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HVDC Inter-Island Link Upgrade Project

Investment Proposal

Part V – Project Costs

© Transpower New Zealand Limited 2005. All rights reserved

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1 SUMMARY ........................................................................................................................ 3 2 BACKGROUND................................................................................................................. 4 3

APPROACH TO ESTIMATING COSTS............................................................................ 4

4 BASIS FOR COSTS.......................................................................................................... 5 4.1 Capital costs.................................................................................................5 4.2 Pole 2 Control System replacement.............................................................7 4.3 Property Costs..............................................................................................7 4.4 Operating and Maintenance.........................................................................7

5 ASSUMPTIONS................................................................................................................. 8 6 SUMMARY OF COST ESTIMATES.................................................................................. 9 7 CONTINGENCIES........................................................................................................... 11

7.1 Price Contingencies ...................................................................................11 7.2 Interest During Construction.......................................................................13 7.3 Physical Contingencies ..............................................................................13 7.4 Summary ....................................................................................................14

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Part V - Project Costs 3

1 Summary

Part V contains the estimated capital costs of the HVDC project. Transpower hassubmitted cost estimates in good faith and expects to be able to recover actual costsreasonably incurred in relation to the approved project through the transmission pricingmethodology. The costs contained in this document are estimates only.

The estimated costs for Transpower’s HVDC project including transmission works,property and project management is approximately $795 million.

Category Item Real CapitalCostEstimate$m (2005)

EstimatedNominalcosts$m

PreliminaryEngineeringstudies

System studies to confirmtechnical requirements

9 15

Environmentaland Property

Acquisition of designations andresource consents and valuationand legal advice for submarinecable

2 3

Transmissionworks

HVDC Converter pole 1 atHaywards/Benmore

291 454

AC Substations – Benmore 11

– Haywards 41

81

Cable 2 x 500 MW HVDC SubmarineCable

90 138

Control system Pole 2 control systemreplacement

10 13

Dismantling Pole 1 at Haywards andBenmore

5 7

ProjectManagementand overheads

Includes detailed engineering,maintaining a project office,consultant engagement andadministration costs

61 84

Total 520 795

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2 Background

Transpower has submitted cost estimates in good faith and expects to be able to

recover actual costs reasonably incurred in relation to the approved project throughthe transmission pricing methodology.

If the actual project costs are greater than the estimated cost included in thissubmission and Transpower was unable to recover these costs, Transpower wouldincur an economic loss. Forecasting errors could lead to windfall losses and coulddeter efficient investment. While considerable effort is made to ensure estimatedcosts represent the expected efficient investment, inevitably such forecasts aresubject to imperfect foresight.

It would therefore be inappropriate to establish a final set of project costs for recovery5 years out from commissioning of an approved investment. Such an approach

would create unacceptable commercial risks for Transpower, and for electricityconsumers. Transpower does not believe it is the Government’s intention that this bethe case.

3 Approach to Estimating Costs

Current cost estimates are based on conceptual designs. It is envisaged detaileddesign for the HVDC Pole 1 replacement project will be carried out under some formof “turnkey” or “engineer, procure and construct” contract. Costs will become morecertain as the project progresses through its various stages, and as risks are

mitigated as illustrated in Figure 3-1 below.

Figure 3-1: Relationship between Project Stage and Accuracy of Cost Estimates

In estimating project costs Transpower’s focus has been to establish an appropriateconceptual design for the capital equipment, preparing order of magnitude costs and

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identifying major sources of risk. Assumptions used in preparing cost estimates arediscussed below.

The cost estimates are “At Approval” costs. As the project progresses, scenarioanalysis techniques will be used to quantify expected variations, and establish a riskprofile for more refined costings. This process will allow the refinement of riskmitigation strategies and the establishment of appropriate bounds for sensitivityanalysis. For clarity, Transpower expects to be able to recover the costs of riskmitigation in addition to direct project costs.

A number of the cost risks (described below) relate to specifics of market conditionsand commercial requirements at the time tenders are let.

For clarity, operating and maintenance costs are not included in this Part in any detailas they do not form a part of the project capital costs. However, for completeness adescription of the basis for estimating operating and maintenance costs has beenincluded in Section 4.

4 Basis for Costs

This section sets out Transpower’s basis for the cost estimates of each majorcomponent of the proposed investment. It also includes information on factors thathave been specifically excluded from the estimates. Costs may vary from theestimates provided due to changes in the general assumptions (contained later inthis part), or to factors excluded from the cost estimates.

As discussed in the introduction to this part, cost estimates for the preliminary designprovided are subject to a high degree of uncertainty which would tend to reduce as

the project progresses.

4.1 Capital costs

4.1.1 Pole 1 ReplacementThe preferred development option involves replacing the existing Pole 1 with a700 MW thyristor pole running in a bipolar configuration with Pole 2.

Budget costs obtained from suppliers indicate that the cost of a 700 MW thyristorpole would cost approximately $290 million.

The costs of decommissioning the existing Pole 1 are estimated to be of the order of$5 million.

4.1.2 AC Switchyard

Table 4-1 provides a detailed breakdown of the AC substation work required forreplacing Pole 1 with a 700 MW thyristor pole.

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Substation Equipment Capital Cost($ million)

Benmore Extensions to 220 kV Switchyard A 0.8Benmore Capacitor Banks, 220 kV 100 Mvar, including 220 kV bay

connections

10.1

Haywards New 220/110/11 kV interconnecting transformers 14.6Haywards New 110/11 kV Condenser transformers 7.2Haywards New 220 kV filter bank including extension to Switchyard B 2.5Haywards New 220 kV filter bank and Switchyard C, including aerial

connection to existing Switchyards4.3

Haywards New 220 kV, 65 Mvar Condenser 12.9Total 52.4

Table 4-1: AC Substation Work Required for New 700 MW Pole 1

4.1.3 Submarine cables

With the replacement of the Pole 1 mercury arc converters with a 350 kV, 2 kA,700 MW thyristor pole, the total inter-island transfer will be constrained by thecapacity of the existing cables to 1200 MW. In order to utilise the full capacity of thethyristor poles, one additional cable is required to be installed.

Analysis has shown that with the installation of a new 500 MW cable in parallel withan existing 500 MW cable, the link could be operated to 1400 MW (700 MW perpole). With this arrangement, a failure of the new 500 MW cable or an old 500 MWcable will reduce the link capacity to 1200 MW.

Installing an additional new cable (rated at 500 MW) as a spare will ensure a firm

capacity of 1400 MW, in the event of a failure of a new 500 MW or old 500 MWcable. The costs of procuring and installing one or two 500 MW cables are shown inthe following table (Table 4-2).

Option Manufacture, delivery andinstallation ($ million)

Terminalstation costs

Total($ million)

1 x 500 MW Cable 53.8 2 55.82 x 500 MW Cable 87.8 2 89.8

Table 4-2 Cost of Procur ing and Installing 500 MW cables

Cost breakdown, provided by the cable manufacturers, indicates that a significantportion (56 %) of the cost is associated with delivery and installation of the cables.Hence, as expected, per unit cost of delivery and installation of a cable would besignificantly cheaper, when more than one cable is delivered and installed. Bothlengths of cable would be delivered on a single ship.

In summary, unless a new cable is installed, replacement of the Pole 1 converterswould only increase the inter-island transfer capacity to a total of 1200 MW.Utilisation of the full capacity of the converters (1400 MW) will require installation of anew cable at a cost of approximately NZ$ 56 million. To install two new cables, withthe aim of keeping one cable as spare, the cost will be about NZ$ 90 million.

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4.2 Pole 2 Control System replacement

An allowance for replacement of the Pole 2 controls in the order of $10 million has

been made. This replacement is required regardless of the options for Pole 1’sfuture. There could be some economies of scale achieved by incorporating the Pole2 control replacement together with Pole 1 replacement, but the level of savings willnot be known until detailed technical specifications and commissioning details arefinalised.

4.3 Property Costs

4.3.1 Property Rights

Transpower’s estimates of the cost to secure the necessary property rights forlocation and operation of the under sea cable (and spare) between Fighting Bay andOteranga Bay are based on the annual fees currently payable for the existing cables.

4.3.2 Environmental Costs

Costs for securing a designation and resource consents pursuant to the RMA havebeen estimated at $1.6 million. These estimates are limited to Council processingcosts, costs to Transpower of engaging specialist professional and legal advice,Transpower staff, and attending various hearings and court appeals. They do notattempt to allocate value to the environment or any environmental degradationresulting from the project.

Economic costs of securing environmental approvals are closely linked to the likelytimeliness of securing designation. Where greater adverse environmental effects arelikely to occur, there is an increased requirement for input from technical specialists,and additional consultation (to fully document and identify ways in which to mitigateadverse effects), reporting, compensation, and property negotiation periods. Thesecommitments carry an additional economic cost.

4.4 Operating and Maintenance

The operating and maintenance costs used in the Part IV economic analysis wereestimated as shown in the table below:

Assets ReplacementPole 1

Existing &Replacement Pole 2

SubmarineCables

HVDCSubstations

HVDCLines

O&M Cost PerYear ($ million)

0.8 0.8 1.7 1.6 0.6

Table 4-3: Operating and Maintenance Cost Estimates

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5 Assumptions

The following general assumptions have been made in preparing capital cost

estimates for this investment:

Cost of Plant and Materials

Material prices are based on budgetary prices obtained from manufacturers/suppliersfor approximate quantities estimated from preliminary designs. They are exclusive ofeconomies of scale for purchasing.

Real costs

Capital cost estimates are in 2005 NZ dollars. No allowance has been made forescalation of prices due to inflation or market conditions.

Engineering, Project Management and Administration Costs

Internal and external engineering, project management and administration costshave been assumed at 15% of overall project costs based on experience of largeprojects.1

Allowances for detailed engineering and contractor’s project management costs havebeen based on past experience and are subject to contract type (Engineer, Procure,Construct or Erect only) and market conditions at the time of tendering.

Project Financing Costs (Interest During Construction)

Project financing costs or interest during construction have not been included in thecost estimates. Instead, it has been assumed that these costs can be expensedduring project implementation.2

Exchange Rates

Budgetary costs have been obtained in the currency of origin and have beenconverted to $NZ using the 5-year forward exchange rates tabled below.

Currency Year 20103

Exchange RateNZD/USD 0.5640NZD/AUD 0.8558

NZD/EURO 0.4343NZD/SEK 3.9749NZD/CHF 0.6197NZD/CAD 0.7286

Table 5-1: Forward Exchange Rates for 2010

When determining a suitable spot foreign exchange rate for costing purposes, thecurrent two year average spot rate is calculated for the applicable currency. This rate

1 For the 1987-1992 DC Hybrid Upgrade project, 15% was used.2 In a national cost/benefit framework the opportunity cost of an investment to society is represented

though the discount rate. Interest during construction represents the opportunity cost of an investmentto providers of funds, and is in essence a value transfer paid by beneficiaries to investors to ensure thatthe investment takes place. As a general principle such value transfers should net out of the economicanalysis.3 ANZ National Bank, 23 March 2005.

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is compared to the current spot rate and the lower of the two rates is used as the‘advised spot rate’. For future payments out to five years, the current forward foreignexchange points are applied to the ‘advised spot rate’.

These rates are updated on a quarterly basis, or if there is a significant movement inthe underlying currency. This methodology is appropriate and is consistent withaccepted market practice. It also ensures that future payments are priced off derivedforward rates not spot rates.

Hedging

The cost of hedging exchange rates and commodity prices has been included in thecost estimates only to the extent that these are represented in forward rates andprices used to prepare the estimates. It has been assumed that any additional costsof hedging can be expensed during project implementation.

Project Time Frame

Costs have been prepared according to the Project Timeline outlined in Part 1.Delays in the project are likely to increase time dependant costs (most particularlyproject management and environmental approval costs) and to increase the riskassociated with other cost estimates (particularly those affected by factors that varyover time such as exchange rates).

Commissioning

Commissioning of the new Pole 1 thyristor converter may require generation to beconstrained on or off. Detailed work will be required to identify commissioning issuesin the current market framework. No allowance has been made for any constrainedgeneration costs incurred for commissioning the new HVDC thyristor converter orcontrol systems.

It is envisaged that multi-party consultation would be required to coordinate andminimise the cost and security impacts of testing and commissioning the new Pole 1thyristor converter and control systems.

6 Summary of Cost Estimates

Table 6-1 below presents two equivalent sets of costs for the proposed investment –the real capital cost estimate and the estimated nominal cost.

• The real capital cost estimate reflects the costs from the perspective of aninvestor today examining the economic commitment involved in a project froma market benefit perspective. It has been prepared using mid-range costestimates, and excludes financing costs. The estimate is in real (constant)terms and is expressed in 2005 dollars.

• The estimated nominal cost reflects the costs from the perspective of theasset owner at the time the assets are commissioned, i.e. it reflects the valuethat will need to be included in the regulated asset base and recoveredthrough regulated charges (including funding costs). The estimated nominalcost figures also include allowances for variation in price and scope. Costsare nominal (dollars of the day) at the time the project is commissioned.

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Category Item Real Capital

CostEstimate$m (2005)

EstimatedNominalcosts$m

Preliminary

Engineeringstudies

System studies to confirm technical

requirements

9 15

Environmentaland Property

Acquisition of designations andresource consents and valuation andlegal advice for submarine cable

2 3

Transmissionworks

HVDC Converter pole 1 atHaywards/Benmore

291 454

AC Substations – Benmore 11

– Haywards 41

81

Cable 2 x 500 MW HVDC Submarine Cable 90 138

Control system Pole 2 control system replacement 10 13

Dismantling Pole 1 at Haywards and Benmore 5 7

ProjectManagementand overheads

Includes detailed engineering,maintaining a project office,consultant engagement andadministration costs

61 84

Total 520 795

Table 6-1: Estimated Capital Expenditure for HVDC Project

The timing of capital expenditures (in 2005 dollars) is shown in Figure 6-1. Initial

expenditures are focused on the acquisition of a route, with expenditure in the finaltwo years focused on major capital items and cable installation. Expenditure in thefinal year of the project amounts to 20% of total project costs.

Phasing of expenditure

0.00

20.00

40.00

60.00

80.00

100.00

120.00

140.00

160.00

180.00

200.00

2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12

Financial year begining July

$ m i l l i o n

Administration and Overheads

Engineering and Investigations

Project Management and Engineering costs

Pole 1 Decommisisoning

Submarine Cables

AC Switchyard

Pole 2 Control System Replacement

New Pole 1 Converters

Environmental and Property

Figure 6-1: Anticipated Incidence of Expenditure on the Proposed HVDC ConverterReplacement Project

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7 Contingencies

The capital cost estimates provided in the earlier sections of Part V have beenprepared to be consistent with the economic methodology described and applied inPart IV. As a consequence, the costs differ from those ordinarily presented in

business cases (and equally from the type of costs upon which revenue recoverymight be based). Furthermore, the costs presented are based on preliminary designwork and are order of magnitude costs.

The purpose of this section is to provide a bridge between the project capital costs,and those that might ordinarily be presented in a business case. They are,necessarily, indicative figures. As noted in Section 2, it is envisaged that detaileddesign for the HVDC Converter replacement project will be carried out under someform of “turnkey” or “engineer, procure and construct” contract. Such anarrangement is likely to have a bearing on, amongst other things the design, timingand currency of project expenditures, and therefore the magnitude of actual costs.

In short, this analysis should not be seen as a substitute for the scenario based riskprofiling which must take place during the next stage of project implementation.

7.1 Price Contingencies

7.1.1 Inflation Adjustment

Capital cost estimates been calculated in real (2005) dollars in order to maintainconsistency with the real discount rate used in the calculation of expected net marketbenefits, to simplify the calculation of market benefits and costs and to providegreater transparency in the comparison of the proposed transmission investment with

non-transmission investment options. The use of real or nominal costs should haveno impact on the outcome of the economic analysis in expected net market benefitterms provided the treatment of inflation is consistent throughout the analysis.

Transpower wishes to recover the actual costs of the proposed HVDC investment.The nominal cost estimate of $795 million including contingencies represents a goodfaith estimate of what those actual costs might be. The $795 million is comprised of$710 million in nominal capital costs (including interest during construction) with afurther $85 million nominal allowed for cost contingencies. Figure 7-1 below showsthe relative impact on major capital items.

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Difference Betw een Real and Nominal Cos ts

0

50

100

150

200

250

300

350

Environment

and

Property

HVDC

Converter

Pole 1

AC

Substations

Submarine

Cables

Control

System

Dismantl ing Pro ject

Management and

Engineering Studies

Cost Categor y

$ m

Nominal $

Real $ (2005)

Figure 7-1: Estimated Capital Costs in Nominal Terms

7.1.2 Exchange Rate Adjustment

In preparing the capital cost estimates Transpower has used 5 year forwardexchange rates to reflect the rates at which the foreign currency denominatedcomponents of the investment might be hedged.

Approximately 18% of the project costs are denominated in New Zealand dollars, andapproximately 3% in US dollars. The remainder of the project costs will bedenominated in the currency of the equipment supplier 4.

While the exchange rates used in preparing Transpower’s cost estimates are forwardrates against which Transpower could hedge, it is important to understand the

sensitivity of estimated costs to changes in the exchange rate assumptions.

As an alternative to the forward rates assumed in the capital cost estimates, the NZDwas assumed to depreciate against the USD from 0.70 NZD per USD to 0.60 in2010, with a similar level of depreciation against the other main currencies. Ratesused in the sensitivity are shown in Table 7-1 below.

4 For the purposes of undertaking this analysis these costs have been split equally between the Euro

and Swedish Krona.

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2005/6 2006/07 2007/08 2008/092009/10 andbeyond 2009/10

ExchangeRate Alternative Exchange Rate Assumpt ion

Cost Estimate Assumption

Nzd/usd 0.700 0.675 0.650 0.625 0.600 0.564Nzd/aud 0.888 0.856 0.825 0.793 0.761 0.856

Nzd/euro 0.504 0.486 0.468 0.45 0.432 0.4343

Nzd/sek 4.585 4.421 4.257 4.094 3.930 3.975Nzd/chf 0.766 0.738 0.711 0.684 0.656 0.620

Nzd/cad 0.814 0.784 0.755 0.726 0.697 0.729

Table 7-1: Alternative Exchange Rate Assumption

Adoption of the alternate exchange rate assumptions reduced the nominal capitalcost of the HVDC Pole 1 replacement proposal by $5 million.

7.2 Interest During Construct ion

Interest during construction has been omitted from the capital cost estimates used inthe economic analysis because it is not consistent with the measurement of nationalbenefit5.

Transpower wishes to recover the actual costs of the proposed HVDC investment,including a return on capital invested during the commissioning of the project. Asnoted in Section 4, Transpower’s preference is to recover these costs duringimplementation of the project. An estimate of the scale of nominal interest during

construction costs implied by the preliminary cost estimates has been prepared,using a 10% pre-tax nominal discount rate6. This amounts to $131 million over theperiod of project disbursements.

7.3 Physical Contingencies

High level estimates of physical contingencies have been estimated for majorcomponents of the capital spending using Monte Carlo simulation in conjunction withthe estimates provided in Section 3. Physical contingencies account for both quantityand cost. Note however that these contingencies are not intended to cover variationsin design or specification.

Converters

Approximately 5% of cases in the Monte Carlo simulation generated project costshigher than $338 million. Deducting from this the preliminary cost estimate of $291million gives a physical contingency for converter costs of $47 million, or 16%. Thisfigure must also be grossed up for inflation, exchange rate and interest duringconstruction, producing a final contingency estimate of $61 million in nominal terms.

5 In a national cost/benefit framework the opportunity cost of an investment to society is representedthough the discount rate. Interest during construction represents the opportunity cost of an investment

to providers of funds, and is in essence a value transfer paid by beneficiaries to investors to ensure thatthe investment takes place. As a general principle such value transfers should net out of the economicanalysis.6 This is consistent with the 7% pre-tax real discount rate applied in the economic test, adjusted for 3%

inflation.

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Cables

Approximately 5% of cases in the Monte Carlo simulation generated project costshigher than $102 million. Deducting from this the preliminary cost estimate of $90million gives a physical contingency for cable costs of $12 million, or 13%. Thisfigure must also be grossed up for inflation, exchange rate and interest duringconstruction, producing a final contingency estimate of $15 million in nominal terms.

AC Switchyards

Approximately 5% of cases in the Monte Carlo simulation generated project costshigher than $59 million. Deducting from this the preliminary cost estimate of $52million gives a physical contingency for AC switchyard costs of $7 million, or 13%.This figure must also be grossed up for inflation, exchange rate and interest duringconstruction, producing a final contingency estimate of $9 million in nominal terms.

7.4 Summary

Table 7-2 provides a summary of the various contingent amounts that have beendiscussed in this section.

Real Costexcluding

Contingencies$m 2005

Impactof

Inflation$m

ExchangeRate

Variation$m

InterestDuring

Construction$m

PhysicalContingency

$m

Nominal Costincluding

Contingencies$m

Engineering Studies 9 6 15

Environment andProperty

2 0 0 1 3

Transmission Works

HVDC Converter Pole 1

AC Substations

Submarine Cables

291

52

90

37

5

11

-2

-2

-1

67

17

23

61

9

15

454

81

138

Control System 10 2 0 1 13

Dismantling 5 1 0 1 7

Project Management 61 8 0 15 84

TOTAL 520 64 -5 131 85 795

Table 7-2: Relationship between Project Costs in Real and Nominal Terms.

The difference between estimated capital costs and nominal costs includingcontingencies is approximately $275 million. However interest during constructionand inflation (which do not affect the economic merits of the project) represent $195million of this difference. In real terms physical contingencies are 13% of capitalcosts, but it should be noted that these cover only a limited number of potentialvariations in project costs.

Transpower wishes to recover the actual costs of the proposed HVDC Pole 1replacement investment. The nominal cost estimate including contingenciesrepresents a good faith estimate of what those actual costs might be. However,given the substantial uncertainties at this time, it would be inappropriate to establisha final set of project costs for recovery at this stage.

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