Sutton Bridge Project

Contractual Innovation in U.K. Energy Markets

U.K. Power Market

Generation Transmission Distribution

& Supply

U.K. Power Market

Gas Supply

• Eastern Group

• Enron

Gas Transmission

• National Transmission System (Transco)

Power Generation

• National Power plc

• PowerGen plc

• British Energy

• Eastern Group

• 40 other licensed Generators

Transmission

• National Grid Co.

Distribution & Supply

• 12 Regional Electric Co.s (Eastern largest)

Pool Pricing

• 1 Day = 48 half hour periods

• Everyday by 10 A.M. Generators submit schedule for next day

Periods Generator Power MW Price GBP

1 PowerGen 10 15

British Energy 7 15.25

Eastern 2 15.50

2

…

48

Pool Pricing

• National Grid Co. forecasted daily demand based on historical models

• Everyday @ 4 P.M. Pool Price is announced.

Periods Generator Power MW Price GBP Demand

1 PowerGen 10 15 15

British Energy 5 15.25

Eastern 2 15.50

2

…

48

Pool Purchase Price

• The cost of marginal generator is “System Marginal Price” (SMP)

• 𝑃𝑃𝑃 = 𝑆𝑀𝑃 + 𝐶𝑎𝑝𝑎𝑐𝑖𝑡𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

• Capacity payment reflect the projected tightness of supply

Pool Selling Price

• Consumers pay “Pool Selling Price”

• 𝑃𝑆𝑃 = 𝑃𝑃𝑃 + "Uplift" 𝐶𝑜𝑚𝑝𝑜𝑛𝑒𝑛𝑡

• Uplift component reflected the cost of maintaining the system.

• Uplift added fairly constant 8% to the PPP.

• In 1995-96

SMP PPP PSP

£ 19.40 per MWh £ 23.86 per MWh £ 25.90 per MWh

Volatility in Electricity Prices (PPP)

• Given the pool mechanism electricity prices varied every half an hour.

• Prices fluctuated in response to variety of short-term, seasonal and long term factors.

• Prices also varied due to variations in fuel prices.

• Weather, plant failures, plant utilization rates

• Volatility (Standard Deviation) as of Nov, 96 – Daily 654%

– Weekly 232%

Volatility in Electricity Prices (PSP)

• RECs bought power from pool at volatile PPP and sold to consumers at less volatile PSP.

• Hence RECs were exposed to fluctuations in power prices.

• Power traders like Eastern and Enron faced with the challenge and the OPPORTUNITY of rapidly changing and volatile markets.

• As it is not possible to store electricity the forward contracts were also highly volatile.

Changing Scenario

• Ongoing regulatory and political discussions about how to set pool prices, both Enron and Eastern believed that strategic benefits of early involvement in power & gas markets were substantial.

• Hence both were committed to the markets.

U.K. Natural Gas Market

• Transco managed National Transmission System (NTS).

• 50 gas suppliers or marketers

• Unlike electricity gas can be stored.

• Gas prices were set daily (not half hourly).

• Hence gas prices were much less volatile.

Correlation Between Gas & Electricity Prices

• Gas was used for purposes other than electricity generation.

• Electric power prices were set by the cost of marginal power producer, which didn’t use gas as a fuel.

• Hence correlation between gas & electricity prices was weak. (0.1 at daily level, 0 on monthly level)

The Eastern Group

• Formal role as a REC

• Pursuing diversification strategy to combine gas supply with gas-fired electricity generation to arbitrage between the two markets.

• Eastern acquired generation unit (6000 MW) when Office of Electricity Regulation (OFFER) did a forced divestiture of coal fired plants.

Enron Corporation

• One of the world’s largest integrated natural gas and electricity companies.

• Enron’s Asset Development Group had expertise in tacking complex power projects globally.

• Six units: – Enron oil & Gas – Enron Gas pipeline group – Enron Ventures – Enron International – Enron Renewable Energy Corp – Enron Capital and Trade Resources

Sutton As a Traditional IPP

• Project Co. which keeps the asset off their balance sheet.

• Assemble a “contractual bundle” to mitigate the project’s risk.

• EPC contract – to build the plant as specified and for a set price and by a certain date.

• Operating and maintenance contract – physical operations.

• Gas supply agreement • Power purchase Agreement

Alternative Proposal

1. Why is Eastern interested in getting additional generating capacity?

• Transformation into an integrated energy company competing in deregulated environment : to provide the entire value chain for electricity.

• Sensed opportunities for rapidly changing gas markets: to create a diversified energy company.

• Consistent with its desire to arbitrage between gas and electricity markets on a daily basis.

Q2

• How would you characterize Eastern’s option under the CTA? When is this option valuable? What happens when gas is priced at GBP 1.25 MMBtu and electricity is priced at GBP 25 per MWh? What happens when gas is priced at GBP 2.50 MMBtu and electricity is priced at GBP 15 per MWh?

Q3

• Should Enron sign the CTA with Eastern, build the plant, or do both? What risks will it face if it does one or the other, but not both? – Risks involved in building the plant alone 1. Price/cost differential between PPP and gas + operating

expenses going negative rendering the plant useless. 2. Technological innovation may lower the cost of power

generation in the industry. 3. Difficult to find counterparties who will sign long term PPAs 4. Project cost overrun, delays.

• Other risks 1. Environmental safety from plant. Regulatory approvals. 2. Financial risks

Q3

• Risks involved in CTA with Eastern 1. When Price/cost differential between PPP and gas + operating

expenses goes positive, Eastern will use the virtual plant or they will exercise the option. Enron without the physical plant will make a loss in this case.

2. Enron’s traders could construct a “hedge” using the physical plant to offset the Eastern CTA.

3. With physical plant Enron will also have the right to exchange gas for power poll proceeds.

• CTA with Eastern provides Enron the annual payments of 68.8 million GBP. This will cover all fixed costs, debt service requirements and a minimum return on equity for the actual plant.

Q4

• How does Enron make money in this deal? What happens if it builds the physical plant, but never uses the plant? How likely is Enron to use it?

Thank You!