1 Department Policy on Hedging Paul G. Afonso, Chairman Massachusetts Department of Telecommunications & Energy March 31, 2004

2 Hedging __________________________________________________________________________________________ On October 9, 2002, the Department issued an Order regarding the implementation of a risk-management protocol for Massachusetts local distribution companies (“LDCs”) (Docket No. D.T.E A). The Order states that the D.T.E. will allow, but not require, Massachusetts LDCs to use financial risk-management instruments to mitigate natural gas price volatility.

3 Hedging (cont.) ______________________________________________________________________________________________________________________________________________________ LDC hedging proposals shall maintain the objective of volatility mitigation and price stability rather than the objective of procuring prices below indices. Hedging programs submitted for Department approval shall demonstrate the effect that the plan would have on the reliability and transparency of commodity price. In addition, such programs shall ensure fair competition in the gas supply market.

4 Hedging (cont.) _______________________________________________________________________________________________________________________________________ Customer participation in LDC hedging programs shall be voluntary, and not mandatory. LDCs shall allocate all costs associated with their hedging programs to program participants only.

5 Hedging (cont.) ______________________________________________________________________________________________ The use of incentive mechanisms in conjunction with LDCs’ financial risk- management programs shall not be allowed because the use of incentive mechanisms in conjunction with LDCs’ hedging programs

6 Hedging (cont.) ____________________________________________________________________________________________________________________________________ (1) would not be consistent with the Department’s goal of promoting market-based regulation and enhanced competition in that it would not “serve as a vehicle to a more competitive environment?” (2) could negatively affect the development of retail competition and customer choice in Massachusetts?

7 Hedging (cont.) ____________________________________________________________________________________________________________________________________ Approval of LDC risk-management proposals will be on a case-specific basis to ensure that any hedging proposal does not negatively affect gas unbundling and customer choice in Massachusetts.

8 Bay State Gas Company’s Gas Cost Incentive Mechanism The Department approved a gas cost incentive mechanism (“GCIM”) for Bay State Gas Company (“Bay State”) in an Order issued on December 5, 2002 (Docket No. D. T. E ). The GCIM will allow Bay State to utilize various financial instruments and trading strategies to lower the overall commodity cost associated with procuring natural gas for its residential customers for an initial three-year period.

9 Bay State Gas Company’s Gas Cost Incentive Mechanism (cont.) The Department notes that Bay State’s GCIM proposal represents the use of innovative portfolio management strategies to achieve lower gas supply costs for customers than is likely to occur under the currently used cost-based CGAC mechanism. The implementation of the GCIM shall be limited to residential customers only so as to minimize any negative effect that it might have on the development of a fully competitive retail market in Massachusetts.

10 Bay State Gas Company’s Gas Cost Incentive Mechanism (cont.) Bay State shall not hedge more than 25 percent of its residential portfolio. There shall be a 25 percent to 75 percent (“25/75") margin sharing between ratepayers shareholders if Bay State makes any “gains” from the GCIM. In case of a “loss”, Bay State shall absorb 100 percent of the loss without passing any of the losses to ratepayers.

11 Bay State Gas Company’s Gas Cost Incentive Mechanism (cont.) Bay State shall limit the financial instruments that it uses in its hedging program to futures and options products, and not over-the-counter (“OTC”) products. To recover any administrative costs associated with the GCIM program, Bay State shall submit a proposal in its next base rate filing to that effect, and demonstrate that customer savings from the GCIM exceed the level of administrative costs to be recovered.

12 NOTE: BAY STATE DID NOT GO FORWARD WITH THE DEPARTMENT-APPROVED GCIM, STATING THAT THE VOLUMES (RESIDENTIAL ONLY) WERE NOT LARGE ENOUGH TO BRING ABOUT ANY SIGNIFICANT MARGINS

13 KeySpan Energy Delivery’s Proposed Gas Procurement Practices The Department approved KeySpan Energy Delivery’s (“KeySpan”) proposal to change its gas procurement practices to mitigate price volatility for its customers in an Order issued on November 13, 2003 (Docket No. D. T. E ). For the winter of , the Company shall lock-in the price (equally over the twelve-month period) for all of its domestic non-storage gas supplies, equaling one- third of its projected normal winter requirements.

14 KeySpan Energy Delivery’s Proposed Gas Procurement Practices (cont.) KeySpan was authorized to use the NYMEX futures market but not financial derivatives.