The Effect of Environmental Regulation uponthe Electric Power Industry:A Rating Agency Perspective

23rd February 2005At the California Public Utility Commission

Regulation of Pollutants

> Four major pollutants> SO2, NOx, Mercury, CO2

> Regulation is fragmented

> Regulation to-date of SO2 and NOx under the Clean Air Act

> Clean Air Interstate Rule: Proposed rule for further reductions in SO2 and NOx emissions

> SO2: 70% below 2002 levels by 2015

> NOX: 65% below 2002 levels by 2015

The Effect on Credit Profiles

> Increasing CapEx

> Rising allowance credit prices

> Leading to> Higher energy costs> Increased leverage and> Lower profit margins

Lessons Learned from SO2

> Complying? > Pollution control devises, fuel switching or

buying credits. > Best solution was probably a combination.

> Buying credits buys time

> Fuel switching was feasible because of the abundance of low sulfur coal

Lessons Learned from SO2

> Building/switching to gas-fired capacity was not always optimal

> Volatile natural gas prices> Limited supply of natural gas

> Avoiding the installation of pollution control devises may be costly

> The recent run up in prices for SO2 credits has generally caused the building of scrubbers to be more economic than buying allowance credits

Purchase Allowances

for 2003

Purchase Allowances

2005

Scrubber3

10.2 36.6 25.1

Compliance Costs Comparission ($ millions)

1 CAIR: Clean Air Interstate Rule; requires a 70% reduction in SO2 emissions by 2015.

2 SO2 emission allowance costs: Jan 2003 = $150/ton, 2005 est = $540/ton.

3 Based on a plant with 1,880 MW capacity and scrubber cost of $200/kw. Number represents annual depreciation of total cost based on a useful life of 15 years.

Source: EPA, Fitch Ratings.

NOx SIP Call > Covers 22 states including DC and affects 35 investor owned electric utilities

> The top five NOx emitting utilities include*: AEP, Southern Company, Xcel, Cinergy, First Energy

> Seen in the market: NIPSCO, Exelon, CMS, and First Energy.

* Ceres. Benchmarking Air Emissions report, April 2004.

CO2 Regulation: Not if but when

> Fitch believes that there will be a carbon law at the federal level however it may be a number of years off.

> Other States currently regulating carbon: Massachusetts, New Hampshire, Oregon, and Washington

> RGGI

> Law suits from eastern states

> Investor requests for additional information

> McCain-Lieberman and Carper

Anticipation of a Carbon Constrained Environment: Current Industry Response

> Participate in the development and/or construction of clean coal technology

> Buy Carbon Credits – Chicago Climate Exchange

> Estimate and inform Investors as to possible costs (for example studies done by AEP and Cinergy)

U.S. CO2 Emissions

> Aggregate electric power sector CO2 emissions expected in 2004 = 2,257 million metric tons1

> A 5% reduction could range from $.7 billion to $4.2 billion2 in costs per annum.

> Top five CO2 emitting utilities include: AEP, Southern Company, Xcel, Cinergy and Progress Energy

> AEP’s costs to reduce CO2 emissions by 2020 range from $0.5 billion to $6.4 billion3

1 Source: Energy Information Administration. 2 Information Based on prices of CO2 emissions ranging from $6 per metric ton to $37

per metric ton.3 Cost estimates based upon McCain Leibermann and the Carper proposals.

Challenges for CO2

> The Power Industry will need economically feasible CO2 emission control technology

> The development of these devises will be challenged by:

> A realistic estimate for the price of “carbon”> The time horizon for investors and

developers> The time horizon for electric power

generators

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