ENERGY REGULATOR OF SOUTH AFRICA

In the matter regarding

THE TARIFF METHODOLOGY FOR PETROLEUM LOADING FACILITIES AND

PETROLEUM STORAGE FACILITIES

DRAFT DECISION

On 25 March 2010 the Energy Regulator approved the Tariff Methodology for

Petroleum Loading facilities and Petroleum Storage facilities.

Draft Reasons for Decision

Introduction

1. The Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) (the Act) requires

that tariffs set in the operation of a petroleum pipeline and approved for

storage facilities and loading facilities by the Energy Regulator must be

based on a systematic methodology applicable on a consistent and

comparable basis.

2. Regulations also guide the way in which tariffs are approved. The current

Regulations in terms of the Petroleum Pipelines Act, 2003 (Act No. 60 of

2003), were published in Government Notice R342 GG 30905 of 4 April

2008.

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3. This Tariff Methodology for Petroleum Loading Facilities and Storage

Facilities has been based on the approved Tariff Methodology for the

Petroleum Pipelines Industry as amended on 26 November 2009 (amended

Petroleum Pipelines Tariff Methodology).

4. Variations from the amended Petroleum Pipelines Tariff Methodology are

discussed below.

5. The storage facilities operating in South Africa cover a wide range of

business models. For example, the very large crude oil storage facilities are

more interested in long term storage contracts than they are in rapid

throughput and turn over of oil. By contrast, a storage facility serving a busy

international airport is likely to be more interested in the opposite.

6. Furthermore, there are storage facilities that are owned and operated by

large vertically integrated multinational corporations, largely for their own

use. There are also merchant storage licensees that do not own and market

their own petroleum but rather serve only customers. And then there are

also small, sometimes rural storage facilities comprising only a few tanks for

a single product type. These examples are just a few of the diverse

business models operating in the industry that this tariff methodology is

designed to serve which contribute to the need for some flexibility in this

tariff methodology.

7. A similar diversity is found among the loading facilities. Currently they range

from off-shore crude oil single buoy mooring facilities to sophisticated

harbour berths loading arms to simple flexible pipes.

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Decision making process 8. On 20 November 2008 the Energy Regulator conducted a storage tariff

model workshop discussing the model it intends to use in evaluating storage

tariff applications.

9. On 17 November 2009, the Petroleum Pipelines subcommittee approved

the publication of the draft tariff methodology for petroleum loading facilities

and storage facilities for public comment.

10. The invitation for public comment of the draft tariff methodology for

petroleum loading facilities and storage facilities was placed on the Sowetan

and Business Report newspapers on 23 November 2009 and the closing

date for public comments was on 23 December 2009.

11. Comments were received from:

11.1. Transnet Limited;

11.2. Chevron South Africa (Pty) Limited;

11.3. Vopak Terminal Durban (Pty) Limited;

11.4. Reatile Resources (Pty) Limited;

11.5. SAPREF (Shell and BP South African Petroleum Refineries (Pty) Ltd;

11.6. Engen Petroleum Limited; and

11.7. Shell South Africa.

12. Stakeholder comments and NERSA’s response to the comments are

summarised in the attached table as Annexure A.

13. A public hearing on the Tariff Methodology for Petroleum Loading facilities

and Petroleum Storage facilities was held on 16 February 2010.

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14. On 25 March 2010 the Energy Regulator approved the Tariff Methodology

for Petroleum Loading facilities and Petroleum Storage facilities and this

was published on the NERSA website on 30 April 2010.

Applicable law

15. In terms of section 28 of the Act, tariffs approved by the Energy Regulator to

be charged by licensees must be based on a “systematic methodology

applicable on a consistent and comparable basis.”1 The Energy Regulator

has approved the Tariff Methodology for Loading and Storage facilities on

25 March 2010 (hereafter, the Methodology) and is available on the NERSA

website.2

Review of the tariff methodology

16. The Act requires the Energy Regulator to “approve” tariffs for storage

facilities and loading facilities, consequently this methodology incorporates

more flexibility than the methodology applicable to pipelines where the

Energy Regulator is required to “set” tariffs. Consequently, Licensees may

use this tariff methodology for storage and loading facilities as a guide or

use any other methodology in their tariff applications. However, the Energy

Regulator will use this tariff methodology to evaluate tariff applications

submitted by licensees.

17. Therefore, all licensees must provide all the information required by this

methodology when submitting their tariff applications.

1 Section 28(2)(a) of the Act

2 www.nersa.org.za

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Allowable Revenue (AR)

18. The Allowable Revenue in the methodology is determined by a similar

formula to the one in the amended Petroleum Pipelines Tariff Methodology.

19. However, a cumulative value of F (approved revenue addition to meet debt

obligations for the tariff period under review) is not applicable to the

methodology for storage facilities and loading facilities.

20. The reason is that Regulation 5 (2) refers to Regulation 4(2), 4(3), 4(4), 4(5),

4(6), 4(7) and 4 (9), but excludes Regulation 4(1) “The Authority may, when

setting tariffs for petroleum pipelines-

(a) require tariffs to follow the general principle of increasing with

increasing distance over which petroleum products are or will be

transported;

(b) consider batch size;

(c) consider funding requirements and debt service requirements of

licensee by adjusting the licensee’s allowed revenue to enable

the licensee’s debt service cover ratio to be maintained at a

reasonable level; and

(d) consider any other relevant matter.

21. Regulation 5(1)(c) does not mandate the Energy Regulator to “consider

funding requirements and debt service requirements of the licensee…” for

tariff approval for storage and loading facilities as it does for tariff setting for

petroleum pipelines in Regulation 4(1)(c).

22. If the operator builds a large completely new facility, debt cover ratios may

be cause for concern. In such cases the Energy Regulator will consider

additional, well motivated, cost of debt factors as part of (Kd) in the formula.

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23. The allowable revenue formula provides for a return on the Regulatory

Asset Base at the Weighted Average Cost of Capital (WACC).

24. The RAB value is determined, similar to the tariff methodology of the

Petroleum Pipelines Industry, as follows:

Regulatory Asset Base = V – d + w ± dtax

Where:

V = Trended Original Cost of Property, Plant, Vehicles & Equipment

d = Depreciation and amortization of inflation write-up to the

commencement of the tariff period under review

w = Net Working Capital

dtax = deferred tax (dtax).

25. Net working capital is determined by inventory + receivables + operating

cash + minimum cash balance – trade payables. However, working capital

generated out of trading (and not loading or storage) activities should not be

included.

26. The use of the WACC requires that the Energy Regulator take a view on the

debt/equity ratio. Generally the cost of debt (Kd) is lower than the cost of

equity (Ke) and therefore the Energy Regulator’s duty to approve tariffs in

the public interest which encourages an optimum use of debt.

27. The proxy used for the market return is the return made by equities on the

Johannesburg Stock Exchange (JSE) All Share Index for the preceding 300

months as at twelve months before the commencement of the tariff period

under review, converted from a nominal to real value.

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28. Given the variety of markets covered by the Tariff Methodology for

Petroleum Loading Facilities and Storage Facilities, the All Share Index

(ALSI) is an appropriate proxy for market returns.

29. Beta is a measure of the volatility, or systematic risk, of a portfolio in

comparison to the market as a whole. Beta is used in the capital asset

pricing model (CAPM), a model that calculates the expected return of an

asset in relation to its beta and expected market returns

30. Beta is calculated using regression analysis, and beta is the tendency of

returns to respond to swings in the market average. A beta of 1 indicates

that the price will move in tandem with the market average. A beta of less

than 1 means that the security will be less volatile than the market. A beta of

greater than 1 indicates that the price will be more volatile than the market

average.

31. The beta must be determined by proxy for licensees that are not publicly

listed and where there are insufficient publicly listed competitors.

32. Therefore, licensees will have to provide their own beta and proxy

companies with detailed information on how the beta was determined when

submitting a tariff application. A single beta for all companies and

circumstances is not regarded as appropriate; therefore any proposed beta

will be evaluated on a case by case basis.

33. The cost of debt can be influenced by many factors such as the financial

standing of the borrower, the use of balance sheet financing or project

financing, the existence or not of ship-or-pay contracts for petroleum

pipelines and many others.

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34. Therefore, it is deemed appropriate to utilize an applicant’s interest bearing

actual cost of debt subject to reasonableness checks. Such checks intend to

make use of the active competition among financiers in the South African

market to assess reasonableness.

35. Tariffs are set for a forthcoming period rather than a past period, therefore

estimates must necessarily be made. It is in the nature of estimates that

they do not always match actual quantum and therefore adjustments must

be made to allowable revenue once the actual figures become available.

The Claw back adjustment (C) in the methodology is designed to achieve

this in each of the elements where estimates have been made.

36. Operating Efficiency Adjustment will not be included in the tariff

methodology for storage and loading facilities as it is will not be easy to

measure efficiency for storage and loading facilities due to the diversity of

the industry. Therefore, clause 6.4.2 which refers to the Operating Efficiency

Adjustment also must be deleted.

Tariff Design and structures

37. Given the diversity of markets served by the various storage facilities and

the diverse nature of the facilities, it is deemed preferable to allow licensees

to craft tariff designs that suit their purpose, subject of course to NERSA’s

approval and the provision of section 21 of the Act (see below), rather than

to have the methodology be prescriptive in this regard.

38. Section 21 of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003)

provides that:

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“Licensees may not discriminate between customers or classes of

customers regarding access, tariffs, conditions or service except for

objectively justifiable and identifiable grounds approved by the Authority.”

39. This is to provide adequate protection to the customers of the storage and

loading facility licensees.

Conclusion

40. The Tariff Methodology for Petroleum Loading Facilities and Storage

Facilities is based on previous experience, international precedent and

takes into account the diversity of the equipment and markets served. This

methodology complies with the legislation and regulatory requirements.

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ANNEXURE A

STAKEHOLDER COMMENTS AND NERSA’S RESPONSES ON TARIFF

METHODOLOGY FOR PETROLEUM STORAGE FACILITIES AND LOADING

FACILITIES

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STAKEHOLDERS’ COMMENT NERSA’S RESPONSE

1. GENERAL COMMENT 1.1. The tariff methodology shows similarities with the methodology to set a tariff of which this tariff methodology should be aligned with the intention to approve the tariff. The methodology has the potential to completely control the market in stead of regulating it. This may result in discouragement of investors.

1.2. In trying to approximate as closely as possible a Cash Flow model, non-cash items should, in principle, be excluded. Non-cash items appearing in various parts of the document are:

- Depreciation cost - Accumulated Depreciation - Amortisation of Inflation Write-up - Accumulated Amortisation of

Inflation Write-up - Deferred Tax expense (this is not

specifically mentioned but must be included in “T”)

- Deferred Tax provision.

These should all be excluded, some from Allowable Revenue, others from Regulatory Asset Base.

1.1. The methodology will be used by NERSA in evaluating the tariff applications. Storage and loading facilities may use any other methods when is applying for approval of tariffs. The Regulations require that a systematic methodology be used in approving tariffs. Regulations for “approval” are very similar to Regulations for “setting”. The Energy Regulator approves a maximum tariff and licencees may give discounts to their customers.

1.2. Regulation 5(2) requires the use of

capital asset pricing model (CAPM) which represent return on and return of asset and does not involve cash flow so all these items have to be included.

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2. RAB 2.1. Propose a replacement value instead of historical value – fully depreciated assets may have huge value to the business and it would be unfair to disregard this in the methodology.

RAV may leave the process open to manipulation as the RAV in all likelihood will be higher than the historical cost and this will result in a higher RAB for companies using the RAV approach as opposed to historical cost.

2.2. Prescribe a uniform approach for all

companies to estimate asset values where original acquisition cost is not available so that all companies start at the same basis in line with Section 28(2)(a)(i) of the Act. An example of a uniform approach would be depreciated replacement costs.

It is suggested to include the full asset value and calculated depreciation based on the period that the asset was used for.

2.3. It is assumed that rehabilitation and

restoration costs are included in the value (v) of the asset, per IAS 16.

2.1. Regulations 5(2) states that “real return on the regulatory asset base which should be determined based on the assets’ inflation-adjusted historical cost less accumulated depreciation”.

2.2. Only when historical costs are proven

not available Regulation (5)(2) states that “an estimated value that the Authority accepts as most closely approximating their historical cost”.

2.3. Regulation 4 (2)(c) states that “the

tariff set by the Authority must enable an efficient licensee to rehabilitate land used in connection with a licensed activity”.

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2.4. Deferred Tax asset or liability should

either be added or subtracted from the RAB if the normalized tax method is used. (Please clarify)

Therefore, rehabilitation of land costs should be provided for as an operational cost on an annual base. The provision (credit) is not deducted from RAB. Restoration is not mentioned in the Regulations.

2.4. If normalized tax is used, then

deferred liability will be subtracted.

Formula : RAB = (v-d) + w – dtax

A deferred tax liability represents a temporary return of capital on which no return is allowed and therefore it is deducted from the RAB. As the license holder starts paying back, to the Receiver of Revenue, the deferred taxation the deduction from RAB reduces. A deferred tax asset represents additional capital investment .The Nersa Tax formula (paragraph 7.3 of the methodology) assumes the cash “to be received” from the fiscuss, but the actual cash flow benefit from the fiscuss materialised only in later years and therefore a return would be allowed on this investment. Deferred tax assets mostly arises as a result of assessed taxation losses not utilised and carried forward.

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2.5. Include Assets under construction

into the RAB.

Does "contributions in lieu of connection charges" (4.1.18) constitute a “set-off of” the Value of the investment rather than a recovery of expenses included in Allowable Revenue?

The deferred taxation liabilities and assets are not trended

2.5. Only if that asset will be brought into operations during the tariff review period. In normal practice return cannot be earned on an asset that is not in operation yet.

3. WORKING CAPITAL 3.1. By including inventory held for sales by the marketing division to its customers, the RAB will be inflated and there is no benefit for the 3rd party in this. The only inventory therefore that should be included in this calculation is that of depot own use – inventory required for the efficient running of the depot operation. Receivables and payables should therefore also be included to the extent that they are incurred for the efficient running of the depot. Trade debtors and creditors should not be included.

3.2. The real rate of return is inadequate

to compensate for the working capital costs.

3.1. This has been incorporated in the methodology to redefine net working capital (inventory, receivable and payables) to exclude working capital belonging to licensee and not the asset base intended to be compensated.

3.2. Working capital resets itself each

year and therefore there is an automatic annual adjustment for inflation in the components of

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working capital.

4. WACC 4.1. Real interest rate does not exist as NERSA calculates the inputs of CAPM model in nominal terms and gross down to real by removing inflation.

Applying the TOC and real WACC will understate return on capital, as working capital will receive real returns and no inflation adjustment therefore working capital is not adequately compensated. The company can receive a high return by investing equivalent amount of money in the bank. Nominal WACC rate is recommended.

4.2. Please clarify if WACC rate should be calculated for each depot or use one WACC rate across different deport in different geographic areas. (Logistics operations as an ancillary business and risks between different sites are different and should be reflected in the WACC.)

4.3. If the pass-through tax approach is

chosen, the cost of debt (Kd) has to be stated in pre-tax terms.

4.1. Regulation (5)(2) stipulates that the value of the RAB has to reflect an inflation-adjusted value. Because the nominal value of the RAB is used, a real rate of return is used (as reflected in the real weighted average cost of capital - WACC). This requirement is also stipulated in section 28(3)(c) of the Petroleum Pipelines Act 2003 (Act No. 60 of 2003).

Inflation is added to the asset base (RAB) and therefore is “taken out” of the nominal return (WACC). Nominal returns on real assets would constitute a double count of CPI and therefore “real returns” are used.

4.2. The methodology has been written to have one WACC for each operator, however, if the operator motivates different risk factors for different depots these will be considered.

4.3. For each component which is

taxable, a gross-up at the existing tax rate is performed. Tax allowances

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It would be unreasonable and unlawful to impose this rule until such time as the outstanding problems (regarding the pre- or post-tax nature of Kd associated with the tax approach) are resolved.

4.4. Please explain the minimum debt

equity ratio of 30% 4.5. Use a risk-free rate without any

adjustments for tax. However, if NERSA believe its approach to be correct, NERSA should provide

are therefore provided for in these grossed-up balances and will be included in the total balance of the allowable revenue.

As can be seen from table 17.3(ii) on page 19 of the Frequently Asked Questions document published on the NERSA website all the components (except Kd) are not deducted to arrive at a taxable income before tax allowance. By grossing up and then adding a notional tax allowance they all effectively become pretax. The licensee therefore receives the tax which it is going to pay. Tax shield on Kd is not given.

4.4. The Energy Regulator will use a

minimum debt equity ratio of 30% is to ensure that operators always have a minimum level of debt funding (cheaper funding) and therefore, do not earn equity returns (more expensive funding) on 100% of the asset. This is to encourage the use of lower cost debt funding.

4.5. The tariff methodology consistently

treats all values on a post-tax real basis because Tax is treated as a separate item (T) in the formula to

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stakeholders with the basis and rationale for such an approach.

4.6. The tariff methodology proposes the

use of the Industrial and Financial Index (FINDI). There is no rationale for this.

4.7. The cost of debt (Kd) should be

stated on post tax basis for the notional approach to the tax allowance, and in pre-tax terms if the pass-through approach is used. Suggest that CPI determinations be used for cost of equity and cost of debt.

determine allowable revenue. In this way the impact of all tax-related matters (burdens as well as benefits) are reflected separately and all tax-related WACC components are treated on a post-tax basis.

4.6. JSE ALSI is weighted towards

resources counters which traditionally are volatile, whereas the FINDI is a more stable index. NERSA will use the JSE ALSI to allow uniformity across the industries that it regulates.

4.7. Flow-through tax is the actual tax

paid by the licensee and is allowed as a tax allowance.

Notional tax does not award the tax shield of the Kd nor does it award the benefit of accelerated wear and tear or deferred taxation benefits. For further calculations please refer to pages 21 to 25 of the Frequently Asked Questions document published on the NERSA website.

5. BETA 5.1. From investor’s perspective, if the Beta is less than 1, future investments will be discouraged.

5.1. This is not supported because international evidence shows that such companies often have betas of greater that 1. Betas are also

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5.2. NERSA should not publish the names

of the storage beta companies without prior consultation. Bloombergs is suggested for beta data and that the same companies used for the petroleum pipelines beta be used for storage and loading facilities.

influenced by companies gearing or by its situation in the investment cycle.

5.2. NERSA will not publish the names of

the proxy beta storage companies. Storage licensees are to provide their own Beta value as well as supporting details. In the meantime the Energy Regulator will conduct a study on beta.

6. EXPENSES 6.1. Seek clarity on how does efficiency gains apply. Requirements for competitive procurement should cater for situations where this is not practical.

6.1. This section (6.4.2) in the Tariff Methodology for Petroleum Storage facilities and Loading facilities will be removed. It is not relevant for storage and loading facilities.

Operating Efficiency Adjustment (OEA) under Claw-back is not relevant for storage and loading facilities.

7. TAX 7.1. How is the estimation of the actual tax payment made if the flow through method is used? Is this calculation left up to the individual companies?

7.1. Flow-through tax is the actual tax paid by the licensee and this is allowed as a tax allowance. Please see page 22 of the Frequently Asked Questions document published on the NERSA website.

8. DEPRECIATION AND 8.1. Please refer to Attachments A and C 8.1. The methodology has been changed

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AMORTIZATION OF INFLATION WRITE-UP

regarding the calculation of the tax allowance. In the formula on page 17 defining “NPBT excluding tax allowance” the first use of the term “+D (historic)” is incorrect. The full depreciation should be included in the allowable revenue before deductions, as this is also what would be applicable when actual taxation is calculated by the South African Revenue Service. In other words the terms should be replaced with “D (historic + amortization).

8.2. For consistency publish a set of

useful lives tables for storage and loading facility assets.

8.3. In terms of IAS 16, useful lives of

assets are to be reviewed annually and adjusted prospectively where there are changes. This conflicts with Clause 8.2 which states that changes in useful life can only be approved by the Regulator. IAS 16 is therefore suggested.

to:

NPBT excluding tax allowance = {(RAB*WACC) + E + D(historic + amortization) + F ± C }- {E + D(historic)}

8.2. This is not supported, as this would

be prescription and will not represent the actual situation per operator. Remaining useful life of an asset should be established by engineering studies carried out by the licensee.

8.3. There is no conflict. A licensee

should inform the Energy Regulator who will approve the change

9. CLAW-BACK 9.1. Specify and explain how the Energy Regulator will arrive at the parameters for volume adjustment.

9.1. The applicant’s previous projected volumes are compared with the actual volumes and the adjustment is applied.

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9.2. Use throughput capacity or projected

actual volume for tariff calculation. 9.3. Budget overspends may be

unavoidable but operating efficiency adjustment does not allow, how will claw-back work for efficiencies? Inefficiencies should be clawed back as well.

9.2. This will depend on the type of

storage or loading facility. 9.4. Operating efficiency adjustment not

be considered in the Tariff Methodology for Storage and Loading Facilities.

10. TARIFF DESIGN Clustering Assets 10.1. Successful use of clustering depends

on how the segmentation is done. In general, charging of average rates, while users only take-up uncommitted capacity at selected locations, may result in major over/under recoveries.

Average rates can be used by those companies with very small variances in costs between facilities.

Tariffs per facility 10.2. Desired alternative for companies

with major tariff differences per facility. This design is preferred by Engen, as it eliminates the risks which result from the use of average rates. Charging average rates, while users only take-up uncommitted capacity at selected locations, may result in major over/under recoveries.

Tariff Design 10.1. Given the diversity of markets served

by the various storage facilities and the diverse nature of the facilities, the Energy Regulator will allow each licensee to presents its tariff designs that suite their purpose for the Energy Regulator’s approval.

NERSA typically approves maximum tariffs and therefore, discounts are at the discretion of the operator.

10.2. Reference to the Clustering Assets,

Tariffs per facility, Benchmarking and Interim tariffs designs has been removed

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Benchmarks based on sample of storage companies 10.3. Successful use depends on whether

the benchmark will be an overall average or clustered. This design still presents the problem of over-under recovery through the use of averages

Interim Tariffs 10.4. Average industry tariff brings with it

the problem of what criteria to use to calculate the average (segmentation). Questions arise as to whether it will be an overall/ national average, by area or by size of operation, etc?