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Eskom still studying Nersa report warning of utility ‘death spiral’

5th March 2018

By: Terence Creamer

Creamer Media Editor

     

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State-owned electricity utility Eskom says it is still studying the reasons for decision (RfD) advanced by the National Energy Regulator of South Africa (Nersa) for restricting its 2018/19 tariff increase to 5.23%, as opposed to the 19.9% hike sought, and would “decide on the way forward thereafter”.

In January, the utility said it was “eagerly awaiting” Nersa’s (RfD), as it had expected to receive a minimum increase of 9% in terms of the tariff-setting methodology.

“We would like to see how Nersa has come up with reasons for 5.23% and if we believe there’s grounds to review it, we will make that recommendation to our board,” acting CFO Calib Cassim said at the group’s interim results.

The Energy Regulator’s decision to limit Eskom allowable revenue for the year to R190.3-billion is justified in a 118-page RfD document, which is highly critical of Eskom’s historic inaccuracies in forecasting sales volumes, as well as the utility’s operational and investment efficiencies.

The Energy Regulator dismissed Eskom’s argument that a “rebasing” for lower sales volumes alone would result in a 9.4% tariff increase from April 1, 2018, noting that the tariff-setting methodology made no reference to any concept of rebasing.

“Although Nersa’s methodology requires the adjustment of the sales volumes to reflect current market conditions, it is incorrect to use the previous year’s revenues as a base for the following year because the revenue required by Eskom is a function of the costs (allowable revenue) and the sales volumes forecast to be achieved. Both the sales volumes and allowable revenue need to be adjusted. The adjusted sales volumes cannot be done in isolation from the related adjustment of costs. Therefore, the Energy Regulator has evaluated Eskom’s allowable revenue, taking into consideration the sales volume levels anticipated to be achieved in the 2018/19 financial year.”

Nersa also concurred with those stakeholders arguing that Eskom was in a ‘utility death spiral’, whereby price elasticity of industrial demand, in particular, had become a primary driver of the lack of demand.

The “vicious cycle” is that of increasing electricity prices leading to declining sales, which results in the utility’s having to recover the same cost base from a shrinking customer base. The net effect is an application for higher tariff increases, which triggers a further decline in sales, which will result in a “utility death spiral if not arrested by way of deliberate and focused intervention”.

“In order to break the vicious cycle, Eskom needs to either reduce its costs (including its fixed cost base) and, hence, its allowable revenue requirement while growing its sales volumes, thereby driving its tariffs to their most efficient level. This should result in smaller tariff increases going forward that will attract additional sales volumes, which will result in even smaller tariff increases and even higher sales volumes going forward and so on, allowing it to transition to a virtuous cycle, which is the desired future state,” the RfD document reads.

The document argues that, when the electricity price rises steeply, the volume of electricity demand will decline significantly, which has a negative effect on electricity sales revenue when the price rises steeply.

Households and firms use less electricity by, for instance, adopting new electricity-saving technologies and by making behavioural change. “However, it is important to note that the total impact of the electricity price increase on volumes will not necessarily occur during the 2018/19 financial year due to the time lag effect. The consumers of electricity, for instance, will not be able to adjust completely their consumption behaviour in the short term.”

To reduce production costs, the regulator directed Eskom to reduce excess capacity and its reserve margin (the estimated margin between the amount of electricity needed at peak times and the electricity that can be produced using available generation capacity), which stood at 35%.

“The high reserve margin results in Eskom’s fixed and variable costs remaining high,” Nersa said.
The regulator also slashed the costs allowed for primary energy to R85-billion against Eskom’s application for R104.8-billion, but cutting revenue for coal, diesel, nuclear and independent power producers. It also eliminated all costs associated with the utility’s integrated demand management programme.

Nersa reduced the capital expenditure component for 2018/19 to R39.1-billion, from the R76.9-billion reflected in Eskom’s application. “As a result, Eskom should not be taking an aggressive capital expenditure approach, but should rather prioritise key projects. This implies that non-priority projects can be delayed to future years when capacity will be required,” the RfD states.

The regulator also disallowed historic cost overruns of R72.3-billion associated with the Medupi, Kusile and Ingula projects. However, Eskom will be given an opportunity to prove to the Energy Regulator that the overruns were prudently incurred.

The RfD is highly critical of Eskom’s control of operations and maintenance expenditure, stating that the utility’s consistent over-expenditure against what was allowed showed a “lack of cost-control measures”.
“In reaching its decision, Nersa considered Eskom’s unwillingness to implement stringent measures to contain its costs. In light of this, Nersa has adjusted the expenditure, taking this into consideration.”

Allowed revenue for overall operating expenditure was reduced by Nersa to R51.1-billion, against Eskom’s application for R62.2-billion. In the determination, the regulator reduced allowed employee benefit costs by R3.9-billion, from R28.2-billion to R24.3-billion, and reduced maintenance costs to R15.2-billion, against a request of R17.7-billion. The allowed revenue for corporate overheads, meanwhile, was reduced to R3.7-billion against R5.7-billion.

The RfD asserts that, overall, the 5.23% tariff increase will have a moderate impact on the different socioeconomic indicators compared to the 19.9% tariff increase proposed by Eskom. “The 5.23% tariff increase is in line with government policy to reduce income inequality, poverty and unemployment.”

The regulator also argued that Eskom’s free cash flow is expected to be positive, even with the lower increase, and that the utility can further improve its cash flow position through capital expenditure (capex) rationalisation, along with better working capital management.

“If Eskom reduces its required capex and improves working capital management, this will limit its funding requirements to reasonable levels. This can ultimately lead to lower expected interest costs than projected in 2018/19.

“For Eskom management to start creating value, both profitability and growth needs to improve as recommended above. This needs to be driven by Eskom’s goals and strategic objectives,” the RfD outlines.

Edited by Creamer Media Reporter

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