Portfolio Committee on Energy Securing financial sustainability (in response to lower tariff decision) May 2013

2 Content Nersa Decision, Rationale and Implications Eskom Response

Summary NERSA granted Eskom 8% X 5, equating to revenue of R862bn which results in a shortfall of R225bn Without appropriate intervention the NERSA decision will impact Eskom The shortfall cannot be made up with efficiencies alone Eskom’s response is being finalised through an integrated delivery programme which will: continue to implement the committed savings of R30 bn and find further efficiencies Consider how the business can be reshaped Identify additional support that may be required Look to the regulatory framework and rules to assist in addressing the challenge Certain policy implications will have to be addressed with Eskom’s shareholder 3

Eskom’s MYPD3 application has a well defined point of reference  Application was based on the regulatory formula allows for the recovery of prudent costs (primary energy and operating ) depreciation and a return on assets which encompassed the following key principles: 1.Eskom’s aim shift its performance across all metrics in line with world class utilities 2.Costs kept at single digit increases -Primary energy increases of 8,6% (including coal at 10%), operating costs increases of 8% (maintenance key driver) 3.Electricity Pricing Policy (DoE - December 2008) – recovery of costs and earning return on assets at replacement value 4.NERSA previously allowed targeted return of 8.16% -Application reached 7,8% by 2017/18, averaged 4% over MYPD period 5.Debt guarantees – government support of R350bn -R60 billion subordinated loan fully drawn 6.Debt levels maintained within R350 billion guarantee ceiling – approximately 80% of funding secured 4 Aim to achieve cost reflectivity improved Eskom’s financial profile and complimented its ability to fund itself with lower risk and government support

NERSA’s disallowances result in a R225 billion cash flow gap over the 5 year period 5 Commentary Total disallowed revenue equates to R225 Billion Key reductions in Primary Energy, Depreciation, Opex and returns The implications have been weighted towards the end of the 5 year period Revenue reconciliation to application Phasing of disallowances Capex 10bn 24bn 41bn 62bn 88bn

Key items which were disallowed by NERSA CostEskomNersaReason given by NERSAEskom response Primary energy R355bnR293bnBased on MYPD 2 coal costs Assumed lower water costs Assumed stable gas prices Used nuclear fuel benchmarks Limited OCGT load factor and stable diesel prices Based on actual coal costs Based on actual water costs Realistic commodity fluctuations Used actual contractual costs DMPR11bnR1.9bnSufficient capacity after Medupi and Kusile to address energy shortfall Mistakenly understood as power buyback programs. Impact on KLO for next 2 years due to shortage in capacity prior to new stations producing energy IPPsR78bnR65bnRephasing of IPPs.Accepted OpexR270bnR222bnMYPD 2 approved manpower Double counting, efficiency for maintenance Other opex escalated with CPI from MYPD 2 Corporate overheads from MYPD 2 Based on actual numbers Did not double count for maintenance Other opex considered change in operating model Corporate overheads on actual IDMR13bnR5bnAssumed that IDM will be undertaken by an agency, based on MYPD 2 performance, limited to inflation Impact on keeping lights on. ReturnR187 bnR138 bnDisallowed inflation adjustments since subject to periodic revaluation; differing WACC and RAB; capex disallowed Incorrect to have real WACC on RAB that excludes inflation DepreciationR185 bnR140 bnDepreciation linked to RAB and Capex allowed. Ignores inflation adjustment and thus based on reduced RAB. Method of depreciation is correct based on allowed RAB and capex. Must adjust RAB for inflation 6

Eskom View  Different assumptions : −What was efficient costs −Execution capability −Steps necessary to ensure security of supply −Inflationary increases in areas not subject to inflationary increases (insurance)  Different cost benchmarks assumed  View of starting point of cost base – forecast MYPD 2 decision v actual results 7

Strategic Implications  No explicit limitation of Eskom’s mandate  The following policy issues need to be addressed with the Shareholder to ensure alignment: −Eskom’s role in build beyond Kusile −Future role in IDM −Further Government support −The regulation of coal prices in SA and declaring coal a strategic resource 8

9 2 2 Eskom Response

New considerations, developments and strategic levers are available since MYPD3 submission 10 Mandate Financial Stakeholder Operational  IPP determination was reduced due to rephasing per DOE allowances and thus reducing costs  An update of IRP2010 is under development to adjust for changes in assumptions  To date no build beyond Kusile is allocated to Eskom  Discussion on a country pact for coal prices has commenced  Despite operational challenges, Eskom closed in a stronger financial position for FY13 than anticipated at time of submission  We have approved a business optimisation and efficiency programme (R30bn cost reduction included in MYPD3 submission has been identified)  In line with prudent operator principle, Board approved a technical operating standard of 80 (EAF) – 10 (PCLF) – 10 (UCLF)  We have secured demand market participation programs  Board decision to reprioritise and redeploy manpower to support operational and strategic imperatives  A joint Shareholder – Inter- government workgroup has been established to consider medium term constraints  We are engaging with NERSA on their MYPD3 determination, relating to the reasons for decision and assumptions made Board approved a Business Productivity Program Board approved a Business Productivity Program

Eskom has developed a holistic plan to address the challenges posed by the determination…  Eskom has 2 year period in which to implement substantial changes to mitigate the shortfall  We have initiated an integrated delivery program to engage stakeholders and ensure financial sustainability  The integrated delivery program has been approved by our board and supported by our shareholder  Business Productivity program delivers 4 key objectives within Eskom’s Integrated Delivery Program 11 … which also gives consideration to the new levers available NERSA response Efficiency and reshaping drive Strategic response for long term sustainability

This plan encompasses a systematic, rational approach to ensure that we are sustainable Major efficiency and sustainability drive Strategic response to ensure long-term sustainability NERSA response 1.Use the Regulatory Clearing Account as a mechanism to claw back against the NERSA determination Shape the business to realise long term efficiency gains Immediate reprioritisation and efficiency drive to identify cash reduction opportunities (over 5 years but with a specific focus on years 1 and 2) Address the Eskom mandate with key stakeholders, to reduce mandatory spend 3 3 Align capex programme in line with available funding options Additional shareholder support Explore funding alternatives 5 5 GAP Regulatory Clearing Account Efficiency Mandate Re =shape Capex Shareholder Funding Options R225bn Gap Gap closed Business Productivity Program 8 8 Roll out of Business Productivity Program (BPP) 8 8

Key Issues to clarify with Nersa  Nersa will be approached to ensure clarity on the application of the regulatory rules and framework to inform decisions that need to be made towards achieving financial sustainability. −The application of the Regulatory Clearing account (RCA) −Commitment in writing on specific treatment of cost variances −Reviewing the benchmark for coal costs and putting in place the sharing mechanism for variances in advance each year −Allowing for shifting of capital expenditure within allowed amount −Allowing for additional benchmarks to be obtained and this be considered in prudency reviews −Committing to an annual valuation of the regulatory asset base −Agreeing on appropriate timing of efficiency improvements, eg, UCLF 13

Next steps 1.Stabilize the business for the next 2 years and roll out of business productivity and re-shaping programme to identify and extract operating and capital efficiencies 2.Achieve a country pact on coal prices 3.Deliver on our capacity expansion program 4.Determine the maximum amount that can be recovered by applying the RCA methodology 5.Agree RCA principles and implementation process with NERSA 6.Confirm Eskom’s role beyond Kusile 7.Explore shareholder support. 8. Confirm list of projects for next 5 years which is aligned to the capital expenditure 14

Thank you 15