Israel Electric Corporation Ltd. Cash Flow Deficit Due to Fuels Costs and Other Subjects Audit. Interim Report. Of November 25, 2012

Transcription

1 Israel Electric Corporation Ltd. Cash Flow Deficit Due to Fuels Costs and Other Subjects Audit Interim Report Of November 25, 2012 Goren Capital Group Ltd. Investment Banking Assisted by: Ernst & Young Museum Tower, 21 Fl., 4 Berkowitz St, Tel Aviv Israel Tel: Fax: mail@goren-capital.co.il

2 Table of contents 1. Background 4 2. Analysis of Gaps between Cash Flows Chain of Events Description Analysis of Cash Flow Gaps Summary of Cash flow Gaps Background Information Securities Law Cash Flow Preparation Processes Information Systems Availability and Accuracy of the Information Required to Prepare a Cash Flow Forecast Analysis of Faults and Failures Arising from the Audit Process General - Cash Flow Preparation Process at the Company Lack of Timely Preparedness of the Finance and Economics Division and All its Departments for Preparing a Reliable Cash Flow Forecast Faulty Inter-Organizational Communication Assimilating the Significance of the Failure at the Coal Power Station and Excessive Consumption that Occurred in July Lack of Procedures Related to Feedback on the Cash Flow from 35 Company Departments 4.6 Cash Flow Approval Process Basing the Suppliers Cash Flow on the Company's Budget, Updated 39 Twice a Year 4.8 Finance Department's Involvement in Fuels Purchase Orders and 40 Timing Thereof 4.9 Failure to Assimilate the Importance of the Cash Flow Submitting Cash Flow Forecasts to the Board of Directors and External 42 Parties 4.11 Left Empty Control Processes Shortage of Manpower Inventory Level Policy Entering Changes in the Cash Flow by the Finance Department Understanding the Significance of the Liquid Gas The Methodology of Building the Fuels Cash Flow Left Empty Budget Preparation and Updating Left Empty Suppliers' Cash Flow Calculation Methodology Recommendations Building a Methodical Process for Preparing a Cash Flow The Representative of the Finance and Economics Division Responsible 52 for Control and Command over the Fuels Cash Flow 5.3 Safety Cushion (Cash Balance) Red Lights Mechanism Establishing a Procedure for Submitting the Cash Flow to External 53 Parties 5.6 Building a Versatile and Updateable Model Preparing a Bi-Annual Budget, that is Constantly Updated 53 Interim Report on November 25, Copy 1 of 1 Copies

3 5.8 Supplementing the Manpower Required to Prepare the Cash Flow at the 54 Finance Department and at the Fuels Administration 5.9 Integration of the Finance Department in the Whole Liabilities Creation Process of the Company Examine Subordination of the Fuels Administration to the Finance and 54 Economics Division, as it was in the Past 5.11 Recommendations related to the Fuels Administration: Assimilation of Methodical Reporting Procedures of Division Managers 55 even in Management Meetings Forum 5.13 Basing the Cash Flow on an "Agreed Upon Scenario Base", Approved 55 by the Finance and Economics Division 6. Conclusion 56 Annexes 60 Annex A Appointment Letter Annex B August and September Cash Flows Annex C IEC's Cash Flow Building Process Annex D Information Systems Annex E Description of Chain of Events as Submitted by the Finance Department Annex F Description of Chain of Events as Submitted by the Fuels Administration Annex G List of Interviews Conducted with Position Holders During the Audit Annex H Cash Flow Report in October 1, 2012, Prices Annex I Minutes of the Emergency Meeting Convened on October 2, 2012 Annex J Letter of IEC's Chairman of the Board of Directors to the Ministry of Finance of September 4, 2012 Annex K Audit of the Company's Risks Review Annex L s Correspondence Presented for the First Time by the V.P. Finance and Economics on November 20, 2012 Interim Report on November 25, Copy 1 of 1 Copies

4 1. Background In view of the repeated disruptions in the supply of natural gas from Egypt, which started in February 2011 and a full stop of natural gas supply from Egypt in April 2012, together with the accelerated depletion of the natural gas quantity in Yam Thetis reserve, which resulted in a considerable decrease in the gas quantity supplied from the reserve to Israel Electric Company ("IEC" or "The Company"), the Company was required to revert to use of alternative fuels at a considerably higher cost than the natural gas cost, until natural gas supply from "Tamar" reserve, expected to start in mid 2013 (as estimated by IEC), will begin. The aforementioned transition to the use of alternative fuels, is expressed in 2012 in the addition of billions NIS to the fuels costs, where the total cost with respect to fuels consumption in 2012 is expected to reach the approximate amount of NIS 23 billion, compared to an approximate amount of NIS 12.7 billion in According to the regulation rules, IEC will receive coverage in the electricity rate with respect to the excessive fuels costs, however, the rate coverage will not be expressed immediately. On March 22, , the Public Utilities Authority - Electricity ("The Electricity Authority") decided to increase the rate for covering the excessive fuels costs, which will be spread over several years ( ). Pursuant to this decision, the Company had to bridge the time gaps until the rate coverage will be completed, that required it to receive external support from the related authorities and from the Government, in addition to internal solutions, with respect to all or the majority of the excessive fuels costs. During 2012, IEC conducted an on-going dialog with the Ministry of Finance, aiming to reach an agreed upon cash flow outline solution for the Company. The solution was needed to solve the liquidity problem deriving from the need to finance the excessive costs of buying alternative fuels up to the end of 2012, which, as aforesaid, will be expressed in the Company's rate in The Company estimated that the expected peak of the crisis will be in the summer months, when consumption volume is naturally the highest and the use of liquid fuels for generation to meet the demand is the highest. In response to the Company's application to the Ministry of Finance and in full cooperation with the State, the letter of the General Director of the Ministry of Finance of January 22, 2012 states that "...agree to provide a State guarantee for a public float of negotiable debentures by IEC... the final amount will be determined according to the cumulative effect of the fuels cost on the cash flow of the Company... the amount will be fully linked to the changes in the actual fuels cost up to the float date and also to a change in the fuels mix...". The General Director of the Ministry of Finance even repeated this undertaking of the State in his letter of May 26, 2012, that determines a series of steps that will enable IEC to raise the funds it needs to purchase fuels in this crisis period, including "the State... will provide a guarantee, or other financing solutions to the cumulative cash flow deficit of IEC, deriving from the excessive fuels cost of the Company and according to the cash flow needs deriving from purchasing these fuels". And indeed, the Company completed two floats under a State guarantee during 2012: April 2012: A private placement in the amount of NIS 1.5 billion. July 2012: A public float in the amount of NIS 2.9 billion, based on a prospectus published on June 26, On August 8, , during talks with the Ministry of Finance, the Company presented a cash flow forecast (in view of the expected cash flow gap with respect to 1 See the decision of the Electricity Authority No. 367 of March 22, 2012 (Decision No. 1). 2 Meetings were held at the Ministry of Finance in August 6, 2012 and in August 8, Interim Report on November 25, Copy 1 of 1 Copies

5 the fuels crisis) hereafter "Cash Flow Report Submitted to the Ministry of Finance", according to which additional NIS 2 billion should be raised to solve the cash flow squeeze up to the end of , according to the following division: NIS 1.5 billion with a State guarantee in September 2012 and additional NIS 0.5 billion in November In addition, the parties agreed during these talks on taking several steps, including postponement of payments to the taxes authority, review of the possibility to postpone deposits in the dedicated account of the emergency plan by the Electricity Authority, reduce the Company's fuels inventory level and more. These actions were expressed on a letter received from the General Director of the Ministry of Finance on Thursday, August 16, 2012 and in the statement made by the Finance Department Manager in the meeting of the Board of Directors 4, on August 16, 2012, that based on the solutions of the Ministry of Finance, the Company is expected to end the year 2012 with a safety cushion of about NIS 1 billion. On Thursday, August 23, 2012, IEC's Audit Committee and Board of Directors approves a float, secured by a State guarantee by way of expanding the negotiable debentures series of the Company, registered for trade on the stock exchange in a total amount of NIS 1.5 billion (Electricity 23 NIS 1 billion and Electricity 24, NIS 0.5 billion). This float was completed successfully on Monday, September 3, 2012 and in addition, according to the outline concluded with the Ministry of Finance, the Company is expected to issue another float in the approximate amount of NIS 0.5 billion during November On August 30, 2012, the Company published its financial statements as of June 30, The Interim report of the Company included (within the Board of Directors' report) the required cash flow forecast for the period of the subsequent 24 months after the financial statements date. In conclusion, at the beginning of August 2012, the Finance Department presented the cash flow that was submitted to the Ministry of Finance and in addition, two cash flow forecasts were prepared in the second half of August, as follows: 1. A cash flow for the Board of Directors, presented when the Board of Directors approved the expansion of the debentures series on August 23, 2012 (including a preliminary discussion on August 16, 2012); and 2. A cash flow that was included in the Report of the Board of Directors within the interim financial statement as of June 30, 2012, presented to the Board of Directors on August 30, These two cash flow forecasts (hereafter "August Cash Flow") are materially identical in all matters related to the cash flow gap deriving from the fuels crisis with the cash flow that was submitted to the Ministry of Finance 5. It should be noted and emphasized that the prolonged dialog with the Ministry of Finance and the outline concluded by the parties were based on the cash flow report submitted to the Ministry of Finance and that the concluded outline of the cash flow solution, presented in the letter of the General Director of the Ministry of Finance on Thursday, August 16, 2012, was approved by the Chairman 6 of IEC's Board of Directors in a response letter to the General Director of the Ministry of Finance on Tuesday, September 4, 2012, stating that, "The Company approves that the mentioned steps..., if and insofar as materialized, are s solution to the liquidity 3 Minutes of IEC's Board of Directors Plenum Meeting No. 1385, convened on August 16, Minutes of IEC's Board of Directors Plenum Meeting No. 1385, convened on August 16, It is noted that the cash flow of August 8, 2012 was presented before the solutions outline was concluded with the Ministry of Finance. 6 In view of the said by the V.P. Finance and Economics in the Management meeting on September 2, 2012, who stated that the solutions of the Ministry of Finance are a cash flow solution up to the end of Interim Report on November 25, Copy 1 of 1 Copies

6 problem of the Company, deriving from the need to finance the excessive fuels costs up to the end of All subject to the most updated forecasts for the end of 2012." In the meeting of the expanded Management, headed by the Company's CEO, convened on Sunday, September 23, , the Company's CEO requested the Manager of the Finance Department to submit an updated report on the cash flow, within the review of the "focused view" system's data, aimed at floating "Red Lights". The Manager of the Finance Department updated that a cash flow gap was identified between the August cash flow and the updated cash flow in hand, based on September forecasts (hereafter, "September Cash Flow"). The identified cash flow gap amounted to approximately NIS 1.4 billion, deriving mostly from an increase in the fuels item. According to the CEO, information about this gap was brought to his attention for the first time in this meeting and he immediately instructed the Deputy CEO, the V.P. Finance and Economics and the Manager of the Finance Department to convene meetings to find immediate cash flow solutions and examine the significance of the cash flow gap and of immediate steps that should be taken by the Company 8. According to the guidelines of the CEO, discussions were conducted on September 24, 2012, at which details of the cash flow gap were presented. In a second discussion, conducted on the afternoon of the same day, the Manager of the Finance Department reported that in addition to the cash flow gap deriving from an increase in the fuels item, there is a cash flow gap in the approximate amount of NIS 380 million, deriving from an increase in the suppliers item and that the total gap between the two cash flows is approximately NIS 1.8 billion. According to the guideline of the CEO, it was instructed that despite the gap, no deviation will be made from the development budget, which means a decrease of approximately NIS 140 million in the cash flow of development suppliers for 2012 and decreasing the cash flow gap to approximately NIS 1.64 billion. On September 24, 2012, the Company sent an immediate report to the Securities Authority on the aforesaid gap. In view of the aforesaid, the Chairman of IEC's Board of Director addressed a letter to Mr. Shmuel Gortler (financial adviser to the Board of Directors) on September 24, 2012, requesting that Goren Capital will conduct an audit of the chain of events that led to the aforementioned situation and will present to the Board of Directors the scope of significance of the said situation. Goren Capital was also requested to present the following to the Company's Board of Directors: The extent of the gap between the cash flow forecast as presented to the Board of Directors and approved by it (August Cash Flow) and the updated forecast (September cash flow), and the causes for its creation. Problems and failures in work processes, if any, that created the said gap. Function of the control, command, reporting and warning systems on the creation of such a significant gap, Goren Capital was also requested to examine, together with the Company's Management, the relevant cash flow solutions, including the need to raise more capital in 2012 and the effect on the cash flow in the years and on the capital raising plans for We wish to note that the last task is being constantly performed by Goren Capital's team in cooperation with the Company's Management and is not part of this special audit. 7 Minutes of the expanded Management meeting on September 23, Quoted from the minutes of the expanded Management meeting on September 23, 2012, at the CEO's office. The subject was raised as a question by the CEO. The V.P. Finance and Economics was abroad on the date of the meeting. Interim Report on November 25, Copy 1 of 1 Copies

7 This audit examined the extent of the gap between the cash flow forecasts, as far as it related to the period up to the end of We wish to emphasize that contrary to certain comments voiced by the capital market and the media, the term "cash flow gap" is a gap between forecasts at different dates regarding the forecast future cash flow and is not a financial shortage, loss or waste, in any way. The Audit Process: This work was prepared with the help of a team from Kost Forer, Gabay and Ksirer Office (Ernst & Young). As part of the audit process, the audit team met different parties at the Company who were and are involved in the preparation of the cash flow. In addition Goren Capital gathered materials from different parties in the Company, believed to be necessary to examine the source of the failures and quantify them, most of which from 2012, including: Minutes of discussions related to the preparation of the cash flow for Minutes of Management meetings convened (either as V.P.s forum or an expanded Management forum) during Minutes of Board of Directors and its Committees meetings, including materials presented to Directors in these meetings. Work procedures and definitions of authority. Work papers and internal correspondence, which served as the basis for preparing the different cash flows during August and September, from the professional parties in the Company. Periodic reports published by the Company and other documents. Announcements published by the Company to the investors through the MAGNA system. Internal Audit Draft report and final report prepared by managers in the Company that were made available to us. Written responses to the draft of the interim report submitted by the Company's employees and Managers, who are affected by the findings of the draft, including the attached annexes (the drafts were submitted directly to the secretary of the Company's Board of Directors and some of these were written by attorneys or received legal advise). Comments of the legal advisors of the Company - Herzog, Fox, Neeman office. It is emphasized that the audit process focused on the preparation process of the Company's cash flow and did not include the preparation process of the financial statements or other processes in the Company. However, we wish to note that talks with different position holders in the Company indicated that the preparation process of the financial statements and the preparation process of the Company's budget are separated from the cash flow preparation process in a structured way and according to ordered procedures. Therefore, the findings of the cash flow preparation process audit do not reflect other processes in the Company, including financial statements preparation process or preparation of Company budgets procedure. In addition, at the request of IEC's Board of Directors on November 12, 2012, we examined whether the risks review (hereafter "The Review") of IEC, prepared by Kesselman & Kesselman PwC (hereafter "The Risks Consultant"), submitted to IEC's Board of Directors in January 2011, indicated a possible failure in the reports subject. See details in Annex K below. Interim Report on November 25, Copy 1 of 1 Copies

8 During our audit, we met the following parties: Mr. Eli Glickman, IEC's CEO. Mr. Yaakov Hain, Deputy CEO and V.P. Generation and Transmission. Mr. Harel Blinde, V.P. Finance and Economics. Mr. Shlomi Zarfati, Attorney, IEC's Board of Directors Secretary. Mr. Zecharia Key, Manager, Finance Department. Mr. Ronen Naor, Head of Overseas Payments and Loans Unit at the Treasury Department, Finance Division. Mr. Shimshon Brookman, Manager, Fuels Administration. Ms. Dina Biran, Fuels Agreements Manager, Fuels Administration. Mr. Moshe Gutman, Manager, Technical Services Department, Generation Division. Ms. Lena Nudelman, Technical Services Department, Generation Division. Mr. Israel Movshovich, Manager, Marketing Division. Mr. Moshe Amit, Manager, Economics and Financial and Rate Planning Unit. Ms. Carmel Wolf, EMT. Mr. Moshe Bachman, Manager, Accounting and Economics Division. Ms. Bella Shick, Overseas Agreements and Financing unit, Finance Department. Mr. Amir Livneh, Senior Assistant to IEC's CEO and Head of Structural Change Administration. Ms. Michal Yogev, Assistant to IEC's CEO. On November 1, 2012, as required by the appointment letter, a draft of the interim report was submitted to the Chairman of the Company's Board of Directors and to the Chairman of the Audit Committee of the Board of Directors. Following this meeting, as instructed by the Chairman of the Company's Board of Directors and by the Chairman of the Audit Committee, the main principles of the report were presented on November 4, 2012, in a special discussion of the Audit Committee of the board of Directors. According to the process determined under the guidelines of the Chairman of the Audit Committee and the legal adviser of the Company, the draft of the interim report was forwarded on November 4 and 5, 2012, to Company employees and Mangers who are affected by the findings of the draft (hereafter, "The Audited"). On November 7 and 8, 2012, written responses to the interim draft were received from the Audited, who, as instructed by the Company's legal adviser, were granted the opportunity to meet, without a time limit, with the auditing team and add verbal responses to the audit report draft 9. To ensure the fairest possible process, the Company's Board of Directors postponed the discussion on the draft of the interim report to November 13, 2012, to grant all the Audited a proper opportunity to present their response to the report's draft and also to enable the auditing team to assimilate these responses in the report, at its discretion. On November 13, 2012, an amended draft of the interim report was submitted to the Company's Board of Directors and to the Audited, to receive their response to the amended draft of the interim report. Responses of the Audited (except the response of the V.P. Finance and Economics) were received up to November 17, The Audited were also granted and 9 Additional meetings took place after forwarding the interim report draft to Managers, according to the responses receipt procedure, as determined above by the Company. Legal advisers to the responders participated in some of the meetings. Interim Report on November 25, Copy 1 of 1 Copies

9 opportunity to have a personal meeting with the auditing team to provide clarifications and stress points after reading the amended draft of the interim report. The updated draft was presented on November 20, 2012, to the Audit Committee of the Company's Board of Directors. In this meeting the Audited were granted an opportunity to state their responses to the draft of the interim report before the Audit Committee. In this meeting of the Audit Committee, the V.P. Finance and Economics submitted his response to the draft of the interim report, which was also then forwarded to the auditing team. Today, November 25, 2012, the interim report of the auditing team is submitted, subject to the guidelines of the Board of Directors. The interim report will be completed and signed immediately, in accordance with the guidelines of the Company's Board of Directors. Completion of the interim report into a final report will be performed according to additional processes, if needed, in accordance with the guidelines of the Company's Board of Directors. Structure of the Report This report includes a review of the following subjects: Chapter 2: Analysis of the Gaps between the Cash Flows This chapter describes the chain of events and also analyses the cash flows gaps and causes for the creation of these gaps. The cash flows that were used as reference points for comparison are: a. August Cash Flow. b. The cash flow presented to the Company's Management in its meetings of September 23, and 24, 2012 and to the Chairman of IEC's Board of Directors on October 2, 2012 ("September Cash Flow"). The cash flows used as reference points are attached as Annex B to this document. 10 Chapter 3: Background Information This chapter reviews subjects we deemed fit to be addressed in this audit, which are not faults in the cash flow preparation process, but reference to them is important for understanding the background and the processes in the Company. Chapter 4: Analysis of the Faults found by the Audit Process Chapter 5: Recommendations Chapter 6: Conclusion 10 According to the appointment letter and the legal interpretation of the Company's legal advisers to the aforesaid, cash flows before August that were included in the Company's prospectus or previous periodic reports were not audited. Interim Report on November 25, Copy 1 of 1 Copies

10 2. Analysis of Gaps between Cash Flows 2.1 Chain of Events Description The following chain of events arises from the numerous meetings we conducted over the last few weeks with different position holders in IEC who were entrusted with the preparation of cash flows forecasts and also from all the materials presented to us: Sunday, August 5, 2012 A cash flow committee meeting is held 11 to discuss the work assumptions to be used as the basis for building the cash flow for August. In preparation for a meeting with the Ministry of Finance, set for August 6, 2012, the Finance Department addresses a request to the Fuels Administration to forward an updated cash flow forecast for 2012, urgently. Monday, August 6, 2012 At the request of the Finance Department of August 5, 2012, the Fuels cash flow is forwarded by the Fuels Administration. In this context, we wish to note several points: a. Forecast quantities of fuels used for generation forwarded by the technical services department at the generation division, which served as the basis for preparing the fuels cash flow by the Fuels Administration related to generation without liquid gas (LNG). b. Despite the aforesaid in section a) above, and in view of the recognized expected obligation of the Company to purchase two LNG deliveries in November and December (although at that date, the agreement for purchasing the LNG was not yet entered and rate recognition was not yet received from the Electricity Authority), the Fuels Administration added to the fuels expenses flow for 2012, payment for two deliveries of LNG in the approximate amount of NIS 400 million, although the assumption of the Fuels Administration was that these two deliveries will not be used for generation. It should be emphasized that this assumption was not specifically included in the cash flow submitted by the Fuels Administration. c. Pursuant to the excessive consumption of diesel oil (in the approximate amount of 75,000 ton) consumed during July due to the failure in the coal operated Orot Rabin power station and also due to the increased demand compared to the forecast (by about 10%), the diesel oil stock as of August 1, 2012, amounted to approximately 220,000 ton. At that time, to the best of 11 The cash flow committee coordinates between the basic assumptions which the different parties in the Company use as the basis for building cash flows that are forwarded to the treasury department. The cash flow committee acts without an official appointment letter and is expected to meet once a month - the Company's cash flow preparation frequency. The committee meets at the beginning of the month, on random dates and its discussions are not documented. In practice, the committee is headed (without a formal appointment) by the head of the Overseas Payments and Loans unit, at the treasury department, who actually builds the cash flow of the Company. The Committee includes parties from different divisions and units, including: treasury department, financing and financial management department and the economics and financial and rate planning unit, all from the Finance and Economics Division, as well as the Fuels and Technical Services manager at the generation department from the generation and transmission division, The role of the committee is to recommend to the manager of the finance department what should the fuels cash flow assumptions be, while coordinating both the expenses side and the income side, which will be the bases for building the cash flow. After receiving the approval of the assumptions from the finance department manager, the head of the Overseas Payments and Loans unit, at the treasury department, who heads the committee, distributes the details of the said assumptions to the committee members. 12 See section 2 in the memorandum from the Finance Department "Chain of Events - Preparations of cash flows August and September 2012" forwarded by the Finance Department (attached as Annex E to this document). Interim Report on November 25, Copy 1 of 1 Copies

11 our understanding, the level of the Company's inventory policy was 300,000 ton. Nevertheless, the cash flow submitted by the fuels administration did not express, by mistake, increased diesel oil purchases in September and October, in the approximate amount of NIS 380 million, to supplement the excessive consumption in July 2012 and meet the inventory target of 300,000 ton. Namely, the cash flow submitted by the Fuels Administration to the Finance Department was based during the whole forecast period on a diesel oil inventory of 220,000 on. Following the receipt of the fuels forecast from the Fuels Administration and pursuant to the instruction of the V.P. Finance and Economics (as used in up to that date), that from a conservative point of view, the cash flow should assume use of LNG from January 2013 only 14, and assume instead consumption of diesel oil for generation during 2012, the Finance Department personnel deleted the expense related to purchasing LNG in the approximate amount of NIS 400 million ($ 50 million in each of the months November and December 2012). In this context, we note that this instruction of the V.P. Finance and Economics was issued in view of the prevalent understanding (conservative, in his opinion 15 ) in the Finance Department that the LNG cost is cheaper (although not significantly) than diesel oil cost 16. The Finance Department prepared a cash flow, using the amended fuels cash flow. Wednesday, August 8, 2012 A meeting is convened at the Ministry of Finance to conclude a cash flow solution for IEC, where the presented cash flow for 2012 is based on data forwarded on August 6, 2012, which included the error of failure to update the fuels purchase by the approximate amount of NIS 380 million, deriving from the excessive consumption in July and the change entered by the Finance Department in the data of the Fuels Administration, namely, deleting the LNG purchase in the approximate amount of NIS 400 million. During the discussions, and as part of suggested solutions, the Company's CEO undertook to examine the possibility that IEC will participate in the cash flow burden in the coming months by reducing inventory quantities in the amount of NIS 200 million (before V.A.T.), namely, a decrease of NIS 230 million (including V.A.T.) in relation to fuels expenses included in the cash flow presented to the Ministry of Finance Reviews of several cash flows before the August cash flow found that the assumptions of the Finance and Economics Division were that LNG purchases will be included in the cash flow from January Although an already sent to him from the Manager of the fuels administration on August 1, 2012, updated that the Company is expected to purchase two deliveries of LNG in This contradicts the said in section 11 to the response of the V.P. Finance and Economics to the draft of the interim report, which stated that "the gap deriving from the entry of LNG... derives from reasons stemming mainly from changes that occurred during September, which were not known to the Company... during August." 15 Minutes of the plenum meeting of IEC's Board of Directors No. 1385, convened on August 16, See section 1 in the memorandum from the Finance Department "Chain of Events - Preparations of cash flows August and September 2012" forwarded by the Finance Department (attached as Annex E to this document). 17 Out of the letter of the General Director of the Ministry of Finance to the Chairman of IEC's Board of Directors: "the Company will act to the best of its ability to place additional financing sources within the current operation of the Company, including reduction of the fuels inventory quantity in a manner that will not affect the needs of the economy from operational and security aspects...". At the meeting of the expanded Management on August 26, 2012, the CEO noted the Company's commitment to decrease the fuels inventory by NIS 200 million; in meetings held with the Company's CEO on October 25, 2012 and on October 28, 2012, the CEO clarified that immediately after closing the meeting in the Ministry of Finance, he instructed the V.P. Generation and Transmission to discuss the issue with the Ministry of Infrastructures and obtain its approval to the said decrease of inventories, since he maintained that the Ministry of Infrastructures holds the sole authority to decrease inventories. The CEO stated that this approval for the decrease was not received as yet and Interim Report on November 25, Copy 1 of 1 Copies

12 In the afternoon of that day, after the meeting with the staff of the Finance Ministry ended and without any relation to this meeting, two messages are sent from the Manager of the Fuels Administration to the V.P. Finance of Economics (these are copies of two messages sent from the Manager of the Fuels Administration to the Deputy CEO and to the V.P. Generation and transmission on August 7, 2012 and on August 8, 2012, respectively). The first 18, of 19:02, in response to the request of the Deputy CEO and the V.P. Generation and Transmission, addressed to the Manager of the Fuels Administration, to check what is the cash flow saving when the diesel oil inventory level will decrease to ton, the Manager of the Fuels Administration replied that: "Our work assumption was a "closing" inventory of 330,000 ton diesel oil at the end of the year". "When wishing to deduct NIS 200 million from the cash flow, approximately 50,000 ton diesel oil should be deducted from the closing inventory, namely, an inventory of less than 280,000 ton". However, the second 19, of 19:03, states that: "At present, the cash flow assumes a purchase of 158,000 ton for September, according to the forecast, without correction to meet inventory objectives." "On the face of it and before checking, the cash flow may increase in view of the actual consumption in July (consumption of 340,000 ton compared to a forecast of only 265,000 ton and the updated consumption we will estimate for August) to meet an inventory target of 280,000 ton at the end of September." We wish to note that these two messages were not clear and unequivocal and phrased, in our opinion, in a vague manner. We believe that it was impossible to understand from them what was the actual diesel oil inventory level when the fuels cash flow was submitted by the Fuels Administration to the Finance Department on August 6, 2012 and it was certainly impossible to understand clearly that the diesel oil level on the e- mails exchange dates was 218,000 ton Although he knew the importance of the cash flow implications of the error in the inventory, in view of the meeting at the Ministry of Finance, the Manager of the Fuels Administration did not take any active action to update, therefore, the understanding of the finance functionaries to decrease the fuels inventory by NIS 200 million is incorrect. The Generation and Transmission Division claims, that a verbal instruction was given to deduct the NIS 200 million. See more details in 4.19 below. 18 We note that the audit team learned about this for the first time only at the meeting of the Board of Directors' Audit Committee, convened on November 20, See section 3.1 in the Fuel Administration's memorandum "Chain of Events - Preparations of cash flows August and September 2012" forwarded by the Fuels Administration (attached as Annex F to this document). 20 The response of the Manager of the Fuels Administration on November 18, 2012 (section 2), claims that the said e- mail message is absolutely clear. In addition, as stated for the first time in section 6 of this response, this message was accompanied by a telephone conversation between him and the V.P. Finance and Economics, in which he clarified the error that was made, the reviews that the Fuels Administration intends to conduct and the expectation that the cash flow will increase to meet the inventory requirements. In his response to a query forwarded to him by the auditing team on the subject, on November 22, 2012, the V.P. Finance and Economics said that "I do not remember such a conversation (just as I did not remember the existence of the said s as well). In any case, if the telephone call did take place, I clearly did not understand from it that there is a material problem in the inventory that is included in the cash flow, as proven by the fact that I did not take any special action on the subject". 21 The response of the V.P. Finance and Economics of November 20, 2012, relating to the two aforementioned messages in section 46c, claimed that "from reading this , together with the subsequent and unclear (in the opinion of the draft's writer as well), it could be deduced that the cash flow includes a closing inventory of 330,000 ton. It certainly was not clear from these messages that the closing inventory in the cash flow is 218,000 ton (!)". Interim Report on November 25, Copy 1 of 1 Copies

13 immediately and clearly, the authorized parties on the error. Namely, just after the cash flow was presented to the Ministry of Finance and concluding an outline for a cash flow solution and on the same day, or on the following day, it was known, at least to the Deputy CEO and the V.P. Generation and also to the Manager of the Fuels Administration, that there is an error in the inventory data used as the basis for the cash flow that was submitted to the Ministry of Finance, but the information about this error was not forwarded clearly. In addition, a request from the Finance Department to the Fuels Administration on August 8, 2012, intended to examine the way to express what was understood as the CEO's instruction 22 to decrease the fuels inventory by NIS 230 million, is answered by an from the Fuels Administration to the Finance Department on August 8, 2012, stating 23, that "NIS 200 million will not be deducted in September, but during September - October", namely, the Fuels Administration does not issue an immediate warning to the Finance Department about the error in the inventory numbers in the cash flow, nor warns that a deduction of NIS 230 million from the fuels cash flow will position IEC at an inventory level that is well below the operational guidelines of the Company 24. In addition, on the same day, following the cash flow committee meeting on August 5, 2012, guidelines related to the preparation of the cash flow are sent to the different departments, where as we were told by the Finance Department, it is clear to everyone, that the supply of LNG will only begin in January Tuesday, August 14, 2012 Due to the need to present an updated cash flow to the Board of Directors, the Fuels Administration prepared a fuels cash flow, based on the generation forecasts that served as the basis for preparing the cash flow on August 6, The cash flow submitted by the Fuels Administration in August 14, 2012 is not identical to the cash flow submitted in August 6, 2012, which served as the basis for the cash flow that was presented to the Ministry of Finance. The differences between these cash flows are as follows: a. The Fuels Administration deleted from the fuels cash flow, expenses related to payments for two deliveries of liquid gas in the approximate amount of NIS 400 million ($ 50 million in each of the months November and December 2012) according to a verbal instruction received from the Finance Department. However, we cannot understand how the Fuels Administration agreed to deduct such a material sum, despite knowing that the Company will be billed for both deliveries in The Fuels Administration also erred by deleting the expense without verifying that it was transferred to the beginning of See Section See section 7 in the memorandum of the Finance Department "Chain of Events - Preparations of cash flows August and September 2012" forwarded by the Finance Department (attached as Annex E to this document). 24 We wish to note that the Manager of the Fuels Administration claimed in his response on November 18, 2012 (section 8), that this message was sent before the error in the inventory numbers in the cash flow was found. We note farther, that this contradicts the statement of the Agreements Manager in the Fuels Administration during our meeting with her on November 11, 2012, see section 31 in Annex G. 25 Section 2 in the memorandum from the Finance Department "Chain of Events - Preparations of cash flows August and September 2012" forwarded by the Finance Department (attached as Annex E to this document). 26 As mentioned, section 10 to the second response of the Manager of the Fuels Administration on November 18, 2012, states that: "There is no error in failing to record at the beginning of 2013, since the cash flow reflects more than 10 deliveries during [if] a smaller number of deliveries will be purchased, the total number of deliveries Interim Report on November 25, Copy 1 of 1 Copies

14 b. In view of the error in the cash flow that was forwarded on August , deriving from failure to take into account fuels purchase due to the excessive consumption of liquid fuels in July 2012, the expense with respect to diesel oil in 2012 by adding a purchase of additional 32,000 ton (approximately NIS 166 million) to meet an inventory target of 250,000 ton of diesel oil (the inventory reflected from understanding the instruction of the CEO to deduct NIS 230 million from the inventory). Namely, instead of decreasing the fuels expenses by NIS 230 million (that would have reflected a decrease in the diesel oil inventory from 300,000 ton to 250,000 ton), the Fuels Administration increased the fuels expenses by approximately NIS 150 million (which reflect an increase from a diesel oil inventory level of 220,000 ton to a level of 250,000 ton). After receiving the fuels cash flow from the Fuels Administration and identifying an increase in fuels expenses, contrary to the expectation that the fuels expenses will decrease according to understanding the CEO's guideline to decrease the inventory level by NIS 230 million, the Manager of the Finance Department decided 27, without a thorough examination, to decrease the fuels expenses in a total amount of NIS 380 million (NIS 150 million with respect to the increase, added by the Fuels administration from 220,000 to 250,000 ton and another NIS 230 million expected to be deducted according to the way he understood the CEO's instruction. This correction reverted the diesel oil purchase to its level in the cash flow submitted by the Fuels Administration on August 6, Thursday, August 16, 2012 Receipt of the letter from the General Director of the Ministry of Finance on the subject of the solution outline for the cash flow of IEC for 2012, indicating that "The Company will act to the best of its ability to provide additional financing sources under the current operation of the Company, including decreasing the fuels inventory quantity in a manner that will not affect the needs of the economy from operational and security aspects..." In the meeting of the Board of Directors 28, to which the cash flow is presented, the Manager of the Finance Department reports that "with the solutions of the in 2013 does not change". We did not relate to this point, since it is not within our work scope, referring cash flow gaps up to the end of Upon receiving the fuels cash flow from the Fuels Administration, the Manager of the Finance Department claims (as quoted from his response to the draft of the interim report of November 8, 2012, sections 48-50) that he conducted an immediate clarification with the Fuels administration, attempting to understand the reason for the increase in the fuels expenses, contrary to the expectations of the Finance Department that the Fuels Administration will decrease the fuels purchase for 2012 by approximately NIS 230 million, according to the CEO, instruction. Since it was not clarified to him, as he claims, in this conversation that the inventory level in the cash flow of August 6, 2012, was an error, he deducted unilaterally the purchase of the additional diesel oil (32,000 ton and an amount of NIS 166 million) and in addition, deducted NIS 230 million from the total sum of the fuels cash flow. Namely, a total deduction of approximately NIS 396 million. We wish to note that in a conversation conducted on November 11, 2012, with the Manager of the Fuels Administration, he denied the existence of this conversation of clarification and the personnel of the Fuels Administration claims that the fact of deducting the purchase of 32,000 ton of diesel oil and the deduction of NIS 230 million from the total fuels cash flow was brought to his attention only when he received a request from the Finance Department to explain the difference between the September Cash Flow to the August Cash Flow (on September 14, 2012). We also wish to note that lack of communication between the Finance Division and Department and the Fuels Administration was mentioned by the V.P. Finance and Economics in meeting No of the Board of Directors on August 23, 2012: "Last evening we found that there are quite considerable sums which we can not fully explain in the field of expenses with respect to fuels... I would say as an understatement, that this is indeed a very disturbing subject for us. We need to study this subject thoroughly. See what happened and also improve our controls in future over the results of the reports". 28 Minutes of IEC's Board of Directors Plenum Meeting No. 1385, convened on August 16, Interim Report on November 25, Copy 1 of 1 Copies

15 Ministry of Finance as concluded now, we are getting through the year nicely and will end it with a safety cushion of about NIS 1 billion". Thursday, August 23, 2012 An updated cash flow is submitted and presented to the Company's Board of Directors, which is similar in essence to the cash flow presented to the Ministry of Finance on August 8, Based on the cash flow presented to it, the Board of Directors approves the expansion of the debentures series in a total amount of NIS 1.5 billion. A budget, financial management and risks management meeting No. 15 of the Board of Directors is held, where Mr. Moshe Bachman presents the updated budget for Thursday, August 30, 2012 Pursuant to receiving the approval of the Company's Board of Directors, the Company publishes its interim financial statements as of June 30, 2012, that includes in the Board of Directors' report, a forecast cash flow for a period of 24 months from the report's date. This forecast cash flow report practically conforms with the report presented to the Board of Directors on August 23, In the same meeting of the Board of Directors, the Manager of the Accounting and Economics Department presents the updated budget for This budget update is approved by the Board of Directors. In addition, the guarantee at the basis of the agreement to purchase 10 deliveries of LNG, of which two deliveries during November - December is signed on that date. Sunday, September 2, 2012 A management meeting in the V.P. rank is convened, in which the V.P. Finance and Economics reports that September floats (NIS 1.5 billion) and November (NIS 0.5 billion), secured by a State guarantee "will solve the cash flow problems up to the end of the year" 30. Tuesday, September 4, 2012 Based on the report of the Finance and Economics Division and at the request of the Ministry of Finance, the Chairman of IEC's Board of Directors sends a letter to the General Director of the Ministry of Finance 31 in which "the Company confirms that the said steps..., if and insofar as will materialize, are a solution to the liquidity problem of the Company, deriving from the need to finance the excessive fuels costs up to the end of 2012, subject to the most updated forecasts for the end of 2012." Thursday, September 6, 2012 The cash flow committee convenes and during the discussion, questions are raised regarding the effect of the LNG on the quantities of liquid fuels used for generation. It is decidinged to check which scenario is more conservative. Sunday, September 9, 2012 The Finance Department sends updated guidelines for the September cash flow through the to members of the cash flow committee, including, among others, an assumption regarding the delivery of LNG from December Thursday, September 13, The purchase agreement was signed on September 14, Quote from the minutes of the Management meeting at the V.P. rank, convened on September 2, See the letter of the Chairman of IEC's Board of Directors to the General Director of the Ministry of Finance of September 4, 2012, in Annex J. Interim Report on November 25, Copy 1 of 1 Copies

16 According to the guidelines of the Finance Department for preparing the September cash flow, the Fuels Administration sends an updated fuels cash flow, based on September 1, 2012 prices, indicating that the gap in the amount of the fuels expenses flow for August up to December is approximately NIS 1 billion (compared to the fuels cash flow sent by the Fuels Administration on August 14, 2012). The main changes assimilated by the Fuels Administration in the September cash flow are: a. The purchase of two LNG deliveries in 2012 (in November and December 2012), where the delivery of November is not used for generation and the December delivery is used for generation and replaces fluid fuels. b. Update the fuels basket for December pursuant to the said in section a above. c. Updated fuels prices, exchange rate and V.A.T. rate. d. Updated payments spreading arrangement with Yam Thetis, enabling IEC to pay its debt in the amount of $ 43 million in three payments of $ 14 million each in the months September, October and November. e. According to their understanding of the CEO's instruction and in preparedness for the winter months, the diesel oil inventory was gradually increased to a level of 280,000 ton up to December, namely, an addition of 30,000 ton compared to the cash flow submitted by the Fuels Administration in August, when the inventory target was 250,000 ton. In addition, pursuant to the approval of the budget for 2012, approved by the Company's Board of Directors on August 30, 2012, the overseas agreements and financing unit, entrusted with the suppliers cash flow, forwards an updated suppliers cash flow, containing an update in the approximate amount of NIS 380 million, compared to the August cash flow, deriving mainly from updating the operation budget for 2012 and from the calculation mode and actual costs allocation to the development budget and to the operation budget. Sunday, September 23, 2012 and Monday, September 24, 2012 In the meeting of the expanded Management meeting, the Company's CEO requested the Manager of the Finance Department to submit an updated report on the cash flow, within the review of the "focused view" system's data, aimed at floating "Red Lights". The Manager of the Finance Department updated that a cash flow gap was identified between the cash flow that was approved by the Company's Board of Directors on August 30, 2012 (which is materially identical to the cash flow that was submitted to the Ministry of Finance) and the updated cash flow in hand, based on September forecasts. The identified cash flow gap amounted to approximately NIS 1.4 billion, deriving mostly from an increase in the fuels item. According to the CEO, information about this gap was brought to his attention for the first time in this meeting and he immediately instructed the Deputy CEO, the V.P. Finance and Economics and the Manager of the Finance Committee to convene meetings to find immediate cash flow solutions and examine the significance of the cash flow gap and of immediate steps that should be taken by the Company 32. According to the guidelines of the CEO, discussions were conducted on September 24, 2012, at which details of the cash flow gap were presented. In a second discussion, conducted on the same day, the Manager of the Finance 32 Quoted from the minutes of the expanded Management meeting on September 23, 2012, at the CEO's office. The V.P. Finance and Economics was abroad on the date of the meeting. Interim Report on November 25, Copy 1 of 1 Copies