Eskom Multi-Year Price Determination (MYPD3) application to NERSA: Update

Meeting report

Chairperson’sOpening remarks
The Chairperson said Eskom had been invited to give the Committee an update briefing on the key features of its Multi-Year-Price-Determination (MYPD3) application. This was not to be seen as setting in motion the process of public hearings, by the National Energy Regulator of South Africa (NERSA), as NERSA would also need to tell the Committee how it planned to consult widely on the Eskom application. This presentation from Eskom would allow the Committee to monitor the NERSA consultation process, from an informed stance. Electricity was vital for economic growth and the lives of the people. The Chairperson highlighted the need to probe how the requests by Eskom were calculated, leaving aside, for the moment, the desirability of further price increases.

Eskom Presentation on Multi-Year Price Determination requests
Mr Mohamed Adam, Divisional Executive: Regulation and Legal, Eskom, said the Multi-Year Price Determination (MYPD3) was the beginning of a public process. An application for new tariffs had been submitted by Eskom to NERSA, as the current three year-price cycle would end in March 2013. Eskom had encouraged all stakeholders to participate vigorously in the process, as it believed that the more views expressed, the better the final outcome.

He confirmed that Eskom was well aware that any increase in electricity prices, particularly given the current financial climate, would have an impact. Eskom aligned its thinking to the State of the Nation Address, in that it sought a price path that would make Eskom financially viable, whilst taking into account the need to support economic growth, job creation and offer support to the poor.

The application ensured that Eskom would cover the costs of supplying electricity to the country, whilst also allowing it to invest, in the future. It had secured the resources to run the existing operations but it must also be remembered that there was a cost to producing electricity. The Eskom application also took into account funding requirements for the additional capacity that would be needed for security of supply into the future. All this had to be balanced against the impact on the economy and ensuring mechanisms to protect the poor.

A stable supply of electricity was essential to power economic growth and improve the lives of South Africans, and this must be recognised in whatever Eskom tried to achieve. The current price of supplying electricity did not cover the full production cost, so this application was continuing along the path of migration to cost-effective tariffs. Eskom believed that all electricity produced must be paid for. This would be the best solution. However, it was mindful of the impact the cost of electricity would have on the economy, especially on small businesses and the poor.

Eskom had proposed that the MYPD process, instead of being three years, as at present, should be extended to five years. Eskom owed South Africa an efficient and well-rounded service. The company was unable to contain the cost below inflation, because of two material respects – the first that the current tariffs were not cost-reflective, and the second the need to ensure security of supply. These two material respects had led to a funding problem in the past. The need to “keep the lights on” meant that extraordinary measures, and higher costs, needed to be taken.

One of the highest input costs was coal, and keeping coal at inflation rates alone was impossible. It would be extremely difficult for Eskom to maintain and pass on inflationary cost adjustments. Eskom had provided funding for the cost of replacing and using its assets, but also had serviced the debt raised to fund new infrastructure for South Africa. The application had taken into account the Independent Power Producers (IPPs), three rounds of the Department of Energy (DoE) Renewable Bid programme for 3 725 megawatts of capacity, and the DoE's Photovoltaic (PV) Plant.

Eskom was asking for average annual increases of 13% for the next five years, in order to meet the company's needs. There was an additional 3% to support the introduction of IPPs. In total, the annual electricity price increases for the next five years would be 16%.

Mr Adam said this proposed increase did not cater for all the power required for the Integrated Resource Plan (IRP) 2010. Decisions would have to be made around the capacity referred to in the IRP 2010. Eskom had included a number of scenarios into the application, so as to facilitate engagements. This ensured that the price implications were transparent.

Mr Adam stressed again that Eskom and the industry needed to recover the cost of generating electricity, including the operating cost and the cost of financing new capacity. A failure to migrate to cost-reflective tariffs would be untenable for the company in the long run. He reminded Members that Eskom had faced severe funding challenges a few years earlier, and would not like to repeat the mistakes of the past. Cost reflective tariffs would ensure sustainability of the industry, and would provide confidence for lenders and investors. Mechanisms had been put in place to protect the poor.

An acceptable argument had been that if more power was required to secure the needs of the country, then there was a need for additional power. This had to be paid for. One model set out the tariff structure. If this did not happen, government would have to pay for the shortfall. He said, however, that other studies had shown that the worst consequences were caused to the economy where government bore the cost of electricity production. Eskom was determined that inefficiencies should not be passed onto customers. At the end of the day, NERSA would only allow for a prudent and efficient cost.

In order to contain and create a safety net to “keep the lights on” and to manage the demand, within the assumed demand growth focus, Eskom suggested that an energy conservation scheme be put in place. The application suggested a legislative framework, but this would apply only in the eventuality that the country needed to use the scheme.

Mr Adam reiterated that Eskom was aware of the impact that electricity price hikes would have on the economy. It would nevertheless strive for the right balance, to ensure viability of Eskom and the industry while protecting the poor and the economy. Eskom had about 5 million customers, most of whom were residential.

He added that 35 000 people were employed at Eskom's built projects, and 12 000 learners were enrolled with the company's skills development systems. By March 2012, R72 billion had been committed to the Broad Based Economic Empowerment programmes. In the new build projects, more than R75 billion worth of contracts were placed with South African providers. The company had the largest energy savings programmes, with 57 million solar energy bulbs, and 285 000 solar geysers installed. About 4.2 million households had been connected to electricity since 1991.

Ms Thoko Molefe, Customer Services, Eskom, expanded on the need to consider protection of the poor. She stressed that the tariff structure would not be the same for residential and the large customers. Within the residential customers, there would be further affordability divisions, as those who consumed less electricity would pay a cheaper tariff. It was important to look at the cost of supply for the smaller customers. It cost Eskom more to supply these customers, hence the subsidies that Eskom was proposing.

In order to cushion the poor, Ms Molefe explained that there was an inclining block tariff, which meant that the lowest block tariff would experience below-inflation tariffs. This was the situation brought about by the MYPD2 application. The current tariff had had some unintended consequences, was very complex for customers to understand and apply, resulting in customers paying more. She said a refined, simpler local residential tariff was being proposed, for low consumption, prepaid electricity. The current Eskom application proposed a national subsidy framework, after analysing the needs for all customers.

Mr Paul Flaherty, Finance Director, Eskom, explained that the company had three sources of funding, from revenue, borrowing and equity. The amount required over the next five years was just over R1 trillion. Eskom had worked with the Department of Energy as to what kind of power production to use, in the MYPD period. Coal provided for most of the R355 billion in primary energy cost, and coal costs would increases by about 10% in the period.

He noted again that Eskom had considered all the determinations that were available by the end of September 2012. It had taken into account the DoE 3 725 megawatts under the Renewable Bid Programme and the 1 000 megawatts of the PV Plant. DoE had provided information on the Independent Power Producers (IPPs), who, over the five year period, were calculated as contributing R78 billion of revenue requirements. This equated to about 39 000 gigawatt-hours in the period, at an average price of R2.12c per kilowatt-hour.

Employee costs accounted for half of the total cost, with other amounts going to repairs and maintenance. Also included in that cost was a target of R30 billion savings that Eskom had put in, as a contribution to becoming more efficient. This was based on the fact that over the last two years, the company made a R9 billion saving on efficiency. Eskom would ensure that its employee costs were kept within inflation figures.

Another part of the revenue application related to depreciation, for the regulatory requirements were based on the depreciated value of the plant. If Eskom were to replace its equipment, in its current condition, it would cost R900 billion. There was 25 more years left within the fleet. Depreciation was only claimed on operational assets.

The last component of the application was the return on assets. The regulator determined that Eskom pre-taxed and should require 8.16%. An independent survey done indicated that Eskom should be entitled to an average of 8.31%.

Mr Flaherty returned to the question of the fleet, saying that a substantial amount was required to maintain it. The country was at risk as a result of the coal increase prices of 10% over the next five years. Eskom had secured a contract that would, over the next five years, supply 80% of its coal requirements. He said 45% of the costs were linked to coal costs, where the mines were paid directly for operations. Tighter controls were required to ensure the mines produced the right quality coal, as that influenced fluctuations in prices. The application had specifically addressed the need to work with the mining industry to make sure that cost was controlled.

Eskom currently employed 43 300 people, and had planned to grow to no more than 45 000 in the period. The revenue application only took the company to the end of Kusile (a power plant still under construction in Mpumalanga). It did not take into account anything new that might be required of Eskom, in terms of the Integrated Resource Plan (IRP).

Mr Flaherty stressed that Eskom's plants were old and needed to be replaced. If depreciation costs were claimed on a historic basis, this would keep the revenue requirements low for a time, but the eventual replacement of the fleet would be five times more expensive, with massive price shocks happening at sporadic intervals as new fleet had to be purchased. Eskom’s electricity pricing policy instead adopted a more linear way of claiming depreciation to avoid future shocks. The question was whether South Africa wanted to phase in price increases now, or wait for price shocks in future. He noted that Eskom still had massive borrowings of around R360 billion, to complete the construction of Kusile.

Eskom had strong government support and had been given a guarantee of 350 billion, but it did not intending using all of that money. If Eskom did not improve its financial ratio, its stand-alone grade would slip, and no amount of government uplift could save a company from being sub-investment grade. It was necessary to ensure that prices covered full cost of production to avoid the situation where the electricity industry was subsidised.

Eskom was committed to a renewable energy mix. Mr Flaherty noted that IRP decisions were needed urgently, and everybody should engage on the “game changes” that could change the future of the country, to consider what was the best option for consumers, whilst ensuring that Eskom was viable.

Mr Flaherty passed the presentation back to Mr Adam, saying it was necessary to explain how the regulatory clearing account worked.

Mr Adam explained that South Africa had a hybrid regulatory system, that was incentive based. The different cost brackets were treated differently. Normal operating costs, like maintenance and human resources, were included in incentives. Once a submission was made, NERSA would allow for whatever cost it believed to be appropriate. If Eskom spent more than it could recover, then this was its own problem. If Eskom spent less than allowed, then it would benefit by making a saving. Any costs over and above those set by the regulator would form part of the cost line for the next period. Over the longer term, the customer would benefit through the incentives.

Another category of costing related to coal, and this too used a hybrid system, because there was some debate how much control Eskom had over coal production. NERSA had accepted that Eskom did not have control over coal cost, but believed that Eskom had some leeway to enforce efficiencies and controls in relation to some costs. NERSA would set a bench mark coal cost. If that was exceeded, there was a sharing mechanism with customers. If it was not exceeded, the benefit of the cost saving would be filtered down to the customer.

The third category was based on certain assumptions and projections around volume and demand growth, and these were not entirely within Eskom’s control. In relation to the IPP cost, NERSA would allow whatever it deemed appropriate. Another area in this category was capital spending. A reconciling mechanism was provided, that, in the case of IPPs, was around volumes. If the discrepancy was between 2% to 10%, NERSA was entitled to evaluate if the costs were prudent. Anything above the 10% bracket would have to be referred to public hearings.

The regulatory mechanism ensured there were certain areas where costs were within Eskom’s control, certain areas where cost-sharing was done with customers, and, for areas outside the control of Eskom, mechanisms would ensure that there were no windfall gains or losses from incorrect projections. In essence, this mechanism kept Eskom honest. There was no benefit in projecting higher or lower numbers.

Discussion
Mr K Moloto (ANC) said the submission by Eskom to NERSA captured issues of risk and stakeholders comprehensively. However, he sought clarity on a number of issues. On page 13 of the application it was stated that NERSA needed to consider an indication of prices beyond Kusile, and he noted that if the issues were not addressed now, Eskom might have to apply again once policy decisions had been made.

Mr Flaherty replied there were policy decisions required on Eskom’s participation beyond Kusile. The company had not perceived any determination.

Mr Moloto said that page 23 of the document said that depreciation was meant to incrementally recover cost of the new plants, and set out some calculations of the return on assets. He sought clarity on the cost of the work under construction, how it related to return on assets, and also how NERSA was involved in the whole process.

Mr Flaherty replied that these figures indicated that the majority of the funding for the capital programme was achieved through Eskom raising debt, which in turn required it to service the interest annually. When calculating the total returns, the debt associated with the assets also had to be brought into account. Eskom did not claim depreciation on the works under construction.

Mr Moloto requested clarity on pages 79 and 80, where reference was also made to the return on assets. He asked for a further explanation on the statement that "Given the funding source on development finance institutions and banks underwritten by export credit agencies, deterioration in the credit profile rating would result in the breach of certain loan categories, resulting in cost defaults in all related loans, and could affect current and future funding of Eskom."

Mr Flaherty said in most of Eskom’s loans, there was a specific requirement that Eskom should always be at a set investment grade, and if it was not, there would be consequences for the loans repayments or re-negotiations. There was a massive risk if Eskom did not remain that investment grade. To mitigate that risk, Eskom needed to be at a stand-alone grade, in order to maintain a strong balance sheet.

Mr Moloto also sought clarity on the assumptions that the presentation made on pages 27 and 28, regarding economic growth. He asked how confident Eskom was about the modelling it had done around economic growth, and if the numbers proposed would hold.

Mr Flaherty replied that a demand forecast was done, on a bottom-up approach, looking at the key industrial customers, what municipalities were saying, and the projections for GDP. An assumption was then made around the demand growth. This assumed that, with GDP of around 4%, demand in South Africa would increase by 1.9% gigawatt hours per annum. A decision was then made as to how much Eskom needed to produce, less what was needed for maintenance, and a reserve to cover unplanned circumstances. Once that was done, this reached the figure that would have to be supplemented by IPPs.

He added that if the IPPs did not get in line, or an unplanned event happened, integrated demand management, demand side initiatives and the energy conservation schemes became important. In a tight system, there would not be surplus capacity, so there was a need to find a balance. If the IPPs did not come on stream in time, Eskom would have to look at sacrificing some of its planned maintenance to make sure it produced enough. The assumptions on demand growth were the best that Eskom could make.

Mr Moloto also sought clarity on the submission on water, as reflected on page 57. He asked if water provision and the cost of producing water would have an impact on the primary energy cost. Again, this raised the question whether Eskom was confident about its numbers and modelling.

Mr Flaherty replied that the issue of water was under control for the next five years. However, water could be an issue beyond the Medupi and Kusile plant completion dates. Water costs would increase as the new schemes came into operation.

Mr Moloto asked about the IPPs, outlined on page 62 of the presentation, and asked for a further explanation on the impact of IPPs on the Eskom tariffs.

Mr Flaherty replied that all the information provided to Eskom, and the volumes of what had to be included, came from the Department of Energy. A lot of the fundamental assumptions emanated from Round 1.

 Mr L Greyling (ID) asked for further clarity on keeping the coal cost at 10%, and securing a country pact as proposed in the document. He added that coal costs were also influenced by transport costs. Mpumalanga had started running out of coal, and very soon the country would have to transport from Waterberg. He thus wondered how realistic were the projections to keep coal costs at below 10% increases.

 Mr Flaherty replied that Eskom had secured 80% of its coal contracts for the next period. Eskom contracts negotiated for certain volumes, and the mines were near to the power stations for the next five years. He agreed that the Mpumalanga reserves were decreasing, so beyond the five-year period, this could be an issue. Consideration had to be given now to future compacts and how costs would be controlled in the future.

Mr Greyling sought clarity on the ratios of 13% Eskom and 3% for IPPs. He also requested a breakdown on the renewable energy and the PV Plant, and said he was interested in how the costs would be managed.

Mr Flaherty replied this information was contained on page 58 of the application document.

Mr Greyling wanted to know if Eskom had considered applying for tax exemption, like some other major investors, since such an exemption could protect the customer from exorbitant tariff increases.

Mr J Smalle (DA) said the price structuring would change if a tax exemption was granted.

Mr Flaherty replied that Eskom did not pay income tax, as it had tax losses. In the five years it was assumed that no tax would be payable. Eskom had applied, and it worked with the South African Revenue Services (SARS), to get allowances and also ensure that it did not pay taxes.

Mr Smalle concurred with the view that the IRP needed to be re-evaluated, in order to bring certainty into the energy mix. The country could not expect any entity to plan energy on assumptions, as that would lead to uncertainty in the economic markets. He asked if there were deadlines to ensure that revised IRPs were made. He also asked if Eskom was looking to work with big consumers in the future, especially if they wanted to take some of the coal generating plants.

Ms Molefe replied that Eskom had tried different tariffs, based on a number of factors as varied as municipalities who introduced tariff increases on 01 July, in line with the Municipal Finance Management Act (MFMA). Eskom determined a tariff for a municipality, who in turn would apply to the regulator to determine its own tariff. The tariffs were restructured to ensure protection of the poor. She stressed that different tariffs applied for residential and commercial use, which explained why different tariffs were reflected in the presentation.

Mr Smalle sought clarity on the block tariffs. He asked if the implementation at municipalities was possible and if it could be rolled out timeously.

Ms Molefe replied that when the MYPD2 was submitted, Eskom had requested that it be given time to ensure that systems were introduced for the first year. Inclining Block Tariffs were not applied. Eskom had gone a long way in preparing for that. The two-block tariff that Eskom now proposed was simpler, and would be easy to implement concurrently with the rest of the tariff.

Ms B Tinto (ANC) asked that the results of NERSA's study on the impact of Inclining Block Tariffs in cushioning the poor should be shared with the Committee. She thought that the application set out some confusing figures, and sought clarity on the increases.

Ms Molefe replied that NERSA invited the public to comment on the study, and Eskom also made a presentation. The proposal was the same as the MYPD; Eskom proposed three different, but less complex, structures for the residential tariff.

Mr Flaherty expanded that Eskom required 16% for the next five years, excluding costs for any new projects beyond Kusile, but including the 3 725 megawatts from DoE. Eskom was also suggesting that if it had to build beyond Kusile, with Eskom covering 65% and IPPs 35% of demand, then it would need five years of increases of 20%, followed by another five years of 9% increases.

Mr S Radebe (ANC) wanted to know if there were any guarantees of certainty around the average increase of 8% on operational costs. This might constrain Eskom in the long run, so he suggested that perhaps two ratios were needed.

Mr Flaherty replied that Eskom did not want to budget for failure. The company had taken a proven operator approach. It believed it had done enough repairs and maintenance, and it had, as required, capped employee costs. Eskom believed that it could achieve R30 billion savings, given its size. There was an 8% target, and Eskom believed it was achievable.

Mr Radebe wanted to know whether Eskom’s debt and borrowing had any impact on the fiscus, especially as it continued to grow. Eskom normally helped government in collection of revenue but it was important to assess the kind of impact its debt had on the fiscus.

Mr Flaherty replied he was not sure, since Eskom was not asking for any direct flows or additional guarantees from government. As outlined, Eskom was trying to ensure that it had no need to call upon the guarantees.

Ms B Fergusson (COPE) was concerned by the coal and transport cost, and wondered if they were realistic. She wanted to know what needed to happen with the IPPs, and the kind of impact they would have.

Mr Flaherty said that Eskom was not concluding anything, but had asked for the 16% increase, including the 3 725 IPPs, as this was what would be required.

Ms Ferguson asked what guarantees there were that Eskom would maintain a multi-year steady increase, as opposed to a peak increase that could have a bad effect on the consumer.

Mr Flaherty replied that, looking over the past eight years, and the increases that South African consumers had to endure, there was now a need to be very decisive. South Africa could not keep postponing proper pricing of electricity.

The Chairperson asked what had been factored in the IPPs’ three windows. He asked what would happen if matters involving inclusion of the IPPs went beyond the three windows.

The Chairperson sought clarity on the energy conservation scheme, and whether it had become part of the energy efficiency strategy in the long term. He also sought clarity and details, on a statement made about the 20% increase scenario. He asked what sectors gave Eskom confidence that it could refine, once the MYPD3 was rolled out.

Mr Flaherty replied that Eskom had factored in the full 3 725 megawatts at various stages, as supplied by DoE. Eskom had also run scenarios for what would happen beyond the three windows. The first considered what would happen if a full IRP build was needed, in which Eskom would do 65%, and here there was a calculation that five years of 20% increase would be needed.

Mr Flaherty replied that the issues included the decision on the IRP 2010, possible game changes in the future, whether the cost of coal technology could decrease significantly, the impact of mining, the need to keep investment growing, and the possible introduction of carbon taxes. However, Eskom had also taken into account the acceleration of electrification and continuation of electrification, based on grants received from DoE.

Ms Molefe added that conservation schemes were seen as a last resort measure, to prevent load shedding. Eskom had factored in a number of calculations, but was of course mindful of the fact that the consumer should not have to pay for something that was uncertain. A pronouncement still had to be made by DoE on the scheme. Eskom was currently working on a voluntary scheme, but at this stage there was nothing regulated.

The Chairperson requested that, in relation to the IRP 2010, the delegation needed to focus on issues that related to price determination, and leave out questions of policy. The same applied to the Independent System and Market Operator Bill (ISMO).

Mr Adam replied that the IRP 2010 looked far ahead into the future, and thus needed ongoing re-evaluations. When Eskom submitted the MYPD3 in September, it was aware of the decision it had to take, and had accepted Ministerial determinations. However there was also an understanding that there would be stakeholder engagements right up to the time that NERSA made a decision on the application.

He noted that further determinations would not have any impact on the application and any variances subsequently found would have to be handled by the regulatory mechanisms. Anything related to capacity would have to be dealt with, after the application. DoE was finalising further determinations, and if they arrived prior to NERSA making the decision, NERSA would have to make a call as to whether those should be included or not.

Mr Adam added he did not wish to get involved in discussions around ISMO, but the issue was the space for other IPPs. Whatever happened with the determinations would set a tone as to what capacity was needed, and who would deliver such capacity.

The Chairperson thanked the delegation for the arguments it had presented within the time constraints.

 NERSA presentation

Mr Charles Hlebela, Head of Communication, NERSA, outlined briefly that six pillars were used in the MYPD determination process. These were as follows:
- Planning: This was where previous decisions were reviewed. An analysis of prevailing circumstances was done, and a draft process plan was drawn, that included timelines.
- Organising: The application was broken down into key elements for the work.
- Analysis of the data would then be done.
- Consultation of the stakeholders would then follow.
- Determination: During this process, all the evidence gathered was consolidated.
- Communication of the decision would be given to the Department, Eskom and the public at large.

Mr Hlebela said that within the current MYPD3 process, requests for written comments had been made. Initially, NERSA had planned to visit all provinces, but due to the delays in receiving the application, it was decided that other platforms had to be used. There would be information sharing sessions with stakeholders, in the form of radio talk shows with the SABC, as well as television information sessions, and use of community radio stations. The programmes would be very interactive, and Eskom would be party to those.

Public hearings would be held from 15-31 January, but venues had not be decided upon. Two days had allocated for the Gauteng province, due to the larger turnout that was expected there. NERSA was fully committed to a transparent consultative process.

Discussion
Mr Greyling pointed out that the dates for the public hearings were during the week, and that was of concern for many people would not be able to get time off from work. He wondered if weekends had been considered, to increase the participation by the general public. He also enquired if there would be live coverage on television as the process unfolded.

Mr Hlebela replied there would be television coverage, although it was not planned as live coverage. He said that the issues raised could be considered further by management.

The Chairperson commented that the vastness of the provinces meant that many people would be disadvantaged and unable to attend, depending on where the public hearing would be held. Public hearings needed to be transparent, and had to empower the people. He felt that it was a weakness that the 16% requested by Eskom was not broken down and explained to the nation. Whilst he conceded that there were efforts to communicate the matters to the country, the process was still limited, and hardly reached the people living in deep rural South Africa.

Ms Tinto commented that the Eastern Cape was vast, and given the historical barriers posed by geographic boundaries, many people would not be aware of public hearings if they were held in Port Elizabeth.

Mr Hlebela concurred there was a weakness with centralising the public hearings in towns, but said that the radio shows were meant to reach wider out to provinces like the Eastern Cape, and the use of community radio stations, using vernacular languages, would also encourage knowledge. The idea behind having Eskom involved was that it could explain how the application was calculated.

The Chairperson said he hoped Members would do their best to encourage the public representatives at provinces and municipalities to consider the matter. The NERSA publicity drive was of some concern, because people would assume that the application by Eskom was the only increase, although municipalities would still be adding their own increases. People would react with emotion, but sadly municipal and Eskom increases were a reality. The Committee would carefully monitor the process through all its stages.

The meeting was adjourned.