CAPE TOWN – Professor Brian Kantor may no longer lecture economics at UCT, but he hasn’t lost the art of a theatrical production. Together with David Holland, the former MD of Credit Suisse London, they had observers at this week’s Nersa hearings whistling, cheering and clapping.
Eskom is asking the National Energy Regulator of SA (Nersa) to approve its request for annual electricity increases of 16% until March 31 2018.
Thus far hearings in Cape Town and Port Elizabeth have been characterised by demonstrations and dry presentations more notable for their inability to present solid alternatives to Eskom’s pricing application than anything else.
Kantor and Holland did not speculate on the impact of the price hikes on the economy or job losses. Nor did they bemoan the absence of competitors or the lack of an up-to-date energy roadmap.
Instead their presentation applied a laser beam to Eskom’s contention that for long-term stability it needs to strengthen its balance sheet and earn an investment grade credit rating. According to Eskom, the way to reach these two goals is to earn a return on assets of close to 8%, a target set by Nersa.
Using a globally acceptable valuation model Kantor and Holland showed that Eskom is demanding an exceptionally and unnecessarily high real return on the capital it has invested. By extension, says Kantor, “its pricing application is excessive.”
In their analysis the academics made use of a valuation model called CFROI (cash flow return on investment) which was developed in the US in the 1980’s and refined by Holland – who is an expert on company valuations and the measurement and analysis of company cash flows – during his tenure at Credit Suisse.
CFROI is calculated on an annual basis and is compared with an inflation-adjusted cost of capital to determine whether a company has earned returns superior to its cost of capital. It provides a more accurate valuation of companies than more traditional methods.
Using this model Holland and Kantor show that after years of artificially low prices, Eskom is already earning an internationally acceptable real return on the capital it has invested and plans to invest. “If this was 2009 I would be sitting on your side,” Holland told the Eskom executives assembled in the front rows of the Nersa hearings.
Using the model Holland shows that Eskom’s median cash flow return on operating assets troughed at a negative 2.5% in March 2009. “This was not a good time for you. It was at a time when new generating capacity was essential to the functioning of the economy.”
But after two rounds of price increases, which saw prices rise from 16.2c per kWh in 2006 to the current 61c per kWh, this position has reversed. “If we strip out the R159bn of presently non-productive construction-in-progress, Eskom’s real rate of return improved to an internationally competitive 3.3% by March 2012,” says Kantor.
In the case of the world’s 100 largest electricity companies, the average real return (which factors in inflation) over the past decade is 3.2%. This is lower than the 6% earned by service companies globally and 10% earned by many SA companies. It can, however, be justified by the fact that electricity generation – especially where the regulated generator and distributor has a high degree of monopoly power – is one of the lowest risk projects available in any economy.
“Our sense is that if such a return [3.3%], if maintained, would be sufficient to justify investment in additional capacity,” Holland said. He then invited the Eskom executives to “sit down with us” to run some pricing scenarios through this model. With appropriate control of costs, he said, the revenue generated will deliver enough cash from operations to support a balance sheet with comparatively high debt ratios – given the essentially low risk nature of its business.
The problem is that Eskom is trying to fund its growth with an unnecessarily small reliance on debt.
“If Eskom gets its way with Nersa it will truly be one of the great companies of the world,” says Kantor. It will be possessed of a balance sheet that would be the envy of the world, especially of the world of public utilities. Eskom’s debt to equity ratio is falling and by 2018 it will have assets that at replacement costs would have a value of over R1trn, more than three times its R300bn of debt.
“The way to fund new electricity is not through higher charges, but through debt.”
The bottom line is that Eskom’s balance sheet objectives are too ambitious and unaltered will be dangerous to the health of the SA economy.