Sutton Bridge Project

Contractual Innovation in U.K. Energy Markets

U.K. Power Market

Generation

Transmission

Distribution & Supply

U.K. Power Market

Gas Supply
Eastern Group Enron

Gas Transmission
National Transmission System (Transco)

Power Generation
National Power plc PowerGen plc British Energy Eastern Group 40 other licensed Generators

Transmission
National Grid Co.

Distribution & Supply

12 Regional Electric Co.s (Eastern largest)

Pool Pricing
1 Day = 48 half hour periods Everyday by 10 A.M. Generators submit schedule for next day
Periods 1 Generator PowerGen Power MW 10 Price GBP 15

British Energy
Eastern 2 48

7
2

15.25
15.50

Pool Pricing
National Grid Co. forecasted daily demand based on historical models Everyday @ 4 P.M. Pool Price is announced.
Periods 1 Generator PowerGen Power MW 10 Price GBP 15 15.25 Demand

British Energy 5

15

Eastern
2 48

15.50

Pool Purchase Price

The cost of marginal generator is System Marginal Price (SMP) = + Capacity payment reflect the projected tightness of supply

Pool Selling Price

Consumers pay Pool Selling Price = + "Uplift" Uplift component reflected the cost of maintaining the system. Uplift added fairly constant 8% to the PPP. In 1995-96
SMP PPP PSP 19.40 per MWh 23.86 per MWh 25.90 per MWh

Volatility in Electricity Prices (PPP)

Given the pool mechanism electricity prices varied every half an hour. Prices fluctuated in response to variety of shortterm, seasonal and long term factors. Prices also varied due to variations in fuel prices. Weather, plant failures, plant utilization rates Volatility (Standard Deviation) as of Nov, 96
Daily 654% Weekly 232%

Volatility in Electricity Prices (PSP)

RECs bought power from pool at volatile PPP and sold to consumers at less volatile PSP. Hence RECs were exposed to fluctuations in power prices. Power traders like Eastern and Enron faced with the challenge and the OPPORTUNITY of rapidly changing and volatile markets. As it is not possible to store electricity the forward contracts were also highly volatile.

Changing Scenario
Ongoing regulatory and political discussions about how to set pool prices, both Enron and Eastern believed that strategic benefits of early involvement in power & gas markets were substantial. Hence both were committed to the markets.

U.K. Natural Gas Market

Transco managed National Transmission System (NTS). 50 gas suppliers or marketers Unlike electricity gas can be stored. Gas prices were set daily (not half hourly). Hence gas prices were much less volatile.

Correlation Between Gas & Electricity Prices

Gas was used for purposes other than electricity generation. Electric power prices were set by the cost of marginal power producer, which didnt use gas as a fuel. Hence correlation between gas & electricity prices was weak. (0.1 at daily level, 0 on monthly level)

The Eastern Group

Formal role as a REC Pursuing diversification strategy to combine gas supply with gas-fired electricity generation to arbitrage between the two markets. Eastern acquired generation unit (6000 MW) when Office of Electricity Regulation (OFFER) did a forced divestiture of coal fired plants.

Enron Corporation
One of the worlds largest integrated natural gas and electricity companies. Enrons Asset Development Group had expertise in tacking complex power projects globally. Six units:
Enron oil & Gas Enron Gas pipeline group Enron Ventures Enron International Enron Renewable Energy Corp Enron Capital and Trade Resources

Sutton As a Traditional IPP

Project Co. which keeps the asset off their balance sheet. Assemble a contractual bundle to mitigate the projects risk. EPC contract to build the plant as specified and for a set price and by a certain date. Operating and maintenance contract physical operations. Gas supply agreement Power purchase Agreement

Alternative Proposal

1. Why is Eastern interested in getting additional generating capacity?

Transformation into an integrated energy company competing in deregulated environment : to provide the entire value chain for electricity. Sensed opportunities for rapidly changing gas markets: to create a diversified energy company. Consistent with its desire to arbitrage between gas and electricity markets on a daily basis.

Q2
How would you characterize Easterns option under the CTA? When is this option valuable? What happens when gas is priced at GBP 1.25 MMBtu and electricity is priced at GBP 25 per MWh? What happens when gas is priced at GBP 2.50 MMBtu and electricity is priced at GBP 15 per MWh?

Q3
Should Enron sign the CTA with Eastern, build the plant, or do both? What risks will it face if it does one or the other, but not both?
Risks involved in building the plant alone 1. Price/cost differential between PPP and gas + operating expenses going negative rendering the plant useless. 2. Technological innovation may lower the cost of power generation in the industry. 3. Difficult to find counterparties who will sign long term PPAs 4. Project cost overrun, delays.

Other risks
1. 2. Environmental safety from plant. Regulatory approvals. Financial risks

Q3
Risks involved in CTA with Eastern
1. When Price/cost differential between PPP and gas + operating expenses goes positive, Eastern will use the virtual plant or they will exercise the option. Enron without the physical plant will make a loss in this case. Enrons traders could construct a hedge using the physical plant to offset the Eastern CTA. With physical plant Enron will also have the right to exchange gas for power poll proceeds.

2. 3.

CTA with Eastern provides Enron the annual payments of 68.8 million GBP. This will cover all fixed costs, debt service requirements and a minimum return on equity for the actual plant.

Q4
How does Enron make money in this deal? What happens if it builds the physical plant, but never uses the plant? How likely is Enron to use it?

Thank You!