© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 1 PMRE/BUET & UH IELE WORKSHOP Overview of Energy Value Chains Dhaka, Bangladesh. January 9-12, 2005

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 2 What is a “Value Chain?” The process of linking specific functions from input through output to delivery, enhancing the economic value of the final product Concepts – “business system,” “industry system,” “commodity,” “commoditization” The issue for energy – building value chains around dynamic commodity markets that require fixed infrastructure for liquidity

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 3 Generic Value Chain Source: Porter, 1985 “Overhead”

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 4 How Thinking Has Changed, I Source: Porter, 1985

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 5 How Thinking Has Changed, II Source: McKinsey & Company

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 6 Overhead? Or Assets? Source: McKinsey & Company

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 7 Applications to Energy Basis risk Supply-demand balances and price volatility Risk management Vertical integration Pricing and price transfers Implications for social welfare, public interest – role of regulation and commercial frameworks

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 8 Derivation of Basis Risk “Basis” Differential between cash/spot and nearest futures price as a result of time, product forms, quality, location “Basis risk”: Uncertainty as to whether differential will widen or narrow Production Transportation Distribution End Use

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 9 The Overall Challenge: Balancing the Market LOW Prices HIGH SUPPLYDEMAND Mean reversion is a reality if market- clearing participants exist

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 10 Price Volatility and Risk are the Trade Offs for Competition: Gas/Power Example with Open Access E&PPipelinesLDCsEnd UsersPower Commodity price risk flows Capacity price risk flows Risk accepting entities

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 11 Comparison with Other Industries Source: McKinsey & Company

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 12 Vertical Integration: Who Is Better Off? Source: McKinsey & Company

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 13 Vertical Disintegration

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 14 A Test of Strategies: Competition vs. Public Interest Source: McKinsey & Company

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 15 Vertical Re-integration Source: McKinsey & Company Who’s left??

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 16 A U.S. Illustration ca (U.S. EIA)

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 17 Why Oil is Different It is a global, fungible commodity –Dollar denomination reduces currency risk Transportation for both crude oil feedstock and refined products (and chemicals) is highly diversified End user products can be competitively priced in open, liquid markets Global risk management system well developed, deep, well financed, well understood

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 18 Global Oil Market Illustration Physical Market BilateralTenders Term Market Forward Deals Specific Market Spot Deals TendersBilateral Futures Swaps & Other OTC Formal Options Source: Oil in Asia by Paul Horsnell

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 19 Natural Gas: the Case of a Complex Value Chain

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 20 What is the natural gas business… …and how should it be regulated? Is it a competitive, upstream-driven business? Is it an economies of scale, monopoly midstream-downstream business that affects the public interest? How much of direct end use and conversion is competitive? If the goal is to build the “natural gas factory,” then policy/regulatory approaches need to facilitate value chain development – “commercial frameworks.” Where does most profit, value creation take place?

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 21 Building the Natural Gas Factory UPSTREAM Exploration and Production (E&P) MIDSTREAM Processing Storage Pipeline Transportation LNG Liquefaction Shipping Re-gasification DOWNSTREAM Distribution and End Use Residential Commercial Industrial Power Generation Transmission Distribution to End Use International Investor Goals Commercialize stranded natural gas production, by: Increasing diversity of midstream options Gaining access to downstream participation where supported by markets (“power the world with gas”) Export

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 22 Worldwide Natural Gas Business System Dynamics: Framework Issues E&P (LNG) Profit driven; ROR decision based on expected prices; monetize stranded reserves Power Gen Profit driven; ROR decision based on expected prices; fuel competition for generation Pipelines Transmission Regulated asset optimization; market rates? LDCs Regulated asset optimization; proximity to final customers (gas, power); market rates? End Users End use based on expected prices; access to competitive supply Benefits of Competitive Supply

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 23 Achieving Competitive Supply COMPETITIVE SALES Commodity Wellhead producers Third party wholesalers for gas Pricing Supply RESERVATION (DEMAND) Fixed cost of investment Return on equity, taxes, long term debt, A&G, DA, O&M COMMODITY (USAGE) Variable cost of operation O&M CONGESTION MANAGEMENT Pricing Transport, Distribution Capacity “Mean reversion” is a reality if market-clearing participants exist, but is often not captured in capacity pricing

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 24 Achieving Competitive Supply COMPETITIVE SALES Wellhead producers Third party wholesalers Pricing Supply The challenges: Entry of new suppliers Managing common pools Developing liquidity to establish location Protecting market transparency Dealing with third party wholesalers that are affiliated with regulated infrastructure Access for new supplies Balancing short term cycles and long term capital requirements for resource development

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 25 Regulated Infrastructure as the Conduit for Supply Competition RESERVATION (DEMAND) Fixed cost of investment Return on equity Taxes Long term debt A&G, DA, O&M COMMODITY (USAGE) Variable cost of operation O&M The challenges: Rate-making transitions Setting maximum allowable rates with market transparency Pricing new capacity Dealing with access for new capacity Determining contestable transportation markets Dealing with market power Balancing short term cycles and long term capital requirements for delivery Pricing Transportation, Distribution

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 26 Achieving Competitive Demand Wholesale Cost Retail Cost Margin Market Price Pricing Consumption Not to scale The challenges: Political will to allow wholesale price fluctuations to flow to retail users Price discovery and transparency Market structure (unbundling) Market power Market oversight Balancing short term cycles and long term capital requirements for delivery

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 27 The U.S. Case Pre-Natural Gas Restructuring PRODUCERS PIPELINESLDCs Locate + Produce Sell to Pipelines Aggregate Storage Sell to LDCs Purchase from Pipelines Serve End User FERC PUCs

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 28 The U.S. Case Post-Natural Gas Restructuring Marketers Gatherers & Aggregators Service Companies End Users Producers Storage Companies PipelinesLDCs Production Storage Services TransportDistribution AggregationGatheringMarketing Transport Services Capacity Brokering LNG Information Services Processing Risk Management FER C PUCs

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 29 U.S./Canada Natural Gas Value Chains Industrial Electric Generation (fuel, bulk market for power) Residential, Small Commercial Physical Bypass Interstate Pipelines “City Gate” “LDC” Transportation (pipe)Sales (commodity) “Unbundling” is the separation of transportation from sales (supply) to allow third party marketing with pipelines providing “open access” and comparable service to all shippers. Most Competitive Competitive Least Competitive Commercial Production Gathering Processing Intrastate Pipelines Often vertically integrated or affiliated

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 30 U.S. Case – How Well Is the Model Performing? Market Issues Transparency of price signals Price volatility Role of pipeline affiliates Demand response Problems in retail competition Supply security and capital to drill Policy/Regulatory Response Encourage market solution to price information No action (but debate) FERC Order 637 Under discussion Georgia re-bundling, absence of state programs Producer incentives and LNG

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 31 U.S. Case: Market Trade Off 1984 (Open Access)-2002 As unbundling for C&I customers proceeded, more cost behind the city gate is absorbed by residential.

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 32 Electric Power: the Case of Balancing a Dynamic System “We will make electric light so cheap that only the rich will be able to burn candles.” – Thomas Edison

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 33 …Electricity Industry Schematic Generation Transmission and Distribution End User PGCs

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 34 The Global View

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 35 Achieving Competitive Demand Wholesale Cost Retail Cost Margin Market Price Pricing Consumption Not to scale The challenges: Political will to allow wholesale price fluctuations to flow to retail users Price discovery and transparency Market structure (unbundling) Market power Market oversight Balancing short term cycles and long term capital requirements for delivery

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 36 RELIABILITY GENERATION TRANSMISSION WHOLESALE MARKET DESIGN Spot market: Pool? Bilateral contracts? Combo? Nodal? Zonal? Other? Congestion Management? ISO geography? For profit v Regulated? Access Rules? Price transparency? How to ensure the expansion of generation capacity with a “healthy” reserve margin? How to ensure the maintenance, expansion and reliable operation of the T&D system? Resource adequacy? Capacity payments? Capacity markets? Number of competitors? Or, market share? NATURAL GAS Stranded gas? © 2001 UH IELE

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 37 Transmission Issues Still searching for the right model that would efficiently: –allocate transmission capacity –maintain & expand the transmission system –manage congestion –arrange for ancillary services

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 38 Electricity Industry Value Chain

© 2005 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. 39 Customers are Reluctant to Switch Source: XENERGY research, state government agencies, January 2002