Energy Risk Management Seminar New York April 5, 2001

Energy Risk Management Seminar New York April 5, 2001 Discussion Highlights Recent Influential Events -- California Crisis Hedging Volatility Developing a Risk Management Program Developing an Execution Strategy

Recent Influential Events The California Crisis

Energy Risk Management Seminar New York April 5, 2001 California Crisis Conditions NYISO Conditions 1. Demand increasing faster than supply 2. Forward price not supportive of new build 3. No recent power plant development 4. Limited new development expected in short term 5. Long lead time to develop large generating facilities (3-5 years) 6. Excessively restrictive environmental rules 7. Price caps 8. Utility objective to beat index 9. Illiquid market 10. Threats to take over generators by state authority 11. Majority of load primarily unhedged          

Hedging Volatility

Energy Risk Management Seminar New York April 5, 2001 Hedging Volatility Hedging –Specific objective driven –Offset by position –Reduces volatility exposure –Reduces likelihood of large losses/gains –Stable expenses Speculating –Profit driven –No offsetting position –Volatility driven –Increased likelihood of large losses/gains –Full spectrum-- from home run to bankruptcy Doing nothing is a decision - you are choosing to speculate on the direction of energy prices

Energy Risk Management Seminar New York April 5, 2001 PJM On-Peak Energy Clearing Price April 1, April 1,

Energy Risk Management Seminar New York April 5, 2001 NYMEX Natural Gas– Daily Settlement ?

Developing a Risk Management Program

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Determine Objectives –Lock in margins –Meet budget and earnings expectations –Increase financial flexibility/ lower cost of capital –Develop growth strategy with price certainty –Focus on Core Business –Ensure financial health –Disaster Insurance –Equalize cash flows –Reduce rate payer exposure –Increase stock price –Capture existing imbedded optionality in contract to maximize value –Secure requirements at better than index

Energy Risk Management Seminar New York April 5, 2001 Quantify Exposure –Analyze existing portfolio: Power: Gas: Load Volume Generation Gas in Storage IPP/supply contracts Supply contracts Financial hedges Financial hedges Other hedges (pump storage, TCCs, Fuel Adjustment Clause) Other risks (Unit outage exposures, sensitivity to weather) –Analyze exposure characteristics Price exposure passed through Political risk threshold Shape of exposed profile Elasticity: impacts of a price increase Developing a Risk Management Program

Energy Risk Management Seminar New York April 5, 2001 Assess Management’s Risk Tolerance and Style –Percentage to hedge –Risks to hold to keep prices low (basis, ICAP, shape) –Threshold levels –Risk appetite/view of selling optionality to reduce prices –Importance of maintaining benefit in a low price environment –Sophistication level –Physical Pricing Strategies (Imbed Options) –Organizational cost structures (budget limitations) Developing a Risk Management Program

Energy Risk Management Seminar New York April 5, 2001 Determine Implied view of market –Up, down, or neutral Understand Available Instruments– (See product descriptions) –Swaps – fixed price, basis, spreads –Options – calls, puts, collars –Combinations/ Exotics –Swaptions, Double-Ups/Downs, Extendables, Digitals, Three Way Collar Developing a Risk Management Program

Energy Risk Management Seminar New York April 5, 2001 Swap Characteristics: – Provides 100% protection against price risk exposure – Known future price – No benefit if price moves in your favor – Can maintain existing physical arrangements Market Price Fixed Price Market Price (Index) Energy End User Supplier

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Swap Inferior Superior Market View Volatile Very Bearish Bearish Neutral Bullish Very Bullish Market Swap Enron pays End user End user pays Enron

Energy Risk Management Seminar New York April 5, 2001 Upfront Fee When market price > strike, customer exercises option. Enron pays customer the difference between market and strike (financial) Energy Floating Market Price (NYISO DAM Index or L3D) Cap--To hedge energy requirements End User Supplier Characteristics: –Provides 100% protection from a rise in prices above the strike. –Guarantees worst case scenario and still maintain potential to benefit from low price environments –Can be tailored as “disaster insurance” (high strike and low upfront premium) –Option can be customized, i.e., daily ahead, monthly, automatic exercise, averaging –Can be structured physically or financially

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Cap Inferior Superior Market View Volatile Very Bearish Bearish Neutral Bullish Very Bullish Market Cap Enron pays End user End user pays Market Price Hedge Payout Hedge Performance

Energy Risk Management Seminar New York April 5, 2001 Collar: To hedge load Market Price in Excess of Upper Band Energy Market Price (Index) Market Price shortfall of Lower Band Characteristics: –Provides a hedge against adverse price move at the upper band. –Receives 100% of a price dip to the lower band.. –Can be structured with no upfront fee. –Guarantees worst case scenario and limited upside potential. –Can be customized: physical, financial, daily, monthly, average Supplier End User

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Collar Market Collar Enron pays End user End user pays Enron End user pays Market Price Hedge Payout Hedge Performance Inferior Superior Market View Volatile Very Bearish Bearish Neutral Bullish Very Bullish

Energy Risk Management Seminar New York April 5, 2001 Characteristics: –No upfront fee –Provides 100% protection at the strike price. –Guarantees worst-case scenario but still maintains ability to participate in favorable price move. –Customize percent participation by adjusting strike price Participating Swap Adjustable Fixed Price Market Price Energy Market Price (Index) End User Supplier

Energy Risk Management Seminar New York April 5, 2001 Inferior Superior Developing a Risk Management Program 50% Participating Swap Market 50%Participating Enron pays End user End user pays Enron (effectively shares in 50% of benefit below strike) Market View Volatile Very Bearish Bearish Neutral Bullish Very Bullish Hedge Payout Hedge Performance

Energy Risk Management Seminar New York April 5, 2001 Determine Customized Strategy –Swap Program: exclusively use swaps, increasing lock in commodity price as it falls (with upper threshold) –Options Program: exclusively employ options, maintain upside potential, pay upfront fee as in insurance –Portfolio Program: i.e. diversify products in strategy to obtain optimal performance –Active Hedging Program: monitor market and make continuous adjustments to maximize performance Developing a Risk Management Program

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Match objectives to strategy Hedging ObjectiveStrategy Disaster ProtectionBuy Calls Cash Flow SmoothingBuy Collar Strategic/ Project HedgeBuy Long Term Swap Hedge Gain MaximizationVarious Combinations of Derivatives

Energy Risk Management Seminar New York April 5, 2001 Developing a Risk Management Program Match strategy to exposure Least expensive Most expensive Highest RiskLowest Risk Flexible Shape Profile: Swap coverage based upon self-shaping, with minimum percentage of peak applied Fixed Profile Coverage: Swap coverage based on fixed profiles for on- peak and off- peak days and various temp. categories Full Load Following: Swap coverage based on actual usage Blocks of Energy: Go long or short “fringe” areas. Swap coverage based on fixed quantity throughout coverage period Load Growth Option: Fix costs for given volumes. End user can increase coverage at any time, according to contract terms

Developing an Execution Strategy

Energy Risk Management Seminar New York April 5, 2001 Developing an Execution Strategy Identify Market Difficulties –Illiquidity Cannot execute large size Cannot deal (even moderately) without moving market NYISO price revisions Limited financial products actively traded –Operational Risk Unit trips not within control

Energy Risk Management Seminar New York April 5, 2001 Outline method of Price Discovery –Small group of counterparties (confidentiality) –Enron-on-Line (EOL) Select a reliable counterparty –Understand that risk management is a dynamic, iterative process that requires a certain level of expertise –Work with Enron to gain market knowledge Newsletters EOL –Best time to execute transaction Market flows Unit outages Weather conditions Developing an Execution Strategy

Energy Risk Management Seminar New York April 5, 2001 Determine Execution Strategies Given Market Limitations –Quiet execution –Enron-on-Line –Work with Enron to develop parameters Understand market conditions and product availability Lay out buying program – dollar cost averaging. Set up targets to execute and thresholds as stop loss targets Determine who has authority to transact Obtain necessary approvals, so as not to miss market opportunities Ensure documents are complete –Include alternate hedging products in portfolio Weather hedges Heat rate swaps/ Btu swaps (link to gas price) Unit contingent outage option Developing an Execution Strategy

Questions?