TRANSNET PETROLEUM PIPELINES TARIFF APPLICATION FOR THE YEAR 2011/12 (01 APRIL 2011 TO 31 MARCH 2012)

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1 TRANSNET PETROLEUM PIPELINES TARIFF APPLICATION FOR THE YEAR 2011/12 (01 APRIL 2011 TO 31 MARCH 2012)

2 Table of Contents 1 Executive Summary Background Approach Regulatory Asset Base ( RAB ) Property, Plant Vehicles & Equipment (V) Indexation Useful Lives Assets to be decommissioned Assets brought into use in the tariff application period under review Summary of asset values Borrowing costs Net working capital (w) Deferred Tax (dtax) Weighted Average Cost of Capital (WACC) Cost of Equity Risk free rate Tax adjustment Formula for converting nominal yields to real yields Compounded vs. un-compounded Annualisation Overall estimate Market risk premium Beta Definition of debt The calculation of beta Real cost of equity calculation Comparison with NERSA s decision on piped gas Comparison with NERSA s decision on electricity Cost of Debt WACC Expenses Labour... 31

3 6.2 Materials and Supplies Outside Services - Professional Fees Fuel Insurance Decommissioning Provision Transnet Corporate Overheads Other Miscellaneous Expenses Electricity Repairs and Maintenance Security Other Costs Income Taxation Depreciation F-Factor Clawback Allowable Revenue Calculation Volumes Conclusion Annexures... 40

4 List of Tables Table 1: Allowable Revenue... 6 Table 2: Assumption Variables... 7 Table 3: Fixed Asset Additions Table 4: Asset Schedule Trended Original Cost Table 5: Working Capital Table 6: Deferred Tax Table 7: Deferred Tax Reconciliation to balance Sheet Table 8: Beta Table 9: Real cost of equity Table 10: Comparison of cost of equity Table 11: Key cost of capital parameters given by NERSA in the electricity decision Table 12: TPL Regulated Petroleum Expense Summary Table 13: Corporate Cost Table 14: Depreciation Table 15: Clawback Table 16: Allowable Revenue Table 17: Volume data... Error! Bookmark not defined.

5 1 Executive Summary Transnet Limited ( Transnet ) submits its 2011/12 petroleum pipeline system tariff application in terms of section 4(f) of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) ( PPA ). This tariff application has been guided by the National Energy Regulator of South Africa s ( NERSA ) Tariff Methodology for Petroleum Pipelines Industry as amended on or about 26 November 2009 ( the methodology ). Furthermore, Transnet has endeavoured to meet NERSA s draft Minimum Information Required for Tariff Applications ( draft MIRTA ). Consequently, projected financial statements for the ring-fenced Petroleum Pipelines for the periods 2009/10 to 2015/16 have been provided. Refer Annexure A for income statement, balance sheet and cash flow statements. This application has been prepared on the basis of the Durban to Johannesburg Pipeline ( DJP ) being down-rated for twelve months of the tariff period in question and the New Multi-Product Pipeline ( NMPP ) (the 24 inch trunk line) being in operation for 3 months of the tariff period. In arriving at the 2011/12 Allowable Revenue ( AR ), Transnet has adhered to the PPA, the Regulations made thereunder and the methodology, save for some deviations from the methodology in the calculation of the cost of equity (Ke). Transnet s approach is supported by literature, international best practice and sound rationale. Further Transnet attaches opinions from Frontier Economics and KPMG in support of this deviation. Refer Annexures B and C. In arriving at the Regulatory Asset Based ( RAB ) for the application, Transnet has used as its base the 2006 Starting RAB ( SRAB ) as set by NERSA. Transnet has requested that any clawback pertaining to the SRAB be effected in the 2012/13 tariff application as the full impact of the 24 inch pipeline will be reflected in the RAB in that year. Transnet has further deducted a proportion (a quarter) of the cumulative levy that would have been received by the end of the 2011/12 year, consistent with the period for which the 24 inch pipeline is projected to be in operation (3 of 12 months). Transnet anticipates bringing its 24 inch pipeline into operation on 1 January 2012 and this has consequently been included into the RAB for a period of 3 months. The cost at which the 24 inch pipeline has been included in the RAB represents the best estimate at the time of this application. Transnet is currently performing an extensive exercise to determine the revised cost of the NMPP project based on the revised construction schedule. Transnet anticipates that a final, approved 5

6 cost will be available at the end of November 2010 and will accordingly communicate to NERSA any material deviation to the costs that affect the 2011/12 application. That is, the cost of the 16 inch pipelines which affect the 2010/11 clawback and the 24 inch pipeline capitalisation which affects the return and depreciation for 2011/12. The AR base on the above is reflected in the table below. Table 1: Allowable Revenue Allowable Revenue Summary 2009/ / / /13 RFD RFD App FC WACC Return on RAB ,226.5 Expenses Depreciation Clawback 65.6 (64.9) (121.6) 0.0 F-factor (35.0) Profit before Tax 1, , , ,426.1 Notional Tax Allowable Revenue 1, , , ,917.0 Transnet files for an AR of R2, million ( base revenue requirement ) for the 2011/12 financial year, a 69% increase in revenue from the 2010/11 AR of R1 224 million as set by NERSA, predominantly as a result of the introduction of the 24 inch pipeline into the RAB for 3 months of the financial year and differences in the calculation of the cost of equity between NERSA and Transnet. Over and above this base revenue requirement, Transnet requests, in accordance with paragraph 9.2 of the methodology, that NERSA considers for this application, an addition to revenue to meet debt obligations ( F-Factor ), for assets in operation and to be in operation during the 2011/12 financial year. The requirements for the F-Factor are dealt with in section 9 of this application. 6

7 The application is derived from the following variables: Table 2: Assumption Variables Assumption Variables 2009/10 Act 2010/11 LE 2011/12 App 2012/13 FC Inflation (CPI) (%) 5.1% 5.5% 5.8% 5.5% Nominal Cost of Debt (Kd) 10.43% 10.89% 10.64% 10.64% Post Tax Real Cost of Debt (Kd) 2.27% 2.41% 1.76% 2.05% Real Cost of Equity (Ke) 5.43% 5.38% 9.91% 13.87% Real WACC (%) 4.67% 4.43% 6.73% 6.54% Average Gearing (%) 30.0% 30.0% 39.0% 62.0% Volumes (bn Litres) Volume Growth (%) -0.3% 4.2% -1.7% 8.7% The determination of the above variables and economic parameters will be discussed in more detail under the relevant sections of the application. 7

8 2 Background Transnet Pipelines ( TPL ) is the pipeline operating division of Transnet. TPL owns, maintains and operates a pipeline system of approximately 3000 km of high pressure petroleum and gas pipelines, which conveys bulk liquid petroleum products and methane-rich gas that traverses the provinces of Kwazulu-Natal, Free State, North West, Mpumalanga and Gauteng. TPL at present transports more than 17.5 billion litres of petroleum products annually. TPL currently fulfils a strategic role in the South African logistical fuel supply chain by ensuring that security of supply to the Inland Market is safeguarded. This is achieved through the optimal utilisation of the pipeline system. Long term projected demand for pipeline capacity has necessitated the construction of the NMPP Project. TPL received a licence from NERSA to construct the necessary infrastructure in the NMPP project on 20 December The infrastructure that is presently being constructed as part of the NMPP project comprises: A 24 inch trunkline from Durban to Jameson Park; A 16 inch pipeline from Jameson Park to Alrode; A 16 inch pipeline from Alrode to Langlaagte; A 16 inch pipeline from Kendal to Waltloo; A coastal pipeline accumulator facility in Durban (Island View); and An inland pipeline accumulator facility at Jameson Park. In line with the revised NMPP construction schedule communicated to NERSA on 02 August 2010, the DJP has to operate at full capacity for a further 9 months transporting all refined products. aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa 8

9 aaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaaa aaaaaaaaaa 3 Approach The building blocks of the methodology are reflected in the following formula 1 : Allowable Revenue = (RAB x WACC) +E +T + D + F ± C Where: RAB = Regulatory Asset Base WACC = Weighted average cost of capital E T D F C = Expenses: operating and maintenance expenses for the tariff period under review = Tax: estimated tax expense for the tariff period under review = Depreciation: the charge for the tariff period under review = Approved revenue addition to meet debt obligations for the tariff period under review = Clawback adjustment (to correct for differences between actuals and forecasts in formula elements as well as efficiency gains and volume differences) from a preceding tariff period in relation to the latest estimates for that tariff period The formula allows for the calculation of an AR for the ring-fenced petroleum operating division. As a result, TPL s storage facility, gas transmission pipelines and non-regulated business areas of TPL have been excluded. Shared non-pipeline assets ( NPAs ) have been allocated to petroleum pipelines on the basis of petroleum pipelines direct gross asset value ( GAV ) as a proportion of the total GAV. 2 1 Refer section 3.2 of the methodology. 2 The method of allocation is per NERSA approved Regulatory Reporting Manuals ( RRMs ). 9

10 4 Regulatory Asset Base ( RAB ) In terms of the methodology, the value of the RAB is the inflation-adjusted historical cost or trended original cost ( TOC ) of property, plant, vehicles and equipment less the accumulated depreciation for the period under consideration plus net working capital and adjusted for deferred tax. The formula for the RAB is as follows: RAB = V d + w ± dtax 3 Where: V D w = Value of property, plant, vehicles and equipment = accumulated depreciation up to the commencement of the tariff period under review = net working capital dtax = deferred tax 4.1 Property, Plant Vehicles & Equipment (V) Property, plant, vehicles and equipment are valued on the TOC basis using the consumer price index ( CPI ) as the inflation measure. Property, plant, vehicles and equipment expected to become used during the forthcoming tariff period have been admitted to the RAB in proportion to the share of the tariff period under review in which they will be used. Pipeline assets have been allocated directly to pipelines and a portion of the NPAs has been allocated in proportion to petroleum pipelines GAV to the total GAV. All assets have also been restated to reflect the values in the PricewaterhouseCoopers ( PwC ) calculation i.e. the SRAB, 2008/09 and 2009/10 (corrected for inflation and depreciation) RABs. The total SRAB set by NERSA is aaaaaaaa NBV as at 31 March 2006 for all regulated assets, of which R2,497m comprises petroleum pipeline assets. 3 In accordance with the NERSA demonstration worksheet made available on 3 November 2009, the RAB values are based on the opening values, plus the write-up for the year and any pro-rata additions, adjusted by the opening value of the deferred tax balance. 10

11 4.1.1 Indexation The historical consumer price index ( CPI ) data has been obtained from Statistics South Africa for the period up to March Thereafter, projections have been obtained from the Bureau for Economic Research ( BER ). The annual average CPI of 5.8% has been applied to the net book value of all assets included in property, plant vehicles and equipment for the 2011/12 tariff application. Assets with zero book value have not been indexed Useful Lives The useful lives of pipeline assets are aligned with the last full valuation conducted by Arthur D. Little ( ADL ) in March Assets to be decommissioned In line with section 27 of the PPA and Regulation 9.4, Transnet has to provide security in respect of its rehabilitation obligations. Transnet has therefore included the full value of its estimated rehabilitation obligation in this application. This amounts to R111.4 million for petroleum pipelines. (Refer to section 6.6). Consequently the assets to be decommissioned have not been included in the RAB. All future adjustments to the provision (and hence the security) will be treated accordingly Assets brought into use in the tariff application period under review Table 3: Fixed Asset Additions 2009/ / / /11 LE Fixed Asset Additions Act App FC Trended Cost , , Petroleum Pipelines , , NPAs

12 Assets valued at R43.4 million were capitalised to refined pipelines during 2009/10. As indicated in the previous tariff application, the 16 inch pipelines being constructed as part of the NMPP project are expected to be capitalised during the 2010/11 financial year. These pipelines are scheduled for capitalisation on 1 January 2011 at a cost of aaaaaa million. The 24 inch pipeline is scheduled to be completed at the end of December The cost at which this pipeline has been admitted to property, plant, vehicles and equipment is aaaaaa million. The 24 inch pipeline assets have been included in the RAB on a pro-rata basis i.e. 3 months only. Transnet is currently performing an exercise to determine the revised cost of the NMPP project based on the revised construction schedule. The amount included in the application is the best estimate at the time of application. Transnet anticipates that a final approved cost will be available at the end of November 2010 and will accordingly communicate any material deviation to the costs that affect the 2011/12 application. That is, the cost of the 16 inch pipelines which affects the 2010/11 clawback and the 24 inch pipeline capitalisation which affects the return and depreciation for 2011/ Summary of asset values The summary of the asset values is shown in the table below: Table 4: Asset Schedule Trended Original Cost 2009/ / / /11 LE Fixed Asset Summary Act App FC Trended Cost 5, , , ,145.8 Petroleum Pipelines 4, , , ,387.5 NPAs Accumulated Depreciation 2, , , ,356.1 Petroleum Pipelines 2, , , ,166.7 NPAs Revalued NBV 3, , , ,789.7 Petroleum Pipelines 2, , , ,220.8 NPAs

13 Assets from 2010/11 onwards (i.e. including 2010/11), have been restated at the PwC values and trended in accordance with the NERSA asset methodology using annual CPI projections and in terms of NERSA s demonstration model related to the methodology. A detailed breakdown of assets into the various petroleum subsystems of refined, crude and avtur are attached in Annexure D. 4.2 Borrowing costs Borrowing costs have been calculated as being the product of average capital expenditure and the nominal weighted average cost of capital ( WACC ). This is in accordance with the Regulatory Reporting Manual ( RRM ). Borrowing costs relating to the capitalisation of the 24 inch pipeline has been included into the RAB on a pro-rata basis i.e. 3 months of the tariff application period. 4.3 Net working capital (w) Net working capital is included in the RAB and is calculated according to the formula provided in the methodology which is as follows: Net working capital = inventory + receivables + operating cash + minimum cash balance trade payables 4 The components are recognised as follows: Inventory is stated at the lower of cost and estimated net realisable value. Net realisable value represents the estimated selling price less all estimated costs of completion and selling; Trade receivables are based on 30 days of turnover. Allowances for irrecoverable amounts are recognised in the income statement when there is objective evidence that the asset is impaired. Other receivables include prepayments; Trade payables are settled within 45 days; and The allowance for operating cash is taken as a standardised factor of 45 days operating expenditure, excluding depreciation and income tax. 4 Refer to section of tariff methodology 13

14 Table 5: Working Capital 2009/ / / /11 LE Net Working Capital Act App FC Inventory Receivables Operating Cash Less: Payables (53.9) (73.6) (95.5) (90.7) Net Working Capital The increase in working capital for the 2011/12 tariff period is primarily as a result of the increase in receivables due to the higher revenue requirement in the year. This increase has also been impacted by an increase in inventory as a result of additional spares (non property, plant and equipment) that have to be procured due to the 24 inch pipeline coming into operation. 4.4 Deferred Tax (dtax) Transnet has adopted the notional tax approach as discussed in section 7 of the methodology. Consequently, the deferred taxation liability has been deducted from the RAB. The annual and cumulative deferred tax amounts are as follows: Table 6: Deferred Tax 2009/10 Open 2009/10 Act 2010/11 LE 2011/12 App 2012/13 FC Deferred Tax (RAB) Annual Depreciation - Historic Cost Less: Wear & Tear (139.9) (257.6) (358.6) (415.5) Deferred Tax (33.2) (279.2) (274.4) Cumulative (8.8) (287.9) (562.4) The deferred tax balance for the purpose of the RAB adjustment relates strictly to the statutory timing differences between depreciation deducted for the purposes of calculating the notional tax allowance, and wear and tear allowances at the beginning of the financial year. Deferred tax liabilities deducted from the RAB are cumulative and stated at opening balances. Table 7 reconciles the deferred tax balance as it appears on the balance sheet to that deducted from the RAB. This balance has been determined by excluding deferred tax on assets prior to the introduction of the notional tax principle in the methodology (i.e. 2009/10). 14

15 Table 7: Deferred Tax Reconciliation to balance Sheet Deferred Tax (Balance Sheet) 2009/10 Act 2010/11 LE 2011/12 App 2012/13 FC Balance per balance sheet , ,299.9 Less: Deferred tax prior to 2009/10 (236.7) (236.7) (236.7) (236.7) , ,063.2 Less: Provisions (27.8) (46.2) (87.4) (131.4) less: Asset revaluation (88.3) (411.9) (907.8) (1,369.3) Less: Current Annual dtax 14.7 (33.2) (279.2) (274.4) dtax taken to RAB (Opening balance) (9.7) (24.4)

16 5 Weighted Average Cost of Capital (WACC) Regulation 4(5) states: The allowable rate of return for licensees must be determined by using the expected efficient weighted average cost of capital (WACC). WACC must be calculated using the weighted average of the licensee sa. Average cost of debt that can realistically be obtained during the period under review; and b. Cost of equity capital calculated by means of the capital asset pricing model or any other appropriate model The approach taken by Transnet in this application is fully compliant with Regulation 4(5). The average cost of debt is calculated in the same way that NERSA calculates this parameter. Also, in line with NERSA, Transnet has applied the capital asset pricing model ( CAPM ) to estimate the cost of equity. However, Transnet has identified certain areas where the methodology and approach to calculating the cost of equity in previous tariff determinations for petroleum pipelines conflicts with the NERSA decision on Transnet s gas transmission tariff for 2010 ( gas decision ); local and international best practice; and the corporate finance literature in the estimation of cost of capital. The sections below explain the mechanics of Transnet s approach, making clear both the nature and motivations for the specific areas in which it has been considered both prudent and justifiable to depart from NERSA s practice. 5.1 Cost of Equity Section of the methodology sets out the formula for calculating the real cost of equity. In this section of the application, we deal in turn with the individual components of the cost of equity calculation embodied in the Capital Asset Pricing Model ( CAPM ), namely the risk free rate, the market risk premium and beta. 16

17 5.1.1 Risk free rate In common with the methodology, Transnet has derived the risk free rate element of the cost of equity from monthly observations, over the 300 months from April 1985 to March 2010, of the prospective yields on government bonds, adjusted for inflation. The methodology specifies that the risk free rate estimated in this way should be reduced to take account of corporate tax. For the reasons set out below, Transnet believes that this adjustment on the part of NERSA is misconceived and Transnet has accordingly not reduced the risk free rate for this reason. On a detailed level, Transnet also notes that with respect to the mechanics of the calculation, NERSA s previous practice differs from its methodology. The mechanics of Transnet s calculation can be thought of as substantively a hybrid of NERSA s methodology and practice Tax adjustment Section of the methodology describes the cost of equity as an After tax allowable real cost of equity. In order to arrive at an after tax cost of equity, NERSA has in previous determinations in relation to petroleum pipelines, imputed a tax shield associated with the risk-free rate component, as though this element reflected interest paid by the company as a taxable expense. (Transnet notes that NERSA has not made this error in the gas decision. See section ) However, the whole of the cost of equity (estimated in accordance with CAPM and including the risk free rate element) is ultimately paid as a dividend out of corporate income, after tax has already been deducted. Hence, although the risk free rate reflects an interest rate, it does not relate to interest on corporate debt that would be a tax deductable expense. It relates to a measure of the cost of government debt and is simply an element of a cost of equity that is already post tax and for which no further adjustment is required. Transnet has asked Frontier Economics Ltd to give an opinion on this matter. Frontier s opinion, which surveys the corporate finance literature on the treatment of the risk-free rate within the CAPM, and the approach to this issue taken by a number of well-established economic regulators in the UK, is contained in Annexure B. It confirms Transnet s view that no further tax adjustment to the risk free rate element is justified and Transnet s tariff application reflects this advice. In addition, Transnet has consulted with leading corporate finance experts in South Africa (KPMG) who have confirmed the correctness of Transnet s approach in respect of its treatment of the risk-free rate (and the use of market values for the equity from peer companies in the determination of the beta for Transnet Pipelines) (refer Annexure C). Further, Transnet 17

18 has reviewed the PricewaterhouseCoopers Valuation Methodology Survey 2007/08 and their Signs of the times Valuation Methodology Survey 2009/10 5 th Edition. In the former, only one respondent (out of 25) indicated that they adjust the risk free rate for taxation. i.e. 96% of respondents do not make the adjustment Formula for converting nominal yields to real yields NERSA s tariff methodology implies that the following formula should be used to calculate the real risk-free rate: 5 where RF Real risk - free rate to be appliedin CAPM m1 1 RF 1 CPI nominal, m m 1. nominal, m is the nominal risk-free rate observed in month m, and m CPI is the contemporaneous rate of inflation, as measured by the CPI index. This formula states that the real risk-free rate to be used in the CAPM formula is to be calculated by taking an average of 300 historic monthly observations of the real risk-free rate, expressed as a monthly rate. The real risk-free rate for each month is to be calculated by taking the nominal risk-free rate for that month and deflating it, dividing through by one plus the rate of inflation measured by CPI for that month. This quotient is then averaged over the 300 month period to obtain an average real risk-free rate. In other words, the formula set out in the methodology calculates an average of quotients. However, in NERSA s past determinations in relation to Transnet s petroleum pipelines, the formula actually applied by NERSA to determine the real risk-free rate used departed from the formula set out in its own methodology. The formula used by NERSA in its calculations was: 12 1 RF 300 m1 Real risk - free rate applied by NERSA in CAPM CPI m1 nominal, m This formula deviates from that in the methodology in two ways. m 1. Firstly, it annualises the average of monthly rates by multiplying these by a factor of 12. Since the risk-free rate values used in the calculation are expressed as monthly rates, some process for annualising these is 5 For simplicity, the formula presented here ignores NERSA s tax treatment of the riskfree rate. 18

19 necessary. NERSA s multiplication by a factor of 12 seems to be aimed at correcting what appears to be a typographical error in the formula in NERSA s methodology, which does not provide for the annualisation of monthly rates. The appropriate methodology to annualise yields is discussed below. Secondly, the formula applied by NERSA also deviates from the methodology by first averaging the 300 monthly nominal yields observed over the relevant sample period, then annualising this figure and, finally, deflating this average nominal yield using the average annualised rate of inflation over the same 300 month period. (Transnet notes that NERSA appears not to have made this error when determining the cost of equity in its in the gas decision. See section ) This approach is inconsistent with the approach set out in the methodology. To apply the methodology, NERSA should have first deflated the nominal risk-free rate observed in each month, and then averaged across these real yields, to obtain the final estimate of the risk-free rate. This latter approach is the one that Transnet has followed when deflating nominal yields to obtain real yields Compounded vs. un-compounded The methodology prescribes that the risk-free rate be determined by reference to Government bond yield data sourced from the South African Reserve Bank ( SARB) and published by NERSA. We understand that bond yield data published by SARB is quoted in units of %pa NACS (Nominal Annual Compounded Semi-annually). 6 Although interest on Government bonds is compounded at six-month (semi-annual) intervals call this six-monthly rate i the annual yield quoted by SARB is calculated by simply multiplying the six-monthly rate by two, i.e. 2i. In other words the yields quoted by SARB are annual un-compounded nominal yields and not the effective (compounded) nominal yields that an investor in these Government securities would earn. Effective, rather than quoted, yields should be used when estimating the cost of equity because quoted yields ignore the effect of compounding (and therefore, the time value of money). 6 Actuarial Society of South Africa and Bond Exchange of South Africa (2003), An Introduction to the BEASSA Zero Coupon Yield Curves, p.6. 19

20 The equation for converting a quoted yield to an effective annualised yield involves compounding the six-monthly (semi-annual) yield over two periods: Effective yield = (1 + i) Annualisation NERSA s formula uses monthly market returns when calculating the MRP. In order to calculate the excess return on the market, it is necessary to calculate from annual yields a monthly riskfree rate that is contemporaneous with the market return observed in each month. In previous determinations, NERSA s approach to calculating a monthly risk-free rate has been to divide the annual SARB yield, observed in each month, by 12. Strictly speaking, this approach is, with respect, incorrect as it ignores the compounding of returns through time. The correct approach for calculating a monthly risk-free rate is to solve for the rate, which if compounded over 12 months, would result in the observed annual yield. Hence, if the observed annual yield in month n were R f,n, then the appropriate monthly yield for month should be calculated as follows: Monthly Yield n = (1 + R f,n ) To re-annualise the monthly yields, the yields calculated for each month within the year need to be compounded forward as follows: 12 n=1 1 + Monthly Yield n 1 The estimate of the risk-free rate to be used in the CAPM formula is simply the average across 25 so annualised yields Overall estimate In summary, when estimating the real risk-free rate for this application, Transnet made no tax adjustment to the risk-free rate; applied an average of quotients; applied effective (compounded) rather than un-compounded yields; and took compounding into account when converting annual yields into monthly yields, and vice versa. 20

21 Using this approach, as applied to the SARB bond yield and CPI data for the 300 months from April 1985 to March 2010, Transnet estimated an average risk-free rate over the specified 25 year period of 4.15% Market risk premium The market risk premium is the return investors can expect to earn, over and above the risk-free rate, by investing in the market. The methodology implies the following formula should be used to calculate the MRP (see paragraph of the methodology): 7 MRPto be appliedin CAPM RM RF where RM is the return on the market in a given month, and RF is the contemporaneous riskfree rate, both expressed as real monthly rates. This formula states that the MRP should be computed as the average (over 300 months) of the arithmetic difference between the (monthly) return on the market and the contemporaneous (monthly) risk-free rate. This difference is commonly referred to as the excess return on the m1 market, and is the most common way in which to apply the CAPM. However, in past decisions by NERSA in relation to Transnet s petroleum pipelines, the formula used to calculate the MRP has been: applied by NERSA in CAPM m1 MRP m1 RM RF 1 This formula deviates from the one prescribed in the methodology in several ways. Firstly, it annualises monthly rates by multiplying these by a factor of 12, thus aiming to address what Transnet reasonably assumes to have been a typographical error in the formula set out in the methodology. The risk-free rate section describes the appropriate methodology for annualising 7 For simplicity the country risk adjustment term ( CRA in the methodology) is omitted from the presentation of the formula here. 21

22 monthly returns, which takes compounding (and therefore, the time value of money) into account properly. Secondly, the formula interprets the excess returns on the market as a quotient of (one plus) the return on the market and (one plus) the risk-free rate. (Transnet notes that NERSA appears not to have made this error when determining the cost of equity in its gas decision. See section ). However, the methodology specifies that the excess return on the market should be calculated simply as the arithmetic difference between the return on the market and the risk-free rate. The approach previously used by NERSA corresponds to neither an arithmetic mean MRP (which is required) nor a geometric mean MRP, which would in any event be inappropriate for use in the CAPM applied by NERSA. It can be shown mathematically that, so long as the average risk free rate of over 300 months remains positive, the use of an MRP derived in this way will consistently lead to an underestimate of the cost of equity. Thirdly, in its computation of the average excess return on the market over the relevant 300 month period, NERSA has previously calculated a quotient of averages rather than an average of quotients. That is, NERSA divided (one plus) the 300 month average of the return on the market by (one) plus the 300 month average of the risk-free rate. This approach is, with respect, incorrect. (Transnet notes that NERSA appears not to have made this error when determining the cost of equity in its gas decision. See section ). Had the methodology permitted excess returns on the market to be calculated using quotients rather than arithmetic differences, NERSA would have to calculate the average excess return on the market by first calculating, for each month in its sample of returns, the quotient of (one plus) the return on the market in that month and (one plus) the contemporaneous risk-free rate. Then, the MRP should have been calculated by averaging over the 300 so-calculated excess returns. Finally, analogously to its practice when deflating nominal risk-free rates, NERSA has calculated the real market returns using a quotient of averages rather than an average of quotients. In other words, instead of deflating the nominal risk-free rate in each of the 300 months and then averaging across each of these values, NERSA has previously calculated the average (over the 300 month period) nominal risk-free rate, and the average (over the 300 month period) rate of inflation, and then deflated the former using the latter. (Transnet notes that NERSA appears not to have made this error when determining the cost of equity in its gas decision. See section 22

23 5.1.5.). This approach is, however, inconsistent with the methodology; the latter is appropriate in this respect. In line with NERSA s 2010/11 determination, Transnet calculated the MRP from ALSI data. Applying the correct MRP formula to these data, Transnet has calculated the MRP for the period 01 April 1985 to 31 March 2010 to be 6.85% Beta The methodology requires betas to be calculated based on six pipeline companies. For this application, Transnet has used the same peers as listed in the NERSA decision on Transnet Pipelines 2010/11 petroleum pipeline tariffs. The companies are: Equitable Resources (USA); Enbridge Inc (Canada); El Paso Energy Corporation (USA); Magellan Midstream Partners L.P. (USA); 8 Plains All American Pipeline, Limited Partnership (USA); and Provident Energy Trust (Canada). Transnet has followed the same broad steps described in the approach set out in Note 3 in the methodology regarding the determination of beta. The high level methodology described in Note 3 involves: delevering of the equity beta for the proxy companies into an asset beta; the determination of a weighted average asset beta from the proxy companies; and relevering of the weighted average asset beta into a proxy equity beta for Transnet Pipelines. Transnet differs in the detail of the way in which certain of these steps have been carried out. 8 In the prior year Magellan Midstream Holdings L.P. (USA) was used. However this company has been delisted and therefore Magellan Midstream Partners L.P. (USA) have been used in this application. 23

24 In principle, the market values of equity and debt should be used when delevering betas (see for example Damodaran, 2001, pp ). The cost of equity is a market-determined rate of return, and therefore all of its components (the risk free rate, the MRP and beta) ought also to be market-determined. Since the equity betas to be delevered are estimated from market data, it would be economically inconsistent to apply the book values when levering and de-levering betas. In practice, data on the market value of equity (measured by market capitalisation) is straightforward to obtain. In contrast, data on the market value of debt is difficult to obtain (since debt is less frequently traded than equity). Following a well-established proxy approach, Transnet has employed the market value of equity and the book value of debt when delevering equity betas. KPMG has confirmed the correctness of Transnet s approach this regard (refer Annexure C). Further, Transnet has used the country tax rate (USA and Canada) in delevering equity betas, and similarly uses the country tax rate (South Africa) in relevering the asset beta. This is consistent with the approach described in the methodology Definition of debt NERSA has defined debt to mean interest bearing debt as reflected in section 5.1 of the methodology. Accordingly, Transnet has only included short term and long term interest bearing debt of the proxy companies when determining the gearing and in the weighting formula. This is consistent with standard market practice The calculation of beta It is well-recognised that beta estimation can be subject to considerable statistical error, and is dependent on the length of the estimation period and the frequency of data in the sample. In order to minimise the statistical error, one would increase the number of observations. In its determination of Transnet Pipelines 2010/11 beta, Transnet understands that NERSA used estimates for proxy companies based on monthly returns over a five year period. Whilst Transnet is of the view that the beta should be measured at a frequency greater than monthly, for the purposes of this application, Transnet has used monthly betas as reflected on Zacks.com, accessed in July We understand that this is a matter that NERSA is reviewing as part of its review of the determination of beta. 24

25 The beta estimated by Transnet for Transnet Pipelines is 0.84, consisting of the levered beta of 0.69 and a risk adjustment of This adjustment is based on the 0.15 small stock premium reflected in NERSA s decision on TPL s 2010/11 cost of equity: Table 8: Beta Tariff Application Beta 0.69 Add: risk adjustment 0.15 Total beta Real cost of equity calculation Using the results of the calculation of the risk free rate, the market risk premium and beta, together with the size of company adjustment specified in the methodology yields a cost of equity of 9.91% as reflected in Table 9 below: Table 9: Real cost of equity Tariff Application Risk free rate 4.15% Market risk premium ( MRP ) 6.85% Beta 0.84 Real cost of equity 9.91% Comparison with NERSA s decision on piped gas Transnet has noted NERSA s approach in determining the cost of equity in respect of its gas decision. In particular, we note that NERSA has, in the gas decision, not applied a tax adjustment to the risk free rate in the cost of equity calculation. This is the same approach adopted by Transnet in this application, and we would submit that NERSA should be consistent and follow this approach when setting petroleum pipeline tariffs. The following table reflects the calculation of the cost of equity for the two industries, using the same data (i.e. covering the period April 1984 to March 2009), save for the beta data which NERSA based on a different set of peers: 25

26 Table 10: Comparison of cost of equity Parameter 2010/11 Petroleum Gas decision 2010 Gas pipeline Notes pipeline ( PPL ) approach applied decision to 2010/11 PPL determination Risk-free rate % 4.33% 1, 2 Beta MRP 7.30% 4.22% 4.22% 4 Real Cost of equity 5.38% 7.19% 7.12% 5 1. In the gas decision, NERSA correctly applied no tax shield adjustment to the risk free rate when estimating the cost of equity. 2. In the gas decision, NERSA correctly deflated the nominal risk-free rate observed in each month, and then averaged across these 300 real yields, to obtain final estimates of the real risk-free rate. That is, the average of the (monthly) quotients was determined. This process for deflating yields is correct and consistent with the (petroleum pipelines) methodology. Therefore, Transnet has used this approach in the present application. 3. Transnet does not have the beta calculation in respect of the gas decision. However, in respect of NERSA s decision on Transnet s petroleum pipeline tariff decision for 2010/11, Transnet is of the view that where feasible, the market values of debt and equity should be used. At the very least, the market value of equity ought to be used when de-levering the equity betas of peer companies. 4. In the gas decision, when computing real market returns that enter into the MRP calculation, NERSA correctly deflated nominal monthly returns by applying the prevailing rate of inflation in that month. Then the excess returns on the market were calculated by subtracting from each real monthly return the contemporaneous real monthly risk-free rate. Finally, the MRP was then calculated by averaging across these 300 excess returns. This process for calculating the MRP is correct and consistent with the (petroleum pipelines) methodology. It is for this very reason that Transnet has used this approach in the present application. 5. Had NERSA applied the methodology it used in its gas decision in its 2010/11 petroleum pipelines decision (i.e. using a risk-free rate of 4.33%, a MRP of 4.22% and beta of 0.67), 26

27 it would have determined a cost of equity of 7.12% i.e. 174 basis points higher than the cost of equity that was actually determined. However, Transnet notes that there are aspects of NERSA s gas decision that Transnet does not agree with. Firstly, NERSA did not account for the fact that the SARB bond yields are uncompounded yields. Transnet has used compounded yields in this application (section ). Secondly, when converting annual returns to monthly returns, and when annualising monthly returns, NERSA ignored the effect of compounding. Transnet has explicitly taken compounding into account in this application (section ) Comparison with NERSA s decision on electricity Transnet has also reviewed NERSA s electricity decision. Transnet notes that in that determination NERSA appears not to have made any tax shield adjustment to the risk-free rate when calculating Eskom s cost of equity. In that determination, NERSA determined a pre-tax WACC, which was comprised of a pre-tax cost of equity and a pre-tax cost of debt. The WACC parameter values from the determination are summarised below in Table 11. Table 11: Key cost of capital parameters given by NERSA in the electricity decision Parameter Eskom Multiyear Price Determination 2010/11 to 2012/13 Pre-tax cost of equity 9.44% Pre-tax cost of debt 7.30% Pre-tax WACC 8.16% In the electricity decision, NERSA states that it determined a MRP of 1.90% and a beta of 1.0; NERSA did not explicitly state the risk-free rate used in the cost of equity calculation. However, it is possible to back out the implied risk-free rate by reference to the cost of debt determined by NERSA. NERSA states that the pre-tax cost of debt is calculated as the risk free rate plus a debt premium (paragraph 106). NERSA determined a debt premium of 240 basis points in Eskom s case, so with a pre-tax cost of debt of 7.30%, the implied risk-free rate is approximately: 27

28 7.30% 2.40% = 4.90%. Applying a value of 4.90% for the risk-free rate, the implied post-tax cost of equity in the Eskom decision, using the CAPM, is approximately: 4.90% % 1.0 = 6.80% In the Eskom decision, NERSA had to convert this post-tax cost of equity into a pre-tax rate. NERSA correctly explained that: In addition, since these MRP calculations are post tax, the calculated cost of equity has to be grossed up for to include (provide for) the corporate tax that will be paid by Eskom. (para 110; emphasis added) In other words, the post-tax cost of equity had to be grossed up to reflect the tax shield. Using a corporation tax rate of 28%, the pre-tax cost of equity becomes: Pre tax cost of equity = Post tax cost of equity 1 T which is exactly the pre-tax cost of equity determined by NERSA. = 6.80% (1 28%) = 9.44% This demonstrates that it NERSA did not, in the electricity decision, apply any tax-shield adjustment to the risk-free rate when calculating a post-tax cost of equity. Had NERSA adopted in the electricity decision the treatment it has applied to the risk-free rate in Transnet PPL s case, it would have calculated a post-tax cost of equity of: 4.90% (1 28%) % 1.0 = 5.43%, which, when grossed up by the tax shield, would have resulted in a pre-tax cost of equity of: 5.43% (1 28%) = 7.54% rather than the 9.44% NERSA actually determined. 28

29 5.2 Cost of Debt Transnet s estimated weighted average cost of debt ( WACD ) as at March 2011 is 10.37% and as at March 2012 is 10.9%. The resulting average for the 2010/11 financial year is 10.64%. The BER projected inflation rate for the 2011/12 financial year is 5.8%, resulting in a real post-tax cost of debt of 1.76%. Provided that NERSA employs a notional tax expense (where the tax allowance imputes the value of the tax shield), it is appropriate to apply a post-tax cost of debt. 5.3 WACC The WACC is the weighted average of the cost of equity and the cost of debt. The cost of equity is 9.91%, and the cost of debt is 1.76%, which, with a gearing of 38.9%, results in a real WACC of 6.74% for TPL. 29

30 6 Expenses TPL s operating expenses are recognized and reported in terms of the International Financial Reporting Standards ( IFRS ). Approximately 85% of the operating expenses are fixed and consequently are not driven by the volume of petroleum products transported. The 2011/12 cost structure for TPL will change due to the commissioning of the 24 inch trunkline in January 2011 and the down rating of the DJP for twelve months of the year. In this section, the expenses which form a significant component of the total operating expenditure and/or those that have shown significant increases compared to 2010/11 are analysed in detail. Expense forecasts (2010/11 Latest Estimate ( LE ) and 2011/12) are based on the latest actual information available. The 2011/12 expenses have been adjusted for inflation in accordance with data provided by the BER. A summary of TPL s expenses is shown in the table below. The variances between 2010/11 LE and 2011/12 forecasts are discussed thereafter: Table 12: TPL Regulated Petroleum Expense Summary 2009/ / / /11 LE Var (%) Var (%) Expenses Act App FC Labour % % Materials & Supplies % % 18.0 Outside Services % % 24.8 Operating Fuel % % 47.9 Legal Expenses % % 0.9 Rent - External Operating Leases % % 13.4 Injuries & damages % 0.0 N/A 0.0 Insurance % % 1.8 Bad Debt N/A 0.0 N/A 0.0 Decommissioning Provision N/A N/A 0.0 Transnet Corporate Overhead % % Corp Social Responsibility % 7.8 0% 8.2 Other Miscellaneous Expenses % % Total operating costs % %

31 6.1 Labour The increase in labour costs is due to the annual salary adjustments to be negotiated and agreed to with organised labour as well as an average increase in headcount. 6.2 Materials and Supplies The material costs relate to the use of drag reducing agents ( DRAs ) to improve the throughput (flow rate) in the DJP in order to meet the demand for fuel in the inland market in the shortterm, as part of the bridging plan initiative until the commissioning of the NMPP. The usage of DRAs will be at 80% of current levels due to the down rating of the DJP. In 2011/12, additional costs will be incurred relating to foam and inhibitors for the NMPP. 6.3 Outside Services - Professional Fees Professional fees are budgeted for according to the planned activities in which the expertise of the professionals will have to be sourced. The above inflationary increase in professional fees is due to the need to perform simulation models for future use of the DJP, revaluation of assets for financial reporting and audit activity relating to regulatory requirements. 6.4 Fuel The 2011/12 fuel projection is aligned with 2010/11 costs due to a successful renegotiation of a gas supply contract to the refractionator at a lower gas tariff with effect from October Insurance The increase in costs is due to the commissioning of the NMPP 16 inch lines in 2010/11 and 24 inch trunkline in the last 3 months of 2011/ Decommissioning Provision The decommissioning costs of the petroleum network of R114m are based on the Transnet Pipelines obligation to rehabilitate the land in terms of the National Water Act, 1998 (Act No. 36 of 1998) and The National Environmental Management Act, 1998 (Act No. 107 of 1998). The cost estimates are based on the following activities that need to be taken into account when decommissioning the pipeline per the American Society of Mechanical Engineers ( ASME ) Codes: 31

32 Disconnecting and removing of above ground structures and other connections from the pipeline; Purging and/or filling with an inhibited liquid to neutralise toxic, corrosive or hazardous substances; Isolating and sealing the pipeline by blanking/end-capping; and Retaining the pipeline under cathodic protection if necessary. The estimated costs of the above activities are based on a selection of quotes obtained from service providers and have been increased based on the long term inflation rate to the date of expected decommissioning and discounted at the long term bond rate. The decommissioning cost estimates do not include activities relating to the upliftment of the pipeline network at the end of its service life as there is no international code or legislation that requires such upliftment. 6.7 Transnet Corporate Overheads As one of Transnet s operating divisions, TPL receives support and services from the Transnet Corporate Head Office. The corporate overheads are allocated to operating divisions based on various defined drivers. TPL s portion (R163m) accounts for approximately 6% of Transnet s total corporate overhead costs and 84% of TPL s allocated cost is allocated to petroleum pipelines on the basis of direct proportional cost. The major cost elements of the Transnet Corporate overhead include: Personnel costs including employee costs (pension and medical aid contributions for present and retired employees); Incentive programmes; Managerial and technical consultancy fees; and Electronic data costs. Table 13: Corporate Cost Transnet Corporate Cost 2009/ / / /13 Act LE App FC Cost Allocated to TPL Cost Allocated to Petroleum Pipelines

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