South African electricity utility Eskom intends to fund its massive investment programme partly through retained earnings and partly through the capital markets, including bond issues.
Initially, the utility intended that these two sources of finance would each contribute 50% of the required funding. However, pressure on its balance sheet, combined with a deteriorating credit rating and the global credit crunch, is serving to constrain Eskom’s ability to draw on either of these sources of funding.
As a result of such difficulties, the utility has announced the postponement of the development of a second conventional nuclear power station on economic grounds. Fortunately, the slowdown in electricity demand growth means that this postponement is possible. However, certain other projects in the utility’s capex suite are critical to ensuring South Africa’s security of electricity supply, and postponement is not an option. Thus, the utility is continuing to use the sources of funding available to it, although it faces challenges on many fronts.
In order to fund any part of its capital expendi- ture programme through retained earnings, Eskom will need to significantly increase the price at which it sells electricity.
Currently, the utility provides electricity at prices that are considered to be among the lowest in the world, and has done so for many years, enabling government to use the promise of cheap power as part of an industrial strategy to attract foreign direct investment to energy-intensive sectors. Eskom’s tariff is, at present, thought to be between three and five times below world norms.
However, it is becoming increasingly evident that the price of electricity in South Africa does not reflect the cost of producing it.
Demand for the low-grade coal resources that once enabled Eskom to generate cheap power is surging globally, increasing the utility’s primary fuel costs. Further, in the context in which the utility is undertaking massive investment in new capacity, it is no longer economically viable to base the price of electricity on the excessively depreciated book value of existing power stations.
Infrastructure reform and regulation expert Professor Anton Eberhard, of the University of Cape Town, explains that the average Eskom electricity tariff in the 2007/8 financial year was 19,45c/kWh, with the power generation component accounting for about 13c/kWh. However, the cost of new coal-fired power gene- ration capacity is above 60c/kWh and nuclear and renewable energy costs are even higher.
Since April 2006, South Africa’s electricity price increases have been dictated by a multi- year price determination (MYPD), which articulates price increases for three-year periods in an effort to introduce consistency, predictability and transparency in pricing, and to send positive signals to potential investors in the country.
The first MYPD allowed for a 5,1% increase in April 2006, a 5,9% increase in April 2007, and a 6,2% increase in April 2008.
Eskom, however, contends that much steeper increases are necessary to ensure the security of South Africa’s electricity supply, and has, since 2007, sought the approval of price increases in excess of those granted in the MYPD.
Initially, Eskom sought to have the increase from April 2008 increased to 18,7%. After evalu- ating the request, and a process of public consul- tation, the National Energy Regulator of South Africa (Nersa) agreed to allow an increase of 14,2% from April 1, 2008 – more than double the 6,2% originally allowed for the period.
Then, in March 2008, Eskom again applied for an increased price hike, submitting to Nersa an application including five possible increase scenarios. Eskom’s favoured option among these was for a real price increase of 53% in 2008/9, backdated to April 1, 2008, followed by a 43% real increase in 2009/10. The 53% would replace the 14,2% increase granted in December 2007.
In response to this application, Nersa approved an increase of 27,5%, which was more than four times the 6,2% increase allowed for in the initial MYPD.
The utility continues to contend, however, and is supported in this contention by many quarters, that even larger tariff increases are necessary to secure electricity supply in South Africa.
The three-year period covered by the first MYPD ended at the end of March 2009. However, by mid-April, Eskom had still not submitted its price application for the forthcoming period. While this delay indicates possible behind-the-scenes lobbying, it also means that Eskom has entered its new financial year without clarity on the price path going forward.
The utility has indicated, however, that it has delayed its submission to Nersa in order to take into account the impact that the global financial crisis is having on consumers. Further, Eskom has attributed the delay to a desire to present not only a request for a price adjustment, but also an integrated funding blueprint.
In reviewing Eskom’s submission, Nersa will find itself having to balance a number of needs – the need to build new power generating capacity, the need for Eskom to deliver on a social commitment to extend the supply of affordable energy to households not currently receiving power, and the need for the utility to remain a low-cost supplier of electricity in order to satisfy industry and attract new investors.
Ultimately, it is believed that Nersa is target- ing the implementation of cost-reflective tariffs by 2013. Further, the regulator has indicated that while tariffs to date have been raised accross the board, in the future, a scalable tariff system could be on the cards, which could assist in achieving capital expenditure (capex) goals while, at the same time, making power accessible and affordable to the poor.
Funding Through the Capital Markets
Eskom’s balance sheet is important not only for funding the utility’s capex programme from retained earnings, but also from the perspective that it is critical in determining the ease with which the utility is able to raise signi- ficant funds from financial markets.
On the back of a deteriorating balance sheet, together with the limited tariff increases Nersa has granted to date, several ratings agencies have already shown concern regarding Eskom’s creditworthiness.
For example, in 2008, international ratings agency Standard & Poor’s placed Eskom on a negative credit watch (although this has since been upgraded from ‘negative’ to ‘developing’), and Moody’s cut the utility’s local and foreign currency ratings. Fitch has had Eskom’s credit ratings on a negative outlook since August 2007.
Also contributing to these downgrade decisions, according to consultancy Frost & Sullivan, has been a perceived lack of strategic direction from within Eskom.
As a result of the concerns of the ratings agencies, Eskom now faces additional difficulty in raising finance, and the loans it does manage to secure are likely to be at higher interest rates. In addition, the downgrades damage the already fragile Eskom brand, and potentially diminish its influence in the region.
Further compounding the problem of downgrades in Eskom’s credit ratings is the fact that the international market is currently risk averse and low on liquidity. As a result, the risk premiums that banks and financial institutions will require will increase further, making the cost of borrowing capital more expensive, when it is available. Thus the cost of borrowing is increasing for Eskom, and the company will pay significantly more in interest.
Eskom initially planned to issue a large international bond in the second half of 2008 and, prior to the collapse of Lehman Brothers, in September 2008, had unveiled a funding plan that involved raising as much as R90-billion offshore over a three- to five-year period.
However, as a result of the global financial meltdown, Eskom announced in October 2008 that it had postponed plans to sell $500-billion worth of bonds internationally for 6 to 12 months, as global financial turmoil was pushing up borrowing costs.
Instead, the group is likely to intensify efforts to raise funds locally and to pursue funding through development finance institutions. Accordingly, in March 2009, Eskom proceeded with a R500-million local bond issue. Further, the company has signed a $500-million, 20-year loan with the African Development Bank (AfDB). This was the largest ever loan granted by the private sector division of the AfDB. The loan, which took 18 months to negotiate, will “drop down over six months”.
The AfDB reportedly views Eskom as a private sector entity and, as a result, did not insist on a government guarantee in its dealings over this loan.
Eskom’s financial director has also indicated that capital could be raised through private placements with US and Japanese funders, through export credit schemes, and through reapproaching banks to raise syndicated loans during the course of 2009.
In an effort to alleviate some of the pressure Eskom is facing in accessing finance in the capital markets, South Africa’s Finance Minister Trevor Manuel, in his 2009 Budget speech, confirmed a R176-billion package that will provide guarantees for R26-billion of Eskom’s existing debt and R150-billion of new debt. This support follows the announcement of a R60-billion long-term subordinated loan (in effect, equity) from the Treasury in 2008. The loan was initially to be dispersed over five years, although this was later decreased to three years, in light of tightening markets and other difficulties Eskom faces in raising funds. As a result, R10-billion was paid to the utility in December 2008, with a further R30-billion to be transferred in the 2009/10 financial year, and R20-billion in the 2010/11 financial year. Eskom has hinted at the possibility that it may approach government for further support.
The guarantees, together with the existing loan, have sent a strong signal of government support for Eskom.
On the announcement by Eskom that it had applied to the National Treasury for guarantees, Standard & Poor’s revisited its local currency credit watch for Eskom from ‘negative’ to ‘develop- ing’. Nevertheless, the ratings agency has indicated that it will seek further details from both the South African government and Eskom regarding the precise conditions surrounding the guarantees package before making a final determination on Eskom’s rating. In particular, the ratings agency is seeking to determine whether the guarantees are, indeed, “unconditional and irrevocable” in their formulation. If the agency discovers any form of conditionality, it may impact on the rating.
A rating speaks to the debt-servicing capability of a borrower, as well as to the timely payment of interest and principle. So, to get the maximum benefit out of a guarantee, it has to ensure timely payment. If the guarantees offered by government are some form of ultimate guarantee, which will only kick in if the company goes into liquidation, then that will not be good enough for the ratings agency.
Regardless, there is no question that the loan injection and the guarantees will take pressure off Eskom from a market-access perspective. However, Eskom’s balance sheet will be far more highly leveraged in future, which has implications for debt-service payments, which will continue to require significant tariff increases. Further, questions remain whether Nersa will be willing to grant the magnitude of increases necessary.
In February 2009, a Nersa member responsible for electricity indicated that the regulator would take a range of factors into account when determining electricity tariff increases going forward, including changing economic conditions, increased capex costs, ratings downgrades and the guarantees offered by the Treasury.