TRANSNET SOC LIMITED PETROLEUM PIPELINES SYSTEM 2014/15 TARIFF DECISION

TRANSNET SOC LIMITED PETROLEUM PIPELINES SYSTEM 2014/15 TARIFF DECISION 13 March 2014 1

Table of Contents Page Table of Contents... 2 List of Tables... 3 List of Figures... 4 Abbreviations and Acronyms... 5 Tariff Decision... 7 Reasons for Decision... 11 The application... 11 The applicant... 12 The decision-making process... 14 Stakeholder comments on the tariff application and DTD... 15 Applicable law... 17 Methodology... 17 Outstanding matters from previous tariff determinations... 18 Assessment of the Application... 19 Calculation of Allowable Revenue... 19 Regulatory Asset Base (RAB)... 24 Weighted average cost of capital, post-tax, real (WACC post-tax, real )... 34 Return (RAB x WACC)... 40 Depreciation (D)... 41 Operational Expenses (E)... 43 Land rehabilitation costs (decommissioning provisions)... 47 Revenue addition to meet debt obligations (F-factor)... 51 Clawback Adjustments (C)... 51 Tax Expense (T)... 67 Volumes... 68 Tariffs... 72 Economic Impact... 76 Inflation... 78 Gross Domestic Product, employment and household income... 80 Conclusion... 80 2

List of Tables Table 1: Tariffs... 8 Table 2: Transnet Requested Changes to Allowable Revenue in Tariff Application... 12 Table 3: Comparison of allowable revenue and the impact of clawbacks... 21 Table 4: Allowable Revenue calculation... 23 Table 5: Calculation of total Regulated Asset Base (RAB)... 25 Table 6: Estimated Balance in the AFUDC and Grant Funding Deferral Account... 30 Table 7: Cumulative Transnet Capital Projects costs not capitalised... 32 Table 8: Net working capital... 33 Table 9: Calculation of timing differences and deferred tax liability... 34 Table 10: WACC calculation... 35 Table 11: Qualifying Interest Bearing Debt Calculation for 2014/15... 37 Table 12: Beta calculation... 38 Table 13: Cost of Equity (Ke) calculation... 39 Table 14: Cost of Debt (Kd) calculation... 39 Table 15: Return on assets... 41 Table 16: Depreciation... 41 Table 17: Summary of depreciation and amortisation of inflation write-up for tariff years 2012/13 up to 2014/15 as reconciled to Transnet s Regulated Asset Register... 42 Table 18-A: Operational Expenditure... 43 Table 19: Land Rehabilitation Provision calculation... 50 Table 20: Summary of clawbacks... 52 Table 21: Sources of clawback... 52 Table 22: Total Clawback pertaining to the 2012/13 tariff period... 54 Table 23: Give back of funds for Land rehabilitation... 55 Table 24: Operating Efficiency Calculation for 2012/13... 56 Table 25: WACC clawback on reduced PPE value for 2012/13... 58 Table 26: Cost of Debt Clawback pertaining to 2012/13... 61 Table 27: Clawback on Depreciation and amortisation due to changes in useful life... 61 Table 28: Revised clawback on Depreciation and amortisation due to changes in useful lives 62 Table 29: Revised 2012/13 WACC due to change in debt ratio... 63 Table 30: Total WACC and Gering change effect 2012/13... 63 Table 31: WACC clawback on reduced PPE value for 2013/14... 65 Table 33: Time value of money on Clawback... 66 Table 34: Normalised Tax Allowance... 67 Table 35: Calculation of volume-distance factors for 2014/15... 73 Table 36: Calculation for the Durban to Alrode and Watloo tariffs for parallel pipeline routes... 74 Table 37: Distance for various destinations based on the simple average basis... 75 Table 38: Comparison of costs by mode of transport... 77 Table 39: Assumptions for Calculating the Petroleum Pipeline Tariff Increase on the Petroleum Price... 78 Table 40: Breakdown of inflationary impacts from the increase in the pipeline tariff percentage points... 79 Table 41: Revised inflation rates after the impact of the pipeline tariff increase... 79 3

List of Figures Figure 1: Transnet s historic pipeline tariffs... 16 Figure 2: Transnet s historic and forecast pipeline tariffs... 17 Figure 3: Allowable Revenue Composition... 22 Figure 4: Energy Regulator verification of Asset Additions in PPE - Inland Accumulation Facility postponed, Coastal Accumulation Facility excluded... 26 Figure 5: Overview of pipeline volumes... 69 4

Abbreviations and Acronyms AaOC AFUDC AR BER CAM CPI CPI f CWIP D d DJP DoE DSCR dtax Dt DTD E EaOC EBIT Eq F GA GDP IATA IDC K d KdA K e LE MAC MIRTA Actual average operating cost Allowance for funds used during construction Allowable revenue Bureau for Economic Research Cost Allocation Manual Consumer price index Consumer price index forecast Capital work in progress Depreciation and amortisation of inflation write-up Accumulated depreciation and accumulated amortisation of inflation write-up Durban Johannesburg Pipeline Department of Energy Debt service cover ratio Deferred tax Debt Draft Tariff Determination Expenses: maintenance and operating for the tariff period under review Estimated average operating costs Earnings before interest and taxes Equity Projected revenue addition to meet debt obligations for the tariff period under review General adjustment Gross Domestic Product International Air Transport Association Interest during construction Cost of debt Cost of debt adjustment Cost of equity Latest Estimate Main automation contract Minimum information required for tariff application 5

MR MRP NMPP NRBTA OEA Opex OpexE PPE PPI RAB Rf RfD Rf t RFR RRM SRAB T t TCP Tff(s) TOC V w WACC WA β β Market return Market risk premium New Multi-Product Pipeline Net revenue before tax allowance Operating efficiency adjustment Operating and maintenance expense Operating efficiency Property, plant, vehicles and equipment Producer Price Index Regulatory asset base Risk-free rate of interest Reasons for Decision The average monthly marked-to-market real risk-free rate of interest for the preceding period indicated Regulatory Financial Reports Regulatory Reporting Manuals Starting regulatory asset base Tax expense Prevailing corporate tax rate of the licensee Transnet Capital Projects Tariff(s) Trended original cost Value of operating property, plant, vehicles and equipment Net working capital Weighted average cost of capital Weighted average β of the proxy firms asset betas beta: The systematic risk parameter for regulated entities providing pipeline, storage and loading facility services 6

NATIONAL ENERGY REGULATOR In the matter regarding THE APPLICATION FOR THE AMENDMENT (TARIFF ADJUSTMENT) OF THE LICENCE TO OPERATE ITS PETROLEUM PIPELINE SYSTEM By TRANSNET SOC LIMITED (Licence number: PPL.p.F3/20/1/2006) Tariff Decision On 13 March 2014, the National Energy Regulator ( the Energy Regulator ) amended Transnet SOC Limited s ( Transnet s ) conditions of licence to operate its petroleum pipeline system as follows: 1. The petroleum pipeline tariffs listed in Table 1 are set from the first Wednesday of April 2014 (02 April 2014) to the last Tuesday of March 2015 (31 March 2015). These tariffs will enable Transnet to realise an increase of 5.08% in allowable revenue compared to the 2013/14 tariff period (an increase from R2,795.61 million in 2013/14 to R2,937.74 million in 2014/15). 2. The tariffs set are maximum tariffs and are exclusive of VAT. 3. The Energy Regulator calculated the Allowable Revenue (AR), taking into considerarion Transnet Pipelines amended application for the completion of the Inland Accumulation Facility in October 2014 (previously January 2014) and postponing the inclusion of the Coastal Accumulation Facility into the Regulatory Asset Base (RAB) until the next tariff periond. 4. The Energy Regulator will initiate a public consultation process regarding Transnet s proposed penalty tariffs within the 2014/15 tariff period. 7

Table 1: Tariffs Volumes (Million litres) 2013/14 Tariff (c/l) 2014/15 Tariff (c/l) % increase/ (decrease) Sasolburg to: Alrode 1.729 2.176 25.87% Airport (Avtur) 3.825 3.393-11.29% Klerksdorp 4.689 7.307 55.83% Langlaagte 2.703 3.252 20.30% Rustenburg 6.565 7.635 16.30% Tarlton 4.561 5.000 9.63% Waltloo 5.609 6.382 13.79% Witbank 5.076 6.102 20.22% Secunda to: Alrode 4.413 5.080 15.12% Coalbrook 8.238 6.115-25.77% Langlaagte 5.259 6.043 14.91% Rustenburg 9.195 10.427 13.40% Tarlton 7.466 7.792 4.36% Waltloo 7.613 6.795-10.75% Witbank 3.531 4.269 20.91% DJP Durban to: Airport (Avtur) 24.421 28.432 16.42% Alrode 23.428 27.215 16.16% Klerksdorp 26.775 32.345 20.80% Langlaagte 24.403 28.290 15.93% Rustenburg 28.265 32.674 15.60% Tarlton 26.260 30.039 14.39% Waltloo 27.308 31.421 15.06% Witbank 26.775 31.141 16.31% Bethlehem 14.086 16.183 14.89% Kroonstad 18.721 21.445 14.55% Ladysmith 8.275 9.553 15.44% Coalbrook (Crude) 21.700 25.038 15.38% NMPP Durban to: Airport (Avtur) 24.421 28.432 16.42% Alrode 23.428 27.215 16.16% Kroonstad 18.721 21.445 14.55% Klerksdorp 26.775 32.345 20.80% Langlaagte 24.403 28.290 15.93% Rustenburg 28.265 32.674 15.60% Tarlton 26.260 30.039 14.39% Waltloo 27.308 31.421 15.06% Witbank 26.775 31.141 16.31% Coalbrook 21.700 25.038 15.38% 8

5. According to the Grant Funding Agreement between the Government of the Republic of South Africa and Transnet SOC Limited, the accounting treatment of the proceeds from the levy is that the proceeds must be recorded in a deferral account and used to offset the Allowance for Funds Used During Construction (AFUDC) related to the New Multi-Product Pipeline (NMPP) project costs. As the NMPP project is not planned to be completed in this tariff period, the balance in this deferral account (net between AFUDC and the Grant Funding) is not transferred to the Regulatory Asset Base (RAB). Since completion of the Systems and Automation and Close out of the NMPP project is planned for April 2017, no part of this credit balance is included in the RAB and will only be included when the project is complete. 6. Since Transnet SOC Limited raises corporate debt on behalf of the regulated activity/business (Transnet Pipelines), Transnet is required to allocate NMPP borrowing costs to the regulated petroleum pipelines activity to reflect causality. This must be done in accordance with the Regulatory Reporting Manuals (RRM) 1 prescript and Transnet s Cost Allocation Manual (CAM) principles 2. 7. Transnet must, in accordance with Regulation 9(4) of the Regulations made in terms of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) 3, ( the Regulations ), provide the Energy Regulator with proof of sufficient financial security for purposes of rehabilitating land used in connection with a licensed activity before the submission of its next application. The financial security must be such that the funds will be available for rehabilitation (dedicated), are protected against erosion by inflation (inflation-linked), are protected against Transnet creditors (ring-fenced) and are available when required (liquid). 8. The 2014/15 depreciation, corporate overhead costs, and operating and maintenance expenses will be subject to review against actual values and any differences will be clawed/given back in future tariff periods. 1 Regulatory Reporting Manual Volume 4: Petroleum Pipelines, GNR 1118 in Government Gazette No. 31392 of 10 September 2008. 2 Transnet s Cost Allocation Manual dated March 2011, approved by the Energy Regulator on 09 May 2011. 3 GNR 342 in Government Gazette No. 30905 of 04 April 2008. 9

9. If and when Transnet Pipelines is corporatised, Transnet must record the regulated assets and liabilities that are transferred to the new corporate entity in line with RRM prescripts and subject to Energy Regulator approval. 10

Reasons for Decision The application 10. On 01 August 2013, Transnet SOC Limited submitted an application for the amendment of its licence to operate its petroleum pipeline system, licensed under licence number PPL.p.F3/20/1/2006. The application was for a 19.88% increase in its allowable revenue for the period 02 April 2014 to 01 April 2015 ( 2014/15 ) and was made in terms of section 23 of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003), hereinafter referred to as the Act. 11. In a letter dated 20 December 2013 Transnet informed the Energy Regulator that it had experienced construction problems at the Durban accumulation facility and amended its tariff application with regard to (a) the commencement of the tariff period from 2 April 2014 to an unspecified future date; and (b) the date of the inclusion of the coastal accumulation facility into the Regulatory Asset Base for the 2014/15 tariff period, also to an unspecified future date.it further requested the extension of the 2013/14 tariff period beyond April 2014 until a further tariff decision was made. This is regarded as the first amendment to the application. 12. In a letter dated 21st January 2014 the Energy Regulator replied that after careful consideration of the legality of extending the tariff period, that this was not possible. 13. At the public hearing held on 6th February 2014 Transnet amended its tariff application for the second time. It now requested a 1.54% increase in allowable revenue as a result of changes to the dates when the two accumulation facilities would become operational. Transnet requested that the Inland Accumulation Facility be admitted to the RAB on 30th September 2014 (instead of January 2014 as initially applied for by Transnet) and advised that the Coastal Accumulation Facility will be ready for operation on 01 April 2015 thus placing it outside of the tariff year under consideration here. 11

14. Subsequent to the public hearing the Energy Regulator received a letter from Transnet in which it referred to the Reasons for Decision given by the Energy Reguator for its decision on Transnet's tariffs in 2013. This letter referred to the fact that the Energy Regulator had in that decision spread the clawback due in that year over two years based on anticipated increases in future tariff periods. Transnet s letter requested the Energy Regulator to consider a deferment of 50% of a bundled clawback of both the 2013/14 and 2014/15 tariff periods (i.e. R220.15 million). 15. A summary of the changes made by Transnet to its tariff application for the 2014/15 tariff period is presented in Table 2 below: Table 2: Transnet Requested Changes to Allowable Revenue in Tariff Application Details % increase to Allowable Revenue Transnet application +19.88% Transnet 1 st amendment Extend 2013/14 tariffs until further notice Transnet 2 nd amendment +1.54% Transnet 3 rd suggestion +9.45% The applicant 16. Transnet SOC Limited (hereinafter referred to as the applicant or Transnet ), is a public company registered and incorporated as such in terms of the company laws of the Republic of South Africa pursuant to the Legal Succession to the South African Transport Services Act, 1989 (Act No. 13 of 1989). The applicant s company registration number is 1990/000900/06 and its registered head office is at 47 th Floor, Carlton Centre, 150 Commissioner Street, Johannesburg. Transnet operates the country s rail network (Transnet Freight), its ports (Transnet National Ports Authority), petroleum and a gas pipeline (Transnet Pipelines) and other operations such as the South African Ports Operations and Transwerk. Transnet Pipelines operates petroleum pipelines, a petroleum storage facility and the gas pipeline and is a division of Transnet SOC Limited. 17. Transnet is a diversified transport and logistics group wholly owned by the South African Government. 12

18. Through its Transnet Pipelines division, Transnet operates approximately 3,800km of pipelines conveying refined petroleum products, crude oil and gas, as well as a storage facility for petroleum products at Tarlton near Krugersdorp. It is the dominant pipeline operator in South Africa and has a de facto monopoly of the pipeline conveyance of petroleum from Durban to inland destinations. 19. On 12 September 2007, Transnet was granted a construction licence (licence number PPL.p.F1/74-75/2007) to construct a 24-inch diameter petroleum products pipeline from Durban to Jameson Park and 16-inch diameter pipelines from Jameson Park to Alrode/Langlaagte and from Kendal to Waltloo, inclusive of accumulator facilities at Durban and Jameson Park. The applicant has named this project the New Multi-Products Pipeline (NMPP) 4. 20. Transnet also stated in its 2012/13 tariff application that the commencement of operation of the 24-inch pipeline would be in January 2012. In this current tariff application, Transnet confirmed that the 24-inch trunk line came into operation on 09 January 2012 and is operating concurrently with the Durban Johannesburg Pipeline (DJP) during the 2014/15 tariff period. However to date it has not been operating on a multi products basis as it only transports diesel. This is because the accumulation facilities at each end of the 24-inch trunk line are still under construction. 21. Transnet states in its current tariff application that it will continue to operate the 24-inch pipeline and the DJP concurrently for the full 2014/15 tariff period. Both the 24-inch pipeline and DJP supply the inland market. However, the 24-inch pipeline will transport diesel only until the completion of the coastal and inland accumulation facilities. Transnet further indicates in its current tariff application that both pipeline assets are used optimally to ensure that inland market requirements are met. 22. Transnet stated in its 2012/13 tariff application that it planned to bring the Inland Accumulation Facility at Jameson Park into operation by January 2013 and 4 In this document, the Energy Regulator refers to Phase One of the NMPP project. Phase One encompasses the 24-inch trunk line, three 16-inch pipelines and the two accumulator facilities in Durban and Jameson Park. 13

Coastal Accumulation Facility at Island View Durban into operation by December 2013. In its 2013/14 tariff application, Transnet revised the planned date for the operationalisation of the Inland Accumulation Facility to coincide with that of the Coastal Accumulation Facility on 31 December 2013. In the current 2014/15 tariff application Transnet once again revised the planned operationalisation of the Coastal Accumulation Facility to October 2014 and the completion of System and Automation to April 2017. 23. In a subsequent letter dated 28 January 2014, and at the public hearing on 6 February 2014, Transnet again revised its planned operationalisation of the Inland Accumulation Facility to October 2014. At this point in time, Transnet cannot with any certainty tell the Energy Regulator when the Coastal Accumulation Facility will be ready for operation, The decision-making process 24. The Energy Regulator published Transnet s tariff application on the Energy Regulator website along with a draft tariff determination (DTD) for public comment on 21 November 2014. Certain elements of the tariff application and DTD were deemed by the Energy Regulator to be confidential and were excluded from the published versions. 25. On 26 November 2013, notices of the tariff application and draft tariff determination, as well as an invitation for public comments were placed in the following newspapers: The Sowetan, The Star, The Mercury, Cape Times, and The Pretoria News. The closing date for written comments was 10 January 2014. 26. However Transnet subsequently amended its tariff application on 20th December 2013, wherein it requested an extension of the tariffs for the current 2013/14 tariff period and a cancellation of the public hearing scheduled for Tuesday 14th January 2014. The Energy Regulator cancelled the public hearing scheduled for 14 January 2014 by means of newspaper adverts on 10 and 12 January 2014. The amendment and cancellation requested by Transnet was prompted by unexpected engineering related construction challenges it is experiencing at the Coastal Accumulation Facility facility at Island View, Durban. 14

27. The public hearing was rescheduled for Thursday 06 th February 2014. Notices seeking comments on the tariff application and draft tariff determination, as well as an invitation to attend the rescheduled public hearing were placed in the following newspapers: The Sowetan, The Star, The Mercury, Cape Times, and The Pretoria News on 28 January 2014 The closing date for written comments was 04 th February 2014. Stakeholder comments on the tariff application and DTD 28. The Energy Regulator received written comments on Transnet s tariff application and the DTD from: a) Airlines Association of Southern Africa (AASA); b) BP Southern Africa (Pty) Ltd; c) International Air Transport Association (IATA); d) Qantas Airways Limited; e) Sasol Oil (Pty) Ltd; f) Shell South Africa Marketing (Pty) Ltd; and g) Total SA (Pty) Ltd. 29. In the DTD, the Energy Regulator took the unusual step of publishing two allowable revenue options. An increase in Transnet s allowable revenue by either 18.80% 5 or 9.80 6 %. The difference between the two options is the date on which the Inland Accumulation Facility is admitted to the Regulatory Asset Base (RAB) at a value of R3,300 million. Many of the comments received by the Energy Regulator supported the an increase of 9.80%. 30. The stakeholder comments are considered in Annexure A. 31. In considering whether to allow or to postpone the Inland Accumulation Facility's admission into the RAB, consideration was given to the benefits that accrue to Transnet for early admission of an asset and the associated costs incurred by the public as a result. 5 Inclusion of Inland Accumulation Facility in RAB in January 2014 (Inland Accumulation Facility NOT Postponed) 6 Inclusion of Inland Accumulation Facility in RAB in October 2014 (Inland Accumulation Facility Postponed) 15

a) Transnet s historic tariffs, nominal and adjusted for inflation, are reflected in Figure 1. Figure 1: Transnet s historic pipeline tariffs b) The historic and forecast tariff for Transnet s pipeline from Durban to Alrode resulting from the the postponement of the Inland Accumulation Facility and exclusion of the Coastal Accumulation Facility is shown in Figure 2 below: 16

Figure 2: Transnet s historic and forecast pipeline tariffs 32. As demonstrated in the Figure 2 above, including the Inland Accumulation Facility in the RAB from October 2014 (and postponing the Coastal Accumulation Facility s inclusion until April 2015) exacerbates the short term tariff spike for the 2015/16 tariff period. Applicable law 33. The legal basis for the Energy Regulator to set tariffs for petroleum pipelines is derived from the National Energy Regulator Act, 2004 (Act No. 40 of 2004) ( the Energy Regulator Act ), read with the Act. Methodology 34. In terms of section 28 of the Act, tariffs to be charged by licensees must be based on a systematic methodology applicable on a consistent and comparable basis 7. To this end, the Energy Regulator published the Tariff Methodology for the 7 Section 28(2)(a) of the Act. 17

Petroleum Pipelines Industry, 5 th Edition, approved on 31 March 2011 ( the Methodology ) that outlines the approach taken in this decision 8. Outstanding matters from previous tariff decisions 35. In its decision on Transnet s 2013/14 tariff application 9, the Energy Regulator decided that it would: a) review the 2012/13 and 2013/14 operational expenses against actual values and claw back any differences; b) monitor the transition of volumes away from road and rail to pipeline transport. 36. Pursuant to these decisions, the Energy Regulator took the following actions: Transnet s operational expenses for the 2012/13 and 2013/14 tariff periods a) An analysis of Transnet s 2012/13 expenses is being conducted as part of the audit of the Regulatory Financial Reports prepared and submitted by Transnet in accordance with the Regulatory Reporting Manuals (RRM) prescript. A clawback, based on the values in Transnet s Regulatory Financial Reports for 2012/13, which were submitted to the Energy Regulator on 31 July 2013, has been implemented in this decision. The final audit report on Transnet s 2012/13 Regulatory Financial Reports was received at the end September 2013. For the details of the clawbacks effected in this decision see the subsection on clawbacks pertaining to the 2012/13 tariff period under Clawback Adjustments below. b) The review of the 2013/14 expenses will be concluded once the audited Regulatory Financial Reports for the financial year ending 31 March 2014 become available. Transnet s operational expenses for the 2011/12 tariff period a) The Energy Regulator received the final audit report on Transnet s Regulatory Financial Reports for 2011/12 on 07 March 2013. In their factual 8 This has now been replaced by the Tariff Methodology for the Setting of Pipeline Tariffs in the Petroleum Pipelines Industry, Version 6, approved on 29 July 2013 which will apply to future tariff applications. 9 Energy Regulator decision of 13 March 2013 on Transnet SOC Limited 2013/14 tariff application. 18

findings report on Transnet s Regulatory Financial Reports, the auditors 10 confirmed that the final value for operating expenses for 2011/12 is R611.36 million. In the 2013/14 tariff determination for Transnet s petroleum pipeline system, the Energy Regulator applied the interim operating expenses of R605.50 million for the clawback calculation pertaining to 2011/12. See sub-section on clawbacks pertaining to the 2011/12 tariff period under Clawback Adjustments for the details of the final clawback calculation. Transnet s volumes transition away from road and rail to pipeline a) Transnet s Annual Results for 2012/13 reflect a 5.1% reduction in total petroleum pipeline volumes shipped from 2011/12 to 2012/13. Refer to the section on Volumes on page 68 below for the Energy Regulator s analysis thereof. Assessment of the Application Calculation of Allowable Revenue 37. Data supplied by Transnet, prepared in accordance with the Energy Regulator s Minimum Information Required for Tariff Application (MIRTA) standard, was used for most of the calculations performed in this determination. Where this was not the case, the reasons for not using the applicant s data are supplied. 38. In line with the Methodology, the following formula was applied to determine Transnet s allowable revenue: Allowable Revenue = (RAB x WACC) + E + D + F ± C+ T Where: RAB = Regulatory Asset Base WACC = Weighted average cost of capital 10 Deloitte, Transnet s statutory auditors, performed the audit of Transnet s Regulatory Financial Report for 2011/12 in line with the prescriptions of section 6.2 of the Regulatory Reporting Manual Volume 1 (GNR 115 in Government Gazette No. 31392 of 10 September 2008). 19

E D F C T = Expenses: maintenance and operating expenses for the tariff period under review = Depreciation: the charge for the tariff period under review = Approved revenue addition to meet debt obligations for the tariff period under review = Clawback adjustment from a preceding tariff period in relation to the actuals for that tariff period = Tax: estimated tax expense for the tariff period under review 39. In this tariff application, Transnet applied for a R555.83 million increase in its allowable revenue an increase from R2,795.61 million in 2013/14 to R3,351.44 million in 2014/15 (19.88%). 40. The Energy Regulator s calculation of the allowable revenue for Transnet in 2014/15 resulted in an increase of 5.08% 11 from R 2,795.61 million for 2013/14 to R2,937.74 million for the 2014/15 tariff period. The quantum of the clawback is dealt with in the section on Clawbacks below. 41. The main reasons for the difference between Transnet s original tariff application and the Energy Regulator s decision is the postponed date at which the Inland Accumulation Facility (at a cost of R3,300 million) is admitted to the RAB (from January 2014 to October 2014) and the postponed date at which the Coastal Accumulation Facility (at a cost of R3,500 million) is admitted to the RAB (from October 2014 to April 2015). 42. Another reason for the differences between Transnet s tariff application and the Energy Regulator s estimates concerns clawbacks. Clawbacks of the 2012/13 and 2013/14 RAB value relate to the late implementation and lower than estimated costs of new NMPP assets (namely the Coastal and Inland Accumulation Facilities), as well as changes in expected useful life of assets and the resulting changes in depreciation and amortisation. Refer to the section on Clawback Adjustments for details on page 51. 11 Inclusion of Inland Accumulation Facility in RAB in October 2014 (Coastal Accumulation Facility excluded) 20

43. The application includes a clawback of R276.78 million including the R226.76 carried forward from 2013/14 tariff year, leaving a R50.02 million clawback. However, the Energy Regulator determined the clawback calculations resulting from this tariff period to be R213.55 million plus the R226.76 million carried forward resulting in a total clawback of R440.31 million. The difference between the two clawback figures concerns the date at which the Inland Accumulation Facility is admitted to the RAB (as discussed above). Also Transnet did not calculate the tax effect of its clawback estimate correctly. The Energy Regulator has decided to defer 50% of the clawback identified in the 2014/15 tariff decision. 44. The period over which clawbacks or givebacks are implmented is a matter of regulatory discretion which may or may not be exercised for a variety of reasons. To avoid possible confusion and error the Energy Regulator is reluctant to bundle clawbacks for different years together and then defer them again, as was suggested by Transnet. Thus the Energy Regulator is of the opinion that only the 2014/15 clawback adjustment should be considered for deferment. The full value of the clawback deferred from 2013/14 of R226.76 million is not adjusted again in the 2014/15 tariff period. However for the 2014/15 tariff period, R106.77 milion (50% of R213.55 million) of the clawback is deferred to the following tariff period. Considerations in this regard are a measure of revenue stability and that the resultant increase in allowable revenue is below the inflation rate. 45. For a summary of the differences refer to Table 3 below. Table 3: Comparison of allowable revenue and the impact of clawbacks Transnet Application R million % Energy Regulator Decision TM 2 October 2014 and TM 1 excluded Rmillion % Total Allowable revenue 2014/15 3 351.44 2 937.74 Total increase excluding clawback 625.30 475.66 Total clawback effect (inclusive of tax effect) (69.47) (333.53) Total increase 555.83 142.13 2013/14 Allowable Revenue 2 795.61 2 795.61 % Increase excluding clawback 22.37% 17.01% Clawback % increase /(decrease) -2.49% -11.93% Total % increase (including clawback) 19.88% 5.08% 21

46. The increase in allowable revenue excluding the clawback would have been 17.01%. However, after the clawback is taken into account, the increase in allowable revenue is reduced to 5.08% (refer to Table 3). Clawbacks are in essence allowable revenue which had been awarded in previous years. 47. The values for the respective components of the allowable revenue as determined by the Energy Regulator compared to the values as applied for by Transnet are graphically presented in Figure 3. A detailed representation is shown beneath that in Table 4. Figure 3: Allowable Revenue Composition 22

Table 4: Allowable Revenue calculation Transnet Application Energy Regulator Decision R million / % / No. Regulatory Asset Base (RAB = {V-d} ± dtax + w ) Value of asset base (V-d) - Plant in Service (PPE) 23 643.71 19 841.02 Grant Funding (Fuel Levy) - - F-factor allowed in previous tariff decision(s) (421.90) (421.90) Deferred tax (dtax) (803.17) (794.13) Net working capital (w) 402.96 356.35 Total Regulatory Asset Base (RAB) 22 821.60 18 981.34 Weighted average cost of capital (WACC post-tax,real ) Debt ratio (d:[e+d]) 35.87% 30.00% Cost of debt (Kd pre-tax, nominal ) 9.61% 9.61% CPI forward looking (CPI f ) 5.80% 5.80% Cost of debt (Kd post-tax,real ) 12 1.06% 1.06% Riskfree rate (Rf pre-tax,real ) 4.46% 4.46% Market Risk Premium (MRP post-tax, real ) 7.03% 7.03% Beta (β) 0.764 0.700 Cost of Equity (Ke post tax, real ) 13 9.83% 9.38% Weighted average cost of capital (WACC post-tax, real ) 6.68% 6.88% Calculation of Allowable revenue (AR) Return on Equity Funding 1 438.67 1 246.31 Return on Debt Funding 86.77 60.36 Return (RAB x WACC) 1 525.44 1 306.67 Operational Expenses (E) 1 031.08 948.95 Operational Expenditure 825.24 808.73 Provision for Land Rehabilitation costs 38.57 38.57 Corporate Overhead Costs 167.27 101.66 Depreciation (D) 551.01 476.08 Clawback Adjustments ( C ) (50.02) (106.77) Clawback deferment (226.76) (226.76) Tax Allowance (T) 520.69 539.57 Allowable Revenue(AR)=(RAB x WACC)+E+D+F±C+T 3 351.44 2 937.74 % increase 19.88% 5.08% 12 13 11 Kepost-tax,real = Rfpre-tax,real + (MRPpost-tax,real * _) 23

Regulatory Asset Base (RAB) The formula for determining the RAB is: RAB = (V d) + w ± dtax Where: V = Value of property, plant, vehicles and equipment d = Depreciation accumulated up to the commencement of the tariff period under review w = Net working capital dtax = Deferred tax 48. Regulations 4(6) and 4(7) of the Regulations deal with the determination of the RAB. 49. Section 4.1.2 of the Methodology states that non-current assets are to be valued on the Trended Original Cost (TOC) basis or in accordance with Regulation 4(7)(b) of the Regulations which stipulates the following:...for assets in operation at the time of promulgation of these Regulations and for which historical cost records do not exist, an estimated value that the Authority accepts as most closely approximating their historical cost 50. Transnet submitted in its tariff application that its qualifying RAB is R22,821.60 million 14 for the tariff period under review. The Energy Regulator calculated the RAB value to be R18,981.34 million. The values of the respective components of the RAB as determined by the Energy Regulator are reflected in Table 5. The differences between the figures arise from the dates on which the Coastal and Inland Accumulation Facilities are admitted to the RAB. 14 Table 3, page 17, of Transet s 2014/15 tariff application. 24

Table 5: Calculation of total Regulated Asset Base (RAB) R million Network Component Total PPE on which WACC is Earned Working capital (calculated per formula and allocated prorata) Deferred tax Total RAB value on which WACC is earned Formula A B C D=A+B+C Northern Network 2 796.90 50.23 2 847.13 Southern Network/ DJP 259.85 4.67 264.52 Total old Refined assets 3 056.75 54.90 3 111.65 New NMPP 13 531.11 243.02 13 774.13 Accumulation Facilities 1 851.50 33.25 1 884.75 Total refined 18 439.36 331.18 18 770.54 Avtur 164.64 2.96 167.59 Crude Oil Pipeline 1 237.03 22.22 1 259.25 Plant in Service [PPE] 19 841.02 356.35-20 197.37 F Factor recovery (421.90) (421.90) Deferred Tax (794.13) (794.13) Total PPE and F factor 19 419.12 356.35 (794.13) 18 981.34 51. The calculations of the individual elements of the RAB are explained below. Value of Property, Plant, Vehicles and Equipment (PPE) 52. The applicant submitted that the value of its operating property, plant, vehicles and equipment (PPE) is R23,221.81 million 15. This value is based on the Energy Regulator approved Starting Regulatory Asset Base (SRAB) 16 plus additions of new assets brought into service. 53. The values are adjusted for inflation in accordance with the Methodology. The Methodology requires that the inflation adjustments must be based on the Consumer Price Index (CPI) and that the same CPI data must be used to convert nominal return values to real return values in the weighted average cost of capital (WACC) calculation. Transnet applied a forecast CPI of 5.80%. 54. Transnet states in the tariff application that the useful lives of assets are aligned with the report of the last full valuation conducted by Arthur D Little in March 15 Table 4, page 19, of Transnet s 2014/15 tariff application. 16 Approved by the Energy Regulator on 25 March 2010. 25

2012 17, with the exception of the DJP, which has been maintained at a useful life of zero. 55. Typically, new assets brought into service have been admitted to the RAB in proportion to the share of the tariff period under review in which they will be used, consistent with paragraph 4.1.8 of the Methodology. The PPE amounts include the pro-rata values of new assets brought into service during the tariff period under review. 56. The Energy Regulator has performed a calculation that assumes that the Inland Accumulation Facility is brought into operation in October 2014 and where the Coastal Accumulation Facility is brought into operation in outside the 2014/15 tariff period i.e. April 2015 reflected in Figure 4 below. Figure 4: Energy Regulator verification of Asset Additions in PPE - Inland Accumulation Facility postponed, Coastal Accumulation Facility excluded 17 This is correct as the latest Arthur D. Little report of March 2013 does not contain a revision of useful lives 26

57. The Energy Regulator analysed both the historical cost values of the new assets, as well as the respective useful lives. The Energy Regulator determined the final value of asset additions in PPE to be R19,419 million, as reflected in Figure 4. F-factor allowed in previous tariff periods 58. The 2011/12 F-factor (R205.78 million) and the 2012/13 F-factor (R165.77 million) awarded to Transnet, is deducted from the RAB as this was an early return of capital and therefore no return on capital can be earned thereon. No F-factor was awarded to Transnet for the 2013/14 tariff period.the F-factor is treated as a negative asset value, trended and amortised over the expected useful life of the NMPP assets (75 years) arriving at a value of R421.90 million for the 2014/15 tariff period. Allowance for Funds Used During Construction (AFUDC) and Grant Funding 59. The RAB values should include the capitalised borrowing costs and the proceeds from the Grant Funding (fuel levy) as determined by the accounting for these amounts. Refer to paragraph 62 for details. 60. The AFUDC is the sum of the net cost of borrowed funds (debt finance) used for construction purposes (interest during construction) and a reasonable rate of return on other funds/financing, like equity, when so used for construction. 61. Section 1.5.4 of Volume 4 of the RRM 18 issued by the Energy Regulator prescribes the manner in which the AFUDC is to be determined as follows: Allowance for funds (financing) used during construction 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 funds (financing) like equity, when so used, not to exceed, without prior approval of the Energy Regulator, allowances computed in accordance with the formula prescribed in paragraph (a) of this subparagraph. 18 Regulatory Reporting Manual Volume 4: Petroleum Pipelines, GNR 1118 in Government Gazette No. 31392 of 10 September 2008. 27

No allowance for funds (financing) used during construction charges shall be included in these accounts for expenditures arising from construction projects which have been abandoned. (a) 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). (b) The weighted average cost of capital rate shall be determined in the manner indicated and approved by the Energy Regulator for the applicable year. 62. In his 2010 Budget Speech of 17 February 2010, the Minister of Finance announced a national fuel levy of 7.5 cents per litre to contribute to the funding of Transnet s NMPP project. This was implemented by means of a Grant Funding Agreement between the Government of the Republic of South Africa through its Department of Energy and Transnet SOC Limited, signed on 22 June 2010 ( the Grant Funding Agreement ). The proceeds of the levy were paid by the Government to Transnet over a three year period at R1.5 billion per annum (pretax, inclusive of VAT). Levy payments commenced in September 2010. 63. The following paragraphs seek to clarify the utilisation of the proceeds of this Grant Funding Agreement and its impact on tariffs. 64. Section 6.1.6 of the Grant Funding Agreement prescribes that, for regulatory purposes, Transnet shall account for the Grant Funding in accordance with guidance provided by the Energy Regulator. The Energy Regulator s decision, Accounting treatment for Construction Works in Progress (CWIP) of Property, 28

Plant and Equipment (Plant) with specific reference to Transnet s New Multi- Product Pipeline (NMPP) and the proposed financial assistance by government to be used by Transnet Pipelines to partially fund the NMPP, dated 27 November 2009, ( the Accounting Guidance ) constitutes the guidance referred to in section 6.1.6 of the Grant Funding Agreement. The Energy Regulator consulted the Department of Energy and the National Treasury in developing the accounting guidance. 65. The Grant Funding Agreement comprises exceptions to/deviations from the normal treatment of AFUDC. 66. According to the Grant Funding Agreement and the approach taken by the Energy Regulator 19, this Grant Funding (pre-tax, inclusive of VAT) will be offset against the AFUDC of the NMPP project. The AFUDC and the Grant Funding monies received are therefore both recorded in a deferral account for the purposes of offsetting against each other. Any difference between the Grant Funding and the AFUDC approved by the Energy Regulator will be capitalised and the depreciated balance will be transferred to the RAB when the NMPP 20 (Phase One) comes into operation. The depreciation of this balance will be calculated over the remaining useful life of the asset to which the balance is added. 67. In previous tariff decisions, the Energy Regulator has not made any determination of the AFUDC for Transnet as plant, property and equipment under construction or capital works in progress (CWIP) are excluded from the RAB. With Phase One of the NMPP being completed in 2017, the difference between the Grant Funding and the AFUDC (the balance in the deferral account) has been calculated and deducted from the RAB 21. 19 The Accounting Guidance dated 27 November 2009 (referred to in paragraph 64) as well as Energy Regulator decision of 31 March 2011 on Transnet Limited 2011/12 tariff application, paragraph 52. 20 Section 2.1.10 of the Grant Funding Agreement defines the NMPP as the New Multi-Product Pipeline currently being constructed by Transnet under licence number PPL.p.F1/74/2007. The licensed activities included under licence number PPL.p.F1/74/2007 include the construction of a 24-inch pipeline from Durban to Jameson Park with three pump stations, a 16-inch pipeline from Jameson Park to Alrode, a 16-inch pipeline from Alrode to Langlaagte, a 16-inch pipeline from Kendal to Waltloo, an accumulator facilty in Durban and an accumulator facility at Jameson Park. Throughout this document the Energy Regulator refers to these licensed activities as Phase One of the NMPP project. 21 The difference between the capitalised borrowing costs and the proceeds from the Grant Funding is transferred to the Regulatory Asset Base (RAB) when the NMPP becomes used (as per the Grant 29

68. Refer to Table 6 for the calculation of the balance in the AFUDC and Grant Funding deferral account. Transnet would have received, as a result of the Grant Funding Agreement, a net value (after tax) of R2,842.11 million by the end of 2013/14. 69. The calculation reflected in Table 6 will be updated once the final value and timing of the AFUDC are determined upon total completion of Phase One of the NMPP project, which is currently estimated to be 01 April 2017. Table 6: Estimated Balance in the AFUDC and Grant Funding Deferral Account Allocation of AFUDC Construction Cost Balance B/F 2012/13 2013/14 2014/15 2015/16 2016/17 Total R million Pro rata allocation to assets taken into operation 16-inch pipeline 2 143 88 88 24-inch pipeline 9 510 563 563 Terminal 1 3 800 255 132 235 264 885 Terminal 2 3 500 235 122 216 243 815 Completion of MAC and Close Out of NMPP (1 April 2016) 2 224 149 77 137 154 317 835 Completion of MAC and Close Out of NMPP (1 April 2017) 2 224 149 77 137 154 317 427 1 262 Adjusted AFUDC Grant Funding Deferral Account 23 400 1 439 408 725 816 634 427 4 449 Gross Grant Funding 3 000 1 500 4 500 Less VAT (368) (184) (553) Less Income Tax (737) (368) (1 105) Net Grant Funding 1 895 947 2 842 Closing Balance carried forward 0 (456) (995) (270) 546 1 180 0 AFUDC calculated for the year 1 439 408 725 816 634 427 4 449 Net Grant Funding for the year (1 895) (947) 0 0 0 0 (2 842) Balance carried forward (456) (995) (270) 546 1 180 1 607 1 607 70. Transnet has in the past pointed to what it believes is an inconsistency the Accounting Guidance prescribes that the average Construction Works in Progress (CWIP) on which finance charges (AFUDC) are to be determined should be Funding Agreement) a credit balance will be deducted from the RAB in accordance with section 4.1.11 of the Methodology. 30

calculated on an annual simple average basis 22 but that the time weighted interest bearing debt is used to calculate the debt ratio. 71. The Energy Regulator is cognisant of this perceived inconsistency. However, applying a time weighted calculation to determine the interest bearing debt is consistent with the principle set out in section 4.1.8 of the Methodology, which stipulates that assets are admitted to the RAB in proportion to the share of the tariff period under review in which they will be used. 72. The Grant Funding Agreement is a special once-off case stipulating the accounting treatment for AFUDC balances applicable to the NMPP, which deviates from the normal treatment of AFUDC. 73. The Energy Regulator is concerned about the fact that the forecasted net AFUDC/Grant funding suspense account has now become a debit balance. This is purely due to the late completion of the project. The Energy Regulator therefore is considering not allowing this debit balance into the RAB to ensure that the consumer is not burdened as a result of delayed completion. The Energy Regulator is busy with an investigation into whether the assets acquired in the NMPP project were prudently acquired or not. Once that study is complete the Energy Regulator will take a decision on any adjustments to the RAB which may be necessary. After that decision has been made there may be a consequential impact on the AFUDC/Grant funding suspense account. 74. If the Energy Regulator decides to allow the AFUDC/Grant Funding Suspense account, the full estimated balance, R679.42 million, will be transferred to the RAB on completion of the Phase One of the NMPP project currently estimated to be in April 2017. 22 Page 1 of 6 of the Accounting Guidance prescribes that, 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 (WACC) multiplied by the sum of: (i) (ii) (iii) (iv) average of opering and closing balance of construction work in progress for a given year, plus average of opening and closing capital inventory balance for a given year, less construction accounts payable, less asset retrirement costs (if any are included in construction work in progress). 31

Transnet Capital Projects cost capitalised 75. In its 2013/14 tariff decision the Energy Regulator disallowed Transnet Capital Projects costs claimed as operational expenses. 23 As these expenses could not be allocated to specific assets (16-inch, 24-inch pipelines or accumulation facilities), the Energy Regulator will be capitalising this value at the completion of the total NMPP project which is estimated to be in April 2017. The current disallowed value to be capitalised is calculated as shown below in Table 7. Table 7: Cumulative Transnet Capital Projects costs not capitalised ACTUAL FORECAST To be capitalised 2010/11 2011/12 2012/13 2013/14 2014/15 R million Balance brought forward 0.00 57.60 59.90 163.57 175.69 TCP costs 54.83 (0.56) 96.48 3.66 0.83 AFUDC On TCP costs 2.77 2.86 7.19 8.46 8.48 Balance Carried Forward 57.60 59.90 163.57 175.69 185.00 Interest rate for AFUDC calculation 10.11% 10.02% 9.20% 10.12% 9.61% Net working capital (w) 76. Net working capital is calculated in accordance with the Methodology. 77. The applicant calculated its estimated net working capital (w) during the tariff period under review to be R402.96 24 million. The Energy Regulator calculated the net working capital for 2014/15 to be R356.35 million, corresponding to the calculated allowable revenue. 78. Transnet states in its tariff application that inventory includes maintenance stock and petroleum stock owned by Transnet Pipelines. 79. Transnet also indicates that the increase in working capital for the 2013/14 tariff period is primarily as a result of (1) the increase in receivables due to the higher allowable revenue in the year and, (2) an increase in inventory driven mainly by the procurement of spares needed for equipment at the accumulation facilities. 23 Paragraphs 124-128, pages 51-52, of Reasons for Decision on Transnet s 2013/14 tariff application. 24 Table 8, page 24, of Transnet s 2014/15 tariff application 32

80. The comparison between the working capital as calculated by Transnet and the value as determined by the Energy Regulator is presented in Table 8. Trade receivables are based on 30 days of allowable revenue. The main reason for the difference between Transnet s working capital and the working capital in the Energy Regulator s decision is, therefore, due to the receivables calculated by the Energy Regulator being lower, corresponding with the lower allowable revenue in the Energy Regulator s decision. Table 8: Net working capital Working Capital Transnet Application R million Energy Regulator Decision Allowable Revenue 3 351.48 2 830.96 Operational expenditure (Excluding Land Rehabilitation provision) 992.51 910.38 Inventory 123.67 123.67 Receivables 279.29 232.68 Operating Cash 122.36 112.24 Less: Payables (122.36) (112.24) Net Working Capital 402.96 356.35 Number of days inventory 13.47 15.94 Number of days Receivables [Receivables/AR*365] Pre clawback deferment 30.42 30.00 Number of days Cash [Operating Cash/ Opex*365] 45.00 45.00 Number of days Payables [Payables/Opex*365] 45.00 45.00 Deferred Tax 81. The deferred tax liability to be deducted from the RAB takes into account timing differences relating only to the regulated property, plant, vehicles and equipment (PPE). Non-asset related balances are not taken into account in the calculation of the normalised tax and therefore the applicant is not expected to receive the cash flow benefit in the calculation of the allowable revenue. In its tariff application, Transnet estimated a deferred tax allowance of R803.17 million 25. 25 Table 9, page 24, of Transnet s 2014/15 tariff application 33