Integration of Physical and Financial risk in Australia s

Integration of Physical and Financial risk in Australia’s National Electricity Market Les Hosking Managing Director and CEO NEMMCO

Presentation – Overview Ø NEM design- gross pool and contract market Ø Settlement inefficiencies Ø Risk management processes Ø Reallocation- offset spot with § contract payments § Futures payments Ø Central clearing- Objectives/Issues 2

NEM Design – Gross Pool G G G • All prices via pool G • Compulsory • Competing generators • Energy only Pool • Marginal price setting • Volatile $-1 k to $10 k R R • Competing retail 3

NEM Design – Contract Market Ø Risk management for Retailers requires · Contracting around compulsory gross pool spot market · Direct generation investment (vertical integration - gentailer) · Demand side control Ø Contracts can take the form of contracts for differences, hedges, swaps or futures · Via bilateral, brokers and exchange traded futures Ø Concerns over financial market liquidity · Vertical integration (gentailers) · Beyond Q 2 2010 climate change uncertainty · Futures contracts strong but not in all locations 4

Gross Pool / Contract Market. Settlements NEMMCO Retailer buys 100 MWh Generator supplies 100 MWh Spot price determined as $100/MWh NEMM CO rgy e , 00 0 0 $1 En erg En Retailer Banking System y$ 10 , 00 0 Settlement = $100 x 100 =$10, 000 per hour via NEMMCO Generat or $6, 000 Contract at $40/MWh = ($100 – $40) x 100 MW = $6, 000 per hour

Gross Pool – financial inefficiencies 0 00 0, NEMM CO $1 y erg n E Retailer Banking System En $1 erg 0, 0 y 00 Generator $6, 000 Ø Ø Ø NEMMCO Circular cash flows Volatile cash flows 33 day settlement High prudential requirements Credit default risks One retailer has failed

Prudential Management Ø Risks from large volatility in price Ø Risks from rapid payment obligations · Largest retailer (20% of NEM) with spot price at $10, 000/MWh will increase exposure to NEMMCO at $1 Million per minute Ø Risk of non payment covered by bank guarantees with NEMMCO · NEMMCO typically holds $1. 5 Billion to $3. 5 Billion in bank guarantees · Level of guarantee (Max Credit Limit) driven by energy traded, average price and price volatility Ø Daily review of participant exposures · Rapid payment requirements when near limits · Default then suspend if obligation not met · Rapid retailer of last resort required 7

NEM Outstandings History 8

Reallocation- Offset spot with contract payments Ø Option to offset the credit from one party (generator) in MW or $ against the debit from another (Retailer) - in line with their financial contract position Ø Slow to be taken up by participants · Confidentially concerns · Counterparty credit issues 9

Mechanics of Reallocation of 100 MW between Generator and Retailer which is valued at $10, 000 NEMMCO Retailer buys 100 MWh Generator supplies 100 MWh Spot price determined as $100/MWh Settlement = $100 x 100 =$10, 000 per hour via NEMMCO e$ t a oc l l ea R En 10 0 00 , $1 y 0, 0 NEMMCO 00 erg En all oc erg y ate $1 0, 0 00 Retailer Banking System Re $4, 000 00 Generator Contract at $40/MWh Strike value paid direct = $4, 000 per hour

Growth in Reallocations - MWh 11

Reallocation by Formula Ø NEMMCO is moving towards reallocation by formula Ø Effectively allows parties to settle derivatives via NEMMCO and net against physical spot settlement Ø Requires licence/exemption from Securities Regulator ASIC 12

Reallocation by Formula Retailer buys 100 MWh Generator supplies 100 MWh Spot price determined as $100/MWh Reallocation of 100 MW swap between Generator and Retailer which is valued at $6, 000 Settlement = $100 x 100 =$10, 000 per hour via NEMMCO 0, 0 ate $1 c llo rgy a Re 00 ne , 0 E $6 Retailer Contract at $40/MWh = ($100 – $40) x 100 MW = $6, 000 per hour 00 Re En all oc erg y ate $6 , 00 $1 0 0, 0 00 Generator

Futures Offset Arrangement Ø Investigations into using positive margins from futures contracts flowing to NEMMCO Ø Has strong upside price stablising effect for retailers Ø Risks need to be understood Ø Complex under insolvency Ø Complex in segregation of accounts in clearing participant and potentially clearing house 14

Futures Offset Arrangement Positive margins Futures Exchange Clearing Participant $6, 000 0 y$ erg En 0 4, 0 Retailer NEMM CO En erg y$ Generat or 10 , 00 0 Futures Contract

Central Clearing – Objectives/Issues Ø Ø Ø Ø Shorten settlement cycle in the NEM Align settlement times of all products Data on amounts owing and to be paid fed to Central Clearer A single party takes responsibility to clear all products All payments made to Central Clearer Prudential regime managed by Central Clearer to be responsible to address defaults and “remove” defaulting parties Ø Synergy with market operation functions Ø Acceptance of compulsory central clearer by participants 16

Conclusion ISSUES • Gross Pool Challenges – vertical integration – liquid Financial markets • Settlement Inefficiencies – offset spot/forward difficulties – protracted settlement cycle – credit squeeze • Central Clearing – outsourcing issues 17