Another downgrade for Eskom. What can they learn from the Marlboro Man?

Eskom is in big trouble.

In fact, if they were a listed company, they would be in existential trouble.

Now, before you conclude this is an article about corruption and cover-ups and the latest Moody’s downgrade, it isn’t. Even a squeaky clean energy parastatal, with proper procedures, robust governance and clear funding options, would have had difficulty avoiding the sort of trouble they are in.

The threat Eskom now faces comes from something it cannot control. It comes from the exponential rate of technological development, that has been happening overseas for at least the last decade.

The simple fact is that solar and wind are now cheaper than both coal and nuclear, particularly in climates such as South Africa.

Just how cheap is solar?

I meet with Ramez Naam, the co-chair of Singularity University’s Energy Department, in Los Angeles earlier this year and discussed the exponential decline in the price of renewable energy.

He explained that in 2017, India had received solar bids at $0.038 per kilowatt hour (Kwh) which is 4x cheaper than the equivalent bids from 2013.

He highlighted that in Mexico, they had received bids at $0.027/KWh.

And finally, he talked about Dubai, which at the time of writing had received the cheapest bid of $0.024/KWh, without any subsidies.

“This is the cheapest unsubsidisied contract for electricity every signed on planet earth using any technology. And this is not an end point as this price is going to continue dropping”

How does this compare to Eskom’s pricing?

Well, on March 27th, 2018, The Citizen newspaper reported the following: –

Eskom shocks with 30% price hike request

They go on to report that municipalities are currently charged, excluding vat, Zar 0.8913/KWh and will have to pay ZAR0.9379/KWh from 01st April.

That’s $0.08/KWh or 3.3x more expensive than the cost of Dubai’s new solar farm.

Not only that but by the time the electricity reaches the consumer, the price has been inflated to 1.3635/KWh or $0.12/KWh which is 5x more!

What this ultimately all means is that Eskom’s problems will increase over the next 10 years. Here’s why.

Virtuous Circles

Just take a moment to study the picture.

It’s showing how there are multiple virtuous activities occurring simultaneously to drive down the price of renewables whilst increasing the cost of fossil fuels.

Simplifying, more suppliers, means prices come down (Swanson’s Law), which increases demand, requiring more supply, meaning more suppliers, meaning prices come down and so on.

The reverse is true for fossil fuels as both actual and future expected demand falls, meaning fewer participants, less innovation which reverses Swanson’s Law, meaning prices at best remain static but ultimately start to increase.

Peabody Energy, the largest and most storied U.S. coal company, filed for Chapter 11 bankruptcy in 2016

The impact for Eskom is significant as approximately 80% of their energy production is currently from coal-fired stations.

So when will the mass migration to renewables start?

This is the question I posed to James Hilburn, co-founder and managing partner of the South African solar company, Econavitas.

“Using every measure possible, the tipping point has already occurred, and we are seeing double-digit increases in demand from business and retail customers who want to utilise solar. If you are considering a solar installation for your home, you should expect a 3.5 to 4 year payback period, which also covers any financing costs.”

This essentially means that your upfront expenses are covered within four years by the reduction in payments to Eskom.

“For customers that decide they want to go fully of the grid, the payback period is typically eight years, as they have the additional cost of battery storage to consider, but these prices are coming down rapidly. We are incredibly excited about the opportunities Tesla’s Powerwall 2 battery will bring which we expect to start importing later this year.”

Although initially the demand for solar will be limited to companies and higher income earners, these are the two most important customer segments for Eskom as they make up a disproportionate amount of their total income.

There are also additional factors that will increase the level of demand for off-grid solutions exponentially.

For example, financing will become more accessible and cheaper as lenders understand the accretive value of solar to home valuations.

In California, studies have shown that solar installations add approximately $6,000 to values for every KWh added.

As soon as the first South African lenders start to finance installations at prime +2% rather than prime +10% or more, we should expect the floodgates to open.

This will also start to open up bundled installations agreements such as used by Solar City, where consumers can buy their panels with no upfront costs.

When Tesla roof tiles start to arrive in South Africa, more barriers will be removed as they offer ‘infinite tile warranties’.

Social drivers will also increase demand from the corporate sector. Boards and executive teams will only push harder for solar and wind solutions not only because of economics, but they now have to show their commitment to environmental sustainability.

Increased supply with continued reduction in installation costs, improved access to financing and a range of emotive drivers will increase demand exponentially over the next few years.

And then who will Eskom invoice?

Eskom’s troubles are therefore only just starting. Not only do they face the real risk of sharp declines in energy demand and therefore revenue. They also still have to find solutions to manage their existing operations and infrastructure.

Falling demand will not mean they are able to reduce costs in a lock-step fashion.

You cannot simply switch off a power station when demand drops. The majority of their agreements are long-term contracts, whether that relates to investment, maintenance, suppliers or financing and hedging arrangements.

I wonder what will happen when we reach a point where coal demand is reduced so significantly that plants ideally should be closed, but cannot be because of contractual issues?

They are very much stuck between a rock and hard place. Raising prices will simply speed up our move to alternatives. Yet if they don’t raise revenue levels, the latest Moody’s downgrade will not be their last.

So, is their situation helpless?

Maybe, but perhaps they could take a lesson out of Philip Morris International.

Perhaps they could pivot…

The Philip Morris Pivot

Philip Morris International, the owners of the iconic Marlboro brand, found themselves in a similar situation to Eskom a few years back.

They were both seeing and projecting a significant reduction in demand for their product, the cigarette.

This was not due to technological advancement, but because of enormous policy and social shifts around the acceptability of smoking.

Increased taxation, class action suits, legislation to limit advertising and laws banning smoking in social environments all played a part in reducing actual and expected consumer demand for cigarettes.

They had reached a crisis moment where they had no choice but to look at alternative strategies. To not do so would simply mean they ended up in a similar situation to many of their customers.

They would suffer a long and painful death.

So they decided to fundamentally change their purpose.

They are no longer the company that sells cigarettes to generate profits for their shareholders.

They are now the company that is on a mission to

“Design a smoke-free future”

Wow.

We can, of course, be somewhat sceptical of anything that a cigarette company pronounces, especially when you consider that for over 50 years they have denied and suppressed information about the impact of tobacco products on health.

None the less, there is plenty of evidence that they mean business this time around.

For example, since 2008, they have reportedly spent $3bill on developing their first ‘smoke-free product’, the IQOS, with stands for ‘I quit ordinary smoking’.

They also built a stunning research centre in Neuchâtel, Switzerland where with the interaction of over 400 scientists they are developing a portfolio of smoke-free products.

In September 2017, Philip Morris announced personal and structural changes which they said were to help in the transition towards a smokeless future.

Commenting on the announcement, André Calantzopoulos, Chief Executive Officer, said:

“There is no doubt that the greatest contribution PMI can make to society is to replace cigarettes with less harmful alternatives. The changes we are announcing today reflect our desire to best equip, empower and support our organization as we transform within a rapidly evolving environment.”

In January 2018 PMI ran a full page add in the UK where they announced their intention to quit!

This surely goes down as one of the biggest strategic ‘pivots’ for a corporate since, well, since Nokia moved from Wellington Boots to mobile phones. Then again PMI’s move is more impressive as Nokia’s transition took more than 50 years.

So what can Eskom learn from PMI’s radical shift?

Well, how about developing a new purpose that better aligns to where the future is heading, which does not include fossil fuels.

Currently, Eskom’s goal is to

“provide electricity in an efficient and sustainable manner, including its generation, transmission, and distribution and sales.”

If this vision statement is an accurate reflection of Eskom’s purpose, then it is not surprising that they struggle to develop and execute strategies that really support and accelerate the transition from fossil fuels to renewable energies.

Firstly, they are focused on ‘providing’.

This fits the vertical, integrated model whereby they will always want to be the primary source of energy (coal and nuclear power stations) and the primary distributor of energy via the grid network.

They are therefore managing a model similar to diagrams a or b.

New technologies are however making the distributed model (diagram c) more efficient and effective. Consumers are literally creating their own energy at the locations they need it.

Secondly, they are focused on their own sustainability. Unfortunately, the sustainability they are referring to is actually their own, in terms of financial, operational and reputational.

If Eskom wants to be the ‘provider‘ (model a not c) and focus on their own ‘sustainability’, they will never be able to take the bold decisions that are required to accelerate South African’s mass adoption of alternative energy sources.

A New Purpose for Eskom?

PMI took the brave, but necessary decision to change their purpose. Eskom should consider doing something similar.

PMI’s goal is now to

“Develop, market, and sell smoke-free alternatives, and switch our adult smokers to these alternatives, as quickly as possible around the world”

Imagine the different decisions Eskom could take if they adapted PMI’s statement to

“Develop, market, and sell renewable alternatives, and switch our customers from fossil fuels to these alternatives, as quickly as possible across South Africa and beyond.”

PMI has also set a goal to

“propose regulatory policies that encourage the replacement of cigarettes by smoke-free alternatives.”

Think about the different conversations that would be held between Eskom, Parliament, National Treasury and the various select committees, if they attempted to promulgate a target of

“regulatory policies that encourage the eradication of energy created from fossil fuels with renewable alternatives within 20 years”

Finally, imagine what decisions and actions Eskom might take if they set an overarching purpose or moonshot to work towards

“making energy as free and accessible as air is today, for everyone”

For PMI they invested heavily in a research centre in Switzerland to design their first batch of smoke-free products.

Perhaps if Eskom were to reset their purpose, they’d similarly create a separately capitalised unit which only focused on accelerating the move to renewables. The unit would be incentivised to innovate and experiment and actively pursue partnerships with the 1000’s of companies and organisations that already exist globally to remove friction from the South African system to accelerate the transition?

The A team would be asked to focus on safety sinking the current Eskom tanker over the next 30 years, whilst the B team would work with the likes of Tesla to build our own massive solar farms and gigawatt battery parks.

Energy equals prosperity

It is very clear that countries with larger energy consumption levels are more prosperous.

In South Africa, the moonshot should, therefore, be, to ensure that every single individual and every single organisation can access as much as energy as it needs for the cheapest price possible. This is perhaps the most effective way to materially enable improvements in living standards and productivity.

Eskom has huge amounts of collective knowledge and experience which, if pointed more towards the future of energy than the past, could transform Africa.

This is also the ideal moment for Eskom to look at making a PMI level pivot in strategy.

They are in crisis. There is a new country management team in place with Cyril Ramaphosa, Pravin Gordan and Jeff Radebe. And there is an abundance of new technologies opening the door to do things that would have been impossible a few years ago.

So, I leave you with one last question.

Purposeful organisations that look to solve genuine societal problems tend to outperform organisations that don’t. My question for Eskom is whether they are trying to help solve the everyday South Africans energy problem, or simply their own?