Frequently Asked Questions (FAQ): Tariff Methodology for the Setting and Approval of Tariffs in the. Petroleum Pipelines Industry.

Transcription

1 Frequently Asked Questions (FAQ): Tariff Methodology for the Setting and Approval of Tariffs in the Petroleum Pipelines Industry Approved 24 August 2017

2 Table of Contents Page Glossary of Terms and Abbreviations REGULATORY ASSET BASE (RAB)... 4 WACC GENERAL WACC BETA WACC THE MARKET RETURN (MR) WACC THE RISK FREE RATE (RF) WACC COST OF EQUITY (KE) WACC COST OF DEBT (KD) DEPRECIATION EXPENSES LAND REHABILITATION F-FACTOR CLAWBACK TAX TARIFF MODEL ON NERSA S WEBSITE NOTES ON MULTI-YEAR TARIFF APPLICATIONS Page 2 of 45

3 GLOSSARY OF TERMS AND ABBREVIATIONS ALSI - All share total return index on the Johannesburg stock exchange C - Claw-back adjustments CPI - Consumer price index D - Depreciation. The charge (normal depreciation and amortisation on the write-up) for the tariff period under review E - Expenditure. Maintenance and operating expenses for the tariff period under review. F - Approved revenue addition to meet debt obligations IRR - Internal rate of return JSE - Johannesburg stock exchange Kd - Cost of debt Ke - Cost of equity MR - Market return RAB - Regulatory asset base Rf - Risk free rate of interest ROE - Return on Equity STC - Secondary tax on companies T - Tax expense. Flow-through and notional tax options TOC - Trended original cost TRI - Total return index PPE - Value of property, plant and equipment net of accumulated depreciation w - Net working capital WACC - Weighted average cost of capital Page 3 of 45

4 REGULATORY ASSET BASE (RAB) Question 1 1. Why is the original value (historical cost) of the regulatory asset base trended? 1.1. Regulation 4(6)(e) of the Regulations in terms of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) as amended by GNR 242 of 765 in GC NO of 28 August 2015 ( the Regulations ) stipulates that the value of the regulatory asset base (RAB) is to be on an inflation-adjusted base. The inflation adjustment is calculated by trending the original (historical) cost on an annual basis with the consumer price index (CPI) to give the trended original cost (TOC). The TOC value therefore reflects the nominal value of the RAB The return on the RAB is calculated in real terms on the nominal value of the RAB The result of applying a real return on a nominal RAB is that tariffs become back-loaded. Back-loading of tariffs implies that tariff levels will increase in real terms over time. This approach ensures that tariffs do not deflate in real terms as the asset ages, but keep up with the trend of inflation. (This is also discussed in 4.1.) 1.4. The back-loading of tariffs also reflects the economic reality of prices generally becoming inflated over time and will therefore counter the effect of huge price increases when new assets replace old assets The way to calculate the TOC value of the RAB (inclusive of depreciation and amortisation of the write-up) is demonstrated in Table 1 below. This table is also published on the NERSA website. Page 4 of 45

5 Table 1: Calculation of TOC value of RAB (inclusive of depreciation and amortisation of the write-up) Note: Further clarity on the meaning of non-current assets allowable in the RAB can be obtained from the Regulatory Reporting Manual, Volume 4, which gives the following classifications: Page 5 of 45

6 ASSETS AND OTHER DEBITS Current Assets 100 Cash and Cash Equivalents 110 Accounts Receivable Accounts Receivable Trade Accounts Receivable Other 115 Accumulated Provision for Doubtful Debts 120 Inventory Materials and Operating Supplies Petroleum Inventory 125 Prepayments 135 Other Current Assets Deferred Debits 142 Preliminary Surveys and Investigation Charges 147 Other Deferred Debits Non-Current Assets Plant in Service Accumulated Depreciation Plant in Service Plant under capital leases and Improvements to leased facilities Accumulated Depreciation Leased Plant and Improvements 176 Line Fill Other Intangible Assets LIABILITIES AND OTHER CREDITS Current Liabilities 200 Bank Overdraft 205 Accounts Payable 206 Account Payable to Affiliated Companies 212 Obligations under Capital Leases Current Portion Page 6 of 45

7 216 Interest Payable and Accrued 220 Dividends Payable 230 Accrued Income Taxes Payable 235 Other Current Liabilities Deferred Credits 238 Unamortized Debt Premium and Expenses 241 Other deferred credits Non-Current Liabilities 245 Provision for Pension and Benefits 255 Long-Term Debt 256 Long-Term Debt-Advances from Affiliated Companies 265 Other Non-Current Liabilities Obligations under capital lease non-current Accumulated provision for self insurance Owners Equity 275 Equity Issued Ordinary shares issued Preference shares issued 280 Contributed Surplus 285 Reserves including excess of appraisal value over depreciated plant cost 290 Retained Earnings Question 2 2. How is AFUDC treated? 2.1. AFUDC includes the net cost for the period of construction of borrowed funds (finance) used for construction purposes and a reasonable rate of return on other Page 7 of 45

8 funds (financing) like equity. Allowances must be computed in accordance with the formula prescribed in paragraph 2.2 below The formula and elements for the computation of the allowance for funds (financing) used during construction shall be the approved weighted average cost of capital multiplied by the sum of:- i) average balance in construction work in progress, ii) plus average capital inventory balance, iii) less construction accounts payable, iv) less asset retirement costs (if any are included in construction work in progress) The weighted average cost of capital rate shall be determined in the manner indicated and approved by the Energy Regulator for the applicable year.as Capital Work in Progress is not subject to TOC this WACC rate should be nominal When only a part of a plant or project is placed in operation or is completed and ready for service but the construction work as a whole is incomplete, that part of the cost of the property placed in operation or ready for service, shall be treated as Plant in Service and allowance for funds (financing) used during construction thereon shall be capitalized with capital expenditure thereof to become the starting PPE cost for that asset. Note: 1. Funds (financing) used during construction on that part of the cost of the plant which is incomplete may be continued as a charge to construction until such time as it is placed in operation or is ready for service, except as limited above. 2. No allowance for funds (financing) used during construction will be included for the portion of projects where a contribution has been received up front on a direct assigned project. For those projects where contributions are received up front and no allowance for funds (financing) used during construction is Page 8 of 45

9 calculated, the contribution would be included in the rate base in the same period as the asset. Question 3 3. Why is the Trended Original Cost not applied to the working capital component of the RAB-formula? 3.1. Working capital resets itself each year and therefore there is an automatic annual adjustment for inflation in the components of working capital If a multi-year tariff application is submitted, the working capital (W) should be inflated with the CPI as at 12 months prior to the specific tariff period. Question 4 4. What benchmarks are used for determining the allowable amounts for the respective elements in the formula for determining the working capital? Net working capital = inventory + linefill + receivables + operating cash trade payables 4.1. Inventory: Inventory is to be valued at the lower of cost or net realisable value Llinefill: Linefill is to be valued at cost of product Receivables: Receivables is to be based on a maximum of 30 days of a licensee s allowable revenue Operating cash: Operating cash is to be based on a licensee s standard practice subject to a maximum of 45 days maintenance and operating expenses, excluding Page 9 of 45

10 depreciation and deferred taxes. Added to this amount will be the minimum cash requirements of a licensee s lender(s) Trade payables: Trade payables is to be based on a maximum of 45 days of a licensee s allowable revenue If licensees have proof that their actual values for the above benchmarks are higher, the higher values can be used. WACC GENERAL Question 5 5. Why is a real WACC and not a nominal WACC applied? 5.1. As explained under question 1, Regulation 4(6)(e) stipulates that the value of the RAB has to reflect an inflation-adjusted value. Because the nominal value of the RAB is used, a real rate of return is used [as reflected in the real weighted average cost of capital (WACC)]. This requirement is also stipulated in section 28(3)(c) of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) Inflation is added to the asset base (RAB) and is therefore 'taken out' of the nominal return (WACC). Nominal returns on real assets would constitute a double count of CPI and thus 'real returns' are used. Question 6 6. What is to be understood by the following two statements? i) Section 28(3)(c) of the Petroleum Pipelines Act 2003 (Act No. 60 of 2003) (the Act): (3) The tariffs set or approved by the Authority must enable the licensee to- (c) make a profit commensurate with the risk; Page 10 of 45

11 ii) Section 4(6) of the Regulations: (6) The allowed revenue to be derived from tariffs contemplated in sub-regulation (2) must include: a) reasonable operating expenses b) reasonable maintenance expenses c) depreciation expenses d) reasonable working capital e) reasonable real return on the regulatory asset base which should be determined on the assets inflation-adjusted cost less accumulated depreciation; and f) other applicable obligations The reasonable return relates to the return earned by the licensee on the RAB and not to the return earned by an equity investor on the RAB. Note that Sub-regulation (2) refers to an efficient licensee and not an equity holder as an entity different from the licensee In view of the fact that Section 28(3) of the Act does not stipulate that the profit commensurate with risk is to be earned in each year, it is taken that the profit (return) is to be earned over the total life of the asset. This profit relates to the profit of the licensee on the RAB and not to the profit of an equity investor as a separate construct The actual return that will be earned by the equity investor each year is a function of the capital structure of the licensee. If the funding structure of the licensee requires the debt funding to be repaid earlier or faster than the life of the asset, it is viewed that the equity holder has chosen to become a 'patient capital' investor. The patient capital investor will therefore wait for the debt capital to be repaid before the full return on equity can be earned. Page 11 of 45

12 6.4. Figures 1, 2, 3 and 4 demonstrate the effect on the annual returns on equity (ROE) under the following two scenarios (patient capital investor): a) debt tenure of 10 years; and b) debt tenure of 25 years. Page 12 of 45

13 Figure 1: ROE per annum (debt = 10 years with equity earned over a period of 10 years) 25.0 % ROE per annum (10 years debt) 20.0 % 15.0 % 10.0 % 5.0 % 0.0 % Years Notional TAX with Deferred Tax adjusted to RAB Required ROE Flow-through actual tax Figure 2: ROE per annum (debt = 10 years with equity earned over a period of 25 years) ROE per annum (10 year debt) Page 13 of 45

14 Figure 3: ROE per annum (debt = 25 years with equity earned over a period of 10 years) 25.0 % ROE per annum (25 years debt) 20.0 % 15.0 % 10.0 % 5.0 % 0.0 % Years Notional TAX with Deferred Tax adjusted to RAB Required ROE Flow-through actual tax Figure 4: ROE per annum (debt = 25 years with equity earned over a period of 25 years) ROE per annum (25 year debt) Page 14 of 45

15 Note 1. Once the debt has been paid off, the equity starts catching up (around years six to eight) and the actual return to equity is at higher levels. The higher levels of equity returns reflect the catching up of returns that should have been earned in previous years, but were forfeited because of having to pay off debt ( patient capital ). 2. The conversion of the RAB to a nominal value (TOC) and the subsequent real WACC that is to be earned on the nominal value result in the addition of CPI values to the asset base that do not match the reduction of the value of the return in earlier years, because the return is calculated in real terms. The returns in earlier years are lower as it takes time for the TOC effect to catch up with the real return effect. Over the life of the asset, the return equalises out. WACC BETA Question 7 7. Why is a beta derived from international companies used in relation to the conditions of the local market? 7.1. There are no suitable comparative companies listed on the local markets. Question 8 8. What are the criteria for selecting the betas of specific companies as a proxy for local companies? 8.1. The proxy companies must be listed on stock exchanges. Question 9 9. Does NERSA publish beta values? Page 15 of 45

16 9.1. Yes, NERSA publishes the value of the unlevered beta applicable to the petroleum industry. The names of the proxy companies utilised for determining the beta value as well as quarterly updates on monthly beta values are published on NERSA s website The beta values proposed for use by the applicant at the various levels of gearing may be found on NERSA s website in a document named Beta values for tariffs in the petroleum pipelines, storage and loading industry. The applicant should select the appropriate beta according to its gearing (efficient target or estimated gearing for the tariff period under review) from the table published within the document For jointly owned assets or where the licensee is comprised of more than one entity, the gearing used will be based on the weighted average percentage debt of the entities that constitute the licensee. The weighting will be based on the percentage share of licensed activity owned by each entity. Question When are adjustments to the industry beta allowed? No adjustments to the beta are allowed. The beta is a measure of systematic risk. Company or project-specific risks should be accounted for separately from the beta as explained in the tariff methodology. Question Which company is used as a supplier of data on beta values of proxy companies? Data is collected monthly on the beta values of proxy companies and is based on data provided by Bloomberg. Page 16 of 45

17 Question At what frequency and over which period is data on the beta value of proxy companies collected? Monthly data for a period of five years is collected. The five-year period is the period ending the year immediately preceding the date of publication, which is at the end of March of every year. Question Is a statistical correction factor applied to the values of the beta? NERSA does not apply any additional correction factor to data utilised for calculating the beta. Question How is the beta calculated? The following example demonstrates how the beta (β) is calculated. For licensees that are not publicly listed and where there are insufficient publicly listed competitors, the equity beta is derived from a proxy beta. To make adjustments for differences in gearing between the proxy and the licensee the process involves un-levering and re-levering as follows: i. obtaining the equity beta for the proxy company; ii. iii. iv. un-levering the beta of the proxy company by the gearing level of the proxy company this unlevered beta is known as the asset beta; calculating the weighted average of the asset betas for the chosen proxy companies; and re-levering the average asset beta by the (approved) gearing of the licensee. Page 17 of 45

18 14.2. Further clarification i. The Harris and Pringle formula, which excludes the tax shields in the notation, will be used. ii. The following steps must be followed when calculating the beta value: Step 1 Calculate asset beta (or un-levered beta) for proxy firms The following formula must be used to determine the asset beta: β a1 = β1 / [1 + Dt/Eq] Where βa1 = Asset beta for proxy company 1 β1 = Beta of proxy company 1 Dt = Debt of proxy company 1 Eq = Equity of proxy company 1 Repeat Step 1 for each of the six (or more) chosen proxy firms. Market capitalisation values for proxy companies will be used where such market values exists. Where no market values exist for proxy companies, book values will be used. Step 2 Calculate weighted average asset beta of proxy firms Weight each of the 6 (or more) proxy firm asset betas by their proportion of the total debt plus equity of the 6 (or more) proxy firms and sum the results using the following formula: Page 18 of 45

19 Where βae (Dt + Eq)n (βa)n = Weighted average asset beta of the proxy companies = Sum of the debt and equity for a specific proxy company = Asset beta of the corresponding specific proxy company n = Sum of debt and equity for all proxy companies = Number of proxy companies Step 3 Calculation of beta (β) for licensee (re-levering of beta) The following formula must be used to determine the beta for the licensee: BL = βae * [1 + Dt/Eq] Where ΒL βae = Beta for the licensee = The weighted average β of the proxy firms asset betas from Step 2. The Energy Regulator may adjust this factor to take account of a difference in country risk ratings between the host country of the proxy firms and South Africa. Dt Eq = The interest bearing debt of the licensee subject to a minimum gearing level of 30 per cent = The equity of the licensee Page 19 of 45

20 WACC THE MARKET RETURN (MR) Question What market index will be used as a proxy for the performance of the South African market? The All Share Total Return Index (ALSI) is used as a proxy for the performance of the South African market as it represents the widest possible spectrum of industries trading in the South African market, as measured by the Johannesburg Stock Exchange (JSE). Question Why is a post-tax market return (MR) used for determining the market risk premium (MRP)? The market returns, as represented by the various JSE indices, reflect earnings after taxation has been provided for (i.e. data is presented on an after-tax basis) No adjustment for Capital Gains tax is made as it is assumed that the equity return holders will hold the investment to maturity and therefore the total return index (TRI) is used There are flaws and challenges inherent in using the post-tax MR as a basis and converting it to a pre-tax MR by grossing it up with the tax rate. This method is thus not used by NERSA As the Allowable Revenue formula treats Taxation as a separate operational item (T), the WACC calculations are all performed on a post-tax basis. Page 20 of 45

21 WACC THE RISK FREE RATE (RF) Question Why are government bonds with a maturity of ten years or longer used? An investor in pipeline infrastructure normally has a long-term investment horizon of at least ten years. A maturity of less than ten years is considered to be subject to short-term fluctuations in the economic environment which could impact on the volatility and validity of this measure for the industry Longer term investment instruments are also more in line with the 30-year MR data used in calculating the WACC. Question What data sources does NERSA use and how frequently does NERSA publish economic data for the purpose of tariff setting and approval? The sources of the economic data utilised by NERSA and the frequency of updating the economic data are provided in Table 2. Table 2: Economic data sources and frequency of updates as provided by NERSA for tariff setting and approval in the petroleum industry Data Source Date & frequency of updating the data on NERSA s website CPI-Historical Statistics SA Quarterly updates of monthly data RSA 10-year Bonds Reserve Bank of SA Quarterly updates of monthly data Market Return ALL Share Total Return Index Quarterly updates of monthly data (ALSI-TRI) on the JSE List of Beta proxy companies as well as the value of the beta applicable for the tariff period Bloomberg Quarterly updates of monthly data Page 21 of 45

22 WACC COST OF EQUITY (KE) Question Are any adjustments to the cost of equity allowed? The following adjustments to the Cost of Equity (Ke) will be considered on a caseby-case basis: CRA = Country risk adjustment. (The real CRA will be added to the risk free rate. The CRA is for assets in another country outside South Africa that are an integral part of the same asset/s within South Africa. The adjustment is for the other country concerned). SSP = Small stock premium. An adjustment to compensate for the lack of specific qualitative abilities of a licensee if warranted. α = Project specific risk if the circumstances warrant such an adjustment LP = Liquidity premium to accommodate assets which are not publicly traded if the circumstances warrant such an adjustment. Note A small stock premium and project specific risk adjustment will be considered in the following cases: a) SSP adjustments: If the answers to the following two questions are no (both answers must be no ), then a SSP adjustment may be applied: In running its business: Page 22 of 45

23 i. does the licensee have access to legal, financial and operational/technical expertise within its own structures/or can the licensee obtain this expertise from its shareholders; and ii. is there a history of the licensee having had access to this expertise under its a previous shareholding dispensation? b) Project specific risk adjustments (if the circumstances warrant such an adjustment) The Energy Regulator needs to be provided with proof of the following project specific risk factors: - construction; - management; - technology; - customer base; - supplier chain; and - other. Question How is the cost of equity calculated? A practical example for calculating the Ke is presented below, making use of assumed values for the respective elements in the formula for calculating Ke. The formula for determining the Ke is: Ke = Rf + (β *MRP) Where: Ke = Post-tax, real cost of equity Page 23 of 45

24 Rf = Riskfree rate of interest (real). (This is the average of the real monthly marked-to-market riskfree rate for the preceding 300 months for all Government bonds with at least a 10 year maturity as at 12 months before the commencement of the tariff period under review) β = Beta is the systematic risk parameter for regulated entities providing pipeline, storage and loading facility services (The beta must be determined by proxy. As a proxy the average of at least six pipeline companies listed on stock exchanges is used. The value of the proxy is as at 12 months before the commencement of the tariff period under review). MRP = Market risk premium (post-tax, real). [The proxy used for the market is the Johannesburg Stock Exchange (JSE) All Share Total Return Index (ALSI with JSE Code J203T) for the preceding 360 months as at 12 months before the commencement of the tariff period under review. The arithmetic average for the 360 months is used.] Note Two scenarios are considered the first where the cost of equity is adjusted for liquidity by multiplying a factor, and the second where the cost of equity is adjusted for liquidity by adding a factor. Examples to calculate these are presented next. Multiplying to adjust for liquidity: In the practical example for calculating the Ke (and multiplying to adjust for liquidity), the values for the elements in the Ke formula are assumed to be as follows: Rf = 4.5% CRA = 0.2% MRP = 7% β = 0.5 SSP = 2.25% α = 0.10% Page 24 of 45

25 LP = 5% Based on the above assumed values, the value of the Ke is calculated to be: Ke = [(Rf + CRA) + (MRP * beta) + SSP + α] * (1 + LP) = [(4.5% + 0.2%) + (7% * 0.5) % %] *(1 + 5%) = (4.7% + 3.5% % %) *1.05 = 11.08% Adding to adjust for liquidity: In the practical example for calculating the Ke (and adjust for liquidity through adding), the values for the elements in the Ke formula are assumed to be as follows: Rf = 4.5% CRA = 0.2% MRP = 7% β = 0.5 SSP = 2.25% α = 0.10% LP = 0.53% Based on the above assumed values, the value of the Ke is calculated to be: Ke = (Rf + CRA) + (MRP * beta) + SSP + α + LP = (4.5% + 0.2%) + (7% * 0.5) % % % = 4.7% + 3.5% % % % = 11.08% Page 25 of 45

26 WACC COST OF DEBT (KD) Question Why is the real cost of debt (Kd) used and not the nominal cost of debt? The inflation adjustment in the cost of debt (Kd) is taken out as this is replaced with the trending of the full value (PPE-d) of the original cost to give the nominal TOC of the RAB Nominal returns on real assets would constitute a double count of CPI and therefore real returns are used. Question Under what scenario will equity investors be in a position to earn their full return as embedded in the Ke portion of the WACC? The reasonable return relates to the return on the asset for the licensee and not for the equity investors. The actual return that will be earned by the equity investor is a function of the capital structure of the licensee as was explained under question 6. If the funding structures of the licensee require the debt funding to be repaid earlier or faster, it is viewed that the equity holder has chosen to become a patient capital investor. The patient capital investor will wait for the debt capital to be repaid before they receive their required return The conversion of the asset base (PPE-d) to a nominal value (TOC) and the subsequent conversion of WACC into real WACC results in the addition of CPI to the asset that does not match the reduction of the rate in earlier years. Therefore, the returns in earlier years are lower as it takes time for the TOC effect to catch up Page 26 of 45

27 with the real return effect. Once the catch up has taken place (around years 6 to 8), the return will be superior. (See graphs in question 6 above.) Question Does the post-tax, real WACC allow the entity enough allowable revenue to pay back its debt which is payable in pre-tax nominal terms? [The WACC (Ke & Kd) is provided for only on a post tax, real basis.] No. The tax shield in the Kd is provided for in the tax formula where the post-tax Kd is grossed up with the tax shield portion of the Kd. This ensures a pre-tax Kd is provided for in the allowable return to match the payment of the financing costs in nominal values In tables 3 and 4 below, the calculation of tax (as per the tax formula in the tariff Methodology) is demonstrated. For each component which is taxable, a grossup at the existing tax rate is performed. Tax allowances are therefore provided for in these grossed-up balances and will be included in the total balance of the allowable revenue As can be seen from tables 3 and 4, the grossing up of balances also applies to the Kd to ensure the tax shield on the Kd is properly accounted and provided for. Page 27 of 45

28 Table 3: Treatment of WACC with Notional Tax

29 Table 4: Treatment of WACC with flow-through tax

30 Question Why is Vanilla WACCreal (pre-tax Kd and post-tax Ke) not used instead of grossing up the post-tax Kd to ensure that the tax shield of the Kd is provided for in the before tax allowable revenue? Vanilla WACC is a calculation where the Ke is post-tax and the Kd is pre-tax The taxation component for the cost of debt is given to the investor by allowing the tax shield in the calculation of taxation allowance (T) as is demonstrated in the above Table 3 and Table The Vanilla WACCreal results in a higher return relative to the notional or flowthrough (with tax shield) options and therefore it is not utilised by NERSA. This is demonstrated in the published model in the TAB flow-through Vanilla where the return achieved is 15.5 per cent, which is higher than the 15 per cent required return. DEPRECIATION Question How is depreciation and amortisation of the write-up portion calculated? See example in Table 1 of Question 1. EXPENSES LAND REHABILITATION Question What is the legal and regulatory foundation for the recovery of land rehabilitation cost? Page 30 of 45

31 26.1. In terms of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) the authority may require a licensee to submit a financial security, or make such other arrangements as may be acceptable to the Authority, to ensure compliance with any licence condition relating to health, safety, security, or the environment, prior to, during or after the period of validity of the licence. Regulation 9 (3) of the regulations provides that the authority must require the licensee to provide financial security for the purpose of rehabilitating land used in connection with a licensed activity and the composition and amount of such security. The Methodology states Provision for land rehabilitation costs are permitted, subject to adequate justification. These funds must be kept in accordance with the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) and subregulation 9 of Regulations The methodology refers to the classification and calculation of the operating expenses (inclusive of the land rehabilitation costs as per paragraph 6.4.7) Sub-regulation 9 states: (1) A licensee must inform the Energy Regulator in writing when it applies to the relevant environmental authority for an environmental impact assessment for the termination of or abandonment of the licensed activity in accordance with the National Environmental Management Act, (2) A licensee must, at least six months prior to the termination or abandonment of a licensed activity, submit to the Authority, proof of the approval of the termination or abandonment of the licensed activity. (3) The Authority must require the licensee to provide financial security or make arrangements as may be acceptable to the Authority for purposes of rehabilitating land used in connection with a licensed activity. (4) The financial security contemplated in sub-regulation (3) may be in any form acceptable to the Authority and may only be used with the approval of the Authority. Page 31 of 45

32 (5) The Authority may, in writing, at any time, require written confirmation from a licensee that it is in compliance with the requirements of the National Environmental Management Act, (6) The Authority may require written proof from the licensee that the authority responsible for administering the National Environment Act, 1998 has approved the environmental impact assessment required by the Act. (7) The Authority may not revoke the licence in respect of a licensed activity, before it is in receipt of a certificate from an independent consultant competent to conduct environmental impact assessments in accordance with the National Environmental Act, 1998, which states that the site has been rehabilitated. The financial instrument must be in a form acceptable to the Energy Regulator as required by section 9 (4) of the regulations. To ensure compliance in this regard it would be the most practical for the financial security structure to be approved by the Energy Regulator in advance. Question How should land rehabilitation costs be calculated and recovered through the Allowable Revenue? Land rehabilitation costs are recovered as part of operating expenses Land rehabilitation cost can therefore NOT be included as part of Property, Plant and Equipment (RAB) and therefore no return is earned thereon The mechanism to collect the land rehabilitation costs is the present value of the future liability less the value of funds in the decommissioning fund to arrive at a balance still to be collected. The remaining balance is then divided by the remaining years to decommission the asset. The formula for this is: Page 32 of 45

33 PMT=[PVfund value]/n Where N = the number of remaining years to decommission PVfund value = the present value of decommissioning costs Fund value = the current balance in the decommissioning fund, being historic contributions (provision for decommissioning costs) plus net returns on such contributions An example of how the land rehabilitation cost is to be calculated is presented in Table 5. Page 33 of 45

34 Table 5: An example on the calculation of land rehabilitation costs Note The value of the land rehabilitation liability in year 10 (R9,662) is covered by the value of the fund at the end of that year (R9,662) excluding the investment returns in that year For the above example, the Depreciation in the Allowable Revenue formula compared to the allowance of the land rehabilitation on an annual basis is demonstrated in Figure 5 below. Note that the upward trend is similar to achieving the goal of raising tariffs as intended by the nominal assets, real return principle used in the methodology. Page 34 of 45

35 Figure 5: Depreciation and TOC Amortisation vs Land Rehabilitation cots Depreciation and TOC amortization vs Land rehabilitation costs Depreciation and TOC amortization Land rehabiliatation cost F-FACTOR Question How is the F-factor calculated and how will it be recovered? Details are provided in Section of the Tariff Methodology for pipeline tariffs. The F-factor will be treated as a return of capital, i.e. deducted from/added to the RAB. CLAWBACK Question When will clawbacks be applied? In the tariff period following the release of audited financial statements of the applicant. Page 35 of 45

36 Question Are there examples of specific clawback calculations? The formula for clawback adjustments is as follows: Clawback adjustments = ARA +(PPE-d)A + DA + KdA + EA + OeA GA More detail on the formulas to determine clawbacks is presented next. Page 36 of 45

37 Allowable Revenue adjustment (ARA) The allowable revenue adjustment compensates the licensee and customers for differences between allowable revenue planned and allowable revenue realised in a specific tariff period. The following formula applies: ARA = ARa - ARr Where ARA ARa ARr = Allowable revenue adjustment = Allowable revenue approved = Allowable revenue realised Value of new operating property, plant and equipment adjustment (PPE-d) The net value adjustment for operating property, plant and equipment (PPE-d)A compensates licensees and customers for differences in operating assets estimated to be in use and operating assets actually in use in the tariff period under review. This pertains to changes arising from additions, decommissioning and disposals of operating assets as well as to the timing of implementing these changes. Timing refers to the difference between the projected date and the actual date when the changes were implemented. Adjustments to the net value of the operating assets (PPE-d)A is determined by applying the formula below: (PPE-d)A = Allowable revenue adjustment on (PPE-d)updates = [(PPE-d)updates x (Dya Dyp)/365] x WACC Where (PPE-d)updates = Net value of the operating assets that will be commissioned, decommissioned or disposed of during the tariff period under review. Page 37 of 45

38 Dya Dyp = Actual number of days from the date when the operating asset(s) was commissioned, decommissioned or disposed of to the end of the tariff period. = Projected number of days from the date when the operating asset(s) was planned to be put into use, decommissioned or disposed of to the end of the tariff period Depreciation and amortisation of inflation write-up adjustment (DA) The depreciation and amortisation of inflation write-up adjustment provides for the differences between the projected depreciation made at the time the allowable revenue was determined and the actual depreciation for the specific tariff period. The following formula must be applied: DA = Da Dp Where: DA = Depreciation and amortisation of inflation write-up adjustment Da = Depreciation and amortisation of inflation write-up actual Dp = Depreciation and amortisation of inflation write-up approved Cost of Debt Adjustment (KdA) If there is a difference between the estimated cost of debt in the allowable revenue and the actual cost of debt for that tariff period, then the allowable revenue must be recalculated using the actual cost of debt and the difference added to or subtracted from the clawback adjustment. The following formula must be used to determine the KdA: KdA = Allowable Revenue recalculated using actual cost of debt Page 38 of 45

39 Allowable Revenue calculated using approved cost of debt Expense adjustment Operating and Maintenance Adjustment (EA) Adjustments on operating and maintenance expenditure provides for differences between expenditure projected at the time of setting the tariffs and the actual expenditure for the tariff period and is calculated by applying the following formula: EA = Ep Ea Where EA = Operating and maintenance expense adjustment Ep = Operating and maintenance expense projected Ea = Operating and maintenance expense actual General adjustment (GA) Provision is made for a general adjustment. This adjustment is for any remaining differences between projected allowable revenue and actual allowable revenue not resulting from efficiency gains, for example: i. debt ratio and the effect thereof on beta, cost of equity, WACC and the taxation effect of these adjustments; ii. iii. taxation adjustments; and other. 1 All other factors and quantum in estimated Allowable Revenue remain the same. Page 39 of 45

40 TAX Choice between two different tax approaches Question What is the difference between flow-through tax and notional tax? The Methodology states that the flow-through tax is the actual tax paid by the entity and this is allowed as a tax allowance. Notional tax expense is the tax due according to accounting requirements. Flow-through tax neither awards the tax shield nor the benefits of accelerated wear and tear (or deferred taxation). Question How is the tax calculated under the following scenarios? Flow-through tax Notional tax Examples on the calculation of tax under the two scenarios are provided in tables 6, 7, 8 and Calculation of the flow-through tax. Tax = {(NRBTA) / (1-t)}*t Where NRBTA t = Net revenue before tax allowance = {(RAB*WACC)+E+D(historic & write up)+f± C} - {E+D(historic) +Kd(nominal)}. = prevailing corporate tax rate of the licensee. Page 40 of 45

41 Table 6: Example of the calculation of flow-through taxes Ke a 5.10 Kd b 1.78 WACC c=a+b 6.88 E d 3.00 D (historic) e 4.00 D (write-up) ee 0.20 Wear and tear allowance eee F f 0.00 C (Clawback excluding tax clawback) g 0 NRBTA= Allowable revenue before tax allowance h=c+d+e+ee+f+g t j 28% Kd (nominal) n 5.88 NRBTA= ((RAB*WACC)+E+D(historic & write up)+f+c)- (+E+D(historic)+Kd(nominal)) Note that the interest is deducted as an actual tax calculation is perfomed k=h-d-e-n (4.80) Tax = ((NRBTA excl tax allowance)/(1-t))*t l=(k/(1-j)*j (1.87) Total Allowable revenue m=h+l Test TAX rate l/(k-l) 28% Note No other non-taxable income or non-deductible expenses have been included above. These will form part of the actual calculation when detail is available. Page 41 of 45

42 Table 7: The effect of using flow-through tax

43 Table 8: Example on the calculation of notional tax Ke a 5.10 Kd b 1.78 WACC c=a+b 6.88 E d 3.00 D (historic) e 4.00 D (write-up) ee 0.20 Wear and tear allowance eee F f 0.00 C (Clawback excluding tax clawback) g 0.00 NRBTA= Allowable revenue before tax allowance h=c+d+e+ee+f+g t j 28% Kd (nominal) n 5.88 NRBTA= ((RAB*WACC)+E+D(historic & write up)+f+c)- (+E+D(historic)) Note that the interest is deducted as an actual tax calculation is perfomed k=h-d-e 7.08 Tax = ((NRBTA excl tax allowance)/(1-t))*t l=(k/(1-j)*j 2.75 Total Allowable revenue m=h+l Test TAX rate l/(k-l) 28% TARIFF MODEL ON NERSA S WEBSITE Question Is there a practical example of how to incorporate all the elements of the tariff methodology into one template? NERSA has published a model on its website with the intention of demonstrating the various options and scenarios by way of testing the target cost of equity by the outcome of the internal rate of return (IRR) of cash flows to investors Some general notes on the model as published on NERSA s website are: 1 Storage Tariff Model Manual Page 43 of 45

44 i. Base case The model presents a base case scenario using the notional tax option where no adjustments are made for deferred taxation to the RAB. ii. F-Factor The model demonstrates the treatment of the F-factor as a return of capital, i.e. the full value of the F-factor is deducted from/or added to the RAB. iii. Notional tax This is the notional tax option with the deferred taxation adjusted in RAB. Note that IRR is higher than targeted as the actual tax and deferred tax cash flows practically lag one year. iv. Tax formula notional The model demonstrates the tax formula for year 1 and also demonstrates the tax shield for each component of allowable revenue. v. Flow-through using Vanilla WACC This represents a flow-through option but with the Kd pre-tax. This means that the tax shield on the Kd is not allowed in the tax calculation as the tax is already included in the pretax rate. Also note that the achieved IRR in this option is higher (15.50 per cent) than the targeted 15 per cent, which is why this option is not followed. vi. Flow-through actual Flow-through tax is defined in the Methodology (paragraph 10.2) as actual tax payments. As can be seen, the resultant IRR is below the target IRR of 15 per cent, which is a result of the tax shield on cost of debt not being allowed. For this reason, NERSA uses the tax flow-through formula to calculate the tax allowance in the model. vii. Graphs The model also has worksheet tabs comparing, by way of data or graphs, the differences between the various tax options (flow- Page 44 of 45

45 through and notional tax) and tenures of debt (10 years versus 25 years). NOTES ON MULTI-YEAR TARIFF APPLICATIONS Question How will NERSA treat multi-year tariff applications? The treatment of multi-year tariffs is presented in the section that follows. Page 45 of 45