SALGA’s submission to NERSARegarding Eskom’s Application for a

Multi-Year Price Determination 2010/11 to 2012/13 (MYPD2)

Midrand, Gauteng22 January, 2010

Overview

1. Introductory remarks – Cllr A. Masondo, Chairperson

2. Detailed presentation – Mthobeli Kolisa, Executive Director:

Municipal Infrastructure Services

– Comments on Eskom’s application

– SALGA’s proposed alternative

3. Questions

Comment: A welcome paradigm shift

• SALGA is encouraged by Eskom’s appreciation of the need for a paradigm shift

“it became clear that a significant paradigm shift is required to achieve a successful outcome for Eskom and South Africa. Stakeholders required a

more inclusive approach to addressing the country’s challenges” (Eskom MYPD 2, 30 November, 2009. p14)

• This shift can only succeed if all stakeholders play their part• SALGA commits to playing its part.

Comment: Policy context (IRP)

• It is concerning to SALGA that Eskom had to prepare its MYPD2 application with little or no clarity on country choices in respect of the following questions(Eskom, MYPD2, 30 November, p15)– How much electricity generation capacity is required to enable economic

growth and social development?

– What is the best mix of primary energy sources (i.e. coal, nuclear, solar, wind, etc) for such capacity?

– Who should build this capacity?

– How should it be funded?

– What is the role of a competitive energy supply environment in the South African economy?”

Comment: Policy context (IRP)

• The Energy White Paper of 1998 committed DME to the development of an integrated resource planning approach to guide these investment decisions and related licensing processes

• A determination on the Integrated Resource Plan was gazetted on 31 December, 2009

• This determination does not adequately deal with these issues • No public consultation has been followed in drawing up the IRP.

Comment: Policy context (IRP)

• SALGA has three main concerns with the IRP process– The delay in putting a regulatory framework in place

– Consultation process before the IRP was published • In the absence of consultation, is the IRP a legitimate document?

– Given the status of the IRP, is the MYPD2 process credible and legitimate? Is there a risk of legal challenge?

• Failure to put sound capacity planning systems into place in good time has led to a low reserve margin, which leads to higher plant utilisation levels, which leads to higher operating costs

• This therefore has had a direct impact on the cost of electricity to municipalities, households and businesses

Comment: Policy context (FBE)

• Government recently adopted the Electricity Pricing Policy (EPP) which recommends that distributors provide free basic electricity (FBE) to qualifying customers.

• This is meant to be funded from the ES• Given the sharp rise in the cost of providing FBE, it may be advisable

to re-open discussion on the Electricity Pricing Policy and the funding of FBE.

• If not attended to, this presents a risk to the viability of EDI and to LG in general

Comment: Compliance with existing policy?

• Does the MYPD2 proposal comply with existing government policy?– Is 30% of planned new generation capacity allocated to independent

power producers (IPPs)?

– Does the plan comply with government’s targets for renewable energy contributions?

– What are the long term consequences for carbon emissions?

• Despite SALGA’s request that Eskom address these issues the application remains silent on these issues.

• SALGA calls upon NERSA to consider the extent to which the MYPD2 complies with existing government policy in making its decision.

Comment: Demand and supply forecast

• Eskom’s application does not address the implications if actual demand differs from the forecast– If demand is materially lower then revenues will be lower and Eskom may

not be able to fund its capital programme. To what extent will this jeopardise security of supply?

– If demand is materially higher then the reserve margin may not be sufficient. To what extent will this jeopardise security of supply?

• SALGA requests NERSA to examine Eskom’s demand forecasting assumptions and to assess the consequences of variations in demand.

Comment: How realistic is the funding strategy?

• SALGA’s original response to Eskom’s 30 September MYPD2 Proposal raised a concern that the Proposal did not contain a clear funding plan for the period and requested that Eskom address this issue more fully in its final submission to NERSA.

• Whilst Eskom’s 30 November Application contains substantially more information on the funding strategy it has also given rise to a whole new set of concerns.

• These are:• Is the funding strategy efficient and equitable?

• Is the funding strategy realistic?– Availability of debt– Availability of equity

Comment: How efficient and equitable is the funding strategy?• Eskom plans to fund an inappropriately high portion of capital

expenditure from annual cash flows. • The current generation of electricity consumers is being asked to pay

for assets that will be used by future generations

Comment: How realistic is the funding strategy?(R millions) FY09/10 FY10/11 FY11/12 FY12/13 FY13/14 FY14/15

Revenue   98,355 132,579 180,107 206,757 236,550

EBIT 710 12,893 36,085 71,239 82,130 95,089

Profit before tax -3,478 7,867 29,305 62,811 72,793 85,337

Tax (current and deferred) -970 2,217 8,231 17,627 20,442 23,973

Net income/-loss -2,508 5,650 21,074 45,184 52,351 61,364

             

             

Capex (inc IDC)   96,303 108,320 103,991 86,310 106,683

Capex   87,646 94,417 86,239 68,783 88,905

IDC   8,657 13,903 17,752 17,527 17,778

             

Funding   60,000 56,000 50,000 35,000 35,000

Shareholder loan & equity   20,000 10,000 10,000    

Clean technology fund     3,000      

Borrowings   40,000 43,000 40,000 35,000 35,000

             

Capex funded from sources other than long-term funding   36,303 52,320 53,991 51,310 71,683

Portion of capex funded from sources other than long-term funding   38% 48% 52% 59% 67%

(Eskom MYPD2, 30 Nov, 2009, p83)

Massive profitsTax leakage

Ambitious programme

Funding constraints

Inappropriate reliance on cash flows

Comment: How realistic is the funding strategy?

• This funding strategy leads to Eskom generating massive profits in future years

• This is very tax inefficient!– the rise in annual profits will lead to a massive expense on company tax

• R17.6 billion by year three and R24 billion by year five.

– This ‘leakage’ from the electricity industry will be a direct result of Eskom’s strategy of funding capital asset creation from annual surpluses – rather than from long term debt.

Comment: How realistic is the funding strategy?

• Is the borrowing plan realistic?

“.....the assumed levels of borrowings and equity are optimistic and may not materialise.” (MYPD2, 30 Nov, 2009, p20)

“……funding in excess of R40bn in FY10/11 and FY11/12 may not be feasible and will need to be raised from unconventional sources, which may be more expensive than projected.” (MYPD2 Application, 30 November, 2009. p21)

• Does the borrowing plan expose the country to undue risk?• Is Eskom likely to request another interim tariff increase?• NERSA should interrogate Eskom’s assumptions regarding its debt-

raising capacity and the nature of the ‘unconventional sources’ referred to in the application – in order to evaluate the probability and consequences of any shortfalls in debt funding.

Comment: How realistic is the funding strategy?Availability of equity• Besides government’s existing quasi-equity commitments over the

MYPD2 period, Eskom is proposing to raise at least R20 billion in private equity in two equal tranches in the first and second years of the period.

• This private equity is proposed to arise from the sale of a partial stake in the incomplete Kusile power station.

• How significant is the risk that such a procurement (or sale) will not be finalised within the target time frame?

• NERSA should take care to examine the implications of Eskom realising lower levels of equity.

Comment: How realistic is the funding strategy?Availability of equity

….equity participation is traditionally a long-term relationship, Eskom must ensure that it brings broader benefits than purely a cash injection.” (MYPD2 Application, 30 November, 2009. p24.)

• How will the sale of a minority stake in the partially built Kusile power

station bring “broader benefits than purely a cash injection”? – Decisions have already been made on design, engineering and

procurement

– Eskom intends to operate the plant

– Where will the investor add value besides the provision of capital?

– What guarantees will the investor require Eskom and/or government to make? How will these effect the long term cost of electricity?

Comment: How realistic is the funding strategy?• Has Eskom considered the sale of other assets, such as stakes in

existing power stations which would present a lower risk profile to investors, and therefore require a lower equity return?

• This option may have several advantages over the Kusile sale option. – Firstly, the existing stations have a performance history which investors

can evaluate, as compared to Kusile which has yet to run.

– Secondly, existing power stations have no completion risk and no risk of construction cost over-runs.

– Lastly, the sale of a significant stake in one or more existing power stations would achieve a real transfer of risk to a private operator, and therefore the prospect of efficiency gains, whereas the sale of a minority stake in Kusile brings no prospect of efficiency gains since Eskom will still be the operator.

• NERSA should evaluate the practicality of the equity component of the proposed funding programme

Comment: How efficient is Eskom?

• In line with the new paradigm Eskom has provided considerably more insight into its costs drivers in the 30 November application, compared to the 30 September application. SALGA welcomes the improved transparency.

• Nonetheless, cost inflation appears excessive, and SALGA expects that NERSA will undertake a detailed due diligence of cost estimates

• For example the information provided in the application seems to suggest that , based on a standard heat rate of Eskom’s gas turbines, the fuel price per litre will be around 1.8x than that suggested in Annexure A: Table of Assumptions.

• SALGA also requests that NERSA review the procurement processes which have given rise to what appears to be abnormally high capital cost per kW of installed capacity at Medupi and Kusile.

Comment: How much risk is too much?

• The 30 September Proposal mentions the word “risk” on 34 occasions

• The 30 November version adds a further 48 instances– “…even with a 45% price increase Eskom had significant cash shortfalls

and was exposed to certain risks. The current approach has increased that risk profile. We have made aggressive assumptions, thus increasing the margin for error. Any one change could therefore have a significant knock on effect (Eskom MYPD2 Application, 30 November, 2009..p20).”

• If the level of risk is as high as Eskom appears to think, is it wise to proceed with the proposed strategy?

• SALGA is not convinced that Eskom has adequately explored or divulged the implications for security of supply if any of the identified risk factors come to pass.

Comment: Overall finding

• It was very difficult for SALGA to form an opinion without access to critical pieces of information such as the IRP and the demand forecast

• However, it appears to SALGA that Eskom is trying to do too much, given its funding constraints.

• Risks are being passed on to municipal distributors and consumers in the form of unreasonable tariff levels and the possibility of further increases. This is unacceptable.

• Primarily the increased risk arises from the decision to lower the tariff increase from 45% to 35% without making a concomitant reduction in the scale of the capital programme.

• SALGA suggests that alternatives be considered to reduce risk and lessen the scale of the tariff increase.

SALGA’s Proposed Alternative

• Eskom’s funding strategy appears to have been shaped by the following constraints:– The projected cost of the capital programme;

– The R40 million cap on annual borrows; and

– The limited options for equity raising.

SALGA’s Proposed AlternativeProposal 1: Raise equity through the sale of existing assets

– If there is willingness to get private equity then selling stakes in other Eskom assets other than Kusile should be considered?

– Sale of significant stakes in existing power stations would transfer real risk to private investors and create potential value

– Increased equity should improve Eskom’s borrowing potentialProposal 2: Reduce revenue requirements by deferring capital expenditure

– Tariff increases would be significantly reduced if a portion of the capital programme is pushed into the next MYPD period

– There is a high risk that this will happen anyway.Proposal 3: Accelerate IPP and DSM programmes

– Private investment will reduce pressure on Eskom’s balance sheet– Smaller IPP projects should be quicker and create less system risk. These are

valuable attributes in a time of uncertain demand and low reserve margins.– Accelerated DSM will be necessary for security of supply.

• Some commentators have suggested that the application of these three options could contain MYPD2 tariff increases to below 30% per year. In SALGA’s view this would be a substantially better outcome than the current Application.

Thank you

Municipal Average %age Tariff increases

Municipality1 July 2008 increase [%]

Eskom average increase – 35.9%

1 July 2009 increase [%]Eskom average increase –

31.3%eThekwini 29.5% 28.0%

Nelson Mandela Bay 30% 25%City of Cape Town 35.8% 33.5%

Ekurhuleni 27.65% 30%City Power 35% 29%Tshwane 27.5% 34%

uMhlathuze 28% 27%Msunduzi 22% 27.5%

Buffalo City 30% 31.3%Mangaung (Centlec) 32.6% 34%

Thank You