chamber of mines submission to nersa regarding the mypd2 price application by eskom by dick kruger,...

Chamber of Mines submission to NERSA regarding the MYPD2 price application by

Eskom

By Dick Kruger, Assistant Advisor, Economics Advisory Unit, Chamber of Mines of South Africa

22 January 2010

Introduction, Role of the Chamber of Mines

Since its establishment in 1889, the Chamber of Mines has established itself as the pre-eminent voice of South Africa’s private sector Mining Industry.

The Chamber represents both large and small, local and international mining companies, and its members account for 90% of the country’s mineral production by value.

The Chamber is essentially an advocacy organisation representing the collective interests of its private sector mining company members.

The Chamber is very similar to the other international Chambers such as the Australian Minerals Council or the Mining Association of Canada.

PRESENTATION OUTLINE

Recommendations

Reliable and competitively priced electricity is crucial to the competitiveness of mining and the country’s

beneficiation strategy?

Specific comments on the Eskom application?

Mining the critical core of the economy?

Exports – key to unlocking South Africa’s economic growth genie

Mining – the critical core of the South African Economy

ROLE OF MINING IN THE ECONOMY IS OFTEN UNDERESTIMATED

• Largest net generator of forex

• Significant generator of employment (semi-skilled and skilled)

• Significant magnet for attracting foreign savings

• Significant multipliers into the rest of the economy

A prosperous mining sector is critical for the prospects of the whole South African economy

5

• Creates 1 million jobs (500 000 direct & 500 000 indirect)

• Accounts for about 18% of GDP (including multipliers & induced effect)

• Critical earner of foreign exchange >50% (incl. secondary products)

• Accounts for 18% of investment (including multipliers & induced effects)

• Attracts significant foreign savings (>30% of value of JSE)

• >30% of all BEE deals done in SA over past 13 years (R200 billion)

• 18.5% of corporate tax receipts (2007 R22 billion, 2008 R33 billion)

• 50% of volume of Transnet’s rail and ports

• 93% of electricity generation via coal power plants

• 15% of electricity demand.

• About 37% of country’s liquid fuels via coal (R30 billion worth)


Recommendations





Exports – key to unlocking South Africa’s economic growth potential

SA’s poor export performance identified as country’s “Achilles Heel”

• Several studies (e.g. Harvard Growth Diagnostic) have identified SA’s poor export performance as the Achilles heel of the economy.

• Poor export performance results in a larger than is necessary current account deficit at +/- 7% of GDP.

• Country is then reliant on s/t speculative capital inflows to cover the country’s poor investment-savings gap (i.e. its large Current Account Deficit).

• The economic leadership of the country recognise the criticality of growing exports to raise the overall growth profile of the economy.

• Key export sectors, such as mining have already faced significant constraints, such as electricity supply.

Too expensive electricity is just as bad as no new electricity for growth

• We fully appreciate that not investing sufficiently in the ESI, will continue to impose a binding growth constraint on the economy, especially for the export sectors.

• However, having no new electricity capacity for growth is just as bad as raising electricity prices too quickly (i.e. by 147% in 3 years).

• There has to be an appropriate balance between price rises and the availability of new supply.


Recommendations






Electricity is not just a commodity, but is an indispensible engine of growth

• Electricity is not a commodity but is a KEY input to the INDUSTRIALISATION and BENEFICIATION ambitions of government and stakeholders.

• In the absence of the finalisation of the INTEGRATED RESOURCE PLAN, the current MYPD2 process is effectively making key decisions that will limit the scope of the country’s future industrial policy choices.

• It is critically important that coherence be achieved between the various policies of government, including electricity pricing.

• The MYPD2 process will also limit the country’s policy options regarding the future structure of the ESI and will entrench the monopoly status of Eskom.

Integrated Resource Plan

Industrialisation,

competitiveness & beneficiation

Vision 2025, for South

Africa

Electricity is not just a commodity & its pricing and availability materially affect our current and future

industrialisation choices

Coherence of policies

Does the MYPD2 process adequately reflect the country’s industrialisation & growth aspirations?

• For a Developmental State, does the corporatisation of public enterprises square the circle for government in terms of the country’s industrialisation, beneficiation and growth aspirations?

• The second 30/11/09 MYPD2 application did show a bit more strategic thinking by government, but we are not convinced that the full consequences of the lack of congruence between MYPD2 and industrial policy has been adequately thought through.

• To realise the full benefits of SA’s mineral resource endowment, cost competitive and reliable supply of electricity is a “sine qua non”

NERSA THEREFORE FACES A HEAVY BURDEN OF DECISION MAKING IN THE ABSENCE OF THE IRP

The South African economy cannot absorb such large price shocks

• Global economy is emerging from the first recession in 61-years – the recovery is anaemic.

• The SA economy went into recession for the first time in 17 years. The economic recovery remains fragile, investment has plunged, consumer expenditure remains weak and more than 1 000 000 jobs have been lost.

• 35% increase will add >1% onto inflation.

• For industries where electricity is a key input, the proposed increases will raise costs substantially and reduce competitiveness.

• For existing industries the ability to adjust production processes takes considerable expense and time (SO THE ADJUSTMENT PROCESS IS SLOW).

Estimates of Electricity Pricing Elasticities in California

(1% rise in the electricity price results in X% decline in demand)

Short run Long run

residential -0.06 to -0.49 -0.45 to -1.89

commercial -0.17 to -0.25 -1.00 to -1.60

Industrial -0.04 to -0.22 -0.51 to -1.82

*i.e. in the short run the ability of the industrial sector to reduce demand is limited. Only over time can investment in new energy efficient technologies be processed.

Hence critical need for smoothing

The Mining Industry will be especially hard hit by the proposals

• Mining is a “PRICE TAKER” and competes on cost.

• Electricity is vital for mines, especially the deep level gold and PGM mines, and is critical for health and safety.

• The industry has some of the biggest cooling plants and ventilation systems in the world, to make it possible to mine underground, and this uses as much as 50% of the electricity on a deep mine.

• Electricity is also critically important for hoisting, processing, refining and beneficiation.

• Most of the low hanging fruit of EE has been used (in past 3 years mining saved >400 MW peak through DSM).

• For existing mines, endeavors to mitigate higher electricity costs would become increasingly difficult and require significant new investment.

The Mining Industry will be especially hard hit by the proposals

• The proposed electricity price increases will significantly raise costs. Problem is costs for most inputs already rising at high rate & no compensation through weaker exchange rate.

• For deep level gold mines, electricity costs by 2012 will be 300% higher than in 2005, versus other costs rising by 100% in the same period.

• Faced with decisions to invest significant capital in EE to counteract higher electricity costs, certain shafts with limited operating lives (say 5-10 years) may be prematurely closed.

• Older shafts will close, export earnings and jobs will be forfeited.

• Mines at the upper end of the cost curve become more vulnerable to closure.

• In ferro alloys, SA becomes a high cost swing supplier.

Electricity costs rise very fast

Electricity becomes 24% of cash costs for gold mines by 2012, versus 13.5% in 2009


Recommendations






General comment and principles• All parties should recognise that electricity is the critical

lifeblood of the SA economy;

• The current Eskom MYPD2 application has to be seen in the light of the country’s long term growth, industrialisation, beneficiation, employment & poverty alleviation aspirations;

• The current MYPD2 application must be viewed in the context of the reform & restructuring of the country’s ESI as the choices made today will have a substantial bearing on the future direction of the ESI & the industrialisation of the country;

• Competitively priced and reliable electricity supply is critically important to realising the industrialisation and beneficiation objectives of government;

• large “bunched up” pricing shocks have a larger economic dislocation effect on the economy, than a smoothed approach of phasing in the price increases over an extended period.

General comment and principles• Country choices and decisions have to be made now (in terms

of the final IRP), solutions must be properly implemented and the various tripartite stakeholders must be allocated responsibilities and should be held accountable for delivery.

• Eskom has potentially been far too conservative in its expectation of the negative demand response to much higher prices. In the short & medium term certain large industrial sectors will cut back on production & investment as there are few alternatives to much higher prices.

• The adjustment process in the face of higher electricity costs is longer in the industrial sectors (where this is possible) versus the commercial and domestic sectors of the economy.

CRITICALLY IMPORTANT ISSUES FOR NERSA TO CONSIDER

• In the absence of final IRP, decisions made in 2010 mustn’t prejudice future strategic choices

• Changes to asset valuation and WACC materially affect price application

• Operating costs

• Primary energy costs and coal

• Question marks on the cost of the build program

In the absence of final IRP, decisions made in 2010 mustn’t prejudice future strategic

choices• The MYPD2 process appears to place the “cart before the

horse” in relation to the expected future structure and funding of the ESI over the next two decades.

• Without a final IRP for the energy side of the economy, it is very difficult to make funding and pricing decisions on issues that are materially relevant to the entire systemic of the ESI.

• At best the current MYPD2 3-year period should be seen as an interim arrangement while the IRP is finalised (expected to happen by June 2010).

Changes to asset valuation and WACC materially affect price application

• The two areas of greatest contention are in the areas of “return on capital” and “depreciation expenses” as the value attached to the weighted average cost of capital (WACC) and valuation of assets have significant implications for the prices of electricity paid by consumers.

• This is because both issues materially affect the return on capital and the return of capital (depreciation) and these areas alone constitute 39% of the average price increase proposed by Eskom for the period 2010/11 to 2014/15.

• The importance of WACC/asset valuation methodologies to revenue streams of electricity utilities does unfortunately and inevitably lead to strong incentives for utilities to try and push the boundaries with regulators on these key issues.

Regulated Asset Base (RAB)

Apply WACC to RAB

Depreciation

Forecast operating expenses•Opex•Primary energy•Capex

Forecast revenue requirement

Forecast sales

Figure 1: How the Cost of Capital (WACC) and the value of the regulated asset base feeds through to electricity prices

Previous years gain/loss

X

+

+

+

=

/

=

Forecast average price

Problems with asset valuation methodologies

• The new asset valuation methodology, which substantially increase the expensing of depreciation costs, results in a significant windfall revaluation gain to Eskom of R378 billion on existing assets in 2010. This results in depreciation charges accounting for the vast bulk of the proposed price increases over the next 5 years.

• While the migration to a modern equivalent valuation methodology is contained in the EPP, it is important that the Regulator questions the relevance of such a methodology for a vertically integrated monopoly like Eskom.

• The problem is that the valuation change means that Eskom will lock in a much higher depreciation charge on assets that have already been paid for by previous electricity users.

• The MEA methodology should only apply to new assets.

Problems with asset valuation methodologies

• Research by the OECD and others indicates that inflation adjusted historic cost calculations are normally used in vertically integrated electricity utilities (such as those found in Japan and France) while modern equivalent asset valuation methodology is used in countries where electricity markets are liberalised (such as the United Kingdom and Australia).

• Eskom is a vertically integrated state owned monopoly.

Should a vertically integrated 100% state owned monopoly apply a normal risk driven

WACC?• Eskom proposed a real pre-tax WACC of 10.3% in MYPD2

versus a 7.3% WACC in the MYPD1.

• The reason that this issue is so important is that a 1 % point change in the WACC can result in a 5 % point change in the pricing application (i.e. a 15 percentage point change in the increase for 3% WACC difference).

• Eskom argues that a 7.3% does not provide a fair risk adjusted pre-tax real rate of return to Eskom and therefore has applied for a rate of 10.3% WACC. This is an area that requires significant scrutiny by NERSA.

• Eskom is not a standalone private company competing in a fully contestable market place with private shareholders. Eskom is a 100% owned vertically integrated public monopoly, with a shareholder that wants to promote industrialisation and development.

• The required rate of return, which is the rate required to cover the cost of capital of investing in electricity in SA is the return necessary to cover the risks of business failure.

• Electricity utilities are generally considered to be low risk businesses as they have proven production technologies & the demand for electricity is generally predictable.

• With a regulatory environment that allows for the pass through of prudent costs and expenses, Eskom enjoys a level of market and pricing security that most businesses do not have.


WACC?

• For a 100% state owned vertically integrated utility with pricing power and which is backed by a strong sovereign balance sheet, the cost of capital should equate to the risk free rate plus a small risk premium.

• Simply stated Eskom has significantly lower risks than the average private sector company.

• Research by Genesis Analytics suggests a real pre-tax WACC of closer to the first MYPD1 application of 7% is relevant.


WACC?

By FY 2014/15 return on capital and return to capital is larger than the current electricity price

Current price

Operating costs

• Operating costs per unit of electricity sold, goes from 16.9 cents per kW in 2010/11 to 22.4 cents per kW by 2014/15, an average annual increase of 8.6%.

• Demand side management costs are included in the operating cost section and rise from R1.5 billion in 2010/2011 to R4.1 billion by 2014/15.

• The Chamber believes that the amount focused on DSM is too small and should be doubled in the MYPD2 period, as DSM is critically important in the short-term in relation to system security (and it is one of the few options for reducing demand in the short and medium term).

• However, the Chamber recommends that the cost of DSM be removed from the MYPD2 application and should instead be funded by the 2 cents per kWh special levy.

Primary energy costs and coal • Total primary energy costs (Eskom and non-Eskom) are

expected to rise from R40 billion to R69.2 billion between 2010/2011 and 2014/15 (up 18.6% pa).

• The overall primary energy number includes the substantial reduction in road repair cost, with this responsibility now transferred to SANRAL. The Chamber supports this development, but is concerned that the exact method of calculating the “shadow toll” is unknown.

• Primary energy costs from 19 c/kW to 29.6 c/kW between 2010/2011 and 2014/2015 (up 18% pa). Higher reliance on the more expensive short-term coal contracts outside of the traditional cost plus tied collieries and long term contract collieries is one of the forces driving these costs.

Chamber does not share the same concerns on coal costs

• Concerns on coal supply and costs are not shared by the Chamber. Coal export opportunities are not a major threat to Eskom’s supply as it consumes low quality coal for which there is a limited export market, & a small domestic market.

• While production costs at the older mines are indeed likely to increase, the concern that deeper mines & more geological disturbances will result in cost increases for coal is not justified as a large part of the additional coal required over the next 3 years will still be produced by opencast mines (which currently account for 54% of Eskom’s coal supply).

• The average price paid by Eskom during 2009 is R121-54/t. During the same period the average price received for steam coal delivered fob in Richards Bay was R536-75/t. i.e. ESKOM GETS A GOOD DEAL.

AVERAGE COAL PRICES - 2009

• ESKOM (DELIVERED) R121-54/T

• DOMESTIC STEAM (FOR) R157-13/T

• EXPORT COAL (FOB) R536-75/T

ENERGY VALUES/COST

• ESKOM 19,1 MJ/KG• DOMESTIC STEAM 24,5 MJ/KG• EXPORT COAL 25 – 28 MJ/KG

• ESKOM (DELIVERED) 0,64 C/MJ.• DOMESTIC STEAM (FOR) 0,64 C/MJ• EXPORT (FOB) 1,91 – 2.15 C/MJ

• So Eskom has the lowest cost coal price and is paying one third the cost per MJ of energy compared to export coals.

Cost of the build program• Eskom’s capex is expected to be R501.6 billion in the period 2010/2011

to 2014/2015, which is R136.2 billion lower than the R637.6 billion in the first proposal.

• However, there are some question marks regarding the relevant costs of the Eskom build program, which may be the result of information asymmetries.

• Net power station costs for Medupi (R124 billion) equates to about US$3.2 million per megawatt (MW) versus costs of $1.3 million per MW in India and US$2 million per MW in the USA.

• The differences may be due to the capitalisation of interest in the cost numbers for Medupi.

• The Chamber recommends that NERSA request a more detailed explanation of these capital costs from Eskom and the comparative benchmarks to ensure a more effective discussion on this key issue.


Recommendations





Exports – key to unlocking South Africa’s economic growth genie

CONCLUSIONS AND RECOMMENDATIONS

• In the absence of a final IRP it is clear that the current MYPD2 application has to be seen as an interim arrangement. However, given the LT nature of the ESI NERSA should consider a longer time period for price determinations.

• It is critically important that the various policy objectives of government (i.e. growth, industrialisation, beneficiation, employment, etc.) are aligned with policies such IRP & EPP.

• While 35% x 3 appears to be better than 45% x 3, the Chamber is seriously concerned that such a sharp increase in prices (up 147% in 3 years) will be materially damaging to the mining & mineral processing sectors.

• In this regard the Chamber recommends that a proper Regulatory Impact Assessment of the costs and benefits of the price increase on investment, growth, exports, employment and transformation be undertaken by government.

• The Chamber is not convinced that a target price of R1.05 per kW by 2012/2013 is realistic, justified or in synchronisation with government development and industrialisation objectives.

• The two issues in the MYPD2 application that require the greatest attention are related to the valuation of Eskom assets and the return on capital calculations, which together account for 39% of the total electricity price increase by 2014/2015.

• The Chamber recommends that NERSA pay special attention to the significant windfall gain made by Eskom by revaluing its assets in terms of the Modern Equivalent Asset value methodology, versus the traditional inflation adjusted historic cost. The MEA methodology is normally only used in fully liberalised electricity markets for private power companies whereas Eskom is a 100% state owned and controlled vertically integrated public utility.



• NERSA needs to unpack the WACC calculation made by Eskom. This issue is very significant because for every 1% rise in WACC the electricity price has to rise by 5 percentage points.

• Through a combination of revaluation of assets and a reconfigured cost of capital the Chamber believes that the price increase can be limited to 25% per annum over the MYPD2 period.

• The Chamber recommends that the amount of resources applied to DSM should be doubled in the MYPD2 period. However, the Chamber recommends that the funding for DSM should be removed from the pricing application and should come from the 2 c/kWh levy collected by Treasury.


• Assuming that none of the depreciation or WACC parameters change and based on some internal calculations (which were checked with external parties), a rough R7 billion equity injection by the state in early 2010 will reduce the proposed price increase in the second Eskom MYPD2 application to 25% (from 35%) in this year. This is a serious issue that has to be considered by government to mitigate against the significant negative impact of a 35% x 3 price increase.

• A 25% per annum increase over three years will be much more manageable and will cause much less damage when compared to a 35% x 3 increase. The 25% x 3 rate of increase would also be congruent with the NEDLAC Energy Summit agreement and the NERSA indicated price increases given in the interim 2009 NERSA pronouncement.


• The South African government has taken an approach of providing a limited quasi equity injection (non-interest bearing loan of R60 billion) and has focused on Eskom raising the necessary finance through tapping the debt markets (with government guarantees).

• With limits to Eskom’s balance sheet ability to handle extra debt (and the risks to the utilities investment grade rating of exceeding a certain debt level), the solution of the government taking on some extra debt (the extra R21 billion split over three years as suggested above) and making this as a further quasi equity contribution should be explored.

Save Electricity, save jobs, grow the economy

Please make a special effort to save electricity

Every little bit of saving helps

Play your role for the benefit of OUR country and the mining industry

Thanks

chamber of mines submission to nersa regarding the mypd2 price application by eskom by dick kruger,...

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