Optimal pricing for sustainability of regulated infrastructure industries South African Economic Regulators Conference of 2012 Deon Joubert 21 August 2012

Main criteria to be analysed 2 Full recovery of all prudent costs incurred over life cycle Price stability Electricity will be analysed as an example of an infrastructure industry

Costs incurred in generating electricity 3 Acquisition cost of asset Operating and maintenance cost (fixed cost) Fuel cost (variable cost)

Costs incurred in generating electricity (cumulative over life cycle) (illustrative) 4 Constant Rand billion

Costs incurred in generating electricity (cumulative over life cycle, levelised) (illustrative) 5 Constant Rand billion Levelised Cost of Electricity (or LUEC: Levelised Unit Electricity Cost)

6 Constant Rand billion Costs incurred in generating electricity (cumulative over life cycle, discounted) (illustrative)

Basic regulatory formula for annual electricity revenue determination 7 AR = PE + O&M + Depreciation + Return on Capital (i.e. %ROA x RAB) AR/sales volume = ave. tariff Same as %WACC x total capital Note: the actual annual capital expenditure (cash capex) is not directly recovered in the revenue of that year

8 Asset related building blocks Constant Rand billion Basic regulatory formula for annual electricity revenue determination Revenue building blocks Pays for interest on capital Pays for redemption of capital (debt principle or equity)

Two main regulatory methods * to quantify the asset-related revenue building blocks : depreciated historical cost (HC) depreciated historical cost (HC) inflation-indexed or depreciated replacement cost (DRC) inflation-indexed or depreciated replacement cost (DRC) * in typical cost-of-service type of revenue regulation 9

Depreciated historical cost method: 10

Illustrative revenue – first operational year of new power station Constant Rand billionHC method 11

Illustrative revenue – first two operational years of new power station Note reduction Constant Rand billionHC method 12

Illustrative revenue – first three operational years of new power station Note reduction Constant Rand billionHC method Both depr. and ROA reducing 13

Illustrative revenue profile – full operational life of new power station Constant Rand billion Revenue (and tariff) essentially covering O&M and PE PV of life cycle depr. and ROA revenue = initial asset acquisition cost HC method 14

Severe tariff instability for single asset, at replacement Constant Rand billionHC method Replacement 15 No change in LCOE at replacement

Tariff instability moderated with multiple assets at regular intervals Constant Rand billionHC method Average revenue / tariff 16 Ave. LCOE

Constant Rand billion Significant tariff instability with two assets * at larger interval HC method Average revenue / tariff Uncertainty re whether incr. will happen could cause funding difficulty * or, two similar groups or batches of assets 17

Inflation-indexed or depreciated replacement cost method: 18

Illustrative revenue profile – full operational life of new power station Constant Rand billionDRC method 19 Starts lower, ends higher than on HC More gradual reduction PV of life cycle depr. and ROA revenue = initial asset acquisition cost

Much less tariff instability for single asset, at replacement (vs. HC) Constant Rand billionDRC method 20 Replacement vs. HC

Tariff instability well moderated with multiple assets at regular intervals Constant Rand billionDRC method 21 Average revenue / tariff vs. HC

Tariff instability manageable, even with two assets * at larger interval Constant Rand billionDRC method * or, two similar groups or batches of assets 22 Average revenue / tariff vs. HC

Conclusions Both regulatory revenue methodologies recover all life cycle costs – an important aspect of sustainability In discounted PV terms the life cycle revenues are equal to one another (no tariff premium for DRC) and the asset-related revenues are equal to initial asset acquisition cost HC very vulnerable to significant tariff instability – which could also cause funding difficulty (which could threaten sustainability) DRC much more stable and robust to large intervals between asset investments (ave. fleet tariff approaches stability of LCOE) Although both methods only cover cost of existing (not future) assets, the tariff stability of DRC greatly facilitates funding for new assets 23

Thank you 24