Consultation Paper

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

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TABLE OF CONTENTS PREAMBLE........................................................................................................................................................................... 3 LIST OF TABLES.................................................................................................................................................................. 4 ABBREVIATIONS ................................................................................................................................................................. 5 1. EXECUTIVE SUMMARY ............................................................................................................................................ 6

PRIMARY ENERGY COST VARIANCE ............................................................................................................ 6 NERSA Staff comment........................................................................................................................... 6

VARIANCES ON CAPITAL EXPENDITURE ...................................................................................................... 7 NERSA staff comment ........................................................................................................................... 7

TRIGGERS FOR A RE-OPENER ...................................................................................................................... 7 NERSA staff comment ........................................................................................................................... 7

ESKOM’S RISK POSITION ............................................................................................................................. 8 PRELIMINARY NERSA STAFF CONCLUSIONS.............................................................................................. 8

2. INTRODUCTION AND BACKGROUND .................................................................................................................... 9 2.1 OVERVIEW OF THE ENVIRONMENT WITHIN WHICH ESKOM’S APPLICATION IS MADE .................... 9 2.2 ESKOM’S APPLICATION .............................................................................................................. 11 2.3 APPROACH TAKEN IN EVALUATING ESKOM’S APPLICATION ....................................................... 11

3. SUMMARY OF NERSA STAFF VIEWS ON ESKOM’S APPLICATION INCLUDING RISK REVIEW OF ESKOM’S POSITION............................................................................................................................................................................ 12

3.1 SUMMARY CONCLUSIONS ON ESKOM’S APPLICATION ................................................................ 12 3.2 SOME SPECIFIC ISSUES AFFECTING THE INDUSTRY IN GENERAL AND ESKOM IN PARTICULAR ..... 16

Industry Pressures .............................................................................................................................. 16 Eskom Risks – Quantifications and Mitigations ................................................................................. 17 Need for Increased Tariffs to Cover Risks .......................................................................................... 19

3.3 RULE CHANGES.......................................................................................................................... 20 General ............................................................................................................................................... 20 Rules on Primary Energy.................................................................................................................... 20 Rules on Capital Expenditure ............................................................................................................. 21 Rules on Trigger for a Re-opener ....................................................................................................... 21

3.4 IMPACT ON TARIFFS – SHORT TERM AND LONG TERM............................................................... 22 3.4 SOME CONCLUSIONS .................................................................................................................. 22

4 RULE CHANGE PROPOSALS AND NERSA STAFF VIEWS ................................................................................ 23 4.1 PRIMARY ENERGY COSTS ........................................................................................................... 23

Proposed rule changes by Eskom ....................................................................................................... 23 Relevant rules/mechanism in current MYPD...................................................................................... 24 NERSA staff views on Eskom’s proposals and current MYPD mechanism ........................................ 25

4.2 ACCELERATED CAPITAL EXPANSION PROGRAMME ..................................................................... 27 Proposed rule changes by Eskom on the CAPEX variances............................................................... 27 NERSA staff views on Eskom’s proposals........................................................................................... 28

4.3 TRIGGER OF A RE-OPENER .......................................................................................................... 30 Summary of issues relating to MYPD re-opener................................................................................. 30 Proposed rule change on MYPD re-opener (Eskom).......................................................................... 30 NERSA staff’s response to the proposed rule changes........................................................................ 31

5. ONCE-OFF RELIEF.................................................................................................................................................. 33 5.1 PRIMARY ENERGY COSTS .......................................................................................................... 33

Expected variance from MYPD........................................................................................................... 34 5.2 ACCELERATED CAPITAL EXPANSION PROGRAMME ..................................................................... 36

Eskom’s request for relief related to CAPEX variances ..................................................................... 36 5.3 MYPD RULE CHANGE SCENARIOS .................................................................................................. 37 NERSA STAFF PRELIMINARY ANALYSIS OF ESKOM’S APPLICATION PRESENTED IN 5 SCENARIOS ..... 37

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SCENARIO 3: ADJUSTED PE COSTS ALLOWED BUT ACCELERATED CAPEX NOT ALLOWED ............................. 37 6 FINAL WORDS ON THE CONSULTATION DOCUMENTS .................................................................................... 38 7 SUMMARY OF CONSULTATION QUESTIONS...................................................................................................... 39

PREAMBLE This report has been prepared by NERSA staff for Stakeholder consultation. It is based on information provided by Eskom which has all been labelled strictly confidential or confidential for NERSA use only. While some of the data should reasonably be withheld from the public domain, adequate consultation would not be possible without releasing appropriate information. The report forms the basis of consultation by NERSA staff (and not the Energy Regulator) ahead of a workshop on 2 October 2007. It should not be seen as the Energy Regulator’s consultation which will only take place in the form of Public Hearings on 22 November 2007. NERSA welcomes comments from all stakeholders on the important issues raised in this paper, so that it can finalise the preliminary conclusions ahead of the workshop. Comments should be sent to Mr Brian Sechotlho or Mr Pule Mothiba, at the National Energy Regulator of South Africa, Kulawula House, 526 Vermeulen Street, Arcadia, Pretoria. Tel: (012) 401 4600 E-mail: mypd@nersa.org.za. The deadline for comments is 27 September 2007.

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LIST OF TABLES Table 1:Summary of 5 scenarios presented from staff preliminary review ..................................... 8 Table 2: Approved MYPD............................................................................................................... 9 Table 3: Summary of Eskom’s revenue adjustment request......................................................... 11 Table 4: Summary of Eskom’s risk position .................................................................................. 18 Table 5: Price and volume of Eskom’s coal sources..................................................................... 33 Table 6: Variance in coal purchase cost from MYPD plan............................................................ 34 Table 7: Total PE Costs................................................................................................................. 35 Table 8: Calculation of additional return on assets ....................................................................... 36 Table 9: Approved MYPD............................................................................................................. 37 Table 10: Adjusted capex allowed but PE costs not allowed ........................................................ 37 Table 11: Adjusted PE costs allowed but accelerated capex not allowed .................................... 38 Table 12: Both adjusted PE costs and adjusted accelerated capex allowed................................ 38 Table 13: Eskom’s proposed price application.............................................................................. 38

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ABBREVIATIONS AsgiSA Accelerated and Shared Growth Initiative for South Africa BER Bureau for Economic Research CAPEX Capital Expenditure CCI Coal cost index CPIX Consumer Price Index excluding interest on mortgage bonds EDI Electricity Distribution Industry EEDSM Energy Efficiency and Demand Side Management GDP Gross Domestic Product GWh Gigawatt hour IMF International Monetary Fund IPP Independent Power Producer LRMC Long Run Marginal Costs MPC Monetary Policy Committee MWh Megawatt hour MYPD Multi-Year Price Determination NIRP National Integrated Resource Plan PE Primary Energy PPA Power Purchase Agreements PPI Producer Price Index RoA Return on Assets RoR Rate of Return SADC Southern African Development Community SAPP Southern African Power Pool SPA Special Pricing Agreements WACC Weighted Average Cost of Capital

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1. Executive Summary This report is intended for stakeholder consultation by the Energy Regulator staff on Eskom’s application for changing the rules applicable within the MYPD. The report includes only staff views on the rule changes. After this consultation staff will take stakeholder views and revise the report for approval by the Energy Regulator. On 30 April 2007 Eskom approached the Regulator requesting a change to the rules within the MYPD. Specifically Eskom’s request is focused on the following areas of the MYPD: 1) Primary Energy cost variances; 2) Variances on Capital expenditure; and 3) Rules on a trigger for a re-opener. Eskom’s request was also that should the rules proposed by them be accepted and approved by the Regulator, that these be applied with immediate effect as of 2008/9. Eskom has also communicated their willingness to accept the under-recoveries of the first two years of the MYPD i.e. 2006/7 and 2007/8. If Eskom’s request for a rule change is accepted by the Regulator, the resultant adjustment would be an estimated average price increase of approximately 18 %. In summary the rule changes proposed by Eskom are as follows: Primary energy cost variance Eskom is proposing that on a yearly basis within the MYPD, just before the end of the financial year, a revision of the primary energy forecasts be made and be used to set the tariffs for the following year after a prudency test by NERSA. This would result in full pass-through of the variances and would involve an annual audit of Eskom’s submission.

NERSA Staff comment Staff is of the view that the above proposal by Eskom would lead to a cumbersome process even worse than that which existed during the RoR days. Also it takes away all risks from Eskom for efficient fuel procurement and places the entire risk to the customers who have no way of managing such risk. NERSA staff is of an opinion that such a rule must not be accepted. However, NERSA staff is also of the view that the risk device (mechanism) that exists within the current MYPD rule is inadequate (given the increased fuel cost risks for Eskom) and must be reviewed to allow for a higher pass-through based on a full assessment of the risk position of Eskom. NERSA staff proposes that the new rule be developed prior to the finalization of Eskom’s application and decision on

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20 December 2007 when the final decision shall be made by the Energy Regulator. NERSA staff further proposes that the new rule(s) be applicable only in the next MYPD and not the current. This is also for reasons of maintaining regulatory certainty. Variances on capital expenditure A similar rule is being proposed by Eskom as for the primary energy cost variances i.e. that on an annual basis prior to the end of a financial year within the MYPD, that Eskom would submit actual year-to-date CAPEX with forecast to the year end. The return of capital and depreciation for variances would then be rolled into the next year for determining the allowed revenue for the next year. The next year’s CAPEX would also be revised and used to determine the revenue. This would again involve some audits by NERSA and determining which parts of the revised CAPEX to allow.

NERSA staff comment NERSA staff is of the view that the current MYPD is adequately covering Eskom for both the timing and cost risk on the capital expenditure; the only factor is that this is only adjusted in the next MYPD for timing differences. For cost differences the current MYPD mechanism allows for the return and depreciation to be earned based on the MYPD plans and only adjusted in the next MYPD. This gives incentives for bringing down capital expenditure costs. NERSA staff acknowledges however, that the protection within the MYPD is only adequate where the capital expenditure programme is a normal one. However, given the quantum of changes between the time when the MYPD was planned and the revised plan there is scope to consider revising the rules. The rules should also be revised for the next MYPD and be finalized prior to the final decision on 20 December 2007. Triggers for a re-opener Eskom is proposing a re-opener trigger based on an adjusted earnings band which strikes a balance between the MYPD incentive power and the appropriate allocation of risk. This earnings band would be applied after adjusting as per the rule change proposals discussed above.

NERSA staff comment NERSA staff is considering this rule change but not in isolation to the CAPEX and primary energy cost rule changes as these would have covered at least 80 % of any risks that Eskom and customers may encounter. Further research is to be made on the new rule and should also be finalized for application in the next MYPD and be concluded before the 20 December 2007 when the decision is made.

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Eskom’s risk position In analyzing Eskom’s application, staff have first considered Eskom’s risk position and have concluded that Eskom is fully covered for risks within the MYPD to a net cover of R3 billion. The only problem is Eskom may not be able to finance its huge and ambitious capital expansion programme. The modeling shows that Eskom’s interest cover will fall below 2 by 2011. In our view, adequate interest cover is normally above 2, in fact it should be above a cover of 2.5 times. It is for this reason that staff concludes that even though there may not be any need to change the rule immediately, there is a need for an intervention by the Regulator. Staff has also looked at other ways of financing the expansion programme and suggests that there could be an equity injection by the shareholder, a single buyer model with PPAs (IPPs investing), the selling of existing Eskom assets to accumulate capital or a combination of any of the three. This issue needs further investigation and discussions with policy makers (Government). Staff has concluded that there is a need for intervention at this stage by the Regulator. However, the quantum of this intervention may not equal that proposed by Eskom. The staff has done a preliminary analysis of Eskom’s application considering the 5 scenarios presented in the table below. The revenue requirements in each scenario result in the following price increase: Scenario

Scenario

2008/09

1 Base scenario MYPD 6.2% 2

Adjusted capital expenditure only without primary energy

8.06%

3

Adjusted primary energy only without capital expenditure

11.0%

4 Both adjusted primary energy and adjusted capital expenditure

14.2%

5 Eskom proposed figure 18.7% Table 1:Summary of 5 scenarios presented from staff preliminary reviews

Preliminary NERSA staff conclusions The report highlights the need for Regulator intervention through some relief to Eskom by an adjustment to their MYPD allowed revenues for 2008/9. It is preliminarily concluded that:

1. The rule changes as proposed by Eskom only be considered after Eskom has provided the Energy Regulator with a full analysis of its short term risk and mitigation plan for those risks. This approach will allow the Regulator to

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determine risk mechanisms to be incorporated within the next MYPD allocating the risk proportionately to Eskom and customers in accordance with the ability to manage the risks.

2. The aspects of primary energy cost volatility be considered in the

consultation regarding the mechanism to be used for the next MYPD.

3. Eskom should provide a clear report on how it is planning to meet the short term security of supply risks, incorporating the estimated cost implications and whether it has linked those costs to the Energy Efficiency and Demand Side Management (EEDSM) programme or not.

4. Before making any final decision on Eskom’s application NERSA will

review the procedures and cost projections in order to ensure that the plan meets the needs of all customers and is likely to offer value for money. At that point it will be possible to consider the extent and nature of the cost recovery and any appropriate regulatory mechanism;

Stakeholder Comment/views # 1 Your views are requested on the overall request by Eskom for rule changes and on NERSA staff’s preliminary conclusions on these proposals. A consolidated list of all the comments and views requested in this consultation is provided in section 7 of the report.

2. Introduction and Background

2.1 Overview of the Environment within which Eskom’s application is made

In February 2006 the Regulator approved a Multi-year Price Determination of Eskom as follows:

2006/7 2007/8 2008/9 Average price increase excl. EDI costs 4.57 % 5.37 % 5.67 %Average price increase incl. EDI costs 5.1 % 5.9 % 6.2 %Allowed revenue excl. EDI costs (Rm) 36 295 39 685 44 106Allowed revenue incl. EDI costs (Rm) 36 693 40 084 44 504

Table 2: Approved MYPD This approval was based on cost projections by Eskom having been analysed and evaluated by NERSA staff and submitted with recommendations to the Regulator. The recommendations and projections

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took into account the assumed inflation rates for the three years, growth projections in the electricity industry, some projections on the foreign exchange rates etc. These assumptions were made based on projections made in 2005 for the three years of the MYPD. There has therefore always been a risk of such projections not fully materializing i.e. that there were going to be some deviations/variances from these projections. The MYPD mechanism had been built in such a way that some of these risks were catered for in protection of both Eskom and its customers given the prevailing risk profile then. In December 2006 Eskom approached NERSA staff requesting for a review of the rules that were approved and applied within the MYPD process. At that time Eskom only submitted issues pertaining to variances with regard to Primary Energy Costs. Presentations were made to the Regulator and the Regulator requested that Eskom must submit a comprehensive application covering all matters that can be cause for a review of the MYPD instead of a piecemeal presentation. A formal submission in this regard was made to NERSA and received on 30 April 2007. Specifically the application requested for rule changes with regard to the following: 1. Primary energy cost adjustment; 2. Variance in Capital Expenditure (CAPEX); and 3. Triggers for a re-opening the MYPD A further request by Eskom was that the revised rules be implemented with immediate effect in the current MYPD i.e. in 2008/9. This would mean some revenue adjustments and price increases from 1 April 2008. Eskom did mention in a meeting with NERSA staff that they will be willing to accept the under-recoveries for the 2006/7 and 2007/8 financial years (in fact in their later application that was received on 18 July 2007, they do confirm this in their revenue requirement calculations) Eskom’s application is largely informed by variances in Primary Energy costs and Capital Expenditure and will not affect other areas of the MYPD except in as far as was already catered for in the MYPD mechanism. The main drivers for these variances are the increased coal costs, the higher transportation costs for this coal i.e. coal imported from non-dedicated mines, the introduction of other more expensive fuel options into the future e.g. gas, the accelerated capital expenditure plan (i.e. plan revised from one presented in MYPD) and the increase in capital costs due mainly to a weaker rand and higher demand for new generation internationally. The implications of approving Eskom’s rule change request is that the 2008/9 allowed revenue to Eskom would have to be adjusted which would then lead to a higher end use price to customers than that approved within the MYPD.

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2.2 Eskom’s application

On 18 July 2007, Eskom submitted to the Regulator a revised revenue requirement calculation based on their request for changes to the MYPD rules to be effected on 1 April 2008. The summary of this application is presented in the table below:

2006/7R’m

2007/8 R’m

2008/9R’m

Revenues per MYPD 36 649 40 038 44 324Applying current MYPD rules – assumptions changing 940

1 411 1 597

Revenues restated 37 589 41 449 45 921Proposed MYPD rule changes 2 135 4 022 5 210 Primary energy cost 2 025 3 352 3 710 Accelerated capital expenditure 110 670 1 500Revised revenues 39 724 45 471 51 131Eskom limits rule changes to 2008/9 -2 135 -4 022 -Revenue determination before clawback 37 589

41 449 51 131

Less: clawback/correction factor (3 years)

-1 659

Revenue requirement for 2008/9 49 472

Table 3: Summary of Eskom’s revenue adjustment request It is clear from the table above that Eskom’s application (if approved) would result in an additional revenue requirement of R3 551 m for 2008/9. This is only for the MYPD rule change decision. In its application Eskom states that they are willing to forego the adjustments for 2006/7 and 2007/8. The total adjustment for the two years would have been R6 157 m.

2.3 Approach taken in evaluating Eskom’s application

NERSA staff approach to Eskom’s application Immediately after Eskom’s presentations to NERSA staff in December 2006, a primary energy focus team was established to determine mainly the root cause of the unexpected variances to Eskom’s primary energy costs. The team was later assisted by a leading consulting firm in the coal market analysis. The purpose of this assistance was to review Eskom’s coal purchases and the factors that influence cost increases (PE costs related). After receiving Eskom’s comprehensive application on 20 April 2007, another team was set up to focus on CAPEX related issues. Another consulting firm was contracted to assist NERSA staff with the overall evaluation of Eskom’s application and making appropriate

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recommendations to the Energy Regulator. The work presented in this report was done largely with the assistance of these consultants. In making recommendations the NERSA internal team consolidated all findings by the various teams and considered all other factors outside of the application and not presented as part of the consultants findings. The approach to the review was to first determine the risk profile of Eskom currently given the protections within the MYPD and also to have a future view of the risk given the new build programme of Eskom and the financing thereof. After determining this risk profile, it was then necessary to make decisions regarding: 1. The changes to the rules; and/or 2. Intervening to assist Eskom given its risk profile

Once the above decisions were made, staff then modeled the potential price adjustment to be allowed to Eskom. The results of the modeling are presented in this report with preliminary NERSA staff conclusions. Stakeholder comments/views # 2 Your views are requested on Eskom’s request for additional revenues and NERSA staff overall approach in evaluating Eskom’s application.

3. Summary of NERSA staff views on Eskom’s application including risk review of Eskom’s position Below are some conclusions made by NERSA staff on Eskom’s application for rule changes and revenue adjustments for 2008/9. These conclusions have been made based on a business risk analysis of Eskom after taking into account mitigating factors within the MYPD. Further to that a view on the financing of Eskom capital expansion has been taken into account which also informs these conclusions.

3.1 Summary conclusions on Eskom’s application 1. NERSA staff have analysed the application by Eskom for three rule changes to apply to the current and future price determinations, these apply from 2008/9 and leading to an increased level of allowed revenues in 2008/9 consistent with a tariff increase of around 18% (as per Eskom’s presentation without review by staff). Rather than consider a change in the regulatory mechanism in isolation, NERSA staff has reviewed the consequences of fundamental changes between Eskom’s submission in 2005 and its application now, and then decide what changes are necessary in regulatory mechanisms. It is necessary that NERSA

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reserves the right to consider Eskom’s need for relief with regard to 2008/9 separately from its consideration of rule changes which may best be reviewed for the next multi-year determination which is currently being developed separately. However, as part of the consultation within this process, the proposals presented by Eskom and NERSA’s staff response to these proposals will be published for stakeholder comments, and conclusions formed within this process will feed into the MYPD2 process. NERSA staff analysis indicates that 4 key business parameters have changed significantly since Eskom’s MYPD submission and the determination based on that submission. As a consequence it will be necessary to allow Eskom some form of price/revenue relief for 2008/9, and to construct appropriate regulatory mechanisms for the next price review (guided by this process). However, that does not mean that it is necessary to accept Eskom’s proposed rule changes. The parameters mentioned above are discussed as follows: a. The level of operational risk cover implicit in Eskom’s MYPD submission (and

broadly consistent with the NIRP then in place) proved inadequate in 2006 when there was a combination of operational failures and demand growth, leading to blackouts at an unacceptable level. Eskom has therefore had to address customer and stakeholder pressure to provide enhanced security of supply both through costly short term measures and contingency plans and by the acceleration of the plans for new peak and base-load capacity;

b. Growing demand in the current decade has been met economically to the benefit of customers by stretching the performance of the existing coal-fired base-load stations. These first two parameter changes both lead to significant upward pressure on Eskom’s marginal cost of production compared with the MYPD submission;

c. Government growth initiatives (especially ASGISA) will lead to significantly higher demand for energy than was envisaged in the MYPD submission. This acceleration in demand is already becoming evident. It will result in prices rising much more quickly than was planned under NIRP in 2005, in order to pay for accelerated capacity plus any related upward pressures on fuel and other operating costs, and to ensure that the expansion plan can be financed; and

d. Eskom’s first line protection against increased costs is the indexation of its revenues to retail price inflation. Certainly its costs have risen more steeply than this index, driven by market price changes in oil and gas, in metals and, for the cost of future capacity, in electrical equipment and generating plant.

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Stakeholder comments/views # 3 Your views are requested regarding the changes in the key business parameters of Eskom and their effect on Eskom’s revenues and costs. 2. Of the changes in business parameters it is of concern that two are not addressed effectively in Eskom’s application, namely: a. the short-term and long-term costs of achieving an acceptable security of

supply given the shortage of supply problems of 2006; and b. Underlying drivers of increases in Eskom’s cost of coal purchases. Both these changes will drive up prices and they need to be properly understood and appropriate regulatory mechanisms need to be developed, not a blanket pass through of consequential costs. 3. The third key parameter change is the acceleration of capital expenditure to meet the higher growth expectations driven by ASGISA. In part this also covers the long term costs of achieving an acceptable security of supply. The key issue here is the extent to which that accelerated expenditure must start to be recovered now rather than later if Eskom is to be able to finance the expansion programme and if customers are to see a reasonably predictable price path. Stakeholder comments/views # 4 Your views are required regarding the expectation for customers to start paying for future capacity or letting future customers pay if Eskom is to be able to finance the expansion programme and if customers are to see a reasonably predictable price path. 4. The fourth parameter change is the increase in Eskom’s costs due primarily to higher coal production costs and higher costs for electrical plant internationally. While important, these would not in themselves indicate the need for any major change in regulatory mechanisms, or for blanket protection through rule changes. Nevertheless Eskom’s application focusses on these points and they need to be addressed. 5. The implication of these changes in business parameters for electricity prices is severe although a final review may lead to some variation on the numbers quoted in Eskom’s application. It is likely that South Africa will have to see two years of significant electricity price rises, followed by a higher level of continuing price increase than was planned in 2005 and at the beginning of 2006 when the MYPD was approved. Prices are now anticipated to rise to fully economic levels in 10 to 12 years, rather than in 25 to 30 as was the case in the 2005 planning horizon. It is envisaged that even at fully economic price levels

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South Africa will still have a significant competitive advantage in electricity price levels over the rest of the world. Stakeholder comments/views # 5 Your views are requested regarding the envisaged significant increases in prices followed by higher levels of continuing price increases than those planned in 2005 when the MYPD was developed and your views on prices reaching economic levels in 10 to 12 years rather than 25 to 30 years as was the case previously.. 6. The changes in parameters have exposed Eskom to significant commercial risk, but NERSA staff is of the view that the risk protection within the MYPD determination has been sufficient at least to maintain Eskom’s viability, but they place at risk its ability to finance the expansion programme. The risk assessments demonstrating this point are included in this report. 7. It is necessary to adapt the regulatory mechanisms to each of these parameter changes and the risks they bring, as well as to adjust prices. However, the appropriate mechanisms cannot be those proposed by Eskom, although they may incorporate elements of those proposals. For example, it cannot be acceptable to apply blanket pass through protection to Eskom in circumstances where certain costs (marginal primary energy, short term security of supply) may be out of control, and there is no evidence to NERSA staff of any strategy to bring them under control. Eskom as a monopoly must continue to bear appropriate risks, and to have the right incentives to manage those risks on behalf of its customers. Stakeholder comments/views # 6 Your views are requested regarding a blanket pass-through protection to Eskom without any evident strategy to bring under control those costs that are perceived to be out of control. 8. In order to move from the preliminary views in this report to a final determination in December 2007 NERSA (with the assistance of its staff) will undertake the following process, and will require Eskom to co-operate as appropriate in the specified elements:

i. NERSA staff will consolidate the comments and views received from stakeholders and present a revised view to the Energy Regulator.

ii. NERSA needs to develop an appropriate regulatory mechanism, with risk protection and incentives for Eskom in its procurement of primary energy but also serving the interests of electricity customers, to apply in the next period of the MYPD. This will be dependent on a common understanding of

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the risks and opportunities and strategies based on a better analysis than the one provided to date by Eskom to NERSA. NERSA staff will have to engage Eskom and undertake further research to determine the appropriate risks and opportunities to be used in developing appropriate strategies for risk management;

iii. NERSA needs to develop a more advanced mechanism for the regulation of capital expenditure for implementation at the next MYPD. This may consider an extension of retrospective adjustments to the allowed return and depreciation, but only in the context of an understanding of the change in the level of risk borne by customers, and what protection can be given to customers as a consequence; and

iv. Eskom will be required to provide a clear report on how it is now planning to meet the short term security of supply risks, incorporating the estimated cost implications whether it has linked those costs to the Energy Efficiency and Demand Side Management (EEDSM) programme or not. Before making any final decision on Eskom’s application NERSA will review the procedures and cost projections in order to ensure that the plan meets the needs of all customers and is likely to offer value for money. At that point it will be possible to consider the extent and nature of the cost recovery and any appropriate regulatory mechanism.

Any determination in respect of 2008/9 tariffs will take into account whether Eskom can fully justify its additional costs. Stakeholder comments/views # 7 Your views are requested on the process to be followed to arrive at a final decision as outlined above.

3.2 Some specific issues affecting the industry in general and Eskom in particular

Industry Pressures 1. The Multi Year Price Determination (MYPD and a linked view of long term prices) was based on growth scenarios in the National Integrated Resource Plan (NIRP2) which is lower than what is now Government initiative. The Accelerated Growth and Shared Initiative for South Africa (ASGI-SA) has significant implications for electricity prices, especially with regard to growth in demand and resultant request for an acceleration in the capital expenditure programme. Because it accelerates the construction of new capacity it leads to a quicker rise in electricity prices towards Long Run Marginal Costs (LRMC). Eskom is also now predicting higher construction costs and a continuing escalation in primary energy costs. The consequence is that prices will accelerate to LRMC levels in 10 years, not 20 as previously predicted, and the LRMC level will be some 20% higher than previously predicted. The long term implication for tariffs is possible increases of 4% to 6% above inflation, rather than 2% to 3% above inflation.

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2. While these increases are high, they will still leave South Africa with a significant advantage over the rest of the world in terms of electricity prices. However, high growth means that the low prices due to excess capacity and written down investment in power stations have come to a more abrupt end. 3. Events in 2006 (blackouts especially in the Western Cape) revealed that the level of operational risk cover built into Eskom’s plans as submitted to NERSA for the MYPD and as incorporated in NIRP2 was not adequate given increasing demand and the incidence of plant failure. As a consequence Eskom has accelerated plant construction, but it also has to take a range of short term measures to maintain security of supply until the capacity comes on line. These costs are additional to those assumed in the MYPD submission, and the need for short term security of supply exposes Eskom in the coal market. Stakeholder comments/views # 8 Your views are requested with regard to industry pressures mentioned above specifically ASGISA and its effects on electricity prices and the acceleration of these prices to LRMC in a shorter time horizon than in the past and on the increased operational risk of Eskom as evidenced with the 2006 blackouts and exposure in the coal market due to short-term security of supply risk.

Eskom Risks – Quantifications and Mitigations 1. In the absence of clear risk quantifications in Eskom’s submission, NERSA staff has undertaken high level analysis of the risks to Eskom over the full three years of the MYPD using Eskom’s current projections (these projections are taken as presented by Eskom without any revision). Staff has also analysed the mitigations and cover available to Eskom. 2. The overall position with respect to Eskom’s risk over the full three years of the MYPD period is summarized in the table below. The analysis shows that there is sufficient cover available to Eskom to cover its risk as quantified on the basis of its application. However, it is also evident that it has used up a large proportion of its available cover, and, while still viable, NERSA staff is of the opinion that Eskom will not be able to finance the expansion on the scale required without relief in tariffs (or from fiscus). Any delay in providing that relief will leave Eskom unable to cover any further risks, and will also result in pent up pressure for increased tariffs.

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All Values in Rbn nominal Eskom Risk Mitigation Higher CPIX 1.827Primary Energy Costs MYPD Variable Allowance

8.8940.460

Increased Capex – time value of associated revenues Less Distribution volume allowance Less time value of accelerated depreciation in Generation

0.497

0.034

0.394WACC Premium 1.900Borrowing Premium 1.900Equity Return & Gearing Conservatism 1.750DSM Revenues and Costs (NERSA figures)

0.800 1.615

Efficiency Gains 2.300Other MYPD Mitigations Distribution Customer Allowance Transmission Losses – lower pass through

0.2480.164

2005/6 Clawback 1.070Net Position 10.439 13.414

Table 4: Summary of Eskom’s risk position The above quantification of risk on capital expenditure reflects the absolute risk to Eskom, but the impact of deferring or bringing forward the recovery of the return and depreciation is very significant for tariffs. The value of deferred return over the three years is R2.175bn, the value of deferred depreciation on Transmission and Distribution is R0.385bn, and if the same depreciation timing was applied to Generation that would come to a further R0.321bn. The acceleration of depreciation in Generation in MYPD gives an accelerated recovery of R1.915bn in the three years of MYPD, but this was intended to give support to general financing risks rather than to cover specific additional expenditure risks. 3. A further mitigation is possible but not certain. Eskom has treated the increase in primary energy costs relative to CPIX as permanent. However, in April the coal component of PPI had fallen below CPIX. If Eskom’s coal contracts reflect this relative change in costs, then revenue increases may begin to exceed coal cost increases. NERSA staff has not tried to assess this probability or quantify it. Eskom has presented no information to suggest that it considers these issues, but its April submission set a “challenge” of reduced primary energy costs compared with its projection. 4. The risks faced by Eskom in its primary energy costs exceed both the specific risk cover and the general risk cover allowed in the higher return. The regulatory mechanism needs to be adjusted to meet the risks and costs involved in the three major changes in business parameters. This will then reduce Eskom’s level of risk to be consistent with the long term cost of capital determined in MYPD. This does not mean that Eskom’s proposals for rule changes have to be accepted. There is a need, however, to review the current

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mechanism and propose appropriate risk mitigation devices taking into account a thorough risk assessment process. Stakeholder comments/views # 9 Your views are requested regarding the high level risk position of Eskom as perceived by NERSA staff and as a basis for concluding on a need for intervention to assist Eskom in its ability to finance it capital expansion programme.

Need for Increased Tariffs to Cover Risks 1. The analysis of risks and mitigations indicate that it would be possible to cover the full risk without any re-opening of the determination, while accepting that tariffs will increase to meet allowable energy efficiency and demand side management activities. However, a fundamental point, as in MYPD, is that NERSA needs to consider how Eskom can finance its business, especially how it can finance the accelerated investment programme in the coming years. While NERSA staff is of the view that electricity customers should not provide equity funding, 2008/9 tariffs must be sufficient to allow Eskom financing to cover justified extra costs from the changed business parameters, and to smooth the transition to a future of significantly higher tariff increases driven by the accelerated growth. It is also appropriate to give electricity customers the message that higher levels of tariff increase will now become the norm given the accelerated growth in forecast demand. 2. Eskom’s financial projections indicate a tight financing position from 2011/12 onwards. The analysis done by NERSA staff confirms this position given the acceleration of the expansion programme. Indeed it may become necessary to consider alternative capitalisation options from that time, such as a shareholder injection of equity, adoption of a “Principal/Single Buyer” role for Eskom so that outside capital can fund projects, or the sale of existing assets under long term power purchase agreements (PPAs) to fund new capacity – or a combination of these to give most efficient financing. Should NERSA decide that the accelerated capital programme should be met in greater measure by future customers compared with Eskom’s view, then re-capitalisation would become necessary within the next two years. NERSA’s position regarding asking customers to fund the whole programme up front, as set out in the initial MYPD determination, is: “The NER is concerned that there may be an expectation that today’s customers will be asked to pay more in the period after this determination in order to meet any cash flow needs greater than can be met from a normal equity return for a utility. It is the NER’s duty to protect the interests of customers should that become the case.” Stakeholder comments/views # 10

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Your views are requested regarding using electricity tariffs to cover the risks and on the possible equity injection, adoption of single buyer model or the selling of Eskom’s assets to finance capital projects.

3.3 Rule Changes

General 1. Eskom’s application is for blanket levels of protection against risk in respect of some 80% of Eskom Generation’s allowed revenues and costs, subject to post-expenditure audits. It is made up of detailed cost data and corporate finance level risk evaluations without any analysis at the level of business risk, which is what is needed if an appropriate regulatory mechanism is to be put in place, rather than blanket protection. The submission highlights shortcomings in Eskom relating to: business risk analysis and management, regulatory interface management and reporting, and planning processes (especially with regard to commercial and market risk). If it had presented a clear view of its business risks in the MYPD submission, then an appropriate mechanism for primary energy would have been constructed then without any need for an interim intervention request from the Regulator. Its latest application perpetuates the problem and staff has had to try to undertake the business risk analysis in order to evaluate the application. This analysis is inadequate when performed by the Regulator or its staff given the information asymmetry. 2. It is of concern to NERSA staff that Eskom has failed to address the reasonable expectation of electricity customers (who are being asked to take on the full risks) that Eskom should face some form of incentive to ensure that customers get value for money. This is demonstrated in Eskom’s request for blanket cover through its proposals for rule changes.

Rules on Primary Energy 3. Eskom’s request for a rule change to allow pass through of primary energy costs in 2008/9 and beyond into future periodic determinations must not be allowed as proposed. There is sufficient evidence from the analysis that Eskom has scope to manage and improve its procurement performance and its management of business risk. In particular there is evidence that the cost shock should have been anticipated. This failure was caused by previous pass through of primary energy costs within the Rate of Return (RoR) methodology. Pass through would also allow Eskom to recover costs arising from exposure in the coal market without any need to take action to mitigate its risk. It is therefore inappropriate for Eskom to have no incentive to deliver improvements other than an audit after the event. This audit would only be effective in so far as determining the prudency of costs. 4. However, there should be a regulatory mechanism that is put in place which provides Eskom Generation with the level of protection consistent with its level of

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business risk, and with the level of risk that it can bear, alongside incentives to manage that risk effectively on behalf of electricity customers. 5. It is accepted that existing contracts carry certain risk and cost profiles, and that Eskom faces uncertain market conditions for an increasing proportion of its coal procurement. Therefore, in principle it is reasonable for it to have a regulatory mechanism that allows a high level of pass through of costs, but one that reflects the opportunity for improvement in the management of primary energy procurement. [This passage will not form part of the public consultation process for reasons of commercial confidentiality and possible increasing of Eskom’s business risk.] 6. It is therefore proposed that NERSA (with assistance from staff) develops (by the end of 2007) an appropriate regulatory mechanism with risk protection and incentives for Eskom, which will also serve the interests of electricity customers, to apply in the next period.

Rules on Capital Expenditure 7. Eskom’s proposed rule change does not retain any effective incentives for Eskom to invest efficiently or to deliver its projects to time. 8. However, given the scale of the acceleration of capital expenditure in the last two years of the MYPD period it is considered appropriate to allow Eskom to recover a proportion of the deferred value early, and this will also assist in Eskom financing its business and in customers facing a smoother level of price increases. 9. The existing rules on capital expenditure already offer substantial protection to Eskom, and allow for full recovery of return and depreciation not allowed for in the event of timing differences leading to increases in capital expenditure. The return and depreciation on cost (not timing) differences within any control period falls to Eskom under the current rules. Given the impact of changes in the value of the Rand on the capital programme, it is reasonable for Eskom to have protection in future periodic price controls for variations outside its control, as long as there are continuing incentives on Eskom to deliver the investment (including management of foreign exchange risks) efficiently and to time. The proposed rule must therefore not be allowed. Staff must work towards defining (by the end of 2007) the appropriate rule change to balance risk and incentives, to apply to the next MYPD, and potentially retrospectively.

Rules on Trigger for a Re-opener 10. Eskom has proposed a new measure which can trigger a re-opening of any periodic determination. This allows a re-opening if changes in expectations or

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performance on both revenues and costs send Eskom’s rate of return outside an allowed band around the level of return used for the determination. 11. There may be merit in Eskom’s proposal as long as the calculation can be agreed in greater detail than as proposed, to be consistent with the determination, and as long as there can be sufficient confidence in the regulatory accounting. However, it is important that re-openers are considered in the context of the overall balance of risks, and this cannot be determined for any period until after the constituent parts of the determination have been decided. For example, a general re-opener may have little to offer if a large proportion of Eskom’s costs is simply passed through, as proposed under the other rule changes. 12. Staff recognises that the macroeconomic re-opener in the first MYPD was too narrowly defined given what has happened since that time. There is also a case for reviewing the parameters for review and re-opening relating to the size of the correction factor. However, this has not yet proved possible to quantify as Eskom has provided no information on how the correction factor is moving. The appropriate time to consider these issues is in the process for the next MYPD.

3.4 Impact on Tariffs – Short Term and Long Term The changes in Eskom’s business parameters are such that they have increased its short term and long term costs substantially. In order to enable the financing of Eskom’s business staff analysis shows that it will be necessary for customers to start to meet the long term costs from 2008/9 as well as the more immediate costs, unless there is some form of re-capitalisation. This is against a background of sales volumes being constrained by shortage of supply capability, and so there is not a growing base of sales in the next two to three years against which the increased costs can be recovered. Eskom’s application for a substantial tariff increase in 2008/9 is viewed as valid in broad terms, and the consequence of the changed parameters is also such as to require a further increase of a similar amount in 2009/10 (This should be taken into account in the preparation for MYPD2). Even beyond that year increases will be higher than was planned in 2005 and will continue to be high until prices reach fully economic levels. Under current growth policies that is likely to be in 10 to 12 years. However, any additional tariff increase in 2008/9 is subject to full scrutiny of Eskom’s costs as submitted to NERSA. NERSA staff needs to provide a view on the levels of these costs. Where these are considered too high and not adequately justified, only those considered prudent will be allowed for price/revenue adjustment.

3.4 Some conclusions

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It is evident from the discussion above that there is a need for Regulator intervention through some relief to Eskom by an adjustment to their MYPD allowed revenues for 2008/9. However, this relief must be considered separately from Eskom’s request for rule changes. The rule change request needs to be dealt with separately and should be taken with great care as its implications will also affect the coming MYPD. Also it is necessary that when giving relief to Eskom that this relief only relates to those areas for which there has been adequate definition of risk and that all risk identified as controllable be left for Eskom to control. In the later chapters of this consultation paper, attempts are made to quantify the level of relief to be provided to Eskom both on primary energy and capital expenditure. Eskom will be required to provide the Regulator with a full analysis of its short-term risk and their planned mitigation of such risk in order to allow the Regulator to determine the appropriate risk mechanism to be incorporated within the MYPD2. This must be done prior to the finalization of the Regulator decision in December as this will feed into the decision making considerations of the Regulator. Staff will engage Eskom rigorously on this issue. In considering the mitigation required by Eskom, savings in operating costs should be used to offset the anticipated increase in primary energy cost. This has not been done in the current assessment.

4 RULE CHANGE PROPOSALS AND NERSA STAFF VIEWS

4.1 Primary Energy costs

Proposed rule changes by Eskom Eskom has proposed the following rule changes to be applied within the MYPD. Eskom’s proposal is for these rules to be implemented immediately in the current MYPD for the 2008/9 financial starting on 1 April 2008:

1. Prior to each MYPD, Eskom will submit a forecast of Primary Energy costs as part of its MYPD revenue application (as currently is done).

2. Prior to the end of each financial year during the MYPD (e.g. after ten months of a given financial year), Eskom will provide NERSA with a report of actual Year-to-Date Primary Energy costs and with forecasted costs for that full year. Forecasted variances against original forecast costs for that year will be rolled in to the revenue allowance (with corresponding

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adjustments to WEPS) for the following year (positive and negative amounts)

3. At the same time, prior to the end of each financial year, the Primary Energy cost forecasts for the following year will be updated as well. This updated forecast will be reviewed by NERSA and once approved will form the base for the following year’s revenue (with the variance component from the previous year (as per 2 above) added or subtracted from this updated base amount).

4. Noting that Eskom must provide NERSA with adjusted WEPS tariffs for the following year prior to obtaining full year actuals for the preceding year, the variance against forecast for that preceding year will be based on 10 month actuals (to February of that year) and two months projections to year end.

• Any error stemming from the last two month projections against full year end actuals will be reconciled as part of the next year’s adjustment.

To ensure that only efficient costs of supply are recovered by Eskom under the adjustment mechanism:

5. Eskom will provide NERSA with a final (independently audited) reconciliation report once full year end accounts are available, including an explanation for the adjustment in terms of price, volume and mix factors being different from forecasts

6. NERSA will have discretion to review the audited reports and disallow costs adjustments if they are shown to be unreasonable. Disallowed cost adjustments would be subtracted from the following year’s revenue allowance.

• NERSA will review existing and new fuel purchase costs to signal to Eskom if/where there are any aspects of the contracts that would lead to a disallowance of price increases.

• NERSA will review any other aspects of variance in Primary Energy costs it deems relevant in review of the reasonableness of expenditure.

Stakeholder comments / views # 11 Your views are requested regarding the rules as proposed by Eskom and their implications on the management of risks within the MYPD for both Eskom and its customers.

Relevant rules/mechanism in current MYPD In converting from the revenue need to the mechanism controlling allowed revenues the approach has been to set a “bottom line” level of output (at the

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transmission/distribution boundary) of 205 TWh per annum, and to fix a level of revenues in each year against that fixed level of volumes. All kWh above that level (excluding output from DME’s IPP plants) then has a revenue allowance at the energy cost of Majuba as per the Eskom submission (adjusted back to 2005/6 prices). This varies year-on-year in real terms in line with Eskom’s own assumptions. In theory this should be adjusted upwards for transmission losses, but it has been left unadjusted in order to provide an incentive for improved management of marginal generation costs. Stakeholder comments/views # 12 Your views are requested on the current mechanism within the MYPD to manage kWh above the fixed level output using Majuba price presented in the MYPD and the adequacy of such mechanism in managing the risks. Proposals on other mechanisms are very welcome and will be considered by NERSA staff in their final recommendations to the Energy Regulator.

NERSA staff views on Eskom’s proposals and current MYPD mechanism Based on the investigation of Eskom’s primary energy cost by NERSA staff and by an independent coal consultant and based on the research of international practices, NERSA staff has concluded that: It would be inappropriate to allow the full pass through of the Primary Energy cost variance as proposed by Eskom. Full pass through would be applicable where a commodity type fuel is used of which the price is controlled or determined in an open market over which the utility has absolutely no control. There is no compelling reason to adopt a rule change approach for the current MYPD because most of the problem would not have occurred if there was proper primary energy planning including proper risk assessment and risk profiling. NERSA staff views are presented as follows: 1. A once-off pass-through adjustment be allowed for 2008-9 without a rule

change based on the following: • This would prevent any adverse economic conditions occurring at

Eskom that would compromise the sustainability of the business; • It would signal that the MYPD mechanism will not be compromised by

planning deficiencies which lead to inefficient operations. 2. The magnitude of the once-off pass through adjustment should be based on a

realistic assessment of the expected primary energy cost for the three year period of the MYPD;

3. A condition for this once-off pass through is that Eskom must come back to the regulator with a proper assessment of its primary energy expenses defining what they can control and what is not controllable;

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4. That the aspect of primary energy cost volatility be considered in the consultation regarding the mechanism to be used for the next MYPD;

5. The incentives of the MYPD mechanism for Eskom to manage their primary energy costs be retained;

6. Allowing pass-through of very specifically identifiable primary energy expenditure of an unusual and unexpected nature;

7. Providing a dead band to ensure that the expenditure considered for pass-through is material;

8. Applying the dead-band below and above the central primary energy cost estimate to correct symmetrically for unusual and unexpected over and under expenditure; and

9. Allowing pass through of gas turbine generation costs. Stakeholder comments/views # 13 Your views are requested on the proposals presented by NERSA staff and their views on Eskom’s proposed rule change for primary energy. Stakeholder comments/views # 14 Stakeholders are asked for their views on the once-off pass-through adjustment for 2008-9 without a rule change as an intervention to ensure the sustainability of Eskom’s business. Stakeholder comments/views # 15 Stakeholders are asked for their views on letting the aspect of primary energy cost volatility to be considered in the mechanism to be used for the next MYPD. Stakeholder comments/views # 16 Stakeholders are asked for their views on the retaining incentives for Eskom to manage primary energy costs and therefore the use of a dead-band below and above the central primary energy cost estimate to ensure that the expenditure considered for pass-through is material Stakeholder comments/views # 17 Stakeholders are asked for their views on the pass through of gas turbine generation costs

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4.2 Accelerated capital expansion programme

Proposed rule changes by Eskom on the CAPEX variances Eskom’s proposed rule changes for capital expenditure adjustment mechanism are as follows: 1. Prior to each MYPD, Eskom will submit a capital expenditure plan (forecast) as part of its MYPD revenue application (as is currently done). 2. Prior to the end of each financial year during the MYPD (e.g. after ten months of a given financial year), Eskom will provide NERSA with a report of actual Year-to-Date capital expenditure and with forecasted costs for that full year. Return on capital and depreciation for forecasted variances against original forecast for that year (timing and cost based) will be rolled in to the revenue allowance for the following year (positive or negative amounts). 3. At the same time, prior to the end of each financial year the capital expenditure plan (forecast) for the following year will be updated as well. This updated forecast will be reviewed by NERSA and once approved will form the base for the following year’s revenue allowance (with the variance component from the previous year (as per par. 2 above) added or subtracted from this updated base amount). 4. Noting that Eskom would need to provide NERSA with an application for adjustments prior to obtaining full year actuals for the preceding year, the variance against forecast for that preceding year will be based on 10 months actuals (to February of that year) and two months projections to year end. 4.1. Any error stemming from the last two month projections against full year end actuals will be reconciled as part of the next year’s adjustment. To ensure that only efficient costs of supply are recovered by Eskom under the capital expenditure adjustment mechanism: 5. Eskom will provide NERSA with a final reconciliation report once full year end accounts are available including an explanation for the adjustment in terms of timing and cost factors being different from forecast. 6. NERSA will have the discretion to review the reports and disallow cost adjustments if they are found to be not prudent. (Disallowed cost adjustments would be subtracted from the following year’s revenue allowance). 7. Eskom will provide NERSA with the updated capital expenditure plan that is to form the basis of the adjusted revenue allowance for the following year and provide details where it varies from the previous year’s plan Current MYPD Eskom argues that its capital programme has risen due to acceleration of demand growth, increase in capacity costs due to market pressures, increase in capacity costs due to the falling value of the Rand against the Dollar and the

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Euro, incorporation of additional environmental protection into coal fired stations and changes in the mix of planned Generation plants. In its application, Eskom further mentioned the alignment of its financial plan to Government’s initiatives (specifically AsgiSA) as the main driver of its accelerated and increased capital expenditure. Eskom’s proposals involve a pass through of capital expenditure costs annually, with significant reporting and auditing of performance after expenditure was incurred. This was sufficiently covered in the current MYPD and Eskom is already required to report to NERSA six monthly on its capital programme, providing information on variances arising in terms of both cost and timing. The existing MYPD provides significant risk cover for Eskom in that it allows retrospective adjustments to allowed revenues on Generation and Transmission where the differences are caused by timing. Where differences are due to cost changes there is no retrospective adjustment, but the difference is incorporated in the Regulatory Asset Base for the next review, and so the investment earns a return and is recovered through the depreciation element over its remaining life. On Distribution there is a variable level of allowed revenues relating to higher demand, and this represents a return and depreciation on any additional investment prior to that investment being incorporated in the Regulatory Asset Base.

NERSA staff views on Eskom’s proposals NERSA staff accepts the reasons advanced by Eskom regarding the cost drivers of its accelerated and increased capital expenditure. Staff believes that there is a case for extending the level of protection available to Eskom under the MYPD for cost variations in capital programme that are outside Eskom’s control as long as there are reasonable incentives and penalties on Eskom to deliver the planned investment programme ( including management of foreign exchange risk) efficiently and on time. The implications for allowing additional return on Eskom’s accelerated and increased capital expenditure in 2008/09 are as follows:

Implications for customers Implications for Eskom Future electricity prices would rise at a faster rate than anticipated in the current MYPD.

It will allow Eskom to finance the expansion programme.

It will limit future price shocks when assets are transferred into commercial operations thus allowing customers to experience a predictable and

It will allow Eskom to recover a proportion of long term costs of security of supply and increased demand early. This will enhance Eskom’s ability to provide reliable and high quality supply

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smoother price path. The existing customer base will pay now for a guaranteed consumption later. It will improve security of supply and boost economic growth.

It will allow Eskom to provide electricity to support government’s growth initiatives (AsgiSA)

The implications for not allowing additional return on Eskom’s accelerated and increased capital expenditure in 2008/09 are as follows:

Implications for customers Implications for Eskom Any delay in phasing the return on assets variance between the MYPD and Eskom’s revised plan (February 2007) into the allowable Regulatory Asset Base would lead to a substantial price spike in the next MYPD.

Eskom will fail to cover justified extra costs from the changed business parameters and that will put pressure on its potential to sustain its operations. Analysis done by staff confirms that Eskom will experience tight financing position from 2011/12 onwards

Customers will experience constant blackouts in the near future i.e. security of supply will be threatened.

This will stifle government’s economic growth initiatives.

In conclusion NERSA staff is of the view that there is a need for Regulator intervention through some relief to Eskom by adjusting the 2008/09 allowed return on assets to take into consideration the effects of the accelerated and increased capital expenditure that Eskom board approved in February 2007. This adjustment will partly cover the long term costs of achieving an acceptable level of security of supply. Stakeholder comments/views # 18 Stakeholders are requested to comment on how the differences between the investment profile and forecasts used for revenue setting must be treated and on how the Regulatory Asset Base should be adjusted for actual expenditure. Stakeholder comments/views # 19 Stakeholders are requested to comment on whether Eskom should be granted interim relief or not based on changes in the capital investment profile and the costs thereof.

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Stakeholder comments/views # 20 Stakeholders are requested to comment on the extent to which an adjustment on the return and depreciation on accelerated capital expenditure (if granted) must start to be recovered, 2008/09 or in the next MYPD. Stakeholder comments/views # 21 Your views are requesting on the overall treatment of Capital Expenditure variances either due to timing differences or differences in costs within a given MYPD whilst giving due attention to efficient planning by the utility being regulated.

4.3 Trigger of a re-opener

Summary of issues relating to MYPD re-opener Eskom argues that the current MYPD re-opener trigger is primarily based on the balance of the correction factor and only tracks revenue variance as compared to costs variance. For this reason, Eskom believes that the current indicator used to trigger a re-opener does not adequately address the considerable range of uncertainties that exists in this stage of capacity expansion and demand growth. Eskom is proposing a re-opener mechanism that will use an earnings percentage band as a trigger for re-opening a determination. In terms of this proposal the target earnings percentage value would be based on the return on capital set for the MYPD. Eskom further proposed that the earnings band be wide enough so that it does not interfere with the incentive properties of the MYPD and would only be triggered where extreme events unfold. This will allow a re-opening if changes in expectations or performance on both revenues and costs send Eskom’s rate of return outside an allowed band around the level of return used for the determination

Proposed rule change on MYPD re-opener (Eskom) Eskom’s proposed rule changes for re-opener trigger are as follows: 1. A transparent and objective trigger mechanism is to be applied in regard

to re-opening of the MYPD; 2. The trigger mechanism would only serve to initiate a re-opening of the

MYPD. The quantum of any adjustments to the revenue allowance stemming from a re-opening of the MYPD would be a matter for NERSA to

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determine in consultation with stakeholders based on the specific circumstances of the case at hand;

3. The trigger mechanism would not limit the right of a stakeholder to apply

for a re-opening of the MYPD; 4. The trigger mechanism is to be referenced against the rate of return

applied to a given MYPD (real pre tax WACC) in the form of an ‘adjusted earnings’ band;

5. The adjusted earnings band will be calibrated, striking a balance between

the incentive power of the MYPD and the appropriate allocation of risk; 6. Adjusted earnings are to be calculated inclusive of any MYPD adjustment

amounts (plus or minus) allowed with regard to the year in question (i.e. adjustments for revenue and/or cost variances as set out in the MYPD, and rule changes applied for in this application if approved); and

7. Adjusted earnings are to be calculated exclusive of revenue off-sets

applied (carried in) from adjustments (plus or minus) allowed in the previous year.

Stakeholder comments/views # 22 Your views are requested on Eskom proposed rules that will govern the trigger for re-opening the MYPD during its control period. Alternative proposals will be happily welcome and considered prior to finalization of the MYPD mechanism.

NERSA staff’s response to the proposed rule changes The MYPD allowed for the re-opening of the determination under certain circumstances. A particular concern was that macroeconomic conditions in South Africa could result in changes in either the revenue or cost assumptions that would lead to windfall gains or losses to Eskom or to customers. The specific condition in the Final Determination for re-opening was: “If CPIX rises, or is expected to rise, at any time by more than 7% per annum, then NERSA and Eskom will discuss the implications on revenues and costs, and NERSA shall reserve the right to re-open the determination.” This implies that CPIX would have to increase to a level of about 12% (assumed CPIX plus 7%). This condition should be considered against the background to the determination of the Government’s target of CPIX lying between 3% and 6% per annum. While the determination protects Eskom’s revenues through indexation against CPIX, it was considered possible that a higher expected CPIX inflation could be driven by

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changes in industry costs that might expose Eskom to undue risk, or conversely could lead to windfall gains. In May 2007 CPIX stood at 6.4% and PPI at 11.3%. In addition, as at 24 July 2007 the value of the Rand had fallen by 10% against the US Dollar and 27% against the Euro since the determination. These changes in core economic indicators suggest that the existing macroeconomic conditions for re-opening the determination might have been narrowly defined in the first MYPD. If as a consequence of the macroeconomic changes Eskom’s overall risk has increased, then it may be necessary to consider the rate of return allowed in MYPD. However, it is important that re-openers are considered in the context of the overall balance of risks. For example, a general re-opener may have little to offer if a large proportion of Eskom’s costs is simply passed through, as proposed under the other rule changes (primary energy and CAPEX). Eskom’s proposal/principle is similar to that used for benefit sharing in contracts, in that a performance band is set within which the utility can retain efficiency gains or incur reduced returns due to poor performance, but outside this band the risk falls fully to electricity customers. The proposal could also be seen simply as a form of safety net or “get out” clause for Eskom that could readily dilute efficiency incentives in the rest of the mechanism. Therefore any re-opener trigger has to be viewed against the balance of risks and incentives in the rest of the determination. In that context it is not appropriate for NERSA to accept any proposal that could set rules for future determinations before the risk and incentive structures for those determinations have been considered or even put out for consultation with stakeholders. For example, if NERSA were to accept the proposed rule changes, then 80% of Eskom Generation’s costs would be passed through, probably rendering any re-opener trigger as proposed irrelevant. NERSA staff accepts that it is necessary to consider re-opener triggers given the uncertainties that can arise over a Multi Year Price Determination, and acknowledges that the condition allowing for a re-opener for macroeconomic changes were narrowly defined in the first MYPD. However, one weakness of Eskom’s proposal is that it relies on a benchmark entirely internal to itself. NERSA staff propose that there be no rule changes for now but that a process for revision of re-opener rules be started. The revised rules would then apply in the next MYPD. The new rule on a trigger for re-opener should not be set in isolation from other rules within the MYPD and should only be set after considering Eskom’s risk position and strategy to mitigate short term risks. Stakeholder comments/views # 23 Your views are requested on NERSA staff response to the proposal by Eskom of the trigger for a re-opener and also on the comment made by NERSA staff that any trigger for re-opening should be set based on the balance of risk to Eskom

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and therefore that this can only be determined once a thorough review of Eskom’s business risk and mitigation strategy has been applied and will only be set for the next MYPD.

5. Once-Off relief

5.1 Primary Energy Costs Primary Energy costs analysis In its application Eskom was mainly concerned about the volatility in coal prices, and in particular the coal price variance. The Eskom coal-fired power stations can be grouped as follows for discussion and analyses purposes:

• Pithead power stations: These power stations are served by a tied colliery under a long term coal contract. Should the power station require more than the contractual amount of coal available from the tied colliery, this has to be obtained from remote coal sources and is transported to the power station by road. This supplementary coal is termed imported coal;

• Non-pithead power stations: These power stations do not have a locally

tied colliery and incurs coal transport cost for all its needs. The R/MWh cost ratio of the three coal sources were as follows in 2006:

Price ratio (R/MWh)

Volume ratio (Tons)

Pithead – contracted coal 1.00 1.00 Pithead – imported coal 1.31 0.07 Non pithead – imported coal 2.05 0.09

Table 5: Price and volume of Eskom’s coal sources Eskom’s primary energy cost consists of the following elements:

• Fuel used at power stations. This fuel usage is proportional to the energy sent out at the power stations and comprises coal at coal-fired power stations; fabricated nuclear fuel at nuclear stations and liquid fuels at gas-turbine power stations.

• Water used in the thermal generation process. The water used for cooling purposes is proportional to the energy sent out at coal-fired power stations.

• Fuel-oil used to start-up generating units at coal-fired power stations and to support combustion at low loads.

• Payment for use of water rights for hydro power generation. The cost of power purchases to supplement production from Eskom’s own power

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stations. This includes both imported and local production by non Eskom generators.

Expected variance from MYPD As power stations are dispatched economically in order of increasing cost, it is to be expected that all the contracted coal at pithead power stations would be planned to be utilised. Any shortfall in contractual volumes would have to come from coal imports, either at the station with the shortfall or by increasing the load on the non-pithead power stations. In view of the high fixed cost component of colliery operations, volume shortfalls at contracted pithead collies are translated in an average price increase. The Eskom coal cost projections shows the following variances on the MYPD estimates of coal purchases in the MYPD period.

R million Price Variance

Mix Variance

Volume Variance

Total Variance

Pithead Contracted -4,072 319 669 -3,083 Pithead imports -2,139 -563 -1,449 -4,151 Non Pithead -988 205 -737 -1,519 Total -7,198 -39 -1,517 -8,754

Table 6: Variance in coal purchase cost from MYPD plan The positive volume variance for pithead contracted coal (R669 million) occurs due to shortfalls in contracted coal. The shortfall also result in a price variance (-R4072 million) due to costs not varying in line with volume variances (fixed costs are independent of volume changes). A further consequence of the volume shortfall is that the imported volumes have to increase (-R1449 million). This increased coal imports result in coal shortages and a resulting price variance (-R2139). At the non pithead power stations more coal is required due to higher than expected demand on the coal fired power stations. This causes a volume variance (-R1517) and a price variance (-R988) due to the increased coal market demand. In Eskom’s revised estimate 1.9% more energy is required from coal-fired power stations despite the overall energy forecast decreasing by 2%. This is due to increased pumping for pumped storage generation and expected lower performance of non-coal fired power stations.

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Eskom expects that their actual primary energy cost will exceed the primary energy cost that was allowed for in the MYPD (R35.1 billion) by R9.8 billion (28%) over the three year control period in 2006 rand values. NERSA Staff performed an independent projection of primary energy costs for Eskom based on Eskom’s results for 2006/7 and the NIRP assumptions, using a consistent 3.8% increase in energy sent out and escalating 2006/7 coal costs at CPI in order to assess how realistic the Eskom PE cost forecast is. It was found that a saving of just over R1 billion could be achieved. In this forecast realistic energy output from base load generation plant was assumed and the amount of coal available from contracted pithead collieries was not exceeded. It was found that Majuba, Camden and the new gas-turbine stations are the marginal stations at which load would have to be increased and decreased for changes in the demand or variances in plant performance. Primary energy cost R million Nominal 2008/9

MYPD PE 2008/9

Eskom revised PE 2008/9

Requested relief for 2008/9

NERSA PE assessment 2008/9

Saving expected on Eskom revised PE

% of Eskom estimate

COAL COST 9,201 13,461 4,260 12,701 760 5.65%

OTHER PE COST

5,891 5,299 -593 4,791 508 9.59%

TOTAL PE COST

15,093 18,760 3,667 17,492 1,268 6.76%

Table 7: Total PE Costs Further, the primary energy cost mechanism will be adjusted to accommodate the increased energy sent out on which Eskom based its primary energy cost projection and any variation from this level of energy sent out will be corrected at the marginal cost of generation experienced at Majuba power station in the 2007 financial year. Stakeholders comments/views # 24 Stakeholders are asked for their views on the independent projections of primary energy costs by NERSA staff especially that it is based on Eskom’s results for 2006/7 and the NIRP assumptions Stakeholders comments/views # 25

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Stakeholders are further requested to comment on the parameters (3.8% increases in energy sent out and CPI) used in the independent projections Stakeholders comments/views # 26 Stakeholders are requested to comment on the assumption made on the realistic forecast on energy output from base load generation plant.

5.2 Accelerated capital expansion programme

Eskom’s request for relief related to CAPEX variances Eskom is requesting an adjustment on return on assets and depreciation on assets to the total value of R1.5 billion. This return is based on Eskom board’s revised five year capital expansion plan of R171, 499 billion that was approved in February 2007. Eskom’s 2008/09 return on assets adjustment based on the calculation below: Capex (nominal R’m 2006/07 2007/08 2008/09 MYPD Feb 2006 14, 175 14, 531 15, 70318 July 2007 plan 16, 141 25, 157 35, 641Variance 19, 66 10, 626 19, 938% Return on assets 7.30% 7.30% 7.30%Returns on average (half year) 72 728Return earned for full year 72 388Return on assets - amount 72 460 1116Depreciation 39 213 399Total capex contributions (RoA + Depr) 111 672 1, 514Rounded off 110 670 1, 500 Table 8: Calculation of additional return on assets Eskom applied for an additional return on assets and depreciation of R1,5 billion. From this R1.5 billion, NERSA staff disallowed customer funded projects and Eskom’s Corporate Division’s capital expenditure. Corporate Division’s capital expenditure is disallowed because it is covered in the allowable centrally administered charges and therefore it does not form part of the Regulatory Asset Base. The customer funded projects are not included in order to avoid double recovery of revenue. Stakeholder comments/views # 27

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Stakeholders are requested to comment on whether customer funded connections/projects should be included or excluded when determining the adjustment return on Eskom’s accelerated and increased capital expenditure. Stakeholder comments/views # 28 Stakeholders are requested to comment on whether Eskom’s Corporate Division’s capital expenditure should be allowed a return as part of the Regulatory Asset Base or Centrally Administered Charges.

5.3 MYPD rule change scenarios

NERSA staff preliminary analysis of Eskom’s application presented in 5 scenarios Scenario1: Approved MYPD

2006/7 2007/8 2008/9 Average price increase excl. EDI costs 4.57 % 5.37 % 5.67 %Average price increase incl. EDI costs 5.1 % 5.9 % 6.2 %Allowed revenue excl. EDI costs (Rm) 36 295 39 685 44 106Allowed revenue incl. EDI costs (Rm) 36 693 40 084 44 504

Table 9: Approved MYPD Scenario 2: Adjusted capex allowed but PE costs not allowed Ref 2006/07

R’m2007/08

R’m 2008/09

R’m2007/8 Prices Revenues (Rm) 39 314 GWh 201 314 Price (cents) 19.80 2008/9 Prices Revenues (Rm) 43007GWh 201 053Price (cents) 21.39Percentage increase (nominal) 8.06%Table 10: Adjusted capex allowed but PE costs not allowed Scenario 3: Adjusted PE costs allowed but accelerated capex not allowed Ref 2006/07

R’m2007/08

R’m 2008/09

R’m2007/8 Prices Revenues (Rm) 39 314 GWh 201 314 Price (cents) 19.80 2008/9 Prices Revenues (Rm) 44 179GWh 201 053Price (cents) 21.97

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Percentage increase (nominal) 11%Table 11: Adjusted PE costs allowed but accelerated capex not allowed Scenario 4: Both adjusted PE costs and adjusted accelerated capex allowed Ref 2006/07

R’m2007/08

R’m 2008/09

R’m2007/8 Prices Revenues (Rm) 39 314 GWh 201 314 Price (cents) 19.80 2008/9 Prices Revenues (Rm) 45 449GWh 201 053Price (cents) 22.61Percentage increase (nominal) 14.20%Table 12: Both adjusted PE costs and adjusted accelerated capex allowed Scenario 5: Eskom’s proposed price application Ref 2006/07

R’m2007/08

R’m 2008/09

R’m2007/8 Prices Revenues (Rm) 40 506 GWh 208 393 Price (cents) 19.44 2008/9 Prices Revenues (Rm) 49 441GWh 214 340Price (cents) 23.07Percentage increase (nominal) 18.7%Table 13: Eskom’s proposed price application Stakeholder comments/views # 29 Your views are requested regarding the price levels presented in the scenarios above. Should the Regulator consider only primary energy or capital expenditure or both of them in Eskom’s rule change application?

6 Final words on the consultation documents The NERSA staff under the leadership of its Chief Executive Officer, Mr Smunda S. Mokoena is looking forward to your participation in the consultation process. Your comments/views are highly regarded for the finalisation of the decision on the application by Eskom for rule changes. We also look forward to your participation at a stakeholder consultation workshop that will be held at Avianto in the West Rand on 2 October 2007.

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7 Summary of consultation questions

Question number Question

1 Your views are requested on the overall request by Eskom for rule changes and on NERSA staff’s preliminary conclusions on these proposals.

2 Your views are requested on Eskom’s request for additional revenues and NERSA staff overall approach in evaluating Eskom’s application.

3 Your views are requested regarding the above mentioned changes in 4 key business parameters and their effect on Eskom’s revenues and costs.

4 Your views are required regarding the expectation for customers to start paying for future capacity or letting future customers pay if Eskom is to be able to finance the expansion programme and if customers are to see a reasonably predictable price path.

5

Your views are requested regarding the envisaged significant increases in prices followed by higher levels of continuing price increases than those planned in 2005 when the MYPD was developed and your views on prices reaching economic levels in 10 to 12 years rather than 25 to 30 years as was the case previously..

6 Your views are requested regarding a blanket pass-through protection to Eskom without any evident strategy to bring under control those costs that are perceived to be out of control.

7 Your views are requested on the process to be followed as outlined above.

8

Your views are requested with regard to industry pressures mentioned above specifically ASFGISA and its effects on electricity prices and the acceleration of these prices to LRMC in a shorter time horizon than in the past and on the increased operational risk of Eskom as evidenced with the 2006 blackouts and exposure in the coal market due to short-term security of supply risk.

9 Your views are requested regarding the high level risk position of Eskom as perceived by NERSA staff and as a basis for concluding on a need for intervention to assist Eskom in its ability to finance it capital expansion programme.

10 Your views are requested regarding using electricity tariffs to cover the risks and on the possible equity injection, adoption of single buyer model or the selling of Eskom’s assets to finance capital projects.

11 Your views are requested regarding the rules as proposed by Eskom and their implications on the management of risks within the MYPD for both Eskom and its customers.

12

Your views are requested on the current mechanism within the MYPD to manage kWh above the fixed level output using Majuba price presented in the MYPD and the adequacy of such mechanism in managing the risks. Proposals on other mechanisms are very welcome and will be considered by NERSA staff in their final recommendations to the Energy Regulator.

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Question number Question

13 Your views are requested on the proposals presented by NERSA staff and their views on Eskom’s proposed rule changes.

14 Stakeholders are asked for their views on the once-off pass-through adjustment for 2008-9 without a rule change as an intervention to ensure the sustainability of Eskom’s business

15 Stakeholders are asked for their views on letting the aspect of primary energy cost volatility to be considered in the mechanism to be used for the next MYPD.

16

Stakeholders are asked for their views on the retaining incentives for Eskom to manage primary energy costs and therefore the use of a dead-band below and above the central primary energy cost estimate to ensure that the expenditure considered for pass-through is material

17 Stakeholders are asked for their views on the pass through of gas turbine generation costs

18 Stakeholders are requested to comment on how the differences between the investment profile and forecasts used for revenue setting must be treated and on how the Regulatory Asset Base should be adjusted for actual expenditure.

19 Stakeholders are requested to comment on whether Eskom should be granted interim relief or not based on changes in the capital investment profile and the costs thereof.

20 Stakeholders are requested to comment on the extent to which an adjustment on the return and depreciation on accelerated capital expenditure (if granted) must start to be recovered, 2008/09 or in the next MYPD.

21 Your views are requesting on the overall treatment of Capital Expenditure variances either due to timing differences or differences in costs within a given MYPD whilst giving due attention to efficient planning by the utility being regulated.

22 Your views are requested on Eskom proposed rules that will govern the trigger for re-opening the MYPD during its control period. Alternative proposals will be happily welcome and considered prior to finalization of the MYPD mechanism.

23

Your views are requested on NERSA staff response to the proposal by Eskom of the trigger for a re-opener and also on the comment made by NERSA staff that any trigger for re-opening should be set based on the balance of risk to Eskom and therefore that this can only be determined once a thorough review of Eskom’s business risk and mitigation strategy has been applied and will only be set for the next MYPD.

24 Stakeholders are asked for their views on the independent projections of primary energy costs by NERSA staff especially that it is based on Eskom’s results for 2006/7 and the NIRP assumptions

25 Stakeholders are further requested to comment on the parameters (3.8% increases in energy sent out and CPI) used in the independent projections

26 Stakeholders are requested to comment on the assumption made on the realistic

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Question number Question

forecast on energy output from base load generation plant.

27 Stakeholders are requested to comment on whether customer funded connections/projects should be included or excluded when determining the adjustment return on Eskom’s accelerated and increased capital expenditure.

28 Stakeholders are requested to comment on whether Eskom’s Corporate Division’s capital expenditure should be allowed a return as part of the Regulatory Asset Base or Centrally Administered Charges.

29 Your views are requested regarding the price levels presented in the scenarios above. Should the Energy Regulator consider only primary energy or only capital expenditure or both of them in the Eskom’s rule change application?

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