A South African woman carrying her daughter on her back runs her take away restaurant by candle light during a sheduled power outage known as load shedding in the impoverished neighbourhood of Masiphumelele

The South African government, it seems, loves policy-making space and resists anything that would constrain this space. It is therefore a pity that very little policy, good or bad, gets to be implemented. Part of the problem is the top-down approach to policy-making. It means that while we get a never-ending supply of policy documents, too little consideration is given to “the facts on the ground”.

Not paying attention to practical implementation makes us vulnerable to poor ideas such as pursuing a nuclear build programme that keeps returning, zombie-like.

Another problem with our policy-making is that it tends to work in functional silos. So, when energy policy is developed, the obvious implementing agent is Eskom yet Eskom is supposed to report to another political department, the Department of Public Enterprises. That there is insufficient co-ordination between the Departments of Energy and Public Enterprises is but a small problem; the facts on the ground are that Eskom is a rogue organisation and does not appear to report to or be accountable to anyone at all. The Standing Committee on Public Accounts (Scopa) is now holding hearings on Eskom’s supply contracts, but from what one can discern, Eskom’s management thinks it can run the utility by creating a series of urgent crises which then allow them to avoid regular procurement processes and then hand contracts to politically connected cronies.

The problem, and one that all South Africans have to confront on an urgent basis, is that we are now well beyond dealing with Eskom through the prism of the country’s energy policies or, frankly, through the prism of the role of what we would like to achieve through our State-Owned Enterprises (SoEs). Eskom, has created new “facts on the ground” and it now needs to be understood primarily as a big macroprudential risk.

The downgrading of South Africa’s foreign currency denominated debt to junk status following the firing of the capable team of former Finance Minister Pravin Gordhan and Deputy Minister Jonas and the imposition of, to put it politely, their substantially less capable replacements, has received a lot of attention. Even before this event, one got the sense that a downgrading was inevitable. A capable team at Treasury was a necessary but not sufficient condition for retaining investment grade status. There are far too many other indicators, such as slow economic growth and poor general standards of governance outlined in the State Capture report. Unless there is a sharp change in direction, local currency denominated debt will also be junked. December 2017 can’t come too soon.

Eskom, however, is already deep into junk territory and we are already paying the price for it. Further, the only reason why it has the credit status it has is because of the implicit support of the government. It is inconceivable, for the moment, that the government would let Eskom go bust. Still, despite being state-owned and a monopoly provider of electricity, Eskom is paying as much as 5%, and sometimes more, than the government pays for new borrowing.

At present Eskom’s total debt is over R320-billion and it plans to borrow over R60-billion per annum in each of the next five years to finance its capital expansion programme. On this basis, total indebtedness is going to top R500-billion – roughly a quarter of the government’s indebtedness.

Examining Eskom’s financial performance is a relatively tricky thing to do. On one hand, it is a trading company with sales, costs of sales and fixed costs – income statement matters. On the other hand, it is an investment company but an unusual one – its investments in generating capacity using debt take place over a decade or longer. During that investment period, these investments generate no revenues. One can examine some of this by focusing on the balance sheet.

As a trading company, Eskom is barely profitable – last reported earnings before interest, tax depreciation/amortisation, interest and tax (EBITDA) was R9.3-billion off revenues of R164-billion. But even this hides some real problems. Increases in revenues have come from huge tariff increases that have tripled in real terms over the past decade but costs too have spiralled – including the price at which it is supplied coal. Fully 40% of Eskom’s coal supply is trucked in, which is often both expensive and of a poor quality. Further, Eskom is starting to discover the upper limits of what it can charge. First, it has failed to secure under-recovered costs through Nersa’s regulatory processes and second, it is discovering that the limits of how much it can charge its customers are not something determined by any regulatory tariff setting but the harder fact of demand for electricity at the price it can be sold for.

Eskom is selling less electricity than it did a decade ago. With declining demand, Independent Power Producers (IPPs) add to Eskom’s financial troubles because although the cost of buying power from them is provided for in Eskom’s tariffs, Eskom is obliged to everything that the IPPs can produce before it adds its own supply. All excess and idle capacity belong to Eskom alone. Eskom paid about R15-billion to IPPs, some of which includes renewables, in its previous financial year but should the IPP programme, including the coal and gas IPPs get the go-ahead, this obligation could double in the short term. Eskom has brought down costs to some extent but many of these costs, like coal contracts and salaries, are baked into the system.

As an investment company, Eskom is a slow-moving train wreck. A big part of the problem are the disastrous Medupi, Kusile and Ingula projects, its existing debt and the funds it is yet to borrow. Chris Yelland did a convincing calculation of the massive (up to now) cost over-runs and then the price at which Medupi and Kusile would have to supply electricity to the grid if they were stand-alone operations.

In short, the price that they could supply the grid when (if) they are completed is well above Eskom’s own selling price for electricity. Eskom disputes Yelland’s calculations but refuses to disclose the details of its own. It should be noted that Eskom cannot even provide the required information to the regulator to enable it to make a tariff determination. Bluntly, Eskom is borrowing to continue financing the construction of stranded assets.

We do not see the impact of this yet. While Eskom’s assets are still under construction, it simply capitalises the interest becoming payable so interest charges are not put through the income statement. Already, Eskom’s capitalised finance costs are bigger than its most recent earnings. A better understanding of what is going on is to look at Eskom’s cashflow statement. Already Eskom pays R22-billion in debt servicing and when Medupi and Kusile come into full service, all the capitalised interest on those investments will have to be serviced. If one includes repaying debt, Eskom’s debt servicing could amount to as much as R50-billion per annum. This is what the credit rating agencies know and that is why Eskom’s debt is so poorly rated.

Eskom simply will not have the cashflows to service its debt. In the meantime, renewables have become the cheapest way of adding new generating capacity. Some calculate that by 2031, new solar PV will be cheaper than that generated from legacy coal-fired plant. Eskom can expect large-scale customer defection, especially from its lucrative commercial and high-end residential base as a result of rooftop PV installations.

The government and therefore the taxpayer has substantial exposure to Eskom. In recent times, has converted a R60-billion loan into equity (it already owns all the shares) and injected a further R23-billion. On top of that, Eskom has a R350-billion Guarantee Framework Agreement in place which allows Eskom to borrow at lower rates. Already, R210-billion of this guarantee has been drawn upon mostly through corporate bonds issued on the local bond market. Eskom’s total liabilities are equal to that of all other SoEs combined. Likewise, the amount represented by Eskom’s corporate bonds is equal to all other SoEs.

A recent RMB client note analyses SoE lending via the issuing of bonds. The Public Investment Corporation (PIC), the manager of the Government Employee’s Pension Fund (GEPF) holds 77% of all SoE issued bonds and that exposure is as much as 10% of total assets managed by the PIC. Private pension funds have a 4% exposure to the SoEs. The macroprudential risk for the country is significant. Indeed, it is exactly this that became one of the factors in South Africa’s recent credit downgrading. In the past, Eskom has had success in raising new debt and refinancing old debt but this is now becoming more difficult and Eskom has had to explore new sources of credit from bilateral funders such as the China Development Bank on terms that are not disclosed.

The longer Eskom, under its current board and management, continues as it has done, the worse it will be for all of us. While we need to get the long delayed restructuring of the electricity market under way, it might be necessary to make short-term interventions. One option worth considering is to revisit The Eskom Conversion Act of 2001 which gave Eskom considerable independence from government – this could include decorporatising Eskom. Instead of trying to avoid having Eskom’s debt become the governments direct responsibility, it should assume this obligation. One immediate benefit of this would be to lower Eskom’s cost of borrowing albeit at the risk that credit agencies would then re-rate the sovereign debt downwards on the basis that government’s Eskom’s debt added to government’s existing debt would be too large in an economy showing no growth.

If the above suggestion seems too radical, the government as shareholder could pass a resolution that all future investing needs to include an element of direct investment from the government instead of just borrowing. This intervention would force Eskom’s investment programme to comply with the country’s own budgeting rules with its associated parliamentary oversight bringing about much needed accountability. Accountability would have to include the kind of investments Eskom should make in the grid to prepare for the coming energy transition dominated by renewables, energy efficiency and battery storage. Immediately, this would reduce the risk that government is blindsided by yet another urgent future bailout of Eskom. Of course, having a properly functioning Treasury and a Parliament that takes its role of holding the executive accountable seriously is critical.

Obviously, any nuclear procurement fantasy should also be dropped. It makes no sense.

We should not fool ourselves. There is a well-known path for countries that do not take their looming macroprudential risks seriously. When they themselves are unable to meet current commitments, whether to creditors, public service salaries, pensions or social grant recipients, new facts on the ground emerge. This includes a creditor determined restructuring. In those circumstances, our beloved policy space virtually disappears. You do what your creditors of last resort tell you to do. DM

Photo: A South African woman carrying her daughter on her back runs her take away restaurant by candle light during a sheduled power outage known as load shedding in the impoverished neighbourhood of Masiphumelele, Cape Town, South Africa 26 May 2015.EPA/NIC BOTHMA