Eskom Amendment Pricing Structure & Retail Tariffs 2009/10 & outstanding workshop issues

Meeting report

Eskom briefing on Amendment Pricing Structure & Retail Tariffs 2009/10, & outstanding workshop issues Mr Jacob Maroga, Managing Director: Transmission, Eskom,  noted that his document on the Amendment Pricing Structure (see document attached) had been provided to the Committee in June this year. He did not intend to go through it again, and asked Members to provide him with specific points on which he should focus or give explanations.

Ms Tinto said that she would like to further explanation of the pricing structure and asked Mr Maroga to present on that.

Pricing Structure explanation
Mr Maroga said that it was important to provide the pricing context for Eskom. He said that Eskom was created in 1923 in order to respond to the challenges and growth of industry in South Africa (SA) in line with the Electricity Act. The Act highlighted electricity as primarily for economic development. The Act focussed on the provision of energy where it was needed, and emphasised that this electricity should be provided cheaply and abundantly, neither for profit or loss. It also specified that the funding should not be State provided. He said that in his view any discussions about funding should be seen in light of this context.

In 1952 the Act was amended but it maintained the central goals of the provision of cheap, abundant electricity. In the 1970s the first major shift in this strategy came with the Capital Development Fund, which was to ensure that enough financial reserves were built to respond to the cost of production. By increasing the tariffs the electricity suppliers were able to respond to the needs of the build programme. In 1983 the De Villiers Commission was formed to discuss these high tariffs, and it was decided that the Capital Development Fund was abolished. It was emphasised that electricity should be priced according to commercial terms and capital funding should be as in any other company.

Since the 1980s the outcomes of this Commission were never tested. Since the abolishment of the Capital Development Fund, another framework to solve the issues had not been set up. There had not been any effort to ensure that there was a formula and a framework to ensure that there were funds to build.

He placed importance on the 1998 White Paper on the Energy Policy of the Republic of South Africa, which encouraged competition and private sector participation in the electricity sector, in line with international developments. In his view the paper had not been implemented with success, as there was still only very little private participation in the industry. He explained that there was concern on the part of investors that Eskom would not have sufficient capacity.

Within SA, Eskom had been instructed not to build further capacity, in line with the efforts to increase investment by the private sector. The White Paper envisioned a competitive industry and private sector involvement, which did not happen. This had the effect that in 2004, when Eskom was instructed to build capacity, it had been left “on the back foot” of capacity development and was financially unprepared to build more capacity.

The Electricity Act had remained ambiguous on the subject of who owned Eskom, but the Eskom Conversion Act (Number 13 of 2001) made it clearer that Eskom was owned wholly by the State. It also stipulated that Eskom should operate under the Companies Act, and should be expected to pay tax and dividends like any other company.

The 2008 Electricity Pricing Policy made it clear that the key elements in the revenue for any entity in the industry should be based on full cost recovery that reflected the evaluation of the electricity assets, based on the replacement costs and market value of the assets. He said a key part was that prices should reflect the economic cost of making electricity and the returns by any company that operated in the industry. This policy also removed discriminatory subsidies from the industry. The policy emphasised the need for the provision and publication of a multi-year pricing index to provide people in the industry with more certainty.

From 1923 until 1998 the dominant paradigm had been to provide electricity for public benefit and to ensure the growth of the economy. From 1998 a new paradigm had emerged, which could be labelled the commercial investment and competition paradigm. This paradigm suggested that electricity should be like any other commodity and Eskom should aim to attract private sector development and a market return. He said that in his view Eskom had not yet been able to fulfil this paradigm. He argued that attracting private sector players into the industry required the potential for shareholders to make good returns. For electricity to get good returns, the most important issue was the price. An investor would judge Eskom’s ability to make maximum returns compared to other countries. South Africa provided the lowest priced electricity in the world, and thus in his view was not attractive to private sector players.

He said that the time had come to make choices and understand the implications of those choices. The funding, pricing and organisation of electricity should be formulated so that it reflected the goals of the country’s development. Power provision was essential to the economy and it thus a clear plan and path of electricity supply was needed. Within Eskom a formula of the direction that it was taking needed to be formulated.

Secondly there was a need to build further infrastructure and there was no current comprehensive integrated funding model that provided Eskom with the confidence that it would have the capacity to build that infrastructure. An interim agreement had been made with National Energy Regulator of South Africa (NERSA) in light of this lack of capacity and absence of a funding model. Together they had decided that before Eskom had a long term pricing initiative in place, it was necessary to use an interim price agreement for a year to make sure that it was well informed by an integrated funding model that would respond to the issues they had raised. The interim application was based on the discussion with NERSA. Eskom had received price determinations from NERSA that there should be 20% to 25% increases. Using the higher number of 25%, and adding inflation, it thus had asked NERSA for a 34% increase. NERSA had made a determination of 31.3%, because inflation was only 6.3%. The environmental labour was introduced that took the effective price increase to these figures.

Fifthly, there were aspirations around independent power projects (IPPs). He said that there were huge opportunities to bring other groups and frameworks to the industry that could be of assistance, and could provide new sources of skills, capital and suppliers. The discussion around electricity could be broadened in South Africa. This, in his view, would stimulate better debate and would give credibility to debate. The issue of market related tariffs would need to be resolved. IPPs in the region were potential sources of power generation particularly hydro and gas (such as from Mozambique). He argued that the security of supply in the region would require these potential power sources, and that a framework needed to be put in place so that regional supply issues were dealt with.

He concluded by saying that industry was key to where the country was going. In his view to solve these issues would require a deep collaborative approach to the discussion and a platform was needed to talk further about these issues.

Discussion
The affordability of power and uplifting the poor.

The Acting Chairperson urged Eskom to consider the affordability of electricity as a key issue. She asked whether the losses that Eskom had already incurred would not affect the poor and their access to electricity.

Mr J Schmidt (DA) said that there was widespread concern around tariffs and said that it was important that Eskom delivered electricity to the nation as cheaply and efficiently as it could.

Ms L  Moss (ANC) said that uplifting the poor was very important and asked whether the next proposed increases would affect the poor, or whether they would be catered for.

Mr S Radebe (ANC) said that the price increases affected people in the rural areas worst of all.

Mr Maroga agreed that uplifting the poor was very important, and that Eskom wanted people to move out of poverty. He said that the macro economic build programme of Eskom should have a positive impact on the poor. In terms of price increases, NERSA had determined that increases for the poor would be less than for others, and would only be 15%. The second issue was whether the free basic electricity provision could be increased, and at how this would be paid for. It would either be at a national level or by industry.

The use of short term contracted coal
Ms Moss asked whether road transport was the only way to transport coal in Mpumalanga and whether rail transport had been investigated. She asked for more information of the cost-effectiveness of each form transport.

Mr Maroga said that as long as Eskom power stations were using short term contracted coal, most of the transport would be by road. Some issues had been looked at with regards to rail transport. He explained that power stations were running at higher than ideal capacity at present, which required the use of these contracts, but once this had been rectified the transport on the road would be reduced. In his view this was a temporary problem, and so the further development of rail transport would not be cost effective in the long term.

Mr Radebe asked whether the use of trucks for coal delivery in Mpumalanga had been investigated. He asked why coal was not being sourced from within each province rather than transported across provinces, as was happening at the Majuba power station.
 
Mr Maroga responded that Majuba was a particular case. When the power station was build it did not have a dedicated mine and consequently short term contracts of coal had been used. He said that Eskom wanted all of Majuba’s coal requirements to be transported by rail, but this was still in the planning stage. He said that it would require a long term solution in terms of transportation.

He explained that historically Eskom had bought coal on long term contracts. Every power station had had tight contracts and had had a mine close to the power station it that would supply the station for its life. The average life of a station was 40 to 60 years. Power stations were thus build on coal resources that would last for long. On that basis a very competitive price for coal was negotiated. The price that Eskom was paying for coal was by far the lowest compared to international companies.

He said that what had changed was the decline of the reserve margin, because Eskom was discouraged from building more capacity with the aim of seeking private investment as of 1998. This had the result that power stations had been run at a higher capacity than normal, without proper consideration of whether the linked mine could supply coal for that level of running. In some cases the mine could not support the higher capacity and thus Eskom had augmented the supply with short term contracted coal, which had extended the life of the power station by around five to ten years.

He explained that the underlying cost of short-term contract coal was more expensive, because of the need to recoup costs in a shorter period. Secondly, short-term contracted coal needed to be transported by road transport from wherever it was available, and the transportation costs added to the price of coal. As the reserve margins had continued to be squeezed, the power stations were run harder. He said that the increase of the cost of coal could be largely attributed to this. He said that the efficiency of procuring coal was being considered.
 
This had been compounded by the shortage of coal in 2008. In 2008 coal availability had fallen to as little as ten days reserve stock; whereas the aspiration was to always have above 20 days of stock. This meant that Eskom had had to use emergency supplies of coal, and the price it was prepared to pay was higher than normal which had increased the cost of using coal.

Mr Maroga said that Eskom had an aim of keeping a minimum stock of 20 days. Two issues had arisen which had prevented this. The first was low stock piles, and the second was the rapid depletion of existing stock piles due to heavy rain. Some mines were open pit mines, which were affected by adverse weather. This had caused the problems last year, and had resulted in low production. In his view upping the stock to 41 days would remove these risks. He said it would be more costly in terms of working capital, but it was risk mitigation.

Mr Schmidt said that five days of the required stock was treated coal, so excuses could not be made about climatic conditions. He said that was not right that Eskom should have bought R2 billion of unnecessary coal for 21 days stock during an economic recession. He said that by Eskom’s own admission it was trying to get rid of short term contracts, and he suggested that it would have been possible to wait until the financial climate was better. In his view Eskom was playing on the sentiments of the Committee and public so that it could get a better increase and get more money so that it could continue the building programme. He said that this could not continue if Eskom continued to be run inefficiently.
 
Mr Radebe asked what was happening with the long term contracts that Eskom had, and what these entailed.

Mr Radebe asked for clarity from where the short term contracts were sourcing coal, and what distance this was in turn from stations. He had received reports from some constituencies that Eskom charged more when the transport was over long distances, because truckers chose to collect coal from further away. This was expensive. He wanted clarity also on how the decisions for sourcing were made.

Mr Maroga said that Eskom was not deliberately elongating the distances so that it could charge more. He explained that Eskom determined the distances travelled and the sources of the coal and that this was closely monitored.

Concern about the state of the roads.
Ms Moss expressed concern that the use of the roads by Eskom would impact on the transport system and the usability of the roads during the 2010 Soccer World Cup. She said that Transnet should be urged to upgrade railway lines to reduce the use of the roads for coal transport.

Mr Maroga agreed that the impact on 2010 should be considered. He said that when trying to find a solution for the road, the question of who should be responsible for the road repairs had arisen, and it was not clear whether the State, Provincial Government or Eskom should bear the costs of repairs. He said that Eskom had entered into a discussion with the Mpumalanga Government and was hoping that the issue would be resolved soon.

Differences in the cost of power across municipalities.
Ms Moss asked how Eskom would monitor municipalities to ensure that there was not a great difference in tariffs between municipalities.

Mr Maroga replied that there were different systems on the use of tariffs and that this was a big issue. He said that it was a reflection of the fragmented state of the distribution industry. In his view when this issue was resolved it would assist the country to uplift the poor. He said that the public should be able to have comfort that the tariffs they were paying were not paying for Eskom’s inefficiencies. The fact that Eskom was a monopoly in production meant that it was important for Eskom to prove that it was efficient.

Eskom’s financial losses.
Mr Radebe asked whether Eskom had developed a recovery plan to recover the losses that it had experienced in the previous financial year and whether the causes of the losses had been investigated.

Mr Maroga said that this was an important issue, and suggested that it would be dealt with more thoroughly in the presentation of the Eskom Annual Report to Department of Public Enterprises. He said that Eskom had anticipated the loss. In 2008 NERSA had provided Eskom with the price increases, and this had been weighed up against the need to keep the lights on. Eskom had chosen to keep the lights on, being fully aware that this would result in a loss. He said that the loss was within the range of the loss Eskom had anticipated. He said that the bottom line of keeping the lights on was a major consideration in planning for an operation loss. If power was not available the impact on the bottom line of the economy would have been massive. He said it was clear that this was not a financially sustainable route to pursue. In this year the plan was to break even, or make a small profit. In his view the cost of electricity provision needed to reflect the costs of the industry.

He explained that the loss seemed worse than it was because of the use of embedded derivatives as part of the accounting process. He explained that embedded derivative losses were an accounting treatment of long term commodity linked contracts. It was a paper loss, rather than a real cash loss, and was dictated by model accounting standards. Those accounting standards sought to achieve transparency. If a long term contract was based on the linkage of commodities, the standards said that those contracts should be valued and their impact should be brought into the income statement. He said that auditors and analysts discounted embedded derivatives in the income statement. He said that in previous years this same process had suggested a bigger profit than the actual profit. Eskom felt that the use of this method was important for transparency, but should not be considered to negatively impact its financial situation.

He explained the pricing situation further, using the example of aluminium contracts, which were entered into when there was a need to respond to the excess capacity; the contracts were appealing because they consumed a large amount of electricity. To attract aluminium, there was a need to link electricity prices to aluminium prices. He said that aluminium contracts were entered into in the 1980s in anticipation of huge economic growth, although this did not in fact happen. There was extensive building in the 1980s and to use this capacity, high electricity-intensive smelters were seen as candidates to attract because they could use this capacity. In order to do this, the electricity price was linked to aluminium. What this meant was that when the price of aluminium had gone up the revenue had gone up and similarly when the price had gone down, revenue had gone down. Secondly, revenue from the contracts was used to hedge the revenue on the price of aluminium. This had prevented full exposure to the price of aluminium. When embedded derivatives were evaluated some contracts had still had 15 or 20 years to go. Accounting treatment evaluated the contracts for the next 15 to 20 years. It was thus only a paper loss. He noted that BHP Billiton was the biggest aluminium customer. The scope of their impact was based on embedded derivatives. He said that this was linked to the commodity linked pricing. He said that Eskom was hoping for a solution that satisfied all parties.

He said that the financial statements had been audited and the auditors were clear and happy about the financial health of Eskom. He said that as Eskom moved forward it needed to be able to deal with the funding model so that it could continue to be financially sound.

Mr Radebe suggested that if the Eskom officials donated their bonuses that year it could assist the company in recovering some of the financial loss.

Mr Maroga responded that was an innovative suggestion but that it would take many years of bonuses to cover the funding gap. He said that he understood that Mr Radebe was suggesting that members should offer some contribution, and would consider this.

Mr Schmidt said that he was worried about the cost effectiveness of Eskom in general and asked for Mr Maroge’s comments on that.

Mr Maroga said that Eskom had benchmarked its costs across the world and that there was evidence that the price of electricity remained very low, if not the cheapest, in South Africa. He said that in terms of maintenance Eskom was meeting and exceeding international examples. He said that load shedding and the electricity shortage were linked to a shortage of capacity in the system. This was not an issue of efficiency. It was necessary to run a tight system until the reserve margins were restored, and this tightness had put the supply of electricity at risk.

Mr Radebe said that the South African Local Government Association (SALGA) was of the opinion Eskom was “in tatters” and that the issues that had arisen were a result of poor planning and research. He asked for Mr Maroge’s view on this.

Mr Motau asked whether Eskom had responded to SALGA’s questions.

Mr Maroga said that Eskom was in the process of engaging with SALGA on the issues that had arisen. He said that through collaboration with SALGA it would ensure that the substantive issues raised were dealt with. He explained that Eskom’s position was a reflection of country level decisions that were made about the industry. He said that some of the policy choices that were made did not have the desired outcomes and in his view this needed to be admitted without placing blame. He said that Eskom needed to review the path that it was on and choose a different path.

In his view there was also a need to reconsider international countries that had been used as benchmarks for the path to be followed. He noted that the United Kingdom (UK) had been used as a model of deregulation. However, an article recently had explained that the UK had not devoted enough attention to the issue of supply and could thus face further shortages. He explained that private sector players were not driven to respond to issues of supply, because they were able to make money, regardless of whether there was a shortage. He said that Eskom needed to review whether it was able to deal with the unique country issues, and was developing the right policy to respond to the future security of supply. In his view all future decisions should first be investigated in terms of their long term impacts. He said that it was possible to learn from the previous paths that were followed and that these lessons could be integrated into future planning.

Mr S Motau (DA) said that whilst the use of embedded derivatives may only be an accounting model loss, it provided a public impression that the management of Eskom was reckless or careless. He said that Eskom’s application for an interim price increase had provided a good summary of the issues, but the issue of transcending these issues was still a challenge. He urged Eskom to balance the funding the building programme against the interests of poor.

Mr Schmidt said that Members were pleased that supplies had not been halted, but said that Mr Maroga had not provided an answer to his original questions. He had said that that cost of production may be cheap in relation to the rest of the world, and this was because there was a national supply of coal. In his view the comparison of prices to other countries was thus unfair. He said that electricity could continue to be provided at cheap prices if it was done properly.

Mr Schmidt also took issue with the description of the aluminium situation with BHP Billiton as a book loss. Eskom had delivered electricity, but had not received the correct money for that. All other aluminium smelters had cut production where as BHP Billiton had increased production, only because it was receiving cheap electricity.
 
Mr Schmidt restated his view that Eskom was not being run effectively. The build up of reserves was the first issue. The international standard was 20 days. He cited Eskom’s 2008 Annual Report, which stated that reserves had been brought up to 41 days, at an additional expense of almost R2 billion on additional coal, yet indicated that this was not shown on the financial statements as an asset.  The costs of moving coal between different stock piles was between R60million and R150million per month. A number of collieries were short-delivering, and charging higher prices for coal, but Eskom was purchasing coal from them.
 
He said that Eskom’s build program was not something new, and so the comments that there was not a plan for the build programme were not right. In 2003 a decision was made in Cabinet to change this. In the report Eskom had stated that it needed R340 billion in the build programme. Government had already loaned Eskom R60 billion. He asked why Eskom was not pursuing the number of outstanding debts of R286 billion that was owed to it by its own debtors, as this would ensure that sufficient funds were in place.

Mr Maroga responded that the figures Mr Schmidt had quoted on the debt owed to Eskom suggested that Eskom was owed more than five times its annual revenue. He said that this was not possible.

Mr Schmidt referred to Eskom’s annual financial statement from March 2009, which said that an amount of R2767 million was the trade deficit that was older than 75 days. He said that this was still a large amount of money.

Mr Schmidt questioned Eskom’s estimates that nuclear energy was too expensive, stating that his research had not revealed numbers as high as those Eskom suggested. He asked where Eskom got its figures. He also made reference to the fact that the deals offered to Eskom had been offered at an appealing funding rate of 85% funding from Arriva. He asked why Eskom did not take up that offer.

Mr Maroga said that given the size and cost of nuclear stations this required an integrated country platform. There was a task team from the Department of Energy to lead the nuclear procurement. He said that although these programmes would be 85% funded, the funding was by way of a loan. It was an incentive, rather than a donation. He said that it was still necessary to evaluate whether Eskom would be able to be funded. The investment decisions that were being made were multigenerational investments. Some decisions might appear easy for now, but could have unintended consequences in the future. Eskom was trying to investigate the long term implications of energy decisions, and nuclear energy was one of those decisions under investigation.
 
Mr Schmidt said that in the last two years a large amount of coal was lost at a number of large stations. In his view, short term coal contracts were not run effectively, and he suggested that Eskom’s internal documents supported his view.

He returned to the issue of BHP Billiton and said that the procurement of Madupe power station had started at R26 billion, but had already been increased to R80 billion, with a further anticipated increase to R120 billion. He said that the right procurement policies were not being followed at Madupe, as had been acknowledged in Eskom’s own internal documents. Coal collieries were currently delivering between 20% and 50% below their burn rates. He expressed concern that Eskom had not instructed them to increase that rate, but had opted rather to build more mines. In his view Eskom’s own mines and the people who were supplying them were under delivering, and this was costing Eskom more because it resulted in the use of short term contracts.

He asked why Eskom did not use the already existing colliery at Majuba by putting in a shelf mine. In his view it was not right to ask NERSA, or any other institution, for further increases, when Eskom was already not running cost effectively and was not providing cost-effective electricity. He said that Eskom was wasting money.

Mr Maroga thanked Mr Schmidt for his questions and said that they showed that the Committee showed an interest in Eskom. In his view the detailed questions that he was asking would be best answered by a visit to Eskom. He issued a public invitation for the Committee to visit Eskom, particularly the coal procurement entity. In his view this would allow Members to engage with these questions in more detail, particularly the issue of coal cost.

The generation of new funding.
Mr J Selau (ANC) asked how the generation of funds and revenue was being pursued in the funding model proposed by Eskom. In his view strategic issues needed to be examined when developing a pricing model, including competition and the impact on the poor. He wondered if Eskom would be able to provide direction by the end of September. He asked if Mr Maroga could provide some idea of which direction Eskom was favouring.

Mr Maroga said that there was a task team in place to look at the funding model. He said that between now and the time that NERSA made a determination there would be more public participation on the choices that needed to be made. In his view this would incorporate the views of most stakeholders.

Other comments.
Ms Moss expressed concern that workers with scarce skills workers were leaving Eskom or South Africa and suggested that Eskom should make every effort to retain skilled workers.
 
She said that in her view climate change was a very important issue and should be monitored. She thanked Eskom for its investment in building schools and said that she hoped that in this process it was educating learners about alternative sources of power.

Mr Radebe said that there was the perception that there were a limited number of supply companies that Eskom would use, and this created issues of lack of competition.

The Acting Chairperson said that the Committee would attempt to attend the presentation of Eskom’s Annual Report to the Portfolio Committee on Public Enterprises, and this would allow Members to gain further answers to any outstanding questions. She explained that many of the members of the Committee were answerable to very poor constituencies and in her view the presentation had helped them to be able to explain tariff increases to those constituencies.

The meeting was adjourned.