Briefing on Electricity Administered Prices

1. Briefing on Electricity Administered Prices CONFIDENTIAL

2. Agenda • Price Drivers • Industrial Policy Issues -Confidential-

3. The electricity price trajectory can only be understood in the context of a progressive decline of investment in infrastructure between 1980 to 2004. -Confidential-

4. Eskom’s average selling price for electricity has been declining since the early 1980s. -Confidential-

5. Had Eskom been given inflation linked increases between 1990 and 2005, the company’s balance sheet would look very different today. 258bn • Presuming the revenue earned interest at an average rate of 5% p.a • At CPIX - 142bn • At CPIX+1 - 197bn • At CPIX+2 - 258bn 197bn 48 bn 142bn 38 bn 29 bn 210 bn 159 bn 114 bn -Confidential-

6. If prices kept up with inflation since 1990, this would translate to a tariff level close to what would have been achieved with a 60% increase in 2008/09 The resultant tariff is within 7% of what was requested by Eskom at the start of the crisis 29c/kWh 9% 27c/kWh 25c/kWh 7% 24c/kWh 5% 2007 (Nominal) 2006 (Nominal) 2005 (Nominal equivalent) 2008 (Nominal)

7. In the same period input costs had been rising at a rate higher than inflation vs. Eskom’s price which has been declining in real terms Index Since January 2004, Coal index has increased by 93% compared to PPI of 29% Source: StatsSA P0142.1 PPI Report Table 14, Mining and Quarrying - Coal -Confidential-

8. The challenge today is to correct the price while providing Eskom with capital for the build program without overly exposing the consumer to massive price shocks. • In reality, the Eskom price increases are less reflective of the regulatory rules, than of a pragmatic attempt by government and Eskom to manage the shock of the price correction. • For MYPD2 the Regulator gave Eskom a 0,8%, 2,8% and 4,2% return on assets instead of an 8% return – this resulted in a funding shortfall of R90 billion which the state covered through a R60bn subordinated loan and guarantees of R350 bn. • For Y12/13 of MYPD, Eskom voluntarily decreased the tariff increase from 25% to 16% based on optimising operational efficiencies and capital expenditures – this will come at a cost of strengthening Eskom’s balance sheet. • In Eskom’s MYPD3 application, the company is continuing to apply for tariff increases well below the 8% return on assets to which they are entitled – a sacrifice of R209 billion. -Confidential-

9. The price increases in Eskom’s MYPD3 application are designed to protect poorer households. -Confidential-

10. Large customers subsidise smaller customers, although their cost per unit is cheaper. 10 -Confidential-

11. However, government’s and Eskom’s sacrifices will come to naught if the municipalities simply “tax” the electricity price. • To be able to compare the different distributors with Eskom, a single customer analysis (snap-short) is provided. • The average prices are applicable for 2011/12 during the winter season i.e. 3 months i.e. June, July and August on time-of-use tariffs (equivalents for Eskom’s Megaflex). A single 22kV customer, 0.61GWh 110% 41% 1 2 3 4 5 6

12. Agenda • Price drivers • Industrial Policy Issues -Confidential-

13. Mining and quarrying emerges as the sector with the greatest reliance on electricity, with electricity accounting for almost 5% of the sectors total input costs Value of electricity consumed expressed as a percentage of intermediate inputs Direct electricity costs as a proportion of total input costs • Interestingly, the ratio of electricity costs to total input costs is higher for the transport, storage and communication and wholesale\retail trade sectors than is it for manufacturing which one would typically expect to be more reliant on electricity • This however is probably because of the considerable variation in reliance on electricity within the manufacturing sector Source: Chamber of Mines in (Pan-African Investment & Research Services, Eskom, May 2011) CONFIDENTIAL

14. 3 A more disaggregated view of the share of electricity in the cost structure of South African industries was presented in a 2008 report by the HSRC. Of 94 sub-industries, non-ferrous metals is by far the most reliant on electricity Value of electricity consumed expressed as a percentage of intermediate inputs The 30 most electricity–dependant sub-industries (electricity costs % of total costs), 2002 Source: Deloitte analysis, based on Human Sciences Research Council (2008) * These estimates were calculated on the basis of data provided in the 2002 Supply Use Tables (SUTs) published by Statistics South Africa (Stats SA) in 2005. Sub-industries are ranked according to the share of electricity in their total costs – only data on the 30 most-dependent industries out of the total of 94 have been presented CONFIDENTIAL

15. 3 Electricity intensity is another measure of the reliance of an industry on electricity based on actual consumption rather than expenditure on electricity. Value of electricity consumed expressed as a percentage of intermediate inputs The 30 most electricity–dependant sub-industries (electricity costs % of total costs), 2002 Key points • There is considerable variation from one manufacturer to the next. • Basic metals industry (which includes iron and steel and non-ferrous metals) is the most electricity-intensive of the thirteen industries • But some of the other manufacturing activities including transport equipment, machinery and food in are among the least energy-intensive. CONFIDENTIAL

16. A comparison of the electricity intensity of SA industries to their counterparts in the OECD suggests that there is significant scope for energy efficiency gains Value of electricity consumed expressed as a percentage of intermediate inputs The 30 most electricity–dependant sub-industries (electricity costs % of total costs), 2002 Scope for efficiency gains • This is particularly true in the non-metallic miners, mining and quarrying, agriculture, paper and basic metals sectors • If South Africa is to remain competitive relative to its OECD counterparts under more stringent trade regimes, including carbon and climate change considerations, improvements in efficiencies will be necessary (Inglesi-Lotz and Blignaut , 2011) • Electricity efficient technologies can be costly and can take a long time to implement, especially within capital intensive sectors like mining. • A study by the HSRC (2008) found that the only short term energy saving options available to the mining sector, which did not involve reducing output, were in the hostels or administrative offices Source: (Inglesi-Lotz & Blignaut, 2011) 16 CONFIDENTIAL

17. The share of electricity in total costs varies considerably from one type of mining operation to another because of the considerable additional electricity costs associated with underground mining Share of electricity in total costs - selected mining companies Mining and quarrying • Of the mining firms, gold are the most reliant on electricity as an input to production (with electricity costs as a percentage of total costs ranging from 6 to 14%), followed by platinum miners and lastly the diversified mining groups. • A major challenge in trying to assess the impact of rising prices at firm level is that there are many instances where costs between local and off shore activities cannot be distinguished from one another – so attempts to assess exposure to rising costs or impact on profitability will not be robust. • This problem is further exaggerated in the case of large global diversified mining groups who are involved in a multitude of activities and typically only report financial results at a group level. Source: (Deutsche Securities (Pty) Ltd, 2010) 17 17 CONFIDENTIAL

18. The manufacturing sector is too diverse to make any generalisations about the vulnerability of the sector to rising electricity prices. Share of electricity in total costs - selected mining companies Manufacturing • Basic metals are one of the most heavily reliant on electricity, both in terms of the share of electricity in direct costs and measures of electricity intensity. • Cement production is also quite heavily reliant on electricity, however the ability of cement producers to pass on increased costs is relatively strong (in a concentrated market the competition will not be willing to absorb price increases unless there is significant surplus capacity) • Paper and pulp-manufacturing is also a relatively energy intensive activity, but the share of electricity in total costs seems to vary considerably from one plant to the next. Sappi report that electricity costs ranged from 5% to 9% of total costs for three of its plants . 18 18 CONFIDENTIAL

19. Improved incentives for energy-efficiency and demand side management could contribute to lower electricity prices although it has been proven that prices are the primary driver of mitigation behaviour… • Promoting the accelerated uptake of energy-efficiency and demand side management initiatives reduces the need for additional generating capacity so provided it is more cost-effective than new supply this can also be considered a strategy to mitigate against higher electricity tariffs. • Studies have noted however that South African firms have historically made little use of public or external support energy efficiency and that increased energy prices and not incentives had been the primary driver of mitigation behaviour. • However, very aggressive, targeted and well administered incentives may result in a process of technological upgrading and increased competitiveness. • Possibly direct the electricity carbon levy taxes towards energy efficiency in priority sectors. Accelerated EEDSM

20. Providing transition credits that are proportional to existing electricity consumption or other carefully targeted subsidies could be a means to accommodate the special characteristics of the most vulnerable industries • Given that electricity in prices in South Africa have been subsidised implicitly by the taxpayer for a considerable length of time, it can be argued that it is necessary to provide additional ‘transition’ support to industries that have come to rely on low electricity prices as a source of comparative advantage and that are vulnerable to price increases . • Providing transition credits that are proportional to existing electricity consumption or other carefully targeted subsidies could be a means to accommodate the special characteristics of these particularly vulnerable industries. •  Identifying the vulnerable sectors for targeted policies would present some significant challenges since there is considerable variation in the vulnerability of different firms and sub-industries within major sectors to electricity price increases • As a start, policy should focus on priority IPAP sectors that are vulnerable and analyse the cost implications of a targeted subsidy. Provide transition support to vulnerable industries

21. Thank You CONFIDENTIAL