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Alan Dent and David Morgan presented the
Committee with an interim report of work to date on the Peer Review of the
HBRIC Ltd RWSS Business Case.
Still a work in progress, with the final
report to be presented at the 30 April 2014 Regional Council meeting.
Deloittes approach to address:
·
Whether HBRC can have comfort that exposure to
calls on capital can be limited to current funding of $60-80M
·
Circumstances under which HBRC may be required
to contribute additional capital, and where possible the quantity of those
potential calls and risks that such calls could eventuate
·
Extent to which Council can have comfort that
the projected returns on its investment have been accurately calculated and are
based on reasonable assumptions
·
How investment returns could vary under
different scenarios
·
Other matters that ought to be brought to
HBRC’s attention in connection with its assessment of the business case.
Process followed:
·
Review relevant background information
·
Provide guidance to HBRIC Ltd of expectations
of matters the business case needs to address
·
Review the business case submitted to Council
·
Reconcile contents of the business case to
guidance and advice provided to HBRIC Ltd by expert advisors
·
Request additional HBRIC/BNZ analysis and
documentation of financial case for RWSS
·
Interview key advisors and documentation
relevant to their advice
·
Review financial case and assumptions
·
Cross reference key assumptions to interview
information and review of relevant documents, including requesting additional
information and comment from advisors as necessary
·
Synthesise information obtained and
conclusions reached into report (ongoing).
Key Components of:
1.
Up front capital investment in physical
infrastructure
2.
Business model drives operating cash flows
necessary to provide investor returns
3.
Ownership model and investment structure that
allocates capital, risk and return to different investor categories.
Interplay
between the 3 key components underpins the financial case. Fundamentally
everything comes back to demand, and how long it takes to get to full uptake
as well as the profile of the uptake.
Focus on:
1.
Understanding the ‘building
blocks’ of the project, the assumptions sitting behind these and how
they’ve been brought together in the financial model
2.
Having obtained comfort of the reasonableness
of the assumptions supporting the building blocks and the way the financial
model was constructed and returns calculated, then used the model to:
·
Assess the overall return on capital under
different uptake scenarios
·
Demonstrate how the internal rate of returns
(IRRs) have been calculated
·
Use sensitivity analysis to identify which
assumptions matter and which are immaterial in terms of the financial case
·
Identify implications for HBRC capital
requirements and returns under different scenarios.
Building blocks
1. Capital costs
of $275 m funding (excluding financing during construction)
·
Final negotiations continuing but contract will be fixed time,
fixed cost including provision for project team during the
construction phase
·
Development costs largely spent with HBRIC contributing some
$9m to date, included as part of HBRC’s proposed investment
·
construction program is one of the major areas
which can expose HBRC (and all investors) to risks, broadly thought of as:
o
Capital cost – the risk that the final
project cost is more than that expected at the point at which the investment
commitment is made. The investor then needs to make up the shortfall which
impacts on the investors returns and potentially the viability of the
project.
o
Delays
– the risk that the project takes longer to reach operation than
expected meaning that revenues and other benefits are delayed and returns to
investors are delayed and/or reduced
o
Performance – the project fails to perform at the expected level
reducing the level of revenues generated and potentially requiring additional
capital to restore the project to an adequate level of performance. Again,
investor returns are reduced and, if the performance shortfall is
sufficiently large, the viability of the project may be compromised.
·
These risks have been locked down to a material extent through
the contracting process and mitigated from HBRC’s
perspective
2. Operating
cash flows
·
Revenue is driven by uptake, with start point
in terms of committed uptake and rate and profile of subsequent uptake by far
the most critical drivers
·
no firm contracted position for the operating
costs, however aggregate operating costs can be estimated to a high degree of
accuracy and are not a material driver of financial performance
·
include pump energy costs and pump and
distribution maintenance (both are aligned with uptake), dam maintenance,
generation plant, lines company charges, mitigation costs and Special Purpose
Vehicle (SPV) management costs
3. Uptake assumptions
·
Three scenarios modelled based on Castalia analysis
·
Actual demand will continue to grow and eventually exceed the
104 million m3 available. Therefore not all users in the command
area have to take up water.
·
Uptake conundrum at financial close – farmers want
certainty in order to sign binding agreements >< the project
won’t have certainty of going ahead until it has binding agreements
o
Early in the construction program a decision needs to be made
on the design and final cost of the distribution network requiring the best
view as to who the final users will be
o
40 million m3 condition precedent
·
Uptake post construction
·
Experience from the South Island says there will be a wave of
early adopters and then a second wave once water flows and farmers are able
to “look over the fence” and observe the benefits of irrigation
·
Inevitably the uptake curve will not look as stylised but
lumpier
·
Later adopters will have to pay full price from day 1
4.
Water User Agreements – key terms
·
Volumetric charge of $0.23 m3 take or pay + Energy
charge – $0.03 m3 for delivered water
·
Foundation Water User discount of $0.06 m3 for 4
years
·
CP1 – Ruataniwha Water LP confirmation that the
distribution network will service one of the nominated delivery points
·
CS1 – parties agree the terms of the Farm Environmental
Management Plan (FEMP)
·
No liability for delivery failure caused by climactic
conditions
·
Payments are monthly in advance (with evenly spread monthly
payments commencing in June each year, 3 months prior to the start of the
irrigation season)
·
Ability to withhold disputed amounts
·
Credit support = two years contracted water charges
5. Investment Model
·
Capital is yet to be locked down but is assumed to be provided
from a combination of arms length sources (institutional investors, bank
debt, related party capital (farmers/local investors, Iwi) and discounted
capital (Crown Irrigation and HBRIC)
·
“Base Case” includes two alike but different
capital structures which are being progressed in the current negotiations
with investors
o
One of these assumes no senior debt at
financial close and therefore the only capitalised interest during
construction relates to CII while the other assumes debt at day one so has
higher costs as it includes capitalised interest on the debt and higher
upfront fees
Fundamental Question
Are commercial returns a function of time and uptake?
- Starting point was to satisfy ourselves that at maturity,
i.e. full uptake, there are sufficient cash flows available to
compensate all capital providers
This provides comfort/assurance that the
need for subsidised capital is due to the fact that there will not be full
uptake immediately – rather than being due to more fundamental issues
with the financial viability of the project.
·
Based on analysis to date, at full uptake there are sufficient
cash flows to provide commercial returns to all investors
·
Under the base case scenario CII is repaid in 2031 and Farmer
note and institutional investors convert to equal investor terms to HBRIC Ltd
·
Steady state cash flows ($ nominal) in 2031 are circa $36m -
$40m before financing (HBRIC Ltd portion circa $9m after tax).
·
Base case assumes senior debt is bought in to help pay out
investors.
·
Proposed gearing levels appear conservative in the context of
what is being achieved for projects with full uptake
·
Debt starts amortising 2038 (repaid 2048) and then refinanced
after the second consent in 2050
Next question – how are returns calculated?
Given the nature of the investments in the RWSS, difficult
to calculate returns other than on an IRR basis, so reviewed IRR calculations
to:
1. Satisfy ourselves
that the basis of calculation is reasonable
2. Identify aspects of
the calculations that Council should note
IRR Returns
1 We
are satisfied that IRR returns have been correctly calculated
2 We
note the following factors that influence these calculations
o
Uptake
o
The quantum and timing of the introduction of debt
o
Interest rate assumptions
o
Assessed value of HBRIC investment at full uptake
o
Refinancing
In summary:
· The construction contract drafting, funding structure, water user
contract, farmer capital raising processes are still in progress, however
assuming the final outcome is delivered within the parameters we have seen
then:
- Capital costs þ
- Capital structure and
funding þ
- Benefits þ
- Uptake
- Initial 40% þ
- Time to full uptake ?
- Full uptake þ
·
Uncertainty as to when full uptake is achieved is the key
project risk and HBRC needs to understand the implications
of this uncertainty for the need for additional capital, and investment
returns.
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