MYPD Methodology

Eskom Response to Consultation Paper

2 June 2016

Eskom is pleased to provide comments

Introduction

Eskom has provided detailed responses to the consultation paper on the

review of the MYPD methodology

Responses to the stakeholder questions have been provided. In addition

Eskom’s proposals for enhancement of certain rules have been provided.

Eskom wish to provide a few additional comments that were not included in

our written response

Eskom appreciates NERSA’s intent to enhance the level of transparency,

relevance and objective realignment of the methodology

Eskom appreciates this opportunity to highlight key aspects of the responses

provided during this public hearing .

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Eskom responses to MYPD Methodology Consultation Paper

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Applicability of MYPD Methodology

Ring fencing and Revenue formula

Return on Assets and Regulatory Asset Base

Operating and Maintenance expenses

Power purchases from IPPs

Forecast of Sales / compensation for variances

Administration and Governance

Risk transfer and Unintended consequences

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Coal Costs

Primary energy costs

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Alignment Regulatory Rules and Legislation

6 12 Conclusion

MYPD methodology needs to be within existing legislative framework

1. Alignment to NERSA regulatory rules and legislation

The MYPD methodology should be aligned with the various NERSA regulatory rules and South

African legislation

These include the following (some of which are in the process of being approved)

• The Electricity Regulation Act (ERA)

• The regulations of the ERA including the New Generation Capacity Regulations

• The Grid Code and Distribution Code

• The regulatory rules for power purchases cost recovery

• The Scheduling and Dispatch rules

• The regulatory reporting manuals - The regulatory financial reporting and non-financial

information reporting

• The Electricity Pricing Policy (EPP)

NERSA to consider where best to position information requirements be included in the existing

regulatory requirements

• With regards to financial information it is recommended that NERSA includes in the regulatory

financial reporting that is undertaken.

• With regards to non-financial requirements, any requirement be included in the non-financial

reporting regulatory rule.

Linking of Regulatory discretion more explicitly to legislation

2. Applicability of MYPD Methodology

Section 6.2 of Methodology: “the Energy Regulator shall not be precluded from applying reasonable

judgment on Eskom’s revenue after due consideration of what may be in the best interest of the

overall South African economy and the public.”

the legal basis for the MYPD Methodology lies in the Electricity Regulation Act, no, 4 of

2006 (“the Act”) in which section 15(1) prescribes the following pricing principles:“

(1) A license condition determined under section 14 relating to setting or approval of prices, charges

and tariffs and the regulation of revenues -

(a) must enable an efficient licensee to recover the full cost of its licensed activities, including a

reasonable margin or return;

(b) must provide for or prescribe incentives for continued improvement of the

technical and economic efficiency with which services are to be provided;

(c) must give end users proper information regarding the costs that their consumption imposes on

the licensee's business;

(d) must avoid undue discrimination between customer categories; and

(e) may permit the cross-subsidy of tariffs to certain classes of customers.”

Eskom proposes that the development of the Methodology should explicitly frame the

definition of Regulatory discretion within the principles set out in above section of the Act.

3. Ring fencing and Allowed Revenue formula must be more transparent at licensee levels

Eskom has proposed that the allowed revenue formula in the MYPD Methodology be clearly presented as 3 separate licensee formulae; i.e. Generation, Transmission and Distribution Allowed Revenue, also utilizing differentiated WACCs

Eskom proposes that cost items be more visible in the formula regarding items such as IPPs, international purchases, and corporate overheads

The implications are that MYPD4 would consist of 3 separate licensee revenue applications, requiring 3 licensee revenue decisions . Therefore for MYPD4 there will be 3 separate licensee RCAs, split into Generation, Transmission and Distribution

Whereas Eskom supports ring fencing from an accounting perspective, Eskom rejects ring fencing at operational activity level. This would be in conflict with the regulator’s own previous statements regarding sound regulation e.g:

“For clarification at present it is NER’s intention to set allowed revenues for the three-year period by reference to the efficient level of costs of Eskom. The fact that it will assess costs in order to determine revenues does not mean in any way that it is setting any form of expenditure cap in total or on any line of expenditure. The NER is aware that this type of “second guessing” of management would be indicative of unstable regulation. The NER principle is that the NER sets the allowed revenues mindful of the need for Eskom to finance its activities, and then it is up to Eskom to manage its businesses and to commit the resources to meet its obligations under its licence, including the required service quality.”

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4. Return of Assets (ROA) and Regulatory Asset Base

(RAB)

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Roll-forward of the RAB - requiring annual indexing up for inflation, Transfer-in of qualifying assets,

Transfer-out of disposals and Depreciation of indexed asset base. Annual indexation is required if ROA

is based on a ‘real’ WACC. Eskom proposes that indexation be implemented as per par. 8.5.3. of the

Methodology:

“Each year the MEAV value will change. Because it is not practical to conduct an entire MEAV study every

year, the value from the last year studied will be increased by the Producer Price Index, each year, until the

next MEAV study is carried out, after which the process will repeat itself”.

WACC formulas – Eskom proposed revisions to certain elements as well as differentiated WACC per

licensee area. Cost of capital includes debt and Equity.

Whilst Eskom supports a phased / gradual transition to cost-reflective prices, Eskom proposes

(a) Only the %ROA be used as the phasing mechanism,

(b) The transition path to full cost-reflectivity be defined in terms of duration, slope, measurement

Eskom further proposes (especially during the phasing period) that reasonability measurements for

MYPD revenue determinations be defined in terms of standard financial metrics such as those related

to interest coverage, debt repayment, debt to equity etc., as required by the EPP

Furthermore Eskom proposes that the RCA’s CECA mechanism be based on movements in RAB

instead of as currently to only track movement in annual capex

Regulatory depreciation and return on the RAB provide the regulatory mechanisms under which

capital investments (principal) as well as the cost of capital (e.g. interest) are recovered over the

course of their economic/regulatory life cycles.

5. Analysis of reasonableness of Operating and Maintenance expenses requires more rigor

Section 7.3 of the current MYPD Methodology (s. 9.3 revised) speaks to the way in which the Energy Regulator is to determine the reasonableness of expenditures. i.e.

“7.3 Costs related to Operating and Maintenance (O&M) will be allowed. The reasonableness of such expenses will, subject to paragraph 7.4, be determined by the Energy Regulator on a case-by-case basis.”

This component of the Methodology has had a substantive impact on MYPD allowed revenue. As an example, in assessing Eskom’s MYPD 3 Revenue Application the Energy Regulator disallowed over R100 billion over 5 years.

‘Base – trend’ approach to allowed expenditures : while trend analyses on base levels have a role to play in testing the reasonableness of expenditures – one might expect that a range of methods would be employed in assessing this complex field of cost accounting and expenditure review.

Eskom’s proposals have therefore called for a more systematic and objective basis for assessing the reasonableness of expenditures. Common practice for operating expenditure reviews to be carried out include utilizing techniques such as: Benchmark studies, Statistical trend analysis and Zero base costing analysis

Eskom also proposes symmetrical treatment of operating cost variances for RCA purposes

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Eskom supports the view articulated in the Consultation Paper that the rules around

Primary Energy are inadequate for the current situation, that revisions are required.

6. Primary energy costs

Eskom supports:

The removal of IPPs and power purchase costs from MYPD Primary Energy rules

with cost variances dealt with under its own MYPD rules.

That further clarity is provided in revision of rules for recovery of OCGT costs.

That the rules on coal cost recovery recognize that coal is purchased under three

broad contract arrangements – each requiring different treatment in terms of cost

recovery and recovery of variances.

In prescribing of behavioural rules to achieve various regulatory objectives unintended

consequences may occur leading to net losses to both Eskom and its customers.

We believe that some revisions proposed by NERSA transfer an inordinate level of risk to

Eskom in areas that are functionally or administratively beyond management’s control.

OCGTs - Eskom has proposed a process audit approach in assessment of OCGT costs.

The sums at stake are enormous and the complexity of regulatory design is material.

7. Coal Costs

Eskom proposes various options for the determination of coal costs including:

• The coal benchmark cost and alpha as determined by the Energy Regulator will be

reported for each of the three broad categories of procurement. The PBR formula will

be specified for each of the three categories in which coal costs are assessed having

regard for the limited ability to revise the terms and conditions of existing contracts –

and the physical limitations of various mine sites.

• R/MWh PBR mechanism provides the utility with an incentive to optimize production by

running the cheapest power stations more than the expensive power stations.

Requirements for 100% accuracy on coal quality and coal volumes, predicting force

majeure, managing coal mines, etc are made. These requirements would likely result in

risks with unintended consequences. These requirements are impossible to be met.

Coal contracting is a complicated process and reviews may not always be beneficial for the

consumer

Pre-commissioning fuel to be considered

Eskom has always provided information to NERSA and will continue to do so. It is best

positioned with other information requirements

Additional time to consider the many issues at hand would be an investment well

made

8. Power purchases from IPPs

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In terms of S35 (4) (1) of ERA the Minister of Energy, in consultation with the Regulator has

the power to make determinations for the procurement of new generation capacity. In

terms of S34 (3) of ERA the Regulator in issuing a generation license to the IPPs is bound

by a S34 (1) Determination.

The Regulator therefore concurs with the Minister of Energy that power will be procured

from IPPs per the various S34 Determinations; subsequently approves on an ex ante

basis the transaction (including the PPAs) as part of the generation license application by

the IPP; and also approves the PPA terms on an ex ante basis in accordance with

current MYPD Methodology Rule 11.2. This fulfils the conditions for full cost recovery in

the regulations pertaining to procurement from IPPs. It is on that basis that the IPP as well

as Eskom enter into the contract.

The cost recovery mechanism in the MYPD rules must therefore ensure full cost recovery

for the duration of the PPA, as long as Eskom complies with the terms of the PPA, and the

MYPD rules should not be inconsistent with a S34 (1) policy decision or S34 (3).

Any PPA costs incurred in terms of DOE-driven IPP programmes which have complied

with the PPA that are not fully recovered through the electricity tariff, will result in the

triggering of the GSFA thus transferring the cost recovery onto Government instead

of the electricity consumer.

Eskom cannot accept cost recovery risk proposed in the consultation paper

Eskom does not support the 5% variance proposed in the consultation paper

9. Forecast of sales / compensation for variances

The introduction of such forecasting accuracy requirements holds the risk of perverse

incentives and dysfunctional behaviour e.g. in that it would encourage very

conservative forecasting, which could create a range of other unintended consequences –

i.e. impact on the RCA balance determination.

Eskom MYPD revenue application process commences 18~24 months before

implementation date, hence for a 3 year MYPD cycle the forecast extends to five years

ahead.

Even a forecast that estimates electricity demand’s future annual growth rate to within 3%

accuracy per annum would compound to a variance of 16% over five years.

Eskom therefore recommends that the compounding effect of variances must be

incorporated – i.e. that 5% variance applies to 1 Year, 10% variance applies to Years 2 &

3, and 15% applies to Years 4 & 5.

Scenario based IRP and MTSAO are based on assumed sales volumes to meet different

defined objectives such as capacity requirements and system adequacy requirements.

The MYPD application requires a bottom-up determination of an assumed sales volumes

that will determine the average selling price.

Due to the significant impact of assumptions on sales volumes – particular attention is

required when NERSA makes a revenue decision

10. Administration and Governance

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Applying Interest on the RCA balance to reflect the time value of money whether

for benefit of Eskom or electricity consumer.

Proposals on administrative aspects of RCA balance liquidations.

Developing quantitative criteria for re-opening a Price Determination (i.e.

Reinstatement of Earnings Band)

Eskom is investigating various funding options including public private partnerships

(PPP) which NERSA would need to consider.

Eskom supports RCA reporting updates but proposes frequency of six monthly

updates to align with other reporting processes such as Eskom interim financial

reporting.

Information requirements could be more appropriately placed under Regulatory

Financial Reporting (RFR) or Non Financial Information (NFI) reporting

Eskom supports the consolidation of tariff design with the ERTSA

– ERTSA to include introduction/restructuring of tariffs.

Eskom has proposed a number of revisions to the Methodology that enhances

transparency and processes

Higher risks requires higher returns which might be a worse overall outcome

11. Risk transfer and unintended consequences

Consultation Paper has the potential to increase the level of regulatory risk, and

increase the likelihood of unintended consequences.

Due to the financial margins it would be difficult to absorb these risks

Certain proposed rules imply risk transfer on issues that Eskom is not able to forecast or

control.

The provision of non-symmetrical rules that penalize Eskom for adverse outcomes – but

don’t incentivise positive outcomes are quite uncommon in terms of regulatory practice .

Some actions prescribed in the proposed rules have the potential to lead to

dysfunctional and sub-optimal outcomes in terms of costs and operational / technical

performance.

Overall the proposed rules will increase Eskom’s regulatory risk which constitutes in the

range of 50% of the entire credit risk assessment.

Eskom recommends that :

NERSA publish a complete draft Methodology to allow stakeholders a second round of

commentary ( which may entail only written comments and no public hearings)

NERSA process allows for further consultations including workshops on key areas

such as coal costs and sales forecasts

MYPD Methodology allocates the risk to Eskom (thus shareholder / taxpayers) instead

of a balanced approach with customers, only where Eskom has sufficient control and

ability to forecast.

Methodology should provide opportunities for penalties / incentives and allows Eskom

to justify the recovery of prudent (i.e. reasonable) and efficient costs

More detailed reasons be published for MYPD and RCA decisions

NERSA should be cautious of the revised MYPD Methodology creating dysfunctional

behaviour

The Methodology should make processes and timings more transparent and explicit

12. Conclusion

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Thank you