1. Electricity Pricing: Presented by: AT Audat (Acting CD: Electricity) 06 August 2013 1

2. Table of Contents Introduction: – Enabling Policy – Legislative Mandate Policy Position: – Generator Pricing (Utility) – Generator Pricing (IPP) – Wholesale Pricing Focus - Electricity Pricing Methodology: – Historical Cost approach. – Depreciated Replacement Cost approach. Eskom’s asset re-evaluation Conclusion 2

3. Enabling Policy Electricity Pricing Policy of 2008 sets out the following electricity tariff setting principles;- 1. “Regulators may select from a range of methodologies to regulate the electricity industry”..allowing a full cost recovery and reasonable return on assets. 2. Following principles should be applied; revenue requirement cost reflectivity transparency and unbundling costs (customer bill) Non-discrimination Access to and Use of Networks Long term price outlook Introduction 3

4. Enabling Policy Electricity Pricing Policy of 2008 sets out the following electricity tariff setting principles;- 3. Must provide for (or) prescribe incentives for continued improvement of the technical and economic efficiency with which services are to be provided; 4. Must give end users relevant information regarding the costs that their consumption imposes on the licensee's business; 5. Must avoid undue discrimination between customer categories and may permit the cross-subsidy of tariffs to certain categories of customers.; Introduction 4

5. Legislative Mandate Electricity Regulation Act of 2006 confers upon the National Energy Regulator of South Africa (NERSA) powers and duty to regulate electricity prices and tariffs. Section 4 (a)(ii) states “the Regulator must regulate prices and tariffs.” Section 14 (1)(d) states “The Regulator may make any licence subject to conditions relating to - the setting and approval of prices, charges, rates and tariffs charged by licensees;. Section 15 (1)(a-e) states “A licence condition determined under Section 14 relating to the setting or approval of prices, charges and tariffs and the regulation of revenues -;.” Introduction 5

6. Recap on key policy position (from EPP); Generating pricing structures must reflect the efficient cost of supply of the generator or alternatively approved Power Purchase Agreement. Tariff structure may consist of the following; (i) capacity charge (ii) energy charge and (iii) ancillary services. Customer must be given an opportunity to sell ancillary services to the grid on a fair and non-discriminatory manner. Generator pricing structures must not hinder efficient and least cost dispatch of the generating units. Policy Position 6

7. 7 In addition to the standard range of pricing products provision is also made in the EPP for the development and introduction of special products and prices. (i.e. demand side management, energy efficiency programmes) The revenue requirement for a regulated licensee must be set at a level which will cover the full regulated business cost. (including a reasonable margin or return). The regulatory methodology must anticipate investment cycles and other cost trends in order to prevent unreasonable price volatility and shocks (price spikes) while ensuring financial viability, continuity, fundability and stability over the short, medium and long term assuming an efficient and prudent operator. Policy Position: (General)

8. 8 Electricity generation pricing structures will reflect the cost of supply of the generator or any approved Power Purchase Agreement (for IPP’s). Generator pricing structures must not hinder efficient and least cost dispatch of the generating units. The price paid for electricity generated in South Africa or imported to South Africa must be based on either the appropriate and approved regulatory method or on conditions set out in the approved PPA. Electricity purchases from new supply options must be evaluated and approved against the appropriate avoided system cost. NERSA may approve a framework to expedite the determination and approval of prices from supply options (e.g. short term purchases). Policy Position: Generator Pricing

9. 9 Additional economic implications following the introduction of renewable energy support mechanism will be factored into the price of electricity in accordance with prevailing policy. Cost of renewable energy sources approved by NERSA will be recouped from customers in the same way as for “conventional” energy sources (for example a Single Buyer of electricity). Licensees must take full advantage of the financial benefits that flow from the Carbon Development Mechanism and other similar mechanisms (including tax concessions) which should be factored into the price of electricity. The environmental levy should be used to fund RE-IPP development instead of imposing an additional 1%- 3% on the electricity price increase. Policy Position: Generator Pricing (RE- IPP’s)

10. 10 Wholesale energy prices must encourage the efficient use of electricity at all times and must reflect the Time Of Use (ToU) structure differentiated cost of supply. The wholesale energy prices structure must be periodically reviewed and updated by the wholesaler. Wholesale energy prices must cover the cost of wholesale energy and purchases. International customers connected to the transmission system must not receive subsidies intended for South African customers. Policy Position: Wholesale Pricing

11. 11 All licensed wholesale purchasers must have access to the wholesale pricing mechanism on a non-discriminatory basis. Wholesale energy prices must be available to all qualifying wholesale purchasers (including licensees who export electricity) on a fair and non- discriminatory basis. (excludes cross-subsidies intended for SA customers) NERSA to determine qualification criteria for Wholesale Electricity Pricing System (WEPS) customers and implementation subject to cross subsidy stipulations in this EPP document. Policy Position: Wholesale Pricing

12. Electricity Pricing Formulation: (Multi Year Price Determination) -MYPD- First MYPD implemented by the Regulator for period 01 April 2006 to 31 March 2009. (Generation, Transmission and Distribution business activities) MYPD incorporates principles of Rate of Return (RoR) and incentive based on the transmission and distribution service incentive scheme. RoR states: “the revenue to be earned by Eskom should be equal to the efficient cost to supply electricity plus a fair return on the rate base” RoR Generation Formula: (in theory) AR = Return on RAB and working capital + OPEX + Depreciation + PE costs + TX charges +/-Risk adjustment Focus: Electricity Pricing 12

13. (Basic Definitions) -MYPD- AR (Allowed Revenue) Revenue that the utility is allowed to collect from the total sales of its commodity. Depreciation Cost allocated to an asset (or asset class) due to both use (wear and tear) and aging (obsolescence). Used to repay current assets and to build cash reserves for new assets. Regulated Asset Base (RAB) {MYPD 3 – Eskom Full RAB} Refers to the measure of the net value of a company’s regulated assets used in price regulation. Drives two of the fundamental building blocks that make up the company’s revenue requirements. Focus: Electricity Pricing (Basic Definitions) 13

14.  Cost Drivers: 1.Acquisition cost of asset (Dep + RoCap) 2.Operating and maintenance cost (O&M) 3.Fuel cost (PE) “Cost reflective revenues” imply recovery of these costs, over the operational life of the assets.  The basic regulatory revenue formula (to recover these costs over the life cycle of the assets) consist of four ‘building blocks’: AR = PE + O&M + Depreciation + Return on Capital - with Depreciation and Return being the mechanism for recovery of the original acquisition cost (whether using historical cost or replacement methods) Note: AR = Allowed Revenue, with the average tariff being AR / sales volume 14 Electricity Generation Costs Dep + Return on Cap are based on Regulated Asset Base (Asset Valuation NB)

15. Life cycle revenue profile of four ‘building blocks’ : historical cost basis (HC) (single asset) HC method The four building blocks as shown in the graph do nothing more than to recover the full life cycle cost, however with steeply declining tariff. ‘Constant’ Rand billion NOTE: Historical Cost (HC), and Levelized Cost Of Energy (LCOE) are equal to each other, and equal to original asset acquisition cost. 15

16. DRC method (MYPD 3 Approval) Life cycle revenue profile of four ‘building blocks’ : replacement value / inflation indexed basis (single asset) The four building blocks as shown in the graph do nothing more than to recover the full life cycle cost, but with much flatter tariff profile. ‘Constant’ Rand billion NOTE: Depreciated Replacement Cost (DRC) and LCOE are equal to each other, and equal to original asset acquisition cost. 16

17. Eskom tariffs set from 1988 to 2000 on basis of Real ROA and ‘current cost’ of assets (similar concept to replacement values) – %ROA however a bit below real WACC% From 2001 to 2008 Eskom was regulated on the basis of historical cost (but making losses in some years) EPP and MYPD2 & 3 intends to migrate back to the original tariff path, without however recovering earlier shortfalls Revaluation of old assets: does it not twice capture the high parts of the life cycle tariff profile?

18. (MYPD Levies) Environmental Levy Determined based on coal production plan as submitted by Eskom. (MYPD 3– embedded in the energy charges {ease of billing by Eskom}) NERSA – advocates for using of this levy purchase “green energy” from RE-IPP programme Carbon Tax Based on calculated/expected carbon emissions and will apply across carbon emitting industries. (i.e. not only on electricity production – coal fired power stations are biggest contributors) Focus: Electricity Pricing (Basic Definition 18

19. Issues to note: The Electricity Pricing Policy needs to be reviewed to take into account current policy implementation challenges. A long-term electricity price path needs to be developed in line with the Integrated Resource Plan (as revised from time to time). Industry is in a state where more power stations needs to be built to facilitate the country’s economic growth aspirations. Tariff will increase as more capital needs to be raised for the build programme (Utility or IPP’s) Rate at which Independent Power Producers are introduced to the industry will have an impact on RSA’s tariff trajectory. Conclusion 19

20. Issues to note: State’s policy must be clear on Eskom financial position Simple formulation: 1. Stand-alone credit rating 2. Rely on state support to raise finance. Both regulatory revenue methodologies (HC & DRC) recover all life cycle costs – an important aspect of sustainability. Although both methods only cover cost of existing (not future) assets, the tariff stability (thus lower risk) of DRC greatly facilitates funding for new assets Conclusion 20

21. Thank You 21