Invest in Power Arie Kapulkin Active Power Investments LLC Niagara Falls, ON 19 September 2012

Outline Overview of Energy Trading Development of Nodal Power Markets Financial trading in Nodal Power Markets Risk Management Opportunities for investors Conclusions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 2

What is Energy Trading? A purchase or sale of energy, paper or physical, for consumption or resale Purchase or sale for consumption or resale in the very short time frame refers to spot energy trading; energy trading in the future refers to futures/forwards Why Trade? Energy Trading results in realization of gains from trade – there is no different from other trading of commodities or goods Examples include: oil, gas, power, coal, emissions, weather, etc.; all these commodities can be traded We can trade products and their derivatives; derivatives are instruments that derive their value from the underlying product Copyright © 2012 by Active Power Investments LLC All Rights Reserved 3

Traded Products: Temporal Dimension Spot (cash) market is same hour/day (Example: Real-Time (RT)) for immediate production or consumption Day Ahead (DA) is a type of the short-term hourly or block-based forward market for the next day Futures or forward market is trading for some remote time period Examples: balance of the month, prompt month, 3 to 5 years out Henry Hub on NYMEX Copyright © 2012 by Active Power Investments LLC All Rights Reserved 4

Traded Products: Spatial Dimension Energy is traded worldwide Oil is traded on major energy exchanges: NY Harbor, WTI – Cushing, Gulf Coast, North Sea, Singapore Gas is traded at Henry Hub in LA and AECO in Alberta and a number of secondary gas hubs; Ze Brugge terminal in Europe, etc. Electricity is traded at great many locations due to its local production and consumption nature: All over the world (Example: Electricity Hubs in the US) Copyright © 2012 by Active Power Investments LLC All Rights Reserved 5

6

Where is Energy Traded? One-to-one: individual bilateral deals Many-to-one: marketers Model pioneered by Enron Requires the company to actively match buyers and sellers Many-to-many: ICE, Nodal Exchange, Futures Markets Platform to enable clearing b/w multiple participants Organized power markets New ways to transact: central clearing of locational bids by system operators (ISOs and RTOs) Copyright © 2012 by Active Power Investments LLC All Rights Reserved 7

Outline Overview of Energy Trading Development of Nodal Power Markets Financial trading in Nodal Power Markets Risk Management Opportunities for investors Conclusions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 8

generation customer service distribution transmission IPP self-generation CUSTOMERS Theory Copyright © 2012 by Active Power Investments LLC All Rights Reserved 9

generation customer service distribution transmission IPP self-generation CUSTOMERS Practice Copyright © 2012 by Active Power Investments LLC All Rights Reserved 10

power exchange generation customer service distribution transmission generation customer service distribution transmission ISO marketing trading ancillary srvcs Transition Copyright © 2012 by Active Power Investments LLC All Rights Reserved 11

Power Marketing and Energy Trading Explosion Utilities, financial houses, marketers, brokers, generating entities, and speculators are buying, selling, and swapping power/energy on an ever-increasing scale The total volume of trade is multiples of the value of the underlying commodity Power marketing / brokering has grown tremendously since the start of deregulation Copyright © 2012 by Active Power Investments LLC All Rights Reserved 12

North American Regional Transmission Organizations Copyright © 2012 by Active Power Investments LLC All Rights Reserved 13

Move from the Zonal To FNM – Nodal Market No intra-zonal constraints enforced Internal Congestion Zones – Constraints enforced between zones Full Network Model (All constraints enforced) Locational Marginal Pricing at each node NP15 SP15 ZP26 Copyright © 2012 by Active Power Investments LLC All Rights Reserved 14

Why Nodal? Efficiency: minimization of production cost – System-wide, incentive-compatible Advanced locational signal for buyers and sellers to match next day needs and supplies Economic signal (LMP) to Gens and Demand Response while protecting load Congestion risk management (CRR/FTR/TCC) and transmission planning Copyright © 2012 by Active Power Investments LLC All Rights Reserved 15

Locational Marginal Prices in Nodal Markets Copyright © 2012 by Active Power Investments LLC All Rights Reserved 16

Outline Overview of Energy Trading Development of Nodal Power Markets Financial trading in Nodal Power Markets Risk Management Opportunities for investors Conclusions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 17

Financial Instruments Virtual Trading: trade DAM vs. RTM – Virtual Supply (Financial Generator): sell DA buy RT – Virtual Demand (Financial Load): buy DA sell RT Congestion Revenue Rights (aka FTR or TCC) – Buy or sell congestion between two nodes – Buy in monthly/seasonal, settle in DAM Copyright © 2012 by Active Power Investments LLC All Rights Reserved 18

Virtuals as Purely Financial Instruments Used to capture the price difference between DAM and RTM at a location If the location price in DAM is expected to be greater than RTM, then an Inc at that location would be the correct tool If the location price in DAM is expected to be less than RTM, then a Dec at that location would be the correct tool Copyright © 2012 by Active Power Investments LLC All Rights Reserved 19

Incs and Decs as Financial Instruments Inc Payoff ($) RT LMP ($) DA RT 2 RT 1 P1P1 P2P2 Dec Payoff ($) RT LMP ($) DA RT 2 RT 1 P1P1 P2P2 Copyright © 2012 by Active Power Investments LLC All Rights Reserved 20

FTR/CRR/TCC: Traffic  Power Copyright © 2012 by Active Power Investments LLC All Rights Reserved 21

Regular Congestion Copyright © 2012 by Active Power Investments LLC All Rights Reserved 22

Extreme Congestion Copyright © 2012 by Active Power Investments LLC All Rights Reserved 23

FTR Properties Financial settlement, no physical delivery Can be acquired centrally or from another participant Can be bought or sold b/w any two pricing locations (aka injection and withdrawal points, or source and sink) defining a path Can cover on-peak or off-peak FTR payoff can be either positive or negative Copyright © 2012 by Active Power Investments LLC All Rights Reserved 24

Financial Perspective Hedgers: offset the expected congestions Speculators: look for most profitable paths Look at FTRs as a stand-alone financial instrument Purchase Forward Contract for congestion difference at a set price Delivery is based upon DAM price differences Copyright © 2012 by Active Power Investments LLC All Rights Reserved 25

Financial Perspective cont. Goal of FTR spec bids: Buy the FTR in the auction at less than the total amount of the congestion revenue which will be paid to the FTR holder throughout the auction period These financial instruments could be thought of as investments that get future “earnings” Copyright © 2012 by Active Power Investments LLC All Rights Reserved 26

Outline Overview of Energy Trading Development of Nodal Power Markets Financial trading in Nodal Power Markets Risk Management Opportunities for investors Conclusions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 27

FTR Holder Risks FTR Holder purchased an FTR with anticipation of congestion happening in one direction Actual system conditions can change from auction assumptions System conditions and DA market clearing can be different than holder’s assumptions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 28

VaR: Portfolio Mapping West Portfolio East Portfolio Copyright © 2012 by Active Power Investments LLC All Rights Reserved 29

VaR and Electricity Market Prices have relatively short histories compared to financial indexes Price distribution: Fat tails, Outliers, Price Jumps in spot prices High Volatilities, Unstable Correlations Copyright © 2012 by Active Power Investments LLC All Rights Reserved 30

Oil & Gas Impact Copyright © 2012 by Active Power Investments LLC All Rights Reserved 31

Stress Testing Focus on potential sources of risk that – Impact the portfolio seriously – Have not occurred in the recent past No standard/scientific way to reliably measure risk – Scenarios tailored to the portfolio Stress testing looks for the worst outcome in contrast to VaR which looks at extreme movements in price distribution Stress testing is more effective when the portfolio has fewer sources of risk Copyright © 2012 by Active Power Investments LLC All Rights Reserved 32

Outline Overview of Energy Trading Development of Nodal Power Markets Financial trading in Nodal Power Markets Risk Management Opportunities for investors Conclusions Copyright © 2012 by Active Power Investments LLC All Rights Reserved 33

Recent and future developments CA TX (ERCOT) SPP Copyright © 2012 by Active Power Investments LLC All Rights Reserved 34

Why invest in power nodal markets? New less efficient markets, higher spreads Higher barriers to entry (talent, data, analysis, process, ISO / regulatory compliance) Uncorrelated with equity, debt, FX, real estate No to very low correlation with other energy commodities such as oil or NG Multiple independent power markets – diversification of opportunities Copyright © 2012 by Active Power Investments LLC All Rights Reserved 35

Copyright © 2012 by Active Power Investments LLC All Rights Reserved 36

Correlation: Copyright © 2012 by Active Power Investments LLC All Rights Reserved 37

Key Points and Conclusions Virtual Offers/Bids – Prediction of RT price with some degree of accuracy is a must to achieve the goal – Diversification across pricing points is a key factor – Offers financial participants risk premiums when arbitraging DA – RT price differences Copyright © 2012 by Active Power Investments LLC All Rights Reserved 38

Key Points and Conclusions FTR –Congestion patterns change over time – Short-term congestion is harder to predict (month-to-month, day-to-day) – Long-term congestion may be more predictable but does change based on new generation/transmission construction (or retirements) – FTRs are a tool that can provide profitable opportunities for financial participants Copyright © 2012 by Active Power Investments LLC All Rights Reserved 39

Questions? Copyright © 2012 by Active Power Investments LLC All Rights Reserved 40