Response to NERSA Consultation Paper

06 May 2011

Strictly Confidential 1

Overview

NERSA‟s consultative approach is welcomed

This response pertains to wind energy projects seeking a PPA under REFIT

Feedback will be provided on assumptions made in the NERSA Consultation

Paper that are not in line with current industry practice and experience

We look forward to an appropriate tariff resulting which will correctly shape this

new industry in South Africa

1 AIIM, Umoya Energy & Hopefield Wind Farm

Umoya‟s Credentials

Umoya Energy (Pty) Ltd was established by African Infrastructure Investment Managers (Pty) Ltd (“AIIM”) as a SPV to develop the Hopefield Wind Farm in 2008

AIIM is an Infrastructure Equity Fund Manager established in 2000 by Old Mutual and Macquarie. AIIM & Kagiso have also established an Empowerment Fund

AIIM has circa R 8.7 billion (US $ 1 billion) of Equity funds under management through 4 investment funds

Funds are deployed as Equity in core infrastructure projects across Africa covering Toll Roads, Telecoms and Power

In RSA AIIM is the largest equity investor in private infrastructure projects – principally the three major Toll Roads and Kelvin Power Station

Renewable energy is a competing asset class and needs to yield returns commensurate to other infrastructure assets to attract equity investment

Umoya (and AIIM) support NERSA‟s objectives of REFIT tariffs that will yield 17% real IRR to Equity Investors

Hopefield Wind Farm

The Hopefield Wind Farm has been under development

since mid 2008, hence the project is very well understood

Significant investment has been made (>R10m) to prove the

resource, to understand the site, to achieve permitting, to

secure competitive EPC pricing, and to develop a bankable

finance model and project.

Infrastructure Equity Investors require certainty of the tariff

they will receive in 3-4 years time when the project will reach

financial close

Decisions to continue developing the Hopefield site were

based on:

April 2009 tariff of R1.25 per kWh plus full indexation

Equating to tariff in April 2011 terms of R1.35 per kWh

The NERSA revisions were a surprise and the proposed

tariff of R0.938/kWh plus partial indexation renders the

Hopefield Wind Farm un-bankable

Date Milestone

Sep 2008 Land secured

Dec 2008 Met mast installed

Sep 2009 Environmental Authorisation

received

Oct 2009 Local rezoning approval

received

Aug 2010 Provincial rezoning approval

received

Sep 2010 CAA approval and SAAF

approval received

Oct 2010 Tenders run for construction

works

Dec 2010 Lead arranger appointed

2 Review of NERSA proposal

Our Approach

Reviewed the impact of the proposed tariff and partial indexation in our detailed

bankable project finance model

Debt Service Coverage ratios were not met

Targeted equity return levels were not met

Created a replica levelised cost model to recalculate & understand the proposed

NERSA wind tariff based on the assumptions stated in the Consultation Paper

Studied the Electric Power Research Institute (“EPRI”) July 2010 report „Power

Generation Technology Data for Integrated Resource Plan of South Africa‟

“Backsolved” from the NERSA tariff to seek to understand the inputs

Compared the assumptions to those observed by Umoya in the South African

market and used in the bankable financial model

In Q4 2010 Umoya ran tenders for turbine supply, balance of plant electrical and

balance of plant civil works so has actual data on market prices for South African wind

farms

Umoya has interviewed lead arrangers and has made a selection, and hence has

accurate pricing on debt and foreign exchange hedging rates

Levelised Cost vs Project Finance Models

Levelised cost Project finance

Industry and Banks generally use a Project Finance Model to appraise projects

The NERSA REFIT tariffs, however derived, must be tested and found to deliver a

17% real IRR in a properly constructed Project Finance Model – a reality check

Assumes equity earns returns

alongside debt in early years – up to

40% of cash flows to equity

Timing of cash flows taken in to

account – equity earns only 20% of

cash flows in early years despite

investing 30% of capital required

Assumes debt is repaid over 20

year project life

Debt is repaid over 15 years in

preference to equity

Capital Cost – Real vs Assumed Inputs

Real market prices appropriate to project construction start date are an imperative

NERSA‟s assumed inputs appear incorrect – 25% too low

Umoya*

Cost

R/kW

NERSA*

Cost

R/kW

Umoya

%

NERSA

%

Overnight capital

cost15,407 15,150 80.5% 95%

Land 407 319 2.1% 2%

Project dev fees 909 - 4.7% 0%

Grid + Interest

during

construction

1,676 478 8.8% 3%

Debt Service

Reserve Account748 - 3.9% 0%

Total 19,147 15,947 100% 100%

*NERSA inputs from EPRI report and Consultation Paper para 6.7 and replica model; Umoya inputs from South African tender

process

Replica levelised cost model cannot

accommodate the proposed 6-10%

developer fee at R0.938 tariff

Interest during construction accounts

for 7% of Umoya‟s total cost, Grid

costs account for <2%

Funding a Debt Service Reserve

account has not been included in

NERSA‟s total project cost

EPRI figures are in Jan 2010 terms –

no inflation adjustment has been

made – cost are at lower end of

market prices seen by Umoya

Allowing for Dev fees closer to 10%, we suggest R20,000/kW = $2,700/kW

Approximately 60% of the capital cost of a wind farm is denominated in Forex

The Rand is a very volatile currency

Foreign Exchange

The current low rates may not be available 12 months from now at financial close -

Options to hedge this exposure have been priced at over R70m

Conservative FX assumptions are required to accommodate some adverse

movements – alternatively project costs must be increased to include hedging costs

Oct 2008 1 EUR = 14.0 Rand

Apr 2009 1 EUR = 12.0 Rand

Apr 2010 1 EUR = 10.0 Rand

Operating Costs – Slide 1 of 4

New industry - so it is difficult to assess the operating costs in years 10 - 20 with any certainty. The past 10 years show original estimates out by 4 to 5 X.

Key components fail << 20yr “design life” – e.g gearboxes = 8 years

NERSA‟s suggested R0.118 per kWh is low when compared to EPRI‟s recommendations, industry analysis from Wind Energy Update (EUR 0.019 per kWh) and Deloitte (EUR 0.016 - EUR 0.022 per kWh)

Operating costs – Slide 2 of 4

Developers can buy certainty for the first 10 years from OEM Vendors

The second 10 yrs is at large – Developers (Investors) must plan for

component replacement, e.g. Gearbox ($500k), Rotors ($200k) etc

RSA CPI does not adequately provide for FX movement 10 - 20 yrs ahead

and Developers (Investors) must hence take a view.

Operating Costs – Slide 3 of 4

What should NERSA / Developers / Investors assume for yrs 10 – 20 ?

Truth is, no one knows

The Wind Energy Update report suggests a material upward trend from E0.022/kWh

Operating Costs – Slide 4 of 4

Allowance made for major

component costs and

increased service costs in

years 11-20

Major components will be

priced in foreign currency -

allowance made for under-

recovery of ZAR depreciation

Unknown if service providers

will give „spare parts

inclusive‟ warranties after

year 10.

Will depend on size of future

market.

Umoya‟s View – As per below, average of R0.24/kWh before local overhead,

increased security and insurance costs, plus costs of energy forecasting

After adding in for the above we suggest not less than R0.30/kWh

Energy yield

The Consultation Paper uses an expected capacity factor of 27% from a typical

100MW wind farm in the calculations

This is slightly high for the country as whole but can be accepted for early projects

as the capacity factor predicted from the P50 energy yield assessment

Banks only evaluate project cash flows based on P90 energy yield expectations

(have a theoretical 90% chance of being achieved) - these are 15-20% lower than

the P50 predictions

Tariffs should therefore be set using P90 energy yield predictions (equating to a

capacity factor of around 23% from this typical farm) to ensure that projects are

able to meet their debt service and equity return targets

Debt Structure and Cost

Tenor Debt to be repaid over 15 years not 20 years as per NERSA

Gearing 70% debt funding and 30% equity funding is in line with

Umoya‟s experience

Cost of debt Despite current low JIBAR rates, the markets expect rates to

increase over the next 15 years

Cost of debt over the project life will be closer to the 15 year

interest rate swap rate rather than 3 month JIBAR

Debt margins are between 3-4% and will only be refined once

the risks in the PPA are assessed

Additional costs will be incurred to hedge interest rate

exposure

The cost of debt is significantly higher than

that proposed by NERSA

Umoya NERSA

Tenor 15 years 20 years

Gearing 70% 70%

Interest rate 8.46% 5.55%

Margin 3.50% 4.38%

Hedge costs 0.50% 0%

Total cost 12.46% 9.93%

Indexation

As equity returns are back-weighted until after debt is repaid indexation on the

full tariff is crucial to ensure that investor returns are not eroded by inflation

Without indexation of the full tariff, the starting tariff must be significantly

increased from those published in 2009

Indexation on the full tariff is recommended

Timing of Tariff Review

Whilst we agree the tariff should be reviewed periodically Investors need certainty to

make decisions about the viability of their projects through the development period

Tariffs should be fixed for at least 3 - 4 years to enable sites to be selected,

developed, financed and constructed before the tariff is changed

Recommend that tariff reviews speak to projects being implemented in 3 – 4 years

time – e.g set today for projects targeting financial close in 2014 (with mechanism to

cater for regulatory delays)

3 Conclusion

Conclusion

REFIT tariffs that yield real returns of 17% to Equity are supported

NERSA must ensure that their proposed REFIT tariff works within the financial models and

governance criteria used by the market – this is reality

NERSA must insure that all Capex costs are included for and are market related

NERSA must consider 20 year risk in determining the O&M component of the REFIT tariff

REFIT tariff revisions should apply to projects being implemented at least 3 – 4 years in the

future to enable investment decisions to be made with tariff certainty

Umoya is of the view that the REFIT tariff for wind energy should be reinstated to

where the market expected it to be, i.e. R1.35 plus full indexation in 2011 terms

Thank You

Thank You