Eskom on its Multi-Year Price Determination (MYPD 3) Application: further engagement

Meeting report

Mr Brian Dames, Chief Executive: Eskom, said that Eskom had on 20 November 2012 released its Interim Integrated Report for the six months ended 30 September 2012 setting out a contextual review of the company’s overall performance from 1 April 2012. On the Multi-Year Price Determination (MYPD 3) application to the National Energy Regulator of South Africa (NERSA), Mr Dames said that Eskom had on 2 November 2012 presented the details of the application to the Committee and from that a number of issues had been raised for which responses were required.

Mr Dames said that the current Multi-Year Price Determination (MYPD 2) would end on 31 March 2012 and so Eskom had to submit an application to NERSA who would determine the country’s electricity price adjustment for 2013/14. Eskom was proposing a five-year determination for MYPD 3, running from 1 April 2013 to 31 March 2018 which would ensure a more gradual and predictable price path for households, businesses, investors and the country as a whole.

Mr Dames said that Eskom’s five-year revenue request translated into average electricity price increases of 13% a year for Eskom’s own needs, plus 3% to support the introduction of Independent Power Producers (IPPs), giving a total of 16%. This would represent a total price increase from the current 61 cents per kilowatt-hour (c/kWh) in 2012/13 to 128c/kWh in 2017/18. This revenue request included targeted savings in operating and primary energy costs due to targeted improvements in efficiency over the period.

In response to the issue of why price increases were necessary, Mr Dames said that Eskom needed to keep the lights on, which had a cost. Owing to historical reasons, electricity was currently charged at below cost-reflective levels and was not sustainable. Electricity prices needed to transition to cost-reflective levels to support a sustainable electricity industry that had resources to maintain operations and build new generating capacity, guaranteeing future security of supply.

Mr Dames said that a failure to accommodate the country’s energy needs would limit investment, resulting in fewer jobs and lower economic output. Cost reflective prices would minimise economic distortions caused by inadvertently subsidising all consumers of electricity. The effect of prices that were non cost-reflective was that every unit of electricity would be subsidised, either by taxpayers or by future users of electricity.

Mr Dames, in addressing the impact of price increases, said that Eskom believed that poor households should be protected from the impact of electricity price increases through targeted, transparent cross-subsidisation in accordance with a national cross-subsidy framework. A failure to achieve cost-reflective prices would sooner impact on South Africa’s economy and its growth prospects. The MYPD 3 revenue application aimed at finding an electricity price path that would contribute long-term economic growth and job creation while minimising the short-term effects on vulnerable sectors and offering protection to low-income households. A gradual phasing in of cost reflectivity would give the country time to adjust to higher prices but there were limits to which this could be done.

Mr Dames said that in keeping with the Electricity Regulation Act (2006), Eskom was allowed to recover its costs, provided that they were efficiently and prudently incurred, and to make a reasonable return. The revenue being requested would cover: primary energy (the cost of basic natural resources such as coal used to produce electricity, including an increase by an average of 8.6% per year within the MYPD 3 period and by 11% per year with IPPs incorporated), operating costs (Eskom’s operating costs would increase by an average of 8% per year within the MYPD 3 period), depreciation which increased by just under 10% on average per year over the period, return on assets (the return would move from 0.9% in Year 1 of the MYPD 3 period to 7.8% at the end of the period, below the NERSA targeted pre-tax return of 8.16%, as well as Eskom’s Weighted Average Cost of Capital [WACC] of 8.31%. Over the entire MYPD 3 period, the return would be less than 4% pre-tax. The country had to deal with the price of coal because this accounted for 50% of Eskom’s cost.

Mr Dames said that Eskom’s revenue requirement up to 2017/18 translated to price increases of 13% for each of the five years, for Eskom’s needs, taking into account the Eskom capacity expansion up to the substantial completion of the Kusile power plant, plus 3% to support the introduction of IPPs, mainly the impact of the Department of Energy Peaker Plant (1020MW) and the inclusion of all three rounds of the renewable energy IPP bid programme (3725MW), giving a total of 16%. It included operating costs, primary energy costs, depreciation and a return on assets.

Mr Dames, in terms of the assumptions, said that Eskom’s application assumed that electricity would increase by 1.9% compound annual growth a year over the MYPD 3 period, and that NERSA would approve extending the control period from the current three years to five. The other assumptions were that there would be single-digit annual average increases in primary energy costs (excluding IPPs) and a mandatory Energy Conservation Scheme (ECS) to prompt South Africa’s largest energy users to curb their usage.

Mr Dames said that the MYPD 3 application was made in the context of some uncertainty about the course of the electricity sector and Eskom’s role within it. Long-term decisions about who would build South Africa’s future generating capacity, were yet to be made, something which was being addressed by Government. The country needed additional capacity beyond 30 September 2012 to ensure future security of supply.

Mr Dames said that in order to provide an idea of the potential costs involved, Eskom had modelled the implications of two scenarios – Eskom being tasked with building 65% of the Integrated Resource Plan (IRP) 2010 capacity as well as a scenario where Eskom would be tasked to build 100% of the IRP 2010 capacity. These two scenarios would provide a reasonable basis on which to understand the pricing implications of the additional capacity needed. The implication of these scenarios was the need for price increases of 20% per annum for the next five years and 9% for the five years thereafter.

In terms of the tariffs, Mr Dames said that Eskom’s revenue requirement would result in a single average price increase that translated into specific tariff increases for each tariff. Eskom has also requested NERSA to consider modifications to the existing tariff structure with residential tariffs structured to simplify understanding and optimising the protection of the poor, while high-usage residential customers would pay more cost-reflective prices. Further tariff restructuring proposals had also been made to make the tariff structures more efficient, cost reflective and improve transparency.

Mr Dames said that Eskom was serving about 4.5 million residential customers that contributed 5% of its revenue. Most of Eskom’s sales were to municipalities, followed by industry, mining, agriculture and the rest. A tariff structure proposed by Eskom would only be applicable to Eskom customers. Eskom was asking for an increase in the unit cost of electricity of 9.8 cents, municipal tariffs would be an average of 13%, -1% for Eskom residential customers with low consumption, 5% for residential medium users, 14% for residential high consumption, 15% for agriculture and 21% for industrial and commercial.

In conclusion, Mr Dames said that the submission of the MYPD 3 application was the beginning of a public process to address the issues raised in Eskom’s application. NERSA would follow a process of public consultation prior to making its decision. The application struck a balance between possible short-term negative effects of increasing electricity prices, the sustainability of the industry and South Africa’s long-term economic and social needs.

Mr Paul O’Flaherty, Finance Director: Eskom, in addressing the cash flows and in particular the necessity for the 16% price increases and why Eskom was not funding its requirements through debt, said that the only sources of funding available to Eskom were debt, equity injected from Government and operating profit from its revenue. Eskom had requested for additional equity injection but that was not forthcoming leaving generation of debt and raising enough operating profits from its revenue.

Mr O’Flaherty said that according to the cash flow a trillion rand of revenue would be needed to pay for primary energy cost (R432 billion), employee costs (R135 billion), demand side management, repairs and maintenance (R138bn). This would leave cash generated from operations for Eskom of R390bn. Eskom’s capital program over the next five years included finishing Kusile (R337bn), the company was also forecasted to spend R65 billion per annum on the capital progamme, repayment of a R126 billion debt on its books, payment of interest of R115 on the debt to be raised. This all indicated a significant shortfall in the cash flow of the company. A R200 billion debt had to be raised to ensure that Eskom could operate, taking the debt to R360 billion.

Mr O’Flaherty said that in order to raise debt, it required Eskom to become an investment grade company (currently a sub-investment grade company in terms of rating making it a junk bond). Eskom got investment status because of Government uplifting. It was suggested that Eskom needed to show that its cash metrics moved towards a more sustainable company. if the tariff increase proposed by Eskom were approved by Nersa, its cash flow would take the metrics to standalone investment grade rating, enabling the company to raise the debt. The concern remained the long-term nature of the debt.

Mr O’Flaherty said that in terms of the R337 billion, R65 billion of that figure was to be spent over the next five years. Half of the R65 billion was to be spent on the completion of Kusile and the other half was for the refurbishment of the major plant and strengthening all Eskom’s distribution and transmission networks.

In terms of the 8,16% return, Mr O’Flaherty said that the return that Eskom would be earning would move from 0,9% to 7,8% and would average at a return of less than 4% over the period. This would be significantly less than the targeted return allowed by NERSA of 8,16% and represented an investment into the economy by Government as shareholder in the region of R200 billion. It was also significantly less than what any private sector entity would accept.

Eskom required on its equity a higher return than the sovereign because of the risk involved and in terms of the cost of debt in a normal environment, the cost of Eskom borrowing was more expensive that the sovereign borrowing. The cost of debt had been calculated by Eskom, NERSA as well by as KPMG, and the costs included in the MYPD 3 application were appropriate.

Responding to the issue of Eskom being a monopoly that should be broken up, Mr Dames said that the structure and ownership of Eskom was a national policy issue, one that Government could address. However, when privatisation was being explored in 1990, the main impediment was that the low electricity prices were not attractive to investors. In the short term, the unbundling of Eskom and the introduction of private participants would not result in lower prices given the higher returns that would be required.

As to whether Eskom would be willing to supply certain municipal customers directly and the rationale for supplying private sector customers directly, Mr Dames said that there were three factors to be considered. First, local authorities had a constitutional right to supply the customer within their jurisdictions. Second, from a technical perspective, whether Eskom was able to supply a municipal customer directly depended on where that customer was located on the network. Third, financial consequences for local authorities as a result of lost revenue, considering that electricity was one of the major sources of such revenue required for them to run the municipalities. Eskom would only be able to supply a customer directly in the municipality zone with the consent of the municipality.

On municipalities adding significant demand-side charges to the electricity tariffs, including non-tariff charges and levies, Mr Dames said that the tariff increase proposed for municipalities was 13%. Eskom was aware that municipalities were adding various costs to the tariff charged to their customers. This was however not a matter that could be addressed by Eskom but rather Nersa.

On whether there was any moral hazard in the way Eskom had calculated the costs of its build programme in calculating the MYPD tariff structure, Mr Dames said that the costs of Eskom’s build programme had been calculated in accordance with the regulatory rules published by Nersa. Eskom did not fund its capacity expansion programme directly through prices. Price provided the basis for Eskom to raise the debt it needed to finance capital expenditure.

In addressing the levelised costs of Medupi and Kusile, Mr O’Flaherty said that these were significantly below the 95c/kWh claimed by the Energy Intensive Users Group submission. Eskom had emphasised that the levelised costs of these projects were well below the average 77c/kWh at which Eskom bought power from IPPs in the latest financial year. Medupi and Kusile costs were in line with international benchmarks.

On the impact of Medupi and Kusile units on Eskom’s pricing approach, Mr Dames said that until the first unit of Medupi is commissioned in 2013, there would still be a tight balance between electricity supply demand due to the need to maintain the aging generation fleet that would ensure long term sustainability, while meeting the demand for electricity. Eskom had identified several supply and demand side interventions such as short term IPP procurement programmes and a residential demand side management programme to assist during this period.

Mr Dames said that the MYPD 3 submission called for a mandatory energy conservation scheme to provide a ‘safety net’ and management of demand to levels assumed in the submission. The growth rates in the MYPD 3 submissions were lower than those required in the New Growth Path and the National Development Plan. There might be a short period of adequate reserve margin but that would disappear very quickly if new generation capacity was not brought on line after Kusile with a growth in the economy. The build programme would not address all the capacity needs of South Africa into the future.

Mr Mohamed Adam, Regulatory and Legal: Eskom, in responding to the impact of price increases on the manufacturing sector, said that in compiling its MYPD 3 application, the impact of price increase on the economy had been considered in addition to guidance from the President’s State of the Nation Address in which he requested Eskom to consider a price path which would ensure that Eskom and the industry remained financially viable and sustainable, but which remained affordable especially for the poor. The choices that had to be made were difficult but Eskom believed that its application achieved an appropriate balance. Eskom had proposed a longer migration path to cost reflective levels and had lowered the rate of return significantly. There was a threshold at which Eskom would also face a tipping point if prices were too low.

Mr Adam said that electricity was crucial to the economy and there was a cost to operate the current plant and also to invest in future capacity. If prices were not cost reflective (the price did not recover the full cost of supply), the shortfall would have to be paid for in another way by Government, which would turn be passed on to the taxpayer by way of additional taxes.

Mr Dames addressing the claim by Energy Intensive Users Group (EIUG) that Eskom’s costs of maintenance were higher than they should be because of unplanned outages running at over 14% of capacity and whether it was more costly to do unplanned than planned maintenance, said that their figures were not accurate. The unplanned outage ratio for the year to date was 10.47%. This was above Eskom’s target but well below the 14% stated by EIUG. The EIUG had also suggested that Eskom targeted a ratio of 90:7:3 for its generation fleet (90% availability, an average of 7% planned maintenance and 3% unplanned outages). This was an aspirational target which was achieved during the 1990s, when Eskom’s power stations were a lot younger with low load factors and that it was not appropriate for the current environment. The tight power system did not allow sufficient opportunity for philosophy based maintenance and this was the balance Eskom needed to strike in keeping the lights on with a constrained system.

On whether the MYPD 3 application had included the 600MW associated with the out of service Duvha unit that had suffered damage, Mr Dames said that the Duvha unit was regarded as a part of the existing capacity and was therefore not reflected under capacity additions, which referred to new build projects. The Duvha unit capacity was included as a part of Eskom’s existing capacity.

Discussion
Mr G Hill-Lewis (DA) challenged Eskom’s definition of cost reflective tariffs. The tariff structure proposed by Eskom posed an extremely dangerous threat to the industrialisation and economic growth and future success of business as well as job creation in South Africa.

In terms of depreciation, Mr Hill-Lewis said that Eskom had re-valued all existing capacity at what it would cost to replace it now and depreciated it, listing it as cost. This he considered ‘unorthodox.’ It seemed that Eskom was accounting for the need to replace every current megawatt capacity in the near future when in fact as had been stated only portions of Eskom’s capacity would need replacing and not every single existing power station. If this is what had been included in the MYPD 3 application, it did not sound right. Assets were being re-valued each year, meaning that the asset would be re-valued the following year and a calculation of depreciation done on the re-valued assets.

Referring to the 4% targeted return in the medium term and 8% in the final year, Mr Hill-Lewis said that he could not accept the answer given by Eskom. Johannesburg Stock Exchange in the last 10 years had returned on average 6.6% per year in the equities market. An offer to any stock exchange investor of a return of 8% above inflation in a very low utility investment would be taken up in no time. A targeted 8% return was exorbitant and unnecessary for a company like Eskom. This return would be funded by ordinary South Africans, business people, employers and entrepreneurs.

Mr Hill-Lewis said that cost reflective tariffs should be looked at on the basis of marginal cost of new generation capacity and not on the depreciation cost of the existing generation capacity. Eskom was building a balance sheet that would make any company in the world proud of as balance sheet to hold up as a model. Eskom did not need that kind of balance sheet in the current South Africa. Eskom had a different social mandate other than the pursuit of profit and it seemed that Eskom was trying to build in five years a balance sheet that would sacrifice industry, business, job creation, growth of industry in the country, something which was unfair and unnecessary.

Mr O’Flaherty replied that in five years’ time, Eskom needed funds that would support it to be an investment grade company. There was support from Government in terms of the R350bn guarantees of which R150bn would be used. In terms of the Government-State ratio, if the Government had to step in and fund all Eskom’s debt, the effect on the sovereign would be extreme. Eskom needed to build a 100% strong balance sheet to be able to support its future growth.

In response to the rate of return, Mr O’Flaherty said that the equity quoted by Mr Hill-Lewis excluded dividends that people were getting. in terms of depreciation, the cost of replacing Eskom’s capacity in 10 years’ time would be significantly higher that it was today. Depreciation was also promoting the desire by Eskom to become a standalone investment grade company.

Mr Dames added that depreciation had been regulated by Nersa and that it had been applied by Eskom in accordance with the regulations.

Mr Hill-Lewis also asked for clarification on the announcement that Mr O’Flaherty was leaving the company in 2013.

Mr Dames replied that it was going to be a big loss for Eskom but there was a successive plan in place. Mr O’Flaherty was to continue until the Annual General Meeting.
 
Mr B Radebe (ANC) said that it was surprising that coal was costing so much and yet South Africa had so much of it. There was a need for a special dispensation on coal for Eskom. Compared to other utilities in the world, was Eskom paying excessively in terms of salaries?

Mr Dames replied that there was enough coal in the country but that it required mining and new mines. Eskom had contracted for coal until 2018 but that an increase in the cost of mining would affect Eskom. The country had to look at the price of coal and have the matter addressed.

Mr Dames said that salaries were not compared with utilities internationally as this would be very expensive. Comparisons were being made with local South African industries. There were negotiations with trade unions in terms of the salaries. Staff were paid better in most cases using the benchmark. There was a threat to Eskom skill from international power companies due to good training and experience.

Ms S van der Merwe (ANC) said that small and medium enterprises were looking for interim relief because of the price shocks that were being experienced. The growth rate of South Africa was faster than Eskom’s prediction and there was need for a balance between saving electricity and increasing Eskom’s customer base. She also asked for Eskom’s opinion on municipality rates.

Mr Dames replied that Eskom had a developmental role to play in the industrialisation of South Africa. However, it was the role of the National Treasury and not Eskom to provide income relief – it was a policy maker’s call to support particular industries. In terms of the growth rate, a bottom up approach assessment had been done on the basis of what plans the Eskom customers had over the next five years coming up with a growth rate of 1.9%. In case of a sudden increase in the growth rate, the Integrated Resource Plan (IRP) provided for a 3% electricity growth in the long-term and if there was a change in growth, the IRP would have to be reviewed.

Responding to the issue of municipality rates, Mr Dames said that customers in South Africa deserved equal treatment, adding that Eskom only charged what was regulated by Nersa and that Eskom had never used its own discretion in setting power tariffs. Tariff consistency had to be addressed.

Mr G McIntosh (COPE) asked if Eskom has any figures on China and its generation cost. He asked for the feasibility of Eskom directly supplying customers with the consent of municipalities.

Mr Dames replied that there was no specific data on China – Eskom would try and get some. On the feasibility of supplying customers directly, it was technically feasible with the consent of municipalities and a joint agreement. But given the impact of on the business model of the municipalities, it is something that required careful consideration.

Mr G Selau (ANC) asked whether Eskom was going to get some share from the Presidential Infrastructure Finances. Where there changes to the anticipated completion dates of Projects Kusile, Medupi and Ingula?

Mr Dames replied that there was no further support in terms of equity from Government.

Mr O’Flaherty, on the timelines of the projects, said that the build programmes were on track with Medupi expected online in 2013, Kusile and Ingula towards the end of 2014.
 
Dr W James (DA) asked if Eskom was willing to be a part of a cost reduction caucus in a bid to look for ways of keeping administered prices down.

Mr Dames replied that Eskom would actively participate in such a caucus.

Mr A Alberts (FF+) asked if there were any other models for the future (asking for outside expertise from which to make decisions on South Africa’s energy sustainability) and whether economic impact assessments had been carried out on South Africa’s economy as a whole. Had studies been done on when IPPs would become self-sustainable?

Mr Dames said that when the financing for Eskom was done, there was extensive outside work from global banks in trying to find a solution. The information would be provided if needed. Economic impact assessments had also be done with input from universities, reports of which were available. Most of Eskom’s debt was long-term (more than 10 years to ensure that the rates were lower).

A South African Local Government Association (SALGA) representative noted that municipalities were not immune to regulations and that they were in compliance with Nersa Guidelines. Municipalities had to factor in other services they were providing, including the cost of maintaining networks.

Mr McIntosh said that he was not convinced that SALGA was prudently incurring costs.

Mr Mabasa asked for the solutions that had been suggested by both Eskom and municipalities?

The Chairperson said there would be a colloquium at which Nersa, Eskom, SALGA, some municipalities, National Treasury, Department of Public Enterprises and the Department of Energy would be invited to try and get solutions.

The meeting was adjourned.