20/20 vision for the kingdom of the blind.
20 November 2017 17:04 (South Africa)
Business

Survivor: Eskom edition, in two easy episodes

  • Dirk de Vos
    dirk-de-vos.jpg
    Dirk de Vos

    Dirk runs a corporate finance and advisory firm, QED Solutions (qedsolutions.co.za) out of Cape Town.

  • Business
dirk-psst-subbedm.jpg

Our Minister of Public Enterprises, Lynne Brown, says privatisation has been rejected and Eskom’s chairman, Zola Tsotsi, also says privatisation of the utility will not happen. We should probably wait for Finance Minister Nhlanhla Nene to present his medium-term budget policy statement next week, which will have to include how he plans to plug the gaping holes in Eskom’s balance sheet. But if decisions are really about choosing from a range of available options, then we should know that these have now become severely constrained as a direct consequence of previous decisions. By DIRK DE VOS.

It is possible to look back and analyse why the choices for Eskom have narrowed down to this point. They are a function of other decisions when more options were available. Some of these decisions were good ones; others much less so.

From previous government policy, the decision in the 1990s to give Eskom an unfunded mandate to rapidly expand electrification to South Africans was one decision; the decision to postpone any new builds was another; and so was the decision to allow South Africa the extended period of some of the lowest priced electricity anywhere in the world, while Eskom’s capital base eroded away.

The huge expansion of the number of people employed by the state, particularly after the financial crisis in 2008 and the substantial above-inflation salary increases, along with a rapidly growing social grants system, has pushed these combined bills to 56,4% of the revenue government gets from mainly taxes. Shortfalls in revenues have been made up from borrowing and government debt has increased to over 1,5 trillion and as much as R2 trillion if state-owned enterprise debt is added.

It can’t go on.

Our existing debt is barely above junk (sub-investment grade) status and if we become more indebted, we will be downgraded to junk bond status. We are at or near what economists call a “fiscal cliff” – expect to hear those words a lot more often. In short, the government has run out of money and until we see far higher growth rates, this is not going to change.

From Eskom’s side, their ballooning salary bill, the delayed tariff increases, the absurd pricing offered to certain customers, like the aluminium smelters, have all played a part. However, the real culprits have been the disastrous capital projects at Medupi, Kusile and Ingula, which are all massively over budget and behind schedule. The “keep the lights on at all costs” policy and the consequent reduction in plant availability was also a poor decision. The recent reports that Eskom is well behind in the maintenance and expansion of the national grid are frankly alarming. It means that Eskom is unable to connect new generating capacity, which is what is now sorely needed.

Privatisation is, of course, anathema to a government which has placed the concept of the Developmental State or an economy in which government plays a central role. Actually, in theory, there are good reasons to have large utilities like Eskom owned by the state. That is the low cost of capital. So, once again in theory, even if private enterprise is more efficient, in large capital projects, the lower costs of capital (or the lower required returns from capital invested) outweigh the benefits of greater efficiency. The other supposed benefit of public ownership is that policy objectives established by government other than generating a return can be pursued as well.

On one level, Eskom has already undergone a privatisation. It has already borrowed R255 billion for which it has an annual debt repayment obligation of roughly R30 billion. Sure, debt is not the same as equity, but as any enterprise company that is so indebted knows well, your creditors have veto rights that can be as constraining as any shareholder. It must surely be the case with Eskom as these creditors would have secured their loans by obtaining pledges over Eskom’s assets. The Eskom debt doesn’t look particularly cheap either.

Eskom’s range of activities is unusually large for an electricity utility. It extends from almost all South Africa’s generation capacity to running the transmission grid and also runs a significant portion of the distribution and retail of electricity to end users. As such, Eskom is core to our economy and “too big to fail”. Because of this, it tends to capture policy makers who may conflate the interests of Eskom with those of the country as a whole. We saw this happening in relation to the banking sector in many developed economies immediately after the financial crisis. Banks had to be bailed out because failing to do so would wreck the whole banking system upon which modern economies are now utterly dependent. If the cost of a bailout is less than the cost of the failure to the economy, there is no real choice. The bail-out of African Bank’s bondholders was a small recent local example.

An obvious policy response is to break big banks up to distribute risk. The fact that this has not happened in the developed countries serves as evidence that the banking sector has captured policy making.

When you are in the position that Eskom is in, survival is what it is all about. There is this rule that they teach you in first aid courses: If you are about to save a drowning swimmer, you need to be careful to approach from behind as there is a real danger that the panicked victim could latch onto you and pull you down with him. We know Eskom needs at least a R50 billion injection immediately which will allow it to raise perhaps an equal amount in additional debt. This can only be done if electricity tariffs also increase at double the rate of inflation and perhaps more than that. This, one might add, is also the best case scenario. Nersa, the regulator, having pared back the previous 16% tariff increase request to 8%, will be left wondering whether it has any role in these events.

Even if Eskom’s balance sheet was plugged, we only defer the problem. Eskom’s generation-transmission-distribution integration means that it is hard to figure out what is going on inside it. Investors use the term “conglomerate discount”. This is the discount that the shares of most conglomerates trade in comparison to more focused companies. There are several reasons for this, but one of them is that it is hard to work out what is going on. One is therefore dependent on excellent management for full disclosure, but management is disincentivised from making such disclosures, particularly when things are not going well, by papering over problems in one area by diverting resources from other areas that then themselves, in time, become problems of their own. And so multiple issues are already multiplying before anyone on the outside really knows what is going on.

What we now have is the worst of all worlds, constant tariff increases well beyond inflation, a lack of a reliable electricity supply and taxpayer-funded bail-outs. There is nothing developmental about that.

The most recent surprise is news about the state of Eskom’s grid as presented in its Transmission Development Plan (TDP). It has had to scale down its plans to refurbish transmission lines and build new ones in the next five years, due to its troubled financial state. One consequence of this is that Eskom is paying a renewable energy plant R2 million per month in deemed delivery of electricity that cannot be connected. Round 3 renewable energy projects have experienced severe difficulties in getting a grid connection and future rounds of much needed capacity look increasingly doubtful. More than that, South Africa’s much needed procurement from the private sector of larger scale conventional sources of energy depend on the grid being able to connect these.

Furthermore, getting our grid to be compliant with something called an N-1 grid code reliability standard has been pushed forward and is also subject to securing funds. It is very important for a country like South Africa to attain this standard because unlike the case in other countries, we cannot rely on our neighbouring countries’ grids in case of failure.

If the grid were to collapse, the whole of South Africa would have no power for at least two weeks.

Lord Tennyson’s description of the state of nature being “red in tooth and claw” springs immediately to mind. The price tag for what needs to be done? According to Eskom, R162 billion. We just can’t keep diverting funds meant for strengthening the grid to fund Medupi and Kusile.

Our country’s debates on privatisation are mere ideological shouting matches and never come to anything. But our fast approaching fiscal cliff is indifferent to all this. So, how to deal with the consequences of previous decisions on Eskom without using the dreaded “p” word?

Firstly, the Independent Systems Market Operator Bill, even in its present form, should now be passed which provides for a separation of the grid from Eskom’s generating assets while keeping ownership of the grid within Eskom. The functional separation could be cemented by appointing an Executive Manager for Transmission, who would also report to the Department of Energy (and not just to the Department of Public Enterprises) and would have real responsibilities for the grid and have a separate budget. As independent Power Producers become a larger part of the generating mix, there needs to be proper grid planning and budgeting for them. NERSA would likely welcome the opportunity of becoming a more effective as a regulator and set about the real task of regulation by, for example, setting standards for grid connections and ensuring non-discriminatory rights of access to kick start bilateral contracts with different types of generators. It is here, at the grid level, that future energy policy can be formulated and implemented.

Secondly, Eskom should move to manage and provide full financial statements for each of its current generators as if they were stand-alone businesses with their own suppliers and arm’s length type Power Purchase Agreements with the Grid entity. Eskom has already started to move more of its technical staff to these generators. This will enable Nersa to commence the process of working out what needs to be done with these and develop clear benchmarking studies. It will also give an opportunity to re-look at Eskom’s existing debt obligations and see how some of the security covenants could be re-negotiated.

Securing private capital investment then would take place at the generator level. The break out just described gives the government something tangible to discuss. There is a lot of money sloshing around in the international system (and domestically) looking for just these types of opportunities. As we saw last week, the consensus is that inflation in the USA is still below the 2% target and looks set to remain that way for another five years at least. This has provided a respite for the weakening currencies and debt servicing costs of developing markets. But this unusual and benevolent situation can’t last forever.

South Africa is suffering from severe infrastructure bottlenecks and these are a constraint on our growth. Much-needed capital can’t be wasted on either recapitalising Eskom’s operations or being locked up in Eskom’s generating assets. We have much better things to do with that capital. DM

Photo: Arnot Power Station near Middelburg in Mpumalanga (Eskom)

  • Dirk de Vos
    dirk-de-vos.jpg
    Dirk de Vos

    Dirk runs a corporate finance and advisory firm, QED Solutions (qedsolutions.co.za) out of Cape Town.

  • Business

Get overnight news and latest Daily Maverick articles






Do Not Miss