MarktoMarket Accounting Enron Global Markets November 2000 Confidential

Mark-to-Market Accounting Enron Global Markets November 2000 Confidential & Proprietary

MTM vs. Accrual • Accrual model recognizes earnings when the product is delivered and/or services are performed - earnings are recognized over the contract life. • MTM recognizes the value of the contract at the inception of the contract. Any future changes in the value are recorded in earnings when changes occur. Confidential & Proprietary 2

How MTM Evolved • MTM is the method of accounting for broker/dealers (traders of highly liquid securities) • SEC allowed Enron to use MTM on price-risk management activities only, as they resembled broker/dealer activities – Adopted with creation of ECT in 1992 – Significant hurdle as we were primarily known as a physical transportation company – Pursued due to our trading strategy – Derive value from contracts and commitments and not physical assets Convinced SEC that majority of ECT’s business entailed trading/dealing in commodities Confidential & Proprietary 3

Who Can Use MTM? Entities That: • Offer products as a dealer; perceived as a risk manager • Have an evolving strategy to meet the market place demand (i. e. , taking and managing positions based on market conditions) • Derive primary assets and liabilities from contract commitments and financial instruments, not capital assets • Create value and complete earnings process at contract initiation (ongoing maintenance/work minimal) Trading Entities Confidential & Proprietary 4

Why use MTM? • Recognizes all earnings/value in the period that the contract is initiated • Reflects the way marketers manage their business – Marketers look to maximize portfolio – MTM provides trader with real-time value of the portfolio • Reflects industry practice for commodity traders/marketers • Highlights the need for deal makers to execute new transactions – Focus is on new deals vs. accrual earnings from old deals – Less reliance on old deals to meet earnings target • Requires identification of all risks at transaction date (i. e. , credit, liquidity, legal, etc. ) Confidential & Proprietary 5

Why Use MTM? (cont’d) • Requires on going management of credit and liquidity risk (adjustment to MTM value of transaction) • Requires constant measurement of the market value of the portfolio resulting in ongoing efforts to manage the portfolio • Accounting matches the economics of the transaction (trading mentality) Management tool for evaluating effectiveness of business decisions Confidential & Proprietary 6

Why does Enron choose to use MTM? • Our primary assets/liabilities are contracts • Reflects industry practice for commodity traders/marketers • We offer products as a dealer, not “user” or “producer” • Incentivizes deal makers to execute new transactions Confidential & Proprietary 7

Mark to Market Application Confidential & Proprietary

Summary of MTM Valuation Process at Recognition Marking of Contract to Mid-Market Values Deductions from Mid-Market Value Market (to prudently reflect Market Risks) Credit (reflecting effect of counterparty credit rating) Market Liquidity Basis Risk Price Risk Management Earnings Discounting (to recognize only the Present Value of Price Risk Earnings) Net Price Risk Management Earnings Other Operational, Legal and Environmental Risks Administrative (cost to service Contract over its life & physical costs) Price Risk Physical (non-Trading) Other Market Risks Confidential & Proprietary 9

Financial vs. Physical Services • Types of transactions that qualify for MTM (financial contracts that involve price risk management) –Fixed price forward contracts –Fixed for floating swaps –Option contracts • Types of transactions that require accrual accounting (physical services) –Physical delivery (requirements) –Contracts requiring delivery on owned assets –Contracts with non-market based damages for non-performance (indicative of physical service) Contracts that require significant future performance risk are generally not markable Confidential & Proprietary 10

Key Contract Provisions for MTM • Firm Quantity – States volumes, minimum volumes, or all requirements (if reasonable and estimable) – Not subject to interruption except in force majeure • Fixed Price – Price per unit (i. e. , fixed, index plus, etc. ) • Force Majeure – Excuses performance in very limited cases, where occurrence of events is beyond the parties’ control – Anticipated events (i. e. , scheduled maintenance, etc. ) should not be considered force majeure • Market Liquidity – Sufficient number of financial counterparties willing to transact under same terms and conditions – Adequate physical liquidity/connectivity Confidential & Proprietary 11

Key Contract Provisions for MTM (cont’d) • Cash Out Procedures for Failure to Perform (“outages”) – Objectively determinable amount (i. e. , cost-to-cover) – Reinforces that earnings process was complete and services provided are financial risk management services – Avoids disputes on damages – Punitive or consequential damages indicates importance of physical performance vs. price risk management activity • Triggering Events and Termination Payments (Liquidated Damages) – Objectively determinable amount (i. e. , PV of replacement contract) – Reinforces that earnings process was complete and services are financial risk management services – Provisions that go beyond market value of replacement contract indicate physical performance risk in contract Confidential & Proprietary 12

MTM Application • Standardized Product Offering • Adequate Liquidity • Fungibiltiy Is It A Commodity? YES NO Are We Managing It As A Trading Activity • • • Firm Price Firm Tenor Firm Quantity Force Majeure Market Based Damages NO YES Accrual Contractual Framework YES Accrual NO Accrual MTM Confidential & Proprietary 13