Straight talking APA chairman lets fly on regulators, gas bans and AGL’s windfall privatisation profits courtesy of the NSW Government

• New APA chair confirms deal with shareholders to reduce “AGL club” board influence
• Lauds AGL’s $1.5 billion Macquarie Generation privatisation deal for 100% payback in 2.5 years
• Regrets not being able to develop NSW gas assets due to effective moratorium
• Slams Victorian gas exploration ban, leaving state reliant on Queensland coal seam gas projects
• Rates legendary APA CEO Mick McCormack highly but can match him on industry knowledge
• Slams recent Queensland coal freight regulatory decision as worst in Australian history

Michael Fraser knows the gas industry backwards. After 30 years at AGL, the last 7 years CEO, he’s now stepped up to chair APA Group, the largest Australian gas pipeline owner with a market capitalisation of $8.7 billion.

APA has been a belter for investors and has an unusual trust structure for a major corporate. It also used to have a board that looked like an AGL retirement club. The club has changed but the trust remains – for now.

Michael Fraser doesn’t hold back on the state of Australia’s energy regulation, making comments that policy makers in Melbourne, Sydney, Brisbane and Canberra will all read carefully.

And what was his best ever deal? Picking up Macquarie Generation for $1.5 billion off the NSW government, shortly before Hazelwood closed. As residents and industry fret about rising power prices, the former AGL CEO points out what a bonanza it has been for shareholders.

Welcome to The Constant Investor Chairman Interview Series.  I’m Stephen Mayne and this week, we’re interviewing Michael Fraser, the recently elevated Chairman of pipeline giant APA Group who’s also a former CEO of AGL and a director of Aurizon Holdings, the old Queensland Rail for the past two years.  Welcome to The Constant Investor, Michael.

Thank you, Stephen.

Now first up, I have to congratulate you and APA on doing what’s called a PAITREO capital raising which is the fairest way to raise capital, where it’s renounceable and where retail investors can trade their rights on market.  It’s a one-for-17, at $7.70 raising $500 million.  How and why did you come to choose to do a PAITREO model given that not many companies have done them over the years?

That’s right and it is a little more complicated from the company’s point of view and can be a little bit more expensive.  But look, Stephen, I think you’ve summed it up in your introduction there.  This is all about the benefit to the retail shareholders because from an institutional point of view it is pretty plain vanilla.  There’s a short window to take up their rights followed by a book build.  So this really is about the flexibility, the optionality if you like, that it brings to retail shareholders.  In our case they have a couple of options when they want to take up their rights and have their shares allotted if that’s what they choose to do. They have the option to sell some or all of those rights if that’s what they choose to do. Or, alternatively, they can sit it out and do nothing and see if there are any proceeds that flow from the retail book build at the end of the process.  It really is all about looking after the smaller retail shareholders.

I guess the key point is the biggest victim in Australia’s capital raising system is the retail shareholder who does nothing and in a non-renounceable gets diluted without compensation.  The PAITREO certainly is the best model to look after them.  Was it a board-driven thing?  The board thumped the table and said ‘we want to make sure we look after retail’, or did your investment banks and advisors come to the table and said, ‘this is now best practice’?

There was a, I will describe it as a fairly brief discussion with management about how it might be approached and it was an agreed position that this was the approach that we should take.

Now let’s talk a bit about APA, it’s obviously Australia’s biggest pipeline company.  It’s capitalised at $8.7 billion, the gearing is up there, it’s sort of in the high 60s, so obviously the safe, long term, secure low risk assets and relatively highly geared.  Is that one of the reasons why you’ve gone for the capital raising, just to get that gearing down a bit and given you’ve also got a heavy pipeline of capital projects?

Yeah, look, there were a couple of primary drivers and whilst the gearing is up there, we were looking out over the next 12 months or so, we would be above the target range that we’ve always said investors we wanted to target.  We’ve got a very big organic capital expenditure program on at the moment.  More than we would normally have, around $1.2 billion worth of projects.  We also have some subordinated notes which did have an equity credit from the ratings agency’s point of view, that equity credit was about to disappear and so that would become – rather than beneficial it would just become an expensive debt.  We looked at the growth projects, we looked at where the balance sheet would end up and we looked at refinancing those subordinated notes and what was the best way to do it and that’s why we raised the capital.

Now APA, it’s quite a unique business, it’s almost five times bigger than your nearest rival in terms of kilometres of gas pipelines.  You’ve got this vast network all over the country.  Is it fair to say that your ability to grow and expand in Australia is that there’s a little bit of regulatory and competition issues with that and just give us the history as to how you did emerge as Australia’s biggest pipeline company?

Well, I mean really it all started back in the 90s with the Moomba to Sydney pipeline having been acquired by AGL back then and AGL grew the pipeline business within it until around 2000 when a decision was made that when you looked at where the growth opportunities were for APA and the level of gearing that it would need to have within it, or what was the appropriate level of gearing within it and what was the appropriate structure if you were going to be able to participate in the growth in the pipeline industry, which was where the focus was back then, then we needed to think about a different structure for the ownership of those assets.

Out of that APA was more than effectively spun out of AGL and AGL remained a major shareholder for some years after that.  But that’s how it started out with those seed assets being the Moomba to Sydney pipeline, the Mt Isa pipeline being the two largest, and then over time APA acquired various assets, went through all the ACCC processes that we needed to go through.  We built assets over time, new pipelines, etc.  In growing the business there were times where the ACCC said to us, you know, Moomba to Adelaide pipeline being at one point where you need to divest that if you’re going to acquire other assets.  We got all the regulatory approvals that we needed along the way and we had the right structure with the trust structure, which we had which allowed us to efficiently distribute the cash that was sitting in the business back to our securityholders.  That’s really the story of how the business grew.

Now speaking of the structure, what are your thoughts on actually corporatizing APA and having a conventional corporate structure?  Because there’s not too many trusts on the market which are not sort of conventional property trusts, shopping centre owners and stuff, with a market cap of $8.7 billion.  I know there will probably be some one-off tax costs, but you get the governance benefits of remuneration voting and appointment of directors and some of those things you do voluntarily.  But the trust structure is not as strong from a corporate governance point of view.  So why not just bite the bullet and corporatize and become a conventional public company?

Well, Stephen, it really gets driven by what’s in the best interests of securityholders and so as I just alluded to previously, when we set this up and the way it is set up there are significant tax benefits that flow to our securityholders.  As an infrastructure company we have a very large depreciation and amortisation charge.  The consequence of that is that the cash flows that come into the business are significantly ahead of the accounting profits if you like.  What’s the most tax-efficient way to distribute that money to our shareholders.  At the moment our shareholders, our securityholders, I’ll use the right term for them, get two forms.  They get an income distribution, which is really just like a dividend out of a normal corporate and that now has some franking credits attached to it, but they also get the cash distributed on a tax-deferred basis, which you can’t do in a corporate structure.

That tax deferral basis provides a significant benefit to our securityholders.  Yes, there is a very substantial cost that would be involved in changing the structure, but at the end of the day, we sit back and ask ourselves the question, what’s the benefit to shareholders.  Certainly, the cost to our securityholders would be outweighed by the benefits.  You say that the governance isn’t as strong.  Well look, we’ve last year put in place a number of changes.  We do now, as you said, give securityholders a vote on the rem report, the two strikes rule, we’ve given them the power to remove directors.  We’ve given them the vote on the directors’ fee pool and we’ve subjected ourselves to the Corporation’s Act termination benefits regime.

I think we’ve looked at it and said, okay, where are the things from a governance point of view that we need to address, we’ve addressed those issues.  We’ve looked at the cost benefit of changing and clearly it’s in the securityholders’ interest to maintain the existing structure because of the way the tax rules work.  But let me also say this, that if, for whatever reason that changes, this is something that periodically the board will come back and look at.  Certainly, if there’s changes to the tax regime and it proves that those benefits are no longer there, then we would look to address the issue.

Could you do a deal with the ATO as part of a transition?  Because I think there’s a broader risk, isn’t there, which is this whole debate about company tax and how much tax companies are paying and whether APA could get caught up in that with, you’ve got a structure which is paying less tax then if you were a regular corporate.  I think there’s a risk that you might get accused of not paying your way, if you like.  So maybe do a deal with the ATO and just corporatize.

Look, the Tax Office has regularly reviewed our structure and to the best of my...show they have raised.  But obviously if circumstances change and facts change and as I just said, if there were to be a change in the law proposed, then we would look to work with it at that time.  But right now we have a clean bill of health from the Tax Office with respect to our structure.  It is the most efficient way to return cash to our shareholders and so we’re doing what’s in their best interests.

Now APA has been a great performer for investors.  I think there was a 17% compound return during Len Bleasel’s 11 year reign.  Just talk us through your relationship with Len.  Len’s a former CEO of AGL and then he retired and then came on APA and did a great job chairing that.  You also are a former CEO of AGL who has now become a chair of APA.  Firstly, was Len a bit of a mentor of yours?  What is the status of your relationship with Len Bleasel?

Well, obviously, I worked as an executive for Len at AGL.  I had a 30-year career at AGL. Len left from memory, it was the beginning of 2001.  So, yeah, I knew Len, I joined AGL back in ’84, so I met him shortly after I joined AGL.  I knew him through that period and we had kept in contact and Len approached me around the time that it was announced that I was leaving AGL about potentially joining APA.  I said that that’s something that I would consider but I wanted to take at least six months off, which I did, after I retired out of AGL and after meeting the rest of the APA board, I was asked to join the board.

Take me through how the succession process worked out in terms of selecting a new chair at APA.  Usually in these situations you have more than one candidate, or you have a possible look outside.  What can you tell us about it? Len’s decided to retire, what was the process you went through?  Because a couple of other retirements were also announced as part of the succession.  Two directors said they were also exiting.  Can you tell us any more about how that whole thing was handled?

Well look, I think, if you take a step back as I was just taking you through when I was originally approached about joining the board.  I think it was fairly conventional from that point of view that as I understand it, the board was thinking about chair succession a number of years ago, recognised that it was important to have a couple of candidates on the board and against that backdrop, given my industry background, I was invited to join the board.  Len had then discussed his likely successor with each director individually and collectively over a period of time. There were, as you would expect, also discussions with shareholders about the chair succession and once Len had settled on the timeframe for his retirement, the board voted unanimously for myself to take on the chair role. 

Now in that discussion with shareholders, as you alluded to, there had been concerns raised about the number of ex-AGL people on the board, despite the outstanding performance that there had been.  As you say, 17-18% compound annual TSR growth over actually a 10 year period.  But the board listened to those concerns and I think it speaks volumes for the other AGL directors that they put their hands up and said it was time for them to be part of a board succession process in an orderly manner.  As you’ve seen John Fletcher has just stepped down, we’ve got two new directors in Peter Wasow and Shirley In’t Veld joining the board, who I’m delighted to have both them join the board and Patricia McKenzie will be stepping down at the next Annual General Meeting.

Was there an element here of okay, we’re going from one former AGL CEO to another as chair of APA, but after discussions with shareholders, we’ll actually going forward have less of an AGL influence.  So obviously, with John Fletcher having just retired, he was the CFO of AGL.  Going forward the board will only have one ex-AGL person.  All that sort of Joe Aston Rear Window, some snide comments about the ex-AGL club at APA, it was discussed with your big shareholders like UniSuper and there was a clear decision to actually address that concern?

Yes, that’s exactly..., we talked to our shareholders, we listened and yes, that was the...of it.  I think everybody’s ended up, as far as I’m aware, extremely happy with the way things have worked out.

I must say, this has never actually happened.  I’m a director of the Australian Shareholders’ Association as well and I’d love to have the day when a board consults with the ASA about chair succession.  So they say ‘Look, we’ve got a couple of candidates, have you got a view?’  It does sort of happen quite informally with some of the big shareholders, but it’s never actually happened with the retail umbrella group, the ASA. I’d love to see it happen one day.  I’m not sure when, but that would be an interesting concept if ASA was ever at a level where it could be informally consulted on things like chair succession.

Well, hopefully it will be quite some years before APA is back in that position to look at chair succession again.

Now let’s talk about your CEO, Mick McCormack, he’s probably one of the 10 best CEOs in the market at the moment, I think I’d say.  He’s had a decade, he’s done a great job.  Everyone says he’s an absolute gun.  Tell us your assessment of why he’s so good, what he brings to the table running APA?

First of all he absolutely understands the industry.  He goes right back.  He’s been in the industry certainly for as long as I can remember.  He’s a no-nonsense kind of guy, he understands how do you make money in this business, how do you make more of it.  He’s been very good with respect to getting the right people around him and I think that’s a really important role for the board to get the right CEO in place.  But then equally I think it’s incredibly important for the CEO to get the right people around them.  So I think Mick understands the industry extremely well.  He knows how to create value in this industry.  He’s got a team of people around him who are very well-equipped for the challenges that APA and the industry generally face and I think they’ve been the key ingredients to his success.

People say he does know an awful lot about the industry.  How well equipped are you, and you’ve obviously had a long time in the industry as well, an AGL CEO for seven years.  How well equipped are you to take him on on an issue and say ‘Hang on Mick, what about this or what about that, I challenge you on this.’  Because he’s long serving, extremely knowledgeable, quite no-nonsense.

Mick and I have probably been in the industry for as long as each other and I think we probably both know as much about the industry as each other.  I think it actually works extremely well.  As I said earlier, I think it was before we started this interview, that the energy industry is in my blood, it’s a passion of mine.  And being in the role like AGL, where AGL has got interests across almost every aspect of the industry, it means you’ve had exposure to it and leaves you well equipped for those discussions.  But it’s a very good relationship with Mick, it’s a robust relationship.  I listen to him and I’d like to think that he listens to me.

Have you had your first chat about succession and how many years he’s got left in the tank?  Because it’s probably the biggest issue for your tenure as chair, is managing that question, I think.

Yeah, look, let me just say that I think it’s fair to say that Mick is obviously closer to his finishing time as CEO than his starting time when you think about the fact that he’s been there for 13 years.  But I expect him to be around for a little while yet.  But as you say, and as I said CEO succession is the most important decision, in my view, that a board will make.  If you get the right person, when that time comes, then you’re a long way down the path to successfully delivering for your securityholders. 

Now let’s have a quick chat about your record at AGL.  The scoreboard was pretty good.  So you started just before the market peaked ahead of the GFC and by the time you finished the share price had gone up and you hadn’t made some of the mistakes that the likes of Origin and Santos had made particularly with GLNG in Gladstone.  But take us through your time at AGL.  How you managed the crisis of the GFC.  People say you were a little bit ill-disciplined with some of the spending you did on the upstream assets.  Is that something you look back and say, look, you did pay a bit too much for some of that acreage that you bought on the upstream side?

Yeah, look, if we go back, to start with your question at GFC time.  So when I came into the role obviously it was just pre-GFC but AGL had suffered a shock earnings downgrade that led to the departure of the previous CEO.  We had been put on a negative outlook by the ratings agencies, so we need to get the balance sheet in order.  The employee engagement at that time was down around 38%.  So that was the situation that I found myself in.  What we did first up was to address the balance sheet.  You mentioned the LNG projects there, we were a large cornerstone investor in QGC.  We sold out of that to BG Group for around $1.2 billion and in the same week, sold out of the PNG LNG project for around the same number.

So over $2 billion worth of asset sales which ended up, you know, took 12 months to get there but occurred in the same week.  That really got the balance sheet onto a stable footing which we needed to do and then we set about investing from there. If I look at the position that AGL is in now, I think the most pleasing thing about it is the really big strategic calls that we made to invest heavily in power generation have proven to be hugely profitable for the company and there were questions asked about that at the time.  So that worked out very well.  If I look at what am I disappointed about is the fact that investments in coal seam assets in New South Wales weren’t able to be brought to market for a whole variety of reasons when that gas is so clearly needed by the market today.  From a strategic point of view it was absolutely the right call but it was disappointing for various reasons we were unable to bring that gas to market.

Fair to say you’re not a fan of Alan Jones and Lock The Gate, you know, don’t do coal seam gas arguments.  I mean in Victoria there’s still a complete ban which seems remarkable.

Well, it is and when you step back and look at the issues around price in both the electricity and gas markets today and reliability in the electricity markets you kind of say what’s it all about and big picture it’s all about the supply side and in the case, gas and electricity markets are heavily interrelated.  In the case of the electricity market it’s the withdrawal of supply by the retirement of old plants and on the gas side it’s not only the start up of the LNG projects in Gladstone but it’s the moratoriums that are in place in New South Wales, Victoria and the Northern Territory.  New South Wales says they don’t have a moratorium but they’re not approving anything.  Effectively there’s a moratorium in place.  That’s the cause of the issue and we need to have a debate that is actually based on science and engineering and not based on scare mongering and philosophical positions if we’re going to rectify the supply side situation.

Well just yesterday, Daniel Andrews and Tim Pallas, the Victorian Treasurer, were talking about putting the environment first and not allowing onshore.  They were sort of being resolute in maintaining it.  I just did a tweet back to them saying, well, you know, you’re putting prices up with this policy, it’s risky.

It’s ironic, I think, that that position sits there in Victoria when they’re very happy to import gas from Queensland effectively, yet if the Queensland government had adopted the same position then there’d be no gas for anyone.  The bottom line is, if we just talk about price, why are prices as high as they are in the gas market at the moment?  Why are they as high as they are in the electricity market at the moment, it’s all about supply.  You know, you can tweak regulations, that’s not going to make a whole lot of difference.  We have to get more supply into the market and as far as the east coast gas market is concerned, we’ve got an answer right beneath our feet.  We just need to and we can, in an environmentally responsible way, based on the science and the engineering, we can happily extract that gas and not damage the environment.

Couldn’t agree more.  Now let’s talk briefly about Aurizon because you’ve been a director there for two years.  So your main gigs, obviously as Chair of APA, and a non-executive director of Aurizon, the old Queensland Rail.  How’s the new CEO Andrew Harding, settling in?  Obviously, you’ve got the young gun Chair up there, Tim Poole who’s been in this series already.  So you’re part of the renewal program up at Aurizon with a new CEO coming on board after you joined the board.  How’s that all unfolding for you?

Look, I think Andrew is doing an excellent job in what are difficult circumstances, is probably the best way to describe it up there, and Tim Poole is doing an excellent job as Chair.  He’s terrific.  So the big issue for Aurizon at the moment is around the regulatory decision that they’ve just received for their central Queensland coal network out of the QCA up in Queensland and I would describe it as probably the worse regulatory decision I’ve seen in Australia.  I mean they’ve given a rail network that is transporting coal with all of the question marks about long term future of coal.  They say it’s equivalent to a water network, a regulated water utility business, has the same risk profile as that, and they’ve given it the lowest return of any regulated asset in Australia.  So that’s the big issue at the moment for Aurizon.

Do you look at your regulatory relationships in APA and sort of just worry a bit that you’ve seen such an adverse decision coming out of Queensland.  Your APA business I guess is very dependent on regulators and what they say in terms of price determinations going forward.

Yeah, look the actual, if you want to go in traditional regulated sense, the actual quantum of our regulated revenue is actually relatively modest.  I think it’s sub 10% for APA at the moment, but that having been said, there is obviously a very big focus on the potential regulation of the gas industry and we’ve now got a new arbitration framework which has been put in place.  So we’re obviously watching very closely and working very closely with regulators and policymakers about how that will play out.  But in the meantime, we’ve been getting on and signing many new contracts with customers right across our suite of assets, with the latest one of those being announced just this week.

All right, Michael, and I always finish up with the Chair, asking about their favourite deal they’ve been involved with over the years which has added value for shareholders or saved a disaster.  Looking back, whether it’s APA or AGL, what’s the deal you’re most fond of being involved in?

Well, look I’d say there’s two of them.  One was the last one that we did when I was at AGL which was to acquire Macquarie Generation and on my rough numbers, that’s, at a two and a half year payback.  So $1.5 billion.  It’s not too many times you’ll buy a $1.5 billion asset and get your payback in two and a half years.  From a shareholder creation point of view, I think that’s been hugely value creative.  I’d say the other one really is the deal that we didn’t do and that was not to pay up when the New South Wales retail assets were privatised, which was a very difficult decision at the time.  When we saw extremely high prices, we decided not to pay up and instead pursue an organic growth strategy which proved to be much more value creative for our shareholders.

In other words, you got your privatisation deals right.  Great returns on Macquarie Generation and you avoided the paying too much for the retail assets.

Correct.

Very interesting.  Any corporate regrets?  Looking back at the deals you did do, one you wish you hadn’t done, or an acquisition you almost pulled off and didn’t quite get to, that you’d like to have done?

Look I think I would just point back to the fact that we weren’t able to develop the gas resources in New South Wales for all the political and other reasons that we’ve seen when they’re so desperately needed by the market.  That’s really my biggest regret when I look back.

All right, Michael Fraser, we’ll leave it there.  Thanks very much for participating in the Chairman Interview Series.  Congratulations again on the PAITREO, which is very fair for retail shareholders and good luck in the period ahead.

Thanks very much, Stephen.

That was Michael Fraser, Chair of APA Group, former CEO of AGL with some very interesting comments on the gas policy debate and some privatisation questions and he’s also a director of Aurizon Holdings.  Thanks for listening, we’ll see you in a fortnight.