Measuring and managing risks on deregulated electricity markets EIPM – Archamps, sept. 23, 2005 Pierre Buffière de Lair Area Manager on European Markets

2 Organization of our presentation Presentation of various OTC products Standard Products Options Indexed Products Swaps Using these products for optimal portfolio management

3 Standard Products (POWERNEXT) Balancing Spot Futures ½ h 1 h Day Week 1 Month 3 Months Year - Basis -- Peak - OTC PNXT RTE 1 h Day Week 1 Month 3 Months Year

4 Standard products on French OTC markets The French Over-The-Counter market is offering products with various deliveries, „base“ and „peak“ ( ) Short-term markets Daily intraday market : hours and hourls „blocks“ Whole days  + 3 days Week-ends  + 1 week-end Weeks  + 2 to 3 weeks Futures markets Months  + 2 to 3 months Quarters  + 2 quarters Years  + 2 years Occasionally, „industrial year“, as of November 1st.

5 Standard products on the French OTC market With respect to spot markets, short-term products are traded continuously on OTC markets. There are arbitrage possibilities between OTC‘s traded in the morning and the clearing of the spot markets Payment after delivery, no margin calls  important credit risk. Utilization by market actors : Short-term : breakeven of energy balance Long-term : price risk management Distribution Hedging profit margins in commercial contracts Producer Hedging a cash flow with respect to production cost Consumer Hedging supply prices Speculator Betting on the evolution of product price

6 What are the determinants of forward prices? Forward prices should at all times forecast the average level of the spot over the delivery period. Arbitrage possibilities There is very little information available on the physical situation at the time of future delivery. Thus, one might forecast in terms of: Macro-economic situation Prices of fossil fuels (marginal costs) Growth (GNP, consumption) Legal framework Production facilities Liberalization Market structure Production technologies Unexpected situations on spot markets are the main elements that can change forward prices.

7 Are futures markets able to predict spot prices?  En 2003: no! Unusual conditions (hot summer, et conversely very mild winter)  Since april 04: significant improvement, since conditions were stable and „normal“  Since feb. 05 : Important volatility, combined with unexpected climatic events Forward = average value of negociation of one monthe before maturity. Spot = average value of all separate days

8 Development of forward prices  Increasing by 30 % since the beginning of 2003  „Bulky“ product but time-volatile. Determinants of quotations are varying in time accoring to expectations of market participnts

9 Options Option buyers receive the right to either buy or sell electricity at a fixed price defined beforehand, whatever the price of power at the time of delivery. Importants elements Various options Call (Right to buy) Put (Right to sell) European, American, Exotic Various time horizons Option on a standard product - Baseload or annual peak (to hedge against medium-term volatility) Hourly Option (can be valued on short-term market) This is an insurance against adverse price variations, with a premium which is a function of: Price of underlying Exercise (or strike) price Time and rules for delivery Type of option Volatility of underlying (in %) Intérest rates The premium is payable upon conclusion of the contract. If the option is exercised, energy is payable at delivery.

10 Payment scheme for buying « Plain Vanilla » options Price of underlying in €/MWh Valeur de l’option en €/MW Call Option Put Option Exercise or strike price Option premium Option premium

11 Special options VPP Right of drawing on a contract with a pre-defined marginal cost Payment of a premium Swings Right of drawing on a contract during a certain number of hours at a pre-defined marginal cost With or without premium Example : « Pumping -Turbining Swing (without marginal cost)» The buyer has the right to ask for 25 MW during 500 hours between january 1, 2005 and december 31, 2005 and will supply 25 MW during 2000 hours over the same period of time

12 EDF’s VPPs : An example of a daily option VPPs are daily options with a previously known strike : VPP « Base » : 8 €/MWh, VPP « Peak » : 33 €/MWh The profitability of a VPP depends upon the price which is reached in the daily auction (  speculation). In order to maximize the value of a VPP, one has to manage it with respect to the spot market, not with respect to the load. A VPP constitutes a good physical hedging if there is a strong correlation between the load and the spot price The strike is quite low, so that the option will almost always be exercized  the product is very close to a forward.

13 SWAPS Principle : exchanging (or swapping) some price structure against another one. The SWAP is the financial part of the transaction. It can either be linked, or not be linked with physical delivery of energy. Some examples Cross Commodity SWAP Indexation of the price of electricity on the price of another commodity Fix-for-floating SWAP Exchange between a spot indexation and a fixed price Geographical SWAP Exchange of energy in some price area against another price area

14 Principles for evaluation of SWAPS SWAPS are priced by premiums, whose values depend upon: The correlation between prices of the two underlying products The prices of underlying products at the time of transaction, as well as their futures prices Evaluation methods: Historical prices Black-Scholes Monte-Carlo simulations

Portfolio optimization with OTC products

16 Structured products are combinations of various tools Valorization of flexibility Selling of daily options by a consumer/distributor, valued by supplier on the spot market or on the « balancing market » Type of flexibility Self-producer Flexibility in production process or customers portfolio Commodity/interest rate indexed products Commodity related to the client’s income Possibility to link energy costs to income and to reduce variations of margins. Weather Derivatives Weather derivatives (small market) Possibility to insure against climatic hazards with some impact on turnover

17 Using forwards for optimization of supplies: example Base load (OTC) Base load (PNXT) Peak load (PNXT) Peak load (OTC) Total needs Power [MW] hours Individual hours (PNXT) Cannot be planified Can be planified in the short term Can be planified in the medium/long term

18 Portfolio management – Stuctured Puchasing Possibilities for optimization d’optimisation Timing of buying Calendar of buying Choice of the most liquid products Dynamic management of positions Short-term optimization on spot markets Cross-management with other balancing areas Contract structure Contract for balancing services or «hosting in third-party area» Distinct contracts for access to the network Framework contracts with OTC counterparties Participation contracts with Powernext Spot and Futures or « contracts for access to the market » with third party Requirements with respect to internal structure Definition of a long-term strategy (price limits) Ongoing activity on electricity markets Information systems for portfolio management Forecasting and floow-up of load

19 Possibility to (voluntarily) reduce consumption is valorized on markets Liberalization of markets led to a significant decrease in capacities to voluntarily interrupt one’s supplies (EDF’s EJP tariffs and other similar schemes). Electricity suppliers with access to the market can optimize flexibility by trading on spot and intraday markets, thereby significantly decreasing costs of purchasing. The value of the possibility to voluntarily interrupt one’s supply is a function of the flexibility of the production unit, in particulier of its capacity to interrupt supplies : At a given time For several ongoing hours And as fast in time (real time) as possible Electricity suppliers thus can make their clients participte in such a value creation, thus decreasing costs of purchasing.

20 Valorization of flexibility – « Interruptible contract » Possibilities for optimization Timing of purchases Choice of the most liquid products Optimization of spot market flexibility and/or on an adjustement mechanism Contract structure Contract for balancing area responsibility or for «balancing area hosting» Separate contracts for access to network Framework contracts with OTC counterparties Requirements pertaining to internal structure Elaboration of a medium-term strategy Ongoing activity on power markets Mastering of production processes or self-production in order to be able to sell flexibility

21 In order to minimize profit margin risks - «indexed contract» Possibilities for optimization Timing of purchases subject to evolution of power and commodity markets Choice of the most liquid products Contract structure Contract for balancing area responsibility or for « balancing area hosting» Separate contracts for access to network Framework contracts with OTC counterparts (EFET) Requirements pertaining to internal structure Elaboration of a medium-term strategy (price limits) In-depth experience of power markets and of turnover-related commodity markets Ability to forecast load curve

22 Conclusions There is a very large number of possibilities for combining products. The more specific the product is, the less liquid it will be, and the less competitive and transparent its market prices will be. Every product has its peculiar characteristics, so that it requires highly skilled pricing staff. The Risk Manager’s advice : Never work with products that you do not understand, or with risks that you do not know how to manage or cover. Use expert services !

Thanks for your attention !