1. Entry Capacity Substitution Workshop 6 – 7 th January 2009

2. 2 Agenda  Timeline  Update on pricing example  Summary of Responses to options presented in workshop 5  Further review of options  Next Steps

3. 3 TCMF – Develop Charging Methodology / Pricing Options Further development of Charging Methodology Develop Charging Methodology Changes at TCMF 07/11/09 Submit Pricing Changes for Approval 27/07/09 Commence informal Consultation on Pricing Changes Approval of Pricing Changes Draft Timeline – Development of Methodology Jan 09Feb 09Mar 09Apr 09May 09June 09July 09Aug 09Sept 09Oct 09Nov 09Dec 09 Workshops 5 – Review status – explain risks/rewards process 5 – High level options – work through of potential options 6 – Industry options – review alternatives 6 – Review all options – narrow down for development 7/8 – Detailed options/examples 9 – Finalised options/examples 10 - Update industry following Informal Consultation 07/01/09 Workshop 6 07/04/09 Workshop 8 07/07/09 Workshop 10 12/05/09 Workshop 9 10/02/09 Workshop 7 Develop stage 1 Licence Direction/Changes 01/04/09 Licence Changes Effective S23 Notice Develop stage 2 Licence Changes 07/09/09 Submit ECS for Approval 07/12/09 Approval of ECS 27/07/09 Impact Assessment as necessary 28D 14D Consult Report 21D 28D Consult Finalise Start consultations Informal Formal 08/06/09 24/08/09 Close formal consultation Consult and Report (non-urgent) Develop UNC Mod Proposals 07/12/09 Approval of UNC Mods 19/11/09 Mod Panel Decision 17/09/09 Mods to Panel 02/07/09 Tx Workstream: present mods IT Systems development 31/03/09 Progress report

4. 4 Substitution Example – Prices At Substitution Workshop 3 on 11 th June 2008 National Grid gave an example of the possible impact of substitution on entry capacity reserve and incremental step prices. An update of these prices was provided at workshop 5. In the example 10mscmd of incremental capacity is allocated at Easington. This is achieved by substituting capacity from other ASEPs: All available capacity from Hornsea, Hatfield Moor and Theddlethorpe; Some of the available capacity from Bacton. Two issues were raised Before / after pricing tables should be supplemented with substitution / no substitution tables for the “after” scenario; Prices at Hatfield Moor increased despite a reduction in the obligated level. A further example was requested Based on Teesside – to be presented at workshop 7.

5. 5 Substitution Example – Prices (Sept 2008 basis) ASEP Initial Prices p/kWh/day Change in obligated level mscmd Post auction prices: with Substitution p/kWh/day Change in obligated level mscmd Post auction prices: with investment p/kWh/day P0P0 P 20 P0P0 P0P0 Easington0.00920.0134+ 100.00950.0141+100.00950.0141 Hornsea0.00900.0101 at P 8 - 0.90.00900.0101 at P 8 00.00900.0101 at P 8 Hatfield Moor0.00280.0033 at P 5 - 0.80.00300.0035 at P 8 00.00280.0033 at P 5 Theddlethorpe0.00820.0120- 49.20.00630.008800.00820.0120 Bacton0.00840.0141- 41.70.00620.010600.00840.0141 NB – P 20 step price relates to an incremental capacity of 50% of the obligated level. Hence, with the exception of Easington, the “new” prices relate (in the substitution example) to a smaller incremental quantity.

6. 6 Substitution Example – Hatfield Moor ASEP Initial Prices p/kWh/day Change in obligated level mscmd Post auction prices: with Substitution p/kWh/day Change in obligated level mscmd Post auction prices: with investment p/kWh/day P0P0 P 20 P0P0 P0P0 Easington0.00920.0134+ 100.00950.0141+100.00950.0141 Hatfield Moor0.00280.0033 at P 5 - 0.80.00300.0035 at P 8 00.00280.0033 at P 5 With Substitution the obligated level at Hatfield Moor is reduced Expect prices to be reduced but they increase Without Substitution the obligated level at Hatfield Moor is unchanged Expect prices to remain constant (possible slight reduction) This does not occur because: The charging model reduced flow at Theddlethorpe to its revised obligated level and balances flows at Garton which is the nearest ASEP with spare capacity, (i.e. obligated - forecast). Increased Garton (and Easington) flow causes gas from Hatfield Moor deeper into the network. Despite a lower flow rate, greater penetration leads to higher prices.

7. 7 Summary of Responses to workshop 5 options Option 1) Draft Methodology 2) Limits on Quantity 3) National Grid Discretion 4) Ofgem Discretion 5) Simple Economic Test 6) Exchange Rate Cap / Economic Test Combination 7) Option Model 8) Sub-Reserve Prices 9) Early Warning System 10) Two Stage Auction 11) BGT Proposal  In the draft Methodology Statement (option 1), shipper bids are the only determinant of shipper interest.  Non-market information could be used to determine how much should be reserved at each donor ASEP (option 2).  Constraints could be applied to the draft MS e.g. an economic test or exchange rate cap (options 5,6).  New mechanisms could be developed to enable shippers to prevent capacity from being substituted away from a donor ASEP, probably by requiring payment of a nominal fee (options 7,8).  Options 3 and 4 build on other options by providing a mechanism to reject substitutions deemed inefficient.  Options 9, 10, and 11 build on other options by providing additional information (or opportunities) to influence bidding strategies.  National Grid received no alternative suggestions after the workshop.

8. 8 Summary of Responses to workshop 5 options Option Responses ABCDEFGHIJTotal 1) Draft Methodology77796578N56 2) Limits on Quantity1011 7108118N76 3) National Grid Discretion978115575N57 4) Ofgem Discretion10911 58 N76 5) Simple Economic Test87978889N64 6) Exchange Rate Cap / Economic Test Combination 10 117 8 LikeY79 7) Option Model88773977Y56 8) Sub-Reserve Prices88793767N55 9) Early Warning System811 9105119N74 10) Two Stage Auction1211 6109119BestY79 11) BGT Proposal6910949 13Y70

9. 9 Summary of Responses to workshop 5 options 70 79 74 55 56 79 64 76 57 76 56 Total Park: variant on option 1011) BGT Proposal Worthy of progressing10) Two Stage Auction An add-on to the final solution – to be considered later9) Early Warning System Park8) Sub-Reserve Prices Fundamentally different approach: Worthy of progressing7) Option Model Worthy of progressing 6) Exchange Rate Cap / Economic Test Combination Part of option 65) Simple Economic Test An add-on to the final solution – to be considered later4) Ofgem Discretion Park3) National Grid Discretion Worthy of progressing: mechanical process - development with option 6 2) Limits on Quantity Basis of other options - retain1) Draft Methodology CommentsOption

10. 10 Summary of Responses: Further Development  Essentially three options to be considered. Market based approach (option 7)  Option Model Additional information approach (option 10)  Two stage auction. Mechanistic approach (options 2/6) with  Limits on the quantity of capacity made available for substitution; and/or  A cap on the Donor ASEP: Recipient ASEP capacity exchange rate; and/or  An economic test

11. 11 Option 7: Option Model Where a Shipper values non-incremental capacity at an ASEP they can, for a price, reserve that capacity. This option would not, necessarily, give the Shipper first option to buy the capacity, but would potentially reserve it at the relevant ASEP for any Shipper to obtain. This option needs to be considered as a means to delay or prevent capacity being substituted from a particularly ASEP. If substitution does progress then this would be in line with option 1 and any chosen elements of option 6. AdvantagesConcerns Shippers can signal future requirements at lower exposure than with full commitment in QSEC auction. Shippers will need to commit to costs before decisions on whether capacity is truly needed. But what are these costs? What do the costs buy? Options may block out other Shippers wanting obligated capacity at the same ASEP. Option prices need to be high enough to prevent spurious reservations but lower than reserve prices. Not feasible at all ASEPs. Regulatory treatment of option fees needs to be considered. Potential systems implications. What is required?

12. 12 Option 7: Option to Buy - example Shipper wants to protect baseline capacity at an ASEP, but is not ready to fully commit Notes: 1 The minimum price for the option will be 0.0001 p/kWh/d. The minimum duration that the option will cover is one quarter The above two conditions result in a minimum fee (payable irrespective of whether the option is exercised) of approx. £1k/mcm There will also be a choice to exercise, that will specify the quantity and reserve price The exercise will only apply to capacity that would otherwise be substituted, i.e. does not block out bids at the same ASEP. The quantities specified cannot be higher than available non-incremental capacity The option is valid for one year Unless the option is exercised, it provides no capacity rights to the holder For any QSEC auction, where the capacity that would be substituted away is covered by an option, this capacity is put to the “back of the queue” Ahead of QSEC auction shipper buys an option 1 over a quantity of capacity at the desired ASEP If the capacity that has been “put to the back of the queue” would still be used in the substitution the NPV value of the bids is compared to the option value (option price * option quantity * duration). If the bid value is higher and the option is not exercised, the capacity is substituted. If the bid value is higher and the option is exercised the shipper with the option is allocated the capacity at the reserve price and for the duration of the option. If the bid value is lower the capacity will neither be substituted nor will it be allocated to the Shipper with the option. Would the option value ever exceed the bid value?

13. 13 Option 7: Option Model – Issues for Consideration  What does the Option provide? Does the Option prevent capacity from being substituted?...or Does the Option put the capacity to the back of the queue for substitution?  What is the Option price (i.e. the price paid to create the Option)? Subject to question above. Same for all ASEPs or linked to ASEP specific reserve price?  Is there an Exercise for the Option? If so, how is it effected? Automatic if ASEP identified as a donor ASEP for substitution? Only if Shipper gives consent at the time that the ASEP is identified for substitution?  What is the Exercise price (i.e. the price paid to be allocated the capacity)? Reserve price at the relevant ASEPs?  What duration does the Option cover? Minimum of one/four quarters? Default lead time plus 1 year?  What is the life-time of the Option? For one year from one annual QSEC auction to the next?

14. 14 Option 7: Option Model – Issues for Consideration (2)  How does an Option Model differ from single quarter booking? May be cheaper to buy single quarter than an option at some ASEPs. Obligation with single quarter booking is delayed into future.  Possible treatment of single quarter bookings. Prevent: through UNC modification Allow and prevents substitution Allow, but permit substitution;  creates conflicting obligations for National Grid  regulatory treatment to be agreed.

15. 15 Option 7: Option Model – Recap  Does an Option Model satisfy the main substitution criteria? Does it offer the benefits of substitution?  Is it unduly restrictive? Does it mitigate the risks presented by substitution?  New long term supply projects  Short term players – price sensitive  New supply projects – marginal fields How difficult would it be to implement?  Systems impact?  Shipper processes?  National Grid processes?  How would this option be developed? Which, if any, elements of option 6 should be considered with this option?

16. 16 Option 10: Two Stage Auction  Several variations (inc. BGT proposal) where QSEC is run in two parts.  Baseline and incremental capacity can be obtained in the first phase.  Only baseline capacity can be obtained in the second stage. This option needs to be considered as a means to prevent capacity being substituted from a particularly ASEP by allowing Shippers an opportunity to respond to perceived vulnerability of certain ASEPs. If substitution does progress then this would be in line with option 1 and any chosen elements of option 6.

17. 17 Option 10: Two Stage Auction - example STAGE 1 QSEC auction held as now but for shortened duration. STAGE 2 “QSEC” reopened for one round of baseline only bids POST - STAGE 2 ASEPs with unsold baseline capacity identified. Substitution Methodology applied. [One week] between stages POST - STAGE 1 Incremental bids identified. ASEPs and quantities published 1. 1 – It would be assumed that bids are valid and that subsequent proposals to release incremental capacity would not be vetoed by Ofgem.

18. 18 Option 10: Two Stage Auction Concerns / Issues? Complex – could add significantly to timelines. Major change to QSEC auction (UNC) – impact on systems. Shippers may  still have to commit earlier than they feel able to;  be incentivised not to bid in first auction round;  have governance issues where bids are required at short notice; and  be unable to accurately identify donor ASEPs prior to stage 2. Shippers at “safe” ASEPs may see unsold capacity substituted due to stage 2 bids, e.g. Shippers at the most likely donor ASEPs may buy existing capacity so that no capacity is available to be substituted away. This means the second best donor ASEP will be used. How would the process by applied for ad-hoc QSEC auctions for new ASEPs?

19. 19 Option 10: Two Stage Auction – Recap  Does a Two Stage Auction satisfy the main substitution criteria? Does it offer the benefits of substitution?  Is it unduly restrictive? Does it mitigate the risks presented by substitution?  New long term supply projects  Short term players – price sensitive  New supply projects – marginal fields How difficult would it be to implement?  Systems impact?  Timelines?  Shipper processes?  National Grid processes?  How would this option be developed? Which, if any, elements of option 6 should be considered with this option?

20. 20 Option 6: Combination Mechanical Approach Capacity Limits / Exchange Rate Cap / Economic Test.  Each substitution opportunity progresses subject to satisfying: Limits set on availability of capacity at potential donor ASEP  Recognises that unsold capacity is not the same as unneeded  What criteria should be used to exclude capacity from substitution? An exchange rate cap:  To avoid excessive capacity destruction at donor ASEPs  Difficult to determine precise value when multiple donor ASEPs or mix of investment and substitution.  What values should cap be set at? An economic assessment:  the value of capacity substituted from the donor ASEP should be compared to the value of the incremental capacity allocated at the recipient ASEP  How should the test be applied?

21. 21 Option 6: Combination: Limit Donor ASEP Quantity Available Any others? Preference? OptionAdvantagesConcerns Increase quantity withheld from QSEC auction Transparent and predictable. Requires Licence change. Inconsistent with encouraging long term signals Limited scope for flexibility / phasing Inefficient: rule applies to all ASEPs Substitute only above historic flows Substitution is intended to utilise capacity at declining ASEPs. Historic flows do not reflect this. Withhold a % of baseline from substitution No Licence change Transparent Contradicts aim of Licence (10% rule) Inefficient: rule applies to all ASEPs Withhold a % of unsold capacity from substitution No Licence change Transparent Inefficient: rule applies to all ASEPs Substitute only above [90%] TBE forecasts Limits aligned to expected future requirements, not an arbitrary value. Could undermine TBE process: potential for disputes over values used: forecasts could be wrong. Other considerations: All options could result in unnecessary investment if substitution opportunities are prevented Any caps to be specified before the relevant auction Scope for soft landing by decreasing quantity protected Previous consultations revealed support for each option, particularly TBE.

22. 22 Option 6: Combination: Exchange Rate Cap. Exchange Rate Cap Aims To prevent overall loss of aggregate capacity within the system Concerns Could needlessly prevent unwanted capacity from being substituted, leading to uneconomic investment. Can be difficult to determine with multiple donor ASEPs and combined substitution/investment scenarios. Criteria Must be simple to apply Justifiable value Over-whelming support for a low value; possible soft-landing (increase in future years). Options 1:1 n:1 (n > 1) No limit

23. 23 Option 6: Combination: Exchange Rate Cap. Exchange Rate Cap OptionAdvantagesConcerns 1:1No loss of total system capacity Could prevent “sensible” substitutions n:1 Facilitates more substitutionArbitrary Greater loss of total capacity Others??? Other considerations: Any cap could result in unnecessary investment if substitution opportunities are prevented Scope for soft landing by decreasing quantity protected Previous consultations revealed support mainly for a low exchange rate cap although some preference for no cap was expressed.

24. 24 Option 6: Combination: Economic Test These tests are intended to measure and compare the value of capacity substituted from a donor ASEP and the value of the capacity released at a recipient ASEP. Where the value at the donor ASEP is highest substitution should not be progressed.

25. 25 Option 6: Combination: Economic Test Potential basis for determination of ASEP capacity “value”. Recipient ASEPDonor ASEP Actual auction bid value- NPV of auction bid value- Incremental capacity project value (from charging model) Project value to recover: TBE level; or pre-auction obligated level Pre-auction P 0 price * incremental capacityPre-auction P 0 price * substituted capacity Licence Revenue Driver (for incremental capacity) Licence Revenue Driver (to recover TBE / obligated) OTHERS?

26. 26 Option 6: Combination: Economic Test Thoughts and concerns? Benefits of substitution are manifest when National Grid is not funded through the Licence Revenue Drivers for incremental capacity. More complex options could increase post-auction analysis requiring increased default lead-times and UNC / Licence changes. Can prevent capacity at high cost ASEPs being substituted to low cost ASEPs at low cost. An economic test may only facilitate substitution from low to high priced ASEPs especially where combined with an exchange rate cap. Will not always prevent TBE forecast capacity needs being substituted away so Shippers may still have to commit earlier than they feel able to. How would test work when recovering capacity at a previous donor ASEP (reverse substitution)? Preference?

27. 27 Option 6: Combination Mechanical Approach Capacity Limits / Exchange Rate Cap / Economic Test – Recap  Does this option satisfy the main substitution criteria? Does it offer the benefits of substitution?  Is it unduly restrictive? Does it mitigate the risks presented by substitution?  New long term supply projects  Short term players – price sensitive  New supply projects – marginal fields How difficult would it be to implement?  Systems impact?  Shipper processes?  National Grid processes?  How would this option be developed? Which elements of this option should be developed further?

28. 28 Summary  Three options considered. Market based approach  Option Model Additional information approach  Two stage auction: substitution only triggered by stage one. Mechanistic approach  Limits on available capacity for substitution  Exchange rate cap  Economic test

29. 29 Summary  Each option has been reviewed against main criteria Substitution benefits Risk mitigation  Three classes of User Implementation  How should these option be developed? Which, if any, elements of the mechanistic approach (option 6) should be considered with the other options? Benefits Risk mitigation Implementation Option 2-stage Mechanical Limit Xch rate Eco test

30. 30 Next Steps  Next Workshop 10 th February 10am to 1pm At Ofgem  Outstanding Pricing Issues  Further Working of Selected Options