1. Entry Capacity Substitution Workshop 5 – 5 th December 2008 Review and Options for Development

2. Agenda  Recap of substitution benefits and impacts  Impact on entry capacity charges  Reserve prices  Incremental step prices  Potential options for substitution

3. Substitution Benefits  Maximise use of existing Transmission network assets for the benefit of consumers.  Avoid both capacity sterilisation and unnecessary infrastructure investment while accommodating changing flow patterns.

4. Substitution Impacts  Substituting capacity to recipient ASEPs to meet incremental capacity requirements will impact on prices paid for capacity at those recipient ASEPs in exactly the same way as if requirements are satisfied through investment (i.e. in the absence of substitution).  Substituting capacity away from donor ASEPs will reduce the reserve price at the donor ASEP (all other things being equal).

5. Substitution Impacts  To trigger incremental capacity at an ASEP where capacity has been substituted away will have minimal impact on the prices that would have to be paid. Therefore the main impacts are:  For long term capacity projects that are economically able to trigger incremental capacity, the potential default lead time of 42 months and the need to provide the necessary User Commitment.  For short term players there may be a greater reliance on the 10% of baseline capacity that is held back to the shorter term. However, this is supplemented by availability of additional capacity through Transfer and Trades and discretionary release.  For marginal gas fields, there may also be a greater reliance on the 10% of baseline capacity.

6. Substitution Example – Prices Reserve Prices (and step prices for incremental entry capacity) are a function of the obligated capacity level. Hence, substitution will generally decrease the P 0 price at donor ASEPs; and Release of incremental entry capacity will generally increase the P 0 price at recipient ASEPs. Revised obligated levels / prices apply from the applicable quarter/month, i.e. from month 42. The assessment undertaken is highly simplistic and ignores all other effects, e.g. substitution may impact supply / demand scenarios which could in turn affect prices, other, non-substitution, issues may cancel out the effects shown, similar substitutions at different ASEPs may have different outcomes. At Substitution Workshop 3 on 11 th June 2008 National Grid gave an example of the possible impact of substitution on entry capacity reserve and incremental step prices. An update of these prices is provided in the following slides. In this example 10mscmd of incremental capacity is allocated at Easington. This is achieved by substituting capacity from other ASEPs: All available capacity from Hornsea, Hatfield Moor and Theddlethorpe; Some of the available capacity from Bacton.

7. Substitution Example – Prices (Sept 2008 basis) ASEP Initial Prices p/kWh/day Change in obligated level mscmd New “post-substitution” Prices p/kWh/day P0P0 P 10 P 20 P0P0 P 10 P 20 Easington0.00920.01100.0134+ 100.00950.01270.0141 Hornsea0.00900.0101 at P 8 - 0.90.00900.0101 at P 8 Hatfield Moor0.00280.0033 at P 5 - 0.80.00300.0035 at P 8 Theddlethorpe0.00820.01100.0120- 49.20.00630.00780.0088 Bacton0.00840.01100.0141- 41.70.00620.00790.0106 NB – P 10 and P 20 step prices relate to an incremental capacity of 25% and 50% of the obligated level. Hence, with the exception of Easington, the “new” prices relate to a smaller incremental quantity.

8. Substitution Example – Prices Where capacity has been substituted away from a donor ASEP, such that the obligated capacity level is reduced, Users can only be allocated capacity to the initial obligated level by triggering, in a subsequent QSEC auction, the release of incremental entry capacity. This may be subject to a 42 month lead-time. In general the step price is driven by the obligated level. Hence, following substitution we would expect the prices at equivalent capacity levels to be the same pre and post substitution for any particular ASEP. However, the IECR methodology requires a minimum increment at each step so the step price required to return to the initial obligated value may, for some ASEPs, be above the initial P0 price as in the given example.

9. Substitution Example – Prices ASEP Initial obligated level mscmd (GWh/d) New obligated level mscmd (GWh/d) Step Price to trigger release of incremental capacity needed to return to initial obligated level p/kWh/day Theddlethorpe56.4 (610)7.3 (79) 0.0088 (P 20 ) (Initial P 0 = 0.0082) Bacton164.7 (1783.4)123 (1333) 0.0087 (P 14 ) (Initial P 0 = 0.0084) In the example the obligated capacities at Theddlethorpe and Bacton are reduced significantly. The step price to return to the initial level is slightly higher than the initial P 0 level.

10. Substitution Example – Prices ASEP Initial obligated level mscmd (GWh/d) Step Price to trigger release of incremental capacity p/kWh/day Project value £m New obligated level mscmd (GWh/d) Capacity obtained for 50% NPV GWh Average Unit Cost p/kWh/d Theddlethorpe7.3 (79)0.008815556.5 (611)1508229 0.006876 (Initial P 0 = 0.0082) Bacton123 (1333)0.0087141166 (1798)1321335 0.007040 (Initial P 0 = 0.0082) In order to return to the original obligated capacity level Shippers will need to place capacity bids at the next QSEC auction at a level that passes the NPV test, i.e. Bids must have an NPV of at least 50% project value Earliest “incremental” bid placed at Q15 (42 month lead time) at the relevant step price. The bidding strategy was designed to maximise the quantity of [capacity * Days] having triggered the incremental quantity. Ignores cost of capacity up to the initial (post-substitution) obligated level. No profiling (winter / summer variations) of bids.

11. Substitution Analysis Timeline National Grid governance QSEC auction closes Incremental Obligated Entry Capacity proposal submitted to Ofgem Substitution analysis Ofgem governance 28 day veto period defined in Licence Allocations to be made 2 months – as defined in UNC section B2.6.7 Indicative Timeline Analysis of alternative investment option Challenge & Review. Audit of results Value of projects can be several £100m. Sanctioning at senior level required. Ofgem response may impact proposals requiring further analysis / governance

12. High Level Choices – Substitution Decision  In the draft Methodology Statement, shipper bids are the only determinant of shipper interest.  Constraints could be applied to the draft MS e.g. an economic test or exchange rate cap.  Non-market information could be used to determine how much should be reserved at each donor ASEP, this opens up the party making the decisions to challenge and lobbying – it also begins to challenge the value of the User commitment process other than as a mechanism for providing funding.  New mechanisms could be developed to enable shippers to prevent capacity from being substituted away from a donor ASEP, probably by requiring payment of a nominal fee. “Condition” Incremental ASEP Donor ASEPComment CurrentBidsAbsence of bids Bids required to hold capacity at donor ASEP Current + constraintsBids Absence of bids + test Bids required + tests need to be passed Non-market (NG or Ofgem decision) Bids Non-market info (e.g. TBE) Subjectivity required New market based process BidsReservation quantity New (low cost) product required

13. Option Assessment Criteria  Each option has its advantages and problems; so how do we assess the most appropriate methodology?  National Grid considers the following criteria are key:  Does the option maximise the potential substitution benefits?  Does the option provide sufficient risk mitigation against unintended consequences?  How easy is the option to implement Is the process transparent and predictable with minimal scope for challenge? Can processes be undertaken within allowed timescales? Impact on systems, Licence, UNC etc  Each option to be rated on a scale of 1-5, where:  “5” fully satisfies the criteria and  “1” does not satisfy the criteria

14. Evaluation of each Option against Criteria Option Assessment Criteria Total Substitution benefits Risk mitigation Implementation 1) Draft Methodology 2) Limits on Quantity 3) National Grid Discretion 4) Ofgem Discretion 5) Simple Economic Test 6) Exchange Rate Cap / Economic Test Combination 7) Option to Buy 8) Sub-Reserve Prices 9) Early Warning System 10) Two Stage Auction 11) BGT Proposal

15.  All obligated entry capacity remaining unsold after the QSEC auction allocations will be available for substitution.  No restriction on substitutions e.g. exchange rates / zones. AdvantagesConcerns Simple to undertake. Transparent - limited scope for challenge. Consistent with Licence obligation. Minimises unnecessary investment. Unlimited loss of capacity at donor ASEPs. May impact on price driven marginal supplies – impact on security of supply. May not be economic and efficient Option 1: Literal Interpretation of Substitution Obligation – as discussion draft

16. Option 2: Limits on Quantity Available for Substitution  As Option 1 but with additional capacity withheld from substitution. Could be based on % of baseline / obligated or historic flows or TBE forecasts. Additional withheld capacity to be agreed with Ofgem in advance of the auction. AdvantagesConcerns Simple to undertake Transparent – if values published in advance. Balances substitution and “economic” obligations. May result in unnecessary investment being undertaken (forecasts could be wrong). Could undermine TBE process: potential for disputes over values used. Does not encourage User commitment.

17. Option 3: National Grid Discretion  This option can be developed in several ways; based on Option 1 but with National Grid rejecting certain potential substitutions. A loosely defined methodology allowing National Grid discretion to apply/vary exchange rates or limit substitutable capacity from donor ASEPs. AdvantagesConcerns Maximises substitution whilst offering some protection to donor ASEPs. Simple to apply (subject to challenges). Allows factors in addition to TBE and bookings to be taken into account. Absence of transparency could lead to dispute and challenge creating uncertainty and delay, requiring extension to the 42 month leadtime. Calls for methodology to detail when / how discretion will be applied will undermine the ability to use discretion. May not encourage User commitment.

18. Option 4: Ofgem Discretion  Based on Option 1. National Grid will submit incremental capacity release proposals to the Authority identifying proposed substitutions. Ofgem may reject certain potential substitutions even if the published methodology has been followed. AdvantagesConcerns Maximises substitution whilst offering some protection to donor ASEPs. Simple to apply. Allows factors in addition to TBE to be taken into account. Decisions not influenced by National Grid commercial interests. Increased uncertainty for TO potentially leading to buy-back costs and wasted investment. Absence of transparency could lead to Ofgem decisions being disputed and challenged creating uncertainty. Calls for Ofgem guidelines on when / how discretion will be applied. National Grid / Ofgem iterations will significantly extend capacity allocation / release timelines.

19. Option 5: Simple Economic Test  As Option 1 but with each substitution confirmed subject to an economic assessment.  This assessment could be applied to restrict substitution in several ways; e.g. if a) Recipient ASEP bids < Donor ASEP reserve price * exchange rate b) Donor ASEP value (to the pre-auction obligated level) > [50%] Recipient ASEP value. a) Based on incremental capacity project values from the Transportation Charging Model b) Based on revenue drivers c) Donor ASEP value (to the TBE level (or other criteria used in option 2)) > [50%] Recipient ASEP value These tests are intended to measure and compare the value of capacity substituted from the donor ASEP and released at the recipient ASEP and preventing substitution where the value at the donor ASEP is higher.

20. Option 5: Simple Economic Test (2) AdvantagesConcerns Values capacity at the donor ASEP Can prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost. TBE options may not apply the test to capacity in excess of forecast. Hence do not place added restriction on unneeded capacity. Places a value on capacity at donor ASEPs even where that capacity is unwanted: assumes unsold capacity is wanted. Substitutions are likely to be multi-donor to single recipient and part substitution / part investment. The process could therefore become highly complex particularly to determine exchange rates. Increased post-auction analysis required. Could lead to requirement to increase default leadtimes. More complex options could require UNC / Licence changes. The value placed on capacity is not the market value.

21. Option 6: Exchange Rate Cap / Economic Test Combination  As Option 1 but with each substitution confirmed subject to: Exchange rate cap: close 1:1 Economic assessment: project value at donor ASEP to recover TBE peak forecast capacity must be less than the project value for the incremental capacity at the recipient ASEP. AdvantagesConcerns Values capacity at the donor ASEP and makes comparative test to recipient ASEP value. Providing some protection short term players and marginal gas fields Will prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost. Maximises substitution without providing total protection to donor ASEPs. Prevents aggressive aggregate capacity loss. Mechanical process – transparent, limited scope for challenge. Places a value on capacity at donor ASEPs even where that capacity is un-booked: assumes TBE forecast capacity will be wanted so may prevent otherwise logical substitutions. Low exchange rate cap combined with economic test only facilitates substitution for low to high priced ASEPs for capacity below TBE level. Will not always prevent TBE forecast capacity needs being substituted away so Shippers may still have to commit earlier than they feel able to. Additional post-auction works required.

22. Option 7: Option to Buy  A Shipper can place a value on non-incremental capacity at an ASEP for an option price.  To comply with the Licence fees need to be cost reflective. AdvantagesConcerns Shippers can signal future requirements at lower exposure than with full commitment in QSEC auction. Shippers will need to commit to costs before decisions on whether capacity is truly needed. Options may block out other Shippers wanting obligated capacity at the same ASEP. Option prices need to be high enough to prevent spurious reservations but lower than reserve prices. Not feasible at all ASEPs. Regulatory treatment of option fees needs to be considered. Potential systems implications. Potentially does not address the concern with price driven marginal supplies.

23. Option 7: Option to Buy – Issues for Consideration  What does the Option provide? Does the Option prevent capacity from being substituted?...or Does the Option put the capacity to the back of the queue for substitution?  What is the Option price (i.e. the price paid to create the Option)? Subject to question above. Same for all ASEPs or linked to ASEP specific reserve price?  Is there an Exercise for the Option? If so, how is it effected? Automatic if ASEP identified as a donor ASEP for substitution? Only if Shipper gives consent at the time that the ASEP is identified for substitution?  What is the Exercise price (i.e. the price paid to be allocated the capacity)? Reserve price at the relevant ASEPs?  What duration does the Option cover? Default lead time plus 1 year?  What is the life-time of the Option? For one year from one annual QSEC auction to the next?

24. Option 8: Sub Reserve Prices  Donor ASEP shippers can reserve capacity through capacity bids at below reserve price. In effect a variant on the Option to Buy model.  Where substitution is identified, capacity will not be substituted if the donor ASEP bid value exceeds the recipient ASEP bid value (bid price * quantity * duration). AdvantagesConcerns Values capacity at the donor ASEP and makes comparative test to recipient ASEP value. May prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost. Potential lack of transparency / complexity could lead to challenge. Would require UNC / charging methodology / Licence changes. Increased post-auction analysis required. Minimum reservation price and revenue treatment to be considered. Potential systems impact. Reduced auction income will impact commodity charges. Does not address the concern with price driven marginal supplies. [When] is the capacity allocated and if so as what?

25. Option 9: Early Warning System  Based on Option 1 but publication of TBE data on new projects ahead of auction  Shippers will be able to bid for capacity at “vulnerable” ASEPs. AdvantagesConcerns Shippers will be able to make more informed decisions as to obtaining capacity to protect it from substitution. No impact on post-auction timeline. Highly subjective – potentially misleads markets. Recipient ASEP bids may not materialise. Confidentiality at recipient ASEPs may be compromised. Additional (substantial) pre-auction analysis works required. If Shippers respond by obtaining capacity at identified donor ASEPs the issue may just cascade to other ASEPs.

26. Option 10: Two Stage Auction  Based on Option 1. Several variations where QSEC is run in two parts.  Baseline and incremental capacity can be obtained in the first phase.  Only baseline capacity can be obtained in the second stage. This allows donor ASEP Shippers to respond in the second stage if they feel that capacity at their ASEP is vulnerable. AdvantagesConcerns Maximises substitution by allowing substitution except where capacity has been sold. Identifies incremental capacity bids, allowing donor ASEP response. Cannot predict outcome – leading to late delivery of pipelines (standard 48 month lead time required) Complex – could add significantly to timelines. Shippers may  still have to commit earlier than they feel able to,  be incentivised not to bid in first auction round, and  be unable to accurately identify donor ASEPs prior to stage 2. Major change to QSEC auction (UNC) – could impact on systems.

27. Options 11: Previous BGT Proposal  Based on Option 1 but Shippers at donor ASEPs can recover substituted capacity at the next QSEC auction at reserve price.  Essentially this is Option 10 (two stage auction) with an extended period between stages. AdvantagesConcerns Allows Shippers to recover capacity without needing to trigger incremental capacity i.e. no NPV test. Shippers may still have to commit earlier than they feel able to. “Recovered” capacity will only be available from 42 months after the second QSEC, i.e. 12 months reliance on availability of short term capacity. Does not fund investment (SO/TO revenue issue).

28. Other Options?

29. Option Shortlist …………….

30. Next Steps By 12 th December - Industry options to be put forward Forward to Joint Office cc andrew.fox@uk.ngrid.com 7 th January - Workshop 6 Location to be confirmed Review industry options; narrow down for further development. Detailed assessment of preferred options.