Eskom Revenue Application. Multi-Year Price Determination (MYPD 4) FY2019/ /22

Transcription

1 Eskom Revenue Application Multi-Year Price Determination (MYPD 4) FY2019/ /22 September 2018

2 Content Content Preface... 7 Executive Summary Key elements of allowed revenue for the 2019/ /22 financial year Recovery of efficient costs Earning a reasonable return on assets Revenue recovery Electricity price impact in 2019/ / Basis of Application Legislative and regulatory framework Electricity Regulation Act (Act No. 4 of 2006) Electricity Pricing Policy Government Support Framework Agreement Municipal Finance Management Act (Act 56 OF 2003) Multi-Year Price Determination (MYPD) Methodology Focus is the revenue application for the 2019/ /22 financial years Guideline on Minimum Information Requirements for Tariff Applications (MIRTA) Eskom retail tariff and structural adjustment (ERTSA) methodology Context of MYPD 4 Application Key assumptions to address possible uncertainty during MYPD 4 period Eskom Governance challenges being addressed Eskom Business Model Eskom responses to business model challenges Allowable Revenue Allowed Revenue formula Allowed revenue if MYPD Methodology is applied Proposed MYPD 4 Allowed revenue application Revenue recovery Electricity price impact during application period Comparison to assumptions in draft IRP While tariff increases debt continues to increase Indicative Standard Tariff Increase Application of the ERTSA methodology Indicative increases by Standard tariff categories July Municipal (Local authority) tariff increase Eskom direct customers (Non-local authority tariff) increases Affordability subsidy charge increase Environmental levy recovery Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 2 of 115

3 Content 5.4 Average tariff category increases Protection of poor households Tariff structural changes during the MYPD4 control period Sales Volumes Introduction to Sales volumes Robust process to project sales volumes Projected sales volume Review of projected sales volumes Energy Wheel Production Plan Background to the production plan Production Planning Process Production Plan outcomes Energy Losses Weighted Average Cost of Capital Regulated Asset Base, Depreciation and ROA Assets (including WUC) comprise the following components: Assets as per the March 2016 asset valuation Work under construction (WUC) Depreciation Assets excluded from RAB Return on assets Capital Expenditure Primary Energy Overall summary of primary energy Trends in primary energy costs Revenue for coal costs Summary of coal burn costs for MYPD 4 period Independent Power Producers (IPPs) Water costs Open Cycle gas Turbine (OCGT) Fuel Demand Response Environmental levy Environmental levy payment Operating Cost Overall summary of operating costs Employee Benefits Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 3 of 115

4 Content Staff complement Employee benefits increases Operating and Maintenance costs Generation maintenance Transmission Distribution Other Operating Expenses Research, Testing and Demonstration Economic Landscape Changes World Bank Report Breakdown of Hidden costs Comparisons, benchmarking and efficiency of Operating and Maintenance cost Transmission and Distribution: Generation: Economic Impact Study Economic Landscape Changes Overview of historical trend in electricity consumption in South Africa Trend in electricity prices Requirements of an efficient electricity pricing regime Macroeconomic impacts of alternative scenarios Aim of the study Key scenario assumptions, and scenarios modelled Interpreting results of hypothetical scenarios particularly post-downgrade Approach Key findings and results Concluding remarks on economic impacts National Treasury and SALGA responses Summary of key responses provided to comments by National Treasury Period of the MYPD submission Economy-wide impacts of the proposed tariff Sales volume assumptions Municipal Debt Regulatory Clearing Account Primary energy Operating expenditure Regulatory asset base and return on assets Proposed tariff increases Summary of SALGA responses related to the MYPD 4 Revenue Application Impact on economy and affordability Customer centricity by lower increases in tariffs Further cost containment is required Depreciation and construction of assets Depletion of coal reserves Changes to energy mix Fraud and corruption Rationalisation of Municipal Tariffs Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 4 of 115

5 Content 17 Revenue requirements for licensees Generation allowable revenue Distribution allowable revenue Transmission allowable revenue Conclusion List of Tables Table 1: Total Allowable Revenue for the MYPD 4 Period Table 2: Eskom Debt Commitments Table 3: Revenue Recovery Table 4: Standard tariff price increase Table 5: Proposed Allowable Revenue Application Table 6: Recovery of Revenue Table 7: Standard tariff average price increase Table 8: Standard tariff increases Table 9: Projected sales forecast Table 10: Energy production per plant mix (GWh) Table 11 : Cost of Capital Table 12: Regulatory Asset Base (RAB) summary Table 13: Extract from Consultant 2016 Asset Valuation Report Table 14: FY2016 RAB values as assumed for purposes of MYPD3 Revenue Decision Table 15: Depreciation Table 16: Assets funded via upfront contributions and DOE Table 17: Return on Assets Table 18 : Capital Expenditure Table 19: Detailed Primary Energy cost Table 20 : Detailed Operating costs Table 21: Quasi-fiscal deficits of Utilities under current performance in country reference years Table 22: Power lines Table 23 : Generation Allowable Revenue Table 24 : Distribution Allowable Revenue Table 25 : Transmission Allowable Revenue Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 5 of 115

6 Content List of Figures Figure 1: Key contributors to increase in Allowed Revenue Figure 2: Contributors to Revenue Requirement Figure 3: Break down of Primary Energy costs Figure 4: Operating costs Figure 5: Extract from Integrated Resource Plan Figure 6: Price levels and increase in debt Figure 7: Current cross-subsidies in Eskom tariffs 2017/ Figure 8: Sales Forecasting Process Figure 9: The Energy Wheel for the Application year 2019/ Figure 10: The Energy Wheel for the Application 2020/ Figure 11: The Energy Wheel for the Application 2021/ Figure 12: Overall Production Planning process Figure 13: Process for valuation of existing assets Figure 14: Coal procured categorised by contract type (%) Figure 15: Annual coal expenditure per supply source Figure 16: Key cahllenges in Eskom s coal procurement environment Figure 17: Coal price comparisons Figure 18: Summary of REIPP costs over life of contracts Figure 19: Average energy price for REIPP contracts (2018 ZAR) over BId Windows Figure 20: Operating costs Figure 21: Projected of number of employees over the MYPD 4 period Figure 22: Comparison of Electric Supply Costs with cash collection in Figure 23: Breakdown of hidden cost Figure 24: Summary of scenarios modelled Figure 25: Impact on trend in real GDP and employment growth Figure 26: Impact on government Debt-to-GDP ratio Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 6 of 115

7 Preface Preface This Multi-Year Price Determination (MYPD) 4 revenue application is for the period 2019/20 to 2021/22 financial years. This revenue application has been prepared in accordance with the MYPD methodology as published by NERSA during October The NERSA revenue and tariff decisions will be implemented from 1 April 2019 for non-municipal customers and from 1 July 2019 for municipal customers. The previous revenue application was for a single year revenue application and was implemented for the one year period from 1 April 2018 to 31 March 2019 for non-municipal customers; and 1 July 2018 to 30 June 2019 for municipal customers. The MYPD methodology addresses two broad aspects, namely, the MYPD allowed revenue application and the adjustment of the allowed revenue through the regulatory clearing account (RCA) process. The focus of this application is the MYPD revenue application for the 2019/20 to 2021/22 financial years. Once NERSA has determined the allowed revenue in terms of the MYPD methodology, the tariffs and price adjustments are determined by NERSA on an annual basis for the three year period. These tariffs and price adjustments are determined in terms of the Eskom retail tariff and structural adjustment (ERTSA) methodology, as published by NERSA during March This revenue application does not include any RCA applications. The RCA applications for the 2014/15, 2015/16 and 2016/17 financial years (2 nd, 3 rd and 4 th years of the MYPD 3 period) were submitted to NERSA during May 2016, July 2016 and July 2017 respectively. NERSA has processed these three RCA applications. The public were afforded an opportunity to provide written comments and NERSA has undertaken national public hearings on the three RCA applications. The RCA balance decisions for the three years were made on 14 June A total RCA balance decision of R32.69 billion was made, as follows: RCA balance of R billion for the 2014/15 financial year; RCA balance of R billion for the 2015/16 financial year; and RCA balance of R8.055 billion for the 2016/17 financial year. The RCA balance of R32.69 billion will be recoverable from the standard tariff customers, local Special Pricing Agreements (SPAs) and international customers. The reasons for decision for the RCA balance decisions are yet to be published at the time of this MYPD 4 submission. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 7 of 115

8 Preface NERSA has communicated that an implementation plan for the RCA balance of year 2 (2014/15), year 3 (2015/16) and year 4 (2016/17) of the MYPD3 will be developed for approval by the Energy Regulator by 30 September Eskom understands the RCA balances are likely to be implemented in a phased manner with effect from 1 April The RCA decision to be made by NERSA by 30 September 2018 coincides with the implementation of the MYPD 4 revenue decision. The RCA application for the 2017/18 financial year (5 th year of the MYPD 3 period) will be submitted during September This brings to an end the RCA applications for the MYPD 3 period. All the RCA applications related to the MYPD 3 period were in accordance with the MYPD methodology published by NERSA during December In addition, the RCA application for the 2018/19 year will be made after the publishing of the annual financial results for the 2018/19 year (submission estimated to be during August 2019) in accordance with the MYPD methodology published during It is thus clarified that RCAs will continue to be applied for on an annual basis, in accordance with the requirements of the MYPD methodology. In the spirit of transparency, Eskom has included detailed submission documents to allow for further robust debate and understanding. These submission documents include: Eskom Revenue Application, Multi-Year Price Determination (MYPD) 4, for 2019/20 to 2021/22 period Eskom Generation Licensee Revenue Application, MYPD 4 for 2019/20 to 2021/22 period Eskom Transmission Licensee Revenue Application, MYPD 4 for 2019/20 to 2021/22 period Eskom Distribution Licensee Revenue Application, MYPD 4 for 2019/20 to 2021/22 period Ancillary services Technical Requirements Independent Economic Impact Studies - An overview of electricity consumption and pricing in South Africa - An analysis of the historical trends and policies, key issues and outlook in The macroeconomic impacts of alternative scenarios to meet Eskom s five-year revenue requirement Abbreviations & Glossary Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 8 of 115

9 Preface Note on Casting of Tables Certain tables may appear not to cast. However, it needs to be noted that in most cases the amounts reflected in the tables are rounded off to the nearest million rand. Thus the totals are a true reflection of the underlying complete amounts. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 9 of 115

10 Executive Summary Executive Summary This revenue application is being made for the 2019/20, 2020/21 and 2021/22 financial years following the Energy Regulator decision for the 2018/19 financial year of an average nominal increase of 5.23%. NERSA determined the total allowable revenue for the 2018/19 year of R190bn. This decision was made on the back of a 2.2% increase for the last year (2017/18) of the MYPD 3 period where it approved the total allowable revenue of R205bn. The allowed revenue resulted in an increase of 2.2% due to the base adjustments made in the preceding years as a result of the approved Regulatory Clearing Account (RCA) balances for Eskom (12.69% for 2015/16 and 9.4% for 2016/17). Both the 5.23% and 2.2% average increases resulted in consumers receiving a below inflation average increase over these two years. The Eskom Board has initiated the process of reviewing the NERSA decision for the 2018/19 financial year through an application lodged in the North Gauteng High Court. The notice was served on NERSA on 7 June NERSA has indicated that it will respond to this application. The application made is for the Court to set aside this administrative decision. Eskom is making a revenue application of R219bn, R252bn and R291bn for the 2019/20, 2020/21 and 2021/22 years respectively. This is arrived at by the following considerations. The implementation of the MYPD methodology will entail Eskom applying for cost reflective revenue that covers efficient and prudent costs as well as a return on assets corresponding to the weighted average cost of capital. A cost reflective tariff is one that allows Eskom to recover its efficient and prudently incurred costs and earn a reasonable return. The remainder of the building blocks in terms of the NERSA revenue formula, for this revenue application are in accordance with the MYPD methodology. This would result in a price increase of over 90% in the 2019/20 year. Due to the stage that the country is in with regards to migration towards cost reflectivity, this is not an option that Eskom is considering. As a first step towards sustainability of Eskom, it would be preferable for Eskom to ensure that the revenue caters for prudent and efficient costs as well as a reasonable return that matches the debt service commitments (interest and debt repayments). Thus the revenue related collectively to depreciation and return on assets must match the debt service commitments entailing the debt repayments and interest payments. This would manifest in a 29% increase in 2019/20, 13% in 2020/21 and 4% in 2021/22 financial years respectively. However, in the interest of the potential impact on consumers, Eskom has agreed to make a further sacrifice. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 10 of 115

11 Executive Summary Eskom, in this revenue application has applied the NERSA MYPD methodology, with a smoothed price path over the MYPD 4 period by phasing-in of the return on assets. The phased implementation was adopted ensure that by the 3 rd year (2021/22) the revenue allowed covers the full debt service commitments. This revenue requirement would correspond to a phased 15% average price increase for each year of the MYPD 4 period. However, the allowed revenue being applied for does not cover the entire debt commitment costs, equating to a cash shortfall totalling approximately R50 billion for 2019/20 and 2020/21. This is a significant sacrifice being made by Eskom in the interest of allowing the economy to adjust as the migration towards cost reflectivity. Eskom will use the proceeds from the liquidation of the MYPD3 RCA decisions to contribute to mitigating the debt service shortfalls. The details are reflected in the summary table below. TABLE 1: TOTAL ALLOWABLE REVENUE FOR THE MYPD 4 PERIOD Allowable Revenue (R'millions) AR Formula Application Application Application Forecast Forecast 2019/ / / / /24 Regulated Asset Base (RAB) RAB WACC % ROA X -1.32% -0.21% 1.45% 1.76% 2.46% Returns Expenditure E Primary energy PE IPPs (local) PE International purchases PE Depreciation D IDM I Research & Development R&D Levies & Taxes L&T RCA RCA + Subtotal R'm Not claimed in Application Corporate Social Investment (CSI) Total Allowable Revenue Eskom s reliance on debt has been increasing over the last few years. This is reflected in the debt commitments for the MYPD 4 period and beyond. The table below shows the debt commitments over the application period. In this MYPD 4 application, Eskom has sacrificed the return on assets to only allow for a significant recovery of the debt commitments for the period. Eskom s total debt commitment is a sum of the debt to be repaid and the interest payment. In the revenue application these payments are required to be accommodated by the sum of the depreciation and return on assets. However, Eskom is applying for the phased recovery that corresponds to a resultant average price increase of 15% for each of Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 11 of 115

12 Executive Summary the three year period. Eskom experiences a shortfall of approximately R50bn over the MYPD 4 period when compared to meeting debt commitments. TABLE 2: ESKOM DEBT COMMITMENTS Eskom Debt Commitments (R'm) Application Application Application Forecast Forecast 2019/ / / / /24 Debt securities and borrowings repaid Interest paid Total Debt service Return + Depreciation Variance in debt service cover As required by the MYPD Methodology, Eskom has requested an independent revaluation of its regulatory asset base (RAB) to determine the depreciated replacement cost. This value of the RAB will differ from the historic cost reflected in Eskom s financial statements, since it is a replacement cost that has been depreciated for the remaining life of the asset. The changes in the key contributors to the increase in the electricity price over the three year application period when compared to the NERSA revenue decision for the 2018/19 year are illustrated in the figure below. It needs to be noted that the two key areas that NERSA made significant changes in its decision when compared to the actual costs and projections provided. These areas included primary energy costs, specifically coal costs and operating expenditure. In most instances, the decision required Eskom to immediately reduce its cost base from 1 April 2018 to what NERSA had previously approved as efficient and prudent revenue in its MYPD 3 decision. Thus it is offered, that the compound average growth rate (CAGR), in the figure below, for primary energy costs and operational expenditure would be significantly lower when compared to efficient and prudent projections for the 2018/19 year. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 12 of 115

13 Executive Summary FIGURE 1: KEY CONTRIBUTORS TO INCREASE IN ALLOWED REVENUE The key reasons for requesting a smoothed price increase of 15% per annum includes that many elements that are outside of Eskom s operational control that contribute to the increase in revenue requirement over the three year period. The two key elements that contribute to this are the increase in debt service costs and IPP costs as illustrated in the figure above. Due to the significant variance between Eskom s application and the NERSA decision for key elements of primary energy, an initial increase is seen for the 2020 year. The subsequent nominal primary energy increases are minimal. Eskom has made every effort to control its operational costs resulting in muted nominal increases and even a decrease in the latter years. Eskom expects that the price impact to consumers for the 2020, 2021 and 2022 financial years will comprise a combination of the MYPD 4 revenue requirement as well the phasingin of the RCAs for the 2015, 2016 and 2017 financial years. NERSA has undertaken to make a decision with regards to the RCA phased implementation by end September It is thus understood that the RCA adjustment decision will be made prior to the MYPD 4 revenue decision and related price adjustments. Eskom is operating an ageing Generation fleet, notwithstanding the new power stations under construction. More than half of the stations and more than half of the coal-fired stations will be over 37 years old by the start of the MYPD4 period. Due to various Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 13 of 115

14 Executive Summary constraints, most notably inadequate capacity and financial limitations, the mid-life refurbishment and enhancement projects that are required to maintain and improve technical performance as plants age, have generally not been implemented. Together with high utilization that places higher than expected wear and tear on components and systems, in particular since 2008, this has contributed to a steady decline in generating plant availability over the past decade. Due to a combination of performance improvements, additional capacity (both Eskom and IPPs), as well as stagnant demand, the rapid decline in availability post 2010 has been arrested and availability has improved to 78% in 2017/18 from a low point of 72%. The constraints, particularly financial, however, remain and the reversing overall trend to maintain and improve current performance continues to be a challenge. 1.1 Key elements of allowed revenue for the 2019/ /22 financial year Eskom s allowed revenue requirement is based on the Electricity Regulation Act, 2006 (Act No.4 of 2006), Section 15(1) requires tariff principles which: Must enable an efficient licensee to recover full cost of its licensed activities, including a reasonable margin or return This basis is reinforced in the Electricity Pricing Policy and the MYPD Methodology. Eskom has applied this principle to the extent possible, where efficient and prudent costs are motivated and included. As referred to previously, the return on assets (ROA) continue to be phased-in over the MYPD 4 period. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 14 of 115

15 Executive Summary FIGURE 2: CONTRIBUTORS TO REVENUE REQUIREMENT The figure above illustrates the key contributors to the allowed revenue for each of the MYPD 4 application years. Key contributors are the debt service costs represented by depreciation and returns. This is followed by primary energy costs and operating costs. 1.2 Recovery of efficient costs a. Primary Energy costs: Primary energy costs equate to the costing of the electricity supply required to meet demand. The three sources of electricity supply are Eskom own generation, domestic independent power producers (IPPs) and regional imports as is depicted in the figure below. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 15 of 115

16 Executive Summary FIGURE 3: BREAK DOWN OF PRIMARY ENERGY COSTS Due to the roll out of DOE renewable IPP programmes up to bid window 4.5, local IPPs have grown over the last few years. Eskom s own generation is used to meet the balance of supply as renewables are non-dispatchable. The expected revenue requirement related to the IPP programme is approximately R105bn for the 2019/20 to 2021/22 application years. Eskom s strategy for the procurement of coal is based on a portfolio mix, with the majority being sourced from long term contracts. However, it is not possible to contract for all of Eskom s coal requirements on long term contracts. It is prudent to have a portfolio of coal supply agreements that allows flexibility to meet changing electricity demand patterns. The largest component of the projected annual coal costs is the costs from existing and new long term coal sources. This is in line with the first principle of the long term coal supply strategy, namely, securing long term contracts with mines close to power stations. Revenue related to coal costs is approximately R198bn for the three year application period. Cross border purchases, substantially from Cahorra Bassa will cost approximately R11bn for the three year period. Approximately R 25bn is the allowed revenue related to environmental levy costs based on a rate of 3.5c/kWh energy generated. It is assumed for the planning period that no further Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 16 of 115

17 Executive Summary rate increases will occur. This environmental energy revenue is paid to the South African Revenue Services (SARS). b. Operating costs: Operating expenses are expected to escalate on a year on year basis from 2019/20 on an average, at less than inflation. Almost half of the operating cost is attributable to employee benefits with the maintenance and other opex making up the remainder. FIGURE 4: OPERATING COSTS It is expected that employee costs will increase, on an average, by less than inflation over the period. Significant efficiencies would be achieved over the period by reducing the number of employees without compromising the required skills in appropriate areas. The employee benefits comprises of direct remuneration (salary, pension, medical aid, bonus, overtime) and indirect remuneration (training and development, temporary and contract staff). Eskom s total labour cost escalations over the last 5 years have tracked the market escalations. As the business strives to accelerate maintenance programmes, and given the ageing plant it is expected that maintenance costs should increase. Eskom will ensure that maintenance is carried out prudently and efficiently. The growth in other operating costs is on average less than inflation for the period. Included in this category are costs such as insurance, information technology, fleet costs, legal and audit services, security, travel expenses, billing costs, connection/disconnection costs, meter reading, vending commission costs and telecoms. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 17 of 115

18 Executive Summary 1.3 Earning a reasonable return on assets Return on assets is computed on a revalued regulatory asset base (RAB) with the intention to cover interest costs and earn an equity return. The opening RAB balance for FY2019/20 is based on the valuation undertaken by independent external consultants, with a modern equivalent asset value (MEAV), which is then adjusted for the latest capital expenditure forecasts for the period FY2020 to FY2022. The average starting RAB value for FY2020 is approximately R 1 268bn. Key reasons for the change in the RAB value is the change in the overnight cost of generation which has increased between the previous 2010 valuation (used for MYPD3 and the FY2019 revenue decision) and the 2016 valuation. The RAB was valued as at 31 March 2016 for the purposes of this application. The previous RAB valuation was undertaken during To minimise the impact of price increases on the consumers the return on assets is phased-in over a longer period than envisaged at the time of the MYPD 3 application. This reflects the sacrifice that Eskom is proposing to allow for migration to cost reflectivity. Thus the return on assets being applied for is R861m and the depreciation being applied for is R 213bn over the three year MYPD 4 period. Eskom, in this revenue application has applied the NERSA MYPD methodology, with a smoothed price path over the MYPD 4 period by phasing-in of the return on assets. The phased implementation was adopted ensure that by the 3 rd year (2021/22) the revenue allowed covers the full debt service commitments. This revenue requirement would correspond to a phased 15% average price increase for each year of the MYPD 4 period. However, the allowed revenue being applied for does not cover the entire debt commitment costs, equating to a cash shortfall totalling approximately R50billion for 2019/20 and 2020/21. This is a significant sacrifice being made by Eskom in the interest of allowing the economy to adjust as the migration towards cost reflectivity. 1.4 Revenue recovery Eskom s Company revenue is recovered from negotiated pricing agreement (NPA) customers, international customers and the balance from standard tariff customers. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 18 of 115

19 Executive Summary TABLE 3: REVENUE RECOVERY MYPD3 Revenue recovery (R'millions) Decsion Decision 2018/19 Application 2019/20 Application 2020/21 Application 2021/22 Forecast 2022/23 Forecast 2023/ /18 NPA and International Customers Standard tariff Customers Total Allowable Revenue The recovery of the Negotiated Pricing Agreement (NPA) revenue is in accordance with the contracts that have been concluded with the entities. The revenue recovered from international customers would also be in accordance with the contracts with the international customers and utilities. 1.5 Electricity price impact in 2019/ /22 The impact on the standard tariff average price increase of the allowed revenue being applied for is reflected in the table below. An assumption is made based on the latest available standard tariff volumes as determined prior to this application being made. In accordance with the NERSA MYPD methodology, a revision on the sales volume to reflect the prevailing situation just prior to NERSA making its decision can be considered by NERSA. TABLE 4: STANDARD TARIFF PRICE INCREASE Standard tariff price impact Unit MYPD3 Decision Application Application Application Forecast Forecast Decision 2018/ / / / / / /18 Standard tariff revenue A R'm Standard tariff sales volumes GWh Standard tariff price c/kwh Standard tariff price adjustments % 2.2% 5.23% 15.0% 15.0% 15.0% 10.0% 10.0% Every effort is being made to smooth the tariff increase over the MYPD 4 period. This results in an average 15% increase over the three year period. As clarified previously, the allowed revenue being applied for does not allow for the debt service commitments to be recovered in each year. The equity return is not at all catered for. This is a sacrifice that Eskom is proposing in the interest of NERSA being in a position to balance the sustainability of Eskom with the impact on consumers. Eskom understands that NERSA will make a decision on the phasing-in of the Regulatory Clearing Account (RCA) applications for the 2014/15, 2015/16 and 2016/17 years. It is thus likely that the average price increases experienced by consumers during the MYPD 4 period would need to take the RCA adjustments into consideration. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 19 of 115

20 Basis of Application 2 Basis of Application 2.1 Legislative and regulatory framework The adherence to the various related legislative, regulatory and licence requirements form the basis of the MYPD application. A revision to allow for the smoothing of the tariff increases as well a migration towards cost reflectivity is accounted for. The following are applicable to the determination of Eskom s allowed revenue and resulting tariff adjustments Electricity Regulation Act (Act No. 4 of 2006) Prescribes tariff principles including: Revenues enabling an efficient licensee to recover the full cost of its licensed activities, including a reasonable margin or return; Avoidance of undue discrimination between customer categories; Permitting the cross subsidy of tariffs to certain classes of customers by the Energy Regulator; Approval of tariffs by the Energy Regulator Electricity Pricing Policy EPP gives broad guidelines to the Energy Regulator in approving prices and tariffs for the electricity supply industry Government Support Framework Agreement The Government Support Framework Agreement (GSFA) with regards to the Department of Energy procured Independent Power Producers, under section 34 of the Electricity Regulation Act, was signed by Government (represented by the Ministers of Energy, Finance and Public Enterprises) and Eskom in In accordance with section 3.1.4(e) of the GSFA, Eskom is required to consult with and seeks approval from the Department of Energy (DOE) together with the Department of Public Enterprises (DPE) and National Treasury with regards to the proposed amounts for IPP purchase costs and payment obligations to be included in any revenue application. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 20 of 115

21 Basis of Application Municipal Finance Management Act (Act 56 OF 2003) Eskom is required to take into account comments from the National Treasury and organised local government on the draft revenue application. The revenue application should include a motivation for adjustment of tariffs; consideration of impact on inflation targets and other macroeconomic policy objectives; Eskom s efficiency improvements and objectives. The need to timeously table approved adjusted tariffs in Parliament for implementation for Municipal customers. Eskom has solicited comments from National Treasury and SALGA. Comments received have been considered in the finalisation of this submission to NERSA Multi-Year Price Determination (MYPD) Methodology The revenue application is based on the requirements of the MYPD methodology as published by NERSA during October The MYPD methodology addresses two broad aspects, namely, the MYPD allowed revenue application and the adjustment of the allowed revenue through the regulatory clearing account (RCA) process. The focus of this application is the MYPD revenue application for the 2019/ /22 financial years. It is clarified that this revenue application does not include any RCA adjustments. NERSA made decisions on the how the MYPD methodology requirements could be complied with in its decision on Eskom s application for condonation during the 2018/19 revenue application. Eskom has made assumptions to meet the requirements of the MYPD methodology in this MYPD 4 application in accordance with the above-mentioned NERSA decisions. In developing the MYPD Methodology, the following objectives were adopted by NERSA: to ensure Eskom s sustainability as a business and limit the risk of excess or inadequate returns, while providing incentives for new investment; to ensure reasonable tariff stability and smoothed changes over time consistent with socio-economic objectives of the Government; to appropriately allocate risk between Eskom and its customers; to provide efficiency incentives without leading to unintended consequences of regulation on performance; to provide a systematic basis for revenue/tariff setting; and To ensure consistency between price control periods. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 21 of 115

22 Basis of Application Focus is the revenue application for the 2019/ /22 financial years Eskom made a revenue application for the 2018/19 financial year during August The final application was for total allowed revenue of approximately R213bn. This corresponded to an absolute increase of 3.7% in allowed revenue when compared to the revised revenue decision for the last year of the MYPD 3 period made by NERSA. However, the price impact would have been higher due to the allowed revenue being recovered from a lower sales volume. This is due mainly to the recovery of the allowed revenue through sales volumes which have decreased by more than 13% when compared to the NERSA decision for sales volumes in the last year of the MYPD 3 period. On 15 December 2017, NERSA made a decision of a total allowable revenue of approximately R190bn for the 2018/19 financial year, representing a 5.23% increase in average selling price albeit reducing allowed revenue by roughly R29bn as compared to Eskom s original application. This corresponds to approximately R22bn less than what Eskom had requested in its revised application (due mainly to a lower assumption on local IPP costs of R7bn). Nersa s decision resulted in dropping the allowed revenue in absolute terms by R15bn from R205bn (2017/18 year 5 of MYPD3) to R190bn (2018/19). On the back of 2.2% increase for the 2017/18 year, this results in an average increase (nominal) of approximately 3.75% over the two years. This is in the context of Eskom still migrating towards being in a position to recover the cost of producing the electricity. This MYPD 4 application revenue application for the period 2019/20 to 2021/22 financial years is made on the back of these previous decisions Application does not include RCA adjustments It is clarified that Eskom has not applied for any RCA adjustments in this revenue application. The RCA process is backward looking and allows for adjustment of future tariffs to address past variances (in accordance with the MYPD methodology) between the revenue decision and the actuals that panned out. When a new MYPD revenue application is made, it is forward looking and based on projected assumptions. There is a direct link between MYPD decisions and RCA applications where risks are managed in RCA applications. Thus if a significant risk is passed to Eskom at the stage of a revenue decision, the impact would materialise in a RCA application. Thus the consumer is protected from the risk at an initial stage during the revenue determination. Variances in RCA applications are linked to two key sources: Variances in costs due to a changing environment and assumptions that materialize after the MYPD decision; Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 22 of 115

23 Basis of Application Assumptions made during the MYPD revenue decision which do not materialise Guideline on Minimum Information Requirements for Tariff Applications (MIRTA) Eskom accepts that MIRTA is not prescriptive. It is a guideline providing direction to the licensee in compiling a revenue application. Eskom will endeavour to address the requirements as far as possible Eskom retail tariff and structural adjustment (ERTSA) methodology The 1 March 2016 ERTSA methodology is the NERSA regulation governing the tariff increases to the Standard tariffs. The ERTSA is applicable to Eskom s Standard tariffs for local authorities (Municipal) and non-local authorities (non-municipal). Once the NERSA has made a revenue determination for an Eskom MYPD application, Eskom is required to submit an ERTSA application prior to the start of each year of approved MYPD period. The ERTSA application consists of an application for the rate of adjustment to Standard tariffs and the proposed Schedule of standard tariffs for each financial year. An indication of this revenue application s impact on Standard tariffs increases to the different tariff groups is contained in Section on indicative increases to Standard Tariffs. For the MYPD4 period, this revenue application does not deal with any potential Eskom tariff changes. Going forward, within the next 3 years, Eskom wishes to provide for tariff structures that meet the changing needs of customers and Eskom. Eskom will make separate submissions to NERSA to propose and implement Standard tariff structures changes during the control period. Although there may be differentiated impact amongst customers, the basis is that the allowed revenues and NERSA decision forecasted sales would be applied to ensure that only the allowed Eskom revenue is recovered. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 23 of 115

24 Context of MYPD 4 Application 3 Context of MYPD 4 Application 3.1 Key assumptions to address possible uncertainty during MYPD 4 period The key reason for the NERSA approval of a single year revenue application by Eskom for the 2018/19 year was the level of uncertainty in the planning horizon. Many of these uncertainties still prevail during the 2018 calendar year when this MYPD 4 revenue application is being prepared. However, the Eskom Board has decided to make certain key assumptions with regards to the specific areas of uncertainty and submit a three year application for the 2019/20 to 2021/22 financial years. A draft updated Integrated Resource Plan (IRP) 2018 was published for public comments on 27 August The public was invited to make comments within 60 days. It is envisaged that the IRP will then be finalised subsequent to this. For the purposes of this revenue application, it is assumed that no further allocations for Eskom-build will be made for the MYPD 4 revenue period in the Integrated Resource Plan, should it be finalised during the MYPD 4 period. No further allocation of Independent Power Producer contracts will be made, in addition to that which has been included in this application, as approved by the relevant Government Departments in accordance with the GSFA. As the Carbon Tax is still in a consultation process it is assumed not to have any material impact on this MYPD 4 revenue application. In the event, that any material impact does occur, relevant adjustments would need to be made. This could be implemented during the ERTSA implementation or RCA adjustment process. It is assumed that legislative changes that markedly affect the operations of Eskom s business and license conditions will not occur during the MYPD 4 period. 3.2 Eskom Governance challenges being addressed The appointment of the new Eskom Board of Directors by government in January 2018 was seen as a step in the right direction for Eskom s operational and financial stability. As at September 2018, the following interventions related to Eskom s governance challenges have been instituted. 10 implicated senior executives exited. Finalisation of outstanding disciplinary hearings relating to senior executives being accelerated. 11 criminal cases opened, five of which involve nine senior executives. Total of outstanding disciplinary cases since April 2018, of which 628 have been finalised, resulting in 75 employee exits. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 24 of 115

25 Context of MYPD 4 Application 239 whistle-blowing cases investigated, 122 of which have been concluded. Disciplinary process is under way in respect of 67 confirmed cases. Remedial action has been taken against 25 staff doing business with Eskom; 7 exited. Lifestyle audits of senior management in progress. There is effective declaration of interest. Investigated all irregular supplier contracts (five are no longer doing business with Eskom). Recovered R902 million from McKinsey with an additional R99 million recovered relating to interest. Eskom is cooperating with eight regulatory bodies conducting major investigations. These are National Treasury procurement investigations, Zondo Commission, Hawks, SIU, Parliamentary Inquiry, National Director of Public Prosecutions, Standing Committee on Public Accounts and SAPS. It is clarified that this MYPD 4 application does not include any of the known cases of corruption, fraud or irregular expenditure. 3.3 Eskom Business Model The Business Model for any organisation refers to the way in which an organisation is structured and financed to deliver specific goods and services to a preferred market in order to fulfil its fundamental objective or purpose. How it does so successfully, speaks to the unique ways in which the socio-economic context together with specific rules of engagement; competitor relations and stakeholder expectations is addressed and ultimately adds value to the customer. Eskom is a State Owned Enterprise (SOE) whose key objective is to assist in lowering the cost of doing business in South Africa; enabling economic growth; and providing stability of Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 25 of 115

26 Context of MYPD 4 Application electricity supply through providing electricity in an efficient and sustainable manner. Like conventional agents of state, the purpose of the organisation is to realise the objectives of Government, which are to eliminate poverty and reduce inequality through specific growth priorities, detailed in the National Development Plan 1. Eskom s objectives to support building a competitive and comparative advantage for South Africa s economy through growth and development, revolves around reliable electricity delivery. This has been possible given an established vertically integrated structure of owning and operating power stations; an integrated national transmission grid and distribution networks, as well as a history of extending electricity access to all citizens served by those networks. Electricity delivery addresses the objective of poverty alleviation, not only through the availability of electricity which is fundamental for economic growth and social development but also because it attracts investment, which in turn drives job creation and increased levels of employment. Another aspect addressed by electricity supply is the reduction of inequality as driven by the transformation programme. This is a three pronged approach that: ensures electrification to those not yet connected to the national grid so that access to electricity for previously un-electrified communities can be rectified focuses on B-BBEEE procurement to support the empowerment of previously disadvantaged sectors of the population and address the class based inequalities of the past develops learners (through a skills and training pipeline aimed to place them effectively in meaningful jobs both within the organisation and/or the industry) and communities (through dedicated CSI efforts) as independent contributors to the wider socio-economic landscape Eskom responses to business model challenges Eskom is currently responding to the threat of a death spiral in a number of ways to transition the business and turn it towards growth. This transitional approach must be both adaptive and resilient with regards to technology choice (current, emerging and future) and how this technology can be applied to accommodate changing demand and supply needs, as well as address competition from disruptive technologies. This means that Eskom has to 1 National Development Plan ( Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 26 of 115

27 Context of MYPD 4 Application consider new generation investments carefully: firstly with regards to the timing to avoid stranded assets, secondly considering the investment risk and thus to explore smaller, incremental responses. The following operating principles will determine the future shape of operations: Ensure that Eskom plant remains consistently reliable and provide the required reserves Increased flexibility by lowering operating minimums New Plant must consider flexible options (OCGTs, CCGTs and Engines) Decrease demand during peak and increase demand during other hours to best utilise the base load plant already on the system. The transition takes into consideration the need for security of supply and the continued viability of the grid, cost reduction to address the financial sustainability crisis and a focus on revenue stability and recovery. Initiatives also include a review of the operating model and consideration of the structure of the company, to ensure efficiency and effectiveness. This is being achieved through the Design to Cost plans which focus on reducing costs, but also diversifying into new products and markets to sell more of the existing and in the longer term, new relevant products. These longer term options for new products and markets are being considered through work on the Future Role of Eskom, such as directly developing new generation in the region considering local and regional market dynamics as criteria. Customer centricity is at the heart of the proposed transition. In particular, investment decisions now need to be made with the changing market and customer in mind. New revenue growth will prioritise those products that are currently disruptive, e.g. renewables through rooftop PV, storage and smart technologies. This will allow Eskom to off-set lost sales and continue to meet changing customer needs. In addition, Eskom will grow into new areas which will boost current electricity sales through selling of excess capacity, working with government to encourage new industrial investment and positioning itself for sales positive technologies such as e-mobility. Eskom will also diversify into markets where core competencies can be sold as a service, as well as leverage the use of land and servitudes. To support this transition and avoid the death spiral, operational improvement; strategic repositioning into new areas will all be needed with the necessary trade-offs. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 27 of 115

28 Allowable Revenue 4 Allowable Revenue 4.1 Allowed Revenue formula Eskom s revenue requirement application for MYPD 4 period 2019/ /22 is based on the allowed revenue formula as reflected in the MYPD methodology: AR = (RAB WACC)+E+PE+D+R&D+IDM±SQI+L&T±RCA Where: AR = Allowable Revenue RAB = Regulatory Asset Base WACC = Weighted Average Cost of Capital E = Expenses (operating and maintenance costs) PE = Primary Energy costs (inclusive of non-eskom generation) D = Depreciation R&D = Costs related to research and development programmes/projects IDM = Integrated Demand Management costs (EEDSM, PCP, DMP, etc.) SQI = Service Quality Incentives related costs L&T = Government imposed levies or taxes (not direct income taxes) RCA = The balance in the Regulatory Clearing Account (risk management devices of the MYPD) 4.2 Allowed revenue if MYPD Methodology is applied Eskom is not considering the scenario where a full return on assets is being applied for. It is felt that the resultant increases would be untenable for the consumer. The Eskom Board has decided to only consider options that continue to phase-in of the return on assets. Comparisons will be made to the debt commitments. This, in essence is a further extension of the implementation of the Electricity Pricing Policy. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 28 of 115

29 Allowable Revenue 4.3 Proposed MYPD 4 Allowed revenue application This revenue application is being made for the 2019/20, 20120/21 and 20121/22 years following the Energy Regulator decision for the 2018/19 year of an average nominal increase of 5.23%. Eskom is making a revenue application of R219bn, R252bn and R291bn for the 2019/20, 2020/21 and 2021/22 years respectively. Eskom, in this revenue application has applied the NERSA MYPD methodology, with a smoothed phasing-in of the return on assets. The phased implementation of the return on assets is to ensure that a significant portion of the interest cost and repayment costs are covered over the three year period. However, the allowed revenue being applied for does not cover the entire debt commitment costs. Due to the smoothing of the price, Eskom does not recover sufficient revenue in the first two years of the application period to enable the payment of the interest and debt commitments in those years. It is only in the third year of the MYPD 4 that the debt commitments are forecasted to be catered for in the revenue application. This is a significant sacrifice being made by Eskom in the interest of allowing the economy to adjust as cost reflectivity is being migrated towards. A cost reflective tariff is one that allows Eskom to recover its efficient and prudently incurred costs and earn a reasonable return. The remainder of the building blocks in terms of the NERSA revenue formula, for this revenue application are in accordance with the MYPD methodology. The details are reflected in the summary table below. TABLE 5: PROPOSED ALLOWABLE REVENUE APPLICATION Allowable Revenue (R'millions) AR Formula Application Application Application Forecast Forecast 2019/ / / / /24 Regulated Asset Base (RAB) RAB WACC % ROA X -1.32% -0.21% 1.45% 1.76% 2.46% Returns Expenditure E Primary energy PE IPPs (local) PE International purchases PE Depreciation D IDM I Research & Development R&D Levies & Taxes L&T RCA RCA + Subtotal R'm Not claimed in Application Corporate Social Investment (CSI) Total Allowable Revenue Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 29 of 115

30 Allowable Revenue 4.4 Revenue recovery Eskom s Company revenue is recovered from international customers, negotiated pricing agreement (NPA) customers with the balance from standard tariff customers. TABLE 6: RECOVERY OF REVENUE Revenue recovery (R'millions) MYPD3 Decsion 2017/18 Decision Application Application Application Forecast Forecast 2018/ / / / / /24 NPA and International Customers Standard tariff Customers Total Allowable Revenue The recovery of the Negotiated Pricing Agreement (NPA) revenue is in accordance with the contracts that have been concluded with the entities. The revenue recovered from international customers would also be in accordance with international customers contracts and utilities. It is clarified that NERSA will make a decision on the phasing of any RCA adjustments related to RCA balance determination made by NERSA during June In accordance with the NERSA communication, the phasing of the RCA implementation will be approved by September Electricity price impact during application period The impact on the standard tariff price increase of the allowed revenue being applied for is reflected in the table below. An assumption is made on the latest available standard tariff volumes as determined prior to this application being made. In accordance with the NERSA MYPD methodology, a revision on the sales volume to reflect the prevailing situation just prior to NERSA making its decision can be considered by NERSA. TABLE 7: STANDARD TARIFF AVERAGE PRICE INCREASE Standard tariff price impact Unit MYPD3 Decision Application Application Application Forecast Forecast Decision 2018/ / / / / / /18 Standard tariff revenue A R'm Standard tariff sales volumes GWh Standard tariff price c/kwh Standard tariff price adjustments % 2.2% 5.23% 15.0% 15.0% 15.0% 10.0% 10.0% 4.6 Comparison to assumptions in draft IRP The following figure illustates the assumptions made in the draft IRP (2018) with regards to the price curve for electricity. This would be used to make comparisons for determining further investments in the electricity industry. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 30 of 115

31 Allowable Revenue FIGURE 5: EXTRACT FROM INTEGRATED RESOURCE PLAN The IRP states that : From financial year 2017/18, the tariffs will immediately move to costreflective levels as per the NERSA methodology The implication of the IRP tariff is By Jan 2019 the cost reflective price would be 110c/kWh (2017) Corresponds to 124c/kWh (2019) Assume 30% increase from 94c/kWh in Jan 2019 By Jan 2022 the cost reflective price would be 115 c/kwh (2017) Corresponds to 154c/kWh (2022) These assumption being made in the draft IRP indicate the significant migration required for Eskom tariffs required to become cost reflective. 4.7 While tariff increases debt continues to increase Since 2008/9 financial year, the average price of electricity has increased from approximately 20c/kWhr to 94c/kWhr in the 2018/19 financial year. It is recognized that this is approximately a five-fold increase. However, a more alarming trend has been an approximate ten-fold increase in Eskom s debt within the same period. It is recognised that Eskom s capital expansion programme has also occurred during the same period. This illustrates the challenges being faced by Eskom as it migrates towards cost reflective tariffs that allow for efficiently and prudently incurred costs with a reasonable return. To be sustainable, there is a need to increase the cash from operations and minimise the amount of debt being raised. Thus the migration towards cost reflective tariffs is central to the Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 31 of 115

32 2007/ / / / / / / / / / / /19 Rand millions Price c/kwh Allowable Revenue sustainability of a utility such as Eskom. Debt would continually need to be raised to be in a position to fund the capital requirements to continue to operations of the business. FIGURE 6: PRICE LEVELS AND INCREASE IN DEBT Price levels and Debt increasing Total debt (LHS) c/kwh (RHS) Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 32 of 115

33 Indicative Standard Tariff Increase 5 Indicative Standard Tariff Increase 5.1 Application of the ERTSA methodology After the NERSA MYPD determination, the increased municipal and non-municipal Standard tariffs are submitted to NERSA for approval; in compliance with the NERSA March 2016 Eskom Retail Tariff and Structural Adjustment (ERTSA) methodology. The provided indicative increases to the Standard tariffs are determined as follows: The annual average increases to the municipal and non-municipal tariffs used to determine the respective municipal and non-municipal annual revenues are the same as per Rule 5 of the ERTSA methodology. The 1 July municipal (Local authority) tariff increase is calculated as per Rule 6 of the ERTSA methodology. That is, for implementation at the beginning of the local authority financial year (01 July) that is three months into the Eskom application year. The 1 July municipal increase provides for the Eskom recovery of the municipal annual revenues during the Eskom financial year. The non-municipal (Non-local authority) average increase is the annual average increase as per the ERTSA methodology Rule 5.8. The Homelight 20A increase follows on Rule 7.1 and Rule 7.2 that provides for the Energy Regulator as part of the MYPD to allow cross-subsidies and that these subsidies can be implemented as a part of the annual average increase: - For the provided indicative increases, as this is a new MYPD application, the nonmunicipal average increase is applied; any lower tariff increases to the Homelight 20A tariff are for the NERSA determination. - In this application, the increase to the Affordability subsidy charge that caters for the recovery of lower increases to the Homelight 20A tariff reflects the recovery of the cumulative lower increases to the Homelight 20A tariff since 2013/14. The affordability subsidy charge increase therefore remains at around the same level as the non-municipal average increase. The ERTSA Standard tariff increases do not result in structural changes and implementation of new tariffs as per the ERTSA methodology rule 3.2. Eskom will make applications for Structural changes after the revenue application that will include updating Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 33 of 115

34 Indicative Standard Tariff Increase the Standard tariffs with the latest cost of supply for tariffs; changes to TOU tariffs, etc. - this is further discussed below. The indicative increases to the Standard tariffs only include the consideration of this application s applied for revenues and forecasted sales and therefore do not include any consideration for purposes of implementing the RCA adjustments as per the Rules 5.1 and 5.2 of the ERTSA methodology. 5.2 Indicative increases by Standard tariff categories After applying the ERTSA methodology to recover revenues through the Standard tariffs, the 2019/20, 2020/21 and 2021/22 indicative increases by Standard tariff categories are set out in the table below July Municipal (Local authority) tariff increase Using the ERTSA methodology; the 15% average increase translates to a 1 July 2019 localauthority tariff increase of 17.60% to municipalities. Municipalities continue to pay at the previous year s rates for the period 1 April to 30 June as per the Municipal Finance Management Act (MFMA). This equates to a price increase of 17.60% from 1 July 2019; a price increase of 14.20% from 1 July 2020 and a price increase of 15.20% from 1 July Eskom direct customers (Non-local authority tariff) increases The 1 April 2019 non-municipal tariffs increase including the Homelight 20A tariff is the ERTSA / annual average increase of 15% for 1 April 2019; a price increase of 15% from 1 April 2020 and a price increase of 15% from 1 April Affordability subsidy charge increase The 28 February 2013 MYPD3 decision `provides that the affordability subsidy charge is recovered from key industrial and urban non-municipal customers. Consequently, the large industrial and urban (non-municipal tariffs paying the affordability subsidy) will on average experience an additional average 0.49c/kWh from 1 April 2019/20 that is an additional 0.48% to the 1 April % increase; an additional 0.9% from 1 April 2020/21 and an additional 1.29% from 1 April 2021/22. This amounts to an increase of 15.41% to the Affordability Subsidy charge on 1 April From 1 April 2020 the affordability subsidy charge increases by 15.71% and from 1 April 2021 this is a 15.84%. 5.3 Environmental levy recovery As part of the ERTSA submission, an environmental levy charge rate(c/kwh) is used to recover the costs of the environmental levy from all customers. For Standard tariffs, the Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 34 of 115

35 Indicative Standard Tariff Increase environmental levy recovery is embedded in the energy tariff charges. For local NPA and export sales an explicit environmental levy charge is applicable. 5.4 Average tariff category increases In summary; the 2019/20 to 2021/22 average tariff category increases is set out in the table below: TABLE 8: STANDARD TARIFF INCREASES Standart Tariff Category Increases 2019/ / /22 Total Standard tariff 15.00% 15.00% 15.00% Municipalities: Municipalities - effective 1 July 17.60% 14.20% 15.20% Eskom Direct Customers (non-municipal tariffs): Businessrate; Public Lighting; Homepower; Homelight 60A; Landrate; Landlight Megaflex; Miniflex; Nightsave Urban; WEPS; Megaflex Gen 15.00% 15.00% 15.00% * Affordability subsidy charge (where applicable) 15.41% 15.71% 15.84% * Other tariff charges 15.00% 15.00% 15.00% Ruraflex; Nightsave Rural; Ruraflex Gen 15.00% 15.00% 15.00% Homelight 20A Block 1 (>0-350kWh) 15.00% 15.00% 15.00% Block 2 (>350kWh) 15.00% 15.00% 15.00% 5.5 Protection of poor households Poor households are particularly vulnerable to increases in electricity tariffs because they have little ability to adapt. Eskom believes it is important to protect these poor households from the full impact of the electricity price increase through targeted subsidies, with a transparent cross-subsidy structure aligned with a national cross-subsidy framework to be developed for the country. To date, tariff subsidies have evolved in the absence of a subsidy framework and there has been very little analysis of the long-term impact on consumers, whether subsidy contributors, recipients, or even the economy as a whole. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 35 of 115

36 Indicative Standard Tariff Increase Subsidies for poor households The government, local authorities and Eskom have put in place a number of measures to ensure that low-income households have access to affordable electricity. These include: The electrification programme, which subsidises the cost of connecting a house to a 20A (low consumption) electricity supply. This complements an already subsidised tariff. The free basic electricity programme, which provides 50kWh (more in some local authorities) of free electricity per month to identified indigent customers. Free energy-efficient CFL bulbs and solar water-heater rebates, which are available to all residential customers as part of Eskom s demand management programme. The IBT, which, together with lower-than-average tariff increases, has resulted in subsidies of up to 42% for all residential customers. These subsidies are currently recovered primarily from Eskom s direct large urban (municipal, industrial and commercial) contribution to Eskom related subsidies because municipalities do not contribute towards the IBT-related affordability subsidies (they also need to cater for their subsidies). customers, with Eskom direct industrial and commercial customers making the largest Figure 7: Current cross-subsidies in Eskom tariffs 2017/18 The Inclining Block Tariff (IBT) was implemented by NERSA to cushion low-income households that use very little electricity. The tariff has been successful in lowering the cost of electricity for the poor. However, Eskom believes that the IBT as it is currently structured does not sufficiently target low-income households and places an unsustainable subsidy responsibility on urban customers. It also encourages affluent customers to move off the grid using PV solar. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 36 of 115

37 Indicative Standard Tariff Increase Eskom recognises that even in the absence of a national subsidy framework the poor still need to be protected against the impact of the price increases. NERSA may therefore allow cross-subsidies between various customer groups to be implemented as part of the annual average price to benefit affected groups. If NERSA continues to protect the poor with lower tariff increases to the Homelight 20A tariff similarly as it did for the 2018/19 decision, the applicable tariff category increases after applying the ERTSA methodology would be 2.4% less than average for Block 1 (>0-350kWh) and 0.4% less than average for Block 2 (>350kWh) for the Homelight 20A tariff. This option provides protection for the poor, but increases the level of subsidies for the nonlocal authority urban tariffs. This may result in changes to the non-municipal and/or municipal increases. 5.6 Tariff structural changes during the MYPD4 control period This revenue application does not deal with any potential Eskom tariff changes, including the proposed rationalization of municipal tariff currently with NERSA for a decision. To provide for tariffs that meet the needs of customers and Eskom, the strategic objectives are as follows: Tariffs to be more cost-reflective in structure i.e. fixed versus variable charges and in level Tariffs that share volume risk between customers and Eskom and allow Eskom and the customer to partner for mutual benefit. Tariffs must ensure fair compensation for the use of the grid by generators and loads Tariffs that incentivize customers to stay connected to the grid. Tariffs that increase sales and ensure adequate recovery of costs Tariff that enable better management demand and supply. In order to pursue these objectives for the benefit of Municipal tariffs, Eskom would submit Tariff structural changes submissions after the MYPD4 decision during the control period; and implement the NERSA decisions on already submitted tariff structural changes. More details of the proposed tariff structural adjustments are provided in the Distribution licensee submission document. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 37 of 115

38 Sales Volumes 6 Sales Volumes 6.1 Introduction to Sales volumes The sales volumes and sales forecasting is summarised here. Details are provided in the Eskom Distribution Licensee submission that forms part of Eskom s submission. Every effort is made to determine the projected sales volumes for the MYPD 4 period to reflect what is known at the time of the submission. As summarised below and clarified further in the Distribution MYPD 4 submission a robust and thorough process is undertaken to provide sales volume projections. The MYPD methodology requires Eskom to provide reviewed sales volume projections subsequent to this submission and prior to the NERSA decision being made. Eskom understands that NERSA will undertake its own analysis before making a decision to determine the veracity of the projected sales volume for the three year period. The determination that NERSA makes on the sales volume projection allows Eskom to recover the allowed revenue decision through the sales volume. The revenue to be recovered is for the fixed and variable costs. If the sales volume do not materialise as in the MYPD 4 decision it implies that Eskom does not recover the fixed costs that it would have if the reality had turned out as in the NERSA MYPD 4 decision. However these revenues are only fully recovered if all the sales are achieved as assumed in the decision. Therefore, in the event of lower sales materialising, it results in Eskom not recovering the allowed revenue components as was assumed. In the event of higher sales materialising than the NERSA determination, it would result in Eskom recovering more revenue than determined by NERSA. Variances are addressed as part of the RCA process. 6.2 Robust process to project sales volumes A five-step process, as depicted in the figure below, is followed to forecast Eskom electricity sales. This process includes the compilation of a six-year monthly detailed forecast with the last four years of the period at an annual level using trends per sector. The process includes a bottom-up approach to compile regional forecasts for each of the 9 regional Operating Units forecasts and for the top industrial and mining customers forecast. This is followed by one-on-one work sessions with the forecasters at each of the regional Operating Units and for customers to verify and confirm the validity of the forecasts. Once agreement and consensus is reached, the 9 Operating units forecasts and the top industrial and mining forecasts are consolidated into an Eskom national forecast. An 80/20 principle is Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 38 of 115

39 Sales Volumes used during the bottom-up approach, that is, customers contributing 80% of the sales per category are forecasted on an individual basis. The individually forecasted customers are predominantly in Top industrial and mining customers category whose annual consumption is greater or equal to 100GWh. The individual customer forecasts apply detailed insights and information on individual customers usage and long-term plans. Thus Eskom is dependent on receiving coherent responses from these customers with regards to their energy requirements. It is plausible that the plans made by these customers for the application period could change. Long term economic forecast trends and commodity prices are also considered. In the finalization of the forecasted sales volumes, all abnormalities and outliers are removed from the historical data before statistical trend analysis and statistical forecasts are applied. FIGURE 8: SALES FORECASTING PROCESS 6.3 Projected sales volume The projected sales volume for the MYPD 4 period, as developed by the robust process described above resulted in the following sales projections. It needs to be kept in mind that since the sales forecasting process is the initial process for the preparation of the MYPD 4 revenue application, it was undertaken at least 9 months before the submission. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 39 of 115

40 Sales Volumes TABLE 9: PROJECTED SALES FORECAST Sales volumes (GWh) Actuals Projection Application Application Application Forecast Forecast 2017/ / / / / / /24 Standard tariff sales Negotiated pricing agreement Export sales Total External Sales Internal sales Total Sales Year-on-year growth (GWh) Year-on-year growth (%) -0.89% 0.04% 1.31% 0.32% 0.97% 0.06% 0.75% 6.4 Review of projected sales volumes As required by the MYPD methodology, Eskom will review the projected sales volumes prior to NERSA making the revenue decision. This will be part of the normal quarterly update that Eskom undertakes. Eskom will then provide NERSA with updated sales volumes to enable NERSA to decide on a viable volume in making its decision. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 40 of 115

41 Energy Wheel 7 Energy Wheel Once the sales volume projections have been developed, the Energy Wheel is developed. The energy wheel is a summary of the balance between the Eskom demand and supply of energy. The energy wheels for the three application years are provided in this submission. The demand side of the Energy Wheel portrays the total projected Eskom sales which are made up of Distribution national sales and Export sales, inclusive of the transmission and distribution losses. This makes up the total amount of energy that needs to be produced to supply customers needs and is the starting point of the production planning process. This energy forecast has been discounted with the impact of demand side management options. The supply side of the Energy Wheel shows the volume of electricity that is required from local and international power stations as well as independent power producers (IPPs) to be supplied to Eskom s distribution and export points (including the losses) to meet the demand of those customers. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 41 of 115

42 Energy Wheel FIGURE 9: THE ENERGY WHEEL FOR THE APPLICATION YEAR 2019/20 ESKOM HOLDINGS SOC LTD ENERGY WHEEL FY2020 ALL FIGURES IN GWh Generation of Electricity Application Available for Distribution Application Total Imports Application Generation Generation (incl IPPs) International Purchases OCGT 211 International Wheeling Pumping (6 838) Wheeling Total IPP Sub Total Total Pumping (6 838) Total South African Power Pool Total Exports Application International Sales Wheeling Total Internal Use Application Demand Application External Sales Application Generated ( 114) Sales Local Internal Use 548 Losses International Total 434 Internal 548 Total Generated ( 114) Wheeling Total Technical & Other Losses Application Distribution Transmission Total Technical & Other Losses - % Application Notes Notes 1 Total External Dx sales excluding internal sales of 548GWh and including international sales of GWh Distribution 7.55% Transmission 2.50% Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 42 of 115

43 Energy Wheel FIGURE 10: THE ENERGY WHEEL FOR THE APPLICATION 2020/21 ESKOM HOLDINGS SOC LTD ENERGY WHEEL FY2021 ALL FIGURES IN GWh Generation of Electricity Application Available for Distribution Application Total Imports Application Generation Generation (incl IPPs) International Purchases OCGT 211 International Wheeling Pumping (6 965) Wheeling Total IPP Sub Total Total Pumping (6 965) Total Total Exports Application International Sales South African Power Pool Wheeling Total Internal Use Application Demand Application External Sales Application Generated ( 114) Sales Local Internal Use 548 Losses International Total 434 Internal 548 Total Generated ( 114) Wheeling Total Technical & Other Losses Application Distribution Transmission Total Notes 1 Total External Dx sales excluding internal sales of 548GWh and including International sales of GWh Technical & Other Losses - % Application Distribution 7.55% Transmission 2.50% Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 43 of 115

44 Energy Wheel FIGURE 11: THE ENERGY WHEEL FOR THE APPLICATION 2021/22 ESKOM HOLDINGS SOC LTD ENERGY WHEEL FY2022 ALL FIGURES IN GWh Generation of Electricity Application Available for Distribution Application Total Imports Application Generation Generation (incl IPPs) International Purchases OCGT 211 International Wheeling Pumping (6 872) Wheeling Total IPP Sub Total Total Pumping (6 872) Total Total Exports Application International Sales South African Power Pool Wheeling Total Internal Use Application Demand Application External Sales Application Generated ( 114) Sales Local Internal Use 549 Losses International Total 435 Internal 549 Total Generated ( 114) Wheeling Total Technical & Other Losses Application Distribution Transmission Total Notes 1 Total External Dx sales excluding internal sales of 549GWh + International sales of GWh Technical & Other Losses - % Distribution 7.55% Transmission 2.50% Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 44 of 115

45 Production Plan 8 Production Plan 8.1 Background to the production plan The details of the production plan are included in the Eskom Generation revenue application submission. Only a high level summary is reflected below. Once the sales forecast projections and energy wheel have been completed, the production planning process is undertaken. The main objective of production planning is to ensure optimal output from available power stations to reliably meet the system demand at least cost, while recognising Generation, primary energy and any other technical constraints. The key principle for Production Planning is for the merit order dispatch to be maintained within known constraints. Constraints may include emissions, coal shortages/surplus, water shortages and any other technical constraints. Merit order dispatch is achieved by deriving the merit order from the primary energy costs as well as power station burn rates resulting in an energy cost (R/MWh) ranking per station from the cheapest to the most expensive. Coal and diesel costs are the major contributors to the variable cost of electricity production, and on its own, results in an accurate relative merit order and optimum dispatch. The Production Plan outcome provides the expected production level at each station which is the basis of the Primary Energy (i.e. Coal, Water, Sorbent Nuclear, OCGT, Start-up Fuel, Water Treatment, Coal Handling and Environmental Levy) cost projections. 8.2 Production Planning Process The following figure summarises the production planning process that is followed. The inputs include hourly demand forecast, planned and unplanned maintenance, ramp rates, variable cost, capacity, number of units per station, minimum generation, operating reserve requirements, commercial operation dates for Eskom new build, Import capacity, IPPs and all other parameters required for modelling the system. Generators are dispatched from the lowest variable cost to the most expensive generator in the system. Consideration is given to particular constraints and requirements. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 45 of 115

46 Production Plan FIGURE 12: OVERALL PRODUCTION PLANNING PROCESS 8.3 Production Plan outcomes The study assumes no restrictions on the fuel availability to the base-load stations, therefore they are only restricted in their output through their available capacity, utilization factors and position in the merit order. A base-load station first in the merit order will generate at full available output in all hours, whilst a base-load station lower down in the merit order will follow the load pattern from hour-to-hour. The table below shows the energy production mix per plant technology from 2019/20 to 2023/24. TABLE 10: ENERGY PRODUCTION PER PLANT MIX (GWH) Production Plan Actuals Projection Application Application Application Projections Projections GWh 2017/ / / / / / /24 Coal Nuclear OCGT Hydro Pumped storage Sere Total Eskom Production IPPs International trader Gross Production Less-pumping Nett Production Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 46 of 115

47 Energy Losses 9 Energy Losses The nature of transporting electricity from generator to the end-users involves losses in energy volumes (electrical or technical losses) that reduce the amount of electricity volumes available for sale to end-customers. In addition, other energy losses may occur due to nonmetered usage related to electricity theft (non-technical losses). The representation of the measure for the levels of the combined total technical and non-technical losses is by way of loss factors. Energy loss is an inherent risk in the electricity business and utilities globally are addressing this issue, which costs billions of rand annually with developing countries being the worst affected. Energy losses are incurred when energy is transferred from the suppliers to the loads through the network. This energy lost, is approximately equal to the difference between the energy supplied and the energy consumed. Transmission losses are determined by the difference between energy injected onto the transmission grid and energy off-take at main transmission substations (MTS) and interconnection points. The transmission losses are projected to be an average of 2.50% for the application period. Distribution losses are determined by the difference between energy purchased (measured at main transmission substations) and energy sold to all Distribution customers. The industry norm for a Distribution network energy loss factor is 10% and the current Distribution energy losses are projected to remain below the loss factor of 10% in the MYPD4 control period. Energy losses have a direct effect and increases generation requirements (both capacity and energy volumes) and primary energy costs. Efforts are put in place to address non-technical losses. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 47 of 115

48 Weighted Average Cost of Capital 10 Weighted Average Cost of Capital The weighted average cost of capital (WACC) component of the building blocks to the allowable revenue formula: AR=(RAB WACC)+E+PE+D+R&D+IDM±SQI+L&T±RCA The WACC is determined in accordance with the requirements of the MYPD methodology. It is clarified that even though the determination for the WACC is made, it is not implemented to the full extent in this MYPD 4 revenue application. Electricity production and distribution is a capital or asset intensive industry i.e. significant up-front capital investment is required in order to acquire the assets which are needed to produce, transmit and distribute the electricity. The capital invested to acquire an asset is thereafter recovered over the full operational life of an asset. The cost of such capital is an inherent cost of the production of electricity and must therefore be recovered through the price of electricity in order for the industry be sustainable, which includes meeting its debt obligations. The capital structure consists of a weighting of equity and debt with Eskom targeting 70% for debt and 30% for equity. Both debt and equity comes at a cost and thus the weighted cost of capital (WACC) is utilised to determine the funding costs for organisations. The NERSA regulatory methodology requires the earning of returns on assets (ROA). These are in lieu of interest costs, which are not separately recovered as a cost component. In the recent past there have been several developments that have transpired which negatively affected Eskom s cost of capital. Credit rating downgrades by Standard & Poor s, Moody s and Fitch rating agencies coupled with sovereign downgrades has placed further upward pressures on funding costs. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 48 of 115

49 Weighted Average Cost of Capital TABLE 11 : COST OF CAPITAL Weighted Average Cost of Capital Debt Equity WACC Costs - Nominal 11.6% 22.1% Weight 70.0% 30.0% WACC nominal pre-tax 8.1% 6.6% 14.8% Costs - Real 6.1% 16.1% Weight 70.0% 30.0% Inflation 5.2% WACC real pre-tax 4.3% 4.8% 9.1% Eskom s updated WACC real pre-tax is 9.1% which is higher than the single year tariff decision by 70 basis points. During the revenue application only a portion of the WACC is claimed against the regulated asset base (RAB). Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 49 of 115

50 Regulated Asset Base, Depreciation and ROA 11 Regulated Asset Base, Depreciation and ROA The capital related aspects of the MYPD allowed revenue formula are considered here. Key aspects that are considered are the determination of the regulatory asset base, depreciation and return on assets. As clarified previously, Eskom is not requesting the return on assets as required by the MYPD methodology. This is the key area where Eskom is making a sacrifice in the interest of only migrating towards a cost reflective return on assets. The relevant aspects of the allowed revenue, in terms of the MYPD methodology considered here are highlighted: AR=(RAB WACC)+E+PE+D+R&D+IDM±SQI+L&T±RCA The ERA and the Electricity Pricing Policy (EPP) require the recovery of efficient costs and earning a fair return on capital. The EPP and the MYPD methodology require that assets are valued at replacement value for setting of regulated revenue. In accordance with the MYPD methodology, Eskom has undertaken a revaluation of all completed assets used in the generation, transmission and distribution of energy as at 31 March This was undertaken by an independent entity that has international experience in the realm of asset valuation for large infrastructure companies. As required by the MYPD methodology, the determination of the regulatory asset base value is based on the costs to replace these assets (i.e. Modern Equivalent Assets Valuation) and adjusted for the remaining life. This valuation has been undertaken in accordance with the guidelines and requirements of the International Valuation Standards. The basis of the valuation was the Eskom fixed asset registers and comparisons were made with market data for actual construction cost of similar assets. This valuation exercise was a continuation of previous asset valuation exercises, during which site visits to samples of the physical assets were performed. The Depreciated Replacement Cost (DRC) was determined through the application of the cost approach methodology, which is a recognised approach for the valuation of specialist assets which are not regularly traded. The cost approach methodology includes the identification of the estimated new replacement cost of assets, which is then adjusted to reflect physical, functional and economic obsolescence. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 50 of 115

51 Regulated Asset Base, Depreciation and ROA FIGURE 13: PROCESS FOR VALUATION OF EXISTING ASSETS The asset values in the Regulatory Asset Base are therefore not shown at the new cost to replace them but at their depreciated replacement cost. For example, if it costs R1bn to replace an asset at the end of March 2016 which has two years remaining life out of a total useful life of 25 years, the depreciated replacement cost at the end of March 2016 would be R80 m (i.e R1bn x 2/25). This valuation forms the basis of the RAB application as shown in the table below. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 51 of 115

52 Regulated Asset Base, Depreciation and ROA TABLE 12: REGULATORY ASSET BASE (RAB) SUMMARY MYPD3 Regulatory asset base (R'millions) Decision Decision Application Application Application Forecast Forecast 2017/ / / / / / /24 Assets (Including WUC) Working capital and Equipment and vehicles Average Eskom RAB Assets (including WUC) comprise the following components: In accordance with the MYPD methodology, the regulatory asset base is comprised of the following: Assets as per the March 2016 asset valuation- the valuation only includes assets already in use in the generation, transmission and distribution of electricity as at 31 March Included in these assets is 1 unit of Medupi of 794MW valued at Depreciated Replacement cost of R40bn. All other assets in construction are not included in the valuation but rather in the WUC. Work under construction (WUC): In accordance with the MYPD methodology, for assets that constitute creation of additional capacity, the capital project expenditures or WUC values (excluding IDC) incurred prior to the assets being placed in Commercial Operation (CO) are included in the RAB and earn a rate of return based on the real WACC. New constructed assets: This refers to assets transferred into Commercial Operation subsequent to the 2016 asset valuation. It includes power station units as well as networks commissioned subsequent to the asset valuation. Once commissioned, these assets are included in the RAB for purposes of earning a return as well as for the depreciation allowance. The depreciation allowance is calculated by dividing the cost of the asset over the number of years that the asset is to be used for i.e. the useful life of the asset Assets as per the March 2016 asset valuation The extract of the Depreciated Replacement Costs (DRC) from the valuation report is shown in the Table below. The valuation report excludes interest during construction (IDC) due to the WUC being included in the RAB for return purposes. In addition, working capital, asset purchases and Work under Construction were also excluded since these were not part of the Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 52 of 115

53 Regulated Asset Base, Depreciation and ROA scope of the consultants valuation project but will be added to the report s values, in accordance with the MYPD methodology. TABLE 13: EXTRACT FROM CONSULTANT 2016 ASSET VALUATION REPORT The RAB summary Table above reflects a growth in the average Eskom RAB of R565 billion between the RAB values as assumed for purposes of the FY2019 revenue decision, and those for FY2020. The key reasons for the growth are as follows: The RAB value for purposes of the revenue determination for FY2018/19 was not based on a valuation exercise, due to the requirement for such valuation only becoming known when the revised MYPD Methodology was published at the end of October 2016, which did not allow sufficient time for the external valuation project to be completed. Eskom thus requested condonation from complying with that requirement and proposed the use of the last public domain RAB values i.e. as for the fifth year of the MYPD3 cycle. NERSA approved the request for condonation. In addition, relative to the RAB for FY2018/19, the RAB for FY2020 is adjusted with subsequent actual and planned capital expenditure and the consumer price index (CPI) adjustments of approximately R196bn between FY2016 and FY The existing asset base as at 31 March 2016 has been revalued, amounting to R853 billion (as shown in Table above) compared to the NERSA determination of R603 billion for FY2016 for purposes of the MYPD 3 revenue decision as reflected in Table below. A key reason for the increase is due to the change in the overnight cost which has increased between the previous 2010 valuation (used for MYPD3 and the FY2019 revenue decision) and the 2016 valuation. The overnight cost for this purpose is determined by the consultants based on global benchmark costs for similar infrastructure projects in the electricity industry. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 53 of 115

54 Regulated Asset Base, Depreciation and ROA TABLE 14: FY2016 RAB VALUES AS ASSUMED FOR PURPOSES OF MYPD3 REVENUE DECISION FY2016 RAB- MYPD 3 Decision (R'millions) Generation Transmission Distribution Total Eskom Property and Plant Equipment & Vehicles Total Work Under Construction Total Working Capital Total average RAB The breakdown reflected in the table above is as per the extract of the NERSA Reasons for Decision for the MYPD 3 revenue determination as shown below: 11.3 Work under construction (WUC) In terms of the MYPD methodology the criteria for inclusion of WUC into the RAB is for those assets that are for the creation of additional generation, transmission and distribution capacity and are defined as follows: - Expansion this is capital expenditure to create additional capacity to meet the future anticipated energy demand forecast. - Upgrade this is capital expenditure incurred to ensure that the current and future energy demand forecast is met. - Replacement this is capital expenditure to replace assets that have reached the end of their useful life in order to continue meeting the current demand. - Environmental legislative requirements this is capital expenditure incurred to ensure that the licensing condition is maintained thereby continuing to meet the current energy demand forecast. A WUC in essence refers to the capital expenditure being undertaken and meets the criteria referred to above for inclusion in the RAB. In terms of the MYPD methodology, the WUC balance is required to earn a return on assets but is not depreciated until assets are Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 54 of 115

55 Regulated Asset Base, Depreciation and ROA transferred to Commercial Operation (CO). Only upon commercial operation (CO) do these assets incur depreciation costs. The transfers to CO from WUC for Transmission and Distribution assets are grouped into the categories of substations and lines. For Transmission, these new assets are depreciated on a normal useful life of 30 years for substations and 40 years for lines. Distribution substations are depreciated on a normal useful life of 30 years and lines on a life of 25 years. Transfers to commercial operation for generation assets are grouped per station and the normal useful life for depreciation is limited to the remaining life of the respective power station Depreciation As is required by the MYPD methodology, the annual depreciation allowance is determined by dividing the cost of the asset less the residual value by the estimated useful life of that asset. Table below reflects the revenue related to depreciation for the MYPD 4 period. TABLE 15: DEPRECIATION MYPD3 MYPD 3 Depreciation (R'millions) Decision decision Application Application Application Forecast Forecast 2017/ / / / / / /24 Generation Transmission Distribution Corporate Total Depreciation Depreciation on assets as per the FY2016 valuation is computed by dividing the depreciated value of the assets over the remaining life of the respective assets as reflected at the end of March There is a steep change between FY2019 and FY2020, which is due to the following: The current asset valuation is higher by about R250 billion in FY2016 compared to the MYPD3 values for FY2016. The reason for this was clarified previously in this submission. The average remaining useful life estimates for the Transmission licensee is shorter in the 2016 valuation when compared to assumption in the MYPD 3 decision whilst the depreciated replacement cost (DRC) values have remained relatively the same. This is due to the comparison to other energy infrastructure valuations undertaken by the consultants who undertook the independent study Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 55 of 115

56 Regulated Asset Base, Depreciation and ROA For the Generation Other category of assets, all subsequent transfers to commercial operation are depreciated over the asset life but limited to the remaining life of the power station. In the case of Transmission and Distribution Other category of assets, all subsequent transfers to commercial operation are depreciated over the normal useful life Assets excluded from RAB The DRC for Transmission and Distribution assets as shown in table above, include assets that are funded via upfront contributions and Department of Energy (DoE). The DoE funds the electrification assets. In terms of the MYPD methodology these assets do not earn a return on assets and their depreciation is not included in the revenue requirement. The total assets shown in Table 12 and the depreciation reflected in Table 15 have therefore been reduced by the values as shown in Table 16 below to exclude such assets. TABLE 16: ASSETS FUNDED VIA UPFRONT CONTRIBUTIONS AND DOE Application Application Application Forecast Forecast Assets funded via upfront contributions and DoE 2019/ / / / /24 Opening balance (44 223) (43 750) (43 071) (42 227) (41 098) Inflation on opening balance (2 477) (2 537) (2 584) (2 534) (2 466) Transfer to CO (662) (643) (704) (763) (826) Depreciation Closing asset values (43 750) (43 071) (42 227) (41 098) (39 643) The transfer to commercial operation (CO) in Table 16 above includes the completed assets which have been funded upfront by customers. These transfers to CO do not include assets funded by DoE since the capital expenditure for these electrification projects have been excluded from this application. The objective of tracking these assets as a separate asset class (as shown in Table 16) is to ensure transparency; therefore both the RAB and the depreciation are reduced accordingly Return on assets Eskom, in this revenue application has applied the NERSA MYPD methodology, combined with a smoothed phasing-in of the return on assets. However, the return on assets at the end of the three year period do not reach the weighted average cost of capital (WACC) as determined in accordance with the MYPD methodology, nor the WACC as was determined by NERSA for purposes of the 2018/19 revenue determination. This phasing in approach Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 56 of 115

57 Regulated Asset Base, Depreciation and ROA was limited to the degree required so as to ensure that the depreciation and return on asset covers a significant portion of the interest and repayment costs over the three year period and fully covers annual debt service costs (interest and principal) for the 2021/22 financial year. TABLE 17: RETURN ON ASSETS Return on assets (R'millions) 2017/ / / / / / /24 Decision Decision Application Application Application Forecast Forecast Average RAB (R'm) Full Return on Assets (ROA) % 7.65% 6.9% 9.31% 9.34% 9.37% 9.39% 9.40% Returns (R'm) Phased in ROA % 4.7% 4.0% -1.32% -0.21% 1.45% 1.76% 2.46% Phased in Returns (R'm) Returns sacrificed (R'm) The table above illustrates the full return on assets (ROA) at the weighted average cost of capital (WACC). The WACC was determined in accordance with the MYPD methodology. The determined WACC was higher than the single year tariff decision by 70 basis points. The returns in the above table indicate the return (ROA) that is determined by the application of the MYPD methodology. However, Eskom is not applying for the full return. The return is phased in to only substantially recover the debt commitments. The percentages for the phased-in return is -1.32%, -0.21% and 1.45% which corresponds to -R16 687m, -R2 765m and R20 314m for the each of the MYPD 4 application years. The returns sacrifice in the table above shows that the extent of the difference between the full application of the WACC and what is actually being applied for. The total ROA should have been R374bn if WACC was applied for. However, Eskom is only applying for a ROA of approximately R1bn over the MYPD 4 period. This results in a total sacrifice in this instance amounts to R373bn. Eskom is cognisant of the impact of implementing this full return and will thus not be making a revenue application related to the full ROA. It is agreed that this is an untenable request and will not be considered. As a first step towards sustainability of Eskom, it would be preferable for Eskom to ensure that the revenue caters for prudent and efficient costs as well as a reasonable return that matches the debt service commitments (interest and debt repayments). Thus the revenue related collectively to depreciation and return on assets must match the debt service commitments entailing the debt repayments and interest payments. This would manifest in a 29% increase in 2019/20, 13% in 2020/21 and 4% in 2021/22 financial years respectively. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 57 of 115

58 Regulated Asset Base, Depreciation and ROA However, in the interest of the potential impact on consumers, Eskom has agreed to make a further sacrifice. Eskom, in this revenue application has applied the NERSA MYPD methodology, with a smoothed price path over the MYPD 4 period by phasing-in of the return on assets. The phased implementation was adopted ensure that by the 3 rd year (2021/22) the revenue allowed covers the full debt service commitments. This revenue requirement would correspond to a phased 15% average price increase for each year of the MYPD 4 period. However, the allowed revenue being applied for does not cover the entire debt commitment costs, equating to a cash shortfall of totalling R50bn for 2019/20 and 2020/21. This is a significant sacrifice being made by Eskom in the interest of allowing the economy to adjust as the migration towards cost reflectivity. It is clarified that in the migration towards cost reflectivity, Eskom has opted to only make adjustments to the ROA being applied for. The depreciation is an outcome of a formula based on the MYPD methodology. The determination of the depreciation is also dependent on the RAB valuation. This has been determined by an independent consultant in accordance with internationally accepted cost based method. The primary energy costs and operational cost projections are based on the actuals experienced for the 2017/18 year. Significant motivations for each of the primary energy and operating cost projections are addressed in each of the Eskom licensee submissions. It is thus surmised that it is reasonable to only use the return on assets for any phasing proposal to be made. This is exactly what Eskom has done in this revenue application. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 58 of 115

59 Capital Expenditure 12 Capital Expenditure 12.1 Background A summary of the capital expenditure to be undertaken in the application period and beyond is provided here. Further details on the capital expenditure projections of each of the licensees is included in the Generation, Transmission and Distribution MYPD 4 revenue submissions that forms part of the Eskom MYPD 4 revenue submission. The MYPD methodology allows for the capital related costs to be recovered over the life of the assets through return on assets and depreciation. Thus it is clarified that capital expenditure is not included in the allowed revenue regulatory formula. The long life capital nature of the electricity industry requires significant focus on build and replacement of assets for the functioning and reliability of the industry to provide the service of delivering electricity. In the application window, Eskom capital expenditure plans will focus on delivering the following projects: Generation new build programme- commercial operation of further units of Medupi and Kusile with some units on accelerated construction plans Replaced, expanded and strengthened transmission grid which gets Eskom closer to N- 1 compliance whilst executing the Power Delivery Plan Generation technical plan capital expenditure Eskom will invest in Cost-Plus mines which will provide Eskom with a more sustainable source of coal. This is included as future fuel. Eskom will also invest in projects to reduce particulate emissions and water consumption, on the journey towards environmental compliance. Investments will be made in the refurbishment and strengthening of existing networks, in building new networks for customers and in connecting IPPs. Eskom does not include DOE funded capex into the regulatory asset base Summary of capital expenditure costs A summary of the capital expenditure requirement is summarised in the table below. It is clarified that capital expenditure funded by other entities is not included. This refers mainly to the funding of electrification by the Department of Energy. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 59 of 115

60 Capital Expenditure TABLE 18 : CAPITAL EXPENDITURE Capital Expenditure (excluding IDC) Actuals Projections Application Application Application Forecast Forecast (Rand millions) 2017/ / / / / / /24 Generation Transmission Distribution excluding DOE funded capex Total licensee capex excluding future fuel Future fuel Total licensee capex Corporate capex Other Eskom Company Capex portfolio (excl IDC) Generation Capital Expenditure Eskom is executing the largest capital expansion programme in Africa and executes projects that ensure environmental compliance, transmission strengthening, customer connections and refurbishment of existing assets in accordance with Eskom s project life-cycle model (PLCM). The two largest projects are the new builds at Medupi and Kusile. Medupi is 95% complete (as at August 2018) with units 6, 5 and 4 already in commercial operation adding MW to the national grid. Kusile is 89% complete (as at August 2018) with unit 1 already in commercial operation, adding 720MW to the national grid. In addition, Eskom is in the process of constructing the following key generation projects: Upgrading other existing plants (Matla, Kriel and Duvha Power Stations). Executing other Generation coal projects, such as emission compliance projects and fabric filter plant (FFP) retrofits. Constructing a 68 km railway between Majuba Power Station and the coal railway hub in the town of Ermelo in Mpumalanga. Executing the Koeberg steam generator replacement project for units 1 and 2. Executing the Ankerlig Transmission Koeberg Second Supply (ATKSS) Project. Executing the distributed battery storage project, as an alternative to a 100 MW Concentrated Solar Power (CSP) plant, at Eskom distribution constrained sites close to renewable energy Independent Power Producer (IPP) plants and at Sere Wind Farm Transmission Capital Expenditure Eskom s transmission network needs to be strengthened and expanded to connect new loads and generation to the network to enable country growth. In addition, investments for asset replacement are required for assets which have reached their end of life in order to sustain a reliable supply of electricity. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 60 of 115

61 Capital Expenditure Strengthening and capacity expansion includes generation integration projects required to ensure that the network is able to evacuate and dispatch power from the source to the load centres. It also includes projects for planned new customer connections, strengthening the transmission network to allow for future demand growth and reliability projects relating to Grid Code compliance requirements. Replacement investments are required when assets have reached their end of life and can no longer be reliably operated. These investments are prioritized based on asset condition, network criticality and risk criteria. Independent Environmental Impact Assessments (EIAs) are conducted in accordance with National Environmental Management Act (NEMA) requirements for expansion and asset replacement projects. Land and servitudes are procured for substation and line construction projects based on valuations from independent and registered land valuators. NERSA has published rules in the Grid Code governing investment in the transmission network. Transmission plans the network according to the Grid Code and subject to funding and other resource constraints, builds the network according to the Transmission Development Plan (TDP). Where insufficient funds are available to develop the network, a consistent set of rules is applied to prioritise projects and allocate funding in such a way that the maximum benefit is gained for customers Distribution Capital Expenditure Distribution capital investments support the continued productive life of assets and the technical conditions necessary to maintain continued electricity supply to secure revenue streams and improve customer experience. The applied for capital expenditure is required to strengthen and refurbish the Distribution network to meet future growth requirements, whilst allowing the network to maintain current performance standards. A key priority is to ensure a reliable and sustainable power supply; the Distribution Licensee will balance the need for resolving constrained networks whilst providing the supporting infrastructure for maintenance activities. Historically, the Distribution network performance gains are reflective of the investment choices made in the capital projects. The Distribution network capital expenditure is employed in activities that are based on extensive planning that are implemented for the required network performance. A 10-year Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 61 of 115

62 Capital Expenditure master plan informs the capital investment programme that supports the forecasted economic growth nodes. The capital investment programme supports the establishment of the required capacity to meet the future electricity demand with network performance at an acceptable level of reliability, maintainability and operability. The capital expenditure is also reflective of the execution capability within the Licensee, which is based on its own historical performance. In compliance to the Grid code, a network development plan is formulated informed by the 10-year master plan for the immediate 3-5 year period. Distribution networks investment drivers The following factors are the key drivers for the CAPEX expenditure: Enabling capacity as a precursor for growth in the economy and support to government led initiatives up until Further progressing towards regulatory and statutory requirements as per NERSA requirements which include NRS requirements. Ensuring commitment to a Distribution landscape that is focussed on universal access, IPP Integration and technological advancements, whilst maintaining current performance. The historical build-up is extensive and although continued investment is provided in this area, given the deterioration in the network s aging profile and regression in the performance of the aged distribution networks, the requested investment may not fully suffice. Capital for strengthening and refurbishing existing Distribution networks and for new IPP projects Environmental Requirements The environmental clause in the Bill of Rights sets the context for environmental protection, providing for an environment which is not harmful to health and well-being and for ecological sustainable development. The National Environmental Act and several Strategic Environmental Management Acts (SEMA s) give effect to the environmental right in the Constitution. The development of environmental legislation has resulted in new and more stringent requirements which Eskom is obligated to respond to in order to continue operating it power stations. Given the nature of Eskom s activities these requirements are far reaching, they affect all the licensees in some manner, including air quality, protection of the natural environment and biodiversity, water use and the impact on water resources, general and hazardous waste management, the utilisation of ash and licensing processes. These legislative requirements lead to operational and capital expenses which must be allowed to Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 62 of 115

63 Capital Expenditure enable Eskom to retain its license to operate. Further details are provided in the Generation Licensee submission Capital expenditure cost elements Basic plant cost Basic plant cost refers to the basic plant cost estimate at a certain base date. Basic plant costs are further sub-divided into placed and unplaced packages, local and foreign component as well as fixed and variable components. No escalation is included in basic plant cost. Contract price adjustments (CPA)/ Escalations Contract Price Adjustments/Escalations refer to the inflationary adjustments on the basic plant cost and are applicable to the variable portion of a contract or cost estimate. Contract Price Adjustments formulae and indices for placed packages are specified in the contract document e.g. SEIFSA Labour index, and are used to calculate these adjustments. Owners development cost (ODC) ODC refers to the internal Eskom resource costs that are allocated to the project i.e. Project management, Engineering, Quality assurance etc. These costs are thus capitalised. It also includes cost directly related to the commissioning of a production unit i.e. commissioning staff, commissioning coal etc. Contingency provision The contingency provision is a risk allowance for unknown future costs, the contingency is assumed based on the perceived risk in the project. Interest during construction (IDC) Interest during construction refers to allocation of interest / borrowing cost to a project during the construction phase. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 63 of 115

64 Primary Energy 13 Primary Energy 13.1 Overall summary of primary energy A summary of the key elements of the primary energy revenue elements are addressed here. Further details are included in the Generation Licensee MYPD 4 revenue submission. This section will cover the primary energy (PE) and levies & taxes (L&T) components of the building blocks to the allowable revenue formula: AR=(RAB WACC)+E+PE+D+R&D+IDM±SQI+L&T±RCA Primary energy costs equates to the costing of the production plan (electricity supply required to meet demand). There are three sources of electricity supply comprising Eskom own generation (majority), domestic independent power producers (IPPs) and regional import of supply (international supply). Due to the roll out of renewable IPP domestic progammes driven by DOE, there has been a growing trend in local IPPs over the last few years. International supply represents substantially the supply from Cahora Bassa. Therefore, Eskom s own generation is used to meet the balance of supply as renewables are non-dispatchable Trends in primary energy costs Eskom s primary energy cost escalations are summarised as follows: Generation own primary energy costs have a compounded average growth rate (CAGR) of 6.4% per annum from 2018/19 to 2021/22 Non-Eskom primary energy costs reflect a CAGR of 14.8% per annum between 2018/19 to 2021/22. Of this, local IPPs have a CAGR of 15.6%. Total primary energy reflects a CAGR of 9.0% per annum between 2018/19 to 2021/22 Coal burn costs reflect a CAGR over the period of 7.8% per annum The table below summarises the primary energy related revenue being applied for in this MYPD 4 revenue application. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 64 of 115

65 Primary Energy TABLE 19: DETAILED PRIMARY ENERGY COST Primary energy costs Actuals Projection Application Application Application Forecast Forecast (R'millions) 2017/ / / / / / /24 Coal usage Coal obligations provisions Water usage Fuel & Water procurement service Water procurement service Coal handling Water treatment Sorbent usage Gas and oil (coal fired start-up) Total coal Nuclear Coal and gas (Gas-fired) Road repairs OCGT fuel cost Demand Market Participation Total Eskom generation Environmental levy IPPs International Purchases Total primary energy Revenue for coal costs While Eskom is a regulated entity, the coal market is unregulated, so Eskom competes with local and global buyers on price and supply. Although South Africa has abundant coal resources, coal in close proximity to the power stations is in dwindling supply. Where coal is procured from sources which do not have a conveyor to the power station stock yard, the coal must be transported by road and/or rail, instead of being moved over short distances on conveyor. This adds complexity to the value chain, as well as cost. Eskom purchases between 113 and 130 Mt of coal per annum. Coal is procured on three types of contracts: Cost Plus Long Term Fixed Price Short/Medium Term Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 65 of 115

66 Primary Energy FIGURE 14: COAL PROCURED CATEGORISED BY CONTRACT TYPE (%) Annual delivered trend in coal costs for each contracting type during the MYPD 4 period is reflected in the figure below. FIGURE 15: ANNUAL COAL EXPENDITURE PER SUPPLY SOURCE Eskom is facing significant challenges with regards to securing coal for the operation of its coal fired power stations. These challenges for the short to medium term are reflected in the figure below. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 66 of 115

67 Primary Energy FIGURE 16: KEY CAHLLENGES IN ESKOM S COAL PROCUREMENT ENVIRONMENT Eskom has historically secured coal at very reasonable prices as reflected in the comparison made by the Chamber of Mines. The trend continues in accordance with projections made by Eskom in this application when compared to the Richards Bay price. The Chamber of Mines has also established for the period 2008 to 2014 (no update available since then) that the most significant contributors to the cost of mining coal, increases above the producer price index. FIGURE 17: COAL PRICE COMPARISONS Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 67 of 115

68 Primary Energy Summary of coal burn costs for MYPD 4 period Coal burn costs reflect a compound annual growth rate (CAGR) over the period 2018/19 to 2021/22 of 8% per annum. Coal burn R/MWh increases above inflation from 2017/18 to 2019/20 and then it stays flat over the rest of the forecasting period. The relatively large increases in the coal cost in 2018/19 and 2019/20 may be attributed to the following: The increase in the volume of coal on short/medium term contracts. The inclusion of unknown coal from 2018/19. The exclusion of coal from Optimum mine (stopped coal supply during 2017/18) for Hendrina Power Station. Increase in transport costs associated with short/medium term and unknown coal. Decrease in volumes from cost plus mines as the impact of delayed investment and ageing of mines manifests. The inclusion of take or pay payments from 2018/19 for coal from Grootegeluk mine for Matimba and Medupi Power Stations Independent Power Producers (IPPs) In accordance with the sections 3.1.4(e) of the GSFA, Eskom is required to consult with and seeks approval from the Department of Energy (DOE) together with the Department of Public Enterprises (DPE) and National Treasury with regards to the proposed amounts for IPP purchase costs and payment obligations to be included in the MYPD 4 application for the period 2019/20 to 2021/22. In addition, as required by the NERSA MYPD methodology, projections for the subsequent two years (2022/23 to 2023/24) are included. Although efficiencies are being realised in various renewable technologies, the Eskom revenue application related to IPP costs increases over the MYPD 4 period. This is due to the additional IPP projects being added to the existing contracts and the escalation included in many contracts that have been finalised. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 68 of 115

69 Primary Energy FIGURE 18: SUMMARY OF REIPP COSTS OVER LIFE OF CONTRACTS Renewable IPP costs continue to increase over the MYPD 4 period due to contractual escalations and increasing number of contracts over the period. This increase in required revenue related to IPP costs takes into consideration the decreasing trend in energy costs of the various technologies over the bid windows (BW) as depicted in the figure below. It is clarified that the contractual commitments made for the earlier bid window, at a higher average energy price, will continue to be met throughout the duration of the contract. FIGURE 19: AVERAGE ENERGY PRICE FOR REIPP CONTRACTS (2018 ZAR) OVER BID WINDOWS Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 69 of 115

70 Primary Energy 13.5 Water costs Eskom receives raw water from the Department of Water and Sanitation (DWS) and Rand Water. This water is then treated for its intended use for human consumption or for the plant. The power stations cannot function without water for cooling the plant and producing steam for the turbines. The cost of water is impacted, not only by how much water is consumed, but to a larger extent by tariffs. Over the 2019/ /22 periods, the total volumes of water consumed decreases, but the cost of water is expected to increase because of the increase in existing tariffs and the introduction of additional tariffs. These tariffs are legislated, as are their increases. The cost of water also depends on the source (certain schemes are more expensive). New infrastructure is likely to be more expensive, so the water from that source will have a higher tariff. Some schemes have specific tariffs; e.g. water from the Vaal attracts the Vaal River Tariff. The introduction of environmentally friendly measures, such as the Demand Management Levy or the Waste Discharge Charge, adds to the cost of water. Eskom is a strategic user of water, consuming approximately 2% of the total annual use of the country, which is equivalent to the consumption of the City of Cape Town. As the demand for electrification grows, there will be an increased demand for scarce water supplies Open Cycle gas Turbine (OCGT) Fuel From a planning perspective, the OCGTs are considered together with the other available supply and demand options as peaking stations for use during peak hours which provides space for essential maintenance at base-load stations as well as for emergencies as a last resort before load reductions during extreme events. The load factor for OCGTs during the forecasting period was assumed to be 1%, which translates to 211 GWh per annum. The fuel used is mainly diesel (Ankerlig and Gourikwa). The price of the diesel is subject to the international USD price of Brent crude oil and the ZAR/USD exchange rate. The official Eskom economic parameters for the forecasting period were used in the calculations of the fuel costs. The diesel used by Eskom is subject to a wholesale discount and a fuel rebate as determined by the Minister of Finance Demand Response The Demand Response (DR) programme fulfils an important role towards power system security (even during times of surplus capacity) by providing the System Operator (SO) with much needed flexibility and reliability. The SO uses reserves to control the interconnected Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 70 of 115

71 Primary Energy power system frequency. These reserves are procured from both generators and the Demand Response (DR) programme through the ancillary services process as defined in the Grid Code. Factors that could affect the frequency stability of the electricity supply include: System constraints caused by severe weather and/or power line faults Generator malfunctions (unexpected trips loss of multiple Generation units) Substantial load and renewables forecast errors due to unforeseen circumstances Environmental levy The environmental levy on the generation of electricity from non-renewable generators was promulgated in July All Eskom generators, with the exclusion of Hydro and Pumped Storage Power Stations, were registered and licenced as manufacturing warehouses as required by the legislation Environmental levy payment From 1 July 2012, the environmental rate is 3.5c/kWh. The actual payments to SARS are determined by the true metered generated volumes. For this submission the Production Plan which measures Energy Sent Out as measured after the high voltage transformer is used to derive the assumed cost. To obtain the Generated volume an expected auxiliary consumption, based on actual historical performance, which is unique to each Power Station is added to the Energy Sent Out volume as published in the Production Plan. This derived Generated volume is then charged at the applicable Environmental Levy rate for that period to obtain the forecasted cost per Power Station. It is assumed for the planning period that no further rate increases will occur. The methodology, as approved by NERSA is based on the principle that the levy is raised at electricity production and that the electricity sales volumes is lower than the production volume. Thus the environmental levy cost is equivalent to the revenue related to the environmental levy. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 71 of 115

72 Operating Cost 14 Operating Cost 14.1 Overall summary of operating costs The operating costs at Eskom level are summarised here. Further details on each of the licensees operating costs are provided in the Generation, Transmission and Distribution MYPD 4 Revenue submissions which form part of Eskom s MYPD 4 revenue application. Integrated Demand Management is addressed in the Distribution Licensee MYPD 4 submission. This will cover the operating expenditure (E) element of the building blocks to the allowable revenue formula. AR=(RAB WACC)+E+PE+D+R&D+IDM±SQI+L&T±RCA TABLE 20 : DETAILED OPERATING COSTS Operating costs (R'millions) Actuals Projection Application Application Application Forecast Forecast 2017/ / / / / / /24 Employee benefit costs Operating & Maintenance Maintenance Opex Operating costs before other income Other income (1 786) (1 127) (1 206) (1 244) (1 301) (1 368) (1 424) Operating costs before Arrear debts Arrear debt Impairments Operating costs with Arrear debts Corporate social investment - not claimed in application (289) (292) (192) (193) (151) (149) (166) TOTAL OPERATING COSTS IDM - disclosed separately (138) (186) (189) (193) (202) (213) (225) Research & development - disclosed separately (111) (167) (176) (187) (198) (210) (223) OPERATING EXPENDITURE EXCLUDING IDM AND R&D Eskom s operating costs, excluding impairments, over the period 2020 to 2022 (application years) have grown at rates less than inflation. Analysis reflects that employee benefits have an average increase of 2.2% (after capitalisation) in this horizon. Similarly, the operating and maintenance costs have an average increase of 4.8% over the period. Significant efficiencies would be achieved over the period by reducing the number of employees and seeking other efficiencies within the workforce numbers without compromising the required skills in appropriate areas will be possible. This will be done by re-training, re-deployment and re-skilling of the work-force and natural attrition. The growth Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 72 of 115

73 Operating Cost in maintenance costs escalates due mainly to the increased maintenance in the network businesses. FIGURE 20: OPERATING COSTS 14.2 Employee Benefits Approximately 80% of Eskom s staff complement belongs to the bargaining unit and 20% are positioned at managerial level. Employee benefits costs are influenced by three main factors: Staff complements Employee benefits increases Level of remuneration Staff complement The planned number of employees for Eskom regulated business is assumed to decrease over the application period. This will occur through planned attrition or alternates that support savings initiatives and efficiencies. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 73 of 115

74 Operating Cost Employee benefits increases When comparisons are made to Eskom s employee benefit escalations, they are either to the overall generic labour market (Market move) or to average settlements (for bargaining unit). The employee benefit costs comprise of direct remuneration (salary, pension, medical aid, bonus, overtime) and indirect remuneration (training and development, temporary and contract staff). Eskom has recently settled its wage negotiations with the employees in the bargaining unit. These settlement increase percentages formed the basis of the revenue application that is being made. The settlement in the bargaining unit, with regards to the wage increases for the 2019/20 and 2020/21 years was 7%. The concomitant adjustments to other benefits, as negotiated, would need to be considered. The salary adjustments for the bargaining unit employees are above the inflation rate. Assumptions were made on the salary adjustments for the managerial employees as well. The overall increase in employee benefit costs is tempered to a certain extent by a decrease in the number of employees. FIGURE 21: PROJECTED OF NUMBER OF EMPLOYEES OVER THE MYPD 4 PERIOD i. In assessing Eskom s market position the following is important: ii. Eskom has consistently benchmarked the salaries and related benefits of all levels of employees to ensure meaningful market alignment. For this purpose Eskom participates in market surveys conducted by both the Deloitte Salary Survey and the PE Corporate Services salary survey. The two surveys cover 850 South African employers, and more than 1.5 million employees. This process allows for the Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 74 of 115

75 Operating Cost meaningful comparison of Eskom remuneration levels within the broader labour market. iii. iv. Eskom operates from more than 450 geographic worksites across the country placing strain on the supply and retention of skills in general. The extent of and the duration of technical training and safety authorisation of employees deployed on the Generation, Transmission and Distribution side of the business, further requires that measures are put into place to stabilise the work force and minimise turnover. As a responsible employer and with due regard to the social and economic challenges, salaries at lower level of the business are positioned above the market median, however managerial level remuneration are closely aligned with the market Operating and Maintenance costs As the business strives to accelerate maintenance programmes, and with the aging of plant it is expected that maintenance costs should increase Generation maintenance The key drivers for generation maintenance costs included Capacity expansion Eskom is in the process of commissioning two new coal power stations Medupi and Kusile. Once fully commissioned, these will increase the Eskom fleet generating capacity by approximately 20%. Reserve storage stations According to the Production Plan, at an overall assumed Eskom fleet EAF of 78%, four coal stations can be placed into reserve storage, as they will not be needed to produce electricity to meet the demand. The stations are Hendrina, Grootvlei, Komati and Camden. In addition, a stress test scenario at an EAF of 75% showed, however, that all 4 stations would need to run to meet the system demand throughout the MYPD4 period. Therefore, at this stage, it is premature to decommission these 4 stations and a decommissioning decision has not yet been made. Generation has, however, reduced the operating costs at these 4 stations over the planning period to reflect a reduction in activities during a period of reserve storage. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 75 of 115

76 Operating Cost Ageing fleet and high UCLF impact on maintenance costs The existing operational fleet of power stations is now on average about 32 years old and more than half of the coal-fired fleet will be older than 37 years by the start of the MYPD4 period. Thus, a real increase in maintenance costs on this ageing fleet over the next 10 years is expected due to additional maintenance activities and mid-life refurbishments on older power plants Transmission Transmission maintenance workload is driven by the size of the network and the age of assets. The expansion of the transmission network will result in increased maintenance workload going forward. Transmission s maintenance strategy includes the compilation and review of maintenance philosophies, standards and procedures. The maintenance philosophy is mostly time-based, but also considers the following: Operational information (usage) On- and off-line condition monitoring Plant performance information Non-intrusive functional testing Statutory requirements Safety of assets and people Maintenance is planned and executed in accordance with maintenance standards and procedures. A maintenance management system is used for maintenance planning and scheduling. Live line maintenance is utilised to overcome planned outage constraints or during emergencies. This requires specialised skills and equipment which has an impact on maintenance costs Distribution Distribution s existing infrastructure has reached an advanced stage of its asset life; planned electrification networks now means certain networks are at near the end of life. Future connection and changes in the customer base requires a sustainable maintenance regime. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 76 of 115

77 Operating Cost The following factors are important maintenance expenditure considerations Aging Network: Refurbishment requirements have been identified to address the aging network. Inadequate refurbishment will contribute to increased maintenance requirements. The inability to address these maintenance requirements will lead to further declines in performance. Access to Skills: Maintenance requirements are based on Distribution having sufficiently skilled resources. Reduction in these will compromise preventative and corrective maintenance requirements Universal Access: Acceleration of the Universal Access Programme will result in corresponding growth in the asset base which impacts the maintenance regimen. Distribution maintenance strategy includes both preventative (planned) and corrective maintenance (faults/unplanned). An increased focus is placed on planned maintenance in shifting performance and will be achieved through a number of key actions: Increase the ratio and time spent on planned maintenance and corresponding reduction in unplanned maintenance towards the end of the application period Focus on Low Voltage (LV) networks due to its close proximity to the customer base, specifically in the electrification areas A new proactive vegetation management which supports and aids the reduction of conductor faults and leads to improved performance in reliability and quality of supply. Distribution continues to embrace efficiency measures through its condition based maintenance programs in its maintenance standards and regimes. These regimes are further reflected within the maintenance strategies Trend in maintenance costs There is an overall increase in maintenance costs over the MYPD 4 application period. The maintenance undertaken is based on activities that need to be undertaken in accordance with the maintenance requirements, strategy and legislative requirements Other Operating Expenses Other operating costs are forecasted to grow from R m in 2019/20 to R m in 2021/22. These costs then forecasted to drop to R13 974m in 2021/22. This reflects certain significant changes that occur during this period. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 77 of 115

78 Operating Cost Included in this category are costs such as insurance, IT (information technology), fleet costs, legal and audit services, security, travel expenses, billing costs, connection/disconnection costs, meter reading, vending commission costs and telecoms. Insurance cost increases reflect the increase in the asset base as well as global premium increases. Factors that influence cover and pricing include insurance claim trends, loss ratio performance, value of insurance excess, new-build programme, reinsurance costs, increases in insured asset values and risk management efforts. The increase in Security expenditure is due to increased initiatives by Eskom to safeguard assets, combat theft incidents and mitigate the related risks. Telecommunication services is required for supervisory control and data acquisition (SCADA) and enabling remote access to fault recording systems as well as control centre communications. Meter reading - reading of Small Power Users (SPU) and Large Power User (LPU) billed customer meters are done mostly on a quarterly basis. Disconnection and Reconnection costs - costs incurred to manage outstanding debt by disconnecting non payers and reconnecting once the payment is made. Shared services costs for billing customers management of inflow and revenue management compliance 14.5 Research, Testing and Demonstration The electricity industry is going through significant challenges driven by technology disruptors as well as market, policy and industry drivers. The power utility needs to respond to these challenges with the need for greater flexibility, rapid technology advances across the entire value chain and adapting to changing business models. Balancing social, environmental and economic imperatives relies heavily on technology development and breakthrough to provide a way forward when all other routes appear blocked. Eskom Research, Testing and Development (RT&D) is therefore dedicated to finding technology solutions that can be applied primarily within Eskom to ensure it fulfils its mandate to South Africa. We are predominantly a technology early follower - Except for a few carefully chosen areas, Eskom does not wish to lead technology development. Rather it will focus on technology identification, acceleration and application, not technology development. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 78 of 115

79 Operating Cost Eskom is a needs driven organisation focussed on the systematic acquisition of knowledge and the application, development, refinement or demonstration of new and innovative technologies and solutions to satisfy Eskom s operational and strategic requirements through centres of expertise. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 79 of 115

80 Economic Landscape Changes 15 Economic Landscape Changes 15.1 World Bank Report Certain points from the World Bank Report, Making Power Affordable for Africa and Viable for Its Utilities, Masami Kojima and Chris Trimble, 2016 have been highlighted below. This is hoped to provide a balanced view of the report. The report suggests that Eskom is overstaffed. Eskom should be able to perform its function with less than half its staff. An analysis of this has been undertaken and is summarised at the end of the section on the World Bank report. Of the 39 countries studied, only the Seychelles and Uganda were fully recovering their operational and capital costs. In only 19 countries did the cash collected by utilities cover operational costs; just 4 of these countries were also covering half or more of capital costs, based on new replacement values of current assets. Such large funding gaps prevent power sectors from delivering reliable electricity to existing customers, let alone expand supply to new consumers at an optimal pace. A utility that does not cover its costs will struggle to deliver reliable electricity in sufficient quantity. Quasi-fiscal deficits the difference between the net revenue of an efficient utility and the net cash it collects averaged 1.5 percent of gross domestic product (GDP). It was feared that the substantial quasi fiscal activities observed in these countries could have large macroeconomic effects as governments were forced to intervene to finance these activities. Most countries may need to increase tariffs. In two-thirds of the countries studied, the funding gap cannot be bridged simply by eliminating operational inefficiencies; tariffs will have to be increased even after achieving benchmark operational efficiency. Small, frequent tariff increases may find wider acceptance than infrequent large increases. To eliminate fuel subsidies, India and Thailand raised fuel prices by small fixed amounts every month, announced in advance, until cost-recovery levels were reached. Targeting tariff increases to customers who account for the bulk of consumption and can afford to pay more would limit adverse effects on the poor. As with commercial losses, it would make sense to focus tariff increases first on large- and medium-size customers, for whom affordability is not as significant a challenge as for small-consumption households. Although the political sensitivity of tariff increases to wealthier consumers Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 80 of 115

81 Economic Landscape Changes cannot be ignored, it should neither be overemphasized. In the face of large utility deficits and low access rates, there is no compelling reason to subsidize those who can afford higher tariffs. Indeed, they could be asked to cross-subsidize low-income consumers more, as long as the latter s total consumption is a small fraction of the total electricity sold. Successful examples of power sector reforms in emerging countries in other regions show that middle- and high-income consumers in all tariff categories usually accept cost-reflective rates provided the quality of electricity services is good. Sharp drop in commodity prices has had significant repercussions for Africa. The prices of commodities crucial to the earnings of many African economies rose between 2001 and 2008, but have fallen sharply since. Some African governments have attempted to expand access to electricity by subsidizing its use, the cost of connection to grid electricity supply, or both. However, in the face of a falling fiscal balance, there is little room for large-scale government support. This restriction underscores the need to improve utility performance, adjust tariffs to achieve cost recovery, and design subsidy support in a way that maximizes the benefits to the neediest. The full cost recovery approach covers all cash needs as well as all capital costs with depreciation and the rate of return on invested capital forming the basis for calculating capital costs and decommissioning costs where applicable. If all costs are fully recovered from payments by consumers, the utility is financially sustainable over the long run. The electricity sector in Africa is far from mature. The medium- to long-term target is to reach tariff levels that fully cover all reasonably and prudently incurred costs. If, revenues fall far short, the first priority is to meet all cash obligations. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 81 of 115

82 Economic Landscape Changes FIGURE 22: COMPARISON OF ELECTRIC SUPPLY COSTS WITH CASH COLLECTION IN 2014 (U.S DOLLARS PER KWH) The Figure above compares the cash collected from bills sent out with the total costs of supply broken down into operational and capital expenditures per kilowatt hour (kwh) billed. The findings show that only the Seychelles and Uganda fully covered both operational and capital expenditures. Cash collected in 19 countries covered operational expenditures, leaving 20 with insufficient cash to cover these. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 82 of 115

83 Economic Landscape Changes TABLE 21: QUASI-FISCAL DEFICITS OF UTILITIES UNDER CURRENT PERFORMANCE IN COUNTRY REFERENCE YEARS Source: Trimble et.al 2016 Note: Quasi-fiscal deficits are in current U.S dollars in the reference year The quasi-fiscal deficit is the difference between the net revenue of an efficient electricity sector covering operational and capital costs and the net cash collected by the utilities. The results of this computation are shown in table above. South Africa had the largest quasi-fiscal deficit in absolute terms, $11 billion Breakdown of Hidden costs Efficient operation also referred to as benchmark performance is defined here as follows: Transmission and distribution losses (both technical and commercial) of 10 percent of dispatched electricity or lower 100 percent bill collection The same staffing level as in well-performing, comparable utilities in Latin America Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 83 of 115

84 Economic Landscape Changes FIGURE 23: BREAKDOWN OF HIDDEN COST Comparisons, benchmarking and efficiency of Operating and Maintenance cost In summary, the World Bank s report estimated that Eskom's Transmission and Distribution (T&D) staff should optimally number around 9596 and Generation 4648, for a total of They describe their methodology as follows: The benchmark number of employees for T&D is set by km of T&D lines with voltage greater than 1 kv and the number of customers. The total numbers of employees reported in the utilities annual reports are compared with the staff complement in utilities in three clusters of power utilities in Latin America with similar numbers of customers and km of T&D lines. Clusters were first identified in SSA, and then reference values were identified using utilities in Latin America with similar characteristics, as described below 3. For Eskom T&D their estimate was apparently based on a network size of 79811km 4 Eskom Generation they used a total installed capacity of 44281MW Transmission and Distribution: and customer base of For The World Bank report s source for Eskom s network size was Eskom's Integrated Report (IR) However, as the table below illustrates, the World Bank s report omitted to factor in the network below 22kV clearly nothing more than a human error that slipped through. 2 Source: World Bank Policy Research Working Paper 7788 : Financial Viability of Electricity Sectors in Sub- Saharan Africa: Quasi-Fiscal Deficits and Hidden Costs - Technical Report - August 2016, Table 10 p.48, August Page 79, for Transmission and distribution 4 Table A4.2, p.89 5 Table 10, p.48 6 Tables A3.1, A3.2, A4.1, p.85 to 88 7 Source: Fact Sheets Statistical Table 3, 'Power lines and substations in service at 31 March 2015' Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 84 of 115

85 Economic Landscape Changes The network size for Eskom as per the World Bank report is thus 21.7% of the actual network size as it was at 31 March 2015: TABLE 22: POWER LINES Using a reference group of fourteen Latin American electricity utilities, the World Bank s report then calculated values for clusters consisting of customer base and network size. For larger networks the ratio was from 33 to 54 customers per km of network. Having derived / assumed ratios for customers per km of network for each cluster in SSA, it thus allowed the optimal employee numbers to be estimated by using either the network size or the customer base. For example: if assuming 50 customers per km of network, it would be possible to express the optimum staffing number metric as either 500 customers per employee, or 10km of network per employee. However, had Eskom s correct network size of km been used instead of km, it would have been apparent that Eskom s network is much less dense in terms of customers per km i.e. around 15 customers per km (due to many individual customers being municipal customers thus not counted as individual Eskom customers). The World Bank report also comments on this matter i.e. The most significant example is South Africa, where Eskom sells to dozens of municipalities, which in turn account for 40 percent of sales to end-users. Therefore for Eskom it would be more appropriate to derive optimal staffing numbers from the (correct) network size which is nearly five times larger, or to use a more moderate ratio of customers per employee given that many customers are located within municipalities and not reflected in the Eskom customer numbers. For example, when using 16km of network per employee (equal to the World Bank report s average for the four largest Latin American networks and higher than their overall Latin American average of 12), it translates to employees for Eskom T&D (similarly, when using a ratio of 240 customers per employee). Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 85 of 115

86 Economic Landscape Changes Generation: For Eskom Generation the World Bank s report estimated the optimum staffing number at 4648 for the total installed capacity of 44281MW, which implies a ratio of 9.53MW of generation plant capacity per employee. This is significantly higher than the World Bank report s implied average for Africa of 2.3MW per employee and with 75% of electricity generation in SSA (excluding South Africa) produced from hydro and natural gas plants it could be argued that the ratio of MW per employee for SSA should be higher than for Eskom, not lower as implied by these numbers. For coal plant specifically, the World Bank report implies a ratio of 2.44MW per employee in the case of Botswana, whilst using a ratio for Eskom of 9.53MW per employee which is also (mostly) coal plant. Eskom s own further research based on published US Government data indicated that the ratio of generation plant capacity per employee for US coal power stations is around 3.7MW per employee. It therefore appears that also on the optimum staffing numbers for Eskom s generation activities, a human error might have slipped in. Using a more moderate ratio of 3.2MW per employee (14% lower than the US data for coal plants, but 30% higher than the World Bank report s ratio for coal as per Botswana and 40% higher than their ratio for SSA for mostly hydro and natural gas plants), it translates to employees for Eskom Generation. It is thus hoped that these clarifications could be made with regards to the World Bank report Economic Impact Study Eskom had commissioned two studies with regards to economic impact. The first is an overview and analysis of economic trends in relation to electricity. Certain trends are discussed here to illustrate the changes in the economic landscape in South Africa. The second study aims to provide an understanding of the macroeconomic impacts of alternative scenarios to meet Eskom s five-year revenue requirement. Each study is summarised here Economic Landscape Changes Deloitte Consulting has undertaken to provide an overview and analysis of economic trends in relation to electricity in South Africa. Certain trends are discussed here to illustrate the noticeable changes in the economic landscape in South Africa Overview of historical trend in electricity consumption in South Africa The relatively energy-intensive mining and manufacturing industries remain the dominant consumers of electricity in South Africa they account for circa 60% of national electricity Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 86 of 115

87 Economic Landscape Changes consumption and about 22% of GDP. The results of several local and international studies on the key determinants of electricity consumption suggest that income or GDP is the dominant driver of demand. The sensitivity of consumers to changes in electricity prices appears to vary significantly over time and depends on the direction and magnitude of price increases and the prevailing price level. There is evidence of strong positive correlation between GDP growth and growth in electricity sales in the country - the correlation coefficient between Eskom s local sales of electricity and GDP over the 20 years between 1997 and 2016 is A previous study found that the income elasticity of demand over the period 1990 to 2005 was almost unit elastic. This means that a 1% increase in GDP was associated with close to a 1% rise in electricity demand (once the influence of other important determinants such as price and supply constraints have been accounted for). In recent years and particularly since FY2012, growth in Eskom s local electricity sales has been much lower than growth in GDP. While GDP expanded at an average rate of 1.9% y/y between FY2012 and FY2016 Eskom s local electricity sales were falling, averaging -0.9% y/y. In FY2013 electricity sales fell by ~4.2% y/y as a sharp fall in the global demand for commodities hit production in South Africa s relatively electricity-intensive mining and manufacturing industries. Supply constraints also put a brake on demand as Eskom re-introduced rotational loadshedding in early 2014, and there was regular loadshedding between November 2014 and September Electricity sales fell at an average rate of -0.3% y/y over the first three years of the 5-year MYPD3 period which runs for 2013/14 to 2017/18 - much lower than the annual growth in electricity sales of 1.8% that it forecast for these years when submitted its MYPD3 application. Much of the sales forecast variance can be attributed to disappointing GDP growth - Eskom assumed that real annual GDP growth would average 4.5% but GDP growth averaged just 1.5% in the first three years of MYPD3. The slower-than-anticipated sales in first three years of MYPD3 were however also a result of unforeseen falls in global demand for commodities and the re-emergence of local supply constraints. With annual GDP growth forecast to average 1.8% for the 5-year period to 2021 (IMF & EIU forecasts), growth in electricity sales is unlikely to average more than 1% per annum particularly given evidence of a persistent trend-decline in the electricity intensity of growth and assuming that real electricity prices will continue to rise as Eskom transitions to a tariff that is more reflective of its prudently and efficiently incurred costs. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 87 of 115

88 Economic Landscape Changes Trend in electricity prices For much of the four decades to 2008/9 real (inflation-adjusted) electricity prices in South Africa were on the decline. By 2007 electricity tariffs in South Africa were among the lower in the world, but the power supply crisis that had been threatening for several years had also reached a critical point. Eskom introduced loadshedding and was given the green light to embark on a massive build programme the first major increase in power generation capacity the utility had undertaken in almost 30 years. Between 2008 and 2013 NERSA approved several sharp increases in annual tariffs which, in line with the regulatory methodology, would enable Eskom to raise the future revenue streams in needed to cover the new build - electricity prices more than doubled in real terms (inflation-adjusted) rising by a cumulative 114%. The sharp increases in real electricity prices over the 5-year period were met with increasing public resistance. NERSA subsequently awarded Eskom increases of roughly CPI plus 2% for the 5-year MYPD3 period. The tariff increases awarded by NERSA over the MYPD3 period (since 2013) have proved inadequate and Eskom s revenue shortfall has begun to mount. In November 2016, S&P Rating s agency further deepened Eskom s non-investment grade status to reflect Eskom s deteriorating financial position which continues to put South Africa s sovereign credit rating at risk Requirements of an efficient electricity pricing regime Electricity pricing regimes often try to satisfy a range of social, economic and political objectives, but we argue that the primary objective must be to ensure that resources are allocated efficiently. In terms of economic theory, a cost-reflective tariff is defined as a tariff equal to the long-run marginal cost (LRMC) of supply. While theoretically robust, LRMC is difficult to accurately estimate and operationalise. It is argued that the RoR methodology usually gives rise to tariffs that are equivalent to LRMC. The extent to which tariffs under the ROR methodology approximates LRMC appears to depend on the basis for asset valuation and/or the rules for depreciating the asset base. While an efficient pricing regime is a necessary requirement to ensure the efficient delivery of electricity services by the utility (even if a monopoly) it is not sufficient internationally accepted governance practices must be adhered to, to ensure that sound and least-cost investment decisions are made. Eskom estimates that an approved tariff of 67.7c/kWh in 2014/15 would need to have risen by 23% in order to reach the fully cost-reflective tariff of 83.9c/kWh. It is noted however that the gap between actual and cost-reflective tariffs is not static, particularly during a period of capacity expansion when new assets are being added to the regulatory asset base. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 88 of 115

89 Economic Landscape Changes Specific strategies for the transition to cost-reflective electricity tariffs in South Africa include: Encourage open conversations on the implicit electricity price subsidies which are heavily reliant on the limited fiscal resources. Support the conversation with a coherent communication strategy that provides the public with information on the magnitude of the subsidy and their shortcomings. The regulator must review its approach on the regulation of municipal tariffs to address large discrepancies in tariffs levied by municipal distributors as this is an obstacle to the transition to cost-reflective tariffs. Government should develop a clear plan for the transition to cost-reflective tariffs, with appropriate phasing and provision of targeted subsidies and other mitigating measures for vulnerable groups Macroeconomic impacts of alternative scenarios Aim of the study The aim of this study is to provide an understanding of the macroeconomic impacts of alternative scenarios to meet Eskom s five-year revenue requirement. While, like previous studies, the study should show the impacts on GDP, employment, and inflation during the five-year period, it should also demonstrate the impact on the fiscus (debt ratios and budget balance). We have also attempted to demonstrate some of the broader or longer-term economic consequences of government debt accumulation in scenarios where tariff increases generate insufficient revenue to cover Eskom s costs this included a scenario where government debt accumulation associated with low tariff increases, triggers a subinvestment grade credit rating downgrade Key scenario assumptions, and scenarios modelled For this modelling exercise, Eskom advised Deloitte to model the impacts associated with three alternative tariff scenarios average annual increases over a five-year period of 8%, 13% and 19% respectively. In November 2016, when this study commenced, Eskom had not yet finalised its forthcoming tariff application nor had it decided whether it would submit a tariff application for a single-year or for a multi-year period. As such official estimates of Eskom s required revenue and sales forecasts over the next five years were not available, the scenarios are therefore hypothetical and we have made the following key assumptions: We assume that the upper-bound annual average increase of 19% is what Eskom requires to reach and maintain a cost-reflective electricity tariff over the 5-year period from 2017 to Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 89 of 115

90 Economic Landscape Changes We assume that Eskom s total revenue requirement is the same across all tariff scenarios and that it is equivalent to the revenue that would be raised if tariffs increased at an annual average rate of 19%. For example, under the 8% tariff scenarios, Eskom experiences an annual revenue shortfall equivalent to the difference between the total revenue raised under a compounded 19% tariff increase and the compounded 8% increase. We then have further scenarios to model how the shortfall will ultimately be recovered e.g. by raising additional government debt (borrowing) or taxes. Three main categories of policy simulations were modelled, each with a different set of assumptions and for three tariff path options 8%, 13% and 19% (where applicable) This resulted in a total of five simulations all of which represent an alternative potential solution to meet Eskom s total revenue requirement over a five-year period. The scenarios modelled included a tariff-only option where electricity tariffs increase at an annual rate of 19% over five years and a baseline scenario (BAU) where tariffs increase at an average rate of 8% and the revenue shortfall is funded by raising additional government debt. Further scenarios included a 13% annual tariff increases with a debt-funded shortfall, an 8% increase with taxhike funded shortfall and a downgrade scenario, explained further below. At the time the modelling was undertaken (January 2017) we judged that there was also a significant risk that steadily rising government debt levels associated with the baseline tariff scenario of 8% would trigger a sub-investment grade (S-IG) credit rating downgrade. To simulate the economic impacts of this downgrade risk materialising we ran an alternative baseline simulation (BAU2) where a steadily rising debt-to-gdp ratio and deteriorating budget balance that is associated with an 8% average tariff increase triggers a S-IG credit rating downgrade. A visual summary of the five simulations modelled is provided in the figure below. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 90 of 115

91 Economic Landscape Changes FIGURE 24: SUMMARY OF SCENARIOS MODELLED Interpreting results of hypothetical scenarios particularly post-downgrade As explained above, the tariff increases are hypothetical. In addition, the potential S-IG downgrade we modelled under the alternative baseline (BAU2:8%, debt) has, in effect, already transpired. While the magnitude of the tariff increases chosen are hypothetical the scenarios still usefully illustrate the relative macroeconomic impacts of the various options available to meet Eskom s revenue requirement which include 1) Increasing the tariff alone 2) a combination of low tariff increases and raising government debt and 3) a combination of low tariff increases and tax hikes. Furthermore, while the anticipated S-IG downgrade has already occurred, it does not mean that credit-rating downgrade risk associated with debt accumulation under a much lowerthan-required tariff increase is now irrelevant or even diminished. As RMB (2017) notes, countries that are downgraded to sub-investment-grade typically experience a continual negative feedback loop. Following a SI-G event, as sentiment sours and interest rates increase, the fiscal position deteriorates. As the fiscal position deteriorates, interest rates rise and economic growth slows, further credit rating downgrades within junk territory are triggered. As RMB (2017) notes, countries take seven to nine years, on average, to recoup their investment-grade rating, following a downgrade, to speculative grade Approach The model selected for the simulation of the alternative scenarios to meet Eskom s revenue requirement is the University of Pretoria General Equilibrium Model (UPGEM) described in Bohlmann et al. (2015). UPGEM is a flexible Computable general equilibrium (CGE) model that for purposes of this study is used in standard recursive-dynamic mode. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 91 of 115

92 Growth in total employment (y/y%) y/y% Economic Landscape Changes Key findings and results The results show that an annual tariff increase of 19% is expected to have a slightly negative impact on GDP and employment growth relative to the baseline scenario (where tariffs rise by 8% a year and government borrows the shortfall). For example, under the 19% tariff scenario (1B), GDP is forecast to expand at an average rate of 2.0% y/y, which is 0.3 percentage points lower than the 2.3% y/y growth forecast in the baseline (BAU1). Total employment is expected to grow at an average rate of 0.9% y/y under a 19% tariff increase compared to 1.2% y/y in BAU1. This implies that under a 19% tariff increase scenario, fewer jobs will be created and sustained annually over the period 2017 to 2021, relative to BAU1. These results are consistent with those NERSA (2013) obtained when it presented the economic impact of similar tariff scenarios in its reason for decision on Eskom s MYPD3 tariff application. FIGURE 25: IMPACT ON TREND IN REAL GDP AND EMPLOYMENT GROWTH 1A, 1B, 3A RELATIVE TO BAU1 AND BAU2 4.0 Real GDP growth A: 13%, debt 1B: 19%, tariff BAU2: 8%, downgrade 3A: 8%, VAT BAU1: 8%, debt Employment growth 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% Our results however suggest that the impact of higher tariff increases on CPI inflation over the next five-year period would be more muted than what NERSA (2013) previously Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 92 of 115

93 Government debt to GDP (%) Economic Landscape Changes indicated. The simulation results suggest that scenarios with higher annual electricity price increases of 13% and 19% (1A and 1B respectively) have very little impact on CPI inflation - inflation rises in both cases by less than 0.1 percentage point, averaging 5.8% y/y in the fiveyear period from 2017 to 2021 and 5.5% y/y thereafter. While the low-cpi impact associated with relatively high tariff increases may seem counterintuitive, it can be attributed to the fact that higher tariff increases are expected to have a negative impact on GDP growth and employment. Given that GDP growth was already expected to be relatively subdued over this period (relatively to potential GDP growth of 3%), sluggish demand is likely to keep inflation in check. We noted previously that in the economic analysis that NERSA presented in 2013, the regulator did not acknowledge the fiscal consequences of lower-than-required tariff increases. Our results show that under the 8% tariff baseline scenario (BAU1) there is a steady and marked deterioration in government s budget balance and that the government debt-to-gdp ratio is expected to reach 75% by 2021 and 104% by By contrast under the 19% tariff scenario, the debt-to-gdp ratio stabilises at ~66%. Given the sharp accumulation of government debt under a much-lower-than-required tariff increase, we also noted that it was likely that BAU1: 8%, debt would trigger a sub-investment grade credit rating downgrade and as such that it would be more accurate to compare the economic impacts of a 19% tariff scenario with a scenario where an 8% tariff increase triggers a SI-G downgrade (BAU2:8%, downgrade). FIGURE 26: IMPACT ON GOVERNMENT DEBT-TO-GDP RATIO - 1A, 1B, 3A RELATIVE TO BAU1 AND BAU2 120% 100% 80% 104% 100% 88% 60% 55% 1A: 13%, debt 68% 67% 40% 1B: 19%, tariff BAU2: 8%, downgrade 20% 3A: 8%, VAT 0% BAU1: 8%, debt Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 93 of 115

94 Economic Landscape Changes As noted earlier, the risk of an S-IG downgrade that we modelled under the alternative baseline (BAU2:8%, debt) has in effect, already materialised. On the 4 th of April 2017, Standard & Poor s announced the downgrade of South Africa's long-term foreign currency sovereign credit rating to sub-investment grade. The results of our downgrade scenario show that when the rise in government debt that is associated with a much-lower-than required tariff increase is sufficient (together with other economic and political risk factors) to trigger a sovereign credit-rating downgrade (BAU2: 8%, debt), South African s end up worse-off than under a 19% annual tariff increase and the negative economic impacts are likely in aggregate to be more severe for the following reasons: Firstly, our results show that under the BAU2: 8%, downgrade scenario, growth in GDP and employment will slow by almost as much as they would under a 19% annual tariff increase. Simulation results show that under both the downgrade scenario (BAU2: 8% downgrade) and 19% tariff scenario (1B:19%, debt) annual GDP growth will be 0.3 percentage points lower than in BAU1. Similarly, under BAU2 and total employment growth is expected to average 1.0% y/y which is an average of 0.2 percentage points lower than in BAU1, while under scenario 1B: 19%, tariff employment will increase at an average rate of 0.9% y/y or 0.3 percentage points lower than BAU1. Secondly, while our results suggest that the negative impact on GDP and employment that follow a downgrade due to debt accumulation under a much-lower-than-required tariff is almost equivalent to a 19% tariff increase, South Africans are likely to end up worse-off in aggregate under the downgrade scenario because of a simultaneous rise in debt and interest rates that doesn t occur under the tariff only scenario. Borrowing costs (or the required return on investment) will rise by 1 percentage point (100bps) under BAU2 relative to the 19% tariff scenario (1B) and the government debt-to-gdp ratio will rise steadily reaching ~75% by 2021 and 100% by 2030 under BAU2, while under the 19% tariff scenario, the debt-to-gdp ratio stabilises at ~66%. Finally, under any scenario (including BAU1, BAU2 and 1B) where the revenue collected via the tariff is insufficient to cover Eskom s prudently and efficiently incurred costs, the price of electricity is being implicitly subsidised. As the World Bank (2010:22) notes: Subsidising energy use involves providing it at a price below opportunity cost. This includes non collection or non payment, selling electricity at a cost that does not reflect the long run marginal cost of supply including capital maintenance. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 94 of 115

95 Economic Landscape Changes The economic harm and distortions that are caused by energy subsidies, including artificially low electricity prices, is well-documented in the international literature. Some of the potential macroeconomic, environmental, and social consequences of energy subsidies, as documented by the IMF (2013) were summarised in Deloitte (2017) as follows: Energy subsidies crowd-out growth-enhancing or pro-poor public spending. Energy subsidies, while often intended to protect consumers crowd-out other priority spending (such as on social welfare, health, and education) and place an unnecessary burden on public finances. Energy subsidies (unless specifically targeted) are a poor instrument for distributing wealth relative to other types of public spending. Energy subsidies discourage investment in the energy sector and can precipitate supply-crises. Energy subsidies artificially depress the price of energy which results in lower profits for producers or outright loses. This makes it difficult for state-owned enterprises to sustainably expand production and removes the incentive for private sector investment. The result is often an underinvestment in energy capacity by both the public and private sector that results in an energy supply crisis which in turn hampers economic growth. These effects have been felt in SA. Energy subsidies create harmful market distortions. By keeping the cost of energy artificially low, they promote investment in capital-intensive and energy-intensive industries at the expense of more labour-intensive and employment generating sectors. Energy subsidies stimulate demand, encourage the inefficient use of energy and unnecessary pollution. Subsidies on the consumption of energy derived from fossil fuels leads to the wasteful consumption of energy and generate unnecessary pollution. Subsidies on fossil-fuel derived energy also reduce the incentive for firms and households to invest in alternative more sustainable forms of energy. Energy subsidies have distributional impacts. Energy subsidies tend to disproportionately benefit higher-income households who consume far more energy than lower income groups. Energy subsidies directed at large industrial consumers of energy benefit the shareholders of these firms at the expense of the average citizen. Deloitte (2017) goes on to give specific examples of the economic harm and distortions that can be attributed to the historic under-pricing or implicit subsidisation of electricity. In South Africa these are argued include: Artificially low electricity tariffs discouraged investment in South Africa s electricity supply industry and helped to precipitate the 2008 power supply crisis. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 95 of 115

96 Economic Landscape Changes The subsidised tariffs frustrated attempts by the government to attract private investment in the early 2000s and helped to precipitate the supply crisis of Subsidised electricity prices promoted investment in capital intensive industries in South Africa at the expense of more labour-absorbing sectors. Kohler (2014) traced the 40-year change in electricity intensity across a number of countries and country groups and found that South Africa has amongst the highest electricity intensity globally. Subsidised electricity prices, encourage the inefficient use of energy and contributed South Africa to becoming one of the single-largest contributors to global GHG emissions. Subsidies on the consumption of electricity generated by Eskom which was mostly coal-based have arguably contributed South Africa becoming the 18 th largest country-level contributor to global CO2 emissions Concluding remarks on economic impacts It may be tempting to conclude that by limiting electricity tariff increases to 8% per annum and requiring that Eskom and/or government borrow the revenue shortfall (and effectively implicitly subsidise the price), it is possible to minimise the negative impacts of rising electricity prices on GDP and employment growth in the short-term. However, the results of the economy-wide impact analysis show that the fiscal and economic consequences of awarding Eskom a tariff that is much lower than what it requires (to recover its prudently and efficiently incurred costs), do eventually (and arguably have now) become evident. Our results show that when the gap between the required and actual tariff increases is large (an 8% increase awarded over five years when we assumed 19% was required) and the shortfall is covered by raising debt, there is a steady and marked deterioration in government s budget balance and debt-to-gdp ratio. For example, under the baseline 8%, debt scenario government debt-to-gdp ratio is expected to reach 75% by 2021 and 104% by By contrast under the 19% tariff scenario, where all the required revenue is raised via the tariff, the results show the debt-to-gdp ratio stabilising at ~66%. 8 Based on data from the EDGAR emissions databased for global atmospheric research Available online at: Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 96 of 115

97 Economic Landscape Changes Over the past 10-years there has been a marked deterioration in both the financial position of Eskom and the fiscal health of the South African government and this is evident from the change in debt and credit metrics that is summarised. Since 2008, South Africa s long-term foreign-currency rating has been downgrade by 3 notches from lower-medium grade to speculative grade or junk by two of the three major rating agencies. Eskom s long-term local-currency corporate bond rating has been downgraded by between 5 and 10 notches, from upper-medium grade in 2008 is now rated highly-speculative by Standard and Poor s. A summary of key debt metrics shows that since 2008 (when Eskom embarked on its massive capital expansion programme) the South African government s capacity to meet its debt obligations (and to raise additional debt or issue guarantees on debt of state-owned enterprises) has become far more constrained and as such vulnerability to eventual nonpayment has increased. In terms of the National Treasury broad risk management guidelines (updated in 2008) 9 net loan debt, provisions and contingent liabilities should not exceed 50 per cent of GDP while the broader SADC macroeconomic convergence target was to limit the metric to 60 per cent of GDP. While this metric stood comfortably within these prudential limits at 34.4% GDP in 2008, in 2017 it stands at 67% of GDP exceeding both the selfimposed risk guideline and broader SADC convergence target. Net loan debt (excluding provisions and contingent liabilities) is expected to reach 47% of GDP in 2017/18 (up from 22.6% in 2007/8). Government now spends 11.5% of its total revenue servicing the interest on debt (up from 8.9% in 2007/8) illustrating how the fiscal space is becoming increasingly constrained. It is also clear that substantial support provided by government to Eskom over the past 10 years both in the form of equity and guarantees has impacted on the deterioration in Government s overall debt metrics. Eskom initially received support from government in the form of a R60bn shareholder loan which was converted into equity in 2015 and in the form of a further R23bn equity injection completed in March Government also approved R350bn worth of guarantees on Eskom s debt of which Eskom had drawn on R218bn worth by 2017/18 (the agreement is to be extend to 31 March 2023). Government guarantees of SOE debt rose from R65bn in 2008 to a total of R445bn in 2017 and 77% of this is for the electricity sector which also covers Eskom s power purchase agreements with IPPs. 9 National Treasury (2008) National Budget Review, February Moody s Investor Service (2017) Moody's places Eskom's Ba1/A2.za ratings on review for downgrade Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 97 of 115

98 Economic Landscape Changes Following the sub-investment grade downgrade of South Africa s long-term foreign currency in April 2017 and subsequent downgrade of Eskom s corporate debt by S&P to highlyspeculative grade, neither Eskom nor the South African government will be in a position to raise further debt to meet Eskom s future revenue requirement without the risk of triggering further sovereign credit rating downgrades. In the present context, if Eskom is awarded much-lower-than-required tariff increases, it will put South Africa at greater risk of remaining within the continual negative feedback loop that countries typically experience following an SI-G event. Our analysis shows that under low tariff scenarios, Eskom s revenue shortfall grows, the fiscal position deteriorates, interest rates rise, sentiment sours, economic growth slows, further credit rating downgrades within junk territory are triggered and the toxic loop repeats. As RMB (2017) notes, countries take seven to nine years, on average, to recoup their investment-grade rating, following a downgrade, to speculative grade. Our simulation results show that in terms of the overall economic impacts - even a sharp 19% annual tariff increase over five-years would be preferable to a scenario where rapid debt accumulation associated with a much-lower-than-required 8% tariff increase triggers further credit rating downgrades. While our results suggest that the negative impact on GDP and employment that follows a downgrade due to debt accumulation under a much-lower-than-required tariff is almost equivalent to a 19% tariff increase, South Africans are likely to end up worse-off in aggregate under the low-tariff downgrade scenario because of a simultaneous rise in debt and interest rates triggered by a downgrade. In addition, in the low-tariff scenarios, the price of electricity remains implicitly subsidised, and as outlined in detail in Deloitte (2017), energy price subsidies are associated with a wide-range of market distortions and economic harm. In conclusion, it would be ill-advised for NERSA to continue to limit Eskom s tariff increases below cost reflective levels. It would also be incorrect given the current context and results of this analysis to assume that this will limit the negative impact on GDP and employment, even in the short-term. Our recommendation is that tariff increases should at least be sufficient to transition Eskom towards a more cost-reflective electricity tariff (prudently and efficiently incurred) over the next 5 years. This will reduce of the risk of South Africa being trapped for a prolonged period in the continual negative feedback loop that countries typically experience following an SI-G rating downgrade. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 98 of 115

99 National Treasury and SALGA responses 16 National Treasury and SALGA responses 16.1 Summary of key responses provided to comments by National Treasury as part of consultation process for the MYPD revenue application Period of the MYPD submission National Treasury felt that a three year application was preferable to a one year application. A three year application provides a medium term view. It is felt that a longer term application will allow for further phasing-in of prices towards cost reflectivity and provide certainty to customers. There is agreement that the Integrated Resource Plan (IRP) will only impact Eskom once the Minister of Energy makes determinations. Eskom has further extended the period towards cost reflectivity by requesting even lower returns on assets than the MYPD 3 period. Thus the application period is not related to the period to migrate towards cost reflectivity. Eskom is in agreement that the Minister of Energy will need to make determinations that will potentially impact Eskom s investment commitments. This is unlikely to occur in the MYPD 4 period. NERSA is likely to provide a price trajectory for the longer term as reflected in the Electricity Pricing Policy. This will provide certainty to customers Economy-wide impacts of the proposed tariff National Treasury s own analysis of the first round effects on consumer inflation shows that a multi-year increase in electricity prices of 15% between 2019 and 2021 from the current trajectory would increase headline CPI by 0.27, 0.31 and 0.32 percentage points in 2019, 2020 and 2021 respectively. A similar multi-year increase of 17.6% increase (i.e. municipal tariff increase), would increase CPI by 0.35, 0.42 and 0.45 percentage points in 2019, 2020 and 2021 respectively, from the current forecast trajectory. Furthermore, it is worth stressing that this analysis does not account for the second round cost of production effects, which are likely exacerbate the overall impact of these tariff increases. National Treasury concurs that shortages of electricity have a more detrimental impact on the economy than higher prices which are used to enable the financing of capacity expansion. Various studies have shown that load shedding (especially unplanned load shedding) has very large negative economic impacts, far more so than various other options which may include running the gas fired power stations, buying back power from large Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 99 of 115

100 National Treasury and SALGA responses consumers, demand market participation and other alternatives. Higher prices tend to have smaller economic impacts as they redistribute electricity and thus production from least productive (less efficient) to be more productive (more efficient) firms. This results in more optimally allocated resources. This is true to the extent that electricity prices converge to cost reflective levels, which are not inflated by operational inefficiencies, poor management and unjustified cost overruns. In the long run, cost reflective tariffs, including the internalisation of the cost of negative externalities associated with electricity supply, will ensure more efficient use of electricity and efficient allocation of resources in the economy and will raise economic growth rates over time. It will provide the right signals for investment in the electricity sector for both Eskom and Independent Power Producers (IPPs) as well as in cogeneration opportunities. The correct pricing of electricity will help to stimulate investment in more efficient and less environmentally damaging production methods and incentivise residential consumers to consume electricity more efficiently. In the short-run, electricity prices also have an important role to play in managing the supply and demand balance. Nevertheless, it is critical to smooth the transition to cost-reflectivity in order to allow consumers to adjust and avoid unnecessary employment and output losses. Moreover, the history of load-shedding, or rolling brown-outs, in which various geographic areas were denied electricity supply in a staggered and planned fashion in order to maintain stability of the grid when demand outstripped electricity supply, has brought several critical concerns to the fore. South Africa may face repeated crises in the electricity sector as a result of the lack of sustainability of Eskom, the sovereign credit rating downgrades and policy and regulatory uncertainty. Rising electricity prices and periods of load shedding have dampened demand for electricity and resulted in domestic and industrial customers switching to alternative electricity supply sources. Therefore, resolving the poor performance and sustainability of Eskom will be critical if South Africa is to achieve the economic growth required to address poverty and progress towards achieving the Government's aim of economic transformation. Impact of electricity price increases National Treasury also ran a shock in its Computable General Equilibrium (CGE) model incorporating a higher price (a 15% increase per year, for three years) in electricity generation and distribution. A 15% annual increase in the price of electricity reduces GDP growth by an average of 0.1 percentage points each year, compared with baseline growth. The macroeconomic effects are tabled below. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 100 of 115

101 National Treasury and SALGA responses Table 1: Macroeconomic effects of an increase in the price of electricity Deviation in average growth from baseline Percentage points Absorption -0.1 Private consumption -0.3 Fixed investment -0.2 Change in inventories 0.0 Government consumption 0.4 Exports -0.3 Imports -0.3 Gross domestic product at market prices -0.1 Source: National Treasury On a sectoral basis, there are pronounced negative effects on the mining sectors, as these are energy-intensive industries, as well as directly on the electricity industry. The electricity industry is directly affected by weaker demand owing to the large increase in the price of electricity. Weaker demand for electricity is seen across the household income groups, but is relatively stronger for the higher income households who can switch to alternative forms of energy. Figure 1: Estimated impact on sectoral GVA growth Source: National Treasury Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 101 of 115

102 National Treasury and SALGA responses Impacts of the proposed tariff on Eskom customers The following comments are based on the research conducted by National Treasury into the impact of electricity tariff increases on households and select listed companies. The findings of the research indicated that the impact on households will be as follows: a. Using household data from the Income and Expenditure Survey, even under a relatively low projected electricity tariff path, electricity expenditure by households will almost double by Lower income households, particularly deciles 1 to 5, will be the most affected as electricity represents a larger proportion of their expenditure basket. b. However, low income groups (LSMs 1 to 4) will be able to adjust more easily as they can use basic non-electricity based appliances to reduce their electricity consumption (e.g. gas/ paraffin cookers) and thus electricity expenditure. c. A sharp increase in electricity tariffs will make electricity-alternative household appliances (e.g. gas stoves, heaters, rooftop PV s) relatively cheaper. This means that households in the higher income groups (LSMs 8, 9 and 10) will be able to mitigate the impacts of the tariff increases on their overall household expenditure. d. Although low and high income households will be able to mitigate the effects of electricity price increases somewhat, National Treasury s findings suggest that middle income households (LSM 5 and LSM 6 in particular) will be the most vulnerable to rising tariffs. This is due to their higher electricity consumption, yet lower average income that limits their ability to invest in appliances that will reduce their electricity consumption more significantly. Thus electricity prices increases will likely have a large negative effect on these households. On the other hand, the findings of the research indicated that the impact on firms will be as follows: e. By analysing the financials of 21 listed companies it was determined that under a high tariff scenario, the net present values of the operating profits of firms could be reduced by up to 17%, dependant on energy intensity. f. Own-generation s viability is growing and some firms have already reached the point where it makes sense from a financial perspective, even in moderate tariff trajectory to invest in own-generation. g. If firms continue to undertake these investments or improve their energy efficiency they Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 102 of 115

103 National Treasury and SALGA responses will be able to mitigate the impact of the tariff increases somewhat. Impacts of the proposed tariff on Eskom and municipalities The mitigation strategies employed by households and firms described above will have an adverse impact on electricity sales for Eskom and municipalities. Looking at households specifically, under relatively conservative assumptions and a moderate tariff path (of a 10% per annum increases over the next 5 years), about 26% of total residential electricity sales could go off-grid by From an analysis of 21 listed companies, our estimates show that the equivalent of up to 34% of mining, 8% of industrial and 1% of commercial electricity generation sales currently supplied by Eskom have the potential to go off-grid by Furthermore, such a steep increase in electricity tariffs will increase the prevalence of nontechnical load losses, as certain households can no longer afford the higher tariffs yet still continue to use electricity. Eskom notes the analysis by National Treasury. Eskom has also commissioned two economic impact studies that have been summarised in this submission and have been included in the submission made to NERSA for public consultation. In addition, a study undertaken by the World Bank, also summarised in this submission, indicates that 81% of the hidden costs (hidden from consumers by not being reflected in price) in Eskom s price of electricity is due to underpricing. Eskom supports Government continuing to developing sector specific incentives and the protection of the poor. In the holistic economic impact study commissioned by Eskom it is demonstrated that the impact on the fiscus would be much more severe if prudent and efficient cost reflective prices of electricity are not applied Sales volume assumptions The sales forecast is perhaps one of the most crucial assumptions as it ultimately determines not only what the price will be but also what expenses need to be covered. National Treasury suggests that further clarity be provided on how sales volumes were assumed. Eskom concurs with National Treasury with regards to the significance of the sensitivity of the sales volume. Eskom makes every effort to ensure that consideration is taken of a variety of factors when determining its proposed sales forecast. In addition, NERSA undertakes its own analysis. NERSA then makes the final decision on the sales forecast to Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 103 of 115

104 National Treasury and SALGA responses form the basis of the MYPD 4 determination. The process that Eskom follows in arriving at a sales volume assumption is a very rigorous one and a huge amount of effort is put into the process to ensure the compilation of an accurate sales forecast over a period of 6 months. It can be confirmed that Eskom definitely compares the bottom up with a top down approach to make sure that the forecast makes sense from all angles and that the bottom up approach is realistic. To test that the bottom up approach forecast is in line with historic trends the total sales growth with many years of history is analysed and interrogated. A linear and exponential trend line to the total sales trend is normally used to check the budget trend line. Eskom further look at a wide variety of relationships, especially the relationship of electricity demand to other macro variables, e.g. GDP, commodity prices, exchange rates. An important part of the forecast is to focus on these relationships specifically for the Key Industrial Customers (KIC) and mines that are reliant on exchange rate and commodity prices. The submission document also shows the major commodity tables and economic parameters that is utilised. In determining price elasticity proper analyses is done with available information and the findings tested with KICs. It is important to note that when you consider income elasticity, one should be careful not to double count the impact of price elasticity. In the price elasticity impact determination there is already a component of the income elasticity, as price elasticity inherently sends a message as to what level customers will be able to tolerate higher electricity bills when competing for spending on other more/equal important expenditures, such as food, water and other. In addition Eskom also had a look at inflation rates, mostly for the residential type of customers, but price elasticity and the savings drives overshadowed that impact. In representative customer engagements, time was spent to discuss the proposed price path and the implication on energy intensive users, but Eskom takes note of National Treasury s suggestion that the price elasticity impact of such a high increase could be more what was anticipated in the submission. In line with the MYPD methodology, the mitigation of the sales variance can be addressed through the consideration of a more recent sales forecast at the time of the NERSA decision. To avert the declining trend Eskom has put in place a growth initiative with stretch targets to grow additional sales over and above what will transpire from the market. A sustainable solution requires a coordinated national (SA Incorporated) effort and should consider all options. Eskom is completely supportive of any policy interventions by the Government in ensuring further economic growth that is likely to attract further industrial investment. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 104 of 115

105 National Treasury and SALGA responses Municipal Debt National Treasury is concerned that in many cases, Municipalities attempt to buffer the impact of Eskom increases by not passing on the full impact of the bulk increase burden to their customers and decreasing maintenance. National Treasury has linked percentage collection of electricity revenue to the price of electricity. It is recognised that high level of debt arrears imposes a burden on Eskom's funding and subsequently tariffs, as the relationship between Eskom prices increases and outstanding debt is a vicious cycle. Therefore, National Treasury recommends that Eskom considers different scenarios for the likelihood of increases in non-payments and the resulting net impact on revenue as a result of the proposed tariff increases. National Treasury recognises the impact that the increasing debt owed by municipalities have on Eskom s financial sustainability and is supportive of the steps being taken by Eskom to exercise their contractual rights in relation to defaulting municipalities as well as other steps, e.g. the installation of prepaid meters, which are aimed at mitigating the outstanding amounts. Eskom understands that the Municipal tariffs are regulated in accordance with a benchmark increase as determined by NERSA. Eskom understands in certain cases, Municipalities request NERSA to allow for electricity price increases to be above the benchmark determined by NERSA. It is understood that NERSA, will address Municipalities not keeping to their license conditions with regards to the requisite maintenance that needs to be undertaken. Eskom notes the suggestions made by National Treasury and will ensure that these activities are strengthened. Eskom appreciates National Treasury support in addressing its recovery of debt Regulatory Clearing Account National Treasury notes that the RCA has not been taken into account in preparing this application and that this may result in amendments to the increases presented by Eskom in the draft application. National Treasury is correct. Eskom will not be including any RCA adjustments in the MYPD 4 revenue application. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 105 of 115

106 National Treasury and SALGA responses Primary energy National Treasury clarifies that Primary energy costs are likely to vary with levels of sales volumes. Eskom indicated that overall primary energy costs are expected to increase by an average rate of above 7% over the MYPD4 period with coal costs increasing at an annual average of about 8%. Concern was raised about detailed information to be provided to NERSA with regards to coal costs. Eskom is required to provide NERSA with estimated costs over coal for a period of 10 years. National Treasury required clarity on the MYPD methodology with regards to revenue related to coal costs. Clarity was required on the MYPD methodology on actual and projected costs of coal. National Treasury cautioned on prudently managing coal stockpiles to avoid high coal stockpiles. National Treasury wishes Eskom and Government to engage with relevant stakeholders to develop a long-term strategy on the procurement of coal. In the application, Eskom states that currently there is no excess generation capacity and their production plan shows that that there will be operational excess capacity as from 2020/21 financial year. However, this contradicts the entity s Medium-Term System Adequacy Outlook (MTSAO) published in October National Treasury wishes to have a competent and independent economic regulator in the water sector. Eskom will provide all the detailed information required in terms of the MYPD methodology. Eskom, in this application will implement the requirements of the MYPD methodology. The actual information will be provided for the 2017/18 year. Projections will be provided for the 2018/19 year. The projections for the three application years and a further two years will be provided in the submission to NERSA. NERSA requests this information to undertake its prudency evaluations on all the cost elements of the regulatory formula. The MYPD methodology recognises that recent actual and projected information is required to determine the prudency of the application. The MYPD methodology recognises that the most recently available information should form the basis of the NERSA determination. Eskom, in this submission will provide further details on the process to be followed with regards to generation units that are in reserve storage. It is clarified that there would be differences between Eskom actuals and the MTSAO scenarios. Further analysis of primary energy costs have been undertaken since the draft submission. Many of the areas highlighted by National Treasury have been addressed. These will be provided to NERSA as part of the final submission. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 106 of 115

107 National Treasury and SALGA responses Eskom has adhered to the MYPD methodology, to the extent possible, when making this revenue application. The MYPD methodology requires the licensee to apply for only efficient and prudent costs. The Eskom Board has decided to review the NERSA 2018/19 revenue decision. Eskom understands that the viability of a water regulator could be explored Operating expenditure National Treasury proposes that Eskom provides more details on the employee benefit costs. It is accepted that further details on the employee benefit costs are provided in this submission Regulatory asset base and return on assets National Treasury proposes that the valuation of the RAB and determination of depreciation in terms of the MYPD methodology be clarified. It is clarified by National Treasury that asset values for regulatory purposes differ from historical values. National Treasury is concerned that Eskom is applying for a return on assets at a rate lower that the WACC. This decision is important in ensuring that Eskom is able to recover sufficient returns to be able to pay its obligations. The financial sustainability of Eskom would be eroded which increases the risk of a call on the government guarantee or that government may be required to support the utility financially. National Treasury believes that it is critical to highlight that Eskom s capacity to continue to operate on a tariff which is below the cost reflective level is a consequence of the extensive support that government has provided to Eskom. This support has enabled Eskom to raise the capital required to undertake the build programme and, moreover, has reduced the cost of borrowing for the entity. National Treasury recognises the need to phase in electricity price increases to achieve a cost reflective level so as to allow the economy to adjust over time. Eskom has requested an independent consultant to determine the RAB value of existing assets. There is a significant increase in the depreciated replacement value of the RAB. Further details are provided in this submission. Eskom notes the motivation for Eskom to be in a position to be able to sustain itself. Credit rating agencies have recognized that the migrating towards a price that reflects the efficient Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 107 of 115

108 National Treasury and SALGA responses and prudent cost of electricity is fundamental for this. It is argued that the only lever being considered to allow for migration to cost reflectivity is the further phasing in of the ROA Proposed tariff increases National Treasury is concerned about the level of cross subsidies that could impact the competitiveness of certain industries. It is not only the average price that is of concern but more so the cross subsidies. A proposal is made to for a more comprehensive debate on the cross subsidies. Eskom supports such a debate Summary of SALGA responses related to the MYPD 4 Revenue Application Impact on economy and affordability SALGA has requested specific information related to various aspects of Eskom s MYPD 4 revenue application. This includes sales forecasting, primary energy, imports, IPPs, operations and maintenance and environmental levy Eskom has endeavoured to update the revenue application submitted to NERSA by addressing the information requested by SALGA. This is undertaken to the extent possible Customer centricity by lower increases in tariffs SALGA is concerned that the 15% increase for three years is not customer-centric. The addition of the RCA adjustment imposes further burden. SALGA feels that customers will opt to go off-grid or result in non-payment. Has impact on poorer communities who opt to use more dangerous forms of electricity. It is felt that all sectors are being impacted. Eskom is still in the process of migrating towards cost reflectivity. Thus Eskom is not yet recovering its prudent and efficient costs and a reasonable return in this application. With regards to distressed sectors, the Department of Energy is leading in the process to address the requirements of various sectors with regards to their electricity needs Further cost containment is required Eskom is urged to continue with finding further efficiencies. Only efficient costs should be applied for. The comparison to inflation related increases are proposed. With regards to Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 108 of 115

109 National Treasury and SALGA responses employee benefit costs non-value adding benefits should not be included. Eskom is committed to ensuring that it continually finds efficiencies. This is evident in the lower than inflation increases in the operating expenditure Depreciation and construction of assets SALGA requested that the MYPD methodology be changed to consider depreciation as reflected in the AFS. A separate application should be made for construction of assets. Eskom is required to comply with the MYPD methodology. Any changes in the MYPD methodology are best addressed with NERSA Depletion of coal reserves Eskom together with Department of Energy need to urgently invest in acquiring new coal mines and supplies in South Africa if the long term sustainability of the coal fired generation assets is to be maintained. Eskom then needs to be held accountable to strict payment terms for the coal supplied. Further, government intervention should be sought to introduce some taxation on the export of coal. At the moment coal mines are getting better prices on the export market and so are sending their coal overseas. These are policy decisions and will need to be addressed in the appropriate forum. Eskom is willing to participate Changes to energy mix SALGA makes various proposals for changes to the energy mix including renewable and nuclear. Proposals are made for additional IPP contracts. These are policy related proposals and best dealt with through the Department of Energy Fraud and corruption SALGA is concerned about the levels of fraud and corruption in Eskom and proposes further transparency. Eskom has clarified in its submission that various measures are underway to address the fraud, corruption and irregularities. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 109 of 115

110 National Treasury and SALGA responses Rationalisation of Municipal Tariffs Concerns have been raised on particular aspects of Municipal tariffs as is being considered by NERSA. NERSA is in the process of addressing the rationalisation of Municipal Tariffs. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 110 of 115

111 Revenue requirements for licensees 17 Revenue requirements for licensees Eskom s allowable revenue requirement comprises that of Generation, Transmission and Distribution businesses. Generation contributes about 75% of the allowable revenue with the networks making up the balance Generation allowable revenue Generation revenue requirement over the three year application period is R632bn. Generation own primary energy is R229bn, IPPs adds R105bn and international purchases of R11bn. The operating expenditure is R96bn. Debt commitments are covered through depreciation and returns of R165 billion over the three year application period. TABLE 23 : GENERATION ALLOWABLE REVENUE Allowable Revenue (R'millions) AR Formula Application Application Application Forecast Forecast 2019/ / / / /24 Regulated Asset Base (RAB) RAB WACC % ROA X -1.32% -0.21% 1.45% 1.76% 2.46% Returns Expenditure E Primary energy PE IPPs (local) PE International purchases PE Depreciation D IDM I + Research & Development R&D + Levies & Taxes L&T RCA RCA + Total R'm Not claimed in Application Corporate Social Investment (CSI) Total Allowable Revenue Distribution allowable revenue Distribution revenue requirement is R98bn over the three year application period. This covers expenditure of R75bn. Debt commitments are covered through depreciation and returns of R23bn. Eskom Holdings MYPD4 Revenue Application FY2019/ /22 Page 111 of 115