1. On 27 August 2017, the National Energy Regulator (the Energy Regulator) approved

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1 NATIONAL ENERGY REGULATOR OF SOUTH AFRICA In the matter regarding APPROVAL OF THE TARIFF METHODOLOGY FOR PETROLEUM LOADING FACILITIES AND STORAGE FACILITIES THE DECISION 1. On 27 August 2017, the National Energy Regulator (the Energy Regulator) approved the Tariff Methodology for the Approval of Tariffs for the Petroleum Storage Facilities and Petroleum Loading Facilities, Version This Methodology replaces Version 3 of the Tariff Methodology for the Approval of the petroleum loading facilities and petroleum storage facilities version 3 of 29 March Applications for tariffs approval for the petroleum loading facilities and petroleum storage facilities submitted after 24 August 2017 will be assessed using the Tariff Methodology for the Approval of Tariffs for the Petroleum Storage Facilities and Petroleum Loading Facilities, Version The Tariff Methodology and Frequently Asked Questions (FAQs) approved on 29 March 2016 are no longer applicable, with effect from 24 August The Frequently Asked Questions (FAQ) approved with effect from 24 August 2017: Tariff Methodology for the Setting and Approval of Tariffs in the Petroleum Pipelines Industry will be applicable for this Methodology. 6. The Reasons for Decision (RfD) document accompanying the Energy Regulator s decision is attached hereto. Page 1 of 15

2 REASONS FOR THE DECISION THE TARIFF METHODOLOGY FOR PETROLEUM LOADING FACILITIES AND STORAGE FACILITIES 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 and loading facilities by the Energy Regulator must be based on a systematic methodology applicable on a consistent and comparable basis. 2. The Regulations in terms of the Petroleum Pipelines Act, 2003 (Act No.60 of 2003) ( the Regulations ) also influence the way in which tariffs are set and approved. The amended Regulations were published in Government Notice 765 GG on 28 August This Tariff Methodology for Petroleum Storage and Loading Facilities (the Methodology) has been derived from the Tariff Methodology for the Petroleum Pipelines. There are no significant differences between these methodologies. REASONS FOR CHANGING THE METHODOLOGY 4. Following the amendment of the Regulations by the Department of Energy (DoE), the Energy Regulator amended its Tariff Methodology (Version 2) in an attempt to align to the DoE s Methodologies and to find a light-handed form in which licensees can submit their tariff applications. Version 3 of the Tariff Methodology is based on the Indexed Original Cost (IOC)/Replacement Value (RV) method that is similar to the Replacement Cost no Depreciation (RnD), in order to converge with the DoE practice of fuel price regulation. Page 2 of 15

3 5. Version 3 of the Tariff Methodology incorporated the standard costing options, which were aimed at simplifying the process of calculating tariffs and shortening the application process for both the applicants and the Energy Regulator. 6. The Energy Regulator has been monitoring the outcomes of the tariffs approved based on Version 3 of the Tariff Methodology. 7. One of the objects of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) is to encourage efficient operation and use of the petroleum pipelines, loading facilities and storage facilities. In the Energy Regulator s review of Version 3 of the Tariff Methodology, the Energy Regulator identified that it is impossible to ensure efficient operation of petroleum storage and loading facilities while the Regulatory Asset Base (RAB), operating costs, and in some cases, volumes are based on standard variables and not actual costs incurred by the licensees. 8. In addition to Version 3 of the Tariff Methodology s failure in ensuring efficient operation of the regulated activities, the following challenges were also identified: a) For the Standard Costing Options, the RAB values used are based on the Department of Energy s Engineering Procurement Construction Management (EPCM) study. It is the Energy Regulator s view that this study overstates the actual values of the storage facilities; b) The operating expenditure cost of initially 102 cents per litre does not reflect the cost of operating all storage facilities, irrespective of the size of the facility. This view is authenticated by the internal operational expenditure study conducted by the Energy Regulator, which revealed, amongst other findings, that the bigger the facility the lower the operating cost per litre; c) There is no criteria for eligibility and efficiency and therefore the Energy Regulator cannot verify the eligibility and efficiency of the assets values as to whether they are correctly stated values; d) Version 3 of the Tariff Methodology does not allow for clawbacks, and therefore no adjustments can be made in instances where projections are significantly inaccurate; and Page 3 of 15

4 e) Version 3 of the Tariff Methodology allows for no depreciation of assets and clawback. 9. Given the identified challenges with Version 3, the Energy Regulator decided that the fourth version of the Tariff Methodology for the Approval of Tariffs for the Petroleum Storage Facilities and Petroleum Loading Facilities, is warranted. 10. Version 4 of the Tariff Methodology for the Approval of Tariffs for the Petroleum Storage Facilities and Petroleum Loading Facilities is identical to Version 2 of the Tariff Methodology for the Approval of Tariffs for the Petroleum Storage Facilities and Petroleum Loading Facilities. PUBLIC CONSULTATION PROCESS 11. A consultation document was published on the Energy Regulator s website for public comment on 5 May Notices inviting the public to comment were published in the Independent Newspapers 1 and the Sowetan newspaper on 5 May Public Hearings to consider the Tariff Methodology were held on 22 May 2017 and 4 July Avedia Energy (Pty) Ltd (Avedia), Oiltanking Grindrod Calulo (Pty) Ltd (OTGC) and Transnet National Ports Authority (TNPA) made representations to the Energy Regulator at these Public Hearings. 13. The Tariff Methodology for Petroleum Loading Facilities and Storage Facilities is attached as Annexure B. The Tariff Methodology is appropriate and complies with the legislation and regulatory requirements. 14. In essence, the comments from stakeholders are centred on the inefficiencies brought about by the lack of clawback and the notional figures used in the standard model. 15. Some stakeholders indicated that the comprehensive method (IOC) could be retained as it rewards investors appropriately. Stakeholders further appreciate the concerns with the notional values and other issues relating to the use of standard option 1 and 2 and therefore suggest retaining only the (IOC/ standard options). Whilst the Energy 1 Business Report, Mercury, The Cape Times, The Star and Pretoria News Page 4 of 15

5 Regulator takes cognisance of these comments it must be noted that the comprehensive method also does not include clawback and depreciation. CONCLUSION 16. On the conspectus of the facts and evidence, it is appropriate and in compliance with the requirements of the National Energy Regulator Act, 2004 (Act No. 40 of 2004) to make the decision set out above. The decision find a reasonable balance between the interests of customers on the one hand and the interests of investors on the other hand. Page 5 of 15

6 Summary of Stakeholder Comments on the Energy Regulator s Intention to Revert to Version 2 of the Tariff Methodology AVEDIA ENERGY Reverting to version 2 of the Methodology Avedia supports the proposal by the Regulator to revert to version 2 of the tariff methodology. Version 2 is more robust and has been tested historically despite the RAB that the Regulator intends to address through the suggested amendments. The costing options are too generic and susceptible to manipulation. Avedia would like the Energy Regulator to indicate when the amended/revised version 3 is expected to be approved and implemented. Avedia suggested that a provision be made where tariff reviews can be made once the new tariff methodology comes into effect. The Energy Regulator will allow a reasonable transition period where tariff applications already submitted to the Energy Regulator when the decision is taken will be processed using version 3 of the methodology. The Energy Regulator will however exercise caution when deciding on multi-year tariffs (the ER will not assess multi-year tariffs longer than 3 years due to lack of economic data). The Energy Regulator is still in the process of amending/ revising the IOC/standard costing options the Tariff Methodology. A separate process will be followed in order to finalise the revised methodology which will include stakeholder consultation. This process deals solely with reverting the TOC methodology. Comments on Elements of the Methodology We support the concept of moving from TOC to IOC/RV on condition that the eligibility and efficiency of assets criteria will be improved. We recommend that the methodology be refined to fulfil both the recovery of shareholder investment and fostering efficiency of assets and eligibility of investments. The current RAB values, based on the DOE s study, are not appropriate across the various infrastructure capacities and volumes. To develop a These comments are noted by the Energy Regulator and will be considered in the review and amendment of the tariff methodology. Page 6 of 15

7 suitable standard costing options studies can be made for specific categories based on the variables that determine efficient tariffs (like capacities, volumes etc). Also, international benchmarks can contribute to determine relevant efficient tariffs. Clawbacks Misalignment between design capacity provided by licensees and that in the license conditions General Clawbacks should be allowed because the assumptions related to costs or market conditions and volumes could change and this risk could discourage investment if clawbacks are not in place. The standard costing options should not be used until suitable standards are developed. The standard options would be an efficient and convenient methodology that mimic reality once suitably developed are tested and implemented. Total SA Based on the very reasons that prompted NERSA to review version 2 of the tariff methodology, Total is not in support of reverting to the old methodology. Total recommends that the current methodology (standard costing options) be retained until such time a new methodology which addresses all challenges identified in all previous methodologies have been developed and finalised. This will be considered when reviewing or amending the tariff methodology. The ER notes the comment which will be considered during the review and the amendment of the Tariff Methodology. Retaining version 3 of the methodology with which major challenges were identified might be inappropriate for the Regulator whose primary mandate is to ensure sustainability of its licensees and public interest and customers. Total SA does not motivate why it is not in favour of reverting to version 2 as version 3 does not address the issues that prompted a review of version 2. The ER is of the view that the IOC methodology is inefficient. Sample size Transnet SOC Ltd The sample size based on which NERSA made a determination or assessment of the tariff methodology effectiveness is less than 10%. Transnet bases this sample size on storage and loading facilities reasons for decisions published by NERSA from April 2016 to March The assessment of the tariff methodology s effectiveness by the Energy Regulator, was performed on a significant sample of 19 tariff applications at the time. To date, 25 applications have been assessed using Version 3 based on standard costing option 1, 2 and the IOC method of the tariff methodology and the Energy Page 7 of 15

8 Regulator retains the view that this ineffective in fulfilling the objects of the Act. Efficiency Higher tariffs Verification of the eligibility and efficiency of the asset values The Tariff Methodology determines a capped revenue. The licensee must ensure that it optimises the operation of the facility to achieve the calculated revenue. In the absence of clawbacks, the licensee must ensure that the facility is operated efficiently. By following a standard model approach, NERSA was aware that during the implementation phase of the Tariff Methodology, there will be information asymmetry. This minor challenge will be removed if the Tariff Methodology is allowed to be implemented until 2019/20. During this time, NERSA would have gathered volume data, regulatory reporting data and the possible benchmarking of the Tariff Methodology with the licensees. This will assist NERSA to recalibrate the components of the standard model to be more reflective of the South African petroleum storage industry. Transnet acknowledges that the Tariff Methodology results in higher allowable revenue. The licensee still needs obtain the volume required to ensure that it can achieve the maximum allowable revenue. The licensee faces challenges with volume risk. The risks are totally on the shoulders of the licensee. The asset determination is a function of the NERSA standard model. NERSA through its petroleum compliance department and a future benchmarking exercise can determine eligibility of the assets in the asset base. NERSA approves maximum tariffs which will mean that the licensee can achieve efficiencies by discounting the tariffs, thereby attracting more volumes. Collecting data for 3 more tariff periods may result in third party access being closed out by being charged excessive tariffs. NERSA has used its current standard options to project 2018 tariffs and these continue to outpace CPI. It is considered necessary to conduct a review of the tariff methodology. Whether or not the licensee achieves its projected volumes, customers are affected by an allowable revenue that outpaces inflation. The risk is thus not entirely on the shoulders of licensees. The asset values from the standards costing model are based on the DOE s EPCM study which is believed to excessively inflate asset values. This prompts the Energy Regulator to assess the eligibility and efficiency of these asset values, the Energy Regulator has found that these asset values are excessive and do not mimic the real cost of the assets. Page 8 of 15

9 Clawbacks Transnet acknowledges that there should be a mechanism if the licensee doesn t achieve certain allowable revenue. A public participation process is required to determine the rules whereby the licensee can approach NERSA for re-openers to its allowable revenue calculation. This will assist to address the matter regarding clawbacks. Re-openers are different from clawbacks. Re-openers do not allow for the recoupment of over recoveries or reimbursement for shortfalls, in proceeding tariff periods and only allows for resetting of tariffs in future periods. In reviewing the tariff methodology the Energy Regulator will attempt to find a solution that weighs all interests in a way that results in fair Interim tariff methodology Transnet proposes that NERSA should maintain the current Tariff Methodology, until the review of the 4th Edition of the Tariff Methodology has been finalised. Licensees have already applied to NERSA using the 3rd Edition of the Tariff Methodology. This will create regulatory burden if these licensees need to re-apply using the 2nd Edition of the Tariff Methodology. tariffs. Continuing to apply a methodology that over inflates tariffs is likely to worsen the instability in the industry. More so when the Energy Regulator is developing a methodology that addresses the issues identified with Version 3 of the methodology, including inflated tariffs. Applications already submitted to the Energy Regulator using the Version 3 of the tariff methodology will be assessed based on the Version3 of the tariff methodology. The decision to revert to the TOC methodology is effective from 24 August Standard costing implications OTGC Having a one size fits all approach is difficult for an industry in which economies of scale and new build vs. old existing assets are differentiators which contribute to the cost complexity. OTGC is also concerned with the different results (tariffs) obtained between the standard costing options and the comprehensive IOC method. OTGC believes that the comprehensive method allows the specifics of each installation to be considered. OTGC believes that the comprehensive method is the first NERSA tariff methodology that provides a viable tariff for new build and therefore This will be considered when developing the tariff methodology. The ER notes the comments with regards to Version 3, standard option 1 and 2 to be discarded and comprehensive method/approach is not consistent with the objective of efficiency because it does not consider depreciation and clawback, and therefore is not efficient or aligned to the ER mandate. Page 9 of 15

10 requests that the comprehensive methodology is maintained as part of the tariff methodology. The comprehensive option addresses most of the OTGC concerns. Changes in NERSA tariff methodologies Clawbacks Since inception of the OTGC project, NERSA has made six amendments to its tariff methodology and these changes effect expected returns of the project. This raises uncertainty issues for green field s projects that are typically funded through debt and equity. OTGC accepts that the tariff methodology will change but requests that the IOC comprehensive method remains unaltered. OTGC understands that the current clawback approach on DJP/NMPP with Transnet is unwieldy and complex to administer. Clawback are inherently included in the New methodology as material changes can allow either NERSA or OTGC a tariff correction. OTCG requests that a clawback mechanism consider the following: - Clear and mechanical in nature with limited optionality. - Only apply to operational cost or volume throughput variations. - All CAPM and other WACC inputs are fixed for the project duration, where this is a limited operating period, and that these parameters Previous amendments to the tariff methodology were minor revisions such as updating of data parameters specifically regarding the Weighted Average Cost of Capital and were mostly based on requests from stakeholders. The Petroleum Pipelines Act is the fundamental legislative tool that governs the determination of tariffs. The Act enforces allowance of return commensurate with risk for equity holders as well as the recoupment of actual costs for debt issuers. The Energy Regulator notes the request by OTGC and will investigate the best practice to ensure that the tariff methodology decided on yields fair tariffs. A clawback mechanism is not one of the elements of the AR formula. The tariff methodology does have a reopen mechanism which differs from a clawback mechanism that only allows for corrections or resetting of future tariff levels. OTGC s recommendations on the Clawbacks will be considered in developing the Tariff Methodology. Page 10 of 15

11 are fixed at the date of the final investment decision or financial close of the project. - Clawback to be prospectively applied only and is not retrospective. - Implementation of a clawback is triggered by variation of operating costs/volumes greater than a fixed threshold. - A third party expert can arbitrate differences between the licensee and NERSA. - Capacity based charges are excluded from clawback. Reverting to version 2 of the Methodology BP Southern Africa BP does not support the Energy Regulator s proposal to withdraw the existing tariff methodology (version 3) for the following reasons: - Removing this methodology reduces the efficiency of the Energy Regulator process and is most likely to result in significant delays in tariff approvals similar to what was experienced in the past. - Changing the tariff methodology without a comprehensive consultation and engagement is detrimental to investment as it results in significant uncertainty for investors. Irrespective of the reason for the change, it simply signals to the investor that the Regulator may at any time and for whatever reason, change the very same model on which the investor is reliant on in order to remunerate that investment. - The recently published list of approved tariffs show that it would be premature of the Energy Regulator to suspend the current Methodology as the tariffs there seem reasonable and comparable to inflation. - The Energy Regulator did not appear to have the capacity to process the amount of tariff applications it received within its own stipulated time frame using the previous Methodology. The new Methodology has therefore provided the Energy Regulator with an efficient manner and the withdrawal of the new methodology will reduce the The Energy Regulator processes ensure that tariff applications are processed within a reasonable time from the date of receipt of complete applications. A proper consultation as per the Rules was followed in this process. The provision for a review does not preclude on-going incorporation by the Energy Regulator of justifiable changes that are considered necessary to immediately capture clarity, transparency and regulatory efficiency benefits. The Energy Regulator will make decisions on the interpretation of the various clauses of the Methodology but any party is entitled at any stage to take decisions of the Energy Regulator on review or appeal as contemplated in the enabling legislations. The tariff applications processed by the Energy Regulator are evident that both standard option 1 and 2 result in high tariffs and overcompensation when Page 11 of 15

12 effectiveness and efficiency of the Energy Regulator as well as that of the sector. - The Energy Regulator did not allow sufficient stakeholder consultation on the issue to withdraw the new Methodology like it did with the lengthy stakeholder consultation when it was implementing it. The Energy Regulator only stated that the new Methodology does not seem to encourage the efficient operation of the petroleum facilities the evidence for this should be presented to the stakeholders before coming to a conclusion. Efficiency It appears that the Energy Regulator has limited understanding of the efficiency concept and has consequently conflicted high tariffs with low efficiency when in fact the opposite may be the correct efficiency. The Regulator has not provided evidence to prove that reverting to the old Methodology will enhance the efficiency of the sector and the possibility is that it will reduce efficiency. To evaluate the efficiency of a regulated tariff the concept of efficiency in an economic sense must first be understood and these are the comments BP is submitting on this topic: 1. Efficiency in economic terms generally relates to optimum resource allocation and is often contextualised in the nature of the market structure. So under a perfect market structure, efficiency is achieved through the market mechanism as by definition all resources are optimally allocated continuously. compared to tariffs based on the TOC tariff methodology. The Energy Regulator has in the past and will continue to process the tariff applications within its stipulated timeframes as detailed in its standard operating procedures. The Energy Regulator does not agree with the comment, a consultation and public hearing for the change of the Tariff Methodology was held on the 22 May 2017 and 4 July 2017 and the communication was published in the Business Day and Independent newspapers for public comments. The Energy Regulator is limited by legislation to determine a cost reflective tariff. The different elements of Allowable Revenue, as well as volumes should reflect this cost effectiveness. In most cases, the RAB values allowed in standard costing options are higher than the actual licensees RAB values. With regards to the operating expenditure, utilising a standard cost of 102 cents per litre assumes that all facilities, irrespective of size, incur the same cost per litre. This leads to inefficient tariffs. - Page 12 of 15

13 2. The tariff in an efficient market is an outcome of the negotiation process and it s important not to conflate lower tariffs with higher efficiency when in fact the opposite is often the case. For example if there is an oversupply of a commodity or service then in a competitive market the price will likely reduce in order to balance supply and demand. The lower price is a reflection of a less inefficient supply position. Methodology Elements RAB The key criteria is the market value of the assets and not whether the tariff is higher or lower than the previous tariff using an alternative methodology. For the Energy Regulator to meet a basic efficiency hurdle, i.e. for it remunerate the asset in the same way that it would be remunerated under perfect competition, the RAB needs to reflect the market value of the asset. NERSA has missed this point as the application of the TOC, RnD and IOC Methodologies do not mimic the market value of the asset. DOE RAS Methodology uses the market value concept as its departure point and it attempts to set the price based on the market value of the assets while allowing for a market return with the addition of reasonable costs whereas the NERSA methodology is based on historic asset values with what appears to be an aberration of the return concept while allowable costs are being reduced through application to direct operating costs. WACC NERSA states that its WACC is real WACC however, for a real WACC to be earned on an asset value the entity must first earn an inflation equivalent return on the market value of the asset. It is flawed to argue that the inflation return is earned through the escalation of the asset value through the TOC approach as CAPM which underpins the WACC methodology has These comments will be considered when developing the Tariff Methodology. It is worth noting that BPSA is also critical of version 3 even though they are of the view that NERSA should retain it. Regulation 4(6)(e) 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 WACC. This requirement is also stipulated in section 28(3)(c) of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003). Page 13 of 15

14 its starting point as the market value of the asset. CAPM uses a nominal WACC. Clawbacks COSTS NERSA has reduced the costs allocated to operational costs only and that appears to have excluded the overhead and allocated costs in the standard models. This leads to inefficiencies as licensees have to cross-subsidise these costs with other parts of the business and operationalise these to include them. BPSA understands the need for efficiency but this statement is incorrect in that the standard costing models are common place in both regulated and unregulated markets they do not ensure nor detract from efficiency. Efficiency is achieved when resources are allocated in line with perfect markets and it s not likely that any model used by the Energy Regulator will achieve this, therefore, the standard costing option are no better or worse than the TOC model in terms of efficiency. NERSA should set a tariff that mimics a perfect market by setting the assets value at the market value allowing a market related nominal WACC and allowing direct and allocated costs to be recovered and allows the scope for commercial negotiations through the establishment of maximum tariffs that all considered generous but prevent the extraction of significant surplus economic rent. Clawbacks are not consistent with efficient markets and therefore the lack of clawbacks is likely to be more efficient than their existence. There is also The cost study undertaken by NERSA has taken into account overhead and allocated costs. NERSA s argument is that the current standard costing model does not encourage efficiency. Allowing a standard amount for operating expenditure also then limits the Regulator s ability to monitor expenditure and if the funds allowed have been spent accordingly. For example, if the Regulator allows 2% of the value of PPE in the total opex costs for maintenance, the Energy Regulator has no mechanism to ensure that the funds allowed are used to indeed maintain the asset. This could lead to perverse incentive of licensees, retaining the funds and not maintaining the assets. NERSA will take this into account in its review of the methodology. Applications reviewed by the Energy Regulator are sometimes multi-year tariff applications, where in most cases even the asset values are projected. Page 14 of 15

15 no rationale for arguing that the lack of clawbacks is a reason to suspend the standard costing options. The Energy Regulator considers the used of the clawback mechanism as an efficient element used to Misalignment between design capacity provided by licensees and that in the license conditions Public consultation process This appears to be a simple administrative error that is easily corrected by NERSA by requesting the applicant to make the correction. It has nothing to do with the methodology used to set tariff and could be present in either methodology. The public hearing process by the Energy Regulator offer no opportunity for discussions on the matter at hand. BP is not aware of any other public consultation process by Government departments that adopts this approach. For example the Department of Energy allows debates by participants even though it still reserves its position and makes it clear that any comments it makes in such consultation meetings are not binding. BP is requesting NERSA to review its public participation process particularly when it comes to matters such as methodologies, rules and regulations. The process should involve debates in some form of workshops to ensure the best outcomes/conclusions. correct over and under recoveries to ensure fair tariffs. In utilising notional design capacity impacts the determination of tariffs under standard option 1 and 2. No other method of determining tariffs would be impacted. The public consultation process followed by the Energy Regulator is based on legislation which governs the processes of NERSA. The Energy Regulator has ensured that due process has been followed in its decisionmaking process. Please refer to the Rules made in terms of section 33 (3) of the Petroleum Pipelines Act. Page 15 of 15