Integrated ElectricsIntegrated ElectricsTwo Steps Forward…One Step BackTwo Steps Forward…One Step Back

Scott PearlScott PearlIntegrated Utility AnalystIntegrated Utility Analyst

The Institute for Regulatory Policy Studies’ The Institute for Regulatory Policy Studies’ Energy Markets at the CrossroadsEnergy Markets at the Crossroads

December 12, 2002December 12, 2002

The Old Model Served Customers Well Since the Great Depression

Raw Materials

(Coal, Oil, Gas, Uranium, Water)

MANUFACTURING

DELIVERY

Franchise Customers

BTU

MWH

Industry Structure• Vertically integrated • Monopoly supplier• State regulation• Obligation to serve /

regulatory compact

2

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Average Real Electric Price (1996 $'s) Average Nominal Electric Price

But Rising Prices Inspired Federal Regulators to Act

Source: EIA and CSFB estimates

3

PURPA (1978)

NEPA (1992)

Order 888 (1996)

SMD (2002)

Oil Crisis (1973)

Ce

nts

/kW

h

Average U.S. Retail Electric Rates

And It All Seemed To Be Progressing Smoothly

• 23 states enacted electric restructuring legislation between 1996 and 2000

• California developed the first U.S. wholesale power exchange in 1998

Source: EIA and CSFB estimates 4

No Retail Competition Retail Competition

Legend

  

Until the California Crisis Exposed…

5Source: Bloomberg and CSFB estimates.

Prices for Electricity and Natural Gas

(1/1/99 – 06/30/01)

$0

$100

$200

$300

$400

$500

$600

Palo

Ve

rde

$/M

WH

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

He

nry

Hu

b $

/MM

BT

U

Palo Verde Henry Hub

0%

5%

10%

15%

20%

25%

30%

1996 1997 1998 1999 2000 2001 2002E 2003E 2004E 2005E 2006E 2007E

The Magnitude of Boom and Bust

6Source: RDI, EIA, NERC, CSFB estimates

US Reserve Margin(1996 – 2007E)

UNDER-SUPPLY

OVER-SUPPLY

The Dangers of Too Much Leverage

• Business and financial risks must be properly aligned

• < 50% debt for manufacturing, lower for risk management

• Lack of tenor matching exposed liquidity concerns

• Financial engineering can be life threatening – ratings triggers

Source: Factset, CSFB estimates. 7

26%

45%

51% 53%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

E&P Steel Paper Chemicals

Debt-to-Capital Ratios for Other Commodity Manufacturers

Source: Factset, CSFB estimates.

Debt / Capitalization Ratio – Integrated Electrics

(1992-2001)

48%

50%

52%

54%

56%

58%

60%

62%

64%

66%

And The Fragility of Investor ConfidenceS&P Utility Index5/1/2001 to Present

8

35

45

55

65

75

85

95

105

July 2001Barrons Article on

Power Glut

December 2001 Enron Bankruptcy

March 2002Dynegy annouces SEC Investigation

for wash trades

May 2002Enron memo

surfaces in FERC investigation

June 2002WorldCom

October 2002TXU reveals liquidity

crisis owing to UK market weakness

September 2002Need for

additional equity by Dominion and TECO touch off a wave of liquidity

concerns

Causing a Re-Examination of The Entire Approach

• Two steps forward, one step back

• 9 of 23 states are re-evaluating retail deregulation (California suspended)

• All eyes on Texas deregulation experiment

Source: EIA and CSFB estimates 9

Status of Retail Deregulation By State

 Restructuring Delayed Restructuring Suspended Restructuring Not Active

Legend

 Restructuring Active

0

5

10

15

20

25

30

35

40

45

50

Apr-90 Apr-91 Apr-92 Apr-93 Apr-94 Apr-95 Apr-96 Apr-97 Apr-98 Apr-99 Apr-00 Apr-01 Apr-02

Pool

and

GTM

A m

arke

t pric

e (£

/ M

Wh)

Pool purchase price NETA Pool Market Mechanism Trend NETA Trend

Pool Market Mechanism NETA

…But If Structured Properly, Deregulation Can Benefit Ratepayers

UK Power Pool Prices12/1988 to 12/2002

10

Australian Power Prices1/1999 to 12/2002

0

20

40

60

80

100

120

140

Jan-99 Aug-99 Feb-00 Aug-00 Feb-01 Sep-01 Mar-02 Sep-02

$/M

Wh

(AU

)

South Australia Queensland South Australia Trend Queensland Trend

• UK prices have declined substantially in response to improved market design

We Envision A Disaggregated World

Manufacturing

• Commodity conversion

• Location, location, location

• New technology, improved

operating efficiency

• Lessons from: E&P, steel,

refiners, paper, chemicals

Risk Management

• Energy intermediaries (retail

and wholesale)

• Intellectual capital /

information nexis

• Strong balance sheet

• Lessons from financial

services/brokerages

Delivery

• Regulated infrastructure

• Regulators drive returns on

capital

• Incentive regulation can

encourage efficiency

• Lessons from UK regional

electrics/transmission

companies

M ANUFACTURING

IPPsGeneration-

FocusedUtilities

EnergyMerchants

IntegratedE lectrics

RISKM ANAGEM ENT

DELIVERY

RAWM ATERIALS

ENDCONSUM ER

11

20,000

25,000

30,000

35,000

40,000

45,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Hour

MW

0

50

100

150

200

250

300

350

400

450

500

$ p

er M

WH

Actual load NP15 Price

With Differentiated Opportunities to Create Value

• Substantial value to be captured through evolution to competitive market – Improve resource allocation decisions and operating efficiency

• Average US Electric Rate - ~ 70% Generation - Cost of New CCGT

~ $72 / MWh~ $50 / MWh~ $45 / MWh

$5 / MWh * 3.9 BN MWh/Yr = $20 BN / YR

Risk Management

• Smooth volatility

Manufacturing

• Improved utilization

Delivery

• Infrastructure Investment

Source: SNL Securities Database and CSFB estimates. Source: California ISO and CSFB estimates. Source: Beacon Energy and CSFB estimates.

12

Nuclear Capacity Factor (1991 –2001) 24 Load & Price – CAISO (7/27/00) Transmission Investment vs Demand

650

670

690

710

730

750

770

790

810

830

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009Su

mmer

Peak

Dem

and (

GW)

155

160

165

170

175

180

185

190

195

200

205

Tran

smiss

ion M

iles (

000s

), (23

0 kV

and a

bove

)

60%

65%

70%

75%

80%

85%

90%

95%

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

• P/E ratios diverged as competitors pursued strategies focused on different aspects of the energy value chain

• Commodity cycle conditions have increased P/E volatility for unregulated players

13

One Year Forward P/E Ratios for Electric/Gas Companies

(1/1/96 to Present)

Source: Factset and CSFB estimates.

And The Markets Are Reaching a Similar Conclusion

0x

5x

10x

15x

20x

25x

30x

35x

40x

1/02/96 7/09/96 1/14/97 7/22/97 1/28/98 8/05/98 2/11/99 8/19/99 2/25/00 8/31/00 3/12/01 9/21/01 03/29/02 09/30/02

1 Y

R F

WD

P/E

IPPs (Manufacturing) Energy Merchants (Risk Management) Integrateds (Delivery)

As Always, the Devil Will Be in The Details

• Near term (managed monopolies)

Generation price caps

Limit market concentration

Mandated reserve margins

Standardized market design

• Long term (free market for generation)

Sufficient investment in transmission grid

Floating retail generation rates / end of stranded cost recoveries

Incentive rate structures for delivery

Emergence of new technology

14