Wednesday, March 01, 2017 2:35 PM/ United Capital Research
In this report, we initiate a coverage of the Nigerian power sector with reviews and insights into developments in the post-privatization era.
In 2013, Nigeria commenced a comprehensive reform of the sector, in a privatization move that was proclaimed to be one of the boldest power reform initiatives globally, with proceeds from divested assets estimated at c.US$3bn.
The overarching objectives of the reform were two-fold: to address chronic efficiency gaps in the old public utilities, and attract private capital needed to propel the sector to meet Nigeria’s fast growing electricity demand.
The question we attempt to answer in this publication is why the sector has seen little progress on these two fronts.
Further, we provide our outlook for the industry and the factors we consider as imperative to the success of Nigeria’s power sector reforms given the experiences of similar countries.
We conclude that bold decisions will need to be made to kick-start a new era in electricity delivery in Nigeria.
Trouble with Nigeria’s Power Sector
The power sector reform in Nigeria has come with both pains and gains, with the former taking the shine off the noble intents of the privatization exercise. Broadly, the challenge with effective and efficient electricity supply in the post-privatized electricity market in Nigeria can be summarised in one word: “shortage”.
From feedstock availability to electricity units delivered to the end-user, there are severe strains that not only threaten the financial viability of the sector, but also practically repel fresh funding and investment across the value chain.
Whilst the persistence of these challenges in a privatised framework does not call into question the validity of the reforms, it points to the need for Nigeria to do more in addressing lingering bottlenecks such as:
· The sub-optimal utilization of generating capacity;
· Inadequate transmission infrastructure and high distribution losses; and
· Low rates of collection.
For example, over 3,000MW of generating capacity is stranded due to gas constraints. Transmission capacity can only wheel 50-60% of installed capacity, while collection losses range between 40-60% at the distribution company (Disco) level.
Route to Bankability: Like Telecoms, like Power?
At the onset of the power sector reforms, local expectations were high as the privatization of the National Electric Power Authority (NEPA)/Power Holding Company of Nigeria (PHCN) was often compared, albeit wrongly, to the revolution engendered by the earlier liberalization of the telecommunications sector.
However, events post-privatization have proven disappointing as the sector continues to grapple with systemic challenges, with negligible improvement in supply relative to the pre-reform era. It would appear that stakeholders took too long to come to terms with the dissimilarities between the two sectors.
With regard to the telecommunications sector, save for early teething problems, bankability was established very quickly as lenders dimensioned the risk-reward potential of the sector in a clear and consistent manner.
This was aided by the fact that the telecommunication companies (telcos) had more control over the “universes” they created and didn’t have as many inter-dependencies as the electricity generation companies (GENCOs) and distribution companies (Discos) have. As a result, the telcos were considered to be more “bankable”.
Getting the economics right: The tariff puzzle
The biggest hurdle against the commercial viability of the Nigerian electricity value chain is insufficient cash flows. This has significantly impaired the ability of the Gencos and Discos to recover all costs and generate appropriate re-turns on investment. It has been a rather daunting task aligning the charges for electricity consumption with the cost of electricity generation, transmission and distribution.
In this regard, to set the tone for our proposition for the Nigeria Electricity Supply Industry (NESI), it would be useful to work with two central principles in mind:
1. The cost of not having electricity is much greater than the cost of putting the right machinery in place given that self-generation costs 62-94kWh, two times grid-based power in Nigeria.
2. An efficient supply system where losses are at the barest minimum and an inefficient system with significant losses (typical of the Nigerian case) will both bear the same cost in delivering electricity to the end user.
With these principles in mind, and as we show later in this report, tariffs should be significantly higher than they are now. Further, gas prices need to be completely liberalised to ensure producers become largely indifferent between export potential and local sale to Gencos.
Seeking quick and optimal generation: Expanding the grid or looking beyond it?
We argue for a decentralized power generation model in Nigeria as current challenges are insurmountable within the existing framework. Currently, the national grid supplies more than 90.0% of Nigeria’s power output.
Efforts seem to be focused on ramping up investment in the grid, but we believe a less centralised structure, where off-grid solutions are prioritised and supply close to 50.0% of power output, would ensure improved efficiency and a more competitive electricity market (similar to what obtains in other jurisdictions).
In this regard, independent system operators and mini-grids must be explored to achieve quick wins in electricity supply. It is clear that the failure to achieve optimal gas utilization is telling on power output, a trend that effectively begs 2 questions:
1. Should Nigeria continue to pipe gas to where generating plants are sited?,
2. Should it generate power where the gas is and transmit the power to where it is needed?
Either way, the oil companies still require significantly higher incentive in the form of large increases in regulated gas prices to build gas infrastructure sufficient to achieve a quantum leap in Nigeria’s power supply.
For the Nigerian transmission sub-sector, achieving the significant amount of non-government funding, as spelt out in the Transmission Company of Nigeria (TCN’s) most recent 5-year outlay will be a key challenge going forward.
The recent change in management of the TCN means that the company is now completely owned and operated by the federal government. In effect, the government will be shouldering the credit risk of the TCN for the foreseeable future.
Given that investors would likely be more disposed to taking sovereign risk directly (preferably via treasury or bond instruments), relative to an indirect exposure via the TCN, a continued government control of transmission will cap capital inflows into the sector.
Therefore, it is important that the government hands-off the transmission sector via a complete privatization or concessioning, if it is to attract the much needed private capital in that space. There needs to be a bold departure from seeing the transmission grid as a national asset that needs to be centrally managed.
The Disco Challenge: Liquidity crisis compounds capital shortfall
In our view, the delay in the implementation of the Transitional Electricity Market (TEM) was the first set-back in the way of capital inflows into power sector post-privatization. Whilst the Interim Rules Period lingered, creating what was effectively a string of non-enforceable contracts, a liquidity over-hang was built up.
The role of government in the settlement and payments system extended far longer than it should, with debilitating impact on investor confidence and the operational efficiency of the market. Further down the value chain, lax regulation and enforcement of sanctions at the Discos level with respect to collection efficiency created cash flow shortages which continue to impede the overall efficiency of the sector.
With regard to capital investment, the Discos are currently overleveraged, hence equity injection is the most efficient way to plug capital shortfalls in the sub-sector. The domestic financial system is overexposed to the sector and lacks the capacity and depth to provide further funding support, especially debt capital.
A good proportion of future Capital Expenditure funding, by necessity, needs to be forex-based which, as of late, has become an issue given the currency volatility and acute shortage of forex being experienced in Nigeria.
Additionally, the existing CBN intervention fund, ranking superior to other debts in the books of the Discos make them highly unattractive for more debt funding especially from domestic sources. Therefore, we recommend off-balance sheet financing as a viable option for getting round cur-rent capex challenges.
Investment Outlook: Long term value, short term pain
In spite of the numerous headwinds confronting the Nigerian power sector today, the electricity market remains an attractive long term investment opportunity. In the medium term, we expect the biggest investment inflows to come into the generation segment which offers the highest risk-adjusted returns at the moment, as the overall systemic risk appears to be skewed in favour of the Gencos largely due to sovereign guarantees backing contracts in that segment.
However, because independent power plants have in-built transmission capabilities (hence not dependent on the grid) they are likely to continue to attract a larger share of investment as the power sector evolves. In this regard, the National Independent Power Plants (NIPPs) will be integral to achieving a major boost in electricity supply over the medium term.
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