Eskom’s cost-based pricing fallacy

Eskom is basing its substantial price increases on the rising cost of producing electricity, but the notion of cost-reflective tariffs is an economic fallacy.

In March 2023, the National Energy Regulator of South Africa (Nersa) approved tariff increases of 18.65% for 2023/24 and 12.74% for 2024/25.

Eskom’s tariffs are based on the cost of supplying electricity in accordance with the requirements of Nersa and the Department of Energy’s Electricity Pricing Policy.

In conjunction with the debt relief from the Finance Minister, Eskom believed these increases would place the utility in a much better financial position.

Former Eskom CEO Andre de Ruyter recently told Business Day that it is important for Eskom to secure cost-reflective tariffs from Nersa.

“If Eskom does not get cost-reflective tariffs, it will be back at Treasury’s door in three to four years with a begging bowl, asking for more money,” he said.

The reason, De Ruyter explained, is that its costs to produce electricity will be higher than the revenue it generates from sales.

“You don’t have to be a business wizard to understand that it is not the solution to a sustainable business,” he said.

Although cost-reflective tariffs intuitively sound like a logical strategy with a monopoly like Eskom, the premise of this model is false. There is no absolute cost of producing goods and services.

In his book, ‘Basic Economics’, renowned economist Thomas Sowell highlights the variable nature of the cost of producing goods and services.

Enterprises in the former Soviet Union, for example, always asked for more than they needed from the government to produce products.

“They take everything they can get, regardless of how much they actually need, and they don’t worry about economising on materials,” he explained.

“After all, nobody at the top knows exactly what the real requirements are, so squandering made sense from the standpoint of the manager of a Soviet enterprise.”

Among the resources that were squandered were workers. Soviet economists estimated that between 5% to 15% of the workers in most enterprises were surplus.

The results were telling. To make one ton of copper, the Soviet Union used about 1,000 kilowatt hours of electrical energy, compared to 300 kilowatt hours in West Germany.

“To produce one ton of cement, we use twice the amount of energy that Japan does,” former Soviet economists said.

Eskom is a perfect example of what happened in the former Soviet Union, where inefficient enterprises have high costs.

A hugely bloated workforce, a widespread waste of resources, and corruption and mismanagement significantly increase costs.

If Eskom bases its prices on its total costs, its employees will not be disincentivised from paying R200,000 for a mop and R80,000 for knee guards.

There will also be no reason to address other problems like Tegeta providing the Majuba power station with out-of-specification coal and undersupplied Eskom by around 265,000 tons of coal.

The reason Eskom is running at a loss is not because it sells electricity for too cheap. It is because of incompetence, corruption, theft, and mismanagement.

No amount of price increases will solve these problems, which is why it continues to record losses despite huge price increases in recent years.

The government has been throwing money at state-owned enterprises, including Eskom, Transnet, SAA, the SA Post Office, and the SABC.

Despite the bailouts, these institutions are now in a worse state than ever. It clearly shows the problem is not funding.

Considering the facts, it is hardly surprising that economist Dawie Roodt is furious that Eskom was allowed to increase electricity prices by over 18%.

He says it creates an uncompetitive business environment, increases inflation, and hurts economic growth.