Review of Entry Capacity and the Appropriate Allocation of Financial Risk Review Group th Sept 2008

Relevant Licence Conditions

3 Licence Conditions in respect of Entry Capacity Release  What are the obligations on National Grid to release entry capacity?  How does this relate to National Grid’s revenue?  How are any default quantities recovered?

4 Licence Conditions in respect of Entry Capacity Release What are the obligations on National Grid to release entry capacity?  Licence Special Condition C8D paragraph 9a*.  The Licensee shall offer for sale a volume of “unsold obligated entry capacity” calculated as  [0.9**] x baseline obligated entry cap +/- capacity substituted to/from the ASEP + previously released incremental cap – sold capacity.  Licence Special Condition C8D paragraph 9f*.  Incremental obligated entry capacity is released in accordance with the IECR methodology (NPV test) and subject to non-veto by the Authority of National Grid’s application which specifies whether the incremental capacity is  “ Funded incremental obligated”: usually but not necessarily requiring investment  “Non-incremental obligated”: released as a result of substitution. * See Licence for precise definitions ** 0.9 factor only applies where capacity is sold 18 months in advance. Otherwise factor is 1.0

5 Licence Conditions in respect of Entry Capacity Release How do capacity release obligations relate to National Grid’s revenue and charges?  Licence Special Condition C8B paragraph 3a* defines the maximum transportation owner “TO” revenue and includes an amount for the “base NTS TO revenue”, i.e. in respect of existing infrastructure, including that required for existing entry capacity.  Licence Special Condition C8C paragraph 3a* defines the maximum system operator “SO” revenue and includes an amount for the “SO entry incentive revenue and costs”. The incentive revenue is further defined in SpC C8D and includes revenue from the release of “funded incremental obligated entry capacity”.  Although TO and SO revenues are building blocks of transportation charges the charges are not defined in terms of TO or SO but in terms of commodity and capacity.

6 Licence Conditions in respect of Entry Capacity Release How do capacity release obligations relate to National Grid’s revenue and charges?  National Grid’s charges are determined in accordance with the Charging Methodology* and are set, consistent with other obligations (e.g. to be cost reflective), to recover the allowed revenue.  Where charges do not recover (e.g. in the event of Shipper default) or are not expected to recover (e.g. where auction revenues are lower than anticipated) the allowed revenue, adjustments may be made to charges. * A copy can be found on National Grid’s web site

7 Licence Conditions in respect of Entry Capacity Release How are any default quantities recovered?  When a Shipper defaults in respect of capacity held National Grid’s actual revenue will be lower than anticipated.  This capacity may be:  existing capacity; covered by the TO revenue stream; or  incremental capacity previously released and now in use; covered by the SO revenue stream; or  incremental capacity with a future release date; covered by the SO revenue stream.  Adjustments may be applied in two ways, depending upon when the under-recovery is identified and the quantity involved:  Revised charges may be set for the remainder of the year;  Any under-recovery can be made good through the “k” factor, i.e. it will be added to the next year’s allowed revenue.

8 Licence Conditions in respect of Entry Capacity Release How are any default quantities recovered?  Revision of charges within year will apply to commodity charges only;  Where the default relates to existing capacity (TO) only entry commodity charges will be revised;  Where the default relates to incremental capacity (SO) both entry and exit commodity charges will be revised.  Application of the “k” factor,  Where the default relates to existing capacity TO related charges will be revised: i.e. exit capacity and entry commodity;  Where the default relates to incremental capacity SO charges will be revised: i.e. entry and exit commodity.  Summary – impact falls solely on other Shippers.

Risk Scenarios

10 Risk Scenarios 1  What would happen if a User was unable to meet its obligation with regard to entry capacity?  Consider the following scenarios:

11 Risk Scenarios 2 – Incremental Capacity with Substitution A new ASEP is proposed and a Shipper triggers release of incremental entry capacity;  National Grid is obliged to make the capacity available.  National Grid will invest / substitute / neither (take the buy- back risk)  Substitution will be in accordance with the substitution methodology;  National Grid receives no revenue driver for incremental capacity released through substitution.  No additional revenue means that there is minimal impact on charges (even following shipper default).  Obligated capacity at the donor ASEP will remain at the reduced level.

12 Risk Scenarios 3 – Incremental Capacity without Substitution A new ASEP is proposed and a Shipper triggers release of incremental entry capacity:  National Grid is obliged to make the capacity available.  National Grid will invest / substitute / neither (take the buy-back risk)  If substitution is not possible National Grid will decide whether to invest in new infrastructure.  National Grid receives the revenue driver for 5 years.  This feeds into the allowed SO revenue calculation and hence charges. If the development collapses and the Shipper revokes its Licence and ceases trading:  National Grid may complete or terminate any investment works. This decision will primarily be based on the timing of the collapse of the upstream project.  After 5 years any investment, economically incurred, will enter the asset base.  This will be in the next price control period and subject to Ofgem approval.  Allowed revenue on investment feeds into charges via TO revenue.

13 Risk Scenarios 4 – Existing Capacity  A Shipper has rights in respect of existing entry capacity:  the Shipper revokes its Licence and ceases trading.  National Grid revokes capacity rights and is obliged to make that capacity available to other Shippers at future auctions (including daily auctions).  This capacity may or may not be re-sold.  Hence National Grid’s actual revenue from entry capacity sales may be lower than anticipated (it could also, but is unlikely to, be higher).  Any under recovery may be recovered through TO related charges in the existing year or the following year.  Annual adjustments may be required in respect of longer term capacity held by the Shipper.

Default risk in the current environment

15 Appropriate Allocation of Financial Risk Why is this an issue now?  The issue has existed for many years, but in a world of big players at established entry points it has not been evident.  The decline in UKCS supplies has led to development of numerous new storage and LNG importation projects.  Recent experience has provided that the developers of these projects:  are more likely to be “smaller” organisations; or  have only a single project, i.e. no other links to the regime.  Hence the developer is less tied to the regime and may find it easier to “walk away” if their project does not progress.  At best this exposes the relevant Shipper (through future transportation charges) to approximately 50% of the project cost. The remainder is picked up by all Shippers.  At worst, the relevant Shipper ceases activities and the entire cost is borne by other Shippers.

Options for application of potential solutions.

17 Options for application of potential solutions  The review group may determine that action is required to reallocate financial risk in respect of entry capacity liabilities.  Should new rules apply to both or either of:  current capacity allocations?  pending capacity allocations?  Should new rules apply to both or either of:  existing capacity allocations?  Incremental capacity allocations?

18 Options for application of potential solutions Options available for re-allocation of financial risk in respect of entry capacity could include: Existing CapacityIncremental Capacity All pending capacity obtained via future QSEC / AMSEC auctions Apply to pending incremental capacity triggered in future QSEC auctions (a). All pending capacity obtained via future RMSEC / DSEC auctions Apply to pending incremental capacity with a release date after implementation of proposals but triggered in an earlier QSEC auction (b). All current and pending capacity obtained via previous QSEC / AMSEC or short-term auctions Apply to current incremental capacity with a release date before implementation of proposals but where the QSEC auction bids that triggered release extend after the date of implementation (c). QSEC auction (option c) Changes implemented QSEC auction (option a) QSEC auction (option b) Capacity release option b Incremental Capacity – Relevant QSEC auctions for various implementation options Capacity release option c Time