RMB FIXED INCOME, CURRENCY & COMMODITIES Electricity Tariff Proposal

RMB FIXED INCOME, CURRENCY & COMMODITIES

Electricity Tariff Proposal

2RMB Fixed Income, Currency and CommoditiesElectricity Tariff Proposal

PART ONE: FOUNDATIONAL PRINCIPLES


The Importance of Electricity

• “Power corrupts, but we need the electricity” - Anon

• Economic development has been intrinsically coupled to electricity use.

• The lack of electricity, or insufficient electricity, is a key concern for all governments.

• If people who don’t have it live close to ‘wires’ that carry it, they find ways to get it.

• Its absence is usually associated with poverty and reduced quality of life.

• The information revolution would not be possible without a stream of electrons.

• It is clearly an integral part of our lives and has a large component of public benefit associated with it.

Source: Carl J Weinberg, “Keeping the lights on – Sustainable Scenarios for the Future”


The Importance of Electricity

“HOW WILL THE ELECTRICITY TARIFF STRUCTURE ENABLE ACCESS TO ELECTRICITY IN ORDER TO MAINTAIN OUR QUALITY OF LIFE IN A SUSTAINABLE MANNER?”

An Electricity Tariff Structure has to therefore facilitate the following 3 objectives:

• Accessibility – It must be such that it does not become a barrier to the effective use of, and derivation of benefits from, electricity for ALL.

• Quality of Life – It should promote continual improvement in quality of life for ALL.

• Sustainability – The tariff should be determined such that the sustainability of electricity supply is assured, as well the sustained promotion of access and quality of life.


Accessibility: The Apportionment of Risk in Tariff Structuring

The electricity tariff has to promote accessibility.

The manner in which the tariff changes also has to promote accessibility.

The ability of different groups of consumers to absorb price increases is vastly different, e.g.:

A household with a fixed monthly income increasing at a much lower rate than the electricity tariff will not be able to absorb price increases as well as a large corporation that has the ability to pass costs onto its customers.

The differing ability of consumer groups to absorb price increases will lead to unequal distribution of access to electricity – those with pricing power will continue to enjoy its benefits, whilst those on low fixed / uncertain incomes will be enjoying a lower level of access.

In order for ALL consumers to continue to enjoy ACCESS to electricity, the manner in which the tariff is structured should cater for the differing ability of groups to absorb increases in price


Quality of Life: The Promotion of Economic Activity

The proposed tariff structure, whilst promoting access to electricity, should also stimulate and promote economic activity:

Through the promotion of economic enterprises and endeavour, the resultant spin offs such as job creation, infrastructure development, etc. will form the backbone of maintaining and improving standards of living.

In order to improve the quality of life for ALL, the manner in which the tariff is structured should promote economic activity and job creation, and ensure that the price of power in SA remains internationally competitive.

• Infrastructure Development

• Job Creation

• Attracting Foreign Investment

• Encouraging Industrial Activity


Sustainability: Matching Revenues with Costs

In order for a tariff structure to promote the sustainability of the electricity system and cater for future expansion, it must be able to:

The above characteristics will ensure that consumers are happy to accept the tariff on an ongoing basis (because they can observe the basis for it).

In order to ensure the sustainability of electricity supply, the tariff structure must lock in profit margins for the electricity utility, protect those margins against rising input costs and have social legitimacy through transparency.

• Keep pace with increased input costs

• Lock in an acceptable profit margin for the electricity utility, regardless of fluctuating input costs

• Furthermore, the tariff structure must be:• Transparent, • Easily observable • Internationally comparable


RMB’s Proposal

In order to create an electricity tariff structure that achieves the following:

• Access to electricity while taking into account the differing abilities of consumer groups to absorb price increases

• Maintains and improves Quality of Life by promoting economic activity and job creation

• Sustainability of Supply by locking in margins and guarding against input costs, while being transparent and observable

RMB Proposes the following:

• A two tiered tariff system

• Coal market linked pricing for energy intensive industries

• Fixed electricity prices with inflation linked increases for smaller business and households

• The establishment of a Listed Power Market in South Africa, in order to:

• Provide a mechanism for energy intensive industries to hedge themselves and manage their price risk

• Create internationally observable and benchmarkable industrial power prices.


Impact on Stakeholders

Stakeholder Impact

Eskom Eskom locks in a guaranteed profit margin to fund the build programme and can also sell power forward as an alternative to debt finance. Eskom is insulated (and actually profits) from rising coal prices.

Government /NERSA

Government will have a stable energy environment and will not have to strain the fiscus to fund Eskom.NERSA introduces a pro-poor, pro-business solution, fulfilling its mandate of responsible power pricing.

Environment The water crisis is partly alleviated and moving to rail alleviates coal waste.

Business &Labour

Business is able to control (hedge) its power costs. More budget certainty means more jobs and interest rates are not under pressure. The protection offered to the poor also eases their cost pressures.

GeneralPublic

The public is charged a fixed low rate with less uncertainty in price increases, ensuring that they continue to have access to cheap power.

ForeignInvestors

Foreign investors will have a basis on which to ascertain the competitiveness of SA power. The ability to hedge as well as transparent pricing mechanisms linked to international markets will give them comfort and a degree of certainty as regards their power costs, making SA an attractive investment destination.

Lenders toEskom

Lenders to Eskom will take comfort from their locked in margins and immunity to the vagaries of the fluctuating coal price.

FinancialSector

The financial sector and JSE will benefit from the trading volumes and the addition of a power market will greatly enhance SA’s financial architecture.

Coal MiningIndustry

Domestic coal miners will achieve export-linked pricing without having to export coal, leading to immediate increases in supply for Eskom without restricting expansion and growth in the sector. In addition, the junior miners will not be prejudiced by lack of export capacity at the RBCT.

Transformation BEE and transformation in the coal mining sector will be facilitated by the increased revenues to coal mines and the removal of the obstacles regarding export allocation.


PART TWO: MECHANICS OF THE STRATEGY


Consider the European Power Market

• Coal is loaded, trucked and railed to Richards Bay Coal Terminal and loaded onto vessels.

• The utility pays the prevailing RB1 price.

• Coal is shipped to Rotterdam and freight paid on the Baltic C4 index.

• The coal is barged inland and stockpiled where it is burnt.

• The utility also pays for carbon to cover their CO2 emissions.

The cost of logistics from the Highveld to RBCT (or Maputo) and then onto Europe (or India) and finally to the specific station all adds to the ultimate burn cost and is reflected in higher European wholesale power prices.

For SA to have higher power prices than Europe would be a tragedy! After all we burn lower grade coal and we don’t need to get it to Richards Bay.

€ / MWh

Fuel Price

Power Price

Carbon Priceda

rk s

pre

ad clean spread


Can Financial Markets be Harnessed for the Benefit of All?

Financial markets are excellent sources of liquidity, price discovery and market intelligence.

These factors make them both useful and detrimental to economic policy objectives.

Advantages

• Offers transparent price discovery

• Offers liquidity and tradability, which makes risk management possible

• Prices encompass qualitative factors and forecast variables, aiding in policy decisions

Disadvantages

• Can be unpredictable and volatile

• Influenced by global conditions, sometimes making them behave contrary to local realities

• Prices based on profit motives

We believe that the power of financial markets can be harnessed to aid the objectives of a developmental state.


The Impact of Arbitrary Tariff Determination

Eskom’s average wholesale tariff is currently very close to European Wholesale spot power prices. The worrying graph is the one on the right showing an immediate tariff increase of some 146%. The grey area represents the probable future price range for European power whilst the 20% spot coal blue line is the prevailing forward curve for coal.

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ZARc/KWh SAPP EEX Phelix Tariff

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Jan-10 Jan-11 Jan-12 Jan-13


The Mechanics of a Market Linked Strategy

The proposed pricing mechanism would work as follows:

SA Power Price = [ (RB1 – 200) / 22 * 3.6 / * 100 / 1000 ] + Carbon EUA + Profit

SAPP = Highveld Coal Price + Carbon + Profit Margin (in ZARc / KWh)

Stochastic Variables Constant

Coal Price: RB1 worked back to Eskom Highveld price and quoted in ZAR/tonneEfficiency (): 35%Carbon EUA: In Europe, around EUR13/mt CO2e, but for Eskom currently zeroProfit Margin: Profit margin as determined by Eskom to cover CAPEX and OPEXEskom Coal: 22 GJ/tonne

• 1 MWH = 3.6 GJ• The factor of 22 takes the ZAR / tonne price of coal and converts it to ZAR / GJ• Multiplying this by 3.6 gives the ZAR price per MWH• The efficiency factor () is based on Eskom’s average efficiency of all their power stations• The factor of 100 converts from ZAR to ZARc• The factor of 1,000 takes the value from MWh to KWh• The Carbon EUA variable makes provision for potential carbon tariffs


The Risk Transfer Mechanism

Germans pay export RB1 + RB:ROTT Freight + Barging+ Carbon

ESKOM pays:20% @ low-grade spot Highveld price80% @ fixed & cost-plus coal contracts

40% - EIUG30% - Municipal Industrials

RMB proposes charging at SAPPvs. currently enjoying relatively favourable rates.

30% - Municipal Domestic

RMB proposes charging a low fixed tariffvs. currently expected to field the brunt of tariff increases.

70% of Eskom revenues exposed to coal price and 80% of costs exposed to low fixed-price coal Coal price increases mean higher profits for Eskom (opposite to a year ago) SA power tariff is always lower than European power tariff

Coal Miners


Result: Appropriately Positioned Tariff Risk

80% of coal purchased on fixed price & cost-plus

20% of coal purchased on spot Highveld Price

Fixed Price Tariffs for The Public

SAPP - linked Tariff for Industrial Users

(EIUG) etc.

ESKOM’s revenues increase with rising coal prices

EIUG consumers hedged against coal price rises (lock-in power prices)

"Whilst all care has been taken by FirstRand Bank Limited (acting through its Rand Merchant Bank division) (Registration No. 1929/001225/06) (the “Bank”) in the preparation of the opinions and forecasts and the information contained in this document, the Bank does not make any representations or give any warranties as to their correctness, accuracy or completeness, nor does the Bank assume liability for any losses arising from errors or omissions in the opinions, forecasts or information, irrespective of whether there has been any negligence by the Bank, its affiliates, officers or employees, and whether such losses be direct, indirect or consequential.

Nothing contained in this document is to be construed as guidance, a proposal or a recommendation or advice to enter into, or to refrain from entering into, any transaction. RMB is an authorised Financial Services Provider."

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RMB FIXED INCOME, CURRENCY & COMMODITIES Electricity Tariff Proposal