Contact - Chief Executive’s Annual Meeting speech
1 23 October 2008
Chief Executive’s Annual Meeting speech
Introduction Thank you Grant, and may I also extend a warm welcome to you today. It’s been another significant year for Contact – a year in which we’ve dealt with a number of key challenges while making good progress on executing Contact’s growth strategy, with a number of key investment initiatives which will, when built, be a significant source of Contact’s shareholder value. Over the next couple of minutes, I’ll discuss the key issues that characterised the last financial year – and how they have influenced the performance of the company in the first quarter of the current financial year. But I would first like to start by outlining Contact’s strategy and where we are in executing on that strategy.
Strategy Slide: Snapshot Many of you know that Contact’s value is derived from its pre-eminent position as New Zealand’s only truly national utility, which generates around 28 per cent of the country’s electricity and is the largest wholesaler and retailer of natural gas, with a total of 650,000 gas, electricity and LPG customers across the nation. One of Contact’s key strengths is the diversity of its fuel supply - hydro, geothermal and natural gas. As we look forward, one of the most important questions that we think about is what are the future sources of fuel to power New Zealand over the next 10 to 20 years? In considering this question, one of the factors we look at when deciding where we should be focussing our investment capital is the relative cost of electricity over the long-term. The cost of electricity is dependent on a number of factors: • the cost of constructing the power plant • any new transmission that may be required • the current and future costs of the fuel • operating and maintenance costs; and 2 • any other costs – like the cost of carbon emissions, which any emitter of carbon dioxide will face when the Emissions Trading Scheme comes into effect for the energy sector in 2010.
Slide: Costs of new generation
This chart shows the cost of electricity from the three fuels that will most likely power new electricity generation in New Zealand over the next 10 – 20 years. Looking at the chart, the first bar on the left shows the cost of new generation from wind turbines. In this case, the cost of wind energy is primarily driven by the cost of the equipment and infrastructure required to build the project, since the fuel is free and the power station doesn’t emit any carbon. The costs of new wind generation range between 8.5 and 11 cents per unit, depending on where the project is. The second bar shows the cost for new natural gas-fired generation – which is between 8.5 and 14 cents depending on two factors: the cost of natural gas and the cost of carbon emissions. The low end of the range optimistically assumes that the current price we pay for natural gas will continue, and there will only be a relatively modest price on carbon emissions of around $23 per tonne. The reality, however, is that natural gas costs will continue to increase – potentially toward the cost of imported natural gas – and the costs of carbon emissions will also increase as the world responds to the priority of climate change. And on the right of this chart, it becomes obvious as to why geothermal is Contact’s number one investment priority. It’s the ideal fuel for New Zealand. In addition to being the lowest cost new generation, it’s not weather dependent like hydro and wind – it’s always on, day in, day out. And on top of that, it’s incredibly climate friendly.
Slide: Geothermal will double over the next five years
Contact is advancing the development of 500 megawatts of new geothermal generation capacity in the Taupo region. The company is already the country’s leading geothermal generator and, with the completion of these new power stations, Contact will have cemented its position as one of the world’s leading geothermal developers. The first of our geothermal projects is the 220 megawatt Te Mihi power station for which we have received final resource consents last month. This is a big step forward for a very important power station that we expect to be in operation in 2011. 3 Additionally, we have now taken the first significant step in the development of the large Tauhara steamfield near Taupo. Construction of the first phase of Tauhara is currently underway, with the second phase – the addition of a further 240 megawatts – in operation in 2012. We are also looking at where our next geothermal opportunities may be beyond these projects. There are likely to be further opportunities in New Zealand but, with the world-class skills and experience that Contact has in geothermal, there will also be opportunities to exploit Contact’s geothermal capabilities offshore.
Slide: Investing in gas flexibility Alongside our 500 megawatts of geothermal projects, good progress is also being made in the construction of a 200 megawatt gas-fired peaking plant at Stratford in the Taranaki area. Designed to fill in the gaps when the rain doesn’t fall or when the wind doesn’t blow, this power station will be able to go from cold to full output in less than 10 minutes. This peaking plant is being constructed just a few kilometres from the location of New Zealand’s first underground natural gas storage facility. Earlier this year, Contact and Origin Energy were successful in acquiring the New Zealand oil and gas assets of Swift Energy. Through that acquisition, Contact secured a much sought-after gas storage option in the largely depleted Ahuroa gas field near Stratford. When the construction of the underground gas storage facility is complete in 2010, Contact will take natural gas and securely store it in the gas reservoir at Ahuroa, for use when the company and the country needs it most. This creates flexibility of gas supply to enable Contact to use its peaking plant and its other gas-fired power stations at times which best suit market conditions.
Slide: wind projects
The other renewable energy source we are advancing is wind. Over the last 18 months, Contact has established itself as one of the leading developers of wind generation, with 720 megawatts of wind projects now in the consenting process. As lower cost geothermal resources are developed, the focus will inevitably shift toward wind generation – particularly as the relative economics of new generation will likely favour wind over gas-fired generation. So, what does this all mean?
Slide: 1,400 megawatts of new generation
Over the next five years, Contact will invest around $3 billion in developing some of the country’s most important electricity generation projects: • geothermal • gas-fired peaking capacity • underground gas storage; and • wind energy. Looking further forward, it’s our view that there will almost certainly be a role for new large scale hydro, and we’re working to ensure that Contact has the best options ready to go when that time comes. Your company is taking the lead in investing in New Zealand’s electricity generation infrastructure and these projects will help deliver a secure and increasingly renewable energy supply for New Zealand, as well as building the foundations for growth and long-term shareholder value.
I’d now like to move on and discuss a key issue, which will need to be addressed to enable the country to fully benefit from the investments I have just outlined. I expect most of you will have seen the coverage and comment around Contact’s decision to increase retail tariffs for South Island customers. I’ll spend a few minutes on the background to the tariff increase, but in summary they reflect the higher wholesale prices, which are the result of a constrained transmission grid. The issue of transmission constraints preventing the free flow of electricity, particularly to the lower North Island and South Island, is of national importance. To paint the backdrop to this, it is worth touching on some of the key events of the last year or so.
Slide: Key events which characterised the last financial year
The last financial year was impacted by three significant events: The first was the unexpected decommissioning of pole one of the HVDC – the electricity transmission cable that connects the North and South Islands. While this piece of infrastructure was relatively old, it was expected that it would remain operational until its replacement was constructed. At this stage the replacement is not expected to be in service for at least four years, and therefore the market has lost a key asset for that time. It is significant because the loss of pole one limits the amount of energy that can be transferred between the islands. 5 The second event was the decommissioning of the New Plymouth power station following the discovery of asbestos. This resulted in the loss of 300 megawatts to the generation market. As a consequence of the dry winter, Contact subsequently recommissioned one of those units to help meet North Island demand during the winter months. On a related note, the asbestos removal from New Plymouth is progressing well and will be completed over the coming months. The third event was the significant drought which affected the entire country, which severely limited the availability of hydro generation. While the drought eased during July in the north, the south remained hydro-constrained until just last month.
Slide: North and South Island storage (first)
These three events culminated such that the country effectively split into two energy markets over the last winter. This was primarily due to the marked difference in hydro conditions prevailing in the North and South Islands. These charts show hydro storage levels for the North and the South Islands between April and October this year. The left hand chart shows that South Island storage (the red line) was well below average (which is the orange line) through to September, at which time the drought broke in the South. The right hand chart shows that North Island storage was below average from April through July, but increased in August to be well above average. Looking more closely at the first two months of the current financial year (July and August), it starts to become apparent why the national transmission system was unable to cope with the demands required of it: Slide: North and South Island storage (second) In August, inflows into the Clutha were near their lowest on record. Slide: North and South Island storage (third) At the very same time – inflows into Lake Taupo were at their highest on record. So while the South Island was short of generation, the North Island was overflowing – not just in hydro, but the thermal plants had to reduce their output because the transmission system couldn’t get all of the energy to the places where it was most needed – in the south.
Slide: Transmission constraints
So what are these transmission constraints? 6 There are two main issues: • The loss of pole one of the Cook Strait cable which links the North and South Islands, which was unexpectedly decommissioned last November; and • The second set of constraints occurred across various parts of the transmission system, particularly between Taupo and Wellington. These constraints prevent the flow of electricity into the Wellington region and result in the cost of supply to Wellington customers being similar to those in the South Island. The investment required to fix these constraints is much less than replacing pole one of the HVDC, but is essential to addressing the key issues facing the electricity market.
Slide: Wholesale electricity prices (first)
Over the last winter, the primary impact of these transmission constraints was seen in wholesale electricity prices. On this chart, we see the wholesale price of electricity from January to September this year. The red line is the South Island wholesale electricity price, and the orange line is the North Island wholesale price.
Slide: Wholesale electricity prices (second)
The first four or five months of the year were relatively normal, with prices in the North and South Islands closely aligned. This was because the transmission system enabled the free flow of electricity between the islands, and thus ensuring the lowest cost energy is used first, regardless of its location.
Slide: Wholesale electricity prices (third)
South Island prices in May rose significantly above those in the North Island and, with the exception of a few weeks in July, remained so throughout the winter.
Slide: Wholesale electricity prices (fourth)
Although both the North and South Island prices were lower in August, the price difference between the two islands continued, with the South Island wholesale price being around 10 cents per unit more than the North. Why was this? In August, the North Island had more electricity supply than it needed, while the South Island – still suffering from the effects of the drought – was constrained by the transmission system from accessing the cheaper energy in the North to meet its demand, and thereby pushing up the price of energy in the South Island. 7 One of the questions that Contact has been analysing is how much of what we saw in August was due to unique extreme weather, and how much was systemic and therefore ongoing. The answer, as you may expect, is that it’s a combination of both.
Slide: Contributing factors
Part of what we have seen is the result of fundamental changes in the supply and demand patterns across the country. What this chart shows is the growth of supply and demand over the last 10 years in each of the two islands. On the left, the North Island’s demand growth over the last 10 years (which is in red) has more than adequately been met from investment in new generation. However, in the south the picture is quite different. There, investment in new generation has been well below the growth in demand. There’s nothing wrong with this. Again, if we go back to the start; the lowest cost sources of new generation have been – and will continue to be over the medium term – in the North Island. However, the investment in North Island generation has been premised on a strong transmission grid to move the power across the country. You could look at it a bit like this: The partner of the lowest cost generation is transmission.
Slide: Transmission flows across the Cook Strait cable
It’s not surprising, therefore, that the South Island has become more reliant on the North Island to meet its energy demand. Which is contrary to the long held belief for us mainlanders that the South Island was the primary source of power in the north. We were brought up with the idea that we should cut the cable. The reality is however that the South Island is becoming increasingly dependent on North Island generation – and therefore the Cook Strait cable. This chart shows the daily flow of power from the north to the south over the last 10 years. Where it’s red, the flow of power is from the north to the south. You can clearly see that southward flow is increasing over time.
Slide: Cost of transmission constraints
So what did these transmission constraints end up costing? Between May and August this year, South Island retailers paid approximately 26 cents per unit for electricity supplied to the South Island across the Cook Strait cable. The total cost was approximately $150 million more than South Island retailers would have otherwise paid if there were no transmission constraints. To put this into context, a retail customer pays about 20 cents per kilowatt hour and this covers all of the costs of generation, transmission and distribution. If these increased costs had been fully charged to customers, they would have been paying double their normal rate, or 40 cents per kilowatt hour. The share of this additional $150 million of cost as borne by Contact is the primary reason that we are not expecting to outperform last year’s result. Slide: Medium-term implications Contact expects that the risk of constraints will be higher until the Cook Strait cable replacement and other transmission investments are made. Accordingly, the North and the South Islands will from time to time operate as separate markets. The South Island will continue to require the flow of electricity from the North Island, but the constraints on the transmission system will limit the energy that can be delivered from the north. This will increase the average wholesale electricity price in Wellington and the South Island, compared with the rest of the North Island. It is for this reason that Contact has taken the decision to reflect the costs associated with the risk of transmission constraints for South Island and Wellington tariffs. While we are paying the price for years of underinvestment in the grid, we strongly support Transpower’s current transmission investment programme. I want to assure shareholders that Contact is doing all that it can to ensure the required investment in transmission capacity is made quickly and as efficiently as possible. Slide: Contact The value of New Zealand’s generation assets, the vision of an increasingly renewable energy future and the ability to ensure a predictably priced and secure supply of electricity to consumers throughout the country, all depend on a strong, modern transmission system that can deliver generation to where it is needed.
Conclusion I appreciate that this has been a somewhat detailed presentation – I hope it has been helpful and provided you with a better understanding of the issues the industry is facing and the opportunities that exist for Contact as it executes its strategy to be the leading energy company in the country. It’s been a pleasure to lead Contact over the last year, and together with my team who are all here I look forward to what’s ahead. Thank you.