Where to from here ??

1. Where to from here ?? The emerging electricity lines industry in New Zealand

2. [This slide added later] • This Presentation was made to the Small Line Company Manager’s meeting in Wellington on Wednesday, 15 March 2000. • Please feel free to share this Presentation with your Board and senior managers, but restrict circulation to within that group. • Please forward any requests for this Presentation by external parties directly to me for consideration.

3. Discussion Topics Brief history of NZ industry Recent events in the NZ industry Present status of the NZ industry

4. Discussion Topics Emerging global trends Possible scenarios for the NZ industry Regulation in more detail Big issues the NZ industry might face Amalgamations in more detail

5. A brief historyof the NZ industry

6. Industry beginnings • Supply in the early 1890’s was largely vertically integrated - ownership was predominantly private or borough council. • Rapid growth in the number of these entities as the agricultural-based economy discovered the benefits of electricity. • Legislative emphasis was on exclusively empowering the Crown to develop hydro generation capacity.

7. Steps toward unification • First step toward unified supply industry was the Electric Power Boards Act of 1918. • Provided for the establishment of bodies corporate elected by rate-payers to supply electricity within a licensed area. • However, two types of bodies emerged… • Electric Power Boards which tended to be in rural areas with undefined ownership. • Municipal Electricity Departments which tended to be in urban areas and were owned by Councils. • Key exception was the Auckland EPB, the only EPB in a major urban area.

8. Further consolidation • Number of EPB’s and MED’s grew from 66 in 1919 to a peak of 94 in 1938. • Also saw the almost total decline of private electricity companies. • Crown had a virtual monopoly on generation, with all other capacity requiring the Minister’s approval. • Emergent structure was essentially vertically integrated, viz...

9. Further consolidation Generation & transmission State Hydro EPB & MED Distribution & energy supply

10. Rationalisation • First attempt was actually in 1921. • Minister tried to persuade the PN Borough to become an “inner area” of the MOEPB - took 75 years to resolve. • Rationalisation of the supply industry dominated Government’s energy thinking from 1945 to about 1973, with 3 significant investigations… • Electricity & Gas Consolidation Act 1956. • Stanton Commission of 1959. • Electricity Distribution Commission 1968.

11. Further rationalisation • Despite these attempts at rationalisation, only a few amalgamations occurred… • Petone & Lower Hutt Gas Board merged into Hutt Valley around 1959. • Opunake and South Taranaki merged in 1963. • Wairere merged into Waitomo in 1976. • Local government reform in 1989 resulted in a few small Council electricity departments amalgamating into the surrounding EPB’s. • Further reduced the number of distribution entities from 60 in 1988 to 52 by 1990.

12. Further rationalisation • Energy Companies Act 1992 required EPB’s and MED’s to become limited companies, to define their owners, and to behave as profitable businesses. • Commercial drivers further reduced numbers to 39 by mid-1996. • Electricity Industry Reform Act 1998 required separation of lines and energy businesses. • Resulted in more amalgamations of line businesses, reducing the number to 31 at the present day.

13. Present status ofthe NZ industry

14. Present structure • At last count the lines industry comprised the following players… • 31 line companies • 1 national transmission company • About 1,538,000 line customers of which 50% are connected to the 3 largest suppliers (United, Vector and Orion).

15. Present structure Generation Ownership Transmission Distribution Contracts Retailing

16. What is drivingthe NZ industry

17. Industry drivers • Strong demands for secure supply. • Increasing focus on asset management practices. • Technology. • Consumer awareness. • Concern over recent profits. • Competition for investment funds. • Restrictions on land use and access. • Political intervention, including the present inquiry into the industry.

18. Comment • Politics will be a major driver of electricity lines industry - electricity always has been a bit of a political football, but it will probably be even more so now. • Previous National government had a very much laissez-faire approach. • Coalition government has demonstrated a very interventionist approach already in other sectors such as Social Welfare, Broadcasting, Workplace Insurance, Education and Health. • Very likely that the electricity sector will be subject to similar intervention.

19. National government • Preference for private ownership. • Strong dislike of Trusts. • Desire for increased competition. • Move toward price regulation. • Preference for amalgamation.

20. Coalition government • Strong opposition to privatisation. • Little concern for shareholder wealth. • Opposed to utilities making profits. • Strong preference for social objectives. • Preference for vertical integration. • Little regard for business costs. • Failure to understand knowledge economy. • Preference for government service provision as well as funding. • Aversion to high salaries. • Preference for ad-hoc intervention.

21. Emerging globaltrends & issues

22. Comment • Many events in the NZ industry are mirrored by global utility events. • Time lag with some issues - NZ may either be a bit ahead or a bit behind. • May provide learning opportunities where we are a bit behind. • Key global issues are…

23. Key global issues • Increasing competition in energy retailing. • Increasing price regulation. • Portfolio approach to investment. • Separation of line & energy businesses. • Integration of gas & electricity. • Emergence of multi-utility businesses. • Changing political climates and risks.

24. Price regulation • We will look later at how price regulation was applied in the UK in the 1990’s. • For now, we note that the price controls in 1995 and 1996 alone cost the distribution industry about £2 billion. • Recent events in Canada and the UK indicate that regulation is really starting to bite hard… • TransAlta’s sale of their lines business in Alberta to Utilicorp because of reduced allowable return. • United Utilities’ and Hyder’s sale of their energy businesses to off-set decreased line revenues (also because of competition).

25. Increasing competition • Retailing is subject to increasingly tight margins. • Driving the industry toward vertical integration to obtain price stability, more so forward integration by the generators. • Happened here with the Big 4 generators. • Happened in the UK with PowerGen and British Energy in particular. • Competition based on differentiation. • Almost choose energy retailer based on what other commodities are desired eg. Sky TV.

26. Portfolio approach • Began when US utilities facing lack-lustre domestic earnings took advantage of the privatisations in the UK, Argentina and Victoria. • Recent about-face in the US buy-up with PowerGen buying Louisville Gas & Electric and actively seeking further US investments. • Sort of happening in NZ with AGL, but government policy is unlikely to see this become the norm.

27. Separation • Separation of lines and energy was enforced by law in NZ about 18 months ago. • Fundamentally re-shaped the NZ industry. • UK industry is voluntarily separating energy from lines, providing the generators with opportunities to forward integrate and secure retail markets… • PowerGen bought East Midland’s energy business. • British Energy have bought Hyder’s energy business, and are tipped to be a leading bidder for United Utilities energy business.

28. Separation • In the US, PG&E are expanding into energy businesses beyond their legacy market around San Francisco. • Key driver for them is moving into unregulated markets and prudently managing the down-side risks (a key strategy is backward integration into gas and coal). • Suggests that voluntary separation could have happened in NZ if retail competition intensified enough to make energy businesses unprofitable for anyone other than generators.

29. Integration • Began in NZ in 1959 when gas merged with electricity in the Hutt Valley, so the idea is certainly not new. • Certainly a major focus of retailers such as Contact, NGC and Fresh Start who have access to gas reserves. • Been a big focus of utilities such as SEEBoard (Beacon Gas) and TU (Lone Star Gas). • Less obvious is the integration of pipes and wires into combined businesses… • Powerco’s acquisition of Hawera Gas. • Southpower’s acquisition of Enerco.

30. Multi-utilities • Privatisation in the UK appeared to kick this one off around 1990. • Two apparent strategies. • Penetration within a geographical area… • North West Water’s acquisition of NORWEB to become United Utilities. • Hyder’s acquisition of Welsh Water and SWALEC, and subsequent amalgamation of operations. • Extension beyond a geographical area… • Scottish Power’s acquisition of MANWEB and Southern Water.

31. Multi-utilities • Uncommon in the US, Australia or NZ because water and waste assets tend to be owned by public bodies. • Some indication from the former government that water and waste assets in NZ could be privatised in the medium term. • Penetration into communications sector in urban areas… • United Utilities and ScottishPower. • Texas Utilities • Downtown Utilities in Sydney, Melbourne and Brisbane.

32. Political risk • Risk of ad-hoc political interference increasing the risks of investing in a jurisdiction. • This risk increases the β in the CAPM, requiring greater returns on capital to be made. • We probably now need to think of NZ as being “politically risky” in terms of utility investments. • One US utility with many global interests has already expressed reservations about investing in NZ.

33. Where is it all going ? • Emerging global trend appears to be separation of lines and retailing. • Actually happening in the very broadest sense of regulated and unregulated businesses ie. separating the pipes and wires from competitive businesses. • Key drivers… • Increasing price regulation of pipes and wires businesses. • Decreasing margins in commodities such as electricity, gas and phone traffic.

34. Where is it all going ? • Different drivers and competencies will be required in each business… • Regulated businesses will need to… • Ruthlessly control costs to deliver increasing returns. • Reduce costs beyond the scope of internal efficiencies, leading to further amalgamations. • Identify arbitrage opportunities, where individual regulatory jurisdictions will allow returns on funds greater than the global cost of capital.

35. Where is it all going ? • Unregulated businesses will need to... • Prudently manage down-side risks associated with commodity trading. • Invest in markets where demand exceeds supply. • Control margins by investing in commodity sources, particularly up-stream gas, coal and water.

36. Big issues the NZ industry might face

37. Big issues • Foreign investment. • Increased scrutiny. • Price regulation. • Further amalgamations.

38. Foreign investment • Foreign investment will very probably decline, for four key reasons… • Coalition government opposition to profits going off-shore. • Halt to further privatisations of generation. • Movement of the electricity lines sector toward a low return - high risk position (perhaps more political risk than commercial risk). • Public perception that profit is bad and evil. • Having said that, NZ will still be closely watched by many foreign utilities such as Utilicorp, GPU, TU, and AGL.

39. Increased scrutiny • Likely to occur in two forms… • Increased scrutiny from special interest groups who know that the Government will take up their cause. • Possibly further increases in disclosure to government agencies - either more detail, or more often.

40. Price regulation • Signaled by the former government. • Forms a significant part of the present inquiry. • Likely to occur in one form or another, and will very probably see a substantial reallocation of benefits from shareholders to customers. • Will be discussed in detail later on.

41. Further amalgamations • Logical step for those lines companies that have exhausted internal cost savings. • Previous government was keen to see more amalgamations in order to reduce the industry cost base. • Exact stance of the Coalition on line company amalgamation is uncertain. • Will be discussed in detail later on.

42. Where might theNZ industry go

43. Possible scenarios • Status-quo • Walk shorts & sandals. • Portfolio. • Bare bones. • Big brother.

44. Status-quo • Description… • Similar to the present industry. • Characterised by… • Much the same structure as at present. • May provide for line companies to resume energy retailing simply on a tit-for-tat basis from the Coalition government. • Tinkering with some peripheral legislation, such as the Workplace Insurance and the Employment Contracts. • No fundamental changes.

45. Walk short & sandals • Description… • Return to the walk shorts & sandals days of the 1970’s. • Characterised by… • Focus on engineering excellence for its’ own sake. • Possible loss of customer focus. • Erosion of shareholder wealth. • Lack of investor interest in industry. • Probable departure of non-technical people.

46. Portfolio • Description • Lines businesses become investments within global portfolios that are bought and sold as returns and risks vary in relation to investor criteria. • Characterised by… • Clear focus on increasing earnings over time. • Regular changes of ownership. • Strong emphasis on cost control. • Strong overseas presence. • Possible increase in listed companies.

47. Bare bones • Description • Price regulation that could cut deeply into overall cost structures. • Characterised by… • Tough price regulation. • Ruthless emphasis on cost control. • Probable exit of investors, similar to TransAlta’s decision to divest their lines business in Alberta. • Possible de-listing of listed lines companies. • Limited funds for reinvestment in networks. • Possible decline in supply reliability over the long-term due to limited funding.

48. Big brother • Description… • Tough information disclosure, possibly as a substitute for price regulation, possibly as well as. • Characterised by… • Extreme requirements for information disclosure, possibly including ad-hoc government intervention. • Possible focus on regulatory body rather than the electricity customer. • Significant resources dedicated to disclosure process.

49. Regulationin more detail

50. Price regulation • Objective of regulation is to restrain profits and to maintain service levels in the absence of a competitive market. • Four main forms of regulation… • Sliding scale • Rate of return • Price cap • Discretionary