Establishing the Independent System and Market Operator (ISMO)

Energy

31 January 2013
Chairperson: Mr S Njikelana (ANC)
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Meeting Summary

A task team, consisting of the Departments of Energy and Public Enterprises, National Treasury and Eskom, had been set up to prepare inputs for the processing of the Independent System and Market Operator Bill (ISMO). It was to perform a scenario building exercise and further due diligence on the future of the transmission sector vis-a-vis the ISMO Bill. Members of the task team presented their report on the due diligence exercise but stated that no solid conclusions about the recommendations had been reached yet, as the ISMO Bill had still not been approved by the Minister.

Eskom explained how the transfer of its assets would affect their operations and creditworthiness. The majority of members agreed that the transfer of assets and transmission from Eskom and the subsequent establishment of ISMO would lead to the downgrading of Eskom as an entity; concerns about the fair compensation of Eskom were also the main points of discussion. Four key focus areas were identified by the task team for the due diligence exercise: the financial, legal, human resources, and technical/ operational impacts on both Eskom and ISMO. However, the focus of the presentation was only on the financial and legal impacts as the rest of the issues were discussed in greater detail in the report.

Scenario building exercises were also discussed, in an attempt to make an informed decision about whether or not to transfer assets and transmission from Eskom to ISMO, but no conclusions were reached as the Bill had still not been finalised. The two options recommended with regards to the ISMO Bill were that the Bill could be processed without the transmission of assets while the working group continued to resolve the remaining issues pertaining to the transfer of transmission assets, the second option was that the Bill could be placed on hold while giving the work group more time to finalise their outstanding work.

Meeting report

Introduction by the Chairperson
The Chairperson began by drawing attention to the late distribution of documents by the task team, handed in only that morning. This was unacceptable as it did not award sufficient time for the committee members to sufficiently scrutinize the documents for discussion during the course of the meeting.

The Chairperson outlined the content of the meeting as focusing on the briefing of the Committee on further due diligence and feedback on the study of the transfer of transmission from Eskom to Independent System and Market Operator (ISMO) with the processing of the ISMO Bill. A recap of last year’s proceedings was given, with the Chairperson stating that there were a number of concerns raised about the transfer of transmission and assets from Eskom into ISMO at the time, therefore it would have been unreasonable of the Committee to give informed feedback immediately, which was why further due diligence was proposed.

Independent System and Market Operator (ISMO) Bill presentation
Mr Ompi Aphane, Deputy Director-General Policy, Planning and Clean Energy: Department of Energy (DoE) spoke on behalf of the task team and highlighted that the task team consisted of members representing government and Eskom. Government was represented by the Departments of Energy and Public Enterprises, and the National Treasury.

Mr Aphane stated that the process of the transfer of transmission from Eskom and the subsequent establishment of ISMO was given a scope which was defined by the Committee itself, and the task team was given the task of conducting a due diligence exercise, which would flag some of the salient considerations of the ISMO Bill and the transmission of assets. In terms of the scope and the approach, Mr Aphane outlined three broad categories of scenarios:
▪ The ring-fencing of ISMO within Eskom for the purpose of transferring the identified functions of the state-owned entity;
▪ The establishment of ISMO through the relevant legislation so that ISMO would be independent of Eskom.
▪ The transfer of transmission from Eskom to ISMO as an independent wholesaler.
Mr Aphane highlighted that the due diligence exercise did not seek to address concerns identified, rather it was to highlight them and open the process up for any further recommendations.

According to Mr Aphane, the key elements which the due diligence exercises looked at were that of the financial, legal, human resource and technical impacts. With regard to the human resource and technical/ operational impacts of the transmission, it was largely up to Eskom to flag the relevant issues for consideration. Barclays/ ABSA was thus contracted to undertake a profitability study with regard to Eskom’s credit rating and financial projections under the different scenarios and to assess what the main impacts of the transfer would be on Eskom. However, the impacts of the transmission transfer on ISMO/ ISMO-TSMO need also to be considered, more importantly to consider, the impact of the transfer on the national balance sheet of the country.

Mr Aphane noted the presentation on the due diligence exercise did not focus on background issues, rather it focused on the issues that would come up in the establishment of ISMO.

He reiterated the point that the presentation did not attempt to provide solutions to the identified challenges and issues, but rather it was to flag them for further recommendations.

Mr Andrias Thabang Audat, DoE Chief Director, Electricity, further elaborated on concerns which came out of the due diligence exercise. After public hearings were held for the establishment of ISMO, the department was asked to go back and conduct a due diligence exercise. This presentation would be discussing the outcomes of the exercise with a main focus on the legal and financial aspects, with recommendations given at the end. He gave a brief outline of the background of the ISMO Bill and highlighted that from the public consultation process, the main concern raised from the public hearings was that of the independence of the transmission assets from Eskom to ISMO. As a result, the processing of the Bill was put on hold until government and Eskom proposed solutions and recommendations to the concern raised regarding the independence of transmission.

The department initially proposed that there would be a three-phased approach. The first phase would be ring fencing of ISMO within Eskom; the second would be the establishment of ISMO through legislation so that ISMO would be an independent institution; the final phase would be the independence of ISMO transmission. The other critical concerns raised by the public were that of ‘willing buyer-willing seller’ as well as the need for the alignment between the Electricity Regulation Act (ERA), the National Energy Regulator of South Africa (NERSA) and ISMO. Therefore the concern was that as the department was busy producing the ISMO Bill, it needed to be aligned with the already existing legislation. As for the progress of the legislation process, Mr Audat stated that ERA and the
National Energy Regulator Act (NERA) were currently at the National Economic Development and Labour Council (NEDLAC) for consideration.

Recap: ISMO Concept and Structure
Mr Audat outlined the current structure of Eskom Holdings SOC Ltd as being comprised of production/ generation, transmission and retail. Therefore with the establishment of ISMO, ISMO would have to enter into agreements of transmission with system operators such as wholesalers and single buyers. The department was then required to conduct further research on the impact the transmission of wires from Eskom to ISMO would have on Eskom, more especially the financial implications of the transfer of assets on Eskom to another entity.

Mr Audat moved on to outline the initial purpose of the ISMO Bill; there were four purposes of the Bill:
establish ISMO as an independent public entity which was financially viable to deliver on its mandate;
ISMO would be an electricity wholesaler providing future opportunity for qualifying customers to purchase electricity as wholesale prices;
▪  ISMO would be a buyer of power from electricity generators (including Eskom GX) in a transparent manner while still promoting efficiency within the electricity value chain;
ISMO would be a planner for new generation capacity in accordance with government policy.

ISMO Bill Public Hearings
According to Mr Audat, the main issue raised in the public hearings was that of the independence of transmission. As a result, DoE, the Department of Public Enterprises, National Treasury as well as Eskom were mandated to conduct a high level due diligence report on the implications of the removal of transmission wires and assets from Eskom, the deadline was the end of January 2013. The DoE was therefore requested to lead the department to provide a bi-weekly progress report to the Portfolio Committee on due diligence.

Four key areas were identified to assist in the assessment of the impact of the transmission on both Eskom and ISMO; these focus areas were the financial impact, legal impact, human resources and the technical impact on both entities. Again it was noted that the presentation would cover the financial and legal impacts as the full report was complete and covered all four components.
With regards to the outcomes of the due diligence report, the financial concern was that should ISMO be established, transmission wires would be moved from Eskom to ISMO leaving Eskom unreimbursed. The legal impact was that of contracts that were currently held by Eskom. With the transfer of transmission from Eskom to ISMO there were legal concerns which have to be considered.

Issues raised by the workgroup’s due diligence report
Mr Audat outlined the legal impacts of the transmission on Eskom as follows:

Transmission Licence
Eskom was currently the holder of the licence, therefore should ISMO be established NERSA needed to make sure that the ISMO also had a licence; the two ways that NERSA could do that was either to revoke Eskom’s current licence and issue a new licence to the Transmission System Operator (TSO) or assign the current Eskom licence to the TSO, therefore the regulator was better positioned to advise on the matter. The second issue with regards to the licence was that upon implementing the restructuring, some legislative changes also need to be considered, in accordance with current legislation.

Grid Code
At all the three phases of the establishment of ISMO, the grid code needed to be amended to keep pace with the different industry phases, the grid code therefore needed to be flexible as the current grid code took a number of months.

Eskom-TSO Power Purchase Agreement (PPA)
The workgroup outlined that should the PPA not be adequately drafted, challenges between supply and demand could arise.

Power Supply Agreements (PSA)
The TSO would require back to backed PSAs for all PPAs it signed, therefore PSAs need to be in line with the Eskom distribution, purchasing and selling pricing structure; this would however create a revenue risk for Eskom distribution.

The Chairperson asked for clarity about the difference between PSAs and PPAs.

Mr Audat explained that PPAs perform a ‘supply’ function and were agreements between generators of electricity such as Eskom and TSO, therefore electricity would be bought from Eskom by TSO. PSAs performed a ‘demand’ function. PSAs were agreements signed between consumers of electricity, whether industrial or household and the wholesaler TSO.

Transfer of current contracts
Before restructuring a careful consideration needed to be given to the existing structures of Eskom, therefore a number of contracts would need to be assigned or transferred from Eskom to the TSO.

Current Eskom intellectual property (IP) and information technology (IT) systems
The TSO would require access or ownership of significant amounts of Eskom’s IP. Also, many of Eskom’s IT systems would be required by the TSO are jointly owned by Eskom transmission and generation.

Transfer of land portfolio (including homelands infrastructure)
The transfer of land from Eskom to TSO could present major risks for Eskom, as land owners may withdraw consent or re-negotiate payments etc as there were a number of property rights which would need to be transferred from Eskom to the TSO.

Dispute resolution
According to the workgroup report, Eskom was concerned that where there was a breach of contract, the TSO may seek to recoup costs from and apply penalties on Eskom; therefore appropriate limitation of liability provisions should be introduced to avoiding extensive litigation risk between electricity market participants. Therefore there needed to be a clear dispute resolution in place.

Mr Audat then moved to the financial Impacts of the transfer on Eskom

Cross-subsidization of electrification and rural customers
According to Mr Audat, the issue of cross-subsidisation was raised in the public hearings with the main issue being that since there were currently different levels of consumers who consume different levels of electricity; the tariff was not standard, some customers paid more than others, and the concern was that currently there was about R5.6 billion cross-subsidies between high-end users and rural customers, rural customers paid less, therefore Eskom needed to increase its tariffs to low-end customers. Funding arrangements therefore needed to be finalised to make sure that low-end customers were not in an unfavourable positions.

Financial Impact on Eskom
Four issues were raised by the workgroup report: Eskom’s existing debt instruments, its credit rating, its ability to raise finance in the future and the government’s ability to fund Eskom going forward.
Mr Audat highlighted that whether or not the TSO was established and the transfer of transmission and assets was approved, these issues would still be a concern to Eskom regardless. The report would be made available to all committee members as it contained a more detailed outline of the workgroup’s report.

Mr Audat said a number of financial issues faced by the newly created TSO were: TSO’s lack of credit worthiness since it was a new entity, its ability to raise finance for the upgrade and expansion of the transmission of assets (for the transmission development 30 year plan) and its working capital requirements. Another issue was the compensation of Eskom for the transfer of wires to the TSO.

Recommendations
Mr Audat reiterated that the working group report went into more detail about the impacts of the transmission on both Eskom and the TSO and it was available. A second report was also available which outlined the mitigatory measures based on the issues raised in the working group report. It was acknowledged that further work was needed before the transfer of the transmission assets.

The working group recommended two options:
▪ The processing of the ISMO Bill without the transmission assets while allowing the working group to continue resolving the issues pertaining to the transfer of assets; or
▪ The ISMO Bill be placed on hold whilst giving the working group more time to finalise the outstanding work on the impact of transferring transmission assets. Therefore the Bill would not be finalised until the work of the working group was concluded.

Discussion
The Chairperson stated that the recommendations presented were welcomed and appreciated, and suggested that questions of clarity be posed to the task team and that any other members from the task team were welcome to respond to the questions.

Mr Mongezi Ntsokolo, Eskom Group Transmission Executive, introduced Ms Vicki Govender, Eskom Chief Legal Advisor, and Mr Trevor Myburgh, Eskom Senior Manager: Corporate Finance. He asked them to elaborate further on the outlined legal and financial impacts of the transfer respectively. He noted that Mr Myburgh was the Senior Manager overlooking the Barclays credit rating exercise.

Mr Myburgh gave a brief background of the work done with Barclays about the credit rating system. Transmission assets were identified as low risk assets which makes it easier to access end cash flows. The outcomes of the Barclays exercise suggested that ISMO was a high risk entity since it was newly established and did not have a balance sheet; it would then need substantial support from government. Restructuring had major implications; one of them being that removing transmission assets from Eskom changed its risk profile and Eskom would be downgraded below investment rate, while the TSO’s credit rating was upgraded.

The Chairperson asked how the credit rating process was managed.

From a legal perspective, Ms Naidoo highlighted that the transfer of assets and transmission from Eskom to ISMO would result in a variety of contractual and regulatory issues arising. High impact analysis was therefore necessary to flag important issues, in order to gain a better understanding of the contractual and legal consequences.

Mr L Greyling (ID) asked whether the transfer of Eskom assets and transmission into ISMO was desirable as a solution to the electricity challenges in the country, and wondered about the timelines for the processing of the Bill and the implementation of the proposed recommendations. With regards to credit ratings, he asked if Eskom’s credit ratings could not be linked to government’s credit ratings.

About the question on whether the transfer of assets from Eskom into ISMO was a desirable for the integration process, Mr Aphane responded that it was as it sought to diversify risk management. He reiterated that the problems with the current structure had not been analysed or discussed as this was not part of the mandate of the task team.

The Chairperson asked Mr Greyling which recommended solution he preferred.

Mr Greyling replied that he supported the adoption of the first recommendation.

Mr J Selau (ANC) enquired about the financial implication to Eskom and ISMO with the adoption of the first recommendation.

Mr K Moloto (ANC) enquired about the PSA agreements; which may not be aligned with the Eskom distribution, purchasing and selling price structure, creating a revenue risk for Eskom. He asked whether the introduction of ISMO would not pose the same risks to Eskom. On Eskom’s intellectual property and IT transfer, he asked whether the same risks would not apply. On the dispute resolution between Eskom and TSO, was Eskom not being given preferential treatment? On cross-subsidization for rural customers, according to the due diligence report, Eskom would be losing key customers with the transfer. Therefore would the introduction of ISMO not raise the same concerns about cross-subsidization for rural areas?

Mr Aphane, responding to why it was necessary to transfer transmission customers into ISMO, stated that ISMO/ TSMO was a middle man between all generators and the markets. Therefore ISMO must have customers, but because ISMO was high risk, Eskom’s balance sheet and its customers need to be transferred into ISMO.

On PSAs and the revenue risk to Eskom, Mr Aphane replied that Eskom’s revenue would be destabilised at the same time. PSAs allowed for a better understanding of the pricing arrangement structure.

The Chairperson suggested that government did not like special agreements and therefore they needed to be avoided and restructured.

Mr Moloto asked about land and whether it would not be difficult to transfer land from Eskom to ISMO. Also asked was the implications of processing the ISMO Bill on Independent Power Producers (IPPs).

In response to the question about IPPs and the challenges they would face, Mr Aphane replied that for any IPP deal to be closed, Eskom insisted on government support and guarantees for IPP transactions. IPPs were therefore in line with government policies such as regional integration.

The Chairperson enquired about the progress with regards to the completion of the ring-fencing phase, phase one, and how far the NEDLAC process was. An enquiry was made about the incubation of Eskom to ensure its credit worthiness.

Mr Ntsokolo responded stating that the ring-fencing phase of ISMO within Eskom was about 90% complete and that some centralised services, such as IT, were still to be finalised.

Mr Moloto wondered whether the transmission of assets from Eskom to ISMO would be of a fair value to Eskom, if so then would it not have a positive impact on Eskom’s credit worthiness?

Mr Aphane, on transferring of transmission and what it meant for Eskom financially, replied that it was unavoidable that the impact on Eskom would be significant. At the moment R350 billion had been guaranteed to Eskom in support of the restructuring programme.

Mr Greyling advised that a TSO was desirable in the long term and that such an end-state should be documented in the Bill

In response to the questions, Mr Aphane stated that the nature of the questions required that they be split between the task team members. Therefore issues such as finance would be dealt with by the relevant task team member. An apology was also given for the late distribution of documents.

Mr Aphane advised that the credit rating should be managed and approached very sensitively. With constant reference to a chart that was on display, he elaborated on credit ratings and the various scenarios to consider. He made reference to taking transmission and assets from Eskom then offering compensation to the entity. The chart was incomplete as it did not take into consideration the impact the transmission would have on the national balance sheet of the country.

With regards to credit rating, the scenarios that need to be considered were that of the impact that it would have on Eskom’s financial ratings. There was a high possibility that Eskom would be downgraded. And since Eskom was a state owned entity, the impact the credit ratings and the transmission had on the national balance sheet was important.

With regard to the credit rating process prognosis, Mr Aphane said that it indicated what could happen in different scenarios and that the bottom line remained that under both scenarios there were high risks, and Eskom was bound to be heavily impacted on both.

Mr Steven Muleya, Deputy Director of Legislation: National Treasury, responded on the issue of the regulation process currently underway for NEDLAC response. The business and labour constituencies had been consulted and the report had been finalised. At the moment they were awaiting approval of the document from the Minister and overall convenors.

Mr Aphane highlighted that the task team was therefore not in a position to state whether the transmission and transfer process were approved or rejected, and that this would be finalised as soon as approval was received from the Minister.

Mr Jeffery Quvane,
Senior Financial Officer: National Treasury, dealt with two remaining questions on finance. The first one raised by Mr Selau dealt with the transfer of transmission assets – which was the first recommendation from the task team. From a government’s point of view the impact was significant as ISMO was a new entity and would not have a balance sheet; therefore it would need government support.

With regards to the fair compensation of Eskom, Mr Quvane stated that from the Barclays report, even if Eskom was given fair compensation, the credit value of Eskom would still be downgraded.
 
Mr Greyling asked for clarity on ISMO and government standing behind it, and asked if government would still need to stand behind the TSO when ISMO had received transfer of assets from Eskom?

Mr Selau stated that, over time, ISMO would be self-sustaining in the long run, as it would be a major wholesaler, taking the majority of Eskom’s customers with it, leaving Eskom negatively impacted.

Mr Moloto suggested that the previous questions first be responded to so that he could ascertain whether a response was still needed from his side.

Mr Quvane responded that the R350 billion provision of guarantees havdbeen allocated to Eskom, and that contributed to the 50% threshold that government met for guarantees.

The Chairperson stated that ISMO was also integral for the nature of its work and should also be a central focus of the discussion and not only Eskom.

Mr Moloto asked if any concerns were expressed about IPPs at the public hearings.

Mr Aphane responded that IPPs look to the buyer before concluding financial arrangements. In this case, the buyers were both government and Eskom.

With regards to the IPPs, Mr Moloto stated that the transmission development plan was unfavourable and asked how did one ensure that IPPs had fair access to the transmission of wires and that the transmission plan was not structured in a way that was unfair to the IPPs.

Mr Greyling asked how the transmission process impacted the energy of the country as a whole in the long term. How would it be tabled in government legislation?

Mr Selau (ANC) agreed with Mr Greyling that matters under discussion could not be finalised today.

The Chairperson reiterated the fact that the purpose of ISMO was to improve operational efficiency. He wanted to know about the operational cost of the two options proposed. He noted that government did not have a roadmap for restructuring the country’s electrical sector as a whole and that was an issue that needed to be addressed.

Mr Ampane responded that in the first recommendation, the ISMO Bill would result in an indefinite loss of customers for Eskom.

The Chairperson thanked all members present for their contributions.

Meeting was adjourned.

[The following members submitted apologies: Mr S Radebe (ANC), Mr S Mayathula (ANC), Ms B Tinto (ANC), Mr J Smalle (DA), Mr B Ferguson (COPE) as well as the Minister and Deputy Minister.]

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