Comments on Eskom’s 2018/19 Revenue Application

Eskom has submitted its application to the National Energy Regulator for an increase in the standard electricity tariff of 19.9% (and for municipalities, 27.5%). The HSF has provided its comments to the Regulator and this brief is a summary of those comments.

Introduction

This brief is a summary of our comments to the National Energy Regulator of South Africa (NERSA), in response to its invitation for public comment on Eskom’s revenue application for the 2018/19 financial year.  To read our full submission, click here.

The overriding problem

The overriding problem in the application has two interlinked aspects:

- the primary reason for a very significant proposed increase in tariffs, flows from substantially lower forecast sales volumes; and

- a complete lack of detailed information by Eskom on how it is controlling its overall cost structure, in a scenario of stagnant sales volumes and an ever-growing electricity generating capacity surplus.  

Supply therefore keeps on growing whilst demand stagnates.

The effect of stagnant demand

Tariff applications are based on a Multiple Year Price Determination (MYPD), stretching over five years.  The five-year MYPD3 programme ran from 2013/14 to 2017/18.  The beginning of the MYPD4 cycle should have been 2018/19, but this has been postponed for a year.  The current tariff application is therefore based on forecasts for a single year, ie. 2018/19.

The forecasts of demand in MYPD3 were much too high, as the second row of the table indicates.  The numbers are taken from Eskom’s application:

As a result of this substantial forecast decrease in sales, Eskom is applying for the tariff price to increase by 19.9% to standard tariff customers, but 27.5% to municipalities.

The current application will not cover the actual cashflow shortfall experienced over the past few years, caused by stagnant demand, but is meant to lead to a cost-reflective tariff for the coming year.  According to the application, the overestimation of sales volumes over the 5-year MYPD3 period is expected to lead to a cumulative shortfall of R68bn over that period and is to be the subject of claims by Eskom to NERSA within the framework of the retrospective account reconciliation mechanism (the Regulatory Clearing Account (RCA)).   Eskom has already submitted two RCA submissions to NERSA to cover the shortfalls for 2014/15 and 2015/16 (for R19.2bn and R23.6bn respectively), and these are explicitly excluded from the current application.  Further RCA claims are expected to be submitted by Eskom, to cover the very substantial balance of shortfalls over the MYPD3 period.  If these claims are approved by NERSA, they will obviously lead to further tariff increases.

Lack of information on Eskom’s strategy and cost-containment

Eskom is a major state-owned entity, which provides a crucial commodity to the economy and individual private consumers, in what is effectively a monopolistic situation.  One would have expected a public utility which has such an important social and economic position in the country, to consider ways of alleviating the pressure of out-of-the-ordinary price increases on individual consumers and on the economy in general.  No serious mention is made of this aspect in the application.  In the process, Eskom projects an attitude of simply carrying on, regardless of the financial pressure it places on the economy as a whole and in particular, on the individual consumer.  

The net effect of Eskom not addressing these issues in any detail is to put NERSA in an invidious position, where it is unable to take a rational decision on the application, especially given its duty to act in a justifiable and transparent manner and in the public interest (as prescribed in Section 9 of the National Energy Regulator Act, No. 40 of 2004).  Section 10(1) of the National Energy Regulator Act also stipulates that every decision of NERSA must be in the public interest and “must be explained clearly as to its factual and legal basis and the reasons therefor”.

If a decision is taken on the insufficient information before it, NERSA runs the risk that a court may be approached to review its decision   -   especially if a substantial tariff increase is approved.  

Information to be provided by Eskom

If NERSA is to be expected to give serious consideration to the application, it would have to be provided with the following:

- an analysis of the reasons for the substantially lower forecasts relating to standard tariff sales;

- how Eskom is managing its overall financial structure in the light of stagnant demand, what it has done to control its costs and how it could mitigate large tariff price increases;

- an analysis of Eskom’s steadily growing generating capacity and the impact of the construction and financing cost of the large new power stations on its financial position;

- a revision of the assumptions for the sales volume forecasts, particularly in the light of completely unrealistic GDP forecasts which are used in the application; and

- Eskom’s financial viability over the medium and longer term, in view of stagnant (or even shrinking) demand, in order to demonstrate to NERSA that Eskom’s business model is financially sustainable.   

Demand and Gross Domestic Product forecasts

The GDP forecasts used for forecasting demand in the application are so greatly out-of-date, that they draw into question the reliability of any Eskom sales forecasts.  For example, the 2018 GDP forecast used by Eskom for purposes of the application is more than double that of the latest forecasts published by the same three outside institutions whose estimates are quoted in the application.  For 2019, the forecast in the application is 59% higher.  As a consequence, we can only assume that Eskom is still overestimating its future sales in a major way.  

Eskom’s increasing surplus generating capacity

Eskom is faced with a steadily increasing electricity generating capacity, which is set to grow even further over the next five years, with the incremental commissioning of the new Medupi and Kusile power stations [1].  In January 2017, the then Interim Group Chief Executive of ESKOM pointed out that there was already a monthly average of more than 5 600MW surplus capacity and that that was enough to cover both the capacity supplied by renewables and the required reserve margin.  In the same presentation, he indicated that the current 43 193MW installed capacity (excluding Medupi), will increase to 54 189MW in 2022 (ie. by 25%).

We therefore have a situation where there is stagnant demand (as also clearly shown in Eskom’s present application), but at the same time, a steadily growing generating capacity, leading to an ever-growing gap between supply and demand.   

In essence, we are moving out of an era where electricity was generated by old assets that had been paid for, into an era where new assets have to be built to replace the old ones and these new assets need to be financed.  It is accepted that there will be cost implications arising from this situation, but since a substantial portion of the generating capacity of these new assets is superfluous to its current requirements, it is even more necessary for Eskom to explain the measures it has put in place to limit the effect on tariffs.  It is surprising that this aspect is not dealt with in any detail in the application.

Eskom’s financial situation

Eskom’s 2016/17 financial results show a negative cash flow amounting to R8.59 billion, ending the year with a positive cash balance of R19.9bn.  Without the Independent Power Producer (IPP) programme, it is questionable whether there would be a cash buffer at all, since it is estimated that Eskom over-recovered large amounts on payments to renewable IPPs in the MYPD3 period (to be reconciled in due course).  The IPPs also enabled Eskom to avoid very large additional diesel costs during the 2014 to 2016 period, which they would not have been allowed to recover from the tariff [2].  

On the basis of using Eskom’s own five-year forecasts which are contained in its latest annual report, and on the further assumption that operational cashflow remains constant (i.e. any tariff increases cancel out the inflationary operational costs, but no more), we are able to make an approximate annual cashflow forecast.  This analysis shows that there will be an average net cash outflow of R32bn over each of the next five years.  (This does not take into account the amount of just under R20bn that Eskom still has in cash at the moment, which in line with prudent financial management should be kept as a cash buffer.)  

In order to deal with this annual projected shortfall of R32bn, Eskom’s revenue of R177bn in the 2016/2017 financial year will have to increase by R32bn in the current financial year for it to break even on a cash basis.  This represents an increase in revenue of 18%.  (As compared to the current tariff increase application of 19.9%.)

In our calculations, we have assumed a zero increase in demand over the next five years.  Given the fact that demand is already stagnant, in the light of current economic growth expectations, taken together with the phenomenon that consumers are trying to cut reliance on Eskom energy where they can, it is more than reasonable.  

Eskom’s predicament

In trying to make sense of Eskom’s predicament, we see it as stemming from a combination of various factors:  

- an overly aggressive capital expenditure programme, coupled with an inability to avoid  major cost overruns and multi-year delays;

- the insertion of an IPP programme by Government which Eskom has to pay for and has grown to dislike, since it would rather find customers for its own surplus electricity capacity (even if it has benefitted from the IPPs, as shown above);

- a massive increase in borrowing (to finance capital expenditure), together with an interest bill which is certainly higher than originally foreseen, due to Eskom’s repeated credit downgrades;

- the slackening of demand as a result of, inter alia, economic growth of less than 1% per annum and the likelihood of continued pedestrian economic growth; and

- consumer behaviour, which is not only trying to limit electricity usage, but is moving away from Eskom altogether, as a consequence of unpredictable supply over the past few years and expected further out-of-the-ordinary tariff increases.

Macro-economic impacts of alternative scenarios

A large part of the application is devoted to an analysis of whether it is better for South Africa to accept a 19% electricity tariff hike or to risk further downgrades which may follow from increasing Government debt, caused (according to this logic) by effectively subsidising the cost of electricity.  

The application states that “In the present context, if Eskom is awarded much-lower-than-required tariff increases, it will put South Africa at greater risk of remaining with the continual negative feedback loop that countries typically experience following a sub-investment downgrade event.  Our analysis shows that under low tariff scenarios, Eskom’s revenue shortfall grows, the fiscal position deteriorates, interest rates rise, sentiment sours, economic growth slows, further credit rating downgrades within ‘junk’ territory are triggered and the toxic loop repeats”.  

Eskom’s analysis here is astonishingly superficial and it is difficult to take it as a serious attempt to analyse what is, in reality, a very complicated interplay of social, political, economic and financial factors.

Reference to a nuclear new build programme

Statements concerning a nuclear new build programme in the application create the impression that Eskom accepts the nuclear programme as a real possibility.  

However, if one attempts to approach this issue in a logical manner, the following questions arise: faced with stagnating demand, how can Eskom attempt to justify a nuclear programme?  How can it be justified in light of a growing surplus of generating capacity (increasing by the year)?  How can it be expected to fund a nuclear programme with an estimated cost of roughly R1 trillion, given its present financial circumstances?   Eskom in fact realises that more debt will not be forthcoming, where it states in the application that “neither Eskom nor the South African Government will be in a position to raise further debt to meet Eskom’s future revenue requirement without the risk of triggering further sovereign credit rating downgrades”.  

Apart from these fleeting references, the issue of a potential nuclear power programme is not addressed in any detail in the application.  In the absence of a serious analysis, the few superficial comments on this topic in the application, can only further damage Eskom’s own credibility.

Conclusion

Our submission to NERSA points out that in light of the lack of relevant information, the only option is to refer the application back to Eskom with the request for the missing information to be provided.  This will allow NERSA to avoid running the danger of judicial reviews for taking an irrational decision on incomplete data.  The wider question which arises from this situation is that of Eskom’s longer term financial viability.

NERSA’s public hearings on this subject will now take place during November 2017 and it is scheduled to give its decision on 7 December 2017.  Details of hearing dates and venues are published on NERSA’s website (www.nersa.org.za).

Anton van Dalsen is Legal Counsellor, Helen Suzman Foundation.

This article first appeared as an HSF Brief.

Notes:

[1] Eskom  

[2] Engineering News