How to remove the Eskom albatross from around SA’s neck

There is a simple way to stabilise electricity prices, cast off Eskom’s crippling debt, boost SA’s credit rating and liquidity, kick-start our economy and yet maintain public sector ownership of critical assets in the electricity sector, all while becoming profoundly green.

It requires a shift of perspective, and so we have developed a metaphor: imagine the country as a modern cargo ship in the middle of the Atlantic. It is driven by both sails (wind) and diesel engines. The engines have broken down and there is no wind — the ship is literally in the doldrums.

A mayday message has been sent and a tugboat has arrived, but has run out of fuel. The ship is leaking and sinking deeper in the water. There is inertia: the tugboat cannot pull.

Time passes, the ship sinks deeper. What to do? The situation seems intractable and a pessimistic mood is becoming despair. It seems a matter of time before the ship sinks and the tugboat saves itself by severing the cable.

The cargo could gradually be thrown overboard, but this would only postpone the inevitable.

Then, magically, someone points out that in addition to gold and diamonds, much of the cargo consists of diesel. If the diesel is transferred to the tug, the tug could pull, the ship would get lighter, its speed would gradually increase, the doldrums would pass, the sails would kick in, the ship would safely reach harbour with everything and everyone intact — bar the diesel.

If we regard Eskom generation (specifically its coal power stations) as an eternal asset like gold or diamonds that must be guarded in perpetuity, the ship (the South African economy) will sink.

If, however, we see it as something with a limited lifetime that must be best used before ceasing to exist (like diesel), all will be well.

Marooned ship

Eskom’s current debt is R350bn and it needs to raise perhaps another R150bn over the next three to four years. This is almost certainly impossible, even with a government guarantee. Eskom cannot stay afloat without a gargantuan government bail-out.

The low electricity price increase, announced by watchdog Nersa in December, has mostly passed the responsibility for funding Eskom from the electricity rate payer over to the taxpayer and the fiscus.

It has been widely reported that Eskom will run out of cash by end of February. Just last week Finance Minister Malusi Gigaba said Treasury did not have the funds to bail Eskom out.

Treasury might break it down into periodic components, fund the most immediate need for some months and hope the problem goes away, but the electricity price is well below what Eskom requires for sustainability, and the question will return again and again.

The build programme for Medupi and Kusile may have to be suspended. We will come to the inevitable choice between a slow submerging and a very unpalatable turn to the International Monetary Fund or World Bank. These institutions would likely impose conditions on lending that would conflict fundamentally with government policy and South African opinions on sovereignty. It would be the impasse of the ship, slowly sinking with no solution in sight.

Fuel for safety and prosperity

The equivalent of the diesel in the hold is the Eskom generation fleet, consisting of 15 coal-fired power stations. These all have limited lifetimes and were built to serve the country and economy before being retired and replaced. Scheduled decommissioning dates start soon and end in 2050 or later.

Given that these assets were meant to be extinguished over time for the common good, we can choose to do so in the most beneficial manner. This would be to remove them from the Eskom fold and to dispose of them to public or private entities as described below.

How it would work

1. The existing power stations would be grouped into three categories:

• Category 0: The oldest, which have recently been calculated to be more expensive to keep than to shut them down immediately: Camden, Hendrina, Komati, Grootvlei and Arnot

• Category 1: All others but Medupi and Kusile: Kriel, Matla, Duvha, Tutuka, Lethabo, Matimba, Kendal, Majuba

• Category 2: Medupi and Kusile

2. Power stations of category 0 would remain with Eskom for controlled immediate decommissioning over the next five years (in sync with Medupi and Kusile coming fully online).

Power stations of categories 1 and 2 would be sold in a staggered manner, one by one, over the next five years in competitive auctions.

3. What is up for sale in these auctions is the power station itself, all its power station-specific obligations (staff contracts, coal-supply contracts, supplier contracts, environmental obligations, etcetera) lumped with a power purchase agreement at a predefined, power station-specific tariff.

4. The power purchase agreement is a contract that entitles the new power station owner to supply a specific amount of electricity annually, an electricity budget, over the power station’s lifetime to the Single Buyer Office (hosted in Eskom’s Transmission System Operator division) at the predefined tariff. The amount of electricity will equate to the expected output at normal system-friendly operations.

5. There will be payment for electricity delivered (and only for electricity delivered) and a penalty for not being available (a “capacity nonavailability penalty”). The new owner of the power station will be fully responsible for maintaining and operating the power station, while the Eskom System Operator, in its national control centre, would be responsible for the day-to-day system-optimal dispatch of the power stations within the technical restrictions and the agreed annual electricity budget, broken down into monthly sub-budgets.

6. The agreed electricity budget would constitute both an entitlement and an obligation. The new power station owner would be entitled to have at least the agreed electricity budget bought or paid for (ie, a “take-or-pay contract”), making the power purchase agreement “bankable” — that is, financeable. On the other hand, the new power station owner would be obliged to produce at least that agreed amount of electricity per year if requested by the System Operator, or face penalties.

7. The power station-specific power purchase agreement tariff would be high enough to cover all coal, employee and operational costs and leave a margin. The present value of that margin over the lifetime of the power station, minus the present value of the expected rehabilitation cost, is the amount of money that can be raised through the auction.

8. From the revenue of electricity sales, the new owner must set aside ring-fenced, insolvency-safeguarded funds for closure and rehabilitation of the power station at the end of its lifetime (and the synchronised end of the power purchase agreement lifetime). The cost of rehabilitation is estimated at a substantial R10m per megawatt, which would be available at the time of closure as a fund to pay for the rehabilitation process. For a typical power station that is between R30bn and R40bn.

9. The duration of each power purchase agreement would be linked to the planned decommissioning date, but would be capped at 20 years. The reason for the cap is that additional years at the tail-end of the power purchase agreement contribute little to the achievable sales price, while power purchase agreements of longer than 20 years would lock the country in unnecessarily long, in light of the fact that in 20 years in all likelihood new solar photovoltaic and wind power, plus batteries, will be significantly cheaper than existing coal-fired power stations.

10. In terms of the bid conditions, staff and existing coal contracts would be maintained as before and would be transferred to the buyers. The purchase sum would be payable upfront in a lump sum. Those prospective buyers able to operate most efficiently would be able to bid highest and would win. That means whoever offers the highest lump-sum price for the power station with all its obligations plus the power purchase agreement would be the new owner.

11. One power station of category 1 could be sold first as a trial. After adjustments to the bid rules for lessons learnt, the remaining power stations could then be auctioned one at a time, in the ascending order of their remaining lifetime. No entity may own more than 20% of the overall electricity budget of roughly 200TWh a year, to prevent anticompetitive behaviour.

12. Category 2, Medupi and Kusile, would be sold in a package with higher tariffs, and resulting higher margins, to take into account the fact that enough capital must be raised through the sale to be able to pay back the associated loans on Eskom’s side. They would also be sold last, after full commissioning by Eskom. It is assumed that Eskom would finalise only units 1-4 of Kusile and scrap units 5 and 6, as it has recently been shown it will be cheaper not to complete than to finish them.

13. Eskom continues to own and operate the pumped storage and peaking plants plus the nuclear power station Koeberg, and otherwise to exist as before, being primarily responsible for planning, operating, expanding and balancing the grid.

14. As old power stations are decommissioned by their new owners at the end of the respective power station and power purchase agreement lifetime, new power plants are procured (also on long-term power purchase agreements) that are the lowest cost addition to the electricity at the time while keeping the security of supply at the accepted level. Based on present market conditions and also trends, this overwhelmingly would be solar PV and wind power, mixed with flexible power generators, demand-response and (in future) battery storage.

Cash injection for SA

The proceeds of the auctions would be a function of where the electricity tariff in the power purchase agreements is pegged. The lower the price, the lower the proceeds. The higher the predefined power purchase agreement tariff, the higher the proceeds from the auction. We have chosen to use moderate, but still cost-reflective, rather than subsidised electricity tariffs. The proposed tariffs per power station are sufficient to cover all operational expenses and would leave a margin whose present value over the lifetime, minus the present value of the funds set aside for rehabilitation, determines the achievable sales price.

In category 1 this margin is pegged at 20c/kWh, leading to power purchase agreement tariffs of between 54c/kWh and 72c/kWh, the variance resulting from the different coal costs per power station.

In category 2, Medupi and Kusile, the proposed contribution margin is 60c/kWh, to be able to achieve a sales price sufficient to repay the associated loans on Eskom side. At such margins and tariffs, the country could raise about R450bn from the series of auctions. This would extinguish all Eskom debt and leave some valuable cash to upgrade the grid and recapitalise the new Eskom.

Price and grid stability

A major benefit would be very stable, affordable and predictable electricity prices.

SA has long been beholden to Eskom’s inefficiency and poor governance. These have had to be paid for by the rate payer or taxpayer. It is a bit like trusting someone with a credit card and hoping they will be responsible: if the trust proves to have been misplaced, the only option is to grimace and pay. This pattern has recurred.

With a sold-off Eskom coal fleet, inefficiencies would lead to losses for new owners but not for the public.

The average electricity price is overwhelmingly driven by the cost of Eskom’s coal fleet. This is about 55c/kWh today. The grid (Eskom transmission and Eskom distribution), customer service, metering, billing and all overheads adds roughly another 30c/kWh, for a total of about 85c/kWh. Medupi and Kusile are costing significantly more than 100c/kWh. As they are completed, the average tariff will increase.

New solar photovoltaic and wind power stations cost only about 60c/kWh to 65c/kWh. If we embark on a least-cost expansion path, replacing old coal predominantly with solar PV and wind, the long-term electricity tariff in SA will stabilise at about 100c/kWh: 70c/kWh for generation and 30c/kWh for the grid and all other costs.

Our grid can easily accept an aggressive roll-out of variable renewable energy until at least 2030, given the current coal capacity installed. Between 2025 and 2050, as this winds down, we’d have to assess the state of international progress on electricity storage and dynamic grid management already developing internationally in grids dominated by variable renewable energy. If required, the country can then invest in storage capacity and/or generation capacity that fits well with renewables, like gas or regional hydro.

Government control of key economic assets

It is axiomatic in the prevailing policy discourse that the government should retain ownership or control over key economic assets, of which electricity is one. The present proposal leaves space for this to occur, in two ways:

• Control over the grid practically constitutes control over the electricity industry. It is a natural monopoly and Eskom would retain that control. The government can control where the grid goes, who it serves, who supplies electricity into it, how it is maintained and how it is built to serve broader objectives like the National Development Plan. The electrons travelling on the grid are similar to the cars travelling on the national road network. It isn’t necessary to own every car in order to control transport in the country. Electricity can be procured from independent power producers while retaining control over the electricity system in the country. This has been proven in many countries.

• Beyond this, there is every possibility that public sector entities like the Public Investment Corporation (PIC) could invest in the auctioned Eskom power stations either through equity or debt or a mix of both, and pay a specialised service provider to operate them on its behalf. They would in fact be exchanging a very open-ended and precarious Eskom bond for an equity investment in a long-term infrastructure asset with a very predictable, long-term return — a much better position to be in. While no entity may own more than 20% of the fleet, to ensure fair play, there are different public sector pension funds that might be interested, while it might also be possible to finance equity for the trade unions.

Effects

Taking this route, Eskom generation would cease to be an unbearable drag on the economy. Its sale would stabilise electricity prices, greatly improve liquidity in the country, and bolster our credit rating and leverage investment through a better economic outlook and certainty about the future electricity price. The energy-intensive mining and beneficiation sectors would benefit particularly. Treasury would be rid of a R350bn albatross around its neck and would be left with far lighter offtake guarantee for the electricity delivered to the grid operator (as it would be performance-based — “no electricity, no payment”).

The PIC could greatly lower the risk profile of its South African investments. Mismanagement of any of the coal power stations would lead to lower profits for the owner but would not affect the electricity price. The scope for corruption would have been curbed significantly.

Eskom would be able to concentrate on what it can do very well: design, build and maintain the grid, and operate the power system as a whole. That capability of Eskom is a national asset and could be leveraged to help electrify the continent. Eskom could become the “super grid company” of Africa and one of the largest in the world.

There is precedent for this: in China, grid and generation have been separated since 2002. The former State Power Corporation of China was divided into one grid company, responsible for building, maintaining and operating the grid, and several generation companies. The purpose was to create competition between the generators. The State Grid Corporation of China today is by far the largest utility in the world with almost 1-million employees, and now provides grid services to multiple countries outside China on concession.

In this proposal, rehabilitation of retiring stations would be fully funded and open to scrutiny. As new power came online, SA would gradually become (again) a country with some of the lowest electricity prices in the world, due to superior wind and solar resources, and would converge on a zero-carbon electricity sector.

At a macro level, government would retain control of the electricity sector, jobs would be safeguarded and we would be able to turn our attention to other challenges the country faces in its journey to greater prosperity and equality.

• The authors were appointed to the inaugural Ministerial Advisory Council on Energy. Dr Bischof-Niemz was the founding head of the Energy Centre at the Council for Scientific and Industrial Research and previously worked for Eskom on the Integrated Resource Plan. He is now head of global business development at Enertrag. Van den Berg is an advocate and former CEO of the South African Wind Energy Association who is now MD of Skrander.