McKinsey will return ‘tainted money’ received from Eskom
Cross-border trade can alleviate regional shortages, profit Eskom, relieve local consumers and aid renewables
Global consultancy firm McKinsey has set aside the R1bn that Eskom has demanded that it repay and was keen to do so, the head of the firm’s public and social sector practice, David Fine, said on Wednesday.
Fine was giving evidence at the inquiry into state capture held by Parliament’s public enterprises portfolio committee. The money was paid for McKinsey’s work on a turnaround plan, but the Treasury had not approved the contract.
“McKinsey does not want any tainted money. We went into a relationship with Eskom in good faith,” Fine said.
Eskom had given verbal confirmation that the contract had Treasury approval, but this turned out not to be the case.
Fine said that even if the court ruled the contract was valid, McKinsey would still give the money back, not because the firm felt guilty about anything it had done, but because the contract did not have the required Treasury approval.
Asked by evidence leader Ntuthuzelo Vanara why the firm did not simply go ahead with the repayment regardless of the outcome of the court case, Fine said Eksom did not want to pay the money twice. It needed to know whether the money should be paid back to Eskom or the fiscus.
Fine said the question had been discussed with McKinsey’s global partners and there was agreement that the money should be paid back.
He said he believed McKinsey had provided value in the work it did for Eskom on the turnaround plan, but that the fee structure should have been capped. However, he had subsequently queried whether Eskom had the management capacity to absorb the extent of the changes proposed in the plan. Eskom’s liquidity position had deteriorated, which posed the question whether the consultants had worked on the wrong problem.
Eskom is also demanding the repayment of R564m from the Gupta-aligned Trillian Capital, which worked alongside McKinsey before discussions about it becoming a supplier development partner were terminated in March 2016. Fine said McKinsey had ended its relationship with Trillian early in 2016 because of concern over its ownership structure.
McKinsey had been under the impression that Trillian, headed by Eric Wood, would be a black-empowered consultancy, but this was not the case. Fine said he also became concerned because some of the people involved in Trillian were potentially politically exposed individuals, or did not have the stature needed to build up a preeminent consultancy firm.
Trillian failed an external due-diligence probe initiated by McKinsey.
McKinsey also did work on Transnet’s market demand strategy and on preparing a business case for the procurement of 1,064 locomotives.
It calculated a cost, excluding hedging costs, of R38.6bn over seven years, but Transnet in the end proceeded with the procurement on the basis of its own cost calculation of R54bn over three years.
Fine said McKinsey had been told the difference was due to different assumptions on inflation, hedging and contract terms.
McKinsey did work for Transnet with Regiments, which brought significant investment banking capabilities. However, concern about Regiments’s underperformance began to deepen in 2015. In February 2016, McKinsey informed Transnet that it would terminate its relationship with Regiments.
Recent reports have highlighted the many challenges facing Eskom, including, most pressingly, difficulties in continuing to service its debt. Underlying Eskom’s liquidity issues are a number of structural problems with the electricity sector in SA, of which we want to highlight three: electricity generation is carbon intensive, increasingly inefficient and the supply deficit that led to load shedding a few years ago has been replaced by an excess of generating capacity.
The good news is that two of these problems could be mitigated by greater electricity exports to SA’s neighbours. However, significant increases in exports will require improved interconnection and transmission infrastructure in the Southern African Development Community (Sadc) region.
SA ranked 105 out of 125 countries in the World Energy Council’s 2016 environmental sustainability index, driven by the country’s continued dependence on coal for electricity generation. Investment in new large coal-fired power plants such as Medupi and Kusile has undermined the progress made through the highly regarded Renewable Energy Independent Power Producer Procurement Programme (REIPPPP) and entrenched SA’s high-carbon energy mix. With supply now in excess of demand, Eskom is stalling the signing of power purchase agreements with the renewable independent power producers.
Like other state-owned entities in SA, Eskom is struggling with efficiency issues. An inability (or unwillingness) to constrain expenses in both capital projects and raw material supply contracts, plus a disproportionate increase in headcount, has led to spiralling costs.
After insufficient expenditure on maintenance of existing plant and inadequate investment in new generation capacity led to load shedding in 2008 (and again in 2014 and 2015), Eskom embarked on a large capital expansion programme, primarily focused on new coal-fired power stations accompanied by plans for new nuclear capacity. In parallel, the Department of Energy approved the REIPPPP, which added more than 3GW of renewable generation capacity between 2011-16.
At the same time, SA’s lacklustre economic growth, energy efficiency improvements and increases in “distributed” or decentralised generation — such as small-scale wind and solar power — have led to stagnant or declining demand for grid electricity. This combination of operational inefficiency and excessive investment in what increasingly appears to be unnecessary capacity has led to rapidly rising electricity tariffs. This trend is likely to continue for years to come, further damping demand in a vicious cycle, which may threaten Eskom’s viability.
Solutions to these three problems exist — the key question is whether the political will is there to implement them.
The structural reforms needed to resolve the conflict of interest at the heart of Eskom’s efficiency problems are well understood — the 1998 energy white paper set out plans for the separation of generation from transmission and distribution and the introduction of a competitive market in generation. A bill to introduce an Independent System and Market Operator was published in 2011. Unfortunately, there is little appetite in the current government for structural reform of Eskom.
Thankfully, however, the other two problems are less intractable and could both be mitigated by increasing electricity exports to neighbouring countries. To reduce carbon emissions, SA needs to increase the proportion of renewables (or nuclear) in its energy mix. With wind and solar now the cheapest new-build generation technologies in SA, the REIPPPP provides an excellent vehicle for doing this. The problem is that the current surplus of generating capacity leaves Eskom with little incentive to sign the power product agreements, connect independent producers to the grid or undertake the necessary strengthening of transmission infrastructure to bring renewably generated electricity from where it is being produced to where it is needed.
However, SA’s surplus of generation capacity is an unusual problem in the region. Many of its neighbours have exactly the opposite problem. Recent droughts left heavily hydro-dependent countries such as Zambia and Malawi with severe supply shortages and extensive load shedding. Increased cross-border trade of electricity could be a win-win solution for SA and its neighbours, generating revenue for Eskom and alleviating power shortages elsewhere. Thinking optimistically, it could relieve price pressure on South African consumers and encourage Eskom to connect the renewable independent power producers to the grid, greening the country’s energy mix.
SA is currently connected to the Southern African Power Pool by 7GW of interconnector capacity to Namibia, Botswana, Mozambique, Lesotho and Swaziland, and exports to the region are already happening. While sales of electricity to domestic customers declined by 1% in the year to March, Eskom’s international sales increased by 12%. Unfortunately, the relative size of domestic versus international sales meant that overall sales still fell over the period (by 0.1%).
Significant increases in exports from SA to the region are therefore needed. However, this will require new cross-border transmission infrastructure or “interconnectors”, as well as the strengthening of existing domestic transmission in power pool countries, such as the Alaska Sherwood line in Zimbabwe. Of the 2.8-million megawatt hours (MWh) of matched trades between members of the pool in 2016-17, only 1-million MWh (37%) was actually completed, largely owing to constraints in the transmission infrastructure. Alongside this, the right commercial and regulatory arrangements need to be in place to ensure that, once built, usage of the interconnectors is maximised.
There are currently nine power pool transmission projects at the feasibility/project preparation stage and a further seven at the prefeasibility stage. These include plans to connect the three members of the pool that are not currently connected (Angola, Malawi and Tanzania), as well as projects to strengthen interconnection between SA and Botswana, and between SA, Mozambique and Zimbabwe.
How can this new transmission infrastructure be financed? Government investment has been the dominant model for interconnectors in Africa, either with government-owned companies each financing their side of the transmission line (such as the Cahora Bassa line between Mozambique and SA) or through the creation of a special purpose vehicle (SPV). Motraco, which connects SA, Mozambique and Swaziland, is an SPV owned by the three state-owned utilities — Eskom, EDM (Mozambique), and SEC (Swaziland).
However, interconnectors can also be privately financed, and this model has worked well in other parts of the world. Given the current fiscal climate in many southern African countries it is an option worth exploring. There are a number of different private finance models but the most common for interconnectors is “merchant investment”, where a private investor builds and operates the interconnection asset and generates revenue by arbitraging the price differential between the two markets it connects.
There is no single “best” solution – interconnectors have been successfully developed under a range of different investment models, both public and private. The choice of investment model will depend on the nature of the project, investor requirements and policy preferences, among other factors.
But increasing investment in interconnection and transmission in the Sadc region should be an urgent priority for SA.