Benefits of privatising the electrical distribution sector



Electricity supply in Africa has consistently been provided by state-owned electricity enterprises for over a hundred years. Electricity distribution is usually undertaken by large vertically-integrated government-controlled utilities, except in very few cases. This article provides an analysis of global experiences in the privatisation of electricity distribution and considerations for its application in an African context.

There is growing demand for infrastructure investment at a time when budgetary constraints limit governments’ capacity to finance these projects. At the same time, it is difficult for public utilities to generate the revenue required for crucial infrastructure updates, or even basic maintenance. The resulting lack of access to a high-quality electricity supply continues to limit the capacity of African economies to reach their potential. The World Bank estimates that power shortages reduce GDP growth by 2% per year. Major international lending banks and development agencies have all promoted a policy of the privatisation of state-owned enterprises, and the liberalisation of access to foreign investment in those enterprises.

Improving operational efficiency should be the priority for utility viability

The World Bank studied the electricity sector in 39 countries in sub-Saharan Africa and only two (Seychelles and Uganda) were fully recovering the operational and capital costs of electricity supply. Only 19 countries were even recovering their operational costs. The bank suggests that improving these utilities’ operational efficiency (to benchmarks comparable to utilities in Latin America) could help a further eleven countries to obtain full cost recovery. Under-pricing remains a problem in the other countries, often due to affordability constraints.

In the study, benchmark performance was considered on three key dimensions: Transmission and distribution losses (both technical and commercial/theft) of 10% of dispatched energy or lower; 100% bill collection and the same staffing levels as in well performing, comparable utilities in Latin America.

The impact of privatisation on utility performance in Latin America

During the 1990s, 116 electric utilities were privatised in ten Latin American countries. Private utilities served less than 3% of consumers in 1990, but more than 60% by 2003. The results of a World Bank study on the performance of these utilities suggest that changes in ownership generate significant improvements in labour productivity, efficiency and product/service quality; and that most of these changes occur during the transition period.

Table 1 summarises the definitions of the variables, trends and observations of the study relevant to this article.

Table 1: Definitions of the variables, trends and observations of the study.
Variable Measure Trends Observations
Output Number of customers No significant change in the rate of new connections before and after the transition. Performance seems to be firm specific, which would suggest that the rate of new connections should be written into the contract targets.
Labour Number of employees Average reduction of the labour force by about 38% during the transition. Changes after the transition weren’t significant. Most SOEs were oversized in personnel. In some cases, the governments reduced the number of employees to try improve the value of the firms. Investors discounted these attempts, considering that the selection policies may have resulted in good employees leaving and bad ones staying.
Labour productivity

Number of customers per employee

Energy sold per employee

Labour productivity showed significant improvements of about 18% during the transition, reducing to about 5% per year thereafter. Continued improvements after the transition speaks to continually improving skills levels of the remaining employees.
Efficiency Energy lost in distribution (technical losses & illegal connections) The average reduction in losses was 5,5% per year during the transition, flattening out thereafter. One might assume that the firms perform better maintenance and investments in the networks and the results would improve in time.
Quality Frequency and duration of interruptions Both the frequency and duration of interruptions improved by about 10% each per year during the transition. After the transition, the estimates show additional improvements of about 25% each.

Governance and incentives drive performance

Similar studies done in Ukraine on 24 electricity distribution companies from 1998 to 2002 showed that privately owned firms respond aggressively to incentives that add to net cash flow. This can be attributed to strong governance and incentive systems for management in private firms; while low salaries in state-owned companies provide weak incentives for high performance.

Private firms are also more likely to comply with regulations than public utilities. Regulators are less likely to impose penalties on government institutions than on private firms. Fining a fellow government institution would be a futile exercise; but closing down and recovering assets from a private company is a severe punishment.

Management must be incentivised to serve the public interest

Harvard Business Review compared privatisation to the spate of mergers and acquisitions in the 1980s; and suggested that the issue is not simply whether ownership is private or public. Rather, the key question is under what conditions will managers be more likely to act in the public’s interest.

Privatisation involves replacing managers appointed by the citizens with managers appointed by shareholders. Privatisation therefore involves radical organisational change and must be managed well. However, mergers and acquisitions demonstrated that ownership alone is not enough to ensure that managers will act in the shareholders’ best interests.

The comparison revealed the following insights:

  • Privatisation will be effective only if private managers have incentives to act in the public interest.
  • Profits and the public interest overlap best when the privatised utility is in a competitive market. It takes competition to discipline managerial behavior.
  • When these conditions are not met, continued governmental involvement will probably be necessary.

Risks to consider

Unlike public utilities, private utilities do not serve a constituency, they serve investors. Electricity infrastructure are by their very nature monopolistic. Therefore, unregulated privately-owned electricity distributers could tend to raise rates to increase profitability; at the expense of the poor. Infrastructure projects are very long-term investments. Privately managed infrastructure concessions therefore cannot allow these long-term assets to be compromised by short-term profit and cash flow objectives.

The challenge of size versus competition with monopolistic infrastructure

In Africa, electric utilities are traditionally vertically integrated national conglomerates that exploit this monopoly. Therefore, there is a challenge of how to introduce competition in this environment.

In most developed capital markets, conglomerates trade at a discount. One reason for this, in developed markets, is that investors believe that they can diversify their risks better than managers in the conglomerates can. Also, maintaining control over the diverse activities within conglomerates is extremely difficult. Hence, it makes sense in the electricity sector to unbundle utilities into their separate business areas: generation, transmission and distribution.

In developing markets, however, companies can diversify their risk better than individual investors can, because the capital markets do not offer investors as diverse a range of asset classes to invest in. Because markets are smaller, there are fewer opportunities for competitors to maintain economies of scale and compete effectively. This means that hoarding management talent from a small pool may make sense. This argument is even stronger in protected markets.

In Africa, talent management and succession planning may have been jeopardised where technical “know-who” is more important than technical “know-how”. Most utilities suffer from a lack of good talent; and where there is potential, there is often a lack of adequate training.

Competition in the US was secured by public utility laws from 1935. Utilities were given monopolies over a limited geographic area, but prevented from expanding their reach. In exchange, utilities agreed to provide reliable electricity to all customers at a regulated rate.

The status of privatisation of electricity distributors in Africa

While most countries in Africa have a single vertically integrated state-owned utility, there are a number of privatisation experiences that we can learn from. Figure 1 shows the various structures of the electricity sectors in Africa.

Fig. 1: Electricity Sector Structures in Africa (source: World Bank).

There are many examples where generation is privatised and operate on an Independent Power Producer (IPP) basis. Nigeria and Uganda have privatised distribution system operators.

The government of Tanzania, through its Electricity Act, has implemented a policy of re-organising the electricity market and unbundling of Tanesco by 2021. This unbundling is intended to improve competition to improve efficiency, attract private investment capital and promote regional trading.

South Africa failed to implement its proposed regional electricity distributors

South Africa proposed restructuring electrical distribution in South Africa, away from Eskom and municipal distributors, to consolidated regional electrical distributors (REDs) to try to fast track electrification.

The key drivers of the reform proposal were:

  • Fragmentation and inefficiencies in most smaller municipal distributors (no economies of scale)
  • Inequitable treatment of customers, tariff variances
  • Financial crisis (many distributors were bankrupt)
  • Inadequate investment in refurbishment and maintenance
  • Loss of experience and skills
  • The need for accelerated electrification

According to the Constitution, electricity reticulation is a municipal responsibility. In terms of the Municipal Systems Act, municipalities have the right to decide who will distribute electricity in its area, and may appoint a service provider in terms of a service delivery agreement.

The fact is that the municipalities receive a large portion of their revenues from electricity distribution, which often subsidises other services; and it’s very difficult to value the infrastructure that has been in service for many decades. So, while municipal revenues need to be protected, refurbishment and maintenance backlogs remain and need urgent attention. Statistics SA showed, using 2013 financial year numbers, how the financial viability of many municipalities “could be tenuous” if they could not resell power bought in bulk from Eskom. The government abandoned the REDs model and the restructuring of the electricity distribution industry went back to the drawing board.

Umeme case study

Uganda has a fully privatised electrical distributor, Umeme. Umeme operates a 20-year electricity distribution concession, effective from March 2005, granted by the Government of Uganda. Their mandate is to operate, maintain, upgrade and expand the distribution network; retail electricity to its customers; and improve the efficiency within the electricity distribution system. Umeme’s license requires the Electricity Regulatory Authority to review and set performance targets once every seven years. Umeme leased the existing infrastructure from its government owned predecessor and paid for its costs during the transfer.

Years of under-investment prior to the concession being granted had led to a dilapidated infrastructure. A total overhaul was need to transform the network into an asset able to serve Uganda’s goals and accommodate its growing need for energy. Financially, the company faced two additional challenges: how to connect more customers to the grid and ensure that the power provided was affordable.

Private equity partner, Actis, took over Umeme in 2009. Actis had a four-part strategy to create value and drive improvements in Umeme:

  • Strengthen Umeme’s management and corporate governance.
  • Drive operational improvements and accelerate network refurbishments.
  • Facilitate improvements in Umeme’s community outreach and communications initiatives, including a safety campaign.
  • Help secure an IFC loan to help finance the refurbishment programme.

Despite a struggling economy, Umeme continue to grow their revenue while reducing theft and improving safety. The increased demand is attributed to the growing industrial sector in Uganda. The utility is however facing challenges of increased financing costs and high operational costs.

Fig. 2 highlights Umeme’s impressive performance in improving efficiency and connecting new customers.

Fig. 2: Umeme performance from 2012 to H1 2017 (Source: Umeme H1 2017 Financial Results).

Some of the key metrics showing the performance of Umeme, as a privately managed concession, are:

  • Increased customer connections from 292 000 in 2005 to 1 019 000 by 2017. 70% of the total customer base is now on pre-paid metering, contributing 20% of revenues.
  • Reduced energy losses from 38 to 17,5%. The loss reduction strategy focused on reduction of commercial losses (estimated at 7%) through public awareness, meter audits, billing efficiency and pro-active use of data analytics to identify and focus activities.
  • Increased revenue collection from 80 to 99%, mainly through prepaid metering and a focus on industrial customers.
  • Invested $500 million in the distribution system, including substations, feeders, rollout or prepaid metering and automated meter reading systems as well as expansion of the distribution grid and new customer connections.

A key challenge facing Umeme now is that of needing to raise long-term capital to evacuate an additional 783 MW of generation capacity, while only having  eight years left on the concession.

Conclusions

Privatisation tends to improve the efficiency and quality of electricity supply, which are important factors in improving the financial viability of electricity distribution utilities. The performance of management is best, when there are strong incentives and governance systems.

Privately managed electricity distribution concessions could help a further 11 countries in Africa recover all of the operating and capital costs of their electrical supply. This additional cash flow could enable them to improve their electricity infrastructure and increase economic growth by about 2% per year.

There is a case to be made that for electric distributors to be competitive, they should:

  • Be geographically focused, small enough to ensure competition, but large enough to achieve economies of scale.
  • Have effective management talent that is incentivised to ensure efficiency, quality and act in the public interest.
  • Operate in a regulatory environment that determines new connections and pricing.
  • Be private insofar as sanctions are meaningful if they breach the requirements of their contracts.
  • Have long-term concessions so that the capital and business time horizons are matched.
  • Ensure that their predecessors receive a return on their investment made prior to transfer.

References

[1] C Trimble and M Kojima: “Making Power Affordable for Africa and Viable for its Utilities”, The World Bank, 2016.

[2] L Andres, V Foster and JL Guasch: “The Impact of Privatization on the Performance of the Infrastructure Sector: The Case of Electricity Distribution in Latin American Countries”, The World Bank, 2006.

[3] S Berg, C Lin and V Tsaplin: “Regulation of State-Owned and Privatised Utilities: Ukraine Electricity Distribution Company Performance”, Journal of Regulatory Economics, 2005.

[4] L Bliss: “The Privatisation of Public Utilities has One Major Upside”, Citylab, 2015.

[5] S Beder: “Critique of the Global Project to Privatize and Marketize Energy”, University of Wollongong, 2005.

[6] JB Goodman and GW Loveman: “Does Privatisation Serve the Public Interest?”, Harvard Business Review, November-December 1991.

[7] J Zinkin: “Are Conglomerates Good or Bad?”, The Star Online, 23 July 2010.

[8] “Case Study: Umeme (Uganda)”, Emerging Markets Private Equity Association, September 2011

[9] “2017 Interim Results”, Umeme

[10] “Integrated Annual Report 2016”, Umeme

[11] Clyde & Co: “The re-organisation of Tanzania’s electricity sector”, January 2017.

[12] A Eberhard: “An overview of the Restructuring of the South African Electricity Distribution Industry”, South African Local Government Association, May 2013.

[13] L Grant: “How electricity powers the revenue of municipalities”, Mail & Guardian, 17 July 2015.

Contact Dale Pudney, EOH, Tel 086 199-9003, dale@eoh-ps.co.za

 

 

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