1.1 This report was commissioned by the South Canterbury Power Trust (“the Trust”) from McKinlay Douglas Limited (“MDL”) to assist trustees identify and assess options for the future role and operations of the Trust in relation to Alpine Energy Limited (“Alpine”), to its fellow shareholders, and to the South Canterbury community both as trust beneficiaries and as electricity consumers. The report is in the nature of a scoping report reviewing a wide range of options as a first step to identifying those which trustees consider should be priorities for the Trust, Alpine and its fellow shareholders in the context of the changes triggered by the Electricity Industry Reform Act 1998.

1.2 The report’s primary emphasis is on the changes taking place in the electricity industry. However, it also looks briefly at the likely direction of change in related infrastructure, especially water and wastewater, and what that might imply both for the Trust’s fellow shareholders in Alpine (in their role as local authorities) and for the Trust’s role on behalf of the community it serves.

2.0 Guiding Assumptions Top

2.1 This report has been prepared on the assumption that trustees are seeking that set of arrangements which will best meet the interests of the South Canterbury community taking account of recent and expected legislative and structural changes within the electricity industry.

2.2 Implementing that set of arrangements may require changes to the trust deed either through the mechanisms included in the deed itself (resolution of not less than four trustees supported by 75% majority on a postal vote of consumers), by application to the high court or by legislation. Essentially, trustees are asserting that, provided there is community support for any particular set of arrangements, then the existing wording of the trust deed should not in itself be seen as an obstacle to adopting that set of arrangements so long as there is a lawful means available to the trust for securing the necessary powers.

3.0 Approach: Outline of Paper Top

3.1 The paper begins with an overview of the reforms encompassed by the Electricity Industry Reform Act 1998 and of the industry response. It includes brief discussion/assessment of the Government’s price control proposals and an analysis of the impact of the reforms on consumers, with particular reference to low income/disadvantaged consumers. This section concludes with a look at the process of change in related areas especially water and wastewater.

3.2 The next section provides an overview of the establishment plan/joint venture model in order to draw out the implications of the “base case” of distribution strictly accordance with the terms of the trust deed with the shareholders’ agreement and company constitution remaining unchanged. The purpose of this is to identify for trustees the likely impact of “base case” distribution as a benchmark against which to compare other options.

3.3 The report then considers issues from a company prospective. It starts with a discussion of directors’ responsibilities, makes brief reference to the incentives typically facing a Chief Executive (to grow the business rather than manage a static endeavour) and then reviews three possible opportunities: status quo, downsizing and diversification. This section concludes with a discussion of balance sheet structure highlighting the increasing emphasis now placed by the commercial sector on the importance of companies maintaining an optimal mix of debt and equity both as a means of maximising the return to shareholders on their investment and as a tool for imposing appropriate disciplines on board and management.

3.4 The next section looks at future options from the perspective of the Timaru District Council. As for the section dealing with Alpine, it is somewhat speculative as MDL has no direct knowledge of the policies or intentions of the board of Alpine or of the Council (we are assuming, that for all practical purposes, the policies and intentions of the Council will shape the decisions taken by Timaru District Holdings Limited as the actual shareholder in Alpine).

3.5 We begin with a review of background documentation as the publicly available statements of council policy. We then discuss the nature of the Council’s shareholding as an “investment” in terms of the Local Government Act and go on to assess the range of possibilities from simple retention to selling or realising part of the investment under a number of different scenarios. Much of the material in this discussion is also directly relevant to the options for the Trust which are looked at in the succeeding section.

3.6 Trust options are considered under two separate heads: distribution and retention. The distribution option is considered first on the basis that there is no change to the shareholders’ agreement or the company’s constitution (essentially the “base case” discussed in section 5) and then on the assumption that changes are sought to deal with (a) the administrative complexity which would result if distribution took place without any change to the shareholders’ agreement or the constitution and (b) with the purpose of entrenching rules regarding shareholding and/or management of the company.

3.7 Under retention we consider the three options of long-term status quo (which would require amending the trust deed as recommended by Simpson Grierson to prolong the life of the trust), sole or majority ownership of Alpine (which would involve the sale or downsizing of the Council’s investment - this discussion assumes the reader will already have considered the material on council options) and finally the long-term possibility of the trust becoming the community owner of infrastructure assets. This is a possibly which could result if the Trust, Council (and possibly the Waimate and Mackenzie councils) and the South Canterbury community took the view that there was merit in the Trust specialising in infrastructure ownership from a community perspective.

3.8 Finally, the substantive part of the report concludes with a discussion of the question of entitlement to income and capital noting that the present arrangements appear to reflect industry rather than community views at the time of establishment of the company and that, with the changes since that time, it maybe appropriate to revisit community views on how the benefits of the trust ownership of Alpine (or the wealth represented by that ownership) should be distributed.

4.0 Industry Stocktake: Future Directions Top

In this section we provide an overview of the changes within the electricity industry resulting from:

· The Electricity Industry Reform Act 1998;

· Industry response both current and possible future; and

· The Government’s proposals on price control for electricity line businesses.

We then consider the likely impact on consumers and, finally, discuss the direction of change in related areas and their implications for lines businesses.

4.1 The 1998 Reforms

4.1.1 The Government’s stated rationale for reform has been to increase competition in the industry in order to bring lower costs to the economy and prices to consumers.

4.1.2 The main features of the reform are:

· Splitting ECNZ so that no one generator is dominant in the wholesale market. This is intended to reduce the wholesale price of electricity (there is evidence that it has already done so);

· Requiring ownership separation of lines businesses from retail and generation businesses in order to avoid cross subsidy which government believed had been used for one or both of the purposes of:

- concealing excess profits in the operation of lines businesses

- using the lines monopoly to prevent competition in the retailing of electricity;

· Requiring the industry to adopt a simple means for consumers to switch suppliers (Government had been concerned that, apart from the anti competitive practices of lines companies, the industry as a whole was also setting metering and reconciliation standards which made switching suppliers uneconomic for all but large customers); and

· Regulating to provide for price control on lines businesses which breach defined threshold levels.

4.1.3 The split of ECNZ, which was conditional on further analysis, has been confirmed. It will take formal effect on the 1^st of April 1999. The independent development groups responsible for the establishment of the three SOEs now have substantial authority so that to a significant degree they are already acting as separate businesses, especially in developing their long term business strategies and relationships.

4.2 Industry Response: Immediate Top

4.2.1 Energy companies were required to choose between remaining in the lines business or the retail/generation business. Two of the larger companies, TransAlta New Zealand Limited (67% owned by TransAlta Energy Corporation of Canada) and TrustPower (majority owned by a combination of the Rotorua Energy Charitable Trust, the Tauranga Power Trust, the Tauranga District Council and Infratil New Zealand Limited a listed utilities investor) and one smaller, Central Electric Limited, decided to exit the lines business. One, Wairarapa Electricity Limited, disposed of both its retail and its lines businesses. The only other network sale that seems to be an immediate possibility is that of Central Electric which has opted to remain in generation. Discussions are currently taking place with Dunedin Electricity over a possible purchase. The remaining energy companies have decided to stay in the lines business and dispose of their retail, and where they exist, generation interests.

4.2.2 The process of rationalisation took place much more quickly than Government had anticipated. There were three main reasons for this:

· Government’s own generators, Contact and ECNZ, both concluded that they needed to build a vertically integrated generation/retail business and moved aggressively to acquire retail businesses;

· It was generally considered that, to be viable long term, a retail business required some 400,000 - 500,000 consumers (approximately 30% of the entire New Zealand market) which put a premium on moving quickly to build up consumer numbers; and

· Potential vendors recognised that the time to get value for their retail assets was the time when several purchasers were actively bidding for such assets.

4.2.3 The major retailers emerging from this process include:

· TransAlta which bought the retail businesses of Power New Zealand and Southpower giving it some 530,000 retail electricity customers as well as a little over 20,000 gas customers in its existing Hutt Valley network;

· Contact Energy which has approximately 450,000 electricity and gas customers as the result of purchasing the retail electricity customers of Eastland, Hawkes Bay, Horowhenua, Tasman, Mainpower, Top Energy and Counties Power, as well as acquiring ownership of United Electricity and thus that Company’s customers, and the gas customers of Enerco;

· ECNZ which has acquired the retail customers of Mercury Energy, which will go to the Waikato SOE, the 130,000 plus customers of PowerCo and Central Power who will be allocated to the Huntly SOE (which also gets Wairarapa’s customers), and customers of North Power, Scan Power, Waitaki Power and Central Hawkes Bay Power all of which, together with any further South Island purchases, will be allocated to the South Island SOE;

· TrustPower which has approximately 150,000 customers (as a consequence of purchasing the retail businesses of Otago Power and West Power) as well as substantial generation capacity; and

· Natural Gas Corporation which has bought the 68,000 retail customers of WEL Energy (NGC is the gas retailer in Hamilton).

4.2.4 Prices paid for lines businesses were generally well in excess of the $300 - $400 per customer which industry analysts had been expecting. As examples, TransAlta paid a little over $600 per customer for the Power New Zealand customer base and a little under $800 per customer for Southpower. ECNZ is thought to have paid more than $800 per customer for Mercury’s customer base (one report put the figure as high as $2,000 per customer).

4.2.5 These figures should not necessarily be taken at face value. In TransAlta’s case, for example, it also purchased the customer meters, electricity supply contracts and related assets. A major component of the price which ECNZ paid for Mercury’s customer base was through assuming Mercury’s liability under long-term contracts for differences in respect of the Stratford and Southdown combined cycle generation plants and the Taupo geothermal plant. ECNZ will be looking to offset the costs by its ability to supply from its own generation and it may also be anticipating a higher price path for the wholesale electricity market than is assumed in the various reported figures.

4.2.6 High prices have also been paid for lines businesses. To date, there have been three transactions:

· The sales by TrustPower and TransAlta, each to Power New Zealand, of their networks;

· The sale by Wairarapa Electricity Limited to Powerco of its network.

4.2.7 The outstanding feature of the network sales was the price paid by Power New Zealand which, in each of its two purchases, was approximately twice ODV. The size of the premium came as a considerable surprise both to the industry and to the Minister. The Minister had previously gone on record as saying that he could not personally see why anyone would want to pay more than ODV for a network as the Government’s regulatory regime would not allow companies to earn excess profits in order to provide a return on high purchase prices.

4.2.8 There seem to be several reasons why Power New Zealand was prepared/able to pay such a high price:

· A belief that it would be able to maintain charges at existing levels. This in itself, at least for the TransAlta network, will give Power New Zealand a return well above a normal Accounting Rate of Profit. At the moment, industry analysts believe that a fair ARP is around 7%; the TransAlta network, on current pricing, was earning approximately 11%. Power New Zealand clearly believes that the government will not force price reductions on network owners;

· A belief that building a much larger network business will allow it to spread overhead more efficiently; and

· Benefits flowing from its American ownership (Utilicorp of Kansas City owns 76% of Power New Zealand’s capital).

4.2.9 This last factor may have been the most significant one. First, American utilities have a great deal of experience in operating in a regulated environment and typically believe that they are well equipped to push regulatory restrictions to their limit. Of greater importance, though, may be a peculiarity of the American tax system. American utility companies enjoy a particular concession under American tax law which can result in them being able to achieve a double deduction for interest costs. Coupled with their ability to borrow a very high proportion of any investment, because of the favourable rating which capital markets give utility companies, this can be a very powerful advantage. Although we have not seen detailed analysis of the extent of this, it is our understanding that an American company could afford to pay approximately twice ODV in a situation where a New Zealand company, bidding just as competitively, could only pay in the order of 1.4 times ODV.

4.2.10 This advantage does not appear to result in any cost to New Zealand taxpayers. In practice, what it amounts to is a direct subsidy from American taxpayers to the vendors of New Zealand network assets paid as an upfront premium. Depending on the point of view taken, this can be seen either as a welcome gift to New Zealand vendors or as an unbeatable advantage for American bidders making it inevitable that any substantial network offered for sale would end up with American owners.

4.2.11 The issue is obviously one of scale. The price paid by Powerco on its purchase of the Wairarapa network was only a little over 1.3 times ODV. This suggests that the Wairarapa network was seen as being too small (or perhaps too difficult to manage) to be attractive to a major bidder - perhaps surprising given that it adjoins TransAlta’s Hutt Valley network.

4.3 Industry Response - Future Developments Top

4.3.1 Further quite major changes are planned/expected. Thus:

· Government is currently scoping the sale of Contact Energy Limited with the intention that the sale should be completed this financial year;

· The high prices paid for the TransAlta and TrustPower networks have prompted speculation that other large network owners may be tempted to test the market;

· Some network companies are actively scoping options for expansion/diversification; and

· A number of energy trusts/trust owned companies are formally or informally reviewing their own future.

4.3.2 It is expected that Contact Energy Limited will be sold in two parts. As a first stage government is currently seeking a cornerstone shareholder to purchase 40% with the remaining 60% to be floated on the New Zealand Stock Exchange through a process similar to that used for Auckland International Airport. Competition is expected to be quite intense with TransAlta and, probably, TrustPower and the Todd Corporation the leading New Zealand bidders but with American and possibly other international companies also interested.

4.3.3 So far, there has been no confirmation by Government that it intends disposing of any of the other generation SOEs. However, it seems certain that the present administration would support further privatisation.

4.3.4 Privatisation of Contact could have some “knock on” effects on the structure of the industry. For example, if TransAlta were the successful bidder for the cornerstone interest, it would have more than half of the retail customers in both electricity and gas as well as substantial generation interests. The Commerce Commission may have reservations about this.

4.3.5 Apart from the networks now owned by Power New Zealand, all of the large distribution networks are owned wholly or substantially by local authorities, trusts or a combination (Mercury and WEL are effectively trust owned. Southpower and Dunedin are local authority owned. Powerco and Central Power, although public companies, each have a combination of trusts and local authorities as their majority owners). Each of these various owners appears committed to public ownership of electricity networks. Whether that commitment would withstand an offer to pay (say) twice ODV without increasing prices is an untested question, especially as the customer relationship shifts away from the council or trust owned business to the electricity retailer(s) operating across the network.

4.3.6 Change will also continue as more than 30 companies, which previously ran both lines and retail (and sometimes generation) businesses now contemplate a future in which they are solely network businesses. It is unlikely that this will be a stable situation. Network businesses will be under pressure to reduce their costs - and this pressure will be coming from electricity retailers who know and understand the business and have the clout to bring considerable pressure to bear.

4.3.7 Companies will also face the fact that simply running a status quo network business is hardly challenging for management. Motivating and retaining good management (except in the largest companies) may be extremely difficult. This has led some commentators to expect a series of mergers amongst network companies as a means of reducing costs and creating businesses of a large enough scale to attract and retain competent management.

4.3.8 There is another scenario which we regard as being equally if not more likely. This is a shift towards outsourcing network management as the norm. Under this scenario, some lines businesses would expand as specialist network managers. Others would simply remain in place as network owners with management outsourced. This latter situation is already the case with companies such as Electricity Invercargill Limited and the Power Company Limited whose network management is outsourced to a joint venture, Powernet. Similarly, Dunedin Electricity Limited is now solely a network owner with management undertaken, under contract, by Delta Utility Services, a company formed from the previous inhouse management of Dunedin Electricity.

4.4 Choice of Retailer Top

4.4.1 Development of a simple low cost means for consumers to change retailers was the third of the four elements of the reform package. This work is being undertaken by the industry itself, primarily through MARIA (the Metering and Reconciliation Information Agreement of the Electricity Market Company which manages the wholesale electricity market).

4.4.2 The industry preference - and Government’s - is for the use of half hourly metering. However, both industry and Government recognise that this is still a relatively expensive option and one which is complicated by the need, for the great majority of consumers, to install a new meter.

4.4.3 In order to comply with the government requirement, the industry is developing an option based on a variant of profiling, a means of estimating consumption for billing purposes without requiring time of use metering. This is expected to be ready for implementation on 1 April 1999 (a discussion of the merits of profiling versus half hourly metering can be found in a paper prepared by MDL in September 1997 for ECNZ - it is available in the library on MDL’s website at www.mdl.co.nz).

4.4.4 Currently we assume that from about the middle of this year retail customers will have the option of switching between electricity retailers at little or no cost. This will meet the Government’s objective of giving all consumers effective choice amongst energy retailers. This has several important implications:

· It will no longer be possible for electricity retailers to treat smaller customers as “captive customers”;

· It will open up the market to competition from non-traditional suppliers; and

· There will no longer be a “incumbent retailer” - something which will have a major impact on customers.

Captive Customer

4.4.5 There is considerable evidence that, prior to the 1998 reforms, electricity retailers discriminated between those customers whose usage was large enough for it to be economic for them to install half hour metering and “shop around” for supply and the great bulk of customers who had no effective choice. Research both by Contact Energy and by ECNZ indicated that, at the extremes, retailers were selling electricity to larger customers at cost or even less but applying a margin over cost in the order of 20% - 30% to other customers. The retail arms of energy companies were enjoying at least two benefits from the relative lack of competitors. First, they were able to compete for large commercial and industrial customers by, in effect, creating a cross subsidy from small customers to large customers. Secondly, many retailers were able to sustain relatively small high cost retail operations simply because their customers had no choice. The extent to which this was the case is highlighted by the general industry view that the minimum viable size of a pure retailing operation under competition is 400,000 - 500,000 customers.

Non-Traditional Competitors

4.4.6 Ease of choice for consumers also means ease of entry for non-traditional suppliers provided that they can justify the marketing and technology investment involved. For a number of parties who have not previously been involved in electricity retailing, this may be achievable as an “add on” to existing activity. Potential candidates include telecommunications companies, major retailers, financial services companies and quite possibly retail or other co-operatives (eg CRT) who may find niche opportunities which can be implemented relatively cheaply on the back of their existing businesses. The basic point here is that the electricity retail market is likely to be extremely competitive. Predicting just how competitive and from where the competition will come is not entirely straightforward as New Zealand is the first country which has restructured its electricity industry through a formal separation of the lines business from the retail (and generation) business. Accordingly there is no international experience which can be used to predict just what will happen in the next phase of development here.

Incumbent Retailer

4.4.7 Until the latest round of reforms, the industry accepted that the power board or MED, and the energy company which succeeded it, had an obligation to supply all comers. Separation of lines and energy, and the move to full competition, means that this will no longer be the case. The impact of this is discussed further when we look at the likely impact on consumers.

4.5 Regulatory Changes - Price Control Top

4.5.1 The fourth element in the 1998 reforms is the introduction of a specific price control regime. Government has clearly concluded that relying solely on the Electricity Information (Disclosure) Regulations has not been sufficient to achieve its desired objectives. Problems have included:

· It was too easy for energy companies to reduce the reported profitability of their lines businesses by the way in which they managed allocation of costs as between their lines and other businesses (this was one reason why the Government required ownership separation);

· There was considerable uncertainty about what would happen if a company reported an accounting rate of profit which suggested that it was exploiting its consumers - the disclosure approach relied on the presumption that, if a company appeared to be earning excess profits, someone would take some kind of action but it was unclear who or how; and

· Concentrating on a single measure - the rate of return - was seen as quite inadequate to achieve the Government’s objective of placing pressure on electricity lines businesses “so that they reduced their costs and set their prices based on these costs”.

4.5.2 In December 1998, the Ministry of Commerce issued a discussion paper (available on the Ministry of Commerce website at www.moc.govt.nz/empg/price control).

This paper sets out the approach government intends to take. Essentially, all lines businesses will be ranked against three criteria:

· Price

· Rate of return

· Security of supply

4.5.3 Rankings on each criteria will range from zero (best performer) to 100 (worst performer). Each six months a weighted average ranking will be established for each company. The Commerce Commission will be under a legal obligation to consider price control for any lines business whose weighted average exceeds 75 for each six month ranking over a defined period (initially two years but increasing to five years).

4.5.4 The presumption is that the Commission will introduce price control for any such company, for a minimum five year period, unless it is able to establish that doing so would be inefficient. The discussion document suggests that this is not expected to be an easy test.

4.5.5 The discussion document explicitly rules out any adjustments to price to “normalise” pricing structures as between different lines businesses other than the deduction of transmission costs (as these are seen to be entirely outside the control of individual companies). The discussion document, after dealing with the question of transmission costs, states:

What, if any, other factors should be used to adjust or normalise the price measure is essentially an empirical question. The Ministry’s analysis has not provided evidence that other factors should be used. The Ministry is willing to reconsider this position if sound evidence can be provided that other factors should be used to adjust or normalise the price measure.

4.5.6 Essentially what the Ministry is saying is that there is no good case for adjusting the price control measure to reflect, for example, the claim that low density rural networks are more expensive to operate than high density urban ones and should therefore have a higher price structure. Where such price differences exist, the higher priced companies will be penalised accordingly.

4.5.7 What lies behind this is a view that exploiting the natural monopoly aspect of the lines business is not simply a matter of earning excess profits; it can also be a matter of failing to deal with high cost structures, either by rationalising costs within an individual business, or by merger, amalgamation etc if the business is simply too small to achieve least cost operation.

4.5.8 The rate of return measure will, as at present, be the accounting rate of profit. The security of supply measure will be SAIDI (System Average Interruption Duration Index).

4.5.9 We note from the Ernst and Young analysis of disclosures for the 1997 financial year that Alpine was the fifth best performer on SAIDI, had the lowest ARP (over the 1995 - 1997 period) and the lowest revenue per kilowatt hour distributed. This suggests that Alpine would not be at threat under the new regime - indeed, the company would have significant scope to increase its line charges and rate of return without running any risk of exceeding the weighted average threshold which could trigger price control.

4.5.10 The same will not be the case for a number of other smaller distributors. They will find that they need to make changes, possibly quite drastic, to their cost structures in order to avoid the impact of regulation. This is consistent with the Government’s clear intention of encouraging lines businesses to be proactive in reducing costs to consumers.

4.6 Impact on Consumers Top

4.6.1 The Government has justified further reform by arguing that it was necessary to ensure that the industry operated on a least cost basis and that the benefits of this passed through to consumers. In arguing that the reforms will achieve this outcome, Government has pointed to such things as:

· The substantial drop in the wholesale electricity price;

· Competition from suppliers such as Contact Energy and First Electric offering customers lower prices and forcing equivalent responses from suppliers such as TransAlta.

4.6.2 These are only some of the consequences which can be expected as the electricity market becomes more competitive. Another, less noticed, consequence is the new incentive which electricity retailers have to concentrate on the profitability of individual customers.

4.6.3 Well in advance of the 1998 reforms, United Electricity was already implementing activity based costing. The purpose of this approach to costing is to identify, ideally customer by customer, the true costs of providing a service. It requires a retailer to be able to allocate the cost of each individual activity (telephone call, letter, whatever) to a particular customer or at the very least customer class where classes are established by common characteristics of relevance for costing purposes.

4.6.4 This work is highlighting the different costs which companies face in dealing with different customers. The costs of handling individual customers can vary quite markedly. Managing the customer account of a high use residential customer who pays by direct debit and never has any reason to contact the retailer can be almost costless. On the other hand, managing the account of a low use low income customer, who wants to make payment by cheque or by cash, who has difficulty in paying bills, and who may be in regular touch with the retailer through its call centre or credit managers, can be extremely expensive.

4.6.5 Prior to the 1998 reforms, energy companies were typically able to manage these costs by spreading them over the entire customer base. So long as the majority of your customers were “captive”, you simply factored in to your revenue requirements the expected total cost of running such things as a call centre, customer management, credit control and so on.

4.6.6 Retailers believe that this will no longer be possible. They expect to see increased targeting of high use/low cost domestic customers as these will be extremely attractive (especially if retailers move into marketing “bundled services” as these consumers will be prime targets for those[1]). On the other hand, low use/high cost customers will be unattractive. Strategies for dealing with these may include:

· Specifically charging those customers for the cost of managing their accounts;

· Especially where credit risk is involved, requiring them to use pay go meters (a standard practice in England); and

· Of perhaps greatest importance from a community perspective, declining to offer service to new customers if it looks as though they will be unprofitable or difficult to deal with.

4.6.7 The UK government’s 1998 white paper “A Fair Deal for Consumers” stated that government’s concern that “we must make sure that, for these essential services, the benefits of competition do not go disproportionately to the better off, and the poorer consumers are protected”. The paper proposed that energy regulators (gas, electricity) should implement an action plan to ensure that disadvantaged consumers benefit from improved efficiency, more choice and greater fairness. The plan “should include measures to reduce the costs of prepayment meters [in New Zealand pay go meters]; to widen the choice of tariffs and payment methods available to disadvantaged consumers; to help consumers in managing debt; to ensure there are clear procedures covering disconnection; and to ensure that as competition develops, the gains do not go disproportionately to one group of consumers at the expense of others”.

4.6.8 In the United States, the question of dealing with low income/disadvantaged consumers is typically dealt with as part of the rate fixing process by the public utility commissions of individual states. It is common for the PUCs to approve a specific amount in the tariff structure for utility companies which is to be set aside to provide services, and subsidise supply, for low income/disadvantaged consumers.

4.6.9 In New Zealand the regulator (the Ministry of Commerce/Commerce Commission) has no power to insist that all customers must receive supply or, if thought appropriate, to require that the additional costs of servicing certain customer categories (for example those for whom supplier requires the use of a pay go meter) should be spread across all customers.

4.6.10 The potential impact on low income customers is quite significant. Competition for relatively high use/low cost customers will be quite intense. It is unlikely that energy retailers will earn super profits - and it may be difficult for them to earn normal profits - from this category of customer. Accordingly, they will have little or no potential to carry excess costs created by other customer groups if they remain committed to earning a market required rate of return across their entire business.

4.6.11 In practice, we expect that energy retailers will increasingly operate on the principle that costs should lie where they fall. This may mean reducing costs - perhaps through the provision of various incentives - for high use/low cost customers whilst at the same time charging other customers the full cost of the services they receive. In many instances, this will simply compound the problem. If a customer is a high cost customer because of difficulty created by an inability to pay, increasing the charges to that customer may only add to the difficulty.

4.6.12 The pay go alternative has some attraction but can be criticised as simply a means of shifting the disconnect decision from the company to the customer. It must also carry with it the concern that such meters are expensive. Typically pay go tariffs are significantly higher than their non pay go alternatives.

4.6.13 In its simplest terms, the choice is probably one between accepting that some members of the community may be unable to obtain electricity supply, and living with whatever consequences flow from that, or accepting that access to electricity supply is an essential service which the community as a whole should support. It is possible that central government may decide to legislate for a role of supplier of last resort. However, in a competitive market, this may be extremely difficult. The alternative may be for individual network owners to require retailers to offer supply and to meet the costs of doing so, for example, by spreading the costs of pay go meters across all customers (a solution under consideration in the UK).

4.6.14 A separate concern is the impact on rural customers - essentially those on long low density lines. In discussion with people handling this issue, including representatives of Federated Farmers, MDL has found some confusion exists both about the existing rights of such consumers and about the likely impact on them of the 1998 reforms. For example, we have found an impression that the Electricity Act creates a firm obligation to supply with that obligation finally ending in the year 2013.

4.6.15 This is not correct. The obligation under the Act is to maintain line services so long as the customer meets the cost. In our judgment this makes rural customers quite vulnerable as it entitles line companies to increase their charges up to the level at which they earn a reasonable return on capital invested. It is important to note that it is a lines company issue and not an electricity retailer issue. There is no particular reason why the energy component of electricity charges should vary significantly as between urban and rural consumers; price differences are driven by lines and transmission costs.

4.6.16 Over time, we think it likely that the impact on rural customers may differ depending on the nature of the ownership of the lines business. An investor owned company is likelier to increase prices to the maximum permitted level than is a trust or local authority owned company which may be likelier to accept an element of cross subsidy within its line charges (but note, in the new competitive environment, electricity retailers will be taking a very close interest in lines charges).

4.6.17 There are also economic arguments supportive of charging the full cost. From an economic perspective, the costs of delivering services to rural customers exist regardless of the price those customers are actually charged. To the extent that there is a divergence between the full economic costs of providing the service and the price charged to the customer, alternative sources of supply such as distributed generation are placed at a disadvantage.

4.7 Related Change: Local Government and Other Infrastructure Top

4.7.1 Continuing reform of the electricity sector is part of a wider programme of microeconomic reform being undertaken by the present Government. The programme is a response to pressures on major infrastructure including:

· Costs and in some cases unacceptable levels of service faced by customers; and

· The need for substantial additional investment and the concern that this should be undertaken as efficiently as possible.

4.7.2 The main areas of reform are water and wastewater services and roading. The Government has established a water and wastewater review with terms of reference which are expected to encourage a “first principles” review of the legal and economic framework for New Zealand’s water and wastewater services. Government has been quite explicit that the review is not about ownership as such. Instead its purpose is to determine an appropriate regulatory regime which encourages:

· efficient investment (in infrastructure and water quality);

· optimal resource allocation (including charging mechanisms and pricing principles);

· sound operational and demand management practices;

· innovation and service improvement; and

· transparency and accountability.

4.7.3 The expected outcome is a regulatory framework which does not favour public ownership or management over private or vice versa - these are seen to be decisions which should be taken by local communities reflecting local preferences.

4.7.4 It would not be surprising if the review includes requirements that:

· The income from water and wastewater services should be taxable (in much the same way as local authority income from municipal electricity undertakings was prior to the Energy Companies Act 1992); and

· Owners/operators of water and wastewater services are required to set their charges on economic principles including a proper allowance for cost of capital.

4.7.5 In each case the rationale will be that a “level playing field” between the public and the private sector is only possible if the activities pay tax and price their services properly.

4.7.6 Proposed changes to roading have received greater coverage. Currently it seems that the favoured option is a single SOE to own and operate state highways and a series of regional Local Authority Trading Enterprises to own and operate roads other than state highways.

4.7.7 Again, there is a strong emphasis on pricing in relation to use wherever possible but with an underlying recognition of the need to preserve the integrity of the roading network. Inevitably this will mean some cross subsidy in respect of roads which receive relatively little usage.

4.7.8 There are common themes running through these two reform programmes and Government’s objectives in respect of the electricity industry. They include the emphasis on economic efficiency and on the use of proper pricing principles where these can be applied.

4.7.9 There is also a strong emphasis on separating out the business of providing services from the separate role of assisting the community decide what services it wishes to receive. There is a strong theme that the business of providing infrastructure is just another service - that the key local democratic issue of deciding the nature and quality of the service is quite separate from the business of providing the service. Although these reforms appear quite controversial, they are driven by concerns that the cost of meeting New Zealand’s infrastructure needs will be out of reach unless providers are not merely encouraged but required to be as efficient as possible in both their investment and operational decisions.

4.7.10 At the local government level there is a strong implication that continuing ownership of infrastructure services is not really a core activity - instead, the core activity is determining the nature and quality of services, negotiating with the provider and monitoring performance. In a complementary development (which is already well advanced overseas) this gradual convergence of understanding of the nature of infrastructure is seeing the emergence of owners/providers who see themselves not simply as electricity, water or roading companies but as utility companies operating across a full range of infrastructure.

4.7.11 This development raises the question of how local infrastructure should be owned and managed and whether there is any longer a case for treating the ownership and management of (say) electricity infrastructure differently from (at least) water and wastewater if not also roading. The potential to shift the burden from ratepayers to users is considerable and we expect to see this option looked at, especially in those parts of the country where the electricity infrastructure is trust owned with the possibility that the trust may see its role not simply as the owner of electricity infrastructure but, on behalf of its community, as the owner and developer of a much wider range of infrastructure.

5.0 Overview of the Establishment Plan/Joint Venture Model Top

5.1 In this section we set out what we understand to be the “base case” for the future of the Trust’s shareholding in Alpine Energy. It is developed from a consideration of:

· The trust deed;

· The Company’s constitution; and

· The shareholders’ agreement.

5.2 The purpose of developing the base case is to establish what would happen if:

· The Trust implemented the likely intention of the authors of the establishment plan, by distributing shares within the maximum 15 year timeframe; and

· It did so purely within the framework of the existing legal rights/powers it has in terms of the trust deed, the constitution and the shareholders’ agreement.

5.3 Distribution prior to the “termination date” may only be carried out in terms of a share allocation plan which has been prepared following a review in terms of section 4 of the trust deed. Trustees have discretion under the share allocation plan to determine “the manner in which and the consumers to whom the shares (if any) and assets constituting the trust fund are to be distributed and such shares and assets may be distributed to a greater or lesser extent to some or all of the consumers”. This wide discretion is limited by the requirement that the share allocation plan must be the subject of a postal vote and have the support of a majority of consumers who exercise their right to vote.

5.4 The trust deed also contains a default provision for equal distribution to all consumers which will be triggered if trustees have not prepared, and consumers supported, a share allocation plan within the timetable set out in the trust deed (based on the termination date for the present trust and for any resettlement trust).

5.5 Trustees thus have some discretion as to the manner of the distribution provided that they can gain majority support. For example, trustees might propose a share allocation plan which distributed shares to residential and farming consumers only, excluding other commercial and industrial consumers in the belief that distributions should go to individuals rather than firms/organisations. We cite this purely as an illustration of the kind of power which trustees may have under the base case provided that they can obtain majority support for it.

5.6 Under the base case, Alpine Energy would remain an “energy company” subject to the requirements of the Energy Companies Act, in particular the obligation to prepare a statement of corporate intent (section 39).

5.7 The current constitution of the Company reflects the fact that it is closely held (with only four shareholders). It would not be acceptable for listing on the New Zealand Stock Exchange.

5.8 The shareholders’ agreement imposes quite significant restrictions which, in practice, could be unworkable post distribution although the agreement appears intended to continue in existence following any distribution. Thus:

· The term “shareholders” is defined as “means the parties to this deed other than Alpine including their respective successors and assigns” (emphasis added);

· The pre-emptive rights apply only to a sale; any distribution pursuant to a share allocation plan could go ahead without any obligation to offer shares to the remaining shareholders; and

· In respect of director appointments, the deed explicitly provides “should the shares held by the Trust be disposed of in accordance with the terms of the trust deed then the transferee or transferees of those shares shall be entitled to the same right to appoint three directors as is given to the Trust under this deed. If there shall be more than one transferee such rights shall be exercised in such manner as those transferees may agree upon”.

5.9 Following any distribution, the new shareholders would be bound by the terms of the shareholders’ agreement (as “successors and assigns”, they would inherit the trust’s obligations). Specifically:

· Shareholders wishing to sell their shares would need to go through the same process as currently applies to the Trust itself. This is likely to prove somewhat cumbersome (especially as Alpine Energy has an obligation to convene a meeting of the “remaining shareholders” each time a shareholder gives notice of intention to sell); and

· They would only be able to appoint directors if they could reach agreement on a basis for appointment - in practice, if the Trust were undertaking a distribution, we would expect it to include in the share allocation plan some mechanism enabling consumers to appoint directors.

5.10 We consider it would be quite difficult to place a market value on shares distributed to consumers, following the distribution. They would not be listed but, in all likelihood, traded through local brokers.

5.11 To all intents and purposes, the Company would be controlled by the Timaru District Council, through Timaru District Holdings Limited, but there would be some uncertainty around this. The Council would have by far the largest bloc of shareholding but would have only three out of seven directors. Assuming that some suitable mechanism was created for the appointment of three directors by the holders of the distributed shares, the board would comprise four directors appointed by local authority interests and three by private shareholding interests. The seven directors would have the primary responsibility for settling the statement of corporate intent. We would expect this to assume somewhat greater importance post-distribution as it would be the means for local authority shareholders (especially the Timaru District Council) to spell out their requirements for the future operation of the Company notwithstanding a 40% private shareholding.

5.12 This could see a two stage SCI process result - a first stage in which the SCI was prepared by the directors of the Company and there was, potentially, considerable input from those representing the private shareholders followed by a second stage in which shareholders sought amendments to the statement of corporate intent (which can be done by ordinary resolution at a meeting of shareholders of the company). We would expect the Timaru District Council to have no difficulty in carrying any ordinary resolutions it wished to promote (but see the comments in paragraphs 6.1.7 and 6.1.8 below).

5.13 Market attitudes would be strongly determined by investor assessment of the long-term intentions of the Timaru District Council. If investors believe that the Council intended the Company to operate in the interests of consumers rather than shareholders, then the shares might not attract much support. Conversely, if the Council seems likely to want a maximum return on its investment, then the shares might be more attractive.

5.14 On balance, we would expect the shares to be seen as an opportunistic investment. Factors influencing this would include:

· The likelihood that many consumers would sell their shares for whatever they could get, especially if they were unused to owning shares and/or of relatively limited financial means; and

· The willingness of opportunistic investors to build a stake in the belief that, over time, the share price should reflect the underlying value (there is plenty of experience from the first round of reform to support this view).

5.15 Under the base case scenario, this outcome would be assisted by the fact that there would be not restrictions on share ownership.

5.16 Long term the effect of this process would depend on the nature of the investor(s) who purchased shares from the initial consumer shareholders. Experience from the 1992 reforms suggest that the greatest interest will come from parties positioning themselves to take eventual control. To the extent that control of Alpine is important to the community, this possibility suggests that “base case” distribution may lead to an outcome the community would prefer to avoid.

6.0 Company Issues Top

In this section we consider future options from the perspective of the Company. We begin by considering the statutory obligations of directors and the incentives facing both directors and management. We then look at the following scenarios for the future of the business:

· Status quo, that is remaining as owner and operator of the Alpine network;

· Downsizing - remaining as a network owner but outsourcing all services; and

· Diversification - seeking to build a business in network management.

6.1 Directors and Management

6.1.1 The conduct of directors of an energy company is regulated both by the Companies Act 1993 and the Energy Companies Act 1992. It is quite common, especially when local authority or trust shareholders are involved, for there to be differing views on the proper conduct of directors and the extent of the discretion which they have in management of the company, including taking major decisions.

6.1.2 Section 131 of the Companies Act requires directors, when exercising powers or performing duties, to “act in good faith and in what the director believes to be the best interests of the company”. Generally this is interpreted as requiring the directors to act in the interests of the company as a whole but directors will need to balance competing interests.

6.1.3 The view commonly taken by commercial directors is that the overriding obligation this duty imposes on them is to manage the company so that, over time, shareholder wealth is maximised (there is a rough parallel with clause 3.7 of the trust deed with its stated object “to encourage and facilitate the company in meeting its objective of being a successful business [an Energy Companies Act requirement] by optimising the company’s return on its assets, and to maximise the benefits for consumers by distributing to consumers in their capacity as owners the benefits of ownership of shares in the company”).

6.1.4 Where an energy company (or a Local Authority Trading Enterprise which operates under a broadly similar regime) has a single shareholder, or a group of shareholders, then it is usual for directors to accept that the “best interests of the company” can properly be defined by shareholders through the statement of corporate intent. However, there have been instances where there have been major differences of view between directors and shareholders. Usually this has happened when shareholders have not been sufficiently rigorous in making it clear what they require the statement of corporate intent to cover. Differences have then arisen where a shareholder has sought by informal means - perhaps oral or written communication to directors but outside the scope of the statement of corporate intent - to influence company policy in ways which could have been but were not spelt out in the SCI.

6.1.5 In some cases, directors have asserted their statutory obligation to act in the best interests of the company as a reason for not complying with shareholders’ wishes and pointed, as well, to section 128 which provides that “the business and affairs of a company must be managed by, or under the direction or supervision of, the board of the company” (the Act provides that this responsibility may be varied by the company’s constitution - in the case of Alpine Energy Limited, the constitution does provide that shareholders can pass resolutions regarding the management of the company but it also provides that such resolutions are not binding on the board).

6.1.6 It is likely that the Companies Act obligations are modified by the provision in section 37(3) of the Energy Companies Act that “all decisions relating to the operation of an energy company shall be made by or pursuant to the authority of the directorate of the company in accordance with the statement of corporate intent”. Provided that the statement of corporate intent is drawn with sufficient care, then this should constrain the discretion of directors. So far as MDL is aware, this matter has not been tested in the courts.

6.1.7 So long as the present shareholding structure remains in place, these matters are probably of academic interest only. Directors appointed by the various shareholders will presumably manage the company in accordance with the statement of corporate intent and that will, presumably, record all of the major concerns which shareholders have. This is no doubt supplemented by discussions between shareholders and the directors whom they have appointed.

6.1.8 The issue becomes more significant if the shareholding structure changes and the company has at least some shareholders whose interest is primarily investment rather than public ownership of an essential service. Under these circumstances it becomes less easy to manage the company so that the conventional objective of maximising shareholder wealth is modified, for example, by a majority shareholder view that the company should give priority to consumer interests, either explicitly or by implication, for example, by setting earnings targets at a level lower than would be set by a board acting purely commercially.

6.1.9 Again, we are not aware that the issue has been tested but we consider it likely that an investor shareholder, with sufficient investment at stake, might consider taking action under section 174 of the Companies Act 1993 which allows an application to the court for relief when the shareholder “considers that the affairs of a company have been, or are being, or a likely to be, conducted in a manner that is, or any act or acts of the company have been, or are, or are likely to be, oppressive, unfairly discriminatory, or unfairly prejudicial to him or her in that capacity or any other capacity”.

6.1.10 In summary:

· The obligation of directors is to act in good faith in the best interests of the company. This is commonly interpreted as seeking to maximise shareholder wealth;

· So long as the present shareholding structure remains, it is open to shareholders, especially through the statement of corporate intent, to set objectives which may modify a purely commercial approach to management of the company;

· Except to the extent that shareholders through the SCI set limits on doing so, directors should act to maximise commercial benefit for the company; and

· If there should be a change in shareholding (for example by distribution of shares) then it may be less easy for remaining public body shareholders to require directors to act in a less than fully commercial manner. Specifically, this could create the risk of an application to the court under section 174 of the Companies Act 1993 on the grounds that the affairs of the company were being conducted in a manner which was prejudicial to the interests of minority shareholders.

6.1.11 In a formal sense, the responsibilities of management follow on from those of directors. Specifically, the role of the chief executive, and his performance agreement, should align closely with the statement of corporate intent and with any separate significant policy decisions of the board.

6.1.12 This formal relationship is complicated by the practical reality that good chief executives will expect their role to be proactive, developing the business of the company rather than simply acting as a caretaker. The incentives facing chief executives are rather well described in the following extract from The Economist for January 9 1999. In an article “How to Make Mergers Work” (admittedly looking at rather larger companies than Alpine Energy) The Economist describes the chief executive’s approach in these terms:

“… wrapped up in sonorous stuff about synergy, plenty of mergers begin with sheer executive boredom. For the folk at the top, running a company can be dull. Organic growth, in a mature market, is grindingly slow. Doing deals is easier - hire a bunch of investment bankers and set them to work - and much more exhilarating. A chief executive spends perhaps five years in the top job: the surest way to make a mark in so short a time is to buy something big. Quite apart from the surge of adrenaline, it brings the gratifying attention of investment bankers, and makes a splash on the financial pages. Brokers are pleased: now your share price will move - one way or another - and so they will make money. Testosterone, vanity and greed are poor ingredients for successful merging.”

6.1.13 What that rather colourful extract emphasises is the natural tendency for chief executives to want to be doing things. Frustrate that tendency and your chief executive, if he or she is at all capable, will look elsewhere.

6.1.14 The board of Alpine Energy Limited can be expected to be very aware of this. We would expect that the Company’s chief executive has been providing the board with reports on options for the development of the business post-separation, including options for reinvestment of capital freed up by the sale of the Company’s interest in United Electricity Limited.

6.1.15 Against this background, we now discuss the three principal options of status quo, downsizing and diversification. We then conclude this section with a note on balance sheet structure.

6.2 Status Quo Top

6.2.1 Under this option, the Company would remain as owner of its existing network business and other interests. Compared with other companies, the impact on Alpine of the 1998 reforms has been relatively minimal as its retail interests were sold to United Electricity several years previous. Principal impacts have been:

· A requirement to dispose of its shareholding in United Electricity;

· Possibly, withdrawal from the Coleridge joint venture. Commercial logic may have dictated that in any event; and

· Some uncertainty regarding its investment in the Opuha Dam Company because the generation capacity exceeds the five megawatt limit in the Electricity Industry Reform Act (section 81 of the Act provides power for the Commerce Commission to grant exemptions; we would expect, and assume for the purposes of this report, that the Company should have a very strong case for gaining an exemption).

6.2.2 Under the status quo option, the Company’s main activities would comprise:

· Ensuring efficient network management; and

· Negotiating with and, as required, monitoring the performance of electricity retailers selling electricity across the network (this would include, if required by shareholders, dealing with customer related issues such as the impact on low income/disadvantaged customers of the move to full competition, customer service standards and so on).

6.2.3 We doubt that the board of directors or management would regard the status quo option as sustainable. Specifically, under this option the Company would have excess capital and would also have relatively high operating/overhead costs - most specifically those associated with maintaining a full head office/chief executive function.

6.2.4 We would expect management to advise directors, and directors to advise shareholders, that the status quo option was consistent neither with meeting shareholders’ objectives for a least cost efficient service to consumers nor with the objective of maximising returns to shareholders within that consumer objective. Instead, we would expect directors/management to explore the two alternatives of downsizing and diversification. Decisions on downsizing or diversification will be within the discretion of directors unless they are constrained by the statement of corporate intent or by the company’s constitution. We would also expect directors and management to explore the option of disposal of the network - their obligation to act in the best interests of the company would suggest doing so unless it was already clear that shareholders would not support such a move. Any disposal of the network would be a “major transaction” as the value involved would exceed 10% of the value of the total assets of the company. Under clause 12.2.1 of the constitution, a major transaction requires the approval of shareholders by a special resolution.

6.3 Downsizing Top

6.3.1 This option assumes that the Company seeks the most efficient means of remaining as network owner. The relatively small scale of Alpine’s network operation, and the difficulty of providing a challenging environment for a competent full time chief executive set the context.

6.3.2 So, in all likelihood, will the commercial strategies developed by electricity retailers. They will want to demonstrate to their customers that they are being proactive in delivering low cost electricity. As First Electric has already demonstrated, the lines charges of network companies will be a prime target in this strategy.

6.3.3 So long as the company remains an independent network owning entity, the board will want to retain responsibility for matters such as:

· The terms of use of systems agreements with electricity retailers;

· Pricing policy;

· The principles governing system maintenance; and

· Capital expenditure

6.3.4 Acting commercially, and on the assumption that they seek to provide a least cost service, we would expect directors to undertake a comprehensive review of how services are provided. This would include an examination of all of the Company’s cost drivers including, in particular, the overhead costs of maintaining a head office/chief executive function.

6.3.5 Options range over:

· Continuing to meet the majority of the Company’s requirements from “in house” sources;

· Contracting out to a range of providers - which would require the company to retain a significant contract management capability; and

· Contracting out the full range of network services to a specialist network manager.

6.3.6 We would expect the third of these three options to appear most cost effective. The main issues it will raise for the Company are:

· Are there sufficient, and sufficiently experienced, network managers in New Zealand to ensure that services are provided on a competitive basis, and to provide an opportunity for benchmarking performance; and

· Will the company be able to monitor, effectively, the performance of its network manager as well as obtain advice, on a cost effective basis, on the four core responsibilities the board would wish to retain.

6.3.7 It seems likely that there will be a competitive market in network management services. Likely competitors include:

· PowerNet, the joint venture network management company owned by electricity Invercargill Limited and the Power Company Limited;

· Delta Utility Services, the network management company created out of Dunedin Electricity Limited; and

· PowerCo Limited and Central Power Limited who are well advanced in negotiations to merge their network businesses. We understand that they see network management for other network owners as a major growth area for their business.

6.3.8 It is possible that other providers will also enter the network management market. Potential candidates include Power New Zealand Limited, Transpower and, possibly, Orion New Zealand (previously Southpower).

6.3.9 Such an approach would retain the present network under Alpine ownership and allow the board of directors to put in place policies reflecting shareholders’ views on how customers should be treated (in practice, of course, customers will be customers of the retailer - as they have been with United Electricity - but the network owner has significant ability to influence their treatment through its use of systems agreements).

6.4 Diversification Top

6.4.1 This is the most complex option for the Company. It is also the one which we expect will be given priority, if only because of the natural tendency within commercial undertakings to give priority to growth over remaining static or ceasing business.

6.4.2 In the particular circumstances of Alpine, there is one other factor which may also encourage diversification. This is the fact that the Company has surplus capital and may consider that there are particular difficulties in making any return to shareholders - specifically the question of how any return of capital might be used by the Trust (this issue is discussed below when we consider balance sheet structure).

6.4.3 Current thinking on diversification as a business strategy is that businesses should only diversify into areas which are closely related to their own core business. This view is based on experience with the conglomerate approach to diversification which was popular some 10 - 20 years ago but which proved, generally, to be disastrous as companies expanded into areas of which they had little or no understanding.

6.4.4 We do not have the kind of detailed understanding of Alpine’s business which can only come from working closely with its management but assume that its core competencies are in network ownership and management - the two areas in which we assume it has specialised since its retail business was sold to United Electricity. There is a view, not universally shared, that there is a sufficient similarity between different network industries to create synergy by combining ownership and/or management of different networks. There is more agreement that this is the case between electricity, gas and possibly water and wastewater than there is with other network industries such as telecommunications because of the differing technologies involved.

6.4.5 There may also be an opportunity to diversify through acquiring adjoining electricity networks. Neighbouring companies, such as Electricity Ashburton and Waitaki Power might be prepared to consider disposal of their networks if the terms, including undertakings regarding future management, were acceptable and they had alternative uses for the capital - but we recognise that this is a relatively low probability at least for the moment. Central Electric, which opted to retain its generation facilities, is understood to be selling its lines business.

6.4.6 The next issue the board would need to consider is whether a diversification strategy should focus on management of other networks, ownership, or both. The board may conclude that it will be difficult to be competitive as a manager either of electricity networks or of water and wastewater networks. As noted, a number of specialist companies are already active in respect of electricity networks. The same situation exists in the water and wastewater industry. A number of major international companies are represented in the New Zealand market in the expectation that, as the restructuring of the water and wastewater industry proceeds, there will be an increasing tendency for local authority owners to contract out management and, in some instances, accept private ownership - either through privatisation of existing assets or through inviting private providers to develop new capacity.

6.4.7 Against this background an objective assessment of options for diversifying through management of other networks may conclude that Alpine is unlikely to be a successful bidder for management contracts.

6.4.8 The potential to diversify through ownership of other networks may be different depending on the priorities set by current networks owners if they contemplate sale. Trust owners, and possibly local authorities (but see the discussion under Timaru District Council issues below) may be prepared to sell networks for less than their maximum value (that is their value in the hands of a purely commercial owner seeking to maximise shareholder wealth) in return for undertakings on the management approach which Alpine would take including how it would handle key customer related issues.

6.4.9 That said, we expect the incentives on existing network owners (electricity or water and wastewater) to favour continuing ownership. We have already pointed out that:

· There is likely to be quite strong competition, in both electricity and water and wastewater, for the opportunity to manage networks thus giving network owners the benefits of economies of scale, and management specialisation, without needing to give up ownership;

· There is a sufficient depth of advisory capacity within the New Zealand economy to assist network owners handle their core concerns including monitoring the performance of network managers; and

· As we will see in the discussion of balance sheet structure, it is possible for network owners to retain ownership whilst withdrawing the greater part of their capital.

6.4.10 The best opportunity for diversification may lie in working with Alpine’s existing shareholders on the argument that there is a case for specialisation in ownership and that Alpine is well placed to provide this, thus relieving its shareholders (at least the three local authorities) of the need themselves to continue owning network infrastructure.

6.5 Balance Sheet Structure Top

6.5.1 Consistent with the view that the primary responsibility of the board of a company is to maximise shareholder wealth, there has been an increasing concentration on the balance sheet structure of companies. Two separate influences are at work:

· A growing recognition that debt is cheaper than equity; and

· A belief, prompted by the increasing use of economic value added methodology, that businesses, or units within businesses, which do not earn at least their market determined rate of capital are destroying value with the implication that, unless the business or unit can achieve the required rate of return, it should be disposed of and the proceeds returned to shareholders.

6.5.2 Equity can seem costless - the decision whether or not to pay a dividend is a discretionary one. If directors decide not to pay a dividend, then the company appears to be paying nothing for the use of the equity provided by shareholders.

6.5.3 Looked at from the shareholders’ perspective, though, equity does indeed have a cost. The cost is the return which the shareholder could have received from the best alternative investment available.

6.5.4 The margin between cost of debt and cost of equity, in any given company, is a function of a number of factors, primarily the risk associated with the business or businesses in which the company is involved. Even in a relatively secure business, such as network ownership, the expected return on equity (the cost) will be higher than the cost of debt unless debt is excessive in relation to the value of the assets.

6.5.5 The conclusion which follows from this argument is that each company should determine the optimal debt : equity mix appropriate to the risk of its business. The “normal” mix is around 50% debt to 50% equity. In businesses such as network ownership, which have a very secure cashflow supported by the natural monopoly character of the network, the optimal debt : equity mix may be closer to 70 or 80 percent debt to 30 or 20 percent equity.

6.5.6 The (now) conventional view is that a company needs to be proactive in managing its balance sheet structure if it is to ensure that returns to shareholders are maximised (obviously what is being spoken of is the percentage return on the shareholders’ investment rather than any absolute figure).

6.5.7 There is a further implication for energy trusts or other public owners wishing to reduce their investment in their energy company. Banks regard networks as an extremely attractive security. MDL has been advised that at least one commercial bank would be comfortable lending up to 100% of the optimised deprival valuation of a network. For energy trusts and other public owners who wish to reduce their equity investment in their energy company, the ability to replace equity with debt (subject to managing the tax issues involved) could provide a quite attractive alternative to sale, allowing them to extract most of their capital whilst still retaining ownership and therefore the ability to determine how the network is managed.

6.5.8 There is a further reason for proactive balance sheet management. This is to make sure that directors and management face real capital market constraints when considering new investments. If a company has relatively little debt, then not only is there a temptation to “grow” the business by looking for new investments. The board and management (and in many companies this really means the management) will face few constraints in doing so. Typically they will be able to finance new investments from spare cash (which may be the Alpine situation following the sale of its interests in United Electricity) or from borrowing which will be easy to arrange because of their strong balance sheet. In this situation shareholders may not have the opportunity of scrutinising the investment proposal and bankers may not have the incentive as they know that their borrowings are very well secured.

6.5.9 In contrast, if a company does have a well managed balance sheet, then any significant new investment may require additional capital from shareholders, who will therefore have an opportunity of considering the investment proposal, and will certainly be closely scrutinised by banks because they could be at risk if the investment is not successful.

6.5.10 For a company in Alpine’s situation, proactive balance sheet management means returning capital to shareholders. That may pose difficulties as:

· The company has less available subscribed capital ($31 million) than it would need to achieve an absolutely optimal balance sheet structure; and

· At least one shareholder - the Trust - may be reluctant to receive a return of capital because of concerns about how it would use that capital - currently it has very limited powers of investment. Living with an inefficient balance sheet structure for Alpine may be a lesser difficulty for the Trust than the alternative of considering whether and how to invest it (including whether to seek consumer approval to a variation in investment powers) or dispose of that capital by distribution.

7.0 Timaru District Council Issues Top

7.1 Background

7.1.1 Our assessment of the issues which Timaru District Council will face in considering the future of its investment in Alpine is based on a combination of:

· Our background as advisors specialising in local government issues; and

· Consideration of Council documentation including Vision 2020 - the Council’s blueprint for its district for the next 25 years - and its 1998/99 annual plan, long term financial strategy and funding policy.

We have not spoken directly with Timaru District Council on this matter and nor would we do so without trustees’ authorisation.

7.1.2 The Vision 2020 document put two options to the Timaru public:

· Maintain at least a 47.5% shareholding in Alpine Energy Limited; and

· Dispose of the shareholding in Alpine Energy Limited.

Public consultation confirmed that the Council should retain its shareholding in Alpine Energy Limited.

7.1.3 The 1998/99 annual plan and long term financial strategy sets out key financial data for the financial years up to and including 2007/08. It discloses that:

· Rates are expected to increase in real terms (that is before the impact of inflation) by 24.3% over the period; and

· Capital expenditure on water supply, sewerage and stormwater, over the same period, will total approximately $56 million.

7.1.4 The 1998/99 annual plan includes the Council’s treasury management policy (this combines the borrowing and investment management policies which a 1996 amendment to the Local Government Act requires the Council to prepare). The investment policy includes the following statements which relate to the shareholding in Alpine Energy:

· The Council maintains investments in the following assets (a) equity investments including LATEs and the shareholdings;

· Equity investments: council investment in such assets fulfils its various strategic, economic development and financial objectives outlined in the strategic plan; and

7.1.5 The policy then goes on to state that proceeds from the distribution of equity investments are not made for general purposes but are to be used for:

· repayment of district wide funded debt; and/or

· repayment of community funded debt; and/or

· fund pre-approved capital expenditure; and/or

· purchase treasury instruments.

7.1.6 All income from Council’s equity investments including dividends forms part of Council’s general revenues to be used for district wide activities (in other words, dividends reduce the general rate requirement).

7.1.7 Apart from the requirement to prepare an investment policy, the only other reference in the Local Government Act to “investment” is in section 223I which provides “subject to any specific requirements relating to any funds, any local authority may invest its funds and the funds under its control in accordance with the provisions of the Trustee Act 1956 as to the investment of trust funds”.

7.1.8 The Trustee Act itself authorises investment of trust funds in any property and then sets out the duties of trustees. The primary duty is that “a trustee exercising any power of investment shall exercise the care, diligence, and skill that a prudent person of business would exercise in managing the affairs of others”.

7.1.9 Treating shareholdings, such as Timaru’s in Alpine Energy, as trustee investments may seem a little unusual when the history of the shareholding is considered. However, it does appear to be accepted practice - no doubt partly because the Local Government Act requirement for the preparation of an investment policy is widely worded, requiring the investment policy to include “the general policy of the local authority on how its financial assets, including, but not limited to, trust funds, special funds, shares, property held in whole or in part for investment purposes, and financial reserves are to be managed.

7.1.10 This approach was considered by the High Court in 1997 in an action brought by the South Taranaki Energy Users Association Incorporated against the South Taranaki District Council regarding the sale of its 100% shareholding in Egmont Electricity Limited to PowerCo Limited. The case concerned the question of whether the Council had properly complied with its statutory obligation, under section 716A of the Local Government Act, to consult.

7.1.11 Evidence was given that the Council’s general manager had advised the Council on the basis that the shares were an investment subject to the provisions of the Trustee Act 1956 and incorporating the prudent person test.

7.1.12 The judge took the view that, for the purposes of the issue he had to decide, not much turned on the fact that the Council had categorised the shareholding as an investment but he did go on to state:

“…the fact of the matter is that Council’s 100% shareholding in Egmont constituted 90% (by value) of Council’s portfolio in a small electricity company which, on the advice of both its directors and consultants, was likely to come under real and adverse threat in the competitive process. I do not believe the Council can be criticised for closely examining the wisdom, in the interests of its broader ratepayer base, of retaining or disposing of that p

interest.”

7.1.13 Against this background, we think it likely that Timaru District Council will feel obliged to manage its investment in Alpine Energy Limited on the basis that it is subject to the requirements of the Trustee Act. The main impact of this is likely to be a reinforcement of the view that the Council holds its investment on behalf of ratepayers NOT on behalf of consumers or other parties. Accordingly, that should direct Council’s attention to ensuring that the value of the investment is maintained while it holds it and, should it dispose of it, that it receives good value.

7.1.14 In the complex world in which local authorities hold assets such as Timaru’s shareholding in Alpine, the specific responsibilities of trustees may in practice be set aside by a Council if it believed that doing so would reflect the views of its ratepayers (who are, in effect, the beneficiaries). At the same time, we would expect the Council to consider the impact on ratepayers of managing the investment in a less than commercial manner. There are specific tradeoffs involved to the extent that Council’s dividend income is less than it would be if the network was managed on a fully commercial basis. Any shortfall needs to be recovered from ratepayers (this is the necessary consequence of the fact that dividends are applied as an offset against the general rate). That might be of little concern if Council ratepayers and Alpine consumers were one and the same. To the extent that they are not, accepting a reduced investment income involves a subsidy from ratepayers to Alpine customers who are not ratepayers[2].

7.1.15 The Council may prefer to stay with the existing situation and not take any initiative itself to change either the shareholding structure of Alpine or the nature of its own investment in the company. This would be consistent with published council policy documents, such as the long-term financial strategy, which simply assumes the status quo situation for the period of the strategy - which extends out to the 2007/08 financial year. This would also be consistent with public responses to council consultations on its vision 2020 document and on the long-term financial strategy itself.

7.1.16 On the other hand, the apparent attachment to the status quo option may simply reflect the fact that the Council has not so far undertaken any publicly available in-depth analysis of options (including the trade-offs in relation to future rate increases and the investments required for other infrastructure activities) and nor has it put other options to its ratepayers in a way which would allow them to assess a realistic range of options and the costs and benefits associated with them.

7.1.17 The Council may also wish to consider the effect, on ratepayers, of selling or realising part of the investment under different scenarios. We have already noted in section four that networks have sold at prices which incorporate a premium to ODV. Council might conclude that sale of the Alpine network would return a sum sufficient to meet its future infrastructure investment requirements and that the combination of that, and the income which could be earned on the proceeds pending further infrastructure investment, would leave ratepayers better off.

7.1.18 We would certainly expect this option to be closely reviewed, especially given the real increase of 24% which the Council’s ratepayers face over the next 10 years.

7.1.19 The difficulty for the Council is that its shareholding is a minority interest subject to a shareholders’ agreement conferring pre-emptive rights on remaining shareholders. This could make it difficult for the Council to act unilaterally in seeking to sell its investment. Prospective purchasers would value the shareholding not on the basis of the network value itself but as a 47.5% interest in a company still subject to the statement of corporate intent requirements of the Energy Companies Act. The pre-emptive rights themselves may not act as a barrier to a third party purchase (would the Trust or the other two councils be prepared to find some tens of millions of dollars in order to step into the shoes of a third party purchaser?) Instead, the agreement is more likely to be seen by any third party purchaser as a clog on the value of the shares because of its continuing application and the way in which it restricts director appointment rights.

7.1.20 That said, a third party might be prepared to purchase the Council’s shareholding, but at a significantly lower value than if there were no restrictions on transfer of shares and director appointments were on a one share one vote basis. Such a strategy would be based on the expectation of purchasing the shares of one or other of the remaining councils, possibly at a premium, in order to secure an overall majority stake. Such a process may be messy for the Council and run into significant political opposition both from ratepayers and from other shareholders.

7.1.21 We conclude that unilateral exit is unlikely to be attractive to the Council; it risks both loss of value and a negative reaction from its community and other shareholders.

7.1.22 If the Council does wish to extract value from its shareholding, we would expect it to explore options which could be pursued with the co-operation of other shareholders. These could include:

· Converting Alpine Energy Limited into a listed or unlisted public company coupled with a flotation of the Council’s shares;

· Seeking a return of capital to shareholders;

· Negotiating a buy back of the Council’s shareholding (to the extent permitted by the Company’s available subscribed capital);

· Negotiating a sale of all or part of its shareholding to one or more of the remaining shareholders; and

· Sale by Alpine of its assets followed by liquidation.

We consider each of these options in turn.

7.2 Listed or Unlisted Public Company Top

7.2.1 Converting Alpine into a listed public company would mean complying with the Listing Rules of the New Zealand Stock Exchange. This would include adopting a constitution which contained no restrictions on transfer of shares.

7.2.2 Adopting the listed company option would carry with it the implication that, eventually, control of Alpine would pass outside of the South Canterbury area even if the Trust remained a 40% shareholder. The Council would be advised that, in order to maximise the return to it from the listed company option, it should persuade the Mackenzie and Waimate District Councils to include their shares in the placement for two reasons:

· So long as the local authority/trust shareholding exceeding 50%, the company would still be subject to the statement of corporate intent provisions of the Energy Companies Act which would have a depressing impact on value; and

· Quite apart from the statement of corporate intent issue, investors would place a higher value on the shares if they thought there was a realistic possibility of control passing to a private party than if it seemed the control was likely to remain in the public sector.

7.2.3 The unlisted option provides scope for attempts to restrict shareholding so that, for example:

· Shareholders must be resident within the South Canterbury area; and

· No one shareholder may hold more than a defined percentage of the capital of the Company.

7.2.4 Experience is that these kinds of restrictions are difficult to enforce long-term, have an adverse impact on share value, and risk passing control from owners to management. This is discussed in more detail in the next section which deals with the various options open to the Trust. For the moment, we simply note that it is a value reducing option which may be unattractive to the Council (even as compared with retaining its shareholding) especially if it takes the view that the Local Government Act requires it to manage its shareholding as a trustee investment.

7.3 Return of Capital

7.3.1 The Company has power to make a return of capital as a distribution. This can include a distribution of capital which will be non taxable in the hands of shareholders up to the limit of available subscribed capital (which we understand to be $31 million). The distribution must be pro rata so that, if the full amount of available subscribed capital was used, the Council would receive $14.725 million. The Trust would receive $12.4 million and the remainder would go the Waimate and Mackenzie District Councils. (Tax considerations may require that this be done as a pro rata share buy back but the practical effect would be the same).

7.3.2 This may not be a particularly attractive option either for the Council or for the Trust. The Council recovers only a relatively small part of its investment. The Trust receives monies which it may prefer not to have (unless, perhaps, it was able to apply them in purchase of all or part of the shareholdings of the Waimate and Mackenzie District Councils, something which would require approval by a majority of consumers through a postal vote).

7.4 Share Buy Back of Council’s Shares Top

7.4.1 The Company has power to repurchase and cancel its own shares. This can be done either pro rata or in respect of the shares of a selected shareholder or shareholders (provided that the detailed procedures in the Companies Act are complied with and that there is express authority in the Company’s constitution - clause 3.1.1 of the constitution provides this). In practice, a buy back applied solely to Timaru District Council’s shareholding would require the agreement of all four shareholders on the value of shares (the Act requires the written consent of other shareholders to the transaction).

7.4.2 For illustrative purposes, assume that shareholders agree that the value of the Company is $93 million (which allows for a premium above ODV for the value of the network) and that the full amount of available subscribed capital, $31 million, is applied in buying back and cancelling a proportion of the Council’s shareholding. The impact on share value, and on shareholding percentage would then be:

Shareholder Value Shareholding

Before After Percentage

$m $m After Buy Back

Timaru 44.175 13.175 21.25%

Waimate 7.012 7.012 11.31%

Mackenzie 4.613 4.613 7.44%

Trust 37.2 37.2 60%

Total 93 62 100%

Effective control would pass to the Trust. Timaru District Council would have an obvious incentive to ask the Trust to buy out the remainder of its shares. We comment on this below.

7.5 Sale to Other Shareholders

7.5.1 Sale to other shareholders will be an attractive option for the Council, provided that a “fair value” can be agreed. For the Council, such a sale would:

· Leave the ownership of the network in local public hands; and

· Give the Council the capital represented by its investment for use elsewhere in its own activities.

7.5.2 If that option were explored, it would be in the interests of all shareholders that the Company first apply all its available subscribed capital in buying back Council shares - this reduces the amount of capital which other shareholders would need to raise.

7.5.3 In practice, the option “sale to other shareholders” almost certainly reduces to “sale to the Trust”. Waimate and Mackenzie both have statutory authority (under the Energy Companies Act) to purchase shares in energy companies but a reading of their annual plans and long term financial strategies suggests that increasing investment in Alpine Energy is not a priority. Both councils are effectively debt free but would need to raise debt or sell other investments to purchase further shares. So long as they were satisfied that the Company would remain in public ownership and control, then they may be quire comfortable with being minority shareholders in a substantially Trust owned company.

7.6 Disposal and Winding Up Top

7.6.1 From a purely commercial perspective the greatest immediate return for Timaru District Council would come from a sale by Alpine Energy Limited of its energy network (and other assets) followed by a winding up (this comment is subject to the impact of tax on this strategy including tax on recovered depreciation and tax on distributions in excess of available subscribed capital).

7.6.2 It would require the consent of other shareholders. Our understanding of attitudes towards loss of control to commercial owners outside South Canterbury suggests that this option would not prove attractive.

7.7 In Summary

7.7.1 We expect the Council to be advised (it may already have concluded) that it should treat its investment in Alpine Energy (strictly speaking in Timaru District Holdings) as an investment to be managed in accordance with the requirements of the Trustee Act. We note that existing council policy documents, such as its long-term financial strategy, assume no change in its shareholding in Alpine.

7.7.2 If the Council does resolve to realise part or all of the value of its investment then:

· It is unlikely to act unilaterally. Such an approach would be value reducing;

· Return of capital by way of a special distribution would be relatively inefficient. The Council would receive less than is available through other options; the Trust would receive a substantial sum of capital for which it may have no immediate use;

· The option of a buyback by Alpine of Timaru District Council shares using the full amount of available subscribed capital should be attractive provided that shareholders can agree on value - it would yield the Council $31 million and would also place some discipline on the Company’s balance sheet;

· The option of sale to other shareholders is likely, in practice, to be a sale to the Trust. It would work best if preceded by a buyback of the Council’s shares; and

· Disposal by Alpine Energy Limited of its network and other assets followed by a winding up is probably the option which would give the Council the highest immediate return. It may not, however, be acceptable either to other shareholders or to the community.

8.0 Trust Options Top

Trust options are considered in terms of the guiding assumption stated in section two, that is, trustees are seeking to determine what set of arrangements will best meet the interests of the community to which they are responsible. It is explicitly recognised that, depending on the set of arrangements preferred by trustees, it may be necessary to seek an amendment to the trust deed or even legislation. The assumption is that, if there is genuine community support for the preferred option, then the means of implementing it will be available and then comment briefly on assessing community support.

We consider Trust options under two separate heads:

· Distribution

· Retention

and then comment briefly on assessing community support.

8.1 Distribution

Distribution is considered first on the assumption that it takes place without change to the Company’s constitution or the shareholders’ agreement and, secondly, that it takes place with some attempt to retain ownership and management within the South Canterbury area.

Distribution Without Change

8.1.2 This is essentially the base case discussed in section five. It will happen if:

· Trustees favour distribution; and

· Trustees either do not seek, or other shareholders will not agree, changes to the constitution and the shareholders’ agreement.

8.1.3 It would result either from the trustees preparing a share allocation plan or from the default option which is triggered if no share allocation plan is finalised and given effect to by the deadline included in the trust deed. The principal difference between distribution pursuant to a share allocation plan, and under the default option, if no change is to be made to the Company’s constitution or the shareholders’ agreement, is the discretion trustees have under a share allocation plan to distribute shares and assets “to a greater or lesser extent to some or all of the consumers” subject to the plan being approved by a postal vote of consumers.

8.1.4 Distribution without amendment to the constitution and the shareholders’ agreement has several features which trustees may regard as unacceptable including:

· It does nothing to address questions of future ownership other than relying on the possibility that the local authorities will retain their interest;

· It creates the extraordinarily difficult situation that any sale of shares by an individual customer triggers the requirement that Alpine convene a meeting of remaining shareholders’;

· It may create some uncertainty regarding appointment of the three directors whom customers would then be entitled to appoint; and

· It may also leave unanswered the question of how shareholders would approve the statement of corporate intent. Alpine would remain bound by the statutory obligation to deliver a draft statement of corporate intent to its shareholders, including all customer shareholders, to consider comments shareholders might make and to deliver a completed statement of corporate intent to each of them once it was finalised.

Distribution With Modifications

8.1.5 We look at two different options - modifications intended simply to deal with the administrative problems which would result if the constitution and the shareholders agreement were unchanged and modifications intended to entrench objectives such as local ownership and control, pricing policy or customer relationships.

Administrative Simplicity

8.1.6 Under this option, trustees would seek agreement of other shareholders to amendments to the shareholders’ agreement and constitution to deal with:

· The process when a shareholder decides to sell; and

· The appointment of directors.

8.1.7 The needed changes should be relatively straightforward. We would recommend amending the Company’s constitution to provide for two classes of shares. Initially, all shares would be in a single class and the existing provisions would apply to them. Any transfer of shares which resulted in the transferee holding less than a defined a number would trigger the conversion of those shares into shares of the second class. Those shares would not be subject to pre-emptive rights. In addition, the Company’s constitution would provide for holders of that second class of shares to appoint directors generally pro-rata to their shareholding.

8.1.8 Consequential amendments would be made to the shareholders’ agreement.

Amendments with Objectives

8.1.9 Here we look at options for entrenching objectives which trustees, with the co-operation of fellow shareholders, may wish to entrench prior to making any distribution.

8.1.10 The first point we make is that it is important to be very clear about what it is the Trust is seeking to achieve. For example, there has been some discussion of restricting ownership to people resident in South Canterbury. If this is to be an objective, trustees should have a clear idea of what it will achieve. The location of shareholders may turn out to have almost no influence on how the Company is actually run. Restricting ownership to people (and firms) located in South Canterbury may simply provide a relatively low entry cost to a party or parties who turn out to be quite rapacious owners.

8.1.11 Trustees might conclude that they wanted to entrench measures which would prevent any exploitation of the lines business monopoly notwithstanding that, over time, full ownership of the Company may pass to private sector interests.

8.1.12 The normal means of entrenching objectives long term is to include provisions in the Company’s constitution. Such measures can usually be divided into two categories:

· Measures affecting the nature or concentration of ownership; and

· Measures affecting the management of the Company.

They may or may not be supported by what is known as a “golden share”.

8.1.13 Measures affecting the nature or concentration of ownership include:

· Provisions defining categories of persons who may or may not be shareholders; and

· Provisions restricting the percentage of shares which may be held by any one shareholder or group of shareholders.

Who May Hold Shares

8.1.14 There are no barriers (other than those arising under legislation such as the Human Rights Act) to a company including in its constitution restrictions on who may or may not hold shares. However, if such a restriction is included, it should be done in full recognition in what it is seeking to achieve and of the tactics which may be available to circumvent the provision.

8.1.15 If the objective is to restrict ownership to the South Canterbury Area, then the constitution could restrict it to:

· Natural persons resident within South Canterbury - but should such a person be required to sell if they moved out of the area;

· Natural persons plus companies or other bodies corporate based in South Canterbury - but this could include companies whose owners were outside South Canterbury; and

· Natural persons and bodies corporate whose beneficial ownership was held within South Canterbury.

8.1.16 This last option might seem to exclude the possibility of an outsider establishing a company in South Canterbury in order to meet the locality requirements for share ownership. In practice, it would not. Such a provision could quite easily be avoided by the establishment of a company, beneficially owned by local persons, but with a call option in favour of an outsider and with funding provided through a limited recourse loan (so that the local person was not at risk through fluctuation in share values) and including provisions on how shares in Alpine would be voted.

8.1.17 Restricting shareholding to natural persons would not avoid this possibility. The same structure could be put in place with an individual resident locally.

8.1.18 To be effective, therefore, such a provision would need to be supported by a requirement in the constitution requiring shareholders to disclose to the company, on inquiry, the nature of any interests behind the ownership shown on the share register and with a further provision entitling the company to forfeit shares if a person or persons outside South Canterbury had a prohibited interest in the shares (which might be defined as any “relevant interest” - see below for discussion of this term). This would require the company to develop a policy on policing its share register which could become quite complicated, especially if people seeking to defeat the objective decided to hold shares through a series of nominees.

Restricting the Extent of Shareholding

8.1.19 This was a common practice for those energy companies which, following the 1992 reforms, sought listing on the Stock Exchange. Typically they attempted to restrict any one shareholding to a maximum of 20%. There were three variants on this approach:

· A prohibition on any one shareholder owning more than 20% of the capital of the company;

· A prohibition on any one shareholder or group of shareholders holding a “relevant interest” in more than 20% of the capital unless shareholders by ordinary resolution gave their approval; and

· a prohibition on any one shareholder or group of shareholders holding a relevant interest in more than 20% but without the shareholder approval exemption (which in practice meant that the 20% level could only be exceeded if shareholders by extraordinary resolution approved a change to the constitution of the company).

8.1.20 The first variant was relatively ineffectual as it did nothing to prevent two or more shareholders or groups of shareholders working in concert. The second and third approaches were much more effective. The term “relevant interest” is defined in the Securities Amendment Act 1988. It covers not just ownership but a very wide range of other interests in shares including formal or informal understandings amongst shareholders.

8.1.21 As an approach, this is certainly effective to prevent one shareholder or a group of shareholders controlling or influencing how more than 20% of votes are exercised. However, what it actually does in practice is to hand over control of the company to management as it makes it virtually impossible for shareholders to work together in developing a common view on matters such as company policy, director appointments etc. It also effectively removes what is regarded as the single major discipline on the performance of investor owned companies. This is the implicit threat that, if a company is not performing adequately, someone who believes that they can do a better job will bid for control and, if successful, change management.

Assessment of Shareholder Focused Options

8.1.22 Both options are value reducing. Neither is acceptable to the New Zealand Stock Exchange so that the company could not achieve a public listing. This of itself depresses value.

8.1.23 Each is also value reducing in its own right. Restricting shareholding to the South Canterbury area would very much limit the market in the shares from the perspective of the ordinary investor. Restricting the percentage of shares which may be held by any one shareholder (especially if the “relevant interest” approach were used) is a signal to investors that the company would be under management control with limited prospect of shareholders being able to affect this.

8.1.24 Any assessment needs also to consider the interests of other shareholders. On the assumption that changes to the constitution are being made prior to a distribution by the trust, but with the three local authorities retaining their shares, then:

· Waimate and Mackenzie may both be relatively comfortable with any proposed changes because of the small size of their shareholdings; and

· Timaru District Council may take a very different perspective. It could assume that, following a distribution by the trust, it would have de facto control of Alpine, especially through the statement of corporate intent process, and so might instead focus very closely on the value of its shareholding should it ever decide to sell. It would probably be advised that a restriction on the size of individual shareholdings would remove any control premium which would otherwise attach to its shares.

8.1.25 The final point to make about both of these approaches, whether or not they are effective to achieve the specific shareholding objective, is that they may have little or no positive benefit for consumers. As already noted:

· South Canterbury shareholders might turn out to be just as rapacious as any other; and

· Measures which have the effect of entrenching management control tend, over time, to result in higher costs

Management Objectives

8.1.26 Rather than (or as well as) incorporating shareholding restrictions in the Company’s constitution, the Trust may prefer to entrench provisions concerning the management of the company. These could cover matters such as:

· Pricing policy;

· Dealing with disadvantaged consumers;

· Procedures regarding diversification, disposal of the network etc;

· Means for incorporating consumer interests in management - for example the creation of a customer advisory board; and

· etc.

8.1.27 If, on a distribution, the trustees wished to entrench these types of objectives, then this can be achieved by writing specific provisions in the constitution and entrenching those provisions through the creation of what is known as a “golden share”. This is simply a single share but with different rights from the rights attaching to the remaining shares in the company. This works to entrench provisions because, under the Companies Act, the constitution of the company can only be altered by special resolution of each interest group. The holder of a golden share constitutes a separate interest group.

8.1.28 If this approach is taken, then trustees need to determine who should hold the golden share. The holder should be a party or parties which has sufficient industry understanding, and sympathy with the reasons for creating the golden share structure, to ensure that it remains effective. This will require ongoing monitoring of the company’s performance and, possibly, from time to time agreeing to amendments to the provisions protected by the golden share to meet changing circumstances. There will be costs involved in this; a way would need to be found for the share allocation plan not only to allocate the golden share but also to allocate what would amount to an endowment to meet the ongoing costs associated with operating the golden share.1

8.2 Retention Top

8.2.1 Three options are considered:

· Status quo;

· Sole or majority owner; and

· Community owner of infrastructure assets.

Each of these options assumes that the Trust has reached the conclusion that the interests of its community are best served by long term public ownership of Alpine Energy Ltd and that this conclusion has the support of its community.

Status Quo

8.2.2 Under this option, the Trust remains in place. The only changes required are those needed to extend the life of the Trust (see the Simpson Grierson legal opinion on this matter).

8.2.3 This option:

· Assumes that local authorities, especially the Timaru District Council, share the objective of long term public ownership and have no requirement to withdraw any of their investment in the company; and

· Shareholders accept the present balance sheet structure of the company with its potentially negative implications for shareholder value.

Sole or Majority Owner

8.2.4 This option assumes that there is an acceptance that consumer interests in the future ownership and operation of Alpine Energy are best reflected through an ownership structure designed explicitly to recognise consumer interests rather than part of a more broadly focused public body such as a local authority. It also assumes that one or more of the current local authority shareholders is willing to downsize or exit from its investment in the company. The one with the strongest incentives may be Timaru District Council - see the discussion of council options above.

8.2.5 This option should be feasible financially, especially as the larger part of Timaru’s shareholding could be dealt with through a share buyback. It would also require an understanding by the Trust and other shareholders of reasons why consumer focused ownership may be preferable to more broadly based public ownership. Reasons could include:

· A consumer focused body may have fewer alternative uses for its capital than a local authority;

· To be truly effective in the interests of consumers, public ownership needs to be proactive in the interests of consumers rather than simply acting as a block to private ownership. This requires that the owner:

- have or be able to acquire the skills and knowledge to be a specialist in the industry so that it can make informed judgments on what constitutes the best interests of consumers;

- be able to act as a forum within which to resolve potentially conflicting consumer interests - for example dealing with measures which might prove necessary if individual consumers have difficulty in getting service from any electricity retailer; and

- be able to monitor, effectively, the performance of the company as a network owner and the performance of retailers trading across the network.

8.2.6 This option also requires that the Trust itself be able to put in place mechanisms which ensure that it is an efficient owner. For example, it is important that trustees do not confuse earning no more than a fair return on the network with providing an efficient low cost service.

Community Owner of Infrastructure Assets

8.2.7 This option is a longer term option which trustees, or their successors in office, might explore if the Trust chose and successfully implemented the option of being sole or majority owner of Alpine.

8.2.8 There are commonalties in network ownership at least between electricity and water and wastewater, particularly in areas such as:

· Asset management;

· Least cost operation (both industries, at least where relatively small networks are involved, are likely to be characterised by outsourcing network management);

· Pricing policy, especially where issues of low income and/or disadvantaged consumers are involved; and

· Acting as owner of a natural monopoly.

8.2.9 Essentially, this is an option which would result from the Trust and the Timaru District Council (and perhaps Waimate and Mackenzie) accepting that it was appropriate for the Trust (through majority or sole ownership of Alpine) to specialise in infrastructure ownership and for the local authorities to specialise in representing the interests of consumers in the services provided by that infrastructure (including the traditional local authority role of regulation).

8.2.10 It would need a recognition by both parties that there were benefits in creating an entity with a single focus on the provision of least cost infrastructure but working in close conjunction with the local authorities as the overall regulator. It would also depend on the parties identifying financial benefits resulting from Trust ownership and control (which would imply a user pays approach for water and wastewater services) as opposed to local authority ownership and control which could still contain within it some vestiges of rates based funding.

8.2.11 The option will look more attractive if, as expected, the current review of the water and wastewater industry results in legislative changes which create a “level playing field” as between public and private sector.

8.3 Community Support Top

8.3.1 The only mechanism provided for under the trust deed for determining consumer views on matters being dealt with by the Trust is the requirement to use the special consultative procedure set out in schedule two. This is to be implemented as part of the periodic reviews required by section four and also in respect of any share allocation plan.

8.3.2 So far, this procedure has been used only once, for consultation on the review undertaken in 1996. Our understanding from trustees is that there was very little public response.

8.3.3 The special consultative procedure is based on section 716A of the Local Government Act 1974 which sets out the obligations on local authorities to consult their public. Experience suggests that it is not generally a particularly good means of establishing public views. What it does do well is provide an opportunity for particular groups within the community who feel strongly about an issue to press their point of view on the body undertaking the consultation. The procedure allows competing interest groups to press their views on the public and seek support, not always based on accurate or well analysed information.

8.3.4 The outstanding example of this is the public consultation which took place some years ago on the proposed sale by the Auckland Regional Services Trust of its majority shareholding in the Ports of Auckland. Opposition was led by a well known talk-back host whose arguments against the sale where full of mis-information - perhaps the one thing which she really got right was the fact that the trust was proposing to sell it shares.

8.3.5 What the campaign did do was tap a deep sense of public unease regarding the proposed sale. The overwhelming opposition demonstrated through the campaign resulted in the proposal being dropped. The lesson from this particular instance is that the special consultative procedure is quite a good means of tapping public attitudes on large simple issues such as sell/don’t sell but inappropriate for gauging views on a range of different and possibly complex issues such as those which confront the Trust.

8.3.6 In this situation the better approach is to undertake a professional survey of public attitudes which may include or be supported by provision of information on various opportunities under consideration. Such a survey is best undertaken by a firm specialising in public opinion research.

8.3.7 In the Trust’s case, this would probably involve a survey of a minimum of 500 consumers selected at random to ensure the statistical reliability of any findings. That should be accompanied/proceeded by briefing the public on the options under consideration with a particular emphasis on seeking the involvement of key opinion leaders throughout the community so as to ensure, as far as possible, an informed public before any opinion survey was undertaken.

8.3.8 MDL has been involved on behalf of clients in commissioning work of this kind and would be pleased to advise the Trust on how best to go about seeking a robust and statistically sound understanding of community values on whatever option or set of options the Trust wishes to pursue.

9.0 Entitlement Top

9.1 If the Trust, with the support of its community, concludes that it should remain in existence long-term, then trustees may also wish to revisit the question of entitlement.

9.2 The distribution provisions of the trust deed are similar to those of a number of other energy trusts. Arguably, this reflects the fact that the process of corporatising electric power boards, and decisions around entitlement to income and capital, were driven much more by the industry than by consumers. The provisions reflect the view, common at the time, that trusts should hold assets on behalf of consumers in that capacity, rather than as firms or individuals with a range of interests, and that distribution of trust income should, as near as possible, be treated as the equivalent of a rebate on electricity charges. This influence can be seen in requirements such as:

· The great bulk of income should be distributed rather than retained to add to the corpus of the trust fund; and

· Trustees must seek a report from directors recommending an appropriate allocation of the dividend amongst classes of consumers based on the contribution made by each class to the earning of that dividend.

9.3 The result can be seen as one of fragmenting an income stream in such a way that it provides relatively minimal benefit - the distribution of $25.10 to each residential consumer was probably of minimal consequence even to the least well off in the community.

9.4 It may be timely, if the Trust is looking at redefining its role, to revisit the distribution question and determine whether the community is happy with the present pattern or would prefer that the Trust have the power to aggregate income and apply it in significant amounts to specific purposes within the trust community.

9.5 The question of distribution of capital is less significant if the trust remains in existence for the long-term especially as the rules for preparation of a share allocation plan do give the trustees a degree of discretion subject to a customer vote.

9.6 Of greater significance may be the Trust’s powers of investment. At present those are very narrowly defined. Effectively they prevent the Trust from using any of its capital for purposes other than reinvestment in the company or investment with the government or major trading banks. There is no power to invest capital in ways which might bring benefits to the local community, even if the form of investment complied with the requirements of the Trustee Act.

9.7 We have noticed a growing tendency amongst at least some trusts (more against licensing trusts and TrustBank community trusts than energy trusts, at least so far) to treat the capital which they hold as a resource which should be available to support projects within the local community, at least where those are capable of providing an acceptable return for the trust. Examples include:

· The recent purchase by a joint venture of the Masterton Licensing Trust and the Tararua Licensing Trust of state housing in the Wairarapa. Although the purchase satisfies the two trusts’ investment criteria, a primary purpose is to bring management of social housing closer to the community.

· The joint venture between the Southland Building Society and the Southland Community Trust to establish a venture capital facility for local businesses. A major motive for this initiative was the belief that Southland as a district was unlikely to attract the attention of private sector venture capital providers.

10.0 Conclusion Top

10.1 This report has been prepared by McKinlay Douglas Limited to assist the trustees of the South Canterbury Power Trust evaluate different options for its involvement with Alpine Energy Limited including, as part of that, some assessment of the interests of and options facing both the Company and other shareholders.

10.2 It has not been the purpose of this report to argue for or against any particular course of action. Instead the intention is that the report will enable trustees to undertake a meaningful review of the different options which may be available to them with the expectation that they will then select one or more options for further analysis.

10.3 We would be pleased to assist them with that process.

McKinlay Douglas Ltd

per

Peter McKinlay

Executive Director

[1] Bundled services refers to the increasing practice of marketing electricity along with other services which can be conveniently marketed or billed through the same channel - this includes such things as telecommunications, home security, financial services, media products and so on.

[2] Two points need to be borne in mind in considering this particular trade-off. First, customers who are not ratepayers, because they rent rather than own property, should for this purpose be regarded as the equivalent of ratepayers as landlords normally try and recover all costs including rates in their rent. Secondly, for simplicity, we have assumed that, for the typical ratepayer, paying a line charge fixed to give Alpine a full commercial rate of return (and thus the council a full commercial return on its investment) would be broadly offset by the impact on the general rate which that ratepayer would pay to the Council.

A Scoping Study Prepared For

The South Canterbury Power Trust

By McKinlay Douglas Limited

Contents

1.0 Introduction: Purpose