1. 22 August 2012 Regulating for productive efficiency – an assessment of the regulatory framework faced by Eskom Presented at the South African Economic Regulation Conference Authors: Jason Aproskie (presenter), Thobile Mbatha and Michael Nicolaou The authors are economists and analysts at Genesis Analytics. The views expressed here are those of the authors and do not necessarily represent the views of Genesis Analytics.

2. Introduction Eskom’s price increased 225% from 2007 to 2012 (MYPD numbers) Importantly, this not being driven only by capital costs

3. Basis for the paper and overview Some evidence internationally of long-term electricity prices tracking, or even bettering, inflation And a popular view that Eskom is currently operated inefficiently Thus the suggestion is that there are potentially unrealised efficiencies in the operation of Eskom Our paper considers the potential for Eskom to realise greater efficiencies in its operational and primary energy expenditure through changes to the regulatory framework: –First, we consider Eskom’s regulatory environment and framework –Second, we broadly consider other regulatory approaches and their potential for use in regulating Eskom –Third, we consider the earnings share approach in greater detail as well as aspects around its design

4. Eskom’s regulatory framework Eskom is regulated on Rate-of-Return (ROR) basis using the Multi- Year Price Determination (MYPD) process Nersa has the power to review and disallow costs in the MYPD application, however: –No appropriate domestic benchmarks –Significant information asymmetries relative to Eskom –Nersa largely accepts inflationary increases and limits above- inflation increases in some cases It is not clear that the power of Nersa to review costs is sufficient to ensure that Eskom only incurs efficient costs

5. A clear basis for introducing performance based regulation ROR is simple and sustainable in that returns are guaranteed However, the recognised failing of ROR is that there is no incentive for efficiency Performance Based Regulation (PBR) is designed to mimic a competitive market environment and thus to align the incentives of the firm to the goals of the regulator (e.g. low cost operation) In addition to evidence of potential unrealised efficiencies, it appears that the intention of the regulator (NER) was originally to move to a PBR based approach –ROR seen as creating a fair rate of return from where PBR could be introduced We broadly consider the potential of three approaches to PBR: a) revenue/price caps, b) yardstick approach and c) earnings share models

6. Price / revenue cap Price increases are typically capped at a measure of inflation less an X-factor (representing expected productivity gains) Arguably creates the greatest potential for efficiency gains Number of challenges and risks: –Significant shift in approach for Nersa and Eskom – setting an appropriate X-factor would represent a significant challenge –Not clear that cap could be credibly enforced If Eskom argues it is (or becomes) too restrictive, could Nersa enforce it in the face of information asymmetries? The potential failure of Eskom would threaten the economy and thus require tax payer funded bail outs – could the regulator credibly threaten to risk this?

7. Yardstick / benchmarking approach Yardstick approach measures performance of regulated firm against industry benchmarks or even virtual (hypothetical) benchmarks Significant challenges in identifying a real benchmark for Eskom’s performance given the lack of clear domestic competitors Virtual benchmarks can deal with this problem however these involve significant complexity in designing Thus there are significant challenges in designing and implementing such a framework

8. Earnings share models Earnings share models allow the benefits of good performance to be shared between the regulated firm and customers –The regulated firm retains some of the additional earnings (e.g. from cost under-runs) –Customers enjoy some of the additional earnings e.g. through lower prices Allowing firms to retain some of the additional earnings creates an incentive for more efficient performance Potential benefits to the earnings share approach in South Africa: –Simplicity and flexibility in application – limited burden for regulator –Avoids challenge of determining what is efficient – regulated firm is incentivised to uncover further efficiencies –Can be “bolted on” to existing ROR approach – thus less of a shift for Nersa and Eskom

9. Application of the earnings share model We do not attempt to conclude that one type of PBR approach is necessarily superior to another, however: –The broad assessment does suggest an earnings model may be most appropriate for regulating Eskom –And Nersa has already pointed to including the principles of an earnings share model for coal costs in future MYPD periods Thus we consider the earnings share model in more detail as a potential option for improving the regulation of Eskom We note two key points: –Firstly, there is no reason why the moral hazard problem would only be present for coal – it should be applied to all opex and primary energy –Secondly, the use of an earnings share model need not disadvantage Eskom relative to the current regulatory framework i.e. one could for instance treat only good performance on an earnings share basis

10. Structuring of an earnings share model (1) Key issue is “alpha” – the degree to which earnings are shared between firm and customers – we identify three considerations: The degree of sharing –The larger the share kept by the firm, the larger the incentive –But the less short term benefit for customers and the greater potential for large profits (arguably less of a concern for state- owned Eskom) Relationship between degree of sharing and performance –Arguably better performance is more costly/difficult for the firm and thus incentives/rewards (the degree of sharing) should be greater Symmetrical treatment of performance? –One may treat bad performance differently to good performance

11. Structuring of an earnings share model (2) A further issue is the actual benchmark for measuring over- or under-performance Experience of Nersa should allow identification of reasonable benchmarks: –First port of call: previous period’s performance plus inflation –Where an imported input then an appropriate international benchmark could be identified

12. Final considerations and conclusions Other considerations in implementation: –Risk with PBR is lower quality – quality standards with financial penalties are a common approach to managing this concern –Key that managers’ contracts are aligned to earnings share model (principal-agent problem) In conclusion: –Apparent unrealised efficiencies in operation of Eskom and thus changes to regulatory framework should be considered –Some form of PBR should likely be introduced to incentivise greater productive efficiency by Eskom –Earnings share model likely represents a best option for improving the regulation of Eskom and can be easily bolted on to the existing ROR approach