D-cyphaTrade Australian Power Futures and Options Training Course June 2010.

d-cyphaTrade Australian Power Futures and Options Training Course June 2010

2www.d-cyphaTrade.com.au 1800 330 101 Disclaimer This document is published by d-cyphaTrade (d-cyphaTrade Limited) and is for information purposes only. The information is only relevant to financial products with a face value or notional value which exceeds $500,000.00 and is not to be relied upon by Retail Clients. The information is subject to change. It does not constitute financial product advice or legal advice and readers should seek their own professional advice in assessing the effect of the information on their circumstances. d-cyphaTrade (d-cyphaTrade Limited) accepts no liability for errors or omissions, including negligence, or for any damage loss or claim arising from reliance on the information. d-cyphaTrade has no involvement in, and takes no responsibility for, the conduct or operation of the financial market operated by Sydney Futures Exchange Limited (SFE), on which the Australian Electricity Futures Contracts (Contracts) are listed. The SFE is solely responsible for the conduct and operation of that financial market. d-cyphaTrade is not a related entity of the SFE. d-cyphaTrade receives commercial benefit from Contract turnover. Futures and options trading involves the potential for both profits and losses and only licensed persons can advise on this risk. You should consider obtaining independent advice before making any financial decisions. d-cyphaTrade Limited, ABN 46 100 426 542, is a New Zealand company registered in New Zealand under the name d-cyphaTrade Limited. Australian Financial Services Licence no: 305331.

3www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade > Who is d-cyphaTrade? > Wholly owned subsidiary of Transpower New Zealand, a State-owned corporation > Services: Energy futures market design and development, market data services, other training and information services. > Not a broker, not a trader > Sydney Futures Exchange (SFE) > Owned by the Australian Securities Exchange ( ASX ) > SFE lists up to 3,000 power contracts, responsible for market operation, trading and clearing infrastructure and procedures, compliance and surveillance > Power futures and options are CFTC approved > SFE pays commission to d-cyphaTrade based on power market liquidity

4www.d-cyphaTrade.com.au 1800 330 101 Agenda

5www.d-cyphaTrade.com.au 1800 330 101 Opportunities > Hedge Funds > Investment Banks

6www.d-cyphaTrade.com.au 1800 330 101 Opportunities Hedge Funds and Investment Banks > Opportunities exist due to: > Emerging market returns (temporary mispricing and spread income) > Exchange traded. CFTC approved > Daily margined (eliminates OTC credit risk), initial margin offset benefits from Clearing House > Independent portfolio/performance valuation > Largest exchanged-traded electricity options market in world > Unique Alpha: Not correlated to equity markets, oil, bonds or metals > Cash settled, hence traders do not require physical power assets > Other energy products Newc coal, Aus gas, NZ electricity. > Enables client package deals (structured carbon, debt, fx and power offtake)

7www.d-cyphaTrade.com.au 1800 330 101 THE AUSTRALIAN ELECTRICITY POOL MARKET

8www.d-cyphaTrade.com.au 1800 330 101 The Physical Power Market (structure)

9www.d-cyphaTrade.com.au 1800 330 101 Australian Trade Practices Legislation National Electricity Rules Regulatory Environment retailersgenerators Market Operator Rule maker: Australian Energy Markets Commission Regulator: Australian Energy Regulator

10www.d-cyphaTrade.com.au 1800 330 101 Geographical Coverage Regions and interconnectors Western Australia Northern Territory Victoria Tasmania South Australia Interconnector New South Wales Queensland Interconnector

11www.d-cyphaTrade.com.au 1800 330 101 Geographical Coverage Generation and Transmission Source: ABARE

12www.d-cyphaTrade.com.au 1800 330 101 The NEM at a glance JurisdictionsACT, NSW, QLD, SA, TAS, VIC RegionsNSW, QLD, SA,TAS, VIC Registered Capacity47,418 MW Registered Generators268 No of Customers8.8 million NEM Turnover 2008-09$9.4 billion Total electricity produced in ’09-’10208 TWh National max winter demand ’08-’09 (28 July 2008) 32,094 MWh National max summer demand ’08- ’09 (29 Jan 2009) 35,551 MWh Source: Australian Energy Regulator, State of the Energy Market 2009

13www.d-cyphaTrade.com.au 1800 330 101 Physical Power Market Physical Power Market Operator Retailer Generators Industrial power consumer  The pool price is calculated by AEMO and changes every half hour (ranges between -$1,000 to +$10,000)/MWh.  All retailers pay the variable pool price to AEMO.  All generators receive the variable pool price from AEMO.  Consumers pay retailer a fixed rate (including retailer’s profit margin), in return for power supply Physical power supply

14www.d-cyphaTrade.com.au 1800 330 101 Design of the NEM > Energy-only Market > Regional Pricing > Market Alignment > Market Separation > The Spot Price > 30 minute intervals > 5 minute dispatch > Determined by price of marginal generator > Cap and Floor > $10,000/MWh > -$1,000/MWh Source: Global Roam

15www.d-cyphaTrade.com.au 1800 330 101 Operating the NEM > Market operator (Independent System Operator): AEMO > www.aemo.com.au > Monitors demand and forecasts supply > Central dispatch via NEMDE (NEM Dispatch Engine) > Calculates and Publishes a floating spot price for each region > Generators “Bidding” Capacity into the Market > 2 days ahead of each trading day (d-2 / “Pre-dispatch) > Bids are to be made in “good faith” > Megawatt availability for each of the 48 trading intervals > 10 price bands > Bids can be resubmitted up to 5 minutes prior to dispatch > Bids are confidential > Bid data is published the day after dispatch (d+1) by AEMO

16www.d-cyphaTrade.com.au 1800 330 101 Sample Generator Bid - 700MW coal fired unit - $140 $120 $100 $80 $60 $40 $20 $0 -$20 -$40 Band 1 Band 8 Band 7 Band 6 Band 5 Band 4 Band 3 Band 2 Band 9 Band 10 50MW @ -$40 100MW @ -$15 200MW @ $40 50MW @ $95 125MW @ $60 50MW @ $70 50MW @ $150 25MW @ $22525MW @ $5,000 25MW @ $10,000 Price per MWh Generation output in MW Generator can bid its capacity in 10 price bands Each price band shows the price at which they are willing to dispatch the specified amount of capacity into the pool Negative bids indicate the minimum operating level Lowest bid is -$1,000/MWh, highest bid is -$10,000/MWH (VoLL)

17www.d-cyphaTrade.com.au 1800 330 101 Pre-dispatch and Dispatch > Daily pre-dispatch schedule covering supply and projected demand > From next trading interval until end of next trading day > Includes spot price forecast > 12 hour and 4 hour forecast > Dispatch > Every 5 minutes according to dispatch algorithm calculated by NEMDE > Dispatches capacity in the most cost-effective way to meet demand > Takes into account loss factors, physical constraints, etc.

18www.d-cyphaTrade.com.au 1800 330 101 Spot Price Determination > Central dispatch process for each region for each 5-minute price interval > Dispatch price which is applicable to all dispatched capacity is set by the most expensive generator that is being dispatched in each region > The Regional Reference Price (RRP) or spot price is the time weighted average of the six dispatch prices in the half-hour trading interval

19www.d-cyphaTrade.com.au 1800 330 101 Generator Dispatch - Sample Price Interval - 17:30hrs 17:05hrs 17:10hrs 17:15hrs 17:20hrs 17:25hrs 5,800MW 5,900MW 6,000MW 6,100MW 6,200MW $25.55 $26.75 $28.68 $31.75 $38.95 Regional Demand Generator Bid Bands Gen 1 Gen 2 Gen 3 Gen 4 Gen 5

20www.d-cyphaTrade.com.au 1800 330 101 Spot Price Determination Generator 2 offer $26.75 Generator 3 offer $28.68 Regional Demand ½ Hour Generator 1 offer $25.55 5,875 5,920 RRP = $26.75 Demand Spot Price (also referred to as “Pool Price” or Regional Reference Price: RRP). All retailers in a region pay the Pool Price set by the most expensive dispatched generator needed to meet demand. All generators receive this price.

21www.d-cyphaTrade.com.au 1800 330 101 Generators and retailers are exposed to pool price risk because.... > Generators sell to the Pool to make a return on their asset investment. > Generators can stop generating if pool prices fall below the generator’s short run marginal cost – although poor investment returns may result; and > May not be feasible to stop generating when pool prices are low (e.g. baseload generators who incur substantial re-start costs). > Retailers buy from the Pool to supply their “fixed price” customers > Retailers cannot “bid” prices and cannot control (or precisely predict) their customer demand. Exception: turning customers off via demand (load) shedding, although limited utilisation. > Solution: Hedge electricity pool price risk with futures and options Spot Market risks for Generators and Retailers

22www.d-cyphaTrade.com.au 1800 330 101 > AEMO invoices retailers based on retailer’s meter flow for the prevailing half hours. > AEMO pays the generators which supplied power for those half hours Invoicing > Retailers pay for power consumed on a weekly invoice, 4 weeks in arrears. > The 4 week lag in payments creates a potential credit default risk to AEMO (in reality the generators suffer a short payment if AEMO is not paid). > AEMO asks for bank guarantees from retailers (AEMO estimates “worst case” guarantee requirement based on 12 month pool price history). Spot Market Cash Flow Settlements Retailers Generators Market Operator Sets 30 minute pool price & invoices weekly

23www.d-cyphaTrade.com.au 1800 330 101 > Also know as non-firm Financial Transmission Rights (FTR) covering 1 calendar quarter. > Auctioned by AEMO (not operated by SFE) > Blind Auction held quarterly via electronic lodgement to AEMO > Auctions bidders must be registered with AEMO > Successful Bidders pay cash upfront SRA settlement and payout calculation > Unit value increases any half hour where interconnect flows from cheaper priced region to higher priced region (in direction of SRA). > SRA Value = (Region1 Price – Region2 Price) x MWh of interconnect flow x (% of interconnect flow each SRA unit is entitled to) > Negative flows i.e. from expensive region to cheaper region can reduce unit value (but cannot reduce below zero). > Units are non-Firm. i.e even if inter-regional prices separate, if transmission flow is constrained, then reduced (or zero) value increase. Settlement Residue Auction Units (SRAs) Transmission rights QLD NSW VIC SA QLD NSW VIC SA QLD NSW VIC SA

24www.d-cyphaTrade.com.au 1800 330 101 > Auctions held quarterly from 1 year in advance > Units available: > SAVIC South Australia to Victoria > VICSA Victoria to South Australia > NSWQLD New South Wales to Queensland > QLDNSW Queensland to New South Wales > NSWVIC New South Wales to Victoria > VICNSW Victoria to New South Wales > Common “theoretical value trade” strategy is to buy SRA unit at a cheap theoretical price compared to the opposing futures inter-regional price spread. > E.g. Buy Southbound “NSW to VIC” Q1 2010 SRA then (1) buy NSW Q1 2010 futures and (2) sell VIC Q1 2010 futures > Risk: value “lock in” via firm futures (or OTC) is at risk if transmission flow becomes constrained during the settlement quarter as pool prices separate. i.e. the non-firm SRA unit does not pay out, and losses occur against the firm futures spread. (e.g. January 2007 – Vic interconnect outage due to bushfire coincided with VIC prices separating from NSW prices) > For more details see: http://www.aemo.com.au/electricityops/sra.html Settlement Residue Auction Units (SRAs) Transmission rights QLD NSW VIC SA QLD NSW VIC SA QLD NSW VIC SA

25www.d-cyphaTrade.com.au 1800 330 101 Historically, Spot market price volatility has been created by: 1. Interconnect outages (e.g. Vic bushfires Jan 2007); 2. Drought effect on Hydro plants and cooling of thermal plants (Feb to June 2007) 3. Generator outages/breakdowns (e.g. mechanical breakdown, mine flooding, intra-regional supply constraints) 4. Generation fuel supply shortages and price shocks (gas/coal supply) 5. Weather-driven demand spikes (e.g. heat wave effect on air- conditioning) 6. Generator maximisation of pool prices (e.g. Summer 2008, 2009, 2010 South Australia) Spot Market Price Drivers

26www.d-cyphaTrade.com.au 1800 330 101 Historical Pool Prices – with futures forward prices Historical pool prices Futures prices

27www.d-cyphaTrade.com.au 1800 330 101 AEMO provides the following forecasts of system supply and demand: 1. Short term (current and day ahead) 1. Short term Projection of System Adequacy (ST PASA) 2. Market Notices (e.g. current outages, low reserve conditions etc) 2. Medium term (out to 2 years) 1. Medium Term PASA 3. Long Term (out to 10 years) 1. NEM Statement of Opportunities (annual) 2. Other adhoc reviews See www.aemo.com.au for live demand, price and market notice updates Spot Market Supply/Demand Forecasts

28www.d-cyphaTrade.com.au 1800 330 101 Free sites: 1. AEMO www.aemo.com.au Intraday spot market price and demand, intraday Market Notices, Annual Statement of Opportunities Review, market forecasts, SRA auction schedule, Introduction to the NEM (handbook pdf) 2. Bureau of Meteorology www.bom.gov.au Weather forecasts, current temperatures, radar loops 3. Australian Energy Regulator www.aer.gov.au State of the Energy Market Report (physical and financial market statistics and overview) Premium spot market data providers include: 1. Creative Analytics 2. Global Roam 3. IES (NEO and Prophet software) 4. Energy One Both provide real time spot market, day after generator bidding etc Spot Market Price and Demand Data Sources (free)

29www.d-cyphaTrade.com.au 1800 330 101 THE AUSTRALIAN ELECTRICITY FINANCIAL MARKET

30www.d-cyphaTrade.com.au 1800 330 101 The Financial Power Market

31www.d-cyphaTrade.com.au 1800 330 101 Australian Corporations Law Chapter 7 Regulatory Environment OTC Traders Futures Traders Futures Market Operator (SFE) Regulator: Australian Securities and Investments Commission (ASIC) Clearing House (SFECC) Clearers

32www.d-cyphaTrade.com.au 1800 330 101 The NEM (Futures Market) at a glance RegionsNSW, QLD, VIC, SA, TAS Potential market sizeUnlimited Futures and Options Turnover 2009$15.7 billion Total energy traded in 2009330 TWh Proportion of underlying physical electricity traded as futures or options 168% Trading Participants: Including retailers, generators, hedge funds, private investors and banks 45+ (estimated) Hedgeable time periodUp to 4 years ahead

33www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX Electricity market Facilitated by SFE Clearers Buy futures Retailers Generators SFE electricity futures are cash settled to the average AEMO pool price during the quarter. Hence retailers buy and generators sell SFE electricity futures to offset (i.e. fix) their variable physical pool price exposure to AEMO. Facilitated by SFE Clearers Sell futures Buy futures Sell futures Speculators/Investors Buy and Sell futures

34www.d-cyphaTrade.com.au 1800 330 101 Futures and Options Liquidity CAL 2009 330 million MWh traded 168% of underlying physical demand May 2009 39.7 million MWh traded 235% of underlying physical demand Options 68% of system demand

35www.d-cyphaTrade.com.au 1800 330 101 Futures and Options Liquidity 200720082009 Futures, Caps & Options contracts traded* 136,092131,404152,873 Avg Daily Volume* 542 contracts 1,158,951 MWh 517 contracts 1,112,716 MWh 600 contracts 1,292,819 MWh % of underlying electricity consumption 149%144%168% Total Traded MWh (Approx) 291 million 283 million 330 million Face Value Traded (Approx)* $16 billion$14 billion $15.7 billion *Contract traded volume is quoted on a 1 MW calendar quarter-equivalent basis. Face value of options is calculated at strike.

36www.d-cyphaTrade.com.au 1800 330 101 Futures and Options Liquidity by State Region Since 2006, The State % breakdown is: NSW - 32% QLD - 31% SA - 2% VIC - 35%

37www.d-cyphaTrade.com.au 1800 330 101 Size of “open” positions (contracts) RECORD OI COB Sept 09 57,820 contracts i.e. 115,640 buy and sell sides Face Value $7.9 Billion

38www.d-cyphaTrade.com.au 1800 330 101 % of Open Interest by State Region

39www.d-cyphaTrade.com.au 1800 330 101 By State % of Options Open Interest

40www.d-cyphaTrade.com.au 1800 330 101 Duration of Futures and Options trades (MWh) (6 month intervals)– FY08/09 Shows most liquidity exists between 6 months and 2.5 years

41www.d-cyphaTrade.com.au 1800 330 101 Example of a contract’s liquidity over time

42www.d-cyphaTrade.com.au 1800 330 101 Most Trades are Executed on which Day of the Week? Majority of trades were executed on Thursday’s (24%). 1.Wed – 23% 2.Tues – 20% 3.Fri– 19.7% 4.Mon – 14%

43www.d-cyphaTrade.com.au 1800 330 101 Trading Time Half-Hourly Intervals

44www.d-cyphaTrade.com.au 1800 330 101 Key Reasons for strong liquidity 1. Increased sophistication of participants 1. Improved credit risk awareness and futures market competency 2. New entrants (hedge funds, banks, investors) 3. Increased reliance by NEM Participants (anonymity and credit risk management) 4. 2007 OTC credit squeeze (contract price rises) forcing NEM Participants to SFE-cleared financial hedges 5. Block Trading (OTC clearing) is popular in energy markets 6. Option trading specialists = multiplier effect on futures (delta hedging) and more trading opportunities 7. Hedge Accounting Standards forcing financial markets accountability and preference for SFE

45www.d-cyphaTrade.com.au 1800 330 101 1. Major financial firms enter 2. QLD retailers privatised, Hedge Accounting Standards introduced 3. VIC bushfires 4. QLD drought 5. VIC 2007 gas fuel exhausted 6. High NSW pool price events. 7. Futures prices reach triple in QLD. Height of OTC credit squeeze. 8. June 07 to Jan 08: Influx of 8 new financial traders 9. November options expiry volume 10. Aus Gov announces ETS. Torrens Island generation dispatch sets SA Q1 2008 pool prices to VoLL 11. Market begins hedging 2010+ ETS risk using SFE options market 12. Independent senators state rejection of ETS 13. May 09 - Gov announces 1 year delay of ETS Price History & Traded volume Event Calendar 2006 to 2009 1 2 6 5 3 & 4 79 10 11 8 12 13

46www.d-cyphaTrade.com.au 1800 330 101 Futures price history examples > Individual quarter price charts > Calendar year price charts > National Power Index (consolidated) price charts > Eastern Power Index (NSW, VIC, QLD consolidated) price charts d-cyphaTrade online data centre provides price history of “implied combinations” also including: Offpeak, calendar year, financial year, inter-regional strips and quarters etc.

47www.d-cyphaTrade.com.au 1800 330 101 Rallying futures price example

48www.d-cyphaTrade.com.au 1800 330 101 Falling futures price example

49www.d-cyphaTrade.com.au 1800 330 101 Electricity Futures Price history 2008 contract price All Regions

50www.d-cyphaTrade.com.au 1800 330 101 Price History – National Power Index Index of NSW, VIC, QLD & SA futures

51www.d-cyphaTrade.com.au 1800 330 101 Price History – Eastern Power Index Index of NSW, VIC and QLD futures

52www.d-cyphaTrade.com.au 1800 330 101 Reasons for Futures Market Growth Presence of Financial Liquidity Providers Individual financial trading firms regularly trade more volume than the production/demand of largest utility companies. They can enter due to daily margining (avoids OTC costs/risks) and because physical generation is not required to trade futures settling to a gross pool market

53www.d-cyphaTrade.com.au 1800 330 101 HOW ENERGY COMPANIES HEDGE WITH FUTURES

54www.d-cyphaTrade.com.au 1800 330 101 Natural Spot Market Price Exposure for generators 1. Generators are naturally long > Large capital investments are made (i.e. building a power station) based on expectation of future generation receipts. > If pool price outcomes in the future are low, the generator’s pool revenue decreases. > i.e. sellers of futures, calls. Buyers of puts. Profit Loss $/MWh Long run marginal cost of generation Loss Unknown future Pool price outcome $/MWh

55www.d-cyphaTrade.com.au 1800 330 101 Natural Spot Market exposure for Retailers 2. Retailers are naturally short > Must purchase power from the pool at an unknown (floating) price in the future but must supply customers at a fixed price. > If spot market purchases in the future are at high spot prices, the retailer’s net profit margin decreases. > i.e. Buyers of futures, put options. Sellers of call options. Profit Loss $/MWh Cost of pool price purchases to achieve breakeven retailer profit margin. Loss Unknown future Pool price outcome $/MWh

56www.d-cyphaTrade.com.au 1800 330 101 The Financial Market for Electricity 1. All financial derivative contracts for Australian electricity are cash settled “Contracts for Differences” 2. Definition: Obligations to pay or receive money based on a formula which references a benchmark (e.g. a variable pool price). 3. Only the difference between the pre-agreed price (or fixed leg) and the benchmark (or floating leg) is payable, not the face value or traded price of the hedge. 4. E.g. “Buying” a futures contract for $50/MWh. The futures buyer does not pay $50/MWh, they become obligated to pay only if the daily settlement price (the futures benchmark) falls below $50. If the benchmark price increases, the buyer receives the difference. i.e. Final hedge loss or profit (and cash flow) = (settlement price - $50/MWh) x contract size. > Better terminology: - “Getting Long” instead of buying; - “Getting Short” instead of selling.

57www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk Futures contracts lock in (guarantee) cash flows benchmarked to an agreed spot price in the future. E.g. futures seller is paid Futures Price minus Spot Price. Profit Loss $/MWh Futures traded price (e.g. $45.00/MWh) Pool price average $/MWh Futures seller’s cash flows Futures buyer’s cash flows

58www.d-cyphaTrade.com.au 1800 330 101 Futures prices converge (at end of quarter) to equal the pool price average of the quarter Final futures expiry price = actual Pool Price QTR average Hence generators and retailers use futures payoffs to compensate them for gains or losses from movements in their pool market price exposures

59www.d-cyphaTrade.com.au 1800 330 101 HOW RETAILERS HEDGE WITH FUTURES

60www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk > Why hedge? > Market risk (both Price risk and Volume risk) NEM Retailers > Price Risk without financial hedges: If pool prices are high, losses result. > Price Risk strategy: “Buy” financial hedges to offset pool prices (i.e. if the pool price cost is high, the financial revenue from hedges is high). Provides revenue certainty. > E.g. buy futures, swaps, options etc

61www.d-cyphaTrade.com.au 1800 330 101 The Hedging Process... Cumulative Futures hedge cash flows offset the gain or loss to Retailer on pool power cost, Thereby “locking-in” the power cost equal to the original futures price SFE cash flow Physical Power cost $50/MWh HEDGE PRICE High pool price average Low pool price average

62www.d-cyphaTrade.com.au 1800 330 101 1. Retailers If pool price outcomes in the future are high, the retailers revenue decreases. Hence, buy futures to hedge the risk Profit Loss $/MWh Unknown future Pool price outcome $/MWh Financial hedge profile (e.g. buy futures) Natural pool price exposure Hedged Portfolio (Natural Spot exposure plus Financial Hedge) Futures hedge pool price risk

63www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk > Why hedge? > Market risk (both Price risk and Volume risk) NEM Retailers > Volume Risk (uncertainty): If retailer’s customers consume more (or less) power than the retailer expected, the retailer is exposed to under or over hedged net position (i.e. physical short not matched to financial long). Dependent on weather conditions, customer churn etc. If consumption (demand) is volatile losses may result. > Volume Risk strategy: “Buy” financial hedges incorporating optionallity. May only need enough to manage the volatile proportion of the retailers customer load. > E.g. Purchase financial Caps, Asian options, load following swaps etc that settle against the pool price (more expensive than standard hedges and not cleared by SFECC)

64www.d-cyphaTrade.com.au 1800 330 101 Cap futures Futures hedge pool price risk NEM Retailers – “Building Block” hedging > Managing demand volume Risk > Using generic (cheapest) financial products to fit probable flat load volume (demand) exposure. Then fill in peak flex risk (i.e. upward demand flex) with more expensive “peak” instruments, just for upward demand flex exposure. Demand Volume (MW) Term Peak futures Cap futures $300+ protection Peak Load futures $63/MWh Base Load futures $37/MWh Quarter 1 Jan to Mar Quarter 2 Apr to Jun Quarter 3 Jul to Sep Quarter 4 Oct to Dec Base futures Lower Base demand forecast Upper Peak demand forecast

65www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk NEM Retailers Using this “building block” approach above for an approximated fit creates volume mismatch losses: 1. If retailer’s actual demand exceeds hedge cover during half hours when pool prices exceed hedge cover price; or 2. If the retailer’s demand is less than the hedged amount during half hours when pool prices are less than the hedge cover price paid. Hence must be compared to relative cheapness of hedging using generic hedges and ability for traders to manage the portfolio dynamically.

66www.d-cyphaTrade.com.au 1800 330 101 Facilitated by SFE Clearers Wholesale consumers can self-hedge using futures and paying own pool cost Retailer 1.Customer pays variable half hourly pool price to Retailer Cost includes smaller profit margin for Retailer but exposes consumer to loss during high pool prices (unless it can afford to load shed) 2.Customer hedges (locks in) its own fixed power cost using futures (at wholesale cost). E.g. Gets long futures at $50/MWh fixed price. a.If customer load not flat 24x7, customer is exposed to half- hour mismatch (risk of increased cost) although load shedding advantage may compensate. b.Customer must manage pay/receive futures variation margins (equal to daily profit/loss) and must lodge security deposit (initial margin) with SFE Clearer Industrial power consumer Consumer fixes futures price Consumer pays variable half hour pool price + % to retailer

67www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk The Wholesale Electricity Price Index (WEPI) The WEPI™ is a demonstrational index that assumes a basic hedge strategy and then calculates the net “cost” of a hedged portfolio against the spot market. The cost considers a generic retailer’s assumed actual demand (based on system demand) vs assumed hedge position against prevailing hailf hourly pool prices. It assumes a portfolio of generic financial hedges based on meeting up to 90% of the highest previous demand volume for that (type of) quarter, and the previous day’s average offpeak demand as the assumed lower demand volume threshold. See http://www.d- cyphatrade.com.au/products/wepi for more details

68www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk > Benefits of hedging with futures and ETO’s versus load following OTC products > Relatively inexpensive (compared to tailored hedging) > Seamlessly adjustable (i.e. can be unwound perfectly) > Avoids OTC credit default risk > Risks of hedging with futures and ETO’s versus load following OTC products > Being partially over hedged during low demand, low pool prices > Being partially under hedged during high demand, high prices > margining cash flow timing implications (positive or negative) must be managed. i.e. Even a profitable long term futures hedge can create negative cash flows in the short term.

69www.d-cyphaTrade.com.au 1800 330 101 HOW GENERATORS HEDGE WITH FUTURES

70www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk > Why hedge? > Market risk (both Price risk and Volume risk) NEM Generators > Price Risk without financial hedges: If pool prices are low, investment losses result. > Price Risk strategy: “Sell” financial hedges to offset pool prices (i.e. if the pool price cost is low, the financial revenue from hedges is high). i.e. “Lock in” a price for future generation via the hedge market to achieve revenue certainty. > E.g. sell futures, swaps, options etc

71www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk 1. Generators If pool price outcomes in the future are low, the generator’s revenue decreases Profit Loss $/MWh Unknown future Pool price outcome $/MWh Financial hedge profile e.g sell futures Natural pool price exposure Hedged Portfolio (Natural Spot exposure plus Financial Hedge)

72www.d-cyphaTrade.com.au 1800 330 101 Futures hedge pool price risk > Why hedge? > Market risk (both Price risk and Volume risk) NEM Generators > Volume Risk (uncertainty): Less frequent uncertainty than a retailer, but effect of serious generation outage may be financially catastrophic. If unforseen and/or prolonged generation outages occur, generators may face a loss on their sold hedges without generation receipts to match it. > Volume Risk strategy: > Enter into hedge contracts that can be reversed quickly if outage occurs or where buyer wears the outage risk (non-firm or F.M clauses – less common these days due to more competitive hedge markets, especially futures).

73www.d-cyphaTrade.com.au 1800 330 101 OPTIONS ANOTHER HEDGE PRODUCT n.b. During 2008, d-cyphaTrade ASX became the world’s largest power options market (by energy)

74www.d-cyphaTrade.com.au 1800 330 101 Options hedge futures price uncertainty > Futures Options contracts provide the Option Holder (option buyer) the right but not the obligation to convert into a futures position at a pre-agreed price (i.e. at the option strike price). > The Options Writer (option seller) is obligated to deliver a futures position to the option holder if the options holder exercises the option. In return for this obligation, the option writer is paid a premium (i.e the original price at which the option is traded) by the options buyer.* > At the expiry date of the option, if the option holder can hedge directly in the futures market at a better price than his option strike, he can merely abandon (i.e. not exercise) the option. > Options are either Call Options (the right to buy futures) or Put Options (the right to sell futures) * N.B.: electricity futures options are marked to market and the premium of the option is not paid for upfront by the option buyer. However, if the option expires worthless, the cumulative variation margins from the option (as it reduces in value to $0.00/MWh) will equal the original traded premium value ($/MWh) of the option – thereby allowing the option seller to “earn/receive” the option premium via positive variation margins.

75www.d-cyphaTrade.com.au 1800 330 101 Option trading objectives Options buyers use options to: 1.Hedge against adverse moves in long term forward market prices. e.g: a.Limit negative SFE cash flows (cumulative variation margins) to the price paid for the option - at least until option expiry b.Unhedged Retailers concerned about hedge-cost increases c.Unhedged Generators concerned about hedge-revenue decreases d.Potential buyers of energy trading businesses hedging uncertainty of sale process (i.e. Potential transfer of under/over hedged portfolio) 2.Speculate on upward or downward futures price trends Options sellers use options to: 1.Earn additional premium revenue. e.g.: a.Retailers selling put options b.Generators selling call options 2.Speculate on upward or downward or sideways futures price trends Food for thought: Combinations of options can be traded to created tailored portfolio payoffs for futures price ranges

76www.d-cyphaTrade.com.au 1800 330 101 Call Options Profit Loss $/MWh Call Option strike price (e.g. $45.00/MWh) Futures Price $/MWh Option buyer’s profit Premium paid to option seller (e.g. $1/MWh) Call Option Breakeven (e.g. ($45.00 + $1)/MWh) Option seller’s loss Call options give the holder (buyer) the right to buy futures at a pre-agreed price. Call sellers earn the option premium for selling the call. The higher the futures price moves, the more valuable the call.

77www.d-cyphaTrade.com.au 1800 330 101 Retailer call purchase to hedge rally May 2006: Retailer buys $38.00 Call for $0.35 July 07 : Call buyer can exercise option into a purchase of futures at $38, when futures are trading at $67 Retailers worst case hedge cost/risk was $0.35/MWh Futures market at $67 means the retailer’s option allowed certainty to purchase at $38. This created a $29/MWh profit in July 2007

78www.d-cyphaTrade.com.au 1800 330 101 Generator buys put instead of sells swap If the futures market is below the $38 put strike at option expiry, the generator can convert into sold futures Option hedge avoids negative variation margin or locking in a swap hedge loss Dec 2006: Generator buys $38.00 Put hedge for $0.41/MWh Option expiry date Calendar 08 Futures Price Generator’s worst case cash flow from cumulative negative variation margins was $0.41/MWh. i.e. price paid for put. A subsequent futures market rally to $67 means the Generator can let the put expire worthless, and: 1.Was protected from sell off at all times 2.avoided negative futures cash flows or swap hedge loss of $29/MWh; and 3.can now sell futures (or OTC) at higher prevailing price of $67 and only “wasted” $0.41/MWh Do I hedge with swaps, futures or options or risk not hedging?

79www.d-cyphaTrade.com.au 1800 330 101 Generator option hedges - $50 Call Generation Forward Curve Buy $40 PUT for $4 Sell $50 CALL at $4 1.Limits the size of Profit or Loss from a futures movement to within the strikes; 2.Net “zero cost” premium + $40 Put Final PORTFOLIO RISK PROFILE Zero cost collar

80www.d-cyphaTrade.com.au 1800 330 101 Retailer option hedges + $45 Call Forward Curve PORTFOLIO PAYOFF PROFILE Buy Call Spread Retailer demand BUY $45 CALL for $4 SELL $55 CALL at $1 1.Reduces loss in a futures rally (by up to $10 strike difference less $3 net premium paid) =$7; 2.Allows retailer to profit from futures sell off (less net premium paid) 3.If futures unchanged, $3 (premium) loss - $55 Call

81www.d-cyphaTrade.com.au 1800 330 101 Put Options Profit Loss $/MWh Put Option strike price (e.g. $45.00/MWh) Futures Price $/MWh Option buyer’s profit Put Option Breakeven (e.g. ($45.00 - $1)/MWh) Premium paid to option seller (e.g. $1/MWh) Option seller’s loss Put options give the holder (buyer) the right to sell futures at a pre-agreed price. Put sellers earn a premium for selling the put. The lower the futures price moves, the more valuable the put.

82www.d-cyphaTrade.com.au 1800 330 101 Options hedge futures price uncertainty Financial Investors, Generators and Retailers all use options to enhance portfolio management. Buyers of options risk losing the full premium value of the option (i.e. if they later chose to abandon the option) but can benefit from unlimited option profits when the underlying futures price moves in their favour. Sellers of options earn the option premium, but face unlimited option losses if the underlying futures price moves against the sold option position.

83www.d-cyphaTrade.com.au 1800 330 101 FUTURES MARKETS ARE TRANSPARENT and provide independent price settlement

84www.d-cyphaTrade.com.au 1800 330 101 Futures markets are transparent > Independent estimate of future pool prices > Observable, relevant > Actual bids, offers and trades – not indications > Achievable project revenue hedge

85www.d-cyphaTrade.com.au 1800 330 101 VIC Summer 2010 Base load settlement prices since April 2008

86www.d-cyphaTrade.com.au 1800 330 101 Electricity Futures Price Curve Victoria 2010 TO 2012 (Base Load)

87www.d-cyphaTrade.com.au 1800 330 101 Electricity Cap Futures Price Curve

88www.d-cyphaTrade.com.au 1800 330 101 Transparency – Public disclosure > Free market data www.d-cyphaTrade.com.au > Other data providers: - Reuters, Bloomberg, others

89www.d-cyphaTrade.com.au 1800 330 101 Transparency – Public disclosure

90www.d-cyphaTrade.com.au 1800 330 101 Transparency – “Best live prices” ARBMASTER (coming soon) to DCT online and REUTERS Real time “best implied” prices with alerts for arbitrage e.g: 1. Best calendar and financial year bid and offer using live orders or implied from futures; 2. Best QTR futures prices from outright orders or from calendar or financial year live prices 3. Implied offpeak (calendar and quarters) using live Peak and Base orders 4. Realtime calculation of National Power Index and Eastern Power Index live bids and offers 5. Preliminary Daily Price Settlement calculation calculated continuously throughout the trading day Allows for tighter SFE price discovery in realtime for traders and brokers

91www.d-cyphaTrade.com.au 1800 330 101 OTC market Transparency > OTC negotiated business SFECC clearing and registration via: 1. Block Trades – OTC deals registered as futures at the Clearing House 2. Exchange for Physical – switching OTC trades into cleared futures positions

92www.d-cyphaTrade.com.au 1800 330 101 CENTRALLY CLEARED FUTURES MARKETS CHARACTERISTICS

93www.d-cyphaTrade.com.au 1800 330 101 Characteristics of a Centrally Cleared Market 1. Standardised contracts (expiry, quantity, location) in a tightly regulated market. The electricity futures contracts are legally binding agreements to buy or sell the denominated quantity of electricity at a fixed time in the future at the agreed price. Cash Settlement only, with no physical delivery involved. All aspects of a futures contract's specifications except price are standardised. Orders are matched on the basis of price and time priority in the exchange. 2. The central counterparty clearer (SFE Clearing Corporation) effectively mitigates counterparty credit exposure between Clearing Participants. The use of a clearing house effectively guarantees (to Clearing Participants) the financial performance of all contracts traded. Through the process of novation and daily margining, counterparty risk is effectively eliminated. The process of novation involves SFE Clearing interposing itself between the buyer and seller, becoming the central counterparty to all trades. Daily margining reduces the size of potential credit default to a one business day price move.

94www.d-cyphaTrade.com.au 1800 330 101 SFE Clearing daily margins Clearing Participants (CPs) and CPs daily margin their trading clients SFE CLEARING Clearing Banks

95www.d-cyphaTrade.com.au 1800 330 101 Characteristics of a Centrally Cleared Market Important Consideration of Daily Margining for NEM Participants > The daily margining process is recognised globally as being critical to eliminate derivative credit default risk, however, > This means that “poorly timed or bad” hedges executed via futures can cause cash flow timing issues for NEM participants. > i.e. AEMO pays generators and collects monies from retailers 4 weeks in arrears (after the pool period has occurred). Most OTC contracts under ISDA are aligned to the AEMO invoice calendar, creating credit risk but matching AEMO cashflow timing. > E.g. a if a generator sells a “loss making” hedge via the futures the generator must pay any “mark-to-market” loss (after the day it occurs) in cash. The same hedge done via OTC whilst creating the same ultimate profit or loss, wont create cash flow obligations until the pool period occurs. > Good traders (who trade profitably) prefer exchange traded products because their hedges create positive cash flow. > Alternatively consider using “bought SFE option hedges”, to limit cumulative variation margins (prior to options conversion into futures) to the premium paid for the option.

96www.d-cyphaTrade.com.au 1800 330 101 Minimising cash flow timing issues using options as hedges > Another way for NEM Participants to reduce the size of daily margin calls on long term hedging is to HEDGE USING “bought” OPTIONS > A generator can hedge by buying put options > A retailer can hedge by buying call options > With a bought options position, the worst (cumulative) variation margin call is limited to the price paid for the option. > Only if or when the option is converted into futures, does the NEM Participant face “non- limited” variation margin risk. > E.g. a Calendar 2013 generation hedge using a put option bought in Jan 2010 limits the worst case variation-margin equal to the option premium, for 2 years and 10 months, up until the option expiry date (just prior to the start of the futures term). Any futures market price rally prior to the exercise date of the option, cannot result in a greater cumulative variation margin against the generator than the original option premium. > Retailers can use bought call option hedges to limit negative variation margins in the same way.

97www.d-cyphaTrade.com.au 1800 330 101 Characteristics of a Centrally Cleared Market 3. Robust Regulatory and Compliance Frameworks The SFE is fully regulated and oversees the activities of its participants to ensure compliance with the Exchange ’s trading and business rules. As market operator, SFE occupies an intermediate position between ASIC and market participants. 4. Electricity market operates anonymously > Benefits of anonymity  Complete anonymity – you can’t determine who the client is from the broker who is executing the order.  Level playing field – Only publicly available information is able to be communicated. This way all clients have access to the same information regarding the futures market. (Once order has been executed brokers may claim having transacted the order).  Retailers and generators can enter new markets fully hedged, without needing incumbent competitors to sell them hedges (or know they’re coming)  Reduces likelihood of “Playing the man, not the ball”

98www.d-cyphaTrade.com.au 1800 330 101 Characteristics of a Centrally Cleared Market 5. Ability of market participants to manage their electricity price risk whilst reducing OTC credit risk. 6. Optimised initial margins and the ability to receive initial margin offsets minimises collateral requirements. This will enable efficient use of capital and lead to reductions in the overall cost of collateral expenditure. Margin levels are monitored on an ongoing basis and are reflective of underlying changes in seasonal and regional volatility. The payment and receipt of variation margins occurs daily as open positions are "marked to market“, minimising outstanding PnL obligations. 7. Price transparency (prices freely available to all market participants). SFE ’s automated trading platform is connected to all major data vendors (Reuters, Bloomberg etc) and will provide the greatest opportunity for price discovery and investment signaling 8. All participants regardless of size are able to contribute to market pricing. 9. One central pool for liquidity provides greater flexibility.

99www.d-cyphaTrade.com.au 1800 330 101 Centralised Liquidity - Brokers > 1 broker agreement provides absolute liquidity to approximately 40+ major counterparties > Eliminates duplicated legal agreements (ISDA) & collateral (bank guarantees) for each potential counterparty > Every trader can “trade with” every other entity in the market via futures, regardless of credit quality or ISDA > Generators, retailers, market customers, banks, non-bank speculators (e.g. hedge funds), small private speculators > Domestic and International players already active in electricity futures – all NEM participants benefit from additional liquidity

100www.d-cyphaTrade.com.au 1800 330 101 Deeper, Centralised Liquidity > d-cypha ASX volumes exceed the OTC market and spot market consumption. > 5 active voice brokers now use futures to overcome “fractured” liquidity in 6 isolated OTC markets (TFS, NGES, ICAP, BGC, MF Global) > Another 6+ futures-only brokers (i.e. Clearing Participants) interact with 5 OTC brokers in a common market place > Traders benefit from a common and transparent market. > Hedge funds and speculators can trade seamlessly against utility company traders > Broking contacts: http://d-cyphatrade.com.au/trading/trading_contacts Comparing OTC to SFE liquidity: A common misconception about OTC trade volume surveys data is that OTC volume = OTC liquidity. In reality, OTC market participants can only transact with a limited number of counterparties – hence effective OTC liquidity is less than reported “OTC market-wide” volume See www.afma.com.au for surveyed OTC electricity market data > Independent trading software vendors: http://d-cyphatrade.com.au/trading/independent_software_vendore Many SFE Clearers provide their own web based trading software to clients

101www.d-cyphaTrade.com.au 1800 330 101 Other Potential Risks and impediments of OTC Trading which hamper liquidity > Non-uniformity in OTC contracts can disrupt OTC liquidity  Carbon tax pass-through price adjustment negotiations?  Force Majeure?  Regulatory disruption (e.g. OTC regulation pending US legislation) ?  Settlement collection risk?  Legal/contract interpretation? > Hence standardised/uniform futures contracts maximise liquidity (i.e. No mucking around negotiating – just trade based on price) > Independent daily price settlement SFE allows margining benefits

102www.d-cyphaTrade.com.au 1800 330 101 CENTRALLY CLEARED FUTURES MARKETS CREDIT RISK AND COLLATERAL MANAGEMENT BENEFITS

103www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies OTC Credit Default Risk. This section: 1. Explains how OTC credit default risk is created and calculated/reported 2. Explains how central counterparty clearing and daily margining reduces OTC default risk Credit default risk: arises due the potential (or actual) cost of (buying or selling) replacement contracts if a counterparty defaults on the original OTC contract. The contract replacement cost will depend on the prevailing market price of replacement hedges.

104www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies of futures v.s. Over the Counter > Australian OTC credit risk landscape: 1. Privatisation of QLD retailers 2. Potential privatisation of NSW retailers and generators 3. Credit downgrades of large retailers (divestment of regulated assets) 4. New entrant, non-bank financial trading specialists very active with small balance sheets 5. Spot market volatility and price rises increase retailer’s spot market guarantee requirements to AEMO 6. Rallying forward markets increase OTC credit default risk for OTC- hedged retailers. Falling forward markets increase credit default risk for OTC-hedged generators 7. Refinancing difficulties due to global credit crunch

105www.d-cyphaTrade.com.au 1800 330 101 > OTC Electricity ISDA settlements – weekly 4 weeks in arrears on accrual (not cash margined via Mark-to-Market prior to final settlement). > If market value of replacement hedge increases, OTC credit exposures often unsecured for years prior to first cash settlement receipts Traded price (fixed leg) MTM credit risk exposure Contract term (1 st cash settlement up to 5 weeks after term commencement) $/MWh OTC cash flows Collateral funding efficiencies Unrealised MTM profit Unrealised MTM loss

106www.d-cyphaTrade.com.au 1800 330 101 The OTC liquidity/credit squeeze Bought at $35.00 during 2005/06 Mark to Market revaluation $67.87 (up $32.87 on OTC deal) $32.87/MWh owed by generators to retailers - for at least 13 months. e.g. $790.1 million owed (at risk of default) per 5,000MW. OTC MtM credit risk exposure

107www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies June 2007 $2 billion at risk ? Based on assumed OTC hedge prices during 2006

108www.d-cyphaTrade.com.au 1800 330 101 Main Benefit of Futures The upcoming slide illustrates the key risk management strength of futures.... Daily Margining

109www.d-cyphaTrade.com.au 1800 330 101 Collection Risk comparison 1. Futures Collection risk = 1 day price move 2. OTC collection risk = 4 years ? random price walk Traded price (fixed leg) Unpaid Mark to Market exposure $/MWh OTC collection (credit) risk accumulates over term if market value of replacement hedge increases How Futures reduce credit risk Futures collection risk limited to 1 day and secured by Initial Margin Deposit with SFE Clearing Participant. SFE Clearing Corp sets IM Deposit to cover reasonable worst case 1 day price move. In the money Out of the money time OTC MtM credit risk exposure

110www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies Futures Daily Variation margins (profit/loss based on marking to market) settled next business day. E.g. Assume futures bought at $101 on 30 Aug (PNH7):

111www.d-cyphaTrade.com.au 1800 330 101 SFE Clearing daily margins Clearing Participants (CPs) and CPs margin trading clients (Dr or Cr) each day SFE CLEARING Clearing Banks

112www.d-cyphaTrade.com.au 1800 330 101 Client Clearing Accounts > Client accounts may be: 1. Instruct (manual) offsetting/netting of matching bought and sold positions; but more commonly… 2. Automatic netting – any position able to be offset or netted off will be automatically closed out upon trade registration. > Client account can also earn interest – This is negotiable with the clearing participant.

113www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies - CAPS SFE electricity options – Funding and credit risk efficiency summary Futures option premium MtM – not paid for upfront by buyer OTC cap hedges normally paid for upfront by the buyer to the seller Q1 2008 VIC Base Cap Futures $24.00/MWh, 2184 hours/MW Assume 500 MW purchased on: 1.OTC. Cash required = $26.2 m If OTC seller defaults, the buyer needs to spend another $26.2m to replace the hedge. 2. SFE. Cash required (IM=$1,000/contract)= $0.5m If seller defaults, buyer’s Cap future remains intact. OTC Cash required $26.2m SFE Cash $ 500k

114www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies - CAPS Cap buyer’s perspective. Initial margins vs. Premium value

115www.d-cyphaTrade.com.au 1800 330 101 1. SFE Option Collateral = 1 day price move (until expiry and/or after exercise into futures) 2. OTC Swaption Collateral = potentially compounding random walk in prices for option term and if exercised, after expiry for another year MTM exposure Collateral funding efficiencies SFECC collection risk limited to 1 day OTC collection risk accumulates during time to expiry and/or after exercise Option Exercise date Term Option strike price Unpaid Mark to Market exposure $/MWh In the money Out of the money

116www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies Assumed OTC MtM (credit risk) exposures Total market credit risk = $163m

117www.d-cyphaTrade.com.au 1800 330 101 SFE CLEARING Clearing Banks Collateral funding efficiencies Entity 1 Entity 2 Entity 3 Entity 4 Entity 7 Entity 6 Entity 5 4 22 6 11 5 18 10 Total market credit risk = Zero (Basel II) 4 Cumulative cash flow result of netting and variation margining by SFECC. i.e. Reduced to net PnL and money owed

118www.d-cyphaTrade.com.au 1800 330 101 SFE CLEARING Clearing Banks Collateral funding efficiencies monies owed (i.e. variation margin payments already paid/received) Entity 1 Entity 2 Entity 3 Entity 4 Entity 7 Entity 6 Entity 5 4 0 0 0 0 0 0 Total market credit risk = Zero (Basel II) 0

119www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies Market wide (and single entity) collateral efficiency improvement Assumes: zero debt recovery rate, I.M interest earned = entity’s cost of cash (or bank guarantee), ignore additional pre-emptive bank guarantees for OTC posted but not utilised by current OTC positions, effective OTC legal netting of in the money and out of the money contracts with same entity.

120www.d-cyphaTrade.com.au 1800 330 101 Buying and selling OTC swaps from 2 different counterparties. 1. Nil Market Price Risk 2. Full OTC credit risk Unrealised Loss $/MWh Swap traded price (e.g. $45.00/MWh) Market value of replacement contracts $/MWh Sell an OTC swap to Fly by Night Retail Buy an OTC swap from Bermuda Generation OTC credit risk from “bought and sold” swaps Unrealised Profit CreditDefaultRisk

121www.d-cyphaTrade.com.au 1800 330 101 Credit Default Risk Buying and selling OTC swaps from same counterparty at a profit. 1. Nil ongoing Market Price Risk 2. OTC credit risk remains – crystallised until expiry Unrealised Loss $/MWh Market value of replacement contracts $/MWh OTC credit risk from “bought and sold” swaps Unrealised Profit Buy an OTC swap from Bermuda Generation Buy Swap at $35.00/MWh Sell Swap at $45.00/MWh Sell an OTC swap to Bermuda Generation 10

122www.d-cyphaTrade.com.au 1800 330 101 US Treasury – OTC regulation > The Obama Administration has submitted draft legislation to Capitol Hill seeking to avoid another credit default meltdown of OTC markets: > Proposed regulation includes: 1. All Standardised OTC to be cleared by registered exchanges / clearing houses; 2. US regulators to seek international adoption of OTC regulation in other countries; 3. Use capital requirements on OTC to migrate OTC towards central clearing houses; 4. Raise capital and margin requirements on all OTC that is not centrally cleared; 5. Given higher risk of non-centrally cleared markets, insist on higher capital requirements on non-cleared OTC in comparison to cleared contracts; 6. Broad definition of “standardised” OTC to minimise regulatory evasion; 7. Regulators to police any attempt to avoid central clearing through spurious “customisation”; 8. Propose steps to make all OTC derivative markets fully transparent > See http://www.financialstability.gov/docs/OTCletter.pdf > Draft legislation has already been passed by US lower house.

123www.d-cyphaTrade.com.au 1800 330 101 SFE Clearing Corporation (SFECC) > SFE Clearing Services provide: > Central Counterparty Clearing – - SFECC principal, to all trades - provides surety of payment, margin netting, risk management & liquidity. - novation enables SFE Clearing to effectively guarantee performance of all contracts to SFE Clearing Participants. > Trade registration, allocation and contract novation > Position reporting and trade processing > Risk Management > Collateral and Treasury Management See www.asx.com.au for more details

124www.d-cyphaTrade.com.au 1800 330 101 Risk Management and Default Procedures > SFE Clearing undertakes a number of activities to manage these risks including the following: > Margins and position monitoring > Capital Based Position Limits > The SFE Clearing Guarantee and Capital Reserve > Admission Criteria, including ongoing minimum financial adequacy requirements > SFE operates a fidelity fund to cover losses sustained by a client of an SFE Participant caused by defalcation or fraudulent misuse of money or other property which was entrusted to the Participant for the purposes of futures trading.

125www.d-cyphaTrade.com.au 1800 330 101 SFE Clearing Participants > SFE Clearing imposes comprehensive entry criteria on SFE Participants, including strict financial requirements. It ensures adequate capital, guarantees and operational safeguards are in place at all times and it continually monitors these. > Default of a SFE Clearing Participant – SFE Clearing has right to: > Attempt to transfer all segregated client positions and moneys to another Clearing Participant > Take control or liquidate the positions in the House Clearing Account or in both the House and Client Clearing Account > Apply the Clearing Participant's commitment and House initial margin deposits to the defaulting Participants position and loss. > 2 Types of Default > House default - Client assets (positions and/or moneys) on deposit with or in the control of SFE Clearing or its participants may not be used or impaired by SFE Clearing in the case of a Clearing Participant default resulting from House activity. > Client default - Initial margins deposited by Clients not causing the default are potentially at risk if there is a default in the Client account of their Clearing Participant. > A list of Clearing Participants can be found on the d-cyphaTrade website - http://www.d- cyphatrade.com.au/clearing/clearing_contacts.

126www.d-cyphaTrade.com.au 1800 330 101 Collateral funding efficiencies Futures Clearing – Efficiency summary 1.Variation margins limit outstandings to 1 day MtM move 2.Initial margins need only cover 1 day move 3.Initial margin deposits are refunded at close out and can earn interest 4.Initial margins only required if a position is open 5.Clearing Participants backed by SFECC (e.g. JP Morgan, Credit Suisse, UBS, Citigroup, Deutsche Bank, Macquarie Bank, HSBC, MF Global). 6.Diversity of SFECC cleared products (fixed interest, equity other commodity) = Less concentration risk (compare to default of California ISO and Calpex in 2001). See Kaminski “Managing Energy Price Risk” 2004. 7.Other prudential safeguards (monitored by Reserve Bank and ASIC) 8.Zero credit risk weighting under Basel II… Efficiencies for Banks under APRA

127www.d-cyphaTrade.com.au 1800 330 101 CENTRALLY CLEARED FUTURES MARKETS BENEFITS FOR HEDGE ACCOUNTING (AASB139)

128www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency > AASB 139 Hedge Accounting benefits from futures 1. Automatic Mark to Market valuation done daily by the SFE 2. Independent derivative revaluation 1. Compare independence of futures price revaluations to: 1. NAB OTC FX revaluation scandal 2. Widespread Energy index price fixing by US Energy companies (e.g. Dynegy, AEP, Williams, CMS, and El Paso) * 3. Futures Price benchmark provides “credit risk neutral” price * Source: Federal Energy Regulatory Commission Investigation March 2003, II-1

129www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency AASB 139 AG71 (excerpt): >.....The objective of determining fair value for a financial instrument that is traded in an active market is to arrive at the price at which a transaction would occur at the reporting date in that instrument (i.e. without modifying or repackaging the instrument) in the most advantageous active market to which the entity has immediate access. However, the entity adjusts the price in the more advantageous market to reflect any differences in counterparty credit risk between instruments traded in that market and the one being valued.

130www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency > AASB 139 Hedge Accounting > Futures prices enable MtM of OTC derivatives, but the OTC contract valuation should be adjusted for OTC credit risk - E.g. Reference futures price, then adjust using OTC product being valued using credit Default Curves and debt recovery rates relevant to the OTC counterparty’s rating… - E.g. Shouldn’t report value of an unsecured “bought” OTC Cap derivative from an CCC-rated (or unrated) seller the same as an A- rated bank (or futures) positions. Otherwise, could buy discounted “junk swaps” at a price discount and sell futures and report a trading profit. - Currently Australian electricity company reporting of OTC electricity derivatives is equivalent to reporting toxic junk bond value as AAA Gov Bonds ???

131www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency AASB 139 – OTC derivative valuation Easy to calculate embedded credit default risk in hedges using counterparty rating default curves or corporate bond yields: Indicative methodology only.

132www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency AASB 139 – OTC derivative hedge valuation. Worked example of calculating embedded credit default risk: A $100 mark to market profit with a CCC counterparty payable in 3 years should be discounted by $46.78 (or $23.39 if applying an unsecured debt recovery rate of 50 cents in the dollar). Source (and for) more up to date Corporate default rates: www.fitchratings.com Recommended reading “How Default and Transition Rates are Calculated”, Fitch Ratings 2006.

133www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework and Transparency AASB 139 – OTC derivative valuation

134www.d-cyphaTrade.com.au 1800 330 101 Compliance Framework – Independence of daily price settlements > Monitored by ASIC, RBA and ACCC > Strict, transparent trading and operating rules > Dedicated Surveillance and Compliance department > Electronic Audit trail (reduces human error) > Independent settlement mechanism and automated/verifiable transaction processing > Trading rules, automatic daily profit and position reconciliation and transparent market place limits potential for “out of market” dealing > (compare to $600 m + Pac Power Generator OTC losses) > Futures Traders deal at “market consensus” prices – full access enables price discovery > Official Daily Settlements Prices established independently by SFE using transparent rules

135www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX FUTURES AND OPTIONS SPECIFICATIONS ……..FUTURES

136www.d-cyphaTrade.com.au 1800 330 101 Contract Specifications Base and Peak Load Futures Underlying Commodity Electrical energy bought and sold in the NSW, VIC, SA and QLD wholesale pool markets conducted by the National Market Management Company (AEMO). TermQuarterly contract 4 1/4 years out (16 – 17 quarters out depending on period) (2 new quarters are listed every 6 months in April and October) Contract Unit1 Megawatt of Electrical energy (for every hour of every day of the period) Profile – PeakPeak period contract (07:00 - 22:00 working weekdays) Profile – Base load Base load contract (continuous 24 hours) Regions4 nodes (regions) - NSW, VIC, QLD, SA. Tick Size$0.05 for quarterly contracts. Tick value varies between contracts to take into account the different hours for each state/load/quarter. Final Cash Settlement Settlement against NEM arithmetic average of Peak/Base half hourly prices rounded to 2 decimal places over the contract quarters. Last Trading DayLast day of the calendar quarter. Peak Holiday Schedule Participant committee established to lock down holiday schedule. Listed on d- cyphaTrade website and cannot change after listing. Daily Settlement Procedures Standard SFE rules apply with some specific electricity considerations. Exchange fee$0.017/MWh per trade. See www.d-cyphatrade.com.au Trading HoursMarket is open 9:00am to 4:50pm (Sydney Time).

137www.d-cyphaTrade.com.au 1800 330 101 Contract Specifications Each quarter has it’s own number of contract hours. Base and Peak futures cover a different number of hours across a given quarter. n.b. Base futures shown to left. $300 cap futures have the same hour coverage as base futures. Peak futures MWh table is determined by holiday schedule (also available on website). http://www.d- cyphatrade.com.au/products/electricity_futures

138www.d-cyphaTrade.com.au 1800 330 101 Contract Specifications: Tick Values 1. Calculating tick value of a single QTR: A $0.05/MWh change in price in a 2010 Q2 base contract will create a profit or loss of: 2184 MWh x 1 contract x $0.05/MWh = $109.20 for a 5c move, or $2,184 for a $1 move. 2. Calculating the tick value of a calendar strip or option over a calendar year: A $0.01/MWh move in a calendar year 2012 base position. Add MWh of Q1, Q2, Q3 and Q4. (2184 + 2184 + 2208 + 2208)MWh x $0.01/MWh = $87.84 for a 1c move’ or $8,784 for a $1 move.

139www.d-cyphaTrade.com.au 1800 330 101 How to read Product Codes 1. First component: > Base or Peak (e.g. B = Base, P = Peak, G = Cap) for quarter futures, or > Base or Peak Strip covering a year of futures (e.g. H = Base Strip, D = Peak Strip, R = Cap Strip) 2. Second component: > State (e.g. N, V, S, Q) 3. Third component: > Relevant quarter (H= Q1, M= Q2, U= Q3, Z= Q4), or in the case of a strip trade > Year-long strip ending with the prescribed quarter (e.g. Z = Calendar Year, M = Financial Year) 4. Fourth component: > Relevant Year (9= 2009, 0= 2010, 1= 2011, 2 = 2012 etc) Note: Options codes as per relevant futures code, with strike price and “C” or ‘P” attached to the right e.g. HVZ105000C is the product code for the $50 call option on Calendar Year 2011 BNZ1 12341234

140www.d-cyphaTrade.com.au 1800 330 101 Summary of Codes Please go to the Handbook for further tables.

141www.d-cyphaTrade.com.au 1800 330 101 Futures prices converge (at end of quarter) to equal the pool price average of the quarter Final futures expiry price = actual Pool Price average

142www.d-cyphaTrade.com.au 1800 330 101 Short Term Market Spot Quarter Contracts > Spot futures quarter contracts remain “whole of quarter” contract. > “balance of quarter” price is implicitly priced into the spot futures contract by traders. > Once the relevant futures quarter has begun pooling, there is a “known” component and an “unknown” component priced into the futures price. > The implied price (?) for the futures quarter can be calculated as follows: Remember, final Futures cash settlement price = average pool price for quarter Assume: Spot futures contract covers 2,208 MWh, and trading on SFE at $100/MWh We’re half way through the quarter ½ way through quarter Known pool price average = $150 From www.aemo.com.au data ? Remaining pool price average = $50 (Implied, weighted by hours) i.e. [($100 x 2,208 hours) – ($150 x 1,104 hours)] ÷ 1,104 remaining hours = ?

143www.d-cyphaTrade.com.au 1800 330 101 Spot Quarter Contracts Price impact of $10k spot price? > Spot prices range from: -$1,000 to $10,000 per MWh / half hour. > An unforseen $10,000 spot price spike for 1 hour can (all else being equal) effect the price of a futures contract trading at $40/MWh by: For a Base contract: > [$10,000- $40] / 2,208 hours = $4.51 per MWh For a position incorporating a year-long strip of 4 Base contracts: [$10,000- $40] / 8,760 hours = $1.14 per MWh For a Peak contract is higher (less hours). > E.g. [$10,000- $40] / 915 hours = $10.89 per MWh

144www.d-cyphaTrade.com.au 1800 330 101 Strip Products The Strip Mechanism This enables Calendar and Financial Years to be traded at one single annual price (also Australian Power Strips). This is a mechanism which bundles 4 quarters, for execution purposes only. Once executed they break down for clearing into 4 individual and independent quarters. Calendar and Financial Year Strips Strips are available for Peak, Base and also for Off-Peak (which breaks down into 4 quarters of base and 4 quarters of Peak) Strips are available out 3 to 4 years (depending on the time of year). Quarter prices are set using a defined algorithm taking into account the previous Quarter settlement prices, adjusted proportionally up or down so that their cumulative average hourly weighted price is equal the strip trade price, i.e. Quarter prices are not allocated at a flat rate over the year. Tick Size $0.01 to enable precise allocation.

145www.d-cyphaTrade.com.au 1800 330 101 Strip Trading – How to calculate quarter prices from an annual price. > SFE standardised strip allocation formula > Standardised allocation > As per the SFE Operational Policies document. > Can also be used on day of option expiry to give indication of quarter price allocation from option exercise. > d-cyphaTrade Calculator

146www.d-cyphaTrade.com.au 1800 330 101 Australian Power Index > Two Power Indices 1. National Power Index (NPI) 2. Eastern Power Index (EPI) > Both Indices represent access to Australian electricity as a separate investment class > Wholesale investment professionals seeking portfolio diversification opportunities have a myriad of potential investment strategies to chose from, benchmarked to Australian electricity prices > d-cyphaTrade ASX Electricity Futures are cash settled without physical electricity delivery, providing professional funds managers with the ability to create electricity price-linked investments directly via their SFE Participant, avoiding many of the costs & risks associated with investing in physical power assets

147www.d-cyphaTrade.com.au 1800 330 101 Australian Power Index Description: > The 2 indices are based on variations of a calendar year index comprising of d- cyphaTrade ASX Australian Electricity contracts for a 1 year duration across either the Australian National (NSW, VIC, QLD and SA) or the Australian Eastern Seaboard (QLD, NSW, VIC) regions. > The average price of d-cyphaTrade ASX Electricity Futures contracts covering a calendar year > It will be quoted for all available calendar years listed including the prompt with a cascading expiry (i.e. Cash settled as each quarter expires)

148www.d-cyphaTrade.com.au 1800 330 101 1. National Power Index (NPI) > The NPI represents a single national basket of electricity futures listed across the National Electricity Market (NEM) regions of NSW, VIC, SA and QLD. > Each calendar year NPI includes the 4 consecutive futures quarters which make up a calendar year. > It represents the average MWh-weighted price of 16 component quarterly futures contracts with a combined minimum energy coverage of 35,040 MWh for each year. > The prompt calendar year NPI may incorporate official cash settlement prices of expired quarters and non-expired futures quarters across the year.

149www.d-cyphaTrade.com.au 1800 330 101 1. National Power Index See www.d-cyphaTrade.com.au for daily NPI

150www.d-cyphaTrade.com.au 1800 330 101 2. Eastern Power Index > The EPI represents the average base load price of electricity across the 3 most liquid regions of the NEM (NSW, VIC and QLD). > It includes the 4 consecutive futures quarters which make up a calendar year, in each calendar year listed on the SFE including the prompt. > Therefore, it represents the average MWh-weighted price of 12 component quarterly futures contracts with a combined minimum energy coverage of 26,280 MWh for each year.

151www.d-cyphaTrade.com.au 1800 330 101 2. Eastern Power Index (EPI)

152www.d-cyphaTrade.com.au 1800 330 101 2. Eastern Power Index (EPI) Comparison of historical price moves to mainstream markets. 2006 to 2008. Price’s compared in relevant traded currency.

153www.d-cyphaTrade.com.au 1800 330 101 WEPI - Wholesale Electricity Price Index Wholesale Electricity Price Index (WEPI) 1. Used for educational purposes only. 2. Not tradable and should not be relied on for hedging decisions or contracting. 3. Much more volatile and “random” price compared to other indices or liquid Calendar Year contracts

154www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX FUTURES AND OPTIONS SPECIFICATIONS ……..CAP FUTURES

155www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX Australian Electricity $300 Cap Futures Underlying Commodity 1 MW of electrical energy per hour on a base load profile for the respective States (NSW, VIC, QLD and SA) over the duration of a Calendar Quarter. Contract TermQuarterly products, out 2 years (8 –11 quarters) Tick Size$0.01 per MWh Exchange fee$0.017/MWh per trade. See www.d-cyphatrade.com.au Cash Settlement Value Is calculated by taking the sum of the NEM half hourly price minus the Cap Price (i.e. $300), wherever the NEM price exceeds the Cap price for each and every half hour over the Contract Period, divided by 2. To derive the Cash Settlement Value in $/MWh divide the above by the number of MWh in the quarter.

156www.d-cyphaTrade.com.au 1800 330 101 $300 Cap Futures - Payout Profile Sum of half hour exceedence divided by half hours in quarter = $0.24

157www.d-cyphaTrade.com.au 1800 330 101 Cap Payout Price

158www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX FUTURES AND OPTIONS SPECIFICATIONS ……..OPTIONS

159www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX Australian Electricity Options Products Calendar Strip Options1 st Quarter Peak Options Option styleAmerican Expiry dateCalendar 2010 & Q1 2010 options 19th November 2009; Calendar 2011 & Q1 2011 options 19th November 2010. Calendar 2012 and Q1 2012 options 21st November 2011. Calendar 2010 and Q1 2010 options 19th November 2009; Calendar 2011 and Q1 2011 options 19th November 2010. Calendar 2012 and Q1 2012 options 21st November 2011. Underlying delivery4 consecutive quarter futures contracts comprising the calendar year (i.e. Q1, Q2, Q3 & Q4) Peak Q1 Futures contract Regions availableNSW, VIC, SA, QLD Exercise typeManual QuotationAUD $/MWh (e.g. $2.34) Minimum Tick increment$0.01/MWh Tick Value (per $0.01/MWh increment) Either $87.60 (for an underlying year which is not a leap year); or $87.84 (for an underlying year which is a leap year) Between $8.85 to $9.30 depending on the number of hours in the underlying Peak Q1 futures contract Exchange fee$0.0085/MWh per trade.$0.0175/MWh per trade. Option Model used for Daily Price Settlement Black & Scholes

How to read Option Product Codes > PQH007500C stands for; > Peak period, > QLD, > Quarter 1, > 2010, > Call option, > Strike price of $75.00 > HNZ204800P stands for; > Base Load strip, > NSW, > Calendar year 2012, > Put option, > Strike price of $48.00 What does HNZ204800P stands for?..… What does PQH007500C stand for?..…

161www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX Australian Electricity Options Products > Listed Options > Manual exercise “use it or lose it” > Last trading time: 12 noon on day of expiry > Expiry date/time: 1:30pm on day of expiry (6 weeks prior to commencement of underlying calendar year) > Expiry method: Clearer to inform SFECC by 1:30pm > Sellers informed of exercise by 3 pm on day of expiry; or > (if exercise occurs on an earlier day) by 45 minutes prior to the start of trading on the following business day > Method of allocation of exercised contracts amongst sellers Clearers: Arbitrary (at SFE discretion).

162www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade ASX Australian Electricity Options Products > Calendar options (special features) > Daily options premium settlements marked to “H” strip settlement price – which can (and do) vary to calendar price implied by quarter futures (relevance to delta hedging) > Can cause daily variation margin swings due to options being valued using H-strip price (via Black and Scholes model) and delta hedges being valued against quarter futures prices > Exercise gives rise to 4 consecutive futures positions – prices allocated relative to previous days quarter futures settlement prices (versus strike) > Upon exercise, futures prices automatically allocated by SFE OPERATIONS

163www.d-cyphaTrade.com.au 1800 330 101 Market Makers > At times, Market Makers operate anonymously and provide a range of valuable services, including: > Continuous Quotation > Request For Quote (RFQ) Price > Settlement Price support at market close > If looking for a price in a specific product – brokers can be asked to issue an EOI, requesting bids and offers from the market. > If you are already working an order and looking for a counter bid/offer – brokers can be asked to issue an RFQ, requesting bids and offers from the market. > Market Makers can earn exchange fee discounts on negotiation with ASX

164www.d-cyphaTrade.com.au 1800 330 101 FUTURES AND OPTIONS TRADING MECHANISMS

165www.d-cyphaTrade.com.au 1800 330 101 Deal Flow Example SFE SYCOM Market Matches best bid / offer & registers trade SFE Clearing Clearing Participant accepts sold position for client Clearing Participant accepts bought position for client Buy orders Sell orders

166www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms 1. Normal On-Screen SYCOM Market 2. Block Trade Facility (BTF) 3. Pre-negotiated Business 4. SYCOM Custom Market 5. Exchange for Physical (EFP)

167www.d-cyphaTrade.com.au 1800 330 101 OTC market Transparency = Block Trades

168www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms SYCOM market (normal on-screen trading) > Orders can be placed via SFE Participants (brokers) via: 1. Online trading systems Independent Software Vendors and/or systems provided by SFE Participants: http://d- cyphatrade.com.au/trading/independent_software_vendore 2. Voice brokers > Orders are matched and filled according to price competitiveness and time order

169www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms Block Trade Facility (BTF) > Off-market trading mechanism that permits brokers (or market participants directly) to bilaterally arrange transactions in the OTC market. > Most Block Trades for electricity are arranged by voice broker > Threshold is 15 lots or greater (per quarter) > Can be submitted to SFE Operations from 9:00am till 5:00pm > Trades publication via 1. Market Broadcast via Message Board (Broker generated) e.g. BT ORDER BVH9 20 @ 105.00 2. Confirmation broadcast when TRADE confirmed (SYCOM generated) > All broadcasts emailed/posted by d-cyphaTrade on free message service. > BTFs do not influence Daily Settlement Prices > BTF trading requires written Client Acknowledgement to Broker (once off)

170www.d-cyphaTrade.com.au 1800 330 101 Block Trade Transparency: Custom & Message Board

171www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms: Pre-negotiated business Pre-negotiation Business > Allows brokers to withhold orders and pre-arrange trades off-market before bringing the negotiated business to the on-screen market (allowing other traders to post orders onscreen) prior to dealing. > There is no minimum threshold > Available from 9:00am till 4:00pm (allowing enough time for the mandatory pre- trade waiting period) > Brokers must not execute pre-negotiated orders prior to 30 seconds after posting the RFQ message. After the 30 seconds, the broker must fill pre-negotiated orders at any better onscreen market price. > Broker must not delay execution by more than 90 seconds after the 30 second waiting period.

172www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms: Pre-negotiated business Pre-negotiation Business: Some Important Considerations > The RFQ message lets other traders know that a pre-neg trade may be about to occur, so they have 30 seconds to put bids or offers on screen if they want a chance to participate. > RFQ messages are broadcast in real-time via front end providers and SYCOM terminals. d-cyphaTrade also provides email alerts (albeit often later than 30 seconds). > Clients to pre-neg business are not guaranteed a “fill” because the market may respond with more competitive prices > Brokers cannot flake (i.e. back out) after an RFQ is broadcast. The broker’s pre- neg orders must be brought to market after 30 seconds. > 30 seconds after RFQ, brokers must deal with any better on-screen orders first, before crossing any balance of their own orders. To view the Questions & Answers from the ASX Information Session (6-Dec) on recent market enhancements to trading mechanisms please go to http://www.d-cyphatrade.com.au/trading/operational_policies/asx_info

173www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms SYCOM Custom Market > Provides ability to trade any spread - between different quarter/strip, node or product (i.e. peak or base). Most common for electricity is inter-regional and off-peak. > Bulletin board type display – working order available on the d-cyphaTrade website (email alerts also available). Quotes not yet reported by Reuters/Bloomberg > Available during market hours > Prices not published, only volumes

174www.d-cyphaTrade.com.au 1800 330 101 Trading OTC strategies via Futures SYCOM Custom Market Enables OTC-styled strategies to be traded via futures > Off-Peak > OP price = ((base price * base hours)-(peak price* peak hours))/(base hours-peak hours) > JanJun and JulyDec > JanJun = ((Q1 price*hours)+(Q2 price*hours))/total hours > JulyDec = ((Q3 price*hours)+(Q4 price*hours))/total hours > Inter-regional > IR spread = (region 1 price - region 2 price) > Option Spread strategies (and delta hedged strategies) For custom market input guide, see: http://www.sfe.com.au/content/sfe/marketdata/cm_instructions.pdf

175www.d-cyphaTrade.com.au 1800 330 101 Futures Forward Curve Above includes implied prices for strategies e.g. Jan-Jun strips and Offpeak. Daily CSV emails available to data centre subscribers (also caps and options)

176www.d-cyphaTrade.com.au 1800 330 101 Options Curve

177www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms To Create - The Australian Power Indices Clients of SFE Participants may create a portfolio of futures contracts which emulate the Australian Power Indices. For example, a hedge fund manager could create an EPI futures portfolio across Calendar 2009 by simultaneously buying (or selling) a basket of 2009 base load futures contracts across NSW, VIC and QLD. This strategy could be executed by: 1. Trading via the SFE SYCOM Custom Market (as a strategy order of any volume) e.g. +20 HNZ9, +20 HVZ9, +20 HQZ9; at prices which average to the desired EPI price. 2. Trading via a negotiated off-market Block Trade (volumes >= 15 MW per quarter) e.g. +20 HNZ9, +20 HVZ9, +20 HQZ9; at prices which average to the desired EPI price. 3. Trading via a negotiated off-market Pre-negotiated Trade (any volume) e.g. +10 HNZ9, +10 HVZ9, +10 HQZ9; at prices which average to the desired EPI price.

178www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms EFP - Exchange For Physical > An EFP transaction is a futures transaction traded off-market simultaneously with an equal and opposite OTC transaction. > The OTC transaction must be for the same or similar quantity or amount of electricity, or a substantially similar commodity or instrument. > There are 2 legs to an EFP:  A futures contract  An equal and opposite OTC swap > An SFE Full Participant or two Full Participants register the futures leg of an EFP with the Exchange.

179www.d-cyphaTrade.com.au 1800 330 101 Trading Mechanisms > Uses/benefits > OTC counterparty credit exposure can be effectively eliminated when an existing swap position is replaced with a futures position. > Reduce balance sheet and margin requirements by netting OTC positions against existing futures. > Off-market - EFPs are negotiated and traded between counterparties off-market with price and volume details not reflected “on screen”. > 24-hour Trading - EFP transactions can be negotiated around the clock (they can only be registered between 7am and 5pm).

180www.d-cyphaTrade.com.au 1800 330 101 EFP Worked Example Assume: > Retailer A has a bought 100 MW of VIC 2013 Base load swap from Generator X at a price of $35/MWh. > VIC 2013 Base load futures settle at $60/MWh. > Retailer A’s credit risk manager calculates that outstanding credit risk exposure to Generator X (based on the current market value of replacement contracts) stands at $21.9 million and halts further OTC trading with Generator X. > The traders of Retailer A and Generator X wish to do a tailored OTC swap deal but now can’t. > Solution: They agree to enter into an EFP to “switch” the OTC exposure into futures thereby eliminating the existing OTC credit default risk and allowing Retailer A’s credit risk manager to lift the OTC trading ban.

181www.d-cyphaTrade.com.au 1800 330 101 EFP Worked Example A’s Clearing Participant X’s Clearing Participant Retailer A EFP Registered Sell Swap (at original price) Buy Futures Buy Swap (at original price) Sell Futures Generator X Retailer A Previous OTC Position Long Swap Credit risk = $21.9 million Short Swap Credit risk = nil Generator X EFP Worked Example

182www.d-cyphaTrade.com.au 1800 330 101 Initial margin impact considered separately Exchange for Physical (EFP) example Retailer A EFP Generator X EFP Bought OTC swap at $35/MWh (original position) Sold OTC swap at $35/MWh (at original OTC price) Bought VIC Base load futures at $35/MWh  $21.9 million OTC Credit risk eliminated  $21.9 million positive variation margin cash flow i.e. ($60 - $35)/MWh  OTC trading lines freed up Sold OTC swap at $35/MWh (original position) Bought OTC swap at $35/MWh (at original OTC price) Sold VIC Base load futures at $35/MWh  $21.9 million negative variation margin cash flow. i.e. ($60 - $35)/MWh  OTC trading lines freed up

183www.d-cyphaTrade.com.au 1800 330 101 Factors that may influence the “spread” (price differential) between the futures price and the Swap price of an EFP differ with each counterparty but may include*: 1.Value of immediate credit risk reduction 2.Value of credit risk avoidance in the future 3.Cash flow funding benefit (or cost) of resultant cash flows: >Variation margins, Initial Margins >Impact on OTC collateral costs (e.g. cost of OTC guarantees) 4.Liquidity Benefit - “freeing up” OTC trading lines and multi-participant liquidity/netting benefits using futures 5.AEMO prudential offset benefits using futures (Futures Offsets) ? 6.Privatisation of Government Owned retailers or sale of hedge book ? 7.Switch OTC to SFE if AUS adopts US-proposed OTC regulation ? * Non-exhaustive list of value considerations Exchange for Physical (EFP) example

184www.d-cyphaTrade.com.au 1800 330 101 SFE SETTLEMENT PRICE RULES

185www.d-cyphaTrade.com.au 1800 330 101 Futures Daily Settlement Procedures > The SFE Operational Policies (v4.3) should be read in conjunction with the SFE Operating Rules (v4.14). Both documents are available at: 1. www.d-cyphaTrade.com.au 2. www.asx.com.au/supervision/rules_guidance > SFE settles up to 3,000 electricity products each night > Electricity futures market trades “onscreen” between 9:00am - 4:00pm AEST

186www.d-cyphaTrade.com.au 1800 330 101 Electricity Futures Daily Settlement Procedures SUMMARY > A preliminary Daily Settlement Price (DSP) for QTRs will be generated at: > the most competitive order at market close; or > if more competitive, the last traded price (including QTR prices allocated to strip trades); > the extreme of the bid / ask spread closest to the last traded price if the last traded price is outside closing bid / ask spread; > If a related strip product (e.g. A calendar year strip) is more competitively bid or offered than the hourly-weighted annual price implied by the 4 relevant QTRs, one or more QTR prices will be proportionally adjusted so that the 4 QTR futures prices equate (as a yearly price) to the strip product price > Futures contract prices resulting from Strip trades are eligible as the ‘last traded price.’ > In absence of trades or valid orders DSP will be prior settlement price. > On Listing Date the DSP will be equal to the DSP of the nearest same calendar month contract. > Off Peak Strip leg prices, Block Trade & EFP prices will not be used for DSP determination.

187www.d-cyphaTrade.com.au 1800 330 101 Worked Example > Operating Rule 1.9.1 > (ii) Where there is either a final bid or a final ask, and there is a last trade price, then the last trade price shall be the DSP, unless the last trade price is below the final bid or above the final ask, then the final bid or final ask shall be the DSP… Q3 2009At closeDSP Last trade Price (LTP) $42.00LTP < Final Bid  Final Bid$42.05DSP = $42.05 Final Ask$42.50N/A 

188www.d-cyphaTrade.com.au 1800 330 101 Secondary DSP adjustments of Strip Products and QTR products SUMMARY 1. Preliminary DSP of strip products will be generated at the most competitive outright order or last trade; 2. An implied calendar year price is derived using the hourly-weighted average price of each preliminary settlement price (PSP) from each of the underlying quarters; 3. As discussed, preliminary DSPs of QTRs and/or annual strips can be adjusted further: 1. if the implied calendar year price (as derived above) is LESS competitive than the most competitive outright order in the relevant strip, then the DSP of the relevant quarterly futures products is proportionally adjusted to meet the strip order; 2. if the implied calendar year price (as derived above) is MORE competitive than the most competitive outright order in the relevant strip, then the DSP of the strip will be adjusted to meet the implied calendar year price; however 4. IMPORTANT: No QTR DSP or Strip DSP will not be set at a less competitive price than a live market order on close in that specific product.

189www.d-cyphaTrade.com.au 1800 330 101 Worked Examples > A) Implied Calender Year Price (using the quarters) is not less competitive than outright orders in the relevant strip product. >........hence, strip price will be adjusted to match the implied price using quarters. Strip price down

190www.d-cyphaTrade.com.au 1800 330 101 Worked Examples > B) Implied Calender Year Price (using quarters) is less competitive than the outright orders in the relevant strip product. Hence, QTRS will be adjusted. QTRs up

191www.d-cyphaTrade.com.au 1800 330 101 Futures Daily Settlement Procedures

192www.d-cyphaTrade.com.au 1800 330 101 Options Daily Settlement Price Rules For further information on Daily Settlement Price determination refer to Operating Rule 1.9. The determination of the Daily Settlement Prices will comply with all of the below procedures. > Daily Settlement Price (DSP) will be generated from last traded price, where more competitive than orders at market close > If last traded price is outside closing bid / ask spread DSP will be the extreme of the bid / ask spread closest to the last traded price > DSP will be generated using the At-the-Money (ATM) Volatility and the Black and Scholes pricing model > ATM Volatility will be generated from i) last traded price ii) if more competitive ATM orders at market close > ATM orders include ATM outright and basis Futures Puts, Calls and Straddle Orders (orders that are not ATM at market close will not be considered for ATM DSP generation) > DSP will not be generated that are less competitive than outright orders at market close > On Listing Date the Volatility level for generating DSP will be equal to the Volatility of the nearest shorter dated Contract > A movement in ATM Volatility will be reflected in all Contract exercise prices, subject to valid orders at market close in the individual exercise prices > DSP of Strike Prices will not settle at premium levels above that of same contract strikes that are further In-the-Money (ITM) > Flat Volatility skews, determined from the ATM Volatility, will be maintained prior to generation of DSP > Block Trade prices will not be used for DSP determination

193www.d-cyphaTrade.com.au 1800 330 101 Options Settlement Procedures Calendar Options 1. Determine DSP of underlying Futures Strip Product (e.g. HQZ2 = $51.80) 2. Determine “default” at-the-money (AtM) Call and Put using Options Model and previous volatility factor 3. If no better AtM call or put bids, offers or last trades (i.e. In $/MWh), then revert to yesterday’s AtM volatility; else > If better AtM call or put bids, offers or lasts, then DSP must meet best order AND reset AtM volatility to meet new DSP.

194www.d-cyphaTrade.com.au 1800 330 101 Calendar Options 4. Use Options Model to calculate all strike DSPs using today’s AtM volatility 5. Skew any strike up or down to meet a more competitive bid or offer, than the preliminary DSP Notes: Skews in Out-of-the-Money strikes are “flattened” the next day (i.e. Skew removed – unless rebid or reoffered each day) Straddles are considered market orders for the purposes of AtM DSP determination. Options Settlement Procedures

195www.d-cyphaTrade.com.au 1800 330 101 Preliminary DSP using at the money volatility But assume, at 4:00 pm: 1. The $53 call is offered $4.40 2. The $58 call is bid $3.80 i.e. better than the preliminary DSP for those out of the money strikes Options Settlement Procedures

196www.d-cyphaTrade.com.au 1800 330 101 The preliminary DSP of out of the money options is adjusted up or down to meet the better market order Also note that the SFE will also adjust DSPs in other strikes which have become subject to a strike- arbitrage (e.g. to avoid a further- out-of-the money option settling higher than a closer-to-the money option). e.g. increasing the DSP of further in the money options to meet a higher DSP in a further out of the money option. If the underlying futures strip price moves to another strike later, that new strike becomes the at the money strike Options Settlement Procedures

197www.d-cyphaTrade.com.au 1800 330 101 FUTURES MARGINING 1. INITIAL MARGIN DEPOSITS 2. VARIATION MARGINS

198www.d-cyphaTrade.com.au 1800 330 101 The Margining Process > There are 2 categories of margins relevant to futures clients: 1. Variation Margins (VM) > VMs are the cash paid or received daily to/from the SFE Clearing Participant and the Client > VMs equal daily profit or loss 2. Initial Margins (IM ) > IMs are security deposits held in cash (or guarantee) > IMs are held to cover a 1 day worst case VM (i.e. a one day shift in futures price) > IMs are returned to the client if the futures position is closed out or expired and the client does not default

199www.d-cyphaTrade.com.au 1800 330 101 Initial Margins and “SPAN calculator” > To determine the size of Initial Margins required from its Clearing Participants, SFE Clearing uses the SPAN (Standard Portfolio Analysis of Risk) margining system. This system was developed by The Chicago Mercantile Exchange (CME) in 1988 and is now the worldwide industry standard. SPAN calculates margins basis portfolio risk and NOT each trade individually. > Electricity margins are adjusted according to each individual quarters volatility (e.g. seasonally adjusted). > Margins are set using historical settlement price data and other factors. > The best way to ensure lower margins is by consistent pricing during the daily settlement process. > Initial margins are currently reviewed monthly. > Up to date SPAN Arrays (complete with individual product I.Ms and margin offsets) are available at: http://www.asx.com.au/sfe/span.htm

200www.d-cyphaTrade.com.au 1800 330 101 Initial Margins - SPAN Scenario Details 1Futures unchanged; Volatility up 2Futures unchanged; Volatility down 3Futures up 1/3 range; Volatility up 4Futures up 1/3 range; Volatility down 5Futures down 1/3 range; Volatility up 6Futures down 1/3 range; Volatility down 7Futures up 2/3 range; Volatility up 8Futures up 2/3 range; Volatility down 9Futures down 2/3 range; Volatility up 10Futures down 2/3 range; Volatility down 11Futures up 3/3 range; Volatility up 12Futures up 3/3 range; Volatility down 13Futures down 3/3 range; Volatility up 14Futures down 3/3 range; Volatility down 15Futures up extreme move 16Futures down extreme move

201www.d-cyphaTrade.com.au 1800 330 101 Initial Margins – SPAN for Futures > For the most recent margin schedules: https://d-cyphatrade.com.au/clearing/margins

202www.d-cyphaTrade.com.au 1800 330 101 Initial Margins – SPAN for Options PSR: Price Scanning Range. To cover futures shift. VSR: (Option only) Volatility Scanning Range. To cover volatility shift. Note: PSR and VSR applied on the basis of the option’s delta and vega (not at 100% weighting). Hence an out-of-the-money and/or hedged option portfolio with low delta and low vega will have substantially lower Initial Margin requirement than an option with large delta and large vega.

203www.d-cyphaTrade.com.au 1800 330 101 Initial Margin Concessions Futures and Options Concessions available for recognised spreads PN:BN 25% 2:1BS:GS 60% 1:1 PV:BV 40% 2:1 BV:GV 60% 1:1 PQ:BQ 25% 2:1 BQ:GQ 60% 1:1 PS:BS 30% 2:1BN:GN 60% 1:1 BS:BV 40% 1:1 BN:HN 80%4:1 BV:BN 50% 1:1 BV:HV 80%4:1 BN:BQ 50%1:1BQ:HQ 80%4:1 PS:PV 45%1:1 BS:HS 80%4:1 PV:PN 45%1:1 PN:PQ 50%1:1 Delta hedged calendar options i.e. 4 QTR futures v.s. 1 calendar option (delta) Cap Futures v. Base Futures 2 peak v. 1 Base Inter- regional spreads

204www.d-cyphaTrade.com.au 1800 330 101 Example of Inter-Month Concessions e.g. SPAN assumes zero risk (zero initial margins) if portfolio has long Q1 product and a sold Q2 product. Hence, strategy would normally, attract nil I.M. To account for time spread price correlation risk, an “Intermonth Charge” (add back) margin is required for each time spread.

205www.d-cyphaTrade.com.au 1800 330 101 Example of an Off-Peak Margin Concessions Span attempts to find the most beneficial initial margin offsets, in descending order, until no further offsets are available on the residual positions. For more details of SPAN or to order a copy of SPAN online, visit www.CME.com

206www.d-cyphaTrade.com.au 1800 330 101 Use of bank guarantee for SFE Initial Margins > Bank Guarantees (BG) are acceptable forms of collateral for clients to use to cover initial margin requirements (pending SFE Clearing Participant agreement). > The benefits of using a BG for futures collateral requirements include:  Australian energy companies are accustomed to using BGs (or equivalent) for the purpose of collateral deposits with AEMO and for OTC trading support. Treasurers and Risk Managers are already comfortable with the use of BGs.  One BG posted to a futures clearer provides access to liquidity supported by up to 40 different energy trading companies (without the need for ISDAs).  BGs may be posted in sufficient value to accommodate various potential position sizes, thereby reducing the need for continuous cash management related to adjustments in futures positions.  Daily variation margins will continue to be received or paid for in cash.

207www.d-cyphaTrade.com.au 1800 330 101 IM and VM Margin Cash flows for a standard futures position (long position) held to expiry n.b. IM = $2,800 per contract

208www.d-cyphaTrade.com.au 1800 330 101 Option Margining (Variation and Initial) The following table illustrates the Initial Margin deposit and also daily variation margin cash flows of an option trade held to expiry and exercised. A Calendar 2007 $39 call option. 8,760 MWh per contract. 41.31 Option Initial Margin assumption for illustrative purposes = $6,500 per contract. But may be lower if delta of option less than 100% (Volatility margin VSR ignored in example). Futures Initial Margin (across Calendar 2007) = $9,700 per 4 consecutive quarter contracts. Impact on Initial Margin of exercise depends on other futures positions (e.g. offsetting) already held.

209www.d-cyphaTrade.com.au 1800 330 101 Privatisation of NSW government owned energy businesses USING EFPs TO CLEAR CREDIT LINES

210www.d-cyphaTrade.com.au 1800 330 101 NSW Electricity Business Risk Management Proposal – Use of EFP Transferring OTC hedge books – Sale of businesses Current Position: Credit risk from OTC contracts between NSW-owned OTC buyers and NSW-owned OTC sellers minimal.

211www.d-cyphaTrade.com.au 1800 330 101 NSW Electricity Business Risk Management Proposal – Use of EFP Transferring OTC hedge books – Sale of businesses But, if new private owner buys the retailer’s OTC book, NSW gov generator immediately exposed to credit default risk of private owner Private Retailer ? NSW Generator also exposed to any subsequent downgrading of retailer credit worthiness

212www.d-cyphaTrade.com.au 1800 330 101 NSW Electricity Business Risk Management Proposal – Use of EFP Alternative solution: 1.Reverse all existing OTC contracts into SFE contracts (via EFP) prior to selling the retailer OTC book; 2.NSW state-owned generator now has only futures positions, and not exposed to credit default of the retailer. 3.Transfer the SFE-only position to the new private retailer;

213www.d-cyphaTrade.com.au 1800 330 101 NSW Electricity Business Risk Management Proposal – Use of EFP OTC hedge contracts are converted into futures via the EFP process OTC leg of EFP SFE leg of EFP

214www.d-cyphaTrade.com.au 1800 330 101 NSW Electricity Business Risk Management Proposal – Use of EFP Final outcome – Government can now transfer SFE-only book to Private owner (via Block Trade) OTC default risk removed NSW Government

215www.d-cyphaTrade.com.au 1800 330 101 Consider the uncertainty facing the potential buyer of a NSW Retail Energy Business. Assume: 1.The retail business’ hedge book is 1,000 MW under hedged (i.e. short) for 2009; 2.4 other parties are bidding for the business Risk 1: If our potential buyer doesn’t pre-emptively manage the hedge book risk but subsequently wins the tender. The portfolio will be short 1,000 MW and any rally in hedge market price prior to business purchase will have undermined business value. Loss = contract price rally $/MWh x 1,000MW. or Risk 2: If our potential buyer pre-emptively buys 1,000 MW of futures or OTC swaps in advance but does not win the business tender. The unsuccessful bidder’s portfolio will be long 1,000 MW and any fall in hedge market price prior to announcement of business sale will have created a loss to the potential purchaser. Loss = contract price fall $/MWh x 1,000 MW. Using options to hedge uncertainty of a competitive asset/business tender

216www.d-cyphaTrade.com.au 1800 330 101 Alternatively, the potential purchaser could: 1.Buy 1,000 MW of call options over Calendar 2009 futures: >Exercise call options into bought futures if successful in the sale process; or >Resell the call options if unsuccessful in the sale process. 2.Buy 1,000 MW of futures and buy 1,000 MW of put options: >If business is purchased, abandon or resell put option (keeping futures hedge); or >If business in not purchased, put option protects against potential futures price fall. If futures prices rallied, resell option and resell futures for a profit. Using options to hedge uncertainty of a competitive asset/business tender

217www.d-cyphaTrade.com.au 1800 330 101 Uncertain if business purchase will be successful Uncertain if long or short 1,000 MW: use options as insurance Unrealised Loss $/MWh Futures price $/MWh Using options to hedge uncertainty of a business purchase Unrealised Profit Short 1,000 MW Portfolio of NSW retailer Buy futures 1,000 MW Price risk if no hedge & business purchase Option premium cost (less if resold)

218www.d-cyphaTrade.com.au 1800 330 101 USING EFPs TO INTEGRATE (OFFSET) FUTURES AND SPOT MARKET RISK

219www.d-cyphaTrade.com.au 1800 330 101 Introduction to Futures Offsets for NEM Retailers > AEMO forces retailers to post up to approx $4.2 billion in bank guarantees to cover 6 weeks of potential pool price purchases; > AEMO calculates bank guarantee requirement quarterly based on an “MCL Price” = 12 months of pool prices x volatility factor x retailer’s average demand (referred to as Maximum Credit Limit). > AEMC Rule change would allow retailers to use futures to offset bank guarantees. i.e. 1. The retailer agrees to pay SFE price increases (from spot futures) to AEMO daily. SFE Clearing Participants confirms daily futures balance and official settlement price to NEMMCO. 2. AEMO reduces retailer’s MCL guarantee by MCL Price – SFE Futures price. > The cheaper the SFE price compared to AEMO’s MCL price, and the more expensive the cost of bank guarantees, the bigger the incentive for the retailer to trade EFPs in order to create futures and then register a Futures Offset with AEMO.

220www.d-cyphaTrade.com.au 1800 330 101 Bank guarantee = original futures lodgement price Futures Offset Arrangements SFE CLEARING Clearing Participant Security Deposit = futures price increases AEMO prudential support Retailer Bank Guarantee Provider

221www.d-cyphaTrade.com.au 1800 330 101 Week 1Week 2Week 3 Week 4 Week 5 Week 6 T0T0 T +7 days T -28 days Aggregate AEMO Bank Guarantee (BG) support = up to $4.2bn (approx) = Historical 12 month pool price x volatility factor x retailer’s expected purchase volume. Price $/MWh Time AEMO Price Estimate – Bank Guarantee Futures Offset Arrangements - EFP Retailer volume (MW) AEMO Bank guarantees held for 6 weeks worth of estimated pool price purchases

222www.d-cyphaTrade.com.au 1800 330 101 Futures Price (at inception) Week 1Week 2Week 3 Week 4 Week 5 Week 6 Week 1Week 2Week 3 Week 4 Week 5 Week 6 T0T0 T +7 days T -28 days Under Futures Offsets, if futures price is less than AEMO’s backward looking price estimate, then Bank Guarantee level is offset. In return, SFE Clearing Participant commits to pay futures cash flows to a AEMO security deposit account – if futures prices increase. $/MWh Time Bank Guarantee offset using futures AEMO Price Estimate Futures Offset Arrangements - EFP Retailer volume (MW) AEMO Bank guarantees held for 6 weeks worth of estimated pool price purchases

223www.d-cyphaTrade.com.au 1800 330 101 Futures Offset Arrangements > Rigid bank guarantees do not provide protection for cumulative pool prices higher than AEMO’s price forecast MCL guarantee shortfalls Q2 2007: Pool prices exceeded AEMO’s forecast (and exceeded bank guarantees)

224www.d-cyphaTrade.com.au 1800 330 101 Futures Offset Arrangements – EFP Illustration of Guarantee savings using FOAs

225www.d-cyphaTrade.com.au 1800 330 101 Immediate Futures Offset – bank internalises security deposit Initial Margin Variation Margin Standard bank guarantee size at reduced fee to retailer due to offset Deposit Positive Variation Margin SFE CLEARING Clearing Bank Security Deposit Bank Guarantee Provider AEMO Retailer

226www.d-cyphaTrade.com.au 1800 330 101 Futures Offset Arrangements Guarantees based on price guess Futures Offsets Reallocations secured only by potential generation

227www.d-cyphaTrade.com.au 1800 330 101 Summary of Opportunities for Retailers and Energy trading banks > Retailers reduce their operating costs > EFP market making. Spread revenue from retailers willing to buy futures & sell OTC each quarter. E.g Retailer who can save $2/MWh may be prepared to “buy futures $0.50 over swap” > May normally reduce bank’s/generator’s other OTC exposure to retailer; > Futures Clearing Business. Increased clearing revenue from retailers (and futures sellers); > Quantum of Efficiency Gain: Current Open Interest in spot quarter futures approx 7,000 contracts but could grow to 18,000 contracts per quarter (to match entire average NEM load).

228www.d-cyphaTrade.com.au 1800 330 101 Calculating the Retailer’s EFP incentive Theoretical example only: South Australia Q2 2009. Assume: > NEMMCO Q2 MCL price = $320.76/MWh (i.e. P=$71.28 x VF=4.5) > NEMMCO MCL hours (6 weeks) = 1,008 > d-cyphaTrade ASX Futures price = $43.50/MWh > d-cyphaTrade ASX Initial Margin = $6,600 per MW = $6.55/MWh of MCL > d-cyphaTrade ASX Q2 hours = 2,208 > Bank guarantee fee = 4% p.a. Calculation: Theoretical Retailer EFP “incentive” spread based on retailer’s cost of funding reduction from Futures Offset. = [$320.76-($43.50 + $6.55)] x 1,008 hrs / 2,208 hrs x 4%/4 = $1.24/MWh. = to $2.7m per quarter on a 1,000 MW load n.b. SFE transaction fees included as add-on within “d-cyphaTrade ASX Futures price”. Could be “free” for retailer if they already had futures hedge.

229www.d-cyphaTrade.com.au 1800 330 101 Retailers can use EFPs to create FOAs > Retailers reduce their operating costs > EFP market will be created. > E.g Broker works a retailer’s order: “buy futures $0.20 over swap” > May normally reduce bank’s/generator’s legacy OTC credit default exposure to retailer; > Or, even more efficient for retailer if retailer has already hedged with futures – i.e. NO MORE TO PAY

230www.d-cyphaTrade.com.au 1800 330 101 Emissions/Renewables trading

231www.d-cyphaTrade.com.au 1800 330 101 Retailers should not be charging customers for carbon (its avoidable) Scenario 1: o Retailer hedges wholesale electricity poorly and agrees to pay extra carbon costs to a high emitting generator via OTC contract. o Price Regulator rewards inefficient Retailer hedge practices by allowing Retailers to on-charge avoidable costs to consumers. Scenario 2: o Retailer hedges wholesale electricity risk efficiently, without paying avoidable carbon costs. o Price Regulator prevents Retailers from passing-through avoidable extra carbon costs onto consumer.

232www.d-cyphaTrade.com.au 1800 330 101 Retailers should not be charging customers for carbon (its avoidable) Retailer A Agrees to pay Extra carbon cost Generator’s Carbon Cost $10/MWh Electricity Cost Generators Carbon Cost Emitting Generators Carbon Charge to customers n.b. SFE alone trades 150% of annual electricity consumption. Consumers ripped off, rewarding high emmissions and inefficient Retailer hedge practices Consumers not ripped off Retailer B Hedges efficiently without Extra carbon cost All Generators, financial traders Scenario 1 Scenario 2

233www.d-cyphaTrade.com.au 1800 330 101 Other energy futures listings (d-cyphaTrade does not design or market these products but does provide data services) 1.Newcastle Coal Futures and Options 2.VIC Gas Futures (cash settled) 3.NZ Electricity Futures and Options 4.Environmental (REC) Futures and Options New Energy Futures Products

234www.d-cyphaTrade.com.au 1800 330 101 d-cyphaTrade free stuff > Free over the phone general information: > Free call 1800 330 101 (within Australia) or +61 2 9237 0900 > Free intra-day email alerts: > Options order email alerts > Off-market email alerts: Block Trades, Custom (strategy) market, Exchange for Physical and Request for Quote > Free intra-day delayed market data online: > Futures and option trades, daily open interest > Free online information: > Product specifications, initial margins, trading rules > Weekly and periodic market news bulletins (Market Wrap and Energy Focus)

235www.d-cyphaTrade.com.au 1800 330 101 Premium services: Historical Charting & Data including off-market deal history Data is available for all of these products: The underlying data can be exported into CSV Settlement price & Open Interest files are available for Futures, Options & Caps. All full trade log history

236www.d-cyphaTrade.com.au 1800 330 101 Premium services: d-cyphaTrade Electricity Futures Training > d-cyphaTrade runs 4 types of full day workshops 1. Electricity Futures & Options Workshop (level 1) 2. Australian Carbon Trading Workshop (level 1) 3. Electricity Options Trading Workshop (level 2) 4. Electricity Futures Data Analysis Workshop (level 1) > Training provided for: > Traders, hedgers > Brokers, Clearers, Banks, Hedge Funds > Risk Managers and CFOs > Government departments and regulators > Tailored in-house training available on request http://d-cyphatrade.com.au/products/training

237www.d-cyphaTrade.com.au 1800 330 101 Recommended Reading 1.AER “State of the Energy Market 2008”. www.aer.gov.au 2.AEMO 2008 State of the Market Report. www.aemo.com.au 3.“Managing Energy Price Risk, The New Challenges and Solutions”, Kaminski V (ed), Incisive Media Investments 2004 4.Fitch Ratings “How default and transition rates are calculated”, 2006, www.fitchratings.com 5.Energy Risk Magazine, January 2005, Incisive Financial Publishing 2004 6.“Energy Reform, The Way Forward for Australia”, Energy Reform Implementation Group, Commonwealth of Australia 2007. www.erig.gov.au

238www.d-cyphaTrade.com.au 1800 330 101 Useful Links 1.d-cyphaTrade: Free helpline, market alerts, futures market information, data services, links to futures service providers, training www.d-cyphatrade.com.au 2.Australian Securities Exchange (ASX and SFE): Futures and ETO market operator: www.asx.com.au 3.AEMO: Spot Market Operator. Calculates and publishes spot market prices www.aemo.com.au 4.Bureau of Meteorology: Weather. www.bom.gov.au

D-cyphaTrade Australian Power Futures and Options Training Course June 2010.

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D-cyphaTrade Australian Power Futures and Options Training Course June 2010.

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