0 Financial Considerations in Environmental Regulation Mark S. Brownstein Director, Enterprise Strategy Ozone Transport Commission Annapolis, Maryland

1

Financial Considerations in Environmental Regulation

Mark S. BrownsteinDirector, Enterprise Strategy

Ozone Transport CommissionAnnapolis, Maryland.November 10, 2004

2

Variables in Assessing The Viability of New Investment

Cost of Capital

Return on Capital

Recovery of Capital

Energy Revenue

Capacity Revenue

3

“Integrated” Generation

S&P Report 10/2004

Company Rating/OutlookBusiness

Profile

FPL A/Negative 8

Exelon Generation

A-/Negative 8

PPL Energy BBB/Stable 8

TXU BBB/Negative 7

PSEG Power

BBB/Negative 8

Duke Energy Trading

BBB-/Stable 10

PSEG Holdings

BB-/Stable 9

AES B+/Positive 9

NRG B+/Stable 9

Reliant B/Stable 8

Dynegy B/Negative 8

Calpine B/Negative 9

Mirant NR/-- 10

Regulated Distribution Companies Merchant Generation


Profile

NSTAR A/Stable 1

Con Edison A/Stable 2

Energy East BBB+/Negative 3

PEPCO BBB+/Negative 3

CT Light & Power

BBB+/Negative 3

PSE&G BBB/Negative 3

Duquesne Light

BBB/Negative 4

S&P Ratings CriteriaDebt, Cash Flow, and Perceived Business Risk

Credit ratings affect access to commercial paper (short-term debt) and effects collateral requirements and the cost of medium/long term borrowing.

Business Profile

Lowest Risk

Highest Risk

1 10


Profile

Exelon A-/Negative 7

Constellation BBB+/Stable 7

Sempra BBB+/Stable 7

Pepco Holdings

BBB+/Negative 5

Dominion BBB+/Negative 7

Xcel BBB/Stable 5

AEP BBB/Stable 6

Entergy BBB/Stable 6

Duke BBB/Stable 7

PPL BBB/Stable 7

PSEG BBB/Negative 7

PG&E BBB-/Stable 6

Edison Int’n BB+/Stable 6

TECO BB/Stable 5

Allegheny B+/Positive 7

Aquila B-/Negative 8

S&P Rating

bps Spread from BBB

AAA 420

AA 350

A 280

BBB 0

BB -490

B -1910

CCC -4500

4

The Unlevel Playing FieldMerchant v. Regulated/Re-Regulated Generation

Total U.S. Generation Capacity:

Merchant* 43%

Utility 36%

Public 21%

60% - 80%

20% - 40%

<20%

Merchant Generation Ownership*

>80%

40% - 60% Source: PowerDat* Represents non-utility and non-public power generation ownership

National Distribution of Merchant GenerationOTC

Expanded PJM

5

The Illustrative Dispatch CurveVariable Cost = Clearing Price = Energy Revenue

In PJM, variable costs for load-following coal or combined-cycle natural gas units typically set the market clearing price, with coal setting off-peak price, and gas setting on-peak price.

Fossi l Steam

$75 +Combustion T ur bine

$50 - $ 70

Baseload Coal

$12 - $ 15Nuclear $ 8 - $ 12

Load Fol lowing Coal

$15 - $ 30

CCGT $ 30 - $ 50

0

20

40

60

80

100

120

MW

$ /

MW

h

6

$3.92

$5.53

7,338 Btu/kWh CCGT w/ burner tip gas prices:

$8.00

5.53 7.86

5.537.86

4.705.85

4.705.85

5.913.31

5.913.31

23.5721.3811.7911.06

$28.80

$40.58

$58.70

$0

$10

$20

$30

$40

$50

$60

$70

NAPP Contract$30/ton

CAPP Contract$30/ton

NAPP Spot $58/ton CAPP Spot $60/ton

DIS

PA

TC

H C

OS

T (

$/M

WH

)

Coal Price per MWh Transportation per MWh

NOx per MWh SOx per MWh

Marginal Coal v. New Natural Gas in PJMToday

Today’s gas priceASSUMPTIONS NAPP CAPP

COAL SPECS (Btu/lb,%S) 13,869,2.1%S 12,942, 0.9%S

HEAT RATE (Btu/kWh) 10,200 10,100

COAL Transportation $15/TON $20/TON

SCR OR Scrubber? NO NO

SO2 Emissions (lb/MMBtu) 2.50 1.30

SO2 COSTS ($/Ton) $500 $500

NOX Emissions (lb/MMBtu) 0.26 0.5

NOX COSTS ($/Ton) $2,300 $2,300

On variable cost, coal beats gas absent a significant and sustained drop in natural gas price.

7

$5.52

$7.80$3.98

$7.58$8.93

$4.60$1.35

$1.08$5.23

$5.18

$15.48$11.20

$36.20$42.03

$0

$10

$20

$30

$40

$50

$60

$70

NAPP 2008 $30/ton CAPP 2008 $40/ton

DIS

PA

TC

H C

OS

T (

$/M

WH

)

Coal Price per MWh Transportation per MWh NOx per MWh

SOx per MWh Hg per MWh CO2 per MWh

$8.00

7,338 Btu/kWh CCGT

w/ burner tip gas at:

$4.04

$4.83

A modest CO2 adder in combination with declining natural gas prices (and rising coal price) can have the effect of pushing load-following coal off the margin.

2008 ASSUMPTIONS NAPP CAPP



COAL Transportation $15/TON $20./TON

SCR OR Scrubber? NO NO


SO2 COSTS ($/Ton) $700 $700


NOX COSTS ($/Ton) $3,000 $3,000

Hg Emissions (lb/Tbtu) 7.54 6.13

Hg COSTS ($/LB) $35,000 $35,000

CO2 Emissions (lb/MMBtu) 205.1 205.2

CO2 COSTS ($/Ton) $5 $5

Marginal Coal v. New Natural Gas in PJMTomorrow

$5.73

2004 Gas Price

2008 Gas Price

8

Marginal Coal v. New Natural Gas in PJMTomorrow: In Competition with Rate-Based Assets

$250M capital investment for a 500MW plant

2008 ASSUMPTIONS NAPP CAPP



COAL Transportation $15/TON $20/TON

SCR OR Scrubber? YES YES


SO2 COSTS ($/Ton) $400 $400


NOX COSTS ($/Ton) $1,900 $1,900

Hg Emissions (lb/TBtu) 2.26 1.84

Hg COSTS ($/LB) $35,000 $35,000

CO2 Emissions (lb/MMBtu) 205.1 205.2

CO2 COSTS ($/Ton) $5 $5

A marginal coal unit in competition with a unit capable of rate-basing control equipment is squeezed from above ($5.80 natural gas in 2008) and below. The rate-based plant enjoys a $10 advantage over the merchant.

$2.20$2.20$5.72

$8.14

$3.68

$7.80$5.44

$5.39 $5.23

$5.18

$11.61$16.15

$11.20$15.48

$0.60$0.60 $3.98

$7.58

$0.32$0.15

$8.93

$4.60

$0.66$0.81

$1.35

$1.08

$42.56

$0

$10

$20

$30

$40

$50

$60

NAPP 2008$30/ton

Controlled

CAPP 2008$40/ton

Controlled

NAPP 2008$30/ton

Uncontrolled

CAPP 2008$40/ton

Uncontrolled

DIS

PA

TC

H C

OS

T (

$/M

WH

)

Coal Price per MWh Variable O&M per MWh Transportation per MWh

NOx per MWh SOx per MWh Hg per MWh

CO2 per MWh

$24.50

$41.72$34.37$31.08

9

Production Cost v. RevenueEarning Enough to Build & Maintain Generation

0

10

20

30

40

50

60

New Gas CCGT New Supercritical PulverizedCoal PJM West Delivered Coal

Existing 500 MW Coal Plant,Retrofitted PJM East Delivered

Coal

Fuel Cost Variable O&M Capital & Fixed O&M

DIS

PA

TC

H C

OS

T (

$/M

WH

)

Energy Revenue

CapacityRevenue

Market Clearing Price

Basic Market Dynamics

Under current market conditions, energy revenues alone are rarely enough to recover the full cost of new investment making the degree of capacity payments critical to the viability of new investment.

Off Peak Market Clearing Price

Energy Revenue

10

Key Takeaways

Cost of capital matters. Companies with the ability to recover capital costs through rate-base or other regulatory mechanisms enjoy lower cost of capital than those fully exposed to wholesale energy markets.

Return on capital matters. Any investment must recover the cost of capital plus a return on investment. Regulated utilities typically expect a return of 9 -11%, while merchant generators expect a higher return as compensation for the additional risk.

Market rules matter. Return on capital is a function of energy and capacity revenues. Currently, energy margins are inadequate to fully recover the cost of capital in new or modified plant, making capacity payments critical to the viability of investment in environmental retrofits and gas-fired generation.

Fuel price matters. Future fuel pricing – natural gas and coal – is a significant variable in investment decisions because of their direct effect on energy margins.

A level regulatory playing-field matters. Companies with the ability to recover the capital cost of emission control equipment enjoy a significant competitive advantage over those that do not. Companies required to internalize the cost of CO2 or other environmental adders are penalized in competition with those that do not face such restrictions. This is the looming reality of an expanded PJM.

Documents

0 Financial Considerations in Environmental Regulation Mark S. Brownstein Director, Enterprise Strategy Ozone Transport Commission Annapolis, Maryland