Transcript Chamber of Mines SA - nersa presentation 2010-01-22

Chamber of Mines submission to NERSA
regarding the MYPD2 price application by
Eskom
By Dick Kruger, Assistant Advisor, Economics
Advisory Unit, Chamber of Mines of South Africa
22 January 2010
Introduction, Role of the Chamber of Mines
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Since its establishment in 1889, the Chamber of Mines
has established itself as the pre-eminent voice of
South Africa’s private sector Mining Industry.
The Chamber represents both large and small, local
and international mining companies, and its members
account for 90% of the country’s mineral production
by value.
The Chamber is essentially an advocacy organisation
representing the collective interests of its private
sector mining company members.
The Chamber is very similar to the other international
Chambers such as the Australian Minerals Council or
the Mining Association of Canada.
PRESENTATION OUTLINE
Mining the critical core of the economy?
Exports – key to unlocking South Africa’s economic
growth genie
Reliable and competitively priced electricity is crucial to
the competitiveness of mining and the country’s
beneficiation strategy?
Specific comments on the Eskom application?
Recommendations
Mining – the critical core of the South
African Economy
ROLE OF MINING IN THE ECONOMY IS
OFTEN UNDERESTIMATED
• Largest net generator of forex
• Significant generator of employment (semiskilled and skilled)
• Significant magnet for attracting foreign savings
• Significant multipliers into the rest of the
economy
A prosperous mining sector is critical for the
prospects of the whole South African economy
• Creates 1 million jobs (500 000 direct & 500 000 indirect)
• Accounts for about 18% of GDP (including multipliers & induced effect)
• Critical earner of foreign exchange >50% (incl. secondary products)
• Accounts for 18% of investment (including multipliers & induced effects)
• Attracts significant foreign savings (>30% of value of JSE)
• >30% of all BEE deals done in SA over past 13 years (R200 billion)
• 18.5% of corporate tax receipts (2007 R22 billion, 2008 R33 billion)
• 50% of volume of Transnet’s rail and ports
• 93% of electricity generation via coal power plants
• 15% of electricity demand.
• About 37% of country’s liquid fuels via coal (R30 billion worth)
5
PRESENTATION OUTLINE
Mining the critical core of the economy?
Exports – key to unlocking South Africa’s economic
growth potential
Reliable and competitively priced electricity is crucial to
the competitiveness of mining and the country’s
beneficiation strategy?
Specific comments on the Eskom application?
Recommendations
SA’s poor export performance
identified as country’s “Achilles Heel”
• Several studies (e.g. Harvard Growth Diagnostic) have
identified SA’s poor export performance as the Achilles
heel of the economy.
• Poor export performance results in a larger than is
necessary current account deficit at +/- 7% of GDP.
• Country is then reliant on s/t speculative capital inflows to
cover the country’s poor investment-savings gap (i.e. its
large Current Account Deficit).
• The economic leadership of the country recognise the
criticality of growing exports to raise the overall growth
profile of the economy.
• Key export sectors, such as mining have already faced
significant constraints, such as electricity supply.
Too expensive electricity is just as bad
as no new electricity for growth
• We fully appreciate that not investing sufficiently in the
ESI, will continue to impose a binding growth constraint
on the economy, especially for the export sectors.
• However, having no new electricity capacity for growth is
just as bad as raising electricity prices too quickly (i.e. by
147% in 3 years).
• There has to be an appropriate balance between price
rises and the availability of new supply.
PRESENTATION OUTLINE
Mining the critical core of the economy?
Exports – key to unlocking South Africa’s economic
growth potential
Reliable and competitively priced electricity is crucial to
the competitiveness of mining and the country’s
beneficiation strategy?
Specific comments on the Eskom application?
Recommendations
Electricity is not just a commodity, but is an
indispensible engine of growth
• Electricity is not a commodity but is a KEY input to the
INDUSTRIALISATION and BENEFICIATION ambitions of
government and stakeholders.
• In the absence of the finalisation of the INTEGRATED
RESOURCE PLAN, the current MYPD2 process is effectively
making key decisions that will limit the scope of the country’s
future industrial policy choices.
• It is critically important that coherence be achieved between the
various policies of government, including electricity pricing.
• The MYPD2 process will also limit the country’s policy options
regarding the future structure of the ESI and will entrench the
monopoly status of Eskom.
Electricity is not just a commodity & its pricing and
availability materially affect our current and future
industrialisation choices
Integrated
Resource Plan
Vision 2025, for
South Africa
Coherence of
policies
Industrialisation,
competitiveness
& beneficiation
Does the MYPD2 process adequately reflect the
country’s industrialisation & growth aspirations?
• For a Developmental State, does the corporatisation of public
enterprises square the circle for government in terms of the
country’s industrialisation, beneficiation and growth
aspirations?
• The second 30/11/09 MYPD2 application did show a bit more
strategic thinking by government, but we are not convinced
that the full consequences of the lack of congruence between
MYPD2 and industrial policy has been adequately thought
through.
• To realise the full benefits of SA’s mineral resource
endowment, cost competitive and reliable supply of electricity
is a “sine qua non”
NERSA THEREFORE FACES A HEAVY BURDEN OF DECISION
MAKING IN THE ABSENCE OF THE IRP
The South African economy cannot absorb
such large price shocks
• Global economy is emerging from the first recession in
61-years – the recovery is anaemic.
• The SA economy went into recession for the first time in
17 years. The economic recovery remains fragile,
investment has plunged, consumer expenditure remains
weak and more than 1 000 000 jobs have been lost.
• 35% increase will add >1% onto inflation.
• For industries where electricity is a key input, the
proposed increases will raise costs substantially and
reduce competitiveness.
• For existing industries the ability to adjust production
processes takes considerable expense and time (SO THE
ADJUSTMENT PROCESS IS SLOW).
Estimates of Electricity Pricing Elasticities in
California
(1% rise in the electricity price results in X% decline in demand)
Short run
Long run
residential
-0.06 to -0.49
-0.45 to -1.89
commercial
-0.17 to -0.25
-1.00 to -1.60
Industrial
-0.04 to -0.22
-0.51 to -1.82
*i.e. in the short run the ability of the industrial sector to reduce demand is limited. Only
over time can investment in new energy efficient technologies be processed.
Hence critical need for smoothing
The Mining Industry will be especially hard
hit by the proposals
• Mining is a “PRICE TAKER” and competes on cost.
• Electricity is vital for mines, especially the deep level gold and
PGM mines, and is critical for health and safety.
• The industry has some of the biggest cooling plants and
ventilation systems in the world, to make it possible to mine
underground, and this uses as much as 50% of the electricity
on a deep mine.
• Electricity is also critically important for hoisting, processing,
refining and beneficiation.
• Most of the low hanging fruit of EE has been used (in past 3
years mining saved >400 MW peak through DSM).
• For existing mines, endeavors to mitigate higher electricity
costs would become increasingly difficult and require
significant new investment.
The Mining Industry will be especially hard
hit by the proposals
• The proposed electricity price increases will significantly
raise costs. Problem is costs for most inputs already rising at
high rate & no compensation through weaker exchange rate.
• For deep level gold mines, electricity costs by 2012 will be
300% higher than in 2005, versus other costs rising by 100%
in the same period.
• Faced with decisions to invest significant capital in EE to
counteract higher electricity costs, certain shafts with limited
operating lives (say 5-10 years) may be prematurely closed.
• Older shafts will close, export earnings and jobs will be
forfeited.
• Mines at the upper end of the cost curve become more
vulnerable to closure.
• In ferro alloys, SA becomes a high cost swing supplier.
Key cost drivers in mining
-40
-30
-10
0
10
20
30
40
50
60
56.1
Reinforcing steel
Diesel costs
-20
-20.3
49.5
-28.9
44.2
Structural steel
6.2
27.9
Increase in gold mining costs (excl. capex)
26.6
19.9
Electricity
27.3
16.3
Average labour costs in mining
14.9
14.3
Average PPI Inflation
0.13
10.5
Mining and quarrying prices
-10.2
6.4
Cement
18
2008
2009 (so far)
70
SA Gold mines, key costs base indexed to 2005,
projections for 2010 to 2012
Electricity
costs rise very
fast
600.0
500.0
Costs base indexed to 2005
Labour costs
400.0
Electricity &
water
300.0
Stores
200.0
Total
4 per. Mov. Avg.
(Electricity &
water)
100.0
2005
2006
2007
2008
2009
2010
2011
2012
Electricity becomes 24% of cash costs for gold mines by
2012, versus 13.5% in 2009
Gold mines, cash cost breakdown,
2009
Gold mines, cash cost breakdown,
2012
Other costs, 3.6
Other costs, 7.0
Stores, 23.8
Stores, 26.2
Labour costs,
49.0
Labour costs,
53.3
Electricity &
water, 13.5
Electricity &
water, 23.6
PRESENTATION OUTLINE
Mining the critical core of the economy?
Exports – key to unlocking South Africa’s economic
growth potential
Reliable and competitively priced electricity is crucial to
the competitiveness of mining and the country’s
beneficiation strategy?
Specific comments on the Eskom application?
Recommendations
General comment and principles
• All parties should recognise that electricity is the critical
lifeblood of the SA economy;
• The current Eskom MYPD2 application has to be seen in the
light of the country’s long term growth, industrialisation,
beneficiation, employment & poverty alleviation aspirations;
• The current MYPD2 application must be viewed in the context of
the reform & restructuring of the country’s ESI as the choices
made today will have a substantial bearing on the future
direction of the ESI & the industrialisation of the country;
• Competitively priced and reliable electricity supply is critically
important to realising the industrialisation and beneficiation
objectives of government;
• large “bunched up” pricing shocks have a larger economic
dislocation effect on the economy, than a smoothed approach
of phasing in the price increases over an extended period.
General comment and principles
• Country choices and decisions have to be made now (in
terms of the final IRP), solutions must be properly
implemented and the various tripartite stakeholders must be
allocated responsibilities and should be held accountable for
delivery.
• Eskom has potentially been far too conservative in its
expectation of the negative demand response to much
higher prices. In the short & medium term certain large
industrial sectors will cut back on production & investment
as there are few alternatives to much higher prices.
• The adjustment process in the face of higher electricity
costs is longer in the industrial sectors (where this is
possible) versus the commercial and domestic sectors of the
economy.
CRITICALLY IMPORTANT ISSUES FOR NERSA
TO CONSIDER
• In the absence of final IRP, decisions made in 2010
mustn’t prejudice future strategic choices
• Changes to asset valuation and WACC materially affect
price application
• Operating costs
• Primary energy costs and coal
• Question marks on the cost of the build program
In the absence of final IRP, decisions made
in 2010 mustn’t prejudice future strategic
choices
• The MYPD2 process appears to place the “cart before the
horse” in relation to the expected future structure and
funding of the ESI over the next two decades.
• Without a final IRP for the energy side of the economy, it is
very difficult to make funding and pricing decisions on
issues that are materially relevant to the entire systemic of
the ESI.
• At best the current MYPD2 3-year period should be seen as
an interim arrangement while the IRP is finalised (expected
to happen by June 2010).
Changes to asset valuation and WACC
materially affect price application
• The two areas of greatest contention are in the areas of
“return on capital” and “depreciation expenses” as the
value attached to the weighted average cost of capital
(WACC) and valuation of assets have significant
implications for the prices of electricity paid by consumers.
• This is because both issues materially affect the return on
capital and the return of capital (depreciation) and these
areas alone constitute 39% of the average price increase
proposed by Eskom for the period 2010/11 to 2014/15.
• The importance of WACC/asset valuation methodologies to
revenue streams of electricity utilities does unfortunately
and inevitably lead to strong incentives for utilities to try
and push the boundaries with regulators on these key
issues.
Figure 1: How the Cost of Capital (WACC) and the value of the regulated asset base
feeds through to electricity prices
Regulated Asset Base (RAB)
X
Apply WACC to RAB
+
Depreciation
+
Forecast operating expenses
•Opex
•Primary energy
•Capex
+
Previous years gain/loss
=
Forecast revenue requirement
/
Forecast sales
=
Forecast average price
Problems with asset valuation
methodologies
• The new asset valuation methodology, which substantially
increase the expensing of depreciation costs, results in a
significant windfall revaluation gain to Eskom of R378 billion
on existing assets in 2010. This results in depreciation charges
accounting for the vast bulk of the proposed price increases
over the next 5 years.
• While the migration to a modern equivalent valuation
methodology is contained in the EPP, it is important that the
Regulator questions the relevance of such a methodology for a
vertically integrated monopoly like Eskom.
• The problem is that the valuation change means that Eskom
will lock in a much higher depreciation charge on assets that
have already been paid for by previous electricity users.
• The MEA methodology should only apply to new assets.
Problems with asset valuation
methodologies
• Research by the OECD and others indicates that inflation
adjusted historic cost calculations are normally used in
vertically integrated electricity utilities (such as those
found in Japan and France) while modern equivalent
asset valuation methodology is used in countries where
electricity markets are liberalised (such as the United
Kingdom and Australia).
• Eskom is a vertically integrated state owned monopoly.
Should a vertically integrated 100% state
owned monopoly apply a normal risk driven
WACC?
• Eskom proposed a real pre-tax WACC of 10.3% in MYPD2
versus a 7.3% WACC in the MYPD1.
• The reason that this issue is so important is that a 1 %
point change in the WACC can result in a 5 % point
change in the pricing application (i.e. a 15 percentage
point change in the increase for 3% WACC difference).
• Eskom argues that a 7.3% does not provide a fair risk
adjusted pre-tax real rate of return to Eskom and
therefore has applied for a rate of 10.3% WACC. This is an
area that requires significant scrutiny by NERSA.
Should a vertically integrated 100% state
owned monopoly apply a normal risk driven
WACC?
• Eskom is not a standalone private company competing in a
fully contestable market place with private shareholders.
Eskom is a 100% owned vertically integrated public monopoly,
with a shareholder that wants to promote industrialisation and
development.
• The required rate of return, which is the rate required to cover
the cost of capital of investing in electricity in SA is the return
necessary to cover the risks of business failure.
• Electricity utilities are generally considered to be low risk
businesses as they have proven production technologies &
the demand for electricity is generally predictable.
• With a regulatory environment that allows for the pass through
of prudent costs and expenses, Eskom enjoys a level of
market and pricing security that most businesses do not have.
Should a vertically integrated 100% state
owned monopoly apply a normal risk driven
WACC?
• For a 100% state owned vertically integrated utility with
pricing power and which is backed by a strong sovereign
balance sheet, the cost of capital should equate to the
risk free rate plus a small risk premium.
• Simply stated Eskom has significantly lower risks than
the average private sector company.
• Research by Genesis Analytics suggests a real pre-tax
WACC of closer to the first MYPD1 application of 7% is
relevant.
By FY 2014/15 return on capital and return to
capital is larger than the current electricity price
Composition of proposed electricity price,
Eskom 2nd application, MYPD2
120
Due to changes in
asset valuation and
the high WACC
100
80
Capital and ROA R'bn
60
Primary energy costs
(total) R'bn
Opex R'bn
40
Curren
t price20
Non-Eskom
0
FY10/11
FY11/12
FY12/13
FY13/14
FY/14/15
Operating costs
• Operating costs per unit of electricity sold, goes from 16.9
cents per kW in 2010/11 to 22.4 cents per kW by 2014/15,
an average annual increase of 8.6%.
• Demand side management costs are included in the
operating cost section and rise from R1.5 billion in
2010/2011 to R4.1 billion by 2014/15.
• The Chamber believes that the amount focused on DSM is
too small and should be doubled in the MYPD2 period, as
DSM is critically important in the short-term in relation to
system security (and it is one of the few options for
reducing demand in the short and medium term).
• However, the Chamber recommends that the cost of DSM
be removed from the MYPD2 application and should
instead be funded by the 2 cents per kWh special levy.
Primary energy costs and coal
• Total primary energy costs (Eskom and non-Eskom) are
expected to rise from R40 billion to R69.2 billion between
2010/2011 and 2014/15 (up 18.6% pa).
• The overall primary energy number includes the substantial
reduction in road repair cost, with this responsibility now
transferred to SANRAL. The Chamber supports this
development, but is concerned that the exact method of
calculating the “shadow toll” is unknown.
• Primary energy costs from 19 c/kW to 29.6 c/kW between
2010/2011 and 2014/2015 (up 18% pa). Higher reliance on the
more expensive short-term coal contracts outside of the
traditional cost plus tied collieries and long term contract
collieries is one of the forces driving these costs.
Chamber does not share the same
concerns on coal costs
• Concerns on coal supply and costs are not shared by the
Chamber. Coal export opportunities are not a major threat to
Eskom’s supply as it consumes low quality coal for which
there is a limited export market, & a small domestic market.
• While production costs at the older mines are indeed likely to
increase, the concern that deeper mines & more geological
disturbances will result in cost increases for coal is not
justified as a large part of the additional coal required over the
next 3 years will still be produced by opencast mines (which
currently account for 54% of Eskom’s coal supply).
• The average price paid by Eskom during 2009 is R121-54/t.
During the same period the average price received for steam
coal delivered fob in Richards Bay was R536-75/t. i.e. ESKOM
GETS A GOOD DEAL.
Eskom coal contracting, value contribution per
contract category
100%
90%
80%
70%
Short-term
contracts
60%
Fixed price
50%
40%
Cost plus
30%
20%
10%
0%
2006
2007
2008
2009
2010
2011
2012
AVERAGE COAL PRICES - 2009
• ESKOM (DELIVERED)
• DOMESTIC STEAM
• EXPORT COAL (FOB)
R121-54/T
(FOR)
R157-13/T
R536-75/T
ENERGY VALUES/COST
• ESKOM
• DOMESTIC STEAM
• EXPORT COAL
19,1 MJ/KG
24,5 MJ/KG
25 – 28 MJ/KG
• ESKOM (DELIVERED)
0,64 C/MJ.
• DOMESTIC STEAM
(FOR) 0,64 C/MJ
• EXPORT (FOB)
1,91 – 2.15 C/MJ
• So Eskom has the lowest cost coal price and is
paying one third the cost per MJ of energy compared
to export coals.
Cost of the build program
• Eskom’s capex is expected to be R501.6 billion in the period
2010/2011 to 2014/2015, which is R136.2 billion lower than the
R637.6 billion in the first proposal.
• However, there are some question marks regarding the relevant
costs of the Eskom build program, which may be the result of
information asymmetries.
• Net power station costs for Medupi (R124 billion) equates to
about US$3.2 million per megawatt (MW) versus costs of $1.3
million per MW in India and US$2 million per MW in the USA.
• The differences may be due to the capitalisation of interest in
the cost numbers for Medupi.
• The Chamber recommends that NERSA request a more detailed
explanation of these capital costs from Eskom and the
comparative benchmarks to ensure a more effective discussion
on this key issue.
PRESENTATION OUTLINE
Mining the critical core of the economy?
Exports – key to unlocking South Africa’s economic
growth genie
Reliable and competitively priced electricity is crucial to
the competitiveness of mining and the country’s
beneficiation strategy?
Specific comments on the Eskom application?
Recommendations
CONCLUSIONS AND RECOMMENDATIONS
• In the absence of a final IRP it is clear that the current MYPD2
application has to be seen as an interim arrangement.
However, given the LT nature of the ESI NERSA should
consider a longer time period for price determinations.
• It is critically important that the various policy objectives of
government (i.e. growth, industrialisation, beneficiation,
employment, etc.) are aligned with policies such IRP & EPP.
• While 35% x 3 appears to be better than 45% x 3, the Chamber
is seriously concerned that such a sharp increase in prices (up
147% in 3 years) will be materially damaging to the mining &
mineral processing sectors.
• In this regard the Chamber recommends that a proper
Regulatory Impact Assessment of the costs and benefits of the
price increase on investment, growth, exports, employment
and transformation be undertaken by government.
CONCLUSIONS AND RECOMMENDATIONS
• The Chamber is not convinced that a target price of R1.05 per
kW by 2012/2013 is realistic, justified or in synchronisation
with government development and industrialisation
objectives.
• The two issues in the MYPD2 application that require the
greatest attention are related to the valuation of Eskom assets
and the return on capital calculations, which together account
for 39% of the total electricity price increase by 2014/2015.
• The Chamber recommends that NERSA pay special attention
to the significant windfall gain made by Eskom by revaluing
its assets in terms of the Modern Equivalent Asset value
methodology, versus the traditional inflation adjusted historic
cost. The MEA methodology is normally only used in fully
liberalised electricity markets for private power companies
whereas Eskom is a 100% state owned and controlled
vertically integrated public utility.
CONCLUSIONS AND RECOMMENDATIONS
• NERSA needs to unpack the WACC calculation made by
Eskom. This issue is very significant because for every
1% rise in WACC the electricity price has to rise by 5
percentage points.
• Through a combination of revaluation of assets and a
reconfigured cost of capital the Chamber believes that the
price increase can be limited to 25% per annum over the
MYPD2 period.
• The Chamber recommends that the amount of resources
applied to DSM should be doubled in the MYPD2 period.
However, the Chamber recommends that the funding for
DSM should be removed from the pricing application and
should come from the 2 c/kWh levy collected by Treasury.
CONCLUSIONS AND RECOMMENDATIONS
• Assuming that none of the depreciation or WACC
parameters change and based on some internal
calculations (which were checked with external parties), a
rough R7 billion equity injection by the state in early 2010
will reduce the proposed price increase in the second
Eskom MYPD2 application to 25% (from 35%) in this year.
This is a serious issue that has to be considered by
government to mitigate against the significant negative
impact of a 35% x 3 price increase.
• A 25% per annum increase over three years will be much
more manageable and will cause much less damage when
compared to a 35% x 3 increase. The 25% x 3 rate of
increase would also be congruent with the NEDLAC Energy
Summit agreement and the NERSA indicated price
increases given in the interim 2009 NERSA pronouncement.
CONCLUSIONS AND RECOMMENDATIONS
• The South African government has taken an approach of
providing a limited quasi equity injection (non-interest
bearing loan of R60 billion) and has focused on Eskom
raising the necessary finance through tapping the debt
markets (with government guarantees).
• With limits to Eskom’s balance sheet ability to handle
extra debt (and the risks to the utilities investment grade
rating of exceeding a certain debt level), the solution of
the government taking on some extra debt (the extra R21
billion split over three years as suggested above) and
making this as a further quasi equity contribution should
be explored.
Save Electricity, save jobs, grow the
economy
Please make a special effort to save electricity
Every little bit of saving helps
Play your role for the benefit of OUR country and the mining
industry
Thanks