THE CHAMBER OF MINES OF SOUTH AFRICA - SUBMISSION TO NERSA

31 January 2013

Key Points:

• The Mining Sector remains the "flywheel" of the South African economy and has considerable potential to contribute to a higher and more sustainable and labour absorbing economic growth rate.
• Reliable and competitively priced electricity for the tradable export sectors is critical to not only create a higher more balanced economic growth profile, but is also key to South Africa's growth, beneficiation and industrialisation ambitions.
• In the past five years, South Africa's electricity price has trebled and Eskom's MYPD3 proposals will more than double the price again.
• The South African economy cannot absorb the proposed further doubling of the price and the Chamber of Mines believes the Eskom proposed price trajectory will lead to the further de-industrialisation of South Africa.
• The electricity intensive sectors such as platinum and gold mining are substantially negatively affected.
• The Chamber of Mines recommends that a proper independent economic impact assessment of the Eskom proposed price trajectory on the key tradable export sectors should be undertaken to help inform the NERSA process.

Johannesburg, 31 January 2013: The Chamber of Mines of South Africa today submitted the mining industry's considerations to the National Energy Regulator of South Africa (NERSA) in response to Eskom's most recent application for electricity price increases from 1 April 2013 to 31 March 2018 (multi-year price determination period three - MYPD3).

The Chamber of Mines, which accounts for more than 90% of South Africa's mining production by value, represents an industry that is both a significant supplier of primary energy for electricity generation as well as a substantial consumer of energy. The Chamber of Mines argues that the mining industry requires a reliable supply of competitively priced electricity to not only enable the functioning of deep level and technologically complex mines, but also to support the continued beneficiation of South Africa's mineral resources.

Presenting to NERSA in Midrand today, the Chamber of Mines noted that the lack of electricity capacity for growth and the rapid increase in electricity costs are factors that contributed to the poor growth performance of the mining sector over the past five years. This in turn contributed to the poor performance of the electricity intensive tradable sectors, which then undermined the country's economic growth path and exacerbated the current account deficit and unemployment challenge.

The President of the Chamber of Mines, Mr Mark Cutifani, said "It is a clearly stated policy position of government that, in order to solve the country's triple challenges of poverty, inequality and unemployment, the economy needs to grow at a more rapid pace and one of the key tenets of being able to sustain a higher level of balanced economic growth is to ensure that the country has efficient and affordable infrastructure to facilitate development".

Mr Cutifani added, "it is our collective view that the electricity price is reaching a tipping point where further excessive increases in the electricity price may result in further restructuring in the platinum and gold mining sectors.

In these sectors alone, despite declines in gold production and a sideways movement in platinum production, electricity costs have increased by over R7 billion when comparing 2012 to 2007. This is based on a threefold (238%) increase in the electricity price in the same period. The, Eskom proposed, further doubling in the price by 2017 is simply unaffordable and will prejudice the platinum and gold mining sectors".

The MYPD3 application is proposing a price path that would take the price of electricity charged to industrial customers from 61 South African cents per kWh in 2012 to 124 cents per kWh by 2017, which equates to a 104% increase or a doubling in the price.

Between 2007 and 2017, the price would have increased a staggering 587%, a nearly seven-fold increase. Unfortunately, the sectors most affected by Eskom's MYPD3 pricing application are the very electricity intensive tradable sectors that the government is targeting to grow at a faster pace in order to enable a faster, more balanced and employment-creating growth profile for the country.

Base metals, mining and quarrying and non-metallic minerals are the most electricity intensive sectors of the economy per unit of GDP created. The impact of the proposed price increase on these energy intensive sectors of the mining industry will be substantially negative. Many business sectors are already battling to accommodate this rate of increase in electricity costs, before the further price increase proposed by Eskom in the MYPD3 application.

While it is clear that the electricity price at 18 cents per kWh back in 2007 was too low, a target price of 124 cents per kWh by 2017 does not appear to be in the best interests of the economy and certainly takes South Africa into an electricity pricing territory where the provision of energy is no longer a competitive advantage for attracting investment and encouraging economic growth.

The Chamber of Mines is of the view that the country's economic and political leadership is faced with  important decisions regarding the country's future economic growth and industrialisation path.

The crucially important discussion on how the country's electricity supply industry fits into national industrialisation, beneficiation and growth frameworks still needs resolution and requires coherence between government policy makers. From the Chamber of Mines' perspective, reliable and competitively priced electricity supply is a critically important facet of the growth, industrialisation and beneficiation objectives of government.

The Chamber recommends that a proper regulatory impact assessment of the costs and benefits of the proposed price increases should be undertaken by government, in particular in relation to the government's plans to encourage greater beneficiation and a growing mining sector as stated in Minerals Policy, the National Development Plan and the New Growth Path. This will expose the tradeoffs that exist in policy and pricing decisions.

Mr Cutifani states "the Chamber is concerned that the primary driver of the large increase in the electricity price between 2013 and 2017 is the large increase in depreciation charges and return on capital charges that are sought by Eskom to achieve stand-alone investment grade rating status.

Government, as a 100% shareholder in Eskom should not just be seeking a stand-alone investment grade rating for Eskom as the only output of its ownership of the parastatal but should also be seeking a cost competitive and reliable electricity price that pays the dividends of further growth, industrialisation and job creation for the country. At this stage it appears that the proposed price trajectory is too skewed in favour of Eskom's stand- alone investment grade rating away from the need for a competitive electricity price for growth and industrialisation".

It is important to dissect the key drivers of the price contained in the Eskom MYPD3 proposal. As  opposed to media speculation it is "return on capital and return of capital" (return on capital invested and depreciation) that constitute the biggest driver of the increase in the electricity price between 2013 and 2017 and not coal (primary energy). Some 65% of the overall increase is attributable to return on capital and depreciation charges. Extra primary energy costs only comprise some 12% of the total price increase. This clearly shows that Eskom is primarily focused on achieving a standalone investment grade rating with negative consequences for the national imperative of growth and industrialisation.

The Chamber therefore makes the following proposals to reduce the Eskom proposed increase to more national interest driven levels:

• The government needs to include price competitiveness and cost efficiency objectives in the shareholder compact with Eskom. The dividends from Eskom should include a price competitive and reliable electricity supply outcome that encourages growth and industrialisation.
• In this regard the government needs to seek an electricity pricing trajectory that keeps the electricity price within the first quartile of the international electricity price curve as published by NUS.
• NERSA should require from Eskom a more detailed statement of the valuation of Eskom assets, as it is this base against which depreciation and return on capital charges are calculated. Eskom has already gained a huge revaluation windfall as a result of the shift to the depreciated replacement cost valuation methodology and it is critical that only the relevant assets are included in this calculation.
• The government and NERSA need to consider lowering the cost of capital charge of 8% that Eskom is applying to its calculations. Eskom is a 100% owned company, is not exposed to significant competitive forces or risk, has a legislated guaranteed market place and has access to a strong sovereign balance sheet and therefore does not require an 8% cost of capital charge.
• The Government, with its strong balance sheet (debt-to-GDP ratio of <40%) should consider providing further sovereign balance sheet support to Eskom to reduce the pressure on cost rises in the short and medium term.
• The Government should consider exempting the tradable export sectors from the fossil fuel electricity levy.
• The R13 billion integrated demand management costs should be removed from the pricing application and this should be covered by the funds derived by the fossil fuel electricity levy.
• The actual need for the DoE open cycle gas turbine peaking plant should be investigated.
• Further private sector participation with access to the grid (ability to wheel) should be encouraged.

On the coal front Eskom believes that the country needs a stakeholder pact to curb electricity demand and limit increases in primary energy costs. The Chamber is of the view that, while South Africa is blessed with sufficient coal resources to meet not only local coal demand, but also demand for exports, substantial investment in infrastructure and new mines will be required to access these coal resources.  

The requisite expansion in mining can only be achieved if an appropriate and competitive return is offered to investors to induce the required investment. Such a competitive return can only be realised if a transparent market price exists for domestic supply of coal to Eskom. The Chamber is concerned that Eskom has not properly calculated the extra capital required to bring on stream new coal mines, and may have underprovided for primary energy in the MYPD3 application.

The attached document summarises the key points of the Chamber of Mines' submission to NERSA in the public hearing process.

NOTE TO EDITORS:

The State of SA Mining Today

Mining is central to the economy and the sustainability of the sector is imperative for the growth of the country and the resultant impact on development. The mining industry's contribution to the national economy, and indeed to virtually all components of positive growth and development in South Africa, has always been, and continues to be, considerable.

Before embarking on the critical task of identifying the key "headwinds" affecting the South African mining sector, it is important to just briefly reflect on the real potential of the sector. In 2011, it is estimated by the IDC that the mining sector helped create about 1.4 million jobs throughout the South African economy. Of these 514 760 were direct mining jobs and another 838 623 jobs were created in industries associated to the mining sector, or because of the spending multipliers of mining. The industry also contributes about 19% to GDP, 50% of the country's merchandise exports, 20% of investment and 17.2% of corporate taxation.

In 2010, the Mining Industry Growth, Development and Employment Task Team (MIGDETT) report on the Competitiveness of the RSA Mining Industry listed the country as having the world's largest in situ value of non- energy mineral resources. The report also recognised that mining could create another 100 000 direct jobs by 2020 (262 000 jobs if the indirect multipliers are added), provided that the barriers to investment and growth could be removed.

In 2009, a report completed by McKinsey for the Chamber estimated that provided cost increases could be constrained to half their previous decade average and that the other barriers to investment could be removed, that another 200 000 direct mining jobs (525 830 jobs including the multipliers) could be created by the sector by 2020. This would also catapult the country's export earnings, contribute to faster growth and accelerate economic development.

While the MIGDETT Competitiveness Report and associated resolutions and recommendations recognised the potential and agreed on a series of interventions to assist the mining sector, the implementation of the resolutions has been slow. However, the key point here is that unless the domestic headwinds are effectively managed, the industry will not be able to realise its full economic, job creating and developmental potential, to the detriment of all South Africans.

The South African minerals complex has been integral as a foundation to the development of South Africa as Africa's largest and most industrialised economy. The country is a world leader in the production of several key minerals (platinum group metals, gold, coal, iron ore, diamonds, manganese, chrome, titanium, etc.), and electricity is key for not only mining operations, but also for the significant further processing of minerals that does take place in South Africa. The mining sector accounts for more than half of the country's merchandise exports.

The mining sector helped generate 18.7% of the country's economic activity (i.e. 18.7% of the Gross Domestic Product-GDP in 2010). Almost one fifth of South Africa's economy is attributable back to the mining sector. Directly the industry's contribution was 9.2%, but this can be more than doubled when the mining supplier industries, downstream industries that use mining outputs and spending multipliers of mining are included.

In 2010, the mining sector helped to create 1,353,383 jobs in the South African economy [Quantec & the Industrial Development Corporation - Input/ Output Models, 2010]

• The sector created 514,760 jobs directly and another 838,623 jobs were created in the industries that either supply goods or services to the mining sector, or using mining products for downstream value addition, or which are related to the spending multipliers from mining and mining employees in the economy. The social multiplier of mining is very significant for South Africa. Given a dependency ratio of about 10 to 1, this means that about 13 500 000 people were directly dependent for the daily food on their table on the 1,353,383 jobs created by the mining sector.

Summary of Key Points made in the Chamber Submission

The following are the key points made by the Chamber in the submission to NERSA.

• That the Mining Sector is the "flywheel" of the South African economy and has considerable potential to contribute to a higher and more sustainable and labour absorbing economic growth rate.
• Unfortunately, the country's electricity intensive tradable export sectors (such as mining) have not been able to realise their growth potential due to international and domestic  headwinds,  which  has  undermined  the  country's  economic  growth performance and exacerbated the unemployment challenge.
• Reliable and competitively priced electricity for the tradable export sectors is critical to not only create a higher more balanced economic growth profile but is also key to South Africa's growth, beneficiation and industrialisation ambitions.
• In the past five years South Africa's electricity price has already trebled from 18c/ kWh in 2007 to 61 c/kWh in 2012 (a 238% increase). The Eskom MYPD3 proposal will more than double the price again to 124 c/kWh by 2018 for large industrial users, meaning a cumulative increase of 589% in the 11 year period.
• The Eskom proposed MYPD3 price trajectory will significantly erode the country's electricity price competitiveness. The Chamber estimates that by 2018, based on the Eskom MYPD3 proposals, inflation differentials and the estimates of price rises in competing nations, that South Africa's electricity price in US dollar terms will move to the second highest cost quartile, from being the cheapest electricity country in 2008.
• The economic impact of Eskom MYPD3 proposals is substantially negative. The South African economy cannot absorb the proposed further doubling of the price on the back of a price that has already trebled. Simply stated the Eskom proposed price trajectory will lead to the further de-industrialisation of South Africa.
• In particular, it is the electricity intensive sectors such as platinum and gold mining are substantially negatively affected. At current prices 50% of the country's platinum mining sector is loss-making. Any further cost pressures from a rapidly rising electricity price will force more of the industry into the red and force more restructuring. In the past 5 years extra electricity costs have added R7 billion extra onto the cost profile of the platinum and gold mining industries. Given that these sectors are price takers and already high cost, the likely implication is mine closures, the sterilisation of ore in the ground and the contraction in the economic benefit that mining can provide to South Africa (GDP, jobs, taxes and export earnings). The Chamber recommends that a proper independent economic impact assessment of the Eskom proposed price trajectory on the key tradable export sectors should be undertaken to help inform the NERSA process.
• The MYPD3 proposal begs the question as to whether the Eskom Shareholder Compact with government is congruent with government's growth strategy (the New Growth Path), the National Development Plan and the industrial policy action plan. The compact does not refer to "competitiveness" and seems to only centre on the "financial sustainability" of Eskom with virtually no emphasis placed on the need for competitive electricity pricing and reliable supply as a cornerstone of the country's growth, employment creation and industrial policies.
• If the government wants to achieve its economic growth and industrialisation objectives it should be targeting an electricity price that remains in the 1st quartile of the comparable electricity price curve. The Chamber proposes that a price path methodology that keeps South Africa within the first quartile of electricity prices for industrial purposes should be considered and adopted by government.
• The existing methodology of "cost reflective pricing' places too little pressure on Eskom to be much more efficient on costs and in operations.
• As opposed to media speculation it is "Return on Capital" (profit) that is the biggest driver of the increase in the electricity price by 2017/18, and not coal (primary energy). In other words, for the increase in price from 71cents per kWh in 2013 to 124 cents per kWh by 2017/18, 65% of the increase is attributable to return on capital and depreciation charges. Extra primary energy costs only comprise 12% of the increase. This clearly shows that Eskom is primarily focused on achieving a standalone investment grade rating at the expense of the competitiveness of South Africa's electricity intensive tradable sectors.
• Given that 65% of the Eskom MYPD3 pricing increase is attributable to depreciation and return on capital charges, it is critically important that the regulated asset base is fairly valued. The windfall gain from asset revaluation, has had a material impact on Eskom's return on Capital and Depreciation claims.The Chamber urges the Regulator to conduct a detailed assessment of the valuation of the regulated asset base to ensure realistic valuation of the relevant electricity assets of Eskom. This will require substantial further disclosure by Eskom as this detail was not provided in the MYPD3 application.
• The Chamber is firmly of the view that government should continue to support Eskom's balance sheet to enable access to funds at sovereign investment grade level. The view that Eskom requires large return on capital numbers to achieve stand alone investment grade status will materially negatively affect the economic and social investment return to government of its 100% share in Eskom.
• Is the Return on Capital number right? It is the Chamber's view that a combination of factors are necessary in the determination of the WACC, but that one of the key metrics of the rate of  return to the state of 100% ownership in Eskom, is competitively priced electricity that enabled growth in investment and employment in the economy. It is not just about the standalone investment grade status of Eskom and what a private company would expect to get as a rate of return.
• Prudently incurred operating costs. The Chamber remains concerned that the existing pricing application award process and the continued emphasis on "cost recovery" provides little incentive for Eskom to materially reduce its cost structures or be very focused on efficiency or cost effectiveness. It is the Chamber's view that Eskom can make a bigger effort on reducing operating costs (water, human capital, overheads) than it is making at the moment. The Chamber proposes that an operating efficiency and cost competitive focus should be built into the pricing mechanism for Eskom.
• Prudently incurred Primary Energy Costs. It is the Chamber's contention that the increase in the costs of coal is not the primary driver of the sharp increase in price proposed by Eskom in MYPD3. The cost of coal as a % of the Eskom proposed price falls from 27.1% of the total in 2013/14 to 21% by 2017/18. Rather it is the large increase in return on capital invested which rises from 4.7% of the price to 27.9% of the price in the same period that drives the Eskom proposed price increase up so high.
• The fossil fuel electricity levy. The Chamber proposes that the government should consider exempting the electricity intensive tradable exports sectors from this levy, until such time as the  generation mix shifts towards more renewable energy technologies (as targeted in the IRP2010).
• IDM costs. The Chamber believes that the current R13 billion IDM costs should be entirely removed from the Eskom pricing proposal and that this amount should be covered by the environmental levy.
• Renewable energy and independent power producers. The need for the DoE open cycle gas turbine peaking plant must be interrogated. Will this plant be necessary in the long term?
• Eskom believes South Africa needs a stakeholder pact to curb electricity demand and limit increases in primary energy costs. The Chamber is of the view that, while South Africa is blessed with sufficient coal resources to meet not only local coal demand, but also demand for exports, substantial investment in infrastructure and new mines will be required to access these coal resources. The requisite expansion in mining can only be achieved if an appropriate and competitive return is offered to investors to induce the required investment. Such a competitive return can only be realised if a transparent market price exists for domestic supply of coal to Eskom.
• The Chamber is also of the view that the only way to ensure a sustainable electricity supply at acceptable prices is to introduce competition into the electricity supply industry.
• The MYPD 3 application alludes to a "recent boom in the coal-export market"   Coal exports from South Africa have not increased over the last decade, on the contrary exports are only now recovering from a slump that occurred during the second half of the last decade. The perception that a lower quality coal, originally destined for Eskom, was now exported to India is debatable. So far the Chamber has not been presented with concrete evidence that Eskom is being deprived of coal as a result of such exports.
• The application alludes to coal quality as a cost driver. Eskom can, however, not expect consumers to pay for its failure to ensure that it gets the product that it pays for. At the cost-plus and long term contract the in situ coal quality is a known factor. Sufficient monitoring should take place to ensure that coal of the correct quality is delivered to the power stations.

Issued by the Chamber of Mines, January 31 2013

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