David Holland and Brian Kantor*
Illusionists know how to divert attention so that they can confuse the audience and practice their magic. Filmmakers are expert at planting “MacGuffins” in plots to distract attention from central developments toward unimportant attention grabbers (Alfred Hitchcock coined the term and was the master of employing them in his mysteries). It is our view that Eskom is using this device in its MYPD 3 pricing application and argument for five years of 16% annual price hikes.
Eskom keeps putting the strength of its balance sheet as the primary purpose of its pricing application. It is in effect front-loading its tariffs, which hurts the country but benefits Eskom’s balance sheet. Eskom’s unrelenting focus on its credit rating is a MacGuffin. The lead player, South Africa’s citizens and economy, would die in this film.
If Eskom gets its way, the wholesale price of electricity will have increased over a 10-year period from an average of 19.9c/kWh to about 120c/kWh. This equates to a compound rate of growth of nearly 18% per annum for 10 years, or an astounding 12% p.a in real terms. No economy can be expected to cope with a shock this large to the price of such a basic service as electricity supply. Aggravating the issue further is that the municipalities have a monopoly (constitutionally protected) to distribute electricity at much higher unregulated prices of their own choosing.
The real threat to the rating
We have argued previously in the press (Business Report, 26 November 2012) and at the National Energy Regulator of South Africa (NERSA) hearing in Cape Town on 16 January 2013 that Eskom’s pricing request is excessive. Its request is not based on sound economic principles and would seriously damage the economy as so many other participants in the public hearings have confirmed.
The higher the price Eskom can charge, the more cash it will generate from operations and the less debt it will have to issue to fund its growth. But this is to confuse the financial and economic decision making process, and translates into grossly overcharging current consumers. Financial structure should be a consequence of a sound business strategy, not its primary objective. Eskom likes to confuse and conflate the investment and the financial decision that should be clearly separated.
Paradoxically, if Eskom gets its way with higher prices and less debt, the economy is likely to grow more slowly and this will damage rather than improve SA’s standing with the credit rating agencies, thus raising the cost of funding RSA and Eskom debt. Eskom thinks otherwise – it likes to believe that less debt will mean a higher credit rating. It should seriously think again. The threat to SA’s credit rating is not its current debt ratios but its economic prospects. Slower growth means less tax revenue, more government spending, larger fiscal deficits and more debt.
An energy czar
We believe the strategy for electricity generation needs to be clarified and agreed at the highest levels of government. An energy czar is desperately needed to help make the essential trade offs for the economy over the short and long run. Such policies would recognise that the very large expansion of generating capacity under way is imperative for the economy. Also to be recognised is that years of under pricing electricity and the failure to plan for a gradual adjustment of prices and capacity has left the country with no alternative but to undertake a very rapid and large expansion of generating capacity.
The failures to plan well for electricity in the past continue to haunt the economy. We need to get over these failures and take sensible decisions for the future. The issue cannot be left for Eskom and NERSA to resolve – it is too important for that.
In March 2008 the total book assets of Eskom amounted to R168bn. By 2018, these assets will climb to R743bn, which is a formidable increase of R575bn (our forecast based on Eskom’s projected capex and growth). Furthermore there is now no practical alternative but to rely on Eskom to manage this growth over the next five years. Today’s burning issue is rather how much of the five-year growth in electricity generating assets should be financed with tariffs and with debt. Well within the five-year window, the energy czar will have to decide on the growth in capacity after 2018 and how it should be financed.
Key questions
Here are key questions and proposals for formulating a clear energy strategy:
1) What growth rate is the country pursuing and how does this translate into capacity requirements for Eskom? Government, which is Eskom’s sole shareholder, must provide clear guidance. Eskom’s task is to meet this strategic objective, i.e. to supply all the electricity that is demanded in SA at a price that makes economic sense. The role of Eskom and other generators as well as other distributors of electricity beyond the next five years will have to be decided as a matter of urgency, but not as urgently as setting the right price for electricity beyond March 2013.
2) What economic return on capital is sensible to meet the country’s needs? If it is too high, industry and employment suffer. If it is too low, subsidisation is required and uneconomic activities promoted. We showed through a benchmarking exercise that a real return on capital of 3% to 4% is sensible and competitive, i.e., “cost reflective”, in Eskom’s terminology for regulated utilities around the globe. Historically, Eskom’s real return on capital was too low, which led to the capacity crisis and extraordinary price increases over the past few years. Eskom has argued that an 8% real return on capital and real cost of capital are appropriate. We showed by comparison with the returns realised by public utilities in other economies and by reference to the lower expected returns on capital invested in much riskier economic activities that this is excessive and uncompetitive. Government needs to set a target for the real return on capital and let NERSA monitor that return and its key financial and operating drivers. The sensible target should be a 3.5% real return on capital, which should also be applicable to new capital investments. Cash Flow Return on Investment (CFROI) is a globally accepted measure of real return on capital, and a metric we like.
3) What is the most economic way of delivering power? This is more technical and involves the usual project economics. Burning coal has high external costs such as environmental pollution and road damage. Game changers include power stations that burn natural and shale gas, which can be built quickly at lower cost and operate more efficiently. The energy and manufacturing renaissance in the US must surely serve as a template and exemplar for government and Eskom. The die has been cast for the present expansion, but a decision needs to be made on the energy sources for the next phase of electricity capacity building beyond 2018. The importance of saving energy via awareness and innovative technology should continue to be promoted, although not necessarily by Eskom.
4) What financing and capital structure is required to fulfill this strategy? Operating cash flow is stable for power companies, which lessens risk and allows them to operate with high levels of debt and leverage. The cost of debt can be managed by government guaranteeing Eskom’s debt (as the Treasury has agreed to do) or by the RSA raising debt on Eskom’s behalf and investing the proceeds of such debt issues as equity in Eskom.
More debt vs higher charges
The choice for the economy is simple: it is either more debt, or much higher charges that damage the economy. In Eskom’s MYPD 3 five year proposals, debt would grow to R338bn (relative to book assets of R743bn and the government’s guarantee of R350bn). We estimate that if price increases were limited to 10% per annum and cash costs were reduced by 5%, Eskom would have a competitive real return on capital and debt peak of about R450bn. Surely this is an unavoidable demand on the borrowing capacity of the RSA or its wholly owned subsidiary Eskom. Government cannot abdicate this responsibility if it is to fulfill its obligation to the wider economy. And the rating agencies should be made to appreciate, as surely they will, that to raise debt to fund essential infrastructure that improves the growth potential of the economy rather than to undermine it, makes economic sense and justifies a better, rather than worse, credit rating
Another issue to consider when setting the target real return on capital invested by Eskom is whether to allow non-productive construction-in-progress as part of the return on capital and tariff calculation. We believe it should be excluded from the economic return calculation because it encourages uneconomic behaviour.
Granting Eskom the right to charge tariffs on construction-in-progress encourages it to build expensive capacity and to keep building. If Eskom is able to charge tariffs on construction-in-progress, it has no incentive to control expansion costs nor to deliver new capacity on time. These are headline issues that perpetually dog the current expansion.
Opaque subsidies
We are also concerned about the opaque practice of having Eskom subsidise poor consumers and independent power producers (IPPs). If government wants to achieve these noble aims, it should do so in a separate, transparent vehicle that taxpayers can monitor not impose an extra burden on some electricity consumers If a separate subsidised vehicle were set up for the support of IPPs, we believe Eskom’s price increase could be sensibly lowered to 7% or 8%.
Government needs to set a clear strategy with a realistic economic return on capital for Eskom. Eskom’s pricing proposal is excessive and would damage the economy irreversibly; all in the name of chasing an investment grade credit rating. We don’t know whether government or Eskom management has set this objective for Eskom, but it is misplaced. Eskom, with government’s blessing, can and should take on more debt to fund its expansion and charge a price that generates a real return on capital of 3% to 4%, excluding construction-in-progress. If this strategy were clearly communicated, the risk of regulatory uncertainty would be reduced and SA could attract the world’s leading power companies and foreign direct investment. In this way SA’s growth, competitiveness and credit rating would be enhanced. This objective is the real star.
*Brian Kantor is chief strategist and economist at Investec Wealth & Investment. David Holland is an independent consultant and senior advisor to Credit Suisse. The opinions are those of the authors’ and do not reflect the views of Investec or Credit Suisse.