South Africa

Op-Ed: Eskom – time to play the cards they have been dealt

By Dirk De Vos 1 February 2018

One ought to be wary of offering any advice to Eskom’s new board and management when they have started out doing exactly what they should have done in the results presentation last week and did so under extremely difficult circumstances. By DIRK DE VOS.

As Eskom’s chairman said, the new board had only taken office 10 days previously and they had three extremely pressing problems, its liquidity issues, governance and to release Eskom’s interim financial results. Failure to do so would have resulted in a suspension of Eskom’s bonds and a catastrophic chain of debt defaults, not only in Eskom’s own debt but in the other State-owned Enterprises (SoEs) as well. We missed that #DayZero by a hair’s breadth. Apparently standby lending facilities of R20-billion by the end of February are being arranged with local banks.

Eskom’s acting chief executive Phakamani Hadebe didn’t put a foot wrong either. Praising the media and making the concession that anyone who cares knows, “the company is in financial trouble”. He also conceded that the sustainability of Eskom cannot be achieved through borrowing. He acknowledged too that no investors would consider discussing funding the power utility “until we address these elephants in the room: corruption”. Perhaps Hadebe’s most encouraging statement and one to which we, as a country, will have to remind ourselves on a constant basis “I don’t see my responsibility as being Eskom, but for the South African economy”. What that conveys is that he understands the ambit of his job. It is not just about Eskom, a nearly R200-billion revenue company, but about the nearly R4 trillion South African economy and its 56-million citizens.

It is still early days and we will need further guidance of what the board and management is aiming to achieve. There is an idea that under new management Eskom can be turned around and can again become a sustainable business. That is a mistake. Eskom in its current format is beyond repair and no management in the world can bring it back. Efforts to do so will be simply wasted and be yet another distraction from the wholesale restructuring of Eskom and the South African electricity sector. It might be of some comfort that even if the Zuma administration’s board and management had not run Eskom into the ground and that its near R500-billion debt overhang and out-of-control operational cost structure was where it should have been, wholesale restructuring is inevitable. Relatively well-run coal based electricity utilities are in trouble all over as the world transitions to cleaner more distributed and flexible sources of energy that have become ever cheaper at an accelerating rate.

Eskom’s interim financial results for six months to 30 Sept 2017 were truly awful (but expected). While some operational metrics are in place, Eskom is just not financially sustainable. Cash from operations are insufficient to service ever growing interest repayments that cannot be capitalised as new capacity (for which the debt was raised) come onto stream. The cost of servicing debt is set to increase yet real sales revenue is declining and price are offset by declining sales volumes.

While Eskom’s late 2017 application for a 19% once-off tariff increase for this year was rejected in favour of a far more modest 5.23% tariff hike, it ought to be remembered that Nersa, the electricity regulator probably had in mind that there are three separate RCA applications for under-recovered revenue from previous years amounting to R60 billion in all. However, further increases drives demand for electricity down. Eskom is well advanced in a utility death spiral and if increases will lose additional customers by reducing demand for electricity, then tariff increases will not help it and high tariffs are reducing South Africa’s competitiveness particularly those countries that are adapting and shifting to renewables. Some calculate that by 2031, new solar PV will be cheaper than that generated from legacy coal-fired plant. At much higher tariffs, Eskom can expect large scale customer defection especially from its lucrative commercial and high-end residential base as a result of rooftop PV installations.

Some parts of Eskom understand the bind it is in and the bind it puts the country in. In its tariff application to Nersa last year, it modelled several scenarios – based on an 8%, a 13% and 19% tariff increase. Eskom’s application sought to demonstrate that 8% annual increases would be too little and would result in it needing a bail out. If this were to occur, Eskom’s modelling shows that there would be a significant deterioration in government’s debt/GDP ratio. Bailing Eskom out to fill the revenue gaps would have our debt/GDP ratio reach 75% by 2021 and 104% by 2030. Under the 19% tariff scenario, the debt/GDP ratio stabilises at around 66%. Eskom’s research points to the fact that if Eskom had to be supported under an 8% tariff increase scenario, the increasing debt/GDP would almost certainly trigger a ratings downgrade for the country with severe consequences to the economy and the cost of debt. It also concedes that under a 19% tariff increase (provided that this would generate the additional revenues – an unsupported assumption), GDP growth would be reduced by 0.3% per annum costing 137,000 jobs per annum to 2021.

There is no get-out-of-jail option some big decisions need to be made about Eskom and the electricity sector. The longer these big decisions are deferred the worse the final outcomes. The measure of Eskom’s board and management cannot therefore be against performing miracles and putting it back to where it was at the beginning of this century. In an essay, The Eighteenth Burmaire of Louis Napoleon in 1852, Karl Marx formulated the role of the individual in history roughly as follows: “Men make their own history, but they do not make it as they please; they do not make it under self-selected circumstances, but under circumstances existing already, given and transmitted from the past.” In more prosaic terms, you can only play the cards you are dealt.

Understanding the extremely difficult circumstances in which Eskom finds itself, these are some suggestions on a path forward for those tasked with the heavy responsibility of managing Eskom:

Short Term – Immediate Implementation

Board, management and political oversight: The first step of a credible board and management appears to have been taken. On a political level, the responsible minister for Eskom, currently the Minster of Public Enterprises Lynne Brown should be replaced. A credible replacement minister should then have the full support of cabinet. Given the macroprudential problem that Eskom presents, perhaps Eskom should report to a future Minister of Finance provided that the minister him/herself was also not part of cabal identified in various state capture reports. Consistent political support will be necessary. All efforts should be directed at incentivizing top management to remain on for a period of 10 years so that Eskom’s institutional memory is rebuilt and retained. Revolving door appointments at the top should be avoided.

Reduce Staff Overhead: Eskom will have to address its cost overheads. In the near term, it needs to reduce its staff compliment to where it was in 2007, at around 36,000 people. In doing so, it will need to be sure that it does not lose the critical skills that it needs. These critical skills might already have exited Eskom and should be incentivised to return.

Regularise the Coal Supply Contracts: Eskom should be compelled to publish the details of every coal contract that it has and is planning to enter into and do so at the level of each power station. At power station level, daily information on stockpiles and outcomes of compliance testing should be published. Perhaps, the monitoring of the performance of all coal suppliers could be done independently but certainly, the quality and quantity of all coal delivered must be properly monitored. Where coal delivered by truck is unnecessary or can be delivered by conveyer belt or rail, those contracts should be terminated. The cost of road transported coal is also the damage that results from coal trucks driving them. Eskom should always buy coal directly and not do so through intermediaries or traders. Where intermediaries are used, they need to disclose their margins or commissions. All future coal contracts or tenders must be published, and every subsequent contract must be exactly on the terms of the tender.

Abandon the completion of 2 units at Kusile: Dr Grové Steyn has argued that depending on the amount still needing to be spent of Kusile’s budget, that it may well be beneficial to abandon two of the planned six units to be built there. This requires a careful assessment but the savings of doing so might be as much as R6-billion.

Medium Term (start immediately to complete within two years)

Decommission Expensive Generators: In the study undertaken by Dr Grové Steyn mentioned above, he argues that in the context of surplus capacity, Eskom should consider the early decommissioning of at least some of the units of Arnot, Camden, Grootvlei, Hendrina and Komati.

Resuscitate Eskom’s internal market Mechanism: During the process of getting the ISMO Bill as far as Parliament, Eskom implemented a comprehensive internal market in terms of which each generator would bid into the grid based on the pricing that they could give. This process determined the dispatch order of different generators based on their different cost and generating profiles. These processes should be revived and the outcome of them made available to the public for further analysis and consideration.

Complete an independent analysis of Eskom’s operations and sign a new shareholder pact: As the political environment is bound to be unstable, it is important that Eskom remains as independent as possible from political interference. Eskom simply because of its size and the revenue that it generates is, as we have seen, a tempting target for political capture. The terms of the shareholder pact will need to be disclosed but will provide the Eskom board with the guidance that it needs. It is suggested that the shareholder pact will also has an explicit requirement to align Eskom’s investment programs with that of the IRP. All tariff applications to the regulator should be done in a manner that allows for full disclosure. The current practice of gaming regulatory processes must be stopped immediately.

Commence the process of separating Generation, Transmission and Distribution: While re-introducing the ISMO Bill and passing it into legislation, it might be preferable to introduce a proper formal separation. Perhaps each generator should be separated from the others. On the distribution side, a process not that different from the Regional Electricity Distributor system, proposed but abandoned in 2006, should be reintroduced. The stumbling blocks that existed then, namely significant surpluses and different cost structures between municipal and Eskom distribution are now less of a concern. Importantly, the transmission grid, liberated from servicing generation will operate independently and contract with its main customers and generators on a pure arms-length basis. Distributors, however they are structured will need to become responsible for demand side management. This includes shifting loads away from the peak periods through time of use metering/pricing and contracting generating or battery/storage capacity to address variable loads.

Longer term (from two-10 years)

In the longer term, much of what can be suggested is subject to what happens at a national level. If South Africa is subject to a debt restructuring/work-outs, then much of what can happen in the electricity supply sector will be determined by our creditors. Nevertheless, the question of accumulated debt will need to be solved or re-structured. The dangers of a creditor led restructuring are large. Making Eskom’s creditors “whole” through the electricity supply system might force a sale of, say, 49% of Eskom “as is”. The result would be a situation where private capital invested in Eskom demands an investor’s return but without the inclination to fix what needs to be fixed. This was the route followed with the Telkom partial privatisation in the 1990’s which set our telecoms sector back by several years. By insisting that Telkom’s monopoly be extended, it also did Telkom no favours even as the dividend cheques to its foreign investors kept flowing. As was the case with Telkom, private investors in Eskom might insist that the long overdue changes needed to liberalise the electricity sector be perpetually deferred.

The important focus in the longer term will be to revert to a growth story. In the past, cheap coal fired electricity shaped the South African economy. Cheap and abundant electricity was South Africa’s comparative advantage. Should South Africa be able to transition into an electricity system that is based on renewables, then the country might be able to reassert this comparative advantage. South Africa is unusually well-endowed with renewable energy resources and the grid should be making the kind of investments needed to prepare for the coming energy transition dominated by renewables, energy efficiency and battery storage.

It is not all bad news. Despite the very poor position of Eskom, there are grounds for some optimism. Looking back from the future, we might regard ourselves as fortunate that nuclear did not go ahead with reforms undertaken in other countries that preceded dramatic changes in the costs of renewables and the potential of storage. South Africa will have the benefit of the experience of others as it moves, as it inevitably will, through the energy transition. Further, because Eskom is not only a wholly state owned vertically integrated monopoly utility, it is also effectively our whole electricity sector. Provided then that debt issues are addressed, South Africa can freely undertake bold reforms restructuring initiatives in a way that other jurisdictions, who restructured earlier this century, cannot do. DM

Photo: An Eskom coal fired power station near Johannesburg, 04 April 2015. EPA/KIM LUDBROOK

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"A long habit of not thinking a thing wrong gives it a superficial appearance of being right and raises at first a formidable outcry in defence of custom. But the tumult soon subsides. Time makes more converts than reason." ~ Thomas Paine

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