RESTRUCTURING THE ELECTRICITY INDUSTRY
REPORT TO THE MINERALS & ENERGY PORTFOLIO COMMITTEE

Wednesday 28 February 2007

THIS CITY WORKS FOR YOU PROGRESS WITH RED1 UP TO 23 FEBRUARY 2007 & WAY FORWARD FOR REDs

Background:

The City undertook the necessary legislative steps outlined in section 78 of the Municipal Systems Act and section 84 of the Municipal Finance Act. RED1 was formally established on 1 July 2005 with the City holding 5 shares. RED1 was a Shelf Company that had been registered with the Registrar of Companies in November 2004. The legal processes carried out in 2005 included: registering the Trade Name as Regional Electricity Distributor One for the Company registered as Friedshelf 516 (Pty) Ltd; registering RED1 for Income Tax, VAT, PAYE, UIF and SDL.

RED1 was established as a municipal entity operating as the service provider to the whole municipal jurisdictional area served by the City of Cape Town electricity undertaking and the metropolitan jurisdictional areas served by Eskom. The City of Cape Town as the parent entity, exercised its Service Authority role, as outlined in section 82 of the Municipal Systems Act, through the Service Delivery Agreement entered into. Initially, two members of staff were appointed as RED1 staff members, with the CEO taking up his position from 1 July 2005 and the COO taking up his position from 1 August 2005. As the COO resigned, effective the end of February 2006, the Director for Electricity in the City of Cape Town took on this additional role of Acting COO. The appointment of the CFO took place in early 2006, he has subsequently left RED1. At this time there are officially three staff members of RED1. They are:

1. the Chief Executive Officer (CEO), Mr Saleem Mowzer,

2. a Personal Assistant, Ms Nazley Hartley and

3. an Executive Manager: Office of the CEO (Strategy & Integration), Anisha Archary

Six Directors were initially appointed to the Board for RED1 in a joint process between the Mayor of Cape Town and the Minister of Minerals and Energy. A further nominee was awaiting appointment to represent Eskom, however, this Board member subsequently resigned, as she was no longer in a position where she could represent Eskom interests. Board meetings have been held every 2 months, or more regularly if required.

Functional Arrangements:

On 28 June 2005, the City entered into a Service Delivery Agreement with the municipal entity, RED1. This agreement appointed RED1 as its service provider for electricity reticulation. This Service Delivery Agreement (SDA) was concluded based on the mandate provided by Council on 31 May 2005 that "the City of Cape Town acquires ownership of the Municipal Entity, RED ONE (Pty) Ltd .., and the City of Cape Town enters into a Service Delivery Agreement (SDA) with RED ONE (Pty) Ltd effective 01 July 2005.

This was not an arbitrary decision of Council to create a municipal entity but was as a result of the section 78 legal process (outlined in the Municipal Systems Act) and based on two letters from the Department of Minerals and Energy stating the policy decision to cater for municipal entities. The SDA had various resolutive conditions that were to be met by 31 December 2006.

As there was no staff and asset transfer on the date of establishment, RED1 contracted the both Eskom Western Region operating within the City's judicial boundaries as well as the City's electricity undertaking to provide the necessary services. This agreement with the City is known as the Operating and Transitional Plan for Transfer Agreement (O&TPT) and allowed for a period of between 12 and 18 months for the transfer of staff and assets to be effected.

Due to there being no nationally approved Asset Transfer Framework nor any approval granted by National Treasury for the City to use either of the Asset Transfer Frameworks proposed, no transfer of assets or staff took place from the City and effectively, as from 1 January 2007, the agreement is, in terms of clause 11.4.1, of no force or effect.

At all times during the electricity restructuring process, the electricity undertaking of the City of Cape Town has remained a ring-fenced internal business unit. At no stage was it "unbundled" into the Service Authority and Service Provider roles, nor were all additional supporting roles incorporated as the final end-state of the REDs has never been clear. The end-state looked slightly different, depending on who one spoke to in EDI Holdings (e.g. including or excluding debtors, EDI Holdings providing all support services through a shared service agreement).

The agreement with Eskom contained numerous suspensive conditions for the transfer of the customers other than domestic customers. The Department of Minerals and Energy responsible for ensuring those suspensive conditions where addressed.

RED1 obtained all funding from the City in the form of a management fee, linked to the Operating and Transitional Plan for Transfer Agreement, for the oversight of the electricity distribution taking place within the full jurisdictional area of the City of Cape Town. As the City had the necessary internal controls and systems and banking account opened in terms of national Supply Chain Regulations, the City managed the daily operational financial affairs of the Company as there was no clarity on the systems and processes that would be used once all the REDs had been established, the financial policies were not in place and there were insufficient staff members to satisfy the internal control measures of the Municipal Finance Management Act and audit requirements. When the operating agreement, and hence all the funding arrangements came to an end, the City remained the agent of RED1 regarding these functions.

Mandate UP to Cabinet Decision:

The Council had previously mandated the officials on 31 May 2005 that "the City of Cape Town acquires ownership of the Municipal Entity, RED ONE (Pty) Ltd. The policy statement made by the Executive Mayor in a joint meeting of the Mayor, various Mayoral Committee members, City, RED1 and EDI Holdings officials on 28 August 2006, confirmed this position.


Cabinet Decision:

On Wednesday 25 October 2006 "Cabinet approved the proposal to create six Regional Electricity Distributors (REDs) which will be established as public entities under the auspices of the Electricity Distribution Industry (EDI) Holdings (Ltd). These entities will be accountable to the Ministry of Minerals and Energy. The next steps will include the drafting of legislation and business plan for the establishment of the REDs.

Once the Cabinet decision had been made it was deemed unnecessary to consider an extension of the two founding agreements as there was no clarity on if and how the municipal entity could be changed to a public entity and if this was a route that could or should be pursued in terms of the Constitutional obligation on the local government sphere to provide electricity. Thus, legal opinion on the impact of this Cabinet decision on the Constitutional right and obligation of the City. (and local government as a whole), to provide electricity reticulation was sought.

Council Resolution:

On 7 December 2006, the Council of the City of Cape Town RESOLVED that

(a) cognisance be taken of the fact that the current contractual arrangements with RED1 will terminate on 31 December 2006 if the conditions precedent are not met;

(b) the officials be mandated to pursue the following route:

I Seek Senior Counsel advice on

i the impact of the Cabinet decision on the Constitutional obligation of the City to provide electricity, and the preferred route considering the Presidential statement on establishing RED1 and the process thus far; and

"ii the legal obligations of the shareholder to RED1;

II approach NERSA regarding the transfer of the distribution and supply licence, which expires on 31 December 2006, back to the City of Cape Town from 1 January 2007 or, if necessary, require RED 1 to surrender the licence to the City;

III communicate with all Electricity Department staff informing them that the provisions of the Operating and Transitional plan for Transfer Agreement and any related dual reporting lines cease and revert to single City reporting lines from 1 January 2007

IV negotiate taking over the lease of SHG House entered into by RED1 to accommodate some of the Electricity Department staff members

V pending legal advice, facilitate any transfer to EDI Holdings that may be required

VI the ad hoc Committee established by the Executive Mayor to oversee electricity restructuring is to brief Senior Counsel on the matters referred to in (b) I (i) and (ii) above.

(c) The Executive Mayor be mandated to call a general meeting of RED 1, which will include a Special Company meeting, in terms of the Company Act, and a special board meeting of the RED 1 Board, where the Executive Mayor, or her delegee, may convey and instruct the board on the way forward as determined by the shareholder;

(d) The Council remains open to negotiation with National Government over the restructuring of the electricity industry.

Electricity Licence:

As the City's Electricity Department staff members were not transferred, it was clear that any dual reporting lines would cease on 31 December 2006, when the Operating and Transitional Plan for Transfer Agreement ran to its conclusion. The Service Provision role would thus revert to the City. The City applied to NERSA (National Energy Regulator of South Africa) to take back the Electricity Distribution and Supply Licence as from 1 January 2007.

This licence was originally transferred to RED1 as from 1 July 2005. The licence also contained various conditions which, due to lack of national clarity and legislative frameworks, could not be met. Due to the change in the direction of Electricity Restructuring as outlined by Cabinet on 25 October 2006, the City determined to approach NERSA for the licence to be transferred back to the City. The City took part in the national hearings held by NERSA on the application by RED1 to have the original licence extended. The basis of the City's application was as follows:

· The City of Cape Town is the service authority for Electricity Reticulation and thus the City determines which service provider will provide the service on behalf of the City.

· Although every effort has been made to effectively get RED1 up and running as a service provider to the City, it appears that national policy and legislation is lagging and, until further clarity is obtained, the City needs to retain full control of the electricity service, particularly as the roles and responsibilities of the REDs have not been clarified;

· The City cannot afford negative publicity for no apparent reason when electricity has always been handled efficiently and effectively in an economically sustainable manner with competence by the City;

· The substratum agreements come to an end as at 31 December 2006 and in the circumstances there will be no legal framework within which RED1 can fulfill the Service Provider role required to adhere to the electricity supply and distribution licence conditions;

· The City retains the Constitutional obligation to provide electricity and must take responsibility for electricity reticulation so as to ensure uninterrupted delivery of the service in the best interest of the local community. The Regulator has the responsibility to ensure that the City is appropriately licenced for the discharge of its constitutional obligations.

The City received confirmation that the licence would be transferred back to the City and an amended Licence from NERSA has been received. The licence term is in accordance with other municipal distribution licences and the licence term for Eskom supplying electricity in municipal areas. The statement from NERSA stipulates that "These licences were all issued under the Electricity Act, Act 41 of 1987 and need to be aligned to the subsequently promulgated requirements of the Electricity Regulation Act, Act 4 of 2006. The Energy Regulator intends to issue new licences in accordance with the Electricity Regulation Act to the distributors from 1 July 2007

Legal opinion obtained by the City stipulates that the reversion of the license to the City and the City assuming these functions that were previously carried out under the agreements concluded with RED1 does not constitute a transfer of RED1 's undertaking to the City which would place certain obligations on the City under section 197 of the Labour Relations Act.

Way Forward with RED1:

The City as sole shareholder in RED1, requested a Special General Meeting to consider the statement of the affairs of RED1 by the directors. The Directors were also to be in a position to inform the City as shareholder whether the company is a going concern or not, and if not, to state the reasons.

The outcome of the Special General Meeting was effectively:

· The Board was requested to lay all the facts on the table, in a single document (there were two new reports submitted that added to and replaced some portions of the document circulated) - that substantiates the position taken by the Board that the City considers EDI Holdings taking over RED1. The Board was to complete their report by 1 February 2007.

· A verification exercise would be undertaken by internal audit on the figures contained in the OTPTA to account for the exact amount owing (if any) to RED1 by the City. Sign off by the Internal Audit department should take place by 1 February 2007.

The City, as sole shareholder, had to evaluate the proposals put on the table by RED1 and the funding available after the verification review in order to determine the ultimate way forward. As stated earlier, once the various operating agreements came to an end, the City, acting as an agent/service supplier to RED1, could only implement any daily operational processes that the Board instructed it to process.

Therefore, in order to ensure the smooth functioning of RED1, it was up to the Board of RED1 to provide the City with an adjustment budget showing the processes to be followed and identifying the funding sources for the operation of RED1 which would then authorise the City to pay the various creditors/liabilities of RED1 after 31 December 2006. This was not put to the City at this time, and the City eventually drafted the necessary adjustment budget to assist the company in meeting some of its operational requirements. At all times the City has endeavored to assist RED1 in being legally compliant. The City still continues to pursue the registration of the correct financial year for RED1, which was noted as incorrect in November 2005, but to date has not yet been rectified by RED1.

At the time of the Special General Meeting, the favoured route by the Board was that there is negotiation on the transfer of shares in RED1 from the City to EDI Holdings on terms and conditions to be agreed. The City had already been approached by EDI Holdings regarding this matter and requested that urgent negotiations be entered into.

Initial discussions indicated that the two parties were negotiating from widely divergent foundations. However, it was agreed that the negotiations would continue.

The final proposal received by the City showed that EDI Holdings would not be prepared to take over RED1 without the City undertaking to fund or continue with the responsibility towards the City's liabilities to RED1 and its employees' salaries. The City is mindful that it is the custodian of public funds and needs to account to the community it serves firstly, and other stakeholder on what has been achieved through the spending of these funds. The City also needs to comply with the requirements of the Municipal Finance Management Act. As the only relationship remaining between the City and RED1 is currently that of the City being sole Shareholder, the City cannot justify the indefinite funding of an entity which no longer has any business.

Decision of the City as Shareholder:

On Friday 23 February 2007, at a special Mayoral Committee meeting, all the information submitted by RED1 was laid before the Mayoral Committee members. It was decided in principle that the only option available to the City, as shareholder, at this time was to voluntarily wind up RED 1 at the request of the shareholder as effectively RED1 has ceased to carry on business. These processes are already underway.

The City of Cape Town has been a dedicated supporter of the electricity restructuring process under the blueprint stipulated by national government some three years ago. For well over two years, City officials have worked tirelessly at ensuring that the tight deadlines for the process have been met, even within the constraints of restrictive local government legislation.

However, it has become clear that the decision to create RED1 as a pilot company for the establishment of the first restructured electricity distributor was premature as, since the establishment of RED1, there have been two new Cabinet decisions changing the nature of this electricity distribution entity.

The first one, on 14 September 2005, dramatically reduced the area over which RED1 would have authority and the second, on 25 October 2006, completely changed the persona of the entity from a municipal entity to a public entity. It further raised serious questions relating to Constitutional legality and placed the process back to the starting line in terms of planning.

The City has consistently maintained its stance that a public entity is not a viable means for the provision of a municipal service. I would remind you that this stance has now been upheld by the Senior Counsel opinion that the City received, which states: "The Cabinet's proposed restructuring of the electricity distribution industry [as outlined in the Cabinet press statement of 26 October 2006] would be subversive of the powers and functions reserved to municipalities in terms of the Constitution. A national public entity, unlike a municipal entity, is not amenable to the executive authority and administrative control of a municipality. The implementation of the policy would be in breach of obligations imposed on national government in terms of S 151 (4) of the Constitution."

At all times in the past three years of planning for the electricity distribution restructuring the City has maintained its support for the objectives of the process and this was re-iterated at the meeting of the full Council of the City of Cape Town on 7 December 2006. However, while the City drafted the original operating agreements with RED1 to allow for an 18 month transfer period as a maximum for the transfer of staff and assets, national government has not been ready with the necessary framework as required in terms of section 14 of the Municipal Finance Management Act in order to facilitate the transfer of capital assets.

EDI Holdings, the company established by the Department of Minerals and Energies to facilitate and aid the transfer process, has also failed to provide support to the City (as opposed to RED1) regarding the electricity restructuring process. Similarly Eskom has not cooperated in achieving the deadlines set for the full operation of RED1.

The City is obliged to use the resources of the municipality in the best interests of the citizens and electricity consumers of the area. The City sets charges at a realistic level and generates a surplus from electricity which is used for a number of social subsidies.

The City continues to provide indigent relief which includes 50 units of free electricity to those residents who use less than 450 units of electricity per month. However, those who can pay for the service do pay and the City redistributes funding to subsidise other services where tariffs and charges are not imposed or are limited to the barest minimum to ensure access by all - such as libraries, swimming pools, clinic services, etc. It is this subsidy funding that the City wants to protect.

The City is one of the few metropolitan municipalities that limit the surcharge to within proposed national norms. The City can no longer utilise public funds, entrusted to the City by the ratepayers in the City of Cape Town, to fund an operation where the future end-state is not clear and there is no supporting legislation and framework to guide the process further.

Way Forward for REDs:

The Constitution of South Africa, (chapter 3) recognises the government is constituted as national, provincial and local spheres of government which are distinctive, interdependent and interrelated.9 All spheres of government and all organs of state within each sphere must respect the constitutional status, institutions, powers and functions of government in the other spheres and not assume any power or function except those conferred on them in terms of the Constitution. The Constitution further stipulates that all spheres of government and all organs of state within each sphere must exercise their powers and perform their functions in a manner that does not encroach on the geographical, functional or institutional integrity of government in another sphere and further, must co-operate with one another in mutual trust and good faith by, inter alia, assisting and supporting one another.

The powers and functions of municipalities are clearly articulated in the Constitution. Every municipality has the executive authority and the right to administer the local government matters listed in Part B of Schedule 4 and Part B of Schedule 5 of the Constitution. This includes Electricity and Gas Reticulation.

Unfortunately, there is no definition within the Constitution of what was envisaged within the word "reticulation". However, the Municipal Structures Act of 1998, allocated all functions and powers assigned to municipalities in terms of sections 156 and 229 of the Constitution. It even went further to specify in detail what some of those functions meant when describing the functions and powers related to electricity services that would be allocated to district municipalities. Section 84 of the Municipal Structures Act stipulates the functions and powers delegated to District Councils related to electricity are as follows: Bulk supply of electricity, which includes for the purposes of such supply, the transmission, distribution and, where applicable, the generation of electricity .The precedent has been set and has been in operation for at least 8 years.

Local Government has a strong developmental role to play in the area over which it is given jurisdiction. The sources of funding for the provision of social and utility services and related infrastructure come from various sources. However, it cannot be denied that electricity income is also a significant income source. If the basis on which this income stream in municipalities is tampered with, the fine act of balancing the municipal budget to provide significant social services funded out of limited economic services becomes nearly impossible. The possibilities of raising funds at local government level are limited and significantly regulated. This regulation will be further tightened through the introduction of the Municipal Fiscal Powers and Functions Bill introduced by National Treasury. This Bill, Draft 3 of 21 May 2006, already addresses the issues of:

· The municipal surcharge;

· The municipal base tariff for water and electricity; and

· Allows the Minister for Finance to review any changes to the powers and functions of a municipality effected in terms of a power contained in any national or provincial legislation.

It appears that the latest Cabinet Decision regarding the establishment of Public Entities in order to provide electricity distribution services has inadvertently taken over a functional responsibility of the local government sphere. The current operating requirements of a Public Entity, as outlined in the Public Finance Management Act, Act 1 of 1999, will make it exceptionally difficult, if not impossible, for municipalities to exercise the Service Authority role outlined in the Municipal Systems Act. The responsibilities of the Service Authority are outlined as follows:

· regulating the provision of the service in terms of agreed performance indicators and an approved performance management system;

· management of the contract for the delivery of the service (Service Delivery Agreement);

· performing its functions and exercising its powers in terms of Ch 5 of the Municipal Systems Act (chapter dealing with IDP);

· controlling the setting and adjustment of tariffs within a tariff policy determined by the municipal council;

· exercise service authority (executive authority, per the Constitution) so as to ensure uninterrupted delivery of the service in the best interest of the local community.

Conclusion:

The City will continue to play an active role in the development of the enabling legislation and generally contribute to the process. Once the full legislative framework is passed by Cabinet and the benefits from any pilot site are evident, the City will .

ensure that the electricity reticulation service in the jurisdictional area of Cape Town is provided to the local community in a financially and environmentally sustainable manner with the organisational and delivery mechanisms meeting the needs of the community.