INDEPENDENT PRICING AND REGULATORY TRIBUNAL    

INVESTIGATION INTO PRICING FOR SYDNEY DESALINATION PLANT PTY LTD  Tribunal Members 

 Mr James Cox, Acting Chairman Ms Sibylle Krieger, Member 

At Level 8, 1 Market Street, Sydney   

On Monday, 22 August 2011, at 9.30am .22/8/11   1 

Transcript produced by Merrill Corporation 

1 Opening Remarks: 2 3 THE ACTING CHAIRMAN: Good morning, ladies and 4 gentlemen. I would like to welcome you to this public hearing, 5 which is being conducted by the Independent Pricing and 6 Regulatory Tribunal. We are inquiring into the prices that 7 the Sydney Desalination Plant (SDP) Pty Ltd can charge for 8 the water supply services it will be providing for the 9 period commencing 1 July 2012. 10 11 I would like, first of all, to introduce ourselves. 12 I am Jim Cox, Acting Chairman and Chief Executive Officer of 13 IPART, I am joined on this review by my fellow Tribunal 14 member, Ms Sibylle Krieger. 15 16 This investigation is being conducted following a 17 request by the Honourable Greg Pearce MLC, Minister for 18 Finance and Services. The Minister indicated that it is 19 important for the community to be able to see what the 20 charges paid for water that is produced by the desalination 21 plant will be, and that prices should be determined 22 independently. The Minister has further indicated that a 23 price determination by IPART is a precursor to the possible 24 refinancing of the desalination plant by way of a lease or 25 similar arrangement. 26 27 The water services supplied by SDP Pty Ltd are as 28 follows: firstly, the supply of non-rainfall dependent 29 drinking water to purchasers; and, secondly, the making 30 available of the desalination plant to supply drinking 31 water that does not depend on rainfall. 32 33 The Terms of Reference provided by the Minister 34 include a number of principles that the Tribunal is 35 requested to consider when making its determination of 36 prices. These principles are: firstly, maximum prices 37 should be set so that revenue that is expected to be 38 generated will recover the efficient costs of providing the 39 monopoly services over the life of the assets. Costs 40 include operating costs, a return on assets and 41 depreciation. 42 43 Secondly, in calculating a return on invested assets, 44 the rate of return should reflect the commercial risks 45 faced by the asset owner in providing the services, and 46 IPART should determine an appropriate opening asset value. 47 .22/8/11 2 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Thirdly, depreciation should reflect the economic 2 lives of the assets. 3 4 Fourthly, the structure of prices should encourage SDP 5 to be financially indifferent as to whether or not it 6 supplies water. The structure of prices should therefore 7 include separate charges for the different water supply 8 services that are provided by SDP. 9 10 Fifthly, the charges for making the plant available 11 should take the form of a periodic payment. This charge 12 should reflect fixed costs including a return on assets, 13 depreciation and the fixed component of operating costs. 14 SDP is to be entitled to charge for the availability of the 15 plant irrespective of the levels of water in dam storages 16 serving Sydney or the availability of water from other 17 sources. 18 19 Sixthly, the charges for the supply of drinking water 20 should reflect all efficient costs that vary with output, 21 including variable energy, labour and maintenance costs. 22 23 This present investigation is to determine prices from 24 1 July 2012. The Minister has requested that the 25 determination cover the period to 30 June 2017. This will 26 give the determination a five-year life with further 27 periodic determinations to be made after that time. 28 29 As part of this investigation, the Tribunal released 30 an issues paper in June 2011, which set out the key aspects 31 of the review process. That issues paper outlined some of 32 the matters that the Tribunal considers to be important for 33 this review, our general approach to price setting, the 34 matters that our Act says we must take into account in 35 conducting an investigation, and a draft timetable for the 36 review. 37 38 In the issues paper the Tribunal called for 39 submissions from SDP Pty Ltd and other interested parties. 40 We are grateful to those who have made submissions to us. 41 All of the submissions received will be carefully 42 considered by the Tribunal in developing its findings and 43 recommendations. 44 45 All the submissions received, and reports from our 46 consultants, are available to the public through the 47 Tribunal's website. .22/8/11 3 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 Before we commence proceedings today, I would like to 3 say a few words about the process for this hearing. 4 5 You have available to you a timetable which indicates 6 the order of proceedings. SDP Pty Ltd will be invited to 7 present on their pricing proposals. A period of 30 minutes 8 has been allowed for this presentation. This will be 9 followed by a similar period for questions from the 10 Tribunal and its Secretariat. Then we will have a period 11 of 20 minutes for comments and questions from the floor. 12 13 Following morning tea we will hear from SFG Consulting 14 via video-link from the United States. You must bear with 15 us while we establish that. SFG Consulting has been 16 engaged by us to review cost of capital parameters for SDP 17 Pty Ltd. This presentation will be followed by questions 18 from the Tribunal and the Secretariat. There will then be 19 a period of time for questions and comments from the floor. 20 21 The paper prepared by SFG Consulting and the peer 22 review conducted by Professor Kevin Davis of the University 23 of Melbourne have been placed on our website. We would be 24 grateful for written comments on these two reports, but we 25 need to receive them before close of business on 31 August 26 2011. Unfortunately, the time constraints imposed by the 27 Terms of Reference, and a need to get a report out by 28 early November, preclude us from allowing a longer period. 29 30 I understand there are some minor corrections to the 31 SFG paper, and I believe there is a note of those. I just 32 emphasise that we do needs comments from you by 31 August, 33 otherwise we will not be able to consider them. 34 35 Assisting the Tribunal today will be Tribunal 36 Secretariat members Amanda Chadwick, Director of Water; 37 and Richard Warner, Manager, Water Pricing. They are sitting 38 on my right, and they will ask questions of presenters. 39 Eric Groom, Principal Advisor to the Tribunal, will also be 40 assisting later in the morning. 41 42 We now commence with representatives from the Sydney 43 Desalination Plant Pty Ltd. Can you please state your 44 names and positions for the record and then make your 45 presentation. 46 47 MR WILSON: Stuart Wilson, Manager, Regulatory Strategy .22/8/11 4 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 and Pricing, Sydney Water. 2 3 MR RAMSEY: Alan Ramsay, Chief Financial Officer for 4 Sydney Water. Despite the fact we say "Sydney Water", we 5 are representing the Sydney Desalination Plant this 6 morning. 7 8 MS WALKOM: Sally Walkom, Manager, Regulatory Projects, 9 Sydney Water. 10 11 Session 1: SDP Pty Ltd 12 13 MR RAMSEY: Thank you, Mr Chairman. 14 15 We have a short presentation that basically covers the 16 high points of the submission which is on your website, and 17 we will go into that now. 18 19 As you have said, the desalination plant is owned by 20 Corporations Act company Sydney Desalination Plant Pty Ltd, 21 which is currently a wholly owned subsidiary of 22 Sydney Water Corporation. It is licensed under the 23 Water Industry Competition Act, with both a network and a 24 retail licence under that Act, and it sells water to 25 Sydney Water under the water supply agreement between 26 SDP Pty Ltd and Sydney Water Corporation. 27 28 The plant is currently sized to produce 250 megalitres 29 of water a day, or approximately 90 gigalitres a year, both 30 in various parts of the key infrastructure, including inlet 31 and outlet tunnels from the ocean, and the water delivery 32 pipeline from Kurnell to Erskineville are sized to 33 500 megalitres a day, if needed. 34 35 The costs of the plant was included as part of 36 Sydney Water's assets in the last price determination by 37 IPART, so the cost of the plant has already been included 38 in customer bills in the current price path. 39 40 The water supply agreement between Sydney Water and 41 Sydney Desalination Plant Pty Ltd sets the terms under 42 which SDP supplies water to Sydney Water and, under that 43 contract, Sydney Water pays an agreed contract price for 44 the water supply. That contract price will be replaced by 45 any price determined by IPART, so the water supply 46 agreement says that the price is the contract price unless 47 IPART determines another price and, when they do, that .22/8/11 5 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 price replaces the price currently in the contract. 2 3 As the Chairman said, the Minister For Finance and 4 Services has asked IPART to set a regulated price for SDP. 5 It will provide independent regulation of prices. It will 6 make the process and the setting of prices transparent to 7 customers, so it's not simply a behind-the-scenes contract 8 between Sydney Water and SDP, and it replaces the contract 9 price in the water supply agreement, as I have said. It 10 also provides the opportunity for IPART to coordinate the 11 prices set for the Sydney Catchment Authority and SDP, the 12 two arms of the bulk supplier market, in a consistent way. 13 14 SDP's operating framework is shown on that overhead, 15 and it is in the submission, of course. SDP has inputs 16 through operation and maintenance of the plan under a 17 contract with Veolia, electricity supply and supply of 18 renewable energy certificates from the wind farm near 19 Canberra. It sells water currently to Sydney Water 20 Corporation, but potentially also to other retail and 21 wholesale customers. It is currently owned by 22 Sydney Water, with the prices for all of those customers 23 being set by IPART under this process. All of the input 24 contracts were set through market action by public tender, 25 and are for a long term. All of those contracts run for 26 approximately 20 years, as you can see on the website. 27 28 The operating rules for the plant are set out in the 29 Operating Licence and in the Metropolitan Water Plan. The 30 essential element of those rules are that SDP must maximize 31 the production of drinking water when dam levels fall below 32 70 per cent and must continue to do so until dam levels 33 rise above 80 per cent. 34 35 These rules were developed after a cost benefit study 36 by the Centre For International Economics, and they are 37 included in the Metropolitan Water Plan. The objective of 38 the rules is to maximize drought tolerance or drought 39 resistance at an optimum cost of water. We want to 40 maximize the amount of water in the dams, which gives you 41 the optimal or longest possible term of drought survival, 42 while minimising the risk that you will lose some of that 43 more expensive water over the dam wall. 44 45 The total consumption of bulk water in the Sydney 46 region is currently around 500 gigalitres a year. The 47 maximum capacity of the plant is currently about 90 .22/8/11 6 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 gigalitres a year. As I have said in the past, it's rather 2 like filling a bucket with an eye-dropper. If you wait 3 until the dams are at a low level before starting the 4 desalination plant, you will have very limited ability to 5 increase the drought tolerance of the system. 6 7 The plant is, as it says there, not large enough to be 8 an emergency drought measure only; it needs to run so it 9 maximizes the amount of water in the dam. 10 11 IPART's determination will set a price for bulk water 12 sold by SDP to Sydney Water, as I have said. It requires 13 also a price for supply to other customers at wholesale 14 level or a bulk price. We assume - although this hasn't 15 been specifically said - the bulk price and the transport 16 and retail costs will be the price that it is required to 17 be sold to other retail customers. To assist that and to 18 ensure competition to the network, Sydney Water intends to 19 submit an undertaking to allow third-party access to its 20 water network. We have done that already in relation to 21 the waste water network and we are working on an 22 undertaking to allow third-party access for transport to 23 the water network. 24 25 We have been asked to talk about the risks faced by 26 SDP in terms of financial risks. There are a number of 27 risks that arise because this is a single asset serving a 28 defined market. There are cost risks associated with 29 membranes and chemical prices if they increase more than 30 forecasts. Those are a risk to SDP, and other inputs as 31 well possibly. If environmental requirements change or get 32 more severe than predicted, that will be a cost of SDP, 33 plus the new taxes, although carbon tax is largely excluded 34 by the existing contracts. 35 36 There is a risk of disruption to supply. As a single 37 asset, there is a risk of accidental damage to the plant or 38 delivery pipeline; major interruptions to chemical supply, 39 which we saw to some extent during the global financial 40 crisis where some chemicals became very hard to source; and 41 appropriately trained staff not available after the water 42 security mode shut down. A long-term shut down of the 43 plant would see staff run right down and they would need to 44 be replaced at the end of that term. 45 46 These are matters that are important for the weighted 47 average cost of capital that IPART will need to consider. .22/8/11 7 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 IPART uses the WACC to determine the return on assets 2 required. 3 4 The calculation of the weighted average cost of 5 capital depends on a number of factors, including the cost of 6 debt and equity funding and risks facing the business. SDP 7 has market risks, and particularly business-specific risks, 8 and many of these can't be diversified because SDP owns a 9 single asset with a fixed technology and currently only one 10 customer. 11 12 In accordance with IPART's normal processes, we assume 13 that maximum prices will be set so that expected revenue 14 will recover the efficient costs of providing SDP's 15 services over the life of the assets. 16 17 The Minister has asked that the structure of prices 18 should ensure that SDP does not have financial incentives 19 either to produce more water than is required by the 20 Metropolitan Water Plan, or less water than is required by 21 the Metropolitan Water Plan, so the major factor in the 22 determination is to try to avoid perverse 23 incentives - financial incentives that would lead to 24 perverse outcomes. 25 26 The water security or availability charge should be a 27 periodic payment to recover the return on assets, return of 28 assets and fixed operating costs when the plant is not 29 producing water. These are basically the costs of 30 capital and costs to keep the plant in being. 31 32 SDP will be entitled to charge for making the plant 33 available to produce water irrespective of dam levels or 34 the availability of water from other sources. These are 35 fixed costs resulting from the sunk capital. 36 37 The variable charge, which is the costs of variably 38 producing water, should reflect the efficient costs that 39 vary with output, including energy, labour and 40 maintenance costs. 41 42 Based on the work we have done for our 43 submission - and this is a table pretty much from the 44 submission - you will see that the capital servicing costs 45 when the plant is operating, including the pipeline from 46 Kurnell to Erskineville, are approximately $2.00 per 47 kilolitre. The fixed operating costs that don't vary with .22/8/11 8 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 output are about 33 cents a kilolitre, and the variable 2 operating costs - the costs that do vary with the amount of 3 water produced - are about 53 cents a kilolitre, and the 4 total full absorbed cost, capital and operating, together 5 is about $2.94 per kilolitre of capacity. 6 7 When the plant is not operating, some operating costs 8 change. Particularly during a period and following a 9 shutdown, operating costs change because maintenance costs 10 that would have been incurred if the plant were operating are 11 deferred. They still occur, and they over a longer or more 12 distant time frame. Unused electricity and RECs can be 13 sold into the market. There are once-off costs to shut 14 down and restart the plant. As I said, the fixed operating 15 costs change during the shutdown and after the shutdown. 16 17 The experience or the event of the shutdown is 18 impossible to predict in a price determination. Whether or 19 not the plant will shut down depends on future weather 20 events, how much water is in the dam, how they change over 21 time, decisions by government on environmental flows and 22 the type and duration of the shutdown that's undertaken if 23 the plant does have to shut down. None of those things are 24 predictable in the price determination. 25 26 In our pricing proposal we propose that when the plant 27 operates, there will be a variable charge to recover 28 variable operating costs of 53 cents a kilolitre and an 29 availability charge, which is broadly equivalent to $2.38 a 30 kilolitre of capacity. 31 32 While the plant is operating and it does not shut 33 down, it is a fairly simple and straightforward price 34 determination. However, when the plant does shut down, the 35 availability charge is reduced slightly because fixed costs 36 are lower, and the availability charge that recovers lower 37 fixed operating costs when the plant is not operating is 38 broadly equivalent to $2.35 per kilolitre of nameplate 39 capacity, as compared to 2.38 a kilolitre previously. 40 41 There are adjustments to those prices needed to 42 accommodate the potential danger of losses on the sale of 43 surplus electricity and renewable energy certificates. As 44 I said, if the plant is shut down, the owner is entitled to 45 sell those commodities into the market and may make 46 windfall gains or losses on those transactions which can't 47 be predicted in the price determination since the price .22/8/11 9 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 determination does not enable a plant to shut down. 2 3 Those adjustments will also enable SDP to recover the 4 once-off costs of shutting down or restarting the plant, 5 and it should accommodate unpredictable variability in 6 fixed operating costs, where that proposed variability 7 exceeds a collar of plus or minus 2 per cent. These 8 adjustments are proposed to be retrospective so that you 9 could make them with accuracy once the plant has shut down, 10 but you cannot get the forecasts correct in advance, 11 because you don't know when the plant will shut down. 12 13 The adjustments aim to match the costs and revenue 14 over time through those retrospective adjustments. As 15 I say, they only apply once the plant has been shut down. 16 They are needed because the shutdown offers alters the 17 operating cost and they include adjustments for energy 18 costs and fixed operating costs and start-up and shutdown 19 costs. 20 21 I have said the variable charge contains fixed 22 forecast market prices, while the fixed availability charge 23 contains contract prices minus the forecast market prices 24 so that the amount that changes with the variable charge is 25 always the market price, and if there is any difference 26 between that and in the contract price, it either is added 27 to or deducted from the fixed price. 28 29 Finally, we propose that, in order to ensure the plant 30 operates in accordance with the Metropolitan Water Plan, 31 and as required by the government, if the plant is not 32 available to produce water as its full nameplate capacity, 33 that is 250 megalitres a day, there should be an abatement 34 of the availability charge. We propose that that be on a 35 rolling 12-month basis, and we propose that available 36 equals producing at least 95 per cent of nameplate 37 capacity, so that in any month or accounting period when 38 the plant does not produce at that level, the availability 39 charge would abate pro rata, or the amount produced divided 40 by the nameplate capacity, but that the operator had the 41 potential to recover that by producing more than that in 42 the following mon th with a rolling 12-month adjustment. 43 44 That was the extent of our submissions. 45 46 THE ACTING CHAIRMAN: Thank you very much for the 47 presentation. We will now have a period for questions. .22/8/11 10 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 We will start off with members of the secretariat. The 2 secretariat. 3 4 MS CHADWICK: Thank you. I have a couple of questions to 5 ask about the energy and the RECs contracts, if I could. 6 Before I start, can I confirm that post a refinancing, 7 these contracts are applicable to the future lessor or 8 purchaser of the plant? 9 10 MR RAMSEY: That's our working hypothesis. The 11 counterparty of the contract is Sydney Desalination Plant 12 Pty Ltd, and provided that entity is maintained in being, 13 then we will assume those contracts will continue. There 14 is no change in control provisions in the contracts. So, 15 our working hypothesis is that those contracts would stay 16 on foot, yes, but there has been no decision as to the 17 structure of any refinancing as yet. 18 19 MS CHADWICK: My next question is about the RECs contract 20 and the proposition that consumers should be asked to pay 21 for the costs of the green energy component. In your 22 planning application, you undertook that it would be fully 23 greenhouse gas offset. The Director-General in response 24 said that that commitment went well beyond what was 25 reasonable of a development proposal. Why should 26 consumers pay the premium for something that exceeds the 27 regulator's reasonable expectations? 28 29 MR RAMSEY: I think there are two arguments around that. 30 At the end of the day, Sydney Water was directed by the 31 government to construct the plant using 100 per cent green 32 or renewable energy. Whether we think it was appropriate 33 or not, the policy setting determined by the government of 34 the day directed us to do it. The second issue goes really 35 to the question of whether that's an efficient price. To 36 the extent that the price of the greenhouse system properly 37 reflects the externalities associated with using black 38 power, or non-green power, then it is an efficient price. 39 The contract is firmed to carbon, so there is no increase 40 in SDP's costs associated with the carbon regime, or the 41 carbon pricing regime, and it is clear that the true 42 external cost of carbon pollution is unknown, but it's 43 arguable, certainly, that the additional costs of RECs is a 44 good proxy for that externality, and to that extent would 45 be an efficient price. 46 47 MS WALKOM: Can I just add that that condition is included .22/8/11 11 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 in the project approval. If there was a change between the 2 Director-General's requirements and the project approval 3 granted by the Minister, then I guess that reflected the 4 cost of that development of desal in Sydney regardless. 5 6 Also, I guess, there are options for who pays for it: 7 either the government pays for it or Sydney Water's 8 customers ultimately pay for it, and I guess we are giving 9 the position that it is more appropriate that the customers 10 in Sydney pay those costs, rather than being passed on to 11 residents of New South Wales outside of Sydney. 12 13 MS CHADWICK: My next question is about the minimum 14 volume included in these contracts. The black energy contract 15 requires you to purchase sufficient energy to run the plant 16 at full capacity for 20 years. Given the operating rules, 17 the 70/80, why is it reasonable that that is the level of 18 energy being purchased? 19 20 MR RAMSAY: Many parts of these contracts are regarded as 21 commercial in confidence by the counterparties to them, but 22 what you say is true; there is a fixed take or pay 23 component in both. 24 25 It is a matter of judgment. When the tenders were 26 called and considered, there was a very wide response. 27 There is a trade-off between obtaining a long-term contract 28 price in fixed real terms with no carbon pass-through, and 29 the amount of volume that you are prepared to guarantee 30 under that contract. It is a commercial judgment. If you 31 look at the tenders received, the judgment was taken that 32 the optimal mix of price and fixed guarantee was where we 33 set it, in terms of what the market was offering. 34 35 We could have got a contract at lower guarantees. 36 Those contracts would have been for a shorter period or a 37 higher price. The judgment was made that this was the 38 ultimate lease. The same applies to both the REC and the 39 Black power contract. 40 41 MS CHADWICK: That judgment exposes consumers to a 42 degree of financial risk, unless you have otherwise hedged 43 that commercial risk. Are you expecting consumers to pay or 44 has it been hedged by SDP? 45 46 MR RAMSEY: It's not clear whether that's a positive or a 47 negative risk. It will depend on the difference between .22/8/11 12 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 the contract price and the market price at the time the 2 circumstance is generated. That's an unknown fact. 3 4 SDP has not sought to hedge that risk. As 5 I understand it - and I can seek advice - I don't think 6 hedges are available in the sort of time frames we are 7 talking about, for 20 years. You might be able to hedge it 8 on a rolling basis, but it hasn't been hedged yet, no. 9 It's arguable that the cost of hedging would be broadly 10 equivalent to the cost of the market difference, in any 11 case. 12 13 MS CHADWICK: My last question is about the decision to 14 enter into a 20-year contract. The point at which the 15 energy contracts were negotiated coincided with a 16 significant increase in average annual energy prices. 17 Given that, can you explain the factors that underpin the 18 decision to enter into such a long contract? 19 20 MR RAMSEY: I wasn't party to that negotiation or to the 21 thinking that went behind it, but we can find that out and 22 take it on notice unless, Daniel, you wanted to say 23 something about that? 24 25 MR COOPER: I think the prices that were gained at the 26 time was when the market had actually come off its highest, 27 and the market price that had actually been received was 28 benchmarked against the market, and was seen as a good 29 price at that time. 30 31 MR RAMSEY: I think the other thing you could say is that 32 it was essential to provide a long-term contract certainty 33 in relation to the REC contract, at least, because of the 34 need to construct the wind farm. That contract is the 35 under-pinning for the construction of the wind farm at 36 Bungendore, that delivers the REC agreement. It was 37 therefore essential to take the RECs over that period of 38 time, or we would not have been able to provide the backing 39 for the construction of the wind farm. Once you have taken 40 the RECs for that period, back to back with the electricity 41 contract, the provision of power, it was agreed it made a 42 lot of sense. 43 44 MS CHADWICK: In terms of those contracts being back to 45 back, there are obviously minimal differences between those 46 two contracts, and it is hard to reconcile without the 47 appropriate minimum volume for Black Energy. It is almost .22/8/11 13 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 double of the RECs, in terms of what was being expected of 2 the plant's operation and what was an efficient level of 3 expenditure. 4 5 MR RAMSEY: I think it's true to say that we would have 6 wanted to take the smallest minimum guarantee we could get 7 for both sides, consistent with getting the best price with 8 the greatest fixed term. 9 10 These contracts were negotiated with different 11 companies at the time, and it so happened that the minimum 12 we could get for the REC contract for the construction of 13 the wind farm with a 20-year fixed price was one volume and 14 in the power contract was a slightly different volume. 15 16 THE ACTING CHAIRMAN: Before we leave that subject, can 17 I just ask you to confirm something I think you said 18 earlier, which is that if a carbon price were to be 19 introduced, the price under both the energy contract and 20 the REC contract would be unchanged? 21 22 MR RAMSEY: That's correct. Both contracts confirm the 23 carbon price. There is no pass-through of any carbon 24 pricing scheme or any other carbon tax, or the Emissions 25 Trading Scheme. The contract price is a fixed real price 26 for 20 years. 27 28 MR WARNER: Firstly, if we are to structure prices where 29 the Sydney Desalination Plant is indifferent as to whether 30 or not it produces any water, where is the incentive for it 31 to actually produce any at all? 32 33 MR RAMSEY: They are required to run the plant under the 34 operating licence consistently with the rules. If they 35 fail to do so, or they fail to produce in accordance with 36 those requirements, they don't get the availability charge, 37 which would be a fairly substantial incentive to produce in 38 accordance with the rules. That's what it is there for. 39 40 Once the plant is outside the rules, it is a question 41 of whether the operator would wish to run the plant for 42 some reason when the dams are at 90 per cent. There is no 43 reason why they couldn't do that, but there is no financial 44 incentive from Sydney Water to do that. There may be from 45 other customers, but not Sydney Water. 46 47 MR WARNER: Just going back to energy for a moment, your .22/8/11 14 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 energy contract runs for 20 years, but those contract 2 prices are currently substantially above market prices. 3 Did you undertake any sort of NPV analysis to justify the 4 decision to contract those sorts of price levels and, if 5 you did, when is it projected that the market prices will 6 exceed the contract prices. 7 8 MR RAMSEY: If I could predict those sorts of things 9 I probably wouldn't have to work for Sydney Water. Daniel, 10 did you want to comment on that? We certainly would have 11 done some NPV analysis, yes. 12 13 MR COOPER: An analysis was conducted, and it was 14 determined depending on whether the carbon price came in or 15 not. If the carbon price came in, the contracts were 16 pretty much in line with market prices as of today, and 17 there would be a cross-over probably in about the 18 eight-year mark if a carbon price was not to come in. 19 20 So, in the latter years of the contract, you would be 21 better off. 22 23 MR WARNER: Can that analysis be made available to us? 24 25 MR RAMSEY: I'd have to take advice on that, Richard. It 26 could probably certainly be made available to the Tribunal. 27 I'm not sure it could be made available publicly. We will 28 have a look at it. 29 30 THE ACTING CHAIRMAN: It would certainly be of interest 31 for us to see it, under both scenarios. 32 33 MR WARNER: Your submission also indicates that chemical 34 and membrane costs are projected to increase quite 35 significantly over time. However, there doesn't seem to be 36 any evidence in your submissions to support those 37 projections. Is there additional information available to 38 support those projections? 39 40 MR RAMSEY: I'd need to ask. 41 42 MS WALKOM: We did pass on some information. As to the 43 membrane prices, we got some industry advice and used our 44 US producer price index for chemicals to forecast increases 45 in membrane prices. For chemicals we used our experience 46 with our water filtration plants to inform our assumption 47 of increases, and past increases already experienced by .22/8/11 15 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 SDP since 2007. I can send that on again. 2 3 MR WARNER: Thank you. 4 5 We also note that there are a number of capital costs 6 that increase, such as the sea water intake pumps, and they 7 are scheduled to be refurbished or replaced at a frequency 8 of eight years, seven years and four years. You would 9 expect those things to happen fairly consistently. What is 10 the reason for the differences in time frames for those 11 sorts of replacements? 12 13 MR RAMSEY: I'm not sure we have that detail to hand, 14 Richard, but we can find out for you. We'll provide that 15 by way of on-notice. We'll provide you with information on 16 that. 17 18 MR WARNER: The same thing happens with screenings 19 where you have 12 years, three years, two years; and wash- 20 water pumps, eight, five, two, then three. 21 22 MR RAMSEY: All of these time frames would have been 23 worked out in conjunction with the operator and with 24 technical engineering advice. We haven't got the detail 25 with us, but we will get a hold of that and get it to you. 26 27 MR WARNER: I just thought if you replaced something at 28 seven years, it would last another seven years. 29 30 MR RAMSEY: You would think that would be the case. It 31 may well be the case. 32 33 MR ENGLISH: It is probably not the same pumps. There are 34 a lot of pumps at the plant. You wouldn't do them all at 35 the same time, based on the operator's experience and the 36 timing they need to do things, how much they can take up at 37 any one time. 38 39 MR RAMSEY: It certainly would depend on the specific 40 pump or piece of equipment being replaced. Some have 41 different lives to others, depending on whether they are 42 pumping sea water or fresh water, for example. But we will 43 get the detail and provide it to you. 44 45 MR WARNER: That would be good if you could clarify that. 46 47 In your submission, you propose a nominal risk-free .22/8/11 16 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 rate of 5.2 per cent. That seems to be substantially 2 higher than current long-term bond rates of 4.5 per cent 3 for 10-year maturities, and 4 per cent for five-year 4 maturities. 5 6 Why should we agree to that sort of mismatch? 7 8 MR RAMSEY: I think the true answer is that the long-term 9 bond has been rather volatile in the last little while, and 10 on a downward trend. This submission was compiled some 11 time ago. 12 13 Stuart, would you like to add to that? 14 15 MR WILSON: Those things are market parameters which 16 will be what they turn out to be. The risk-free rate is not 17 really a proposal; it is just what it was when we 18 calculated it. 19 20 MR RAMSEY: Certainly the government ten-year bond rate a 21 few months ago was 5.2, 5.3 and 5.4. Currently it is 4.5, 22 as you say. It has been quite a sudden change and it might 23 suddenly change back to where it was. 24 25 MR WARNER: So is it is no special case, just market 26 rates. 27 28 MR WILSON: Yes. I think that parameter is one that just 29 drops out at the time you do the final WACC calculation. 30 That was just the number when we calculated it. 31 32 MR RAMSEY: It needs to be averaged over time. The 33 approximate risk-free rate is a ten-year bond. 34 35 THE ACTING CHAIRMAN: If I can pick on that, it needs to 36 be averaged through time; can you explain what you mean by 37 that? 38 39 MR RAMSEY: Stuart may know this better than I, but 40 I presume that when setting a rate for a WACC, you wouldn't 41 take the rate on the day, but you'd look at what the rate 42 had been or was likely to be over a period of time and take 43 the average of that period. 44 45 THE ACTING CHAIRMAN: We normally take the 20-day average. 46 47 MS KRIEGER: Just while we are on this topic, if I could .22/8/11 17 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 interrupt, you have said that you don't agree with IPART's 2 recent move to look at a five-year bond rate over a 10-year 3 bond rate. What is SDP's current average term of debt? 4 5 MR RAMSEY: The current average term of debt for SDP is 6 quite short. I don't have a figure in my mind, but it is 7 probably in the order of 18 months to two years, but that 8 was an artificial construct. That was done deliberately to 9 allow maximum flexibility to the government in terms of how 10 the final business was structured. 11 12 As an ongoing proposition, we would envisage that the 13 tenure of debt should be matched as close as possible to 14 the length of the life of the assets. Sydney Water's 15 marginal debt is probably an average tenure of 10 plus 16 years - 10 to 12. We would expect something similar for 17 SDP once the structure is properly established and it has 18 been worked out. 19 20 In relation to the five versus 10, we understand the 21 proposition that because of the regulatory resets, a 22 structure where interest rates are reset on a rolling 23 five-year basis has weight. However, we think that the 24 proposition fails on the basis that irrespective of how 25 frequently or infrequently the interest rates are reset, 26 the cost of debt for a 10-year tenure debt or a 15-year 27 tenure debt, will be the 15-year rate. If you swap it out 28 every three years, the swap market will equilibrate the 29 difference between the 15-year tenure and the three-year 30 rate. We will make submissions to the Tribunal on that 31 matter in relation to Sydney Water's own price submission. 32 33 MR WARNER: Thank you. Your submission lists a number 34 of risks that will be retained by SDP Pty Ltd, such as the 35 risk of damage to your bulk water pipeline. What is your 36 response to the Sydney Catchment Authority's contention 37 that the majority of SDP's risks can be wholly or 38 largely mitigated by management action or by taking out 39 insurance? 40 41 MR RAMSEY: There is some weight in the insurance 42 argument. These are not as clear market risks as a highly 43 theoretical case might look at. We are not perversed about 44 providing the cost of that insurance, as reflected in the 45 cash flows. Whether it is an adjustment to the weighted 46 average cost of capital to reflect the risk in the beta, or 47 whether it's an increase in cash flow to cover the assumed .22/8/11 18 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 cost of insurance, we are not really fussed about, but 2 clearly there is a risk there. Most of it would be 3 insurable - not all of it, but most of it would be 4 insurable - but at the moment it is not insured. If it is 5 to be treated as an insurable risk then the cost of that 6 insurance needs to be included in the cash flow. 7 8 THE ACTING CHAIRMAN: If I can just clarify, are you 9 saying that, at the moment, there is no provision for 10 insurance against these risks or self-insurance in the cash 11 flows? Is that the case or not? 12 13 MR RAMSEY: There is no provision in the cash flow, in the 14 current submission cash flows for the insurance of those 15 sort of higher-level catastrophic risks that we put in the 16 table. 17 18 THE ACTING CHAIRMAN: Perhaps you can clarify that. 19 20 MR RAMSEY: We can, but there certainly hasn't been. We 21 haven't approached the market to look at whether we can 22 insure against a ship dragging its anchor across the 23 pipeline in Botany Bay and putting the plant out of action 24 for nine months while we replace the pipe. You could 25 presumably get that insurance in the international market, 26 but we haven't included the cost of that. We have 27 submitted it is a risk and it should be included in the 28 WACC. The alternative is to include it as an insurable 29 risk 30 31 MR WARNER: Your submission proposes 32 an equity beta of 0.9. I put to you that SDP's cash flow 33 suggests that its returns are likely to be independent of 34 those of the market as a whole, suggesting a lower beta. 35 What are your comments on that? 36 37 MR WILSON: Yes. We have said that the equity beta for 38 SDP is slightly lower than the market as a whole. However, 39 if you look at the UK, they have many of the same 40 adjustment mechanisms around cash flows and it has an 41 equity beta of 0.9. As Alan has said, we have also 42 considered that specific risks that we have identified need 43 to be covered through that equity beta. 44 45 MR RAMSEY: I think the answer is, purely as a market 46 comparator, the true veta is somewhere between 0.8 and 1, 47 probably, but we have assumed that that would be the factor .22/8/11 19 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 that takes account of those specific risks we spoke of. 2 However, you could argue for a lower beta, and would argue 3 for a lower beta, if the cash flows are adjusted to account 4 for insurable risks on the assumption they were insured. 5 6 MR WARNER: Could you explain your proposal for allocating 7 fixed costs, or the fixed component of the availability 8 charge if SDP has multiple customers? In other words, this 9 third-party access regime of yours takes off and we have a 10 whole pile of direct customers. 11 12 MR RAMSEY: We propose that the availability charge be 13 distributed amongst the customers pro rata to the volume 14 they take, compared to the volume of the plant. 15 16 MR WARNER: Is that contracted volume? 17 18 MR RAMSEY: It could be contracted volume, or it could be 19 retrospective adjustment with actual volume. 20 21 The assumption is that if 10 per cent of the output is 22 sold to others, then 10 per cent of the availability charge 23 would be carried by those others. 24 25 MR WILSON: The underlying principle there, Richard, is 26 that there is an insurance value in the plant that should 27 be borne by all customers in the Sydney region regardless 28 of retailers, so that there should be a distribution of the 29 fixed charge to those customers, if there are other 30 retailers. 31 32 MR WARNER: I'm just trying to figure out how to structure 33 that, that's all. 34 35 MR RAMSEY: Essentially, the proposal is the price of 36 water supplied by SDP would be the same for all customers, 37 whether it is Sydney Water or any other entity. 38 39 MR WARNER: We normally don't make retrospective 40 adjustments in our pricing determinations. This not only 41 raises issues about which you just spoke, but also your 42 pricing adjustment mechanisms. I guess that touches on 43 forecasting errors and those sorts of things. Forecasting 44 errors crop up from time to time and we usually try to 45 account for those in the next determination. Why should 46 SDP be treated differently? 47 .22/8/11 20 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 MR WILSON: I think you have had adjustment mechanisms. 2 You have an adjustment mechanism in Sydney Water's 3 determination for changes in SCA costs that came about 4 because of a misalignment of the two determinations, so 5 I think IPART have been able to make adjustments. 6 7 The key rationale in this case is because costs aren't 8 known with precision when the plant is in shutdown, and 9 that really just necessitates adjustment mechanisms where 10 perhaps for Sydney Water, longer-term, there has been a bit 11 more certainty in the cash flows. 12 13 MR RAMSAY: I think the real reason is that this is not 14 an estimating error. This is a function of a change in 15 cost base associated with an unpredictable event. The 16 unpredictable event is when the plant will shut down and if 17 it will shut down. That's impossible to predict in 18 advance. 19 20 When it does, in the absence of an adjustment, there 21 are potential windfall gains or windfall losses to the 22 owner that are very substantial. We couldn't see any 23 equity in asking the owner to carry that risk and, more 24 importantly, perhaps we couldn't see any equity in asking 25 Sydney Water's customers to pay for the windfall gain that 26 the owner would generate in the event of a shut down. 27 28 For example, if the power contract was in the money 29 and substantially in the money, and the plant had to shut 30 down because of a sudden very heavy rain event over the 31 dams, say six months or 12 months after the current price 32 determination, the owner of the plant would get very 33 substantial gains from that contract over the full life of 34 the determination, or until the plant restarted. We 35 couldn't see any reason why the customers of Sydney Water 36 should be required to contribute to that. 37 38 MS KRIEGER: Can I just ask you a question on a related 39 area to what you have just been discussing. You referred 40 before to the potential situation where the dams are at 41 90 per cent, so the plant is shut down so far as Sydney 42 Water is concerned, but could be operating for the benefit 43 of third-party customers. 44 45 MR RAMSEY: Yes. 46 47 MS KRIEGER: Is it intended that the revenues from that .22/8/11 21 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 production be brought to account in this annual overs and 2 unders potential clawback accounting that you are talking 3 about, or would they be quarantined? 4 5 MR RAMSEY: No. Our intention would be that they would be 6 brought to account - that the full operating costs and 7 revenues of the plant would be allocated against its 8 determination. 9 10 MS KRIEGER: Otherwise there would be an asymmetric 11 position. 12 13 MR RAMSEY: Yes. 14 15 MS CHADWICK: Despite whatever flexibility we can find to 16 account for things that you suggest are not forecasting 17 errors, once our determinations are made, we don't have the 18 power to vary a determination. We note that Sydney Water 19 is proposing to transfer its pipeline to SDP, and you have 20 suggested that we should include that in the determination 21 of prices. How do you envisage that prices should be 22 determined in the event that that eventuality does or does 23 not occur before we need to make prices? 24 25 MR RAMSEY: The answer is that I don't know the answer. 26 The hope was that this would surface before the Tribunal 27 had to make a determination. I recognise this is rather a 28 knotty problem, and there hasn't been a decision that the 29 pipeline will transfer SDP, although it has clearly been 30 asked that the task force looking at the refinancing 31 proceed on the basis that it should be. 32 33 I would think we will get a decision on this in the 34 near future. At that point, we'll have certainty. Until 35 that, I don't quite know how the Tribunal could deal with 36 that other than setting an alternative price - a price with 37 it and a price without it. 38 39 MR WILSON: To facilitate that, as you have said in the 40 submission, all the costs of the pipeline are separately 41 identified, so if the Tribunal wanted to, it could do a 42 price with and without and make it conditional on whatever 43 happened with the transfer. 44 45 THE ACTING CHAIRMAN: I think from an IPART point of 46 view, it would be concerned to avoid a situation where the 47 customers of Sydney Water would be paying for a pipeline .22/8/11 22 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 twice, once in New South Wales pricing and once in 2 Sydney Water's pricing. I think we have to be careful to 3 avoid that. 4 5 MR RAMSEY: Yes, we agree with that. 6 7 MS CHADWICK: In terms of the forecast capital rate, the 8 desalination plant is supplied by a 125 kilowatt feeder, 9 which is currently due to be replaced - so it is an 10 electricity feeder which is due to be replaced. Is SDP 11 liable for the cost of the feeder and was that considered 12 in your asset management strategy for the plant at all? 13 14 MS WALKOM: I think that fee arises from Ausgrid 15 decommissioning its 33 kilowatt supply. 16 17 MR RAMSEY: I might ask Daniel. 18 19 MR COOPER: The feeder you are talking about is a standby 20 feeder for the plant. The main feeders for the plant are 21 new and going to a new Ausgrid substation. That's the main 22 feeder. The standby feeder that you are talking about, 23 Ausgrid are changing their network in that area and 24 replacing a 33 kilowatt system with an 11. The cost for 25 that replacement is quite low, but we are currently seeking 26 to make sure that that standby feeder is still in place on 27 the ongoing running plant. 28 29 MR RAMSEY: But the cost of the 11 KV replacement feeder 30 is, I think, part of our Cap Ex in the submission. 31 32 MS CHADWICK: And SDP is liable for that cost? 33 34 MR RAMSEY: For that component that we included in the 35 submission, yes. 36 37 MS WALKOM: I think Ausgrid has said that to us 38 previously, that it's for us to pay for - for SDP to pay 39 for. 40 41 MS CHADWICK: My last two questions are of clarification. 42 The first one is just in terms of the start date for the 43 determination that you are seeking. 44 45 MR RAMSEY: I think we have assumed 1 July 2012 as a start 46 date for the determination, but I will confirm that for 47 you. I believe that's what we have assumed. .22/8/11 23 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 MS CHADWICK: The second one is in terms of the event that 3 the plant's augmentation is triggered in the course of the 4 determination period, what do you expect would occur in 5 that eventuality? 6 7 MR RAMSEY: The provisions for expansion of the plant to a 8 400 or 500 megalitre capacity are still being considered. 9 The time frame from the point of decision to do the plant 10 expansion to the point of first water is probably in the 11 order of two to three years. Given the level of dams 12 currently, I would think it highly unlikely - highly 13 unlikely - that there would be a decision to proceed with 14 the augmentation in light of this price determination. 15 16 In subsequent price determinations, the structural 17 arrangements around how it will happen will be much 18 clearer, so you will be able to take that into account. 19 20 MR WARNER: Your proposed price structure is based on an 21 average annual availability of the plant of 94 per cent. 22 23 MR RAMSEY: 95. 24 25 MR WARNER: Okay. When the plant's operating at higher 26 than 94/95 per cent, your proposed variable costs would be 27 recovering surplus revenue, effectively. Is it reasonable 28 to expect that a new plant would have a higher 29 availability, given that it's brand new and it has been 30 tested for two years? 31 32 MR RAMSEY: The plant does have a capacity in excess of 33 its own capacity, and has been running in excess of that in 34 recent times. 35 36 It has a feature that allows the operator to recover 37 any period in the rolling 12 months, when they operate less 38 than 95 per cent of nameplate capacity and incur an 39 abatement charge. The thing that allows them to recover 40 that abatement charge is that they can run for a period 41 above the nameplate capacity. 42 43 I don't understand, your point, Richard, that if they 44 are operating above nameplate they are generating surplus 45 revenue. They will generate additional revenue, but that 46 revenue will only be equal to the costs. Depending on the 47 Tribunal's determination, if the true cost is 53 cents a .22/8/11 24 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 kilolitre and the revenue of 53 cents a kilolitre, then 2 they are covering the costs of the excess production, but 3 they are not making any additional profit on that. 4 5 MS CHADWICK: In terms of the proposition that you put to 6 us about the availability charge in the event that there is 7 a customer other than Sydney Water, and the suggestion that 8 we have the capacity to adjust prices to take account of 9 that on the unders and overs basis, do you consider that 10 there is real likelihood of competition to emerge in the 11 bulk water market? Is that something we genuinely need to 12 take account of in structuring prices, and what is that 13 assumption based on? 14 15 MR RAMSEY: We believe that there is real likelihood of 16 competition in the bulk water market and possibly more 17 likely in the retail market for Sydney Water. 18 19 The Water Industry Competition Act facilitates that 20 and provides a legal structure for that to happen. There 21 is a new supplier of bulk water in SDP that can 22 conceivably purchase non-desalination water to mix and sell 23 at the market price. If it feels that it can manage the 24 retail end of its costs better than Sydney Water, it should 25 be able to sell at retail at a lower cost than 26 Sydney Water, and we believe there is a higher likelihood 27 of competition emerging, possibly not in this price 28 determination, but certainly over the life of the next two 29 price determinations. 30 31 MS WALKOM: I was just going to add that new development 32 areas obviously will provide the potential for that 33 opportunity. 34 35 MR RAMSEY: We can't say with absolute certainty that this 36 customer will emerge and take retail, but we think once all 37 of the structural elements are in place, experience and 38 other markets would indicate that competition will emerge. 39 40 THE ACTING CHAIRMAN: I guess we are interested in 41 following that up a bit further, if we could. 42 43 You suggest that the demand will come from new 44 developments rather than existing customers. I guess what 45 is attractive about this different sort of water that would 46 encourage people to purchase it from SDP rather than 47 Sydney Water? I'm interested on your thoughts on that. .22/8/11 25 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 MS WALKOM: Powered by renewable energy; that could be a 3 point of interest. 4 5 MR WILSON: Under the Water Industry Competition Act, 6 there is a growing number of retail and network operator 7 licences for recycled water. So, the structure of the 8 industry is changing. If you are supplying recycled water 9 to customers in developments, and dealing with waste water, 10 it's only a short step to say, "We'd like to just do all 11 the water" and then have some agreement to take over. 12 13 It's really based on the observation that the Water 14 Industry Competition Act isn't static; it has led to 15 significant changes already. 16 17 MR RAMSEY: Perhaps most importantly- and I know in the 18 United Kingdom they are keen to promote retail competition 19 - if the owner of the plant feels that it can supply water at a 20 lower retail cost than Sydney Water, it 21 can arguably sell at a lower price than Sydney Water unless 22 the retail component is set by IPART as well. 23 24 If IPART determines the bulk water price for SDP and 25 the access agreement and the transport and delivery costs, 26 the retail component is contested. In those circumstances, 27 we think it is likely a competition will emerge. 28 29 THE ACTING CHAIRMAN: Thank you. 30 31 THE ACTING CHAIRMAN: We are now open to questions 32 or comments from people sitting in the back of the room. If 33 you want to make a comment, please indicate that and 34 identify yourself for the benefit of the transcript. 35 36 Are there any comments or questions? No. Thank you 37 very much. We can ask you now to step down, if you wish. 38 39 We will now break for morning tea and resume at 40 10 past 11. Thank you very much. 41 42 SHORT ADJOURNMENT 43 44 45 46 47 .22/8/11 26 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Session 2: SFG Consulting (Via Videolink) 2 3 THE ACTING CHAIRMAN: Can we now resume after the 4 break. I have been asked for a copy of SFG Consulting's report, 5 and I'm told the answer is that it is on our website. We 6 are also running off a few copies, so they will be 7 available after the session if you wish to take a paper 8 copy with you. 9 10 We will now move on to the next session, which is a 11 presentation by SFG Consulting. SFG Consulting are via 12 video-link from the United States. If we are ready to 13 start, I will ask Jason to make his presentation. 14 15 MR HALL: Everyone, please bear in mind that you can see 16 me, but I cannot see you, so whatever communication you 17 have for me, you will have to interrupt if you want to ask 18 a question. You can't raise your hand, because I don't 19 know how many people are in the room or what sort of 20 non-verbal communication is going on. 21 22 THE ACTING CHAIRMAN: If I can just explain, Jason, I am 23 Jim Cox. With me is Sibylle Krieger, Tribunal member; 24 three members of the Secretariat, Eric Groom, Richard 25 Warner and Amanda Chadwick, who will ask you questions 26 in due course; and an audience of 30-odd who will also be 27 given a chance to ask questions. 28 29 MR HALL: Also bear in mind that I didn't hear that very 30 well. The audio isn't very good from my end, but we will 31 do our best. 32 33 I think the best thing to do is start. I don't mind 34 taking questions as we go, so if you have questions along 35 the way, please ask them. I will just give a brief 36 introduction to what our role in the engagement is, a brief 37 introduction to our conclusions and the rationale behind 38 those conclusions, and I think within about 10 to 39 20 minutes, I'll be done, but feel free to ask questions 40 before that point and we will have time for questions after 41 that as well. 42 43 We were engaged to provide advice with respect to two 44 specific parameters with regards to the regulated rate of 45 return - that is, the equity beta assumption and the 46 assumption about leverage. 47 .22/8/11 27 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 The impact of those two things on the regulator's rate 2 of return is that equity beta is an estimate which goes 3 into the capital asset pricing model of how much estimated 4 risk exposure the regulatored entity has. So, in terms of 5 estimates of equity beta, we are concerned about how much 6 economic exposure equity holders have to fluctuations in 7 economic conditions. We also call this market risk, or 8 economic risk, and in general we call it systematic risk. 9 10 It is important to understand when you think about 11 this idea of a company-specific risk versus market risk, 12 that one of the assumptions which underlies the capital 13 asset pricing model, which is used to set the required 14 return to equity holders, is part of the regulated rate of 15 return. It is this idea of diversification. 16 17 The principle behind the capital asset pricing model 18 is that equity holders will bid up the price of the assets 19 to the point where equity holders are only being 20 compensated for bearing what we call market risk. The 21 principle is that investors have to be diversified; it is 22 not the companies themselves that have to be diversified. 23 24 So the fact that the Sydney Desalination Plant, or 25 indeed any other regulated entity, is only exposed to one 26 asset or one industry does not impact upon the required 27 return to equity holders as part of the capital asset 28 pricing model, provided that investors in assets in general 29 have the ability to be diversified. It is that idea of 30 diversification which affects asset pricing under this 31 economic model. 32 33 To give us a reference point, a typical firm in the 34 marketplace has an equity beta of 1. In its most recent 35 water determinations, IPART adopted an equity beta of 0.9 36 in setting regulated prices for assets of Sydney Water. 37 So our benchmark for a regulated water utility at this 38 stage in New South Wales is an equity beta estimate of 0.9. 39 40 The second parameter we were asked to look at is the 41 assumption about leverage. This is going to affect the 42 regulated rate of return because the higher the proportion 43 of capital which is provided by debt holders, the lower 44 will be the regulated rate of return, because we are 45 drawing a higher proportion of our finance from debt 46 holders who require lower returns because they bear less 47 risk than equity holders, and they also receive greater tax .22/8/11 28 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 benefits than equity holders. 2 3 So, as a reference point, the typical listed firm in 4 the Australian market has leverage of around about 5 30 per cent, so about 30 per cent of its capital is 6 provided by debt holders; 70 per cent by equity holders. 7 And again, in its most recent water determinations, IPART 8 adopted a leverage of 60 per cent. 9 10 For the typical water utility in New South Wales, the 11 regulator has previously determined that optimal financing 12 or benchmarking financing assumption is adequate to sustain 13 leverage of double the typical firm in the Australian 14 marketplace, because of cash flows. 15 16 I will try to put this in context, because while 17 people involved in regulation in the water industry in 18 Sydney in general are going to be familiar, there could be 19 people in the public forum here who are not necessarily 20 across all the issues involved. 21 22 We have this reference point where, for the typical 23 firm in the marketplace, the equity beta assumption is 1, 24 and gearing is around about 30 per cent. For a benchmark 25 water utility in New South Wales, the regulator has 26 previously determined that it could sustain an investment 27 grade credit rating by taking on 60 per cent debt financing 28 and still have an equity beta estimate of 0.9, which is 29 10 per cent below the typical firm in the Australian 30 market. So this sort of leads into an interaction between 31 these two things. 32 33 Even though we would say that for a regulated utility 34 you are just going to have very low asset risk, very low 35 volatility operating profits in association with changes in 36 market conditions, when you put 60 per cent leverage into 37 that asset the volatility of returns to equity holders 38 starts to increase to the point where, in previous 39 determinations, IPART determined that an equity beta 40 estimate of 0.9 is appropriate. 41 42 Now we are going to come to the conclusions that we 43 have reached with regard to the Sydney Desalination Plant, 44 because we really should think about those things in the 45 context of what is the typical leverage of any sort of 46 given business in the Australian marketplace, what is the 47 typical risk exposure by that given business, and then what .22/8/11 29 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 is the estimate of the amount of equity risk for a water 2 utility in New South Wales, and what is the estimated 3 gearing which the water utility of New South Wales could be 4 expected to sustain. We want to think about the 5 Sydney Desalination Plant in the context of those things. 6 7 With regards to equity beta estimates, there are a few 8 standard methods that are adopted to estimate this equity 9 beta, or this exposure to market risk. One thing we want 10 to emphasise when we think about equity beta estimation is 11 the word "estimate". There is no way to directly observe 12 the true equity beta of a company. You can only make 13 estimates in a fairly indirect way. However, one of the 14 indirect ways we estimate equity beta is to perform an 15 analysis of the association between returns of listed 16 companies and market returns. 17 18 This estimation technique is called "ordinary least 19 squares regression". The way to illustrate this technique 20 is that if I just refer to a figure in our report, in which 21 we have a scatter plot here for an index, in which we 22 construct a whole list of water utilities in the 23 United States and in the United Kingdom. What that scatter 24 plot represents on the horizontal axis is market returns in 25 excess of the risk, and on the vertical axis an 26 equally weighted index of stock returns over a period of 27 about 30 to 40 years - there are 460-odd data points in 28 that figure. The slope of that line through the data 29 points represents the association between stock returns and 30 market returns. 31 32 What we are trying to do when we estimate equity beta 33 is estimate the association between a return of the stock 34 and return to the market in expectation. What we have in 35 analysis of historical returns is actual returns and they 36 are very different from the expected returns. This is a 37 very indirect way of trying to estimate just how the return 38 to equity holders would change if returns to the 39 marketplace were above or below expectations 40 41 We have adopted a number of statistical techniques in 42 our report to come up with these final numbers and to go 43 through every single line in our report to come up with 44 these conclusions would take a few hours. So I want to 45 move directly to our conclusions, and maybe if I just refer 46 to our executive summary or our introduction to explain the 47 rationale behind some of these things. .22/8/11 30 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 We performed this ordinary least squares regression 3 analysis, which is a fairly standard technique, but it is a 4 fairly individual way of estimating equity beta. We say in 5 the first paragraph of this indirect introduction that if 6 we were to simply look at the historical return information 7 and not consider its imprecision and not consider issues 8 significant to the Sydney Desalination Plant, we would come 9 up with an estimate of the equity beta which is 0.65, which 10 is in the bottom part of that second paragraph. 11 12 I say there are issues specific to the 13 Sydney Desalination Plant which should be considered, and 14 there is also the matter of internal consistency to be 15 considered. 16 17 We have reason to believe that this analysis of 18 historical returns can be very imprecise. One of the 19 reasons that these can be considered to be fairly imprecise 20 is that sometimes they lead you to estimates of systematic 21 risk exposure which are inconsistent with other parameter 22 estimates. Specifically, if we consider the idea that 23 equity holders should earn returns which are at least the 24 level of returns available to debt holders, the appropriate 25 equity beta estimate increases to 0.74. 26 27 The rationale for that is that, at the moment, debt 28 holders are facing fairly large premiums, if you compare 29 yield to maturity on debt versus the risk-free rate of 30 interest. So it wouldn't make sense if equity holders were 31 pricing assets in the equity market at a level at which 32 they would earn a lower return than would be available to 33 debt holders. 34 35 In our report, we discuss this issue of internal 36 consistency and we say that it just wouldn't make sense to 37 have an equity beta estimate which is around the level of 38 0.65 because the implication of that, if you incorporate 39 that with a market risk premium asset of 6 per cent, 40 that equity holders would be earning less than the debt 41 holders in a normal market condition. 42 43 We also go into a fair amount of depth in our report 44 about the internal consistency and it is a fairly complex 45 area. One of the issues which came about in our 46 discussions with the Tribunal is the difference between the 47 yield to maturity on debt and what we call the expected .22/8/11 31 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 return. When we observe yields available to debt holders 2 in the marketplace, we are observing the return available 3 to those debt holders if they receive all of their promised 4 payments and if there are no interest rate fluctuations 5 over the life of the period of the debt, so they are able 6 to reinvest all of the cash flows with the same yield to 7 maturity. 8 9 In our report, we are using a yield to maturity 10 estimate of the debt of around about 7.9 per cent. That is 11 not the expected return to debt holders. When we talk 12 about expected returns to the cost of capital, what we are 13 talking about is the returns which investors would receive, 14 on average, given all possible outcomes. One outcome to 15 debt holders is that there is going to be default. So, on 16 average, if there is a default and debt holders perhaps 17 only recover 50 cents in the dollar, on average those debt 18 holders might only receive between 6.5 and 7 per cent as a 19 return. On average, the expected return on debt is going 20 to be less than the yield to maturity. 21 22 When we talk about equity, theoretically what we are 23 talking about is an average outcome or an expected return 24 to equity holders. One issue which comes up in this 25 analysis is maybe we should only be thinking about 26 providing returns to equity holders which at a minimum are 27 at least as large as the expected return to debt holders 28 rather than the yield. We say that that is fine in theory 29 but, in reality, what we haven't set in regulated prices is 30 a normal business case, a normal estimate of volumes. 31 32 In this particular case we have one scenario where the 33 plant is operating and one scenario where it is not, but in 34 each case it is a normal business case. In a normal 35 business case, our firm will not be able to obtain 36 financing from equity holders at a return which is less 37 than available to the debt holders. If you think about 38 those two things together, the minimum implied 39 internally - and this is an estimate - for the equity beta 40 would be at least 0.74. We are suggesting that the 41 analysis on historical return in an ordinary least squares 42 regression underestimates what is an appropriate equity 43 beta in the context, but it gives us a reasonable starting 44 point. 45 46 Then we consider each specific to the 47 Sydney Desalination Plant and, in its submission, the .22/8/11 32 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Sydney Desalination Plant identified a number of risks. 2 I think part of that submission was basically saying the 3 nature of the regulatory process is not going to allow them 4 to recover, in the appropriate way, compensation for 5 bearings these risks. 6 7 We could not identify reasons why any of those risks 8 identified by Sydney Desalination Plant were systematic in 9 nature and, therefore, they shouldn't be factored into an 10 appropriate estimate of the equity beta. It is correct to 11 say that these risks should be accounted for in determining 12 regulated price, such that if the Sydney Desalination Plant 13 is bearing a lot of downside risk, then prices should be 14 set at a level which means that, on average, they would be 15 able to recover, in an appropriate way, compensation for 16 bearing those risks. 17 18 The fact that there are risks that a business is 19 exposed to does not necessarily mean that the required 20 return is going to be higher if those risks are 21 company-specific, because we have this idea, and you 22 capitalise the price model, and investors are going to 23 price assets at a level which only reflect their systematic 24 risk. Even though we have an asset that is only exposed, 25 in this case, to one asset, one industry, that is not the 26 theory which underlies the capital asset pricing model. It 27 relates to investors and their ability to diversify. 28 29 Ultimately, we come to a conclusion that an 30 appropriate estimate for the equity beta would be 0.8. 31 We get to that conclusion on the basis that we have in the 32 most recent estimate for systematic risk from the regulator 33 of 0.9 for a particular water utility, a minimum equity 34 beta estimate of around about 0.74 which would be 35 internally consistent with other parameter estimates, such 36 that equity holders earn a return which is at least the 37 yield for maturity available to debt holders. 0.8 lies 38 between those two things. So, it seems to be a reasonable 39 outcome, all things considered. 40 41 I'm just going to pause for a moment. I can't see any 42 non-verbal communication in the room. Does anybody have 43 any questions specifically relating to our analysis of 44 equity beta that they want to raise? 45 46 THE ACTING CHAIRMAN: Eric? 47 .22/8/11 33 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 MR GROOM: I think it may be easier to wait until the end, 2 because we have to go to the podium to ask questions in a 3 way that you can hear us. 4 5 THE ACTING CHAIRMAN: We will have questions at the end. 6 7 MR HALL: That is fine. 8 9 So we reached the conclusion that an equity beta 10 estimate of 0.8 would be appropriate. 11 12 We then considered the estimate of what's the 13 appropriate leverage. The issues relating to leverage are 14 different. When we think about the leverage, we are 15 basically saying what sort of debt could sustain a 16 particular credit rating, and a rating agency is not going 17 to consider purely systematic risks; a rating agency is 18 going to consider primarily the probability of default. 19 20 The way we think about this is, well, to start with, 21 what are the typical credit ratings issued by Standard & 22 Poor's, the largest rating issue? The typical is a 23 BB+ rating. There were a million credit ratings issued by 24 Standard & Poor's as of 1 January 2009, and it is 25 approximately the median credit rating issued by 26 Standard & Poor's if you look at all the ratings it issued 27 historically. 28 29 The bulk of credit ratings issued by Standard & Poor's 30 are within the range of BB+ to BBB to BBB+. As a default 31 option, Standard & Poor's issues credit ratings which are 32 approximately investment grade and typical BBB credit 33 ratings are assigned by a regulator setting a regulating 34 rate of return. 35 36 We started off by thinking at 60 per cent leverage, 37 what do the risk metrics of the Sydney Desalination Plant 38 look like? We reconstructed some financial statements for 39 the Sydney Desalination Plant plant based upon information 40 in its submission, and what we observed is, if you look at 41 financial ratios on a level basis, on a static basis, at 42 60 per cent leverage, and if you look at risk metrics 43 published by Standard & Poor's for all firms and assume 44 this particular company has excellent business risk, a very 45 low risk, low volatility of its operating profits, this 46 could suggest that it could sustain a BBB rating. 47 .22/8/11 34 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Its financial ratios are reasonably stretched in the 2 sense that EBIT relative to interest ratio is generally 3 below 1.5 in any given year. If you look at its free cash 4 flow available to make interest payments - we'll call that 5 a free cash flow to interest ratio - it is typically 6 somewhere between 1.5 to 1.9 in any given year. 7 8 At 70 per cent leverage, these financial ratios still 9 suggest that it would sustain a BBB credit rating, given 10 that a large number of the risks have been transferred to 11 its contract or via its operating and maintenance 12 contracts. If a typical water business in New South Wales 13 could sustain a 60 per cent leverage, we suggest that the 14 Sydney Desalination Plant could sustain a slightly higher 15 level of leverage and still not breach ratios which are 16 consistent with a BBB credit rating. 17 18 We also looked at the probability of default 19 associated with different credit ratings and, historically, 20 in a five-year period, there is a 2 per cent chance that a 21 BBB rated security is going to incur at least one instance 22 of default within a five-year period. That solved what 23 sort of volatility operating profits would be consistent 24 with this probability of default. We don't know exactly 25 how volatile the operating profits of the Sydney 26 Desalination Plant could be, but that solved what sort of 27 volatility operating costs would result in a 2 per cent 28 chance of default at least once over a five-year period. 29 That range of that volatility is around about 6 to 30 19 per cent. 31 32 If, in a typical year, operating costs could rise by 33 $6.00 to $19.00, relative to what we would typically 34 observe, that sort of variation would be consistent with a 35 BBB credit rating at 70 per cent leverage. At a 36 60 per cent leverage, which is sort of the default leverage 37 option for regulated entities, we suggest that it could 38 probably sustain a credit rating of A-. 39 40 We would be reluctant to see a leverage of something 41 which exceeds 70 per cent, and we would be reluctant to see 42 a regulated estimate of the credit rating which exceeds A-. 43 The reason for this reluctance to see a leverage assumption 44 or a credit rating assumption which deviates from the 45 boundary is because we don't observe deviation from those 46 boundaries very often. 47 .22/8/11 35 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 For instance, if you take a leverage from the same 2 firms where we analysed the equity beta using ordinary 3 least squares progression, we had 16 firms there, the 4 average leverage on an historical basis for those 16 firms 5 was 43 per cent, and 15 of those firms had leverage within 6 a range of 32 to 65 per cent. Just two of those 16 firms 7 had historical average leverage within the range of 60 to 8 65 per cent. 9 10 Given that we have observed an historical average 11 leverage of water utilities above 65 per cent, we would be 12 reluctant to have any sort of regulation which assumed 13 leverage which exceeded 70 per cent, which is slightly 14 above the upper end of that range. 15 16 We do know that currently in its projections the 17 Sydney Desalination Plant has a higher leverage than that. 18 It has a leverage, from memory, of about 80 per cent, and 19 that's paid down fairly quickly. 20 21 When we analyse the financial information of Sydney 22 Desalination Plant, we reconstructed the financials on the 23 assumption that it was not government-owned. The 24 ownership structure was irrelevant to our analysis. We 25 assumed that SDP was paying tax, for example, so it couldn't 26 pay down debt. If we were to factor in the fact that it has a 27 government owner and it is not actually paying tax, we 28 would have overestimated the appropriate leverage. We are 29 coming up with leverage which we would observed if this 30 firm was a typical firm. 31 32 We also balance the credit rating above the A- level. 33 If you look at the distribution of historical credit 34 ratings, 19 per cent of those credit ratings are A- and 35 above, and only 12 per cent of credit ratings are at the 36 level of A or above. So, if we think about a scenario 37 where the firm has 60 per cent leverage and an assumed 38 credit rating of A-, we are basically saying that, even 39 given that high leverage, this firm is in the top fifth of 40 the distribution in terms of default risk. If we think 41 about a BBB credit rating in combination with 70 per cent 42 leverage, we are basically saying this firm's approximately 43 in the top 45 per cent of the distribution in terms of 44 credit ratings. 45 46 Given that Standard & Poor's doesn't issue credit 47 ratings above A- more than one in five times, we will be .22/8/11 36 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 reluctant to set the credit rating above that letter. 2 3 To paste all of that information together, our 4 recommendation is that an equity beta estimate of 0.8 is 5 appropriate and a credit rating of BBB with 70 per cent 6 leverage is also appropriate. As an alternative, we say a 7 credit rating of A- could be sustained if the regulator was 8 to maintain the typical assumption of 60 per cent leverage. 9 10 That is my 20-minute summary. We can go to questions 11 now, if you like. 12 13 THE ACTING CHAIRMAN: Thank you very much. We will 14 now proceed to questions. I think people have to come up to 15 the lectern. We will have questions first from the 16 secretariat and then from people in back of the room. 17 18 MS CHADWICK: Jason, this is Amanda Chadwick here. 19 20 MR HALL: Yes. 21 22 MS CHADWICK: In terms of non-systemic risk, you argue 23 that they shouldn't be included in the beta, consistent 24 with the CAPM theory. Is that proposition consistent with 25 market practice, such as the valuation of traded stock? 26 27 MR HALL: Yes. 28 29 If an analyst was coming up with the cost of capital 30 estimate for companies where they were doing discounted 31 cash on a valuation, or if someone working in an investment 32 bank was also coming up with that equity beta investment as 33 part of their cost to capital computation, they would use 34 an equity beta estimate which only incorporates systematic 35 risk. What they may do is add some sort of 36 company-specific risk premium to their analysis, but they 37 won't incorporate the equity beta. 38 39 I'm not saying that that's an appropriate way to think about 40 issues of company-specific risk, but if you take a more 41 extreme case, suppose you were an analyst and you were 42 valuating a technology company that was currently incurring 43 operating loss, so it's not currently profitable, it maybe 44 has to get a lot of capital, this is a very risky stock. You might 45 have some projected cash flows which you discount 46 at a rate 30 per cent, and this will be a fairly typical 47 thing that an analyst does. .22/8/11 37 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 You can also make the argument that the company has 3 risks which are almost entirely company-specific. It might 4 have an new technology or a new source code. If it is a 5 concept which is either going to succeed or fail, you could 6 say that that success or failure has nothing to do with how 7 market price is going to move, but the analyst is still 8 using a discount rate of, say, 30 per cent. 9 10 What the analyst is doing in that case is not 11 considering a series of expected cash flows at a discount 12 rate which reflects those expected cash flows; what the 13 analyst is doing in that case is having an optimistic 14 scenario. It is projecting, say, the success scenarios, 15 but saying, "I think the probability is that success is 16 low, but I am going to discount that success scenario with 17 this very high discount rate". 18 19 I am saying that what you are observing this analyst 20 do in practice is they are coming up with a technique in a 21 fairly crude manner to discount an optimistic case at a 22 high discount rate. If the analyst thought that through 23 and thought about on average what sort of capital is one 24 projecting for this business, and then discount those 25 expected cash flows at an appropriate discount rate, which 26 only reflected systematic risk, they would come to the same 27 conclusion. 28 29 Your question is: do we only consider systematic 30 risks in the discount rate? Analysts consider 31 company-specific risks when they are doing their valuation. 32 Some of those analysts that you will talk to will 33 incorporate some of those company-specific risks into a 34 discount rate, but all they are doing there is having a 35 quick and dirty technique for factoring in a high rate of 36 return, discounting an optimistic scenario at a high 37 discount rate. 38 39 What we said in our report is that we can have an 40 expected or required cost of equity capital which only 41 looks at systematic risks, but if there are 42 company-specific risks which are asymmetric in nature, they 43 have more downside risk. People should think about what is 44 the expected cash flow which takes into account this risk, 45 and regulator's prices should reflect those expected cash 46 flows. 47 .22/8/11 38 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Does that make sense? 2 3 MS CHADWICK: Yes, it does. Just to follow up on the last 4 element of that, if the non-systemic risks are to be put in 5 the cash flow, am I correct in assuming from your 6 statements that you should only include the cash flows 7 where those risks are asymmetric, they can't be recovered 8 from a third party? 9 10 MR HALL: Whether they can be recovered from a third party 11 or not is a different issue to whether they are asymmetric. 12 I think the best way to think about it is to think about 13 what scenarios are going to cause this risk to occur, and 14 think about the ultimate cash flows which the entity is 15 going to receive as a result of those cash flows. 16 17 Say there is some cash flow event - say there is an 18 explosion or say the chemical composition of the water is 19 terrible so the water is polluted, or some disastrous 20 event - then you would say, "Given this event, what 21 recovery do we have from the contractor? What recovery do 22 we have from an insurance payout?" And you would think 23 about what are the ultimate cash flows that Sydney 24 Desalination Plant would bear as a result of this exposure. 25 26 If those risks are indeed asymmetric, then we should 27 think about what is the probability of those events, the 28 cash flows which will result in that event, and think about 29 can we set some sort of price which truly reflects what the 30 average cash flows would be from these possible outcomes. 31 32 MS CHADWICK: Thank you. 33 34 MR GROOM: Jason, it is Eric Groom here now. I have a 35 couple of questions. 36 37 Firstly, continuing along the theme of beta, in his 38 comments Professor Kevin Davis suggested that the 39 adjustment to the beta estimate may not be relevant in this 40 case. 41 42 I think his argument goes along the following lines: the 43 adjustment you make assumes that nothing is known about 44 the stocks generating an a priori assumption of a beta 45 of 1. But in this case, arguably, we know that the stock 46 is coming from the utility sector which tends to have betas 47 systematically below 1. Then I think his argument follows .22/8/11 39 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 that perhaps the adjustment is not required. Would you 2 like to comment upon that? 3 4 MR HALL: Yes. My comment is that we don't know. 5 The only reason that you would know that the value estimate 6 for utilities is below 1, is because people have previously 7 run an ordinary least squares regression on stock returns 8 and market returns. 9 10 You have to think, "Well, before I analysed the 11 association between stock returns and market returns, what 12 do I know about the systemic risk of this stock?" 13 14 There is a section in our report where we have 15 included, in response to those comments, we say it is 16 reasonable to argue that, for this water utility, we know 17 that its operating risk is going to be below that of a 18 typical business. The volatility of cash flows in 19 association with market conditions is going to be less than 20 for another given company. We also know that its leverage 21 is going to be above that of a typical company. 22 23 We don't know just how much that leverage has moved 24 the equity beta up from that low base in comparison to that 25 of a typical firm with 1. Prior to analysing the 26 association of stock return to market returns, we do not 27 have information which suggests that the risk is going to 28 be different from a different stock which has a beta of 1. 29 The only reason that someone would say that is because they 30 had previously analysed the relationship between historical 31 risk stock returns and market returns. 32 33 When we perform our ordinary least squares regression 34 analysis of this, and we use all available information from 35 these comparable returns, if we are going to have a prior 36 expectation which is different from 1, there would have to 37 be some quantification on a basis which is not drawn from 38 that risk return analysis. If we have that information, we 39 would use it. 40 41 MR GROOM: Moving to another aspect of your beta analysis, 42 which concerns the differentiation between up market and 43 down market periods. Firstly, this seems to be a relatively 44 new innovation in the analysis, or a new development, so to 45 speak. 46 47 In discussion, you have suggested an intuitive .22/8/11 40 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 explanation in terms of inflexibility for costs 2 relative to revenues - that is, there was greater 3 inflexibility downward in costs relative to revenues than 4 upwards. 5 6 Applying that analysis to SDP correctly, we seem to 7 have to go to the contractual position of SDP and the 8 regulatory environment which is required to be established, 9 which seems to closely match revenues to costs through the 10 business cycle. 11 12 In that context, is there another intuitive 13 explanation for that apparent difference between upmarket 14 and downmarket periods that could be applied to SDP, noting 15 that in fact you do mention in your paper that the beta 16 arises not just from operational risks and revenue cost 17 risks, but also financial risks? 18 19 MR HALL: Yes. There are two things to think about. 20 I'll just go back to my chart here. 21 22 If we look at the blue line, that measures our 23 constant exposure of stock returns to market returns in 24 rising and falling markets, and the red line illustrates or 25 is asymmetric to the market movements. What this says is 26 that with the typical water utility, their stock return has 27 more exposure to the market when the market has fallen, and 28 they also have less exposure to market returns when the 29 market is rising, at the very point when the investor would 30 like exposure to market returns. 31 32 The preferred pay-off for an equity investor would be, 33 if you follow my hand here, to have a market neutral 34 exposure rated at zero in the falling market, and very 35 steep exposure to market return through a rising market. 36 That is an option for a pay-off structure. That would be 37 ideal for the equity investor. We haven't imposed a 38 non-lineal relationship between stock return and market 39 return. That simply is the line through the data, where we 40 have this check point as the point where market return 41 equals the risk. 42 43 What we go through in our paper is, if there are 44 theories or reasons why we observe this particular stock as 45 to the asymmetric exposure, we say one of those reasons, 46 and it has been put in the literature, is that none of 47 these assets, which are very capital intensive, are able to .22/8/11 41 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 disinvest during an economic downturn. An example would 2 be through a capital intensive firm, a factory, in an economic 3 downturn, you can't reduce your asset base. You are 4 basically amortising the same fixed costs over a smaller 5 amount of volume, so you are finding it difficult to 6 recover your cost to capital. On the other hand, if you 7 are running a services business where you have a lot of 8 investment in human capital, it is easy to reduce that 9 capital, but people end up out of work. 10 11 That is why information has been put forward in the 12 literature for this asymmetric exposure. It is not 13 necessarily the estimate or the reason why we have this 14 asymmetric exposure. It just happens to be that, in the 15 data we observed an association between market return and 16 stock return during rising and falling markets. 17 18 Another reason that we have a beta estimate which is 19 substantially above zero, which Eric pointed out, is that 20 beta estimates are not driven purely by cash flow exposure; 21 they are driven by change in investor's required return in 22 different market conditions. 23 24 Say, for example, we have a very volatile equity 25 market at the moment, and you have share prices falling, 26 and the reason share prices are falling right now is 27 because investors are very concerned about what future cash 28 flows are going to be, and they factor in their required 29 rate of return. They also factor in additional volatility. 30 Right now, you can say that investors' required returns of 31 their equity risk are increasing because they are expecting 32 volatility to increase in the future. When an investor's 33 required return goes up, asset prices will fall. 34 35 Even if you have assets which have very low cash flow 36 exposure to changing market conditions, if they have 37 exposure to fluctuations in investors' required returns, 38 you are still going to have prices falling. 39 40 We have another reference in that paper to one of 41 Kevin's papers where he shows that even government bonds 42 have significantly positive beta estimates, even though, 43 for all intents and purposes, Australian government bonds 44 are default free. 45 46 That could be one reason why we also observe this 47 asymmetric risk exposure for assets which are more capital .22/8/11 42 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 intensive, because they also have a more annuity-like cash 2 flow stream. They have less variation and cash flows in 3 accordance with market prices. 4 5 We don't know why we observe this asymmetric exposure 6 leads to volatility. We don't know exactly why we observe 7 this asymmetric exposure for other firms in a market place 8 which has high tangible assets in their asset base. What 9 we observe is that this asymmetric exposure was very much 10 line the sort of asymmetric exposure we observed for the 11 broader part of what we call value stocks in the 12 marketplace, which has been referred to elsewhere in the 13 literature. 14 15 While we say there's volatility in the desalination 16 plant, it's not going to necessarily be the case that this 17 investment problem is going to be the cause of this 18 asymmetric exposure. If we are going to use returns from 19 listed water utilities to somehow paint up our equity basis 20 in the desalination plant, what we are saying is that we 21 should properly account for this asymmetric exposure in our 22 analysis. 23 24 If you go through the report in sort of a rationale 25 way thinking about this, we have to either think whether 26 this returns analysis does or does not provide a reasonable 27 basis for estimating systematic risk exposure. If we think 28 about whether this series of historical stock and market 29 returns does reflect the systematic risk of a relative 30 water utility, whether this sample reflects in the 31 population an outcome of what we should expect, then we 32 should place weight on the relationship in that data. 33 34 If we say that, "Well, we are not going to believe 35 what the data tells us about asymmetric risk exposure", and 36 there is reason to believe that the data shouldn't be 37 relied upon entirely to start with, well, we shouldn't 38 really think about the constant risk exposure either. 39 I don't think we should look at data and try to then say, 40 "Well, I want to look at part of that data, and not look at 41 all the relationships present in that data". 42 43 We don't know exactly why this asymmetric exposure is 44 present in this sample data here, but we do know that it's 45 not inconsistent with the asymmetric exposure which is 46 observed in other industries with tangible assets. 47 .22/8/11 43 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 MR GROOM: If I could turn to the issue of leverage, you 2 have presented us with two options, in a sense: a BBB+ and 3 70 per cent leverage; or A- and 60 per cent leverage. In 4 discussing that, you referenced a median credit rating for 5 all businesses in Australia, which I think you suggested 6 was BB. 7 8 However, AER and ourselves have put forward in the 9 past evidence that suggests that the median credit rating 10 for a utility business is somewhat higher. I think the AER 11 suggested A- and that was consistent with our data. If we 12 were to have regard to the median credit rating, should we 13 have regard to that for businesses in general or for 14 utility businesses? 15 16 MR HALL: I think, first of all, we didn't mention BBB+, 17 we said BBB was 60 per cent, but that doesn't really 18 matter. 19 20 I think you have to think about what you said in 21 context. When we are saying let's look at this 22 distribution of historical credit ratings, you are correct 23 that for utilities you observe credit ratings which are 24 higher than those observed in the industry, but you also 25 observe far less. What we are saying is that we just don't 26 observe a fairly high proportion of credit ratings which 27 are above A-. 28 29 In thinking about what credit rating is appropriate, 30 and given that there is a fair degree of imprecision with 31 what credit rating would be appropriate for any of the 32 business, and that we are not conducting the same sort of 33 detailed analysis which is conducted by a rating agency, if 34 we observe that the mass of credit ratings for all rated 35 entities is within this range of A- down to BBB-, we are 36 saying we are reluctant to go outside of that range. 37 38 So while you might observe the typical credit rating 39 for a utility would be, say, BBB + to A-, and I'm happy to 40 concede that will be true, you are not going to observe 41 very many of those utilities with credit ratings which are 42 above A-. And given that we don't observe credit ratings 43 above that level very often, it is very difficult to say 44 that the credit ratings of A- would be appropriate in this 45 particular case. 46 47 MR GROOM: If I could turn to the consistency argument, .22/8/11 44 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 which again is a very important part of your paper. In 2 discussion you mentioned equating expected return to debt 3 and expected return to equity under a normal business case, 4 in which case you suggested the yield to maturity for the 5 debt was a relevant expected return to debt. 6 7 We have observed, not necessarily in Australia, but 8 overseas, that regulated firms can fail and regulation does 9 not rule out business failure. There is a suggestion from 10 Professor Kevin Davis that the relevant expected return to 11 debt is the comparator - that is, an adjustment to the 12 yield to allow for possible default. Does that suggestion 13 still have weight? 14 15 MR HALL: No, I don't think so. 16 17 I think you have got to think through three stages. 18 There is the case where the firm's volumes of revenues turn 19 out exactly as projected in an ordinary case. The Sydney 20 Desalination Plant has submitted estimates of volumes and 21 the regulator is going to use those estimates of volume and 22 costs to come up with the regulated pricings, and hope 23 things turn out exactly as hoped in a normal business case. 24 25 In that normal business case, which is going to 26 comprise the vast majority of outcomes, essentially 27 outcomes, or summarise the majority of outcomes for a 28 businesses, if you were to reject that normal business case 29 and go to equity investors and ask them for capital, it 30 would be very unlikely that you would observe them handing 31 capital to the business because, on average, because of the 32 risk of default, they are going to earn higher returns than 33 debt holders. 34 35 So you can contrive scenarios in which the return to 36 equity holders is, say, 7 per cent in the normal business 37 case and the return to the debt holders is 7.5 per cent, 38 and in the default case, the return to equity holders, 39 well, they lose their share and return to debt holders 40 might be minus 50 per cent. But if you contrive that case, 41 you also have to come up with a third case, and that third 42 case is where the return to equity holders exceeds the 43 return to debt holders. 44 45 Given that, we don't have information which typically 46 is going to be used to contrive that third case for the 47 equity holders to do particularly well. It is difficult to .22/8/11 45 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 justify coming up with a regulated rate of return which 2 sees the equity holders earning less than the debt holders 3 in a normal business case. 4 5 I think the firms are actually going to market with 6 the capital. In a normal business case they have to show 7 the equity holders that they are going to return above 8 yield to maturity on debt, and show the equity holders 9 that, on average, they are going get a return which is 10 higher than that available to the debt holders. 11 12 It is difficult to sell equity to those equity 13 investors on the basis that "I know that in a normal 14 circumstance you are going to do worse than the debt 15 holders, but there is this really good outcome where you do 16 so much better, and that, on average, you do better than 17 debt holders." 18 19 I think in that normal circumstance, you would see 20 those people to prefer to take on debt. 21 22 MR GROOM: If we were talking about a more typical 23 regulated business under incentive regulation that gave you 24 the opportunity to earn a higher than expected return 25 during the regulatory period, based on better control of 26 their own costs, would that not provide the offsetting blue 27 sky option of a higher than normal return? 28 29 MR HALL: Theoretically, that could be the case, but 30 I think if you were to set a regulated return to equity 31 holders on the basis of that blue sky option, there would 32 have to be some quantification of what that blue sky option 33 is. 34 35 To argue that equity holders aren't going to be happy 36 with 7.5 per cent in the normal business case because they 37 could do really well later, I think someone would have to 38 actually compute how they are going to do better down the 39 track; how are they going to earn a return which is above 40 yield to maturity on debt in this optimistic business case 41 and, therefore, actually earn their return of 7.5 per cent 42 which exceeds the expected return to the debt holders. 43 44 What we have in front of us in setting regulated 45 prices is typically the normal business case, or I think 46 the words we use in our report is the "solvent going 47 concern scenario", and we have the estimates of the .22/8/11 46 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 probability of default and recovery rates in the event of 2 default, but we typically don't observe a regulator 3 considering the very good case in which it justified the 4 return to equity holders which, in a normal case, is below 5 the yield to maturity on debt. 6 7 MR GROOM: Thank you. I will hand the floor back to Jim. 8 9 THE ACTING CHAIRMAN: Are there further questions from 10 the secretary? No. 11 12 Now is a chance for people sitting in the back of the 13 room to ask a question. Can you please come to the lectern 14 so Jason can hear you and introduce yourself. 15 16 MR ALLEN: Jason, it is David Allen here. 17 18 Water utilities in Australia always have the function 19 of providing utility for the people of Australia, and they 20 always had a AAA rating. Now, as you say, they have got a 21 lower rating and there is quite a lot of risk associated 22 with it and the main function now is to provide return to 23 the shareholders. If we just look at one or two risks; we 24 might have a very wet decade or two wet decades, or maybe 25 Australians have got a trillion dollars worth of debt on 26 their credit card and can't pay it. What sort of fallback 27 arrangements have you got with the New South Wales 28 government if your company ceases to become viable? 29 30 MR HALL: Is that a question for me? 31 32 MR ALLEN: Yes. What fallback arrangement have you got 33 with the New South Wales government if your company 34 ceases to be viable? 35 36 THE ACTING CHAIRMAN: Jason is a consultant to us, to 37 IPART, on the issues to do with WACC. He is not working 38 for SDP, so he can speak for SDP. He can speak on general 39 principles, perhaps. 40 41 MR HALL: I note the question, but it's not my risk of the 42 company. I don't know what happens if SDP are not viable. 43 44 MR ALLEN: Does anybody know? 45 46 MR RAMSEY: It is a risk that the shareholders would 47 carry, until such time as they could convince the .22/8/11 47 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 regulator, subsequent to a revised determination, that they 2 need to be recompensed at a higher level. 3 4 MR WILSON: My understanding of the regulatory task is 5 that when IPART sets the WACC, it tries to look at 6 benchmark firms, not Sydney Water, nor SDP, but what would 7 a normal firm in the market be looking for as a return. 8 9 THE ACTING CHAIRMAN: I guess what we do is we set a 10 regulated price so that the regulated entity can earn a 11 commercial rate of return on its efficient costs. I guess 12 the risk, if it performs less well, is a risk that is borne 13 ultimately by the shareholders until such time as a revised 14 determination is made. 15 16 MR ALLEN: My second and last question is about the asset 17 itself, which is metropolitan water, and metropolitan water 18 is worthless unless we spend enormous amounts, billions of 19 dollars, of money on it, whereas water from rural 20 Australia, into which our cattle defecate, is worth 21 billions of dollars. 22 23 I just wondered how much the company has paid for the 24 asset, and I wondered if anybody on the panel can say 25 something about the ethics of this whole process, which 26 seems to be rather dubious - the ethics and the logic all 27 seem to be rather dubious to me. 28 29 THE ACTING CHAIRMAN: Perhaps I can have a go at some 30 of that. 31 32 Obviously, we are dealing with a valuable commodity, 33 which is a commodity - water. Water does have important 34 alternative uses, including from environmental flows in the 35 course of the Nepean and that is obviously part of the 36 government's policy in thinking about water. So, I think 37 it is recognised that water is a valuable commodity. 38 39 What I think governments have chosen to do with the 40 desalination plant is to wish to have a source of water 41 that is not dependent on rainfall, and that is the decision 42 I think taken by Mr Iemma's government, and it was taken to 43 an election. That is the process that is gone through 44 here. 45 46 I think where we are now at is a desire to set the 47 prices for the Sydney Desalination Plant in a more .22/8/11 48 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 transparent way than has been done in the past, so people 2 will know what are the costs exactly and why are they 3 incurred and why are they the efficient costs. That is 4 where I think we are at now. Obviously, I think the 5 government wishes to consider various leasing options for 6 the Sydney Desalination Plant. That is their prerogative. 7 8 MR ALLEN: How often will we see the cash flow statements 9 from this company running this? That is really my last 10 question. 11 12 THE ACTING CHAIRMAN: That probably is an issue for us 13 to think about in making our determination. 14 15 For other businesses that we regulate, we do publish 16 information on their prices and services and their 17 financial positions, and I would imagine we will do the 18 same for the desalination plant. 19 20 MR RAMSEY: As a Corporations Act company, our 21 corporation is required to publish annual financial statements, 22 including cash flow statements. 23 24 THE ACTING CHAIRMAN: Are there further questions? 25 26 MR SCOTT: Hi, Jason. Mr Scott from QIC here. 27 28 I want to ask a slightly theoretical question about 29 betas. In particular, how do you see the estimates of beta 30 being influenced by regulatory decisions. Put another way, 31 where do regulatory decisions sit in the spectrum of 32 specific risk versus market risk? 33 34 MR HALL: Are you asking what regulators consider? 35 36 MR SCOTT: I guess I was asking what effect do the 37 decisions of regulators have on the betas of the companies 38 that they regulate. All the companies are regulated. I'm 39 curious as to where you see regulated risk on that 40 systematic risk spectrum. 41 42 MR HALL: Certainly those regulatory regimes are going to 43 affect the returns on those companies and, therefore, there 44 is going to be a feedback to the estimate of equity beta. 45 46 When, say, a regulator in the UK comes up with a 47 series of regulated prices which are, say, positive news .22/8/11 49 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 for the company, or bad news, there is going to be stock 2 returns in that particular month which reflect those 3 regulatory decisions. 4 5 That is going to influence the relationship during 6 that time period between stock returns and market returns. 7 All we can hope for is that, in the sample of data, there 8 is going to be good news and bad news for those regulated 9 entities which are coming out at random times and, 10 therefore, don't affect the estimates of equity beta which 11 are derived from that sample. 12 13 This is a problem affecting beta estimates not just 14 for regulated entities, but any industry in which you don't 15 have a long enough sample period. If you think 16 specifically about the issue of regulation and whether that 17 is going to either dampen or inflate the equity beta 18 estimate for those regulated entities, that is going to be 19 something which is jurisdiction-specific. 20 21 For example, if regulators have a regime where they 22 set a particular price for a five-year period, and that 23 price per unit is unchanged, there is no recovery of 24 unexpected costs, there is sort of a fixed and a variable 25 cost component to the regulation, those price-fixing, for 26 want of a better term, regulatory regimes are going to 27 expose the companies to more systematic risks than other 28 regulatory regimes because, for that five-year period, 29 their cash flows are going to be influenced to a large 30 degree by how their volumes move with market movements, 31 and that is also going to be influenced by what sort of 32 industry they are in. 33 34 For a business supplying drinking water, it is going 35 to have volume risks which are substantially lower than a 36 business supplying energy, where the volume-related risk is 37 going to be substantially higher. 38 39 I can't answer the question, though, as to whether 40 there is particular bias in beta estimates for regulated 41 entities above or below what you would expect to see in the 42 absence of regulations for those entities. All I have 43 given you is a statement saying that there are going to be 44 things specific to different jurisdictions which could 45 influence the equity beta estimate up or down to what you 46 would observe in the absence of regulation, and there are 47 going to be shocks to stock return as a result of .22/8/11 50 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 regulatory decisions which, in a particular time period, 2 would influence equity betas up or down, depending on 3 whether those shocks come at a time when the market is 4 rising or falling. 5 6 Last week we had an adverse market event. If there 7 was positive news for a regulated entity during that 8 particular week, you would have dampened the equity beta 9 estimates if you didn't have a sufficiently long period of 10 time, but I don't know whether the process of regulation on 11 average is going to inflate or dampen the beta estimate, 12 where there is a bias in the numbers. All I can say is 13 that it will create a degree of uncertainty which you have 14 to think about if you have a fairly small period. 15 16 MR SCOTT: I think there were two issues there. One point 17 was about beta estimates and the estimation process, how 18 being regulated might affect the estimation process. 19 20 There was a comment you made near the middle of your 21 answer which I think went to the heart of what I was 22 asking, which was that the regulator's decisions to 23 allocate risk could create a situation for the company that 24 justified a higher or a lower beta than comparables, 25 depending on how the comparables' regulators had allocated 26 the risks. 27 28 Does that summarise part of your answer? 29 30 MR HALL: Yes, I think that is true. The precision with 31 which you can factor in that particular regulatory 32 influence is limited. The equity beta estimates in general 33 are very emphasised, and to go into the nuances of one 34 regulator has one particular process, another regulator has 35 another process, you really should be reluctant to shift 36 the equity beta estimate too far to one extreme or the 37 other, because for most of those sort of considerations 38 people only consider them on a qualitative ground. 39 40 It is very difficult to quantify exactly whether that 41 means you should shift your equity beta estimate from 0.8 42 to 0.85 or 0.9, given the high imprecision of the equity 43 beta estimate. 44 45 I think that would mean we are trying to say what do 46 we observe in the marketplace, how do we think about risk 47 exposure on a relative basis, and we think about Sydney .22/8/11 51 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 Desalination Plant relative to the comparable firms and 2 other water utilities in New South Wales, and we think 3 about the broader market. Basically we try to apply some 4 sort of reasonableness to these estimates, such that they 5 are not unduly inferenced by the qualitative arguments 6 which are difficult to really put numbers around. 7 8 THE ACTING CHAIRMAN: Thank you. I think the ultimate 9 thing to think about is whether the risk is systematic or 10 not. I think that is highly relevant. 11 12 MR SCOTT: My next question relates to qualitative versus 13 quantitative factors. In your discussion on credit 14 ratings, I think your analysis has largely focused on 15 analysis of financial ratios. 16 17 Do you have a feeling for the extent to which credit 18 rating agencies weight those financial outcomes, financial 19 ratios, versus qualitative judgments when arriving at their 20 credit ratings? 21 22 MR HALL: Yes. What we know, on average, is that credit 23 ratings issued by rating agencies can be largely replicated 24 by a quantitative analysis. There have been a whole host 25 of studies done in the 1980s where researchers basically 26 observe credit ratings, they observe the financial listed 27 companies which have those particular ratings, and back out 28 an equation of what sort of weight the credit rating 29 agencies are placing on different credit ratings. 30 31 They apply those estimated weights in a sample test to 32 predict what ratings would be issued by those rating 33 agencies, given these weights placed on interest coverage 34 and leverage and cash flow coverage. Basically, the 35 quantitative sample analysis works pretty well. You can 36 basically predict around about three quarters of credit 37 ratings within one-notch either side of that rating just by 38 purely a quantitative analysis. 39 40 The credit rating agencies do, in an individual case, 41 go into a great deal of company-specific analysis, so they 42 think about industry risks and they think about management 43 quality. They do a lot of company-specific analysis. It 44 is not clear, though, just how much additional value was 45 obtained by the company-specific analysis relative to the 46 quantitative analysis which you can do with those financial 47 ratios. But that's an average result. .22/8/11 52 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 For an individual case, they will go into a great deal 3 of company-specific analysis and they will apply 4 qualitative judgment about industry conditions and about 5 management's ability to respond to changes in those 6 industry conditions. So they will apply better credit 7 ratings if they had confidence in management about the 8 integrity of what management is telling them about their 9 prospects, and about their ability to change tacks if 10 industry conditions worsen and their ability to raise new 11 finance in the event of those adverse events. 12 13 I am now coming to the Sydney Desalination Plant 14 itself. The rating agencies are going to consider a bunch 15 of company-specific factors which, on the one hand, are not 16 relevant to our analysis and that, in particular, is the 17 government ownership of the analysis, but on another level 18 they are going to company company-specific assets in a 19 qualitative sense which we cannot directly observe. We are 20 not going to form a judgment about the management's ability 21 to respond to an adverse event; we are simply going to say 22 there is this possibility that you are going to have shocks 23 to the business which could cause a default. 24 25 So the way we quantify this is by basically saying if 26 there was a shock to operating costs at a given level, what 27 would that mean about the risk that in any particular year, 28 EBIT would fall below interest, or free cash flow would 29 fall below interest, and not try to apply a judgment to 30 what is management's ability to respond to those shocks, 31 because we are not qualified to make that judgment. 32 33 MR SCOTT: Thank you. That is a very full answer to my 34 question. I have one more hopefully brief question. 35 36 Do you have a feel for what the range of credit 37 ratings is in the sample of companies that you used to 38 estimate the beta? 39 40 MR HALL: Less than half of them actually had a credit 41 rating. Of the ones that did have a credit rating, there 42 were maybe four which had an A-. There was maybe one 43 with a BB+. They were better than the typical distribution 44 which you can see on my screen here, but we didn't analyse 45 those credit ratings. We only had current ratings for 46 those firms and we have not correlated those ratings with 47 financial ratios for those companies. .22/8/11 53 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 2 MR SCOTT: That is fine, thank you. 3 4 MR HALL: Between six and eight out of the 16 would have 5 had a credit rating. 6 7 THE ACTING CHAIRMAN: Thank you for your questions. 8 9 MR HALL: Also, I should say, in addition to that, those 10 credit ratings of those businesses also reflect the 11 regulation and government ownership characteristics of the 12 particular business. So some of them will have some degree 13 of government ownership, and some won't, and they will be 14 influenced by the implicit government support for those 15 regimes. 16 17 You can't directly match the credit rating of those 18 water utilities on to the credit ratings for the 19 Sydney Desalination Plant, because we can't directly 20 observe just how much weight is placed on any implicit 21 government guarantees. 22 23 THE ACTING CHAIRMAN: Thank you, that was very 24 helpful. Are there further questions? 25 26 MR CAMPBELL: My name is David Campbell, and I am with 27 the firm Acil Tasman Pty Ltd. 28 29 I am interested more in your reaction to a way of 30 looking at this problem and seeing where it fits. 31 I haven't had the benefit of reading through your paper, 32 but there are obviously a fair few comparisons based on 33 looking at other utilities and the like, and you have 34 talked about other New South Wales water utilities. 35 36 A very brief history is that this desalination plant 37 that stands emerged out of a risk management strategy in 38 the depths of a drought that looked likely to be and ended 39 up being worse than we'd seen before, but that the approach 40 taken to bringing it in was essentially one of seeing the 41 desalination strategy as a real options position in the 42 context of the whole of the system integrity, and that the 43 desal plant and the capability to build the plant and to 44 upgrade the plant and to operate the plant embodied options 45 to deliver insurance to the system as a whole. 46 47 I just observe that it seems to me that such a .22/8/11 54 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 business looked at on its own doesn't look a lot like a 2 water utility that has a dominant position in running a 3 portfolio of assets delivering water. Its primary product 4 is insurance. It happens that you tend to run a small-ish 5 desal plant fairly hard in order to limit the risks of 6 having to upgrade that plant. You are buying insurance 7 against the need to trigger an upgrade, as opposed to being 8 primarily a supplier of water. 9 10 I am just interested, in that context, in two issues: 11 One, in a sense, the appropriateness of an asset pricing 12 approach to the whole problem relative to a real options 13 approach to the position you might take; but, secondly, the 14 relevance of that sort of a business - does it look like 15 another water utility in New South Wales or is it in some 16 sense more fundamentally different that might have some 17 implications for the analysis and the interpretation, 18 specially how you relate it to something like a 0.9 beta 19 that you might have seen emerging in relation to near 20 monopoly water businesses in the past, versus a supplier of 21 not water, but water security services to a wider 22 portfolio? 23 24 MR HALL: I think your point is well taken, that the 25 business is different to your monopoly water business, but 26 I think it's a question which is a more broader regulatory 27 question for those sort of businesses. You could apply the 28 same sort of analysis to a gas plant, and electricity. 29 30 I don't think that we can consider that in the context 31 of the work that we've done. We are working within a 32 framework where the regulated price is going to reflect the 33 regulator's asset base, and charges and a fixed and 34 variable pricing structure is going to reflect a return on 35 that asset base. 36 37 You are suggesting that maybe a building block 38 approach to setting a regulated price in this instance may 39 not necessarily be appropriate, because this is basically a 40 very large investment in ensuring the supply of water for 41 Sydney. I think it is well outside the scope of 42 determining our beta estimate. I think it means that if 43 you were to consider this business in a fundamentally 44 different way, you wouldn't start with the regulated asset 45 base and try to determine what sort of price is appropriate 46 for a return on capital on a regulated asset basis; you 47 would start with the scenario that says 'What is the .22/8/11 55 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 probability that this asset is going to be called upon to 2 produce a large amount of water', or what is the profile or 3 what are going to be the triggers to determine whether you 4 run it hard, or whether you have to, as you say, upgrade in 5 another particular circumstance. 6 7 That sort of approach is where you consider it a 8 reprieve, where you say here is the stage we are at now, 9 and here is branching out into the future, up and down 10 movements of events which could trigger different outcomes 11 for this plant. 12 13 One event is that we have another terrible drought in 14 which this plant eventually has to be upgraded to secure 15 the safety of the water supply. At the other extreme, 16 there are a series of tremendous rainfall years which means 17 the plant is mothballed for 15 years, and within that you 18 have a series of intermediate points in which it may be 19 called upon for an upgrade, it may operate at medium-term 20 capacity or it may be mothballed for some period of time. 21 22 What you could do with all of these potential outcomes 23 is say what would be the capital of acquiring those 24 outcomes, and what would be the subsequent cash flows, and 25 does the upside or the downside generate a return which is 26 sufficient to have the owner of these business earn their 27 return on capital. That is a fundamental difference and 28 considerably a more complex approach than has been 29 considered in the regulation of this water business in this 30 particular case. 31 32 That is a long way of saying that you can't really 33 think about how you would consider this real options 34 approach to an estimate of equity beta. What you can do is 35 consider a real options approach to the whole framework of 36 the regulator's price, and that may in turn influence a 37 return which is appropriate, given that real options 38 framework. I don't think you can just say, "Well, it 39 should influence the equity beta or the credit rating on 40 the leverage to a particular degree". 41 42 I can use an analogy where we were involved with 43 assisting IPART in setting regulated tariffs or retail of 44 electricity and gas usage and we considered a building 45 block approach as part of our analysis in that particular 46 context. That was a context where a building block 47 approach was applied, a different framework applied, for .22/8/11 56 Sydney Desalination Plant Transcript produced by Merrill Corporation

1 setting regulated tariffs which considered different volume 2 outcomes in association with different market conditions. 3 4 The same could be applied in the case of the Sydney 5 Desalination Plant, but it is considerably a more complex 6 analysis than what has been undertaken in the building 7 block approach here. Certainly it is outside the scope of 8 what we have negotiated. 9 10 It's a terrible answer, I know, because it is going to 11 sound like a weak answer, that it is outside of our scope, 12 but hopefully I have outlined what the framework would be 13 if you were to consider that real options approach to 14 regulate that asset. 15 16 THE ACTING CHAIRMAN: Are there further questions? 17 No. We will let Jason go. Thank you very much for being 18 prepared to help us by getting at up some unearthly hour in 19 the morning. We are grateful for that. 20 21 We will now bring this session to an end. I think the 22 point to emphasise here is that we are working really very 23 hard to reach our decision, as we are required to do, by 24 6 November. We are very interested in further written 25 comments from you. Those have to be made by 31 August. 26 If we get any later than that, we will not be in a position 27 to consider them. Please do provide us with further input, 28 but you will need to do that by 31 August. 29 30 Thank you very much for your attendance and 31 participation. 32 33 AT 12.35PM THE HEARING WAS ADJOURNED ACCORDINGLY 34 35 36 37 38 39 40 41 42 43 44 45 46 47 .22/8/11 57 Sydney Desalination Plant Transcript produced by Merrill Corporation