Eskom’s application for Multi-Year Price Determination (MYPD) Rule Changes

2. Eskom’s application for Multi-Year Price Determination (MYPD) Rule Changes Avianto - 2 October 2007

3. Recapping on the MYPD • In February 2006, the NER had made a determination of the revenues allowed for Eskom Generation, Transmission and Distribution for the period 1 April 2006 to 31 March 2009 • The allowed revenues and the percentage price increase were as follows: • On 30 April 2007, Eskom made an urgent application for rule changes to be applied to the current MYPD • Eskom is proposing that the rule changes be applied in the last year of the MYPD being 2008/9 and in the next MYPD (2009-2012)

4. Stakeholder comments received • NERSA presents a summary of stakeholder comments received in response to the consultation paper of Eskom’s application for Multi-Year Price Determination (MYPD) rule changes • Comments have been received from 5 Stakeholders which are Chamber of Mines, EDI, EIUG, Eskom and Sasol • NERSA has sought to represent stakeholder views fairly and accurately while still providing the information in a format suitable for reference.

5. Issues for discussion • Eskom’s application – Mbulelo Ncetezo • Eskom Risk Position • Primary Energy costs • Variance on Capital Expenditure • Triggers for re-opener • Once-Off Adjustment • General issues and Way forward

6. Summary • Eskom approached the Energy Regulator requesting a rule change within the MYPD on 30 April 2007 • Eskom focussed on the following areas: • Primary Energy cost variances • Variances on capital expenditure • Rules on a trigger for re-opener • If the rules are accepted, they apply with immediate effect • Eskom is willing to absorb under recoveries of the first two years of the MYPD i.e. 2006/7 and 2007/8 • If Eskom’s request is accepted by the Energy Regulator, the resultant adjustment is 18% price increase

7. Eskom’s proposals for rule change • Primary Energy cost treatment • On a yearly basis within the MYPD, just before the end of the financial year, a revision of primary energy forecasts be made • New Forecasts be used to set tariffs for the following year after a prudency test by NERSA • This will results in a full pass-through of the variances and • Involves an annual audit of Eskom’s submission by NERSA

8. Eskom’s proposals for rule change • Variance on capital expenditure • A similar rule as Primary Energy (i.e. an annual basis prior to the end of a financial year within MYPD, Eskom submit actual year to date Capex with forecast to year end) • The return and depreciation for variances will be rolled into next year’s for allowed revenue of next year • Involves annual audit of Eskom submission by NERSA

9. Eskom’s proposals for rule change • Trigger for a re-opener • Current re-opener based on balance of correction factor (only tracks revenue variances, not costs) • Does not track uncertainties in stage of expansion and demand growth • A re-opener based on adjusted earnings band • It strikes a balance between MYPD incentives and allocation of risk • Re-opening if change in costs and revenues pushes rate of return outside allowed bands • If accepted, be applied immediately

10. Conclusions on Eskom’s application • The relief be considered after a full analysis of Eskom short term risk and mitigation plan • NERSA to determine risk mechanism for the next MYPD sharing risk to Eskom and customers in accordance to the ability to manage risks • Aspects of primary energy volatility be considered in the next MYPD • Eskom provides a clear report on how it is planning to meet short term security of supply risks • Before any final decision, NERSA will review procedures and costs projections, to consider the extent and nature of cost recovery and any other appropriate regulatory mechanisms

11. Conclusions on Eskom’s application

12. Issues for discussion • Eskom’s application • Eskom Risk Position– Brian Sechotlho • Primary Energy costs • Variance on Capital Expenditure • Triggers for re-opener • Once-Off Adjustment • General issues and Way forward

13. #1 Your views are requested on the overall request by Eskom for rule changes and on NERSA preliminary conclusions on these proposals Need for full short and long-term risk quantification and auditing What mechanism is used for regulating PE costs and aligning it with MYPD? Support for request for Eskom to provide report on short-term risk mitigation strategy. Report to also be used by customers for better assessment of security of supply risks Preference for rule change to implemented in 2008/9 and then carried forward into MYPD2 Eskom’s opinion is that they have already provided a risk review of the PE costs but will provide a report to NERSA soon. A view is also suggested that service quality mechanism be put in place to ensure customer needs are addressed. Conclusions on Eskom’s application

14. #2 Your views are requested on Eskom’s request for additional revenues and NERSA overall approach in evaluating Eskom’s application The application was for a rule change followed by revenue adjustment Preference still exists for this approach or rather Ad-hoc revenue adjustment followed by PE cost adjustment mechanism Noted Eskom’s agreement to forego revenue adjustments for shortfalls in first 2 years. However, Eskom still posted a profit of R6 454 m. Any adjustment would have resulted in significant over-recovery for Eskom Eskom should not be allowed to maintain a high cost of operation and also be allowed to apply for increased PE and CAPEX costs Conclusions on Eskom’s application

15. #3 Your views are requested regarding the changes in the key business parameters of Eskom and their effect on Eskom’s revenues and costs Agreed that Eskom should increase their baseload Gx capacity. Coal not preferred option but rather nuclear National growth not new to industry and Eskom should have foreseen it; Agreed that commodity and metal prices has increased more than average inflation Agreed that Eskom is exposed to external cost pressures. However increase in marginal cost due to operational failures and subsequent contingency plans should be absorbed by Eskom. The cost associated with 2006 blackouts should form part of this application Increasing prices should not lead to devastating effect on EDI Support for broad conclusion by NERSA Conclusions on Eskom’s application- Changing parameters

16. #4 Your views are required regarding the expectations for customers to start paying for future capacity or letting future customers pay if Eskom is to be able to finance the expansion programme and if customers are to see a reasonably predictable price path Present customers have benefited from investments made several decades ago. Advantage of cost of service and MYPD is that it spreads costs over time Concern that even with price increase for financial viability, such prices are set against a lack of cost-reflective tariffs in SA Imperative that customers must pay for economic cost of electricity as well as for future capacity – prices must reflect replacement cost Agreed that drivers in increase PE cost be analysed fully Conclusions on Eskom’s application- Changing parameters

17. #4 Your views are required regarding the expectations for customers to start paying for future capacity or letting future customers pay if Eskom is to be able to finance the expansion programme and if customers are to see a reasonably predictable price path Coal cost production is a volume business – per unit cost should therefore decrease as production increases as fixed cost contribution lowers. Not clear how far higher volumes from locked collieries were able to mitigate the costs associated with imports or, alternatively, if risks of lower than contracted delivery from tied collieries are borne exclusively by Eskom Existing customers will have to contribute to new Gx as the full capacity will not taken up in the short-term by new customers – existing customers will benefit from spare capacity and reliable supply Prices should cover for real cost based expenditures and not future capital charges (which Eskom should provide) Summary conclusion on Eskom’s application- Changing parameters

18. #5 Your views are required regarding the envisaged significant increases in prices followed by higher levels of continuing price increases than those planned in 2005 when the MYPD was developed and your views on prices reaching economic levels in 10 to 12 yrs rather than 35 to 30 yrs as was the case in previously Price increases of 12 – 13 % above inflation will have severe impact on intensive users due to the long-term nature of their operations Risk impact to the economy needs to be fully understood and the message also be sent to foreign investors Ripple effect of inconsistent price increases may lead to perceived unregulated market Conclusions on Eskom’s application- Changing parameters

19. #5 Your views are required regarding the envisaged significant increases in prices followed by higher levels of continuing price increases than those planned in 2005 when the MYPD was developed and your views on prices reaching economic levels in 10 to 12 yrs rather than 35 to 30 yrs as was the case in previously Independent studies show that prices are too low for sustainability with greater concern being on reliability of supply Even without any rule change, there would still be a price spike in 2009/10 under same MYPD – prudent to intervene earlier Current mechanism does not address higher coal cost production and international plant price increases – heart of matter Conclusions on Eskom’s application- Changing parameters

20. #6 Your views are required regarding the blanket pass- through protection to Eskom without any evident strategy to bring under control those costs that are perceived to be out of control Eskom is not requesting a blanket pass-through but rather that PE costs consists of a higher uncontrollable component and must therefore be managed as pass-through item Eskom accepts need for appropriate incentives Why did Eskom not fix coal prices with their suppliers in line with the MYPD? The risk is simply passed downstream whilst there was an accepted price increase arrangement Conclusions on Eskom’s application- Changing parameters

21. #7 Your views are requested on the process to be followed to arrive at a final decision as outlined above Process supported in principle; Ambitious to expect to develop the main aspects of the rule changes by 20 December and would only be feasible had NERSA accepted Eskom’s proposal regarding rule changes for 2008/9; One of the reasons for the present dilemma is the MYPD1 was developed in a highly compressed programme – internationally 24 months Propose that the adjustments only be for 2008/9 and rule changes only be done within the MYPD2 cycle i.e. not on 20 December One stakeholder proposes a multi task team (lead by NERSA) to recommend rule changes Conclusions on Eskom’s application- Changing parameters

22. #8 Your views are requested with regard to industry pressures mentioned above specifically ASGISA and its effects on electricity prices and the acceleration of these prices to LRMC in a shorter time horizon than in the past and on the increased operational risk of Eskom as evidence with the 2006 blackouts and exposure in the coal market due to short-term security of supply Paragraph not clear. Term LRMC need clearer definition. If this term means the cost of new capacity, it’s not clear how this can happen since in 10 years most of the capacity will still be old and written down Had prices been at LRMC levels, the expansion programme would have been fundable with minimal price increases Reason for the inevitable price increases is the CAPEX programme forces inefficient prices to LRMC levels Industry specific issues - Eskom in particular

23. #8 Your views are requested with regard to industry pressures mentioned above specifically ASGISA and its effects on electricity prices and the acceleration of these prices to LRMC in a shorter time horizon than in the past and on the increased operational risk of Eskom as evidence with the 2006 blackouts and exposure in the coal market due to short-term security of supply 2006 blackouts were evidence of tight network capacity conditions that Eskom is currently operating under – need to strengthening certain projects in the Cape that were planned for later years Faster growth rate translates to higher demand for coal creating a sellers market in the process Natural market forces will lead to higher demand and no reserve margin, it can no longer substitute artificially lower prices. Why is this all of a sudden so new? Industry specific issues - Eskom in particular

24. #9 Your views are requested regarding the high level risk position of Eskom as perceived by NERSA staff and as a basis for concluding on a need for intervention to assist Eskom in its ability to finance it capital expansion programme High risk levels are acknowledged but Eskom should also reduce operating costs to mitigate and not only rely on inflated tariffs Eskom requests NERSA to provide details of the required for clear risk quantifications Agrees that Eskom may not be able to fund its capital programme Agreed that current mechanism is inadequate and needs to be reviewed Eskom does not agree with the conclusions by NERSA that it was covered for risk to a net cover of R3 bn – Eskom has given details of this as part of disputing Summary of Eskom’s risk position

25. #10 Your views are requested regarding using electricity tariffs to cover the risks and on the possible equity injection, adoption of a single buyer model or selling-off of Eskom’s assets to finance capital projects Support for increased tariffs to cover CAPEX expansion risks Eskom would still maintain its competitive advantage of lower prices Eskom’s analysis show that financing pressures would come as early as 2008/9 if no adjustments are made to revenues Equity injection is not a viable option in the long-term given the size of the expansion programme Equity injection more preferred Single buyer model not preferred due to technological limitations and possible higher return by private investors Need for Increased tariffs to cover Risks

26. Issues for discussion • Eskom’s application • Eskom Risk Position • Primary Energy costs – Willie Boeije • Variance on Capital Expenditure • Triggers for re-opener • Once-Off Adjustment • General issues and Way forward

27. #11 Your views are requested regarding the rules as proposed by Eskom and their implications on the management of risks within the MYPD for both Eskom and its customers Eskom should have backed up the primary energy cost by appropriate contracts to mitigate against the risk and stay within the MYPD Further clarification of Eskom’s proposal is appropriate Eskom is not proposing “blanket pass-through” but an adjustment mechanism that ensures no windfall gains or losses Primary Energy costs

28. #12 Your views are requested on the current mechanism within the MYPD to manage kWh above the fixed level output using Majuba price presented in the MYPD and the adequacy of such mechanism in managing the risks. Proposals on other mechanisms are very welcome and will be considered by NERSA staff in their final recommendations to the Energy Regulator Generally stakeholders concur with the principle One stakeholder argues that the use of the fuel cost of the Majuba power station as a proxy is inadequate because: - The principle assumes that the fuel cost of Majuba is predictable and controllable whereas the reality is Majuba obtains all its fuel from a variety of short and medium term contract which implies a very high degree of risk and uncertainty regarding the price to be paid for that fuel - It assumes that the incremental electricity demand can all be met by Majuba power station. Primary Energy costs

29. #13 Your views are requested on the proposals presented by NERSA staff and their views on Eskom’s proposed rule change for PE Generally stakeholders support the proposals; One stakeholder does not agree that the PE costs problem was a planning and risk profiling issue PE costs for MYPD 1 were based on the best forecasts available at the point in time and that there should be a pass-through of PE costs subject to an analysis of prudent cost by NERSA Primary Energy costs

30. #14 Views are asked on the once-off pass-through adjustment for 2008/9 without a rule change as an intervention to ensure the sustainability of Eskom’s business A once-off pass through will only alleviate the present problem without addressing similar future problems. Others would prefer that the rule changes as proposed be implemented for 2008/9 regarding PE and Capex costs as there is still some uncertainty in regard to costs for 2008/9 Primary Energy costs

31. #15 Views are asked on letting the aspect of PE cost volatility to be considered in the mechanism to be used for the next MYPD Primary energy costs must have back-to-back agreements to ensure primary energy cost volatility is covered By not adequately considering the aspects of costs volatility, it forces projections to be made of inherently unpredictable issues Primary Energy costs

32. #16 Views are asked on retaining incentives for Eskom to manage PE costs and therefore the use of dead-band below and above central PE cost estimate to ensure that the expenditure considered for pass-through is material Stakeholders support incentives where there is stability and forward costs can be forecast with accuracy Where volatility exists, overly mechanistic incentives structures leads to poor outcome Dead-band for PE cost is not an appropriate mechanism, it provides a rough measure for allocating variances Primary Energy costs

33. #17 Views are asked on pass through of gas turbine generation costs Generally stakeholders agree Primary Energy costs

34. Issues for discussion • Eskom’s application • Eskom Risk Position • Primary Energy costs • Variance on Capital Expenditure – Juwith Magabe • Triggers for re-opener • Once-Off Adjustment • General issues and Way forward

35. #18 Comments are asked on how the differences between the investment profile and forecasts used for revenue setting must be treated and on how the Regulatory Asset Base should be adjusted for actual expenditure There is a need for adjusting the 2008/09 allowed return on assets to take into account accelerated and increased CAPEX Prudent cost based variances in CAPEX must be applied to the RAB Asset base must be adjusted for the actual costs incurred in commissioning the asset or strengthening the network Eskom is exposed to external cost pressures beyond its control but increase in marginal cost of production due to operational failures and the subsequent expensive contingency plans should be absorbed by Eskom e.g. capital costs associated with the 2006 blackouts Views on Eskom’s proposals – Capital Expenditure

36. #19 Comments are asked on whether Eskom should be granted interim relief or not based on changes in the capital investment profile and the costs thereof The construction of additional Generation plants is imperative and in the interest of future security of supply we support NERSA’ scenario 4 ( adjustment for both PE and CAPEX) Eskom should be given an immediate relief through return on capital and depreciation for 2008/09 financial year The introduction of interim relief will defeat the purpose of the MYPD i.e. diminish certainty provided by multi year determination There is no doubt that Eskom requires additional revenue in the foreseeable future to undertake the necessary expansion of its Generation capacity Views on Eskom’s proposals – Capital Expenditure

37. #20 Comments are asked on the extent to which an adjustment on the return and depreciation on accelerated capital expenditure (if granted) must start to be recovered, 2008/9 or in the next MYPD Immediate cash flow is required to relieve Eskom of the current capital constraints due to the fact that they have absorbed under recoveries for 2006/07 and 2007/08 If adjustment is delayed to the next MYPD cycle, Eskom would require an adjustment for 2006/07 to 2008/09 in order to compensate for higher CAPEX costs Prices should cover for real costs based on expenditure and not for future capital charges. Adjustment on return and depreciation on accelerated CAPEX must start in the next MYPD as provisional expenditure has already been built into the tariffs Views on Eskom’s proposals – Capital Expenditure

38. #21 Your views are requested on the overall treatment of Capital expenditure variances whether due to timing differences or differences in costs within a given MYPD whilst giving due attention to efficient planning by the utility being regulated It is imperative that capital expenditure variances due to timing differences are adjusted for as per Eskom proposal (4.2 of the consultation paper) Agree that Eskom is exposed to external cost pressures beyond its control such as equipment cost escalation The MYPD rules have addressed this matter and we support continuation of the treatment of timing based changes in CAPEX Views on Eskom’s proposals – Capital Expenditure

39. Issues for discussion • Eskom’s application • Eskom Risk Position • Primary Energy costs • Variance on Capital Expenditure • Triggers for re-opener – Thifheli Mashapa • Once-Off Adjustment • General issues and Way forward

40. #22 Your views are requested on Eskom proposed rules that will govern the trigger for re-opening the MYPD during its control period. Alternative proposals will be happily welcome and considered prior to finalisation of the MYPD mechanism Agreement on the concept of re-visiting the re-opener Earnings band has been proposed and it carries incentives on certain costs categories However one stakeholder raised the fact that the trigger should only re-open in extreme conditions and ensure a stable energy market It shouldn’t take away certainty of MYPD Trigger for re-opener

41. #23 Your views are requested on NERSA responses to the proposals by Eskom of the trigger for a re-opener and also on the comment made by NERSA that any trigger for re-opening should be set based on balance of risk to Eskom and therefore that this can only be determined once a thorough review of Eskom’s business risk and mitigation strategy has been applied and will only be set for the next MYPD In general stakeholders support the comment raised Earnings band would have a number of beneficial characteristics Mechanism proposed not in isolation with other rules Trigger for re-opener

42. Issues for discussion • Eskom’s application • Eskom Risk Position • Primary Energy costs • Variance on Capital Expenditure • Triggers for re-opener • Once-Off Adjustment – Pule Mothiba • General issues and Way forward

43. #24 Your views are requested on the independent projections of primary energy costs by NERSA especially that is based on Eskom’s results for 2006/7 and the NIRP assumptions Pithead collieries fell short of their obligations, why no penalties for no delivery on pit head collieries PE costs submitted in Eskom's’ application are already conservative (already reduced from initial estimates) NERSA analysis of PE costs need to be shared with Eskom Once-Off adjustment

44. #25 Your views are further requested on the parameters (3.8% increases in energy sent out and CPI) used in the independent projections Use of CPI in forecast of fuel costs is overly simplistic and prone to error; Coal cost increases above CPI Once-Off adjustment

45. #26 You are requested to comment on the assumptions made on realistic forecast on energy output from base load generation plant Planning and forecasting of energy output is highly complex There are limitations to Eskom in meeting electric energy produced and peak demand NERSA need to share assumptions with Eskom Once-Off adjustment

46. #27 Stakeholders are requested to comment on whether customer funded connections/projects should be included or excluded when determining the adjustment return on Eskom’s accelerated and increased capital expenditure The current practice in the MYPD is to exclude them Stakeholders agree customer funded projects should be excluded Connection charges do not form part of price increase and tariff charges Once-Off adjustment

47. #28 Stakeholders are requested to comment on whether Eskom’ Corporate Division’s capital expenditure should be allowed a return as part of the Regulatory Asset Base or Centrally Administered Charges Corporate expenditure is incurred for the benefit of generation, transmission and distribution divisions and allocated to this divisions A return on corporate assets should be disallowed as it is included in Eskom holding capital expenditure Once-Off adjustment

48. #29 Your views are requested regarding the price levels presented in the scenarios above. Should the Regulator consider only primary energy or capital expenditure or both of them in Eskom’s rule change application There should be consideration for both PE and capex in the application Utility should be compensated for prudent costs plus a fair rate of return Eskom’s PE and capital expenditure costs recovers prudent costs plus fair rate of return Options 1 to 3 are not viable Scenario 5 includes adjustments for both PE and capex Once-Off adjustment

49. Issues for discussion • Eskom’s application • Eskom Risk Position • Primary Energy costs • Variance on Capital Expenditure • Triggers for re-opener • Once-Off Adjustment • General issues and Way forward – Mbulelo Ncetezo

50. #General comments Rule changes at this stage of EDI restructuring have a negative influence on the establishment of REDs Tariffs and Equity injection are only two viable options, further investigations should be done The introduction of the MYPD provided a measure of certainty regarding electricity prices, the rule changes must not detract from that purpose Some stakeholders support the undertaking that Eskom application should only be done when a full analysis of Eskom’s risks and mitigation plans for those risks have been provided General comments