Greg Martin Speech: Gas and NZ Economy

ADDRESS BY

GREG MARTIN, CHAIRMAN NGC

NGC WINTER LECTURE SERIES 2003

WELLINGTON, 30 JULY 2003

GAS AND THE NEW ZEALAND ECONOMY

Thank you Phil ….

Minister Hodgson and distinguished panellists, ladies and gentlemen.

I am delighted to address this, the first of the NGC Winter Lecture Series, and to share my thoughts on natural gas and its role in the New Zealand economy.

My address has a particular theme of overseas investment in New Zealand, with a focus on energy growth.

I think you’ll agree that this is a big subject. In keeping my contribution to about 20 minutes, I have abridged some sections of my discussion. The full text is in the copy available to you at the conclusion of the lecture, and accessible on NGC’s website.

I believe I can bring two perspectives to the topic:

As Chairman of NGC, I have the perspective of a New Zealand company looking to investment opportunities.

The other hat I wear is that of Managing Director of AGL, which brings the perspective of an overseas company with international investments, including here in New Zealand.

You might expect this particular Australian to have a somewhat jaundiced view of investing in New Zealand, after NGC lost $300 million in its electricity retailing business in 2001. That hurt all of NGC’s shareholders, including AGL.

It demonstrates that, despite diligent planning, investments sometimes don’t turn out for the best.

We have recovered, and have learned from the experience. We remain keen to pursue appropriate investment opportunities, but our approach is now more cautious; our decisions more deliberate.

AGL is not a fair weather investor. We have been in New Zealand for more than 10 years.

Nevertheless, investment here, like anywhere else, is all about maintaining an ongoing business case.

Governments and industry have a common drive to always do better by seeking out opportunities. Where they can differ, is in how they think about, and address the issues.

For companies, there is an incentive to invest – if just to maintain asset values and operational capabilities.

For example, as NGC observed at its recent investor conference, it needs to look at spending $20 to $50 million a year to maintain its current asset level, and to organically grow the business.

Of course you commit capital for reasons other than shoring up the balance sheet.

As guardians of their owners’ funds, company boards and management have a duty to ensure that every dollar spent enhances the business platform, makes a return, and increases enterprise value.

Shareholders are otherwise entitled to ask: “Why spend it in the first place?”

AGL, like other companies, applies strict criteria to investment prospects.

We are in the particular business of energy, and the investments we make tend to be large and long-term.

A key consideration for us, then, is that the regulatory climate is conducive to this type of sunk investment, and that it won’t suddenly change.

Most people expect stable, secure and reasonably priced energy supplies that not only meet the needs of today, but are capable of fuelling the economic growth of tomorrow.

I firmly believe this is achieved most effectively in a light-handed regulatory environment, which encourages investment in well functioning and efficient markets.

Let me now look more closely at the energy supply environment in New Zealand, and the particular role of gas. First, some historic context.

Like many other countries, New Zealanders first got their gas from coal gasification plants. The first coal gas plant began operating in Dunedin - the Minister’s home town – in 1863. So gas, in one form or another, has played a role in the New Zealand economy for 140 years.

The big change for New Zealand came in 1959 with the discovery of the Kapuni natural gas field and the subsequent decision by the Government of the day to use this gas as a premium fuel.

That is how NGC was born. It was established by the Government in 1967 to buy the gas from the Kapuni joint venture, treat it to market specifications, and pipe it to Auckland and Wellington for direct use by consumers in those centres, as well as in towns and cities along the pipeline route. Deliveries started in 1970.

The strategic use of natural gas as a premium energy offered consumers a fresh commodity that was competitively priced and environmentally superior to the old manufactured gas product.

Kapuni was the precursor to a series of discoveries, including Maui, that, in the space of 30 years, saw natural gas rise to become New Zealand’s single most important source of primary energy, and fundamentally change the energy supply mix.

In that period, natural gas, more than any other energy source, has fuelled the nation’s growing appetite for energy.

From 1974 to 2001, when primary energy supply increased by over 90 percent, gas production increased 20-fold, and its contribution to total supply rose from just over 3 percent, to almost 33 percent.

Apart from supplying the gas, the fields make a further important contribution in the form of oil, condensate and LPG.

Demand for gas remains strong. It is used in over 230,000 homes and businesses, it is an efficient and reliable swing fuel for electricity generation, and it is the energy of choice for many of New Zealand’s large value-creating industries – including those competing in international markets.

For a country with a strong environmental ethic, it is no doubt pleasing to see a doubling of non-hydro renewable energy production in the period since 1974.

However, while production may have doubled, the contribution of non-hydro renewable energy to overall supply rose by only one percent – from 5.7 percent in 1974 to 6.7 percent of total supply in 2001.

This indicates to me that, in an energy market where electricity demand is growing at around 2 percent a year, significant energy users can’t rely on renewable energy alone to meet their needs.

Indeed, as the energy supply mix changes with the earlier than expected wind-down of the Maui gas field, New Zealand must look increasingly to the full range of energy supply resources at its disposal.

This appears to be already happening, with proposals for greater coal-fired generation at Huntly, and for the conversion of the New Plymouth power station to dual gas/oil capability.

As a result of these changes, I see a growing tension between New Zealand’s aspirations for economic growth and its desire to meet environmental performance targets.

The challenge, for the country and for intensive energy users, is to find creative solutions to reconcile the need for stable and secure energy supplies using all resources available, against the nation’s environmental commitments as a signatory to the Kyoto Protocol.

New Zealand’s experience with international supply instability in the 1970s demonstrated the importance to a nation’s economy of secure, reliable and reasonably priced energy.

Supply security is helped by New Zealand’s ability to produce much of its own primary energy – currently about 70 percent.

Imminent changes to the energy supply mix pose some key questions. Among them:

how valuable, strategically, are indigenous resources?; to what extent does New Zealand want to, or need to, maintain a level of indigenous production?; and what kind of economic and investment parameters are needed to best deliver security, reliability and best price?

New Zealand’s oil and gas fields currently contribute about a third of New Zealand’s primary energy supply. But, by definition, they are declining resources. As they diminish, the gap must be filled by other means.

One way is to improve energy management efficiency –sound business sense in any case - and I am aware of the Government’s objectives in this regard.

Beyond this, energy can be obtained by:

exploring for, and developing, new hydrocarbon reserves; increasing production of other forms of energy; and importing it.

Of these, the most evident recent trend has been in imports.

While there are discoveries awaiting development, oil imports have more than doubled since the peak of indigenous oil production in the late 1980s.

More recently, reduced Maui gas offtakes following the reserves redetermination has required LPG imports to help meet winter peak demand. This is likely to continue until new LPG supplies come on stream.

With the market signals for new production – particularly for gas – growing stronger, and with the right investment climate, I would expect exploration activities to increase exponentially in the near future.

The importance of natural gas to the economy is confirmed by the Government in its Policy Statement on the Development of the New Zealand Gas Industry, where it says: “The Government is committed to a sustainable and efficient energy future. Natural gas will play a significant part in achieving that commitment.”

This is reinforced in Minister Hodgson’s comment to the Gas Association earlier this year that: “Gas is critical not only for direct users, but for New Zealand’s electricity supply security.”

New Zealand’s current developed and undeveloped gas reserves of around 2,250 petajoules is not an unhealthy position, but new reserves are being added at a rate substantially below consumption.

Of immediate concern are timing issues around bringing undeveloped reserves to market, and around field deliverability.

Under the known reserves position, the gas market is expected to decline to a sustainable level of around 120 to 150 petajoules a year in the decade following the expected Maui depletion in 2007/2008.

Demand reduction will come primarily from the cessation of petrochemical production, particularly methanol, and the gas substitution proposals for electricity generation at Huntly and New Plymouth.

The Minister’s vision for the role of natural gas takes on additional importance in the context of the Government’s environmental objectives.

In Australia, where 80 percent of electricity is generated from coal, gas is being pursued as a transitional, or “green” option.

However, the ability for natural gas to make a full contribution in New Zealand is changing – and the clock is ticking.

Given the 5 to 10 year exploration-to-production lead time, investors, both in New Zealand and overseas, are looking at how New Zealand is approaching its energy supply challenges.

There has been considerable improvement in New Zealand’s international ranking of petroleum investment attractiveness – from 36th to 14th in the last three years - and I hope this will convert to a more active exploration programme.

Upstream activity would certainly benefit from wider involvement.

We have seen consolidation of most developed and undeveloped reserves into the hands of three companies – a major and two intermediates - acting individually, as well as together in a variety of joint ventures.

There is then a large gap between them and the variety of small independent explorer/producers who are making a valuable, but relatively modest contribution to the exploration effort.

Moreover, since the consolidation, there has been a lack of offshore drilling, discovery and development, delays to projects and increased project costs. This is of concern because of the greater probability for significant discoveries to be made offshore.

I hope the market signals will be loud enough, and clear enough, to attract a greater number of strong, independent, mid-sized players with the financial and operational resources and commitment to take the search to a higher level.

By world standards, New Zealand is under explored. I share the view that it has yet to reveal all of its oil and gas reserves, and that natural incentives for explorers will arise as market opportunities for new gas expand.

But, it’s an international business.

New Zealand may well meet explorers’ fundamental requirement for prospectivity, but it has the drawbacks of distance, consequently higher exploration costs, and an isolated, relatively small market.

From this position, New Zealand is competing for exploration capital against lower cost, lower market risk regions with equivalent or better prospectivity. Accordingly, some major exploration companies set the bar higher for New Zealand in respect to their capital return and production growth requirements.

New Zealand must therefore compete effectively in other important areas that influence the exploration spend – economic and market growth prospects, tax and royalties regimes, compliance costs and impediments to development.

I note that upstream participants suggest a number of measures the Government could take to enhance New Zealand’s attractiveness and encourage further investment in gas exploration and production, without embracing a “pick winners” policy.

They include aligning royalty structures with countries like Australia, amending various accounting and tax treatments, and mitigating barriers to development.

Attractiveness would also be improved by developing further depth and breadth to the gas market in a way that retains all the elements of competitive supply.

So, to the question of the climate for energy growth in New Zealand, I say the potential is good, but it could be great.

Which brings me to the final theme of my address this evening, “Perceptions of New Zealand as an Investment destination.”

Economic growth in New Zealand has been running at over 4 percent, but I note it is forecast by NZIER to slow to 2.2 percent and 1.8 percent over the next two years.

I know that New Zealand would like to achieve a consistently higher growth rate to take it to its desired position in the top half of OECD countries.

The drivers are there, and the potential for growth hinges on New Zealand’s ability to leverage its competitive advantages, and to offer policies conducive to investment in its future.

Energy availability and reliability represent just one component – albeit a critical one - in attracting investors, but I would like to offer it as an example of how perceptions can be shaped.

From an offshore point of view, the electricity shortages of 2001 and, more recently, the hydro reserve scare that brought calls for power savings leading into this winter, have not helped New Zealand’s reputation for reliability.

It is not a good look for potential overseas investors to see such volatility, let alone New Zealand industries preferring to shut down operations – or considering relocation offshore - rather than suffer unreasonably high power prices, and supply threats.

The Government has responded by establishing the Electricity Commission, although I am aware of debate as to whether it required Government intervention, or if it was best left to the market participants to meet the supply security challenge.

Generators are responding to market signals for new generation capacity, and several proposals are on the drawing boards.

Before NGC sold its Taranaki Combined Cycle power station, it had completed the planning consent process to add a further 500 megawatts of capacity.

It’s unfortunate that gas-fired generation proposals have been clouded due to uncertainty around future gas availability.

In this regard, it is worth noting that, if large volumes of gas were to be found in the Canterbury region – and it is a region with some prospectivity – a 500 megawatt gas-fired power station could be built for less than half of the cost of the proposed, similarly-sized, $1.2 billion hydro project.

It is not known when security reserve capacity will be available, and the electricity industry properly prepared to manage another dry winter.

Add to this a prognosis for a decline in gas availability to somewhere between 50 and 70 percent of current annual supply levels post 2007, and I can’t help but feel that New Zealand is in a Catch-22.

With uncertainty around energy supplies, New Zealand may find it harder to attract the investors, who feed economic growth, which in turn drives energy supply growth and improves supply availability and reliability.

Potential investors may be cautious until they have a sense of how energy supply will evolve, and they can feel confident their investment will not be adversely impacted by energy instability.

Is this already happening?

These Statistics New Zealand figures on foreign investment in New Zealand shows a 19 percent decline in total investment from 2001 to 2002.

A different report in the Business Herald recently told us that annual Foreign Direct Investment declined from US$4 billion in 2001 to US$300 million in 2002. This was reported as the biggest FDI decline of any OECD country.

Is this a manifestation of caution over investment in New Zealand, or simply confirmation of the nature of international investment funds - that they will land where they obtain the best return?

Perhaps both, but there may of course be other explanations, such as general investment caution post-September 11.

We know that the Government is committed to economic growth. The Speech from the Throne last August contains strong references to sustainable growth, to building on New Zealand’s natural advantages and deepening the competencies associated with them.

This is an important message for the outside investor. It confirms acceptance by Government that, notwithstanding its social policy objectives, it must increase the pie if it is to avoid playing a zero-sum game.

New Zealand, with its rich national tapestry, will do best by playing to its strengths:

it is a stable democracy, it has a distinctive Kiwi “can do” attitude and know-how, it has demonstrated technical innovation, and it is a wonderful lifestyle destination.

All are elements that appeal to the finer instincts of overseas investors.

But the one attraction that really singles New Zealand out – that gives New Zealand a vital competitive edge - is its light-handed regulatory approach. It should not be relinquished.

I therefore view with growing concern a trend of regulatory creep.

In recent times, the regulatory spotlight has fallen on utilities and the infrastructure sectors.

Telecommunications companies, electricity lines businesses, ports and airports have all run a long, complex and costly gauntlet of regulatory scrutiny. I find at least some encouragement in the Government’s decisions not to further regulate the ports or airports once the issues had been examined robustly.

Now it is the turn of gas transporters.

I understand the Government’s desire to gain an insight into the industry’s pricing practices, but I hope it is equally appreciated by Government that such a long process, running until November 2004, imposes direct financial costs of millions of dollars.

In addition, as recently as this month, there are indications the gas industry will become subject to backstop legislation and rolled in to a bureaucracy set up to deal with an electricity sector that couldn’t agree on self-governance.

I understand it will be used only if the gas industry can’t establish self-governance arrangements in a timely and satisfactory manner. This, however, is undefined, and the threat comes at a time when the industry is actively addressing the government’s policy objectives and, I must add, making very significant progress.

The unpalatable fact is that quite unnecessary regulatory powers are proposed to address issues that have not previously been raised, and to establish remedies when they already exist.

The negative signals this type of regulatory opportunism sends to investors can have far-reaching implications for New Zealand and its economy.

NGC will participate fully in these processes, but we sound a caution that the constant application of people and financial resources to regulatory compliance and regulatory management is draining on those resources, diminishes shareholder value, and discourages investment.

This is evident in Australia, which takes a far greater hands-on approach to regulation of business. Overseas investors come and go. They constantly monitor industry structures and scan the regulatory horizon – and they will withdraw if they feel regulation is unnecessarily eroding the business environment.

New Zealand as an investment destination competes against such places as Queensland, which offers enticements like tax and planning breaks.

But a business, having set up shop, then has to operate within a fairly rigid regulatory framework.

By contrast, New Zealand doesn’t generally offer enticements, but a business setting up here has been able to expect greater flexibility in managing and growing the business to the benefit of everyone.

Investors become very nervous if they suspect the rules might suddenly change, or markets will behave differently than intended.

As you might expect, many large companies considering an investment offshore conduct a thorough “country profile” as part of a comprehensive investment risk assessment.

Such a profile of New Zealand might reveal other areas of investment concern:

Are property rights protected, particularly in the context of the settlement of Treaty of Waitangi matters?

On this point, I get some comfort from the Prime Minister’s assurances on the public asset nature of oil and gas reserves and, more recently, on Crown ownership of New Zealand’s foreshore and seabed. However, I note that these and other claims are very much active and subject to detailed negotiation.

- Have New Zealand’s infrastructure systems reached saturation?

There is general awareness, for example, that urban transport networks, particularly in Auckland, are under strain.

I am aware that this matter will receive attention under the infrastructure stocktake announced in this year’s Budget.

- What impediments are there to developing and operating new industries?

Recent Resource Management Act amendments have a narrow focus on renewable energy development. There remains a continuing concern over the RMA processes and their effect on the timely and cost-effective development of new enterprise.

- In the electricity sector, a potential investor might reflect on participation in a market where the Government is both the regulator and the dominant direct commercial competitor.

- Is the taxation regime competitive? According to a KMPG survey earlier this year, New Zealand’s 33 percent corporate tax rate is nearly three percentage points above the international average.

As such, it stands among the highest in the Asia-Pacific region and can be regarded as a negative factor in attracting foreign investors.

There are numerous other benchmarks that potential investors will analyse in reaching their decisions.

All of them represent challenges that I am sure are well known to the Government.

There will be occasions when a particular investment opportunity will attract instant and significant interest. Take for example, the bidding war for TranzRail.

At other times, despite a capacity and willingness to invest, it may not happen because no appropriate opportunity exists.

This is currently the case with NGC, which is proposing a $475 million cash capital return to shareholders, as there are no immediate significant investment opportunities for reinvesting the power station sale proceeds.

However, generally speaking, the level of investment will relate to the willingness of the host country to recognise the fundamental requirements for investment and to shape a stable and attractive environment for it.

For many investors, that environment is one in which light-handed rules facilitate efficient and effective markets, and allows them to work free from the uncertainty of regulatory opportunism. In conclusion, ladies and gentlemen, New Zealand has a very positive international reputation and a number of significant advantages that are inherently attractive to potential investors.

There are issues that may cause investors to hesitate. As I see them, the primary ones surround confidence in future energy supply, risks to New Zealand’s competitive edge from regulatory intervention, and taxation levels higher than those of countries chasing the same discretionary investment dollar.

On the positive side, companies have a strong motivation to invest to maintain and grow their businesses, but they are likely to be more cautious and conservative than before.

The New Zealand economy is forecast to grow, and we all have an interest in achieving a growth rate higher than the 2 percent foreshadowed for the next two years.

With economic growth and an appropriate focus on the fundamental needs of investors, New Zealand can expect to be in the sights of the offshore investor and to prosper into the future.

Thank you …

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