Ausgrid: Inside a utility soap opera, and the billions at stake

Main Points

1. Hong Kong’s Cheung Kong Infrastructure (CKI) and State Grid of China [SGC] already own considerable utility infrastructure in Australia, and CKI in particular has an excellent reputation as an operator.
2. SGC was likely to have paid a higher price than anyone else.
3. The value of Ausgrid will swing by billions of dollars depending on the outcome of the AER’s appeal to the Federal Court against a very legalistic ACT ruling over 2014-2019 regulated revenues. The hearings for this appeal will be in October and the judgment could just possibly be delivered prior to the sale being concluded. Having read the AER’s grounds for appeal, we think it would be very foolish to write off the chances of the appeal succeeding.
4. The assets are worth more to foreign buyers because:
   1. Overseas buyers have a lower cost of capital;
   2. Most utility infrastructure is structured as a combination trust/company (stapled security). If the income from a trust is fully distributed it is taxed in the hands of the recipient at their tax rate. In essence we think that offshore buyers may pay significantly less tax than Australian buyers. Tax “efficiency” is enhanced by significantly overgearing the assets.

Sale to overseas bidders knocked back

On Thursday, the Australian Government, announced that neither State Grid of China nor Cheung Kong Infrastructure would be allowed to bid for the 50.4 per cent of Ausgrid that the State Govt of NSW is selling unless they could address certain “concerns”.

Concerned? These guys already own lots of the assets

We note that in Australia CKI is the majority owner and operator of the wires and poles in South Australia (with the listed stapled security Spark Infrastrucure [SKI]), is the majority  owner and operator of two of Victoria’s distribution businesses (Citipower and Powercor) again with its partner SKI, owns 100% of the gas transmission and distribution business Envestra [ENV]. ENV owns the gas distribution business in South Australia, a part of the gas distribution business in Victoria, Southern NSW and QLD. CKI is also a major investor in UK electricity distribution assets.

SGC owns 19.9% of  listed stapled security Ausnet. Ausnet owns and operates Victoria’s electricity transmission business, is one of 5 electricity distribution operators in Victoria and also owns one of the gas distribution businesses in Victoria. SGC also owns 60% of Jemena which owns another electricity distribution business in Victoria and most of the gas distribution in NSW.

It’s fair to say, in our view, that CKI’s Australian assets have been the most efficiently run in the NEM, as judged by the AER. We have never heard any criticism of its interests in regard to national security. Jemena was recently allowed to win, a very out of the money, bid to build a pipe to bring gas from the Northern Territory to Eastern Australia.

Implications for price

The AFR reported, via the usually impeccably reliable “Street talk” column that SGC was expected to bid over $13 bn for the stake. How good are these numbers? We calculate as follows:

Figure 2 Ausgrid earnings and asset multiples at SGC bid price: Source AFR, ITKe AER

By comparison, the four listed comparable investments, AUS, DUE, SKI trade as follows:

Figure 3:(very) Rough multiples of listed utility infrastructure stocks

You can see that the sharemarket tends to value these assets, once they have been “optimised”, and including some “extra non regulated” revenue at about 8.5X ebitda and at about 1.4X regulated asset base [RAB].

If Ausgrid sold for 1.4X RAB then 50.4% would be worth around $10.7 bn. So right there we can see $2 bn going away.

For another comparison we can look at what was paid for Transgrid as recently as last year. A consortium paid $10.4bn for 100% of Transgrid last year representing 1.6 X EV:RAB and FY15 EV:Ebitda of 16X. SKI owns 15% of the consortium. In general investment banking analysts were critical of the price paid although the SKI share price has held up well.

AER appeal to the  Federal court is the shadow hanging over Ausgrid

We previously noted that Ausgrid and the other NSW electricity distribution businesses are regarded as the least efficient in the NEM. As a result the regulator decided to cut Ausgrids 2014-2019 revenues by an eyebrow raising 40% compared to what Ausgrid was looking for. The following chart is from the AER’s final report. It’s really worth looking at this chart for a minute. It shows that:

Ausgrid’s real revenues increased 150% between 2005 and 2012 and increased 66% between 2010 and 2013.

The difference per year between what Ausgrid wanted going forward (green line) and what the AER allowed (purple line)

Figure 4: Ausgrid revenue history and various paths.

We translate those revenue differences to ebitda, earnings before interest, tax & depreciation, the prime metric in utility profit estimation as follows:

Figure 5: profit implications of AER v Ausgrid revenues.

To recap, Ausgrid appealed to the Australian Competition Tribunal[ACT] and the ACT essentially found in favour of Ausgrid on the three major grounds of appeal. The ACT instructed the AER to remake its decision and basically guided how this should be done.

Reports were that this was an absolutely massive legal case with barristers stacked 3 deep and some parties having to get counsel from Melbourne since every Sydney barrister who knew the subject was already engaged on the case. The whole appeal process was entirely opposite to the spirit of “better regulation” and contrary to recommendations of a review of the appeals process.

That review had recommended that a separate body to the ACT should be formed since there was wide spread feeling that the ACT review process had been frankly too legal and too one sided.  The Review of limited merits appeal concluded:

“The Panel therefore recommends that a new, wholly administrative, review body, provisionally labelled the Australian Energy Appeals Authority (AEAA), take over all, or the great bulk of, energy sector review work currently undertaken by the ACT, and in particular that the AEAA take over review of NSP revenue/price determinations.” (See p5 of document).

But this was not adopted by the SCER and we have ended up with the dogs breakfast served up by the appeal outcome. We think there is sufficient unhappiness at where things are that the Review Panel’s recommendations for a new body will in time be revisited.

The  AER didn’t accept the ACT’s decision and has appealed it to the Federal Court with the hearings to be held in October.

There are three major underlying issues in contention and we not expressing the legal language or points but what we perceive as the underlying “common sense” issues:

1. Whether benchmarking is an appropriate method for estimating allowable costs for Ausgrid and whether the AER used benchmarking in an appropriate way to produce an appropriate outcome.
2. Whether the AER was entitled to calculate interest rate revenue allowances in the way it did (using a ten year forward looking moving average)
3. A more technical question on the gamma allowance.

At first we didn’t think the AER stood much of a chance in the appeal. However, having paid our $50 to get a copy of the AER’s filing of 24 March, we now think they may have more of a chance. The  AER argues that the Tribunal expressed “concerns” about the use of “estimated” econometric data to estimate Ausgrid’s costs, but made no finding that the estimates were materially inaccurate or unreliable.

To us the AER is saying the Tribunal complained about using econometric data just because it was econometric data, and the Tribunal wants the AER to use “bottom up”  Ausgrid costs but is not entitled to so order and in any event didn’t provide enough guidance to enable that to be done.

The appeal grounds around the appropriate cost of debt are much more legal, and in part, turn on whether the ACT was even entitled to consider the matter and whether the appropriate “benchmark entity” is a regulated utility or an unregulated entity. The AER also argues that the ACT effectively states that the existing cost of debt for a regulated entity is by definition to be regarded as efficient whereas that need not automatically be correct.

David Leitch is principal of ITK. He was  formerly a Utility Analyst for leading investment banks over the past 30 years. The views expressed are his own. Please note our new section, Energy Markets, which will include analysis from Leitch on the energy markets and broader energy issues. And also note our live generation widget, and the APVI solar contribution.