Electricity supply challenges are credit negative, with metros most affected

September 10th, 2019, Published in Articles: EE Publishers, Articles: Energize

Municipalities in South Africa are heavily dependent on surpluses from the sale of electricity [1]. In FY2018, surpluses [2] from electricity distribution comprised roughly 44% and 46% of gross operating balance for rated metropolitan municipalities (metros) and local municipalities, respectively, leaving municipalities vulnerable to supply and demand dynamics in the sector.

Over the past two years, worsening load shedding (Fig. 1) by national power producer Eskom – in response to power shortages – has resulted in lower revenues and surpluses for rated metros, a credit negative. We expect gross electricity surpluses to gradually fall further as load shedding continues and encourages additional large power users (LPUs) to go off-grid. Given the highly regulated structure of local revenue generation, we expect municipalities to offset these pressures by cutting services which have previously been cross-subsidised by electricity surpluses.

Fig. 1: Energy availability significantly deteriorated in late 2018 to early 2019 (Eskom).

South African municipalities are heavily dependent on surpluses from the supply of electricity.

In FY2018, electricity surpluses generated, on average, 44% and 46% of gross operating balance (GOB) for rated metropolitan and local municipalities, respectively.

South Africa’s national government, through Eskom, is responsible for ensuring the generation and transmission of electricity across the country, and municipalities are responsible for its distribution to consumers. The National Electricity Regulation of South Africa (NERSA), in accordance with the Electricity Regulation Act, provides guidelines and approves all electricity tariffs.

The tariffs which consumers pay to municipalities (retail tariffs) include charges for the generation, transmission and distribution of electricity, which include staff, repair and maintenance costs. As a result, retail tariffs are higher than bulk supply tariffs (the tariffs which Eskom applies to municipalities), enabling municipalities to generate a surplus. Electricity distribution also gives municipalities some leverage in ensuring that consumers pay any outstanding debts owed to the municipality, by penalising non-paying households through cutting their electricity supply.

Fig. 2: Electricity revenues are the largest single contributor to operating revenues for rated municipalities (Fiscal 2018 issuer’s financials and Moody’s).

Although South African municipalities’ operating revenue sources are relatively diversified, revenue from electricity sales is the most significant source, and surpluses are used to cross-subsidise other municipal services. In FY2018, electricity surpluses contributed an average of 44% and 46% to GOB for metropolitan municipalities and local municipalities, respectively. In FY2018, electricity sales equalled, on average, 35% of total operating revenues for rated metros and 45% for rated local municipalities.

Electricity supply challenges are credit negative for municipalities, particularly metros.

Eskom’s load shedding has encouraged LPUs to go off-grid, reducing purchases from municipalities. Metros will be the most affected because they generate more than 50% on average of their electricity revenue from LPUs. We estimate that if this trend were to continue, the gross operating balance (GOB) for metros would decline by an average of 7% over the next three years (falling from an average GOB of R2,8-billion to an average R2,6-billion).

Load shedding by Eskom is credit negative for municipalities as it reduces the operating surpluses generated by electricity sales. Over the last three years, all metros have recorded a decline in the contribution of gross electricity surplus [3] to operating revenue as consumers, particularly LPUs, turn to alternative energy sources. The City of Tshwane experienced the highest decline (five percentage points), with gross electricity surplus to operating revenue dropping to 8% in FY2018 from 13% in FY2016, followed by the City of Johannesburg (Baa3 negative) and Nelson Mandela metropolitan municipality (Baa3 stable/Aaa.za), for which gross electricity surplus fell by three and two percentage points respectively, between FY2016 and FY2018.

Fig. 3: Electricity gross surplus contribution to operating revenue consistently declined for all larger rated metros in 2018 (Issuers’ financials and Moodys).

Disruptions in electricity supply has prompted a number of LPUs with the financial and technical capacity to go off the national grid and produce their own electricity. The impact of this has been greater for metros than for local municipalities, given that they generate more of their electricity revenues and surpluses from LPUs. In anticipation of LPUs using alternative power sources or completely going off grid, metropolitan municipalities are already budgeting for lower electricity revenues.

The cities of Tshwane, Ekurhuleni and Johannesburg have the highest reliance on LPUs for their electricity revenue at 80%, 60% and 55% respectively, and would therefore be most affected by an increase in the number of LPUs going off grid. These metros are characterised by large scale industries, including automotive and manufacturing, requiring heavy power-driven machinery.

Fig. 4: Metros’ operating revenues are largely dependent upon contributions for large power users, 2018 (Issuers and Moodys).

In addition, the energy minister announced in May 2019 that the national government will issue more licences to independent power producers (IPPs) to generate electricity and feed into the national grid. We expect this to accelerate the decline in municipal revenues over the medium term, as more LPUs will go off-grid. The City of Johannesburg has already recorded a 25% decline in LPU revenue between FY2017 and FY2018.

We forecast a 25% decline in revenue from LPUs for all rated metros over the next three years. Based on this assumption, we expect a 7% decline on average in budgeted gross operating balances for all rated metros over the same period. The cities of Tshwane and Ekurhuleni, which have the highest exposure to LPUs, will be the most impacted, with a forecasted decline in gross operating balances of 10% and 8%, respectively. This decline is significant – it constitutes, for example, approximately 15% of their refuse removal revenue.

Municipalities have limited revenue flexibility to counteract pressures.

Municipalities are currently unable to diversify their electricity sources. In addition, other revenues are relatively inflexible, with tariffs set by the national government. As a result, pressures from electricity supply challenges are likely to be mitigated by spending cuts.

Fig. 5: Tswane’s and Ekurhuleni’s high exposure to electricity revenue and large power users makes them the most exposed to electricity supply challenges (Issuers and Moodys).

Municipalities currently have limited revenue flexibility to counteract these pressures, a credit negative. According to current regulations, municipalities can only purchase electricity from Eskom, limiting their flexibility to counteract the impact of electricity supply challenges. While the City of Cape Town (Baa3 stable) has taken legal action to allow them to procure up to 400 MW of renewable energy from independent power producers (IPPs). In addition, although municipalities are permitted to have their own generation plants, they only provide a small proportion of energy relative to demand, leaving Eskom as the main supplier of electricity to municipalities and thereby limiting their ability to offset supply challenges from the provider. Furthermore, the fact that municipalities cannot increase electricity tariffs without NERSA’s approval also limits their flexibility to deal with the decline in electricity revenues.

Fig. 6: Metros’ decline in GOB will range from 3% to 10% (Issuers’ financials and Moodys).

They also lack flexibility with regard to other major sources of revenue, including property rates, government grants and water rates – municipalities need national government approval to increase property rates and water tariffs, while government grants provided to municipalities are solely determined by the national treasury. Surplus from electricity revenue is generally used to cross-subsidise the provision of basic services (largely for low income households) and cover part of the capital expenditure budget. If the surplus declines, municipalities are likely to reduce these costs and become more reliant on capital grants and borrowing to fund their capital expenditure budget.

This will likely limit the ability of municipalities to efficiently provide basic services to the public. Municipalities are also likely to reduce the amount used in cross-subsidising other services to counteract the reduction in operating surpluses. This would likely have a large social impact, given the country’s high-income inequality and unemployment rate of 29% in the second quarter of 2019.

Notes

[1] Municipalities make a surplus on electricity by buying it at bulk tariffs from Eskom and selling it to consumers at retail tariffs.

[2] Surplus is calculated as electricity revenue minus bulk purchases (80%) and fixed costs (20%).

[3] Gross electricity surplus is calculated as electricity revenue minus bulk electricity purchases.

Contact Daniel Mazibuko, Moody’s, Tel 011 217-5481, daniel.mazibuko@moodys.com

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