IDENTIFICATION AND ASSESSMENT OF CREDIT EXPOSURE Michelle Wilson, Credit & Risk Manager – Transco plc 25 April 2003

CONTENTS Credit Exposures Arising – Gas and Electricity Industries Other comparable industries Definition of “Best Practice” Assessing Exposures Assessing Counterparty Risk Application to Gas and Electricity A Way Forward?

CREDIT EXPOSURES ARISING – GAS AND ELECTRICITY INDUSTRIES Transactions giving rise to credit exposure Transmission Transportation Distribution Energy Connections Durations and Value Duration Generally one to two months (short term – use of system charges) 20+ years(long term – connections)

CREDIT EXPOSURES ARISING – GAS AND ELECTRICITY INDUSTRIES Value – Peak Exposure£m Short Term Transmission608 (exc. Termination amounts) Transportation496 Energy - Gas41 Long Term Connections£1 billion (Termination amounts)

OTHER COMPARABLE INDUSTRIES Comparable Industries? Oil Telecomms Airports Other Commercial Entities Benchmarking exercise required Level of Regulation Risk v Reward Performance Bad Debt as % of Sales Days Sales Outstanding Money at Risk Processes

Energy Best Practice in U.S. 14 June 2002 (Committee of Chief Risk Officers) Credit Allocation and Financial Risk Analysis Contracts Measurement Monitoring Mitigation Participants included Aquila, Duke Energy, El Paso DEFINITION OF BEST PRACTICE

ASSESSING EXPOSURES Money at Risk a) Exposure minus Independent Security b) Exposure further reduced by use of independent credit ratings (trading counterparty or PCG) a)b) M.A.R. M.A.R. £m £m Transportation Transmission Energy - Gas 18 0

ASSESSING EXPOSURES Grounds for Credit 1.Competitive Conditions costs associated with granting credit opportunity cost of lost sales credit terms of industry 2.Probability that a customer will not pay 3.Size of Account 4.Extent to which goods are perishable Issues relevant to industry 1.Costs associated with granting credit 2.Credit terms of industry 3.Probability that a customer will not pay

ASSESSING EXPOSURES Credit Terms – Generally 0 – 30 days (but up to 90 days) Credit Cycle – Generally 0 – 60 days (45 days D.S.O. on 30 day terms) No. of days Credit Terms - Gas 12 - Electricity Credit Cycle Approx. no. of days Transmission 15 Transportation 53 Energy - Electricity 32 - Gas 78

ASSESSING EXPOSURES Impact of Default Bad Debt Profitability – ‘the bottom line’ Reputation ‘Knock on’ impacts-failure of Creditor -failure of other Creditors -price increases – Creditor or Industry -credit policy change, eg Bank Lending

ASSESSING COUNTERPARTY RISK Trading Counterparties Methods of Assessment Establishing Objective Criteria Availability and Reliability of Information Strengths/Weaknesses of Agency Credit Ratings Monitoring and Frequency of Review

ASSESSING COUNTERPARTY RISK Trading Counterparties a)Direct-Trading Counterparty b)Indirect-Parent Company Guarantees -Personal Guarantees -Financial Institutions – Letters of Credit, etc. -Insurance Cover -Charges over Assets

ASSESSING COUNTERPARTY RISK METHODS OF ASSESSMENT Analytical Methods Financial Statements – Financial Ratios Credit Reports – Dun & Bradstreet - Moodys/Standards + Poors Trade References Bank References Commercial Intelligence Share Price Financial Announcements “On the ground” London Gazette Credit Circles/Contacts

ASSESSING COUNTERPARTY RISK Establishing Objective Criteria Traditional/Subjective Guidelines “five C’s of credit” 1.Character 2.Capacity 3.Capital 4.Collateral 5.Conditions Statistical Models determine probability of default 1.Large pool of customers studied to find historic relation to default 2.Determine who is and is not creditworthy

ASSESSING COUNTERPARTY RISK LogicaEPFAL Credit Scoring Methodology Uses Quantitative & Qualitative Information Determines credit limit based upon default probability (based upon investment grade rating) Statistical Model Issues Generally - Subjectivity – Initial Credit Limit - Consistency – must be applied to all customers - Smaller customers

ASSESSING COUNTERPARTY RISK AVAILABILITY AND RELIABILITY OF INFORMATION Financial Statements - out of date - reflective of actual position? - audited or unaudited -easily available Credit Reports - dependent upon level of investigation undertaken by Agency - readily available Trade References - reliability questionable - confidentiality issues - not readily available Bank References - need permission of debtor - reliability questionable Payment History - immediately available Commercial Intelligence -readily available -“hearsay” – may be factually incorrect Credit Circles/Contacts -becoming less popular – restrictive practices - reliability questionable

ASSESSING COUNTERPARTY RISK Strengths/Weaknesses of Agency Credit Ratings (Moodys/S+P) Strengths-Easily Obtained -Professional Analysts -Use Robust Analytical models -Recognised Globally -Used in many Industries -Good “Early Warning” system Weaknesses-Can only be used for assessment of large companies -Expensive -Causes “cliff edge” effect?

ASSESSING COUNTERPARTY RISK MONITORING AND FREQUENCY OF REVIEW Generally 6-12 month review cycle Daily assessment -charges not invoiced/invoiced -published information -local knowledge -payment default Ability to react to information Immediate Issue -depends upon contractual provisions -commercial contracts – usually immediate -monopoly – depends on contract operated -Days Notice Transmission0 Transportation0 – 30 Energy – Electricity 0 Gas0 - 30

APPLICATION TO GAS AND ELECTRICITY Single or Multiple Approaches? Currently single approach to initial assessment Multiple approach to ongoing assessment but inability to act on all in timely manner Opportunity -review multiple approach to initial assessment -address issues in respect of reaction to information received Package Solutions? Opportunity -identify market consultants to assist?

A WAY FORWARD ? Participation by industry representatives and credit risk experts in a Risk Workgroup as suggested by Ofgem Invite risk assessment experts Identify weaknesses in current regimes Identify ‘Best Practice’ amongst Gas/Electricity and comparable industries Define future approach to identification and assessment of credit exposures