3. Commercial Viability
3.1 Introduction
ERTU has been asked to consider whether each of the three new SOEs, as they are proposed to be structured, would be viable commercial entities. ERTU interprets commercial viability as meaning that, within the assumptions set out in Section 1, a commercially viable electricity generating company is one that:
- is able to survive (operate without going into liquidation or requiring financial support from its shareholders) under all reasonably foreseeable market and operating circumstances; and
- is projected in most reasonably foreseeable market and operating conditions, including all probable market outcomes, to provide enough positive free cash flow and net profit after tax to enable it to:
- compete effectively in the wholesale electricity market;
- have funds to reinvest in the electricity sector;
- provide acceptable returns to its shareholders; and
- borrow from the private sector on competitive terms.
A credit rating approach to evaluation forms an important part of ERTU's assessment of commercial viability. ERTU considers a minimum target credit rating of investment grade (i.e. a rating above Baa3/BBB-) is necessary for commercial viability. Standard & Poors defines a BBB rating as "having adequate capacity to pay". This corresponds closely to the definition of commercial viability outlined above. The rating analysis therefore provides useful guidance even if a company has little or no debt and would not be seeking a credit rating.
3.2 Approach to Addressing Commercial Viability
ERTU approached the question of commercial viability by determining a base case scenario for the new SOEs and comparing this with a number of less favourable scenarios.
The base case scenario establishes a set of realistic but conservative future financial assumptions for each SOE and the wholesale electricity market as a whole. ERTU has prepared a detailed operational model of the New Zealand wholesale electricity market. ERTU has considered the likely interactions between wholesale and retail markets and believes these markets will track each other closely over the medium to long term. Accordingly, SOE retail operations have not been included explicitly in the market model.
ERTU engaged Credit Suisse First Boston NZ Limited ("CSFB") to construct a detailed financial model of each SOE. These models examine the base case and various alternative scenarios (including a variety of demand growth, hydrology and new investment scenarios) and incorporate the forecast financial effects of ERTU's recommendations, at least insofar as the wholesale market is concerned
As with the ERTU market model, CSFB's financial models do not include SOE retail operation cashflows which are relatively minor for the acquisitions made to date. However, ECNZ retail acquisitions have been included in the balance sheets of the relevant SOEs and any retail customers are treated in the analysis as part of each SOE's hedge portfolio.
The Reform Package anticipates asset transfers to the new SOEs will be at book value. It is expected that the new SOEs will revalue their assets after 12 months of operation. However, in preparing the financial model, CSFB has not taken account of the potential revaluation of each SOE's assets.
ERTU and CSFB have also analysed the sensitivity of each SOE's financial performance to unfavourable variations in:
- the demand for electricity;
- hydrological conditions; and
- different pricing strategies.
ERTU considers that these are a representative range of adverse contingencies the new SOEs could face.
3.3 Conclusion on Commercial Viability
The modelling results show that all three new SOEs would be commercially viable under a wide range of market conditions. Waikato SOE and South Island SOE are robust in their ability to withstand extreme market conditions. Huntly SOE will face much greater volatility in its revenues and profits, and could face some difficulties under extreme market conditions.
A significant factor in these difficulties is the proposed terms of the Fletcher Challenge Heads of Agreement (FCE HoA). ERTU has allocated this FCE HoA to the Huntly SOE on the basis that the Huntly SOE will assume responsibility for advancing the issue without prejudice to the status of the agreement. ERTU considers that the Huntly SOE would be able to negotiate alternative fuel supply arrangements which would reduce the volatility of revenues and profits and enhance shareholder returns when compared with the arrangements set out in the FCE HoA. Nonetheless, ERTU considers that the Huntly SOE would be commercially viable even if its gas purchase arrangements were as set out in the FCE HoA.
ERTU's final opinion is that all three of the SOEs will be commercially viable entities.
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