1. Credit Matrix Methods in the Draft APPA Alternative Schedule M to the EEI Standard Contract Bill Balson Presentation to APPA Legal Seminar October 15, 2007 Thanks to Tom Ingoldsby of Schiff Hardin for his collaboration.

2. Oct. 15, 2007Credit Matrix OverviewPage 2 Mark-to-market collateral triggers create financial risk for some APPA counterparties. Illiquid assets combined with liquid liabilities creates the potential for problems A buyer in a PPA is an example of a counterparty with potentially liquid liabilities Many APPA members have illiquid “assets” in the form of your customers In the event of a collateral call, you cannot “liquidate” your assets, which is the financial prescription for maintaining a financial hedge.

3. Oct. 15, 2007Credit Matrix OverviewPage 3 While long-term fixed-price PPAs were intended to reduce risk to buyers, EEI’s collateral provisions frustrate that intent. Fixing a buying price for a known period is intended to reduce risk In the event market price declines below your contract price, sellers view the mark-to-market value as a debt you owe them. EEI’s Schedule M can trigger a margin call even when there is no meaningful prospect for default. A margin call for a long-term contract can inject financial distress into an otherwise solvent buyer. Ironically, this risk occurs when a buyers overall cost is declining!

4. Oct. 15, 2007Credit Matrix OverviewPage 4 The credit matrix approach we propose cures the underlying problem, while protecting both counterparties. There is no dispute that both counterparties require credit protection. Mark-to-market collateral calls are inappropriate protection when the risk they create exceeds the risk they intend to cure. Credit matrices provide credit protection by providing assurance the buyer will maintain agreed financial performance metrics.

5. Oct. 15, 2007Credit Matrix OverviewPage 5 The credit matrix approach uses readily available financial data. “Days of Cash on Hand” –with respect to a Specified Party, the ratio of (a) unrestricted cash and cash equivalents as of the last date of the Measurement Period to (b) the sum of Operating Expenses and Fixed Charges for the Measurement Period divided by the number of days in the Measurement Period. “Fixed Charge Coverage Ratio” –with respect to a Specified Party, the ratio of (a) Operating Revenue for the Measurement Period to (b) Fixed Charges for the Measurement Period. “Interest Coverage Ratio” –with respect to a Specified Party, the ratio of (a) Operating Surplus for the Measurement Period to (b) Interest Expense for the Measurement Period. “Quick Ratio” –with respect to a Specified Party, the ratio of (a) Quick Assets as of the last date of a Measurement Period to (b) current liabilities of such Specified Party as of the last date of a Measurement Period. –Quick assets are convertible to cash on short notice. “Total Debt to Total Capitalization Ratio” –with respect to a Specified Party, the ratio of (a) Total Debt as of the last date of the Measurement Period to (b) Total Capitalization as of the last date of the Measurement Period.

6. Oct. 15, 2007Credit Matrix OverviewPage 6 The metrics are flexible. Not all of the metrics need to be used. Additional metrics can be added. The definitions of the metrics can be modified to fit the financial needs of the counterparties. Counterparties can choose to utilize the credit matrix for neither, one or both.

7. Oct. 15, 2007Credit Matrix OverviewPage 7 Two “tiers” are defined for each metric. Tier 1 represents a financially healthy counterparty. –Meeting these metrics implies the counterparty does not pose a material risk of default. –Falling below any of these metrics can trigger a demand for credit assurances. Tier 2 represents the potential for financial distress. –Falling below these metrics implies a material risk of default –Falling below these metrics may trigger mark-to-market collateral requirements or default, depending on the choices of the counterparties

8. Oct. 15, 2007Credit Matrix OverviewPage 8 The counterparties should agree to reasonable ratios that reflect actual expected financial ranges. All ratios are indications of a possible range of relationships between Tiers One and Two and should not be considered as a recommendation for any particular transaction. The First Tier ratio should be set at a reasonable ratio below the ratio determined under Party B’s most recent financial statement as of the Effective Date. For example, if the current ratio is 1.5, the First Tier could be 1.4, but should be set so as to permit normal fluctuations to be expected.

9. Oct. 15, 2007Credit Matrix OverviewPage 9 Each counterparty has a credit matrix with APPA Schedule M to facilitate ease of contract execution. Check if Applicable Financial Performance Measure First Tier [1] [1] Second Tier Interest Coverage Ratio 1.41.0 Quick Ratio1.51.0 Fixed Charge Coverage Ratio 1.x [2] [2] 1.0 Days of Cash on Hand 9060 Total Debt To Capitalization Ratio.7.9 Other:

10. Oct. 15, 2007Credit Matrix OverviewPage 10 Credit ratios provide credit protection by assuring counterparties that the intent is to manage financial performance within a healthy range. Collateral calls are avoided by the buyer in this proposed credit matrix approach by maintaining historic tariffs, collections, and capital budgets. In a market with declining prices, maintaining tariffs constant will ordinarily lead to lower average buying prices. In a market with rising prices, the buyer has exposure to the seller’s potential default.

11. Oct. 15, 2007Credit Matrix OverviewPage 11 Credit matrices can be applied to sellers if desired. Conceptually sound, but may be undesirable to them. Anticipates providing current financial information they may not want to share. It’s fine to apply credit matrices to the buyer side and mark-to-market collateral to the seller. But, be prepared to exercise your rights!

12. Oct. 15, 2007Credit Matrix OverviewPage 12 Thank you. Contact information Bill Balson 26209 Dori Lane Los Altos Hills, CA 94022 650-823-2510 wbalson@pacbell.net Financial risk management Certified GARP financial risk manager (FRM)