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Financial andCommercial Analysis –Second TasmanianInterconnector

Department of theEnvironment and Energy

22 December 2016

A member firm of Ernst & Young Global LimitedLiability limited by a scheme approved under Professional Standards Legislation

NOTICE

Ernst & Young (“EY or “we”) was engaged on the instructions of the Department of Industry,Innovation and Science1 (“the Department”) on behalf of the Tasmanian Energy Taskforce toundertake commercial and financial analysis in relation to a second, Tasmanian energy interconnectorin accordance with our contract dated 21 September 2016.

The results of Ernst & Young’s work, including the assumptions and qualifications made in preparingthe report, are set out in Ernst & Young's report dated 22 December 2016 ("Report"). The Reportshould be read in its entirety including the applicable scope of the work and any limitations. Areference to the Report includes any part of the Report. No further work has been undertaken byErnst & Young since the date of the Report to update it.

Ernst & Young has prepared the Report for the benefit of the State and Federal Governments, and hasconsidered only the interests of the potential viability of a second cross interconnector betweenTasmania and Victoria. Ernst & Young has not been engaged to act, and has not acted, as advisor toany other party. Accordingly, Ernst & Young makes no representations as to the appropriateness,accuracy or completeness of the Report for any other party's purposes.

No reliance may be placed upon the Report or any of its contents by any recipient of the Report for anypurpose and any party receiving a copy of the Report must make and rely on their own enquiries inrelation to the issues to which the Report relates, the contents of the Report and all matters arisingfrom or relating to or in any way connected with the Report or its contents.

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1 The energy function from the Department of Industry, Innovation and Science has been transferred to the Department of theEnvironment and Energy. For the avoidance of doubt, EY has used the original engagement department for this notice.


22 December 2016

Department of the Environment and EnergyCanberra, ACT, 2600

Financial and Commercial Analysis – Second Tasmanian Interconnector

To Whom it may concern,

In accordance with work order dated 21 September 2016, pursuant to agreement with the TasmanianEnergy Taskforce to undertake commercial and financial analysis in relation to a second, Tasmanianenergy interconnector (“Agreement”), Ernst & Young (“we” or “EY”) has been engaged by theDepartment of Industry, Innovation and Science (“you”, “the Department” or the “Client”) on behalf ofthe Tasmanian Energy Taskforce to provide financial and commercial analysis in relation to the suitablecommercial and delivery models (the “Services”) in relation to a proposed second Tasmanianinterconnector (the "Project").

The enclosed report (the “Report”) sets out the outcomes of our work. You should read the Report inits entirety. A reference to the report includes any part of the Report.

Purpose of our Report and restrictions on its use

Please refer to a copy of the Agreement for the restrictions relating to the use of our Report. Weunderstand that the deliverable by EY will be used for the purpose of assisting the Department in itsinvestigation into the relative merits of a proposed second Tasmania to Victoria interconnector, and inparticular the potential commercial and delivery model(s) in which a proposed interconnector couldoperate, should a decision be made to proceed to delivery of the project (the “Purpose”).

This Report was prepared on the specific instructions of the Department solely for the Purpose andshould not be used or relied upon for any other purpose.

This Report and its contents may not be quoted, referred to or shown to any other parties except asprovided in the Agreement. We accept no responsibility or liability to any person other than to theDepartment or to such party to whom we have agreed in writing to accept a duty of care in respect ofthis Report, and accordingly if such other persons choose to rely upon any of the contents of thisReport they do so at their own risk. Third parties seeking a copy of this Report will require permissionfrom EY, and will be required to sign an access letter in the format agreed to between EY and theDepartment.

Nature and scope of our work

The scope of our work, including the basis and limitations, are detailed in our Agreement and in thisReport.

Our work commenced on 21 September 2016 and was completed on 22 December 2016. Therefore,our Report does not take account of events or circumstances arising after 22 December 2016 and wehave no responsibility to update the Report for such events or circumstances.

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Limitations

The outputs and advice provided within the report considers a number of combinations of inputassumptions relating to future conditions, which may not necessarily represent actual or most likelyfuture conditions. Additionally, the modelling outputs that have been utilised within this report aresourced from work conducted separately by EY and can be found within the “Market dispatch costbenefit modelling of a second Bass Strait Interconnector – Report” which is also subject to similarrestrictions in use and limitations. The outputs inherently requires assumptions about futurebehaviours and market interactions, which may result in forecasts that deviate from future conditions.There will usually be differences between estimated and actual results, because events andcircumstances frequently do not occur as expected, and those differences may be material. We take noresponsibility for the achievement of projected outcomes, if any.

We highlight that our analysis and Report do not constitute investment advice or a recommendation toyou on a future course of action. We provide no assurance that the scenarios we have modelled will beaccepted by any relevant authority or third party.

Our conclusions are based, in part, on the assumptions stated and on information provided by theDepartment during the course of the engagement. The commercial and financial analysis arecontingent on the collection of assumptions as agreed with the Department and no consideration ofother market events, announcements or other changing circumstances are reflected in this Report.Neither Ernst & Young nor any member or employee thereof undertakes responsibility in any waywhatsoever to any person in respect of errors in this Report arising from incorrect informationprovided by the Department.In the preparation of this Report we have considered and relied upon information from a range ofsources believed after due enquiry to be reliable and accurate. We have no reason to believe that anyinformation supplied to us, or obtained from public sources, was false or that any material informationhas been withheld from us.

We do not imply and it should not be construed that we have verified any of the information providedto us, or that our enquiries could have identified any matter that a more extensive examination mightdisclose. However, we have evaluated the information provided to us by the Department as well asother parties through enquiry, analysis and review and nothing has come to our attention to indicatethe information provided was materially misstated or would not afford reasonable grounds upon whichto base our Report.

This letter should be read in conjunction with our Report, which is attached.

Thank you for the opportunity to work on this project for you. Should you wish to discuss any aspect ofthis Report, please do not hesitate to contact Craig Mickle via email at [email protected].

Yours sincerely

Craig MicklePartner

Department of the Environment and EnergyFinancial and Commercial Analysis – Second Tasmanian Interconnector EY ÷ i

Table of Contents1. Executive Summary ............................................................................................................ 1

1.1 Key Findings ................................................................................................................. 21.2 Detailed Findings .......................................................................................................... 31.3 Relationship to the EY Market Dispatch Cost Benefit Modelling ......................................... 8

2. Background...................................................................................................................... 102.1 Overview.................................................................................................................... 102.2 Basslink ..................................................................................................................... 102.3 Scope of Work ............................................................................................................ 112.4 Approach to Assessment ............................................................................................. 112.5 Structure of this Report............................................................................................... 13

3. Commercial Analysis ......................................................................................................... 143.1 Overview of Commercial Model analysis ........................................................................ 143.2 Qualitative and Quantitative Analysis............................................................................ 163.3 Detailed results – Base Case ......................................................................................... 223.4 Detailed Results – Alternative Cases ............................................................................. 263.5 Detailed results – Hybrid models ................................................................................... 323.6 Conclusion – Commercial Analysis ................................................................................ 34

4. Procurement Models ......................................................................................................... 364.1 Procurement considerations ........................................................................................ 364.2 Ownership structure – 1 Owner vs 2 Owner ................................................................... 364.3 Procurement Model Options......................................................................................... 374.4 Procurement Summary ............................................................................................... 38

5. Validation ........................................................................................................................ 405.1 Market Sounding Participants ...................................................................................... 405.2 Case Study Validation ................................................................................................. 41

Department of the Environment and EnergyFinancial and Commercial Analysis – Second Tasmanian Interconnector EY ÷ 1

1. Executive Summary

In April 2016, the Australian and Tasmanian governments established a joint feasibility study (theStudy) into whether a second Tasmanian interconnector could improve Tasmania’s energy security andfacilitate large scale renewable energy investment. The Study is investigating the benefits of a secondhigh voltage direct current (HVDC) interconnector (the Project, 2IC), construction of which wouldincrease transfer capacity of electricity between Tasmania and Victoria.

EY have been engaged to undertake two separate tasks, firstly, market modelling to evaluate the costsand benefits of a second interconnector (“Market dispatch cost benefit modelling of a second BassStrait interconnector Report – 22nd December 2016”) and secondly, to provide Commercial andFinancial analysis in respect of the second interconnector (“this Report” or “Financial and CommercialAnalysis – Second Tasmanian Interconnector – 22nd December 2016”). This Report provides thefindings that result from our analysis in respect to the assessment of commercial models for thesecond interconnector, ranging from fully regulated to fully merchant options.

The report “Market dispatch cost benefit modelling of a second Bass Strait interconnector” presentsthe market modelling assessment of the merits of a second interconnector.

The market modelling (“Market cost benefit modelling of a second Bass Strait interconnector Report –22nd December 2016”) is best used to form a view on the merits of having a secondinterconnector. The commercial and financial analysis (Financial and Commercial Analysis – SecondTasmanian Interconnector – 22nd December 2016”) is best used to form a view on whether a privateparty might be willing to fund a second interconnector.

The purpose of this Report is to consider and analyse the commercial and financial impact of variousoptions to deliver the second interconnector. The analysis is a desktop study and preliminary in nature,consistent with the conceptual stage of the Project’s development. A range of hypotheticalcommercial operating models have been assessed on a qualitative and quantitative basis to capture thefull scope of potential options.

The commercial operating models considered range from fully regulated, partly regulated, fully marketand partly market exposed. For the purposes of the analysis, it is assumed that the 2IC (and Basslinkwhere relevant) could attain the relevant status and, if required, existing commercial arrangementscould be modified.

► A second interconnector could be developed under the following models:

► A regulated transmission asset with the contribution of costs evaluated under a RIT-T typeprocess, with revenues determined through the Australian Energy Regulator (AER)’s typicalprocess

► A Market Network Service Provider (“MNSP or merchant interconnector”), whereby all revenuesare determined by the ability of the operators to profit from arbitrage opportunities that existbetween Tasmania and Victoria. The profit, and ultimately the viability of the interconnector, isthe responsibility of the operator.

This Report also considers variations of these commercial models, such as Basslink operating as anMNSP with the 2IC operating as a regulated asset and vice versa. With MNSP interconnectors beingexposed to considerable revenue volatility that could negatively impact commercial viability, the reportalso considers two hybrid models. The partially regulated and partially merchant models involve somerisk sharing between governments, consumers and the private sector in order to improve the viabilityof the Project:


► Partially Regulated Assets – defined as assets that earn a fixed return with revenues over andabove the viability line shared between the owner of the interconnector and the Government.These are becoming increasingly popular in Europe and are typically called Cap and Collar or Capand Floor Models

► Partially Merchant Assets – defined as assets that operate outside of regulation, i.e. theinterconnectors generate their own revenue stream, but still requires some form of governmentassistance in order to support the viability of the commercial model.

Please note all prices in this report refer to real June 2016 dollars unless otherwise labelled. The netpresent values are discounted to 2016-17.

1.1 Key FindingsAssessing the commercial structures that may be used to develop the Project raises substantialcommercial complexities due to the interactions that the operation of the assets would have on eachother.2 This means that the second interconnector cannot be viewed in isolation of Basslink.

These complexities are not limited to either a merchant or regulated approach. A more merchantapproach to the development of the Project exacerbates these complexities because of theimplications for the existing owners of Basslink, and those that derive value from its use. A moreregulated approach to the development of the Project reduces these complexities, but does notremove them entirely, as any inconsistency in the status of the two interconnector’s risks creatingmaterial distortions.

These complexities mean that:

► A merchant 2IC is unlikely to be commercially viable without harmonising the commercialarrangements in regard to Basslink and providing some level of funding support. The model istherefore likely to favour joint ownership

► A regulated 2IC is likely to be commercially viable, assuming it could attain that status, but wouldalso require some harmonisation of the commercial arrangements in regard to Basslink.Regulation could however achieve that this without joint ownership.

The advantages of the regulated approach should, however, not be surprising given that the Project isbeing driven primarily by objectives that are broader than the commercial opportunities for arbitrage.In determining the appropriate commercial and delivery model for a second interconnector, clearconsideration needs to be given to the reasons for its development, as that will have the greatestbearing on the most appropriate delivery model.

2 We have not had access to the BSA between BassLink and HydroTas as part of this work and are only aware of its broadcommercial terms. We also do not have visibility of the restrictions on HydroTas’s bidding behaviour. We understand, however,that Basslink in essence currently operates as a quasi-regulated asset (i.e. bids in at zero and HydroTas’s bidding behaviour isconstrained).


1.2 Detailed FindingsTable 1 contains a summary of the various models assessed, with some initial commentary on theircommercial viability.

Table 1: Model Summary

Commercial Model Key Features Viability

Base Case – 134.► Basslink – MNSP► 2IC - MNSP

1. Basslink operates as a pure MNSP (noavailability charge is earnt)

2. 2IC enters the market as an MNSPasset

3. Unless there is a single owner for bothinterconnectors would compete forflow to ensure efficient use of theassets

► Model only likely to be practical inscenarios where HydroTas canparticipate as owner, who wouldthen be incentivised to ensure itsviability

► Some form of guaranteed revenueslikely to be required as the marketrisks are considered too great fortypical investors

Base Case – 2.► Basslink – MNSP► 2IC - MNSP

1. Basslink remains a MNSP whilstearning an availability charge (mimicscurrent operations)

2. 2IC enters the market as an MNSP3. Commercial restrictions in the

Basslink Services Agreement betweenHydroTas and Basslink Pty Ltd (BPL)limit 2IC operating as overflow cableonly (only utilised when Basslink is atcapacity)

► Similar to above, models are onlyviable with ongoing revenuesupport

► No true MNSP’s are currentlyoperating in the Australianlandscape

Alternative Case 1.► Basslink – MNSP► 2IC – Regulated

1. Basslink remains MNSP (withavailability charge)

2. 2IC meets RIT-T to become aregulated asset

3. 2ICs’ regulated revenue determinedby Regulator

► Model provides support for 2IC atthe expense of Basslink

► Pure MNSP operations for Basslinkwould negatively impact its viability(currently earns an availabilitycharge)

Alternative Case 2.► Basslink – Regulated► 2IC – MNSP

1. Basslink becomes a regulated assetwith regulated revenues

2. 2IC to operate a MNSP

► Similarly to Alternative Case 2,Basslink regulation will furthersupport its operations

► 2IC would not be viable withoutHydroTas’s support

Alternative Case 3.► Basslink – Regulated► 2IC – Regulated

1. Basslink becomes a regulated assetwith regulated revenues

2. 2IC regulated, revenue determined byRegulator

► Regulated models provide somelevel of surety in regards torevenue which will support theviability and delivery of a secondinterconnector

3 In the market modelling report, this is the “MNSP Base Case”4 In the market modelling report, this is similar to the operational assumptions of Base Case unregulated interconnector.Importantly, the market modelling assumes that both interconnectors act co-operatively such that the bidding of the twointerconnectors maximises the total revenue of the interconnectors. However, from a commercial perspective, this would onlybe the case where the interconnector is owned by the same owner. Further, this Report does not include consideration any ofthe market benefits, as these are unable to be captured by the asset owner to generate commercial returns. See Section 1.3 fordiscussion of the relationship to the market modelling


Commercial Model Key Features Viability

Hybrid Case 1.► Basslink – Partially

Unregulated► 2IC – Partially

Unregulated

1. Both Interconnectors are partiallyunregulated (MNSP), with anavailability charge

2. Government provides partial upfrontgrant, lowering capital costs andtherefore ongoing impact onconsumers.

► As this model is in essence anMNSP structure with some level ofgovernment support in the form ofgrants, the revenue required toremain viable would be lower thanpure MNSP options

► Still requires the support ofHydroTas to remain viable

Hybrid Case 2.► Basslink – Partially

Regulated► 2IC – Partially

Regulated

1. Both Interconnectors are partiallyregulated

2. Both Interconnectors are supportedby a partial transmission charge(Floor)

3. Both Interconnectors earn 25% of thearbitrage revenues

► Partially regulated models have thepotential to provide some regulatedrevenues and exposure to marketrisks

► Model would be appealing toinvestors, though none are inoperation in Australia and wouldrequire government policy shift

Finding 1: Basslink must be considered in the delivery of 2IC.

► Both Basslink and 2IC connect Tasmania to the rest of the NEM, which creates the potential forcompeting bidding behavior between the two links in an unconstrained market.

► 2IC can operate with reduced transmission losses, which means it can bid more competitively thanBasslink, in an unconstrained world.

► The position and approach adopted by Hydro Tasmania (HydroTas) in its bidding behavior wouldbe crucial.

This means that the optimal commercial model for the 2IC to be procured may not produce the optimaloutcome overall for other key stakeholders.

Finding 2: Commercial structures and operational assumptions that impact bidding behavior arecritical to the delivery models assessment.

► The BSA sets out the commercial arrangements between Basslink and HydroTas. We understandthat the commercial structure consists of an availability charge for capacity, plus a variablepayment linked to electricity flows.

► In the event that the majority of flows are transmitted through 2IC, Basslink would still be paid itsavailability payment at a minimum subject to maintaining minimum availability requirements, butmay not receive its variable payments.

► To the extent that competition restrictions exist in the BSA (for example Basslink has dispatchpriority over 2IC), this may materially impact the ability of 2IC to generate revenue to cover itscapital repayments.

Finding 3: Commercial models which expose the asset owners to revenue risk have the potential toimpact the ongoing commercial viability of Basslink and 2IC

► Operating model options that have both links acting as MNSPs and separate ownership, exposethe asset owners to considerable revenue and asset stranding risk. Without operationalrestrictions, sub-optimal market outcomes may eventuate:

► Either very low competitive pricing which creates financial stress for the asset owners; or


► Pricing is maintained at artificially high levels due to the pricing power a duopoly mightpossess.

► MNSP models actively encourage profit maximisation at the expense of the other interconnector.With the new interconnector able to deliver lower transmission losses, though newer designcapability and improved technology, the newer interconnector could garner a majority of theenergy flows, which will further isolate Basslink’s ability to generate a rate of return that wouldsupport its ongoing operation and viability.

► MNSP models with a high degree of revenue risk expose asset owners to significant volatility inforecast revenue. For an interconnector which captures benefits from the price differentialbetween Tasmania and Victoria, this revenue is expected to be challenging for financiers toforecast and ultimately raise debt against.

► MNSP options are expected to attract a risk premium by financiers to compensate for this risk,and result in much lower gearing (the proportion of debt to debt plus equity) compared to modelswith more stable and secure cashflows.

► The bidding behaviour (and strong market position) of HydroTas may impact the ability offinanciers to take a long term view on the ability to secure revenues to repay investors.

Finding 4: A form of the regulated asset model for 2IC could be expected to minimise financingcosts and creates more options for how the Project can operate alongside Basslink

Regardless of whether Basslink remains a MNSP, or is regulated, delivery of 2IC under a regulatedasset model is likely to have advantages because:

► This would reflect the underlying reasons why the 2IC would be built (i.e. not to provide additionalcapacity that can pay for itself by operating as an MNSP in the short term). It would also reflectthe difficulties that the MNSP model has previously encountered in Australia.

► Fully regulated models for 2IC and Basslink on balance offer the greatest level of benefits toelectricity consumers and also to the owners of the interconnectors. It would however impactnegatively on private generators, which may expose consumers to higher costs over the longerterm.

► It effectively encourages the higher utilisation of the second interconnector as it will benefit fromreduced transmission losses being newer technology and design which could undermine theviability of Basslink (if it remains a MNSP), whilst simultaneously impacting the energy securitybenefits of dual interconnectors.

► Enables a broader range of benefits to be delivered to consumers through regulated assetframework and can be structured so government and other beneficiaries can contribute funding tothe link.

► Regulated assets owner takes the risk on changes of regulated returns made by the AER on a five(or more) year basis.

However, under this model, regulation would be required to provide the incentives to encourageefficient maintenance of the assets.

Finding 5: There may be potential to refine the regulated asset model to enable other beneficiariesof the Project to contribute to the funding of the Project

► Government may consider funding a proportion of the capital costs through providing an upfrontgrant to the Project delivery company. We expect that this would reduce the Regulated Asset Base(RAB) that the regulated return would be based upon and mean that taxpayers rather thanelectricity consumers bear part of the cost.


► A cap and floor model, similar to what has been implemented by Ofgem in the UK could alsoprovide incentives for efficiency.

► Further investigation would need to be undertaken into variants of regulation that could meetthese objectives.

Finding 6: While revenue modelling indicates that a fully merchant MNSP model has the potential tobe feasible, the risk premium for the transfer of revenue risk is unlikely to be considered feasible bythe financing market

► Indicative modelling of MNSP revenues show considerably higher net present values than itsregulated counterparts, over the project life for 2IC.

► MNSP models with a high degree of revenue risk expose asset owners to significant volatility inforecast revenue. For an interconnector which captures benefits from the price differentialbetween Tasmania and Victoria, this revenue is expected to be challenging for financiers toforecast and ultimately raise debt against.

► The cost of equity finance for a fully unregulated link likely to be high (15-20+%) given highvolatility of cash flows.

► Currently Basslink is the only MNSP in Australia. DirectLink and MurrayLink interconnectors wereconstructed as MNSPs with merchant revenue exposure, but subsequently applied to the AER toreceive regulated status as ‘competing’ regulated interconnects were built or expanded.

► Market sounding of financiers and energy asset owners confirms this finding.

Finding 7: The introduction of 2IC may impact the commercial viability of Basslink, which mayrequire the asset owners to consider their options in relation to the commercial model andownership structure

The EY electricity market modelling report indicates that Basslink is forecast to be impacted with theintroduction of 2IC. The reduced profitability of Basslink may result in the asset owners:

► Considering applying to the AER for regulated asset status

► Considering a sales process for the asset

► Seeking to renegotiate terms with HydroTas

► If it is assumed that Government does not have any levers to compel Basslink to become regulatedor modify its commercial model, this would represent a key risk to the delivery of 2IC.

Finding 8: A single owner for 2IC and Basslink is preferred on balance, unless both assets areregulated

► Under the MNSP model a single owner is likely to be the only viable model. This is also likely to betrue if only one asset is regulated unless other constraints are imposed.


► Separate asset owners is only likely to be viable if both assets are regulated.

Finding 9: An initial assessment indicates limited ability for a MNSP to capture revenue benefitsother than the difference in pool prices

► There is currently limited scope for third party revenues from other renewable energy generators.

► Whilst there are strong wind sites in Tasmania which may result in differences in capacity factorsbetween new Tasmanian wind farms (when compared to the marginal project in Victoria), theadditional transmission costs associated with paying to reserve capacity to supply power to themainland (e.g. under a Power Purchase Agreement) is unlikely to make these projects feasible.


Finding 10: Procurement model analysis indicate a contestable regulated model (applied forprojects with significant capital costs) would enable competitive bids for construction, operationsand ownership of the asset

► The regulated asset model is market tested, and competitive for transmission assets.

► It could be expected to deliver the Project at a low cost of capital.

► We understand that only 3 HVDC suppliers are capable to meet the technical specificationsglobally, which may impact the competitiveness of the procurement.

► The existing DNSP arrangements in Tasmania and Victoria would be expected to continue for theprocurement of requirement network connection infrastructure for new generation andconnection to the existing grid.

Finding 11: Where a MNSP with a capacity charge is preferred, a Build Own Operate Transfer(“BOOT”) delivery model represents a viable delivery model

► BOOT transfers majority of construction, maintenance, operations and ownership to the privatesector.

► Bidders would compete on what their minimum availability charge is to deliver and operate theasset over the project life.

► Maintains strong incentives for the asset owner to ensure the asset is available and maintain andmaintain and operate the asset to reduce transmission losses.

1.3 Relationship to the EY Market Dispatch Cost Benefit ModellingEY have been engaged to undertake market modelling (“Market cost benefit modelling of a secondBass Strait interconnector – 22nd December 2016”) and to provide commercial and financial analysisin respect of the second interconnector.

This Report provides commercial and financial insights in respect to the assessment of commercialoperating models for the second interconnector, ranging from fully regulated to fully merchantoptions. This Report considers these alternative options in our analysis to form a view on the ability ofthe private sector to fund the second interconnector under a range of commercial models, not limitedto regulated or MNSP only cases.

The market modelling report (“Market cost benefit modelling of a second Bass Strait interconnectorReport – 22nd December 2016”) presents the market modelling outcomes of the merits of a secondinterconnector under fully regulated and MNSP cases only. This report (“Commercial and FinancialAnalysis – Second Tasmanian Interconnector – 22nd December 2016”), takes the outcomes and datafrom the market modelling MNSP case only and applies the data in alternative ways in order toconsider the range of commercial operating models that may deliver a second interconnector (pleasesee Section 3 for greater detail).

The market modelling under the regulated asset case examine the merits of a second interconnectorlargely by examining the NEM wide market benefits it would provide (such as lower production costsor deferred capital costs). The modelling conducted as part of the “Market cost benefit modelling of asecond Bass Strait interconnector Report – 22nd December 2016” is intended to consider the potentialfor the second interconnector to be classified as a regulated asset by meeting the requirements of theRegulatory Investment Test for Transmission (RIT-T).

For the MNSP option, the electricity market modelling report considers the market revenues that mightbe expected to flow to the owner of the second interconnector, and also the financial impact on otherrelevant parties in Tasmania: Basslink, Hydro Tasmania and energy consumers in Tasmania.


The impact of a second interconnector on these parties is heavily dependent on the arbitrageopportunities to be exploited and the operating behaviour of the second interconnector. Althoughmarket benefits may result from the operation of the MNSP, these benefits do not form the basis of theviability of the asset, as the second interconnector asset owner is unable to capture these benefits asproject revenues. Rather, the viability of the MNSP is formed by an expectation of revenues derivedfrom arbitrage benefits between Tasmania and Victoria with appropriate consideration of the range ofmarket and regulatory risks associated with the asset.

The choice of whether one is superior to the other is a function of a broader view about the risksassociated with wholesale market exposure and the viability of having competition in the provision ofinterconnectors. This Report does not consider the financial impact of the range of operating modelsexplored on other market participants such as Hydro Tasmania (HydroTas) and Tasmanian electricityconsumers.

This Report uses the same underlying data as the market modelling for the MNSP cases. The financialmodelling however examines the merits of a second interconnector separately from any marketbenefits, and as such attempts to determine the private benefits it would provide (i.e. those that can becaptured by and accrue to the owner of the asset). Under the regulated model, those private benefitsare largely divorced from the operation of the asset and the market benefits it delivers because privatebenefits flow indirectly through the regulated returns as determined by the Australian EnergyRegulator. Under the pure merchant model, however, those private benefits are largely a function ofthe owner’s ability to exploit arbitrage, and are therefore largely dependent on wholesale marketconditions. Furthermore, the private benefits depend on the extent to which to the owner of thesecond interconnector can capture these when there is another interconnector (and associatedcommercial arrangements) that influence the extent to which this possible.

The operating assumptions of Basslink and the second interconnector in the MNSP Base case providedas part of the Market Modelling (see “Market cost benefit modelling of a second Bass Straitinterconnector Report – 22nd December 2016”) is similar to the operating assumptions of the twointerconnectors in the commercial and financial analysis Base Case 1 scenario. Alternative operatingmodels such as converting Basslink to a regulated interconnector while operating the secondinterconnector as an MNSP have not been modelled in the market modelling.

This Report considers these alternative options in our analysis to form a view on the ability of theprivate sector to fund the second interconnector under a range of commercial models, not limited toregulated or MNSP only cases. Simplifying assumptions were made to illustrate the potential financialimpacts and ability of the private sector to fund the second interconnector for the range of commercialmodels. Where these commercial model alternatives are worthy of further investigation, additionalelectricity market modelling of these alternatives at the next phase of project development issuggested.


2. Background

2.1 OverviewIn April 2016, the Australian and Tasmanian governments established a joint feasibility study (theStudy) into whether a second Tasmanian interconnector could improve Tasmania’s energy security andfacilitate renewable energy investment. The Study is investigating the benefits of a second highvoltage direct current (HVDC) interconnector (the Project, 2IC), construction of which would increasetransfer capacity of electricity between Tasmania and Victoria.

2.2 BasslinkBasslink is the incumbent Tasmania to Victoria high-voltage transmission line (interconnector) thatoperates between George Town in Tasmania and Loy Yang in the Latrobe Valley area in Victoria. It wascommissioned in early 2006 after Tasmania joined the NEM. It is owned by the publicly listed KeppelInfrastructure Trust (SGX: A7RU), and is the only unregulated interconnector in the NEM. Basslink isthe world’s second longest subsea electricity interconnector, with a nominal capacity to export 594MW from Tasmania to Victoria, and import 478 MW. It cost $874 million.

When the development of Basslink was endorsed by the then Labor Government in 1998, they set outseveral goals and strategic objectives for the construction of the interconnector including:

► Improve the security of electricity supply and reduce the exposure to drought conditions inTasmania

► Provide Tasmania with access to electricity prices determined competitively in the NEM

► Provide a means by which electricity generated in Tasmania can be sold into the NEM and providea new source of peak generating capacity in the NEM.

Basslink generates revenue in a similar way to generators in the NEM; by bidding into the spot marketits capacity to deliver energy, with the returns determined by the price difference and the energy flowsbetween Victoria and Tasmania. In 2002, HydroTas signed the Basslink Services Agreement (BSA), ineffect agreeing to lease the cable over 25 years and pay a facility fee. The BSA is for an operationalperiod of 25 years, with an option to extend the term for a further 15 years.

The BSA allows the owners of Basslink to swap that market-based revenue for an agreed fixed facilityfee, plus performance-related payments. The agreement also gives HydroTas the rights to control theway in which Basslink bids its interconnector capacity, either flowing in or flowing out of Tasmania.Graph 1 is indicative of how Basslink is supported by the availability payment vs. the potential returnthat could be generated through pricing differential.


Graph 1: Basslink Revenue Stream

2.3 Scope of WorkThe report that follows cover four (4) main topic areas to assist in making a determination on thepreferred commercial operating model(s) and procurement model(s) that could best support deliveryof the Project. The four (4) areas of focus are as follows:

► Assess the range of Revenue/ Business Models via a qualitative assessment and considerationbased on the operating models already in existence in the electricity markets (Regulated, Non-Regulated, and/ or combinations of both)

► Run a series financial analyses on each of the model(s) determined above

► Assess the financial viability of each model(s)

► Determine the range of delivery models available

► Assess the suitability of each model(s) to deliver a second interconnector

► Validate findings through market soundings.

The report is intended to be utilised in the financial and commercial sections of the final feasibilityStudy report being prepared by the Tasmanian Energy Taskforce.

The Report uses the price forecasts for MNSPs from the EY electricity market modelling in this reportto inform the quantum of arbitrage benefits may be able to capture by the asset owner of 2IC.

2.4 Approach to AssessmentThe report follows the four (4) steps that are outlined below in Figure 1. It follows a structuredprocess on each of the three (3) key work streams to enable Step 4 (listed below) to occur. Thisapproach is based upon Infrastructure Australia’s National Infrastructure Procurement Guidelines.

Figure 1: 4 Steps to determine the Procurement Model.

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The focus of each of the four steps of our approach are discussed below in greater detail.

The Report considers:

► Commercial operating models (e.g. Fully regulated, partly regulated, fully market and partlymarket exposed) “the Commercial Operating Models”

► Procurement models (e.g. Design & Construct, Build Own Operate Maintain, State build thentransfer to private sector upon operations). These procurement models also include a range ofprivate and public sector funding options “the Procurement Models”

► Underlying operational scenarios which will draw on the market modelling work stream (e.g.growth in Tasmanian wind energy generation, Victorian coal fired generator retirement), andwhich may materially impact on the revenue profile of the asset, particularly over the longer term.

The report enabled each of these combinations (Figure 2) to be assessed against the revenue scenariosfrom the EY electricity market modelling report in a bespoke financial model, in order to generate arange of quantitative outcomes that inform the financial and commercial outcomes.

Figure 2: Procurement Models and Commercial Models combinations that are possible outcomes for the Project

STEP 1:Data Gathering

STEP 2:Operational

Model Analysis

STEP 4:Validation

STEP 3:Delivery Model

Analysis

► Objectives► Risks► Unique project

Characteristics► Agency & Market

capability

► Consider thesuitability of

► Regulated Models► MNSP Models► Hybrid Models

► What precedentexists for theproject?

► What does themarket think?

► Which model bestachieves therequirements andobjectives whilstreducing risk?


2.5 Structure of this ReportThis report is structured as follows:

► Section 3: undertakes the qualitative and quantitative analysis of the commercial operatingmodels considered in this Report

► Section 4: undertakes a qualitative analysis of the delivery model and ownership options available

► Section 5: validates the preliminary findings of sections 3 & 4, summarising the key findings of themarket sounding exercise and outlines case studies for the delivery of interconnectors


3. Commercial Analysis

3.1 Overview of Commercial Model analysisThis section:

► Identifies a range commercial models available to the Project

► Undertakes a qualitative assessment of the potential feasibility of these options. Under eachoption, the commercial structure that may make each option feasible from a financing perspectiveis undertaken taking into consideration keys risks, and revenue

► Undertakes a series of qualitative financial analyses on each of the identified commercial modelsin order to create a holistic overview of the options available to government to pursue thedevelopment of a second interconnector

► Assumes that Basslink and 2IC are able to meet the RIT-T.

3.1.1 Commercial Model OptionsTable 2 summarises the key features of commercial models under which the two interconnectors couldpotentially operate and variation between them. These commercial models are assessed against a fixedcriteria that will help to determine the most appropriate operating model.

Table 2: Commercial Model Variations

Commercial Model Key FeaturesBase Case – 1► Basslink – MNSP► 2IC - MNSP

► Basslink operates as a pure MNSP (no availability charge is earnt)► 2IC enters the market as an MNSP asset► Unless there is a single owner for both interconnectors would

compete for flow to ensure efficient use of the assets

Base Case – 2► Basslink – MNSP► 2IC - MNSP

► Basslink remains a MNSP whilst earning an availability charge(mimics current operations)

► 2IC enters the market as an MNSP► Commercial restrictions in the Basslink Services Agreement

between HydroTas and Basslink Pty Ltd (BPL) limit 2IC operatingas overflow cable only (only utilised when Basslink is at capacity)

Alternative Case 1► Basslink – MNSP► 2IC – Regulated

► Basslink remains MNSP (with availability charge)► 2IC meets RIT-T to become a regulated asset► 2ICs’ regulated revenue determined by Regulator

Alternative Case 2► Basslink – Regulated► 2IC – MNSP

► Basslink becomes a regulated asset with regulated revenues► 2IC to operate a MNSP

Alternative Case 3► Basslink – Regulated► IC – Regulated

► Basslink becomes a regulated asset with regulated revenues► 2IC regulated, revenue determined by Regulator

Hybrid Case 1► Basslink – Partially Unregulated► IC – Partially Unregulated

► Both Interconnectors are partially unregulated (MNSP), with anavailability charge

► Government provides partial upfront grant, lowering capitalcosts and therefore ongoing impact on consumers.

Hybrid Case 2► Basslink – Partially Regulated► 2IC – Partially Regulated

► Both Interconnectors are partially regulated► Both Interconnectors are supported by a partial transmission

charge (Floor)► Both Interconnectors earn 25% of the arbitrage revenues


3.1.2 Qualitative CriteriaTable 3 includes the six main assessment criteria that have been used to assess the various businessmodels listed in Table 2. It includes a summary explanation of its importance and the critical issuesthat need to be addressed.

Table 3: Assessment Criteria

Criteria Explanation Importance Rationale for weightingOperational

Risk Transfer

Which business model providesthe greatest level of effective risktransfer of secondinterconnector?

High

The ability to appropriately manageand transfer risk to the privatesector is a key differentiatorbetween the models.

It is of high importance due todemand and price risks of theasset, and technology andconstruction risk of delivering anundersea cable

OperationalUtilisation/Incentives

Which business model(s)encourage the greatest level ofinterconnector utilisation/operational efficiency?

Medium

The ability to ensure a high level ofutilisation/ encourage the efficientuse of the interconnector isdeemed as medium importance.

EnergySecurity

Do any of the potential businessmodels improve or hinder theenergy security benefits that anadditional interconnector couldprovide?

Medium

An operational secondinterconnector is important factorin ensuring energy security forTasmania and therefore has amedium rating. With dualinterconnectors potentiallyavailable should 2IC be developed,it has slightly lower importancethan if it was a stand aloneconnection.

Financial

FinancingCosts

Which business model offers thelowest financing costs? Low

The cost of financing in relation toother criterion is of less importancethan the ability to actually securefunding.

Suitability forFunding

Which business model isbankable? Medium

The ability for the commercialmodel to be bankable is of mediumimportance in a high levelassessment. The models need to beable to support debt funding in theabsence of investor appetite forpure market risk.

MarketAppetite

Is there market appetite for thebusiness model? High

The commercial model selectionwill ultimately determine both thetype of investor and appetite forthe asset in the long run. In theabsence of full governmentfunding, this is a critical criteriawhich justifies its high rating.


A short overview of the assessment scoring can be seen below.

Assessment Scoring:

To facilitate the qualitative assessment of the options against each criterion, the following ratingsystem was adopted:

Table 4: Options Assessment Scoring

Each score and rank is then be weighted by multiplying the ‘Assessment Score’ by the ‘Importance’rating. The importance rating attracts the following weightings: High = 3, Medium = 2 and Low = 1.

The assessment criterion above was selected and weightings agreed in conjunction with theDepartment. The assessment criteria are representative of the key considerations that need to beaddressed when assessing the benefits and risks of possible commercial and delivery models.

Throughout the financial analysis and market sounding process, the calculations and feedback tendedto ultimately focus on which model would provide the most bankable revenue profile, whilst stillproviding an avenue to attract the required level of funding to deliver the 2IC.

3.2 Qualitative and Quantitative Analysis3.2.1 Quantitative Assumptions and financial modelling approachEY developed a cashflow model to enable the quantitative assessment of the commercial models. Inthe first instance, for the MNSP models the projected electricity flow profiles (provided as part of theMarket Dispatch Cost Benefit Modelling), are utilised to determine a revenue profile for each of theMNSP models. Secondly, the capital costs and ongoing operating costs then flow through the financialmodel to calculate the likely profitability and free cash flows. This enables a determination of the valueof the 2IC generated cash flows has to potential investors. Thirdly, the cash flows are then assessedagainst some high level project financing criteria (internally generated internal rates of return, debtservice coverage ratios, positive Net Present Values) in order to quantify the ability of each MNSPmodel to attract or sustain investment.

In regards to the regulated models, we have modelled a high level regulated asset financial modelstructure to calculate the future cost impacts. The regulated models are not reliant upon marketgenerated revenues for their viability, therefore the financial model considers the costs of deliveringthe project (capital costs, ongoing operating costs, required investment returns) to calculate theongoing annual payment that would be required to sustain the 2IC. These are the quasi cash flows theproject could theoretically generate under a regulated environment, which have value to investors, andin a similar manner to the MNSP models, are then assessed against the high level project financing

Rating Number Descriptionüüü 3 Option is extremely effective in satisfying the requirements of the

criterion.üü 2 Option is effective in satisfying the requirements of the criterion.ü 1 Option just satisfies the requirements of the criterion.û 0 Option is ineffective in satisfying the requirements of the criterion.ûû -1 Option is extremely ineffective in satisfying the requirements of the

criterion.


criteria (internally generated internal rates of return, debt service coverage ratios, positive NetPresent Values) to determine their attractiveness to investors.


Table 5 contains the operating assumptions that were used within the quantitative analysis.5

Please note, the report is not assessing the suitability of these assumptions as they have been eitherprovided by third parties (Tasmanian Energy Taskforce) or are indicative of typical market financingterms that EY, in its experience, deem suitable for this type of analysis. All assumptions should not berelied upon outside of this report and would need to be independently verified in a competitive process.EY takes no responsibility to the accuracy of these figures.

Financial revenue and cost outcomes in the Report are in 2016 dollars unless otherwise labelled.

Table 5: Assessment Criteria

Assumption Input

2IC Capital Cost A$930 million (June 2015 $)

2IC Operating Costs A$16.7 million annually (June 2015 $)

2IC Construction Period 6 Years beginning 2020

2IC Operational State Date 2026

Inflation (CPI) 2.0% p.a.

Cost of Equity Funding 15.0% p.a. (post tax nominal)

Cost of Debt Funding 5.03% p.a. (post tax nominal)

Capital Structure (Gearing) 75% debt ; 25% equity

Loan Term 20 Years

Debt Service Coverage Ratio (“DSCR Target”) >1.5x

Discounting base date The net present values are discounted backto 2016 terms.6

Discount rates Two scenarios are presented: 7% nominaland 10% nominal discount rates7

Source: Tasmanian Energy Taskforce, EY assumptions.

5 It should be noted that the same cost of capital assumptions are used for all commercial models. This is a major simplifyingassumption (given they entail different risks) but ensures consistency with the market modelling. The implications of weakeningthat assumption is discussed when presenting the results.6 The electricity market modelling report discounts its real prices forecasts to 2026/27 terms7 The electricity market modelling report applies 7% and 10% real discount rates to real cashflows, where this Report convertsrevenues and cost to nominal terms, and applies nominal discount rates


3.2.2 Qualitative SummaryTable 6 shows that the results of the qualitative commercial models assessment. The MNSP scenario (Base Case 1) generates the greatest risk transfer andutilisation, though this comes at the expense of funding suitability, whereas the dual regulated scenario (Alternative Case 3) offers the greatest suitability forfunding, though this comes at the expense of risk transfer and utilisation of the second interconnector.

Table 6: Qualitative Score Summary

Criteria Importance Base Case 189 Base Case 2 Alt. Case 1 Alt. Case 2 Alt. Case 3 Hybrid Case 1 Hybrid Case 2

Both MNSP’s

Both MNSP’s –Commercial

Restrictions on2IC

Basslink MNSP,2IC Regulated

BasslinkRegulated, 2IC

MNSPBoth Regulated Partially MNSP Partially

Regulated

Risk Transfer High üüü üüü ü ü ü ü üü

OperationalUtilisation Medium üüü ü üü üü üü üü üü

Energy Security Medium ü ü ü ü ü ü üü

Suitability forFunding Low ü ü üüü ü üüü üü üüü

Financing Costs Medium ü ü üüü ü üüü ü üüü

Market Appetite High ü ü üü ü üü ü üü

Score 10 8 12 7 12 8 14

Weighted Score 23 19 24 24 24 16 29

The Hybrid Case 2 model ranks highest as it takes the best parts of the regulated model (a minimum transmission charge to support funding), whilsttransferring some MNSP revenue risk exposure to incentivise asset utilisation and enable higher investor returns. The ability of this model to generate furtherreturns (over and above the transmission charge) provides an additional benefit of incentivising asset owners to ensure the link is utilised, as they are able toshare a portion of the arbitrage revenues that they otherwise wouldn’t in a traditional regulated model.

8 In the market modelling report, this is known as the “MNSP Base Case”9 In the market modelling report, this is similar to the operational assumptions of MNSP Base Case. Importantly, the market modelling assumes that both interconnectors act co-operatively such thatthe bidding of the two interconnectors maximises the total revenue of the interconnectors. However, from a commercial perspective, this would only be the case where the interconnector is owned bythe same owner. Further, this Report does not include consideration any of the market benefits, as these are unable to be captured by the asset owner to generate commercial returns. See Section1.3 for discussion of the relationship to the market modelling


3.2.3 Quantitative Summary – 40 YearsTable 7 below highlights both the profitability of each commercial model over 40 years. It is important to note that the modelled outcomes are based uponhypothetical market scenarios that were produced by the EY electricity market modelling team on behalf of the Tasmanian Taskforce.

Table 7: Modelled Scenario Summary – 40 years

Investor Suitability Summary

Scenario (NPV 2016 terms) Base Case 1 Base Case 2 Alternative Case 1 Alternative Case 2 Alternative Case 3 Hybrid Case 1 Hybrid Case 2

Description Both MNSP’s


Restrictions on2IC




Regulated

NPV (2016) of InterconnectorRevenues @ 7% ($m) – 2IC 1,662 598 1,152 1,662 1,152 662 1,314

NPV (2016) of InterconnectorRevenues @ 7% ($m) – Basslink 598 1,013 1,013 791 791 - -

NPV (2016) of InterconnectorRevenues @ 10% ($m) – 2IC 827 304 619 827 619 353 695

NPV (2016) of InterconnectorRevenues @ 10% ($m) – Basslink 304 515 515 407 407 - -

Project IRR 12.7% 3.9% 9.9% 12.7% 9.9% 9.9% 11.2%

Equity IRR 18.2% 1.7% 15.0% 18.2% 15.0% 15.0% 18.1%Cash flow sufficient to support debtrepayments Yes No Yes Yes Yes Yes Yes

2IC financeable No No Yes No Yes No Yes

Notes

Market revenuesare seen as “risky”and unlikely to be

able to be fullytransferred to theprivate sector. Will

be difficult tofinance as pureMNSP withoutprice support.

Similar to BaseCase 1, MNSP

based revenuesare unlikely to

attract funding dueto the riskiness ofcash flows. Poorutilisation of 2IC,and consequential

low returns.

As 2IC would havethe benefit of

regulatedrevenues, willincrease thelikelihood of

attracting fundingto deliver the

project at a lowcost of capital.



attract reasonablefunding levels dueto the riskiness of

cash flows.




project at a lowcost of capital



attract reasonablefunding due to theriskiness of cash

flows.

As 2IC would havethe benefit ofregulated, or

minimum cash flowpayments, willincrease thelikelihood of


project· The net present values are discounted to 2016 terms using nominal post tax discount rates of 7% and 10% respectively. Note that for Base Case 1, the NPV of Interconnector Revenues are different to MNSP Base Case 1 in

the electricity market modeling due to different discount rate assumptions as set out in Table 4. The differences in assumptions are appropriate as the discounting is undertaken for different purposes, and variances havebeen reconciled.


3.2.4 Quantitative Outputs Summary – 50 YearsTable 8 contains the same scenarios and outputs as the summary table above, with adjustments made to consider the outputs over a 50 year operationalperiod.

Table 8: Modelled Scenario Summary – 50 YearInvestor Suitability Summary

Scenario Base Case 1 Base Case 2 Alternative Case 1 Alternative Case 2 Alternative Case 3 Hybrid Case 1 Hybrid Case 2

Description Both MNSP’s


Restrictions on2IC




Regulated

NPV (2016) of InterconnectorRevenues @ 7% ($m) – 2IC 1,745 616 1,211 1,745 1,211 697 1,380

NPV (2016) of InterconnectorRevenues @ 7% ($m) – Basslink 616 1,073 1,073 843 843 - -

NPV (2016) of InterconnectorRevenues @ 10 ($m) – 2IC** 845 308 635 845 635 363 712

NPV (2016) of InterconnectorRevenues @ 10 ($m) – Basslink 308 528 528 418 418 - -

Project IRR 12.7% 4.0% 10.0% 12.7% 10.0% 10.0% 11.3%Equity IRR 18.0% 2.1% 15.0% 18.0% 15.0% 15.0% 18.1%Cash flow sufficient to support debtrepayments Yes No Yes Yes Yes Yes Yes

2IC financeable No No Yes No Yes No Yes

Notes

MarketRevenues are

seen as “risky”and unlikely tobe able to be

fully transferredto the privatesector. Will be

difficult tofinance as pureMNSP withoutprice support.


based revenues areunlikely to attractfunding due to theriskiness of cash

flows. Poorutilisation of 2IC,and consequential

low returns




project at a lowcost of capital.


based revenues areunlikely to attract

reasonable fundinglevels due to theriskiness of cash

flows.




project at a lowcost of capital


based revenues areunlikely to attract

reasonable fundingdue to the riskiness

of cash flows.

As 2IC would havethe benefit ofregulated, or

minimum cash flowpayments, willincrease thelikelihood of


project


3.3 Detailed results – Base Case3.3.1 Base Case 1 – Both MNSP’s - QualitativeTo consider Base Case 1 from a qualitative perspective, the operating assumptions for eachcommercial model is compared against the criteria, to provide the key takeaways provided inTable 9.

Table 9: Key Takeaways – Base Case 1

Criteria Key Takeaway Rating

Risk Transfer► MNSP assets provide the greatest transfer of risk from

the interconnectors, particularly for demand and pricerisks.

üüü

OperationalUtilisation

► Both interconnectors will be encouraged to operate at thehighest level of utilisation as they are directly competingagainst each other for energy flows, unless they areoperated by the same asset owner.

üüü

Energy Security

► Whilst dual interconnectors offer greater energy security,this is offset by the potential impacts on viability as bothinterconnects compete for flow, forcing down profitabilityand sustainability.

ü

Suitability of Funding

► With limited capability to accurately forecast futurewholesale energy prices there is no guarantee that theprice differential will be great enough to profit from thearbitrage and underpin revenues that support funding.

ü

Financing Costs

► As financing is so heavily reliant upon arbitrage which willbe an unreliable cash flow, financiers will see thiscommercial model as presenting them with the highestlevels of risk and therefore pricing will represent theriskiness of the investment.

ü

Market Appetite► Without reliable market data, revenue remains relatively

uncertain which will impact investor confidence andfinance ability.

ü

In Base Case 1 both interconnectors operate as MNSP’s (no availability charges or other formsof revenue support) that are attempting to profit from any price differential that may exist oneither side of the interconnector in order to generate their revenue. This model encourages thehigh utilisation of the interconnectors (as flow equals the potential ability to generate returns)though reliability of funding needs to be addressed.

The financeability of this commercial model is the key limitation. As MNSP generated revenuesare forecast to be highly volatile and reliant upon the electricity generator (HydroTas) to helpensure there are price differentials to take advantage of, this model is expected to struggle toattract reasonable levels of funding and is not regarded as a viable commercial model.

The revenue impact and uncertainty of MNSP operating models is illustrated in sensitivityanalysis of the second interconnector revenues when the mainland market is oversupplied. Theelectricity market modelling report (section 6.2.2) estimates that revenue falls by approximately40% in an oversupplied market compared to MNSP Base Case 1. This outcome has a materialimpact on commercial viability.


3.3.2 Base Case 1 – Quantitative AnalysisGraph 2 below shows annual revenue for 2IC and Basslink, with the 2IC being a newly designedinterconnector, in a market environment where 2IC competes against Basslink for energy flows.Due to the lower loss factors of 2IC, 2IC would garner a significant portion of the potentialrevenue that could be earned through arbitrage, which is consistent with the qualitativeassessment.

Graph 2: Revenue scenarios under Base Case 1 – MNSP’s

3.3.3 Key Modelling ResultsTable 10 below shows that based upon the assumptions used in the modelling, that theoutcomes generated are indicative of a project with strong financial metrics. The NPV’s are high,the Project and Equity IRR’s are also high. When considering the figures in isolation, it wouldseemingly support a high gearing ratio (Debt to Equity), all of which are attractive to investors.

Table 10: Financial modelling results for the MNSP Commercial Model

Base Case 1 – Dual MNSP

ScenarioOutputs

40y operations 50y operations

MNSP NPV (2016) @7% ($m)2IC 1,662 1,745Basslink 598 616MNSP NPV (2016) @10% ($m)2IC 827 845Basslink 304 308Other 2IC financial metricsProject IRR 12.7% 12.7%Equity IRR 18.2% 18.0%Debt Fundable Yes YesFinanceable No No

Whilst this commercial model seemingly provides all the required outcomes of a fundableproject, when overlaid with the issues raised in the qualitative assessment, namely, theunreliability of market generated cash flows, along with the encouraged interconnectorcompetition, this model is actually unlikely to be fundable, nor desirable by energyinfrastructure investors. This is further evidenced by the fact that no true MNSP interconnectorsare in operation in Australia.

050

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We note the market modelling assumes that both interconnectors act co-operatively such thatthe bidding of the two interconnectors maximises the total revenue of the interconnectors.However, from a commercial perspective, this would only be the case where the interconnectoris owned by the same owner. The financial outcomes above reflect MNSP outcomes where bothassets are owned by single party. We note that electricity market modelling suggests if HydroTasmania was the owner of its current assets and the two interconnectors and bid to maximiseits total wholesale revenue, in most trading intervals it would derive maximum benefit frombeing able to export energy (i.e. bidding close to zero).

► In order for this model to be viable, HydroTas would need to have greater capacity tooperate the interconnector (as a participating owner).

► Alternatively HydroTas would need to enter into offtake contracts with the interconnectorowner to ensure they have consistent access to electricity flows at discounts to theprevailing market prices in order to generate revenues.

3.3.4 Base Case 2 – Both MNSP’s – Commercial Restrictions on 2IC -QuantitativeBase Case 2 varies slightly operationally from Base Case 1 in one key area, specifically, putting aconstraint on the second interconnector’s ability to access energy flows. This model is assumedto have a commercial restriction in place in the Basslink BSA that ensures Basslink receives amajority of flow from HydroTas, with the second interconnector operating as a pure MNSP.

Table 11: Key Takeaways – Base Case 2


Risk Transfer

► MNSP assets provide the greatest transfer of risk from theinterconnectors, particularly for demand and price risks.

► Ongoing support and partial risk transfer to underwrite therevenues required to service any form of financing.

üüü


► 2IC will operate essentially as an overflow cable only as it’sno longer in competition for the initial 500MW which is thecapped capacity of Basslink in this modelling.

ü

Energy Security

► Model restricts the capability of 2IC to support itself ifoverflows are limited which could negatively impact energysecurity, as its viability is critical to keeping the assetoperational.

ü

Suitability of Funding ► Funding will be difficult to secure unless guarantees for aminimum flow level is achieved which could support funding.

ü

Financing Costs ► Expect financing costs (if funding can be supported) to beexpensive if no availability payment is made.

ü

Market Appetite

► Guarantees would need to be provided at least for“minimum” flow access to ensure some level of revenue canbe generated if the intent is to encourage non-governmentfunding sources.

ü


In a similar outcome to Base Case 1, all the scores with the exception of Risk Transfer are low. Ina commercial model that is unable to provide some certainty of revenues or support for flowsthrough the 2IC, this model is unlikely to attract sufficient funding from investors to meet capitalrepayments. Any form of commercial restriction on 2IC from accessing a fair amount of flowfrom HydroTas significantly impacts its profitability. This model also limits the efficient use of2IC (as there is no incentive for Basslink to change its operating efficiencies to better utilise 2IC).

3.3.5 Base Case 2 – Quantitative AnalysisWith Base Case 2 placing commercial restrictions on the availability of energy flows for thesecond interconnector, Basslink is now the major beneficiary of the arbitrage revenue (Graph 3)able to be generated in this scenario. Whilst 2IC would typically garner a majority of the flow dueto its ability to provide lower losses to HydroTas, this benefit is not able to be realised.

Graph 3: Revenue scenarios under Base Case 2 – Commercial Restrictions

3.3.6 Key Modelling ResultsSimilarly to the previous case Table 12 below contains the outputs generated from the financialanalysis. The NPV for 2IC is less than Base Case 1, and the project and equity IRR would notmeet most investors’ minimum criteria. This is compounded by the fact that this model is notable to support a significant level of gearing that would be required to deliver the secondinterconnector.

Table 12: Financial modelling results for the Base Case 2 - Commercial Restrictions

Base Case 2 – Dual MNSP with Commercial Restrictions

ScenarioOutputs

40y operations 50y operationsMNSP NPV (2016) @7% ($m)2IC 598 616Basslink 1,013 1,073MNSP NPV (2016) @10% ($m)2IC 304 308Basslink 515 528Other 2IC financial metricsProject IRR 3.9% 4.0%Equity IRR 1.7% 2.1%Debt Fundable No NoFinanceable No No

0

50

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300

350

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If the second interconnector is unable to garner a fair portion of energy transfers fromHydroTas, it will be severely restricted in its ability to generate revenue. The “riskiness” of therevenue profile, means like Base Case 1, this model is unlikely to be financeable.

► The inability of the model to support adequate gearing levels and provide minimum marketreturns for investors, coupled with the fact that revenue is still generated via arbitrageopportunities (and therefore out of the control of the interconnector owner), also meansthis model is unlikely to be commercially viable.

3.4 Detailed Results – Alternative Cases3.4.1 Alternative Case 1 – Basslink MNSP, 2IC Regulated - QualitativeAlternative Case 1 is a commercial model where Basslink remains an MNSP (and earning anavailability charge), and the second interconnector enters the market as a regulated asset. Thismodel assumes no commercial restrictions are in place and that the assets will be utilised byHydroTas as they are required.

Table 13: Key Takeaways – Alternative Case 1


Risk Transfer ► Third party revenue risk not transferred to the privatesector asset owner of 2IC.

ü


► 2IC is only seeking to earn a return on its capital investedand cover operating costs, meaning it could potentiallyoffer lower access costs to the NEM, increase operationalutilisation and ensure minimal costs are passed on toelectricity consumers as they don’t pay an arbitragepremium.

► However, asset owners are not financially incentivised tooptimally maintain and operate the infrastructure (otherthan through the regulated asset’s minimum requirements).

üü

Energy Security

► Dual interconnectors will increase energy security forTasmanians purely through the addition of a secondary linethat can operate viably as a backup should one or the otherline be unavailable.

ü

Suitability of Funding ► Increases the level of funding suitability through reliablecash flows to service investor funding üüü

Financing Costs► With 2IC having reliable and consistent cash flows then

financing costs would be expected to be competitive withother recent regulated asset sales processes.

üüü

Market Appetite

► From a pure investment perspective, if guarantees can’t beprovided on returns generated through arbitrage that couldconsistently be exploited, then a regulated scenario willdrive market appetite as investors will have greater insightinto the expected returns which will increase the desire forthe asset.

üü


This model has considerable advantages over the pure MNSP models previously assessed due tothe increased financeability of regulated revenues, which could lead to improved outcomes inrelation to the bankability of this model as this offers a considerably lower risk profile forinvestors.

3.4.2 Alternative Case 1 – Quantitative AnalysisThe cashflow profile of this model visually is different from the previous models. As can be seenGraph 4 below, Basslink’s revenues are directly linked to its ability to generate returns viaarbitrage opportunities which is evidenced by the volatile line, whilst 2IC earns a consistentregulated return, hence almost no variation in the revenue profile.

Graph 4: Alternative case 1 – Basslink MNSP, 2IC Regulated

3.4.3 Key Modelling ResultsWhen considering this model with the Base Case options, the outputs in Table 14 indicate thatwhilst the NPV’s may be somewhat lower, they are still strong outcomes, enhanced by the abilityof this commercial model to generate equity IRR’s of approximately 10% (expected to besufficient for a regulated asset) and is capable of supporting a high gearing ratio. This model issupported by regulated revenues for 2IC (limited only to what is required to repay debt, coveroperating costs and applicable depreciation).

Table 14: Financial modelling results for Alternative case 1 – Basslink MNSP, 2IC Regulated

Alternative Case 1 – Basslink MNSP, 2IC Regulated

Scenario Outputs40y operations 50y operations

MNSP / regulated NPV (2016) @7% ($m)2IC 1,152 1,211Basslink 1,013 1,073MNSP / regulated NPV (2016) @10% ($m)2IC 619 635Basslink 515 528Other 2IC financial metricsProject IRR 9.9% 10.0%Equity IRR 15.0% 15.0%Debt Fundable Yes YesFinanceable Yes Yes

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The biggest issue this model faces is it exposes BassLink to market generated returns which willultimately impact its ability to generate market linked returns above the availability charge.► BassLink would need to be able to enter into offtake contracts in order to ensure access to

electricity flow and provide a consistent revenue stream.► With HydroTas being responsible for ensuring base load domestic supply to Tasmania first

and foremost, MNSP’s are unlikely to be commercially viable due to their inability to controldemand flow from HydroTas.

This commercial model provides superior outcomes for 2IC when considering the benefits ofregulation on the projects ability to support debt and deliver long term viability. For 2IC, thismodel would likely be financeable by both debt and equity investors.

3.4.4 Alternative Case 2 – Basslink Regulated, 2IC MNSP - QualitativeAlternative Case 2 is a variation on the Alternative Case 1.



Risk Transfer

► Delivers a greater level of risk transfer over the AlternativeCase 1, though with Basslink becoming regulated, there needsto be comfort that this is a sustainable outcome for 2IC toensure its viability given the transfer of demand and pricingrisk and enable effective risk transfer.

ü

Operational Utilisation ► Encourages greater competition that will benefit energyconsumers at the expense of profits for the interconnectors. üü

Energy Security► With 2IC being MNSP, the commercial viability risks increase

which could negatively impact energy security should the assetbe vulnerable to failure through limited revenues.

ü

Suitability of Funding

► With cash flows from the 2IC being directly impacted by theability of the asset to generate revenue through arbitrage(needs to compete with Basslink’s to impact on pricing tosecure flow), reliability of cash flows becomes a concern.

ü

Financing Costs► As the asset is subject to inconsistent cash flows being

generated, expected riskiness will increase and therefore this isexpected to be represented in an increase in funding costs.

ü

Market Appetite► With limited certainty into the expected cash flows of the asset

and no firm guarantee of energy flows along the link, themarket will have less appetite for this structure.

ü

In this model, Basslink would operate as a regulated asset (earns a regulated transmissioncharge), whereas 2IC would operate as a pure MNSP. The model assumes no restrictions of flowsbetween either of the interconnectors, as 2IC is expected to compete against the regulatedBasslink for flows. This model encourages 2IC to bid, at a minimum, the same equivalent valuethat it would cost HydroTas to use Basslink.

As previously explored in prior models, with 2IC expected to generate revenues from marketarbitrage opportunities and the high levels of risk associated with that revenue profile, it scoreslow in regards to the finance criteria and therefore is an assessed as an unsuitable model tosupport the delivery of a second interconnector.


3.4.5 Alternative Case 2 – Quantitative AnalysisIn a similar structure to the Alternative Case 1, though in this instance revenue for Basslink isregulated, whilst 2IC operates as an MNSP. In Graph 5 below, it should be clear that Basslink’srevenues are relatively consistent, with 2IC being directly exposed to market generated returns,which on face value look considerably higher than a regulated return.

Graph 5: Alternative case 2 – Basslink Regulated, 2IC MNSP

3.4.6 Key Modelling ResultsThe key outputs in Table 16 are similar to the outcomes generated in Base Case 1, specificallywhen looking at the NPV’s, Project and Equity IRR’s. This commercial model could alsotheoretically support high gearing levels, though as 2IC is back to generating arbitrage revenues.

Table 16: Financial modelling results for the MNSP Commercial Model

Alternative Case 2 – Basslink Regulated, 2IC MNSP


MNSP / regulated NPV (2016) @7% ($m)2IC 1,662 1,745Basslink 791 843MNSP / regulated NPV (2016) @10% ($m)2IC 827 845Basslink 407 418Other 2IC financial metricsProject IRR 12.7% 12.7%Equity IRR 18.2% 18.0%Debt Fundable Yes YesFinanceable No No

Similarly to Base Case 1, this commercial model provides a significant NPV along with strongproject and equity IRR’s. As 2IC’s revenue is again MNSP based, due to the riskiness of cashflows, this model is unlikely to be financeable.

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► Though in a similar outcome to Base Case 1 (high NPV’s), this model still relies uponHydroTas supporting the 2IC by providing access to electricity flows at a discount to theprevailing markets at the time in order for the interconnector to generate revenue.

► Without some form of offtake agreement (from HydroTas) or HydroTas participating insome form of ownership structure in 2IC to support it commercially, this model is unlikely tobe commercially viable due to the inability of 2IC to generate consistent returns to repaylenders.

3.4.7 Alternative Case 3 – Both Regulated - QuantitativeThe next case considered is a scenario where both Basslink and the second interconnector areoperating in regulated commercial models.



Risk Transfer► Limited revenue risk transfer to asset owners (as

above) as both assets are regulated and not exposed todemand and price risks.

ü


► HydroTas would be free to operate both links as theywish with limited commercial implications.

► However, asset owners are not financially incentivisedto optimally maintain and operate the infrastructure(other than through the regulated asset’s minimumrequirements).

üü

Energy Security

► Regulated revenues for both interconnectors improvesenergy security for Tasmania as regulation will underpinthe viability of both interconnects, meaning thelikelihood of both assets being unavailable would below.

ü

Suitability of Funding► Regulated returns on the 2IC will provide a higher level

of funding when compared to MNSP’s as cash flows arepre-determined and could be more easily financed.

üüü

Financing Costs

► With 2IC having reliable cash flows, as long as they cancomfortably meet funding covenants then financingcosts would be expected to be competitive with otherforms of funding.

üüü

Market Appetite

► For 2IC to have meet the RIT-T requirements, the assetwill be generating a return to cover funding, returns onfunding and operating costs, meaning an increasedinterest in the assets.

üü

In this instance, neither Basslink nor the second interconnector have viability concerns at thesame level as MNSP models as their revenues are determined by the regulator. From a financingperspective, this commercial model structure meets the requirements that most investors wouldbe looking for, namely low risk, bankable revenue profiles, though the tradeoff is risk transferand utilisation are relatively low.


3.4.8 Alternative Case 3 – Qualitative AnalysisAt the opposite end of risk transfer spectrum to the Base Case options, this commercial modeloption provides an ongoing regulated return for both Basslink and 2IC. As Graph 6 shows therevenue lines for both interconnectors are stable, only increasing overtime in line with anyinflationary impacts.

Graph 6: Alternative case 3 – Basslink and 2IC Regulated

3.4.9 Key Modelling ResultsTable 18 shows that this commercial model provides improved outcomes in most areas, thoughas expected the NPV’s and Project IRR’s are not as strong as you would expect to see in outrightMNSP operations. The significant benefit of this model though is the regulated revenues thatcould support the ongoing viability of the interconnectors.

Table 18: Financial modelling results Basslink and 2IC Regulated

Alternative Case 3 – Basslink and 2IC Regulated


Regulated NPV (2016) @7% ($m)2IC 1,152 1,211Basslink 791 843Regulated NPV (2016) @10% ($m)2IC 619 635Basslink 407 418Other 2IC financial metricsProject IRR 9.9% 10.0%Equity IRR 15.0% 15.0%Debt Fundable Yes YesFinanceable Yes Yes

The dual regulated commercial model is able to support a level of funding, and internal rates ofreturn that will attract investors to support the development of a second interconnector. For2IC, this model would likely be financeable by both debt and equity investors at a relatively lowcost of capital.

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► The dual regulated commercial model is able to support a level of funding, and internal ratesof return that will attract investors to support the development of a second interconnector.

► This model does not address the higher loss factors that Basslink suffers from and mayultimately lead to reduced operational viability as HydroTas by default would want to selectthe second interconnector for transmission due to lower losses.

► Depending on total flows across both interconnectors may force Basslink to operate as anoverflow cable only.

3.5 Detailed results – Hybrid models3.5.1 Hybrid Model 1 - Partially Merchant Commercial ModelIn contrast to the partially regulated model, a partially merchant model functions in afundamentally different way. The regulated version attempts to create additional value forinvestors by creating a floor and providing the opportunity to share in some upside, whereas themerchant version is designed to lower the level of return required to remain viable through someform of government assistance. For example, a government grant towards the capital costsrequired to deliver a second interconnector, instantly lowers the level of revenues that wouldneed to be generated by the interconnector in order to sustain the viability of this model.

Graph 7: Partially Merchant Commercial Model – Reduction in Transmission Charge

3.5.2 Key Modelling ResultsWhen compared to the partially regulated model results above, Table 19 highlights that theNPV’s, project and equity IRR’s in this model are lower. On face value the model can also sustainhigh levels of gearing, though this imposes a higher cost on consumers as the interconnector isstill operating in profit maximising mode. As we discuss above, models that ultimately requiresmarket generated returns to recover capital is unlikely to be viable and fundable.

Table 19: Financial Modeling Results - Partially Merchant

Partially Merchant Model


2IC – NPV(2016) @7% ($m) 662 6972IC - NPV (2016) @10% ($m) 353 363Project IRR 9.9% 10.0%Equity IRR 15.0% 15.0%Debt Fundable Yes YesFinanceable No No

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Regulated revenue 2IC partially merchant 40y operating period


► The interesting take away from this model, is that in a market that could consistently returnstrong market driven revenues, this would offer considerable appeal over a pure MNSPcommercial model by covering the asset owners repayment of capital.

► As the asset would still operates as a MNSP, this model is unlikely to be funded withoutconsiderable revenue generation support from HydroTas.

3.5.3 Hybrid Model 2 - Partially Regulated Commercial ModelA partially regulated commercial model is one in which at a minimum, the asset is able togenerate a regulated return in order to cover debt, operating and associated deprecation coststhat to underpin the viability of the interconnector, whilst still offering the owner of theinterconnector an ability to generate some market returns, though the partial sharing of anyarbitrage revenue that could be realised.

These commercial models are increasingly popular in Europe and are known as Cap and FloorModels. They earn revenue through the payment of a capacity charge, which is set at a minimumamount of revenue that the interconnector can earn. This means that, if an interconnector doesnot receive enough revenue from its own operations, its revenue will be ‘topped up’ to the floorlevel.

The top up payment, in this instance would come from HydroTas, which in turn will recover thatsum from transmission charges applied to all users of the NEM. This model also passes on theviability of the interconnector to consumers, who are essentially underwriting the revenue riskto pay for the investment. In circumstances where the interconnector’s revenue exceeds a pre-determined cap, the interconnector will transfer the excess revenue to HydroTas, which in turnwill reduce the transmission charges for consumers.

Graph 8: Partially Regulated Commercial Model – Capped Upside (25%)

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Regulated revenue 2IC partially regulated 40y operating period


3.5.4 Key Modelling ResultsWhen considering Table 20 against the variations of the models already analysed above, itshould be clear as to the benefits this type of model provides.

Table 20: Financial Modeling Results - Partially Regulated

Partially Regulated Model


2IC – NPV(2016) @7% ($m) 1,314 1,3802IC - NPV (2016) @10% ($m) 695 712Project IRR 11.2% 11.3%Equity IRR 18.1% 18.1%Debt Fundable Yes YesFinanceable Yes Yes

With the benefit of “minimum” ongoing payments due to the floor function of this model, it wouldlikely attract funding should this type of commercial structure become available in Australia.

► The benefits of this model comes in the form of capped higher returns for investors over atraditional regulated model, which will encourage greater investment, whilst providing lowercosts to consumers as they are only exposed to a capped upside rather than what mayotherwise could occur under MNSP type models.

► For this model to be considered in the Australian context, it would require a significantpolicy shift to supporting this type of commercial structure, though it does offer improvedviability over MNSP models and increased attractiveness for investors over a pure regulatedmodel.

3.6 Conclusion – Commercial AnalysisIn a simplistic view, it would easy to take the key outputs from the qualitative and quantitativeanalysis and draw conclusions that MNSP scenarios are profitable and would encourage thehighest level of investor interest, whilst regulated assets may offer lower costs to consumersand are potentially more suitable to debt funding. The reality is that determining the appropriatecommercial model is considerably more difficult.

With MNSP’s (at a high level) offering greater levels of returns, the level of market exposed riskis considerable. To generate their revenue the interconnect would need to rely upon HydroTasmaking electricity available to the interconnector at a level that is consistently lower thanmainland prices so that the asset owner can profit off the price differential to sustain theconnection or generate substantial revenues through ancillary services.

The fact that the price differential is very difficult to forecast outright, and that HydroTas is notoperating with the profitability of the interconnector in mind, mean the potential revenuestreams are highly volatile and difficult to predict.

On the other hand, regulated models by nature are considerably more fundable than MNSP’spurely due to their revenue profile being pre-determined through regulation. Whilst regulatingassets provide cost of funding benefits when compared to MNSP’s, they may not alwaysencourage the most efficient use of the assets, nor generate the levels of returns that someinvestors may require due to the reduction in risk profiles.


The key to the selection of the preferred commercial model is directly related to the outcomethat government is seeking in relation to the second interconnector. If the overarching goal is toensure energy security and to open further renewable generation options within Tasmania thenforms of regulated models should support this goal as they can operate without the need to be inprofit maximising mode as their return is already determined.

Alternatively, if the goal is to deliver a second interconnector that encourages the greatest levelof third party investment in a competitive environment with little concern given to their viabilityor risk profiles, then MNSP models that offer exposure for asset owners to generate greaterreturns than regulated models would be preferred, assuming that these revenue streams areconsistently available and are attractive for investors considering their risk profile.

In light of these two extremes, the advantages of the hybrid models, and in particular thepartially regulated model, looks to offer the benefits of regulation for investors (i.e. lower riskprofiles) whilst offering some of the MNSP benefits (i.e. efficient asset operation and potential toshare in increased revenues). As with all options, the pros and cons of the range of commercialmodels are considerable and cannot be considered in isolation.

The analysis indicates that for a second interconnector to be delivered in the currentenvironment, it will more than likely, at least initially need to be supported by some level ofregulated return or availability type charge, similar to Basslink or the Cap and Floor models inoperation in Europe, in order to attract funding and provide a viable commercial model.


4. Procurement Models

4.1 Procurement considerationsThis section focuses on the range of procurement model options for 2IC. Figure 3 belowidentifies the considerations which need to be addressed prior to any procurement modeldecisions. As can be seen, operating models (Section 4) are typically the starting point, beforeconsidering the impact of ownership structure which then help form the decision process aroundprocurement model choices.

Figure 3: Decision flow

4.2 Ownership structure – 1 Owner vs 2 OwnerAs section 4 considers the range of commercial models, the next steps in the process is tooverlay those decisions with the impact that the ownership structure may have on procurementoptions. Table 21 contains the range of ownership structures available depending on the numberof potential asset owners of both interconnectors.

Table 21: Ownership structures

Ownership Ownership structures

One Owner (Basslinkand 2IC) State-owned (S) Existing operator (E) New Operator (N)

Two Owners(Basslink / 2IC) S / E E / S S / N N / S E / N N / E

In broad terms, under a one-owner model, interface risks are reduced, commercial complexity isreduced and the flexibility and adaptability in how the asset is operated is increased given thesingle-ownership and governance structure.


In addition, by controlling both Basslink and 2IC, loss-minimising operational practices can beundertaken by the owner to improve the utilisation of both assets in an efficient manner whichmay also deliver improved energy security outcomes.

The market modelling under Base Case 1 where both assets are MNSPs assumes that bothinterconnectors act co-operatively such that the bidding of the two interconnectors maximisesthe total revenue of the interconnectors. However, from a commercial perspective, this wouldonly be the case where the interconnector is owned by the same owner.

Operating model options that have both links exposed to revenue risks (MNSP’s) and haveseparate ownership structures may impact the commercial viability of the assets. Withoutregulatory restrictions, sub-optimal market outcomes may eventuate such as:

► Low competitive pricing which creates financial stress for the asset owners

► Pricing is maintained at artificially high levels due to the pricing power of the duopoly

Conversely, under a two-owner model, benefits may include increased price competitiveness,increased opportunity for innovation as well as a diversification of risk through separatedownership and governance structures.

With Basslink being a privately owned MNSP, the Government presumably has minimal levers tocompel Basslink to become a regulated asset or consider a change to its commercial model. Thisrepresents a key risk to the delivery of 2IC. It is also important to consider that an option toextend the BSA in 2031 for another 15 years exists, though it is unknown at this stage if thatoption will be executed.

Should Basslink find itself in a less than ideal operating scenario, the options available include:

► Considering applying to the AER for regulated asset status

► Considering a sales process for the asset

► Seeking to renegotiate terms with HydroTas

4.3 Procurement Model OptionsTable 22 below sets out the key procurement models available for this type of asset. Inundertaking this assessment, each model has been evaluated against their ability to meet theproject objectives. There are a variety of revenue models which might influence the desirabilityof each approach. The potential delivery models for 2IC, and their relative advantages anddisadvantages include:

Table 22: Procurement model options

Procurement Method Description Advantages Disadvantages

Design & Construct (D&C) andtransfer to private sector

Under a D&C and transfer approach,Government would procure the designand construction of 2IC with the D&Cprovider transferring ownership backto Government / current operatorfollowing completion.

► Price certainty and valuefor money (depending onstructure of commercialmodels)

► Time (to market and tocompletion)

► Risk management► Flexibility to change


Procurement Method Description Advantages Disadvantages

Design, Build and Maintain (“DBM”)

Under a design, build and maintainmodel, Government would contract aprivate entity to design, build andmaintain the asset, with operationalresponsibilities retained byGovernment.


► Risk management

► Price certainty and valuefor money

► Flexibility to change

PPP / Build Own Operate Transfer(BOOT)

Under a PPP / BOOT model, a privateoperator would be contracted todesign, build, operate and maintain2IC, with Government providingrevenue to the operator under anavailability payment

► Risk management► Price certainty and value

for money


► Flexibility to change

4.4 Procurement SummaryA contestable regulated model (applied for projects with significant capital costs) is likely toenable competitive bids for construction, operations and ownership of the asset

► The regulated asset model is market tested, and competitive for transmission assets

► It could be expected to be delivered with relatively a low cost of capital

► With only 3 HVDC suppliers capable of meeting the technical specifications globally, concernneeds to be given to the impact this may have on the competitiveness of the procurementmodel

► The existing DNSP arrangements in Tasmania and Victoria would be expected to continuefor the procurement of required network connection infrastructure for new generation andconnection to the existing grid

Should an MNSP commercial model with a capacity charge be the preferred choice, a Build OwnOperate Transfer (“BOOT”) delivery model should deliver an optimal outcome

► BOOT transfers majority of construction, maintenance, operations and ownership to theprivate sector.

► Bidders would compete on what their minimum Capacity Charge is to deliver and operatethe asset over the project life


► Maintains strong incentives for the asset owner to ensure the asset is available andmaintain and maintain and operate the asset to reduce transmission losses.

► Much like the commercial model analysis, procurement decisions cannot be considered inisolation. Ideal procurement outcomes are a derivative of both the government’s goals andobjectives of the second interconnector.

► This analysis also highlights the importance of the level of the need to consider theimplication of the one vs. two ownership structure may also have on the procurement andlong term viability of two interconnectors.


5. Validation

5.1 Market Sounding ParticipantsAs part of this report, EY undertook a series of market soundings in order to validate the keyoutcomes for each series of analysis on the various commercial models contained in section 3.

The various market participants included were:

► HydroTas► Clean Energy Finance Corporation► APA Group► Macquarie Bank► AusNet Services► HRL Morrison.

Each participant provided considerable insights into the commercial models, which aresummarised in the following sections. The views expressed below are EY’s key takeaways fromthose discussions and it should not be concluded that they reflect the views on any particularparty consulted with.

A widely held view was that clarity in relation to the key objectives for considering a 2IC is acritical prerequisite to making an assessment on the appropriate commercial delivery model.Some provided insights (and expressed strong views in both directions) into why a secondinterconnect might be required and whether there may be other ways of meeting thoseobjectives. Our focus is however on how the Project might be best delivered, if a decision wastaken to proceed with it.

5.1.1 MNSP ValidationIn line with the outcomes of the analysis in section 3, the general feedback from the marketparticipants was that whilst HydroTas continues to operate outside of the ownership structure ofthe interconnector in Tasmania, MNSP type models (and their variations) are unlikely to becommercially viable.

The market traditionally aims to seek out investment opportunities that contain a risk profilethat can be managed in order to generate revenues. As HydroTas isn’t currently operating (noris it envisaged that this will change) with the viability of the interconnector in mind, for outrightasset investors this presents too greater risk. Market participants are unable to manage theirmarket exposure as HydroTas dictates the access to flow and the price that interconnectorsmust pay.

HydroTas would need to shift its operating position in order to be able to provide greateropportunity for the 2IC interconnector owner to share some of the arbitrage revenue (preferablythrough an offtake contact with the asset owners) which enables consistent revenue generationto be achieved, underpinning the investment and viability of a second interconnector.

5.1.2 Regulated ValidationIn a similar outcome to the conclusions from section 3, the market participants were in generalagreement that when compared to the alternative market exposed commercial models, someform of regulated model structures, or alternatively models that also include minimum payments(transmission charges, availability fees or floor supports) that ensure the ongoing viability of theinterconnector are significant risk exposure improvements over outright MNSPs.


The market was quick to point out that the current RIT-T is a challenging test to be met and that2IC may have trouble meeting the requirements to become regulated. It was the markets’suggestion that alternatively, should the interconnect not meet the regulation test, then “quasi”regulation in the form of ongoing payments (much like Basslink’s availability charge or the Capand Floor Model in operation in Europe) could be viable variations to consider.

Given the choice between an MNSP model that has terms dictated by HydroTas versus aregulated commercial model that has an almost guaranteed revenue stream, it was clear thatthe market believed that in the current environment, regulated structures would providesuperior outcomes, if the objective is to deliver a second interconnector.

It was also noted, however, that a considerable re-working of the regulatory arrangements mightbe required if the second interconnect was to achieve regulated status.

5.2 Case Study Validation5.2.1 Terranora Case StudyTerranora (formerly known as Directlink) is an electricity network asset that spans 63kmbetween Mullumbimby and Bungalora in New South Wales. The interconnector was constructedwith the aim of addressing the power shortage in South Queensland, and surplus capacities inNew South Wales.

The interconnector has a nominal capacity of 180MW and is owned by a joint venture (JV)between Emmlink Pty Ltd (a wholly owned subsidiary of Country Energy) and HQI Australia LtdPartnership. The asset was commissioned in December 1999 and started operations in April2000. At a construction cost of US$70 million, Directlink was the first time that transmissionsystems of New South Wales and Queensland were linked.

Directlink was originally built to operate as an MNSP market network, trading between the NSWand Queensland region. This meant that the asset earned its revenues based on the spot pricedifferential between the New South Wales and Queensland electricity regions.

However in early 2004, the JV submitted an application to the AER requesting to convert theasset from a market network service to a regulated network service. This stance was taken asthe MNSP operation was proving to be unprofitable as the asset was consistentlyunderperforming due to operational issues. In order to support the NEM and provide greatersurety in regards to its viability, DirectLink applied to achieve regulated status.

Following the decision to reclassify the asset as a prescribed transmission service (and therebyreceiving regulated revenue), the AER determined the Regulatory Asset Base and MaximumAllowed Revenues for the nominal 10 year period.

5.2.2 Murraylink Case StudyMurraylink is an interconnector that provides a corridor for the flow of electricity between theSouth Australian and Victorian regions of the NEM. The interconnector covers 176 km from RedCliffs in Victoria to Berri in South Australia and has a limit of 200MW capacity. Theinterconnector is the world’s longest underground power transmission system and cost in excessof $175 million.

The asset was commissioned in 2002 by Murraylink Transmission (TransÉnergie Australia), asubsidiary of TransÉnergie (the transmission division of Hydro-Québec, Canada). It is now ownedby Energy Infrastructure Investments consortium and operated by the APA Group. In early2013, the Murraylink applied to be treated as regulated asset and agreed adopt 5 yearregulatory control period (commencing 1 July 2013 and concluding 30 June 2018).


In a similar vein to Directlink, Murraylink was having considerable issues remaining viableoperating as an MNSP and therefore sought to become regulated. Whilst there was considerableconcern within government at the time as they “believed the asset owners were prepared to takemarket risk and therefore should not be supported by the South Australian consumers” theregulator believed that the considerable benefits offered by the interconnector to the overallNEM was worth supporting via regulation.

5.2.3 International PrecedentsIn order to support the ongoing development of electricity interconnectors in the UnitedKingdom (UK) and mainland Europe, a commercial model is emerging that is designed tounderpin the viability of interconnects. In a joint project between National Grid Plc and EliaGroup (Belgian) called the Nemo Link, subsea and underground cables are being connected toeach country, allowing the flow of electricity between them to occur as demand requires.

In order to ensure the viability of the interconnectors and guarantee security of electricitysupply, the interconnectors are being delivered using Cap and Floor commercial models. Thefloor is the minimum amount of revenue that an electricity interconnector can earn. If aninterconnector does not earn enough revenue from its operations, its revenue will be topped upto a minimum ‘floor’ payment (funds transferred from the system operator, which is thenrecovered from transmission charges applied to all users of the electricity transmission system).

The cap is the maximum amount of revenue for an electricity interconnector. Should aninterconnector’s revenue exceed the cap, the interconnector then transfer’s excess revenuesback to the system operator, which is used to reduce transmission charges. The cap on revenuesprovides benefits in return for their exposure in managing the floor price. For theinterconnectors, it supports an investment route to underpin viability.

Figure 4: NEMO Link Project: European Cap and Floor Interconnectors

The cap and floor model is designed to encourage greater investment into electricityinterconnectors as they are structured to strike a balance between commercial incentives andrisk mitigation to enable predictable revenue streams to support development.

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