Big power M&A reaches Australia
The proposed partial privatisation of the electricity distribution and transmission networks (Networks) in New South Wales announced by the State Government of New South Wales (State) will, if completed, mark the final phase of the privatisation of the electricity sector in New South Wales. By Shaun McGushin, partner, Corrs Chambers Westgarth.1
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The privatisation of the Networks is contingent upon the current Government receiving a mandate at the State election in March, 2015.
The State Government of Queensland has also announced in September 2014 that it proposes to privatise not only the Queensland transmission and distribution networks, but also its generation and remaining retail assets, by way of long-term lease subject to it receiving a mandate at the next State election (which may occur between March and June 2015). This should also mark the final phase of the privatisation of the electricity sector in Queensland.
In this paper we highlight the significant issues that potential private sector investors will need to be aware of, including those that will need to be addressed if the privatisations are to proceed. Whilst the focus here will be on New South Wales, the same issues will largely apply to Queensland with one fundamental difference as referred to below.
The Networks in New South Wales are currently 100% State owned and comprise of:
(a) TransGrid– A transmission business with a regulated asset base of A$6.1bn and 12,800km of transmission lines.
(b) Ausgrid– A distribution business with 1.6m customers, a regulated asset base of A$14.4bn and 41,000km of distribution lines.
(c) Endeavour Energy– A distribution business with 890,000 customers, a regulated asset base of A$5.3bn and 34,500km of distribution lines.
(d) Essential Energy - A distribution business with 800,000 customers, a regulated asset base of A$6.8bn and 200,000km of distribution lines.
The State has stated that it intends to maintain an overall 51% ownership level across all four electricity businesses including maintaining 100% of Essential Energy. The shares that will be retained by the State will come under the guardianship of a new New South Wales Future Fund, which will be a statutory asset fund with the potential to fund future liabilities of the State, and with a particular responsibility to protect the value of assets held by the State.
The State has also imposed four conditions for the partial privatisation, which are stated to be designed to promote the public interest and address community concerns. These are:
(a) Electricity network prices will be discounted by 1% off regulated prices until 2019;
(b) The jobs of permanent award employees will be protected (and treated consistently with previous transactions);
(c) No adverse impact on electricity reliability; and
(d) The regional presence of businesses will be maintained.
What is for sale?
A fundamental issue for investors is what is actually for sale. The State has not yet identified how it will apply the 51% retention of ownership in practice.
As a result it is not certain if investors will be able to obtain control of the Networks and this will clearly impact on any decision of investors to bid for the Networks. On this we must await further clarification from the State.
Two other factors that may impact investors are:
(a) It is possible that at least one of the Networks (either with its current asset base or after a restructure (for example, a breaking up of Ausgrid)) may be privatised by way of an initial public offer (IPO). The Networks being less volatile in their earnings may be a more attractive asset to be the subject of an IPO than generation assets.
(b) The Queensland Government has announced that it proposes to fully privatise the Queensland transmission and distribution networks (comprising Powerlink, Energex and Ergon Energy). It appears likely that the privatisations in New South Wales and Queensland will be in competition with each other. However a fundamental difference here is that in Queensland’s case the privatisations will be less complex for investors as they will be full privatisations with the State of Queensland ceasing to hold any interest.
The partial privatisation of the Networks will be effected by way of a 99-year lease of the Networks. This lease structure has been utilised before by the State in other privatisations. It has also been used (albeit with a 200-year lease) in the privatisation of the electricity distribution network in South Australia.
Enabling legislation will be required to be enacted by the State to facilitate the privatisation and to best achieve the Government’s objectives in an efficient and timely manner. The legislation is likely to be similar to the Electricity Generator Assets (Authorised Transactions) Act 2012 but dealing with the lease of the Networks. The Electricity Corporation (Restructuring and Disposal) Act 1999 of South Australia may also be used as a model on some aspects.
A likely structure for each Network may be:
(a) A new holding company (Hold Co) is established under the Corporations Act 2001 or a new statutory corporation limited by shares is established under the State Owned Corporation Act 1989.
(b) The Network assets will be transferred to Hold Co. A new company (Lessee Co) will be established, most likely under the Corporations Act. This is the entity through which the investors and the State, through the Future Fund, will hold their interests in the Network.
(c) Hold Co will enter into a 99-year lease with Lessee Co. Similar to the South Australian model there may be two separate leases covering the business assets and the land upon which the Networks are situated.
(d) The relationship between the Future Fund and the investors will be governed by a joint venture agreement, shareholders agreement or similar arrangement. This will, among other things, provide for the governance and control of the Lessee Co.
The ultimate sale structure may vary but the underlying issues for investors will remain essentially the same in relation to the State retaining an ownership interest.
The key issues of the arrangements governing the shareholders of Lessee Co will include:
(a) Funding – including ongoing obligations to contribute equity and the impact on ownership interests. If the Future Fund does not contribute any additional equity that may be required, will its interest be diluted?
(b) Operational – how the Networks are to be run including the implications for the regulated asset base and the submission of price review submissions;
(c) Control – identifying the split between board and shareholder approvals, the threshold for those approvals and how any majority vote is constituted; and
(d) Transfers – the application of pre-emptive rights and sell downs of interests.
There is likely to be some tension between the desire of the State to provide comfort to the electorate about the control of the Networks and its role as a regulator and the requirements of investors that the Networks and their operation is de-politicised and run as a private-sector business.
The Networks are heavily regulated under the National Electricity Law and the National Electricity Rules. The Rules are made by the Australian Energy Market Commission but enforced by the Australian Energy Regulatory (AER) with the potential for limited merits review to the Australian Competition Tribunal. How the regulatory framework determines the Networks’ returns will be a fundamental issue for investors to understand.
Given their monopoly status, the Networks must apply to the AER every five years to assess their terms and conditions of supply. The current AER determination (which was for a transitional regulatory control period for one year) expires on June 30 2015 and the next revenue determination will apply for a regulatory control period from July 1 2015 to June 30 2019. The National Electricity Rules (in chapters 6 and 6A) set out the framework that the AER must apply in making its determinations for distribution and transmission networks.
The AER uses a building block model that accounts for a network’s operating and maintenance expenditure, capital expenditure, asset depreciation costs and taxation liabilities, and for a return on capital to determine a maximum allowable revenue over the regulatory control period.
Most of the core transmission or distribution services provided by the Networks are heavily regulated under the Rules. There are, however, other services such as metering that are able to be negotiated with customers within the framework provided by the Rules.
The significance of this issue has been highlighted by the draft revenue determinations recently released by the AER for the Networks. The draft determinations propose an overall reduction of allowable revenue by between 24% and 35% to address perceived “gold plating”. This reduction, if adopted, has been estimated to reduce retail electricity prices in New South Wales by as much a 10% for an average household or small business.
The AER will issue its final revenue determination for the regulatory control period for 2015–2019 on April 30 2015 following further consultation with the Networks and the stakeholders. However, it seems certain at this stage that the determination will be the subject of a limited merits review by the Australian Competition Tribunal; this will add up to another six months to the process. Thereafter, the determination may be the subject of a judicial review with further resulting delays for up to another six months.
In addition to the reduction in network revenue, which will follow as a consequence of the final determination, investors will also need to factor into any bid the 1% reduction that needs to be discounted off regulated prices for the regulatory control period (unless the Government agrees that this has been more than achieved by the AER’s determinations).
Investors may not have certainty, therefore, for a fundamental aspect of the Networks’ business prior to at least the first one or two privatisations being completed. The impact of this upon the sale proceeds that may be received by the State on any partial privatisation remains to be determined.
The partial privatisation of the Networks will be effected by a 99-year lease to Lessee Co. This structure should be reasonably familiar to investors and financiers and should not raise any insurmountable issues.
The key terms of each lease are likely to include the following:
(a) Rent and prepayment – there will be a prepayment of rent equal to the net present value of the entire amount of the rent due for the term.
(b) Ownership – Hold Co will retain ownership of the Network. Lessee Co will have a leasehold interest only and must at the end of the lease return the Network to the Lessor. Return conditions will need to be satisfied and security may need to be provided towards the end of the term to secure this obligation.
(c) Operation and maintenance – Lessee Co will be responsible for the operation, repair and maintenance, although this function may be sub-contracted out. Lessee Co will take all risk as to the existing and future condition and performance of the Network and may be required to indemnify Hold Co in this regard.
(d) Additions to the Network – Lessee Co should own any additional discrete assets it acquires to enhance or expand the Network. However, Hold Co will have an option to acquire such assets on termination and the sale price, if any, payable by Hold Co may depend upon the circumstances of the transfer.
(e) Termination payments – from the investor perspective Hold Co should be obligated to make a termination payment if the lease is terminated for any reason (particularly having regard to the upfront payment of the rent). This payment, as a minimum, should cover the bank debt.
Whilst not peculiar to the lease structure, two other significant issues that will need to be dealt with are:
(a) Sale of assets – if the State proposes to sell the Networks in the future then Lessee Co should have a pre-emptive right to acquire the Network. This will raise valuation issues and what amounts to a fair sale price.
(b) Sell-down by the State – it appears that the State through the Future Fund will be able to sell down further its interest in the Networks in the future This will depend upon the political circumstances at the time but the likelihood should not be ruled out. Whereas investors may wish to have a pre-emptive right to increase their interest in the Networks, the State may wish to have the option of introducing third parties so that the “ownership” of the Networks is spread.
The financing of the Networks will present challenges for the State, investors and financiers. However this should not be unique to the Networks. Some particular issues to consider at this stage are:
(a) Availability of sufficient credit – Depending on the timing, the debt markets will need to finance the privatisation of the transmission and distribution networks in both New South Wales and Queensland. The scale of the financing required may lead one to question whether there will be sufficient debt available in the market to cover all the privatisations, particularly if the privatisations are not appropriately staggered in their timing.
(b) State as a financier – An interesting question here is whether the State may become a financier, particularly if there is likely to be any shortfall in any financing. Given the Rebuilding NSW plan recently announced by the State setting out the allocation of the expected A$20bn of sale proceeds towards new infrastructure, it may be unlikely that the State will wish to become a financier or to provide any form of credit support. In addition, the State has stated on numerous occasions its intention to retain its AAA credit rating.
(c) Change of control and further sell-downs – From the financiers’ perspective they will wish to have any future sell-down by the State of its interest in the Networks and the potential change of control that this entails subject to their consent under the finance arrangements or an option to be repaid or refinanced.
Whilst the issues for the privatisation of the transmission and distribution networks in Queensland will be similar to New South Wales, one fundamental difference is that in Queensland there will be a full privatisation. As such, the complex issues relating to investors and the State being co-owners of the Networks will not arise in the case of the Queensland transmission and distribution network and the privatisation process will be more straightforward for investors.
From an investor perspective, this may be a significant advantage over New South Wales. In relation to regulated returns, the same issues can be expected to apply in the case of Queensland. The AER will in due course be making determinations for the next regulatory control periods for Queensland (being July 1 2015 to June 30 2020 in the case of distribution and July 1 2017 to June 30 2022 in the case of transmission) and, subject to the outcome of any review of the AER’s determination for the Networks, it can be expected that the AER will take a similar approach here and significant reductions in allowable revenue will follow.
There is little doubt that the partial privatisation of the Networks will be an excellent opportunity for the State to invest in new infrastructure as outlined in Rebuilding NSW and also represents an excellent opportunity for the private sector to invest in one of the last remaining significant assets in the electricity sector on the eastern seaboard of Australia. As one commentator has stated: “It is the right thing to do for NSW”2. The same may be said for Queensland.
1 – The author would like to acknowledge the contribution of his colleagues at Corrs Chambers Westgarth to this article including his partner, Thomas Jones, and Chelsea McClements (Overseas legal trainee, Slaughter & May).
2 – Martin Ferguson, Infrastructure Partnerships Australia Reform Series, November 21 2014.