Financial Transmission Rights

The Electricity Commission is currently consulting the industry on what best

transmission hedge product to implement. Given Transpower’s support for an efficient
and successful electricity market, we want to work with regulators and the electricity
industry in an effort to raise the level of understanding of FTR options and risks so that
an informed decision on the best option for New Zealand can be achieved.

FTRs are financial hedges that help protect energy purchasers or generators from price
uncertainty caused by transmission losses and constraints.

They confer the right to receive the difference between the prices at the nodes between
which the hedge is written for a defined amount of megawatts and a defined period of
time. FTRs can be matched with an energy hedge to provide a high degree of price
certainty.

FTRs are a standard component of the market design in most overseas electricity markets
that, like New Zealand, are based on locational marginal (or nodal) pricing. New
Zealand has yet to introduce an FTR product, or any other form of tradable transmission
hedge.

Financial Transmission Rights advice provided to the Electricity

Commission

On 6 July 2009 the Electricity Commission sought Transpower’s advice in relation to

FTRs and Locational Rental Allocations (LRA) by 24 July 2009.

FTR Background
Nodal prices introduce locational price risk

In electricity markets using locational marginal pricing (LMP, or nodal pricing), price
differences between two points, or nodes, in a network are caused by network losses and
constraints (locational risk). Consequently, energy contracts cannot be established at a
fixed price without either the seller or the purchaser assuming locational price risk, where
there is any risk of constraints arising between the generation and offtake locations.

FTRs can help reduce locational price risk

The only cash stream correlated with nodal price differences is the rentals and the only
known product that effectively exploits this correlation is a financial transmission right
(FTR).

The holder of an FTR receives the rentals associated with the FTR for a fixed capacity,
duration and direction. If matched with an energy contract the FTR owner is fully
hedged.

LMP markets around the world have implemented some form of tradable FTR as an
important risk management tool in an integrated market design.

FTRs can protect investment

FTRs also protect “first movers” from future demand growth on transmission assets and
provide a means for transmission investors and regulators to compare the cost of
transmission constraints with the cost of new investment.

Locational price risk is partially managed through vertical integration

In the absence of tradable instruments the New Zealand electricity industry has moved to
regional vertical integration between retail and generation. Whilst this arrangement
provides good hedging characteristics for some it may not for others and has limitations
for independent electricity retailers.

Locational price risk can be managed in many ways

In New Zealand the discussion about locational risk management has been concentrated
on two extremes:

• an allocation of the rentals to purchasers in some proportion to the price in excess

of some average price
• sophisticated tradable financial instruments such as Transpower's 2002 FTR
Design.

These two extremes reflect the theoretically worst and theoretically best outcomes in
terms of economic efficiency. In reality, some middle ground with a degree of
tradeability may be the right outcome for practical purposes. The type of instrument
should be chosen to meet efficiency and market design considerations, but the degree of
sophistication of the instruments should be determined and evolved by users themselves.

FTR-related submissions made by Transpower

Through its submissions Transpower has expressed its view that a tradable financial
instrument is consistent with good market design principles but acknowledges that the
degree of sophistication required may be significantly less than proposed in 2002.
We want to work with regulators and the electricity industry in an effort to raise the level
of understanding of FTR options and risks so that an informed decision on the best option
for New Zealand can be achieved.