Investor Uncertainty November 2008

K Peter Kolf General Manager & CEO Economic Regulation Authority 25 November 2008 Investor Uncertainty WA 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 1Regulator’s perspective 2The role of markets & their impact on investors 3Investor uncertainty 4The importance of gas to the WA economy 5Managing risks in the energy sector 6The 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

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 mainly mineral processing 35% Mining 34% Electricity Generation 26% Other Carnarvon PJ 33% Perth 9.9 PJ 3% SUPPLY Commercial & Residential 5% DEMAND NWS PJ 64% Gas Supply and Demand Western 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

Varanus Island Impact 3 June 08

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 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