Snowy cap forms as Hydro sale issue [March 13, 2006]

IT will be Australia's largest initial public offering in recent years, but the $3 billion-plus government sell-down of Snowy Hydro is no walk in the park.

Snowy is expected to be highly sought after by the market, given growing demand for renewable energy stocks and the group's strong emotional appeal to mum and dad investors.

The business is also considered the jewel in the crown of electricity generators given its ability to switch on power supply very quickly, meaning it can supply the market at peak times at premium prices.

But despite all the appeal, this is unlikely to be a straight equity sell-down given the unique issues facing the government vendors.

There also remains the matter of whether or not to raise extra capital concurrently with the sale, and how to explain the tricky world of derivatives to the buying public.









The work has begun with the vendors -- the NSW, federal and Victorian governments -- last week appointing Goldman Sachs JB Were, Macquarie Bank and UBS as privatisation lead managers, while Credit Suisse is advising on the offer's structure.

And discussions have begun on whether an ownership cap of anywhere between 5 and 15 per cent should be required.

That would limit foreign shareholding of an asset close to the heart of many Australians given the imagery of the Snowy region, the project's role as an early promoter of multi-culturalism within its workforce and the success of such an engineering feat.

But probably more importantly from a political point of view, it would make it less palatable to the large infrastructure funds.

The spectre of Macquarie Infrastructure Group or any of its acolytes milking fees from an asset as well-loved as the Snowy would be close to political suicide as elections loom.

The NSW Government, which owns 58 per cent of the Snowy and initiated the sale to plug its ailing budget, will go to the polls in March next year and Victoria (a 29 per cent owner) is due for an election by November 2007.

And therein lies the political imperative for a hassle-free sale with minimal political fallout.

An ownership cap will dampen demand for Snowy shares from overseas and local investors (whether they be infrastructure funds or any of the Snowy's energy rivals) but it will also remove the potential for controversy.

And if the ownership caps are introduced, the extent of reduced demand will depend on the size of the caps and how long they will remain in place. The worst-case scenario from a pricing perspective will be if caps remain in perpetuity.

There's also some doubt as to whether Snowy's rivals, such as Origin Energy, Alinta or AGL, could pass muster with the competition regulator given Snowy Hydro's role as the "middleman" in the electricity market.

Snowy is a powerful player in the pecking order of electricity providers given its ability to provide critical energy quickly at peak times. But if AGL controlled Snowy, for example, would it be so keen to provide contracts to Origin to cover those peak periods? And on what terms? And what would that mean in terms of the market power of AGL or any of its competitors?

Others disagree, saying all the electricity generators are moving to an integrated model. And that includes Snowy Hydro, which bought Victorian energy retailer Red Energy at the end of 2004 and now also owns two gas-fired electricity stations.

But that model is also attracting the regulator's interest, with the Australian Competition & Consumer Commission saying it is concerned that vertical integration of generation and retail within this market may increase barriers to entry for new players.

But with the prospectus due to be lodged in May ahead of a June listing, the advisers are also crunching other issues.

The Snowy is expected to attract huge retail demand -- again given the nature of the asset -- but there may also be some difficulty in explaining Snowy's operations to those same mum and dad investors. That is because Snowy Hydro is not simply a seller of electricity but an energy trader, which means it needs to enter myriad derivative contracts with its customers.

That has the benefit of smoothing earnings volatility but it's a highly complex business and often difficult for retail investors to understand.

It's also understood that Snowy Hydro's last profit was hit by new accounting rules that require all those derivative contracts to be marked back to market value. On that basis its net profit fell from $158 million in 2004 to $148 million in 2005.

Those new accounting rules have introduced a level of accounting volatility to Snowy's earnings, but do not affect the underlying result.

And while some investors may consider derivatives risky, Snowy has the great benefit that all its contracts are backed by a physical asset -- the water in its dams -- so there is comfort that it can always deliver on its contracts.

Another issue is whether just to sell down the governments' stakes or seek extra capital.

Snowy has already sought to grow through acquisition, and its name has been linked to a gas-fired "peaker" station soon required for western Sydney at an estimated cost of $200 million.

Given the strength of the market and initial interest in the offer, a substantial increase in the amount to be raised could probably be satisfied.

There's also support to expand further into the retail sector to again reduce the Snowy's risk.

For example, if electricity demand is weak and few customers are calling in their Snowy contracts but the business must still release water as decreed by the terms of its water licence, the resulting electricity could be sold to its own customers.



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