • Spark spreads now under water • Conventional wisdom in unconventional times does not work

21. The State of Financial Electricity • Too much price volatility: 1998, 1998, 2000, 2001 etc. • 2002: Collapse of financial trading • Result: real-time hourly market and next day market • Relaunch of electricity futures by NYMEX: • NYISO and PJM West • ISO indexes and ICE • Mark to model

22. The State of Electricity Markets • Little speculation • Supply balancing • Short-term oriented • Destruction of forward price curve • Price volatility continues (real-time commodity) • At least 2 more years to rebuild trading • Electricity becomes a “strategic commodity” just like oil; i.e. it will never be fully deregulated

23. Electronic Trading and the OTC Markets (Setback also) • Over 60 Internet energy platforms have failed • Over hyped and just starting to be used • The Internet is just one more marketing channel and information tool • Consumers are slow to change behavior

24. What’s left of Electronic Energy Trading and Exchanges • NYMEX ACCESS • Automated Power Exchange • Natural Gas Exchange (NGX) • Intercontinental Exchange (ICE) • TradeSpark • Where’s the EnronOnline business?

25. What’s To Come? • Supply balancing rather than speculative trading • Less trade volumes for gas as well • Weather derivatives: not a fungible commodity, really a reinsurance product • Movement to new markets • Green trading markets are real, government mandated and protected

26. What’s To Come? • Heavy heavy regulatory intervention in markets • FERC “Standard Market Design” is California all over again (economists and engineers can’t make markets) • Launch is September 2004 • Traders are much smarter than government regulators • More and honest financial disclosure necessary • Wall Street Banks are not energy companies and can’t replace the loss of liquidity

27. The Government Reaction • Investigations • FERC’s SMD (Sept 2004) and RTOs • State Commissions focused on wrong ball • CFTC is six months to a year behind markets • Overregulation is imminent • This will not produce one MW of power or one molecule of gas • No federal energy policy except bones to ethanol and coal lobbies

28. Environmental Market Evolution • Biggest financial challenge of energy industry • The Beginning: Today • Opaque prices • Little trading and poor liquidity • Few participants • Wide arbitrage opportunities and fat margins • Tremendous inefficiency • Regulatory uncertainty • Cross commodity plays with weather and coal

29. The Next Market: Environmental Trading • Environmental markets emerge (1995) • SO2 (volatility and options) • NOX in 1999 • CO2 (100+ trades and growing globally) • Bush moves on GHG are confusing • In North America, we make markets

30. The Next Market: Environmental Trading • GHG is ready to roll • Energy & agricultural industries are heavily impacted and have liabilities • CO2 trades already starting at state level and will be grandfathered in • Renewable portfolio standards in 14 states: started in Texas last year • Negawatt market under development

31. The Next Market: Environmental Trading • Green Trading markets may be $3 trillion market opportunity globally compared to $5 billion in SO2 and NOX trading today • A North American Market, European and Asian • Carbon is a fungible commodity just like oil, and therefore a global market is emerging with cross border opportunities

32. Bundling All the Risks: The Future of Carbon Trading • John Hancock Natural Resource Trade in Australia: • Reforestation Play • Water Play • Renewable Energy Play • Carbon Play • Real Estate Play • Backed by Zurich Re

33. Visions of the Future: Post Enron • The Emerging Trading World: • Energy hedging still in its infancy 25 years after first futures contract • Application of financial engineering to environmental structured and project finance • Globalization will accelerate trading solution (Rest of the world is hot about energy trading and risk management)

34. Visions of the Future: Post Enron • Enron’s loss mostly confined to gas and electricity • Loss of market maker and risk taker in gas and power (25-30% of gas markets) more significant • Largest gas & power market maker and others gone • Set back for energy hedging for at least two years for gas and power

35. Visions of the Future: Post Enron • More physical vs. financial trading especially for power devolving • Opportunities in coal, emissions, and oil trading • Loss of EnronOnline • Loss of aggressive deregulation advocate

36. Visions of the Future: Post Enron • Deregulation politicized and dead (i.e. Gray Davis in California) • More regulation coming in energy and financial markets • Don’t meet more laws, need proper enforcement • More financial disclosure • Markets work, Enron didn’t

37. Visions of the Future: Post Enron • Debunking of all Enron/McKinsey propaganda: • Asset light • Disintegration of energy industry • Telecommunications bigger than energy • Virtual utility • Etc., Etc. Etc: Common sense is important!

38. Visions of the Future: Post Enron • The loss of responsibility in the energy patch • Phantom trading • Sleeving • Market manipulation • Bonuses not tied to real financial performance • Traders are too young, arrogant and stupid to have this much responsibility • Risk controls are preeminent: market-to-market windows based straight through processing • Volatilities are growing

39. Visions of the Future: Post Enron • More volatility coming due to cancellation of projects • Companies in trouble: AES, Calpine, Dynegy, CMS, Panda, Mirant, Williams, Reliant, Aquila and others to join the list • Movement back to coal due to increased gas production and deliverability problems • Create more emissions activity • More consolidation: Bigger Globalized Utilities and Big Oil Waiting in the Wings

40. Visions of the Future: Post Enron • Heavy handed government regulation and investigation underway • Strangulation of markets in the near-term • FERC and SEC will lead the charge • Only the Fed can protect the financial markets • Death of the financial electricity market is not overstated • Liquidity crisis brewing: migration of OTC gas to NYMEX accounts for doubling of volumes in past year and now NYMEX has OTC Clearing

41. Visions of the Future: Post Enron • Accelerating energy market consolidation • Wellhead to wires: Big oil learns the power business slowly • European and to a lesser extent Japanese & Korean utilities enter the US market • Fewer global players with mega portfolios of generation assets (70,000 -100,000 MW) • Energy will always be an asset heavy business

42. Visions of the Future: Post Enron • More volatilities coming and more cross commodity arbitrage: • emissions and coal • emissions and weather • coal and other fuels

43. Visions of the Future: Post Enron • The markets will be rebuilt • Talent will migrate from energy trading to environmental trading • Financial controls will be better • Less liquidity in all markets now • Accelerated consolidation and globalization