THE VIABILITY OF THE ESTABLISHMENT OF THE NATIONAL RED / 7th RED

1. THE VIABILITY OF THE ESTABLISHMENT OF THE NATIONAL RED / 7th RED PRESENTATION TO THE PARLIAMENTARY PORTFOLIO COMMITTEE ON MINERALS AND ENERGY By The NERSA Secretariat 23 June 2006 Smunda Mokoena – Chief Executive Officer

2. DISCLAIMER • Due to the short notice the Regulator did not have the opportunity to consider its response and as a result, this presentation is that of the Secretariat only. • The Energy Regulator requests the opportunity to make its submission to this Committee later, once it has formulated its position and more importantly, to extensively comment on the Seven-RED-Model, as soon as more information is available. • Due to the unavailability of information underpinning the National / Seven-RED-Model, this presentation is a preliminary view of the NERSA Secretariat; • This submission is consistent with previous NER decisions. • We are aware of the Cabinet decision of 14 September 2005.

3. OVERVIEW OF SUBMISSION • PURPOSE OF PRESENTATION • CONTEXT OF COMMENTS • EDI restructuring effort • Models evaluated • Basis for modelling • Maximum number of financially viable REDs • Modelling criteria • Financial objectives • THE SIX RED (BLUEPRINT) MODEL • THE NATIONAL RED MODEL • MITIGATING CONDITIONS FOR NATIONAL RED MODEL • CONCLUSION • REQUEST TO PPC

4. PURPOSE OF SUBMISSION • To provide comments on the proposed structure of the distribution industry, particularly the National RED (RED 7) • To ensure that the objectives for restructuring are met in reforming the EDI. • To give the PPC an overview of the development and effort in the restructuring process.

5. EDI Restructuring Effort EDIH 2003 - Present NELF 1993/4 EDIRC 1998/01 EWG 1995/6 ERIC 1997/8 Farm Inn Consultations 2002/3 NELF led to establishment of the NER. NER to restructure through licensing MSF 2005/6 5 Distributors Restructuring Task Force Cabinet Max. number of Financially viable REDs Reticulation issue Voluntary participation Revised Boundaries Non viable entities Inter RED subsidies 24 consultative workshops Detailed modeling International consultants Consolidate into 1 to 17 International Consultants Detailed Modeling EDI Blueprint 6 REDs Financially Independent Mandatory participation NER PARTICIPATION IN GOVERNMENT COMMITTEES

6. G T G T G T D D RED RED RED RED Customers Customers Customers Customers Customers Customers G T D W G LG LG LG LG LG T T T T Customers Customers Customers Customers Customers Customer Choice Customers Structure Models Evaluated 1. Vertically integrated 2. National Distributor 3. Regional Distributors (Recommended) 4. Eskom and some LGs (New Model) 5. Splitting wires and trading

7. EWG Recommendations adopted by Cabinet in 1998 • That the industry be consolidated into • the maximum number of financially healthy independent regional distributors • to strengthen the weakest distributors, • facilitate a standardisation of tariffs, • facilitate the electrification programme and to • increase the efficiency of the industry • so it can continue to be an engine for growth and prosperity. • That the industry • move to cost-reflective tariffs and • that transparent taxes be established for • electrification and • other municipal services • to ensure the industry is able to meet its obligations long-term.

8. EDI Restructuring Effort EDIH 2003 - Present NELF 1993/4 EDIRC 1998/01 EWG 1995/6 ERIC 1997/8 Farm Inn Consultations 2002/3 NELF led to establishment of the NER. NER to restructure through licensing MSF 2005/6 5 Distributors Restructuring Task Force Cabinet Max. number of Financially viable REDs Reticulation issue Voluntary participation Revised Boundaries Non viable entities Inter RED subsidies 24 consultative workshops Detailed modeling International consultants Consolidate into 1 to 17 International Consultants Detailed Modeling EDI Blueprint 6 REDs Financially Independent Mandatory participation NER PARTICIPATION IN GOVERNMENT COMMITTEES

9. Viable 1 5 10 15 20 25 30 Industry viability Not Viable Number of Distributors “Maximum number of financially viable REDs” • Any number of REDs can be viable if they charge their full cost to consumers and the consumers are able to pay. • The challenge is to find a position where tariffs reflect cost and are aligned between distributors. • Within a RED, the cost to supply customer categories are pooled to have equitable tariffs. Proposed number of distributors • EWG process, between 1 to 17 • ERIC process, optimum 5 • EDIRC process, recommended 6 • New proposal • 6 Metro REDs (Urban) PLUS 1 National RED (Municipalities and Rural) • National RED not financially independent; • REDs not balanced; • No supporting report • No evidence of detailed modeling.

10. EDI Blueprint Modeling Criteria • Size – loss of economies of scale in creating businesses that are unmanageably large; • Balance between REDs • Urban / rural customers: each must have a significant urban load centre; • Load mix: domestic load is a key cost driver and should be balanced across REDs; • Assets employed: Broad equivalence in the assets employed; • Load density (MWh per km line) should be balanced; • Load factor: balanced within a small range, above 70% LF; • Income per household balanced across REDs • Financial independence • Avoid long term financial transfers between REDs; • Implementation cost • Observe network configuration; • Observe facility requirements: Control centers; work management centers; stores and depots; • Observe significant geographical boundaries: physical and political.

11. Financial requirements • Need strong robust REDs • Fund ongoing operation; • Fund required new capital expenditure; • Service debt; • Earn reasonable return on equity at prices which reflect efficient supply costs. • Blueprint Recommendations • Reliance of any one RED on financial transfers from other, financially stronger REDs should be avoided, except for the possibility of limited financial support during the establishment phase. • A system in which some REDs are financially strong and others weak would be a critical mistake, and against the long-term interests of final customers. • Any scheme of inter-RED financial transfers would quickly come under pressure, and be the cause of difficulty and tension from the outset. • A desire by the stronger REDs to avoid/minimise the cash transfer is inevitable, the effect of which would be to place the weaker RED under financial strain – to the ultimate detriment of the final customer.

12. EDI Restructuring Effort EDIH 2003 - Present NELF 1993/4 EDIRC 1998/01 EWG 1995/6 ERIC 1997/8 Farm Inn Consultations 2002/3 NELF led to establishment of the NER. NER to restructure through licensing MSF 2005/6 5 Distributors Restructuring Task Force Cabinet Max. number of Financially viable REDs Reticulation issue Voluntary participation Revised Boundaries Non viable entities Inter RED subsidies 24 consultative workshops Detailed modeling International consultants Consolidate into 1 to 17 International Consultants Detailed Modeling EDI Blueprint 6 REDs Financially Independent Mandatory participation NER PARTICIPATION IN GOVERNMENT COMMITTEES

13. THE SIX RED BLUEPRINT MODEL Process and Analysis • Developed through a very thorough consultation process • Based on extensive independent consultancy support • Rigorous modelling with aim of achieving restructuring objectives • Recommendations were preceded by substantial expenditure to enable the best possible solution Outcomes • Restructuring objectives met; • REDs are balanced; • REDs are independently financially viable; • Mandatory participation by both Eskom and the municipalities;

14. THE SIX RED BLUEPRINT MODEL (Cont…) Outcomes Continued • No gross tariff disparities in neighbouring communities; • Cost reflective tariffs and viable supply areas; • Potential for a better credit rating; • More attractive to scarce skills; • Faster decision making; • Best able to incorporate / be responsive to local stakeholder input and needs; • More likely to foster competitive behaviour leading to improved levels of service and efficiency

15. THE NATIONAL RED MODEL PROCESS AND ANALYSIS • No public document • No evidence of a detailed study and analysis • Not aware that stakeholders, including NER / NERSA were consulted on the change to a National RED / 7th RED OUTCOMES • REDs, not balanced; • National RED not financially viable; • National RED is substantially larger: long communication lines, removed from local constituencies;

16. THE NATIONAL RED MODEL (Cont…) OUTCOMES CONTINUED • Potential for large tariff discrepancies with Metro REDs and negative impact on customers; • Require subsidies from Metro REDs or the Fiscus: tension and reluctance to subsidise potential inefficient operations; • Reluctance to cash transfers will place the National RED under financial strain; • Challenge to regulate efficiency of operations - National RED can not be benchmarked against the Metro REDs; • Single rural entity with central planning and execution – potentially stifles much needed innovation and learning and inter RED competition. • Voluntary participation in the REDs is likely to result in the industry not changing substantially from its present status. • Unresolved policy issues.

17. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Financial viability of the National RED Concerns • The National RED is not financially viable; • Continued financial support is required to contain tariffs at equitable levels between the REDs; • Metro REDs will be reluctant to transfer cash to the National RED; • Metro REDs will be reluctant to accept a higher bulk purchase tariff (wholesale) than the National RED Condition • Provisions from the fiscus be put in place to fund a National RED.

18. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Ownership and Governance of a National RED Concerns • Uncertainty regarding industry ownership and governance; • Transition arrangements are likely to cause further uncertainty and delay restructuring to the end state. Condition • A firm policy position must be taken regarding the ownership and governance structure of the National RED and implemented from day one. • Transfer of staff, assets and customers to the REDs on day one.

19. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Regulation of the National RED Concerns • No provision is made for the Regulator (NERSA) to regulate the National RED • The Regulator is the only entity that can ensure the regulatory objectives are achieved • Regulatory skills are scares. Condition • Appropriate legislation be put in place to ensure the National RED, and the Metro REDs are regulated by NERSA

20. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Municipal levies (taxes to replace surpluses) Concerns • Municipal revenue will be impacted by the restructuring of the EDI. • Uncoordinated taxes could result in irrational and discriminatory levies on electricity sales. • Customer resistance to input taxes impacting competitiveness. • Discriminatory windfall taxes to municipalities with large users. Condition • legislation to ensure fair and equitable levies are raised by municipalities, to replace the existing surpluses generated

21. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Tariff rationalisation Concerns • The National RED will have a different cost structure from the Metro REDs. • The regulatory principles for rationalisation of tariffs in the industry can not be applied uniformly; • Cost reflective tariffs will not be uniform between REDs; • Customers will want to move RED boundaries. Condition • Metro REDs should be allowed to expand their customer base to adjacent areas in the National RED.

22. MITIGATING CONDITIONS FOR NATIONAL RED MODEL Issue: Voluntary participation by municipalities Concern • Voluntary participation of municipal distributors in the National RED is a major cause for concern in restructuring; • An inflexible stance by stakeholders will continue while unresolved policy issues can still be influenced in their favour; • An inappropriate industry structure could result; • Using incentives to encourage voluntary participation may lead to discriminatory treatment of consumers by the National RED. Conditions • Outstanding policy issues must be urgently resolved to obtain mandatory municipal participation.

23. CONCLUSION • Not enough time was available for the Energy Regulator to formulate its position; • We have no details on the National RED; • We have supported EDI restructuring throughout the existence of the NER; • We have indicated our preference for the six RED model, based on sound restructuring principles; • Notwithstanding, we recognise that if policy makers wish to proceed, we will support it . • Subject to the mitigation conditions for the deficiencies of the National RED model;

24. CONCLUSIONS (Cont..) • Continued delays in the restructuring and policy uncertainty is at the expense of the industry. This is reflected in • Underinvestment in infrastructure; • Lack of appropriate maintenance; • Loss of skills and deterioration of assets; • Excessive transfer of electricity revenues to municipal surpluses. • Policy finalisation is a matter of critical urgency; • Delays increases restructuring costs; • Delays may limit potential investors.

25. Request to PPC • The NERSA Secretariat respectfully requests that the Parliamentary Portfolio Committee consider the comments and recommendations of the NERSA Secretariat. • Due to the unavailability of a public document on the National RED, the Regulator, respectfully request an opportunity to comment on such a document, once it is publicly available. Thank you for your attention