NATIONAL ENERGY REGULATOR OF SOUTH AFRICA

NATIONAL ENERGY REGULATOR OF SOUTH AFRICA In the matter regarding DETERMINATION OF THE MUNICIPAL TARIFF GUIDELINE AND THE REVISION OF MUNICIPAL TARIFF BENCHMARKS FOR THE FINANCIAL YEAR 2011/12 DECISION On 25 November 2010, the Energy Regulator decided as follows: 1. A guideline increase of 20.38% is approved for the 2011/12 municipal tariff review process. The 20.38% guideline increase is based on the following assumptions: municipal bulk purchase cost of 70%; bulk electricity purchase price increasing by 26.71% ; salaries and wages increasing by the assumed 2011/12 Consumer Price Index (CPI) 1 of 4.8% plus 2% as per the agreement between Local Government and its unions 2 ; and repairs and maintenance, capital charges and other costs increasing by the assumed inflation forecast of 4.8%. 2. The benchmarks for the 2011/12 financial year are approved as follows: Domestic Domestic Domestic Domestic Commercial Commercial Industrial Block 1 Block 2 Block 3 Block 4 Prepaid c/kwh 0 50kWh 51-350kWh 351-600kWh >600kWh 2000kWh 2000kWh 43800kWh RED 1 58 63 67-72 93-98 109-114 117 122 117 122 117 122 RED 2 58 63 67-72 93-98 111-116 115 120 115 120 118 123 RED 3 58 63 67-72 93-98 109-114 117 122 115 120 118 123 RED 4 58 63 66-71 90-95 109-114 115 120 115 120 118 123 RED 5 58 63 67-72 93-98 109-114 115 120 117 122 117 122 RED 6 58 63 66-71 90-95 109-114 117-122 117-122 118-123 1 National Treasury Forecasted Figure based on the Medium Term Budget Policy Statement (MTBPS) of 27 October 2010 2 This was confirmed with the South African Local Government Association (SALGA) Page 1 of 23

3. The Municipal Tariff Assessment timelines (aligned to the National Treasury Budgetary Process) are approved as presented in Annexure 1. 3 End. 3 It is important to note that in order for NERSA to adhere to these timelines, and/ for these timelines to be effectively implemented, the onus is on the licensees to ensure the timeous submission of their 2011/12 tariff applications. Page 2 of 23

REASONS FOR THE DECISION BACKGROUND AND INTRODUCTION 4. On an annual basis, NERSA calculates an appropriate tariff guideline increase, which is then communicated to municipal distributors as a guide in determining their annual electricity tariffs. 5. This guideline does not preclude a distributor from the legal obligation to apply to the Energy Regulator for tariff increases before implementation. 6. NERSA also reviews the tariff benchmarks and recommends new benchmarks that would be used in the evaluation of the municipal tariff evaluations. 7. In order to assist municipalities in meeting their budgeting process timelines and to ensure timeous submission of their tariff applications, NERSA embarked on a consultative process to ensure the finalisation of the 2011/12 municipal guideline increase at a much earlier time than previously done. 8. The fact that the determination on Eskom s second Multi-Year Price Determination (MYPD2) was already approved by the Energy Regulator in February 2010, makes it possible to have the determination of municipal tariff guideline and the application process approved much earlier than the previous years. The plan takes into account National Treasury s budgetary processes as well as NERSA s Information Resource Management (IRM) department in the collection and processing of Distribution Information Forms (D-forms) from licensees. 9. The Energy Regulator made decisions on the following matters: o o o the 2011/12 municipal tariff guideline in line with the decision on Eskom s application for the MYPD2; the 2011/12 municipal tariff benchmarks that are used in guiding average tariff levels; and the 2011/12 municipal tariff application process timelines. THE DECISION MAKING PROCESS 10. On 15 September 2010 the Energy Regulator approved the publication of the indicative municipal guideline consultation paper. This was published on NERSA s website on 16 September 2010 with an invitation to stakeholders for comments. The closing date for comments was 4 October 2010. Page 3 of 23

11. On 7 October 2010, the Energy Regulator held a public hearing, where stakeholders presented their views relating to the indicative guideline. 12. The issues raised in the written comments and at the public hearing have been considered in the determination. 13. On 25 November 2010, the Energy Regulator made its final decision on the municipal guideline and benchmarks and the municipal tariff application process timelines for the 2011/12 financial year. THE OBJECTORS AND OTHER INTERVENING PARTIES 14. On 19 and 20 September 2010, NERSA published a notice in national newspapers inviting stakeholders to comment on the NERSA consultation paper titled: Determination of the municipal tariff guideline and revision of municipal tariff benchmark for the 2011/12 financial year. 15. Prior to the finalization of the aforementioned document a meeting was held with National Treasury to discuss the basis and the components of the guideline increase. 16. On 21 September 2010 a workshop/meeting was held with the Association of Municipal Electricity Undertakings (AMEU) on this topic. 17. A total of 11 stakeholder comments were received. These were made up of comments from four municipalities namely: City of Cape Town, Langeberg, Buffalo City and Ethekwini. Other stakeholders who sent written comments were namely: The Association of Municipal Electricity Undertakings (AMEU), South African Local Government Association (SALGA), Southern Cape Karoo Electricity Forum, Institute for Municipal Finance Officers (IMFO), Sustainable Energy Africa (SEA), Power Measurement and Distribution (PM&D) and F M Smit trading as FSI Services. 18. A total of six verbal representations were made by various stakeholders during the public hearing held by NERSA, namely: AMEU, SALGA, IMFO, Ethekwini municipality, Steel and Engineering Industries Federation of South Africa (SEIFSA) and the Southern Cape Karoo Electricity Forum. ANALYSIS OF STAKEHOLDER COMMENTS 19. The following section deals with the comments received and issues raised by stakeholders together with NERSA s analysis of these issues. a) Approach used in determining the guideline Stakeholder Comments 20. It is inappropriate for NERSA to act as if the establishment of Regional Electricity Distributors (REDs) is already under implementation. Page 4 of 23

21. The analysis done towards determining benchmark weight, and the resultant averages should be categorised into metros, secondary and smaller municipalities. 22. The determination of the guideline was based on a random selection of D- forms and averaging is fundamentally flawed as each municipality has its own unique networks, customer bases, consumption and challenges. 23. There is no mention of tariffs to promote energy efficiency yet it is known that this is an inevitable shift for tariffs in future. 24. The proposed cost structure assumptions (i.e. bulk purchases, salaries, maintenance etc.) can be used as a starting point when determining the increase applicable for a municipality, however municipalities should be allowed to show the actual costs incurred based on the budgets and these should be used, if proven legitimate. NERSA Analysis 25. EDI Holdings was mandated by the Department of Minerals and Energy with the purpose of restructuring the Electricity Distribution Industry (EDI). In order to ensure that this is carried forward, EDI Holdings established the REDs. NERSA adopted this concept and has managed over the past few years to strive to rationalise tariffs in line with the RED structure. Without a specific policy direction, it is not advised to move away from this concept. 26. NERSA acknowledges that a one size fits all approach is not an ideal one, however given the uniqueness of each entity, categorising municipalities per size (i.e. metros, medium and small municipalities) would still not achieve a perfect fit for all 189 licensees. An ideal situation will only result when each municipality is assessed individually based on its unique cost structure and load profile. It must be noted though, that this approach would counter the uniformity that NERSA is striving to achieve within municipalities in a RED boundary. Further, in analysing applications, NERSA does consider each municipality s unique characteristics and challenges. 27. The graph below highlights the different cost structures of the various municipalities based on a sample including of metros, medium-sized and small municipalities. It highlights that the bulk purchase cost component varies from one municipality to the other regardless of the size of the municipality. The graph also illustrates that the NERSA-determined level of 70% for the bulk purchase costs, which is based on a method of averaging, is currently the optimal solution available, as it represents the mid- point for the majority of municipalities. The same principle is applicable to the rest of the cost components (repairs and maintenance, other costs etc.). Page 5 of 23

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28. Furthermore, a study on the categorisation of municipalities would require extensive research and consultation which would impact on the timelines for the finalisation of the guideline increase for 2011/12. Given this time constraint, NERSA could not undertake such a study in this financial year. NERSA will consider this in the 2012/13 financial year. 29. Apart from the above, another positive step taken by NERSA in trying to assess municipalities individually is the introduction of the rate of return methodology for large metros which is effective from July 2011. 30. NERSA fully supports the implementation of tariff structures that promote energy efficiency e.g. time-of-use tariffs. Furthermore, while the primary objective of the IBT as introduced by NERSA in 2010/11 is protection of the poor, the secondary objective is promotion of energy conservation. 31. With regard to paragraph 24 above, it must be noted that although NERSA determines an average guideline increase applicable to municipalities, NERSA does consider municipalities with different cost structures (higher than guideline increase) on a case-by-case basis. However, the responsibility is on the municipality to demonstrate these differences in its cost structure, to NERSA. These municipalities are also required to give a presentation at a public hearing wherein they are required to further motivate their case. Reasons commonly accepted by NERSA for higher than guideline increases include the following: extensive repairs and maintenance programmes; capital expenditure programmes; need for additional funds due to the need to fill in critical vacancies (increased human resource costs); rationalisation and restructuring of tariffs: allowing municipalities with low tariff levels to increase by above the applicable guideline in order to bring them in line with the tariff benchmark levels of the respective REDs; municipalities facing serious financial challenges and municipalities placed under administration and any other special electricity related project that a municipality undertakes such as Demand Side Management (DSM) initiatives. Finally, when above the guideline increases are granted, there are certain conditions imposed on these municipalities. These include the need to ringfence the additional funds granted and reporting on a regular basis on progress made on these projects. NERSA further monitors these conditions to ensure compliance. Page 8 of 23

b) Views on other costs Stakeholder Comments 32. Municipalities are often highly dependent on revenues from electricity sales which are used to subsidise other services. It is unclear if the other costs category includes such revenues beyond electricity sector costs, and what ranges of costs would be acceptable in tariff design. 33. The contribution to the rates account or surcharge should be excluded from the cost structure and definitely not be included in the category other cost. By including it in the cost structure NERSA is effectively regulating provision that falls out of their regulatory competence. 34. With aging infrastructure, a municipal percentage of a total cost of 8% and an expected increase of 6% is not sufficient. The rapid increase in the rate and severity of deterioration is becoming a problem for municipalities that are not replacing network infrastructure when it is past its expected working life. 35. The notion that other costs are more than repairs and maintenance and should therefore be reduced is incorrect. These are real expenses over which electricity departments in many cases do not have control, over such as administrative charges by the municipality. The unilateral change of other costs from 10% to 8% cannot be supported unless proper research regarding the cost that represents the 10% has been conducted. NERSA Analysis 36. Below is NERSA s definition of other costs and it includes the following cost components: contribution to capital, contribution to funds i.e. o capital development fund, o tariff equalisation renewal fund, o bad debt reserve, o maintenance provision, and o other costs; charges allocated from other municipal departments, charges allocated to other municipal departments and general expenses. The definition above illustrates that Contribution to rates account and all municipal surcharges do not form part of the Other costs structure, as it is perceived. Page 9 of 23

37. Repairs and maintenance in the cost structure refers to normal planned maintenance and according to NERSA s guideline, 6% of the total costs is allowed for this cost category. Any other maintenance that is of extraordinary nature (e.g. dealing with backlog maintenance) is dealt with and considered separately and must be motivated for by the municipality. Furthermore, extensive capital expenditure projects are also considered separately and do not form part of the cost structure again these projects must be properly motivated for by the municipality. 38. According to the 2011/12 guideline, NERSA has indeed shifted the percentage weightings of the different cost elements. The other costs cost element has been decreased by two percentage points, to 8%. This was done to make allowance for higher costs, particularly for repairs and maintenance and capital charges, and is a measure to encourage municipalities to address their significant repairs and maintenance backlogs and aging infrastructure needs. This concept is also supported by the South African Local Government Association who stated that: The Electricity Distribution business has an obligation to financially contribute to Other costs, however, weighted against the need to invest more in infrastructure, and given the current state of infrastructure, the proposal to reduce the weight on Other costs is supported. c) Views on arrear debt Stakeholder Comments 39. The 0.5% provision is not adequate to address the problem at hand. Many municipalities have debtors days of more than 120 days, and outstanding non-current debt exceeding 50% of its annual revenue. A very large percentage of this money can or will not be recovered. The bad debt provision will thus have to be much more. 40. There are clear stipulations in GRAMAP and Municipal Finance Management Act (MFMA) of how bad debt should be addressed. It is therefore proposed that municipalities make the required provisions as allowed for in the legislation / regulations and submit this to NERSA. 41. The benchmark for bad debt should be in terms of electricity revenue and not the total revenue of the municipality. In this regard, 5-10% of electricity revenue would be appropriate. NERSA Analysis 42. The following are NERSA s definitions of bad debts and arrear debts: Bad debts are debts that will remain uncollectable and therefore written off at the end. Page 10 of 23

Bad debts forms part of the other operating costs, but the municipality must manage them in a manner that will not sacrifice the overall efficiency of the electricity trading account. Arrear debts are debts that have not been paid and remain due or owed. 43. Due to the aforementioned comments received by stakeholders, it is necessary for all licensees to provide NERSA with their current levels of arrear debt (as per the above definition) for 2010/11. This will enable NERSA to accurately determine the optimal levels of debt and thereby set the appropriate targets for 2011/12. d) Cross-subsidisation between customer categories Stakeholder Comments 44. The current NERSA proposals for IBTs for all domestic customers is rejected in its totality as: it does not comply with current policy, it is not practically implementable; and the negative impact is not sustainable. This is a subject that needs a separate debate which is ongoing between NERSA and AMEU. 45. The cross-subsidy to the low income consumers remains important and should be encouraged and preserved in addition to the Free Basic Electricity (FBE). 46. Cross subsidisation does not only subsidise indigent customers. All domestic customers benefit, thus resulting in massive loss of income to municipalities. 47. Real costs of electricity need to be defined for all customer groups, i.e. costs from generation, transmission, distribution, as well as internalising the environmental costs of electricity. 48. Cross subsidisation can only be modelled once the make-up of the customer base is known. The greater percentage of domestic customers in most municipalities does not buy enough electricity to get to the Block 3 tariffs. In reality, the cross subsidisation between customer groups is restricted by the customer mix within the municipality. To achieve a lower percentage increase for lower domestic blocks without further significant subsidisation from commercial customers, the current block design and/or tariff benchmarks need to be reconsidered. 49. The subject of cross subsidisation is one which should be determined by National Treasury. National Treasury has been neglecting its responsibility Page 11 of 23

in this respect. The current cross subsidisation in the EDI is taking place in a policy vacuum from a National Treasury point of view. NERSA Analysis 50. The principle of an IBT is supported by the South African Electricity Supply Industry: Electricity Pricing Policy GN 1398 of 19 December 2008 (EPP) which states that: : Low income tariff customer subsidization: Charging an appropriate tariff structure that allows for maximum subsidization at low consumption levels with gradually reducing cross-subsidies as the consumption levels increase. Furthermore, Section 16(e) of the Electricity Regulation Act, 2006 (Act No. 4 of 2006),states that the Regulator, may permit the cross-subsidy of tariffs to certain classes of customers. 51. The IBT structure has been designed to make allowance for the achievement of the objective of (1) protecting low-income tariff customers and (2) promoting energy efficiency. The Block 1 & 2 rates of the IBT are therefore set at subsidised rates, Block 3 is set to recover the average distributed costs and Block 4 to recover marginal cost plus residual revenues for domestic/residential customers. Therefore high consumption users who do not change their consumption pattern will not benefit /are not subsidised by the IBT structure. 52. The IBT s for municipalities that have a predominantly domestic customer base, a customer mix that is not ideal or low consumption domestic customers, will be considered on a case-by-case basis, i.e. NERSA will consider above the benchmark increases for these municipalities which will assist in reducing the cross-subsidies required from the rest of the customer base. Again, it must be noted that sufficient evidence of revenue impacts, customer numbers and consumption levels must be provided. e) Other issues impacting electricity price increase Stakeholder Comments 53. Eskom s High season and Low season tariffs play havoc with municipal cash flow. It is the start of the new financial year, and customers with credit bought in June, see the credit in July, however the municipality has to pay Eskom s High season tariffs. With no money in reserve as the financial year has just started, municipalities are having an ever increasing cash flow problem. 54. NERSA has approved a tariff increase of 26.71% for Eskom to municipalities, but no mention is made of tariff restructuring, or the Eskom proposed implementation of punitive IBTs for reactive energy. Page 12 of 23

NERSA Analysis 55. Time-of-use tariffs (TOU) have higher rates during peak periods and lower rates during off-peak periods. If a municipality is purchasing from Eskom on a TOU tariff, the municipality must consider its load profile/ consumption in its budgeting and forecasting process. 56. The 26.71% used as the bulk purchase percentage increase for municipalities in the calculation of the guideline, has been confirmed by Eskom s draft retail tariff submission to NERSA. It must be noted that there are no planned structural adjustments for the 2011/12 financial year. f) Appropriateness of financial analysis and benchmarks Stakeholder Comments 57. Percentage power cost and surplus benchmarks are supported; however the only problem with surpluses is that municipal financial statements are not ring-fenced and significant costs are hidden. Furthermore, NERSA has no control over this with a proper cross subsidy framework being compiled by National Treasury. 58. System losses benchmark is supported. The only problem is that the figures provided to NERSA are manipulated to yield acceptable losses. Large utilities with many large customers still experience very high losses. NERSA should obtain the data of any area that has losses of over 12% and detailed strategies of correcting this. These high losses should then be deducted from the allowed surplus. 59. The financial analysis does not consider the unique circumstance of each utility and their sustainability into the future. NERSA Analysis 60. During the analysis of the tariff applications, NERSA considers the financial health of the municipality in line with the financial benchmarks as set by NERSA. This includes the assessment of the surplus levels, system loss levels and average selling price versus the average purchase price. The information used for this analysis is obtained from the latest D-forms submitted by the municipality. 61. One of the requirements for submission of the D-forms to NERSA is that the forms need to be signed off by either the municipal Chief Financial Officer or the head of electricity technical service. NERSA therefore expects information supplied to be authentic and correct. 62. In instances where the analysis reveals very low surpluses, NERSA assists municipalities by considering higher tariff levels. In circumstances where the system losses of municipalities are also at extreme levels, NERSA requests the municipality to submit plans on how it intends to curb these Page 13 of 23

system losses. These plans are then monitored by NERSA to ensure that these inefficiencies are corrected. This aims to demonstrate that NERSA does not look at these financial indicators in isolation but considers the overall impact on tariff levels, revenues and efficiencies of the municipality. g) Appropriateness of benchmarking licensees against approved benchmarks Stakeholder Comments 63. The benchmark exercise is not appropriate as it only refers to the unit tariff and does not include aspects like basic charges, KVA charges, as well as time of usage. 64. All the benchmarks relating to IBTs are rejected. Tariffs must be applied as per EPP and other policies, then benchmarks can be used as a first indication of possible problems. These benchmarks should not be used to require changes but rather to use legitimate motivation provided by municipalities for the differences. 65. Criteria used to define Commercial (2000kWh) and Industrial (200kVA, LF30%) is not reflective of the customer base and therefore has little value in providing guideline for these customer categories. NERSA Analysis 66. All the commercial and industrial benchmarks are determined with all costs embedded into the benchmark level i.e. it is an average tariff level consisting of the basic charge, energy charge and demand charge. 67. The table below indicates the levels by which the 2010/11 IBT benchmark levels were adjusted together with the rationale for these increases resulting in the 2011/12 IBT benchmark levels. 68. The table aims to highlight that these benchmark levels have been set to meet the objective of protection of the poor. Municipalities that believe that these benchmarks are inappropriate or not applicable, they are required to submit an updated cost of supply study to support their need for such deviations. Page 14 of 23

Block Consumption Levels Block 1 1-50 kwh Block 2 51-350 kwh Block 3 351-600 kwh Block 4 >600 kwh Basis of benchmark increase Limited to CPI ( as allowed for Eskom) CPI + % equal to or less than Eskom Real WACC% allowed Average (fully distributed) cost Domestic High benchmark plus guideline increase(long Run Marginal Cost + Residual Revenues) Rationale for the baseline point To ensure that the increases in this benchmarks category remain within inflation level and provides protection to the low income customers. Maintain the objective of low income customer tariff subsidization for those customers who spill over from first block by retaining same baseline for both block 1 and 2. To ensure that the increases of average consumption households are limited to the average guideline increases Higher end of the residential benchmarks and representative of the marginal cost for additional supply h) Appropriateness of benchmarking licensees tariff benchmark levels against each RED Stakeholder Comments 69. The difference in costs amongst the REDs is minimal and the justification of the table is highly questionable. NERSA Analysis 70. The minimal difference in the level of the benchmark levels is due to the effort by NERSA in order to harmonise the tariff levels within the RED areas. i) Timelines for tariff approval process Stakeholder Comments 71. The setting of timeframes is welcomed and municipalities look forward to the timeframes being met in order to ensure a legally compliant and robust process for 2011/12. Page 15 of 23

72. The local government elections taking place as early as May 2011, could impact on municipal budget preparation timeframes with some Councils aiming to approve their 2011/12 budgets earlier and before the elections. 73. The proposed timeline is not keeping in line with the requirements of MFMA, as MFMA stipulates that utility s final increase must be submitted by 15 March following all the necessary consultations including public hearings. Draft budget must be submitted to Council by 31 March. Expectations are for NERSA to have wound up its process and advised of the approved tariffs in time to input into the municipal budget process. 74. The idea that seeks to align the tariff approval process with MFMA requirements is supported. However, a need to differentiate between the two appeal processes is important, i.e. differentiate between a normal appeal process and a tribunal appeal process as per NERSA Act. 75. Communication of an approved tariff guideline by November is essential. Ideally, municipalities must submit initial applications and receive NERSA decision before end of May 2011. Resubmissions and public hearings to take place during April with final decision by May 2011. NERSA Analysis 76. The Municipal Tariff Assessment timelines (aligned to the National Treasury Budgetary Process) have been adjusted according to the comments received from stakeholder and is presented in Annexure 1. 77. Further engagement with key stakeholders (SALGA, AMEU and National Treasury) on these timelines is ongoing. 78. It is important to note that in order for NERSA to adhere to these timelines, and for these timelines to be effectively implemented, the onus is on the licensees to ensure the timeous submission of their 2011/12 tariff applications. APPLICABLE LAW 79. NERSA is the regulatory authority established as a juristic person in terms of section 3 of the National Energy Regulator Act, 2004 (Act No.40 of 2004). NERSA s mandate is to regulate the electricity, piped-gas and petroleum pipeline industries in terms of Electricity Regulation Act, 2006 ( Act No. 4 of 2006), Gas Act, 2001 (Act No. 48 of 2001 and Petroleum Pipelines Act, 2003 ( Act No. 60 of 2003). In terms of section 4(ii) of the Electricity Regulation Act, 2006 (Act no. 4 of 2006) the National Energy Regulator must regulate prices and tariffs. Page 16 of 23

DETERMINATION OF THE MUNICIPAL GUIDELINE Municipal Tariff Guideline 80. The guideline for the 2011/12 financial year has been calculated after taking into consideration Eskom s approved MYPD2. Eskom was granted an average increase of 25.8% increase for the 2011/12 financial year. This increase amounts to 26.71% for municipalities, which is due to the MFMA time lag. (i.e. municipalities implementation of 1 July). 81. When determining the percentage increase guideline for 2011/12, the following issues were also considered: the proposed Eskom price increase for 2011/12 applicable to municipal distributors; the analysis of other municipal costs besides purchase costs; tariff rationalization within a demarcated area and within a RED boundary and NERSA s regulatory objectives. 82. The revised weights as per the 2008/9 D-forms are as follows :- Current benchmarks (%) Revised benchmarks (%) Bulk Purchases 67 70 Salaries 12 12 Repairs & Maintenance 6 5 Capital charges 4 3 Other costs 11 10 Table 1: Revised benchmark weights NERSA views on other costs: 83. Other costs are expenses that cannot be classified in terms of the municipal cost structure. The sampled municipalities allocate 10% of their revenue for other costs; this percentage is more than the costs of repairs and maintenance and capital combined. To rectify this situation it is proposed that the 10% be reduced by two percentage points. The reduced two percentage point should be added evenly to capital charges and repairs and maintenance. This would enable municipalities to invest more on their infrastructure. Page 17 of 23

Current benchmarks (%) Revised benchmarks (%) Bulk Purchases 67 70 Salaries 12 12 Repairs & Maintenance 6 6 Capital charges 4 4 Other costs 11 8 Table 2: Revised weights based on reduced other costs 84. The following assumptions were taken into consideration; bulk purchases have been increased by 26.71%; CPI equal to 4.8%; salary increases assumed at CPI plus 2% (as per agreement between organised local government and Unions); repairs and maintenance, Capital charges and Other Costs have been increased by CPI and the benchmark for bad debt is assumed at 0.5% of the total revenue of the municipality. 4 85. In determining the latest CPI forecast for the 2011/12 financial year, NERSA used the inflation figure as quoted in National Treasury s economic policy and outlook and the Medium Term Budget Policy statement (MTBPS) delivered by the Minister of Finance on 27 October 2010. This publication provides the latest official headline inflation forecasts; the forecasted inflation for 2011/12 is 4.8%. 86. NERSA s inflation figure, as calculated by Bureau of Economic Research (BER) is 5.5% for 2011/12. However, to avoid inconsistencies between municipalities, whose costs are generally calculated using National Treasury s guidelines, NERSA will assume National Treasury s forecasted figure of 4.8%. 87. When determining the percentage increase guideline for 2011/12, the following issues were considered and some assumptions made: The Eskom price for increase for 2011/12: Municipal distributors purchase their energy requirements from Eskom who generates 96% of the energy that is consumed in the country. It is therefore necessary that when considering the level at which municipalities will increase their tariffs, the Eskom price increase be taken into consideration. Based on the current study done in determining the guideline the electricity purchases by municipal distributors make up approximately 70% of their total costs to supply end-use customers; 4 This assumption is based on Eskom s approved arrear debt in the MYPD2 application. Page 18 of 23

The analysis of other municipal costs besides purchase costs: While purchase costs make up the bulk of municipal costs ( approximately 70% on average), municipalities are also subjected to other costs like operating and maintenance costs. Increases to these costs have a bearing on the municipalities ability to distribute electricity. Tariff rationalisation within a demarcated area and within a RED boundary: The process around tariff rationalisation within a future RED is an ongoing process. As an endeavour to tariff rationalisation, municipalities are divided into six RED s. NERSA adjusts the benchmarks to obtain a 5c/kWh margin between the upper and the lower limits of the required price. Currently municipalities which fall within the same RED are assessed on the benchmarks of that particular RED. If the required increase for a municipality is outside the guideline percentage, the increase is limited to the benchmarks in order for the tariffs to fall within the range for that RED, unless when the municipality has submitted a motivation stating reasons as to why it is applying for an increase that is above the guideline increase. Where such anomalies occur, the applications are treated on a case-by-case basis. This is based on the information provided by the particular applicant. 88. The formula for calculating the guideline: Where:- (%B x %BPI) + (%S x %SI)+ (%R x %RI)+(%C x %CCI)+(%OC x %OCI) (70 x 26.71) + (12 x 6.8%) + (6 x 4.8%) +(4 x 4.8%) +(8 x 4.8%) 18.70 + 0.82 + 0.29 + 0.19 + 0.38 20.38% B = % Bulk purchases BPI =% Bulk purchase increase S = % Salaries SI = %Salary increase R = % Repairs RI = %Repairs increase C = % Capital charges CCI =% Capital charges increase OC = % Other Charges OCI =% Other Charges increase Page 19 of 23

COST LINE ITEM PREVIOUS COSTS % MUNIC % OF TOTAL COST EXPECTED INCREASE % WEIGHTED AVERAGE EXPECTED INCREASE Purchases 67 70 26.71 18.70 Salaries and wages 12 12 6.8 0.82 Maintenance/Refurbishmen 6 6 4.8 0.29 t/recapitalisation Capital charges in total 4 4 4.8 0.19 Other costs 11 8 4.8 0.38 % increase 20.38% Table 3: Calculation of the guideline for the 2011/12 financial year 89. It is considered to be appropriate to consider 70% of electricity cost as benchmark for energy purchases for a municipality. This was done according to a NERSA calculation based on a summary of municipality s data that was done in 2010; where a sample of municipalities electricity purchase costs was calculated as a percentage of total municipal costs and an average was reached per RED. The municipalities which were used in the sample study were selected based on the availability of the D-Form information submitted to NERSA by different municipalities. The percentage power costs for each of the six REDs ranged between 58% and 78%. This then resulted in an average of 70%. This benchmark ensures that municipalities are able to manage their costs more efficiently. There is a drive to push all municipalities to that level of efficiency. Municipal Tariff Benchmarks 90. The existing benchmarks are based on five assumed tariff/customer categories and average consumption levels for these categories. It should be noted that these are average consumption levels and that there may also be other tariff classes at various municipalities which will cater for other customer classes or consumption levels that are very different from the ones that are assumed. Where such anomalies exist, the applications will be treated on a case-by-case basis based on information provided by the applicant. 91. The criteria used in evaluating tariff increase applications from municipalities are as follows: o NERSA endeavours for efficiency by making sure that the tariff levels are within the benchmarks and are not excessive. o striving for rationalisation and harmonisation of tariffs in general, and particularly within a RED demarcation. o striving for an appropriate recovery of revenue from different customer categories. o while allowing cross subsidisation making sure that it is not excessive. Page 20 of 23

o promoting correct pricing signals through tariffs. 92. In analysing financial indicators more emphasis is put on the following issues: o system losses, if excessive and if there is an opportunity to improve on the surplus without increasing the tariffs o average price ratio where this is excessive and there is evidence of over recovery. This gives the regulator more reasons to limit the tariff levels. o surplus levels where it is excessive and there is evidence of over recover o where there is a special capital infrastructure upgrading. o where the connection fees were paid upfront by customers. o realignment of tariffs to allow for correct pricing signals 93. The Regulator will investigate the reasons, facts and evidence when considering a municipal motivation for a tariff increase above the guideline. 94. The existing benchmarks that are being revised are based on five assumed tariff/customer classes. Consumption levels for these customer classes are also assumed. It should be noted that these are average consumption levels and that there may also be other tariff classes at various municipalities which will cater for other customer classes or consumption levels that are very different from the ones that are assumed. Where such anomalies exist, the applications will be treated on a case-by-case basis. 95. For the purposes of benchmarking the following customer classes are assumed: domestic Tariffs 5 o Block 1 (1 50 kwh); o Block 2 (51 350kWh); o Block 3 ( 351 600kWh); and o Block 4 (> 600kWh); commercial (small business) single phase tariff this tariff is assumed to apply to small businesses and is generally a two part tariff consisting of both on energy and basic charge, with an assumed consumption level of 2000 kwh per month; commercial Prepaid this is generally a single energy rate tariff which may include some capital / fixed charges; and industrial / Large user tariff - This is a tariff for large customers (mainly industrial) low voltage assumed at a 30 % load factor (LF) and a maximum demand (MD) of 200 kva, which would give an average consumption level of 43 800 kwh. 5 Domestic tariffs are based on the Inclining Block Tariffs (IBT) structure where the domestic low consumption level is assumed to be at 400kWh and the domestic high consumption at 800kWh. Page 21 of 23

96. The Regulator is aware of the fact that some municipalities use consumption levels that are different from what NERSA has assumed but for purposes of this report the mentioned consumption levels are used. This is so that the comparisons can be done on an apple to apple basis. Financial Benchmarks 97. When determining tariff increases for distributors, a financial analysis to test the efficiency and financial viability of the distributor is performed. This analysis is performed based on established financial indicator benchmarks to give an indication of the performance of the municipality i.e. to test whether the municipality is not overcharging its customers and whether the municipality will be able to continue as an ongoing concern given its current revenues from sales of electricity. 98. The following financial benchmarks are applicable: Average benchmarks Financial benchmarks (Tolerable range) Percentage Power cost 70% 58% - 78% Surplus percentage 15% 10% - 20% System losses 10% 5% - 12% Average Sales Price/Average Purchase Price ratio 1:1.5 1:2.1 1:1.5 1:2.1 Cross-subsidisation ratio (Commercial/ Domestic) 1:1.2 1:1.2 6 Cross-subsidisation ratio (Industrial/ Domestic) 1:1.25 1:1.25 7 Table 4: Applicable financial and technical benchmarks with the tolerable ranges 99. When revising the cost structure, the other ranges did not change except for the percentage power. This cost increased from the initial 67% to 70%. According to the analysis done, this figure is still within the range that was calculated in the previous tariff adjustment process. The lower and upper range of the power cost had to be increased by 3%, this was based on the difference between 67% and 70%. 100. When developing the domestic blocks, commercial and industrial benchmarks the following issues were taken into consideration: o Block 1 8 - The 2010/11 benchmarks were increased by the CPI inflation of 4.8%. 6 This is applicable to municipalities with an appropriate customer base/ mix i.e. municipalities that have sufficient domestic, commercial and industrial base. Municipalities that fall outside of these ratios will be treated on a case by case basis. 7 Ditto 8 The increases on block 1 up to block 4 tariffs are based on the Eskom s approved IBT structure. Page 22 of 23

Conclusion o Block 2 - The 2010/11 benchmarks were increased by CPI of 4.8% plus weighted average cost of capital of 8.16%. this results in a total increase of 12.96%. o Block 3 and 4 - The 2010/11 benchmarks were increased by the municipal tariff guideline increase of 20.38%. o The 2010/11 commercial and industrial benchmarks were increased by the municipal tariff guideline of 20.38%. 101. Based on the available reasons, facts and evidence NERSA s conclusion is set out below as follows: A guideline increase of 20.38% for the 2011/ municipal tariff review process. The 20.38% guideline increase was based on the following assumptions: o municipal bulk purchase cost of 70%; o bulk electricity purchase price increasing by 26.71% ; o salaries and wages increasing by the assumed 2011/12 Consumer Price Index (CPI) 9of 4.8% plus 2% as per the agreement between Local Government and its unions10; and o repairs and maintenance, capital charges and other costs increasing by the assumed inflation forecast of 4.8%. The municipal electricity tariff benchmarks for 2011/12 are as follows: c/kwh Domestic Block 1 0 50kWh Domestic Block 2 51-350kWh Domestic Block 3 351-600kWh Domestic Block 4 >600kWh Commercial Prepaid 2000kWh Commercial 2000kWh Industrial 43800kWh RED 1 58 63 67-72 93-98 109-114 117 122 117 122 117 122 RED 2 58 63 67-72 93-98 111-116 115 120 115 120 118 123 RED 3 58 63 67-72 93-98 109-114 117 122 115 120 118 123 RED 4 58 63 66-71 90-95 109-114 115 120 115 120 118 123 RED 5 58 63 67-72 93-98 109-114 115 120 117 122 117 122 RED 6 58 63 66-71 90-95 109-114 117-122 117-122 118-123 Table 5: The average benchmarks for 2011/12 End 9 National Treasury Forecasted Figure based on the Medium Term Budget Policy Statement (MTBPS) of 27 October 2010 10 This was confirmed with the South African Local Government Association (SALGA) Page 23 of 23

Annexure: 1 Timelines for annual municipal tariff review Dates Aug 10 Aug - Sept Details Mayor tables in council a schedule of key deadlines for various budget activities as outlined in section 21 of the MFMA Meeting with National Treasury and SALGA to discuss financial parameters and assumptions used in the determination of the guideline Meet with AMEU to discuss initial thoughts on the municipal guideline 6 Oct 10 Public Hearing 30 Oct 10 Due date for municipalities to submit their D-forms for the next tariff applications process Oct 10 National Treasury process - Municipal informal public meetings with key stakeholders, government spheres and entities 25 Nov 10 NERSA approval municipal guideline and benchmarks 26 Nov 10 Communicate indicative guideline increase to municipalities and put the draft decision on NERSA website, End Nov 10 Dec 10 Feb 11 30 Jan 2011 Dec 10 May 11 Mar 11 National Treasury issues a budget circular to all municipalities. Municipalities compiles and submit draft tariffs application for consideration by NERSA *Deadline for municipalities to submit draft tariff applications to NERSA NERSA analyses applications and approval of tariffs within the guideline increase and communication of NERSA s decision to municipalities (incl. Revised application/appeal process) Mayor tables municipal and entity budgets and budget related policies (Draft) for consultation processes Apr- May 11 Public submissions on draft budget Council hearings to consider submissions Mayor resubmit amended budget for council approval and adoption 1 June Finalised budget is tabled in council again Applications above guideline Mar & April 11 Public Hearing for above guideline applications Mar May 11 Regulator meeting to approve above guidelines tariffs April - May 11 Consideration and approval of revised applications (appeal) 1 July 11 Implementation of approved budget including NERSA approved tariffs Sep11 Approved tariffs to be published on the website. Legend for the municipal tariff review process MFMA prescribed budgetary process for 2010/11 municipal financial year NERSA municipal applications and approval process Page 24 of 23