National Electricity Regulator Tariff Approval Process Presentation to: Parliamentary Portfolio Committee on Minerals and Energy Prof Anthon Eberhard – Board Member Dr Wolsey Barnard – EM: Regulation Mr Brain Sechotlho – HoD: Tariffs and Pricing 9 April 2003

Agenda South Africa’s electricity industry National Electricity Regulator (NER) Tariff regulatory methodology Tariffs structures and customer categories Eskom price increase process Municipal price increase process Future tariff regulation Future electricity prices South Africa’s electricity industry National Electricity Regulator (NER) Tariff regulatory methodology Tariffs structures and customer categories Eskom price increase process Municipal price increase process Future tariff regulation Future electricity prices

South Africa’s Electricity Industry

The Supply Chain DEMAND SIDE SUPPLY SIDE GENERATION TRANSMISSION & DISTRIBUTION MARKETING, SALES, & CUSTOMER SERVICE RESIDENTIAL AGRICULTURAL INDUSTRIAL KEY CUSTOMERS COMMERCIAL PRIMARY ENERGY SUPPLY

Generation Eskom 4 Mun/Private ( MW) 96% 4% Max demand MW) Transmission Eskom - 100% Distribution Eskom 177 Munic’s Sales 55% 45% Customers 40% 60% SA Electricity Industry

End Use 191 TWh Domestic 19.4% Agriculture 2.3% Mining 17.4% Industry Manufac. 42.4% Comm. 10.3% Transport 3.1% General 5% SAPP Imports Eskom T r a n s m i s i o n Distribution Purchases for End Use 194 TWh Municipal and Other Distributors 45% Eskom Distributors 55% 0.1% 44.9% 55.1% Gross Generation 198 TWh Eskom 95.7% Munic. 1.3% Private 3.1% SAPP - Exports from South Africa Energy Flow between the role players in the Electricity Industry in South Africa

Distribution of electricity Eskom is a national distributor – Eskom customers in WC and Limpopo province have the same tariffs Municipalities distribute only to customers within their demarcated boundaries – local distributor –Eskom distribute to its customers within municipal boundaries Differences between Eskom and Municipal tariffs –Different customer mix –Different consumption patterns –Dependent on surpluses made by munic’s Eskom is a national distributor – Eskom customers in WC and Limpopo province have the same tariffs Municipalities distribute only to customers within their demarcated boundaries – local distributor –Eskom distribute to its customers within municipal boundaries Differences between Eskom and Municipal tariffs –Different customer mix –Different consumption patterns –Dependent on surpluses made by munic’s

National Electricity Regulator (NER)

Power and Functions of NER Powers/ functions/ mandate of NER are to be found in the Electricity Act, Government Policies and Mandate from Minister of Minerals and Energy Objects: “Exercise control over the electricity supply industry so as to ensure order in the generation and efficient supply of electricity” Functions: –Issue licences; generation above 5 GWh annually –Determine prices/conditions for electricity supply –Settle disputes –Collect information –Perform inspections of equipment –Advise Minister on any matter relating to the ESI Powers/ functions/ mandate of NER are to be found in the Electricity Act, Government Policies and Mandate from Minister of Minerals and Energy Objects: “Exercise control over the electricity supply industry so as to ensure order in the generation and efficient supply of electricity” Functions: –Issue licences; generation above 5 GWh annually –Determine prices/conditions for electricity supply –Settle disputes –Collect information –Perform inspections of equipment –Advise Minister on any matter relating to the ESI

Role of NER Protect interests of electricity customers Ensure efficient electricity supply industry Ensure lowest cost electricty prices Ensure acceptable quality of service and supply Ensure long term provision and development of electricity services Ensure fair play amongst suppliers – level playing field Protect interests of electricity customers Ensure efficient electricity supply industry Ensure lowest cost electricty prices Ensure acceptable quality of service and supply Ensure long term provision and development of electricity services Ensure fair play amongst suppliers – level playing field

Tariff Regulation Methodologies

Different regulation methodologies used worldwide by regulators: –Benchmarking –Rate of Return Regulation (RoR) –Incentive Based Regulation (IBR) Methodology will be dependent on the state of development of the electricity industry Apply different methodologies for Eskom and Municipalities – Eskom national utility that generate, transmit and distribute; Municipalities only distribute electricity Economic Regulatory Methodologies

Rate of Return (RoR) Cost plus methodology of evaluating tariff increases Definition: The revenue required by an entity is equal to the cost to supply plus a fair rate of return on the rate base Methodology was published on the NER website for comments – Comments received and methodology is being refined Cost plus methodology of evaluating tariff increases Definition: The revenue required by an entity is equal to the cost to supply plus a fair rate of return on the rate base Methodology was published on the NER website for comments – Comments received and methodology is being refined

RoR formula ROR is calculated as a Weighted Average Cost of Capital Where the cost of debt is given by the Government bond R153 The cost of equity is calculated using the Capital Asset Pricing Model Assets are allowed only when productive Expenses are allowed using the prudency judgement ROR is calculated as a Weighted Average Cost of Capital Where the cost of debt is given by the Government bond R153 The cost of equity is calculated using the Capital Asset Pricing Model Assets are allowed only when productive Expenses are allowed using the prudency judgement

Incentive Based Regulation To follow RoR Gives incentives for the improvement in productivity Given by this formula  P(new) = P(old) [1+CPI –X + Z] Difficult to calculate X Applied with some successes in Britain, Norway, Australia, New Zealand etc Favoured in many countries because it closely mirrors competition To follow RoR Gives incentives for the improvement in productivity Given by this formula  P(new) = P(old) [1+CPI –X + Z] Difficult to calculate X Applied with some successes in Britain, Norway, Australia, New Zealand etc Favoured in many countries because it closely mirrors competition

Tariffs structures and customers categories

Tariffs structures and customer categories Domestic low tariff –Applicable for residential low usage customers (Average usage equal to 100 kWh/month) Domestic high tariff –Applicable for residential high usage customers (Average usage equal to 800 kWh/month) Rural tariffs –Applicable for customers in rural areas (Rages form very low to very high seasonal consumption) Commercial tariff –Applicable to small businesses with an average usage of 2000 kWh/month Domestic low tariff –Applicable for residential low usage customers (Average usage equal to 100 kWh/month) Domestic high tariff –Applicable for residential high usage customers (Average usage equal to 800 kWh/month) Rural tariffs –Applicable for customers in rural areas (Rages form very low to very high seasonal consumption) Commercial tariff –Applicable to small businesses with an average usage of 2000 kWh/month

Tariffs structures and customer categories cont. Large/industrial tariff –Applicable for large customer who are on a Maximum Demand (MD) meters – NER uses a MD of 200 and a load factor of 30 % as a benchmark Special pricing agreements –Large customers that have short to medium term contracts linked to generation availability and/or commodity prices Large/industrial tariff –Applicable for large customer who are on a Maximum Demand (MD) meters – NER uses a MD of 200 and a load factor of 30 % as a benchmark Special pricing agreements –Large customers that have short to medium term contracts linked to generation availability and/or commodity prices

Eskom price increase process

Eskom price increase process The revenue requirement methodology was applied –Determine the revenue that Eskom requires to run its operation in the following year; compare it to the previous year’s revenue and approve the percentage if reasonable – cost based methodology Govt compact (1994 & 1996) – Eskom to decrease their prices in real terms by 20 % by 2000 –Compact achieved The revenue requirement methodology was applied –Determine the revenue that Eskom requires to run its operation in the following year; compare it to the previous year’s revenue and approve the percentage if reasonable – cost based methodology Govt compact (1994 & 1996) – Eskom to decrease their prices in real terms by 20 % by 2000 –Compact achieved

Eskom price increase process 2001 Corportarisation of Eskom – become tax paying entity Shareholder compact between government and Eskom Eskom applied for an increase equal to CPI CPI estimated at 6.2 % NER decided to use the CPI – X + Z formula: X was to be an efficiency factor and Z was an allowance for uncontrollable costs and other risks faced by Eskom (last year of electrification funding) –X = 2 and Z = 1 –Price increase = 5.2 % Corportarisation of Eskom – become tax paying entity Shareholder compact between government and Eskom Eskom applied for an increase equal to CPI CPI estimated at 6.2 % NER decided to use the CPI – X + Z formula: X was to be an efficiency factor and Z was an allowance for uncontrollable costs and other risks faced by Eskom (last year of electrification funding) –X = 2 and Z = 1 –Price increase = 5.2 %

Eskom price increase process to current –Development of RoR methodology –RoR applied for the Eskom price increase Price increase history 2002 to current –Development of RoR methodology –RoR applied for the Eskom price increase Price increase history Year CPI7.4 %8.6 %6.9 %5.2 %5.4 %5.7 %10.1 % Eskom4.0 %5.0 % 4.5 %5.5 %5.2 %6.2 %8.4 % Diff.3.4 %3.6 %1.9 %0.7 %(0.1 %)0.5 %3.9 %

Eskom price increase process Bi-weekly meetings with Eskom as early as January  Discussions are around the methodology to be applied and the format of the application and not about the number/percentage increase to be approved Eskom submits application at end July for only one increase per annum in January the following year NER staff evaluates application from July to mid-October Towards end of October NER’s Tariffs and Pricing committee considers staff recommendations and makes further recommendations to NER board NER board considers recommendations and makes final approval where satisfied NER informs Eskom of its decision Eskom informs customers Bi-weekly meetings with Eskom as early as January  Discussions are around the methodology to be applied and the format of the application and not about the number/percentage increase to be approved Eskom submits application at end July for only one increase per annum in January the following year NER staff evaluates application from July to mid-October Towards end of October NER’s Tariffs and Pricing committee considers staff recommendations and makes further recommendations to NER board NER board considers recommendations and makes final approval where satisfied NER informs Eskom of its decision Eskom informs customers

Municipal price increase process

Municipal Tariffs Munics buy from Eskom and then sell to end- use customers Munics then puts a mark-up on Eskom’s price –Eskom price normally lower than municipal price In 1995 the NER developed the a documents called “Interim National Distribution Tariff System (INDTS)” to guide munics in moving towards similar tariffs – At least in terms of structures The process has been reasonably successful –Rationalised municipal tariff structures from about 2000 to 1100 Munics buy from Eskom and then sell to end- use customers Munics then puts a mark-up on Eskom’s price –Eskom price normally lower than municipal price In 1995 the NER developed the a documents called “Interim National Distribution Tariff System (INDTS)” to guide munics in moving towards similar tariffs – At least in terms of structures The process has been reasonably successful –Rationalised municipal tariff structures from about 2000 to 1100

Brief summary of the INDTS Pricing philosophy Cost behaviour and cost definitions Recommended tariff structures Allocations of cost in structures Benchmarking of electricity prices Cross subsidies Taxation of electricity Document is on NER website Pricing philosophy Cost behaviour and cost definitions Recommended tariff structures Allocations of cost in structures Benchmarking of electricity prices Cross subsidies Taxation of electricity Document is on NER website

Future tariff regulation

Future plans for tariffs Tariff structure rationalisation –Demarcation –In preparation for REDs Evaluating current munic applications according to RED area Further benchmarking is necessary Development of methodology of regulating the retail part of the business –Different from rest of electricity sector - low asset base Transparency and cross-subsidies –Within customer tariff structures –Between tariff structures Tariff structure rationalisation –Demarcation –In preparation for REDs Evaluating current munic applications according to RED area Further benchmarking is necessary Development of methodology of regulating the retail part of the business –Different from rest of electricity sector - low asset base Transparency and cross-subsidies –Within customer tariff structures –Between tariff structures

Cross-subsidisationCross-subsidisation - AgriculturalBulkCommercialDomesticElectrificationIndustrialTraction Revenue Cost c/kWh

Future Tariff structures Will apply Rate of Return methodology for Eskom until divided into separate entities Incentive Based Regulatory Methodology (IBR) will be introduced when ESI and EDI restructuring is completed - Transmission Framework for managing municipal tariffs in process of refinement in preparation of REDs Introduction of Wholesale Electricity Pricing System (WEPS) for large customers Will apply Rate of Return methodology for Eskom until divided into separate entities Incentive Based Regulatory Methodology (IBR) will be introduced when ESI and EDI restructuring is completed - Transmission Framework for managing municipal tariffs in process of refinement in preparation of REDs Introduction of Wholesale Electricity Pricing System (WEPS) for large customers

WEPS Developed in order to level the playing field between large municipalities/Eskom distribution/large customers Unbundling of the tariffs into energy, wires and customer service components Allows for more transparency and cost reflectivity Currently in the process to introduced for a selected group of customers where unbundling is possible Developed in order to level the playing field between large municipalities/Eskom distribution/large customers Unbundling of the tariffs into energy, wires and customer service components Allows for more transparency and cost reflectivity Currently in the process to introduced for a selected group of customers where unbundling is possible

Future electricity prices

Demand Forecast Southern Africa

Future prices SA was in fortunate position of generation over capacity for last 20 years SA will have to invest in new peaking generation capacity within the next 4 to 8 years –These investments needs 3-5 years lead times, depending on the technology that will be used –Replacement costs of base load power station about R35 billion Will also need to invest in Demand Side Management processes – can extend the building of the next power station for up to 5 years Government announced that private sector will be given opportunity to invest in next generation capacity –Will invest if returns are market related and linked to risks –Eskom as a corporate entity operates in the same environment Electricity prices will increase to allow for these future investments SA was in fortunate position of generation over capacity for last 20 years SA will have to invest in new peaking generation capacity within the next 4 to 8 years –These investments needs 3-5 years lead times, depending on the technology that will be used –Replacement costs of base load power station about R35 billion Will also need to invest in Demand Side Management processes – can extend the building of the next power station for up to 5 years Government announced that private sector will be given opportunity to invest in next generation capacity –Will invest if returns are market related and linked to risks –Eskom as a corporate entity operates in the same environment Electricity prices will increase to allow for these future investments

Conclusion NER used internationally accepted regulatory methodologies RoR methodology has been applied for Eskom price increase – done on an annual basis –Last 7 years price increases were below CPI –National distributor Municipal tariffs evaluated according to INDTS –Tariffs have been rationalised –Need refinement in preparation for REDs Future tariff regulation will be influenced by ESI and EDI restructuring processes Future electricity prices will increase due to future capacity requirements NER used internationally accepted regulatory methodologies RoR methodology has been applied for Eskom price increase – done on an annual basis –Last 7 years price increases were below CPI –National distributor Municipal tariffs evaluated according to INDTS –Tariffs have been rationalised –Need refinement in preparation for REDs Future tariff regulation will be influenced by ESI and EDI restructuring processes Future electricity prices will increase due to future capacity requirements