National Treasury and Eskom: The curate’s egg

National Treasury’s package of measures for dealing with Eskom is another case of the curate’s egg – it is only good in parts.

The Treasury has come up with a package of measures to sustain Eskom. Some of these measures will be welcome, others less so. Unfortunately the government, the sole shareholder of this failing corporation, is not willing to fully recapitalise Eskom so that it can complete its current programme without further damage to the hardpressed users of electricity – firms and households.

According to the announcement by SA Treasury (media statement, 14 September):

“Firstly, government will support Eskom’s application to NERSA for tariff adjustments in line with the Regulatory process. Tariff adjustments remain the key mechanism that will provide the electricity supply industry with a sustainable solution, meaning that it will provide Eskom with the revenue and cash flows the utility needs to complete the current programme of building power stations, repay debt and interest thereon. NERSA will still apply its regulatory oversight, and prudency tests to ensure that costs across the industry have been efficiently incurred.”

Thus the user is the one who mostly has to cover the higher costs Eskom has incurred in producing electricity in recent years – with the blessing of government, Nersa and Eskom. This worryingly raises the issue of Nersa’s independence to pursue a broad public interest, which is its remit. The justification for recovering these much higher costs by way of a 16% annual increase over five years, was partially rejected by Nersa as an unjustified burden on electricity consumers in 2013. Nersa conceded Eskom an 8% annual increase over the five year tariff adjudication period.

The difference between eight and sixteen per cent has become Eskom’s cash flow problem, which higher tariffs unfortunately will now largely resolve.

After the Nersa ruling was announced in February 2013, which allowed a 3% real return on the additional capital to be invested by Eskom in Medupi and elsewhere, we wrote:

“We have pointed out before that the less Eskom charges, the more debt it or the SA State will have to issue to fund its heavy and essential expansion programme, absent a willingness to sell off some of its generating capacity to private owners.

“It would be a very good idea to have other managers running power stations so that useful comparative benchmarks on operational costs could be established for Eskom. Such partial privatisation might be judged essential should extra debt have to be issued.

“In Eskom’s case for 16% annual increases it had estimated that some R350bn of debt would have to be issued by 2018. We have calculated that this debt would rise to over R500bn if price increases were confined to 8% and similar operational and capital costs were incurred. Nersa is of the view that these costs, as estimated by Eskom, should be better controlled. If Eskom achieves these cost controls, it would improve cash flow and reduce the volume of debt finance.

“The SA Budget and borrowing plans have factored in about R330bn of Eskom debt. This will have to be revised higher. And with the extra government borrowing requirement now running at about R190bn a year, this additional debt of approximately about R30bn a year for five years, will not be welcome to the Treasury or the bond market.”
If Eskom were a private business it would be shareholders who would have to recapitalise the business or allow it to go out of business and sell off the viable assets to other operators. But a government owned and sanctioned monopoly has price setting powers that make a mockery of shareholder responsibilities when operations turn out badly. Prices (essentially higher taxes imposed on particular consumers by the government providing an essential product or service for which few immediate alternatives are available) can be set high enough to solve all potential financing problems. Higher prices for these critical services have profoundly important influences on both the capacity of households to spend on the capacity of factories and mines to compete on local and foreign markets. But this takes second place to the short term debt management concerns of Treasury.

Capitalising Eskom means either Treasury raising more debt (something the debt rating agencies and the Treasury do not like since it could lead to higher costs of borrowing) or selling off some of its underperforming assets. The latter option would not only help avoid more debt (which would please the rating agencies) but, more important, would lead to more effecient operations and lower electricity costs. This is not by some kind of alchemy but because private owners have very different incentives to the government as shareholder. They do not have the power to simply pass on the costs of failure to a compliant consumer and so are more likely to avoid them.

While the fiction that Eskom and the government somehow stand apart in debt markets is maintained by the Treasury in its statement, there are some helpful aspects to the Treasury plan for Eskom. In addition to the government guarantee for R50bn of additional debt to be issued by Eskom, there will also be an injection of equity capital to be funded by proceeds of privatisation (called “leveraging non-strategic government assets”. There is also the prospect of much greater private production of electricity to come, especially through foreign-owned and funded nuclear power plants on a large scale.

There is now a growing recognition in policy circles of what private production and its foreign funding of future electricity generation can provide for the SA economy. Determining the right mix of privately owned additional generating capacity (coal, gas or nuclear) and the degree to which the government (taxpayer) will have to stand as guarantor of the revenues to be received from the providers of additional capacity, will no doubt exercise all the negotiating capcity of our energy planners over the years to come.

However for now, the issue is how to best manage Eskom. According to the media statement:

“Equity injection: An allocation of funding will be given to Eskom to help relieve the impact on electricity consumers, as well as add additional support to Eskom’s balance sheet, which needs to be strengthened. This will be funded from leveraging non-strategic government assets. Details in this regard will be provided by the Minister of Finance as part of budget announcements.”

The rating agencies have enquired about the assets that might be sold to support the Eskom balance sheet. Let us suggest just one of these: the Airports Company of South Africa (ACSA). This is a highly profitable, wholly-owned government business that is generating impressive amounts of cash from a largely completed capital expenditure programme. The cash being generated by this company is being used to repay debt at a rapid rate, leaving the balance sheet strong enough to support offshore expansion that can hardly be regarded as strategically important for South Africa.

This company had a book value in March 2014 of R23.57bn with net debt of R10.9bn – a net gearing ratio of 48%. Net cash generated in operating activities grew from R1.17bn in 2010 to R4.12bn in 2014. After tax profits of R1.7bn were recorded in 2014, and R97.52m was paid as dividends. That is, a highly conservative pay out ratio of 17.5 times that no activist investor would regard as satisfactory, particularly in the light of the balance sheet strength.

What could ACSA be worth on privatisation? A comparison with Ferrovial SA (FER) the Spanish company that owns Heathrow, among other airports, might provide some ball park indicators. According to Bloomberg, book assets of FER amount to US$23.714bn with a similar debt ratio to that of ACSA. The recent operating performance of FER, represented by cash from operations, has however been highly variable,. It could not be regarded as an obvious growth company in the way that ACSA might be. By contrast however, FER has been on a vast asset and debt reduction programme since 2011. These actions, while limiting growth, have been regarded as value adding for shareholders.

For the record, according to Bloomberg, this listed airport company, of no doubt great strategic importance in the UK and Spain, had a recent market value of US$11.52bn, trading on 1.81 times its book value or 10.5 times its cash flow and 18.8 times its earnings at a dividend yield of 3.7%.

The same multiples applied to ACSA would make it worth about R50bn, depending on assumptions about regulated revenue growth and operating costs and capex plans.

Clearly it is an asset of considerable value to the republic. An initial public offering of even a non-controlling share of the company would surely help to establish its value to its shareholders. Until then, a demand from the shareholder for a much larger flow of dividends – up to R2bn a year – would not strain the balance sheet and help immediately to close any government revenue shortfalls. It is surely, given the strained circumstances of RSA finances, more important for ACSA to pay up than it is to expand abroad. And it may well be a similar story for some of the other assets of the SA government.