In promising to rewire the nation by offering $20 billion of low-cost loans, the Australian Government has created an exceptional opportunity for developers and contractors willing and able to tackle the technical challenges of delivering electricity infrastructure to the exacting standards of the National Electricity Market (NEM).
The first and very significant challenge for the would-be head contractor, however, is tendering for and negotiating a contract with a Transmission Network Service Provider (TNSP). Although the TNSPs are strictly regulated, each has a monopoly over its region and many aspects of the capital projects they undertake are non-contestable. Therefore, in many cases, TNSPs can exercise considerable influence over the terms and the risk allocation of their contracts. A significant influence on this risk allocation is the legislative framework for TNSP revenue.
Regulatory Asset Base
As is well known in the market, the maximum revenue of a TNSP is determined for each 5-year period by the Australian Energy Regulator (AER). The AER makes this determination on the basis of the value of the TNSP’s regulatory asset base (RAB) and a forecast of the TNSP’s operating and capital expenses for the period. Where a major capital project is initiated by the TNSP during the 5-year period as a ‘contingent’ project’, the AER can make a further determination, with the forecast capital costs of the project increasing the TNSP’s revenue cap (and NEM electricity costs) sometime years in advance of the delivery of the project.
The AER, naturally, takes a conservative view of project costs at the forecasting stage because allowing a higher forecast means higher costs for consumers. The AER has regularly reduced cost estimates proposed by TNSPs and sought to ensured that projects are delivered at comparable market rates around the country.
One of the more interesting elements of the AER process (which takes upwards of 12 months for each TNSP) is the reconciliation which occurs at the end of each 5-year period. Here, the AER adjusts the RAB for the difference between its earlier forecast of the TNSP’s capital costs and the actual costs incurred. To ensure that a TNSP does not inflate its RAB by overspending against the approved forecast (commonly referred to as ‘gold-platting’), the AER has the power to reduce the RAB for inefficient ‘overspend’ by the TNSP.
Given this regulatory framework, project delivery for a TNSP (and thus a head contractor’s interaction with the TNSP) seems to involve two distinct phases:
- in seeking the AER’s approval for its forecast project costs, the TNSP is incentivised to maximise the capital value of the project to maximise its RAB. As noted above, the AER seems to recognise this and routinely discounts TNSP forecasts; and
- once the capital cost forecast is determined, the incentive for the TNSP shifts to avoiding the expenditure of excess capital costs that run a sufficient risk of not being added to the RAB or not being recoverable until the next 5-year period.
One contracting model that reflects this approach to project delivery is a turnkey EPC, wherein the head contractor accepts (and prices in) substantial risks in exchange for a lump sum contract price that reflects the AER determined forecast for the project. In this way, the value of the risk is capitalised by the TNSP in its RAB irrespective of whether it eventuates. If the risk does eventuate, the TNSP avoids the risk of the cost escalation not being capitalised.
Labour and Materials
Unsurprisingly, one risk that TNSPs have sought to pass to head contractors is the escalation in the cost of labour and materials. In current market conditions, this risk allocation would prevent a TNSP from exposure to the sudden escalation in both cost types over the last 12 months. It is worth noting, however, that this appears to be more luck than prescience, given that the AER mathematical models used as recently as early 2022 expected an annual inflation rate of about 2.5% over the next five years. In this context, it seems unlikely that, until quite recently, the AER would have accepted a project costs forecast that correctly anticipated the cost escalation that has transpired.
The consequences of the spike in labour and materials costs that are playing out in the residential building industry to devastating effect, also impact multibillion transmission line projects and will likely crystalise losses at some level of project delivery across the delivery period of the project. Those head contractors unlucky to enter the procurement market with prices already elevated potentially face the long task of building projects that have been rendered unprofitable before the foundations of the first pilon are dug out.
Setting the tone
What can the AER do in this context?
With its stated purpose of making energy consumers better off, now and in the future, the AER mandate seems broad enough to achieve short term outcomes (eg, preventing unnecessary price increases) without losing sight of how short-term decisions may impact the long-term trend of capital costs in the sector.
Thus, on the one hand, it seems entirely reasonable for the AER, in the context of the hypothetical EPC described above, to refuse to capitalise the escalation of costs (should the TNSP actually incur them), especially as the head contractor is already to be compensated for the risk (however inadequately) in the contract price. On this approach, the TNSP would stick to the contract and the head contractor would potentially suffer a significant loss.
On the other hand, however, the AER may wish to consider the chilling effect of outsized losses on future market participation and pricing. Not only is there a risk that one of the few top tier contractors with the requisite expertise and experience will exit the market (noting that many of these contractors are domiciled outside of Australia), but future contracts may be bid at still higher premiums to account for the risk.
Faced with unique and (by AER’s own methodology) unexpected market conditions, the AER has an opportunity to set the tone on how it (and as a result the TNSPs) will deal with certain types of risk in the industry. This is given particular significance in view of the importance of well-constructed and thus reliable transmission networks for alleviating ongoing NEM system issues and unlocking further renewable generation development.
Recovering escalation costs
Head contractors that have accepted the risk of and have been caught out by escalating costs may consider approaching the TNSP and the AER to discuss the possibility of an amendment to the EPC whereby:
- the contract price is reduced for the premium reasonably attributable to the risk of escalation;
- the contract price is increased for the newly forecast cost of materials and labour; and
- procurement occurs on an open book basis and the contract price is further adjustable for any unders and overs,
so that the overall increase in the capital costs actually incurred by the TNSP are added to its RAB. Further consideration may need to be given to the financing costs of and risk to the TNSP associated with an increase to the contract price.
Author: Michal Magat