faq for setting of petroleum pipelines - nersa and... · ppe - value of property, plant and...

Frequently Asked Questions (FAQ):

Tariff Methodology for the Setting and Approval of Tariffs in the

Petroleum Pipelines Industry

Approved

24 August 2017

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Table of Contents Page

Glossary of Terms and Abbreviations .......................................................... ..............4

REGULATORY ASSET BASE (RAB) ................................................................................... 4

WACC – GENERAL ............................................................................................................ 10

WACC – BETA ................................................................................................................... 15

WACC – THE MARKET RETURN (MR) ............................................................................. 20

WACC – THE RISK FREE RATE (RF) ............................................................................... 21

WACC – COST OF EQUITY (KE) ....................................................................................... 22

WACC – COST OF DEBT (KD) .......................................................................................... 26

DEPRECIATION ................................................................................................................. 30

EXPENSES – LAND REHABILITATION ............................................................................. 30

F-FACTOR ......................................................................................................................... 35

CLAWBACK ....................................................................................................................... 35

TAX .................................................................................................................................... 40

TARIFF MODEL ON NERSA’S WEBSITE .......................................................................... 43

NOTES ON MULTI-YEAR TARIFF APPLICATIONS........................................................... 45

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GLOSSARY OF TERMS AND ABBREVIATIONS

ALSI - All share total return index on the Johannesburg stock exchange

C - Claw-back adjustments

CPI - Consumer price index

D - Depreciation. The charge (normal depreciation and amortisation on the

write-up) for the tariff period under review

E - Expenditure. Maintenance and operating expenses for the tariff period

under review.

F - Approved revenue addition to meet debt obligations

IRR - Internal rate of return

JSE - Johannesburg stock exchange

Kd - Cost of debt

Ke - Cost of equity

MR - Market return

RAB - Regulatory asset base

Rf - Risk free rate of interest

ROE - Return on Equity

STC - Secondary tax on companies

T - Tax expense. Flow-through and notional tax options

TOC - Trended original cost

TRI - Total return index

PPE - Value of property, plant and equipment net of accumulated

depreciation

w - Net working capital

WACC - Weighted average cost of capital

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REGULATORY ASSET BASE (RAB)

Question 1

1. Why is the original value (historical cost) of the regulatory asset base trended?

Answer

1.1. Regulation 4(6)(e) of the Regulations in terms of the Petroleum Pipelines Act,

2003 (Act No. 60 of 2003) as amended by GNR 242 of 765 in GC NO. 39142

of 28 August 2015 (‘the Regulations’) stipulates that the value of the

regulatory asset base (RAB) is to be on an inflation-adjusted base. The

inflation adjustment is calculated by trending the original (historical) cost on

an annual basis with the consumer price index (CPI) to give the trended

original cost (TOC). The TOC value therefore reflects the nominal value of

the RAB.

1.2. The return on the RAB is calculated in real terms on the nominal value of the

RAB.

1.3. The result of applying a real return on a nominal RAB is that tariffs become

back-loaded. Back-loading of tariffs implies that tariff levels will increase in

real terms over time. This approach ensures that tariffs do not deflate in real

terms as the asset ages, but keep up with the trend of inflation. (This is also

discussed in 4.1.)

1.4. The back-loading of tariffs also reflects the economic reality of prices

generally becoming inflated over time and will therefore counter the effect of

huge price increases when new assets replace old assets.

1.5. The way to calculate the TOC value of the RAB (inclusive of depreciation

and amortisation of the write-up) is demonstrated in Table 1 below. This table

is also published on the NERSA website.

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Table 1: Calculation of TOC value of RAB (inclusive of depreciation and amortisation of the write-up)

Note:

Further clarity on the meaning of non-current assets allowable in the RAB can be obtained from the Regulatory Reporting Manual, Volume 4, which

gives the following classifications:

_______________________________________________________________________________ FAQ: Approved on 24 August 2017

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ASSETS AND OTHER DEBITS Current Assets

100 Cash and Cash Equivalents

110 Accounts Receivable

110.003 Accounts Receivable – Trade

110.004 Accounts Receivable – Other

115 Accumulated Provision for Doubtful Debts

120 Inventory

120.001 Materials and Operating Supplies

120.003 Petroleum Inventory

125 Prepayments

135 Other Current Assets

Deferred Debits

142 Preliminary Surveys and Investigation Charges

147 Other Deferred Debits

Non-Current Assets

171.001 Plant in Service

171.002 Accumulated Depreciation – Plant in Service

172.001 Plant under capital leases and Improvements to leased facilities

172.002 Accumulated Depreciation – Leased Plant and Improvements

176 Line Fill

195.002 Other Intangible Assets

LIABILITIES AND OTHER CREDITS Current Liabilities

200 Bank Overdraft

205 Accounts Payable

206 Account Payable to Affiliated Companies

212 Obligations under Capital Leases – Current Portion


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216 Interest Payable and Accrued

220 Dividends Payable

230 Accrued Income Taxes Payable

235 Other Current Liabilities

Deferred Credits

238 Unamortized Debt Premium and Expenses

241 Other deferred credits

Non-Current Liabilities

245 Provision for Pension and Benefits

255 Long-Term Debt

256 Long-Term Debt-Advances from Affiliated Companies

265 Other Non-Current Liabilities

265.001 Obligations under capital lease – non-current

265.002 Accumulated provision for self insurance

Owners’ Equity

275 Equity Issued

275.001 Ordinary shares issued

275.002 Preference shares issued

280 Contributed Surplus

285 Reserves including excess of appraisal value over depreciated plant cost

290 Retained Earnings

Question 2

2. How is AFUDC treated?

Answer

2.1. AFUDC includes the net cost for the period of construction of borrowed funds

(finance) used for construction purposes and a reasonable rate of return on other


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funds (financing) like equity. Allowances must be computed in accordance with the

formula prescribed in paragraph 2.2 below.

2.2. The formula and elements for the computation of the allowance for funds (financing)

used during construction shall be the approved weighted average cost of capital

multiplied by the sum of:-

i) average balance in construction work in progress,

ii) plus average capital inventory balance,

iii) less construction accounts payable,

iv) less asset retirement costs (if any are included in construction work in

progress).

2.3. The weighted average cost of capital rate shall be determined in the manner

indicated and approved by the Energy Regulator for the applicable year.As Capital

Work in Progress is not subject to TOC this WACC rate should be nominal.

2.4. When only a part of a plant or project is placed in operation or is completed and

ready for service but the construction work as a whole is incomplete, that part of the

cost of the property placed in operation or ready for service, shall be treated as Plant

in Service and allowance for funds (financing) used during construction thereon shall

be capitalized with capital expenditure thereof to become the starting PPE cost for

that asset.

Note:

1. Funds (financing) used during construction on that part of the cost of the plant

which is incomplete may be continued as a charge to construction until such

time as it is placed in operation or is ready for service, except as limited above.

2. No allowance for funds (financing) used during construction will be included

for the portion of projects where a contribution has been received up front on

a direct assigned project. For those projects where contributions are received

up front and no allowance for funds (financing) used during construction is


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calculated, the contribution would be included in the rate base in the same

period as the asset.

Question 3

3. Why is the Trended Original Cost not applied to the working capital component of the

RAB-formula?

Answer

3.1. Working capital resets itself each year and therefore there is an automatic annual

adjustment for inflation in the components of working capital.

3.2. If a multi-year tariff application is submitted, the working capital (W) should be

inflated with the CPI as at 12 months prior to the specific tariff period.

Question 4

4. What benchmarks are used for determining the allowable amounts for the respective

elements in the formula for determining the working capital?

Answer

Net working capital = inventory + linefill + receivables + operating cash – trade payables

4.1. Inventory: Inventory is to be valued at the lower of cost or net realisable value.

4.2. Llinefill: Linefill is to be valued at cost of product.

4.3. Receivables: Receivables is to be based on a maximum of 30 days of a licensee’s

allowable revenue.

4.4. Operating cash: Operating cash is to be based on a licensee’s standard practice

subject to a maximum of 45 days’ maintenance and operating expenses, excluding


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depreciation and deferred taxes. Added to this amount will be the minimum cash

requirements of a licensee’s lender(s).

4.5. Trade payables: Trade payables is to be based on a maximum of 45 days of a

licensee’s allowable revenue.

4.6. If licensees have proof that their actual values for the above benchmarks are higher,

the higher values can be used.

WACC – GENERAL

Question 5

5. Why is a real WACC and not a nominal WACC applied?

Answer

5.1. As explained under question 1, 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 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).

5.2. Inflation is added to the asset base (RAB) and is therefore 'taken out' of the nominal

return (WACC). Nominal returns on real assets would constitute a double count of

CPI and thus 'real returns' are used.

Question 6

6. What is to be understood by the following two statements?

i) Section 28(3)(c) of the Petroleum Pipelines Act 2003 (Act No. 60 of 2003) (the Act):

(3) The tariffs set or approved by the Authority must enable the licensee to- (c)

make a profit commensurate with the risk;


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ii) Section 4(6) of the Regulations:

(6) The allowed revenue to be derived from tariffs contemplated in sub-regulation (2) must

include:

a) reasonable operating expenses

b) reasonable maintenance expenses

c) depreciation expenses

d) reasonable working capital

e) reasonable real return on the regulatory asset base which should be determined

on the assets’ inflation-adjusted cost less accumulated depreciation; and

f) other applicable obligations.

Answer

6.1. The reasonable return relates to the return earned by the licensee on the RAB and

not to the return earned by an equity investor on the RAB. Note that Sub-regulation

(2) refers to an ‘efficient licensee’ and not an equity holder as an entity different from

the licensee.

6.2. In view of the fact that Section 28(3) of the Act does not stipulate that the ‘profit

commensurate with risk’ is to be earned in each year, it is taken that the ‘profit’

(return) is to be earned over the total life of the asset. This profit relates to the profit

of the licensee on the RAB and not to the profit of an equity investor as a separate

construct.

6.3. The actual return that will be earned by the equity investor each year is a function of

the capital structure of the licensee. If the funding structure of the licensee requires

the debt funding to be repaid earlier or faster than the life of the asset, it is viewed

that the equity holder has chosen to become a 'patient capital' investor. The ‘patient

capital’ investor will therefore wait for the debt capital to be repaid before the full

return on equity can be earned.


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6.4. Figures 1, 2, 3 and 4 demonstrate the effect on the annual returns on equity (ROE)

under the following two scenarios (patient capital investor):

a) debt tenure of 10 years; and

b) debt tenure of 25 years.


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Figure 1: ROE per annum (debt = 10 years with equity earned over a period of 10 years)

ROE per annum (10 years debt)


ROE per annum (10 year debt)

% 0.0

% 5.0

% 10.0

% 15.0

20.0 %

% 25.0

1 2 3 4 5 6 7 8 9 10 11 Years

Notional TAX with Deferred Tax adjusted to RAB Required ROE Flow-through actual tax


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ROE per annum (25 years debt)

Notional TAX with Deferred Tax adjusted to RAB Required ROE

Flow-through actual tax


ROE per annum (25 year debt)

0.0 %

5.0 %

10.0 %

% 15.0

% 20.0

25.0 %

1 2 3 4 5 6 7 8 9 10 11 Years


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Note

1. Once the debt has been paid off, the equity starts ‘catching up’ (around years six

to eight) and the actual return to equity is at higher levels. The higher levels of

equity returns reflect the ‘catching up’ of returns that should have been earned in

previous years, but were forfeited because of having to pay off debt (‘patient

capital’).

2. The conversion of the RAB to a nominal value (TOC) and the subsequent real

WACC that is to be earned on the nominal value result in the ‘addition’ of CPI

values to the asset base that do not match the ‘reduction’ of the value of the return

in earlier years, because the return is calculated in real terms. The returns in

earlier years are lower as it takes time for the TOC effect to catch up with the real

return effect. Over the life of the asset, the return equalises out.

WACC – BETA

Question 7

7. Why is a beta derived from international companies used in relation to the conditions

of the local market?

Answer

7.1. There are no suitable comparative companies listed on the local markets.

Question 8

8. What are the criteria for selecting the betas of specific companies as a proxy for local

companies?

Answer

8.1. The proxy companies must be listed on stock exchanges.

Question 9

9. Does NERSA publish beta values?


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Answer

9.1. Yes, NERSA publishes the value of the unlevered beta applicable to the petroleum

industry. The names of the proxy companies utilised for determining the beta value

as well as quarterly updates on monthly beta values are published on NERSA’s

website.

9.2. The beta values proposed for use by the applicant at the various levels of gearing may

be found on NERSA’s website in a document named “Beta values for tariffs in the

petroleum pipelines, storage and loading industry”. The applicant should select the

appropriate beta according to its gearing (efficient target or estimated gearing for the

tariff period under review) from the table published within the document.

9.3. For jointly owned assets or where the licensee is comprised of more than one entity,

the gearing used will be based on the weighted average percentage debt of the

entities that constitute the licensee. The weighting will be based on the percentage

share of licensed activity owned by each entity.

Question 10

10. When are adjustments to the industry beta allowed?

Answer

10.1. No adjustments to the beta are allowed. The beta is a measure of systematic risk.

Company or project-specific risks should be accounted for separately from the beta

as explained in the tariff methodology.

Question 11

11. Which company is used as a supplier of data on beta values of proxy companies?

Answer

11.1. Data is collected monthly on the beta values of proxy companies and is based on

data provided by Bloomberg.


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Question 12

12. At what frequency and over which period is data on the beta value of proxy companies

collected?

Answer

12.1. Monthly data for a period of five years is collected. The five-year period is the period

ending the year immediately preceding the date of publication, which is at the end of

March of every year.

Question 13

13. Is a statistical correction factor applied to the values of the beta?

Answer

13.1. NERSA does not apply any additional correction factor to data utilised for calculating

the beta.

Question 14

14. How is the beta calculated?

Answer

14.1. The following example demonstrates how the beta (β) is calculated.

For licensees that are not publicly listed and where there are insufficient publicly

listed competitors, the equity beta is derived from a proxy beta. To make

adjustments for differences in gearing between the proxy and the licensee the

process involves ‘un-levering’ and ‘re-levering’ as follows:

i. obtaining the equity beta for the proxy company;

ii. un-levering the beta of the proxy company by the gearing level of the proxy

company – this unlevered beta is known as the asset beta;

iii. calculating the weighted average of the asset betas for the chosen proxy

companies; and

iv. re-levering the average asset beta by the (approved) gearing of the licensee.


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14.2. Further clarification

i. The Harris and Pringle formula, which excludes the tax shields in the

notation, will be used.

ii. The following steps must be followed when calculating the beta value:

Step 1 – Calculate asset beta (or un-levered beta) for proxy firms

The following formula must be used to determine the asset beta:

β a1 = β1 / [1 + Dt/Eq]

Where

βa1 = Asset beta for proxy company 1

β1 = Beta of proxy company 1

Dt = Debt of proxy company 1

Eq = Equity of proxy company 1

• Repeat Step 1 for each of the six (or more) chosen proxy firms.

• Market capitalisation values for proxy companies will be used

where such market values exists. Where no market values exist

for proxy companies, book values will be used.

Step 2 – Calculate weighted average asset beta of proxy firms

Weight each of the 6 (or more) proxy firm asset betas by their proportion of

the total debt plus equity of the 6 (or more) proxy firms and sum the results

using the following formula:


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Where

βaE = Weighted average asset beta of the proxy companies

(Dt + Eq)n = Sum of the debt and equity for a specific proxy

company

(βa)n = Asset beta of the corresponding specific proxy

company

= Sum of debt and equity for all proxy companies

n = Number of proxy companies

Step 3 – Calculation of beta (β) for licensee (re-levering of beta)

The following formula must be used to determine the beta for the licensee:

BL

Where

= βaE * [1 + Dt/Eq]

ΒL = Beta for the licensee

βaE = The weighted average β of the proxy firms asset betas

from Step 2. The Energy Regulator may adjust this

factor to take account of a difference in country risk

ratings between the host country of the proxy firms and

South Africa.

Dt = The interest bearing debt of the licensee subject to a

minimum gearing level of 30 per cent

Eq = The equity of the licensee


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WACC – THE MARKET RETURN (MR)

Question 15

15. What market index will be used as a proxy for the performance of the South African

market?

Answer

15.1. The All Share Total Return Index (ALSI) is used as a proxy for the performance of

the South African market as it represents the widest possible spectrum of industries

trading in the South African market, as measured by the Johannesburg Stock

Exchange (JSE).

Question 16

16. Why is a post-tax market return (MR) used for determining the market risk premium

(MRP)?

Answer

16.1. The market returns, as represented by the various JSE indices, reflect earnings after

taxation has been provided for (i.e. data is presented on an after-tax basis).

16.2. No adjustment for Capital Gains tax is made as it is assumed that the equity return

holders will hold the investment to maturity and therefore the total return index (TRI)

is used.

16.3. There are flaws and challenges inherent in using the ‘post-tax’ MR as a basis and

converting it to a ‘pre-tax’ MR by grossing it up with the tax rate. This method is thus

not used by NERSA.

16.4. As the Allowable Revenue formula treats Taxation as a separate ‘operational’ item

(T), the WACC calculations are all performed on a post-tax basis.


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WACC – THE RISK FREE RATE (RF)

Question 17

17. Why are government bonds with a maturity of ten years or longer used?

Answer

17.1. An investor in pipeline infrastructure normally has a long-term investment horizon of

at least ten years. A maturity of less than ten years is considered to be subject to

short-term fluctuations in the economic environment which could impact on the

volatility and validity of this measure for the industry.

17.2. Longer term investment instruments are also more in line with the 30-year MR data

used in calculating the WACC.

Question 18

18. What data sources does NERSA use and how frequently does NERSA publish

economic data for the purpose of tariff setting and approval?

Answer

18.1. The sources of the economic data utilised by NERSA and the frequency of updating

the economic data are provided in Table 2.

Table 2: Economic data sources and frequency of updates as provided by NERSA for tariff setting

and approval in the petroleum industry Data Source Date & frequency of updating the

data on NERSA’s website CPI-Historical Statistics SA Quarterly updates of monthly data

RSA 10-year Bonds Reserve Bank of SA Quarterly updates of monthly data Market Return

ALL Share Total Return Index

(ALSI-TRI) on the JSE Quarterly updates of monthly data

List of Beta proxy

companies as well as the

value of the beta applicable

for the tariff period

Bloomberg Quarterly updates of monthly data


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WACC – COST OF EQUITY (KE)

Question 19

19. Are any adjustments to the cost of equity allowed?

Answer

19.1. The following adjustments to the Cost of Equity (Ke) will be considered on a case-

by-case basis:

CRA = Country risk adjustment.

(The real CRA will be added to the risk free rate. The CRA is for assets

in another country outside South Africa that are an integral part of the

same asset/s within South Africa. The adjustment is for the other

country concerned).

SSP = Small stock premium. An adjustment to compensate for the lack of specific

qualitative abilities of a licensee if warranted.

α = Project specific risk if the circumstances warrant such an adjustment

LP = Liquidity premium to accommodate assets which are not publicly

traded if the circumstances warrant such an adjustment.

Note

A small stock premium and project specific risk adjustment will be

considered in the following cases:

a) SSP adjustments:

If the answers to the following two questions are ‘no’ (both answers

must be ‘no’), then a SSP adjustment may be applied:

In running its business:


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i. does the licensee have access to legal, financial and

operational/technical expertise within its own structures/or can

the licensee obtain this expertise from its shareholders; and

ii. is there a history of the licensee having had access to this

expertise under its a previous shareholding dispensation?

b) Project specific risk adjustments (if the circumstances warrant such

an adjustment)

The Energy Regulator needs to be provided with proof of the following

project specific risk factors:

- construction;

- management;

- technology;

- customer base;

- supplier chain; and

- other.

Question 20

20. How is the cost of equity calculated?

Answer

20.1. A practical example for calculating the Ke is presented below, making use of

assumed values for the respective elements in the formula for calculating Ke.

The formula for determining the Ke is:

Ke

Where:

= Rf + (β *MRP)

Ke

= Post-tax, real cost of equity


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Rf = Riskfree rate of interest (real).

(This is the average of the real monthly marked-to-market

riskfree rate for the preceding 300 months for all Government

bonds with at least a 10 year maturity as at 12 months before the

commencement of the tariff period under review)

β = ‘Beta’ is the systematic risk parameter for regulated entities

providing pipeline, storage and loading facility services

(The beta must be determined by proxy. As a proxy the

average of at least six pipeline companies listed on stock

exchanges is used. The value of the proxy is as at 12 months

before the commencement of the tariff period under review).

MRP = Market risk premium (post-tax, real).

[The proxy used for the market is the Johannesburg Stock

Exchange (JSE) All Share Total Return Index (ALSI with JSE Code

J203T) for the preceding 360 months as at 12 months before the

commencement of the tariff period under review. The arithmetic

average for the 360 months is used.]

Note

Two scenarios are considered – the first where the cost of equity is adjusted for

liquidity by multiplying a factor, and the second where the cost of equity is adjusted

for liquidity by adding a factor. Examples to calculate these are presented next.

Multiplying to adjust for liquidity:

In the practical example for calculating the Ke (and multiplying to adjust for liquidity),

the values for the elements in the Ke formula are assumed to be as follows:

Rf = 4.5%

CRA = 0.2%

MRP = 7%

β = 0.5

SSP = 2.25%

α = 0.10%


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LP = 5%

Based on the above assumed values, the value of the Ke is calculated to be:

Ke = [(Rf + CRA) + (MRP * beta) + SSP + α] * (1 + LP)

= [(4.5% + 0.2%) + (7% * 0.5) + 2.25% + 0.10 %] *(1 + 5%)

= (4.7% + 3.5% + 2.25% + 0.10%) *1.05

= 11.08%

Adding to adjust for liquidity:

In the practical example for calculating the Ke (and adjust for liquidity through

adding), the values for the elements in the Ke formula are assumed to be as follows:

Rf = 4.5%

CRA = 0.2%

MRP = 7%

β = 0.5

SSP = 2.25%

α = 0.10%

LP = 0.53%

Based on the above assumed values, the value of the Ke is calculated to be:

Ke = (Rf + CRA) + (MRP * beta) + SSP + α + LP

= (4.5% + 0.2%) + (7% * 0.5) + 2.25% + 0.10 % + 0.53%

= 4.7% + 3.5% + 2.25% + 0.10% + 0.53%

= 11.08%


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WACC – COST OF DEBT (KD)

Question 21

21. Why is the real cost of debt (Kd) used and not the nominal cost of debt?

Answer

21.1. The inflation adjustment in the cost of debt (Kd) is ‘taken out’ as this is ‘replaced’ with

the trending of the full value (PPE-d) of the original cost to give the nominal TOC of

the RAB.

21.2. Nominal returns on real assets would constitute a double count of CPI and therefore

‘real returns’ are used.

Question 22

22. Under what scenario will equity investors be in a position to earn their full return as

embedded in the Ke portion of the WACC?

Answer

22.1. The reasonable return relates to the return on the asset for the licensee and not for

the equity investors. The actual return that will be earned by the equity investor is a

function of the capital structure of the licensee as was explained under question 6. If

the funding structures of the licensee require the debt funding to be repaid earlier or

faster, it is viewed that the equity holder has chosen to become a ‘patient capital’

investor. The ‘patient capital’ investor will wait for the debt capital to be repaid before

they receive their required return.

22.2. The conversion of the asset base (PPE-d) to a nominal value (TOC) and the

subsequent conversion of WACC into real WACC results in the ‘addition’ of CPI to

the asset that does not ‘match’ the ‘reduction’ of the rate in earlier years. Therefore,

the returns in earlier years are lower as it takes time for the TOC effect to catch up


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with the real return effect. Once the catch up has taken place (around years 6 to 8),

the return will be superior. (See graphs in question 6 above.)

Question 23

23. Does the post-tax, real WACC allow the entity enough allowable revenue to pay back

its debt which is payable in pre-tax nominal terms? [The WACC (Ke & Kd) is provided

for only on a post tax, real basis.]

Answer

23.1. No. The tax shield in the Kd is provided for in the tax formula where the post-tax Kd

is grossed up with the tax shield portion of the Kd. This ensures a pre-tax Kd is

provided for in the allowable return to match the payment of the financing costs in

nominal values.

23.2. In tables 3 and 4 below, the calculation of tax (as per the tax formula in the tariff

Methodology) is demonstrated. For each component which is taxable, a grossup at

the existing tax rate is performed. Tax allowances are therefore provided for in these

grossed-up balances and will be included in the total balance of the allowable

revenue.

23.3. As can be seen from tables 3 and 4, the grossing up of balances also applies to the

Kd to ensure the tax shield on the Kd is properly accounted and provided for.

Table 3: Treatment of WACC with Notional Tax

Table 4: Treatment of WACC with flow-through tax


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Question 24

24. Why is Vanilla WACCreal (pre-tax Kd and post-tax Ke) not used instead of grossing up

the post-tax Kd to ensure that the tax shield of the Kd is provided for in the before tax

allowable revenue?

Answer

24.1. Vanilla WACC is a calculation where the Ke is post-tax and the Kd is pre-tax.

24.2. The taxation component for the cost of debt is ‘given’ to the investor by allowing the

‘tax shield’ in the calculation of taxation allowance (T) as is demonstrated in the above

Table 3 and Table 4.

24.3. The Vanilla WACCreal results in a higher return relative to the notional or flowthrough

(with tax shield) options and therefore it is not utilised by NERSA. This is demonstrated

in the published model in the TAB ‘flow-through Vanilla’ where the return achieved is

15.5 per cent, which is higher than the 15 per cent required return.

DEPRECIATION

Question 25

25. How is depreciation and amortisation of the write-up portion calculated?

Answer

25.1. See example in Table 1 of Question 1.

EXPENSES – LAND REHABILITATION

Question 26

26. What is the legal and regulatory foundation for the recovery of land rehabilitation cost?


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Answer

26.1. In terms of the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) the authority may

require a licensee to submit a financial security, or make such other arrangements as

may be acceptable to the Authority, to ensure compliance with any licence condition

relating to health, safety, security, or the environment, prior to, during or after the

period of validity of the licence. Regulation 9 (3) of the regulations provides that the

authority must require the licensee to provide financial security for the purpose of

rehabilitating land used in connection with a licensed activity and the composition and

amount of such security. The Methodology states ‘Provision for land rehabilitation

costs are permitted, subject to adequate justification. These funds must be kept in

accordance with the Petroleum Pipelines Act, 2003 (Act No. 60 of 2003) and sub-

regulation 9 of Regulations.

26.2. The methodology refers to the classification and calculation of the operating expenses

(inclusive of the land rehabilitation costs as per paragraph 6.4.7)

26.3. Sub-regulation 9 states:

(1) A licensee must inform the Energy Regulator in writing when it applies to the

relevant environmental authority for an environmental impact assessment for

the termination of or abandonment of the licensed activity in accordance with

the National Environmental Management Act, 1998.

(2) A licensee must, at least six months prior to the termination or abandonment

of a licensed activity, submit to the Authority, proof of the approval of the

termination or abandonment of the licensed activity.

(3) The Authority must require the licensee to provide financial security or make

arrangements as may be acceptable to the Authority for purposes of

rehabilitating land used in connection with a licensed activity.

(4) The financial security contemplated in sub-regulation (3) may be in any form

acceptable to the Authority and may only be used with the approval of the

Authority.


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(5) The Authority may, in writing, at any time, require written confirmation from a

licensee that it is in compliance with the requirements of the National

Environmental Management Act, 1998.

(6) The Authority may require written proof from the licensee that the authority

responsible for administering the National Environment Act, 1998 has

approved the environmental impact assessment required by the Act.

(7) The Authority may not revoke the licence in respect of a licensed activity,

before it is in receipt of a certificate from an independent consultant

competent to conduct environmental impact assessments in accordance with

the National Environmental Act, 1998, which states that the site has been

rehabilitated.

The financial instrument must be in a form acceptable to the Energy Regulator as

required by section 9 (4) of the regulations. To ensure compliance in this regard it

would be the most practical for the financial security structure to be approved by

the Energy Regulator in advance.

Question 27

27. How should land rehabilitation costs be calculated and recovered through the Allowable

Revenue?

Answer

27.1. Land rehabilitation costs are recovered as part of operating expenses.

27.2. Land rehabilitation cost can therefore NOT be included as part of Property, Plant and

Equipment (RAB) and therefore no return is earned thereon.

27.3. The mechanism to collect the land rehabilitation costs is the present value of the future

liability less the value of funds in the ‘decommissioning fund’ to arrive at a balance still

to be collected. The remaining balance is then divided by the remaining years to

decommission the asset. The formula for this is:


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PMT=[PVfund value]/n

Where

N = the number of remaining years to decommission

PVfund value = the present value of decommissioning costs

Fund value = the current balance in the decommissioning fund, being

historic contributions (provision for decommissioning

costs) plus net returns on such contributions.

27.4. An example of how the land rehabilitation cost is to be calculated is presented in Table

5.


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Table 5: An example on the calculation of land rehabilitation costs

Note

The value of the land rehabilitation liability in year 10 (R9,662) is covered by

the value of the fund at the end of that year (R9,662) excluding the

investment returns in that year.

27.5. For the above example, the Depreciation in the Allowable Revenue formula compared

to the allowance of the land rehabilitation on an annual basis is demonstrated in Figure

5 below. Note that the upward trend is similar to achieving the goal of raising tariffs as

intended by the nominal assets, real return principle used in the methodology.


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Figure 5: Depreciation and TOC Amortisation vs Land Rehabilitation cots

F-FACTOR

Question 28

28. How is the F-factor calculated and how will it be recovered?

Answer

28.1. Details are provided in Section 4.2.14 of the Tariff Methodology for pipeline tariffs.

The F-factor will be treated as a return of capital, i.e. deducted from/added to the RAB.

CLAWBACK

Question 29

29. When will clawbacks be applied?

Answer

29.1. In the tariff period following the release of audited financial statements of the applicant.

-

200

400

600

800

1 000

1 200

1 400

1 600

1 800

1 2 3 4 5 6 7 8 9 10

Depreciation and TOC amortization vs Land rehabilitation costs

Depreciation and TOC amortization Land rehabiliatation cost


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Question 30

30. Are there examples of specific clawback calculations?

Answer

30.1. The formula for clawback adjustments is as follows:

Clawback adjustments = ARA +(PPE-d)A + DA + KdA + EA + OeA + + + GA

30.2. More detail on the formulas to determine clawbacks is presented next.


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30.2.1. Allowable Revenue adjustment (ARA)

The allowable revenue adjustment compensates the licensee and customers for

differences between allowable revenue planned and allowable revenue realised in

a specific tariff period. The following formula applies:

ARA = ARa - ARr

Where

ARA = Allowable revenue adjustment

ARa = Allowable revenue approved

ARr = Allowable revenue realised

30.2.2. Value of new operating property, plant and equipment adjustment (PPE-d)

The net value adjustment for operating property, plant and equipment (PPE-d)A

compensates licensees and customers for differences in operating assets estimated

to be in use and operating assets actually in use in the tariff period under review.

This pertains to changes arising from additions, decommissioning and disposals of

operating assets – as well as to the timing of implementing these changes. Timing

refers to the difference between the projected date and the actual date when the

changes were implemented. Adjustments to the net value of the operating assets

(PPE-d)A is determined by applying the formula below:

(PPE-d)A

Where

= Allowable revenue adjustment on (PPE-d)updates

= [(PPE-d)updates x (Dya – Dyp)/365] x WACC

(PPE-d)updates = Net value of the operating assets that will be

commissioned, decommissioned or disposed of during the

tariff period under review.


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Dya = Actual number of days from the date when the operating

asset(s) was commissioned, decommissioned or disposed

of to the end of the tariff period.

Dyp = Projected number of days from the date when the

operating asset(s) was planned to be put into use,

decommissioned or disposed of to the end of the tariff

period.

30.2.3. Depreciation and amortisation of inflation write-up adjustment (DA)

The depreciation and amortisation of inflation write-up adjustment provides for the

differences between the projected depreciation made at the time the allowable

revenue was determined and the actual depreciation for the specific tariff period.

The following formula must be applied:

DA = Da –

Dp Where:

DA = Depreciation and amortisation of inflation write-up adjustment

Da = Depreciation and amortisation of inflation write-up actual

Dp = Depreciation and amortisation of inflation write-up approved

30.2.4. Cost of Debt Adjustment (KdA)

If there is a difference between the estimated cost of debt in the allowable revenue

and the actual cost of debt for that tariff period, then the allowable revenue must be

recalculated using the actual cost of debt and the difference added to or subtracted

from the clawback adjustment. The following formula must be used to determine the

KdA:

KdA = Allowable Revenue recalculated using actual cost of debt –


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Allowable Revenue calculated using approved cost of debt1

30.2.5. Expense adjustment – Operating and Maintenance Adjustment (EA)

Adjustments on operating and maintenance expenditure provides for differences

between expenditure projected at the time of setting the tariffs and the actual

expenditure for the tariff period and is calculated by applying the following formula:

EA =

Where

Ep – Ea

EA = Operating and maintenance expense adjustment

Ep = Operating and maintenance expense projected

Ea = Operating and maintenance expense actual

30.2.6. General adjustment (GA)

Provision is made for a general adjustment. This adjustment is for any remaining

differences between projected allowable revenue and actual allowable revenue not

resulting from efficiency gains, for example:

i. debt ratio and the effect thereof on beta, cost of equity, WACC and the

taxation effect of these adjustments;

ii. taxation adjustments; and

iii. other.

1 All other factors and quantum in estimated Allowable Revenue remain the same.


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TAX

Choice between two different tax approaches

Question 31

31. What is the difference between flow-through tax and notional tax?

Answer

31.1. The Methodology states that the flow-through tax is the actual tax paid by the entity

and this is allowed as a tax allowance. Notional tax expense is the tax due according

to accounting requirements. Flow-through tax neither awards the tax shield nor the

benefits of accelerated wear and tear (or deferred taxation).

Question 32

32. How is the tax calculated under the following scenarios?

Flow-through tax

Notional tax

Answer

32.1. Examples on the calculation of tax under the two scenarios are provided in tables 6,

7, 8 and 9.

32.2. Calculation of the flow-through tax.

Tax = {(NRBTA) / (1-t)}*t

Where

NRBTA = Net revenue before tax allowance

= {(RAB*WACC)+E+D(historic & write up)+F± C} -

{E+D(historic) +Kd(nominal)}.

t = prevailing corporate tax rate of the licensee.


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Table 6: Example of the calculation of flow-through taxes

Ke a 5.10

Kd b 1.78

WACC c=a+b 6.88

E d 3.00

D (historic) e 4.00

D (write-up) ee 0.20

Wear and tear allowance eee 10.00

F f 0.00

C (Clawback excluding tax clawback) g 0

NRBTA= Allowable revenue before tax allowance h=c+d+e+ee+f+g 14.08

t j 28%

Kd (nominal) n 5.88

NRBTA= ((RAB*WACC)+E+D(historic & write up)+F+C)-(+E+D(historic)+Kd(nominal)) Note that the interest is deducted as an actual tax calculation is perfomed k=h-d-e-n (4.80)

Tax = ((NRBTA excl tax allowance)/(1-t))*t l=(k/(1-j)*j (1.87)

Total Allowable revenue m=h+l 12.22

Test TAX rate l/(k-l) 28%

Note

No other non-taxable income or non-deductible expenses have been included above.

These will form part of the actual calculation when detail is available.

Table 7: The effect of using flow-through tax


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Table 8: Example on the calculation of notional tax

Ke a 5.10

Kd b 1.78

WACC c=a+b 6.88

E d 3.00

D (historic) e 4.00

D (write-up) ee 0.20

Wear and tear allowance eee 10.00

F f 0.00

C (Clawback excluding tax clawback) g 0.00

NRBTA= Allowable revenue before tax allowance h=c+d+e+ee+f+g 14.08

t j 28%

Kd (nominal) n 5.88

NRBTA= ((RAB*WACC)+E+D(historic & write up)+F+C)-(+E+D(historic)) Note that the interest is deducted as an actual tax calculation is perfomed k=h-d-e 7.08

Tax = ((NRBTA excl tax allowance)/(1-t))*t l=(k/(1-j)*j 2.75

Total Allowable revenue m=h+l 16.83

Test TAX rate l/(k-l) 28%

TARIFF MODEL ON NERSA’S WEBSITE

Question 33

33. Is there a practical example of how to incorporate all the elements of the tariff

methodology into one template?

Answer

33.1. NERSA has published a model on its website with the intention of demonstrating

the various options and scenarios by way of testing the target cost of equity by

the outcome of the internal rate of return (IRR) of cash flows to investors1.

33.2. Some general notes on the model as published on NERSA’s website are:

1 Storage Tariff Model Manual

http://www.nersa.org.za/Admin/Document/Editor/file/PetroleumPipelines/Tariffs/Storage%20Tarif%20Model%20Manual.pdf


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i. Base case – The model presents a base case scenario using the

notional tax option where no adjustments are made for deferred

taxation to the RAB.

ii. F-Factor – The model demonstrates the treatment of the F-factor as a

return of capital, i.e. the full value of the F-factor is deducted from/or

added to the RAB.

iii. Notional tax – This is the notional tax option with the deferred taxation

adjusted in RAB. Note that IRR is higher than targeted as the actual

tax and deferred tax cash flows practically lag one year.

iv. Tax formula notional – The model demonstrates the tax formula for

year 1 and also demonstrates the tax shield for each component of

allowable revenue.

v. Flow-through using Vanilla WACC – This represents a flow-through

option but with the Kd pre-tax. This means that the tax shield on the

Kd is not allowed in the tax calculation as the tax is already included

in the pretax rate. Also note that the ‘achieved IRR’ in this option is

higher (15.50 per cent) than the targeted 15 per cent, which is why this

option is not followed.

vi. Flow-through actual – Flow-through tax is defined in the

Methodology (paragraph 10.2) as actual tax payments. As can be

seen, the resultant IRR is below the target IRR of 15 per cent, which

is a result of the tax shield on cost of debt not being allowed. For this

reason, NERSA uses the tax flow-through formula to calculate the tax

allowance in the model.

vii. Graphs – The model also has ‘worksheet tabs’ comparing, by way of

data or graphs, the differences between the various tax options (flow-


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through and notional tax) and tenures of debt (10 years versus 25

years).

NOTES ON MULTI-YEAR TARIFF APPLICATIONS

Question 34

34. How will NERSA treat multi-year tariff applications?

Answer

34.1. The treatment of multi-year tariffs is presented in the section that follows.

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