Restructuring of the Electricity Distribution Industry
March 2002
1. Introduction
Since the early 1990s, there has been much discussion about the restructuring of the electricity distribution industry (EDI), which has been driven by the need to address the substantial fragmentation of the industry. This submission assesses the intergovernmental fiscal implications of the proposed restructuring.
1.1 Electricity and the reform of the energy sector
The energy sector as a whole has been the subject of a significant review process since 1994. It is government’s intention to increase access to affordable energy services, encourage competition within energy markets, promote cost-reflective energy prices, and replace hidden subsidies with transparent ones.1
The reform process is already far down the road. Eskom was converted into a tax- and dividend-paying entity in January 2000 through the Eskom Amendment Act of 1998, and Parliament is currently considering the Eskom Conversion Bill, which will unbundle Eskom’s generation and transmission functions and license each entity separately.
1.2 Restructuring of the electricity distribution industry
A significant restructuring initiative is the rationalisation of the distribution industry. Municipal distribution differs greatly in terms of customer density, size and type of customer base, geographic spread, financial base, and effectiveness. The substantial fragmentation of the industry has produced a number of problems:
Discussion around the restructuring of the industry has taken place over the past decade in numerous forums and committees, including the National Electrification Forum, Electricity Working Group, and Electricity Restructuring Interdepartmental Committee (ERIC).
ERIC was tasked with developing a government position on the issue and completed its report in 1996. Based upon the report, the Department of Minerals and Energy (DME) submitted a memorandum to Cabinet in 1997 that recommended the following:
The findings and recommendations of the ERIC Report were subsequently confirmed and elaborated upon in the Energy White Paper of 1998.
The rationale behind the proposals is that the optimal area for the effective performance and sustainability of electricity reticulation is much greater than the area of any single municipality.5 By restructuring the industry, it is intended that the following will be achieved:
To take the process forward, the Department of Minerals and Energy commissioned PricewaterhouseCoopers (PwC) to model the various RED options and to develop the proposals further. The team reported regularly to an Electricity Distribution Industry Restructuring Committee (EDIRC) and submitted its report to the Department in August 2000. The final recommendations of the EDIRC were submitted in January 2001.
1.3 Electricity restructuring and the intergovernmental fiscal system
The Financial and Fiscal Commission (FFC) is reviewing the electricity restructuring proposals in order to assess the impact of the proposals. The re-organisation of the electricity distribution industry has three significant implications for the intergovernmental fiscal system:
It is incumbent upon the FFC to provide such an assessment owing to the requirements of the Constitution. In this regard, several sections of the Constitution are relevant:
The restructuring of the Electricity Distribution Industry is a complex process, involving aspects such as competitiveness, profitability, and cost structures. Given the legislative mandate of the FFC, the analysis that follows focuses on the implications of the proposals for the intergovernmental fiscal system and the overall system of local government finance. Section 1.3.1 of this document outlines the principles which inform the FFC’s approach to the restructuring, Section 2 sets out the proposals being put forward by the EDIRC, Section 3 discusses the intergovernmental fiscal implications, and Section 4 describes some of the possible financial effects for municipalities. An evaluation of restructuring initiatives in Europe is provided in the Appendix.
1.3.1 Principles
Over the years, the FFC has articulated a number of principles that inform its approach to public finance. These are to be found primarily in the Framework Document of 1995,7 as well as in subsequent submissions to Government. The principles relevant to this submission are provided below.
Principle 1: No stakeholder should experience a deterioration in its circumstances owing to the restructuring process, unless this is an explicit policy decision.
Given the mandate of the FFC to consider the needs of all three spheres of Government, it is incumbent upon the Commission to consider the effect of the restructuring proposals in globo and to assess whether there is a "collective gain" for the industry, Government, and the country as a whole. It is the aim of the analysis that follows to identify the beneficiaries of the process and those stakeholders who may experience a deterioration of their circumstances.
The exception is where a policy decision has been taken with respect to a stakeholder. In the case of electricity distribution, Government has decided that distribution will be transferred from Eskom to REDs, with Government holding Eskom’s shares. This will clearly affect Eskom’s balance sheet.
Principle 2: Redistribution should be funded primarily by national government.
It is important to distinguish between mechanisms for redistribution, such as low-income subsidies, and the sources of redistribution. In its submission on the Division of Revenue 2002/03, the FFC outlined the crucial role of national government in redistribution:
A principle of public finance is that poverty alleviation should be financed through national tax revenues, because the base of national taxes is much broader than that of local jurisdictions. The tax incidence on any particular region or group is thereby minimised and economic distortions avoided.8
This principle has implications for the drawing of boundaries and for consumer cross-subsidies, which are discussed in Section 3 below.
Principle 3: The competing demands of economic growth and redistribution should be carefully balanced.
It is Government’s aim to achieve both equity and growth, however trade-offs are necessary. For example, Government has recently identified a number of rural development nodes, and national and provincial departments are expected to prioritise funding in these locations. Government has made it clear that funds for the development nodes must come from existing budgets, that is, resources will be diverted from other projects or jurisdictions.
The FFC addressed this issue in its Framework Document:
…fiscal transfers may be required to encourage regional development and employment to their maximum potential. As in other cases, the benefits of improving equity by providing services in rural areas must be weighed up against the benefits of doing so in urban areas.9
It is ultimately the role of Government to decide on these trade-offs. The choices around the municipal levy on electricity provide one example of the trade-offs that must be made (see Section 4.2 below).
1.4 Electricity restructuring and the Constitution
One of the functions of municipalities as laid out in Schedule 4B of the Constitution is electricity reticulation. There is a question as to whether the current proposals conform to the Constitution with respect to 1) the definition and execution of electricity reticulation; and 2) the requirement that municipalities relinquish their legislative and executive authority over electricity reticulation to REDs.10
It is not the mandate of the FFC to enter into this debate, and the analysis provided in this submission is based upon the assumption that the proposals are consistent with constitutional principles. However if it is found that the proposals pose constitutional difficulties, the Commission will comment on any revised proposals that are generated.
2. The restructuring proposals
There are a number of aspects of the current proposals that have significant ramifications for fiscal equity and for the local government finance system more generally. The proposals with intergovernmental fiscal implications are as follows:
3. Intergovernmental fiscal implications of the proposals
3.1 Electricity consumption subsidies
It is the aim of the restructuring process to create independent and financially viable Regional Electricity Distributors. In order to achieve this, boundaries need to be drawn in such a way as to obtain a balance of customers in terms of type, such as domestic and industrial customers.
The boundaries also need to take account of income levels of domestic customers to ensure that each RED has a comparable distribution of low-income households. The tariffs paid by low-consumption households do not reflect the costs of service provision. This means that recently electrified households receive an operational subsidy of R70 per month, which translates into an extra 4% on the overall the price of electricity. The Energy White Paper has noted this situation, and has recommended that moderately subsidised tariffs for poor domestic consumers should be continued for equity reasons.15
The EDIRC proposals take this recommendation forward in proposing that the long run average price to low-income customers should be capped at 30c/kWh. While the Draft Stage 1 Report of July 2000 recommended that this be recovered through a consumer cross-subsidy, the final recommendation of the EDIRC is that a task team should be appointed to assess whether this subsidy should be funded through a consumer cross-subsidy or from the local government equitable share. If funded through a consumer cross-subsidy, the levy has been estimated to be between 1.8% and 7.7%, depending on the RED.16
The proposal is based upon the assumption that there will be no fiscal flows between REDs or between national government and REDs, so as to ensure that the REDs are completely independent financially.17 If it is assumed that low-income consumers are subsidised within RED boundaries, it places much importance on the drawing of the boundaries as the number of low-income consumers across the REDs needs to be balanced. Furthermore, the significant differences in cross-subsidies (between 1.8% and 7.7%) are cause for concern.
The proposal for a consumer cross-subsidy should be placed in the context of Government’s policy to provide low-income residents with a free basic amount of electricity each month. The restructuring proposals were formulated as the "free basic services" policy was being finalised, and the calculations for the consumer cross-subsidy therefore did not model the effects of a free (limited) supply of electricity.
As noted in Section 1.3.1 above, the FFC supports the principle that redistribution should primarily be addressed nationally. The Commission proposed in its Submission for 2002/03 that the cost of free electricity should therefore be funded nationally (through the equitable share or through a conditional grant) and to a lesser extent through consumer cross-subsidies.18
If electricity distribution is transferred to REDs and billing systems are transferred as well, the national subsidy for free electricity would need to take the form of conditional grants to the REDs. This would be contrary to the current proposal that there be no fiscal transfers to REDs.
The national subsidy would have to be in the form of a conditional grant, as the equitable share is for the local government sphere only. This may occasion a constitutional problem: if electricity is identified as a basic municipal service, then any funding shortfalls in service provision should be funded through the equitable share.19 Therefore, if electricity is deemed to be a basic service, mechanisms would need to be found to channel the lifeline subsidy to consumers without violating constitutional provisions.
The provision of a national conditional grant would take pressure off the consumer cross-subsidy, allowing electricity prices to be more cost-reflective and minimising the intra-RED variations in the cross-subsidy charged to consumers. It would also allow more flexibility in the drawing of RED boundaries, since the proportion of low-income consumers within a boundary would not play as significant a role.
3.1.1 Proposal
The FFC proposes that tariff support to low-income consumers be financed primarily by a national grant to REDs for the provision of free electricity, and to a lesser extent by a consumer cross-subsidy.
3.2 Capital Subsidy
Between 1991 and 1997, over 2.4 million households were newly electrified.20 The cost of electrification has been borne primarily by Eskom, and much of this expenditure has been debt-financed. In addition, Eskom was exempt from paying income tax or dividends until January 2000, when it became liable for income tax, secondary tax on companies, capital gains tax (once introduced), value-added tax, and the skills development levy.21 This new tax-paying status will also apply to REDs in future. The increasing debt load and liability for tax has implications for the financing of the capital electrification program.
The electrification program still needs to address considerable backlogs: over 3.3m households, 17,000 schools, and 1,000 clinics have no access to electricity.22 Government committed itself to funding both grid and non-grid connections at the average rate of R3000 per connection for 300,000 connections per year from 2001 to 2005, and 250,000 connections per year from 2006 to 2010.23
However, recent budgetary allocations indicate that these targets will not be met. The Department of Minerals and Energy requested an allocation of R1.2bn per year to meet its electrification targets by 2010, and an allocation of R600m per year for the next three years was approved by Cabinet in December 2000.24 There are no plans to obtain additional income from the electricity sector for capital electrification, hence the implication of the budget allocation is that the time period to meet electrification targets will be extended considerably.
The ERIC Report noted that electrification is a priority that should be funded at a national level to ensure no region or customer segment is unfairly burdened with the expense.25 Furthermore, capital outlays for electrification ought to be financed through general taxation revenue collected nationally or central government borrowing, since financing from general taxation minimises economic distortions.
The White Paper recognises that although there is no direct link between the source of national taxation revenues and their allocation, the capital electrification subsidies will be offset to a degree by the additional income tax collected from the industry.26 It should be noted, however, that the PwC Report recommends that new tariffs be phased in over five years, which would significantly reduce the tax and dividends paid to government. If tariffs were not phased in, the amount paid to government would be R1.12bn in Year 1, whereas it would be R22m in Year 1 with a five-year phase-in period.27
There is a suggestion in the EDIRC Blueprint Report of January 2001 that Government may expect consumers to cover the difference between the government allocation and required funding:
It is unclear whether this implies that the subsidy to low-income consumers would include both operating and capital costs. If so, this would mean that if a consumer cross-subsidy is implemented by REDs, the levy paid by consumers could significantly increase the price paid for electricity, particularly if key industrial customers are excluded from paying the levy.
Furthermore, it is unlikely that REDs will be willing to top up the national subsidy from their own funds as they will not generate profits from the majority of the (low-income) households that are still to be connected to the grid.
In view of the likelihood that the inclusion of capital costs in the consumer cross-subsidy will place too heavy a burden on consumers and that it will not be in the financial interest of REDs to contribute to these capital costs, it is proposed that capital electrification be financed by national government.
3.2.1 Proposal
4. Implications for local government finance
For those municipalities that supply electricity to residents, electricity distribution plays a significant fiscal and operational role in the municipal finance system. The manifestations of this are examined in turn, as are the measures proposed in the EDIRC Report.
4.1 Local government revenue
As a source of revenue, electricity charges make up 31% of income received by municipalities. Once the costs of provision are accounted for, the surpluses generated from the distribution of electricity comprise between 4.6% and 7% of total local government revenue.28 It should be noted that many municipalities – particularly those in rural areas – do not distribute electricity, and these averaged figures therefore reveal the significance of electricity as a source of revenue for distributing municipalities.
Local government currently raises over 93% of its own revenue on its operating budgets, although this figure is an average and hides significant disparities among municipalities. The small proportion of nationally collected revenue flowing to local government reflects the ability of local government to raise the bulk of its own revenue.29 Significant changes in revenue from electricity distribution would therefore jeopardise the fiscal autonomy of local government and place more pressure on the central fiscus.
4.1.1 Electricity and other municipal services
The surpluses generated from electricity provision are generally used to cross-subsidise other municipal services. Surpluses are transferred to the general rates account, which in turn may make up for losses incurred in trading or economic services, or which may fund the provision of other municipal services. In effect, these surpluses are equivalent to the principle of the "local government levy" of the PwC proposals, with the difference that the levy will increase transparency.
The current scenario can lead to situations where the cost of electricity provision is inflated by the allocation of costs for other municipal services to the electricity account. Indeed, a case could be made that electricity surpluses are generally under-reported owing to the tendency in municipalities to allocate disproportionate costs to the electricity account, and thus nominal surpluses should be treated with caution.
Cross-subsidisation between services can serve a useful function, particularly where local conditions influence the costs of service provision (for example, if purchase and distribution of water is expensive). From the viewpoint of tax incidence, the advantage of significant subsidisation from the electricity account is that the electricity revenue base is much broader than the property rates base. On the other hand, profits from electricity may compensate for the inefficient provision of other services and can obscure financial realities within a municipality.
Distribution of electricity carries another significant advantage for municipalities: those with the capacity to operate sophisticated billing systems can link electricity provision to the (non-)payment of rates and other municipal services. This provides municipalities with a powerful mechanism for consolidated billing and integrated customer management.
4.1.2 Electricity and property rates
When surpluses from electricity are transferred to the general rates account, this places a downward pressure on property rates. In addition, electricity departments often supply the operational infrastructure for other aspects of municipal service delivery, whether technical, administrative, or financial. For example, many municipal electricity departments install and maintain street lighting.
In Cape Town, a study of the financial impact of the PwC proposals revealed that electricity services within the Cape Metropolitan Area (CMA) contribute R269m per annum to the rates funded services, and an additional R86.5m of non-electricity overhead costs are charged to the electricity account (known as departmental recharges). These amounts make up 20.1% of the CMA total rates bill.30
4.2 EDIRC proposal: Local government levy
As noted in section 2 above, the EDIRC Report recommends that local government continues to receive the income from electricity, and that this income will come from dividend income and the local government levy (in other words, it is cash neutral). As dividend income increases, the local government levy will decrease proportionately, with the cash received by distributing municipalities remaining at R2.4bn in real terms. The Report recommends that the levy should not remain in place indefinitely, and consideration should be given to phasing it out after five years.31
It is not clear from the EDIRC Blueprint document of January 2001 whether this levy will be available as a revenue instrument to all municipalities or only to municipalities that distributed electricity prior to the establishment of the REDs. Recommendation 33 indicates that local government income should continue at current audited levels, implying that only distributing municipalities would apply the levy. Clarity is needed on whether the local government levy will be available to all municipalities or only to municipalities currently distributing electricity.
4.2.1 Evaluation of the levy
If the EDIRC is recommending that only distributing municipalities be allowed to impose the levy, then the proposal differs from previous government recommendations. The ERIC Report recommended that all municipalities be allowed to tax electricity via an excise tax within a limit set by government. Municipalities would then set their own rate (within the limit) and show the tax separately on each consumer’s bill. Municipalities receiving "unduly large surpluses" would, within a set period of time, have to reduce their dependency on electricity surpluses to the established limit. The Energy White Paper confirmed these principles.32
It is likely that all municipalities will be empowered to place a levy on electricity sales, as this is consistent with previous policy positions and the constitutionality of the selective application of a levy could be challenged. Furthermore, it would be difficult to distinguish between "distributing" and "non-distributing" municipalities, as many non-distributing municipalities have been amalgamated with distributing municipalities.
If the levy is available to all municipalities as a revenue instrument and the total amount is capped (say at R2.4bn), then distributing municipalities will experience a significant net loss and the non-distributing municipalities will gain access to a new revenue source, at least for a limited (five-year) time period.
The possibility of allowing a higher cap for only distributing municipalities should be investigated, so as to take account of the net loss experienced by some municipalities. The upper limit of the local government levy could be set lower than is currently recommended (the preferred 6-RED option allows for an 11% local government levy), and municipalities with surpluses that significantly exceed this could be allowed a higher cap. The R2.4bn would be exceeded since all municipalities (current distributors and non-distributors) would be collecting this revenue. Further discussion of the R2.4bn cap is provided in Section 4.2.2 below.
The debate would then be whether the higher cap for distributing municipalities should remain in place. Government may wish to support the municipal jurisdictions that make a substantial contribution to the economic output of the country by leaving the higher cap in place for a longer period of time.33 As noted in Principle 3 of Section 1.3.1 above, it is ultimately the role of Government to decide upon the trade-off between economic growth and redistribution.
From a governance point of view, it would be important to introduce a variable levy rather than a fixed one, as municipalities can be held more directly accountable for the raising and expenditure of public funds. As noted in the FFC’s recommendations for 2001, the ability to raise their own revenues offers subnational governments a valuable degree of freedom that allows them to implement programs of their choice and size. If a sector of government is required to raise (part of) its revenue, its accountability is increased because of the resulting obligation to justify to its electorate the taxes it raises in terms of the services the revenue will pay for.34
4.2.2 Evaluation of the cap and phasing out of the levy
In terms of the quantum that would be directed to municipalities through the levy, the R2.4bn estimated surplus is based upon a 1993 estimate of aggregate "bottom-line" transfers from municipal electricity departments, indexed for inflation, and an additional 20% to take account of "above-the-line" contributions in situations where electricity is not ring-fenced.35 However, the amount does not take account of:
Given that the estimated surplus of R2.4bn will influence the cap placed on the local government levy, the calculations need to be re-examined.36
Furthermore, the compensation to municipalities needs to be evaluated on the basis of the loss in receipts. This loss (in opportunity cost) is likely to increase over time, for municipal receipts from electricity supply would increase in the absence of any restructuring of the electricity distribution industry. Thus there appears to be no rationale for limiting the loss of receipts to a fixed amount, namely R2.4bn.
It is also likely that the quantum of the cap will remain the centre of political controversy, with discussion as to whether it is too high or too low. One solution is to be more flexible about the absolute cap and therefore about the setting of the rate itself.
The EDIRC Blueprint Report also proposed that the local government levy be phased out over time. If dividend income to municipalities does not increase proportionately to the phasing out of the levy, the local government sphere will experience a net loss of revenue. Indeed, decisions on the distribution of dividends will only partly be in the hands of municipalities, and it may be that no dividends are distributed in some years.
One of the reasons given for phasing out the levy is that a levy on electricity is an inefficient means of raising tax revenue, as it will serve to distort electricity consumption and promote an inefficient allocation of resources in the energy sector.37 In this respect three comments are germane:
Given that distributing municipalities rely heavily on electricity surpluses to finance other municipal services and that they consequently do not receive significant transfers from the fiscus, there is a compelling argument to implement and maintain a local government levy in order to raise revenue for the local sphere of government.
It should also be noted that levy income will be fairly predictable, whereas dividend income will depend upon profitability and shareholder decisions on dividend declarations. Furthermore, the REDs will be subject to company tax, secondary tax on companies, and a tax on net dividends declared. Taken together, these taxes result in an effective tax rate averaging 33%. The assumption that dividend income will eventually overtake levy income should therefore be questioned. Further concerns with regard to the allocation of shares and payment of dividends are raised in Section 4.3 below, and the conclusion reached by the Commission is that the restructuring process should focus on compensation through the local government levy and not through dividend income.
If the levy were to be phased out, the net loss of revenue would have to be accommodated in some way through the intergovernmental fiscal system.
4.2.3 Evaluation of the proposal to impose the levy on large customers
The EDIRC Blueprint Report introduces the idea of a contribution to local government funding from large customers, and suggests that such a contribution could be phased in over time.40
Even a small levy on large customers will produce significant revenues, but differences in the tax capacity of municipalities would be exacerbated. For example, if a large corporation such as Alusaf is located in a municipality, significant revenues will accrue to that municipality while a neighbouring municipality will receive no benefits whatsoever. Consequently, the introduction of even a very low levy will require the introduction of an equalisation grant.
A more viable alternative would be the imposition of a local government levy on large industrial customers, with the revenue being collected by national government and being disbursed through the local government equitable share.
4.2.4 Proposals
- Municipalities should be allowed to set the levy up to a maximum level.
- The possibility of allowing a higher cap for distributing municipalities should be investigated, so as to take account of the net loss experienced by some municipalities.
- The local government levy should not be phased out unless fiscal mechanisms are in place to fully compensate for the loss of revenue.
- The figure of R2.4bn should be re-examined, given the concerns noted in Section 4.2.2 above.
- Given the increasing loss in receipts to local government implied by the restructuring process, consideration should be given to regular increases to the absolute cap on local government revenue.
- The local government levy should not be phased out. The phasing out of the local government levy should be considered only if the financial impact on the local government sphere is fully understood and if measures to address the fiscal consequences are in place.
4.3 Shareholding
Equity in the REDs will be apportioned according to the net assets transferred from municipalities to the REDs.41 Municipalities with net assets will therefore be allocated shares, while municipalities with net liabilities and those that do not supply electricity will not receive any shares.
The proposed allocation of shares and the associated dividend payments would continue the uneven fiscal position of municipalities. The proposals would accentuate inequalities because:
In effect, the current proposal will perpetuate historic patterns of resource allocation. Municipalities incorporating previously white towns will be allocated shares, while municipalities located in areas with predominantly poor and rural residents (that were previously supplied by Eskom) will receive no shares.
It is important that the new system of electricity distribution in South Africa should break with the past. There are a number of ways in which the shareholding issue could be addressed. For example, some of Eskom’s shares could be allocated to non-distributing municipalities, or all municipal shares could be transferred into a global "local government share".
The FFC is of the view that the shareholding issue is not of primary concern with respect to local government finance. Rather, the emphasis should be on:
It should be noted that some distributing municipalities would suffer unduly if they were to lose most of their electricity assets in the restructuring process. One way in which to address this would be to distinguish between different kinds of assets. It may be that electricity reserves would be retained in cash by municipalities, net current assets would be transferred and compensated in cash, and only fixed assets would be converted into shares in the REDs.
4.3.1 Proposals
4.4 Implications of the proposals for the system of local government finance
4.4.1 Electricity and credit control
The distribution of electricity plays a significant role in credit control, as many municipalities cut off the electricity supply of residents who have not paid municipal service charges that are more difficult to collect. Some municipalities "load" an additional charge on the pre-payment tariff of residents in arrears, allowing the arrears to be collected over a period of time. Removal of this mechanism will significantly hamper revenue collection efforts.
The consolidation of water, electricity and rates accounts also offers considerable advantages to municipalities and customers alike. The removal of the electricity account would mean a) loss of economies of scale in billing procedures; b) diminished debt management capability; and c) reduced scope for customer relationship management. Given that local government is required to collect income from a much wider range of income groups than national government, these mechanisms are essential in developing effective and accountable local government.42
There are additional implications for the arrears situation. The widespread installation of pre-payment meters by municipalities has resulted in a much higher collection rate for electricity charges than for water, refuse removal, or sanitation charges. However, many municipalities do not distinguish in their financial records between the arrears for different services, consequently the significant arrears for water, sanitation, and refuse removal are often concealed by the high collection rate of electricity charges. Indeed, the increased payment rates in some municipalities can be ascribed to the installation of pre-payment meters.
4.4.2 Electricity and cash flow
Electricity income provides a significant source of working capital for municipalities. However, electricity undertakings also require working capital, and the extent to which the overall cash flow is positive or negative depends upon the municipality and the nature of the distribution network.
In the Cape Metropolitan Area, it was initially thought that the loss of electricity income would have an overall negative impact on working capital requirements. However a study of the issue in the CMA revealed that electricity services utilise more working capital than they generate, and that the transfer of electricity to REDs would provide a one-off cash inflow of R191.4m and generate an annual interest saving of R12m.43
A further aspect is the possible improvement in cash flow owing to the transfer of liabilities to the REDs. As with the issue of working capital, other municipalities would have to be surveyed in order to gauge whether cash flow is positively or negatively affected by the proposals. It may well be that the results would be different for metropolitan, district, and local municipalities.
4.4.3 Electricity and local government borrowing
By transferring assets to REDs, municipalities lose the right to use such assets as collateral, thereby reducing their ability to borrow as the risk to lenders and the cost of debt to municipalities increase. A number of options for the design of instruments that could be issued to current owners of distributing assets have been put forward.
It is proposed that municipalities may exchange their assets for shares (ordinary or preference), debt instruments (loan notes, loan stock, debentures, promissory notes), or debt instruments convertible into shares. While shares carry voting rights and are therefore linked to the governance mechanism, debt instruments have a call on the assets of the business and are a more flexible form of security for raising finance. The PwC Report recommends that compensation should be in the form of shares, as they are more consistent with stand-alone REDs as normal commercial entities.44
The issue of how this would affect the ability of local government to raise finance has not been addressed. It is likely that this depends on the extent to which a municipality uses electricity assets as collateral to raise loans for purposes other than electricity distribution.
It should also be noted that any reduction in revenue has a negative influence on credit ratings and therefore on access to finance more generally.
4.4.4 Electricity and the demarcation process
Local government is still in transition, having to deal with recent boundary determinations that have seen 843 municipalities consolidated into 284. Introducing EDI restructuring in this uncertain environment presents difficulties in assessing the full impact of restructuring. In addition, the demarcation process is imposing short-term administrative costs that are putting pressure on municipal budgets.
RED boundaries should follow the new municipal boundaries. This will ensure that that residents of a given municipality do not fall within different REDS and are then subject to different tariff structures.
In addition, the proposals for the six REDs indicates that two of the REDs are not financially viable, and it is unclear what would happen if such a RED would fold in future. If the municipal boundaries are the natural boundaries of a RED, it will be easier for the municipalities affected to address the situation.
4.4.5 Conclusions
In addition to losses from electricity receipts, the transfer of electricity distribution from municipalities to REDs may well generate new costs for municipalities. Owing to their hidden nature, such costs have not been quantified. For example, compliance costs will increase owing to the de-linking of electricity supply and the payment of other municipal accounts. There is a need for a detailed study to estimate these costs in order to ensure that municipalities are compensated for such losses.
4.5 Proposals
- A detailed study of both the costs and benefits of the transfer should be carried out to ascertain whether a net loss will result.
5. Conclusions: electricity restructuring proposals
As noted in Section 1.3, it is the aim of this report to consider the effect of the restructuring proposals in globo and to assess whether there is a "collective gain" for the industry, government, and the country as a whole.
Withdrawing the function of electricity distribution from municipalities has far-reaching consequences. The EDIRC Blueprint Report is silent on the impact of the proposals on cash flows, credit control, and borrowing. Indeed, the proposals pay inadequate attention to implications of the proposals for the local sphere of government.
On the revenue side, income will be reduced in the long-term owing to weakened credit control, decreased cash flow, and increased financing of working capital requirements, and it is likely that the overall cash surplus will be reduced for most distributing municipalities. Much of the reliance on electricity as a source of revenue, credit control, and cash flow is owing to an intergovernmental finance system that places significant responsibility on local government to raise its own revenue.
Municipalities are for the most part in a precarious financial situation. Given the importance of the local government sphere in the delivery of basic services and its current transitional and troubled financial status, the needs of the electricity distribution sector should be balanced against the needs of local government. If it is the goal of the intergovernmental fiscal system to strengthen the financial autonomy and accountability of local government, then any reforms which result in a weakening of that autonomy will result in additional pressures on the central fiscus.
It is therefore recommended that a longer transition period be developed, even if this entails extra efficiency costs. This would ensure that the impact on the local sphere of government could be carefully monitored and appropriate action taken where municipalities are adversely affected by the changes.
In terms of equity considerations, the FFC favours approaches that promote equity. The local government levy should be a revenue instrument available to all municipalities, but the negative impact on distributing municipalities should be addressed. The allocation of RED shares only to distributing municipalities should be re-considered, as it would perpetuate historic patterns of resource allocation.
Implementation of the proposals may undermine some aspects of local government capacity in the long term, as with the potential loss of consolidated billing systems and integrated customer management. It is important to note these effects and design measures to address them.
5.1 Overarching proposal
Annexure:
The taxation and restructuring of electricity distribution in Europe: Comparative lessons for South Africa
Prof Guy Gilbert, University of Paris
December 2000
Introduction
The effect of the taxation of electricity on economic growth and competitiveness in South Africa rests on three assumptions:
These assumptions cannot be directly tested, but international comparisons give some insights on the following points:
1. Electricity, electrification and local governments
In a large number of European countries, local governments have long played an active role in the provision and distribution of electricity. This was the current situation before World War I in France, Germany, Spain, and Scandinavian countries.
Local governments played a decisive role in the electrification of rural areas. In France, for example, the distribution of electricity was a local public service from 1909 and was usually delegated to private firms. After World War I, a specific fund was created for electrification in rural areas. It was funded by the revenues of a general tax on electricity (a proportional tax on the sales of electricity levied on non-industrial customers and capped at 8%), and a specific grant from the central state. Its purpose was the amortisation of the capital expenditures of rural electrification. Electrification was completed in the 1950s, but the electricity tax did not disappear. The rural electrification fund was eliminated only recently and the electricity tax is still levied, even in municipalities (like Paris) where electrification was achieved almost a century ago.
The role of local governments in the distribution of electricity is presently very limited except in a few cases. Even if, as in France, this role was important at the supra-municipal level, the situation has completely changed (or will in the near future) with the introduction of the EU reforms in the electricity distribution industry. But the local taxes on electricity do survive.
2. Taxation of electricity
Electricity has long been an important source of revenue for European governments, but the taxation of electricity has usually been separated from the general taxation of goods and services. For example, in a large number of countries, and for a long time, the sale of electricity has not been subject to the normal rate of VAT.
Significantly, deregulation policy in the electricity distribution industry has not led to the disappearance of the taxation of electricity (including local taxes). Moreover, substantial differences still remain.
Up to now, the disparities in the effective rates of taxation have not been significantly reduced. The direct comparison of taxes on electricity is a complex matter because electricity is subject to a high number of taxes and because these taxes are very different from one country to another.
It is useful to compare separately the taxes borne by the generators and distributors (which are directly charged to the companies), and the taxes directly charged to the consumer (these taxes are generally collected by electricity companies via invoicing). The following table lists the electricity taxes borne by companies:
Summary of taxes borne by electricity companies
|
Country |
% of turnover |
ECU/100kWh consumed |
|
Portugal |
16.52 |
1.44 |
|
Germany |
14.40 |
1.23 |
|
Belgium |
12.33 |
0.88 |
|
Sweden |
9.74 |
0.54 |
|
France |
9.10 |
0.76 |
|
Luxembourg |
8.59 |
0.60 |
|
Norway |
8.27 |
0.48 |
|
Spain |
6.70 |
0.51 |
|
Austria |
5.18 |
0.51 |
|
The Netherlands |
n.a |
n.a |
Source: Eurelectric, "Tax harmonisation in the electricity sector in the EU in 1997," June 2000.
The taxes borne by the electricity companies thus vary from 5.2% to 16.5% of the sales price and 0.48 to 1.44 ECU/100 kWh consumed. This range has not been reduced in the recent past.
The differences in income tax can be divided into two categories: differences specific to the electricity sector (exemption of certain public companies and the different purposes of public and private companies), and differences that apply to all industrial sectors (accounting and valuation regulations, depreciation systems, disallowed charges, tax exemptions, and deductions and tax rates).
The differences between other taxes are more difficult to explain and often depend on national policy regarding the power of local authorities. As far as local taxes are concerned, it should be noted that in most countries the power to tax electricity belongs to the national or federal authorities. Belgium is the only exception, where regional, provincial, and local authorities have almost unlimited power to levy taxes.
For a long time, a number of EU countries have imposed a system of taxation on consumption specific to electricity distribution, in addition to the generally applied VAT. Such taxes generate considerable revenue for the state levying them and constitute a large percentage of the turnover of electricity companies.
The various VAT percentages are represented in the first column of the following table: the percentage of VAT invoiced/turnover, and the VAT invoiced in ECU per kWh consumed in the last column. Nine countries levy a specific tax on electricity consumption besides VAT. This VAT is levied on a uniform basis, but the rates vary between 0 and 25%. Denmark is notable for its high taxes on consumption, whereas taxes paid by companies are very low.
Taxes on consumption other than VAT
|
Country |
% of turnover |
ECU/100kWh consumed |
|
Denmark |
n.a |
n.a |
|
Italy |
n.a |
n.a |
|
Sweden |
15.40 |
0.87 |
|
Norway |
7.98 |
0.46 |
|
Austria |
7.31 |
0.73 |
|
Portugal |
5.00 |
0.43 |
|
The Netherlands |
n.a |
n.a |
|
France |
4.30 |
0.32 |
|
Belgium |
0.45 |
0.03 |
Source: Eurelectric, "Tax harmonisation in the electricity sector in the EU in 1997," June 2000.
Altogether nine countries levy a specific tax on electricity consumption besides VAT. The various VAT percentages are represented in the following table:
VAT on electricity
|
Country |
% |
% of turnover |
ECU/100per kWh consumed |
|
Germany |
15.0 |
15.0 |
1.28 |
|
Austria |
20.0 |
20.0 |
1.99 |
|
Belgium |
21.0 |
17.63 |
1.27 |
|
Denmark |
25.0 |
n.a |
n.a |
|
Spain |
16.0 |
16.0 |
1.21 |
|
Finland |
n.a |
n.a |
n.a |
|
France |
20.6 |
22.2 |
1.65 |
|
Great-Britain |
n.a |
n.a |
n.a |
|
Greece |
18.0 |
n.a |
n.a |
|
Ireland |
12.5 |
n.a |
n.a |
|
Italy |
10-19 |
n.a |
n.a |
|
Luxembourg |
6.0 |
6.05 |
0.43 |
|
The Netherlands |
17.5 |
n.a |
n.a |
|
Portugal |
5.0 |
5.0 |
0.43 |
|
Sweden |
n.a |
8.93 |
0.51 |
|
Norway |
23.0 |
17.02 |
0.98 |
|
Switzerland |
6.5 |
n.a |
n.a |
Source: Eurelectric, "Tax harmonisation in the electricity sector in the EU in 1997," June 2000.
Large industrial customers in Europe were liable to reduced tax rates before the restructuring of the European electricity sector, and they still are after the reforms. Moreover, neither the taxes levied on small to medium customers (households in most cases) were significantly cut since 1996, nor the disparities reduced among the countries. This is probably due to the absence of direct substitutes for the type of electricity supply consumed by this type of customer.
2. Effects of electricity restructuring on costs, prices, and productivity
The opening of the electricity distribution industry in Europe to national and international competition has been achieved in four successive phases since 1996 in Norway, the United Kingdom (the process began prior to this in the UK), and Sweden; since 1998 in Spain and Germany; since 1999 in Belgium and Italy; and in France since 2000. Even if the deregulation process is not completely achieved at this point in time, it is possible to draw some (preliminary) lessons useful for the South African EDI.
Three general lessons emerge from the comparative review of the performances of EDI in seven European countries, namely Norway, United Kingdom, Germany; Spain, France, Belgium, and Italy.45
Effect on prices
- The wholesale prices of electricity decreased sharply (-25 to –30%) the first year; but they diverged the years after. They sharply increased in the UK, reflecting the powerful market power of electricity companies in this country; in the meantime they remained fairly stable in the Nordic countries. In addition, the instability of wholesale prices is much higher after the reform than before, refecting more the influence of climatic factors than the effect of competition itself.
- The retail prices have been cut in the UK (owing to the national regulator), but remained stable in the Nordic countries.
- The "eligible" customers (consuming over 150 Gwh ) largely benefited from the cut in prices, but this only occurred in the UK after the intervention of the national regulator. In the Nordic countries, the tariffs that the "eligible" companies faced prior to the reform were so low that the reform could have hardly reduced the prices.
The wholesale prices remained stable (or even slightly increased) in Spain, but fell in Germany between 1998 and 1999.
- For the "eligible" customers (over 70GWh), the ranking of the countries with respect to electricity prices is unstable over time.
The table below expresses the ranking for 1996 and 1997 in terms of the percentage of electricity prices in the UK in 1996. (Note that competition caused UK electricity prices to fall by 7% over the one-year period).
|
1996 |
1997(after deregulation reform) |
|
1 UK (100%) |
France (83) |
|
2 France (104) |
Belgium (90) |
|
3 Belgium (107) |
UK (93) |
|
4 Italy (111) |
Germany (100) |
|
5 Spain (126) |
Spain (103) |
|
6 Germany (134) |
Italy (110) |
- For small to medium industrial customers
The volatility of the national performances is very high. Except for the Nordic countries, which remain the champions in terms of prices, the UK has not in globo reinforced its competitiveness. Some other countries have reduced prices sharply (Spain), while others have increased theirs (Belgium, Germany). In total, the ranking of the countries differs sharply from one class of consumer to another.
- For small to medium individual customers
The comparative advantage of the "pioneer" countries is unclear. The Nordic countries and the UK have lower prices for medium-sized customers but higher for small customers.
The general lesson is that the magnitude of the fall in electricity prices which is expected from any restructuring of the distribution industry depends on
Effect of deregulation on productivity and factor costs
Distribution of productivity gains to the producers, customers, and the labour force
The general lessons of the European experience are:
The UK model, where the main winners appeared to be the shareholders of private firms, and the main losers the labour force (there was a sharp cut in the labour force employed in the electricity branch). Consumers experienced uneven consequences, the only cut in prices benefiting the medium-size consumers;
The Nordic model, where the reform benefited consumers moderately (prices fell but not too much, especially for large customers because Nordic prices were the lowest in Europe), at the expense of the labour force, but to a lesser extent than in the UK.
The Spanish model, where no major changes occurred due to the powerful market position of the duopoly in the electricity distribution industry.
In Germany, the prices have not been heavily affected. Productivity gains benefited the strongest companies on the market, which entered into a tough competitive game and repetitive merging operations.
Conclusions
The results of these comparisons contain some lessons for the restructuring of the electricity distribution industry in South Africa:
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