By: John V. Tesoriero Vice President, Deputy General Counsel

STATUS, EFFECTS AND RATIONALE FOR FINANCIAL TRANSACTIONS IN ELECTRICITY MARKETS AND POSSIBLE EFFECTS ON MARKETS PRESENTED BY PROPOSED LEGISLATIVE AND REGULATORY CHANGES2009 Energy Bar Association Mid-Year Meeting, December 3, 2009 By: John V. Tesoriero Vice President, Deputy General Counsel and Senior Compliance Officer Louis Dreyfus Highbridge Energy LLC

Preliminary Note: Any views or opinions expressed in this presentation are mine alone and do not necessarily reflect the views of Louis Dreyfus Highbridge Energy LLC or any of its affiliates (“LDHE”). The materials herein are not the product of research conducted by LDHE and neither LDHE nor any of its officers, directors, agents or employees, make any warranty, expressed or implied, of any kind whatsoever, or assume any responsibility for any losses, damages, costs or expenses, of any kind of description, relating to the adequacy, accuracy or completeness of this material or its use. Neither LDHE nor I accept any responsibility to update any opinions or other information contained in this material.

Overview • Introduction – Common Financial Transactions in Electricity Markets (FTRs, Virtual Transactions, Swaps and Options) • Market and Consumer Benefits of Financial Transactions in Electricity Markets • Proposed Legislation Relating to OTC Derivatives and Potential Effects on Electricity Markets

I. Introduction - Common Financial Transactions in Electricity Markets • Financial Transmission Rights – congestion hedging • Virtual Energy Transactions – aka convergence bidding • Swaps and Options

Introduction – Common Financial Transactions in Electricity Markets A. Financial Transmission Rights arbitrage prices at different locations in the Day-Ahead Energy Market (DAM) in RTO and ISO Organized Markets B. Virtual Energy Transactions arbitrage price differentials between the DAM and the Real-Time Market (RTM) at one location in RTO and ISO Organized Markets C. Cash Settled Swap and Option Transactions are entered into bilaterally in OTC Markets or are cleared to a Clearinghouse (CME/NYMEX or ICE)

Introduction –Common Financial Transactions in Electricity Markets A. Financial Transmission Rights • TCCs, FTRs and CRRs (collectively FTRs) entitle their holders to collect or pay congestion rents between two points on an RTO/ISO system • FTRs exist in the five RTO/ISO markets which include both a DAM and a RTM, both of which settle as clearing price locational marginal price (LMP) markets • LMPs consist of three components: Energy, Losses and Congestion • FTRs settle on the DAM based on the difference of the Congestion Component at the Point of Withdrawal (POW) and the Congestion Component at the Point of Injection (POI)

Introduction – Common Financial Transactions in Electricity Markets A. Financial Transmission Rights • If the LMP/Congestion Component at the POW is greater than the Component as the POI, the FTR holder is paid this congestion rent (opposite is true for counterflow FTRs) • Question: Does this cash-settled transaction look like a “Swap” for regulatory purposes? (see later)

Introduction – Common Financial Transactions in Electricity Markets B. Virtual Energy Transactions • Virtual Energy Markets • Present in four eastern RTOs • CAISO will begin using these in 2011 • Virtual Supply Transactions (“Incs”) • Bid in the DAM • Virtual supply bids are accepted when lower than physical energy bids • Virtual suppliers receive DAM Energy price ($/MWH) at one location and pay RTM price at same location for same hour • Virtual supplies decrease DAM energy prices • Virtual supplies are profitable only when the DAM price is higher than the RTM price for the same hour at the same location

Introduction – Common Financial Transactions in Electricity Markets B. Virtual Energy Transactions • Virtual Load Transactions (“Decs”) • Bid in the DAM • Virtual load bids are accepted when higher than the otherwise applicable DAM clearing price • Virtual load must pay the DAM energy price at one location and receive the RTM price at the same location for the same hour • Virtual load transactions are profitable only when the RTM price is higher than the DAM price at the same location for the same hour • Virtual transactions tend to increase convergence between the DAM and RTM prices • Transacting market participants make money on virtual transactions only when they cause convergence • Question: Does this cash-settled transaction look like a “Swap” for regulatory purposes? (see later)

Introduction – Common Financial Transactions in Electricity Markets C. Swap and/or Cash Settled Option Transactions - Swap Transaction: a contract where parties agree to exchange periodic payments, with one party usually paying a fixed price with the other making payment based on a price determined by reference to an index or source to determine the value of an underlying asset (e.g. price of electric power or other commodity during the period) - Cash Settled Option Transaction: a contract which will make a periodic payment to the holder of the option if the reference price is greater (Call Option) or less than (Put Option) a fixed Strike Price during the term of the Option in exchange for the holder making a Premium payment - Collectively called “Swaps” - Types of Swaps Used in Power Markets: - Transactions entered into between Eligible Contract Participants in bilateral OTC markets for Exempt Commodities (metals and energy) not entered into a Trading Facility are exempt from CEA - Cleared Transactions done on electronic trading platforms between Eligible Commercial Entities in an exempted Commercial Market or on a Designated Contract Market - These transactions whether cleared or non-cleared clearly are “Swaps” for regulatory purposes

II.Market and Consumer Benefits of Financial Transactions inElectricity MarketsA. FTRs • Financial traders in the FTR markets add liquidity, competition and revenues to the markets. • Every time a financial trader wins an FTR, it does so by bidding more than others for an FTR. Absent these bids, there would be less competition for the FTRs and the auction revenues would be lower. • Lower auction revenues mean lower payments back to load serving entities or utilities—ultimately, this means lower revenue credits for customers. • See e.g., NYISO Attachment H—an automatic revenue-crediting mechanism for TCC auction revenues to reduce the Transmission Service Charge. • The NYPSC can reflect similar credits in establishing retail rates. • Cumulatively, financial traders add liquidity and competition to the market. • When FTRs are longer-term, this liquidity and competition will help to send more robust and accurate long-term price signals to help stimulate investment where and when needed.

II. Market and Consumer Benefits of Financial Transactions inElectricity MarketsB. Virtual Transactions • Virtual energy transactions arbitrage the difference between day-ahead and real-time prices and bring convergence between these markets • Virtual transactions add liquidity • Resulting convergence helps to reduce the day-ahead energy premium • Virtual transactions affect prices, but cannot be the basis for exercising market power • Virtual transactions are not profitable unless they bring convergence between the day-ahead and real-time markets • Virtual trading which would cause divergence opens up profitable arbitrage opportunities for other market participants which will arbitrage the divergence away • The financial market is returned to a competitive state

II. Market and Consumer Benefits of Financial Transactions in Electricity Markets C. Observations of Dr. David Patton (IMM for MISO and ERCOT and Market advisor for NYISO and ISO-NE • Virtual Trading - Virtual trading allows financial players to arbitrage the prices in the day-ahead and real time markets • When virtual traders profit, they cause day-ahead and real-time prices to converge. • Convergence is vital because the day-ahead market coordinates the commitment of generation and accounts for most of the short-term trading in the RTO markets. • The liquidity in the day-ahead market provided by virtuals also tends to mitigate attempts to raise prices by withholding supply or lower prices by under-purchasing. (Market Power Argument) • In liquid, well-functioning markets, the available arbitrage profits should be relatively low. • Virtuals can be used to attempt to manipulate day-ahead prices up or down, but this is mitigated by general market liquidity and the market is monitored for this conduct. [Note: Market participants consistently losing money on virtual transactions and creating divergence will stand out] • Note also – FTR/Virtual Transaction disgorgement rules in RTO/ISO Tarrifs. • FTR Trading Financial players play a key role in ensuring that FTR prices reflect their value (i.e., the entitlement to congestion revenue) • When financial players profit from the purchase of FTRs, they are causing the FTR prices to converge with the true value of the FTRs • Like the virtuals, as liquidity in the FTR markets increase, the arbitrage profits should decrease

Dr. Patton’s Diagram Regarding Midwest ISO FTR Profitability 2005 - 2008

Dr. Patton’s Diagram regarding Virtual Transaction Profitability in the Midwest ISO Market April 2005 to April 2007

II. Market and ConsumerBenefits of Financial Transactions inElectricity Markets C. Observations of Dr. Patton (Continued) 1. Arbitrage profits related to Virtual Transactions generally decreased from 2005 until near the end of 2008 as liquidity increased: - 2006 – 69 cents per MWh - 2007 – 43 cents per MWh - 2008 – 32 cents per MWh (actually negative after RSG cost allocation changes in November 2008) 2. Profits in FTR markets decreased after first year of operation as liquidity increased.

II. Market and Consumer Benefits of Financial Transactions in Electricity MarketsD. Question: What can happen when financial transaction markets are disrupted and become less liquid? - November 2008 – FERC hands down a Final Order allocating substantial portion of costs RSG costs to virtual suppliers and makes application of the decision retroactive back to September 2007. The result is virtual supply drops by 60% and cleared demand by 30% from pre November levels. (See MISO State of Market Report, page 40) • Fall 2008 – Spring 2009 - PJM, NEPOOL and MISO all have reduced virtual trading activity (likely a by product of the financial crisis) but MISO reductions are steeper and slower to recover - A total of 18 market participants defaulted and less than half of them return even after retroactive application of RSG Order is removed by FERC in May 2009 - All 18 had sufficient collateral to cover trading risk – retroactive imposition of uplift charges, (i.e. regulatory risk) caused defaults and impact still felt even after FERC remedied this on rehearing. • 2008 State of Market Report filed in July 2009 – MISO IMM comments: “While the virtual supply cleared for all participants has decreased by almost 60 percent, the amount cleared by the largest three participants decreased by more than 80 percent. These trends are cause for concern because active virtual trading in the day-ahead market promotes price convergence with the real-time market, which facilitates an efficient commitment of generating resources. In addition, active virtual supply protects the market against attempts to raise day-ahead prices by economically withholding physical generation or making excess load (or virtual load purchases. We filed comments with the Commission related to these findings and will continue to monitor these trends.” (2008 MISO State of the Markets Report p. 41)

II. Market and Consumer Benefits of Financial Transactions in Electricity MarketsD. Question:What can happen when financial transaction markets are disrupted and become less liquid? (Continued) • Potential Market Impact – There is significant evidence that regulatory uncertainty and prospect for higher costs of transacting does have a direct effect on virtual bidding activity (i.e. market participants reduce activity and/or drop out) and this has a demonstrable impact on DA Premium. (Seee.g. pp. 9-17 of Affidavit of Brian D. Tang, Exhibit 2 of Reply Brief of DC Energy Midwest LLC and Integrys Energy Services, LLC filed October 10, 2008 in connection with MISO RSG matter (Docket No. EL 07-86)). - Data shows a reduction in Cleared Virtual Supply Offers, an imbalance of Virtual Supply Offers to Virtual Bidding Offers and deviation in DA Premium at CIN Hub as RSG Proceeding went through different stages in 2006-2008 Conclusion: Market participation and liquidity is tied to cost and regulatory uncertainty in the marketplace to the possible detriment of the end users and rate payers

III. Proposed Legislation Relating to OTC Derivatives andPotential Effects on Electricity Markets A. Common Elements of the Proposals: - Mandatory Exchange Trading or Clearing of “Swaps” transactions between Dealers or “Major Swap Participants” - Definition of a “Swap” in House Financial Services Bill “SWAP.— "(A) IN GENERAL - Except as provided in subparagraph (B), the term ‘swap’ means any agreement, contract, or transaction that - "(iii) provides on an executory basis for the exchange, on a fixed or contingent basis, of one or more payments based on the value or level of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred, including any agreement, contract, or transaction commonly known as a[n]... commodity swap; or "(v) is any combination or permutation of, or option on, any agreement, contract, or transaction described in any of clauses (i) through (iv).” - Definition of a “Major Swap Participant” in House Financial Services Bill “Major Swap Participant" means any person who is not a swap dealer and “(i) who maintains a substantial net position in outstanding swaps, excluding positions held primarily for hedging, reducing, or otherwise mitigating commercial risk; or (ii) whose outstanding swaps create substantial net counterparty exposure (current and potential future) that would expose counterparties to significant credit losses that could have a material adverse effect on capital of those counterparties.” - Other versions of this focus on “net counterparty exposure that could have serious adverse effect on financial stability of this US banking system or financial markets”

III. Proposed Legislation Relating to OTC Derivatives andPotential Effects on Electricity Markets -Would provide express CFTC regulation of these participants and transactions (e.g. market manipulation and different legal standards) - Capital and Margin Requirements for trades whether Cleared or OTC (higher requirement than cleared trades) - Possible Large Trader Reporting and Speculative Position Limits for Significant Price Discovery Contracts - Required Transaction Reporting for non-Cleared trades - Certain Business Conduct Requirements - Limited End User Exemption relating to margin and reporting requirements

III. Proposed Legislation Relating to OTC Derivatives and Potential Effects on Electricity Markets • Stated purposes of OTC Derivatives Legislation - Increase Transparency of markets - Protect against Systemic Risk (so called “interconnectedness” concerns) - Control “Excess Speculation” in certain markets - Detect and deter Market Manipulation

III. Proposed Legislation Relating to OTC Derivatives and Potential Effects on Electricity Markets C. Some Questions and Unresolved Issues: - What is a “Swap” transaction? (Do FTRs and Virtual Transactions and other power market oriented products approved by FERC qualify?) - Issue of physical transactions (and bookouts) not going to delivery a “Swap?” - Scope of End User Exemption (The current trend is to narrow the exemption) - Are even small or mid-sized traders and marketers and other financial players going to be “Major Swap Participants” and thus subject to Capital Requirements, Reporting Requirements and Business Conduct Requirements? - Does this create an (unfair) advantage for End User Utilities as opposed to financial players? (FERC policy of Equal Access to Markets and Eliminating Barriers to Entry) - Are RTO/ISOs going to have to qualify as “Clearinghouses” or “Exchanges?” - What are the responsibilities and burdens associated with such a designation (costs to consumers)? - If not, will FTRs and Virtual Transactions have to clear to some other entity? - Potential Credit considerations of payments made for physical transactions vs. FTRs and Virtual Transactions being cleared somewhere else (issue of netting and bankruptcy considerations) - Bear in mind RTO/ISO Credit reforms made during 2007 and 2008

III. Proposed Legislation Relating to OTC Derivatives andPotential Effects on Electricity Markets C. Some Questions and Unresolved Issues (Continued): - Will there be speculative position limits imposed by CFTC? (see Significant Price Discovery Contracts based on LMP) - Do FERC Products now become subject to CFTC regulations for market manipulation and what is the impact of having two regulators applying different legal standards in one marketplace? Big Questions: • What impact will this have on regulated power markets? (Law of Unintended Consequences?) • How does the new regulation advance its stated goals in this context? - Transparency - Systemic Risk - Excess Speculation - Market Manipulation

D. Swaps Market and Typical Wind Farm Project Financing Structure With Hedging Developer/Borrower Lenders CreditAgreement Swap Agreement Pledge by Borrower in Favor of the Lenders Swap Providers • Sale of Energy: Developer/Borrower (the “Borrower”) sells energy to RTO/ISO (“RTOs”). There is no Power Purchase Agreement (“PPA”) in which to grant a security interest in favor of the Lenders. • Hedging Energy Price Fluctuations: Borrower hedges fluctuations in electricity prices by entering into a cap and a floor with a Swap Provider. Swap is a hedge on natural gas. If natural gas prices move above the cap price, Borrower pays Swap Provider. If natural gas prices move below the floor price, Swap Provider pays the Borrower. • Offset of Risk:Payments under the swap offset the increase or decrease in electricity prices because electricity prices track the natural gas market; the swaps replace the PPA when there is a shortage of liquidity in the PPA market.

D. Swaps Market and Typical Wind Farm Project Financing Structure With Hedging • Basic Assumption:Lender is willing to finance development but has a secured cash flow as protection depending on market prices and projected cash flow of the project Borrower. Questions: - What impact does this security device (or lack of availability thereof) have on pricing and feasibility of the financing? - Is there an additional cost of capital (for Lender and certain Borrowers) which needs to be factored in for new regulations and does mandated Initial Margin cost something that will need to be factored in to use OTC derivatives cash flow as a secured hedge? - Does the answer depend on whether project Borrower is somehow affiliated with a Major Swap Participant?

By: John V. Tesoriero Vice President, Deputy General Counsel