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Table of Contents

• Introduction
• Commercial Viability
• Effective Competitor Assessment
• Initial Debt Funding
• Optimal Capital Structure
• Key Assumptions

Other South Island IDG Documents

• Certification Report
• Environmental Report
• Legal Report
• Establishment Plan
• Business Plan
• Draft Statement of Corporate Intent

Introduction

At the request of the South Island IDG, Credit Suisse First Boston NZ Limited ("CSFB") has prepared a report on the financial viability and competitiveness of the South Island SOE as part of the South Island IDG's certification requirements in relation to the proposed break-up of ECNZ. As required by the terms of reference specified by ERTU for the South Island IDG, this report:

• Projections of the expected financial performance of the South Island SOE.
• Consideration whether the South Island SOE will be a commercially viable company following the proposed break-up of ECNZ.
• Consideration whether the South Island SOE will be an effective competitor in the wholesale electricity market following the proposed break-up of ECNZ.
• Identification of an optimal capital structure for the South Island SOE.

In addition, a review of the initial allocation of debt from ECNZ and future financing requirements were considered.

The key conclusions of the report are summarised below.

Commercial Viability

In testing SISOE's commercial viability, the following key factors were considered under a wide range of reasonably foreseeable market and operating circumstances:

• The level of profitability and equity returns.
• The ability to repay opening debt from operating cash flows and the requirement to refinance opening debt as it falls due.
• The ability to maintain an investment grade credit rating (i.e. a minimum credit rating in the "BBB" category).
• A comparison of capital structure and financial position relative to comparable companies which are deemed to be commercially viable.

The approach taken in assessing SISOE's commercial viability was very similar to that adopted by ERTU in its interim certification report to the Government reflecting general agreement with that approach.

The report concludes that SISOE will be a commercially viable company following the proposed break-up of ECNZ. In making this assessment, it was noted that:

• SISOE generally exhibits a high level of profitability throughout the forecast period under all scenarios except for one.
• Returns on shareholders' funds are generally low during the early years of the forecast period, reflecting the depressed spot price and the South Island SOE's fixed cost structure, but improve significantly over the period.
• SISOE is projected to repay all of is opening debt by the end of the 2010 financial year (at the latest) under all scenarios except for one.
• The key credit rating ratios indicate that the South Island SOE should be able to achieve a "BBB" ( investment grade) credit rating. The South Island SOE exhibits a robust financial performance under all of the alternative scenarios considered without requiring shareholder support. SISOE should be able to achieve an "A" credit rating within three to four years as its credit rating ratios are expected to improve significantly from the 2003 financial year onwards; and
• SISOE's opening capital structure and financial position are similar to those of comparable companies which are considered to be commercially viable.

Many of the key assumptions underlying the financial projections are conservative. This conservatism inherent in the financial projections strengthens the view that SISOE will be a commercially viable company.

Effective Competitor Assessment

In assessing whether the South Island SOE will be an effective competitor in the wholesale electricity market, ERTU has asked the South Island IDG to address the following three issues:

• Whether SISOE will be able to compete (i.e. that the South Island SOE will be commercially viable);
• Whether SISOE will compete.
• Whether there are any significant impediments to SISOE competing.

The main potential impediments to SISOE competing in the wholesale electricity market considered, in addition to those already considered in relation to commercial viability, are:

• The allocation of generation assets and related contracts, consents and resources to SISOE.
• The risk of Government intervention.
• The loss of significant purchasers and a lengthy outage of the HVDC link.
• Another generator having a dominant position in the wholesale electricity market.
• The final allocation of ECNZ hedge contracts and retail businesses to the new SOEs.

Based on the criteria outlined by ERTU for assessing whether SISOE will be an effective competitor, it was considered that SISOE would be an effective competitor in the wholesale electricity market following the proposed break-up of ECNZ. In making this assessment, it was noted that:

• SISOE will be commercially viable following the break-up of ECNZ and hence will be able to compete in the wholesale electricity market.
• The SI IDG has provided a strong indication that SISOE is willing and intends to compete in the wholesale electricity market.
• There are no reasonably foreseeable impediments which will significantly restrict SISOE competing in the wholesale electricity market.

The assessment that SISOE will be an effective competitor is supported by the key observations and conclusions of ERTU's Market Analysis Report dated 1 September 1998 in respect of SISOE.

Initial Debt Funding

The proposed allocation of debt to SISOE has a book value of $527.4 million and has maturities ranging from October 1999 through to May 2005. It was considered this book value understates the effective initial opening debt position as:

• SISOE will not receive any initial allocation of working capital from ECNZ.
• SISOE will assume a significant capital expenditure programme which is only partially completed.
• The interest cost of the allocated ECNZ debt is significantly above the level at which SISOE could expect to refinance.

The composition of allocated ECNZ debt portfolio shows that:

• SISOE will need to refinance some or all of the $49.5 million of allocated ECNZ debt maturing in October 1999.
• $278 million, or over half of the South Island SOE's initial debt allocation, will need to be repaid in October 2001.
• The maturity profile of the ECNZ debt is relatively short compared with the long-term nature of most of its generation assets.

SISOE will need additional debt facilities of up to $100 million in place as at 1 April 1999 to meet its funding requirements over the following 15-month period. To the extent that a cash balance is provided to SISOE as part of the assets transferred, the need for these additional debt facilities will be reduced.

Optimal Capital Structure

The optimal capital structure for SISOE was considered to be one where the market value debt to debt plus equity ratio in the range 25%-30%. In forming this conclusion, it was noted that:

• The optimal amount of leverage is likely to be lower in the short run than in the long run pending resolution of uncertainties regarding future competitor activity, completion of the current capital expenditure programme and other funding requirements.
• A comparable company analysis suggests SISOE should target debt to total capitalisation and debt to enterprise value ratios in the range of 25%-35%.
• For reasons relating to commercial viability and access to debt capital markets, SISOE should target an investment grade credit rating of at least "BBB" and preferably "A".

Conclusions reached regarding SISOE optimal capital structure are broadly consistent with the South Island SOE's opening capital structure based on the allocation of $527 million of debt from ECNZ. It was considered that it would not be prudent for SISOE to pay a special dividend or to return capital to its shareholder within the first two years.

Key Assumptions

The report has been based on certain key assumptions including:

• That the proposed break-up of ECNZ and establishment of three new SOEs proceeds as outlined in ERTU's Transaction Structure Report and Implementation Plan dated 1 September 1998.
• That all information supplied to us by representatives (including advisers) of the South Island IDG, ERTU and ECNZ is complete, correct and not misleading in any material respect.
• That there are no material changes in the opening balance sheet and financial projections for the South Island SOE between the date of our Report and the date of the proposed break-up of ECNZ is implemented.
• That the existing regulatory regime will remain essentially unchanged, that a wholesale electricity market substantially similar to the existing New Zealand Electricity Market will be available and that the new SOEs will participate in this market.