TRANSNET PETROLEUM PIPELINES TARIFF APPLICATION FOR THE YEAR 2012/13 (01 APRIL 2012 TO 31 MARCH 2013)

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1 TRANSNET PETROLEUM PIPELINES TARIFF APPLICATION FOR THE YEAR 2012/13 (01 APRIL 2012 TO 31 MARCH 2013)

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 The Levy Borrowing costs Net working capital (w) Deferred Tax (dtax) Weighted Average Cost of Capital (WACC) Cost of Equity Risk free rate Market risk premium Beta Real cost of equity calculation Cost of Debt WACC Expenses Labour Materials and Supplies Outside Services - Professional Fees Operating Fuel Insurance Decommissioning Provision Transnet Corporate Overheads Other Miscellaneous Expenses Electricity Repairs and Maintenance Security... 30

3 6.8.4 Other Costs Income Taxation Depreciation F-Factor Clawback Volume adjustment Operating efficiency adjustment Cost of debt adjustment Stock adjustment inch pipelines adjustment inch pipeline adjustment /11 SRAB Allowable Revenue Calculation Volumes Conclusion Annexures... 44

4 List of Tables Table 1: Allowable Revenue... 7 Table 2: Assumption Variables... 7 Table 3: Index Table Table 4: Fixed Asset Additions Historic Values Table 5: Fixed Asset Additions Trended Values Table 6: Asset Schedule Table 7: Levy Schedule Table 8: Calculation of AFUDC Table 9: Allocation of AFUDC Table 10: Working Capital Table 11: Deferred Tax Table 12: Real cost of equity Table 13: Summary of TPL Regulated Petroleum Expenses Table 14: 2012/13 decommissioning provision Table 15: Transnet Corporate Cost Allocated to TPL Table 16: Depreciation Table 17: Clawback Table 18: Operational efficiency adjustment Table 19: Cost of debt adjustment Table 20: Claw back against 2010/11 product reconciliation stock balance Table 21: Claw back 16 inch NMPP operational from June 2011 rather than January Table 22: Claw back 24 inch trunkline Table 23: 2010/11 RAB Clawback Table 24: Allowable Revenue Table 25: Volume data... 42

5 1 Executive Summary Transnet SOC Limited ( Transnet ) submits its 2012/13 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 the Setting of Tariffs in the Petroleum Pipelines Industry, 5 th Edition approved 31 March 2011( the methodology ). Furthermore, Transnet has endeavoured to meet NERSA s draft Minimum Information Required for Tariff Applications ( MIRTA ). Consequently, projected financial statements for the ring-fenced Petroleum Pipelines in Transnet for the periods 2010/11 to 2013/14 have been provided. Refer to Annexure A for income statement, balance sheet and cash flow statements. This application has been prepared on the basis of both the Durban to Johannesburg Pipeline ( DJP ) and the New Multi-Product Pipeline ( NMPP ) (the 24 inch trunk line) being in operation for the full 12 months of the tariff period. In arriving at the 2012/13 Allowable Revenue ( AR ), Transnet has adhered to the PPA, the Regulations made thereunder and the methodology. In arriving at the property, plant, vehicles and equipment for the application, Transnet has used as its base the 2006 Starting RAB ( SRAB ) as set by NERSA. This SRAB, was trended for the years 2008/09 and 2009/10 in line with the PricewaterhouseCoopers (PwC) Report and consequently the 2009/10 RAB as determined by Transnet and approved by NERSA has been loaded into the Regulatory Reporting System. This amount has subsequently been trended (in accordance with the NERSA methodology) to arrive at the 2012/13 property, plant, vehicles and equipment value. Transnet anticipates bringing its Jameson Park Terminal (TM2) into operation on 1 January 2013 and has accordingly included the asset into the 2012/13 regulatory asset base ( RAB ) for a period of 3 months. The cost at which this asset has been included in the RAB represents the best estimate at the time of this application. Clawback for the period includes the 16 inch pipelines that are currently in operation, the 24 inch trunkline, and the 2010/11 RAB as informed by the PwC report. Included further is a clawback on product stock in respect of the reconciliation process. 5

6 Transnet has dealt with the levy and borrowing costs on the 24 inch trunkline in accordance with Transnet Limited Petroleum Pipelines System 2011/12 Reasons for Decision ( 2011/12 decision ) in which the total borrowing costs on the 24 inch trunkline was limited to the cumulative levy amount received for the tariff period in question. Based on the above, Transnet has calculated an AR of R2,479.8 million ( basic allowable revenue ) for the 2012/13 financial year. Over and above this basic 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 during the 2012/13 financial year. Transnet requests that NERSA considers the award of a F-Factor equating to 3 times the cash interest cover ratio (2.45 times according to the NERSA methodology), in line with the requirements of its credit rating agencies and loan covenants as well as NERSA s 2011/12 decision. The requirements for the F-Factor are dealt with in section 9 of this application. Transnet wishes to point out that the F-Factor is a temporary measure to assist Transnet during periods where the required cash interest cover cannot be achieved for assets in operation with basic tariffs. This will be returned to the consumers by reducing the RAB in future tariff periods when the revenue from the basic tariffs is sufficient to attain a cash interest cover of 3 times i.e. a cash interest cover of 3 times is achieved without the assistance of a F-factor. Consequently, this will result in lower tariffs in those periods. Transnet has accordingly calculated a F-Factor based on a cash interest cover of 3 times (which equates to 2.45 times utilising the NERSA ratio), which in turn results in an AR of R3,558.4 million. Given the above, Transnet files for a revenue requirement of R3,558.4 million, an 83% increase in revenue from the 2011/12 AR of R1,957.7 million as set by NERSA. This increase is predominantly as a result of the inclusion of the 24 inch trunkline for 12 months of the tariff period, the introduction of the Jameson Park accumulator facility into the RAB for 3 months of the financial year and the F-Factor. The AR calculation based on the previous detail is reflected in the table below. 6

7 Table 1: Allowable Revenue AR Summary 2011/12 RFD 2012/13 App Basic AR 2012/13 App F-Factor AR 2013/14 FC F-Factor AR WACC Return on RAB , , ,460.3 Expenses Depreciation Clawback (285.4) (264.8) (264.8) 0.0 F-Factor Profit before Tax 1, , , ,675.2 Notional tax Allowable Revenue 1, , , ,548.1 Where: RFD = Reasons for decision App = Application FC = Forecast The application is derived from the following variables: Table 2: Assumption Variables Assumption Variables 2011/12 RFD 2012/13 App Basic AR 2012/13 App F-Factor AR 2013/14 FC F-Factor AR Current CPI (%) 5.18% 5.75% 5.75% 5.55% Historic CPI (%) 8.58% 8.58% 8.69% Weighted CPI (%) 7.23% 7.32% 7.75% Nominal Cost of Debt (Kd) (%) 10.36% 10.36% 10.64% Post tax Real Cost of Debt (Kd) (%) 2.36% 1.62% 1.62% 2.00% Real Cost of Equity (Ke) (%) 8.94% 9.89% 9.55% 8.95% Real WACC (%) 6.41% 5.94% 6.03% 6.86% Nominal WACC (%) 15.03% 15.14% 16.08% Average Gearing (%) 38.46% 47.77% 44.33% 30.00% Volume (billion Litres) Volume Growth (%) 2.5% 2.5% 0.5% 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. These pipelines convey 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 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 as part of 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 coastal pipeline terminal in Durban (Island View) ( TM1 ); and An inland pipeline terminal at Jameson Park ( TM2 ). The following NMPP project assets have been completed and have been brought into operation during April and May 2011 per notification to NERSA at the time: A 16 inch pipeline from Jameson Park to Alrode (25 May 2011); A 16 inch pipeline from Alrode to Langlaagte (25 May 2011); and A 16 inch pipeline from Kendal to Waltloo (30 April 2011). The 24 inch trunkline which is scheduled to come into operation on 1 January 2012 will operate concurrently with the DJP during the 2012/13 year. The DJP will operate at a lower flow rate and the 24 inch trunkline will transport diesel only until the completion of the coastal and inland terminals. This will result in the optimal utilisation of the pipeline assets to ensure that the inland market s requirements are met. 8

9 3 Approach The building blocks of the methodology are reflected in the following formula 1 : AR = (RAB x WACC) +E + D + F ± C + T Where: AR RAB = Allowable revenue = Regulatory Asset Base WACC = Weighted average cost of capital E D F C T = Expenses: operating and maintenance expenses for the tariff period under review = Depreciation and amortisation of inflation write up: 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 from a preceding tariff period in relation to the actuals for that tariff period = Tax: estimated tax expense for the tariff period under review 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 the latest approved Cost Allocation Manual ( CAM ). 1 Refer section 3.2 of the methodology. 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 2 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 weighted average of the historical and the projected forthcoming tariff period consumer price index ( CPI ) as the inflation measure 3. Property, plant, vehicles and equipment expected to come into use 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 the pipelines business and a portion of the NPAs has been allocated in terms of the latest approved CAM. 2 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. 3 The historical CPI is in proportion to equity and the forthcoming tariff period projected CPI is in proportion to debt. 10

11 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 2012/13 RAB was calculated using the NERSA Demonstration Model, utilising the approved 2010 RAB. In arriving at the Property, plant, vehicles and equipment for the application, Transnet has used as its base, the 2006 Starting RAB ( SRAB ) as set by NERSA. This SRAB, was trended for the years 2008/09 and 2009/10 in line with the PWC Report and consequently the 2009/10 RAB as determined by Transnet and approved by NERSA (per letter Starting Regulatory Asset Base (SRAB) and Clawback dated 04 November 2010) has been loaded into the Regulatory Reporting System. This amount has subsequently been trended to arrive at the 2012/13 property, plant, vehicles and equipment value. NERSA has clawed back in its 2011/12 decision the 2008/09 and 2009/10 RABs. Clawback on the 2010/11 RAB has been calculated in this tariff application Indexation The weighted average of the historical and the projected forthcoming tariff period CPIs has been used to trend property, plant, vehicles and equipment. CPIs have been calculated based on the Transnet financial year and not a calendar year. The historical consumer price index ( CPI ) data has been obtained from Statistics South Africa for the period up to March The projected CPI for the 2012/13 tariff period has been obtained from the Bureau for Economic Research ( BER ). The weighted average CPI of 7.3% has been applied to the net book value of all assets included in property, plant vehicles and equipment for the 2012/13 tariff application. Assets with zero book value have not been indexed. The weighted average CPI has been arrived at as follows: Table 3: Index Table Financial Year Indices (%) Historical CPI (%) Forecast CPI (%) Ave Gearing (%) 31-Mar % 8.8% 3.8% 30.0% 31-Mar % 8.7% 5.6% 30.0% 31-Mar % 8.6% 5.8% 44.3% 31-Mar % 8.5% 6.0% 47.9% 11

12 4.1.2 Useful Lives The useful lives of pipeline assets in the RAB are aligned with the report of the last full valuation conducted by Arthur D. Little ( ADL ) in March 2009 and specific amendments per the index valuation conducted (by ADL) in March See Annexure B 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 a proportionate value of its obligation to be recovered in its 2012/13 application. This has been informed by the latest audited independent study conducted in the 2010/11 financial year, the results of which were duly communicated to NERSA on 07/06/2011. The amount included in the application is R20.7 million for petroleum pipelines (refer to section 6.6 for a detailed calculation). Consequently the assets to be decommissioned have not been included in the RAB. 12

13 4.1.4 Assets brought into use in the tariff application period under review Table 4: Fixed Asset Additions Historic Values Total 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Petroleum PPE , , , Inch Pipelines Inch Trunk line... Terminals Other Refined PPE Capitalised Borrowing Costs 0.0 1, Inch Pipelines Inch Trunk line... Terminals Levy 0.0 (1,894.7) (947.4) , , ,101.4 Non-Pipeline Assets Total , , ,118.2 Pro-rated Petroleum PPE , , , Inch Pipelines Inch Trunk line... Terminals Other Refined PPE Capitalised Borrowing Costs Inch Pipelines Inch Trunk line... Terminals Levy 0.0 (473.7) (947.4) , ,646.5 Non-Pipeline Assets Total , ,

14 Table 5: Fixed Asset Additions Trended Values Total 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Petroleum PPE , , , Inch Pipelines Inch Trunk line... Terminals Other Refined PPE Capitalised Borrowing Costs 0.0 1, Inch Pipelines Inch Trunk line Terminals Levy 0.0 (1,931.5) (1,016.7) , , ,221.5 Non-Pipeline Assets Total , , ,239.0 Pro-rated Petroleum PPE , , , Inch Pipelines Inch Trunk line Terminals Other Refined PPE Capitalised Borrowing Costs Inch Pipelines Inch Trunk line.... Terminals Levy 0.0 (482.9) (1,016.7) , ,681.0 Non-Pipeline Assets Total , ,

15 The NMPP 16 inch Kendal to Waltloo pipeline was brought into operation at the end of April 2011 and the Jameson Park to Alrode and Alrode to Langlaagte pipelines were operationalised by the end of May These assets have been capitalised at a cost of.... million. The pipelines where scheduled for operation on 1 January 2011 in the 2011/12 tariff application at a cost of million. Consequently clawback on these assets has been calculated for 3 months of the 2010/11 tariff period and 2 months of the 2011/12 tariff period. Clawback has further been calculated against the actual capitalised cost for 10 months of the 2011/12 period. The 24 inch pipeline is scheduled to be completed at the end of December The cost at which this pipeline was admitted to property, plant, vehicles and equipment in the previous tariff period was.... million (before prorating for 3 months). As stated in the previous tariff application, this amount represented the best estimate of the asset at the time and that Transnet would communicate the final Board approved cost of the NMPP after the November 2010 Board meeting. This was duly communicated to NERSA on 10 December 2010 in Transnet s letter Response to NERSA request for additional information, detailing that the final approved cost estimate for the 24 inch trunkline is.... million. Consequently clawback has been calculated against the final approved cost of the asset for 3 months of the 2011/12 tariff period. TM2 is scheduled to be in operation from 1 January 2013 and have been included in the RAB on a pro-rata basis i.e. 3 months only. These assets have been included in the RAB at a cost of million. 15

16 4.1.5 Summary of asset values The summary of the asset values is shown in the table below: Table 6: Asset Schedule Historical Cost 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Historical Cost PPE 5, , , ,042.5 Capitalised Borrowing Costs 0.0 1, , ,467.7 Levy 0.0 (1,894.7) (2,842.1) (2,842.1) Accumulated Depreciation PPE 2, , , ,320.3 Capitalised Borrowing Costs Levy 0.0 (6.3) (44.2) (82.1) NBV PPE 3, , , ,722.3 Capitalised Borrowing Costs 0.0 1, , ,413.8 Levy 0.0 (1,888.4) (2,797.9) (2,760.0) Fixed Assets - TOC 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Revalued Cost PPE 5, , , ,172.4 Capitalised Borrowing Costs 0.0 1, , ,743.2 Levy 0.0 (1,931.5) (3,089.2) (3,311.0) Accumulated Depreciation PPE 2, , , ,509.0 Capitalised Borrowing Costs Levy 0.0 (6.4) (47.6) (91.8) NBV PPE 3, , , ,663.4 Capitalised Borrowing Costs 0.0 1, , ,683.2 Levy 0.0 (1,925.0) (3,041.5) (3,219.2) Note: Above are total year end balances as contained in the TPL Regulatory Balance Sheet 16

17 Where: LE = Latest estimate NBV = Net book value The 2010 asset value as agreed with NERSA and reflected in its letter titled Starting Regulatory Asset Base (SRAB) and Clawback dated 04 November 2010, has been trended in accordance with the NERSA asset methodology using the weighted average CPI (refer 4.1.1) and in terms of NERSA s demonstration model related to the methodology. Of note, the 2010 asset value was informed by the PwC exercise performed in 2010 on the SRAB. A detailed breakdown of assets into the various petroleum subsystems of refined, crude and avtur are attached in Annexure D The Levy The cumulative levy received and receivable by the end of 2012/13 has been deducted from the RAB. The total amounts received and receivable by the end of 2012/13 and deducted from the RAB are as follows: Table 7: Levy Schedule 2010/ / /13 Total Rm Rm Rm Rm Cash Output vat Income tax Net levy recognised in the RAB

18 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 ). In the 2011/12 tariff application, the borrowing cost on the 24 inch trunkline was allowed into the RAB for a quarter of the 2011/12 tariff period. In the 2011/12 Decision, NERSA limited the amount of the borrowing costs capitalised on the 24 pipeline to the amount of the levy recognised for that period. Based on the cumulative levy to be recognised in the 2012/13 tariff period, there is no longer a limitation on the borrowing costs to be recognised on the 24 inch pipeline. Borrowing costs relating to the capitalisation of TM2 has been included into the RAB on a pro-rata basis i.e. 3 months of the tariff application period. Table 8: Calculation of AFUDC Calculation of AFUDC Balance BF 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Opening CWIP 5, , , ,997.2 Closing CWIP 11, , , , , , Deduct Levy (473.7) (1,421.1) (2,368.4) 0.0 Opening Levy 0.0 (947.4) (1,894.7) 0.0 Closing Levy (947.4) (1,894.7) (2,842.1) 0.0 Average CWIP After Levy 8, , Interest Brought Forward , , Total 8, , , ,218.5 Percentage Debt (NMPP) 81.56% 66.01% 66.82% 70.92% Percentage Equity (NMPP) 18.44% 33.99% 33.18% 29.08% Nominal Cost of CWIP Debt 10.89% 10.64% 10.36% 10.36% Nominal Cost of CWIP Equity 30.98% 22.65% 22.52% 23.98% AFUDC 1, , AFUDC Limited by Payment on IS ,

19 Where: AFUDC = Allowance for funds used during construction Table 9: Allocation of AFUDC Allocation of AFUDC Balance BF 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Total 16 Inch lines Inch line TM TM Total Allocated , Pro-rated 16 Inch Inch TM TM Total Allocated 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. Inventory balances includes maintenance stock and petroleum stock owned by Transnet Pipelines; 4 Refer to section of tariff methodology 19

20 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. Table 10: Working Capital Working Capital 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Inventory Receivables Operating Cash less: payables (57.5) (86.8) (105.2) (115.0) Net Working Capital The increase in working capital for the 2012/13 tariff period is primarily as a result of the increase in receivables due to the higher AR 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) for the 24 inch pipeline and TM2. 20

21 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 11: Deferred Tax Deferred Tax (RAB) 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Annual Depreciation - Historic Cost PPE Capitalised Borrowing Costs Levy 0.0 (6.3) (37.9) (37.9) Less Wear & Tear (199.7) (1,513.3) (2,025.0) (2,633.5) PPE (199.7) (1,586.8) (2,135.7) (2,670.9) Capitalised Borrowing Costs 0.0 (116.1) (173.5) (246.8) Levy Difference (11.3) (1,272.4) (1,678.8) (2,169.2) Annual Deferred tax (3.2) (356.3) (470.1) (607.4) Cumulative (3.2) (359.5) (829.5) (1,436.9) Deferred Tax taken to RAB 0.0 (3.2) (359.5) (829.5) 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. 21

22 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 Transnet has based the calculation of its weighted average cost of capital on NERSA s calculation of Transnet s WACC for 2011/12, which it has rolled-forward to 2012/ 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 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 1986 to March 2011, of the yields on government bonds, adjusted for inflation. Using NERSA s approach, as applied to the SARB bond yield and CPI data for the 300 months from April 1986 to March 2011, Transnet estimated an average risk-free rate over the specified 25 year period of 4.38%. 22

23 5.1.2 Market risk premium The market risk premium ( MRP ) is the return investors can expect to earn, over and above the risk-free rate, by investing in the market. This premium includes returns to investors in the form of dividends and capital appreciation, measured by the All Share Index ( ALSI ). Using NERSA s approach, as applied to the ALSI data for the 300 months from April 1986 to March 2011, Transnet estimated an average MRP over the specified 25 year period of 6.38% Beta The methodology requires the beta to be calculated based on betas for at least six pipeline companies. For this application, Transnet has used the same peers as listed in the NERSA 2011/12 decision. The companies are: Equitable Resources (USA); Enbridge Inc (Canada); El Paso Energy Corporation (USA); Magellan Midstream Partners L.P. (USA); Plains All American Pipeline, Limited Partnership (USA); and Provident Energy Trust (Canada). Transnet has followed the same 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: de-levering 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 re-levering of the weighted average asset beta into a proxy equity beta for TPL. Transnet has employed the market value of equity and the book value of debt when de-levering equity betas. This approach is consistent with NERSA s approach in its 2011/12 decision. 23

24 Further, Transnet has used the Harris and Pringle approach as prescribed in the methodology to de-lever the equity beta of the peer companies and to re-lever the asset beta to arrive at an equity beta for TPL. The asset beta was determined as the weighted average of the unlevered beta s of each of the peer companies, weighted by the total capital stock of each peer company. For the purposes of this application, Transnet has based its estimation of the beta on monthly data. The weighted average asset beta for the six peer companies determined by Transnet was This was converted to an equity beta for TPL by using the prescribed Harris and Pringle approach. The gearing for TPL for 2012/13 was estimated to be 44.30%, resulting in a Debt: Equity ratio of 0.8. Using this Debt:Equity ratio to convert the asset beta to an equity beta results in an equity beta for TPL of 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 9.55% as reflected in Table 12 below: Table 12: Real cost of equity Tariff Application Risk free rate 4.38% Market risk premium ( MRP ) 6.38% Equity Beta 0.81 Real cost of equity 9.55% 5.2 Cost of Debt Transnet s estimated weighted average cost of debt ( WACD ) for 2012/13 is 10.36%. The BER projected inflation rate for the 2012/13 financial year is 5.75%, resulting in a real post-tax cost of debt of 1.62%. 24

25 5.3 WACC The WACC is the weighted average of the cost of equity and the cost of debt. The cost of equity is 9.55%, and the cost of debt is 1.62%, which, with a gearing of 44.30%, results in a real WACC of 6.03% for Transnet Pipelines. 25

26 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 2012/13 cost structure for TPL will change due to the 24 inch trunkline (to be commissioned by January 2012) being in operation for the entire year as well the DJP which will be operated at a reduced flow rate and lower pressures. It will further be impacted by the planned operationalisation of TM2 from 1 January In this section, the TPL annual expenses which form a significant component of the total operating expenditure in the AR calculation and/or those that have shown significant increases compared to 2011/12 are analysed in detail. Expense forecasts (2011/12 Latest Estimate ( LE ) and 2012/13) are based on the latest actual information available. The 2012/13 expenses have been adjusted for inflation in accordance with data provided by the BER, except for electricity (municipal tariff increase) and fuel (brent crude), where specific indices to indicate expected increases where utilised. 26

27 A summary of TPL s expenses is shown in the table below. The variances between 2011/12 LE and 2012/13 forecasts are analysed in detail thereafter: Table 13: Summary of TPL Regulated Petroleum Expenses Expenses 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Salaries & Wages Materials & Supplies Professional Fees & Survey Costs Operating Fuel (68.5) Legal Expenses Rent - External Operating Leases Injuries & damages Insurance Bad Debt Other Expenses Electricity Security Telephone & Data Transport & Accommodation Decommissioning Provision Transnet Corporate Overhead Software & Fin Leased assets Other Miscellaneous Operating & Maintenance Expenses 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 associated with the operationalisation of the NMPP assets from 630 to Materials and Supplies In 2012/13, additional costs will be incurred relating to foam and inhibitors for the NMPP. 27

28 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. Professional fees include internal and external audit fees; SAP and desktop support as well as consulting fees for the bridging plan initiatives. 6.4 Operating Fuel The 2012/13 fuel cost is based on the projected fuel price per litre (for ordinary travel increased by the 550km long NMPP line) as well as additional costs pertaining to the NMPP standby generators. It should be noted that the net credit reflected in 2010/11 is as a result of a reversal of a provision previously calculated against operating fuel of R91 million. 6.5 External Operating Leases As a result of the commissioning of the NMPP, higher costs are expected due to the increase in operational activities such as servitude management and additional kilometres to be travelled for maintenance purposes (ordinary travel increased by the 550km long NMPP line). These increased activities will result in the lease of additional vehicles and increased helicopter flights. 6.5 Insurance The increase is as a result of the inclusion of insurance costs for the 24 inch trunkline for 12 months of the 2012/13 year as opposed to 3 months in 2011/12 (the trunkline comes into operation on 1 January 2012) and the commissioning of TM2 by 1 January Decommissioning Provision In line with section 27 of the PPA and Regulation 9.4, Transnet has to provide security in respect of its rehabilitation obligations. In line with the 2011/12 tariff decision, Transnet has included a proportionate value of its obligation to be recovered in its 2012/13 application. This has been informed by the latest audited independent study conducted in the 2010/11 financial year the results of which were communicated to NERSA on 07/06/2011. This amounts to R20.7 million for petroleum pipelines based on the amortisation per Table 14: 28

29 Table 14: 2012/13 decommissioning provision MAINLINES AVTUR CRUDE DJP DWP KENDAL FEEDERLINES DEPOTS WITH TANKS DEPOTS WITHOUT TANKS REFRACTIONATOR JMP TPO ALR ALR TO LLA KDL TO WAO 24" LINE PUMPSTATIONS Total Decommissioning Provision USEFUL LIFE OF ASSETS COMMISSIONING DATE TARIFF APPLIUCATION DATE AGE OF ASSETS REMAINING LIFE OF ASSET Amount recovered over remaining life Consequently the assets to be decommissioned have not been included in the RAB. 6.7 Transnet Corporate Overheads TPL as one of Transnet s operating divisions receives support and services from the Transnet Corporate Head Office that include financial, treasury, legal and human resources support. The corporate overheads are allocated to operating divisions based on various defined drivers. The costs allocated to TPL for the 2012/13 year is R189.8 million which is approximately 6.1% of Transnet s total corporate overhead costs. Based on the direct proportional cost allocation, 80.8% of TPL s allocated cost is assigned to petroleum pipelines. The major cost elements of the Transnet Corporate overhead include: Personnel costs including post-retirement benefits; Incentive programmes estimates; Managerial and technical consultancy fees; and Electronic data and telecommunication costs. No corporate social responsibility costs have been included. 29

30 Table 15: Transnet Corporate Cost Allocated to TPL Transnet Corporate Cost 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Total Allocation to TPL Less: Social Investment Spend (2.4) (4.0) (5.5) (5.7) Corporate Cost excl Social Investment Allocated to Petroleum Percentage allocation (%) 80.8% 80.8% 80.8% 80.8% 6.8 Other Miscellaneous Expenses Other miscellaneous expenses include the following significant items: Electricity Electricity (R189 million) is one of the cost elements that is volume driven as TPL s transporting activities are the main source of electricity consumption. The net increase of 25.1% in 2012/13 is predominantly due to the 25.9% Eskom tariff increase. It should further be noted that both the 24 inch trunkline and the DJP will operate for this tariff period Repairs and Maintenance Repairs and maintenance expenditure is based on the scheduled preventative maintenance plans for assets in use and for anticipated breakdowns. The increase is due to increased maintenance activities and the higher cost of maintaining the ageing DJP. The maintenance of the DJP line is of importance as the asset is ageing and the technical integrity of the line has to be maintained until its withdrawal from petroleum transportation use in order to meet the fuel requirements of the inland market. In addition to the higher DJP maintenance costs, 2012/13 costs also include the full-year maintenance of all the NMPP lines as well as the new telecommunication network and CCTV equipment Security This increase is due to the phased implementation of the National Key Points Act, 1980 (Act No. 102 of 1980) requirements with 3 new NMPP pump stations needing protection and in general, the anticipated security industry salary increases. 30

31 6.8.4 Other Costs The higher than inflation cost increase for 2012/13 is mainly due to the increase in Telecommunication and Data Costs as a result of the anticipated high volumes of data transmission due to the NMPP and new National Operating Centre sites. 7 Income Taxation Transnet has elected to use the normalised (notional) tax approach in its tariff application. Normalised tax refers to an estimated normalised tax expense with respect to the regulated activity for the tariff period under review. In accordance with the methodology it is calculated based on the following formula: Tax = (NPBT (excluding tax allowance) / (1-tr)) x tr Where: NPBT (excl tax allowance) = {(RAB x WACC) +E + D (of total TOC asset base) + F ± C} {E +D(historic)} tr = prevailing corporate tax rate The income tax allowance using the above formula amounts to R659.5 million in 2012/13. 31

32 8 Depreciation Depreciation is calculated on a straight line basis over the useful lives of the assets as per the methodology. The useful lives currently reflected in the regulatory asset register are aligned to the report issued by ADL it the last full valuation conducted in March 2009 and specific amendments per the index valuation (by ADL) conducted in March See Annexure B. Table 16: Depreciation Depreciation 2010/11 Act 2011/12 LE 2012/13 App 2013/14 FC Historic Depreciation PPE Capitalised Borrowing Costs Levy 0.0 (6.3) (37.9) (37.9) Revaluation PPE Capitalised Borrowing Costs Levy 0.0 (0.1) (3.3) (6.3) Total Depreciation PPE Capitalised Borrowing Costs Levy 0.0 (6.4) (41.2) (44.2) The estimated regulatory depreciation charge for 2012/13 is R398.8 million. Depreciation relating to new assets has been prorated in the year of capitalisation based on the period in which they are in operation. 32

33 9 F-Factor Transnet requests, in accordance with paragraph 9.2 of the methodology that NERSA considers for this application a F-Factor allowance for assets in operation and to be in operation during the 2012/13 financial year. As previously communicated to NERSA, rating agencies and Transnet loan covenants prescribe a cash interest cover of 3 times. The ratio utilised in the setting of this cash interest cover of 3 times is as follows: Cash generated from operations after working capital changes/total finance cost (including capitalised borrowing costs) Transnet understands that the ratio utilised by NERSA in terms of the methodology and NERSA s guidance document titled Interest Cover Ratio Range for the Petroleum Pipeline Industry ( Cash Interest Cover Guidance document ) is the following: EBIT/interest payable in the tariff period under review Where: EBIT = earnings before interest and taxes In its 2011/12 tariff application Transnet demonstrated that a cash interest cover of 3 times the Transnet ratio equates to 2.45 times the NERSA ratio. Transnet understands that the cash interest cover range that NERSA considers for purposes of awarding a F-Factor allowance is defined in the Cash Interest Cover Guidance document which specifies a range of times utilising the NERSA ratio. The cash interest cover for the basic AR is 1.3 times, utilising the NERSA ratio. Transnet accordingly requests that NERSA allows a F-Factor allowance to bridge the revenue gap between this 1.3 times and the required cash interest cover of 2.45 times, (utilising the NERSA ratio in both instances), for its 2012/13 tariff application. Transnet has calculated this additional revenue requirement to be R million, excluding the impact on the tax allowance. 33

34 10 Clawback The following formula has been used to determine the Clawback adjustment: Clawback adjustment = VA + OEA + FA + DCA + UA+ IA + GA Where: VA OEA FA DCA UA IA GA = volume adjustment = operating efficiency adjustment (only if more efficient) = approved revenue addition to meet debt obligations (F) adjustment = debt cost adjustment = used asset adjustment = inflation adjustment = general adjustment for any remaining differences between projected Allowable Revenue and actual Allowable Revenue not resulting from efficiency gains including tax. A summary of the clawback is shown in the table below. A detailed analysis on the clawback has been performed thereafter. A total clawback of R265 million has been included in the allowable revenue ( AR ) calculation. Table 17: Clawback Clawback NERSA 2010/11 RFD TPL Actual Clawback Volume adjustment 1,224 1,243 (19) Operating Cost Clawback (188) Operating Efficiency Cost of Debt 1,223 1, Stock (8) (8) SRAB Clawback on 2010/11 Clawback on 16 Inch Pipelines (122) (122) Clawback on 24 Inch Trunk Line Clawback (212) Time value of money 2010/11 14% (16) Time value of money 2011/12 16% (37) Total Clawback (265) (32) 34

35 10.1 Volume adjustment Paragraph 10.1 of the tariff methodology allows for differences in projected and actual volumes being clawback. The difference between the actual 2010/11 revenue and the revenue per the 2010/11 RFD has been clawed back Operating efficiency adjustment Paragraph of the tariff methodology permits a clawback against expenses based on a 2 step approach. Clawback on the operating expenses: projected less actual Clawback on operating efficiency: determined as the difference between operating efficiency projections made when the tariff was set and the actual operating efficiency achieved during the tariff period. The formula used is as follows o OeA = (EaOC AaOC) * actual volumes * 50% Where: OeA = Operating efficiency adjustment AaOC = Actual average operating costs (Actual operating expenditure volumes) EaOC = Estimated average operating costs (estimated operating expenditure estimated volumes 5 : Table 18: Operational efficiency adjustment 2010/11 RFD TPL Actual Volumes (billion litres) Expenses EaOC & AaOC Operating Efficiency 94 It should be noted that the actual costs of R473 million has been impacted by the reversal of a R91 million provision. 5 Paragraph of the tariff methodology 35

36 10.3 Cost of debt adjustment Paragraph of the tariff methodology indicates that where there are differences between the estimated cost of debt and the actual cost of debt, then the AR must be calculated using the actual cost of debt and the difference clawed back. The formula used to determine the debt cost adjustment is: KdA = Allowable Revenue recalculated using actual cost of debt Allowable Revenue calculated using projected cost of debt 6 Table 19: Cost of debt adjustment 2010/11 RFD TPL Actual Cost of Debt 2.22% 3.86% Return on Equity Return on Debt Expenses Depreciation Clawback (65) (65) F Factor 0 0 1,114 1,143 Notional Tax AR 1,223 1,261 Clawback 38 Other than the change in the cost of debt, all other components of the calculation has been kept constant Stock adjustment NERSA has previously advised that the product reconciliation process does not form part of the tariff application. Consequently, a clawback has been calculated on product reconciliation stock on which a return has been previously claimed as such stock was included in working capital. This has 6 Paragraph of the tariff methodology 36

37 been based on the last completed tariff period that is still open for review based on the final product reconciliation stock numbers for that period i.e. March March 2012 will be clawed back in the 2013/14 application. Product reconciliation stock has been not been reflected in the stock value reflected in the working capital of the current (2012/13) application. Table 20: Claw back against 2010/11 product reconciliation stock balance Stock 2010/11 RFD /11 Actual Clawback based on WACC Return inch pipelines adjustment The NMPP 16 inch Kendal to Waltloo pipeline was brought into operation at the end of April 2011 and the Jameson Park to Alrode and Alrode to Langlaagte pipelines were operationalised by the end of May 2011.These assets have been capitalised at a cost of... million. The pipelines where scheduled for operation on 1 January 2011 in the 2011/12 tariff application at a cost of... million. Consequently clawback on these assets has been calculated for 3 months of the 2010/11 tariff period and 2 months of the 2011/12 tariff period. Clawback has further been calculated against the actual capitalised cost for 10 months of the 2011/12 period. 37

38 Table 21: Claw back 16 inch NMPP operational from June 2011 rather than January inch clawback for last 3 months of the 2010/11 year Value of 16 inch line taken into account in 2011/12 RFD Capital ratio Mar Ke (for 3 months) 70% 5.38%... Kd (for 3 months) 30% 2.22%... WACC 4.43%... Depreciation... Total inch clawback for 2 months of the 2011/12 year Value of 16 inch line taken into account in 2011/12 RFD Capital ratio Mar Ke (for 2 months) 62% 8.94%... Kd (for 2 months) 38% 2.36%... Wacc 6.41%... Depreciation... Total inch clawback for 10 months of the 2011/12 year cost difference RFD... Final Cost... Difference in Cost... WACC Return... Depreciation RFD... New Depreciation... Difference... Total Total Clawback on 16 inch lines

39 inch pipeline adjustment The 24 inch pipeline is scheduled to be completed at the end of December The cost at which this pipeline was admitted to property, plant, vehicles and equipment in the previous tariff period was... million (before prorating for 3 months). As stated in the previous tariff application, this amount represented the best estimate of the asset at that time and that Transnet would communicate the final Board approved cost of the NMPP after the November 2010 Board meeting. This was duly communicated to NERSA on 10 December 2010 per Transnet s letter Response to NERSA request for additional information, detailing that the final approved cost estimate for the 24 inch trunkline is... million. Consequently, clawback has been calculated against the final approved cost of the asset for 3 months of the 2011/12 tariff period. Table 22: Claw back 24 inch trunkline Clawback on 24 Inch pipeline cost difference Value per 2011/12 Application... Revised value WACC Return... Depreciation RFD... New Depreciation... Depreciation Variance... Total Clawback on 24 inch line

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