ELECTRICITY DISTRIBUTION INDUSTRY (EDI) RESTRUCTURING : 11August 2005

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1 ELECTRICITY DISTRIBUTION INDUSTRY (EDI) RESTRUCTURING : 11August 2005 PURPOSE 1. To update Council on the latest information in respect of the Electricity Distribution Industry Restructuring; 2. To engage into a Section 78 process of the Municipal Systems Act and ringfencing of the electricity business; 3. To advise Council on the Way forward. BACKGROUND It has long been of concern that, in the words of the Minister of Minerals and Energy, the South African Electricity Distribution Industry (EDI) is in financial crisis. Many of the municipalities are loss-making entities as a result of inefficiencies, a lack of capacity, theft, and a history of non-payment by users. Furthermore, there is an extent of electricity cross subsidising other essential services within certain municipalities, which requires significant financial restructuring and ringfencing, prior to amalgamation with other municipalities and Eskom to form the Regional Electricity Distributor s (REDs). It is reported that Eskom is suffering bad debts on its bulk supply, with municipality arrears estimated at R100 million in July Furthermore, the haphazard development of the EDI (for historical reasons) has led to widely differing tariffs, varying levels of reliability and billing procedures. Restructuring of the EDI is a significant undertaking and is driven largely by the considerable fragmentation that the industry currently experiences. In the municipal distribution environment this has resulted in: Wide disparities in cost, tariffs and service levels; Poor quality of supply; Economies of scale not being captured by many small and medium sized municipal distributors; and An industry that is unable to meet its long-term financial obligations due to cross-subsidisation of other municipal services and electrification programmes. EDI restructuring is an urgent national imperative. Complying with EDIrestructuring guidelines is critical if the EDI is to be re-organised into a more modern, efficient and sustainable structure. This will undoubtedly benefit most stakeholders, not least consumers and staff. Restructuring of the electricity distribution industry (EDI) has been necessitated by a number of key drivers and these are described below:

2 1. Financial crisis facing the electricity distribution industry 2. Inadequate maintenance of networks 3. Unequal treatment of consumers across the country 4. Significant disparities in tariffs 5. Inefficiencies owing to fragmentation 6. Absence of economies of scale 7. Limited opportunity to introduce competition Given the above challenges, the aims and objectives of the restructuring process are: To ensure that EDI is well placed to meet the basic needs and requirements of electricity consumers in South Africa - regardless of location or income To ensure acceptable and sustainable levels of supply security and quality; and to provide for high levels of customer service to all users To eradicate disparities for consumers as a result of historic development of the sector or location To establish a structure and financial arrangements that support the achievement of government s electrification programme To ensure arrangements that provide for a sustainable supply to lowincome consumers at affordable prices To ensure the future REDs can operate on a sustained financially viable basis as independent businesses Achieving the aims and objectives of the restructuring process will require a coordinated and focused approach. To this end, EDI Holdings (Pty) Ltd was established to oversee the restructuring process. The Role of EDI Holdings (Pty) Ltd EDI Holdings (Pty) Ltd has been established to plan, control and manage the process of the establishment and implementation of the six financially and operationally independent REDs. Its goals are: To ensure that the new RED businesses are able to provide secure employment to their employees, provide skills development and training, as well as to operate within nationally agreed terms and conditions of employment; To ensure the reform process is taken forward within well planned and managed transitional arrangements in the interests of all electricity consumers nationwide; and To ensure the transition is done within the context of a comprehensive human resources strategy and an agreed Social Plan, thereby protecting interests of individuals impacted by the reform, and ensuring the arrangements are consistent with government policies towards skills development and social protection.

3 EDI Holdings (Pty) Ltd and its requirements The requirements of EDI Holdings (Pty) Ltd are for the municipalities to: 1. Create at least a Separated Operational Entity (SOE) or a municipal entity (ME) in line with the Ringfencing Framework ; 2. Develop a list of the people, assets and liabilities that will be transferred to the RED s; and 3. Create a separate set of financial statements for each RED. What is a Separated Operational Entity (SOE)? The mission of an SOE is to distribute and sell electricity and provide customer services as per the NER license. The basic characteristics of a Municipal SOE are: An interim business, operationally and financially separated (stand alone) from the parent organisation, that is ready for integration into a RED; The SOE is not a separately created juristic person by law but it is a profit centre of the Municipality. If the municipality resolves through its S78 process to create a legally separate entity it can do so by creating a ME. The Municipality remains the owner ; An entity utilising existing Municipal business processes, infrastructure, staff and information systems where services provided between SOE and municipality are managed through Service Level Agreements/Service Delivery Agreements; A practical functional business not focused on new development other than preparing for RED integration it is recommended that any new investment and/or loan must be secured with the EDI restructuring in mind; The Service Provider, whilst the Municipality is the Service Authority and holder of the distribution license from the NER; and An entity with clear accountabilities and responsibilities both internally to the SOE itself as well as those between the SOE and the Municipality. If the S78 process reveals that a municipal entity (ME) is the preferred option the process of the SOE will be followed by legal separation with the municipality still remaining the sole owner of the entity. Government is desirous of accelerating this project so that certainty can be achieved in regard to Electricity Supply in our country. Clearly the restructuring itself is dependant on enabling legislation. The draft Bill that was submitted for comment did not clarify whether it will be voluntary or mandatory for a supply industry to be included in a RED. According to the Constitution, existing supply authorities have the right to do reticulation, but the draft Bill stated that the Minister may decide on the final position.

4 Although participation appears at this stage to be voluntary, all indications are that participation will in future become compulsory to ensure all the REDs are viable. This means that legislation will be amended to make provision for a compelled restructuring. DISCUSSION The EDI Restructuring process has advanced to the stage where the State President in his address to the nation made reference to the process and put target dates to it. The first RED was established on 1 July 2005 in the Western Cape and all six are scheduled to be in operation by January The first RED was the merging of the City of Cape Town and ESKOM at the initial stage and other municipalities will be included over time. Announcement of the second RED to be formed is awaited in due course. In the meantime, it became clear that much work is required and can be done in preparation for the execution of restructuring until the legislation has been enacted. This work inter-alia involves the ringfencing of Municipal Electricity undertakings and ESKOM and the preparation of the transfer Schemes as proposed in the draft EDI Restructuring Bill. A further requirement is to implement the mechanisms the Section 78 process of the Municipal Systems Act in preparation for the EDI Restructuring. 1. Association of Municipal Electricity Undertakings (Southern Africa) strategy report The AMEU has recommended a strategy that municipalities should follow to prepare for restructuring of the electricity distribution industry: The recommendation is for municipalities to: a) Carry out a review of their electricity service delivery mechanism according to the process specified in Section 78 of the Municipal Systems Act, Act No. 32 of To save cost, it is recommended that only such investigation and consultation specified in the Act be done to make the S78 decisions. b) Update their electricity asset register in preparation to apply an asset valuation methodology provided by EDI Holdings Ltd. c) Begin to identify resources and costs involved in providing the electricity service and commence with a ringfencing of the electricity service from the remaining municipal services to establish the true business value of this service. d) Communicate details of the restructuring with employees of the electricity service and key stakeholders. 2. EDI transitional labour relations structure establishment agreement An EDI transitional labour relations structure establishment agreement was concluded between EDI Holdings, ESKOM, SALGA and the Trade Unions on 29 October 2004.

5 This agreement was concluded to establish an EDI Transitional Labour Relations Structure that will identify human resource issues and formulate national guidelines to deal with these issues. 3. EDI cooperative agreement In order to facilitate the preparatory work prior to enabling legislation, the Department of Minerals and Energy (DME) with the assistance of a projectworking group has prepared a co-operative agreement between DME, NER, ESKOM and SALGA. These agreements include an accession agreement, which when signed by a Municipality, binds them to the same agreement. SALGA has given consideration to this matter and after having clarified certain issues in bi-lateral discussions with the Minister of Minerals and Energy, signed the agreement. It is the understanding from all parties who signed the agreement that it will be in the national interest that all Municipalities accede to the agreement and move forward on the EDI Restructuring. 4. Section 78 Process Section 77 of the Municipal Systems Act details the circumstances under which municipalities must review and decide on mechanisms for provision of municipal services. Section 78 describes the criteria and process a municipality must follow to conduct such an examination of both the existing and other specified mechanisms for service delivery. The mechanism aims to ensure that new service mechanisms are well understood prior to introduction due to the nature, extent and importance of the services under review and to consider the impact and sustainability on the community and the municipality. At this stage, any decision to move forward with restructuring requires that the municipality follow an MSA Section 78 process as the preliminary step. EDI Holdings has invested in a toolkit module to streamline the MSA Section 78 process, with specific reference to electricity distribution services. This toolkit module will assist Municipalities to undertake the Section 78 assessment process, with or without external advisory assistance, in a balanced and costbenefit driven manner. This toolkit module is intended to be used as a guide, and caution must be exercised at all times when interpreting benchmarks and data. The MSA Section 78 process comprises 4 components: An internal assessment A decision to remain with an internal mechanism or investigate an external mechanism (Section 78 (2)) An external mechanism assessment (Section 78 (3)), and finally A decision to pursue the internal or the external mechanism and in which format (Section 78 (4)).

6 Given that both the internal and the external assessments are very similar in their extent and analytical requirements, and in light of the EDI restructuring process currently underway, it should be noted that it is recommended that the external assessment could and should be instigated in all cases. This will ensure that all options are fully investigated prior to a final decision being made, thereby limiting any need for a further investigation at a later stage. Four main processes will be need to be executed which will provide the outputs required to address the above mentioned areas. Process 1: MSA s.78 (2) Decision An initial Council decision is required to instigate an Electricity-specific MSA s.78 assessment. The project champion or sponsor should utilise the MSA Rationale Report Template to motivate for a concurrent s.78 (1) and (3) exercise to be conducted. This template outlines the unique case for the Electricity Distribution Industry and the associated rationale behind why all service delivery mechanisms, including the RED (external), should be investigated comparatively prior to making a final restructuring decision. This decision should then be viewed as the s.78 (2) decision. Once this decision has been taken, the Council may choose to issue a Request for Proposal (RFP) to prospective professional service providers to assist with the process, unless it is anticipated that the exercise will be performed in-house. Process 2: Stakeholder Consultation All stakeholder consultation processes should run concurrent to the assessment process (Process 3). Firstly, the community must be notified of the municipality s intention to investigate external service delivery mechanisms (as per MSA s.78 (3)). Secondly, a consultation process must be established to engage organised labour regarding its views on both the internal and external service delivery mechanisms. Finally, written summaries of the views of organised labour and the community must be gathered and submitted alongside the findings of the s.78 (1) and (3) assessments. Process 3: MSA s.78 (1) and (3) Assessment The objectives of this component are to: Understand the emerging trends in municipal electricity service delivery, taking into account the MSA s.76 options, the changing role of the NER, the strategic needs of the municipality and the EDI restructuring process Understand the status quo of the current service delivery mechanism. This involves gaining a holistic understanding of the entity, covering technical, financial, information technology, human resource and customer service performance Measure and compare the current performance of the entity using technical, financial, HR and service indicators Understand the potential implications from an environmental, human health, well-being and safety, development and employment perspective Review the potential external service delivery mechanism options

7 Measure and compare the current performance of the entity using technical, financial, HR and service indicators Understand the potential implications from an environmental, human health, well-being and safety, development and employment perspective Prepare a report detailing the status quo and case for change Manage and ensure the active participation of stakeholders in regular meetings Manage and gain access to all relevant information and documentation such as existing drawings, maps, service records, meter records, demographic information, consultants reports, Service Level Agreements (SLA s), business strategies etc. Complete a business case evaluation of possible external service delivery mechanisms using high-level financial modelling (cost-benefit analysis techniques) within the context of legal, regulatory, institutional and risk frameworks. Process 4: MSA s.78 (4) Decision A final Council decision is then required to conclude an MSA s.78 assessment. 5. Ringfencing The EDI Blueprint compiled by Price Waterhouse Coopers under the guidance of DME proposes that RED formation begin with separation and ringfencing of distribution activities from the parent organizations. To this end, EDI Holdings has developed a framework and toolkit to assist with the processes. The restructuring of the electricity industry in South Africa is conducted within the provisions of the draft EDI Restructuring Bill of May 2003, which provides for the creation of regional electricity distributors through a process of ringfencing. The reasons for ring fencing are not solely for this purpose and others can be stated as follows: NER licence requirement GAMAP compliance Identify Actual Costs Enables optimal utilisation of resources and more accurate budgeting Provides the basis for determining an appropriate service level agreement Provides the basis for determining value of assets to be transferred to the RED Position municipality to maximaise it s interest in the future RED

8 Ringfencing in the context of this exercise is the initial step of the process towards Regional Electricity Distributors (REDs) formation, during which all existing electricity distribution activities are separated and ring-fenced in their current parent organisations. It results in the creation of a Separated Operational Entity (SOE) ultimately positioned for amalgamation into the REDs. The process consists of five levels of separation namely financial, operational, human resources, legal, and ownership separation. The following diagram depicts the process to be followed from ringfencing to the creation of Regional Electricity Distributors (RED). Achieving the goals of Financial Separation, Operational Separation & Human Resources Separation could be achieved with the assistance of the EDI Ringfencing process specified in the relevant toolkit. Operational Ringfencing Overview Operational ringfencing is the process of separating the day-to-day business activities and operations of the ring-fenced business from it parent business. This exercise involves the operational ringfencing of electricity distribution elements from the municipality. These elements include: Assets; Employees; IT components; Contracts and existing service agreements; Policies and procedures

9 Operational ringfencing is comprised of three major activities as described in the diagram below. Mapping municipal business activities to standard value chain business activities Identifying direct and shared elements Making arrangements for services The activities are initiated by mapping municipal business activities to standard value chain business activities as described in the diagram above. This activity is followed by the identification of the direct and shared elements that are used for the execution of business activities. Identification of the elements involves the physical checking of the element by activity and categorising the elements as direct or shared. The last activity involves making arrangements for services. All shared elements are grouped into services. Arrangements are made for both services rendered and services received by electricity. These arrangements are internal business agreements documented in the form of service level arrangements. The key concept in the approach to Operational Ringfencing is the use of a standard electricity distributor value chain against which to benchmark municipal electricity business activities. Operational Ringfencing aims to identify and make arrangements for the key operational elements associated with these value chain processes. Standard core value chain processes (illustrated below) typically include: Purchase Electricity energy trading and settlements. Network asset creation development of the network including electrification. Manage availability of supply network operations and energy balancing. Maintain network planned and corrective maintenance.

10 Electricity sales and customer service processes to initiate customer service, meter to cash with credit management, disconnections, reconnections and management of revenue losses, including customer interactions through call centre, web based or walk-in centre. In addition the processes that support the value chain processes are analysed; Corporate management. Human resources management. Finance management. Commercial management. Information management. Human Resources Ringfencing Overview Human Resources Ringfencing cuts across all the processes of the electricity distribution value chain. It is an exercise aimed at ensuring that all employeerelated activities within the electricity service are considered during the ringfencing exercise. With regards to human resources, there are two workstreams. One of these workstreams focuses on human resources as a business support function. The tasks of this workstream are handled under the Manage People process and falls an integral part of the Operational Ringfencing. The second workstream focuses on Human Resources as it applies to all employee-related activities within the electricity service. This workstream is called Human Resource Ringfencing and its activities are described below. The first activity includes: Consolidating all process-specific employee registers into one employee register. This task will require that the Human Resource ringfencing workstream interact with all workstreams in terms of soliciting processspecific employee registers.

11 Revising and/or developing an organisational structure that will suit the requirements of the Separated Operational Entity (SOE). Revising and/or creating roles to meet the requirements of the SOE. Conducting a competency analysis. The second activity includes: Identifying human resources systems. Identifying bargaining structures. Evaluating benefits accrued & liabilities. Identifying conditions of service. Completing the above activities will follow a step-by-step process with each step characterised by specific actions and supported by a number of templates, hints and rules. The diagram below depicts the step-by-step process to be followed when conducting Human Resources ringfencing: The restructuring of the electricity industry is driven primarily through the separation of the operational and financial activities of the municipalities (i.e. Operational Ringfencing & Financial Ringfencing) to form a Separated Operational Entity (SOE). This restructuring has a direct impact on the human resources activities of the municipalities. It is through the Human Resource Ringfencing exercise that such impact will be handled. More specifically, Human Resources Ringfencing will firstly focus on ensuring that all electricity service related employees are accounted and none are left stranded. This will

12 be done through the consolidation of the various process-specific employee registers. Secondly, any changes in the functions of the electricity service will be handled either through revising the organisation structure or developing an organisation structure that will meet the requirements of the SOE. Thirdly, accompanying this task will be the revision and/or creation of roles. Fourth, to ensure that the necessary skills are identified and thus transferred into the SOE, a competency assessment will be conducted. Parallel to this task will be the identification of human resources systems, identification of bargaining structures, evaluation of benefits accrued & liabilities (conducted under Financial Ringfencing) and identification of conditions of service. All of these tasks are carried out to ensure that all employee-related activities of are taken into account during the ringfencing exercise. It should be clearly understood that this exercise will run across the boundaries of all departments and will also affect staff in other departments than the CEE. Financial Ringfencing Overview The Ringfencing Framework defines Financial Ringfencing as follows: Financial separation isolates the value of assets, liabilities, revenues and costs of a ringfenced business. However, unlike operational separation, it does not provide a mechanism for bringing about the isolation of activities that give rise to financial items. It reports on but does not control separation. It also looks backwards, reporting on past events, rather than looking forward to influence future activity. Financial ringfencing is therefore the process of isolating the value of assets, liabilities, revenues and costs by utilising past events through the financial statements and the maintenance of the separate chart of accounts as identified through the process of preparing the opening balances.

13 As reflected in the diagram above, the financial ringfencing includes: Formatting the financial statements of the municipality Preparation and maintenance of the opening balances for electricity Maintenance of the income and expenditure for electricity Formatting the budgets for electricity Preparing a standard set of financial statements for electricity Preparation for liability transfers for electricity Principles for performing Asset Valuation The Financial Ringfencing methodology as applied in the proposed EDI Holding process is underpinned by two key activities: Identification of the opening balances; and Maintaining the assets, liabilities, revenues and costs of Electricity as separate accounts. The following approach will be followed: Use the last set of audited financial statements of the Municipality and format it; Identify the opening balances pertaining purely to electricity and maintain these balances on a weekly/monthly basis; Maintain the income (revenue) and expenditure (costs) as identified relating to electricity on a weekly/monthly basis; Format the budgets for the new financial year identifying all projects (capital) and income and expenditure (operating) relating to electricity; and

14 Complete financial statements for the ringfenced entity. The key outcomes of Financial Ringfencing are listed below: a. Formatting Financial Statements A standard Balance Sheet, A standard Income Statement, and A standard Cash Flow Statement, Of the Municipality s books at the date of the last set of audited financial statements to use as a base for the rest of the Financial Ringfencing exercise. b. Preparing and Maintaining Opening Balances for electricity A Trial Balance of opening balances for the Electricity ringfenced entity, signed and confirmed by the relevant parties. A Trial Balance starting with the confirmed opening balances which is maintained and updated per month for the ringfenced entity. c. Maintaining Income and Expenditure for electricity A chart of accounts relating to income and expenditure accounts created for the ringfenced entity. A chart of accounts that is maintained and updated per month for the ringfenced entity utilising the information as obtained from the completed operational ringfencing exercise. d. Formatting Budgets for electricity A standard Capital Budget for the next five years. A standard Operating Budget for the next five years. A standard Cash Flow Projection for the year applicable. All of the above are to be maintained and updated on a monthly basis by way of the Cash Flow Projection. e. Standard Set of Financial Statements for electricity A set of financial statements for the ringfenced entity in the format as requested. f. Preparation for Liability Transfers for electricity Identification of all long-term and short-term liabilities relating to electricity in preparation for the transfer to the legal entity. g. Principles for performing Asset Valuation Principles have been defined by EDI Holdings for the asset valuation exercise. (An asset evaluation toolkit is also available from EDI Holdings)

15 Note: The ringfencing initiative is one of the various activities aimed at restructuring the electricity industry. Ringfencing is therefore not an end in itself but part of a broader restructuring effort. The process is required, in any event, in terms of the licensing requirements of the NER and in preparation for the introduction of GAMAP RECOMMENDED THAT: 1. Council notes the developments to date in the EDI Restructuring in SA and the expected increased pace of developments during 2005 to 2007 to complete the restructuring in accordance with the State President s address to the nation in May 2004; 2. Council notes the EDI transitional labour relations structure establishment agreement concluded between EDI Holdings, SALGA and the Trade Unions. 3. Council notes the voluntary participation of Local Authorities the EDI Restructuring. 4. Council supports participation in the EDI Restructuring to best position and prepare for the EDI Restructuring in the best interest of both Council and the staff to be transferred into RED 5; 5. the CEE in liaison with the CEO be authorized to implement all mechanisms to comply with Section 78 of the Municipal Systems Act in preparation for the EDI Restructuring; and 6. the CEE in liaison with the CFO and CEO be authorized to financially and operationally ring-fence the electricity core business of the electricity distribution business within the municipality up to the Financial, Operational and HR separation level in order to determine the true value thereof and best prepare for the EDI restructuring.

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