The State's Budget woes - Is there another way?

(Published Friday 18th November, 2011. The Mercury)

Pressure is mounting on the government.  Demands to maintain expenditures are strident, even though revenues have fallen significantly over recent times, and the attacks have been relentless whenever reductions in expenditure are announced.

Over the last few years expenditures have increased in line with increasing revenues, setting up additional public service functions and staff.  However, the downturn in the economy has changed the picture. 

The main culprit is declining revenues from the GST. Consumer confidence is down, and consumers are spending less, or buying goods offshore.  Such goods do not attract GST.

Furthermore, the formula on which GST reimbursements to the States are based is under review, with the threat being that such a review will not go in Tasmania’s favour.

The Government has responded by cutting hard into its expenditures, saying the budget must remain in surplus and that it will not contemplate going into net debt.  Net debt is a situation where it needs to borrow to pay its bills.

Cuts in education and health have elicited visceral attacks on the government, an uproar from a range of affected interests, and howls of protest from its own employees.

Protest meetings and street marches have become the order of the day – Ministers are lampooned and Cabinet is fractured, with the Green Ministers claiming that the budget decisions were not their responsibility. Not an edifying sight on their part.

So much pain all round. - Has it all been worth it?  And is it necessary?

First up, going into net debt means borrowing money to pay the bills.  Many have argued that this is not a good policy and have called on the example of the household budget to explain their position.  We cut the cloth to suit the circumstance.

However, the question “Should we go into debt at all?” is one that needs to be asked, and analysed. 

If no action is taken to rein in expenditure, then maintaining the status quo is not a clever option.  Expenditure outstrips receipts.  Borrowing money to pay employees and to spend on other recurrent expenditures will lead to the nightmare scenario of borrowing money to pay the interest on moneys already borrowed. A bad situation simply gets worse.

If money is borrowed to assist in a transition which leads to less future expenditure then this is not a bad option at all, because of future savings that can be made.  However the Government does not appear to have considered this alternative, which means less pain for those affected and buys time to bring in appropriate transitional arrangements.

In fact, this is a much more sensible option because it would enable the government to be more strategic in determining where to make the cuts, rather than the “across-the-board slash-and-burn” approach presently being employed.

In previous articles I have mentioned that a review of departmental management is long overdue, and that the focus of government programs should be on outcomes, rather than processes. Whether it involves planning issues, the management of our hospitals, or running our power utilities, taxpayers should be concerned to ensure their dollars are being used effectively.

However, the present arrangements bypass this step.  Government says to its Heads of Department – expenditure needs to be cut.  The manager elects to cut services.  Cutting services is the easy option for a manager to take.  The odium falls on the government for forcing reductions in expenditure.  But the real issue remains: it is not the services being cut, but whether the management of those services is being done effectively.  In other words, is management doing its job properly?  I don’t see this question being asked at all.

Furthermore, money that is spent on capital works, and in particular on works that assist the economy to generate wealth, should not be considered inappropriate expenditures, as the revenues raised from the increased economic activity will cover the expenditures outlaid.  In fact not making that investment now will lead to a lesser economy later.

And spending money on timely maintenance of existing infrastructure such as roads will ensure that greater amounts of money are not required later to fix even bigger problems of dilapidated assets.

So, in summary, going into debt is not necessarily a bad thing, as long as it can be shown that there is a return on that investment.

Given this situation, it is interesting to note that every other State in the Commonwealth has brought down budgets that have moved them, or have expectations of moving them, into a position of net debt.  A recent report from the ANZ, entitled “Australian Public Sector Chartbook” provides a snapshot of each State’s circumstance.  Essentially, net debt in every State except Tasmania is forecast to be in the vicinity of 3 to 5% of GSP.  Victoria in fact is forecast to be above 6%.  Tasmania stands alone in following an ideological commitment to “no net debt”.

And yet expenditure patterns are not that divergent. Employee-related expenditure in all States is around 45% of all expenditures, and what is called “Other Operational Expenditure” is around 25%.  Tasmania’s pattern of spending is similar to other States.

However, as Ruth Forrest MP has pointed out (Mercury 16 November), we have dipped our fingers in the cookie jar, and there is very little in the way of cash reserves left to play with.  The wild swings in the GST revenues make it imperative for a small economy like Tasmania to cut a new deal with the Commonwealth, to even out these swings and roundabouts.  Suggested cuts in the GST revenue should be balanced out by such an arrangement.  Such a deal is an imperative and the State should waste no time in putting its case together.

And that case should include a commitment to reform in the public sector.  It is essential, no question.  However, maybe it’s time the government revisited its approach to keeping the budget in surplus.  Surpluses of themselves should not be the goal.  Effective management should be.  With street marches, stopwork meetings and the general collapse of morale in the public service, and legitimate concerns being expressed within the broader community, government could do itself a real favour by loosening the purse strings a little and buying itself time to become more strategic in its reform agenda.

Surrealism in Tasmania's Forestry Debate

(Published Tuesday 15 November, 2011. The Mercury)

One hundred days has passed since the signing of the Intergovernmental Agreement (IGA) by the Commonwealth and State governments.  Question: Has the IGA stood up to its promise to end the conflict in our forests?  Consider the following matters.

Under the IGA, the two governments agreed to remove UP TO 572,000 hectares of native forest, purported to be high conservation value forest, from active forest management. This is subject to two separate and independent verification reports.

The first report involved the immediate setting aside of 430,000 ha of native forest into informal reserves.   Under the IGA, this is an interim matter only, and is designed to ensure immediate cessation of forest works in 41 coupes UNLESS it can be proven necessary to continue harvesting in these coupes to satisfy existing contractual commitments.  This report was delivered to the government in early October, but has not yet been released.  It should be!  It concludes that FT must have continuing access to at least 25 of these coupes, to ensure that its contractual commitments for sawlog and peeler log supply to domestic timber businesses can be met.

The second report is required by 31 December, and will detail the boundaries of high conservation value forest UP TO 572,000 ha.  This independent committee (chaired by Jonathan West) has been appointed, but it already seems unlikely that this committee will report on time.  This begs the question of what will happen to the timetable set out in the IGA.   Concern has also been raised regarding the impartiality of appointments to the process followed by the committee.

Every talking head chants the mantra of “high conservation value”.  Yet this phrase is meaningless.  Like beauty, it is in the eye of the beholder, and like beauty, it is equally ephemeral. It is without definition, and yet it is held up to be the definitive determinant for the setting up of the boundaries of UP TO 572,000 ha.

Forestry Tasmania has advised both governments that, if such an area is set aside, then it will not be able to meet its continuing, legally contracted supply commitments.  Governments seem incapable of absorbing and responding to this fact.

Gunns announced last year it was getting out of native forest for commercial reasons.  The government has since paid an amount of $23 million to Gunns AND wiped off their $24M debt to FT, whilst paying $11.5 million to FT as compensation.  I am surprised the Federal Minister did not seek has own legal advice regarding these payments..   Compensation should only be paid if the company was adversely affected by a government decision.  This was patently not the case, and in fact there remains an argument that Gunns should have been sued by FT for breach of its take-or-pay contracts.  If Government has that sort of money to throw around, then perhaps they should have considered allocating it to health and human services, where the need is truly great.

A $700 million dollar per year sector of a vital industry is being forced out of business by government, which will then pay an amount of $7 million per year to manage the extra reserves for a period of five years - a pale shadow of the industry’s worth - plus an amount of $120 million over fifteen years for Regional Development projects.  Is this money sufficient recompense? I doubt it!

Under the IGA, $45m has now been released for contractors to exit the industry.  An intriguing scenario to be sure, for Labor governments to be closing workplaces and putting people out of work! 

Money is being paid in compensation before agreement has been reached on the areas to be reserved.  What if no Agreement is reached?  The Legislative Council has already indicated it will oppose details contained within the IGA, including the payment to Gunns and the creation of further reserves.  So it is likely that the agreement will not be ratified anyway. A political imbroglio for sure! 

Is this compensation package a true reflection of the value of the industry to the economy?   A recent paper by Steven Davis of the University of Chicago and Till von Wachter of Columbia University estimates that being laid off costs a typical male worker 11% of his future earnings, in present-value dollars. During a recession, when longer spells of unemployment lead to more loss of human capital, that rises to 19% (as cited in The Economist 29/10/11).
Do the sums! As an example, take 3,500 forestry workers, for half of their 40 year working life, at a wage of $50,000 pa.  The loss of earnings alone is enormous.  

Many people, including the Premier and Prime Minister, have chanted the mantra that changed market conditions have caused the industry to falter.  This is simply not true.  The market is still buying wood product, the sawmillers are selling all they can produce, veneer products continue to find markets, and the overseas markets are still buying product, including woodchips, from Australia.  It is true that Gunns management had difficulties in the offshore market for woodchips, but Gunns is not the industry, and I suspect the market difficulties were more a Gunns issue, as that of industry.

And there are buyers for Gunns’ sawmills.  If the market is as bad as some would have us believe, then what has possessed these people to buy into the business?

Plantations have been mooted as being the answer to the industry’s woes.  If so, what was the question, because all parties know that neither the softwood plantation resource nor the present eucalypt plantation resource can substitute for high value sawn timber from native forests.

And then there is the Triabunna mill site.  Let us not delude ourselves over this matter.  The new owners of the Triabunna mill site did not purchase that site to continue operating a chipmill. After all, the owners boasted at the time of the purchase they were going to close the mill in order to start a tourism venture.

The company has stated it will only allow a certain type of wood to be processed at the site.  So it is obvious the company is playing games.  My bet is that not another woodchip will cross that wharf, and that a new wharf facility will need to be built.  More capital outlay, and an unnecessary one, but industry and government should not be held to ransom by the conditions imposed by the new owners.

The IGA is the culmination of the roundtable process, which was meant to bring all interested parties together, to resolve the forest conflict.  Yet many interest groups have complained that their interests were not represented at the table, and have disowned the process.  Forest conflict continues unabated.

 To emphasise the point, Peg Putt has just returned from a trip to Japan where she has endeavoured to destroy the reputation and the market for Ta Ann, the subject of which was endorsed within the IGA.

To summarise, the IGA has not delivered what it promised.  So many of our fellow Tasmanians have been put out of work.  Our economy has suffered.  Fact continues to play second fiddle to a mantra of emotion and eco-vanity.  The signatories to the IGA have been duped by interests that have been constant in their opposition to the industry.    Such a result is unforgivable, and an indictment on those responsible.

The IGA is perilously close to collapse, no question about it.  So perhaps it is now pertinent to ask “What then?”

The Cost of Power - Part 2 (Published 03.11.2011. The Mercury)

http://www.themercury.com.au/article/2011/11/03/273875_opinion.html
Part 2 The Tasmanian Experience

Part 1 examined the development of the NEM (National Energy Market) from a national perspective.

In Tasmania, three utilities were created from the disaggregation of the old Hydro Electric Corporation (HEC).  Hydro Tasmania was to be responsible for power generation, Transend for high voltages transmission, and Aurora for distribution (poles and wires) and retail sales. An arbitrary distribution concerning the allocation of the old HEC debt landed Hydro with over $1000m, and Aurora around $350m.  Transend was debt-free.

The later addition of the Basslink cable has connected us with the mainland and enabled full participation in the NEM.

Hydro generates most of its power from water, and unlike thermal generators, can adapt to rapid changes in demand in quick order.  As long as the water is there, Hydro can be a significant player in the NEM.  Even through the drought, when water storages were low, Hydro was still able to provide power into the grid and pay its loan guarantee fee to the State.

Hydro derives its income from NEM market sales, arbitrage over Basslink, and its consulting business, Entura.  It also has a successful and growing retail business on the mainland called Momentum, servicing a niche market for clean energy.

For some years, especially during the drought years, the interest payments on the debt allocation significantly constrained Hydro’s operations, including essential maintenance of its generating assets.  In 2008, the government shifted some $220m of debt over to Transend, enabling Hydro to operate more efficiently.  The advent of the “carbon” tax will be of competitive advantage to Hydro, essentially by making its coal-fired competitors less competitive.  A great opportunity for its Momentum business.  

First and foremost, Hydro is a business.  It competes in a national market, and the price it charges for its power is determined by the market, and a regulatory oversight ensures it provides power at market prices.  It provides major customers with bulk power under 24/7 take-or-pay contracts, and, although disbelieved by some, is charging commercial prices for that power. 

To me, Hydro has been an outstanding success story.  It has managed our water resource well, it has developed a successful wind-farm business, it has adapted to changing circumstances, it has become a successful trader in a national market, its business model of being a renewable energy business has provided it with competitive advantage, and its consulting arm is recognised throughout the world bringing renown to Tasmania. And it provides substantial dividends to the State.  

Transend had the good fortune of starting its life debt-free.  As a monopoly business it is tightly regulated, and its opportunities to value-add are limited.    Transend’s revenue is derived from a revenue reset mechanism, whereby the price charged relates to the value of the assets under management.  The higher the asset value, the more it is paid.  In other words, it is in Transend’s interests to have high-value assets, as distinct from appropriate assets.  It has in the past followed an extraordinary risk-averse strategy, with little evidence of business rigour. Compare the increase in its charge rate (71%) against the CPI (21%) since 2003.  And staff numbers from 50 to over 300.  Maybe the reset mechanism needs a reset.

Government should also seriously consider transferring the poles and wires business from Aurora to Transend.  Bringing the regulated monopoly power delivery businesses together is a natural fit and could deliver synergies and cost savings resulting in cheaper power prices.

A new Chairman and CEO must deliver more commercial rigour to Transend’s operations.  In fact, Government must insist on it.

Aurora is responsible for the distribution and retail sales of power.  It buys power on the open (wholesale) market, which has significant price fluctuations, but needs to sell power at fixed prices.  It must therefore embark on a sound risk management profile in order to remain viable.  At the same time, it is at the cutting edge of our concern about power prices.  However, demands for concessional rates are in fact community service obligations that should be paid for by government.  In other words, Aurora should be allowed to run as a commercial business and pay a dividend to the State, which then determines how that money should be spent.

Government gifted Aurora an onerous legacy in the Tamar Valley Power Station.  A new gas-fired station, it was half-built when its owners went broke.  The government  purchased it, paying far too much for a distressed asset, then handed it to Aurora to complete the build.  To its credit, the task was completed on time and on budget.  However the station was an expensive construct, and the debt still needs to be serviced.  Furthermore, Aurora then “negotiated” an onerous take-or-pay gas supply contract, which has made the station an absurdly expensive operation to run.

More concerning is the approach the company has taken to its computerization program. It is common knowledge that there was a $50 m overrun implementing new billing software.  A disaster, true blue.  The reasons given were “we underestimated the task”.  Maybe we have overestimated the skill of its senior management. And no further action has been taken – where is the accountability? 

The Aurora business model is in need of some review.  By its actions, it is obvious that Aurora is still searching for its niche.  Is it a “poles and wires” business, a retailer, a generator, and to what extent should it be a national trader? All important questions.

Some folk remain critical of these entities – if a government business makes money it is at our expense, if they are losing money we have to subsidise them, again at our expense. Whichever way we look at it we lose.  In my view, this is not the correct approach.

Throughout this article I have endeavoured to paint a picture that these utilities need to be run as businesses.  The NEM has caused our utilities to be businesses.  They may be owned by government, but they are commercial entities operating in a competitive national market, and need to be given the freedom to do so.  Performance is a matter for their Boards.  That is where the focus of their boards and management must lie.  Questions about performance are really questions about their governance. 

There is a regulatory oversight to ensure they operate in a fair and proper manner, but at the end of the day their task is to return a profit and pay a dividend to the State. The role of government should be limited to its relationship with the Boards.  And no more.  It is then up to the government to determine how that dividend should be spent. 

Hopefully the review will come to the same conclusions.

The Cost of Power - Part 1 (Published 02.11.2011. The Mercury)

http://www.themercury.com.au/article/2011/11/02/273675_opinion.html
Power prices continue to rise, and the public are demanding a better deal.  An act of political appeasement with the Greens has led to an inquiry to review the operations of Tasmania’s three power utilities.  It has now taken over 12 months, it is forecast to cost taxpayers over $3 million dollars, it has distracted the utilities from their main game, and its report is now well overdue.  Has it been worth it?

It all began with the National Competition Policy, established in the late 90’s.

By 1998, all state–owned electricity utilities were broken up (disaggregated) into separate generation, transmission and distribution/retail companies. In each of the mainland states a number of generation and retail companies were created.  The purpose of this national policy was to create competition and therefore lower prices.  States complied, because they would be penalized (by reduced payments from the Commonwealth) if they did not conform to this new policy.  A separate management company (NEMMCo) was then created to oversight the behavior of these companies in a newly-created National Energy Market, or NEM.  Has this policy worked?

Victoria embraced this policy with gusto.  It broke up the old SECV into a number of different entities, promptly sold them and made a killing.  The buyers thought they would also make a killing but soon found out it was not to be, and after many changes of hands, the present owners of these assets are managing them as best they can.

The same could not be said for New South Wales and Queensland, where the entities created from the breakup of the old utilities remained in public ownership.  Unfortunately for them, the long-awaited efficiency improvements and price reductions did not occur.

The NEM plan involved generators bidding blocks of power at particular prices into a ‘market’, and for retailers to buy the lowest-priced bids in the market.  The theory being that the generators would bid in as low as possible, in order to sell their power in the market, and thus provide retailers with low-priced power, which they could then provide to their customers, again in a competitive environment.

Practice does not always follow theory, and for some years, both generators and retailers struggled to come to terms with this new market-based reality.  Lack of proper risk management structures in the trading environment have caused grief to a number of players, especially when the market has been volatile, such as hot days, generators (gen-sets) going down etc.  Practice eventually began to conform to the theory, but hiccups have continued to occur.

Private companies that were operating at that time found they could generate power in one State and sell it in another, and so they began to buy up strategic assets.   This was not foreseen by the planners at that time. In fact no sooner had disaggregation occurred than a de facto re-aggregation (vertical integration) began to take place with generators buying retailers to become ‘gen-tailers’ and sell directly to customers.  This mitigated risk.  A single generator was at risk from a collapsing or rapidly varying bid price, and the retailer from a varying market price for purchase, yet having to provide a fixed price to the customer. Having a foot in both camps mitigates these risks.

The breakup of the public assets began to look like a transfer of those assets to private hands, using the mechanism of a national electricity market to do so.  By default, public policy appeared to suggest a transfer of public involvement from power operations to power regulation through NEMMCo. 

 Most mainland generators are coal-fired power stations, and their interest is to run their gen-sets at a constant rate and thus to provide a constant amount of power into the grid - in other words to provide base-load power.  Hydro stations, whilst also being good base-loaders, are better equipped to turn their gen-sets on and off with fluctuating demand, and thus better equipped to provide peak-load power.

Wind and solar, small beer in the grand scheme of things, can provide neither, due to the vagaries of the weather, and whatever benefits are provided by being “renewable” is both prohibitively costly and inefficient as there is always back-up required.  So thermal gen-sets have to be operating anyway.  However, in conjunction with hydro, these renewable energy sources can provide power into the grid as and when, with hydro acting as a backup battery, a sensible synergy.  Well sensible if we ignore the massive cost burden new renewable forms of generation create; a little discussed fact being that wind power is 3-4 times as expensive as power from a coal-fired power station and this alone will dramatically increase power bills if Australia reaches its target of 20% of its power from renewable means by 2020.

 The new federal government initiative of putting a “price on carbon” - in reality carbon dioxide the gas -  emissions, will now impose an additional tax regime on coal-fired generators.  Many coal-fired generators are now considering getting out of the generation business altogether, and a number have responded to the Federal Government calls for Expressions of Interest to do so.

The Federal Government hopes that “cleaner” energy sources, such as gas, will replace coal-fired generation, but the policy remains unclear, and a sudden departure of existing generators from the scene could cause problems in reliability and capacity to supply. For example, Hazelwood, a brown coal generator targeted for closure, produces some 20% of Victoria’s power.

So, public money will now be spent to assist those leaving, more public money will be spent encouraging new entrants (note that gas is at least 50% more expensive than coal), and yet further funds will be spent to subsidise inefficient forms of energy production.  At the same time the power supply system has become less reliable and less secure.  One is left to wonder whether the public has benefited at all from the policy of disaggregation trumpeted as the new era of competition only 15 years ago.

Tomorrow Part 2 - The Tasmanian Experience