The five key questions Nersa will have to answer

5th February 2010 By: Terence Creamer - Creamer Media Editor

The vital issue of electricity supply security will be the elephant in the room when the National Energy Regulator of South Africa (Nersa) meets to make a final determination on what yearly tariff increases to grant Eskom for the three-year period between April 1, 2010, and March 31, 2013. But, to reach that point, there are really five somewhat more mundane, or technical, questions that the energy regulator will need to consider and answer ahead of its February 24 announcement.

The first of these relates to whether Nersa has the legal authority to arrive at a decision at all.

At first blush, this is a nonquestion. But, on deeper inspection, there may be a problem. In fact, a number of speakers at the January public hearings into the merits, or otherwise, of Eskom’s application questioned whether the policy environment truly existed for Nersa to make the tariff determination.

The most strident of these critics was former Water Affairs director-general, and now University of the Witwatersrand academic, Dr Mike Muller. In his submission, Muller described the process to determine the tariff increases for South African electricity producer Eskom as “formally dysfunctional”. Therefore, he called on Nersa to recuse itself and to request the political authorities to make the policy decisions necessary for a tariff determination to be made. Alternatively, those same political authorities could use the information garnered from the regulator’s national roadshow, as well as from the written submissions, to make an immediate political intervention in the “national interest”.

Similar concerns about the current policy void were expressed by a number of other presenters, but Muller was the first to argue that these deficiencies actually imperilled the Nersa process.

Valuations and Returns
Should Nersa be satisfied, however, that the legal building blocks are indeed in place, even though these may be flimsy (and it should point this out, in no uncertain terms), then it will need to move on speedily to resolving four other the tariff-determining questions.

Its next, and arguably the biggest, decision relates to whether or not it agrees with the asset valuation methodology used by Eskom in the second multiyear price determination period (MYPD2) application.

The utility has interpreted the stipulation (contained within the electricity pricing policy) for a revaluation of its assets to mean that it should use the modern equivalent asset (MEA) revaluation model.

By contrast, many presenters have argued that the “less subjective” index historic cost (IHC) methodology would be the best regulatory practice.

The MEA method, analysis by Genesis Analytics showed, could inflate Eskom’s revenue requirement and, in turn, its tariff request by as much as 10c/kWh. And, if accepted, it could even lead to a revenue windfall for Eskom.

Thirdly, there is the question of what constitutes a reasonable and sustainable rate of return for a State-owned enterprise, such as Eskom – a question that has links as much to the valuation model chosen as it does to one’s ideological perspective.

Eskom proposes that its return be based on a weighted average cost of capital, or WACC, of 10,3%, arguing that this had been benchmarked.

But the Chamber of Mines (CoM), among many others, argued that the utility’s real pretax WACC should be equivalent to the risk-free rate plus a small premium, owing to the fact that Eskom is considered to be a low-risk, long-term business owned and supported by the State. This means that the WACC calculation should be as much as three percentage points lower than that proposed by Eskom. The chamber also warned that every 1% rise in the WACC represented a five- percentage-point increase in the electricity price.

Costs and DSM
Fourthly, Nersa will have to decide whether it agrees with Eskom’s operational- and capital-cost assumptions.

Genesis Analytics described Eskom’s modelled cost increases (relating to primary energy, as well as general running costs) as “generous”. Naturally, this view found many supporters, who urged the regulator to interrogate Eskom’s surging operational costs, as well as those associated with its R400-billion build programme. They also urged the regulator to put in place instruments and a monitoring mechanism to ensure greater efficiency at the utility.

Finally, there is the question as to whether Eskom should receive money for demand-side management (DSM).

In its application, Eskom has sought to recover R1,5-billion in DSM costs for 2010/11, R1,8-billion in 2011/12 and R2,8-billion by 2014/15. This money would be applied to various demand-reduction programmes, including the installation of solar water heating and the roll-out of energy efficiency solutions in commercial buildings, factories and mines. The aim is to reduce demand by 2 000 MW, or 8,5 TWh.

Now, there is broad-based support for the concept, with the CoM even suggesting that Eskom’s application lacked ambition in this regard.

But most presenters also argued that Eskom is a conflicted participant in DSM, as its core objective is to supply and sell more electricity, not less.

For this reason, most stakeholders are of the view that the DSM budget should be excluded from the application, that an independent agency be empowered to take up the programmes and that its budget be derived directly from the fiscus.

Overall, “less generous” return and cost-increase assumptions, as well as the exclusion of DSM and roads-related costs, Genesis Analytics showed, would enable the regulator to approve three yearly increases of 25%, with the “comfort” of knowing that Eskom would remain sustainable.

On the other hand, Eskom has some fairly robust arguments contesting each one of these key points, with its acting chairperson and CEO, Mpho Makwana, also warning that there is a real risk that the determination process may have to be “reopened” in the event that the lower increases granted by Nersa could be shown to be unsustainable.

Without doubt, these will be the toughest questions ever pondered by Nersa and there is every possibility that it could emerge as the political fall guy – especially given that it is going to have to do the responsible thing and set aside the politics of the moment to deal with the very real, yet less immediate threats to electricity stability.