Notwithstanding the confected hysteria from the gas lobby over the impending “cliff” in gas supply, it is now clear that it is demand for gas that is dropping sharply, not supply.
The numbers were there in black and white in AGL’s earnings presentation the other day, albeit somewhat buried: domestic demand for gas down 8.4 per cent; business demand down 10.3 per cent last year.
As they mutter on menacingly about “gas shortages” and “price spirals”, the gas producers are merrily piping their stuff up to Gladstone, to be turned into LNG and shipped off to Asia.
“A train wreck” was how Incitec Pivot chief executive James Fazzino described energy policy at Incitec’s recent earnings release.
Incitec is a very large gas consumer. But it is also merely one of millions. All consumers, business and personal alike, are affected by rising prices. They are a drag on the entire economy.
And besides the upward pressure on prices arising from the shift towards export parity pricing (Gladstone LNG), the public is being hoodwinked by industry on access charges.
The reason the gas lobby wants nobody to notice the drop in demand is that – just as occurred with the gold-plating of the electricity market and the consequent doubling in electricity bills – there is a gold-plating racket afoot in the gas market too. The industry is paid according to its inflated forecasts. So there is no interest in letting on that demand is really in decline.
The magic word in all this is DORC (Depreciated Optimised Replacement Cost). David Johnstone, professor of finance at the University of Sydney, says DORC is deployed by those who own the gas distribution assets to “game the regulator” and fetch an inflated return on their assets.
Even where an asset, say a pipeline, is 40 years old, where the costs have already been “sunk” many years before by taxpayers, they are still claiming a return on it as if it were brand new. DORC assesses the replacement cost rather than the actual cost.
This “free lunch”, as Johnstone puts it, is tolerated by governments and regulators because it has allowed them to maximise their returns from privatisation.
The DORC formula for electricity pricing was invented by economists in the 1990s and played into the hands of the infrastructure owners (including governments). “It granted a virtually riskless 8 per cent-plus-inflation rate of return on the notional ‘current replacement cost’ of all existing assets. The owners stretched this to the limit, trying to include even the hypothetical replacement cost of easements on land,” says Johnstone.
“If they owned an asset that was say 40 years old, and long paid for by taxpayers, they were permitted to engage an engineering firm to determine how much that asset would cost to build today. Given that the owners paid the engineering consultants for this service, they were keen to assist with answers that the owners liked. Owners were also granted compensation in their tariff stream for some notion of ‘depreciation’ on the supposed replacement cost that was written on the piece of paper.”
Professor Johnstone was once a consultant to some major corporate customers of the infrastructure owners, BHP among them. Johnstone wrote BHP’s submission to the competition regulator (the Australian Competition and Consumer Commission), advising that DORC was inefficient and susceptible to “cost padding”. He wrote in favour of valuing assets at their actual cost (DAC).
Johnstone told Fairfax Media that clients that were big gas users protested to regulators that the formula was a “license to print money” but they were loath to make a big fuss on the basis that the tariffs were only a small part of their overall costs, and they did not want to upset the governments who wished to make the assets attractive to potential buyers.
“For asset owners, the formula represented their whole bottom line and they spent great sums pushing its ‘economic rationality’. The end result was that owners were gifted 8 per cent (plus depreciation and inflation) on an asset base that was effectively a made-up number,” says Johnstone.
“The role of economists in this game deserves mention. Nobel Prize winning economist George Stigler depicted economists qua consultants as hired guns. They could construct science and rhetoric to suit any argument, and could write up the page starting with the conclusion at the bottom.”
In a paper on DORC, Johnstone describes the owners of Australia’s energy transmission infrastructure assets (gas pipelines and electricity grids) as “natural monopolists safe from any practical economic risk of private-sector investors”. Thanks to DORC, it’s all reward, little risk. And a good deal of the reward goes to foreign-controlled players from Singapore, Hong Kong and China.
For a measure of how epic, yet reliable, the business of winning a regulated return from the regulator for one’s regulated asset base (RAB) can be, look no further than the number one player in the pipeline market, APA Group.
For investors, we are talking a return of 10 times their outlay, a 19 per cent annual compound return over 14 years. As for cash, operating revenue has grown from $245 million in 2004 to $1.3 billion.
Getting back to Johnstone’s point about risk and reward, the industry claimed, and received, a 10 per cent risk-free return from the regulator in the last regulatory period.
It should be noted that not all APA’s assets are regulated, some are based on commercially driven contracts. Unlike normal markets, however – where things go up and down – when it comes to access tariffs (rental charges) paid by third-party users to the owners of energy transmission assets (pipelines), they just go one way on the RAB – up.
And thanks to a compliant regulator the costs charged by gas operators are lumped together and go straight through to customers’ energy bills.
DORC is such a lucrative caper that Hong Kong multinational Cheung Kong Infrastructure just splashed a multiple of 1.5 times RAB to mop up pipeline owner Envestra. It was in a bidding duel with APA (which clearly knows what a plush wicket it is on, but the price tag on Envestra was already over the top).
Envestra last recorded $554 million in annual revenue, but CKI is splashing $2.37 billion to buy it. This is the sort of valuation investors might ascribe to an internet stock and it only points to one thing; the Hong Kong people reckon that with the help of DORC they can win back a handsome return from the regulator.
They have only to look at how their peers are faring, the ones that are at all visible in a public accounting sense, such as AusNet Services (formerly SP AusNet) or DUET Group.
These two are triumphs of financial engineering which, like APA, run extremely high debt levels – and therefore pay little tax (profits are soaked up in interest payments) – as they see virtually no risk in their business model of claiming DORC aplenty from the Australian Energy Regulator.
At its last result, DUET notched up earnings before interest, tax, depreciation and amortisation (EBITDA) of $798 million, a interest expense of $435 million and a puny tax expense of $16 million. None of them pay anywhere near the 30 per cent corporate tax rate.
To cut a long story short, then, the gas customers of Australia get smashed on their power bills while privatised monopolies – thanks to government – get steady, riskless double-digit returns … on which they pay cynically little tax.
As Johnstone says, there should be a proper review of the Australian regulators’ advocacy of DORC asset valuations. Why should gas consumers pay again for assets which were already paid for years ago?