1. Zone Merger – learning from experience and developing an evidential based approach Target Model Workshop 3, London 11 April 2011 Nigel Sisman Senior Adviser

2. Zone Merger opportunities and challenges 2 Challenges Risks of internal congestions -changes in flows may expose new constraints -Which options to manage risk Establishment of “balancing market operator” -New operational and settlement functions Enhanced cross-border TSO cooperation - Increased contractual, tariff and operational complexity Opportunities Enhanced trading opportunities -Focussed liquidity -Robust price indexes Simpler transportation arrangements -Less entry/exit zone bookings Easier system user balancing -Access to functioning balancing markets … free lunches do not exist; so how do we assess the tradeoffs?

3. Presentation structure Learning from merger experience Developing an evidential approach to assess challenges Understanding liquidity and trading depth Conclusions 3

4. Learning from merger experience 4

5. Recent Merger Experience Gas experience France - a single TSO experience Integration of northern hubs to create PEG Nord Germany – a multi-TSO experience A stepwise integration towards two zones … and lessons learnt from electricity? 5

6. French experience PEG North/West/East merger 2 Full Entry/Exit PEG zones –For reasonable scenarios 360 M€ investment 6 PEG Nord has the critical size for liquidity to develop 6 IP, 1 LNG terminal, 9 storages, 330 Twh of demand which enabled : The creation of a gas exchange (Nov 2008) The development of market based balancing An increased attractivity for CCGT projects … zone merger facilitated by investment

7. German experience Progressive reductions in number of zones -By 1.4.2011 3 zones -Legal obligation by 1.8.20132 zones Balancing Operators introduced “Statistical firm” capacity model -Successful model if no sudden major changes of market behaviour occur  Otherwise capacity reduction Prerequisites -Intense cooperation and trust between involved TSOs needed -Specific characteristics of the individual grids need to be considered -Involvement of NRA when defining the model 7 … increasing complexity necessitates cost benefit analysis for next step … zone merger facilitated by reflecting congestion risks in system user’s capacity entitlements

8. Electricity experience Scandanavia experience single Swedish price zone but significant internal constraints “Constraints exported to national borders” accusation of discrimination domestic/international consumers Swedish pricing zones to be established 8 … the underlying physical realities of transmission are important … internal constraints must be “small” to ensure efficient merger outcomes

9. Developing an evidential approach to assess challenges 9

10. The Challenge of Zone Merger Internal bottlenecks are “transferred” to new zone borders New risk management approaches needed Zone mergers have implications benefits from enhanced trading environment redistributive effects between system users tariff implications changes in values of flexibility offered to market/TSOs. 10 Enlarged Zones Less certainty and changed flows Increased risk of internal congestion

11. Managing internal congestion risks in enlarged zones Investment Flow commitments Reduced firmness of capacity or reduction of capacities Point-to-point capacity arrangements Constrained on/off (local purchase/sale of gas behind/in front of constraint) or combinations of any of the above 11 … the options may have different costs and different benefits in delivering enhanced liquidity

12. Possible methodology to assess potential for internal congestion costs arising from zone merger 12 Simulation model Internal Constraints Freq/Size Evaluation model Flow scenarios Network Model Investment Options Capacity availability options Flow commitment options Balancing - constrained on/off options Preferred option or combination costs

13. International merger involves greater challenges Legal framework Tax issues Governance Location of virtual trading points Who manages the system Regulatory and Member State sovereignty 13 … international zone merger in gas has not yet been delivered

14. Understanding liquidity and trading depth 14

15. Benefits of larger zones – liquidity and trading depth 15 How deep and liquid does the market need to be? What criteria define a “Functioning” market? … what value do we attach to: traded volumes? churn rates? competition measures (HHIs)?

16. Assessing market efficiency - daily NBP Gas Trades National Grid data Improvements in balancing regime and market experience Simple commoditised, zero tolerance daily balancing

17. … over 100 players each side of the market …. HHI around 370 on both side of the market Recent NBP trading & liquidity National Grid data … but how do we value the consumer benefit of this level of liquidity?

18. Conclusions Mergers afford both opportunities and challenges First steps may be straightforward but challenges escalate rapidly Trading/liquidity benefits delivered via a range of alternative approaches but physical constraints can’t be too great Assessing benefits and costs How do we assess benefits? How to assess best option(s) for risk mitigation? 18 … no free lunches; evidential approach should support the case for zone merger