ESKOM'S REVENUE APPLICATION

MULTI-YEAR PRICE DETERMINATION (MYPD 2)

2010/11 - 2012/13

Comments to NERSA from the City of Cape Town

Introduction and Executive Summary

This comment is based on the revised Revenue Application by Eskom dated 30 November 2009, read in conjunction with the Proposed Revenue Application of 30 September 2009.

The main points from the City that will be expounded in more detail later in the document are that:

1. Once again, blatant disregard for the legislative requirements has been shown and due process has not been followed by Eskom.
2. The holistic and integrated approach, that the City has previously raised, is appreciated but is not being pursued to its fullest potential.
3. While due regard for the plight of the poor is always supported, it cannot be to the detriment of the legislated requirements of implementing cost reflective tariffs. The City would caution against the constant limiting of one particular set of tariffs, creating a base tariff that is not cost reflective, even before any subsidy is provided.
4. All funding options available to Eskom are explored and a concise cost benefit analysis should be presented to inform the discussion on funding.
5. The City welcomes the clarity and stability that the longer term view on electricity pricing can bring about. However, there is still significant concern regarding the level of the price increases, particularly with the current economic climate and level of unemployment that the country finds itself in.
6. Due regard should be given to local government, as a significant purchaser of generated electricity, to purchase electricity at the Wholesale Electricity Pricing System (WEPS) tariff and with the same tariff increase as the rest of the country without any "claw-back".
7. Exploitation of any above-average increases must be limited through capping the surcharge and contribution to rates funded services at municipal level through the provisions contained in the Fiscal Powers and Functions Act, Act 12 of 2007.

QUESTIONS RAISED BY NERSA IN THE "ISSUES PAPER" PUBLISHED ON 30 OCTOBER 2009:

The Funding Model

Stakeholder Question 1: What are your views of funding by the shareholder and debt as provided by Eskom in its application?

It is the role of the Board to manage the financial viability and sustainability of the organisation they serve. The Eskom Board needs to evaluate the viability of the Company (Eskom) and manage the funding options in the most efficient manner, even putting in a recovery plan where necessary. The Board needs to consider various funding options and seek guidance from financial experts on the various funding facilities that are available. It is expected that the Board would exercise full fiduciary responsibility and not approve any budget (as required by section 52 of the Public Finance Management Act (PFMA), Act 1 of 1999) that was not fully supported by the required revenue raising proposals (or tariff proposals), split between operating and capital requirements, showing the expected capital expenditure over the medium term together with the proposed funding sources.

It is difficult to understand that there is still no approved funding model for the capital expansion programme and any funding model has repercussions for the operating budget, and thus for any valid and approved budget to be in place, the Board must have weighed up various different funding options, in conjunction with guidance received from national government.

PROPOSALS:

·         It is proposed that a full cost vs benefit analysis of all the various funding options be prepared in line with the required building programme in order that the stakeholders, and more importantly, the Board, can fully assess the financial implications of one option against another and ensure that the necessary budgetary provisions are created.

The potential to recapitalise Eskom from National Treasury providing grants to applicable local authorities to buy the distribution systems from Eskom should not be overlooked. The longer term benefits of regularising the role of Eskom as the generator of electricity (or generator and transmitter) should not be overlooked. In the light of the operating cost base for the Distribution portion of Eskom's business, as shown on page 53 of the 30 November submission, this proposal should not be dismissed lightly.

Stakeholder Question 2: What are your views of funding through the tariffs as stated by Eskom?

Funding through tariffs is not the only option available to Eskom. Obviously the tariffs need to be raised sufficiently to cover the costs of servicing loans, but they should not be used at this time to also raise revenue which will be utilised to fund capital expenditure. Total transparency on the real costs of generating electricity at current levels must be given - and if these are far from the current tariffs, then a process of phasing in these tariffs can be considered by NERSA which will give direction and certainty to all.

While the concept of tariffs reflecting the true economic cost of electricity is supported, the statement that tariffs must also "allow for the accumulation of sufficient reserves to fund infrastructure and still retain a healthy enough balance sheet to raise sufficient debt to fund the remainder" (paragraph 3.2.2 of the Interim application for 2009/10 increases and similar type comments in the Proposed MYPD 2 submission) must be tempered by the statement that this will be done within the legislative framework for public entities and in accordance with applicable accounting policy. Thus, the impact of the capital expansion must be clearly seen in the tariffs, allowing consumers the right to set the pace of the expansion programme through effecting changes in demand. Any planned profit (before or after tax) funded through additional charges on tariffs are vehemently opposed unless these funds are ring-fenced and reserved for allocation to future capital expenditure. This is not the time for the shareholder to be taking dividends or income taxes.

PROPOSALS:

Eskom must clearly show what portion of the tariff increase is to be utilised to service debt levels as well as showing the portion used to fund expansion programmes directly from revenue, if any.

The affordability of tariffs to the country as a whole and the impact on the economy is of national importance. The line function departments responsible for oversight of Eskom, as a State Owned Entity, should have considered both the economic impact of the proposed tariff increases as well as reviewing the tariff structure as an appropriate mechanism for raising revenue in order to balance the (Board approved?) budget for Eskom. The deliberations informing the pricing proposals that are not aligned to CPI percentages should form part of future submissions.

Stakeholder Question 3: What would be the appropriate balance for the Eskom's funding options?

As Eskom has not pursued all options, it is extremely difficult to give an objective opinion. The proposal is limited in the approaches mentioned. Commenting on the balance of funding options is therefore inappropriate.

The best solution will always be that the shareholder assists with the recapitalisation programme to smooth the transition to a more stable future. Reliance on consumer income and borrowings is not appropriate in the current economic climate. The average South African should not be expected to effectively carry the double burden of funding a national loan and national guarantees on Eskom loans as well as the capital costs of raising these guaranteed loans.

PROPOSAL: A per point 2.1 above.

3.Cost of Capital

Stakeholder Question 4:

Does Eskom's proposal on the real pre-tax weighted average cost of capital (WACC) represent a fair and reasonable risk adjusted return?

Provide comments regarding the components of the pre-tax WACC as proposed in the Eskom application.

Stakeholder Question 5:

Comment on the transitionary rate of return to be implemented on a phased approach in line with the real-pre-tax return calculation.

Comment on whether these should be considered as transitionary or a representative risk adjustment rate of return?

Stakeholder Question 6: What are your views on the benchmarks adopted by Eskom for Market Risk Premium and the Equity beta?

Stakeholder Question 7: Is the return on equity suggested by Eskom representing a fair real return for a regulated utility?

PROPOSALS:

These questions should be answered by industry experts.

A standard framework dealing with these issues and the standards envisaged should be set by the Regulator, to ensure that a uniform approach is applied and certainty created.

Regulatory Asset Base

Stakeholder Question 8:

What is the best way of implementing the replacement cost valuation method?

Should the revaluation reserve be allowed to Eskom as a return of capital (amortisation added to allowable revenue) and a return on capital (the revaluation reserve added to the Regulatory Asset Base (RAB) on which a reserve is earned)?

Should the revaluation of assets be phased in over time, (e.g. over five years as per EPP or as proposed by Eskom), to limit the impact on prices?

Stakeholder Question 9:

Should the revaluation of assets be conducted on the basis of the Modern Equivalent Assets (MEA) as prepared by Eskom or should other alternative replacement methodologies be considered?

Other replacement methodologies include Depreciated Replacement Cost (DRC) of "like for like", Indexed Historical Cost, Reproduction Cost, and Modern Equivalent Asset Valuation (MEAV) adjusted for condition of asset and depreciation. Please comment on the most appropriate valuation methodology to use.

Stakeholder Question 10: How should the principle of stable and predictable price be achieved given the requirements of the Electricity Pricing Policy (EPP) to revalue assets?

PROPOSALS:

These questions need to be answered by industry experts or Accounting Policies applicable to a State Owned Entity.

A standard framework or Accounting Policy dealing with these issues should be formulated and the standards envisaged should be set by the Regulator, to ensure that a uniform approach is applied and certainty created.

5.         Operating Expenditure

5.1    Stakeholder Question 11: What are your views on the operating costs as presented in Eskom's application?

It is unrealistic of Eskom to include increases that exceed the inflation level during the current economic climate. These levels of increase should not be supported unless the increases can be justified against the expansion of resources due to the build programme.

5.2.    Stakeholder Question 12: Comment on the above inflation OPEX increases.

The whole concept of above inflation increases without SIGNIFICANT justification, is contrary to the legislated framework for the submission which states that the submission should clearly demonstrate the steps taken by the organ of state to improve its competitiveness or efficiency in order to reduce costs (see section 42 (3) (b) (ii) of the MFMA).

PROPOSAL:

The fact that the submission of 30 November 2009 reduces the initially proposed costs fairly significantly over the MYPD period and beyond, brings into question the credibility of the original submission and it is therefore proposed that the figures be further interrogated. This is particularly so when there is no clear justification for the reductions brought into account on page 51 of the revised submission. To the contrary the statement on page 58, that "50% of positions in the new business for FY 11/12 will be filled by redeployment and 100% thereafter" (page 58 of 30 November application), shows clearly that efficiencies were not originally considered when the first proposal was made.

5.3     Stakeholder Question 13: Comment on the justification of higher maintenance costs in the light of capacity constraints, ageing plant and ensuring security of supply.

PROPOSALS:

The fact that the submission of 30 November 2009 reduces the initially proposed costs fairly significantly over the MYPD period and beyond, brings into question the credibility of the original submission and therefore it is the City's view that the figures need to be further interrogated.

The fact that Eskom states on page 54 of the 30 November proposal that "relatively low maintenance has technical implications for operations performance in an ageing fleet" (pg 54) and "Eskom ... will notify NERSA should the cost reduction factored into the revised application put undue strain on the system" (page 59) should NOT be considered as a potential for the 3 year MYPD 2 Tariff determination proposal to be opened at any stage during the MYPD term.

There is no mention of whether the initiatives to improve maintenance standards in lower-income areas and informal settlements to improve reliability of supply (par 6.7.5.1 of the 2009/10 Interim Price Application) were effective and the impact this initiative has had. This should have informed, to some extent, the current submission.

Stakeholder Question 14: Are Eskom's human capital costs that are driven by the expansion program reasonable and justifiable?

Please see the comments under point 5.2 above.

PROPOSAL: see proposal under point 5.2 above.

Primary Energy & Production Plans

Stakeholder Question 15: Comment on the Eskom sales forecast and the balance of production and sales in the MYPD2 control period.

PROPOSALS:

This balance between sales forecasts and production should be evaluated by industry experts.

The City sees a role of the Regulator being that of setting the level for the required reserves.

Stakeholder Question 16: Comment on the mix of generation that is used to meet the load requirements.

PROPOSALS:

National Government and the Regulator need to support alternative energy sources and ensure that these are readily available to the public.

Once these alternative energy sources are commonly available in South Africa, building regulations need to be changed to ensure that every new building and every alteration to a current building is fitted with the most efficient means of energy available, with, for example, all homes being targeted with solar water heaters.

Stakeholder Question 17: Present views on aspects of coal fired power station costs and colliery production:

The continued coal price escalation above inflation on an already high base that already provides for coal being transported by road;

The increase in the volume of coal transported by road until rail transport becomes available;

Transporting coal to power station with tied collieries when the contracted production of the tied colliery is unable to meet the burn requirements of the power station. What is the feasibility of increasing mine production above contractual levels for a few years?

Expediting the rail and conveyor transport of supplementary coal to power stations.

PROPOSAL:

A national stance on clean green energy and reduced carbon emissions needs to be taken immediately. This stance will inform the development of further coal powered generation plants and the transport of coal in the future.

Stakeholder Question 18: Present views on Eskom's coal stockpiling strategy:

The minimum coal stock that should be carried at each power station;

The target coal stock days of 42 days;

Mine contingencies being covered by mine stock to assure contractual deliveries; and

Minimising coal stock building from other than local tied collieries.

PROPOSAL:

·         The City sees a role of the Regulator being that of setting the level for the required stockpiling, creating certainty and aligning to the risk appetite of the Regulator with regard to electricity generation and the reserve generation levels.

Stakeholder Question 19: Present views on the coal transport infrastructure and on Eskom's funding of public road maintenance and repair.

Funding of public road maintenance and repair is not considered a cost of generating electricity and should not, in any way, be claimed through electricity tariffs or related electricity charges.

The initiative to have a "shadow toll" charged to Eskom, as outlined in the submission of 30 November 2009 is not supported while Eskom is a VAT and tax contributing supporter of the South African economy, as, effectively these taxes are already funded out of tariffs and therefore the users of electricity are already paying for infrastructure maintenance. The end-user of electricity should not bear the burden through the national fiscus funding structures of PAYE, VAT, etc as well as through the electricity tariffs.

PROPOSAL:

Nationally raised funding should be used by Provinces to repair the roads which they maintain. Relevant service level agreements could be entered into between the departments at a national or provincial level based on certain key roads/routes, setting service standards, with a view to securing adequate coal deliveries in order to sustain electricity generation.

Stakeholder Question 20: Present views on the water cost projection and expected further increases during the MYPD2 period.

Stakeholder Question 21: Present views on the price of OCGT fuel and the expected price escalation over the MYPD2 period.

Stakeholder Question 22: Present views on the average price of Independent Power Producers (IPP) generation and whether the projected IPP volumes are realistic.

Stakeholder Question 23: Present views on cost and volumes of power imports in the MYPD2 period.

PROPOSAL:

·         All these questions should be answered by industry experts. Only real costs of electricity generation should form part of the calculation of cost reflective tariffs.

Energy Efficiency & Demand Side Management

takeholder Question 24:

Comment on the recovery of full Energy Efficiency and Demand Side Management (EEDSM) costs

Should only a portion of the EDSM costs be allowed to be recovered through the tariff with the rest of the costs being allocated from government funds or any other means of funding EEDSM?

It is essential that there is continual development of EEDSM initiatives and the forming of partnerships with various stakeholders to ensure that the demand for electricity supply is reduced. There are numerous initiatives that can be pursued and Eskom is in the ideal position, being a public entity, to rally support of the very policy makers that can make a difference. However, it would appear that initiatives to reduce the demand for electricity supply are, in effect, counterproductive for Eskom as it reduces the potential revenue of Eskom. It also creates uncertainty in the minds of investors of the predictability of the revenue streams, which automatically pushes up the cost of capital investment. It is therefore proposed that EEDSM initiatives should be handled by another entity. EEDSM costs are being incurred due to the natural advancement of the energy industry, energy efficiency management procedures and green processes being followed throughout the world. These are not direct costs and the consumer should not be penalised for an industry that was pushing sales in the midst of information that supports alternate energy mechanisms.

PROPOSALS:

·         Due to the above reasons, it is therefore proposed that EEDSM initiatives should be handled by another entity. EEDSM costs are being incurred due to the natural advancement of the energy industry, energy efficiency management procedures and green processes being followed throughout the world. These are not direct costs and the consumer should not be penalised for an industry that was pushing sales in the midst of information that supports alternate energy mechanisms.

·         EEDSM would be far more effective if it was implemented at the distribution stage of energy supply. This distribution stage is not covered by Eskom in many cases, but by municipalities. Thus, even if this funding is allowed to be covered by tariff increases, it should only be an allowable expense for the short term.

Stakeholder Question 25:

·         Comment on table 11 of the application (pg 46 of Eskom's application - "Demand side management savings and costs") which outlines that savings realised in relation to the cost incurred (i.e increasing in R/MW saved over the next three years);

·         How should funds be allocated between Energy Efficiency (e.g. Compact fluorescent lamps) and Demand Side Management (Load Management, Demand Market participation);

·         Should the tariff signals be enough to incentivise customers to manage their electricity demand (e.g. load management)?

PROPOSALS:

·         Refer to the proposals under point 7.1 above.

·         While the proposal to increase tariffs sufficiently to incentivize users of electricity to manage their demand, this policy principle cannot be put in place until alternative energy sources are freely available and competitively priced in South Africa. See the proposal under point 6.2 above.

Stakeholder Question 26: Comment on the following:

·         The cost structure of the Power Conservation Programme (PCP) as proposed by Eskom;

·         Should the cost of PCP be recovered through Eskom's tariff or other funding?

·         Should the PCP trading function be housed within Eskom or elsewhere?

PROPOSAL:

·         As the aim of the PCP is to reduce energy consumption of end users, it is appropriate that the costs are recovered from the end users through the tariff rather than from other sources. All distributors will face PCP implementation costs and Eskom's costs should be ring-fenced and be recovered from Eskom's end user customers only and be excluded from the tariffs charged to municipal distributors. Currently only Eskom's System Operator (SO) has the closest-fit capacity and systems to house the PCP trading function. To avoid the additional costs and significant delays in developing capacity elsewhere, the function should be housed there. Conflict of interest concerns can be adequately managed and will be largely reduced by the System Operator becoming independent from Eskom.

8.         Research & Development Costs

Stakeholder Question 27:

·         What criteria should be used to allow or disallow research projects?

·         Which research projects should be allowed?

Stakeholder Question 28: What would be a reasonable cap on the expenditure for research and development which Eskom undertakes?

PROPOSAL:

·         These questions need to be answered by industry experts and should be aligned to the national stance taken on reduced carbon emissions and green energy (see points 6.2 and 6.3 above)

9.         Economic Impact

Stakeholder Question 29: What are your views on the statements made by Eskom regarding the job creation aspects of the capital programme versus the job losses that could be experienced by through less competitive industries, and the impact of limited power supply on the GDP and economy versus the tariff implications impact on the GDP and economy?

Stakeholder Question 30: What are your views on the impact of the proposed increases on the different sectors of the economy?

Stakeholder Question 31: What are your views on the inflationary consequences of the proposed tariff increases?

Stakeholder Question 32: What are your views on economic assumptions made by Eskom, particularly regarding GDP growth?

Stakeholder Question 33: What are your views of the impact of electricity prices on inflation and GDP?

There is still significant concern regarding the level of the price increases, particularly with the current economic climate and level of unemployment that the country finds itself in.

PROPOSAL:

·         These are not questions that the stakeholders should be answering but rather should be expounded on by Eskom in terms of the legislative requirements as outlined in section 42 (3) (b) (i), in order that stakeholders can give a clear assessment of their views on the stance, assumptions or principles applied by Eskom. Future submissions should contain far more clarity and fully substantiate how the national government's inflation targets and other macroeconomic policy objectives have been taken into account.

Eskom Tariff Structures, Protection of the Poor & Free Basic Electricity

Stakeholder Question 34: Comment on whether the existing cross subsidies should be retained, reduced or increased.

Stakeholder Question 35: 

·         Express your views on the need to provide cross-subsidies to the poor, cushioning high price increases;

·         Which group(s) of electricity customers should provide such cross-subsidies?

Stakeholder Question 36:  Express an opinion on which customer groups should be considered as poor and requiring protection.

Stakeholder Question 37: Comment on the proposal for a Free Basic Electricity levy to be collected by government from all electricity customers (Eskom and municipal).

10.5  Stakeholder Question 38:  

·         Comment on the practicality of a single national inclining block rate tariff to be applied to all domestic/residential customers;

·         Provide views on the design principle and structure of an inclining block rate tariff.

10.6  Stakeholder Question 39:  Comment on the preferred or alternative method/ mechanism that should be used to provide protection to the poor against high electricity prices.

Besides funding some of the infrastructure, which then immediately becomes an Eskom asset, the City also has to pay over the funding requirements for the free basic electricity provided by Eskom to Eskom customers within the jurisdictional boundaries of the City of Cape Town. In accordance with the NERSA ruling on the 2008/09 tariff levels, the rate at which Eskom can charge this cost to municipalities is in accordance with the Homelight 1 20A tariff. This tariff amounts to 58.94c per kWh[1][1]. However, this tariff is applied to those customers using less than 150 kWh a month (calculated on average over a 12 month period - May to April each year.) The Free Basic Electricity supplied by Eskom for customers using between 150 kWh and 450 kWh is the actual tariff on which Eskom supplies them - thus ranging between 45,05 c/kWh (for those customers on the Combo (prepaid with a service charge) to 66,35 c/kWh (for Homelight 2 60A customers.) If these customers were transferred to the municipality concerned, the cost of servicing these customers would be in line the bulk tariff charged to municipalities. The current average bulk supply rate is in the region of 25.24c per kWh[2][2]. It is unclear why Eskom should "profit" from the poor via the municipal coffers.

While every endeavour made to ease the plight of the poor is always supported, it cannot be to the detriment of the legislated requirements of implementing cost reflective tariffs. Rather than a single national inclining block rate tariff to be applied to all domestic/residential customers, consideration should be given to an indigent tariff that includes the free basic electricity component, a second step at a national rate and a third step at the cost reflective rate applicable to all other domestic/residential consumers

PROPOSALS:

·         The City would caution against the constant limiting of one particular set of tariffs, creating a base tariff that is not cost reflective, even before any subsidy is provided.

·         It is the City view that as Regulator, NERSA should be setting a country-wide Indigent tariff that includes the Free Basic Electricity component.

11.      Any Other Comments

11.1  Stakeholder Question 40: Comment on the statements made that

·         Without such high increases as proposed by Eskom there will be an inadequate supply of electricity; and

·         High increases will have a negative impact on inflation and the GDP and all other macro economic activities.

11.2  Stakeholder Question 41:  Comment on Eskom's statement of South African electricity prices compared to international electricity prices.

The proposals raised under Paragraph 9 are equally relevant to these questions.

11.3  Stakeholder Question 42:  Make any other comments on the overall application.

PROPOSALS:

·         Due regard should be given to local government, as a significant purchaser of generated electricity, to purchase electricity at the Wholesale Electricity Pricing System (WEPS) tariff and with the same tariff increase as the rest of the country without any "claw-back".

·         The vertical integration of Eskom and the lack of a national Cost of Supply Study obscures the real cross-subsidization between customer categories and comparative prices.

·         Exploitation of any above-average increases must be limited through capping the surcharge and contribution to rates funded services at municipal level through the provisions contained in the Fiscal Powers and Functions Act, Act 12 of 2007.

·         It was sad to see that, although this is effectively the third submission made by Eskom within the current legislative requirements, the submission was once again made without following the due process outlined in the legislation (section 42 of the Municipal Finance Management Act, Act 56 of 2003). The submission was made directly to NERSA and not firstly distributed for comments. This has resulted in a limited time for responses on the final submission which has to be read together with the earlier Proposed Revenue Application, at a time of the year when the world is rushing to complete a myriad of tasks before "silly season" sets in. It is also disheartening to see that various issues, once again, are not fully substantiated and that the submissions (when reading the two documents together as now has to be done, do not, in all aspects, comply with the legislative requirements.

·         As Eskom is a public entity, administering public funds, providing a service that could have a profound effect on the economy of the country, it is disappointing that the oversight role of the Board, national government and possibly even the Regulator would appear to not have been stringently exercised. It is proposed that certain performance indicators are highlighted at Board level and the Board be held accountable to achieve these indicators.

·         Absolute transparency on all future operations is essential for Eskom to retain credibility. Transparency on the proposed medium term tariff proposals will also give certainty to the business sector if these proposals, supported by a realistic budget and strategically prioritised capital plan, are open for public inspection.

·         Local government must not be compromised during the process and due regard must be had for the public participation processes and timeframes linked to the budget process - the support for one state owned entity must not bring about draconian consequences for another sphere of government and the incompetence/ineffectiveness should also not have dire consequences for the people of the country who are users of electricity.

Source: Cape Town City Council, January 20 2010

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[1][1] As per page 25 of the 2008/9 Tariffs and Charges published by Eskom in July 2008

[2][2] As per paragraph 3 of the Media Statement published by NERSA on 18 June 2008 on NERSA DETERMINATION ON ESKOM'S APPLICATION FOR PRICE INCREASE