EDINBURGH — No wonder South Africa’s government finds itself caught between a rock and a hard place regarding the nature of both Eskom and its debt, says a London-based sovereign and credit specialist. Writing for the Financial Times, Pavel Mamai cautions that Eskom, a company that is too big to fail, is fast running out of road but no one seems to be tackling the problem. “The government will have to act sooner or later and the longer it waits, the stronger the likelihood of significant policy mistakes along the way, and the more expensive the solution will be,” warns Mamai. – Jackie Cameron
By Thulasizwe Sithole
Amid rising fears that the South African economy is stuck with low growth, major financial institutions along with the South African National Treasury have cut their 2018 growth forecasts for Africa’s most industrialised economy, says a Financial Times columnist.
“One of numerous issues the government is facing is the financial health of Eskom, South Africa’s state-owned monopoly power utility company. The company’s semi-annual results announced on November 28 highlight just how daunting this issue is,” notes Pavel Mamai, founder of ProMeritum Investment Management, a London-based EM sovereign and credit specialist.
“The company’s debt has grown to nearly 15 times its Ebitda (earnings before interest, tax, depreciation and amortisation). Interest payments on this debt consume around 90% of Ebitda. Debt servicing requirements (interest and debt repayment) exceed Ebitda by nearly two times, meaning that servicing existing debt requires taking on yet more debt,” says Mamai.
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“All capex and other cash outlays also need to be debt-financed. Cash levels have fallen from R17bn ($1.2bn) at the end of September to R11bn now. At this burn rate, Eskom would run out of cash by the end of March, unless it manages to borrow more, further increasing its debt.
“Any private company with financial results such as this would inevitably end up in bankruptcy proceedings. Eskom’s auditors have reportedly requested a fresh letter of support from the National Treasury to sign off its accounts on a “going concern” basis.
“How did Eskom come to be in this situation? Much attention has been paid this year to various corruption scandals. Indeed, corruption in the past is responsible for some operational issues today, and is probably one of the major reasons the National Energy Regulator of South Africa was always reluctant to give Eskom the tariff increases that were required. However, the roots of Eskom’s problems run much deeper,” says the specialist.
The causes lie in Eskom’s parastatal nature and its use by the South African government, within its development state mindset, as a means of distributing subsidies, according to Mamai.
“Because it is part of the country’s core infrastructure, it provides the government with a means of supporting household incomes via low electricity tariffs. Eskom is the country’s largest employer and pays wages to 48,000 employees, which is 20-25% more than it actually needs (compared with international peers).
“It is also used to subsidise some of South Africa’s poorest municipalities, such as Soweto, which pay no more than 10% of their electricity bills without the risk of being cut off. And because the majority of South African electricity production comes from coal fired power plants, which are owned and operated by Eskom, the price paid by the public utility for the coal it requires has significant knock-on effects across multiple industries, most notably mining.
“Eskom has for years served as a conduit for subsidies bound for black economic empowerment coal producers and the renewable energy sector. Performing such a significant social function comes at a cost, with completely inadequate revenues that cannot support high operating costs and capital expenditures funded by ever-increasing borrowing,” he continues.
The South African government is the enabler, guaranteeing more than 60% of Eskom’s debt.
“Still, Eskom’s cost on government-guaranteed debt is 2-3 percentage points higher than the government pays on its own debt. In other words, the government would save 2-3% by borrowing directly and lending on to Eskom instead of being liable for its debt,” explains Mamai.
“Instead, it chooses to pay for the privilege not to have Eskom’s debt included in its own debt metrics. A dubious privilege, in my view, since rating agencies largely see through this and add back Eskom’s debt when assessing the government’s overall debt levels.”
Mamai asks what a turnaround of the largest energy producer on the African continent might look like.
Here are some options:
- The company could increase tariffs and/or reduce its bloated payroll, in which case the public is made to take the hit;
- Alternatively, it could abandon its role as a conduit for government subsidies for various economic sectors, most notably coal and renewable energy. Most likely, such changes in the operating model will be necessary within the framework of a social compact in the long run. However, the more immediate focus of both Eskom and the government should be on the fact that it is doubtful any of the above will prevent the company from running out of cash in the short run;
- In the immediate future, there really are two possibilities: Eskom has to partially write down its debt and/or significantly decrease interest, in which case its creditors are made to bear the brunt of the company’s turnaround, or the government foots the bill.
“I believe that numerous hurdles to an efficient debt restructuring mean that the government will ultimately have to opt for some form of bailout. In terms of the hurdles mentioned above, restructuring state-guaranteed debt could lead to a substantial increase in the government’s own funding costs, sovereign rating downgrades, and an increase in financial market volatility,” says Mamai.
“Restructuring of Eskom’s non-guaranteed debt, which makes up less than 40% of the total, would not be enough to decrease leverage to sustainable levels. Furthermore, a selective default on non-guaranteed debt only would open Eskom to legal action by the lenders, which would stand a decent chance of success in the very transparent South African legal system based on English law.
“Protecting Eskom from creditors through legislation could further undermine the investment climate and cost a lot of political capital. However, bailing out the energy giant would be tantamount to acknowledging that Eskom is a de facto state-run company and its debt effectively sovereign.
“The government, which is pre-occupied with the upcoming elections, would surely prefer to kick the can down the road — particularly until after elections expected in May 2019. Throw in the fact that there is little domestic appetite in South Africa for an increase in energy tariffs and it is easy to see why nothing has happened.”
No wonder South Africa’s government finds itself caught between a rock and a hard place regarding the nature of both Eskom and its debt, says Mamai. “Eskom, a company that is too big to fail, is fast running out of road but no one seems to be tackling the problem. The government will have to act sooner or later and the longer it waits, the stronger the likelihood of significant policy mistakes along the way, and the more expensive the solution will be,” adds the expert.
- Pavel Mamai is founder of ProMeritum Investment Management, a London-based EM sovereign and credit specialist
