Integration of Physical and Financial riskin Australia’s National Electricity Market

Les HoskingManaging Director and CEO

NEMMCO

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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

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Pool

R R

G G GG

NEM Design – Gross Pool

•All prices via pool

•Compulsory

•Competing generators

•Energy only

•Marginal price setting

•Volatile $-1k to $10k

•Competing retail

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

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Contract at $40/MWh= ($100 – $40) x 100MW= $6,000 per hour

Retailer Generator

NEMMCO

Gross Pool / Contract Market- Settlements

Energy $10,000Energy $10,000

NEMMCO

Retailer buys 100MWhGenerator supplies 100MWhSpot price determined as $100/MWh

Settlement = $100x100 =$10,000 per hour via NEMMCO

$6,000 Banking System

NEMMCO Circular cash flows Volatile cash flows 33 day settlement High prudential

requirements Credit default risks One retailer has failed

Gross Pool – financial inefficiencies

Retailer Generator

NEMMCO

Energy $10,000Energy $10,000

$6,000Banking System

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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

NEM Outstandings History

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$0

$1

$2

$3

2003 2004 2005 2006 2007 2008

Billi

on $

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

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NEMMCO

Mechanics of Reallocation

Reallocate $10,000 Reallocate $10,000 Energy $10,000Energy $10,000

Retailer buys 100MWhGenerator supplies 100MWhSpot price determined as $100/MWh

Settlement = $100x100 =$10,000 per hour via NEMMCO

Reallocation of 100MW between Generator and Retailer which is valued at $10,000

Retailer Generator

$4,000 Contract at $40/MWhStrike value paid direct= $4,000 per hour

Banking System

NEMMCO

Growth in Reallocations - MWh

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0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2006 2007 2008

% Energy Reallocated (MWh) vs Total Customer Energy

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

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Retailer Generator

NEMMCO

Reallocation by Formula

Reallocate $6,000

Reallocate $6,000 Energy $10,000Energy $10,000

Retailer buys 100MWhGenerator supplies 100MWhSpot 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

Contract at $40/MWh = ($100 – $40) x 100MW= $6,000 per hour

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

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Retailer Generator

NEMMCO

Futures Offset Arrangement

Energy $10,000Energy $4,000

Futures Exchange

ClearingParticipant

Positive margins

$6,000

Futures Contract

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

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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