Eskom’s pricing proposal for the MYPD2 Nersa public hearings Jan 22, 2010

1. Eskom’s pricing proposalfor the MYPD2Nersa public hearingsJan 22, 2010 Dr. Miriam Altman Executive Director Centre for Poverty, Employment & Growth HSRC maltman@hsrc.ac.za

2. Eskom request • Eskom has applied to NERSA in respect of the MYPD 2, over the period from 2010/11 to 2012/13. • Its initial submission in September 2009, Eskom requested a 45% nominal increase in each of the three years. • A revised application in Nov 2009, reduced this request to 35% per annum for three years, then rising by 13% pa for 2 years, based on revised assumptions.

3. Central cost drivers = • Increasing primary energy costs, especially in respect of coal • A revaluation of assets on the basis of Modern Equivalent Assets (MEA) approach versus previous applications were based on inflation-indexed historic asset valuations. • An increased requirement for electricity generation, currently expected to be produced by Eskom, thereby inducing a substantial capital expenditure programme • An assumption that equity and loan finance would be limited, requiring high reliance on funding capex from tariffs • Revised applications assumes: • An assumption of reduced sales arising from DSM induced savings of 8.5 TWh over five years as well as the diffusion of solar water heating. • The building of Kusile is delayed and certain expenditures that had been expected are removed in relation to initiating coal fired power station (coal 3), nuclear power, and IPP expenditures, amongst others. • Cost reductions in opex, especially to reflect reduced sales as a result of DSM initiatives as well as efficiency improvements. • The provision for road maintenance and repair is removed after 2010/11, with the understanding that the maintenance would be undertaken by the provincial government or the SA Roads Agency Ltd (SANRAL) with Eskom paying “shadow toll fees” amounting to about R 6bn • An assumption is made of additional borrowing by R 8.5 bn, and of R 20 bn in private equity, sourced from the private sector.

4. Background to our input • Submission in 2008, and commentary early 2009 • In this period: • Re-modelling of eskom finances • Modelling of economy-wide impacts • Stakeholder dialogue

5. How to use our financial modelling results • The financial modelling is indicative of the potential impact that different approaches to pricing might have on Eskom and on the economy. • The model is not precisely the same as that used by Eskom, but we believe it is sufficiently close to give a solid indication of impacts. • They are shared with the intention of offering an independent technical view on Eskom’s pricing proposal. • We present only one alternative scenario. However, the model is ideally used to ask ‘what if’ questions about other pricing scenarios.

6. What we did • Review of eskom figures – previous years, initial submission, revised submission • Engagement with Eskom and experts • As with other commentators, our main concerns include: primary energy costs, construction costs, cost of capital, rising opex, etc. • We are especially concerned with treatment of SPAs and exports • Is about 10% of revenue, but don’t know what share of expenditure or if included/excluded in Eskom application • For a baseline model, we have: • used new assumptions built into Eskom’s revised application • altered the macroeconomic assumptions • reduced & elongated the introduction of price increases • used historic asset valuation

7. Assumptions on macroeconomy • Eskom’s macro-economic assumptions are not made clear and sometimes seem not to be internally consistent. • This particularly relates to its assumptions about the CPI, PPI, exchange rates, and GDP growth rates • We introduced assumptions used by national Treasury

8. Our scenarios • We present one scenario based on following: • Retain 2c levy for 5 years • Introduction of 3% opex reduction every year • Higher borrowing (R 50bn over 5 years) • Financial targets in our modelling • Interest cover must be more than 2 • Limit of additional borrowing to R 10bn pa on avg • Achieve approx 80c/kWh by end of 5 year period in real terms • WACC to exceed 8 • Could also consider scenario without toll fees (R 6bn), DSM (R13bn), etc. However, they are included in costs for this round

9. Scenario to stimulate discussion

10. Implications • Nominal price increase proposed = 32/31/30/13/13 • Price: • Reaches 0.98c/kWh by 2014/15 (vs R1.05 in Eskom revised submission) – nominal • Reaches 0.79c/kWh by 2014/15 (vs R 0.84c in Eskom submission) – real 2009/10 Rand • Borrowing: • treated as residual, with cap • approx R 50 to 60 bn more than currently planned by eskom • would require R 27.3 bn more guarantees • Levy retention: • Just over R 5 bn pa = R 26.3bn over 5 years • Loss of income (Rbn) to fiscus for ?? Energy saving measures??

11. Economic impact • a 27% price increase could cause electricity consumption to fall by 5%, whereas the 72% price increase would be required to reduce consumption by 10%. This assumes that price is the only consideration, and that there are no incentives. This shows how difficult it can be to rapidly reduce consumption past the first phase of ‘low hanging fruit’. • The potential economic impact of a once-off price rise of 35% could include: • CPI rises by 1.2% more than it would otherwise. Half the inflationary impact stems from the direct impact on electricity costs for consumers, and half from the indirect knock-on effects on the cost of other goods in the CPI. • Low income households are disproportionately affected. The CPI for poor households rises by 1.6%, as opposed to 1.1% for rich households. • Even if poor households received free electricity, their costs would rise by 0.7% as a result of the indirect effects of the 35% electricity price increase. • The PPI would rise by 1.3 % more than it would otherwise, and this would raise the cost of a representative basket of SA exports by 0.9%. • The impact on GDP would be very small, approximately -0.1%. • The impact on employment depends on how companies respond. We estimate that total employment might fall by between 0.24% and 0.60%. This amount to about 25,000 to 50,000 jobs, mostly expected to be lost by lower skill workers.

12. Economic impact • electricity accounts for approximately 1.1% of all costs in services and manufacturing • 1% or less of total costs in 55 out of 94 sectors and less than 2% in 72 sectors. • On average, electricity accounts for 1.7% of household expenditure • Sectors where electricity accounts for 4% or more of costs = Firms will adjust, and will be more concerned with security of supply

13. Support for adjustment is urgent • Eskom still budgets R 13.4 bn for DSM over 5 years • DSM is not core to Eskom’s business and should rather be implemented by agencies set up for this purpose • Eskom’s approach barely grazes what is possible on industrial side over the medium term. • DSM incentives should be aligned to existing industrial cash and tax incentives available to firms and consumers for physical and process innovations. • The dti has introduced the Developmental Electricity Pricing Programme (DEPP) to attract new investments that would benefit from a discounted electricity price. • There are existing programmes that could be altered slightly to have an important impact on the energy efficiency. Examples of these programmes include: • the accelerated depreciation allowances on manufacturing equipment, mining, bio-waste and small-medium enterprises. • the dti’s Small, Medium Enterprise Development Programme (SMEDP) subsidises the capital investment of new and expanding firms in a range of sectors. • The dti’s Critical Infrastructure Programme (CIP) is a non-refundable, cash grant that is available to the approved beneficiary upon the completion of an infrastructure project that can be shown to underpin a group of further investments in a location. • New programmes would be needed for services such as accommodation, property and retail • Such adjustments could potentially halve the economic impact, and also put SA on a lower energy usage path

14. Other comments • Assymetric information creates difficulty in making recommendations. • Value of independent model – can be used to shift assumptions and ask ‘what if’ • Urgent need for certainty re: price path to achieve target • Private investment - whether in existing or new, can Eskom really raise more than 20 bn over the next 5 years in private equity? • Key policy choices need to be made alongside, esp by Treasury, DPE and DoE. This creates difficulty for revised application and our recommendations • Approach to buffering the poor needs to be concluded, and not only for indigent