24 January 2019

TECHNICAL STRATEGY NOTE: EQUITIES

Neels Heyneke

Senior Strategist

Tel : +27 11 535 4041

Nheyneke@Nedbank.co.za

Mehul Daya

Strategy: Research Analyst

Tel : +27 11 295 8838

MehulD@Nedbank.co.za

24 January 2019

TECHNICAL STRATEGY NOTE:

EQUITIES

NEELS HEYNEKE

Senior Strategist

Tel : +27 11 535 4041

Nheyneke@Nedbank.co.za

MEHUL DAYA

Strategy: Research Analyst

Tel : +27 11 295 8838

MehulD@Nedbank.co.za

24 January 2019

TECHNICAL STRATEGY NOTE: EQUITIES

Neels Heyneke

Senior Strategist

Tel : +27 11 535 4041

Nheyneke@Nedbank.co.za

Mehul Daya

Strategy: Research Analyst

Tel : +27 11 295 8838

MehulD@Nedbank.co.za

24 January 2019

CORPORATE CREDITINSIGHTESKOM

NTHULLENG MPHAHLELE

Tel : +27 11 537 4163

NthullengM@Nedbank.co.za

JONES GONDO

Tel : +27 11 530 4050

JonesG@Nedbank.co.za

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 2

Pg.

1. Executive Summary 3

2. NERSA Tariffs – Allowable Revenue 4

3. Corporate Governance 8

4. Government Support 10

5. Financial Profile 12

6. Liquidity Profile 15

7. Appendix A: Allowable Revenue Formula 20

8. Appendix B: Eskom Eurobonds 23

9. Contacts 25

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TABLE OF CONTENTS

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 3

• There is a lot of debate about Eskom’s future prospects. Default versus bailout, extend guarantee facility or reduce to

lower contingent risks, split the group and privatise or keep it intact, slow attrition of jobs or deep job cuts once-off.

• We view Eskom’s challenges through a narrow credit lens, and frame the debate into a question of whether certain

assumptions are appropriate for an entity trading business-as-usual or one in distress? Furthermore, we reduce all the

complexity to a question of how each key credit factor helps or hinders its immediate access to liquidity?

• Current assets lag current liabilities and Eskom’s “ccc-level” stand-alone credit profile implies that it is in credit distress

with a liquidity survival horizon of less than twelve months without some kind of extraordinary support. We therefore

believe that a bailout option is a virtual certainty because Eskom is unable to trade its way out of its liquidity crunch

without an extraordinary tariff increase (beyond what it has requested in its MYPD4 application).

• In our view, NERSA’s tariff determination is unlikely to help Eskom’s liquidity profile over the MYPD4 period. We think

the tariff formulation framework presumes Eskom is a going-concern, and the institution has proved to be impartial to

Eskom’s requests for higher tariffs. We therefore interrogate whether NERSA is meeting its mandate with respect to

Eskom’s financial sustainability.

• Corporate governance reforms are taking shape, albeit at a slow pace. The new board and management have

appeased Eskom’s funders somewhat, but the completion of the corporate turnaround, improved project

implementation, investigations into malfeasance, a clean audit outcome all remain critical to its legal covenant

compliance, especially for its World Bank loan.

• Although Eskom has requested the government to consider a R100bn (2% of GDP) bailout package, we estimate that

Eskom’s liquidity shortfall is in the order of R150bn, and about R190bn would set its liquidity profile onto a sustainable

path. Using Moody’s debt-to-GDP ratio of 60% as a threshold, the government has the capacity to support Eskom to

the tune of R212bn. Hence, Moody’s believes that R100bn of support would not automatically induce a government

downgrade on its own, but it would need to take into account the use of proceeds and whether this would be enough

to stabilise Eskom’s liquidity.

• Still, Eskom’s systemic importance has to be taken into consideration as this heightens the joint-default probability

between the government - as debt guarantor and shareholder - and Eskom itself. This has implications for the pricing

of debt in that the value of a government guarantee (as credit substitution) diminishes. At the same time,

extraordinary support is likely to improve Eskom’s stand-alone credit profile. This points to a convergence of credit risk

between the guarantor and the issuer.

EXECUTIVE SUMMARY

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 4

NERSA is set to announce Eskom’s MYPD4 tariffs on 1 March 2019

Context

Rating agencies have, for a long time now, considered NERSA’s tariff decisions as a critical credit constraint for Eskom’s

credit rating profile; so much so that, structurally, allowable revenues do not allow Eskom the flexibility to generate

adequate cash flow buffers to cover all the uses of cash – principally debt service costs. Importantly, this does not mean

that rating agencies apportion blame to NERSA for Eskom’s financial woes. It is more a factual statement that allowable

revenues are a binding constraint on Eskom’s credit profile – an aspect that is not entirely within the control of Eskom’s

management.

It is probable that Eskom’s advisors have presented its board with multiple revenue scenarios and, therefore, the steps to

be taken in order to turn the organisation around based on its actual liquidity-survival horizon – a response function. This

possibly explains why Eskom’s corporate strategy has been delayed until there is some certainty about tariffs. We would

expect Eskom’s turnaround scenarios to also include some combination of extraordinary government support, including

bailouts, debt transfers or debt forgiveness, loan renegotiations and adjusted project-implementation timelines.

However, even these measures are dependent on Eskom’s allowable revenues.

How has NERSA performed against its mandate and stated regulatory objectives?

NERSA is a legally mandated regulator for the energy sector, including electricity, piped-gas and petroleum pipelines.

NERSA determines Eskom’s allowable revenues on a multi-year basis and has done so since 2006. The basic premise of the

multi-year price determination (MYPD) methodology is that “the revenue to be earned by Eskom should be equal to the

efficient cost to supply electricity plus a fair return on the rate base”. The MYPD methodology derives a set of average

prices for each of Eskom’s three business divisions (Generation, Transmission and Distribution) over a three-year horizon.

There are six regulatory objectives that are incorporated in the MYPD methodology.

In the table on page 5, we comment on how NERSA may or may not have fallen short of its regulatory performance

objectives over the years. Eskom is a complex organisation, and striking the right balance between producer and

customer interests through regulations is incredibly difficult, especially given the context of socio-political and policy

malaise and subsequent economic underperformance prevailing in South Africa over the past decade.

We believe that NERSA’s regulatory tools and mandate for the electricity sector probably need to be reformed and updated

alongside Eskom’s business turnaround process.

NERSA TARIFFS – ALLOWABLE REVENUETHE BINDING CONSTRAINT

Source: NERSA MYPD Methodology

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 5

NERSA TARIFFS – ALLOWABLE REVENUE

Regulatory objectives incorporated in the MYPD

frameworkComments

1. To ensure Eskom’s sustainability as a business and limit the risk of excess or inadequate returns, while providing incentives for new investments, especially in generation

NERSA has been unable to ensure Eskom’s sustainability. The argument might be that Eskom did that all on its own• Eskom’s financial sustainability as a business is on the verge of collapse. • Eskom argues it derives inadequate returns from its allowable revenues to

support its working capital needs and capital structure. At this point in time, Eskom has had to curtail any new capex in generation, and its aging fleet is unlikely to operate efficiently or reliably, given its higher-than-normal utilisation.

• Eskom cites a World Bank working paper on the “Financial Viability of Electricity Sectors in Sub-Saharan Africa” as evidence that the allowable revenues in South Africa are insufficient to cover costs and that regional peers suffer similar problems, implying that benchmarking may not be accurate.

• Management and governance lapses also explain, in large part, Eskom’s inability to implement its financial and operational objectives. The World Bank rates Eskom’s investment implementation progress “Unsatisfactory”.

2. To ensure reasonable tariff stability and smoothed changes over time, consistent with the socio-economic objective of the government

NERSA has generally provided consistent and stable tariffs; however, these tariffs have typically been below Eskom’s stated operational requirements and therefore, the cost of the implicit subsidy is borne by Eskom through a revenue sacrifice in the tariff:

• In tis MYPD4 application (See Chapter 15), Eskom suggests that the regulator’s allocation of commercial risks are inappropriately skewed in favour of customers. In other words, electricity in South Africa is heavily subsidised by Eskom, through its revenue sacrifice.

• According to the World Bank, Eskom’s persistent revenue-expenditure gap has led to several bailouts from the government, including a R60 billion debt forgiveness package in 2015, in the form of a Subordinated Loan Special Appropriation Amendment Bill. South Africa’s quasi-fiscal deficit (QFD*) and hidden costs are the highest in Sub-Saharan Africa -- estimated to average US$11 billion per annum.

*(QFD is the value of the implicit subsidy computed as the difference between the average revenue charged and collected at regulated prices and the revenue required to fully cover the operating costs of production and capital depreciation).

• NERSA Service Quality Incentives (SQIs) exist for Transmission and Distribution (T&D) licensees. SQIs are currently being developed for Generation. In the MYPD3 and RCA Year 5 period, Eskom did not incur any T&D SQI penalties for inefficiency or unreliability; however, it is questionable whether this will be sustained over the MYPD4 period.

3. To appropriately allocate commercial risks between Eskom and its customers

4. To provide efficiency incentives without leading to unintended consequences of regulation on performance

5. To provide a systematic basis for revenue/tariff setting

Similar to the objective (2) stated above, NERSA has provided a transparent tariff-setting framework that has been implemented consistently throughout MYPD price-control periods. However, questions remain on the appropriateness of the tariff outcomes, given the financial difficulties Eskom faces. 6. To ensure consistency

between price-control periods

Sources: NERSA MYPD Methodology; The World Bank; Eskom

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 6

Considerations for the MYPD4 tariffsThe MYPD framework presumes business-as-usual; what about Eskom in distress?

• NERSA has a logical framework to determine multi-year electricity tariffs per licensee. However, we think that Eskom’sdistressed financial status creates uncertainties that complicate the model and could undermine its effectiveness, in ourview.

• With Eskom’s liquidity-survival horizon (all things being equal) estimated at less than six months, it seems rash toestimate a multi-year pricing horizon with any level of confidence when the applicant itself is less than certain about itsturnaround strategy. It is as if the turnaround plan is dependent (almost entirely) on the allowable revenues.

• We think that when NERSA considers the MYPD4 tariff decision, it may have to exercise more discretion than it mayhave allowed itself in the past, which makes their outcome less predictable.

• There is a sense that Eskom might be employing a brinkmanship strategy with NERSA (for the tariff decision) and thegovernment (for a potential bailout). By capitulating, perhaps far too easily, to the moral hazard of being ‘too-big-to-fail’,Eskom might believe that it could coerce NERSA into granting it the 15% tariff increase it has applied for. This might thenprovide Eskom the opportunity to defer a difficult corporate restructuring, and gradually cut costs and reduce debt overa longer time horizon. If this tactic fails on 1 March 2019, then Eskom has said it will have to rely on the government asits lender of last resort, to bail it out with R100 billion.

• In our opinion, NERSA has a tough balancing act to manage. Ultimately, it will want to stick to the precedent set by itsdecision-making and uphold its reputation of independence and neutrality. However dire Eskom’s situation might be,the regulator cannot be inconsistent by changing the rules for just this one time, and it cannot assume the roles of both,the referee and the player. Ultimately, its decision must be able to withstand a legal challenge in a court. The tariffoutcome will be consequential for the fiscal balances, because the government will then be in a better position toquantify the extent to which it may need to provide extraordinary support to Eskom.

• In previous MYPD consultations, two key aspects of the allowable revenue formula have repeatedly been points ofcontention. These are:

1. The valuation of the regulated asset base (RAB);

2. The required return on assets (ROA), based on assumptions made to calculate the Weighted-Average Cost ofCapital (WACC). These returns on assets are used to derive an appropriate level of cash to cover interestpayments. Eskom targeted an EBITDA-to-Interest coverage ratio of 2.5x over the MYPD3 period. However, actualreturns incorporated in the allowable revenue formula are gradually phased-in, resulting in a lag in the timing ofcash flow.

A steep tariff hike or a government bailout, which is worse for the economy, and who can decide?

South Africa is faced with an impossible ‘choice’ in its bid to change Eskom’s financial trajectory, and has to decidewhether a 15% tariff hike in MYPD4 will have a less negative impact on the economy than an R100bn governmentbailout. Unfortunately, NERSA cannot consider this toss-up because it would be beyond its scope; meanwhile, thegovernment cannot interfere with nor influence NERSA’s decision, and vice versa.

NERSA TARIFFS – ALLOWABLE REVENUETHE BINDING CONSTRAINT

Source: NERSA MYPD Methodology

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 7

NERSA TARIFFS – ALLOWABLE REVENUE

• Eskom requested an independent revaluation of its regulatory asset base (RAB) to determine the depreciated replacement cost. This value results in a structural break in the historical trendline of the RAB. The key reason for the change is the overnight cost of generation (as at 31 March 2016), which has increased since the last valuation was conducted in 2010.

• Initial commentary coming out of the recent NERSA public consultations on the MYPD4 application suggests that NERSA is likely to reject the revaluation, and more so that it will question whether certain assets fit the definition of an asset in use.

• The RAB is a key driver of the allowable revenue formula and, therefore, the tariff imposed on consumers. (See page 21) for further commentary about the RAB.

• Eskom has proposed to make a revenue sacrifice by phasing-in costs related to its fair return on assets and depreciation in order to cushion the impact of the price escalation on consumers. However, this results in a forecast cash shortfall to cover debt over the next two years.

• The actual return on asset is reasonable, but the phasing-in of it leads to a sizable revenue sacrifice (peaking at over R100bn in 2019/20), which Eskom can ill-afford, especially because it will be unable to cover debt service costs (< 1.0x in 2019/20). Over MYPD3, Eskom’s debt service coverage has been well-below the target of 2.5x

• In our view, the methodology to calculate returns needs to consider Eskom’s financial-distress profile over the MYPD4 period in order to recoup a fair return, different from business-as-usual operating conditions, especially without resorting to other, somewhat controversial, measures, such as asset revaluations, in order to generate a “fair” return. (See page 22 for distressed adjustments to the WACC).

• Ultimately, any government support (guarantees, debt transfer or equity bail-out) has an impact on the WACC by changing the gearing ratio and nominal cost of debt.

Regulatory Asset Base (RAB): 2012/13 – 2023/24

The return on assets profile presumes Eskom is a “going–concern” and not in distress

Source: Eskom; NERSA

MYPD3 (Year 5) single-year

decision

0

200

400

600

800

1000

1200

1400

1600

ZAR

Bill

ion

s

RAB Applied for RAB Approved

MYPD3

MYPD4

RAB Revaluation

RAB revaluation conducted in 2010

0

20

40

60

80

100

120

-2.00%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21 2021/22 2022/23 2023/24

Approved Approved Approved Approved Approved Approved Applied Applied Applied Forecast Forecast

ZAR

Bill

ion

s

Return Sacrifice (ZAR Blns) Full Return on Assets Phased-in Return on Assets

0.0

0.5

1.0

1.5

2.0

2.5

3.0

2013/14 2014/15 2015/16 2016/17 2017/18 2018/19 2019/20 2020/21 2021/22 2022/23 2023/24

Approved Approved Approved Approved Approved Approved Applied Applied Applied Forecast Forecast

Tim

es (

x)

Debt Service Cover

Eskom target ratio (2.5x)

World Bank IBRD Loan Covenant (1.3x)

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 8

CORPORATE GOVERNANCESLOW PROGRESS

Reforms have done little to enhance creditworthiness

The modus operandi of the government has been to fix errant state-owned companies (SOCs) by:• Replacing managements and boards• Reviewing their strategies and the alignment thereof with the Shareholder Compact

In January 2018, the government overhauled Eskom’s board, appointing executives with more experience and credibilityin an attempt to restore confidence in the SOC. Other top management positions were also filled later in the year with thepermanent appointment of a CEO and CFO. With some stability at the helm, the hope is that Eskom will now have afighting chance to turn around its fortunes; but first, the focus is on averting a liquidity crunch by achieving a cost-reflective tariff and receiving adequate extraordinary government support. Trading its way out of its challenges hasproved to be unfruitful. Eskom delayed the release of its new corporate plan twice in 2018. We expect that the new planwill be released once the outcome of NERSA's tariff decision has been released.

Notwithstanding the steps that have been taken to strengthen governance and oversight, the outcomes are not yetmeaningful enough, on their own, to enhance Eskom’s creditworthiness. However, unlike in the case of liquidity risk, weno longer see corporate governance as a credit rating constraint on a forward-looking basis. There may still be some noiseonce the multitude of forensic and criminal investigations produce some results, but we see these as mostly retrospectiveand expect that the reputational profile of the new management team will be no worse.

Our assessment of the impact of reforms on key management and governance factors

Scoring factors and sub-factors Improved Unchanged Weakening

Strategic Positioning

Risk Management/Financial Management (The deteriorating financial condition is captured elsewhere in the scorecard)

Organisational EffectivenessGovernance

Source: Nedbank CIB; S&P Methodology: Management and Governance Credit Factors

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 9

CORPORATE GOVERNANCETHE WORLD BANK LOAN DEPENDS ON IT

High overall project risk: specific risks associated with the proposed restructuring and the key risks facing the project include:

• Eskom may not progress as planned on measures it is taking to address the issues of governance and internal controls

• Eskom’s poor financial position may continue

• Technology risk may delay implementation (specifically the distributed battery storage project (BSP), which replaces the CSP

• Eskom’s lack of commitment may result in the BSP not proceeding. The sheer number of battery storage sites could be a challenge in meeting the already tight timeline

• Ministerial Determination (DoE allocation/amendment) may be delayed. Eskom has an allocation of 100 MW for CSP in IRP 2010, which will need to be changed to 100 MW solar PV. Eskom is currently engaging with the Department of Energy (DOE) and NERSA to amend the allocation.

• Owing to Eskom’s poor financial position, the company is not in compliance with the target under the loan agreement requiring the borrower to achieve a Debt Service Coverage Ratio equal or greater than 1.3x. Eskom did, however, achieve an EBITDA Margin of above 25 percent. Eskom has submitted the required financial plan explaining how it plans to achieve the target as required by the covenant according to the World Bank.

Management and governance lapses could have triggered acceleration rights for preferred creditors

The World Bank Eskom investment support project (P116410)

Source: Nedbank CIB; The World Bank

In the shadow of state capture allegations, Eskom’s qualified audits and a weakmanagement and governance track-record prompted some of its biggest lendersto almost accelerate the repayment of loans extended to it. The case of theDevelopment Bank of South Africa (DBSA) was a prominent example. Had theDBSA pursued its rights, we believe Eskom’s entire capital structure could havecollapsed, not because of cross-default clauses and pari-passu treatment, butbecause Eskom’s single largest bilateral lender, The World Bank would have had toautomatically recall its US$3.75bn facility as a preferred creditor, ranking abovethe DBSA in the payment waterfall in case of a default. In our view, this could be akey reason why bilateral lenders had little other choice but to condone Eskom’scovenant breaches, restructure loans and resort to moral suasion to instigatechanges in management and governance. In other words, if a lender were todecide to accelerate Eskom’s debt, its recovery chances would be slim because ofthe size and scale of super-senior creditors on the repayment waterfall.

Eskom has been delinquent in its compliance with some of the legal covenantswith the World Bank on a number of occasions, and its project delivery track-record has been lacklustre. At the end of November 2018, as part of its monitoringand evaluation (M&E) framework, the World Bank issued a “Project Status andRationale for Restructuring” report on its loan facility to Eskom. The M&Eframework sets out an overall project risk rating and tracks performance againstthe project’s original development objective, as well as the implementationprogress against predefined milestones and benchmarks.

Moderate HighSubstantialLow

Overall Project Risk Rating

Moderately Satisfactory

Highly Unsatisfactory

Moderately Unsatisfactory

Highly Satisfactory

Project Development Objective (PDO) & Implementation Progress (IP)

PDO IP

The World Bank: Eskom Investment Support Project (P116410)

• The original project development objective (PDO) of the World Bank’s Eskom Investment Support Project for South Africa is to enhance its power supply and energy security in an efficient and sustainable manner so as to support both economic growth objectives and South Africa's long-term carbon mitigation strategy.

• To achieve the PDO, the project supports the financing of: (a) the Medupi Coal-Fired Power Plant (4,800 MW), using supercritical (clean-coal) technology; (b) associated transmission lines; (c) Majuba rail; (d) investments in renewable energy – a 100 MW wind farm (Sere) and a 100 MW concentrating solar power plant (Kiwano CSP) to diversify sources of electric power; and (e) technical assistance to assist Eskom in developing regional projects and for improving demand-side and supply-side energy efficiency.

• This specific project is co-financed by Eskom, African Development Bank, European Credit Agencies, China Development Bank and other financiers. The estimated total cost to completion is US$18.4bn (an increase from US$13.86mn as at the appraisal in 2010). The IBRD-78620 loan was approved on 8 April 2010 and was scheduled to close on 31 December 2019. The net commitment is US$3,75bn – US$3,04bn has been disbursed (81%) and 19 percent is undisbursed (US$713mn) as at 28 November 2018.

“The PDO and IP ratings have been in the unsatisfactory ranges since October 2013. The original reason was poor implementation progress (leading to construction delays) of the Medupi power plant component and lack of progress on the Kiwano Concentrating Solar Power (CSP) sub-component.The delays in construction of the Medupi power plant have now been addressed. Since 2017, issues related to Eskom’s corporate governance and internal controls, a qualified audit in 2017 and 2018 and deteriorating financial conditions contributed further to the poor ratings. An action plan pertaining to Governance, Internal Controls and project-related items was agreed upon with Eskom during the 2017 Annual Meetings with the World Bank to address the concerns, and significant progress has been made. A new permanent Eskom Board was appointed on January 20, 2018, a new permanent Group Chief Executive Officer (CEO) was appointed in May 2018 and a new Chief Financial Officer (CFO) was appointed on November 28, 2018.Eskom has also made significant progress to address the root causes that gave rise to irregular expenditures, which led to the qualification of the FY17 and FY18 audit reports. The main rationale for the restructuring is to substitute Kiwano CSP with a Battery Storage Program (BSP), which would install batteries at some existing Eskom-owned and fully fenced-out substations close to locations where renewable wind and solar photovoltaic (PV) feed into the Eskom grid. This would enable the PDO to be achieved”.

UnsatisfactorySatisfactory

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 10

GOVERNMENT SUPPORTEXTRA-BUDGETARY SUPPORT IS ALMOST CERTAIN

Implicit vs explicit government support in the ratings

Eskom’s “ccc-level” stand-alone ratings imply that the entity is unlikely to

trade its way out of financial distress without some form of external

support. S&P has the most severe stand-alone assessment at ‘ccc-’.

The agency describes ‘ccc-’ as follows:

“A default, distressed exchange, or redemption appears to be inevitable within six months, absent unanticipatedsignificantly favourable changes in the issuer's circumstances”.

However, the notches of uplift reflect parental support from the government as its sole shareholder, as well as its importanceto government’s policy objectives. It merely describes the closeness of Eskom to the government and is structurally baked intothe core rating model. This uplift is what is commonly referred to as implicit support and does not indicate any form of fiscal orquasi-fiscal support. However, it is distinct to the following explicit forms of government support that could raise Eskom’sissuer rating even further to the upper limit of equalisation with the government. Explicit support is typically fiscallyquantifiable:

• Ongoing government support: This could include planned or budgeted transfers from the government to Eskom (similar tothe way municipalities receive appropriations from the fiscus). In practice, Eskom has received significant ongoing supportin the form of a R350bn government guarantee facility. In our opinion, Eskom’s distressed status implies that ongoingsupport is necessary, but no longer sufficient.

• Extraordinary or extra-budgetary support: Eskom has received bailouts in the past, including direct equity injections anddebt forgiveness packages from the government. Eskom has now requested the government to consider an R100bn debttransfer facility in the near term, and we think support will be forthcoming from the government. On the other hand,Eskom could also seek flexibility and support from its regulator, NERSA, for special tariffs or quicker tariff phase-ins, butdeviations of this nature are unlikely to be accommodated.

Beyond Eskom’s role and link to the government (the implicit support framework), there are other considerations, which wethink will drive the government’s decision to provide further explicit support measures to Eskom:

• Systemic importance to the economy: apart from its importance to the government’s policy objectives and the economy;Eskom is systemically important in the sense that it is too big to fail. This is a key distinguishing feature of Eskom’srelationship with the government compared to peer state-owned companies that may have an equally important role toplay in the economy and to advance the government’s policy objectives.

This link is not always highlighted in South Africa’s credit story, save for the contingent risk of Eskom’s guaranteed debt onthe government. For instance, even if Eskom had little debt and no government guarantees, we think that itsfailure would still pose a systemic crisis for the economy, which would be credit negative for the government and wouldrequire extraordinary support.

Too big to fail also implies that in times of distress, there will be a trade-off between Eskom and the government’s ratings.Unbudgeted support applies pressure on fiscal balances and is credit negative for the government. Meanwhile, the much-needed capital injection eases Eskom’s liquidity position and is credit positive for Eskom. Therefore, the value of aguarantee diminishes as the guarantor’s creditworthiness declines, while unguaranteed positions benefit from theimprovement in Eskom’s stand-alone credit profile.

With the government in speculative grade and Eskom in credit distress, the joint probability-of-default (PD) rises and becomes amore prominent consideration for lenders. In theory, lenders should, therefore, seek alternative risk mitigation fromuncorrelated third-parties, but these are either too expensive or impractical. We think the pricing between Eskom’s recentlyissued guaranteed and unguaranteed Eurobonds do not reflect the joint-PD risks yet, nor do the CDS spreads between thegovernment and Eskom (See appendix for charts)

Source: Fitch, Moody’s, S&P

Moderate Almost Certain

Extremely High

High Moderately High

Very High

Low

Likelihood of extrabudgetary support from the government Eskom is systemically important to the South African economy. We think that its distressed liquidity position

and the unlikely prospect of an adequate tariff-rate decision in the MYPD4 period increase the likelihood of a

government bailout.

Stand-alone rating

Implicit Support

Notches of uplift

Fitch ccc BB 5

Moody’s caa2 B2 3

S&P ccc- CCC+ 2

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 11

Sources of liquidity for the government • We believe the government would favour a debt-transfer solution for Eskom or a combination of debt-transfer/debt forgiveness and equity

injection. In 2015, Eskom received a subordinated loan from the government, which allows the government to claw back at some point in the

future. Ultimately, Eskom’s aim is to extinguish it’s liquidity problem by any means necessary and the option to exercise moral hazard because it is

too big to fail will likely work in its favour.

• From what we understand of Eskom’s bond indentures, a debt transfer would be similar to the government exercising its step-in rights as a

guarantor. In other words, the government services Eskom’s debt obligations in the name of Eskom, but this does not constitute a default.

However, S&P mentions that it would consider such a distressed exchange as a default event.

• The tariff determination by NERSA will help to derive the required bailout amount. We set out the government’s debt metrics below, followed by

some scenarios of bailout amounts based on 1) Eskom’s requested amount; 2) Target liquidity ratios we believe will address its challenges and 3)

Moody’s debt-to-GDP rating threshold at 60%.

• The important point is that timely support is a must, because the implied liquidity-survival horizon of Eskom is less than six months, in our view.

• Equally important is to recognise that more guarantees are unlikely to unlock liquidity from funders. Guarantees are for business-as-usual credit

conditions. Eskom is in liquidity distress, and tangible, timely and extraordinary support in full is now necessary, in our opinion.

GOVERNMENT SUPPORTCAPACITY TO SUPPORT

2018 MTBS (Rbn) 2018/19 2019/20 2020/21 2021/22

Gross loan debt 2 817,7 3 038,4 3 349,6 3 679,9

Less: National Revenue Fundbank balances (Cash)

-271,4 -215,4 -215,9 -222,6

Net loan debt 2 546,3 2 823,0 3 133,7 3 457,3

As percentage of GDP:

Gross loan debt 55,80% 56,1% 57,4% 58,5%

Government's gross borrowing requirement 230,3 315,9 316,6 326,9

government Liquid Assets

Contingency reserves 0 7,0 8,0 12,0

government’s shareholding in Telkom:41% shareholder (R13.4bn). Assume they reduce their holding by 10% at the current share price (R64,07 as at 21-Jan-2019).

3,3

Source: National Treasury; Nedbank CIB

*Based on our own calculations and assumptions, using S&P framework. See page 15

Bailout Scenarios FY2018/19Rbn

% of GDP Gross debt-to-GDP (%) fully-loaded

National Revenue Fund Balances (Cash) + Other Liquid Assets Cover

Ratio (x)

Bailout amount requested by Eskom 100 2,0% 57,7% 2,7x

Bailout required by Eskom to extinguish its liquidity shortfall (sources minus uses of cash >= 0)*

156,8 3,1% 58,8% 1,7x

Bailout amount required by Eskom to achieve a liquidity ratio of 1.2x sources-to-uses of cash as per S&P’s criteria*

193,7 3,8% 59,5% 1,4x

Debt-to-GDP ratio threshold (60%) as per Moody’s criteria 212,1 4,2% 59,9% 1,3x

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 12

43% 47% 48%53% 56%

16%17% 13%

12%13%7%

8%8%

8%8%

3%1% 6%

6%7%

11%13% 13%

30%

34%

0%

20%

40%

60%

80%

100%

120%

140%

2018 interim results (A) 2019 interim results (A) 2018/19 (E)* 2019/20 (F)* 2020/21 (F)*

Co

st %

of

Rev

enu

e

Primary Energy Costs Employee Benefit Costs Ops and Mainenance Other operating expenses Depreciation&Amort.

FINANCIAL PROFILE

• As a regulated entity, Eskom’s revenue is primarily dependent on the tariff setting process by NERSA, giving the utility limited control over its top line

• The utility’s operating expenses will continue to grow at a pace that exceeds projected revenues, which will result in losses at an operational level – continuing to cast doubts on its ability to service debt

• Other operating costs mainly represent employee benefits costs, as well as repairs and maintenance. Salaries seem to be a sticky issue with unions and Section 189 of the Labour Relations Act . To restructure the workforce and retrench redundant labour is a long and drawn-out process and will probably not result in meaningful changes to the cost base. Eskom tried to defer maintenance, but this only decreased operational reliability.

Analysis of earnings before interest and tax

Operating cost to income ratio

Note: A - actual, E – estimated; F – forecasted ; * MYPD4 forecasts

Sources: 2018-2019 – Eskom’s interim financial statements; 2019/20-2020/21 – Eskom MYPD4 Application

Eskom has reported from an IFRS perspective that it

can contain operating costs

An indication that allowable revenues will lag costs, although the regulator believes Eskom’s cost-control is

not robust enough for efficient operations

Break-even point

0

50,000

100,000

150,000

200,000

250,000

300,000

2018 interimresults (A)

2019 interimresults (A)

2018/19 (E)* 2019/20 (F)* 2020/21 (F)*

Rm

Primary Energy Costs Other Operating Costs Depreciation and Amortisation Sales Revenue

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 13

-40%

-20%

0%

20%

40%

60%

80%

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019(E)

2020(F)

Gross Margin % EBIT Margin % Net Income Margin %

FINANCIAL PROFILE

Historical review of operating cost base

Margin analysis

Source: S&P Capital IQ; Eskom Application (MYPD4)

Source: S&P Capital IQ

Provisions for bad debts and other operating expenses more than doubled,

with the remaining cost base also growing at a rate higher than the revenue growth of

18% achieved in 2009

Gross profit margins have been worsening because of an increase in cost of sales. Cost of sales (primary energy costs) is driven by own generation costs and IPPs, making up 90% of primary energy costs

Primary energy costs and employee benefit costs are the main drivers of Eskom’s operating cost base, leaving

the utility with little room to maneuverer in its attempt to cut

operating costs

Expectation Cost Driver

IPPsAdditional IPP contracts and cost escalation of existing contracts

Own generation costs

Rising coal costs as transport costs climb and an increased demand for Eskom's coal specification in the international market

Expectation Cost Driver

Depreciation and amortisation

Major power plants, Kusile and Medupi, are expected to become fully operational commercially

Employee costs

Even though Eskom is expected to downsize its workforce, employee costs will rise to reflect the recently approved above inflation wage increases

Maintenance and operations

An ageing fleet and acceleration in deferred maintenance programmes

Expectation Cost Driver

Interest expense

We expect yields to rise as the strength of government guarantees wanes

We expect all major costs to continue to rise over the MYPD4 application period and can, therefore, also expect Eskom to continue relying on clawbacks to recoup these additional costs

Note: E – estimated; F – forecasted ; * MYPD4 forecasts

* *

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2018 Interim

Rm

Ops. and Maintenance Selling General & Admin Exp. Depreciation & Amort. Provision for Bad Debts Employee Benefit Costs Primary Energy Costs Other Operating Expenses

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 14

52,042 54,89664,797

73,386

19,757 19,317

26,549

29,590

2,681 2,768

3,127

3,533

8,086 8,061

8,068

8,272

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

FY2016/17(A) FY2017/18 (A) FY2018/19 (E) FY2019/20 (F)

Rm

Generation costs IPPs International electricity purchases Environmental levy

International purchases and environmental levy remains stable, while generation costs and IPPs

continue to rise.

90% of Primary

Energy Costs

FINANCIAL PROFILE

Breakdown of primary energy costs

Historical and forecast cost of coal

Source: S&P Capital IQ, Eskom Application(MYPD4)

• Unknown costs are rising as coal contracts end while insufficient new mining investments have been made. New contracts could be more expensive as global demand for Eskom’s coal specifications rise, and the probability is high that these mines will be too far to have conveyers power stations, therefore increasing transport costs

• Eskom’s coal shortages may persist, due to its low rating potentially causing existing coal suppliers to diversify away from the utility. The utility’s top 10 major coal suppliers are Exxaro, Anglo Operations/Seriti Coal, South32, Universal Coal Development, Iyanga Mining, Tshedza Mining Resources, Umsimbithi Mines, Koomfontein Mines, Keatong Mining and Wescoal Mining. Fifty percent of the coal produced by Wescoal Mining is sold to Eskom through a fixed-price contract. The company reportedly did not benefit from higher coal prices in the FYE2018 due to this high single-customer concentration and the cost structure of the contract

• Other coal costs include water and fuel for open cycle gas turbines (“OCGT”), which are expected to rise due to power stations that have reached the end of their useful life being shut down or placed into extended coal reserves. OCGT costs are typically a clawback item rather than a forecast included in the allowable revenues application; we think this should perhaps be included in the application, given the high likelihood of the cost materialising

• IPP costs rise as Eskom enters into additional IPP projects and the cost of existing contracts escalates. The more the fleet is out of operation (for whatever reason) the more Eskom has to take from IPPs, which are currently considered a costly source. Nevertheless, PPAs dictate the minimum amount Eskom has to take and the price thereof

• The cost of producing its own energy for Eskom vs generating through IPPs – 2019/20 forecast:

2019/20 Total Cost (Rm) Production (GWh) Rand Cost per GWh

IPPS 29 590 13 985 2.12

Own Generation Costs 73 386 224 977 0.33

IPP Costs 2017/18 % change 2018/19 % change 2019/20

Total cost (Rm) 19 317 37% 26 549 11% 29 590

Production (GWh)

11 851 17% 13 904 1% 13 985

Cost per GWh 1.63 17% 1.91 11% 2.12

Note: A - actual, E – estimated; F – forecasted ; * MYPD4 forecasts

* *

• Cost per GWh of IPPs is almost double the forecasted standard tariff price of R1.09per GWh

• 180c difference

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 15

Source: Eskom MYPD4 Application; Eskom Annual Financial Statements; S&P

Note: Guarantee headroom does not imply there is committed cash immediately available from the guarantor, but merely

that a third-party lender can benefit from up to R14bn worth of guarantees. Strictly speaking, this cannot be counted as a

committed source of cash.

LIQUIDITY PROFILE

MAPPING THE WAY FORWARD

Eskom is a very complex company with multifaceted challenges that cannot be fixed overnight. We think the utility has only a narrow set of options going forward, the core of which will be rebalancing its sources and uses of cash, which includes its working capital cycle. As a regulated entity, Eskom has more influence over its cost-reduction and liability usage measures than it has over revenue collection and cash flow generation. The latter is due to its inability to pass costs on to consumers through the regulated tariff, which has been insufficient to cover Eskom’s rising cost base. At the same time, municipal arrears are climbing, and as a result, earnings are not yielding enough cash flow to meet the utility’s normal working capital requirements.

We have assessed Eskom’s liquidity to be ‘weak’ for the FY2019/20 (see the S&P liquidity spectrum described below), with a forecast liquidity gap of R156.75bn and very few options available to fill the gap. This casts doubts on the entity’s ability to continue operating as a going concern over the next 12-18 months without extraordinary support.

Forecast liquidity FY2019/20

S&P liquidity spectrum

Eskom’s ‘weak’ liquidity profile caps its S&Pstandalone credit rating at ‘b-’. So, any corporateturnaround strategy or government support packagemust necessarily focus on improving Eskom’ssustainable liquidity position in order for its rating toemerge out of the distressed space.

Total sources of liquidity (A) 28 025

Cash and liquid investments 26 985

Proceeds from sale of assets (book value as at 30 Sep 18)

1 040

Uses of cash (B) 184 776

Expected CAPEX 64 728

Debt maturities 73 221

Forecasted FFO (operating loss) 25 012

Forecasted working capital 21 814

Cash-based post retirement benefit outflows 518

A/B 0.15

A-B - 156 751

AdequateLess than adequate

Weak

A/B 1.2x Less than 1.2x Reflects a material deficit

over the next 12 months

A-B Positive Zero or below

Stand-alonecredit profile

Anchor rating must be at least

‘bbb-’

No higher than ‘bb+’

‘b-’ or lower

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 16

Rm

Loans Receivables 8 569

Other Assets 355

Total Assets 8 924

Debt Securities and Borrowings 7 033

Other Liabilities 851

Total Liabilities 7 884

Proceeds from the sale of assets – Eskom Finance Company’s book value

Available headroom in government guarantee (as at September 2018) – for illustrative purposes only

Source: Eskom interim financial statement; National Treasury tender document; Eskom annual financial statement

LIQUIDITY PROFILE

SOURCES OF CASH

Eskom Finance Company:

• The employee home loans book has about 16,000 customers

• Loan-loss ratio is below 0.1%

• More than 90% of mortgage repayments are managed by deducting money from the employees salary each month

The holding company is still in the process of evaluating bids for the subsidiary. We, however, think that the proceeds from the sale will not have any material impact on the utility’s funding needs. The proposal to sell the company was opposed by unions back in 2015 when Eskom was considering divesting some of its assets. Eskom is reportedly yet to hold talks with unions about this planned sale. Fitch estimates that the sale could be concluded only in FY2020, but this does not negate the likelihood of a forced sale within the next 12 months.

Cash and liquid investments – as at 30 September 2018

Cash and cash equivalentsR17 342m

Short term investments

R8 236m

Trading asset securitiesR1 407m

Rbn

R41bn in guaranteed debt is maturing over the

financial years2019 and 2020

Available headroom in the government guarantee facility does not imply the availability of committed cash. Therefore,

we exclude this from the sources of cash calculation

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 17

LIQUIDITY PROFILE

USES OF CASH

Funds from operations

Rm Year Ended 31 Mar 2020

EBIT* -20 352

Depreciation and Amort 64 651

Capital Expenditure - 64 728

Net working Capital Prior Year - 26 398

Net working Capital Current Year 21 814

FFO - 25 012

*EBIT calculation

Forecasted sales Primary energy costs

Depreciation and amortisation

Other operating expenses

Generation costs 64%

IPPs26%

International electricity purchases

3%

Environemntal Levy 7%

Employee Benefits

47%

Maintenance29%

Arrear debt impairment

22%

Other costs2%

Source: Eskom MYPD4 Application; Nedbank CIB

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 18

Expected capital expenditure

LIQUIDITY PROFILE

USES OF CASH

2019/20

Generation 47 924

Transmission 7 098

Distribution (excl. DOE funded capex) 5 783

Future fuel 1 597

Corporate Capex 1 400

Other 926

Total 64 728

Working capital

2019/20

Current Assets

Receivables 26 405

Inventories 41 003 Loans Receivable Current 15 Other Current Assets 13 377

Total Current Assets 80 800

Current LiabilitiesAccounts Payable 39 613 Unearned Revenue, Current 4457Other Current Liabilities 14916Total Current Liabilities 58 986

Net Working Capital - 21 814

Source: Eskom MYPD4 Application; S&P Capital IQ; Nedbank CIB

2009 - 2018 working capital cycle

-50

0

50

100

150

200

Ave

rage

Day

s

Avg. Days Sales Out. Avg. Days Inventory Out. Avg. Days Payable Out. Avg. Cash Conversion Cycle

Trend in capital expenditure*

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

2017/18 (A) 2018/19 ( E) 2019/20 (F) 2020/21 (F) 2021/22 (F)

Rm

Generation Distribtuion Future fuel Corporate Capex Other

Completing of Kusile and

Medupi

Debt maturities

FYE2020 FYE2021 FYE2022 FYE2023 FYE2024

Capital Repayments 34 115 49 951 49 431 56 085 92 952

Interest Payments 39 058 45 115 46 041 49 384 48 607

Total Debt Service Costs

73 173 95 066 95 472 105 469 141 559

0

10,000

20,000

30,000

40,000

50,000

60,000

Apr2019

May2019

Jun2019

Jul 2019 Aug2019

Sep2019

Oct2019

Nov2019

Dec2019

Jan2020

Feb2020

Mar2020

Other2020Debt

ServiceCosts

Rm

Interest Capital World Bank Loan

R41.2bn(Translated using the spot rate on 17/01/19 of

R13.72)

Unguaranteed domestic

bond ECN20 with an

outstanding amount of

R5bn matures

Government guaranteed

dollar denominated

DFI Term Loan

Forecasted debt service costs

The World Bank could accelerate the repayment of the projectfinance loan granted to Eskom in 2010 should it continue to failmeeting the Project Development Objectives and ImplementationProgress requirements that were recently assessed as being“Moderately Unsatisfactory” and “Unsatisfactory”, respectively.US$3.75bn was committed, 81% (US$3bn) of that has beendisbursed as of November 2018. The loan agreement ends on 31December 2019 and was restructured to mature on 31 December2020 with revised covenants

• We are not certain whether the R100bn bailout requested from the government will be utilised over a year or spread over a period of time

• Should it be granted, it should cover just under 1.5 years of capital and interest payments.

12 months 30-Sep-18

Note: A – actual; E – estimated; F – forecasted ; * MYPD4 forecasts

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 19

• Eskom’s access to funding improved in 2018, following a period in which SOCs were placed under high scrutiny after Futuregrowth released a report on the alarming state of SOE governance. The situation was exacerbated by numerous SOCs, including Eskom, being implicated in allegations of state capture

• Eskom may have been able to improve its access to liquidity, but given that 79% (taking into account the R20bn bridging facility that was used to fund maturities) of the rand-denominated funding and 60% of dollar-denominated funding have been ring-fenced for specific projects, this improvement will not have a significant impact on the utility’s liquidity position and free cash flow

Various sources of funding obtained in 2018

Planned vs committed funding, 2018/19

Source: Interim results presentation

14

68

5

2 5

90

19

95

0

13

00

0

6 8

60

15

00

0

21

27

4

1 5

44

21

64

7

6 5

29

1 9

84

-

D F I s E C A s I n t e r n a t i o n a l B o n d s

L T D o m e s t i c B o n d s

S T D o m e s t i c B o n d s

S t r u c t u r e d P r o d u c t s

Rm

Planned Committed

R1.35

R6.75

R1.50

R2.89

R20.00

$0.2

$2.5

$1.5

0

0.5

1

1.5

2

2.5

3

0

5

10

15

20

25

GermanDevelopment

Bank(kfW)

Domestic BondIssuances

AgenceFrancaise de

Developpement

AfricanDevelopment

Bank

ST Bridge toBond Facility

BRICS Bank ChinaDevelopment

Bank

Eurobondissuance

US$

Rbn US$bn

To support Eskom’s transmission capital

expenditure, cannot be used for general purpose

funding

Funds to go to Medupi power station

• At the end of September 2018, Eskom secured R52.98bn of its R72.085bn (73%) funding requirement for the 2018/19 financial year and a meaningful portion of its 2019/20 requirements

• This was promising evidence that some of the commitments and expectations communicated in the results presentation were credible and reliable, implying that the new management was capable of delivering what they promise

• For us, this is an important underpin for any renewed confidence in Eskom’s management, but its liquidity challenges will persist because access to the domestic bond market (including structured products) remains essential for general purpose funding, including working capital, and rolling of existing debt

• The Eurobond market is open to Eskom, but will be too expensive, to the extent that it would likely exacerbate the negative cash flow situation

LIQUIDITY PROFILE

ACCESS TO LIQUIDITY

Rbn

Source: Interim financial statements; Various sources

We think Eskom was able to unlock funding to complete projects because of the World Bank report that suggested significant restructuring of projects and loans

Only half of these targets have been met thus far, this suggests a poor access to alternative

channels, which is consistent with the assessment of a “weak” liquidity profile

The Eurobond market seems to be the only

open channel, but it is an expensive source of

funding

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 20

MYPD Methodology: Total Allowable Revenue Formula

AR = (RAB X WACC) + E + PE + D + R&D + IDM ± SQI + L&T ± RCA

APPENDIX A: ALLOWABLE REVENUE FORMULA

Generation formula Transmission formula Distribution formula

Allowable Revenues = Allowable Revenues = Allowable Revenues =

Return on Regulated Asset Base (RAB)

and working capital +Return on Regulated Asset Base (RAB)

and working capital +Return on Regulated Asset Base (RAB)

and working capital +

Generation opex + Transmission opex + Distribution opex +

Generation depreciation + Transmission depreciation + Distribution depreciation +

Efficient primary energy costs (inclusive

of non Eskom generation Eg. IPPs) +Transmission charges (network costs,

losses & ancillary charges) + Allowances for Service Incentives +

Transmission charges pass-through

(regulated separately) ± Allowances for service incentives ±Allowance for Demand side

management and efficiency +

Risk management adjustments (includes Regulatory Clearing Account (RCA) clawbacks)

Risk management adjustments (includes Regulatory Clearing Account (RCA) clawbacks)

Transmission revenues pass-through

(regulated separately) +

Generation revenues pass-through

(regulated separately) ±

Risk management adjustments (includes Regulatory Clearing Account (RCA) clawbacks)

The total allowable revenue formula aggregates the divisional licensee allowable revenue formulae

Source: NERSA, Eskom

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 21

MYPD Methodology: Total Allowable Revenue Formula

AR = (RAB X WACC) + E + PE + D + R&D + IDM ± SQI + L&T ± RCA

APPENDIX A: ALLOWABLE REVENUE FORMULA

Line item Technical definitions*: Select items Comment

RAB

• Long-term fixed assets covering production and supply of electricity

• Fixed and other assets that are not in a used and useable form will not be included in the RAB

• Used and useable means the asset should be in a condition that makes it possible to meet demand in the short-term (within 12 months)

• Working capital is included in the RAB for the purpose of calculating return, and Return on Capital is based on the replacement value of the assets (modern equivalent asset value (MEAV), adjusted for the remaining useful life to reflect physical, functional and economic obsolescence)

• Eskom recently completed an independent asset valuation exercise

• Customer-funded assets and prepayments are deducted

• Mothballed and/or impaired assets will not earn a return, although maintenance of such assets with a definite plan for future use will be allowed in operating expenses

• Eskom has gone to great lengths to explain that part of its older fleet, which has been placed in “Reserve Storage” should still form part of the RAB (as contingent capacity – in case forecast energy availability does not materialise as planned).

• If NERSA wants to fully or partially exclude these units from the RAB, we think it will ultimately have to opine on whether Eskom’s true intention is to mothball these units and whether it will take longer than 12 months to bring them back online. Eskom’s application is not firm in terms of having a definite plan on the use or usability of these units over the MYPD4 period.

• Bringing these units back online will require a significant re-investment in plant and fuel, which is likely to reverse any cost-savings in the near-term and exacerbate Eskom’s financial woes.

• The average Eskom RAB climbed 80% from the 2018/19 MYPD3 existing decision to the 2019/20 MYPD4 application. This is because Eskom recently completed an independent asset valuation exercise, and new assets are expected to be brought into commercial operation (Kusile and Medupi).

• The revaluation method adopted for the RAB is not the cost to replace the existing asset (i.e., MEAV), but the depreciated replacement cost (which probably undervalues the asset base – see pg. 51 of the MYPD4 application). The revaluation reserve is not included in the WACC. The revalued asset earns a return, but the revaluation reserve is amortised annually.

• As such, we think there is a structural break in the RAB between MYPD4 and previous decisions, and therefore, the ball is in NERSA’s court on whether it will accept the new asset valuation methodology.

Source: NERSA, Eskom *A full treatment of the definitions can be found on the NERSA webpage

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 22

MYPD Methodology: Total Allowable Revenue Formula

AR = (RAB X WACC) + E + PE + D + R&D + IDM ± SQI + L&T ± RCA

APPENDIX A: ALLOWABLE REVENUE FORMULA

Capital Asset Pricing Model (CAPM)

Business As Usual (BAU)Distress

(adjustments for a higher cumulative probability of default)

Capital Asset Pricing Model (CAPM)

Risk-free rate R186 benchmark bond

CPI

Real risk-free rateInflation-adjusted risk-free rate of

return

Beta Proxy benchmark using peersBottom-up beta using cash flow valuation over a truncated time horizon or proxy

based on peers with a similar standalone bond rating

Market risk premium

Historical average return of the JSE ALSI adjusted for resources bias (i.e., JSES FINI index) - 25 year

historical average

Real cost of equity30% weighting

Debt premium

Actual cost of debt – risk-free rate;Given Eskom is government

guaranteed, this premium is more like a country risk premium

(assume full credit substitution)

• For a normal corporate, a CDS spread would be an appropriate add-on. However, no adjustment is possible for Eskom.

• We believe that Eskom’s systemic importance is appropriately captured in its credit rating, including the joint-default risk (the probability that both, the borrower and its guarantor would fail simultaneously).

• However, we do not think that this is adequately captured in the overall cost of debt (either via the risk-free rate or directly in Eskom’s weighted-average cost of debt or both).

Nominal cost of debt

Real cost of debt70% weight

Gearing Actual gearing ratio

Tax rate

Pre-tax WACC

Post-tax WACC

Source: NERSA, Eskom *A full treatment of the definitions can be found on the NERSA webpage

Weighted-Average Cost of Capital (WACC)

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 23

APPENDIX B: ESKOM EUROBONDSGUARANTEED VS UNGUARANTEED

Yield

Price

Source: Bloomberg

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 24

APPENDIX B: ESKOM CREDIT DEFAULT SWAPS5YR CDS-IMPLIED CREDIT RATING (MOODY’S)

5YR

10YR

Source: Bloomberg

CREDIT INSIGHT 24 JANUARY 2019 | PAGE 25

Nthulleng MphahleleAnalystTel: +27 11 537 4163NthullengM@Nedbank.co.za

Jones GondoSenior Credit Research Analyst Tel: +27 11 535 4050JonesG@Nedbank.co.za

Links to Recent Publications

• Fiscal slippage vs investment pledges, Published 26 October 2018• SA MTBPS – Moody’s rating implications, Published 25 October 2018• SA government Credit Rating – Moody’s, Published 15 October 2018• SA government Credit Rating Preview – Moody’s, Published 11 October 2018• SA government Credit Rating Action – S&P, Published 29 May 2018• Eskom Holdings Downgraded – A Story of Waning Implicit Support, Published 29 March 2018• SA government Credit Rating Preview – Moody’s, Published 20 March 2018• Pre-Budget Credit Insight, Published 21 February 2018• Market Update – Eskom Holdings SOC Ltd, Published 18 January 2018• Market Update – Steinhoff, Published 16 January 2018

CONTACTS

Analysts