Thursday, June 29, 2023

Financability and network infrastructure

The energy transition requires new electricity generation to replace the fossil fuel fleet (mostly coal in Australia) and meet growing demand arising from the electrification of the transportation and heating sectors. AEMO's modelling calls for significant new transmission assets to connect this generation, though some (including me) think AEMO is underestimating the potential for distribution connected generation to meet more of the needs.

The plans to build massive new transmission assets raises questions of financeability; will anyone be prepared to invest in or lend to the operators the funds required to make these investments. The AEMC is currently considering one rule change request from the Australian Energy Minister on financeability, and another from the same source on how to accountfor concessional finance (the Rewiring the Nation funds) in the regulatory framework. Energy Networks Australia has submitted an alternative rule change on financeability

These concerns raise important questions beyond the simple issues inherent in their substance. The Australian Government's proposals for market reform in electricity focussed on the creation of a single national grid under government ownership that would enable the operation of competition in generation (see my chapter A History of Electricity Reform in Guillaume Roger's On the Grid).  The reforms did not follow this path with separate state based transmission networks being separated from generation and the NEM actually operating as a set of five inter-connected markets. 

Privatisation was not a high priority of the Australian Government in this reform. It was aggressively pursued by South Australia and Victoria in the face of fiscal pressure arising from the boom and bust of the late 1980s and early 90s. Privatisation was only recently pursued in NSW (byway of 99 year lease). Part of the promise of privatisation was to avoid the issues of the need to call on government to finance growth; and yet now that growth finally arrives we question the ability of private capital to fund it.

Ultimately the financeability questions really should have us examining the wisdom of privatisation, especially of the structurally separated market platform - transmission. 

A more challenging threat to the the record of privatisation has emerged in the UK in the water sector. The challenge there is led by Thames Water. The current headline is their ability (or inability) to raise the capital (10 billion pounds) necessary to meet operating standards. How they have got themselves into the mess is a combination of regulatory failure, investor greed and new investor stupidity.

Starting with regulatory failure, the UK water sector was initially regulated under the RPI-X model, before its mofification to the RAB model in the face of concerns that pure RPI-X might erode financability. The RAB model guarantees the operator an NPV>0 outcome - they will get investment fully repaid with a return on capital. It also includes incentive components allowing the operator to retain some of the benefits of cost saving as (economic) profit. However it has clearly done so without prohibitting cost reduction to occur at the expense of service quality. 

The beneficiary of this weak regulation was the owner of Thames Water from 2006 to 2017 - Australia's Macquarie Bank. As well as extracting profit from reducing cost at the expense of service quality, Macquarie loaded the businesses with debt (they changed the gearing ratio). If I load a business with extra debt I can return shareholder equity as special dividends. These were the greedy investors.

The stupid investors are those who bought the business from Macquarie. They haven't been able to generate any returns and inherit the problems of running down service quality. A challenge for regulators is that the service quality impact of underinvestment are only apparent some years after the investment falls away. 

One of the reasons for the failure of privatisation was that Governments didn't sufficiently understand the difference between privatising as listed entities and privatising through private investment. A lot of the theory of the efficiency of private investment hinges on the shareholder capital model. The benefit is three fold. The first is the requisite public reporting required of listed businesses and the resulting scrutiny applied by financial analystys. The second is the daily evaluation of company performance by the market. A focus on short term returns may be (is) destructive, but limitting market transactions to turnover measured in decades simply results in avoided scrutiny. And when these transactions do occur they are made by businesses accessing confidential data being advised by merchant bankers whose incentive is for the transaction to occur - it is a recipe for purchasers always over paying. The third is genuine competition, the framework of private ownership by big super funds or by big infrastructure players (thinking Ontario Teachers and Hutchisom Whompoa as examples of each) results in all the businesses globally having similar strategies and tacit collusion, especially in their regulatory engagement.

Having listed entities solves many problems. The financeability question can be resolved by simply creating a pricing outcome of how much new equity investors require to support the new project. The performance question is resolved by the greater transparency applied through market listing.

It is probably too late to reverse the privatisations, but we should cettainly do no more (e.g. the NBN). It isn't too late to institute licence conditions that require a proportion of the equity capital of these businesses to be listed, limits on the shareholding by related parties of the listed stock, and boundaries on gearing. The businesses will all no doubt cry blue murder about government interference in areas that should be decisions of investors and management. The simple counter is that the buisinesses only exist courtesy of a goverment licence for monopoly. 

I hold no hope that any policy maker will have the courage to pursue this essential reform. But that is a different problem.

Life is what happens while you are busy making other plans JWL

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