South African Finance Minister Tito Mboweni tabled a bill before the National Assembly which would see national state-owned power utility Eskom benefit from an allocation of R59 billion over the next three years. This is in addition to the R69 billion that was announced earlier in the year to be allocated to Eskom over the next three years in order to fund the restructuring of the entity into three separate entities – namely generation, distribution and transmission. According to the bill, R59 billion will be allocated to Eskom over three years, with R26 billion to be allocated for the 2019/2020 financial year and R33 billion to be allocated for the 2020/2021 financial year. The intention of the allocated money is to assist Eskom in meeting its financial obligations.
What has become increasingly apparent is that Eskom is not able to generate enough revenue to meet its operational and debt requirements. Years of mismanagement (and corruption) has resulted in a ballooning debt burden which currently stands at around R440 billion. Around 62% of this debt is government guaranteed¹, which places additional strain on the fiscus at a time when government is struggling to finance its own obligations – particularly with South African debt to GDP rapidly approaching 60%, without considering state-owned enterprise (SOE) debt.
What is clear is that Eskom is not sustainable in its current form. A study published by the World Bank in 2016 found that the utility was potentially overstaffed by 66%. Eskom currently employs approximately 49,000 people, an increase of 16,000 people from 10 years prior. The company has itself admitted that its workforce is too bloated by approximately 16,000 people. Whether Eskom can reduce headcount is debatable, given an unemployment rate of close to 29% in the country (significantly higher in terms of youth unemployment) and the fact that any job cuts are opposed by the labour unions that played a vital role in helping President Cyril Ramaphosa gain power.
The National Energy Regulator of South Africa (NERSA) has granted Eskom permission to increase electricity tariffs by around 7.6% per annum for three years (ending March 2022). This is just over half of the annual percentage requested by the utility, despite electricity prices increasing by more than double the inflation rate over the past decade.
Given the recent load shedding, it might come as a surprise to some that Eskom does have enough installed capacity to meet the electricity needs of South Africa. The issue is that many units are either being maintained or are not working due to years of a lack of maintenance. This means that the current level of electricity production is well below the potential level that Eskom can produce, as evidenced by the declining energy availability factor over time that is currently sitting at around 72%.
Eskom expects future costs for operating, capital and primary energy expenditure to increase significantly over the next five years. Operating and maintenance costs are expected to increase by 17% over the next five years, largely due to the significant costs associated with fuelling and maintaining coal-powered stations.
What should be evident from the above is the significant mismatch between what Eskom is likely to be able to charge for electricity and the associated costs for generating that level of power. This is even before considering the costs associated with meeting emissions standards over the next decade. The utility has committed to spending R63 billion to comply with emissions laws by 2025 which is well below the R300 billion Eskom estimates it needs to spend to comply with these laws. Evidently, Eskom is currently the largest threat to the stability of the South African economy. Urgent intervention is needed from government in order to stabilise the SOE that is currently responsible for producing 95% of the electricity production of the country.
Credit rating agency Moody’s – the only agency to rate South Africa’s sovereign debt as investment grade – has continually highlighted the burden that Eskom places on the South African fiscus. A downgrade to sub-investment grade from Moody’s would result in South Africa losing its place in the all-important Citigroup World Government Bond Index (WGBI). The Bank of America has estimated that this may result in outflows of around R200 billion from the South African bond market.
A downgrade to sub-investment grade from Moody’s would result in it becoming more expensive for government to borrow money, as bonds will probably have to be issued at higher yields to compensate investors for the increased credit risk. This would likely result in government relying more on citizens to fund the country’s current account and budget deficits through higher taxes. The outflows from the bond market would also likely result in a weaker rand, making essential imports more expensive. A significantly weaker rand would result in higher inflation, as imports of essentials become more expensive for ordinary South Africans. The South African Reserve Bank (SARB) would probably need to react to higher inflation by increasing interest rates, putting pressure on consumers with significant debt.
The above highlights some major concerns around the state of the finances of both the government and Eskom and we urge investors to proceed with caution. Investors should focus on not making knee jerk changes to portfolios based on news headlines or economic developments. Investment markets adjust rapidly to new information and it is worth remembering that the return an investor receives is ultimately highly dependent on the price that one pays for that asset.
South Africa has flirted with a sub-investment grade rating from Moody’s for quite some time and yields have adjusted accordingly to bring us in line with several other countries that are already rated as below investment grade. While an exit from the WGBI would result in outflows from our bond market, this is likely to, at least, be partially offset by inflows from funds which track sub-investment grade indices – particularly given the low levels of yields available to investors in the developed world.
Another option that could provide financial support to the indebted fiscus that is being considered by government, is that of prescribed assets. This would require a percentage of retirement savings be invested in bonds issued by the South African government and state-owned enterprises such as Eskom. The requirement would provide these companies and the South African government with regular investments in order to fund operating activities as well as help them to repay debts. This would be similar to the situation South Africa faced between 1956 and 1989 when half of all retirement savings in South Africa had to be invested in government and parastatal bonds.
At Morningstar, we continue to build portfolios through a valuation driven lens. We assess the intrinsic value of an asset class based on our assessment of the future cash flows that can be generated from that asset class. We prefer to focus on the fundamental value of an asset class rather than being influenced by news headlines. We will continue to track developments closely and communicate as and when asset allocation or manager changes to portfolios are necessary.