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Questions and warnings on Eskom’s push for standalone investment grade rating

15th February 2013

By: Terence Creamer

Creamer Media Editor

  

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Crying is all right in its own way while it lasts,” CS Lewis once said. “But you have to stop sooner or later, and then you still have to decide what to do.”

South Africans have done much crying over the past few years as electricity prices surged and even more tears were shed during the recent National Energy Regulator of South Africa (Nersa) hearings into Eskom’s third multiyear price determination period (MYPD3) application.

But by February 28, a decision must be made – one that is unlikely to find universal favour, even with the governing African National Congress, despite that fact that there is genuine sympathy this time around for the position in which Nersa finds itself.

Nersa’s mandate is neatly confined to deciding on an allowable revenue figure that balances the objective of protecting electricity consumers and the country’s growth and policy objectives with the need to ensure that the monopoly utility remains financially sustainable.

However, the context in which such a determination must be made is far untidier. There are plentiful energy policy loose ends, the economy’s growth and employment prospects remain weak, certain key, electricity-heavy export sectors are staring down a competitiveness barrel, and Eskom, which is undertaking a R450-billion capital programme, cannot yet be considered financially stable.

Following broad-based consultations, the utility, which at one stage was signalling its intention to apply for three yearly tariff increases of 20%, eventually applied for yearly increases of 16%, spread over an extended five-year horizon from 2013 through to 2018.

In monetary terms, the MYPD3 application boils down to an allowable revenue allocation request of nearly R1.1-trillion to cover primary energy costs of R355-billion, operating costs of R270-billion, purchases form independent power producers (IPPs) of R78-billion, integrated demand management costs of R13-billion, depreciation of R185-billion and a return on assets of R187-billion.

Should the tariff increase be approved, Eskom’s average selling price would rise from 61c/kWh currently to a nominal 128c/kWh by 2017/18, or a real price of 96c/kWh.

The Case For
Over the past few weeks, Eskom has delivered a compelling, albeit unpopular, case for a 13% increase to cover its operational costs and deliver a “fair” return and a further 3% to cover the costs that will arise from the introduction of new renewable-energy IPP projects and the Department of Energy’s peaker projects.

Eskom has argued that, in the absence of any immediate prospect for an equity injection, it has reached the limit of its capacity to cost- effectively raise new debt and that it, therefore, has no other option but to seek to bolster revenue from price rises.

CEO Brian Dames reaffirmed to the Nersa panel that, in ongoing engagements with government, it received confirmation that no future support should be expected beyond the R60-billion subordinated loan already extended, along with R350-billion in government guarantees.

Elaborating on the financial sensitivities, CFO Paul O’Flaherty indicates that R25-billion will be shaved off its revenues over a five-year period for every percentage-point reduction in its yearly price-increase request. To avoid capi- tal and maintenance slippages, the funding shortfall will have to be met through additional debt, which is likely to be extremely expensive, owing to the fact that Eskom is already “heavily geared” and lacks a standalone investment grade rating.

The “uplift” Eskom has already received from government has enabled the group, O’Flaherty elaborates, to close what had been a R300-billion funding gap in 2009. But it is not sufficient to enable the utility to raise additional debt, as it is already “pushing the debt limits to the maximum”. Over the coming five years, the utility is already obligated to make debt repayments of R127-billion and interest payments of R115-billion. “So we need to maintain our debt within [the current] ceiling. We cannot operate outside of that ceiling, because, on a standalone basis, we are not investment grade.”

Investment Grade?
However, Eskom’s emphasis on securing an investment-grade rating, primarily through large increases in its depreciation and its returns, has come in for sharp criticism. Together, deprecia- tion charges and the returns make up R372-billion of the revenue application.

Nersa panellists have already questioned whether the aspiration to secure an investment grade could be considered a deviation from government policy, as there is no such stipulation in the shareholder compact governing the relationship between Eskom and the Department of Public Enterprises.

But a number of business and labour group’s have questioned the very philosophy behind the move, given that Eskom remains fully government owned.

Chamber of Mines senior executive for strategy and economics Roger Baxter points out that the return on capital and the return of capital, or depreciation, being sought constitutes 65% of the average price increase proposed. He argues that the increases are, thus, patently designed to accelerate Eskom’s transition to a standalone investment grade, but at the expense of other economic and policy imperatives.

Likewise, Energy Intensive User Group (EIUG) chairperson Mike Rossouw has argued that less emphasis should be placed on “bulking up the balance sheet to meet credit agencies’ expectations, and more focus placed on prudent cost management that ensures optimum efficiencies and allocation of capital only to those areas where it is necessary”.

The chamber and the EIUG have, thus, called on government to consider providing further sovereign balance sheet support to Eskom to reduce the pressure on cost rises in the short and medium term.

Rossouw says the shareholder needs to “put skin in the game”, by extending further guarantees and by lowering the electricity environment risk through greater policy certainty, describing the current standalone-rating strategy as “unjustified and dangerous”.

However, O’Flaherty has argued that the transition to a standalone investment grade is implicit in the shareholder compact stipulation that Eskom be financially sustainable.

“What is absolutely important . . . is that we have to be a ‘going concern’ . . . we must be financially sustainable. The investment grade and where you pitch the business within the support you get determine your going-concern nature.”

He acknowledges that the main drivers behind its double-digit request are the depreciation and return-on-assets components of the application, but stresses that this should be understood within the context of a “historical underrecovery”.

Besides this important question, Nersa has also been asked to take account of the prevailing context in which the request has been made – a context that has already seen electricity prices treble between 2007 and 2012.

Further electricity price shocks, business, labour and community groups have warned, could cause serious economic and social damage at a time when South Africa’s immediate growth and employment outlook is far from benign.

Business Unity South Africa’s (Busa’s) Profes- sor Raymond Parsons says that, while its members accept that inflation-contained increases are probably unrealistic, further price shocks could place as many as 13 key sectors at risk.

Increases at the rate proposed by Eskom is likely to take a number of enterprises to a “tipping point”, particularly those in the mining and metals sectors, which account for 60% of South Africa’s export earnings.

The current application is, therefore, at odds with South Africa’s economic policy objectives, which aim to rebuild the country’s industrial base, and expand mineral beneficiation and the tradable export sector.

The negative effects of the application are also likely to be compounded by the premiums imposed by municipalities. Speaker after speaker have, therefore, appealed to Nersa to help address “excessive” mark-ups ahead of the start of the municipal financial year on July 1.

As for the regulator, it stands between the proverbial rock and a hard place – one that has been made all the more uncomfortable by recent African National Congress pronouncements indicating that there may be some form of extra-regulatory negotiations under way on the matter.

That said, the time for tears has passed and the time for a decision is fast approaching.

Edited by Martin Zhuwakinyu
Creamer Media Senior Deputy Editor

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