QUEENSLAND TREASURY

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FISCAL REFORM BLUEPRINT

FISCAL REFORM BLUEPRINT

CONTENTS

EX ECUTIVE SUM M ARY

PART A

SUSTAINABILITY OF THE FISCAL POSITION

P A R T E

PROPOSED REVISED FISCAL MANAGEMENT PRINCIPLES

P A R T C

R ESTO RING Q U E EN SLA N D ’S FINANCES

C l Intergovernmental Financial Relations

C2 Implications o f Horizontal Fiscal Equalisation for Fiscal Policy

C3 Employee Expenses and Wages Policy

C4 Agency Expenditure Management

C5 Capital Spending, the Balance Sheet and Financing

C6 Utility Pricing

C7 Reform o f Government Owned Corporations

IN C O M IN G G O V ER N M EN T BRIEF FISCAL REFO RM BLUEPRINT

EX ECUTIVE SUM M ARY

SU STA IN A BILITY OF Q U EEN SLA N D 'S FISCAL PO SITIO N

Q ueensland’s fiscal position and outlook is unsustainable and restoration must be an urgent priority

for this term o f Government.

Up to 2005-06, Queensland debt levels were low and stable. In the period from 2005-06 to 2009-10

the level o f State debt more than doubled. Debt in 2014-15 is expected to be almost 5 times greater

than 10 years prior.

In the period from 2005-06 to 2010-11, General Government expenses grew at almost double the

rate o f revenue (with the latter impacted by the GFC). The main drivers o f this growth are

employee expenses attributed to the number o f employees and wages. Employee expenses

increased by 40% over the period 2004-05 to 2007-08.

Capital spending rose by 170% from 2004-05 to 2008-09. Over this time, the capital program went

from being modestly funded by borrowings (15% in 2004-05) to primarily funded by borrowings

(70% in 2008-09) to currently being virtually fully funded by borrowings. This in tum has resulted

in interest expenses rising rapidly across the forward estimates.

The revenue environment has also fundamentally changed. The economic conditions which drove

GST and transfer duty revenues in the decade leading up to the GFC are not about to be repeated.

All States are under some degree o f fiscal stress and are undertaking restorative measures.

Treasury’s medium term fiscal analysis serves to demonstrate that a long and sustained period o f

restorative fiscal measures and unprecedented fiscal discipline is required to restore the State’s

fiscal position, stabilise the debt to revenue position and return the State’s AAA credit rating.

Expenditure growth must be brought under control, with the key being slower growth in employee

expenses.

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O n the capital side, a prolonged period o f lower capital spending is required. Priority should be

given to funding maintenance o f the existing infrastructure base with expansions only in line with

population and economic growth.

Over the medium to long term, if the State is to return to AAA, it will also need to substantially

reduce the stock o f debt. This is likely to require a substantial asset sale program with proceeds

directed to debt reduction. This would likely lead to a return to AAA based on the Standard and

Poor’s methodology.

Ultimately, a return to AAA under the M oody’s assessment (and even achieving a solid AA+) is

more likely to depend on structural improvements to the budget rather than the sale o f commercial

enterprises.

There is a clear risk that M oody’s will, within the next couple o f years, reduce Queensland’s

standalone credit rating (and potentially the credit rating as a whole) if Queensland cannot achieve

significantly lower deficits and levels o f debt than forecast in the 2011-12 MYFER.

A NEW W AY FO RW A R D - REVISED FISCAL PR IN C IPLES

The existing fiscal target o f an operating surplus is too narrow, as achieving this target is

insufficient to arrest the growth in debt.

A key recommendation is therefore to replace the operating surplus target with a General

Government net lending surplus target by no later than 2015-16. This would require an

improvement in the General Government sector o f at least $ l ‘/2 billion in 2015-16. In effect, this

requires a return to the “no borrowing for social infrastructure” principle under the successful fiscal

trilogy that guided Queensland fiscal policy in the 1990s.

In the absence o f m ajor asset sales (which are not being contemplated for this term o f Government),

this revised fiscal target could potentially allow Queensland to achieve a AAA credit rating by

2019-20 on the S&P’s criteria but m ost likely only a solid AA+ on the M oody’s methodology.

In light o f the current fiscal position, Treasury has reviewed the current fiscal objectives and

principles. The following revised principles are recommended.

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Principle 1 Stabilise then significantly reduce the Non'financial Public Sector Debt to

Revenue Ratio

Principle 2 Ensure growth in expenses does not exceed growth in revenue

Principle 3 Achieve a General Government sector net lending surplus as soon as possible

but no later than 2015-16

Principle 4 Maintain a competitive tax environment for business

Principles Target full funding of long term liabilities such as superannuation in

accordance with actuarial advice

STRATEGIES TO RESTORE QUEENSLAND’S FINANCES

After enjoying rapid expansion, economic growth has slowed considerably in recent years. This

not only reflects the impact o f the GFC and the 2011 floods, but also that some o f the underpinnings

o f the previous ‘boom ’ (e.g. credit expansion) were unsustainable.

Economic growth is forecast to strengthen, but the composition o f that growth will be very different

from the past. M ining investment is forecast to surge, while the non-mining sectors - which

represent 90% o f the economy and employment, are likely to experience below average growth.

This suggests an environment in which there is a strong dichotomy between the headline growth

numbers (which should be strong) and the views o f the broader community about the true state o f

the economy. Importantly, it also suggests a relatively weak revenue environment with little

prospect o f a return to the surge in revenues that characterised the decade preceding the GFC.

Queensland’s financial position is retrievable - the current position has borrowing levels consistent

with at least a very strong AA+, and a fully funded superannuation scheme. The issue is the

forward projections and the borrowing implied by those projections makes Queensland highly

vulnerable to shocks and is contrary to the principles o f intergenerational equity.

Just as the reasons for the deterioration in Q ueensland’s finances over recent years are many and

varied, so are the remedial actions and strategies required to address the situation. Treasury sees

the following strategies as being critical:

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Strategy 1 Protect the financial interests of the State in matters of Intergovernmental

Financial Relations

Strategy 2 Set revenue and expenditure policies to achieve a sustainable budget position

having regard to the implications of horizontal fiscal equalisation

Strategy 3 Control growth in employee expenses

Strategy 4 Provide agencies with the tools and flexibility they need to manage their

budgets, and enforce accountability

Strategy 5 Make high quality decisions around capital spending, the State’s balance sheet

holdings and financing

Strategy 6 Ensure utility pricing policies are fiscally responsible

Strategy 7 Pursue ongoing commercial reform of Government Owned Corporations

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Strategy 1 - Intergovernmental Financial Relations

Heavy reliance on Australian Government financial assistance - representing 48% o f state revenue

in 2011 -12 - makes its level and form a critical issue for the Government.

W hile there have been some positive developments in terms o f hinding agreements, and in

assistance to Queensland following the floods, the recent trend in financial relations has been

towards further restricting the policy and revenue flexibility o f the states. There is a trend o f

significant cost shifting from the Australian Government to the States.

Opportunities to reallocate roles and responsibilities have been missed in favour o f locking in

“shared responsibilities”, most notably under the National Health Reform Agreement. The National

Disability Insurance Scheme and Education (Gonski) reforms are heading in the same direction.

In a number o f policy areas, the Australian Government is unilaterally announcing m ajor policy

“reforms” that impose costs on the states which they are not in a position to fund.

The GST is now not the ‘growth tax’ originally envisaged with an increasing share o f consumption

expenditure being directed at areas outside o f the GST base. At some point, the issue o f the

appropriateness o f the current base and rate will need to be revisited.

The current GST Distribution Review led by former Premiers Brumby and Greiner could have

significant implications for Queensland. O f particular importance to Queensland is the treatment o f

mining royalties - there is a flaw in the current methodology that leaves Queensland and Western

Australia with less royalties (in net per capita terms) than other states.

The Australian Government has since provided the Review with a further two terms o f reference -

asking the panel to consider ways o f penalising states that do not conform to Australian

Government policy direction in respect o f the mining tax and state tax reform. The Review should

not be dealing with these issues.

Given the improvement in Queensland’s share o f GST in the most recent relativity update (single

year relativity above equal per capita), it is not in Q ueensland’s interests to accept any change in the

current system for the medium term unless it provides a demonstrable benefit - most likely in the

form o f a greater share o f royalties.

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Resource rent taxation could have been a better model for resource taxation in Australia had it been

implemented in consultation with the states - possibly in conjunction with the reform o f royalties

and with appropriate revenue sharing arrangements with the states.

State tax reform has the potential to deliver significant economic and budgetary benefits, but would

be very difficult to achieve.

To some extent, all o f these issues are related and point to the broader need for some bold reform o f

spending and revenue raising responsibilities in the federation.

Strategy 2 - Revenue and Expenditure Policies and Horizontal Fiscal EQualisation

It is important to note that the key fiscal ratio used by rating agencies relates debt to revenue

(capacity to service). W hile a focus on debt reduction / containment is vital, it is no less critical that

the State’s revenue base be protected and matches expenditure growth.

Horizontal Fiscal Equalisation (HFE) seeks to put states on a similar fiscal footing to deliver a

standard set o f services. For example, i f a state’s own source revenue base is performing relatively

well (or poorly), it will receive a lower (or higher) share o f the GST pool.

The fact that state fiscal capacities are equalised means that policy settings and efficiency are

paramount. An economy that is performing relatively strongly in terms o f generating revenue

cannot compensate for an imbalance in the revenue and expenditure policy mix or inefficiencies in

service delivery.

Queensland has historically been positioned in a policy sense as the low tax state - no fuel tax, no

financial institutions duty, generous principal place o f residence stamp duty concessions and

generally lower tax rates across the board. Queensland was only able to have low tax policy

settings and achieve balanced budgets by virtue o f lower than average levels o f service provision

and public sector wages.

Over the past 10 to 15 years, Queensland’s overall expenditure effort has moved towards the

national average whereas Queensland’s revenue effort remains below the national average. The

CGC framework is another way to view the relative strain Q ueensland’s budget is under.

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If Queensland commits to expenditure above the national average in terms o f either the scope or

levels o f services, it can only be paid for by lower than average expenditure in other areas; or higher

than average tax levels.

Similarly, i f Queensland commits to lower than national average tax levels, it can only be paid for

by lower than national average expenditure levels. This trade-off needs to be fully recognised in

establishing the fiscal strategy for the State.

Understanding the process o f HFE is very important in the context o f current debates about how

resource states should “use” their royalty revenues. Royalties collected by Queensland are

redistributed between all states and territories. Queensland receives roughly a per capita share.

Higher royalty collections in Queensland simply equates to a lower share o f the GST. Higher

royalty collections therefore do not provide the resource states with the fiscal capacity to provide

additional services or lower taxes relative to other states.

If the State does not w ish to pursue available taxation reforms (eg broadening land tax and payroll

tax as recommended in Henry Review), user charges and fees for service revenue provide one o f

few remaining areas o f revenue “room” for the State. In particular this requires further

consideration o f cost recovery, including in areas o f health, education and public transport. At a

minimum, increasing charges in line with CPI each year is essential, noting that this will still erode

cost recovery over time (as major inputs such as wages increase in real terms).

Further, the State needs to avoid locking in growing public subsidies for commercial utility services

such as electricity and water where cost reflectivity in pricing is critical to demand management.

The State’s weak fiscal position does not allow for higher relative State subsidies in these areas.

Strategy 3 - Growth in Employee Expenses

Employee expenses have increased by around 8.7% per annum over the period 2000-10 to 2010-11.

This is much higher than both inflation and the Australian public sector average.

Compositional changes explain the bulk o f the difference in the divergence from the average.

Public sector numbers have also grown at a much higher rate than population, with the majority o f

the growth in Health.

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These outcomes generally reflect policies to bring wages for service delivery staff in line with

national averages and m ajor service delivery pushes in areas such as Health and Education. Equally

the weight o f numbers behind service delivery means attempts to contain expenses that exclude the

“frontline” will not deliver significant savings.

The 2.5% wages policy is appropriate having regard to Queensland’s budget circumstances.

However, it is not and cannot be delivered without legislative support. Arbitration will in all

likelihood produce outcomes that will have significant adverse fiscal consequences.

Treasury’s preferred fallback position is a legislated “bounded CPI” option (1.5% to 3.5%) with a

periodic window for genuine productivity discussions.

Addressing a large deficit in a budget dominated by employee expenses will require further

measures beyond wages policy. At a minimum, Government should deliver on the further $150

m illion per annum reduction already included in the forward estimates (announced in the 2011-12

MYFER) by w ay o f a tight time-limited second round voluntary separation program.

From a range o f difficult options, a limited program o f targeted redundancies (less generous than

the V S?) based on reviewing and reducing the scope and scale o f Government activity is the

preferred mechanism to achieve a significant reduction in expenses while maintaining service

delivery capacity.

Strategy 4 - Provide A2encies with Flexibility to Manage their Budgets

Expenditure levels in most service areas o f the Queensland Government are now consistent with

other comparable jurisdictions in Australia.

Generally, agencies have a good track record o f m anaging within their budgets. Queensland Health

has been a notable exception over recent years - budget overruns in Health portfolios is a recurring

theme across the states.

However, agency budgets are under increasing pressure as they have been required to absorb

non-labour operating cost increases and meet efficiency dividend targets.

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Service delivery agencies are also struggling under the weight o f their infrastructure footprints,

which are generally m uch larger than their interstate counterparts. The State needs to find less

capital intensive ways to meet its policy and service delivery objectives.

The current fiscal position o f the Government and subdued revenue outlook means it is not going to

be possible to improve service delivery or deal with these pressures by providing additional funding

to agencies. Achieving repair o f the G ovem m ent’s fiscal position depends critically on agencies

m anaging within their budgets.

At the same time though, agencies are restricted in managing their operations in the most efficient

and effective way. Providing greater management flexibility going forward is critical i f agencies

are to m eet their budget and service delivery targets.

K ey enablers for investigation are: (a) pursuing m ore cost effective procurement from the NGO and

private sector; (b) removing inflexible industrial relations practices; (c) providing agencies with

greater discretion to manage their infrastructure footprints; and (d) reducing the burden o f whole o f

Govemm ent directives, standards and guidelines.

The issue o f “waste” or” doing more with less” receives much public attention. Govemment must

be fhigal, but costs such as advertising, publications and travel are relatively modest in the context

o f the budget. The more serious questions o f public policy choices and opportunity cost (i.e.

effectiveness as well as efficiency) need to be understood.

Critical to the fiscal repair and future budget sustainability will also be a robust program review

function to identify options to improve efficiency and innovate. Past experience suggests this is

m ost likely to be successful if an independent review body tackles the reviews in an open and

public manner (eg. Productivity Commission model).

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Strategy 5 - Capital Spending, the State’s Balance Sheet Holdings and Financing

Capital Spending and Project Evaluation

Govemm ent is under intense pressure to spend m ore on capital. No Govemm ent in Australia has

made more o f an expenditure effort in this regard than the Queensland Govemm ent (although there

are questions about the quality and cost effectiveness o f the investment).

The recurrent costs o f infrastructure are in the order o f 10-15% o f the capital costs. The

expenditure on capital has had a significant impact on the recurrent budget. It has also come at a

cost in terms o f new projects being preferred over the important issue o f maintenance o f the existing

asset stock.

In order to arrest the growth in debt, Queensland will have to become accustomed to spending far

less on capital than has been the case over the past decade. As outlined in Parts A and B,

Queensland needs to align its capital spending ambitions to the available cash flow generated by the

budget. Large scale new projects (e.g. cross river rail) are unaffordable.

Going forward, processes need to be established to put major capital expenditure proposals under

more rigorous review focussing on the outcome sought, rather than the project. In many cases,

small tactical capital or demand management interventions may produce better economic and

service delivery outcomes than the “major project” .

Queensland will need to invest more time and resources in the preparation o f robust business cases

and the clever rationing o f available capital. That is, against the backdrop o f a hard budget

constraint, the ability to rank the value o f projects in relative terms (as opposed to simply producing

a positive NPV) is vital. The Queensland Projects Unit, along with Infrastructure Queensland,

could provide the appropriate vehicles through which to achieve this.

Infrastructure Financing and PPPs

There is a role for the private sector to play in the area o f social PPPs (for example hospitals and

schools). W hile social PPPs do not result in balance sheet benefits (as both arrangements result in

similar liabilities on the State’s balance sheet), there is the potential for the State to achieve value

for money through the targeted use o f PPPs.

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In order to m axim ise value for money in social PPPs and to counter the high debt margins in the

current PPP market, the Govemment should investigate the use o f hybrid models aimed at reducing

the private financing requirement. Options include the Govemment Contribution Model (where the

Govem m ent provides upfront contributions) and European models where the Govemment

participates as one o f the senior debt financiers.

The Govemm ent should also seek to maximise the scope o f asset management services included in

PPPs to ensure potential benefits associated with social PPPs are maximised.

It is unlikely that any economic PPPs (for example toll roads) will be o f interest to the private sector

in the short to medium term due to the markets being unwilling to take ‘greenfield’ demand risk in a

form that w ould be acceptable to govemment. However, for new toll roads, it is a viable option for

the State to fund the constm ction o f the toll road and then sell its interest after traffic pattems have

been established.

PPP availability models for roads, where there is no toll and the State pays the operator ongoing

service payments for keeping the road maintained and available (eg Peninsula Link in Victoria), are

considered unlikely to represent value for money for the State. However, i f a road asset had more

complex constm ction characteristics and more significant maintenance requirements (e.g. a tunnel),

then a PPP availability model could be considered, albeit similar to social PPPs, it would likely

require some form o f hybrid financing structure.

Commercial Infrastructure Provision and Financing

In order to avoid fiarther increases in the State’s borrow ing levels, to the maximum extent possible,

the Govemment should seek to have commercial infrastm cture required for the resources sector (for

example water and port infrastmcture for use by m ining and energy companies) funded by users

and where possible, owned by users or other private providers.

W here it is necessary for Govemment, through GOCs, to be involved in the ownership o f

commercial infrastructure, users should be required to fund the development o f that infrastmcture

through upfront payment stmctures. This approach has been used in the Wiggins Island Coal

Export Facility development and is currently under negotiation with the users o f the proposed

Connors River Dam and pipeline to M oranbah and the multi-cargo facility at the Port o f Abbot

Point.

E S -ll

Asset Divestment

In all likelihood, asset sales will in future have an important role to play in reducing State debt and

refocussing G ovem m ent’s management effort on delivering and improving core Govemment

services. The public policy rationale for continued ownership o f these businesses, which largely

operate in accordance with national regulatory frameworks, is weak.

Treasury acknowledges the G ovem m ent’s public commitments m ling out asset sales during this

term. Government should however, during this term, undertake a structured review into the

following assets to infonn future public debate and decisions around State ownership:

• the State’s electricity transmission and distribution assets (Powerlink, Energex and Ergon)

• RG Tanna Coal Terminal.

Divestment o f the above assets has the potential to almost halve the State’s forecast debt levels from

$85.4 billion (2014-15) to around $47 billion. In addition to significantly improving the risk

position o f the State, the divestment program w ould alleviate difficulties experienced by QTC in

achieving the State’s borrowing program requirements.

Strategy 6 - Utility Pricing

Over the past decade, there have been significant increases in prices consumers pay for retail

electricity and water. W hile some o f the emphasis o f reforms in those sectors has been on cost

reflective pricing, stmctural reform has not caused the price increases.

There are many reasons for the price increases, not least o f which has been large increases in capital

expenditure reflecting population growth and improved service levels.

M arket based reforms need to be sustained to support productivity and economic growth. Critically

for the State’s fiscal performance going forward, policies that seek to ameliorate price impacts on

consumers must also have regard to the implications for the budget and debt levels.

Water

In South East Queensland (SEQ), water prices are increasing annually reflecting the $7 billion in

investment in new water supply infrastructure following the drought.

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The annual cost o f operating the SEQ water grid is around $1 billion, with current water prices

m eeting only half o f the cost o f supply. Under the lOyear bulk water price path, prices will

continue to increase to 2017-18 to reach ‘full cost recovery’.

The final bulk water price in 2017-18 reflects the cost o f supplying water and provides capacity to

repay that part o f the debt which reflects the accumulated losses o f supplying water at less than full

cost for the first 10 years o f the bulk water price path. It is only these accumulated losses that are

scheduled to be repaid over 20 years. The debt repayment profile for the assets themselves is

consistent with the expected asset lives.

Steps have been taken to remove some costs from bulk water prices. This includes removal o f costs

associated with the Traveston Dam, cost savings from switching the desalination plant onto

standby, shutting parts o f the W estern Corridor Recycled Water Scheme and modest savings from

the m erger o f Seqwater and Watersecure.

The continuing low demand for water will have significant adverse implications for the debt profile.

Originally, water consumption was assumed to be around 230 litres per person per day, revised to

200 litres in 2010. It is now more realistic to expect it may be around 180 litres per person per day.

A comprehensive review o f bulk water prices is required to avoid significant increases in debt. On

current estimates, price increases for the last five years o f the bulk water price path will need to

increase to $85/household per year compared to the $54/household per year currently announced to

avoid W GM debt escalating to over $6 billion and the repayment period extending to 2037-38.

Capping bulk water prices or extending the bulk water price path period also results in

unsustainable escalation in debt.

Any further structural realignment involving the W GM will require a comprehensive assessment of

financial and accounting risks, particularly insofar as the transfer o f around $3 billion in current and

projected borrowings undermines the financial solvency o f Seqwater/LinkW ater. Further, any

w rite-off o f non-performing assets is likely to require the transfer o f debt (at least $1.9 billion over

the next four years) to the General Govemm ent sector. The interest costs o f this debt - potentially

around $136 million per annum - will simply add to the General Govemm ent Budget deficit.

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Electricity

Electricity prices have increased over the last five years, due to increasing costs o f electricity

generation (including higher fuel costs and a transition towards less carbon-intensive generation),

and increasing costs o f distribution due to large capex programs.

These increases have been compounded by the Benchmark Retail Cost Index (BRCI) which, when

applied to a range o f electricity tariffs set almost two decades ago, has m eant that the prices paid by

different types o f customers are unlikely to reflect the costs o f supply. From 1 July 2012, the BRCI

and existing tariffs will be replaced with new cost reflective tariffs.

On 30 March, the QCA will release its Draft Determination on electricity prices for 2012-13. The

increase will include the price impact o f the carbon tax (the Australian Govemment estimated a

10% increase in the average household bill). Other key drivers will be increases arising from

renewable energy schemes and network costs.

The G ovem m ent’s capacity to restrict electricity price increases is limited. Electricity generation

costs are detemiined in the national energy market and reflect the cost o f inputs.

The G ovem m ent’s prim ary ability to moderate the rate o f increase in prices comes through ensuring

that Energex, Ergon and Powerlink operate as efficiently as possible - including through

implementation o f the recent Review recommendations to reduce capital expenditure and limiting

the costs imposed by State Govemment ‘green schem es’. Queensland has the highest solar

feed-in-tariff in Australia. Urgent review o f the scheme is recommended.

There are significant Budget and legal risks associated with capping electricity prices. Given that

electricity retailers in Queensland are privately owned, actions which restrict their ability to cover

their costs opens the Govemm ent to either paying a CSO, or facing legal action for lost revenue.

The smaller retailers may choose to leave the Queensland electricity market.

Strategy 7 Ongoing Commercial Reform of Government Owned Corporations

The 12 Govemment owned corporations (GOCs) can, and should, make a considerable contribution

to stabilising and improving the State’s finances through a program o f further reform.

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Raising the rates o f return achieved by the GOCs in their core businesses as well as through their

new projects, together with seeking to maximise the involvement o f the private sector in larger

GOC projects, will contribute materially to the State’s fiscal task in two ways.

Firstly, it will reduce the call that the GOCs as a whole place upon the State’s balance sheet to

finance new projects through seeking new debt and equity. Secondly, it raises the capacity o f the

GOCs to finance projects, at least partially, from retained earnings.

Over time, this will act to reduce the current net budgetary flow to the GOCs from the State Budget

in order to finance uncommercial activities. This would come about through increased dividends

and current tax equivalent payments (TEPs) to the State from the GOCs and reduced equity

contributions from the State to GOCs as a result o f the improved operational performance and

greater capital efficiency.

Treasury recommends the following six actions be put in place to maximise the contribution o f the

State’s ownership in the GOCs to meeting the fiscal challenge:

1. Strengthening the GOC model and the pursuit o f commercial outcomes

2. Structural reform where needed - ensuring that the GOCs are o f the scope and size to deliver

services efficiently with appropriate returns to Govemm ent as owner

3. Improving GOCs’ operating efficiency

4. Improving GOCs’ retum on capital deployed

5. M inimising GOCs’ call on debt and equity funding from the State

6. Consideration o f divestment where the private sector is better able to deliver and finance the

services, and/or manage the risks involved.

It is recommended that a key focus o f reform and savings options in the coming year be QR where

there are substantial opportunities available to reduce the cost o f delivery o f services and to exit

from uncommercial activities currently pursued that appear to produce poor value for money in

terms o f broader public benefit.

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pPART A SUSTAINABILITY OF THE FISCAL POSITION

FTSCAI. TRENDS

The critical fiscal issue facing Queensland in the immediate future is the high and rising level o f

State debt. This level o f debt is making access to the funds necessary to provide essential services

and infrastructure difficult in an environment where, during periods o f high financial market

volatility and risk aversion, financial markets are effectively closed for all but the highest rated and

m ost liquid o f borrowers. Significant debt levels also expose the State to interest rate risk.

Up to 2006-07, Queensland’s debt levels were low and stable. The m ajority o f the State's debt was

held by Public Non-financial Corporations (PNFC) and debt in the General Govemment (GG)

sector was small and manageable, representing around 20% o f the State’s debt.

However, large capital expansions and a significant increase in expenses led to a rapid and

substantial growth in debt from 2006-07 onwards. The slowing o f revenue growth from the highs

experienced from 2006-07 to 2008-09, including as a result o f the Global Financial Crisis from late

2008, also contributed to the rise in debt.

As illustrated in Chart A .l, the level o f State debt almost tripled over the period 2005-06 to 2009-10

and culminated in the credit rating downgrade in 2009. Debt continues to grow across the forward

estimates with debt in 2014-15 expected to be 5 times greater than 10 years prior.

C hart A.1 G ro ss B orrow ings by S ec to r

□ P 'lFC90,000

SO.OOO

70.XO

50.X0

5 eO.OOO

c A 40,000

30.XO

20.XO

10.XO

A-l

Composition and Drivers of Debt

Despite a build up o f debt in the PNFC sector between 2005-06 and 2010-11 mostly as a result o f

spending on commercial w ater and transport (rail and port) infrastructure, the GG sector was the

m ain contributor to the growth o f State debt over this period.

To put this into context, debt in 2010-11 was 12 times greater in the GG sector than in 2005-06

whereas debt in the PNFC sector less than doubled over the same period. The slower growth in

debt in the PNFC sector can be attributed to asset sales and a deliberate policy to encourage private

sector investment in commercial infrastructure where appropriate.

The build up o f debt is forecast to continue over the forward estimates with State debt forecast to

reach $85.4 billion by 2014-15. GG debt is the m ajor contributor to growth in debt over the

forward estimates with GG debt forecast to exceed the level o f debt in the PNFC sector in 2011-12

and to be around 40% greater by 2014-15.

The drivers o f this debt accumulation are clear from the growth in expenses and the State’s capital

program.

Expenses

As indicated in Chart A.2, growth in General Govemm ent expenses between 2000-01 and 2005-06

averaged 6.62% while revenue grew on average by 10.5% per annum. In the period between

2005-06 and 2010-11, expenses grew at an average annual rate o f 10.51% compared to average

annual revenue growth o f 6.88% per annum.

C hart A.2 E x p en se s and R evenue G row th

G eneral G overnm ent S ec to r12%

10% H

8%

6 %

4%

2 %

0%

Expenses I Revenue

2000-01 to 2005-06 2005-06 to 2010-11 2010-11 to 2014-15

A-2

To put this expenditure growth in context, Queensland’s expenses growth (net o f disaster expense)

significantly outstripped that in New South W ales and Victoria over the period 2000-01 to 2010-11.

It is forecast to grow m ore closely in line with that in the other states over the forward estimates.

C hart A.3A verage A nnual E x p en ses G row th C om parison

G eneral G overnm ent S ec to r

O2000-01 to2010-11 ■2010-11 to2014-15

% -

N ew South W ales V ictoria Q ueensiand

N o te : Q u e e n s la n d 's e x p e n d itu re g ro w th is n e t o f d is a s te r e x p e n se

Since 2005-06 Queensland’s actual expenses per capita have exceeded the average o f the other

states. In 2010-11, the additional spend in Queensland compared to the average o f the other states

was more than $700 per person with the differential in 2013-14 and beyond expected to be just less

than $900 per person.

Analysis indicates that the m ain drivers o f this growth are employee expenses. Employee expenses

have increased by around 8.7% per annum over the period 2000-01 to 2010-11, compared to an

average rate o f growth in employee expenses o f 7.1% per annum on average in the other

jurisdictions.

Employee expenses growth over that period can be broken down into wages growth o f around 5.1%

per annum and growth in employee numbers o f around 3.4% per annum.

In the 3 year period 2005-06 to 2007-08 public sector employee expenses increased by 40% in

Queensland.

A-3

The size o f the Queensland public service has increased on a full time equivalent basis from

146,323 in June 2000 (4.1% o f the Queensland population) to 200,022 in June 2010 (4.4% o f the

Queensland population) and 206,800 in June 2011 (4.5% o f the population).

W hen looking at the purpose o f this expenses growth, data suggests that the key driver in

Queensland moving from spending less per capita in 2004-05 to substantially more per capita in

2009-10 is the increase in health spending over the period.

Section C.3 o f this document explores growth in employee expenses in more detail.

The current forward estimates are predicated on expenses growth in the GG sector reducing to an

average o f 3.66 % per annum from 2010-11 to 2014-15 (4.65% excluding disasters), less than half

o f the average growth in the preceding decade. Even with this substantially lower rate o f expenses

growth, GG debt is forecast to grow by around $17 billion over the Budget and forward estimates

period. Restraining expenditure growth to this rate will be difficult to achieve. It will require

considerable fiscal discipline, with the Govemment needing to strictly control all additional

spending, whether driven by policy or parameter adjustments. Low wage outcomes (no real

increases unless offsets by cashable productivity) are essential.

The composition o f expenditure growth is also critical. For example, i f the level o f growth in health

spending (25% o f State Budget) is to continue at around 8% per annum, the rest o f the budget needs

to grow at 1% below real per capita. To grow all key frontline human services (approximately 45%

o f the State Budget) at real per capita and health at 8% per annum, the rest o f the State budget

(around 30%, mainly transport) would need to decline in absolute (i.e. nominal) terms. This does

not take into account that some expenditures (e.g. interest and superannuation expenses) are non

discretionary.

Revenue

State revenue collections have been significantly impacted by the change in economic conditions

following the Global Financial Crisis. Average revenue growth was ZVi percentage points lower in

the second half o f the decade compared to the first half.

As shown in Chart A.4, revenue has stabilised at a structurally lower level with estimates o f transfer

duty in 2011-12 around SI billion less than achieved in 2007-08 and coal royalties not expected to

retum to their 2008-09 peak during the forward estimates period.

A-4

Chart A.2 above illustrated that expenditure actually increased at a faster rate in the second h a lf of

the decade despite the weaker revenue growth. This in part was as a result o f decisions taken in the

middle o f the decade. Expense growth at the State level, which often involves service delivery

systems, is difficult to vary in line with rapid changes in economic conditions.

Nonetheless, while the pace and magnitude o f the post-GFC revenue decline was unexpected, it is

equally true that expenditure policy decisions made during the peak o f the revenue boom left the

budget highly exposed to any subsequent, and perhaps inevitable, downturn.

The expenditure “overshoot” during this decade is far from unique to Queensland. It is to varying

degrees the backdrop to the difficult budget circumstances being faced by all tiers o f Govemment in

Australia at present.

C hart A.4 T ran sfe r Duty and Goal R oyalties

2000-01 A ctual to 2014-15 E stim ate3,500

3.000

2.500

2,000

1.500

1.000

500

0 -

■ T ra n s fe r Duty ■ C o a l R oyalties

Capital

As can be seen in Chart A.5, capital spending rose dramatically in the four years preceding the

credit downgrade, with a 170% increase from 2004-05 to a peak o f over $15 billion in 2008-09.

Over this time, capital spending has gone from being modestly funded by borrowings (15% in

2004-05) to being virtually fully funded by borrowings in 2011-12. This heavy reliance on

borrowings is seeing interest expenses rise by around %Wi billion over the forward estimates.

A-5

C hart A.5 P u rc h a se s o f Non F inancial A sse ts

Non-financial Public S ec to r

l e . o o o -

1 4 ,0 0 0 -□

12,000 -

1 0 , 0 0 0 -

8.000 -

e,ooo -

4 .0 0 0 -

2,000 ■

'V 'P

Chart A.5 indicates that there w ere many policy drivers o f this capital expansion. Since the early

part o f the last decade, the budget has had to try to accommodate several m ajor infrastructure efforts

- any o f which even on their own would be regarded as historically significant. These include:

• the South East Queensland Infrastructure Plan transport spending

• the upgrade o f the electricity distribution network arising from the Somerville Review

• the water infrastructure upgrade

• the “more beds for Queensland” hospital rebuilding and expansion program.

Chart A.6 also indicates the continuing role played by transport in the overall size o f the forward

estimates capital program with health driving the growth in the 2010-11 to 2012-13 period. The

very high level o f “other” in 2009-10 and 2010-11 reflects in large part the implementation o f the

Australian Govemm ent’s stimulus program.

A-6

C hart A.6 Major C ontribu to rs to G row th in

P u rc h a se s of Non F inancial A sse ts Non-financial Public S ec to r

000,000 □ Environment and Natural Resources inci Water ■ HealthO Transport and Roads D Energy • Other

7,000,000

6 ,000,000

5,000,000

,000,000

3,000,000

2 ,000,000

1 ,0 0 0 ,0 0 0

oino

(O9

COo

CT>O Oo

Net financial liability to revenue ratio

The net financial liability to revenue ratio demonstrates the significant absolute and relative

deterioration in the affordability o f Queensland’s debt accumulation since 2005-06.

130% -

C hart A.7Net F inancial Liability to R evenue Ratio

Q ueensland v e rsu s O th er S ta te s Non-financial Public S ec to r

110%

90%

70%

50%

30%

10%2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15

A-7

The growth in debt in the GG and PNFC sectors related to the expansion o f the capital program are

m ajor drivers o f the deterioration in this measure. W hile the capital expansion in the PNFC sector

could m ostly be considered commercial with some entities earning a regulated rate o f return

(Energex, Ergon and Powerlink), there is often a lag between the capital investment and the revenue

earned on that investment causing a deterioration in the ratio, which will continue where investment

continues to grow strongly.

Conclusion

The deterioration to Q ueensland’s fiscal position largely occurred in the years post 2005-06. Up to

2005-06, Queensland debt levels were low and stable. In the period from 2005-06 to 2009-10 the

level o f State debt more than doubled. Debt in 2014-15 is expected to be almost 5 times greater

than 10 years prior.

In the period from 2005-06 to 2010-11, GG expenses grew at almost double the rate o f revenue.

The main drivers o f this growth are employee expenses attributed to the number o f employees and

wages. Employee expenses increased by 40% over the period 2004-05 to 2007-08.

Capital spending rose by 170% from 2004-05 to 2008-09. Over this time, the capital program went

from being modestly funded by borrowings (15% in 2004-05) to primarily funded by borrowings

(70% in 2008-09) to currently being virtually fully funded by borrowings. This in tum has resulted

in interest expenses rising rapidly across the forward estimates.

This growth in expenditure occurred during the peak o f the revenue boom that left the budget highly

exposed to the perhaps inevitable downtum.

A-8

DEBT, CREDIT RATINGS AND THE FUNDING TASK - LOOKING FORWARD

W hile the current forward estimates end in 2014-15 (to be extended to 2015-16 in the 2012-13

Budget), Queensland Treasury undertakes a scenario based analysis out to 2020 to gauge the

sustainability o f the fiscal position under various scenarios.

The current forward estimates are predicated on a no policy change basis being achieved. This will

be difficult to accomplish. Indeed, the 2011-12 M YFER saw an increase in GG expenses and

capital across the forward estimates relative to the 2011-12 Budget ($2.6 billion and $260 million

over four years, respectively).

Based on a scenario where spending over the next 10 years mirrors what has happened over the

preceding 10 years, the unsustainability o f that approach becomes apparent.

Historical Spending Growth Scenario

As outlined earlier, expense and capital spending has grown significantly over the last 10 years, in

particular the period since 2005-06. If this expenses growth continued for the years following

2015-16 an operating deficit position o f around $5 billion could be expected by 2019-20.

This combined with increasing capital purchases ($9 billion in GG alone by 2019-20) would see

GG debt climb to around $86 billion in 2019-20 - more than that forecast for the State as a whole in

2014-15. The comparable figure for Non-fmancial Public Sector debt would be around

$130 billion.

W hile such a scenario is an extreme one, it serves to reiterate the need for action.

Fiscal Discipline Scenario

An alternative and m ore probable scenario has Government undertaking some fiscal action to

prevent further deterioration o f the State’s finances.

This scenario assumes employee expenses grow at no more than 5.75% per annum in contrast to the

8.7% per annum growth averaged over the period 2000-01 to 2010-11. This scenario also assumes

the capital program is at a level that maintains the existing capital program in real terms after

providing for population growth.

A-9

Under the fiscal discipline scenario, the GG will return to a marginal net operating surplus in 2015-

16, increasing to a surplus o f around $3 billion in 2019-20. However, even surpluses o f this size

will not be large enough to stabilise borrowings. Borrowings will continue to increase as long as

net operating surpluses remain insufficient to fullv fund new capital purchases (noting the operating

surplus will need to be larger to take account o f the reinvestment o f interest eamings and equity

injections to GOCs).

Chart A.7 provides a comparison o f the GG net operating balance out to 2019-20 under the two

scenarios outlined above as well as if a net lending surplus is achieved by 2015-16 (refer latter

discussion on revised fiscal principles).

C hart A.7 Net O perating B alance

H istorical and F iscal D iscip line S cen a rio s G eneral G overnm ent

4,000

Fiscal discipline scenario H istorical grow th scenario3,000

•Zero n e t lending from 2015-16

2,000

1,000

( 1 ,0 0 0 )

( 2 ,000 )

(3,000)

(4,000)

(5,000)

( 6 ,0 0 0 )

What is the Right Level o f Capital Investment in the GG Sector?

Maintenance o f the existing capital base is a significant issue for the Queensland Govemment with

the recent focus on new infrastructure rather than maintenance o f the existing capital base. This has

real intergenerational issues to the extent that borrowings have been undertaken to build this

infrastructure.

The GG capital program should at least maintain the capital stock in real terms after providing for

population growth.

A-10

The Victorian Independent Review o f Finances considered that the sustainable level o f General

Govemm ent net infrastructure investment, after looking at service enhancements, productivity and

technical change, should be around 0.5% o f GSP. In Queensland, over the 4 years from 2006-07 to

2010-11, the GG capital program averaged 2.8% o f GSP, rising from 1.6% in the first half o f the

decade. After depreciation this figure was 1.9% o f GSP.

W hile Queensland’s stronger population growth and a m ore decentralised population would justify

a higher capital program than Victoria on a proportion o f GSP basis, the recent level o f investment

in the GG sector is considered in excess o f what was affordable.

If Queensland were to have a capital program that maintained the existing capital stock and

provided for population growth (i.e. a sustainable capital program), capital purchases would grow

from an estimated $5.2 billion in 2015-16 to $7.2 billion in 2019-20 (compared to a GG program o f

$9 billion under the historical spending scenario). A sustainable capital program o f $7.2 billion

would be consistent with a GG capital program o f around 1.4% o f GSP (0.6% net investment after

depreciation). However, given Queensland’s existing and forecast level o f debt, consideration also

needs to be given to the S tate's debt reduction strategy and whether a capital program o f this size

can be sustained. If it is determined that a capital program o f this size is necessary to keep pace

with economic and population growth, then a greater portion o f the program will need to be funded

from cash requiring significant reductions in expenses or increases in revenue.

Drawing on Treasury’s scenario analysis, a $7 billion GG capital program in 2019-20 would

correspond to net acquisitions o f non-fmancial assets (i.e. new capital purchases after depreciation

is excluded) o f ju st over $2 billion - and require a net operating surplus o f at least this amount to

achieve a net lending surplus. However, given the non-cash elements o f the operating statement

(particularly the reinvestment o f investment eamings) and also the extent o f equity injections to

GOCs, for debt to remain constant or fall, the operating surplus and net lending surplus would need

to be significantly greater than $2 billion.

Hence, it is to be expected that short o f any substantial asset sales program, borrowings and debt in

the GG sector will continue to grow, albeit more slowly, rather than decline in absolute terms.

A -ll

In the PNFC sector, debt is also projected to continue to grow, driven by the capital expenditure and

borrowing requirements o f Ergon, Energex, Powerlink and Queensland Rail. W hile the capital

spending in Ergon, Energex and Powerlink is largely for commercial purposes and earns a regulated

rate o f return, there is often a lag in the revenue flow related to this spend meaning that debt to

revenue measures (such as the net financial liabilities to revenue ratio) will deteriorate in times o f

rapid capital expansion.

Under the fiscal discipline scenario, State debt would climb to over $100 billion by 2019-20. Even

under tighter fiscal control than seen over the past 10 years, there is no repayment o f debt under this

scenario. Nevertheless, looking at the key credit metric o f net financial liabilities to revenue, this

scenario sees the ratio stabilise at 2014-15 levels then gradually fall as revenue growth exceeds

growth in debt (refer Chart A.8). Hence, the Budget and economy over time is better able to sustain

or afford this level o f debt.

C hart A.8 Net F inancial Liability to R evenue

H istorical and F iscal D iscipline S cen a rio s and Z ero Net Lending N on-financial Public S ec to r

150%

^ ^ F i s c a l discipline s c e n a n o140%

H istorical grow th scen ario

130%Z ero n e t lending from 2015-16

1 2 0 %

110%AAA Credit Rating Range

100%

90%

70%2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20

A-12

Given the com plexity o f ratings agency methodologies, and the interaction o f various measures, it is

difficult to estimate with any precision what is the highest level o f debt that would still be consistent

w ith a AAA credit rating. Ratings agencies also all have different approaches to determine the

rating. Nevertheless, under the most conservative approach o f considering debt levels in isolation:

• as Chart A.8 demonstrates, under the fiscal discipline scenario Queensland would retum to just

within the Standard and Poor’s AAA credit range by 2019-20

• a net lending surplus from 2015-16 would significantly increase the likelihood o f upgrade

• Queensland would be unlikely to reduce debt levels to within M oody’s range for a standalone

credit rating o f A aa by 2019-20, even under the net lending target.

To advance this timetable under the Standard and Poor’s methodology, a substantial program of

asset sales would be required. The sale o f Energex, Ergon and Powerlink in 2012-13 would see the

net financial liability to revenue ratio drop to comfortably fit within the Standard and Poor’s AAA

credit rating range from 2012-13 with it being easily maintained under both the fiscal discipline and

zero net lending scenarios (refer Chart A.9).

However, it is vitally important for the achievement o f a AAA rating under the Standard and Poor’s

methodology that all asset sales proceeds be applied to reducing debt rather than going towards

funding infrastructure not currently in the forward estimates.

C hart A.9 Net F inancial Liability to R evenue

H istorical and F iscal D iscipline S cen a rio s an d Z ero Net L ending W ith and W ithout A sse t S a le s

N on-financial Public S ec to r

^ ^ ^ F i s c a l discipline scenario with a s s e t sa le s

^ ^ " H is to r ic a l growth s c e n a ^ Witt

Zero n e t lending f ro n ^ 0 1 5 -1 6 with a s s e t sa le s

Fiscal discipline s c ^ a r i o without a s s e t sa le s

120%

1 1 0 %

AAA Credit Rating Range

100%

80%

70%

60%2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20

A-13

W hether a retum to AAA following the sale o f these three businesses is possible under the M oody’s

m ethodology is unclear given the complexity o f their methodology.

The M oody’s m ethodology does not involve a specific trigger for downgrades/upgrades. Instead it

is based on a baseline credit assessment that weighs different elements. One o f these is a

Non-fmancial Public Sector debt to revenue ratio that extracts what M oody’s considers to be debt o f

self-supporting entities. The debt o f Energex, Ergon and Powerlink is considered self-supporting.

Consequently, the sale o f these entities under the M oody’s methodology is unlikely to result in a

significant ongoing improvement in the debt to GG revenue ratio. W hat is likely a once off

improvement in debt through the application o f net sale proceeds to debt reduction but an ongoing

loss o f revenue through the reduction in dividends and tax equivalents.

A Final Note on Revenue Policy

The focus o f this section has been on containing growth in expenditure and reducing the size o f the

capital program as the preconditions to stabilising debt and charting a path back towards AAA.

Utilising Q ueensland’s “tax room” to address the deficit has not been discussed.

It is im portant that Govemment be aware o f the dual role that revenue plays in the credit

assessment. Clearly, the key fiscal ratios used by rating agencies relate debt to revenue (as the

fundamental measure o f capacity to service debt). If the State’s deficits (and debt) increase as a

result o f a reduction in revenues, whether as a result o f economic conditions or policy decisions, the

key ratios are doubly impacted - that is, on both the numerator and denominator part o f the ratio.

A-14

Conclusion

Treasury’s medium term fiscal analysis serves to demonstrate that a long and sustained period o f

restorative fiscal measures and unprecedented fiscal discipline is required to restore the State’s

fiscal position, stabilise the debt to revenue position and retum the State’s AAA credit rating.

Expenditure growth must be brought under control, w ith the key being slower growth in employee

expenses.

On the capital side, a prolonged period o f limiting the capital program to fund maintenance o f the

existing infrastructure base and expansions only in line with population and economic growth is

essential.

The Treasury analysis shows that whilst the net financial liabilities to revenue ratio eventually falls

under the fiscal discipline scenario as revenue growth exceeds debt growth, the State is unlikely to

be in a position to reduce debt in the next 10 years. Indeed, only extraordinary austerity measures

and significant asset sales could provide sufficient cash to allow for repayment o f debt. It is more

probable that with a strict approach to spending the rate o f debt accumulation will slow

significantly, making debt more manageable and affordable, as the growth in revenue exceeds

growth in debt, driving the ratio o f debt to revenue (or alternatively net financial liabilities) down to

more sustainable levels.

The sale o f Energex, Ergon and Powerlink with proceeds directed to debt reduction would likely

lead to a retum to AAA based on the Standard and Poor’s methodology.

Ultimately, a retum to Aaa under the M oody’s assessment (and even achieving a solid Aa+) is more

likely to depend on stmctural improvements to the budget rather than the sale o f commercial

enterprises.

There is a clear risk that M oody’s will, within the next couple o f years, reduce Q ueensland’s

standalone credit rating (and potentially the credit rating as a whole) if Queensland cannot achieve

significantly lower deficits and levels o f debt than forecast in the Mid Year Fiscal and Economic

Review.

A-15

PART B REVISED FISCAL PRINCIPLES

International research (IMF, OECD, W orld Bank) shows that countries that have achieved large

public debt reductions have been supported by good fiscal rules, particularly the combination o f

debt, expenditure and budget balance targets.

Treasury has reviewed Queensland’s current fiscal principles and has proposed a revised set o f

principles as outlined below. It is noted that the Govemment committed to its own set o f fiscal

principles during the election campaign. These have been mapped to Treasury’s recommended

principles to demonstrate how the Government’s principles can be achieved.

1. Retum the budget to surplus by 2014-15 and pay down debt

2. Ensure expense growth does not exceed revenue growth

3. Subject m ajor capital projects to Cost Benefit Analysis

4. Put in place a plan to regain the AAA credit rating to reduce the cost o f borrowing

5. Fully fund long term liabilities such as superannuation in accordance with actuarial advice

Proposed Principle

Stabilise then significantly reduce the N on-financia l Public Sector D ebt to Revenue Ratio

Relates to the Govemment Principles of:

• Retum the budget to surplus by 2014-15 and pay down debt

• Subject m ajor capital projects to Cost Benefit Analysis

• Put in place a plan to regain the AAA credit rating to reduce the cost o f borrowing

A debt to income ratio allows a jurisdiction to determine how affordable its debt levels are and

consequently is the key fiscal principle supporting a fiscal sustainability objective. For this reason,

some form o f debt to revenue ratio features in all major ratings agency methodologies and is usually

a feature o f any government’s fiscal principles.

There are three main measures o f debt to income. The two mostly commonly used ratios are debt to

gross domestic/state product and debt to revenue. Debt is usually defined as borrowings but in

some circumstances includes deposits held and advances received. The third main measure o f debt

to income is a ratio that compares some form o f net financial liabilities to revenue.

B - l

N et financial liabilities (as defined by Standard and Poor’s) is the sum o f borrowings, deposits held,

advances received and the superannuation liability less cash and deposits and investments, loans

and placements. W hile all o f the other line items for calculating net financial liabilities are readily

available from the State’s accounts, the Standard and Poor’s calculation (currently used for the

fiscal principles) is not well known, requires an understanding o f its definition and differs from the

net financia l liabilities line published in the State’s accounts.

A debt to GSP measure on the other hand is simple to understand and calculate. However, it is

more relevant for a national govem ment which has greater influence over the level o f economic

growth and greater revenue raising power than a state govemment.

A debt to revenue measure is a better and m ore direct indicator o f affordability than debt to GSP as

it better reflects what a state can control. Further, both debt and revenue are separate line items in

the State’s accounts, meeting the criteria o f simplicity and transparency. For Queensland, debt

should be defined simply as borrowings.

Treasury recommends the adoption o f a debt to revenue ratio measure given all data is readily

available from the State’s accounts, is easily comparable to other jurisdictions and has a clear

relationship with the State’s ability to service its debt.

The timeframe and target level o f the ratio depends on the measures Govemm ent is willing to take

over a specified period. For example a retum to a AAA credit rating (M oody’s) would require the

debt to revenue ratio to fall below 80% (noting this excludes self-supporting debt and is compared

to GG revenue). To achieve this by the end o f the current forward estimates (2014-15) would

necessitate a cumulative reduction in debt o f around $23 billion by 2014-15 meaning no capital

program and substantial cuts in services - not achievable or desirable.

Adopting the principle o f no net lending for the General Govemment sector from 2015-16 (refer

forthcoming discussion) may achieve the AAA credit rating by 2019-20 on the Standard and Poor’s

m easure but probably not M oody’s.

B-2

Proposed Principle

E nsure expense growth does n o t exceed revenue growth

Relates to the Govemment Principles of;

Ensure expense growth does not exceed revenue growth

W hile arguably fiscal sustainability can be achieved through a debt target alone, research suggests

most success is had when a debt target is combined with an expenditure target.

Given the im pact particularly o f technical adjustments on expenses or revenue in any one financial

year, Treasury’s preference is to measure the achievement o f this principle on a rolling five year

basis (actual, Budget and 3 forward estimate years). This reduces the volatility o f changes in

revenue or expenses (e.g. advance payments for NDRRA). Single year calculations are particularly

problematic when expense deferrals are factored in as they have the effect o f reducing the base year

and growing the following year despite the total spend being unchanged.

Govemm ent should note that this principle will be heavily influenced by factors outside o f its

control. By w ay o f example, movements in the Commonwealth bond rate will have a direct impact

on the superannuation interest cost and hence total expense. Similarly, changes to QTC spreads

will impact on forecasts o f borrowing costs. For this reason, the proposed principle may not

accurately m easure Government’s progress in restraining discretionary expenditure. Therefore, it is

important for Govemment to be able to demonstrate restraint in discretionary expenditure and

matters w ithin its control.

B-3

Proposed Principle

A chieve a G eneral G overnm ent sector n e t lending surplus as soon as possible bu t no later than

2015-16

Relates to the Govemment Principles of:

• Retum the budget to surplus by 2014-15 and pay down debt

• Subject m ajor capital projects to Cost Benefit Analysis

• Put in place a plan to regain the AAA credit rating to reduce the cost o f borrowing

The achievement o f an operating surplus in itself is not sufficient for Govemment to attain fiscal

sustainability or maintain or improve its credit rating given the impact o f capital investment on the

debt position. Govemments need to strike a balance between an investment in capital to meet

population and economic growth and the affordability o f that infrastructure. ^

As discussed previously, borrowing should not be undertaken for the maintenance o f the existing

capital base. This means that Govemm ent needs a minimum o f a balanced budget position

(depreciation and maintenance are expensed) with any operating surplus used to fund new capital

expansion. The size o f that surplus should be determined by the appropriate size o f the capital

program and the sustainability o f current debt levels.

W hile it is arguably appropriate to borrow for new essential infrastructure when debt levels are

manageable, they are currently too high.

N et lending (fiscal balance) combines the new capital program and the operating surplus. It is

defined as the net operating balance less net acquisitions o f non-financial assets (purchases o f

non-financial assets less depreciation).

A positive net lending balance means there is funds available for investment or debt reduction. A

negative net lending balance means there is a call on financial markets to help fund the spending

needs o f that sector.

B-4

In view o f it combining the operating balance with the capital program, Treasury recommends the

adoption o f a principle based on net lending. The target should be set in view o f the debt to revenue

principle as well as the appropriate level o f capital investment.

It is considered that the principle should focus on the General Govemment sector given capital

investment in the PNFC sector should be strictly limited to projects that eam a commercial retum,

where it is not appropriate for the private sector to fund the project.

To achieve a target net lending balance, Govemm ent needs to adjust its net operating balance by

adjusting its revenue and/or expenses or change its level o f capital investment, or a combination of

all o f these.

The broader net lending measure has other benefits over the more narrow operating surplus

measure. One o f the findings o f the recently commissioned audits o f State finance in New South

W ales and Victoria is to highlight the large role Commonwealth capital grants play in determining a

State’s operating result.

Commonwealth capital grants are received as revenue on the operating statement and expensed as

capital expenditure on the cash flow statement. W hile this is undoubtedly the correct accounting

treatment, it has served to understate the challenges the States face in respect o f their recurrent

operations. All States would have large/or much larger deficits were it not for this accounting

treatment. This again supports the use o f net lending as a better measure o f sustainability.

On the basis o f the previous discussion on the appropriate level o f capital investment in the GG

sector, a capital program (under the fiscal restraint scenario) o f $5.2 billion is forecast for 2015-16,

rising to $5.7 billion in 2016-17 and steadily to $7.2 billion by 2019-20. On the basis o f a capital

program o f this level, General Govemm ent debt is forecast to grow from $50 billion in 2014-15 to

$64 billion by 2019-20.

2015-16 2016-17 2017-18 2018-19 2019-20$ Billion $ Billion $ Billion $ Billion $ Billion

N et o p e ra tin g b a la n c e 0 .0 5 0 .5 0 .6 2 .0 2 .8

P u r c h a s e s o f non -fin an c ia l a s s e t s 5 ,2 5 .7 6.1 6 .7 7 .2

N et A cq u is itio n s o f non -fin an c ia l a s s e t s

1 .5 1.6 1.8 2 .0 2 .2

G ro s s B orro w in g s 5 2 .4 5 5 .6 5 9 .0 6 1 .5 6 3 .6

N e t L end ing (1 .4 ) (1 .2 ) (1 .2 ) (0 .0 4 ) 0 .6

B-5

Given the significant debt position o f the State, it is considered prudent that Govemment target

zero net lending - that is no call on financial markets for the General Govemment recurrent and

capital requirements from 2015-16 until debt is stabilised.

If the capital program is taken as a given, a zero net lending target would require Govemment to

focus on the net operating balance and achieve an operating surplus o f around $1.5 billion in

2015-16. This will require an increase in revenue or decrease in expenditure (or a combination

thereof) o f around $1.5 billion in 2015-16. To the extent the capital program is available to

contribute to the target, the operating surplus requirement would be smaller.

2015-16 is considered a suitable year to achieve this target as it provides time for Govemment to

make and implement decisions o f this magnitude, especially if reductions in the capital program are

going to contribute to the savings task. O f course, it is envisaged that savings would be achieved in

earlier years, but that they would ramp up to $1.5 billion per annum in 2015-16.

Should Govemm ent achieve a target net lending surplus position by 2015-16 the debt to revenue

ratio will have declined to around 144% in that year from its forecast level o f 146% in 2014-15.

The debt to revenue ratio under a net lending surplus will drop to ju st under 130% by 2019-20 (or

108% on a self-supporting basis), still well outside the M oody’s standalone Aaa range o f 80%.

Although, this is an especially conservative benchmark, since other factors such as slowing the rate

o f debt accumulation and achieving a net lending surplus could mean that a AAA rating is

achievable with a debt to revenue ratio above 80%.

Proposed Principle

M aintain a competitive tax environm ent fo r business

It relates to the Government’s principles of:

• Retum the budget to surplus by 2014-15 and pay down debt

• Put in place a plan to regain the AAA credit rating to reduce the cost o f borrowing

There are various methods o f measuring tax competitiveness, but they show a similar picture.

B-6

Queensland already has a relatively competitive tax environment for business. As can be seen from

Chart B. l , Q ueensland’s General Govemm ent taxation revenue as a percentage o f GSP has fallen

over the past decade (in part reflecting the relative weakness in the property sector and the abolition

o f State taxes under the Intergovemmental agreement). Queensland’s tax take is also significantly

less than the average o f the other states.

C hart B.1T axation R evenue a s a P ercen tag e o f GSP

G eneral G overnm ent S ec to r

Al S ta te s a n d T e rr ito rie s

Proposed Principle

Target f u l l fu n d in g o f long term liabilities such as superannuation in accordance with actuarial

advice.

It relates to the G ovem m ent’s principles of:

• Fully fund long-term liabilities such as superannuation in accordance with actuarial advice

One o f the enduring features o f Queensland public finance has been setting aside funding, on an

actuarially determined basis, to m eet long term employee entitlements - most notably

superannuation and long service leave. This policy was put in place long before the issue o f

unfunded public sector employee obligations started receiving public attention in Australia in the

1990s in the context o f the introduction o f accrual accounting.

B-7

Despite the very difficult climate in investment markets over recent years (and with the transfer o f

the Queensland M otorways asset), Queensland’s employee entitlements remain, for all intent and

purposes, fully funded. The Australian Govemment and other States have plans that aspire to this

over coming decades.

In comparing the financial positions o f Australian States, it is debateable whether Queensland

receives adequate recognition for the financial assets that it holds. For example, Queensland has a

much higher ratio o f financial assets to liabilities than any other State - an important measure o f

relative financial strength. Unlike other jurisdictions, Queensland will not have to borrow over

com ing decades to fund the retirement benefits o f public servants.

The Queensland policy framework was put in place at a time when Queensland had very low levels

o f debt. It is an open question as to whether, in light o f Queensland’s current debt levels, the same

policy decision would be made today. A t present, Queensland is both a significant borrower and

investor.

Nonetheless, the policy ensures a disciplined approach to managing intergenerational exposures and

should be maintained.

Queensland’s defined benefit scheme was closed to new members in 2009, and the majority o f

public servants now hold accumulation accounts - whereby the member, rather than the

Govemment, carries the investment risk.

The defined benefit cohort will retire progressively over the coming two decades, with the scheme

commencing to decline this decade and be all but finalised by 2035. Unlike schemes in other

States, benefits are largely lump sum - there is no long tail pension liability. The strategic

imperative now therefore is to manage the financial assets in a way that minimises investment risk

and ensures cash flow is available to meet scheme obligations as they fall due. QIC has made

considerable advances in this regard over the last two years and the portfolio is well positioned.

Conclusion

Q ueensland’s current fiscal position has necessitated a review o f the State’s fiscal principles.

Treasury recommends the adoption o f the revised principles to apply from the 2012-13 Budget.

PROPOSED PRINCIPLES

Stabilise then significantly reduce the Non-fmancial Public Sector debt to revenue ratio

Ensure expense growth does not exceed revenue growth

Achieve a General G ovem m ent sector net lending surplus as soon as possible but no later than 2015-16

M aintain a competitive tax environment

Target full funding o f long-tenn liabilities such as superannuation in accordance with actuarial advice

B-9

C .l. IN TERG O VERN M EN TAL FINANCIAL RELATIO NS__________________

Queensland is heavily reliant on Australian Government funding, representing $21.1 billion or 48%

o f Queensland’s total revenue in 2011-12. O f this, $18.9 billion supports funding o f State

Govemm ent own expenditure and $2.3 billion is passed on to non-govemm ent schools, local

govemment and other non-state govemment entities. This Australian Govemment funding is

composed predominately o f GST revenue grants and payments for specific purposes.

GST Revenue Grants

GST revenue grants are the State G ovem m ent’s single largest revenue, expected to total $9.1 billion

or about 20% o f total revenue in 2011-12.

The Federal Treasurer allocates GST revenue amongst the states and territories based on advice

from the Commonwealth Grants Commission (CGC). The CGC is tasked with determining an

allocation o f GST such that all states and territories will have a fiscal capacity enabling them to

deliver a comparable level o f services to their resident populations.

GST revenue grants are not allocated to any specific purpose, with states having full discretion on

their use.

Specific Purpose Payments

In 2011-12, Queensland expects to receive approximately $5.8 billion from the Australian

Govemment in Specific Purpose Payments (SPPs), as set out in Table 1.1.

2011-12 $ million

2012-13 $ million

2013-14 $ million

2014-15 $ million

H e a lth c a re /N a tio n a l H e a lth R efo rm 2 ,5 4 7 2 ,731 2 ,9 4 8 3 ,2 9 2E d u c a tio n 7 5 3 8 0 8 871 9 4 5N on G o v e rn m e n t S c h o o ls 1 ,7 0 5 1 ,8 5 6 2 ,0 2 9 2 ,191Skills & W o rk fo rce D e v e lo p m e n t 2 7 3 281 2 8 9 2 9 7D isab ility S e rv ic e 2 3 7 2 5 4 272 2 9 5A ffo rd ab le H o u sin g 2 4 9 2 5 6 2 6 3 2 7 0Total SPPs 5,765 6,185 6,672 7,290

C - l - l

SPPs are indexed payments for healthcare, education (including non-govemment schools), skills

and workforce development, disability services and affordable housing. Structured to grow over

time in response to cost and demand drivers, and moving over time to an equal per capita

distribution among states and territories, SPPs are the most reliable o f the Commonwealth

payments. There are no conditions for either their receipt or their use beyond the requirement that

the payments are allocated to the designated broad service area and do not replace state funding.

This gives the State G ovem m ent flexibility to use the funds in the m ost appropriate way.

National Partnership Payments

In 2011-12, Queensland expects to receive approximately $5.9 billion from the Australian

Govemment in National Partnership Payments (NPs) as set out in Table 1.2.

Table 1.2Q ueensland Forecasts o f NP Revenue from the Australian G overnm ent

Policy Area 2011-12$ million

2012-13 $ million

2013-14$ million

2014-15 $ million

H ealth 5 7 9 4 7 3 381 160E d u c a tio n 6 1 5 399 316 2 8 8C o m m u n ity S e rv ic e s 441 77 76 79H o u sin g 169 185 178 156T ra n sp o rt/M a in R o a d s 1 ,3 1 4 1,051 1 ,0 5 2 146N atu ra l D is a s te r R e lief 2 ,5 9 4O th e r 172 130 69 4 4Total NPs 5,885 2,317 2,072 872

There are over 50 NPs across a diverse range o f policy areas. In general, they are intended to

reflect Australian Government or joint Commonwealth-State policy reform priorities and be o f

limited duration. Australian Government funding can take the form o f project, facilitation and

reward payments, the last being conditional on satisfactory performance against the requirements

and objectives o f the agreement.

Funding for the Improving Public Hospital Services NP will reduce from $147 million in 2013-14

to $21 million in 2014-15 and the Commonwealth has been reluctant to indicate any intention to

continue this payment.

C-l-2

CURRENT ISSUES - ROLES AND RESPONSIBILITIES

COAG’s signing o f the Intergovernmental Agreement on Federal Financial Relations (IGAFFR) in

December 2008 represented a theoretical high watermark in the recent financial relationship

between the Australian Govem m ent and the states and territories.

The objectives o f the IGAFFR included establishing a new framework for:

• collaborative working arrangements, including clearly defined roles and responsibilities and fair

and sustainable financial anangemenls, to facilitate a focus on long tenn policy development

and enhanced govem ment service delivery

• enhanced public accountability through simpler, standardised and more transparent performance

reporting by all jurisdictions, with a focus on the achievement o f outcomes, efficient service

delivery and tim ely public reporting

• reduced administration and compliance overheads

• stronger incentives to implement economic and social reforms.

The IGAFFR reduced the number o f payments for specific purposes, although this was largely

cosmetic as many w ere renamed as National Partnership Agreements, and a small number were

amalgamated into the five major SPPs. It improved the funding arrangements for these SPPs,

setting a base and formulas for growth funding that provided a new level o f certainty for states. It

also established a new framework o f National Agreements and Partnerships intended to improve

clarity on respective responsibilities in relation to reform and shift the emphasis from control o f

inputs to the achievement o f outputs and outcomes measured by relatively few and simple

indicators.

Since the inception o f the IGAFFR, the principles underlying the agreement have been steadily

eroded. The number o f separate payments has increased from 81 at 1 July 2009 to an expected 147

as at 1 July 2012, while the number and degree o f Australian Govemment controls and

accountability mechanisms have been growing. The growth o f these restrictions and burdens being

imposed particularly in relation to NPs are leading to a re-evaluation o f their benefit.

C-1-3

W hile NP funding is often beneficial for the State, providing additional funding to support

important service delivery and other policy objectives, in practice they have not come without

potential downsides which suggest that negotiations over an NP require careful consideration.

The risks for the state inherent in NP agreements include:

• disproportionately influencing state service delivery and resourcing priorities (in some cases

involving relatively small Commonwealth funding contributions)

• the absence o f any ongoing Commonwealth funding contribution which exposes the state to the

ongoing cost o f services/programs that are initiated.

• significant components o f Commonwealth funding being conditional on meeting specific and

challenging targets

• the overhead cost burden o f detailed interaction with the Commonwealth agencies (reporting,

monitoring, approval processes, etc.)

• a blurring o f roles, responsibilities and accountabilities between the Commonwealth and the

states.

There are signs that the experience o f encroaching Commonwealth controls seen in relation to NPs

may eventually be replicated for SPPs. There appears to be pressure from some Australian

Govemment agencies for additional conditions to be applied to several SPPs - to date, the Housing

and the Skills and W orkforce SPPs. Applying additional conditions to the receipt or use o f SPPs

would erode one o f the m ajor beneficial reforms o f the IGAFFR and should be strongly resisted by

state govemments.

Greater transparency, simplicity and certainty, the intended design features o f the new

intergovemmental financial framework, have been eroded in other ways.

The largest SPP, that o f health care, will be effectively replaced from 2014-15 by funding under the

National Health Reform Agreement (NHRA), signed by all govemments in August 2011. Under the

NHRA, the Australian Govemment will fund 45% o f “efficient” growth o f activity based services,

increasing to 50% from 1 July 2017. The Australian Govemment has guaranteed that it will

provide at least $16.4 billion in additional funding to the States through these revised funding

arrangements between 2014-15 and 2019-20, compared with the funding that would have been

provided through the former National Healthcare SPP. Q ueensland’s share o f this is expected to be

around $3% billion.

C-l-4

The additional funding is welcome but comes with a complex shared administrative and funding

model in the form o f the National Health Network. The original National Health and Hospitals

Reform Commission, which reported back to the Australian Govemment in early 2009, advocated

for a much clearer delineation in roles and responsibilities between the States and the Australian

Govemment for the different components o f the health system.

The framework towards w hich the Australian G ovem m ent appears to be gradually moving is a type

o f federal purchaser-provider model by which the Australian Govemment sets national policy and

provides funding, while states are responsible for service delivery, for which they are accountable to

the Australian Govemment.

The risks and trends in Commonwealth State relations outlined above are evident in a range o f

current developments. The Australian G ovem m ent is unilaterally announcing major policy

“reforms” that impose costs on the States which they are not in a position to afford.

National D isability Insurance Scheme (NDIS)

• Commonwealth is advancing a hybrid govem ance model for an NDIS with policy/regulatory

authority increasingly resting with the Commonwealth but with no commensurate commitment

to funding - this would create a scheme which has no certainty o f funding and no clear lines o f

accountability and responsibility.

• The current Commonwealth strategy appears to be to seek to raise community expectations,

lock the states into implementation and ultim ately put forward a funding proposition which

places a heavy burden on the states to im plement the NDIS.

Gonski Review o f School Funding

• The recommendations o f the Gonski Review again have the potential for increased

Commonwealth influence over the distribution o f resources across state school systems (e.g. a

National Schools Resourcing Body setting school resourcing standards and loadings and

developing standards to which school buildings should be built and maintained)

• Gonski provided an indicative national cost o f $5B p.a. to implement new resourcing standards

but the Commonwealth has made no funding commitment in its response

• Again the Commonwealth is seeking to engage the states on Gonski without any discussions on

a funding framework or funding parameters

C-l-5

Skills Reform

• The Commonwealth is looking to replace the Productivity Places Program with a Skills Reform

National Partnership

• The current proposal for 5 year funding would see a significant reduction in funding over the

first 3 years relative to the Productivity Places Program with an increased level o f funding in the

last 2 years

- However over h a lf o f the funding would be subject to achieving very challenging training

outcomes and therefore would be at risk to the State

• The Commonwealth is seeking to influence training reforms and the quantum o f state training

provision while effectively reducing funding to the States.

C-l-6

GST AND GST DISTRIBUTION REVIEW

The GST revenue grant received by the Queensland Govemm ent is a factor o f the size o f the GST

revenue pool and the proportional share o f the pool received by the State.

The total GST revenue pool is susceptible to both short and long term changes in economic

conditions. In the short term, GST revenue reflects movements in consumption spending, which

can vary with economic conditions.

The GST revenue pool grew strongly in the early to mid-2000s before falling with the onset o f the

GFC and has grown sluggishly since.

Taking a longer term perspective, growth o f the GST revenue pool has been trailing general

economic growth and has failed, at least to some degree, to be the ‘growth tax’ that was anticipated

at its inception. Chart 1.1 shows that the ratio o f GST revenue to GDP has steadily declined over

recent years.

C hart 1.1 Decline o f GST a s a s h a re o f GDP

105 G ST/G DP T a x ab le consum ption /G D P

100

95

85

Source: ABS Cat No. 5206.0, Australian Government Budget Papers No. 1 and No. 3 and Queensland Treasury estimates post 2009-10.

This reflects, in part, a similar historical and expected trend in taxable consumption as a share o f

GDP. In particular, households have been boosting savings and becoming more cautious with

discretionary spending, which is generally subject to GST, while m aintaining non-discretionary

spending, which includes a number o f exempt categories.

C-l-7

In the longer term, the issue o f the appropriateness o f the base and rate may need to be revisited.

A ustralia’s GST rate is low by international standards and the current base that excludes important

areas o f consumption is not consistent with the original design objective o f creating a broad based

consumption tax. It could be argued that increasing the rate and broadening the base o f the GST

would be arguably both good tax policy and support the revenue base o f the states.

The other factor determining the State’s GST revenue is its share o f the pool. This is determined by

the CGC in an annual process o f assessing the fiscal needs and capacities o f the states and

territories, and recommending to the Federal Treasurer a distribution o f GST revenue grants that

will ensure that state and territory govemments will be able to deliver a comparable level o f

services and infrastructure to their residents.

Some states’ dissatisfaction with the CGC process led to the Australian Govemm ent announcing a

Review o f the GST Distribution in 2010. Q ueensland’s own concems focus on the Commission’s

mining assessment, which is excessive in its redistribution o f GST revenue. Although mining

revenue represents only 7% o f all state revenues in aggregate, it is responsible for 76% o f the GST

redistributed as a result o f revenue assessments. As a result, Queensland and W estem Australia

effectively benefit less from mining royalties on a per capita basis than the other states and

territories, as shown in Table 1.3.

Table 1.3Com parison o f Mining Revenue and G ST Distribution''

NSW VIC QLD WA SA TAS ACT NT AUST

9 4 6 4 4 2 ,2 4 2 2 ,9 7 3 140 35 168 6 ,5 5 0

1 ,3 2 5 1 ,8 4 5 (1 ,2 1 3 ) (2 ,5 2 0 ) 3 7 9 127 125 (69) 3 ,8 0 2

2,271 1 ,8 8 9 1 ,0 2 9 4 5 3 5 1 9 162 125 99

322 352 2 3 6 2 0 6 322 3 2 4 3 5 9 4 4 6

M ining r e v e n u e '($ million)2 0 1 1 -1 2 G S T red istribu tion^ (S million)N e t m in ing re v e n u e ($ million)N et m ining re v e n u e ^ fS p e r capita)________________Notes:1. Num bers m ay not add d ue to rounding2. Figures a re the average mining revenue from 2007-08 to 2009-10 and do not therefore reflect ch anges to mining royalties announced

in the W estern Australian G overnm ent’s 2011-12 Budget.3. CGC redistribution for mining revenue based on average a s se s se d revenue raising capacity from 2007-08 to 2009-10.4. Calculated using 2007-08 to 2009-10 average populations.Sources: Queensland Treasury, Commonwealth Grants Commission Report on GST Revenue Sharing Relativities - 2011 Update____

The GST Distribution Review led by former Premiers Nick Greiner and John Bmmby and South

Australian businessman Bmce Carter represents an important opportunity to rectify the problems

with the current CGC assessment process, o f which the mining assessment is only one.

C-l-8

The Review, charged in M arch 2011 with examining and making recommendations on possible

changes to the form o f fiscal equalisation among the states and territories, could have significant

and long lasting financial implications for the states.

To date, the Review has only released issues papers and received submissions, and has not publicly

provided any clear articulation o f the direction it may be taking. However, that may change with

the release o f an interim report in March.

All state treasurers and their treasuries have been contributing to the public debate and Review

consultation process. W ith the Review scheduled to soon release its interim report, followed by its

final report in September, the process is reaching a critical stage during which each jurisdiction will

be seeking to maximise its influence on the outcomes o f the Review.

In November last year, the Australian Govemm ent provided the Review with a further two terms o f

reference — asking the panel to consider ways o f using the distribution o f GST to provide incentives

and disincentives to promote future State tax reform and mechanisms to discourage states from

increasing their royalties.

This is an inappropriate use o f the GST distribution system which should be focused on ensuring all

states and territories have the fiscal capacity to provide a comparable level o f services, and not

prosecuting Australian Govemm ent policy objectives.

Given the improvement in Queensland’s share o f GST in the most recent relativitv update (single

vear relativity above equal per capita), it is not in Q ueensland’s interest to accept any change in the

current system for the medium term (3 to 5 years) unless it provides demonstrable benefit - most

likely in the form o f a greater share o f royalties.

C-i-9

TAX REFORM

As the Australian Government often uses its greater financial capacity as leverage to intervene in

state policy, a more robust state revenue base would provide states with a stronger position in

negotiations with the Commonwealth.

There are two ways to achieve that stronger revenue base - unilateral state revenue reform or

cooperative national revenue reform.

M ore than a decade o f tax reviews and commentary, culminating in the A ustra lia ’s Future Tax

System Review and last year’s Tax Forum, have established, at least at the academic level, a broad

consensus on the preferred direction o f the reform o f state taxation.

According to this broad consensus, state tax reform should satisfy at least three objectives:

1. redesign o f existing taxes to improve their efficiency. Usually this means a reduction in and

flattening o f tax rates, with a compensating broadening o f the tax bases.

2. restructuring o f the tax mix to reduce reliance on less efficient taxes and increase reliance on

more efficient taxes. Taxes that minimise the distortion o f economic decisions are generally

considered more efficient - usually these are broad based taxes or taxes on immobile bases,

such as land. Transaction taxes are considered inefficient because they discourage beneficial

transactions and result in resource misallocation. In the state context, transaction taxes such as

stamp duties are often targeted as inefficient taxes, while payroll tax and land tax are considered

to be more efficient, particularly if their bases were broadened.

3. State tax harmonisation. Each state and territory has its own taxation regime, with its own

legislation and administration. With many business operations now crossing state borders, this

increases compliance costs as different tax office requirements must be met in each jurisdiction.

Greater tax harmonisation, it is argued, would reduce the regulatory burden facing businesses

and other organisations operating interstate.

Achievement o f these reform objectives would be highly challenging and, to some degree,

problematic. Broadening the payroll and land tax bases would result in the entry o f many new

taxpayers into the state tax system, sometimes for relatively little additional revenue. Even revenue

neutral tax changes will create many potential winners and losers, with the latter likely to argue

strongly for compensation. It is perhaps not surprising that proposals by individual states to

undertake reforms o f these types in the last decade have been strongly resisted by segments o f the

C-l-10

community and generally failed to achieve their objective. At least to some degree, reform must be

‘bought’ and state governments will not be in a fiscal position to do so.

N ational Tax Reform

A ustralia’s federal system has played an important role in producing the form o f state taxation that

exists today. The Australian Constitution limits the taxation powers o f the states, the Australian

Government has used its financial strength to monopolise income taxing powers and redesign

federal financial relations through the GST, and tax competition among the states has shaped their

taxation structures, with mixed results.

It is also likely that the federal system will continue to play an important part in the future

development o f the state tax system. For example, the Australian Government’s resource rent taxes

and carbon tax, whatever their other benefits and faults, will present a limitation on the ability o f the

Queensland Government to further access its traditional mineral resource base.

Often to the detriment o f national tax policy, the Australian Government has introduced a number

o f tax measures without adequate consultation with the states. Resource rent taxation could have

been a better model for resource taxation in Australia had it been implemented in consultation with

the states and industry - possibly in conjunction with the reform o f royalties and with appropriate

revenue sharing arrangements with the states that reflected the states’ need for stable streams o f

revenue.

The Australian Government has a greater fiscal capacity than the states to financially support

national tax reform. M any commentators have argued that the Australian Government’s access to

the income tax base should be shared with the states and, along with the GST, presents a possible

funding source for state tax reform and for strengthening the state revenue base. The ability o f

states to impose a surcharge on top o f the Australian Government’s income tax schedule would

allow states to access a robust, stable and broad revenue base that would increase the states’

capacity to reform and strengthen their revenue systems.

Similarly, state tax reform may be facilitated by a jo in t approach with some or all o f the other states

and territories, whether or not that is with the cooperation and assistance o f the Australian

Government.

C-1-11

Taking advantage o f the opportunities offered by our federal system may assist in advancing state

tax reform.

All of these issues are related and point to the urgent need for bold reform of spending and

revenue raising responsibilities in the federation.

C-1-12

C.2. IM PLICA TIO NS OF H O RIZO NTAL FISCAL EQ UALISATIO N FOR FISCAL PO LICY_______________________________________________________

Any government m anaging state finances in Australia needs to understand the implications o f the

Comm onwealth Grants Commission (CGC) process. The CGC advises the Australian Government

on the distribution o f GST revenue among the states based on the principle o f Horizontal Fiscal

Equalisation (HFE).

The objective o f HFE is to distribute GST in such a way as to provide all states and territories with

the same fiscal capacity to deliver a standard set o f services - after taking into account jurisdictions’

expenditure needs and revenue raising capacities. Expenditure needs and revenue raising

capacities are influenced by factors such as the demographic profile o f residents, socio-economic

status, resource endowment and economic performance.

The CGC collects a vast amount o f data from states and territories that can be useful in comparing

policy settings and performance. Some key measures are outlined below.

Revenue raising capacity - A ratio which indicates the capacity of a state to raise revenue relative to the

average. It reflects the size of a state’s revenue base per capita relative to the average and is measured by

dividing assessed revenue per capita by average revenue per capita.

Revenue raising effort - A ratio which indicates the actual effort made by a state to raise revenue relative to

the average effort. It is primarily a measure of the deviation of a state's tax rates and efficiency in ensuring

compliance from the average rates and compliance efficiency. It is measured by dividing actual per capita

revenue by assessed revenue per capita.

Cost o f service ratio - A state’s per capita cost of providing services at average standards, relative to the

average per capita cost. It is calculated by dividing per capita assessed expenses by per capita average

expenses.

Level o f service ratio - A ratio that reflects how a state’s policies on the level of services provided and the

relative efficiency with which they are provided vary from the average policies. It is measured by dividing

actual per capita expense by assessed expense per capita.

C-2-1

Chart 2.1 takes data from the CG C’s 2012 Update to illustrate Queensland’s revenue raising effort

and level o f service provision across some key categories. W ith the exception o f motor taxes,

Q ueensland’s revenue raising effort in 2010-11 remains below average. The expenditure picture is

mixed, with Welfare, Housing and Justice Services spending below average and Health, Roads and

Transport spending well above average.

C hart 2.1Q u e en s lan d ’s R elative R evenue and E xpenditure effo rts

M ajor C ateg o ries 2010-11

145

135

125

115

105

95

85

75

Revenue Raising Effort [ % '■ )

■ | l |I

Level of Service Provision (%^)

ll.S'»

-% o f A u s tra lia n A ve rag e E ffo rt

Leaving to one side debates about methodology and time lags, HFE puts states on a similar fiscal

footing. It is a state’s policy setting therefore that determines its relative budget outcomes. An

economy that is performing relatively strongly in terms o f generating revenue does not compensate

for an imbalance in the revenue and expenditure policy mix or inefficiencies in service delivery.

Therefore, over the medium term:

• if a state commits to expenditure above the average in terms o f either the scope or levels o f

services, it can only be paid for by lower than average expenditure in other areas; or higher than

average tax levels

• similarly, i f a state commits to overall taxation levels below the average, it can only be paid for

through lower than average expenditure levels overall.

(The only exception to the above is if a state operates at a very high level o f efficiency in the

delivery o f its services. That is, a state might be able to sustain service levels consistent with the

national average and revenue raising effort below the national average if it provides those services

more efficiently than other states.)

C-2-2

This policy trade o ff can also be viewed from a longer term perspective.

For example, in the 1970s, 1980s and much o f the 1990s Queensland was clearly positioned in a

policy sense as the low tax state. Queensland had no fuel tax, no financial institutions duty,

generous principal place o f residence stamp duty concessions and generally lower tax rates across

the board.

Queensland was only able to have low tax policy settings and achieve balanced budgets by virtue o f

lower than average levels o f service provision and public sector wages.

Over the last ten to fifteen years, the Government has moved to increase service provision and

wages o f service delivery staff towards national levels. Queensland’s overall expenditure effort

now approximates 100% - 105%. At the same time, and despite revenue policy measures over

recent years, Queensland’s overall tax effort remains well below 100%.

Unfortunately, the volatility o f the data series along with periodic substantial changes in the

m ethodology makes it difficult to chart a trend over a long time period (refer Chart 2.2).

Nonetheless, the CGC data provides another framework through which to view the issue o f

Q ueensland’s large budget deficit and relative budget position amongst States.

C hart 2.2 C om parison o f Effort R atios

Total Tax and Total E xpenditure

110

1 0 5

100•Total Tax

Effort

Total9 5 . _ Expense

Effort

9 0

8 5

8 0

2 0 0 7 - 0 8 2 0 0 8 - 0 9 2 0 0 9 - 1 0 2 0 1 0 - 1 1

Understanding the process is particularly im portant in the context o f current discussions about how

states such as Queensland and W estern Australia should use their mining royalties.

C-2-3

Although the bulk o f mineral production in Australia is generated in Queensland and Western

Australia, the net impact o f the HFE process is that royalty revenue is redistributed between all o f

the states and territories through their GST distribution. Higher royalty revenue in Queensland and

W estern Australia simply means less GST revenue for Queensland and W estern Australia.

Therefore, mining royalties do not provide states such as Queensland or W estern Australia with the

capacity to provide additional services or infrastructure or reduce taxes relative to other states.

Non m ining states such as Victoria and Tasm ania benefit as much in fiscal terms from mining as

Queensland and Western Australia.

C-2-4

C.3. EMPLOYEE EXPENSES AND WAGES POLICY___________________

GROWTH IN EMPLOYEE EXPENSES

Employee expenses have increased by around 8.7% per annum over the period 2000-01 to 2010-11.

This has been a major factor in the structural deterioration o f the Queensland Budget and compares

to an average rate o f growth in employee expenses o f 7.1% per annum on average in other

jurisdictions.

Employee expenses growth over that period can be broken down into wages growth o f around 5.1%

per annum and growth in employee numbers o f around 3.4% per annum.

In the period 2005-06 to 2007-08 (at the time o f the Health Action Plan) employee expenses

increased by 40%.

Wages Growth

Australian Bureau o f Statistics (ABS) data confirms that the Queensland public sector has become a

relatively high wage jurisdiction over the last decade. In 2010-11, Average W eekly Earnings

(AW E) in the Queensland public sector was $1,184 per week, around 1% (or $10 per week) more

than the Australian average for the public sector. This is the second highest o f the states after

New South Wales.

This is a significant tumaround from 2000-01 when AW E for the Queensland public sector was

$740, around 5.6% (or $44 per week) less than the comparable Australian average. In 2000-01,

Queensland was ranked fourth highest o f the states.

Since 2000-01, wages in the Queensland public sector have increased by $54 per week more (or

$2,800 more in annual terms) than the Australian average. In real terms, Queensland public sector

AW E has increased by 16.7% since 2000-01, compared to 12.7% nationally.

C-3-1

Sector

Table 3.1 AW E 2000-01 to 2010-11

A verage W eekly E arn ingsNominal Real ($2010-11)

Aust

NSW

Vic

Qld

SA

WA

Tas

10-11 00-01 A 10-11 00-01 APrivate 957 618 339 957 821 136Public 1,174 784 390 1,174 1,042 132Private 964 668 296 964 877 87Public 1,193 838 355 1,193 1,100 93Private 932 602 330 932 792 140Public 1,102 755 347 1,102 992 110Private 965 596 369 965 816 149Public 1,184 740 4 4 4 1,184 1,014 170Private 844 573 271 844 767 77Public 1,109 765 344 1,109 1,026 83Private 1,083 587 496 1,083 796 287Public 1,161 726 434 1,161 984 176Private 768 497 271 768 656 113Public 1,059 728 331 1,059 960 99

However, it must be noted that this result is also impacted by the changing relative composition of

public sector labour force (for example Queensland employing relatively more highly paid doctors

has increased its average compared to other jurisdictions).

To neutralise these effects, the W age Price Index measures changes in the price o f labour over time

holding the quality and quantity o f labour purchased by employers constant.

C hart 3.1 W age P rice Index, Q u een slan d

(annual % change, original)

•Total Public • Pri'.Qte

6

5

4

3

2 ------S ep -9 9 SepkO? S ep -0 9 Sep-11S e p -01 S e p -0 3 S e p -0 5

S o u rce ; A B S 63 4 5 .0

C-3-2

The W age Price Index for the Queensland public sector rose by 50.8% over the decade to 2010-11 -

faster than the Australian average for the public sector o f 49.2%, but much closer than the AWE

measures. In this regard, w hile it remains true that wages in the Queensland public sector have

increased more than the Australian average, it is likely that compositional changes explain the

m ajority o f that above Australian average growth.

Table 3.2 supports this aggregate assessment with information on wages outcomes for a number o f

occupations. Queensland public sector wage increases in the last decade have significantly

outstripped CPI, with the highest growth being for doctors and nurses.

Employee Group Period Average Inc % CPI %T e a c h e r s 1 9 9 9 to 2 0 1 0 5 5 .9 4 4 .0N u rse s 2 0 0 0 to 2011 6 5 .0 - 7 8 .8 4 5 .6S e n io r D o c to r (excl a l lo w a n c e s ) 2 0 0 0 to 2011 5 1 .6 - 5 5 .6 4 5 .6S e n io r D o c to r (incl. a l lo w a n c e s ) 2 0 0 0 to 2011 7 4 .5 - 9 1 .3 4 5 .6P o lic e (excl re c e n t Q IR C d e c is io n ) 2 0 0 0 to 2 0 1 0 4 7 .0 - 6 4 .1 4 0 .3A 0 6 2001 to 2011 4 6 .5 - 5 6 .7 3 7 .4

The high range o f outcomes also shows the significant benefit o f progression through increments

and the influence o f allowances. The headline numbers cited in agreements often dramatically

understate the size o f the increases achieved.

Growth in Public Service Numbers

The size o f the Queensland public sector has increased on a full time equivalent (FTEs) basis from

146,323 in June 2000 (4.1% o f the Queensland population) to 200,022 in June 2010 (4.4% o f the

Queensland population), and 206,802 in June 2011 (4.5% o f the population).

To put that into context, i f the size o f the public service had remained at the same percentage o f the

population as in 2000, in 2010-11 employee numbers would have been 188,195 (ie 18,600 FTEs

lower) and expenses would be around SW i billion lower (all other things being equal).

As a proportion o f population, the Queensland public sector (4.4%) is slightly smaller than Western

Australia (4.5%), but much higher than New South W ales (3.9%) and Victoria (3.8%). There is an

argument that on the basis o f geographic dispersion states like W estern Australia and Queensland

would as a matter o f course have a higher proportion.

C-3-3

The Queensland public sector employment increased by 60,480 over the period June 2000 to June

2011. Almost half o f this increase is in Health (up 28,633), with the next largest contributor

Education (up 13,889). O ther than Health, the increase in all other agencies relative to 2000 is

broadly in line with population growth. The Voluntary Separation Program (VSP) which has

reduced public sector numbers post June 2011 would have impacted on all o f these categories, but

prim arily will reduce the “rest o f the public service” category. This should start to become

apparent when the December quarter 2011 actual data becom es available.

Agency Jun>00 % of pop Jun-11 % of pop Change Contribution%

C o rre c tio n s a n d E m e rg e n c y 8 ,431 0 .2 4 1 0 ,8 2 2 0 .2 3 2 ,3 9 2 4P o lic e 1 0 ,3 3 7 0 .2 9 1 4 ,4 9 7 0.31 4 ,1 6 0 7H ea lth 3 9 ,3 8 4 1.11 6 8 ,0 1 7 1 .42 2 8 ,6 3 3 4 7D E T 5 2 ,8 2 8 1 .48 6 6 ,7 1 6 1 .46 1 3 ,8 8 9 23R e s t o f pu b lic s e rv ic e 3 5 ,3 4 4 0 .9 9 46 ,7 5 1 1.01 1 1 ,4 0 7 19Total 146,323 4.11 206,802 4.44 60,480 100

Source: Public S e rv ice C om m ission \

Level Jun-00 Jun-11 ChangeContribution

%

A 0 1 E q u iv a le n t 2 ,6 0 5 769 (1 ,8 3 6 ) (3)A 0 2 E q u iv a le n t 3 8 ,1 2 4 3 8 ,3 6 9 2 4 4 0A 0 3 E q u iv a le n t 2 4 ,9 3 3 37 ,0 6 1 1 2 ,1 2 8 20A 0 4 E q u iv a le n t 2 3 ,8 0 9 2 8 ,5 5 0 4 ,741 8A O S E q u iv a le n t 1 9 ,4 8 5 2 9 ,4 1 0 9 ,9 2 5 16A O S E q u iv a le n t 2 4 ,7 4 0 3 8 ,1 1 8 1 3 ,3 7 8 22A 0 7 E q u iv a le n t 6 ,5 1 8 1 4 ,4 7 5 7 ,9 5 7 13A O S E q u iv a le n t 1 ,9 0 0 1 0 ,7 7 5 8 ,8 7 4 15S O E q u iv a le n t S E S a n d a b o v e

2 ,2 5 7 5 ,0 3 4 2 ,7 7 6 5

E q u iv a le n t 1 ,951 4 ,2 4 3 2 ,2 9 2 4Total 146,323 206,802 60,480 100Source: Public S erv ice C om m ission

Over the period 2000 to 2010 employment numbers increased in all AO levels, other than a fall in

the number o f A O ls. The proportion o f public servants who are A 0 5 and below fell by 10%,

whereas the proportion who are A 0 6 and above rose by 10%.

The agency where this increase in higher classifications was most pronounced was Health,

reflecting in part the employment o f more senior medical professionals (for example, while SES

numbers in the public service increased by 2,292 over the decade, 1,672 o f this increase was in

Health - Senior Medical Officers (doctors) are generally classified as SES).

C-3-4

Conclusion

W ages in the Queensland public sector have grown at a faster rate than the Australian public sector

average, but this is likely to reflect in part an increase in the compositional weighting towards more

highly paid staff - an in particular health professionals.

Public sector numbers have also grown at a much higher rate than population, but the overwhelming

m ajority o f the growth has been in Health, Education and Police.

These outcomes are not unanticipated. W hile Queensland historically paid public sector employees

much less than their interstate counterparts, for well over a decade now the presumption has been

that salaries for key public sector occupations should match the national average.

Similarly, while it is difficult to be definitive using aggregate data, the growth in public sector

numbers would seem to be broadly consistent with major policy/expenditure pushes by Government

- generally in response to public concern about “under-provision”. That is, and while there are

exceptions, the bulk o f the growth relates to deliberate policy decisions o f Government. W ith the

exception o f Health, there is not a general problem around FTE management.

It is also clear from the above that no serious attempt to control employee expenses growth can

exclude Health because as this paper has shown health is the m ain reason why employee expenses

growth has been so high.

C-3-5

WAGES POLICY

Employee expenses are forecast to increase by only around 5.0% per annum over the period

2010-11 to 2014-15. This would be around 60% o f the actual growth rate over the past decade, and

is broadly in line with the 2.5% per annum wages policy and FTE growth in line with population

growth.

The 2011-12 Budget forward estimates were prepared on the basis that when existing agreements

expire, wages will increase by 2.5% per annum in line with the Government’s wages policy, and

that only those increases will be fully supplemented.

Most other jurisdictions currently have a 2.5% wages policy. Implementation everywhere has

proved problematic.

A u s tra lia n C a p ita l T errito ry

N e w S o u th W a le s

N o rth e rn T errito ry

S o u th A u s tra lia

T a s m a n ia

V ictoria

W e s te rn A u s tra lia

Table 3.5W ages Policy by Australian Jurisdiction

S o m e a g r e e m e n ts h a v e b e e n c o n c lu d e d b a s e d o n 2 .5 % w a g e in c r e a s e . H o w ev er, th is is o ften in p a ra lle l w ith e n h a n c e d e m p lo y e e e n t i t le m e n ts (e .g . le a v e ) . O th e r a g r e e m e n ts h a v e b e e n fo r h ig h e r o u tc o m e s (3 -4% ).

T h e N S W Industrial R ela tions A m e n d m e n t (Public S e c to r C onditions o f E m ploym ent) A c t 2011 ( a s s e n te d in J u n e 2 0 1 1 ) lim its pu b lic s e c to r w a g e in c r e a s e s to 2 .5 % a lth o u g h in c r e a s e s a b o v e th is level w ould b e a c c e p ta b le w h e re fu n d e d from e m p lo y e e re la te d c o s t sa v in g s . T h e A ct d o e s th is by requ iring th e N S W In d u stria l R e la tio n s C o m m is s io n to g iv e e f fe c t to th e G o v e rn m e n t 's policy o n c o n d itio n s o f e m p lo y m e n t fo r th e pub lic s e c to r a s d e c la r e d u n d e r re g u la tio n s .

2 .5 % - in c r e a s e s a b o v e th is limit a r e to b e o f fs e t by e ffic ien cy m e a s u re s

2 .5 % . H o w ev er, s o m e r e c e n t a g r e e m e n ts h a v e b e e n fo r m o re th a n th is.

N o p e r c e n ta g e in c r e a s e s e t . W a g e in c r e a s e s a r e to b e “a ffo rd a b le a n d s u s ta in a b le w ithin a g e n c y b u d g e ts a n d fo rw ard e s t im a te s . R e c e n t m e d ia re p o r ts o f 2 .5 % o u tc o m e s b e in g a c h ie v e d .2 .5 % g u id e lin e r a te . I n c r e a s e s a b o v e th is m u s t b e fu n d e d by rea l b a n k a b le p roductiv ity c o s t o f fs e ts . R e c e n t m e d ia r e p o r ts in d ic a te in c r e a s e s o f m u ch h ig h e r th a n 2 .5 % h a s b e e n n e g o tia te d (e g . n u rs e s ) .

W a g e in c r e a s e s e q u a l to p ro je c te d P e r th C P I. I n c re a s e m ay b e h ig h e r If fu n d e d th ro u g h e ff ic ie n c ie s b u t Is c a p p e d a t g ro w th in W A W P I.

Clearly, Queensland’s budgetary circumstances require that wages policy needs to be considered in

the context o f affordability. Indicative estimates o f the deterioration in the operating deficit from

deviations from a 2.5% outcome are shown in Table 3.6.

C-3-6

Tab le 3.6Increase in Budget Deficit Relative to Existing 2 .5% W ages Policy

2011-12

$ million2012-13 $ million

2013-14

$ million2014-15 $ million

2015-16 $ million

W a g e O u tc o m e - C PI F o r e c a s f 3 .3 0 % 2 .5 0 % 3 .0 0 % 2 ,7 5 % 2 .7 5 %

I n c re a s e in D eficit 12 64 130 2 1 5 2 8 0

W a g e O u tc o m e 3% 3% 3% 3% 3%

I n c re a s e in D eficit 8 95 2 0 5 3 2 5 4 5 0

W a g e O u tc o m e 3 .2 5 % 3 .2 5 % 3 .2 5 % 3 .2 5 % 3 .2 5 %I n c re a s e in D eficit 11 140 3 0 5 4 9 0 6 7 5

W a g e O u tc o m e - P o lic e Q IRC^ 3 .8 0 % 3 .8 0 % 3 .5 0 % 3 .5 0 % 3 .5 0 %

I n c re a s e in D eficit 2 0 2 4 5 5 2 5 7 8 0 1 ,0 3 5Notes:1. 2 0 13-14 C P I fo recast o f 3% (M Y FE R 2- W age in c reases a re app lied to tranches

es tim a te o f ac tual ou tcom e fo r 2012-13), exc ludes th e im pact o f th e ca rbon price, o f ag reem en ts, ra ther than financial years.

Current Policy - 2.5%

The current policy is 2.5% per annum with ultimate reference to the Queensland Industrial

Relations Commission (QIRC) to resolve disputes through arbitration.

The unions will not agree to a 2.5% per annum outcome and the QIRC is unlikely to deliver it in

arbitration.

In last year’s Police enterprise bargaining (EB) determination, the QIRC stated that it would

consider each case on its merits but that “the principal object o f this Act is to provide a framework

for industrial relations that supports economic prosperity and social justice” .

The QIRC also refers to the prim ary effect o f the determination being the maintenance o f real

wages and reiterated its view that it does not support a one size fits all wages policy and that it

would expect the type o f industry to be considered when developing the wages policy.

Police received increases o f 3.8%, 3.8% and 3.5%. It therefore seems inevitable that wages

outcomes will be much higher than the 2.5% if determined by arbitration.

Replication o f the Police outcome across the rest o f Government would add nearly $800 million to

the deficit in 2014-15 and push the return to surplus out indefinitely.

A number o f agreements were negotiated towards the end o f 2011. These included: Health

Practitioners; Non-Clinical Hospital W orkers; Education Cleaners; and Teachers Aides.

C-3-7

Two models were generally followed in reaching these agreements:

1. wage increases o f 2.5% per annum, plus 0.5% per armum for productivity, plus a $500 increase

in the base to take effect at the end o f the agreement, or

2. 3% or $30 per week, whichever is the greater.

The effective outcome o f these agreements was average increases in the order o f 3.25% per annum.

Treasury included the full cost o f these agreements in the 2011-12 MYFER.

Model 1. in theory maintains the 2.5% wages policy as the net fisca l outcome, on the basis that the

increase over and above 2.5% is funded through productivity savings.

In practice though in many areas across Government it will be difficult to identify and realise

cashable savings without reducing FTEs. The productivity measures agreed to have generally been

“soft” .

Treasury has always acknowledged that there are areas in which it is difficult to achieve significant

cashable productivity gains — teachers aides is often cited as an example. Perhaps the bigger

productivity issue in the public sector is the host o f clauses in EB Agreements that restrict

management prerogative in areas such as resourcing, procurement and organisational structure to

name a few. A priority should be restoring the ability o f management to manage.

Given the current position taken by the unions and the QIRC, the 2.5% cannot be given effect

without legislative amendment. Unless the 2.5% can be supported by legislation, a new policy

needs to be formulated. This is a pressing issue with m ajor employee groups such as Teachers,

Nurses, Doctors (senior medical officers) and the Core Public Service up for negotiation this year.

Maintenance of Real Wages - The CPI Option

Under this proposal, employees would receive half yearly increases based on Brisbane headline CPI

outcomes. - i.e. real time adjustment for employees to cost o f living pressures.

On the basis o f Queensland Treasury’s 2011-12 MYFER inflation forecasts, this would involve a

wage increase o f 3.3% in 2011-12; 2.5% in 2012-13; 3.0% in 2013-14; and 2.75% in 2014-15 (note

these increases reflect the previous year’s forecast - making adjustments in arrears for actuals).

This would increase the deficit by around $12 million in 2011-12 rising to $215 million in 2014-15.

C-3-8

The theoretical argument against the CPI option is that it removes the ability o f real wages to fall in

response to adverse external events. Real wage flexibility is important to maintain employment if

economic conditions deteriorate. Pragmatically though, the existing negotiating framework/system

has only ever produced real wage increases - at least a CPI outcome allows for some slowdown in

wages growth if the economy is weak and inflation moderates accordingly.

A further argument against the CPI outcome is that it exposes the Budget to risk if the Reserve

Bank is unable to maintain inflation within the mid point o f the 2% to 3% target range. For

example, inflation increased by 5.1% in 2007-08.

Therefore, to ensure it is economically responsible for both employees and employers, a CPI policy

should have an upper and a lower tolerance limit. A tolerance limit o f 1 percentage point would

seem reasonable — on an annual basis this would be 1.5% to 3.5%.

The policy would also need to be able to adjust out "compensable policy changes", where

Government has used the tax and transfer system to compensate people for a policy induced

inflationary impact. The forthcoming carbon tax (and previously the introduction o f the GST)

would represent a compensable policy change, the price effects o f which would need to be adjusted

out. The Government Statistician could calculate and declare the adjustment.

From a wages policy perspective, parties usually regard m aintaining real wages as the base outcome

and productivity measures to be additional. The key to this proposal is recognition that many o f

the workplace initiatives that need to be pursued in Government should rightly be regarded as

normal management discretion and have no place in EB agreements.

In return though, the Government could, after a period, agree to open a productivity window, in

which there is a focussed discussion based around sharing the gains from genuine productivity

initiatives (eg. award simplification) - a discussion not clouded by the noise o f the base offer.

Although a CPI linked policy would have more support from employees than the current wages

policy, it would still likely need to be supported by legislation to have real effect.

Table 3.7W age growth fo r various public sector em ployees

W a g e a t Ju ly 2001

W a g e a t A u g u s t 2011

% C h a n g e 10 y e a r s

C PI (t-1) % C h a n g e 10 y e a r s

A d m in istra tiv e O ffice rl $ 1 ,8 6 9 .5 0 $ 2 ,7 3 8 .1 0 4 6 .5 $ 2 ,5 2 3 .8 9 3 5 .0

P o lic e S e rg e a n t $ 2 ,0 1 1 ,5 8 $ 3 ,2 2 8 .7 5 6 0 .5 $ 2 ,7 1 5 .7 0 3 5 .0

C la s s ro o m T e a c h e r $ 2 ,0 1 8 .8 0 $ 2 ,9 8 2 .3 0 4 7 .7 $ 2 ,7 2 5 .4 5 3 5 .0

R e g is te re d N u rse $ 1 ,7 0 1 .8 1 $ 2 ,8 0 3 .6 9 6 4 .7 $ 2 ,2 9 7 .5 0 3 5 .0

C-3-9

EMPLOYEE EXPENSES AND THE SAVINGS TASK

The 2.5% wages policy for agreements going forward is required to maintain the existing forward

estimates position. As outlined in Part A, the problem at hand is a Budget with large underlying

deficits and which is dominated by employee expenses. Unfortunately, it is hard to avoid the

conclusion that the task o f fiscal repair requires further employee expenses savings.

The 2011-12 M YFER outlined that additional savings o f $ 150 million per annum ongoing would be

sought under an extension o f the Voluntary Separation Program.

There are a num ber o f possible options that could be considered to control the wages bill, some of

which are controversial and will be opposed by public sector unions with potential for significant

industrial disputes.

The Abolition of Leave Loading or an Increment Freeze

All public service employees receive 17.5% leave loading at a cost o f around $190 m illion per

annum.

This would be rightly criticised by employees as a reduction in working conditions, and tourism

groups will also be critical suggesting this will harm the tourism sector.

Automatic increment increases are very common amongst most o f the public service that are

employed below director level - including administrative, professional, technical and operational

schemes. The theory is that employees over time become m ore knowledgeable and capable and that

this should be recognised in wages.

Although arrangements vary, a single increment is generally worth at least a 2% increase in wages.

Excluding teachers and nurses, around 25,000 public servants are expected to receive an automatic

increment increase in 2011-12 and the average increment appears to be around $2,000 per annum.

A freeze on increments for two years (with no catch-up) would deliver savings o f around

$40 million in the first year and $70 million ongoing in the second year. If this was extended to

teachers and nurses the savings would be significantly more.

This measure m ay be seen as inequitable, as it is impacting on a particular cohort o f workers (for

example those already on the top increment would not be effected).C-3-10

Regardless o f whether the original policy rationale for leave loading or automatic increments is still

valid, in substance their abolition is simply another w ay o f reducing real wages. Given the degree

o f difficulty associated with this, a more achievable goal in terms o f wages policy would be the

CPI/maintenance o f real wages approach.

Options for Reducing Employee Numbers

A policy o f no forced redundancies has been in place for many years. This has led to periodic

“voluntary retirem ent” programs to achieve savings. These programs, which operated with ATO

approval in term s o f being eligible for tax concessions, gave the employer very little discretion as to

which employees would exit. As a result, the public sector in many cases lost some o f its most

capable employees, while retaining some o f the least productive.

The Voluntary Separation Program was a response to this concern as it provided employer

discretion, albeit from a pool o f staff who expressed interest.

Because o f its voluntary nature, it has not allowed agencies to remove people who m ay be

detracting from agency performance or are difficult to place.

Redundancies, whether under existing standard public service guidelines or the more generous VSP,

result in significant up front expense.

Natural attrition (in conjunction with some type o f recruitment freeze) is in a short term financial

sense the m ost cost effective way to reduce employee numbers. The challenge with the natural

attrition model is that it does not discriminate. Providing the employer with some discretion over

who leaves will lead to smaller reductions in agency capacity for a given reduction in staff numbers.

W hether using a broad voluntary redundancy program or natural attrition, the problem with these

approaches is similar to that o f the “efficiency dividend” . That is, they are not a substitute for

making policy choices about the role o f Government.

The downturn in the revenue outlook for states is such that a fundamental review o f the scope and

scale o f Government is required. The objective o f such a review should be to identify areas that

Government should scale down or vacate and redundancies offered accordingly (this o f course

would not preclude exploring options for redeployment first). Government needs to be cautious

about blanket exemptions for “the frontline” in this context.

C-3-11

One option w ould be a combination o f the approaches, for example: that is 1. re-open the existing

Voluntary Separation Program for a short period o f time; while 2. commencing the process o f the

detailed review o f the operations o f Government, the conclusions from which would then be used to

support further m ore targeted savings.

C-3-12

C.4. AGENCY EXPENDITURE MANAGEMENT_______________________

EXPENDITURE LEVELS

Historically Queensland was categorised as a low taxing, low spending jurisdiction. However, over

the last two decades and particularly the last 10 years, expenditure growth in Queensland has

generally outpaced that in other jurisdictions as Queensland Governments have sought to address

comparative differences in service levels and standards. Examples o f these initiatives include:

• introducing a Prep Year into schooling

• moving to the national police to population ratio

• improving child safety services

• im proving hospital bed numbers

• increasing effort in disability services

• substantially increasing wages for doctors, nurses and clinical staff

• increasing public transport infrastructure and services.

As a result, expenditure levels across a range o f service areas are now consistent with other

comparable jurisdictions such as New South W ales, Victoria and W estem Australia.

Table 4.1 sets out comparative expenditure data for service areas covered by the Report on

Government Services (ROGS) or Commonwealth Grants Commission data. In terms o f

expenditure effort relative to other jurisdictions, the key service area where Queensland spending is

well below the national average is disability services. However, there are a number o f areas where

Queensland spending is significantly above the national average, including child protection,

services to industry and the ambulance service and transport.

C-4-1

Year NSW$

VIC$

QLD$

W A$

SA$

Aust.avg

$

Children's services (Includes day care and preschool services)

P e r ch ild a g e d 0 -1 2 y e a r s 2010-11 190 2 6 6 2 0 4 5 5 6 49 9 291

Child Protection & Support Services 2010-11 168 100 153 121 107 139

School education (per FTE student)

G o v e rn m e n t s c h o o ls 2009-10 1 4 ,1 2 3 13 ,001 1 4 ,1 4 8 1 7 ,8 5 4 1 3 ,9 0 9 14,380

N o n -g o v e rn m e n t s c h o o ls 2009-10 2 ,1 5 6 1 ,5 3 6 2 ,1 8 8 2 ,4 8 5 1 ,5 7 0 1,990

VET - per person, 15-64 years 2010-11 3 1 4 322 3 0 3 361 301 325

Police services 2010-11 3 9 3 3 4 7 3 8 5 4 7 2 380 395

Court administration

C rim inal 2010-11 27 32 3 0 4 4 35 32

Civil 2010-11 15 19 10 33 13 28

Corrective services 2010-11 134 94 116 2 1 7 115 130

Emergency management

F ire s e rv ic e s 2010-11 125 193 107 140 111 141

A m b u la n c e s e rv ic e s 2010-11 95 103 119 60 N/A 92

Health management issues

M ental H ea lth 2009-10 168 165 171 2 0 5 192 175

H ea lth T o ta l G P S 2 0 0 9 -1 0 1 ,9 7 3 2 ,0 8 3 2 ,2 7 9 2 ,1 9 5 2 ,6 6 0 2,165

Disability Services 2010-11 2 4 6 2 6 0 199 2 3 3 2 3 5 238

Housing (social housing) 2010-11 2 8 6 163 1 4 4 2 4 7 2 0 3 225

Homelessness Services 2010-11 18 2 0 19 26 31 21

C-4-2

AGENCY BUDGET MANAGEMENT

Budget Controls

Traditionally, Queensland Government agencies have had a good track record o f living within their

budgets.

The main exception over recent years has been Queensland Health (Health). Despite receiving

average annual budget increases o f 13.7% since the announcement o f the Health Action Plan in

2005, Health has regularly required both significant MYFER and end o f year budget

supplementation.

In part, this reflects the seemingly endless demand for health services, the above CPI increases in

wages and the cost o f medical technology and supplies etc. However, it also reflects a break down

in budget discipline within Health due to (a) the absence o f internal management controls,

particularly in terms o f staff numbers; and (b) the inability o f the controls that are in place to

genuinely influence the spending behaviours o f the Health districts.

Treasury considers that the management o f Health has made significant efforts over the past twelve

months to address the situation, but that the ability o f Health to ensure the new Local Health and

Hospitals Networks (LHHNs) live within their budget depends crucially on the support it receives

from Government.

Ultimately the issue in managing the Health budget is to develop a culture within the service

delivery arm, and particularly with clinicians, that resources will always be constrained relative to

community expectations and that resources are being used as efficiently and productively as

possible.

In this context a key thrust o f national health reforms is the funding o f services on an efficient cost

basis. It will be critical that LHHN governing councils can drive this cultural change. W hile in

terms o f the public debate it is easy to carry the argument that “patient care is more important than

money”, Health spending has effectively crowded out other important priorities such as Education

and Disability Services. In addition, i f it continues, the weight o f numbers behind Health’s

MYFER and end o f year supplementation requirements will act as a significant drag on the

Government’s Budget repair efforts.

C-4-3

AGENCY FUNDING PARAMETERS

Traditionally, agency funding formulae had three m ajor components:

Escalation for Wage Costs: Supplementation o f employee related expenses, based on negotiated

wage outcomes, less an amount representing that component o f the outcome to be funded through

increased labour productivity.

Agencies generally only receive supplementation for the State’s share o f employee expenses, on the

assumption that increased wage costs for those employees funded through Commonwealth

programs or user charges will be funded through those sources (i.e. the “non-State” share).

Non-Labour Escalation: Supplementation o f non-labour components - loosely described as

operating expenses, based on movements in the Brisbane Consumer Price Index, less an amount

representing general efficiencies in procurement and operations - i.e. the CPI-X approach.

Growth Funding: A number o f agencies also receive some form o f growth funding to reflect the

service demand pressures on key government service areas. For exam ple:

• Queensland Health - based on the costs o f additional hospital bed/service capacity being

delivered through the More Beds for Hospitals capital program.

• Education and Training - based on enrolment increases and new school infrastructure. In the

area o f vocational education, the forward estimates currently provide a fixed annual growth

funding provision o f $8 million per annum.

• Queensland Police Service (QPS) - to provide for consistency in policing effort, the QPS

receives a growth funding provision linked to the population growth rate.

• Department o f Transport and M ain Roads - is appropriated revenue equivalent to total motor

vehicle registration fee collections (the M VR fee increase o f 20% in July 2009 is excluded from

this calculation).

C-4-4

2011-12

$ million2012-13

$ million2013-14

$ million2014-15

$ million

H ea lth (M o re B e d s ) 2 1 9 .4 3 8 3 .6 2 22 .1 3 7 4 ,5

E d u c a tio n ( P a ra m e te r s M odel) 4 4 .4 5 1 .4 6 9 .9 8 2 .8

P o lice 2 4 ,5 2 7 .7 2 8 .0 2 7 .8

C o m m u n itie s 3 4 .5 3 7 .9 42 4 3

C o m m u n ity S a fe ty

A m b u la n c e 1 6 .7 17.1 17 .8 1 8 .4

F ire 18 .0 1 7 .7 2 3 .6 2 1 .5

T ra n s p o r t a n d M ain R o a d s (M VR) 43 .5 4 5 .3 47.1 4 8 .9

Note:DET num ber d o e s not include revision to P aram eters Model funding or B asket Nexus paym ents to non-state secto r (currently held in a contingency awaiting allocation).

Agencies have continued to receive supplementation for negotiated wage outcomes, albeit that

some find it difficult to fund the “non-State” element o f wage outcomes - particularly with

Commonwealth program escalation in the past being largely limited to CPI.

In 2004, non-labour escalation was removed. This decision was taken to help fund a significant

increase in resourcing for the then Department o f Child Safety in response to the recommendations

o f the Forster Review. It is has not been reintroduced.

There are some exceptions:

• the Queensland Police Service has continued to receive non-labour escalation

• a non-labour escalation factor for school-based operating costs and correctional services

operating costs was approved for implementation at the 2011-12 M YFER, with the first full

year o f implementation 2012-13.

A Government policy decision some years ago endorsed a uniform CPI indexation methodology to

non-Govemment organisations in the community and health services sectors. Agencies are funded

for those indexation costs.

However, given the absence o f non-labour escalation, agencies generally have taken a cumulative

budget cut in real terms equivalent to 20% o f non-labour costs.

C-4-5

The m ajor outstanding measure from previous savings rounds is the achievement o f the

$500 million per annum efficiency savings by 2014-15. This can probably be achieved, but not

increased.

Beyond a point, “across-the-board” efficiency savings produce perverse outcomes that are

disconnected with the priorities o f the public and are not a substitute for genuine public policy

choices.

Further, with Health, Education and Com m unity Safety experiencing budget pressure and requiring

regular supplementation, it is not credible to increase the efficiency targets o f those agencies.

Agencies regularly come to the budget process with a list o f “funding issues” and “cost pressures”

which in part reflect the absence o f adequate cost escalation. In this respect, it is likely that

Government already funds some o f these pressures through the budget process, but in an ad-hoc

manner.

The re-introduction o f non-labour escalation has been roughly costed at $200 million per annum

cumulative. This is unaffordable in the current context.

The best outcome would be for Government to consider the partial and progressive reintroduction

o f non-labour escalation as circumstances allow.

C-4-6

CRITICAL BUDGET ENABLERS

The current fiscal position and subdued revenue outlook mean it is not going to be possible to

improve service delivery or deal with these pressures by providing additional Budget funding to

agencies. Achieving repair o f the overall fiscal position depends critically on agencies managing

within their current budgets and a rigorous process o f review and evaluation o f existing programs

and services to achieve improved value for money outcomes for the community.

For m ost agencies, the issue is not so much whether they have adequate management controls in

place. It is that they need to be provided with the suite o f tools and flexibility to allow them to

manage their budgets - and in return, be accountable for them and to pursue opportunities to deliver

more efficient and effective programs and services.

However, this is not simply a Budget issue. There is currently significant debate about the need for

Governments to make policy changes in a range o f areas to boost economic productivity. The State

Government accounts for around 15-20% o f activity in the Queensland economy, and it is

inconsistent to advocate for economic productivity generally while not addressing the issues

undermining productivity in the public sector itself.

Program/Service Evaluation

There is no current systematic approach to program/service evaluation in order to identify

opportunities for improving efficiency and effectiveness or to redirect resources to

programs/services that produce better value for many outcomes for the community.

W hile the Budget Service Delivery Statements include measures and targets around quantity,

quality, timeliness and cost, the usefulness o f these measures in effecting change is limited.

The challenges inherent in creating an effective program/service review process are:

• a Government willingness to deal with transparency and criticism arising from robust evaluation

• a commitment to act on review findings and avoid program reviews simply becoming a

compliance process

• to create a review mechanism that has w ide acceptance from stakeholders in terms o f quality,

expertise and independence.

C-4-7

The scale and breadth o f Government programs and services is such that a targeted and prioritised

approach to program/service evaluation is required and which has the potential to deliver significant

improvements in efficiency and effectiveness.

In this context it is suggested that an evaluation and review process be developed involving:

• an initial scan o f program/services to identify initial priorities for review/evaluation over the

first two years o f Government

• an independent review mechanism be developed that can create multidisciplinary review teams

with a mix o f subject content expertise and evaluative/analytical skills oversighted by an

independent review board

• the review reports being considered by Govemm ent and publicly released with proposed actions

by Govemment.

The Productivity Commission model is one such approach that could be considered.

Managing the Infrastructure Footprint

Govemm ent is under intense pressure to build more infrastructure. No other state govemment in

recent history has made more o f an expenditure effort in this regard than the Queensland

Govemment.

This capital expenditure effort is reflected in Queensland’s high per capita capital spending over

recent years relative to the other states. Also, the value o f the General Govemment capital stock

(i.e. property, plant, equipment and land) is high in relative per capita terms.

Tab le 4.3G eneral G overnm ent Capital Stock Per Capita

2010-11W e s te rn A u s tra liaV ictoriaQ u e e n s la n d N e w S o u th W a le s

31,68016,81817,56237,625

Infrastructure provision should not be an end in itself - rather it is a means to a service delivery or

economic end. The desire for more infrastructure is insatiable, particularly if not viewed in the

context o f the opportunity cost.

C-4-8

The recurrent costs o f infrastructure taking into account borrowing costs, maintenance and

depreciation are in the order o f 10-15%. The major generational effort the Govemment has made

has had a significant impact on the recurrent budget but also at the agency level. The capital

intensive agencies are stmggling under the weight o f their infrastructure footprints on their

recurrent budgets and need more flexibility to divest and reinvest to maintain standards.

Going forward, processes need to be established to put capital expenditure under more rigorous

review focussing on the m ost efficient way o f achieving the outcome sought, rather than

“the project” . In many cases, small tactical capital interventions may produce better economic and

service delivery outcomes than a m ajor project.

There also needs to be greater focus on maintaining existing assets to achieve optimal asset life

rather than continual replacement with new assets.

Procurement Flexibility

Outsourcing by the public sector has been implemented across a range o f services in Australia and

intemationally, with varying results. There are times when governments should fund services, but

need not, and perhaps should not, actually provide them. Some services could be better provided

competitively, and govemments could serve public interest better through regulation without

ownership or a direct service provision role.

There are a number o f benefits commonly associated with outsourcing, and the ability to achieve

these benefits will depend on the nature o f the service to be outsourced and the factors associated

with implementation. The objectives for outsourcing include:

• cost savings

• introducing external upfront investment

• accessing specialist expertise, knowledge or technology

• improving service delivery standards

• increasing flexibility in service

• reducing headcount/fewer industrial relations issues

• increasing accountability in service provision.

C-4-9

The disadvantages o f contracting out can include the potential for:

• reducing accountability and/or loss o f control by Govemment for contracted services

• loss o f privacy and confidentiality o f personal information

• collusive tendering and other tendering problems

• reducing quality o f services;

• transaction costs o f outsourcing

• savings to govemment resulting from losses to other groups, rather than from increases in

efficiency

• increasing costs to government if service is “over-scoped’

• the effects on levels o f employment and on the wages and conditions o f employees o f

contractors.

Savings are m ost likely from outsourcing where the required service can be easily specified and

monitored, and where a competitive market o f potential suppliers exists. Other significant factors in

the success o f outsourcing include Govemm ent having appropriate negotiation and contract

management skills. Empirical studies o f outsourcing have indicated savings o f between 3% and

20%. In many cases, Govemm ent providers have been permitted to submit tenders, and savings

have been achieved regardless o f whether the private or public sector wins the contract.

In terms o f the suitability o f outsourcing in Queensland, it would seem that environmental factors

would not impede the implementation o f outsourcing as Queensland’s strong economy and number

o f potential suppliers would enable competition in the market and the size and capability o f the

public sector would indicate that the appropriate support and expertise should be able to be sourced

to manage an outsourcing program.

The costs and benefits o f outsourcing must be considered on a case by case basis. For a range o f

reasons, outsourcing/contestability has not been pursued in the Queensland public sector - the

analysis has not been undertaken.

Treasury’s preferred position is that a coordinated review o f all Govemm ent services be undertaken,

to identify whether there are Govemment services that m ay be delivered more efficiently if

outsourced.

C-4-10

Addressing Restrictive Industrial Practices

Over time, agency enterprise bargaining agreements have become increasingly restrictive,

substantially limiting agency management flexibility. In addition, a layer o f agency custom and

practice has further limited management flexibility, and limited the productivity o f the public

sector. These limitations, embodied in Enterprise Bargaining Agreements, take a number o f forms

including:

• enforcement o f maximum class sizes in the Teachers’ Enterprise Bargaining Agreement

• requirements for excessive periods o f advance notice o f rosters in the Queensland Ambulance

Service, limiting the capacity o f management to respond to emergent issues

• poor implementation o f the reclassification o f health practitioners which led to a cost blowout in

the implementation o f the last Health Practitioners EBA

• workplace consultative arrangements prescribed in the Teachers’ EBA

• proposals for inclusion o f teacher cooperation with Teaching and Learning audits in the next

Teachers’ EBA

• a range o f restrictions on Queensland Health in regard to staffing operational changes,

restructures, contracting out, etc.

• the myriad o f allowances in many service delivery areas which create significant operational

inefficiencies in addition to complicating other reforms, for example payroll processing.

Reducin2 Deadweight Administrative Costs

It is almost inevitable that over a period o f time in a large bureaucracy, be it the public sector or a

large corporation, there will be an accumulation o f deadweight administrative processes and

requirements.

Treasury has been able to identify some 380 pieces o f legislation, directives, standards, policies and

guidelines which it has to comply with. Out o f these documents fall well over 8,000 requirements

that Treasury must comply with in conducting business.

C-4-11

■Source 2008

Number

2009 2010 2008

Requirements

2009 2010

N on- S ta tu to ry A c c o u n ta b ilitie s 193 2 2 3 2 0 8 3 ,5 5 4 3 ,5 7 3 3 ,3 7 3

S ta tu to ry A cco u n tab ilitie s 139 169 174 4 ,5 9 2 4 ,7 7 3 4 ,8 5 4

TOTAL 332 392 382 8,146 8,346 8,227

M any o f these requirements arc based on “a one-size fits all” view o f Government agencies, take no

account o f relative risk and would not pass a cost-benefit analysis.

All organisations need to have standards to ensure good corporate governance. The problem is that

agencies are devoting an increasing amount o f resources to defensive compliance activities. This

comes at the expense o f innovation, service delivery and morale.

These are issues which should be pursued aggressively, but are more likely to be a tool which will

assist agencies in m eeting existing efficiency targets and promoting accountability for budgets

rather than realising savings back to the Budget.

As the sponsors and promoters o f many o f these requirements, Ministers and the collective CEO

group have a key leadership responsibility in driving efficiencies in this area. This will require

substantial cultural change.

C-4-12

C.5. CAPITAL SPENDING, THE BALANCE SHEET & FINANCING

As outlined, capital spending in the four years preceding Queensland’s credit downgrade

increased by 170% to a peak o f over $15 billion in 2008-09. Capital expenditure has gone

from being partly funded by borrowings (15% in 2004-05) to fully funded by borrowings.

In order to arrest the growth in debt, Queensland will have to become accustomed to spending

far less on capital than has been the case over the past decade. Put simply, Queensland needs

to realign its capital spending ambitions to the available cash flow generated by the budget.

Treasury sees the following areas as critical to achieving the required moderation while

ensuring high quality infrastructure is delivered in support o f the Queensland economy.

1. Establish processes to put major capital expenditure proposals under rigorous review

focussing on the outcome sought (rather than “the project”) and conduct that analysis in a

way that allows for prioritisation o f scarce capital on a whole-of-Govemment level.

2. Pursue targeted PPPs based on value for money (rather than balance sheet) purposes.

Note value is m ost likely where the scope o f asset management and ancillary services

included in PPPs is maximised and private sector financing is minimised.

3. Have commercial infrastructure required for the resources sector (for example water and

port infrastructure for use by mining and energy companies) funded by users and where

possible, owned by users or other private providers.

4. Over the medium term (3-5 years), and following a structured review, consider

divestment o f commercial assets where there is no compelling policy reason for public

ownership. Use those proceeds to reduce debt and stress on the State’s balance sheet.

5. Where it is necessary for Govemment to be involved in the ownership o f commercial

infrastmcture, users should be required to fund the development o f that infrastmcture

through upfront payment stmctures.

C-5-1

PROJECT EVALUATION

The State has frameworks in place to assist agencies to undertake analysis o f capital projects

and ensure decisions are based on rigorous analysis and deliver value for money outcomes

which meet service priorities. Despite this, capital projects have been announced or approved

without being properly evaluated or supported by a robust business case.

In cases where projects are announced prior to evaluations being undertaken, the outcome is

likely to result in higher costs and sub-optimal service outcomes. This is bad for the budget

and Queensland’s econom ic performance.

Furthermore, project evaluations are often seen by agencies as a compliance exercise required

to secure funding for the agency’s preferred project rather than a process through which a

service problem is clearly articulated and a robust analysis o f options to address the identified

service need is undertaken to arrive at a recommended solution.

There has been a clear tendency to favour new capital projects as the solution to problems

rather than consider other options, such as enhancements to existing infrastructure to optimise

utilisation, demand management measures or a combination o f supply-side and demand-side

measures. In many cases, small tactical capital interventions may produce better economic

and service delivery outcomes than the “m ajor project” .

There are clear benefits in applying greater discipline to project evaluation processes and this

should be an area o f focus going forward.

Similarly, there is no clearly defined methodology or process applied to the prioritisation o f

capital spending. Against the backdrop o f a hard budget constraint, the ability to rank the

value o f projects in relative terms (as opposed to simply producing a positive NPV) is vital.

Pragmatically, enhancing the quality and prioritisation o f capital decisions would require

greater central agency involvement (i.e. agencies will not prioritise at the whole-of-

Govemment level). However, modest investment in this area could deliver significant

medium terms fiscal and economic benefits. The Queensland Projects Unit, along with

Infrastructure Queensland, would provide the obvious vehicles for this.

C-5-2

INFRASTRUCTURE FINANCING

Public Private Partnerships

A PPP is a risk-sharing relationship between the public and private sectors to deliver public

infrastructure and related non-core services where the private sector takes responsibility for

some or all o f the financing responsibility for a project.

Queensland’s approach to PPPs, which is set out in the Value for M oney Framework, is

generally consistent with the National PPP Guidelines.

PPPs fall into two broad categories being social PPPs and economic PPPs. Social PPPs are

generally arrangements w here the private sector builds, owns and operates a public facility

(for example a hospital or school) but does not collect revenue or charges from users directly.

Instead the govem ment pays ongoing service payments to the private sector provider over the

life o f the concession.

It is important to note that due to the ongoing payment obligations associated with social

PPPs, the liability for these payments is recognised on the State’s balance sheet. This is not

dissimilar to the treatment o f borrowings under traditionally govemment financed

infrastmcture. As such, there are no real balance sheet benefits to social PPPs.

The benefits associated with social PPPs are primarily derived from the rigours associated

with private finance in tenns o f contract management and also through the benefits o f having

the constmctor o f a facility working in partnership with the entity that will be responsible for

its ongoing maintenance as they are both part o f a single consortium. This is generally

referred to as whole o f life benefits and reflects the expectation that given the relationship

between the constm ctor and the operator, the facility will be constmcted in an optimal way

considering the cost o f the facility over its entire life rather than a constm ctor simply seeking

to deliver a facility at the lowest cost (possibly leading to much higher ongoing maintenance

costs).

In broad terms, for a social PPP to represent value for money for the State, these benefits must

be sufficient to offset the additional costs associated with private finance.

C-5-3

Queensland has delivered a number o f social PPPs including the Southbank TAPE facility

and the SEQ Schools project. The Gold Coast Rapid Transit project is currently in the

construction phase and bids were recently submitted for the Sunshine Coast University

Hospital project.

Recent issues in debt markets have led to a significant increase in debt margins on PPP

projects. As a result, it has become more difficult for social PPPs to represent value for

money for the State.

In order to seek to address this issue, and more generally to maximise the value the State

receives through PPPs, it is necessary for the State to consider options to minimise the

premium paid for private financing in PPPs. Options include the Government Contribution

Model (where the Government provides upfront contributions) and European models where

the Govemment participates as one o f the senior debt financiers. These options should be

considered for any potential social PPPs which are assessed under the Value for M oney

Framework.

The Govemment should also seek to maximise the scope o f asset management services

included in PPPs to ensure potential benefits associated with social PPPs are maximised.

Economic PPPs are generally arrangements where the private sector builds, owns and

operates a public facility (for example a toll road) and collects revenue or charges from users

directly.

Due to the performance o f toll roads in Australia generally, it is unlikely that any new

economic PPPs (for example toll roads) will be o f interest to the private sector in the short to

medium term. This is primarily due to issues in relation to ‘greenfield’ demand risk which

relates to the unknown risk o f usage o f a toll road that has not been built. W hile there have

been various options put forward for managing this risk in a way that would encourage

private finance to participate in future toll road PPPs, none o f the options put forward appear

to be in a form that would represent value to Government.

However, for new toll roads, it is a viable option for the State to fund the construction o f the

toll road and then sell its interest after traffic pattem s have been established.

C-5-4

PPP availability m odels for roads, where there is no toll and the State pays the operator

ongoing service paym ents for keeping the road maintained and available (eg Peninsula Link

in Victoria), are considered unlikely to represent value for money for the State. This type o f

arrangement effectively leads to the road becom ing a social PPP as the private financiers are

paid by an ongoing service payment from the State rather than users.

The prim ary reason that these arrangements are unlikely to represent value for money for the

State is that the key drivers o f value for social PPPs are generally not sufficient to offset the

private finance prem ium due to the much lower quantum and complexity o f asset

management services associated with a road as opposed to a hospital or school.

Commercial Infrastructure

Commercial infrastructure, such as ports, rail, water and other infrastructure required to

service commercial developments (eg coal mines), has traditionally been procured, financed,

owned, operated and maintained by Govemment, through GOCs. Users o f the infrastructure

then enter into a long term, take or pay agreement on commercial terms with the GOG and are

generally required to provide appropriate parent company and/or bank guarantees to support

their obligations under these agreements.

Even when these arrangements are stmck on a commercial basis, there is a significant lag

between constm ction (and outlays) and revenue flows. This acts as a drag on the State’s

credit metrics.

Given the fiscal constraints outlined above, to the maximum extent possible, the Govemment

should seek to have commercial infrastmcture owned and funded by the private sector - such

as mining companies and developers that rely on the infrastructure to service their resource

developments, or financial institutional and strategic investors.

In recent years, the State has been successful in facilitating private sector involvement in the

development and financing o f major commercial infrastructure and it is no longer expected

that Govemment will fully fund, own, operate and maintain commercial infrastmcture

developments. Examples include the user funded model recently implemented for the

development o f the W iggins Island Coal Export Terminal (WICET) as well as the

development o f large scale LNG facilities at Curtis Island in the Port o f Gladstone by private

sector consortia.

C-5-5

W here it is necessary for Govemment, through GOCs, to be involved in the ownership o f

commercial infrastructure, users should be required to fund the development o f that

infrastm cture through upfront payment stmctures. This may still enable the GOG to play a

role in the facilitation o f the development and perform an operations and maintenance role if

necessary, but avoids the need for increased State borrowings.

A full user funded model is being proposed by N orth Queensland Bulk Ports (NQBP) for the

development o f the multi-cargo facility (MCF) at the Port o f Abbot Point. Under this model,

each o f the selected preferred proponents for development o f Terminals 4-9 at Abbot Point

will be required to fund upfront the constmction o f the MCF and the related common user

infrastmcture, in addition to their own particular onshore terminal and offshore w harf

stmctures. This will avoid the State having to borrow more than $3 billion to fund the

estimated capital cost o f constmction.

In the case o f the Connors River Dam and the pipeline to Moranbah, a partial user funded

approach is being proposed by SunWater. This model envisages SunWater funding and

owning up to a tw enty percent stake in the entity that will own the water infrastm cture assets,

with the balance owned by the respective users. This model is also proposed by SunW ater as

the basis for the funding and ownership o f additional water infrastmcture assets identified to

support the continued growth o f the mining sector. This would avoid the State having to

borrow more than S2 billion to fund the Connors River Dam and pipelines projects, and

potentially a further $2.6 billion to fund proposed future water projects in the medium term.

NQBP and SunW ater are working with the potential users and owners o f these infrastmcture

assets to establish appropriate stmctures and funding arrangements to meet the objective o f

minimising the impact on the State’s balance sheet while facilitating delivery o f infrastmcture

necessary for the continued expansion o f the resources sector in Queensland.

C-5-6

ASSET DIVESTMENT

As outlined, the inability to stabilise debt represents a serious intergenerational risk to the

State.

Treasury acknowledges the Government’s clear public commitments ruling out asset sales

during this term. Asset sales will in all likelihood need to be contemplated over the medium

term if Govemm ent wishes to significantly reduce the State’s borrowing levels.

Treasury has undertaken a desktop review o f the State’s GOC assets to detennine: which

assets may be suitable for divestment; likely sale proceeds; potential policy, structuring or

other commercial issues associated with each asset; and possible timing considerations. The

outcomes are outlined below. One option for Govemm ent would be to commission a

structured review o f this type during this term o f Govemm ent to inform future public debate

and decisions around ownership.

Balance Sheet Review

Govemment businesses comprise a significant portion o f the State’s balance sheet. The

2011-12 M YFER estimates that as at 30 June 2012, total assets will be $275.2 billion, with

Govemment Owned Corporations (the PNFC sector) accounting for 21.5% o f this (or $59.1

billion). Total public sector debt is estimated at $62.4 billion at 30 June 2012, with the GOCs

accounting for 48.4% o f this (or $30.2 billion).

In order to determine whether to proceed with a program o f asset sales, or indeed which assets

would be the most appropriate to sell, GOCs were assessed against a broad framework which

sought to determine which assets should comprise any package o f asset sales.

In general, the framework consists o f a number o f questions that need to be considered when

contemplating an asset sale. The questions are grouped into categories that seek to

encompass the range o f issues that should be considered before Govemment can determine a

way forward. The categories o f questions include: impact on the balance sheet; status o f the

industry; the need for govemment involvement in the industry; market appetite; required

business/industry restmctures; and other policy considerations.

C-5-7

Powerlink, Ergon and Energex

The report concluded that there were no significant impediments to the sale o f Powerlink,

Ergon or Energex. The report estimates that the divestment o f Powerlink could provide

approximately $6.5 billion in sale proceeds. Divestment o f Energex and Ergon could provide

sale proceeds o f approximately $10.1 billion and $8.9 billion respectively. These are all

conservative estimates and higher values m ay be achieved depending upon the transaction

structure and market sentiment at the time o f divestment.

Due diligence processes for the sale o f these regulated assets would likely be easier than some

previous sales processes due to the existing regulatory framework. The sale preparation will

not need to create and implement a suitable performance regime for the entity in private

ownership (the AER already has performance incentives built into its regulatory regime).

In addition, the regulatory framework is understood and accepted by the industry. This will

also reduce the ongoing/legacy work required for Govemm ent with respect to enforcing these

conditions on the purchasing entities.

Note that the sale preparation for Ergon will require transferring the Ergon retail load to

another State owned entity. The most logical entity would be one o f the State’s generation

companies. However, this would present ACCC issues that would need to be resolved.

W hile the size o f these entities would be expected to produce some challenges from a sale

process and structure perspective, this was considered to be a manageable issue.

RG Tanna Coal Terminal

The report estimates that the divestment o f RG Tanna Coal Terminal (currently owned by the

Gladstone Port Corporation (GPC)) could provide sale proceeds o f between $870 m illion and

$1,020 million. These estimates were derived using GPC 2011-12 EBITDA multiples

(6 times and 7 times respectively) as proxies for a valuation range for RG Tanna.

W hile no formal due diligence has been undertaken on the asset, there are likely to be some

contracting arrangements that need to be managed in the context o f a sale. A comprehensive

legal due diligence would be required to determine the extent o f any contracting irregularities

and it is likely that these arrangements would need to be formalised prior to any sale process

being undertaken.

C-5-8

Significant work is being undertaken by GPC regarding the LNG industry. Any sale o f the

RG Tanna Coal Tenninal would need to be cognisant o f this, and be undertaken in a manner

to minimise disruptions to these developments.

Electricity Generators - Stanwell and CS Energy

The restructure o f the Queensland electricity generation sector was completed on 1 July 2011.

The three electricity generators: CS Energy Limited (CS Energy), Stanwell Corporation

Limited (Stanwell) and Tarong Energy Corporation Limited; are now trading as two

(CS Energy and Stanwell).

The restructure o f the electricity generation entities was a response to the increasingly

challenging environment facing the sector with increased competition from

vertically-integrated retailers, continued capacity oversupply in the market and substantial

ongoing private sector investment in generation capacity all acting to drive down revenue

captured by the govem ment owned generators.

W hile the restructure o f the electricity generation entities is expected to deliver tangible

benefits, ownership o f these assets represents a significant risk to the State's balance sheet. In

particular, the current wholesale pool prices and the near term outlook indicate subdued

performance from electricity generators, with independent analysis indicating the

$31.85 M W h average wholesale electricity price for 2010-11 was 30% below long mn

marginal cost and compared to the historical average o f $45.46/MW h (real).

In the near tenn, carbon pricing will lift aggregate prices, but it is expected that average

wholesale electricity prices will remain weak due to a combination o f factors including

continuation o f additions o f intermediate and peaking plant and energy growth has flattened.

However, in the medium to long-term two factors are expected to place upward pressure on

wholesale electricity prices towards and beyond long-mn marginal cost. These factors are

tightening reserve margins and gas prices moving towards export parity levels as the

Gladstone LNG projects move to export delivery phase.

This expected recovery in wholesale pool prices will improve revenue and profit performance

by the generation sector, and subject to greater certainty being realised in relation to carbon

pricing, it is expected that there would be a potential opportunity from about 2016 for a sale

o f the electricity generators to occur.

C-5-9

C.6. UTILITY PRICING - FISCAL IM PLICATIONS

SEP BULK WATER PRICES

In M ay 2008, bulk water prices for the period 2008-09 to 2017-18 for South East Queensland

(SEQ) were announced to support the cost o f supplying bulk water in SEQ including funding the $7

billion capex program for new drought related bulk water infrastructure.

This involved substantial price increases across SEQ, with prices increasing in excess o f 300% (in

real terms) over the decade in some council areas. However, Govemment decided to:

• im plement a 10-year bulk water price path to smooth bulk water price increases

• accept a cost o f debt return only on the $7 billion in newly-constructed drought assets.

The difference between the cost o f providing bulk water and the revenue collected by the Water

Grid M anager (WGM) from water sales accumulates as W GM debt. There are no assets associated

with W GM debt. It reflects accumulated deficits over the first 10 years o f the bulk water price path.

The total debt for the SEQ bulk water sector over the period to 2027-28 is shown in Chart 6.1. It is

budgeted to peak at over $10 billion in 2016-17, largely driven by the debt held by the WGM, and

retum to ju st over $7.5 billion in 2027-28. Only the W GM debt is to be repaid over 20 years. The

debt associated with drought infrastructure is effectively ‘repaid’ over the useful lives o f the assets

(i.e. an average o f around 60 plus years). For example, the average useful life o f the Southern

Regional Pipeline is 75 years and the Tugun desalination plant up to 30 years.

C hart 6.1

T otal Bulk W ater Entity D ebt 2011-12 to 2027-28

S,000

6,000

2,000

• Segw ater ■ LinkWater ■ SEO W ater Grid IVtenager

C-6-1

The 20 year debt payback period for the W GM debt is a balance between managing the WGM debt

and lim iting price increases to a reasonable level. Extending the payback period for the WGM

increases this debt significantly and the final bulk water price (discussed later).

The QW C recommends bulk water prices, consistent with the following principles:

• a 10-year price path until 2017-18 to smooth price impacts on customers, with ‘full cost pricing’

to be achieved by that date including the capacity for full repayment o f the W GM debt to be

achieved by 2027-28

• ‘drought’ assets to earn a cost o f debt retum rather than a commercial WACC, although

non-drought assets acquired from the councils continue to eam a W ACC rate

• bulk price increases are calculated based on a constant dollar bulk price increase in each year

across the 10 year price path

• any over recovery by the W GM for the initial period (compared to that forecast) to be used to

reduce the W GM debt rather than to reduce bulk water prices.

Based on review in December 2010, the W GM debt was estimated to peak at $2.86 billion in

2016-17 and be repaid by 2027-28. However, continuing low water demand (originally 230 1/p/d

and currently based on demand returning to 200 1/p/d by 2017-18) has meant that without additional

price increases, this WGM debt will increase above the level projected in December 2010.

A comprehensive bulk water price review is due to occur before 2013-14 for the last five years of

the bulk water price path.

A range o f factors influence the W GM debt position and the need for further adjustments to bulk

water prices to ensure that the W GM debt is repayable within the 20 year period.

Managing Annual Water Grid Costs

In 2011-12, the estimated cost o f operating the SEQ water grid is between $950 million and

$1 billion, including the interest on the W GM debt. O f these costs, around 65% to 70% are capital

costs (i.e. depreciation and a retum on capital).

C-6-2

operating and Maintenance Costs

Operating and maintenance costs account for around 30% to 35% o f the total costs o f providing

bulk water services. A large proportion o f these costs are fixed, including operational staff,

electricity, chemicals, materials etc.

The potential for substantial operating cost savings from amalgamation o f water entities is limited.

It is estimated that the head office savings from the merger o f Seqwater and W aterSecure are likely

to be around $2 million. A m erger o f other bulk water entities is likely to result in savings o f a

similar level.

Some operational savings will be achieved from the changed operating arrangements for the

desalination plant and the W CRW P, however in the case o f the latter, costs are being incurred to

successfully demobilise the plants, with savings occurring over the longer term.

As part o f its 2012-13 review o f Seqwater and LinkW ater costs, the QCA has been directed to

undertake a comprehensive review o f the prudent and efficient operating costs for Seqwater and

LinkWater. Consideration is also being given to reviewing the W GM operational costs. It is

expected that the QCA will recommend productivity targets to be achieved by Seqwater and

LinkW ater over the medium term.

Depreciation Costs

The asset lives used for calculating bulk water prices reflect the average weighted asset lives for

drought assets and are based on the estimated asset life o f the assets at commissioning. This

includes asset lives o f around:

• 150 years for dams (for example, Wivenhoe, Somerset and North Pine)

• 75 years for pipelines

• 30 to 35 years for water treatment plants (including the GCDP and the W CRW S).

The depreciation approach and asset lives are consistent with those applied for similar assets in

other States.

C-6-3

Capital Charges

The regulated asset base (RAB) for Seqwater and LinkWater is currently estimated to be around

$8.7 billion. It has been set based on the following:

• non drought assets (i.e. assets purchased from councils in 2008) included in the RAB at the

acquisition cost (based on the KPM G valuation)

• drought assets included in the RAB at the cost o f construction and at the time o f commissioning

• assets are not to be optimised from the RAB.

The m ajority o f the assets held by Seqwater and LinkWater are debt funded, leaving little scope to

change capital costs. To the extent that assets are ‘w ritten-off, this will mean transferring debt

from the SEQ water entities’ balance sheets to the General Govemment balance sheet. This is

discussed further below.

Drought assets eam a cost o f debt retum only, while non-drought assets earn a commercial WACC.

The W GM debt is currently receiving the benefit o f lower than average interest rates o f around 6%

to 6.5%; however, over the remaining years to 2027-28 there is the likelihood that interest rates

could exceed the average 7% assumed. Any shorter term benefit o f lower interest rates means that

the W GM debt accumulates at a lower rate.

A key challenge for managing future increases in bulk water charges is ensuring pmdent investment

in new and replacement assets. W hile the majority o f the capital program in response to the drought

has been completed, both Seqwater and LinkW ater require ongoing capital expenditure to maintain

and upgrade existing assets. The QCA has been charged with ensuring this investment is prudent

and efficient.

There is also scope to delay some projects required to m eet urban water demand, such as the

W yaralong W ater Treatment Plant and related infrastructure. This could mean delaying investment

in these assets until into the 2020s.

Dealing with Lower than Projected Water Demand

Long term water demand is the m ost significant risk for the W GM debt. The current bulk water

price path is based on residential water consumption increasing from 180 1/p/d to 200 1/p/d over the

period from 2011-12 to 2017-18.

C-6-4

However, water demand is heavily influenced by the weather and by consumer behaviour. There

appears to have been a longer term behavioural change evident in SEQ, reinforced by the

continuing Permanent W ater Conservation measures which encourage restricted water use.

The QWC is currently investigating a likely long term water use pattern, with a credible prospect

that residential water demand remains around 180 1/p/d in the longer term. If this level o f demand

transpires, it will mean that either:

• without increases in the bulk water price, the W GM debt would peak at over $6 billion and not

be repaid until 2037-38, or

• bulk water prices would need to increase from $2,812/ML ($2010-11) in 2017-18 to $3,504/ML

($2010-11) to allow for the repayment o f debt within the 20 year period.

C hart 8.2

Low D em and - D eb t R epaym ent C om parison

6.000

5 5 0 0

5,000

4,500

4,000

3500-----S

3,000

2,500

2,000

tooo

500

.A,y ■>

• 180 I/p/d no price in c rease 180 I/p/d with price inc rease 200 I/p/d base model

Aside from residential demand, two other factors are also influencing total water demand:

• lower than projected population growth - population growth is at historic lows with a likely low

growth scenario over the next few years.

• lower non-residential demand - higher prices, slower economic conditions and water

conservation regulations are reducing non-residential water demand. Non-residential demand

accounts for around 30% o f water sales, meaning lower growth in this area will also have a

m ajor adverse implication for W GM revenues.

These factors will need to be considered in the 5 year bulk water price review.

C-6-5

Bulk Water Price (and Debt Repayment Periods)

The two other major variables impacting on the W GM debt are the bulk water price and the period

o f tim e over which the WGM debt is repaid.

As indicated earlier, the 20 year debt payback period for the W GM debt was considered to be the

appropriate balance between m anaging this debt and keeping price increases to a reasonable level.

Extending the payback period for the W GM increases this debt significantly.

As shown in Chart 8.3, maintaining a 10 year price path but increasing the debt repayment period to

25 years or 40 years increases the peak debt from $2.86 billion (current estimate) to $3.6 billion and

$9.7 billion respectively. It should be noted that the following increase in W GM debt does not

include the impact o f lower than currently projected demand.

C hart 8.3 P eak D ebt C om parison

WGM D ebt R epaym en t o v er 20, 25 an d 40 y ea rs

10.000

9.000

8 .0 0 0

7,000

5 ,000

4 ,000

3,000

2 ,000

1,000

0

.s'-

• 20 ye a rs 25 y e a rs ---------40 ye a rs

Consideration could be given to writing o ff non performing assets in order to reduce the WGM

maximum debt. For example, i f the W CRW S was written off, it could potentially reduce the

W G M ’s maximum debt under a low demand scenario (180 1/p/d) from $3.4 billion to $2.3 billion.

The impact o f this on the WGM debt is illustrated in the Chart 8.4.

C-6-6

C hart 8.4Im pact on WGM of W riting Off Non Perform ing A sse ts

3 , 5 0 0

3 , 0 0 0 •

2 , 5 0 0

2,000

5 0 0

1,000

5 0 0

o

< •>9>’

B a s e C a s e • 1 8 0 I / p / d U p d a t e d B a s e C a s e 1 8 0 I / p / d e x c l- W C R W S

As well as reducing the WGM maximum debt, writing o ff the WCRWS will reduce the annual

household bulk water bill in Brisbane from $699 under the published price path to $591 in 2017-18.

However, writing o ff the WCRWS would result in approximately SI .9 billion o f associated debt

being transferred from the south east Queensland bulk water entities to the General Govemment

sector. The State would need to divert approximately $136 m illion per annum from core

Govemm ent services such as health and education to meet the interest incurred on the transferred

debt.

C-6-7

ELECTRICITY PRICES

Since 2007-08, regulated retail electricity prices have been escalated annually by the increase in the

cost o f supplying electricity, calculated using the Benchmark Retail Cost index (BRCI).

Responsibility for calculating the BRCI was delegated to the QCA. In nominal terms, Queensland

retail electricity prices increased by 64% from 2007-08 to 2011-12.

The increase in retail electricity prices since 2007-08 reflects cost increases in each sector o f the

electricity industry. Electricity prices are increasing across all parts o f Australia, and are likely to

continue rising at levels well above CPI over the coming years.

Table 9.1 C ost Drivers o f E lectricity Prices

Key cost driversElectricity generation(around 40% o f su p p ly co sts)

Network (around 50% o f su p p ly costs)

Retail(around 10% o f su p p ly co sts)

O v e r th e la s t five y e a r s , e lec tric ity g e n e ra tio n c o s ts h a v e in c r e a s e d a s a r e su lt of:

• h ig h e r fu e l c o s t s (b o th c o a l a n d g a s )

• in c re a s in g c o s t o f c o n s tru c tin g nev / g e n e ra t io n , p articu la rly g a s a n d ren ev ^ ab le e n e rg y

• m a rk e t s u p p ly /d e m a n d sh o c k s , s u c h a s th e 20 0 7 -0 8 drought.

T h e c u r re n t p u r c h a s e c o s t o f e lec tric ity (ex c lu d in g th e c a rb o n p rice ) is a t h is to ric lo w s d u e to n e w g a s e n tr a n ts , o v e r su p p ly in th e m a rk e t, lo w er e lec tric ity d e m a n d a n d th e d o m in a n c e of v ertica lly In te g ra te d g e n e r a to r s (w h ich h a v e th e c a p a c ity to b id in to th e N atio n a l E lectric ity M a rk e t a t lo w er p r ic e s ) .

N e tw o rk e x p e n d itu re in Q u e e n s la n d h a s b e e n s ig n if ic a n t o v e r th e la s t n u m b e r o f y e a r s . E n e rg e x a n d E rg o n E n e rg y a r e fo re c a s t to s p e n d $ 1 5 ,6 billion o n th e ir e lec tric ity n e tw o rk s (cap ita l a n d o p e ra tin g c o s ts ) o v e r th e five y e a r s to 3 0 J u n e 2 0 1 5 . T h is level o f e x p e n d itu re is re q u ire d d u e to:

• in c r e a s e s in e lec tr ic ity d e m a n d d u e to p o p u la tio n g ro w th a n d h igh p e a k d e m a n d

• th e c o s t o f e n s u r in g n e tw o rk reliability, inc lud ing m e e tin g se c u r ity o f su p p ly s ta n d a rd s .

T h is c o m p o n e n t in c lu d e s c o s t s to s e rv e c u s to m e rs , s u c h a s billing a n d a c c o u n t m a n a g e m e n t , a n d th e re ta il m arg in (w hich in c r e a s e s p ro p o rtio n a te ly w ith n e tw o rk a n d g e n e ra tio n c o s t in c r e a s e s ) .

Issues with the BRCI and Reform of Electricity Prices and Tariff Structures

By 2008-09, issues with the BRCI m ethodology and tariff structures became evident. In June 2009,

the QCA was directed to undertake a review. In its two reports, the QCA concluded:

• the BRCI methodology was flawed, given it applied a single escalator to a variety o f tariffs with

different cost structures

• tariff structures were unlikely to reflect supply costs, and did not provide good price signals to

customers. The QCA noted that one o f the most significant factors contributing to the lack o f

cost reflectivity was that tariffs did not reflect the mix o f fixed and variable costs o f supply (i.e.

fixed charges were too low to reflect fixed supply costs).

C-6-8

The QCA recommended a fundamental overhaul o f the price-setting framework, and

implementation o f an altemative approach based on a Network ‘N ’ plus Retail ‘R ’ cost build-up.

This approach involves electricity prices for each tariff group being set based on;

• the direct pass through o f the relevant network charge ‘N ’ for each tariff group as approved by

the Australian Energy Regulator (AER)

• an allowance for the purchase cost o f energy (including the carbon tax) and retail costs

determined by the QCA - ‘R ’.

The new cost reflective approach to setting electricity prices and tariffs will come into effect from 1

July 2012. The approach being adopted in Queensland is generally consistent with the approaches

used by interstate regulators for example New South W ales, South Australia and the Australian

Capital Territory.

The QCA will release a Draft Determ ination on electricity prices for 2012-13 on 30 March 2012,

and a Final Determination by 31 M ay 2012.

Excluding changes in electricity prices due to tariff reform, retail electricity price increases in

2012-13 will be impacted by a range o f factors:

• the introduction o f the carbon price from 1 July 2012 (and impacts on energy generation costs) -

the Australian Govemment estimated an average bill increase o f 10% in 2012-13

• cost increases arising from renewable energy schemes such as Q ueensland’s solar feed-in tariff

(FiT), and the Australian Governm ent’s small-scale renewable energy scheme

• continued increases in network costs.

Beyond 2012-13, electricity prices are likely to increase at rates in excess o f CPI due to continued

increases in the cost o f providing network services and reflecting the ongoing increases in the costs

o f electricity generation. The latter is particularly sensitive to future gas prices and the development

o f new gas-fired generation in Queensland.

Price increases for each customer will also be influenced by the new cost-reflective tariffs being

developed by the QCA. This m eans that the overall impact on a custom er’s electricity bill will

depend on the type and size o f the customer, and which tariff they are on.

C-6-9

Additional Electricity Price Reform Options

Controlling underlying cost drivers is the most effective way to mitigate future electricity price

increases, noting there are a number o f factors outside the control o f the Queensland Govemment.

Electricity generation costs are set in the National Energy Market, and reflect the costs o f inputs

such as coal, gas, the carbon price and the Australian Government’s Renewable Energy Target.

Areas within the scope o f the Queensland Government’s control include state based green schemes,

such as the Solar Bonus Scheme (SBS), and the perfonnance o f Energex, Ergon and Powerlink.

Queensland’s SBS pays customers 44c/kW h for surplus electricity generated from solar PV systems

until 1 July 2028, with the cost recovered through retail electricity prices. W ithout change, the

cumulative NPV cost o f the SBS is estimated to be $1.8 billion.

Queensland is now the only state operating its feed-in-tariff (FiT) without a capacity cap, reduced

FiT rate, or changed end date. Queensland’s FiT is now also far in excess o f the commercial value

o f energy produced, as recently assessed by IP ART at 8-lOc/KWh. IP ART also recommended that

retailers be required to pay 7.5c/KW h o f scheme costs.

It is questionable whether the benefits o f the current SBS outweigh the significant costs to all

electricity consumers, particularly given the Commonwealth’s small-scale renewable energy

scheme provides financial assistance to consumers. Options for the SBS include closing the scheme

to new applicants, or reducing the FiT rate to more closely align with the commercial value o f

energy produced (and considering w hether retailers should be required to pay part o f this).

Closing the SBS now to new subscribers is estimated to limit the amount to be recovered through

future electricity prices to around $760 million, while reducing the FiT to 6c/KWh is estimated to

limit the cost o f the scheme to $828 million.

W ith the aim o f mitigating future network capex, the second Sommerville Review was tasked with

reviewing savings proposals from Energex, Ergon and Powerlink. On 8 December 2011, the Panel

found $545 million o f distribution capex savings could be achieved over the current regulatory

period to 30 June 2015 without impacting network reliability.

C-6-10

The capex savings accepted by the Panel are likely to have a relatively small impact on electricity

prices during the remainder o f the regulatory period, with electricity prices for an average

household around $30 lower in 2014-15 than otherwise might have been the case.

Costs and Risks in Government Involvement in Retail Electricity Price Setting

In the event Government decides to subsidise retailers for any proposal to reduce electricity prices

below supply costs (i.e. price capping), significant funds would be required. Based on 2011-12

retail electricity prices, each 1% reduction in electricity prices would reduce revenue to retailers

around $60 million.

Freezing the variable component o f residential tariffs, and allowing the fixed component (which is

currently only around 6% o f an electricity bill) to increase in line with QCA pricing decisions,

would have cost around $175 m illion in 2011-12.

There are significant legal/sovereign risks and costs associated with interfering in the electricity

market, particularly with the aim o f reducing regulated electricity prices below the actual supply

costs. In particular, there will be adverse impacts on retailers and competition in the retail

electricity market where the increase in retail electricity prices does not reflect the increase in actual

supply costs incurred.

Retailers are likely to have already hedged a significant part o f their future energy purchase costs,

and may be unable to recover this expense. Further, retailers may be unable to recoup forgone

profit in later years if franchise customers switch to different retailers.

As a result, retailers are very likely to take legal action against Government to recover lost revenue,

unless the Government funds the difference between announced prices and adjusted prices through

a direct subsidy to retailers. This subsidy would be required on an annual basis until such time as

the Government allowed prices to return to cost reflective levels, with a potential price shock at the

time.

C-6-11

Ergon (EEQ) Uniform Tariff Community Service Obligation

Ergon’s EEQ provides retail electricity to over 680,000 customers in its area (approximately 97% of

the State outside SEQ). EEQ has the lowest customer density o f any network in the western world

for the 100,000 kilometres o f distribution network west o f the Great Dividing Range.

The Government’s Uniform Tariff Policy objective is to ensure that all Queensland electricity

customers o f a similar type who have not elected to enter a market contract for their electricity, pay

the same price for electricity (notified prices) regardless o f where they live. For m ost EEQ

customers the cost o f supply is significantly greater than the revenue received through notified

prices. The shortfall is covered by a Community Service Obligation (CSO) payment from

Government.

From 2005-06 to 2010-11, the annual cost o f providing the CSO has been volatile, ranging between

$252 million and $619 million and averaging around $400 million per annum. The CSO is

projected to grow over future years due to significant increases in network costs.

The amount o f the CSO paid to EEQ to provide the Uniform T ariff arrangement is calculated as the

difference between the total costs o f supply less revenue received from the retailing business. The

CSO funding arrangements reflect:

• higher network costs per customer than the Energex area

• higher energy loss factors from supplying energy over a wide area

• the very high costs o f remote and isolated area supply

• these being offset by revenues from the retail business.

Tariff reform m ay reduce the profitability o f EEQ compared to the current BRCI methodology.

This will also impact on the costs o f providing the CSO because the profits it generated subsidised

the losses associated with unprofitable customers.

The potential increase in the Uniform Tariff CSO impacts for 2012-13 will not be known until after

the QCA releases its Draft Determination on 30 March 2012, w ith the estimated increase in the

CSO ranging from $100 million to $250 million. The extent to which tariff reform reduces EEQ ’s

overall revenue from retail electricity sales is highly dependent on the QCA's treatment o f its:

• method for estimating energy costs in the revenue allowance

• inclusion o f competitive headroom in the revenue allowance

• method o f determining tariffs for large customers in the Ergon area.

C-6-12

Uniform Tariff and the Treatment of Large (lOOMW plus) Non-residential Customers

From 1 July 2012, large non-residential customers in SEQ will no longer have access to regulated

prices - a regulated tariff will only apply to large non-residential customers in the EEQ area. This

also means that from 1 July 2012, large customers (greater than lOOMWh per annum) in the Ergon

area will then be the only large customers in Australia retaining access to regulated prices (with the

exception o f Tasmanian where the cut o ff is 160MW).

The QCA has yet to determine how it will set prices for the EEQ large customers given that it is not

setting an equivalent regulated tariff in the SEQ area. The two options likely to be considered by

the QCA for setting Ergon large customer tariffs are an Ergon specific large customer tariff or a

tariff more reflective o f the Energex area. These two options have very different implications for the

Uniform T ariff CSO and potential competition in the Ergon area.

Following the release o f the QCA’s Draft Determination on 30 M arch 2012 the Government may

wish to consider whether it is appropriate for large Ergon customers to continue to have access to

regulated (subsidised) prices, particularly as this does not occur in the rest o f Australia (for

customers >160M W h p.a). Large customers are generally in a superior position to smaller

residential/business customers in term s o f the incentive, expertise and capacity to manage their

electricity consumption, and to negotiate market contracts.

C-6-13

C.7. GOVERNMENT OWNED CORPORATION REFORM_____________

FINANCIAL TRENDS

There are now 12 GOCs in the Energy (five), Transport (five), W ater and Funds Investment sectors

(one each). W ith the exception o f QIC, they all sit within the Public Non-financial Corporations

(PNFC) sector o f the State’s accounts.

The GOCs dominate the sector, with the other major entities being the South East Queensland

W ater Entities. The GOCs comprise a significant, but declining, share o f the State’s revenue and

assets, reflecting in part the significant asset sales o f the 2006 to 2011 period as well as relatively

stronger growth in General Government (GG) sector activities (for example health, education).

Treasury’s view is that there will need to be careful consideration going forward as to whether the

State’s fiscal and economic development objectives as well as management o f risk may not be

better served by transferring further assets to the private sector. The ongoing public policy rationale

for the State’s continuing involvement in many o f the businesses is at best unclear, with the

activities o f the electricity transmission and distribution entities in particular largely determined by

the national regulatory framework.

In the interim, the GOCs should make a considerable contribution to stabilising and improving the

State’s finances through a program o f further reform.

This reform agenda should be targeted at both operating costs and capital efficiency o f the GOCs to:

• encourage lifting their rates o f return, improving dividends to government as owner

• minimise their call on the State to provide debt and equity to m ajor new projects.

The full financial relationship between the Government, as represented by the GG sector and the

GOCs, can be gathered from Chart 7.1 which breaks down the “Net Flows’’ (net operating flows) to

Government. These flows are the dividends and tax equivalent payments (TEPs) made by the

GOCs to Government as owner, and the CSOs paid by Government to GOCs (specifically, QR,

Ergon and Sunwater). These CSOs pay for services that, in the absence o f such payments, would

otherwise be uncommercial and not justified for a corporations law company to provide.

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C hart 7.1 GOG Net F low s to G overnm ent

X C TE 3CC c-srv:e Ps^nerts f-tet Pov^ to 3c-«f'in6T

Chart 7.1 shows a steadily improving trend in dividends and TEPs (most GOCs pay a “standard”

80% o f Net Profits After Tax (NPAT) payout ratio). Over the period to 2015-16, the dividends

trend is dominated by the returns fi'om the regulated entities - Energex, Ergon and Powerlink as

well as QR. In the case o f QR, the dividends largely represent the return o f the Return on Asset

(ROA) component o f the Transport Service Contracts (TSCs). On the other hand, there have been

large increases in CSOs to QR and Ergon since 2009-10.

Chart 7.2 compares overall GOC Gearing (that is, debt / debt + equity) with that o f the rest o f the

State Government.

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C hart 7.2GOC G earing R atio v s Non-GOC G earing Ratio

r X •S sa rrg H o - - F n s ': a l Ni5--3'DC j s a r n ;

Gearing is relatively higher in the GOC sector, indicative o f the more commercial approach with

most G O Cs’ Balance Sheet targeted to sit in the BBB credit rating range on a stand-alone basis but

also indicative o f the capital-intensive nature o f the businesses.

It is not possible for GOC gearing to continue to rise without endangering the stand alone credit

ratings o f the GOCs, which are generally targeted in the BBB (investment grade) range. In

approving large projects, the Government should be aware that these projects are likely to require

“equity injections” from the budget in order maintain these gearing ratios. The only way for the

budget to fund equity injections is through borrowings. For this reason, at the total State level,

major new GOC projects that get approved will likely be funded entirely from borrowings.

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Chart 7.3 compares G OCs’ capital expenditure w ith the balance o f the NFP sector.

C hart 7.3 GOC C apex and Non-GOC C apex

■ 303 CaptaJ Expenjitire ■floivFinancial Mon-GCC Upital Exp-enditurs

Over the period to 2015-16, while there is a significant reduction in capital works forecast, it is

important to understand that the figures only include approved projects. The tendency as a

particular year progressively works its way from being the last year in the forward estimates to

being the Budget year is for the amount o f projected capital works to increase as projects are

approved. In the actual year, on the other hand, the established trend is for the final actual capital

expenditure to fall short o f forecast due to delays, weather, etc..

Ergon, Energex and Powerlink have revenue bases that are highly stable and largely locked in

through regulation, and they are geared at their currently targeted BBB+/A stand-alone ratings

ranges. Nevertheless, their resultant liabilities to revenue ratios are high, and act to drive up the

NFP sector ratio - a key metric for the Standard and Poors ratings agency.

W hile these entities remain within State hands, it will be that much harder to make significant

inroads into the State’s liabilities to revenue ratio.

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GOVERNMENT OWNED CORPORATIONS REFORM STRATEGIES

In the past five years, there have been a number o f reforms to the GOCs Sector, including:

• exiting from a range o f activities where the purposes for State ownership were no longer

relevant, or where the risks involved could be efficiently managed by the private sector

• a clear preference for GOCs to pursue major projects that maximises the private sector

involvement in the project, e.g., the Wiggins Island Coal Export Terminal

• restructures o f the Ports and Generation GOC businesses to better position those GOCs for the

future in the markets in which they compete

• devolution to boards o f a range o f responsibilities from Shareholder approval

• development o f policies aimed at providing guidance to GOC boards while further empowering

to manage the businesses, for example Investment Guidelines.

Treasury recommends that a six point strategy be put in place to maximise the contribution o f the

State’s ownership in the GOCs to meeting the fiscal challenge:

1. strengthening the GOC model and the pursuit o f commercial outcomes

2. structural reform where needed - ensuring that the GOCs are o f the scope and size to deliver

services efficiently with appropriate returns to Government as owner

3. improving GOCs’ operating efficiency

4. improving GOCs’ returns o f capital deployed

5. minimising GOCs’ call on debt and equity funding from the State

6. consideration o f divestment where the private sector is demonstrably better able to deliver and

finance the services, and/or manage the risks involved.

Strengthening the GOC Model

Governments choose to own GOCs for a range o f purposes, usually associated with correcting for

perceived or known market failures that may not be adequately addressed by appropriate regulation;

or to pursue significant economic development and/or social policy objectives in a commercial

manner so as to ensure the m ost efficient delivery o f those outcomes in the public interest.

It is incumbent upon Government as owner to regularly review the purposes o f GOC ownership and

structure to ensure that continued public ownership o f the business with its resultant call on scarce

public resources is justified. W here it is assessed that is the case, the commercial GOC model

offers the best methodology for achieving successful outcomes.

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For the model to work fully as intended, however, owner interference needs to be kept to a

m inim um or where deemed necessary, pursued through well known, established mechanisms

(CSOs, Board Directions). GOCs also need to maintain close, deep relations with Shareholding

Ministers, Treasury through the Office o f Government Owned Corporations (OGOC) and Q IC .

The proposed GOCs Governance reforms start with the choice o f Shareholding Ministers, and the

role o f Government departments with the GOCs. There has always been, and continues to be, a

difficult tension for line shareholder agencies in separating their policy and regulatory roles from

that o f the ownership role in respect o f the GOCs, leading to non-commercial policy and service

requirements being placed on GOCs often without funding.

It is recommended that consideration be given to changes in the Government Owned Corporations

Act for there to be one only Shareholding M inister - that role should be with the Treasurer. In the

interim until legislation can be changed, it is recommended that the same two M inisters be

appointed as the Shareholding Ministers for all GOCs (the Treasurer and a Minister without policy

or regulatory responsibilities for the GOCs).

Under this model, line agencies will only have responsibility for planning, policy and regulatory

matters, and GOC monitoring would transfer to OGOC. The advantages o f such a governance

reform include that it:

• removes the inherent conflict for the line M inister as a Shareholding M inister between the

ownership role and portfolio responsibilities for policy, planning, safety, etc.

• realises efficiencies by enabling rationalisation o f the current duplication o f shareholder

advisory and monitoring functions within line agencies

• allows a sharper focus on clear commercial direction from the GOCs Minister/s - particularly

important in the current fiscal context

• allows the line M inister to focus on portfolio matters such policy, regulation, etc.

• reduces the opportunity for GOCs to have implicit or indirect obligations placed on them

without the funding implications being considered

• provides for a simplified, more responsive and more easily understood relationship for the

GOCs with the Government as owner.

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The second important plank to the proposed governance reforms involves the appointment and pay

level o f the GOC Boards. It is recommended that Queensland follow the lead o f some other

jurisdictions, and im plement a more independent process for GOC Board appointments, and to

determine remuneration. In particular, it is proposed that there be:

• minim um skills criteria set against which potential Board candidates can be assessed, including

completion o f the Australian Institute o f Company D irectors’ course and active participation in

their stated profession to ensure their skills remain valid and relevant

• GOC Board Nominations Committees be established in line with ASX principles, to formally

manage Board succession planning, assess Board m em bers’ performance more rigorously and

put forward nominees for Government consideration

• a panel o f independent consultants engaged by the Government to help GOCs identify suitable

candidates for Board appointment, including taking over responsibility for the “Register o f

Nominees” currently held by OGOC

• a GOC Boards Nomination Panel, chaired by the Under Treasurer or his nominee, with an

external member and the relevant GOC Chair, formally propose Board nominees to the

Government following consideration o f names from the GOCs and consultants (similar to the

arrangements now in place in Tasmania and New South Wales)

• a maximum term for Board members o f nine years, that is three by three year tenns for all

Board Chairs and Members to ensure appropriate and effective Board renewal.

The third component o f the proposed governance reforms involves the monitoring o f the GOCs, and

the process and requirements o f the annual Statements o f Corporate Intent (SCI) and Corporate

Plans (CP) in order to drive a stronger, long term focus on building shareholder value and

increasing returns on capital deployed in the GOCs. The recently released NSW Financial Audit

(the Lambert Report) examined this area and recommended the adoption o f much o f the framework

already in place in Queensland and managed by OGOC.

Structural Reform Options

H olding Companies

It is proposed that the concept o f establishing a “Holding Company” to sit over the existing GOCs

in two key sectors be thoroughly investigated. The existing GOCs under such a model would then

be prescribed subsidiaries under the GOC Act:

• the first is in respect o f the Energy Distribution N etwork GOCs, Energex and Ergon

• second is in respect o f a “Queensland Ports Holdings Corporation” to take responsibility for

managing the four current Port GOCs.

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In general, a holding company structure can present a number o f benefits in housing entities with

com mon business activities, such as:

• less investment to achieve the restructuring compared to a full merger

• the ability to control key operations with a smaller, more highly skilled and more focussed

governance structure (in particular, stronger Board and Senior Executive)

• better capacity to channel private sector investment into major infrastructure and limit the call

on Government finances through debt and equity

• more effective management structures that provide for better alignment o f key management

functions to achieve greater efficiency o f operations

• benefits in terms o f industrial relations (eg. Enterprise Bargaining at the subsidiary level)

• ability to focus regional management and staff on operational and project management to

improve asset performance and revenue generation

• streamlined corporate and back office operations and costs including through Joint Venture

subsidiaries such as used successfully by Ergon and Energex with Sparq.

It is also proposed that, at the same time as the Energex/Ergon holding company reform, an

alternative arrangement be put in place to manage the energy component o f the “Ergon Load”, that

is, the 600,000 or so retail customers o f Ergon who are not able to access the competitive market

due to their costs o f services being higher than the uniform tariff. W hile there may be commercial

sense in Ergon continuing to bill and manage these customers, there are clear natural hedge and

commercial benefits to the energy load o f these customers being managed directly by one or both o f

the Gencos, or otherwise contracted out.

Both o f these proposals will require at least the informal acceptance o f the Australian Consumer

and Competition Commission (ACCC) before proceeding. It is recommended that informal officer

level discussions with the ACCC and Australian Energy Regulator (AER) (the latter in respect o f

the Energex and Ergon proposal only) commence immediately on such a potential policy decision.

In respect o f the Ports, the review also presents the opportunity to again review whether the

community ports (for example Thursday Island) that are now part o f Ports North should be retained

within a GOC model, transferred back to Transport or placed in a Statutory Authority structure.

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Potential N ew GOCs

The Governm ent should also take the opportunity to review whether any o f the other Government

owned businesses currently not operating under the GOC model should in fact be corporatised.

There are a number o f businesses that should be reviewed, including:

• W orkcover

• South East Queensland water entities, particularly in the context o f a potential restructure o f the

current institutional architecture.

The corporate design o f the SEQ bulk water authorities was modelled closely on the institutional

and governance framework for Government owned corporations. W hile industrial considerations

underpinned the decision to establish the businesses as statutory authorities, the corporate model

was designed to provide a ready platform for future conversion to GOCs.

The key criteria for assessing whether these and other government-owned businesses could be

assessed as corporatisation candidates include whether:

• it operates commercially

• it does, or could, make a profit and provide a return to the State

• the commercial objectives can be separated from the broader social objectives

• it could comply with the requirements o f the Corporations Act, including the requirement o f

directors to prevent insolvent trading

• it does not undertake Govemment policy making or regulatory functions, or i f it does, can these

be efficiently transferred to another agency

• it is a separate stand-alone entity that does not represent the State.

Improving GOCs’ Operating Efficiency

The third important set o f reforms then goes to the operational efficiency o f the GOCs. As

commercial businesses, if run without unnecessary interference, GOCs should be earning rates o f

return broadly comparable to that o f their commercial counterparts.

Through the SCI and CP process each year, GOCs set out their performance targets for the year.

W ithin these documents, key measures are scrutinised and monitored by OGOC on behalf o f the

owner. Every GOC is required each year to calculate its corporate Weighted Average Cost o f

Capital (WACC), reflecting the appropriate cost o f debt and equity to the business bearing in mind

its known risks. Individual projects with known higher risks then require returns in excess o f that

corporation W ACC to be justified to proceed on a commercial basis.

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It is proposed that process be formalised to make it a clear requirement o f all major projects that

either require Shareholding M inister approval, or seek additional debt and/or equity funding from

the State, to derive a project-specific W ACC that reflects the risks o f the investment, consistent

with normal private financing arrangements.

W hile EBIT and EBITDA returns o f the GOCs as a whole are forecast to improve over the forward

estimates period, performance could be further driven by pushing the GOCs harder through

imposing tougher “stretch” targets. Regulated GOCs also still tend to have a few unregulated

activities within their operations, m eaning appropriate target rates o f return should be in excess o f

what they are provided through their regulator, or in the case o f QR, as ROA through the TSCs.

The level o f operational interference in the GOCs currently effected as a result o f a range o f policies

issued by the Govemment impinge, sometimes significantly, upon the commercial operations o f the

GOCs and restrict the level o f responsibility that should be entrusted in strong commercial Boards.

In particular, we argue that the current application o f directed policies, in particular wages policy,

on GOCs should be reconsidered in their entirety.

The only case where Treasury believes retention o f the wages policy should be considered is for

those GOCs that are regulated or largely funded by the Budget, i.e. QR and the three regulated

Energy businesses. Other GOCs should be given the flexibility to manage their workforce as they

see necessary to achieve their commercial outcomes.

Similarly, there should be a review o f the current tight guidelines on Senior Executive remuneration

in the GOCs. W hile it is not appropriate for GOCs to be market leaders, current guidelines keep

pay to m arket median unless under special circumstances, and with the exception o f the QIC, keep

performance pay to 15%. Arrangements should be more tailored to fit the circumstances o f the

business that each individual GOC is in.

The following current govemment policies should be removed from the GOCs to assist in stronger

operational performance:

• State Procurement Policy

• Local Industry Policy

• Carbon Offsets Purchasing for Air Travel

• QFleet Climate Smart Policy

• Corporate Entertainment and Hospitality GuidelinesC-7-10

• A ir Travel Policy

• Building and Construction Industry Code o f Practice

• Sport and Recreation Sponsorships Policy.

As com mercial entities with clear operational performance targets to achieve for their owner, GOCs

should be free to choose, as with their private sector competitors, the appropriate approach that best

fits their organisation on all o f these matters.

Pursuit o f further efficiencies in particular individual GOCs are clearly available. It is

recom mended that all GOCs be offered the opportunity to develop a Voluntary Employment

Redundancy (VER) program to proceed in 2012-13. Other labour saving initiatives to be

considered could include staffing number limits, hiring freezes, redeployment and relocation (which

in m ost cases would require union negotiation), and so on.

Among the GOCs which Treasury considers would benefit significantly in operational and

commercial terms from a VER round and other labour saving initiatives are QR (we believe at least

500 places could be achieved in a VER), CS Energy, Stanwell, Energex and Ergon.

In particular, there is also substantial work to be done with QR where removal o f a range o f

unfunded/underfunded services and demands could produce substantial budgetary benefits through

either lowering the cost o f the CSO or improving Q R’s returns. Discussed in detail elsewhere in

this document, these operational inefficiencies include:

• Traveltrain, in particular the western services which are poorly patronised (the M ITEZ Report

highlights the efficiency costs o f the Inlander in restricting train paths)

• Kuranda Scenic Rail and Heritage Rail operations which are unprofitable

• Citytrain, with its high cost structure driven by too many underutilised stations and guards on

the trains (contrary to metropolitan operations elsewhere in Australia)

• Large number o f Heritage properties which should be sold or commercially dealt with.

In the case o f Energex, there are a range o f fees known as “Schedule 8 Fees”, allowed for under the

National regulatory regime that they are currently prevented from pursuing as a result o f the

M inisterially determined Queensland Electricity Code. These include in particular fees for

de-energisation/re-energisation o f premises.

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For Powerlink, a critical issue will be resolution o f their five-year regulatory reset with the AER,

which will come into effect from 1 July 2012. The AER is scheduled to issue its final

determination by 30 April 2012. The draft determination included tough productivity targets in

their operating expenditure allowance which, i f retained in the final determination, will act to drive

greater efficiencies through the business.

There also are a range o f uncommercial legacy assets and contracts that should be thoroughly

reviewed to assess potential options to exit those arrangements, or at least place them onto a more

appropriate commercial footing. Examples include some o f the historical contract arrangements at

the ports, where assets have been provided at a nominal cost to the customer.

Capital Efficiency

On the capital side, key metrics to monitor are Retum on Assets and Return on Equity. Current

forecast rates o f ROA/ROE for 2011-12 and the forward estimates o f around 5% to 7% are not

sufficient for a commercially focused owner, and the GOCs should be striving to achieve rates o f

ROA/ROE at or above their WACCs.

Comparison with some leading ASX-listed entities provides further guidance. For the six years to

2010-11, the two large energy Gentailers, Origin and AGL have achieved average retums on equity

o f 8% and 7%, respectively.

As part o f the further reforms for QR, a thorough review should be undertaken o f the “base” capital

works program by an accredited, credible independent party to ascertain whether it can be delivered

at a lower cost to govemment w ithout putting at risk passenger or employee safety or service

reliability. Such a review would also thereby identify intemal funding sources for substantial

capital investment needs going forward for QR such as the Federal disability requirements.

It also is recommended that a fundamental review be undertaken o f the Transport Services Contract

funding model and associated institutional arrangements with the Department o f Transport Main

Roads, Translink Transit Authority and QR. Better aligmnent o f service requirements and

incentives is required to better drive inefficiencies out o f the system, and allocate responsibilities

for services and assets to the body best able to manage them. Greater use o f appropriate

benchmarking o f costs should also be reviewed.

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In the case o f the Gencos, it is important to affirm the sound decision to exit new business

development to meet increased demand in favour o f an approach to maximise the retum s and

economic life o f the current portfolio thereby gradually reducing the Government’s market

exposure to under 50%. This approach leaves growth in new market demand to the private sector

which has demonstrated it can more than adequately provide capacity to m eet such demand.

CS Energy also currently holds significant surplus coal reserves in the Surat Basin at Kogan Creek,

Glen W ilga and Haystack Road that could potentially be monetised, particularly once the Surat

Basin Rail is built, in conjunction with upgrade o f the Miles to W andoan section o f track, thereby

providing rail access to the port o f Gladstone. Due to the high quality o f the cropping land in

respect o f the Haystack Road resource, any development for coal mining purposes would have to be

by way o f underground mining. This could though provide CS Energy with potentially an

altemative revenue source, as the Curragh Coal Contract with W esfarmers achieves for Stanwell.

In respect o f the Network GOCs, it is recommended that the Government proceed with the

implementation o f the ENCAP Review conducted late in 2011. The savings as identified by the

Panel total approximately $1,345 billion from 2011-12 to 2015-16, and approximately

$1,545 billion if taken out to 2016-17. Energex and Ergon were directed by Shareholding Ministers

on 11 February 2012 to incorporate the expected reduction in capital expenditure programs into

their pricing proposals to the AER for the remainder o f their current regulatory determination.

Financing the Growth Capital

This set o f reforms is about taking further the direction already underway through the recent

successful negotiations for a user-funded new coal terminal at the Port o f Gladstone (Wiggins

Island Coal Terminal) and the substantial dredging project underway at the port also funded in large

part by the users (gas companies developing LNG plants).

Already, that model is being further developed to facilitate delivery o f the Connors River Dam and

Pipelines by Sunwater, and the Abbot Point M ulti Cargo facility and associated Terminals Nos. 4-9.

A new governance model has been established whereby a “State Funding Panel” , representing both

debt (QTC) and equity (Treasury/OGOC) has been established, and a much closer, interactive

approach to project development between proponent GOC and QTC/Treasury is taken, more akin to

that o f a private project developer and its financiers.

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GOCs are now being actively encouraged to pursue user-funded models more thoroughly through

their businesses. Powerlink, for example, has already taken this up through the use o f 50% upfront

fees on its unregulated projects with mining and gas customers to largely pay for the required

capital expenditure and minimise borrowing needs on these unregulated projects. Powerlink also

use astute conservative planning methodologies and strong project delivery skills to target WACC

retum s on these unregulated projects well in excess o f their regulated retums.

A likely strong candidate for a privately financed approach early in the new term will be expansion

o f the Port o f Townsville, and associated rail works on the M t Isa line and at the port. There has

recently been a report released into the supply chain on behalf o f MITEZ pointing to the need for

coordinated approach to infrastructure planning in the corridor to attract private investment into its

upgrade to handle expected large increases in customer demands over the next 30-50 years.

For those new projects that Govemm ent as owner continues to fund through debt and equity, the

intent is to drive home to the GOCs the absolute imperative that retum s must be very attractive to

the owner in commercial terms, well above target WACCs (such as what Powerlink is targeting), in

order to win govemment approval.

In the case o f QR, as noted earlier, the larger part o f the business is the CSO-funded activities. It is

recommended that any capital decisions directly related to the provision o f CSO services require

CBRC approval, and be considered in the usual Budget context.

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