Investor Uncertainty November 2008

• K Peter Kolf• General Manager & CEO• Economic Regulation Authority

• 25 November 2008

Investor UncertaintyWA Energy 2008 – Tonkin Corporation

Important Notice

• This presentation has been made available in good faith by the Economic Regulation Authority (Authority). This presentation is not a substitute for professional advice. No person or organisation should act on the basis of any matter contained in this document without obtaining appropriate professional advice.

• The Authority and its staff members make no representation or warranty, expressed or implied, as to the accuracy, completeness, reasonableness or reliability of the information contained in this document, and accept no liability, jointly or severally, for any loss or expense of any nature whatsoever (including consequential loss) arising directly or indirectly from any making available of this document, or the inclusion in it or omission from it of any material, or anything done or not done in reliance on it, including in all cases, without limitation, loss due in whole or part to the negligence of the Authority and its employees. This notice has effect subject to the Trade Practices Act 1974 (Cwlth) and the Fair Trading Act 1987 (WA), if applicable, and to the fullest extent permitted by law.

• Any summaries of legislation, regulations or codes in this presentation do not contain all material terms of those laws or obligations. No attempt has been made in the summaries, definitions or other material to exhaustively identify and describe the rights, obligations and liabilities of any person under those laws or provisions.

Introduction

Reflect on experience to date

Not offering advice or policy prescriptions

Overview

1 Regulator’s perspective

2 The role of markets & their impact on investors

3 Investor uncertainty

4 The importance of gas to the WA economy

5 Managing risks in the energy sector

6 The future for investment – a positive outlook?– Challenge for the future

Part 1: The Economic Regulation Authority

Functions:• Administers access to monopoly infrastructure• Licenses service providers• Monitors & regulates markets• Carries out inquiries (referred by government)

Key features:• Independence• Transparency• Consultation

Objectives of Independent Economic Regulation

• Facilitate private sector provision of services

• Make best use of monopoly infrastructure

• Enhance competition upstream/downstream

• Consumer Protection and Fair Trading

– Interface with Energy Ombudsman

Part 2: Economic Efficiency & the Role of Markets

• Productive efficiency• Allocative efficiency• Dynamic efficiency (long run)

– Inefficient markets waste resources– Singularity– Does not address the distribution of income or wealth

Electricity

All other commodities

Long Term Interests of Consumers

Optimum

Max π

The Objective Function

Maximise:• Long term interests of consumers

Subject to:• Social advancement• Environmental protection• Economic prosperity• Interests of investors & service providers• Re-elect Minister

Economic Prosperity

Environmental Protection

Election of Minister Long Term Interests

of Consumers

Interests of Investors

Part 3: Investor Uncertainty

• What a time for a talk on investor uncertainty!

Source: Australian Securities Exchange Web Site

XJO, S&P/ASX 200

Investor Uncertainty

• Classic bubble to bust

• Each phase self propelled:

– Bubble: Low interest, increased appetite for risk, higher asset prices

– Bust: Reduced appetite for risk, lower asset prices, default

• Was regulatory failure involved?

– Short term borrowing for long term investment

• Does every generation need to learn it over again?

Investor Uncertainty

• Uncertainty is core concern for regulators

• What do we mean by investor?

• Examples:

– Market risk premium

– Regulatory risk

– Systematic/diversifiable risks

Market Risk Premium

Market Risk Premium = Broad-based stock index - Risk-free rate (Bonds)

References:• Bishop Steven (2007), Capital Value Pty Ltd, “A review of market risk premium and

commentary on two recent papers” Oct 2007• Brailsford Tim, Handley John C and Maheswaran Krishnan (2007): “A re-examination

of the historical equity risk premium in Australia” April 2007• Gray and Officer (2005): Gray Stephen and R R Officer, “A review of market risk

premium and commentary on two recent papers: A report prepared for the Energy Networks Association” August 2005

• Hancock (2005): The South Australian Centre for Economic Studies, “The Market Risk Premium for Australian Regulatory Decisions: Preliminary Report” April 2005

• Hathaway (2005): Capital Research Pty Ltd, “Australian Market Risk Premium” January2005

Market Risk Premium Australia 1883-1998

-35

-25

-15

-5

5

15

25

35

45

55

1888

1893

1898

1903

1908

1913

1918

1923

1928

1933

1938

1943

1948

1953

1958

1963

1968

1973

1978

1983

1988

1993

1998

Data Year

Value [%]

Premium

Linear Trend

Power Trend

Source: Stephen Grey’s data

Regulatory Risk

• Regulatory risk high on companies’ risk barometer• Few would argue that regulation is unnecessary• However, regulatory risk ill defined:

– Emanates from new legislation (uncertainty)– Or changes to legislation (unintended consequences)– Can be the result of regulatory discretion (uncertainty)– New legislation can take decades to settle– Can be associated with compliance cost– Can be associated with complexity

• Regulators should be predictable• Regulatory risk is diversifiable• Need to differentiate from sovereign risk

Systematic/diversifiable risks

• CAPM (WACC) compensates for Systematic Risk• CAPM provides market returns (opportunity cost of capital):

– Above market returns are a matter for government policy

• Incentive regulation seeks to avoid limiting returns• Project specific risks covered through diversification and:

– Long term contracts– Take or pay contracts– Tariff design to mitigate risk– Other forms of hedging– Accelerated depreciation (risk of stranding)

Reference: “Review of Rate of Return Methodologies and Practices” IRIC, 2003, ERA Web Site

Part 4: The Importance of Gas to the WA Economy

• Natural gas around 50% of primary energy in WA• Verve Energy (3240 MW):

– natural gas generates 35% of Verve’s electricity

• Currently gas for local use in short supply• Gas price exceptionally high (up to around $12/GJ based on

US$60 bbl oil price)• Oil price down US$55 from US$147, 11 July 2008, West

Texas Intermediate (WTI)• Gas prices expected to settle in medium term

Industry mainlymineral processing 35%

Mining 34%

Electricity Generation 26%

OtherCarnarvon110.8 PJ 33%

Perth9.9 PJ 3%

SUPPLY

Commercial & Residential 5%

DEMAND

NWS213.8 PJ 64%

Gas Supply and DemandWestern Australia Domestic Market ~ Year to Sept 2007

Sources: ABARE & Energy Quest, Energy Quarterly Nov 2008 Note: Supply excludes gas used for LNG production but is included in demand

Part 5: Managing Risks in the Energy Sector

• Things happen• Varanus Island Incident costly ~ $2bn• Could have been much worse:

– No loss of life– No widespread power outages– Incident appears to have been managed well– No emergency powers called on

STEM and Balancing Prices

0

50

100

150

200

250

300

350

400

450

500

Sep-0

6

Oct-06

Nov-0

6

Dec-0

6

Jan-

07

Feb-0

7

Mar

-07

Apr-0

7

May

-07

Jun-

07

Jul-0

7

Aug-0

7

Sep-0

7

Oct-07

Nov-0

7

Dec-0

7

Jan-

08

Feb-0

8

Mar

-08

Apr-0

8

May

-08

Jun-

08

Jul-0

8

Aug-0

8

$/M

Wh

Weekly Average Volume Weighted Balancing Demand Price

Weekly Average Volume Weighted Balancing Supply Price

Weekly Average Volume Weighted STEM Price

Varanus IslandImpact3 June 08

Regional Quarterly Volume Weighted Average Spot PricesNational Electricity Market

0

50

100

150

200

250

Mar

-99

Sep-9

9

Mar

-00

Sep-0

0

Mar

-01

Sep-0

1

Mar

-02

Sep-0

2

Mar

-03

Sep-0

3

Mar

-04

Sep-0

4

Mar

-05

Sep-0

5

Mar

-06

Sep-0

6

Mar

-07

Sep-0

7

Mar

-08

Sep-0

8

$/MWh

Queensland

New South Wales

Victoria

South Australia

Tasmania

13 Sept 08

Managing Risks in the Energy Sector

• Impact of Ike – on Houston & Galveston– ~ 400 lives– Mass evacuations– Military control– No electricity 10 days +– No water 3 days +– Nightly curfews 7 days +– Most petrol stations & stores closed – no power– Communications down, can’t charge mobiles– Cost $???bn

Managing Risks in the Energy Sector

• Multi level contingency planning:– Industry needs to take responsibility for its commercial wellbeing– Government focus on community wellbeing– Well developed markets likely to be helpful– Fuel diversification– Fuel storage and transport contingency planning– Recovery plans

Part 6: The future for investment – a positive outlook

An investment of $1 in stocks at the end of 1882 and rolled over at the end of each year, stocks would have grown to $273,466 at the end of 2005.

A similar investment in bills would have grown to $539 and a similar investment in bonds would have grown to $834.

Brailsford Tim, Handley John C and Maheswaran Krishnan (2007), p16

Challenge for the future

The challenge is to develop rules that promote efficient decentralised decisions harmonising personal and public interests (Adam Smith’s invisible hand).

Need to avoid intrusive information intensive and administratively costly approaches through the development of market based systems.

Investor Uncertainty November 2008