Miner-backed study calculates 'sustainable' Eskom price hike at 25%

South Africa's State-owned power utility Eskom could lop a further ten percentage points annually off its application for tariff increases of 35% a year between April 1, 2010, and March 31, 2013, and still emerge as a sustainable organisation able to fund its operations and its capital programmes, new research by consultancy Genesis Analytics asserts.

The analysis, which has been completed on behalf of several mining and industrial clients, including the Chemical and Allied Industries Association and AngloGold Ashanti, would be presented to the National Energy Regulator of South Africa (Nersa), which is scheduled to host public hearings into Eskom's tariff application between January 11 and January 22.

Genesis Analytics chairman Stephan Malherbe told Mining Weekly Online on Friday that the outcome of a 25% a year price path, which could be "frontloaded if necessary", would be an electricity price of 62c/kWh, rather than the 81c/kWh (by March 2013) outlined by Eskom. Nevertheless, Eskom would remain "sustainable" and would also be earning an acceptable rate of return by the end of the period.

However, the research paper, which has not been distributed publically, was also premised on a far greater role for independent power producers and their balance sheets in the domestic and imported power mix.

Eskom would need to find ways to close what would be a R30-billion to R40-billion funding gap that could not be covered by shareholder injections and/or loan capital raised during the three-year period. This could be achieved by increasing the stake on offer to private investors in Eskom's R142-billion Kusile power station from 30%, to relieve further funding pressure and to make the acquisition more attractive to private investors, many of which would generally only be keen on taking majority interests in such ventures. The study also moots a ‘development bond', which would seek to tap South Africa's relatively deep pension-fund resources poll as one method of closing the gap.

BEST PRACTICE

Senior researcher Anthony Felet, an Australian national with extensive regulatory experience in the UK, explained that the key difference between Eskom's calculations and those presented in the Genesis Analytics study, related to assumptions regarding primary energy and operating costs, as well as the methodology used to calculate the utility's return of assets.

Felet described Eskom's expectations of operational and capital costs escalations as "generous" and well above the outlook for producer price inflation. While the utility's use of the "subjective" modern equivalent asset valuation model, rather than the more commonly used indexed historical cost approach to determine a fair rate of return, was, in his view, a deviation from "best practice".

"Because it costs a lot more to replace assets now than what they cost originally, the result is a far higher tariff than would have been the case otherwise. This essentially results in a free lunch to Eskom," Felet explained in an interview.

When Genesis Analytics applied the index historical cost approach a more modest tariff figure emerged, as did far lower depreciation figures, owing to the lower asset values employed.

ACCEPTABLE RETURNS

Eskom, however, believes that the index historical costs model yielded rates of return that were below long-term "acceptable levels".

The utility has asserted that its proposed percentage rates of return over the three-year period should reflect a partial migration towards a percentage rate of return which reflects Eskom's true pre-tax real weighted average cost of capital, as part of the equation to achieving cost reflective pricing within five years as required by South Africa's electricity pricing policy (EPP).

In its bid to "smooth" the increases, Eskom has incorporated a "phased approach" to the achievement of cost reflectivity, which Eskom has argued would mean that the medium- to long-term benchmark rate of return would not be fully recovered during the MYPD2 period - the utility calculates that the average real pretax return on assets will be 4,1%, as opposed to its weighted average cost of capital of 10,3%.

While it was willing to accept a lower return during the three-year period, Eskom argued that the regulatory model needed to move in a way that ensures eventual alignment with the EPP.

The utility also argued that, while its shareholder was unlikely to extract profits in the form of dividends during the tariff-review period, a sustainable return was still required to ensure capital for further expansions. In other words, it would argue that a return on equity provides the capability for a business to reinvest in the industry by providing the nondebt capital for expansion of the assets.

Further, the return also had a direct bearing on the ability of Eskom to borrow funds, as lenders require a sound earnings profile that demonstrates the ability to repay these funds' principle and interest in uncertain economic and commercial environments.

Eskom has indicated that it will tap both domestic and capital markets at a rate of around R47-billion a year between 2010 and 2013, and that the higher anticipated cost of such borrowings also had to be factored into its benchmark rate of return.

Eskom has explained that its submission to Nersa shows that funding is not a substitute for payment, and that, despite its efforts to ensure smoothing, the consumer would eventually have to pay, in line with the prescripts of the EPP.

Nevertheless, there is likely to be much haggling over the percentage return on assets required, with both business and labour indicating recently that they are unhappy with the proposed framework.

PRICES HAVE TO RISE

For his part, Malherbe stressed that there was no disputing the fact that Eskom's tariff needed to rise, noting that, at 25% a year, South Africans would still experience a doubling in nominal tariffs over the period.

"No doubt our figures will not be as low as some people would like, but we believe the outcome is a sustainable, effective, well-resourced power sector in South Africa," he added.

By contrast, Eskom's approach, which sought to "pre-fund" its capital programmes over a short horizon "off the backs of consumers", would not only have serious economic consequences, but could even lead to unintended windfall profits.

"We believe we have applied best regulatory pricing practices to arrive at a result that is sustainable and equitable," Malherbe asserted, while stressing that the study's outcomes should be seen as part of adding to the national debate rather than the final word or solution.

Public hearings into Eskom's application for a 35% a year hike in its tariffs for the three-year period from April 1, 2010, to March 31, 2013, will kick off in Mpumalanga on January 11, before moving to all of South Africa's eight other provinces and culminating on January 21 and 22 at hearings scheduled for Gauteng.

Nersa would make known its final determination by February 24, 2010, with the approved increases then scheduled to come into force on April 1, 2010, the start of Eskom's financial year.