Fixing Indebted State-Owned Enterprises

The recent decision of the government to privatize state-owned enterprises (SOEs) which are operating in various industries has caused unease. What worries many is the inclusion of massive enterprises such as Ethiopian Airlines and Ethio-Telecom for partial privatization. One entity that is up for partial sale is Ethiopian Electric Power (EEP). It is the biggest SOE in Ethiopia by asset size. As of 30 June 2015, it had total assets of ETB 201.02 Billion, out of which 98.2pct was invested in tangible fixed assets. 79pct of tangible fixed assets account construction in progress and advance payments to contractors.

Over the past decade, EEP has expanded massively and built up enormous debt, local and foreign, to construct power plants. There is no enterprise in Ethiopia as highly indebted as EEP. The construction of Great Renaissance Dam (GERD) is the main factor for assets expansion and debt build up.

EEP’s indebtedness has implications for whether it is kept as SOE or put up for sale.
Keeping aside the matters pertaining to poor recording keeping and malpractice in the treatment of some transactions, for which EEP earned a disclaimer audit report, the annual report of EEP has many financial facts, which may concern potential investors.

EEP is an extensively leveraged entity as it has taken on massive debts for completed as well as ongoing projects. The financial risks it is exposed to arise from such leveraging. The audited annual report of EEP (7th July 2015), which I believe is the latest audited report available, shows that EEP’s capital and reserves account 14.6pct of its total financing. Long-term financing, including its current maturity portion and accrued interest, accounts for 80.6pct of its funding.

EEP borrowed ETB45.35 billion from foreign lending institutions and development agencies at interest rates of between four percent and nine percent. It also issued corporate bonds of ETB112.3 billion repayable semi-annually at interest rate of six percent to Commercial Bank of Ethiopia (CBE). The amount reached ETB199.1 billion as at 31 December 2017, according to the quarterly report of the NBE. Despite the bonds being agreed to repaid semi-annually, no repayment has been made in the past three years, as per NBE reports, resulting in arrears of tens of billions. There is no hope of making payments soon as ongoing projects will take long to generate cash flows.

EEP banked ETB2.692 billion, showing an increase of 70pct from the preceding year, from sale of electricity and other services. It incurred 76pct and 13.7pct of its turnover for production costs and administration expenses. This means production and administration costs represent more than 90pct of its turnover.

The costs didn’t stop here. As EEP financed its operation and projects by bonds and loans, local and foreign, interest cost and foreign exchange losses inflicted so much pain on EEP.

EEP incurred ETB7.1 billion interest in 2015 (Interest could be more than Birr 10 billion in 2017). ETB1.8 billion went through profit and loss account, plunging EEP into ETB1.19 billion losses. The remaining ETB 5.3 billion was capitalized on ongoing project costs.

Exchange rate loss on foreign borrowing of ETB 873 million was capitalized. EEP was seriously criticised in the audit report for such practices. If the amount went through profit and loss account, according to proper accounting practice, EEP’s losses would have been over two billion birr in 2015. Over several years, EEP added ETB 2.94 billion foreign exchange losses to fixed assets to reduce its annual losses.

Interest on loans and bonds taken for ongoing projects is being added to project costs. By the 30 June 2015, ETB15.12 had been capitalized and by now, the figure could be double.

With current level of corporate bond debt, EEP pays ETB12 billion a year. A small fraction of it goes through the profit and loss account. The rest is added to project costs. What is worrying is that the longer the projects take, the more the interest cost to be capitalized

Massive interest expenses coupled with bloated project costs due to inflation could push the total cost of the projects such as GERD up to twice the original estimate. This will make the cost of production of electricity expensive.

When EEP’s ongoing projects commence operation all interest costs will be treated as expenses. How can EEP cover over ETB 12 billion interest per annum while its recent year’s turnover was ETB 2.69 billion? Without doubt, to remain break-even, revenues equal to expenses, EEP will have to have a turnover of more than ten-fold of the 2015’s sales of electricity when GERD and other projects become operational. How is it realistic?

The economic life of power generation plants, and transition lines is between five and 60 years. Such long-life assets should be funded by financial instrument suitable for purpose. Yet, EEP mainly uses bonds redeemable in seven years, payable semi-annually. The mismatch between asset life and terms of funding causes strain on solvency of an entity. That is why EEP has accumulated enormous arrears due to non-repayment of bonds in recent years.

So far EEP has not been squashed by financial burdens as it has been accumulating arrears and building up more loans by issuing bonds to CBE. As a result, enormous resources of CBE are tied with EEP. There is also no possibility that EEP would pay as it agreed.

Foreign currency-denominated loans pose serious exchange rate risks with serious financial impact. These risks are exacerbated when there is devaluation or depreciation of the Birr. Has EEP developed a strategy to hedge such risks and protect itself against hundreds of millions exchange rate loss?

Private investors, foreign and local are driven by profit motive. An enterprise that is loss making, highly-indebted, has accumulated enormous arrears, has spent much resources on projects, use unsuitable financial instrument for funding, and its future profitability questionablemay not be attractive to investors. Note also that EEP’s poor record keeping, which resulted in disclaimer audit report, may disappoint potential buyers.

If investors come up with offers, they may demand many concessions such price hikes, monopoly position, restructuring etc to make EEP financially attractive. This has implication for consumers.

Whether EEP is partially sold or not, its financial situation should be reviewed. Utility enterprises should use cheap sources of long-term finances with reasonable non-repayment period, a mix of foreign and local debts, utilize appropriate hedging and shorten project periods to reduce capitalized interest costs. When the financial situation of EEP is restructured, it could become an efficient utility provider.

6th Year . June 16 – July 15 2018 . No.63