The Impact of Electricity Price Increases and Eskom s Six-Year Capital Investment Programme on the South African Economy

Transcription

1 The Impact of Electricity Price Increases and Eskom s Six-Year Capital Investment Programme on the South African Economy Note: This report is the final research project commissioned by Eskom entitled: The Impact of Electricity Price Increases and Eskom s Six-Year Capital Investment Programme on the South African Economy. No section of it should be reproduced without prior permission from Eskom. i

2 Table of Contents Preface Detailed Executive Summary Chapter Macroeconomic Impact of Electricity Price Increases Executive Summary Introduction Simulations Design and Eskom s Recommended Financing Strategy Time-Series Macro-Econometric (TSME) Approach to Analysing the Impact of Electricity Hikes Computable General Equilibrium (CGE) Approach to Analysing the Impact of Electricity Hikes Conclusion Chapter Evaluation of the Impact of Price Increases on the Cost Structure of the Various Sectors and Industries Executive Summary Introduction Role of Electricity in CPI Dynamics Secondary Impact: Role of Municipalities Energy Intensity of Sectors Empirical Survey of Impact of Electricity Price Increases Conclusion Chapter Macroeconomic Impact of Eskom s Six-Year Capital Investment Programme Executive Summary Introduction Time-Series Macro-Econometric (TSME) Approach to Analysing the Impact of Capital Expenditure Computable General Equilibrium (CGE) Approach to Analysing the Impact of Capital Expenditure Conclusion Chapter Net Impact of the Increase in Electricity Prices and Eskom s Six-Year Capital Investment Programme Executive Summary Introduction Time-Series Macro-Econometric (TSME) Approach to Analyse the Net Impact of Electricity Price Hikes and Eskom s Capital Expenditure Computable General Equilibrium (CGE) Approach to Analyse the Net Impact of Electricity Price Increases and Increased Capital Expenditure Conclusion Chapter Impact of the Increase in Electricity Prices and Eskom s Six-Year Capital Investment programme on Poor Households Executive Summary Introduction Impact on the Poor through Household Consumption Impact on the Poor through Job Creation ii

3 5.4. Mitigating Measures of the Negative Impact of Electricity Price Increases on the Poor Conclusion References Appendix A: Time Series Macro-Econometric (TSME) Model Description A1. Model Specification and Closure A2. Methodology and Data A3. Simulation Results A4: Definition of Price Scenarios A5: Long-run Inflation Trend A6: NERSA Price Scenarios and the Indicative Baseline Price Path Results Appendix B: Computable General Equilibrium (CGE) Model Description B1: The UPGEM Model B2: Closure Rules B3: Equivalent Variation Calculation B4: Limitations of the Model B5: Simulation design Appendix C: Industry description as Used in the University of Pretoria s Computable General Equilibrium (CGE) Model Appendix D1: Computable General Equilibrium (CGE) Detailed results (Chapter 1) Appendix D2: Computable General Equilibrium (CGE) Detailed results (Chapter 3) Appendix D3: Computable General Equilibrium (CGE) Detailed results (Chapter 4) iii

4 Preface In December 21, Eskom commissioned Pan-African Research and Investment Services (Pty) Ltd to investigate the impact of electricity price hikes as well as Eskom s Capital Expenditure Programme on the SA economy. The present report presents the preliminary outcome of this multi-faceted research. Generally speaking, electricity price hikes have, by and large, a negative impact on the economy whereas Eskom s multi-year investment programme leads to positive outcomes in both the short and long term. The report is made up of four chapters. Chapter One summarizes the econometric analyses of electricity price hikes and their impact on the SA economy, with specific focus on key macroeconomic indicators such as GDP growth, employment and investment. Chapter Two focuses on electricity prices and sectoral/industry cost structures. A high level survey of firms in different sectors is used to assess the first-round impact of price increases on the firm s cost structure. This survey is still in progress, and as the number of respondents rises, the results will be updated in the next draft of this report. Chapter Three captures the impact of Eskom s capital expenditure programme and its impact on the SA economy and key macroeconomic indicators. Chapter Four integrates the previous three chapters, focusing on the net effects of price increases (largely negative) and investment impact (by and large positive); this chapter also examines issues related to the financing options for Eskom s capital investment programme. Chapter Five analyse the impact of the electricity price increases and Eskom s capital expenditure on the poor. It also provides the mitigating measures put in place by NERSA and a critical review of these is presented

5 Detailed Executive Summary The Importance of the Energy Sector The energy sector of the economy remains an integral part of infrastructural development which, in effect, will set the foundation for broad based sustainable long term economic growth and development. It is apparent that the current and future growth of an economy is tied to sufficient and reliable energy availability and the equitable access to it. Figure 1 shows the positive relationship that existed between GDP and energy production in South Africa over the years. Given the bi-directional causal effects that exists between the two variables (i.e. GDP determines the level of energy produced and vice-versa) it could be argued that the prosperity of the country is very dependent on efficient and sustainable supply and distribution of energy. Technically, availability of energy is a precondition for growth. Figure 1: Relationship between GDP and Energy Statistically, about 9 percent of the variation in the South African GDP can be explained by energy while on the other hand the same percentage variation in energy production is explained by GDP. However, any shock to the energy sector is expected to directly affect the entire economic growth of the country. The most recent energy crisis of Q1-28 is a case in point. As illustrated in the above chart, the direct contribution of the energy sector to the GDP is relatively small at 2%. However, the sector plays a significant indirect role. This sector serves as a critical input for all the other sectors of the economy

6 The structure of the South African economy reflects a very high energy intensity use in the production process. The mining & quarrying sector - which had been the bedrock of the economy over the past century - is one of the most energy intensive sectors in which electricity constitutes about 5 percent of the total intermediate inputs. Within the mining sector, some commodities are more energy intensive than others. In general, gold mining in South Africa is largely deep underground mining, thus requiring electricity intensive technology. Other sectors such as transport & communication, wholesale & retail trade, manufacturing and agriculture also recorded relatively high levels of energy use as inputs in their production processes. Manufacturing in particular is energy intensive, and some industries, such as aluminium smelting and related industries, are exceptionally electricity intensive. Not only does GDP growth require adequate and reliable electricity, but to address the developmental needs of the country sustainable energy provision is a must. For example, developmental backlogs such as housing, urban amenities, and social services increase the country s demand for electricity. In effect, the growing level of urbanisation increases the demand for sustainable electricity. Over the past two decades, South Africa s urban dwellers have risen to 65% of the total population. The need for adequate, reliable and accessible electricity has risen accordingly. Importantly, the Government s New Growth Path aims at expanding some strategically important sectors within the economy. Significantly, all these sectors are highly energy intensive. The chart below illustrates the key sectors targeted by NGP and Government s Industrial Policy Action Plan (IPAP 2)

7 Going forward, assuming that NGP and IPAP2 succeed, the SA economy s energy intensity is likely to rise and hence the adequate availability of electricity in the country will be even more critical for socio-economic success. From a political economy perspective, the most pressing need in the country is the creation of jobs - decent jobs. Job creation without growth and development is impossible, likewise is the growth and development without adequate energy unsustainable. As such, addressing the question of adequate energy is a pre-condition for both the growth and developmental goal of the country. Cost of supplying a sustainable energy It is stating the obvious that to provide a sustainable supply of energy more capital investment is needed. Over the years the South African economy has been sustaining itself with the stock of energy infrastructure built before Thereafter not much investment in the building of more capacity that would cater for the growing demand, arising from higher economic growth and/or developmental needs of a modern economy, was done. The failure to invest adequately has created a real constraint to the growth prospect of the country. However, the need to increase energy capacity in the country has become evident to all stakeholders within the society. In response, Eskom has drawn up a six-year capital investment programme that will increase energy capacity in the country to levels in line with the expected rise in national electricity demand (Table 1). Table 1: Eskom Capital Expenditure Programme Capital Expenditure (excl IDC excl Cost of Cover) FY1/11 FY11/12 FY12/13 FY13/14 FY14/15 FY15/16 FY16/17 R'm Generation 63,249 69,563 53,585 34,955 49,119 77,28 89,827 Transmission 14,533 11,327 16,112 16,667 22,99 23,592 24,392 Distribution 8,654 1,75 12,784 14,893 17,129 2,129 22,187 Corporate (incl ED) Research and Development 851 2,76 3,628 2, ,63 2,332 TOTAL 87,967 94,673 86,533 69,17 89, , ,19 Cumulative 87, , , , ,52 554, ,392 In the process of achieving a sustainable supply and distribution of energy in South Africa, Eskom will need to finance its capital requirements, generate more revenue in order to be able to finance its required capital expenditure. The options available in financing the required capex include: 1. User charges - increases in electricity prices 2. Government capitalisation of Eskom 3. Private sector investment 4. A mix of all of the above. Each of these options has its respective pros and cons

8 Increasing User Charges Financing Eskom s capex requires considerable increases in electricity charges. Sudden and substantial increases, however, lead to disruptions for many business firms that had not anticipated such sharp increases. Furthermore, business operations that are operating at the margins of profitability cannot absorb substantial cost increases, be it electricity or other costs. A good case in point is our marginal gold mining industries, or some of the manufacturing firms that are hard-hit by a mix of currency appreciation and unfavourable global economic conditions. For such firms, it is not the increase per se that matters, rather it is the quantum of increases in the short term that leaves them with little or no degrees of freedom to absorb the production cost increases. In such cases, business firms have no option but to scale down operations, lay off workers and in some extreme cases even close down. Increasing user charges however has distinct benefits too. Key amongst them is the following: a. It creates a platform for sustainable and reliable electricity generation in the country. b. It helps set electricity prices at cost-reflective levels. In the long term, this is a pre-condition for an efficient allocation of resources within the economy. The country s dynamic global competitiveness requires that we ensure all resources used are as cost-reflective as possible. c. Economic stability over the long term necessitates sustainable use of all resources - electricity included. d. Cost-reflectivity will also open up opportunities for alternative energy options. This in turn will diversify sources of energy in the country, and lead to further stability arising for diversification. In the following sections of this report we analyse the implications of user charges for the economy and for the various economic sectors, both in the short term and in the long term. Government Capitalisation of Eskom This option has its own systemic implications. At face value, if government capitalises Eskom, it reduces the need for raising user charges. So in the short term, the economy operates along its business as usual. However, there are implications for this scenario over the medium to long term. Most importantly, the following issues arise: I. Government capitalisation of Eskom entails either tax increases or a rise in government debt. Both these developments have a medium to long term distortion impact on the stability of the economy. Whilst the arguments here are complex and interrelated, large scale capitalisation of Eskom will constrain the government s ability in financing key requirements in socioeconomic infrastructure

9 II. III. This approach also delays energy charges becoming cost-reflective, and as such it is not favourable for the long term efficient utilisation of the country s resources. Nor is it helpful in promoting the economy s dynamic global competitiveness. Government s adequate capitalisation of Eskom, if it leads to the subsidization of electricity charges, will also entail social welfare implications. It is likely that it will exacerbate the already highly skew distribution of income in the country. Private Sector Investment Whilst this option is clearly part of the medium to long term solution, it is constrained by the following factors: I. There is no guarantee that private sector investment would entail lower increases in user charges. In fact, the contrary might be true, at least in the short term. II. III. It is safe to argue that in the short term the regulatory framework for private sector participation is not in place. As such, this option remains a viable one over the medium to long term. In general, private sector investment should be encouraged with a view to diversify the sources of national energy supply. In the process, care should be taken that cost-reflectivity is not compromised and market contestability is encouraged. A Mix of All Options In reality, Eskom s capex is partly financed via National Treasury s capitalisation and partly with the help of user charge increases. Whilst politically this might be inevitable, it is important that the key elements of long term sustainability are not undermined in the process. The impact of electricity price hikes and Eskom s capital expenditure Given the above background analysis on the importance of the energy sector to the economy and the cost of supplying a sustainable energy to the country, a quantitative impact analysis of the effects of electricity price hikes and Eskom s capital expenditure programme on the economy was carried out. Two basic approaches are used in the analysis, namely: I. A Time-Series Macro-Econometric (TSME) model and; II. A Computable General Equilibrium (CGE) model 1. 1 Detailed analysis of the model specifications and various price scenarios adopted are presented in the integrated reports. Only the results from NERSA price scenarios (TSME model) are presented in this detailed summary. The results from the CGE model are also presented in the integrated report. The CGE results are in tandem with TSME results

10 An econometric analysis of the impact of electricity price hikes The necessity to introduce a series of electricity price hikes over the next few years will have multifaceted negative impacts on the entire macroeconomic system. The economic impact analysis of electricity price hikes illustrates (see Chapter 1 of the integrated report) the adverse impact on major macro variables (i.e. GDP, employment and investment) in the economy. The simulation results from the TSME model revealed the macro implications of the current wave of electricity price increases. Under the NERSA price scenario, the 25% p.a. increase in electricity prices over a five-year period and 6% p.a. over a further five-year period will have a direct impact on inflation leading to an increase of about 2.82% over the long-run ( see Table 2). Given the role played by inflation - linkage between the various segments of the economy - this will lead to declines of about 1.8%,.22% and 1.53% in output (GDP), employment and investment respectively. During the short-run, the impact will be mostly affecting household consumption and exports, mainly due to the direct effect of inflation. Short-run implications of the price hikes in a dynamic model is found not to be very robust due to the slow adjustment processes that are embedded in the economy whereas, in the static system (CGE) robust short-run implications are captured (See integrated report). Under the various NERSA price scenarios, the impacts become less severe on the macro variables as prices are spread out over a longer period of time (Table 2). In general, the more time the economy has, the better it can adjust. Hence, much of the adverse impact occurs in the short term where business firms have little, if any, scope for process re-engineering and general technological adjustments. At the sectoral level, the sectors that will shed most jobs in the long-run due to (NERSA: 25% 5yr & 6% 5yr) the hike in electricity prices are; the mining sector (-2.78%), transport & communication sector (-1.21%) and wholesale & retail trade sector (-.9%). The impact on GDP has a similar trend. These sectors are also the three sectors with the highest energy intensity. The electricity, gas & water sector on the other hand will boost jobs within the sector in the long-run by about 13.85%. This is due to the positive impact that electricity prices will have on the sector s capital investment, growth and job creation. However, the employment impact during the short-run across sectors will be positive except for manufacturing, mining and agriculture (detailed results are presented in the integrated report)

11 Table 2: Economy-wide Impact of Electricity Price Hikes - NERSA Scenarios Long-run Employment Output Investment Household Consumption Real Wages Exports Imports Exchange Rate (R/$) Consumer Inflation 25% 5yr & 6% 5yr -.22% -1.77% -1.53% -2.81% -1.19% -.16% -3.97% 4.99% 2.82% (-18,635) (-R31.5billion) (-R5.9billion) (-R31.5billion) (-R9.5billion) (-R.65billion) (-R18.8billion) (7.7) (4.52%) 25% 3yr & 11% 7yr -.18% -1.43% -1.46% -2.22% -.97% -.11% -3.8% 3.92% 2.2% (-15,247) (-R25.5billion) (-R5.6billion) (-R24.9billion) (-R7.8billion) (-R.44billion) (-R14.6billion) (7.59) (4.5%) 25% 3yr & 6% 7yr -.15% -1.26% -1.21% -1.99% -.86% -.11% -2.82% 3.65% 2.11% (-12,76) (-R22.5billion) (-R4.7billion) (-R22.4billion) (-R6.9billion) (-R.44billion) (-R13.3billion) (7.57) (4.49%) Short-run 25% 5yr & 6% 5yr -.7% -.12% 9.62% -.37% -.14% -.35% -1.72% 6.3% 5.4% (-5,929) (-R2.1billion) (R37.1billion) (-R4.2billion) (-R1.1billion) (-R1.4billion) (-R8.1billion) (7.74) (4.62%) 25% 3yr & 11% 7yr -.6% -.11% 6.98% -.33% -.5% -.32% -1.55% 5.21% 4.37% (-5,82) (-R1.96billion) (R26.95billion) (-R3.7billion) (-R.4billion) (-R1.3billion) (-R7.3billion) (7.68) (4.59%) 25% 3yr & 6% 7yr -.6% -.11% 6.8% -.33% -.5% -.33% -1.54% 5.18% 4.34% (-5,82) (-R1.96billion) (R26.26billion) (-R3.7billion) (-R.4billion) (-R1.3billion) (-R7.3billion) (7.68) (4.59%) The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Long & short-run actual (in parenthesis) impacts are calculated based on current values

12 Econometric analysis of the impact of Eskom s capital expenditure Eskom s planned six-year capital investment programme is targeted to boost generation, transmission and distribution of electricity in the economy. Meanwhile, this will have a direct and indirect positive impact on the growth and development of the country. The economic impact analysis of Eskom's capital expansion provided in this report reveals a positive impact on major macro variables (i.e. GDP, employment and investment) in the economy. Under a dynamic system (model), the 18% increase in capital investment in the electricity sector over a six-year period will have an indirect impact on inflation leading to a decline of about.1% over the long-run. This will lead to increases of about.7%,.1% and.6% in output (GDP), employment and investment, respectively (Table 3). Table 3: Economy-Wide Impacts of an Increase in Eskom s Capital Expenditure Long-run Short-run Employment.1% (847).2% (169) Output.7% (R1.3billion).1% (R.2billion) Investment.6% (R.23billion) 1.8% (R6.95billion) Household Consumption.9% (R1billion).4% (R.4billion) Real Wages.5% (R.4billion).4% (R.32billion) Exports %.7% (R.3billion) Imports.7% (R.33billion).1% (R.5billion) Exchange Rate (R/$) -.18% (7.28) -.12% (7.29) Consumer Inflation -.1% (4.39) -.11% (4.39) The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Long & short-run actual (in parenthesis) impacts are calculated based on current values. On the other hand, similar but more robust impacts are revealed under a static system (CGE). An 18% increase in capital expenditure will, over the long-run, lead to about.75% and.79% decline in GDP and skilled employment, respectively (See integrated report). The bigger impacts in the CGE model are linked to its static nature. Measured over time the share of investment in the electricity sector relative to total investment in the economy is fairly small. The positive impacts of the shock are insignificant, due to the relatively small share of electricity investment in total investment in the economy. The price block which serves as a linkage between the different segments of the economy is not directly linked to investment in electricity. However, a weak transmission mechanism of the shock on the macro and sectoral economy is detected in both the short-run and long-run

13 At the sectoral level, the electricity sector will boost employment by about 1.5% in the long-run. Impacts on other sectors in terms of job creation will remain negligible. The same trend also applies to the GDP impact but with a higher magnitude (See integrated report). Net impact of electricity price increases and Eskom s capital expenditure The electricity price impact analysis reflects negative implications on the macro and sectoral economy, whereas, positive implications on the economy will occur when Eskom s six-year capital investment comes to the fore. However, the magnitude of the price impacts on major variables is found to be higher than those of the capex impacts. In this regard, the net impact of an increase in electricity prices and Eskom s capital expenditure will continues to be negative on major macro variables (i.e. GDP, employment and investment) in the economy. This can be attributed to the direct effects that electricity prices have on inflation. The simulation results from the TSME model revealed the net implications of the wave of electricity price increases over the next few years and the six-year Eskom capital expenditure programme (18% annual average) on the macro economy. In the long-run, household consumption, GDP, and investment will continue to be mostly adversely affected by the price hikes. During the short-run, the impact continues to be mostly affected in household consumption and exports, mainly due to the direct effect of the inflation. At the sectoral level, the sectors that will shed most jobs in the long-run are; the mining sector, transport & communication sector and wholesale & retail trade sector. The same trend also goes with the impact on GDP. The electricity, gas & water sector on the other hand will continue to boost jobs within the sector in the long-run (See integrated report). Beyond the direct impacts of price increases and capex spend; the secondary impact of creating sustainable energy supply depends entirely on the multiplier effects arising from the establishment of new industries and the general rise in investment trends. As mentioned before, no modern economy can sustain growth and development without an adequate and sustainable energy supply. At the same time, the sufficient conditions for rising investment, growth and development go far beyond the availability of energy. The broader socio-political and regulatory environment has to be favourable for rising investment in various sectors. Therefore, the desired positive effects of investment in the energy sector are contingent on many other factors. The social outcry against rising electricity charges is in part also due to the intergenerational aspects. To put it plainly, the current generation is forced to pay hefty price hikes, whilst future generations could benefit. In general, democratic societies find it hard to deal with such intergenerational issues

14 Impact on poor citizens Given the importance of energy in the economy, it is expected that any positive or negative shock in this sector will have direct implications for the well-being of the people. However, an inadequate supply or access to energy will undoubtedly continue to trap the marginalised people in poverty as opportunities to create wealth in the economy will be limited. On the other hand, increasing user charges on electricity in order to be able to supply sustainable electricity may be harmful to individuals, households and firms in the economy, particularly those in low income groups. Based on the econometric results of the static (CGE) model, increasing electricity prices by 25% will impact negatively on household consumption with the poorest households most severely hit. The classification of households is taken from the StatsSA classification (StatsSA 24). In the short-run, consumption by the poorest households will decline by about 1.2% while the richest households will reduce their consumption by about.6%. In the long-run, consumption by the poorest and richest households will fall further to about 2% and 2.6% respectively. The progressivity of the long-run impact is mainly due to the assumption of fixed skilled real wages (Table 4). Table 4: Impact of Increases in Electricity Prices and Capex Long-run Poorest household Richest household 25% electricity price increase -2% -2.6% 18% capex increase 1.2% 1.2% Short-run 25% electricity price increase -1.2% -.6% 18% capex increase 1%.2% Simulations from CGE model With regard to Eskom s capital expenditure programme, the impact of an 18% capex increase will impact positively on household consumption. Poor households will increase their consumption by about 1% in the short-run while the rich households consumption will marginally increase by about.2%. In the long-run, the poor and rich households consumption will increase by about 1.2% each (Table 4). Therefore, the net impact of increases in electricity prices and capex will remain negative, for both the poor and rich households. Furthermore, the impact of the increase in electricity prices and capex on the poor can be investigated through the number of jobs created/lost in the process. It is expected that the majority of poor citizens belongs to the semi and unskilled labour force while the majority of the rich are skilled. It is estimated that about 55% of total employment in the country are semi and unskilled and the remaining 45% are skilled. Therefore, 55% of the total jobs lost or created, as presented in Tables 2 & 3 above, comes from the poor population. For instance, about 1,25 jobs out of the 18,635 total job losses (as a result of the 25% 5-year and 6% 5-year price increases) comes from the poor population while about 466 jobs out of the 847 jobs created (as a result of the 6-year 18 % annual

15 capex increase) goes to the poor population. In this regard, the overall net impact will be most severely felt by the poor. To mitigate this negative impact, NERSA has put in place measures that will soften the burden on the poor. The Inclining Block Tariff (IBT) was promulgated by NERSA as part of the MYPD2 decision. The IBT is a tariff where higher consumption comes at a higher price (NERSA, 21). This is to ensure that low income (poor) customer enjoy a tariff subsidisation, easy tariff communication as well as retaining Eskom revenue neutrality. Summary of the IBT rates is presented in Table 5. Table 5: NERSA Approved Inclining Block Tariff (IBT) for Residential Customers Source: NERSA 21 Eskom's implementation of the IBT was two-fold: For account customers, the above IBT was implemented. For pre-paid customers, the weighted average increases - the percent variance between the home light 29/1 average prices compared to the IBT average prices - was implemented. The IBT system is seen as an immediate and additional price relief to customers consuming less than 35 kwh per month. This group of people or households are considered by NERSA to be poor. However, this assumption is subject to criticism

16 Chapter 1 Macroeconomic Impact of Electricity Price Increases Executive Summary The decision of Eskom to embark on a series of electricity price hikes over the next few years will have multifaceted negative impacts on the entire macroeconomic system. However, the economic impact analysis of electricity price hikes provided in this chapter reveals a huge impact on major macro variables (i.e. GDP, employment and investment) in the economy. Under a dynamic system (model), the 24.8% increase in electricity prices over a three-year period will have a direct impact on inflation, leading to an increase of about 2% over the long-run. Given the role played by inflation - linkage between the various segments of the economy - this will lead to about 1.1%,.12% and.9% decline in output (GDP), employment and investment, respectively. On the other hand a similar impact is revealed under a static system. A 24.8% increase in electricity prices will over the long-run period lead to about 1% and 1.3% decline in GDP and skilled employment, respectively. Short-run implications of the price hikes in a dynamic model are found not to be very robust due to the slow adjustment processes that are embedded in the economy whereas, in the static system, robust short-run implications are captured

17 1.1. Introduction The energy sector of the economy remains an integral part of infrastructural development which, in effect, will set the foundation for broad based sustainable long term economic growth and development. However, in the process of achieving an efficient supply and distribution of energy in South Africa, the state-owned utility company, Eskom, will need to generate more revenue in order to be able to finance its required capital expenditure. This implies that the very low price of electricity enjoyed by South African citizens over the years will have to take a new upward trend, which is expected to have multifaceted effects on the economy. In this milieu, this chapter seeks to explore the impact of Eskom s three years electricity price hike on the macro and sectoral economy both in the short- and long-run. Two basic approaches are used in the analysis that follows in, namely: III. IV. A Time-Series Macro-Econometric (TSME) model and; A Computable General Equilibrium (CGE) model. The TSME model quantifies the impacts of the electricity price hike on the economy under a dynamic framework while the CGE model seeks to examine this in a static framework. The static framework (CGE) in this instance may not be able to capture the structural changes that occurred over the years in the economy. On the other hand, the dynamic framework (TSME) may also not be able to capture the impact on the sub-industries component of the economy. In addition, the CGE model takes into consideration the micro implications of any shocks in the system while this is not so explicit in the TSME. However, these two approaches are expected to complement each other. It is important to note that the econometric analysis presented in this study represent a comparative static analysis. This means that the models only take into consideration one particular shock (electricity prices) to the system while every other thing remains the same. Therefore, the magnitude and direction of the response variables could have been cushioned by other shocks - monetary and fiscal shocks - in the system. The rest of the chapter is structured as follows; Section Two describes the model s simulations design and Eskom s recommended financing strategy. Section Three analyses the impact of the electricity price hike using a time-series macro-econometric model while Section Four s analysis follows the CGE approach. Section Five provides an overall conclusion of the chapter

18 1.2. Simulations Design and Eskom s Recommended Financing Strategy Five short-run and long-run simulations are tested from the TSME model while four short-run and long-run simulations are tested from the CGE model. Given Eskom s policy decision to increase electricity prices by about 25% on average over the next three years, the total price increase will be about 75%. Therefore, in both the short-run and the long-run TSME model, electricity prices are exogenously increased by 24.8% over a three year period (Scenario 1), 15% over a five year period (Scenario 2), 1% over a seven year period (Scenario 3), 8% over a ten year period (Scenario 4) and a combined effect of 24.8% over a two year period and six% over a four year period (Scenario 5). The first four of these scenarios are also applied to the CGE model but due to the static nature of the model, only a once-off effect can be detected. Each of these scenarios will add up to 75% and are expected to have different implications on some major macro and sectoral variables in the economy which can eventually lead to change in Eskom s policy on electricity price fixing. Scenario 5 is extended in order to assess the impact of the price increases if Eskom decided to increase prices in line with inflation (6%) after two consecutive years of about 25%. In addition to this, the model also simulates the NERSA price scenarios and the indicative baseline scenario. See Appendix A4 and A6 for a definition of the various price scenarios and the results of the NERSA price scenarios respectively. The baseline scenario (similar to Scenario 3) indicates the optimal electricity price path for the economy. Over the past four decades (197-28), growth in electricity price is averaged at 1%. The current backlog started in 1994, with growth in electricity prices averaging about 4.5% between 1994 and 28. Therefore, increasing electricity prices at its baseline trend (1% over a longer period) would be a better price path that will not have any negative impact on the economy. Given Eskom s R693.4 billion six-year capital expenditure programme, the financing strategy that will complement the above price scenarios will depend on the interest rate paid on the type of bond issued to the market. Therefore, the Future Value (FV) of R693.4 billion borrowed from the market can be expressed as: FV = PV ( 1+ r) Where PV is the present value (R693.4 billion) of the total capex, r is the prevailing interest rate on the bond issued and n is the number of years that the bonds are issued for. Based on this, the prevailing interest rates on the government bond that will be applied to each price scenario above are presented in Table 1.1 below: n

19 Table 1.1: Future Value of Capex Based on Applicable Bond Rates Price Scenarios Government Bond Rates (%) Future Value (FV) of Capex as at October 21 (Amount to be borrowed: R billion) Scenario (-3 years) R832.1 Scenario (3-5 years) R977.7 Scenario (5-1 years) R1,13.2 Scenario (1 years over) R1,54.7 Scenario (5-1 years) R1,53.97 Source: South African Reserve Bank and PAIRS Calculation From the above table, if Eskom adopted price scenario 1 - where electricity prices will have to be increased by 24.8 % over a three-year period - a 6.12% interest rate will be charged on the bond issued and the total amount to be paid back will amount to R832.1 billion. However, Eskom s electricity pricing strategy should depend much more on the scenario that will have the least severe impact on the economy. The next two sections analyse the impact of these price scenarios on the macro and sectoral economies. An analysis of the capex impact is presented in Chapter Time-Series Macro-Econometric (TSME) Approach to Analysing the Impact of Electricity Hikes This approach looks at the short and long-run impact of electricity price hikes on the economy in a dynamic system. It takes into consideration the dynamic adjustment processes and provides a contemporaneous feedback of any shock to the entire system. The time-series macro-econometric model captures the four major aspects of the economy, which are: the real segment, the external segment, the monetary segment and the public segment. The price blocks, however, serves as a linkage between the various segments both at the macro and sectoral production level. However, a disaggregated sectoral model was adopted whereby the macro impacts were captured through an aggregation of the various sectors of the economy. A more detailed explanation of the model specification & closures, data & methodology can be seen in Appendices A1 & A2, respectively. The producer and consumer prices represent the price blocks, which links the various segments of the economy together. The long-run producer price equation is explained by the level of nominal wages, oil prices, capacity utilization, user cost of capital and electricity prices while the consumer price equation is primarily driven by the level of producer prices, nominal exchange rate and excess

20 demand. Therefore, any change in electricity prices will have a direct impact on production prices and eventually on consumer prices. Due to the difficulty encountered in data disaggregation, it is assumed that both households and firms face the same final prices. Therefore, the impact of a change in electricity prices will be reflected on consumer prices, which will feed through the system and eventually have different effects on major variables at both the macro and sectoral level. All the results are reported as percentage changes (elasticity) from the baseline scenario. In other words, the results are not forecasts of various economic variables, but rather deviations from its short and long-run path due to increases in the price of electricity. For instance, if the short-run impact of a 24.8% increase in the price of electricity on inflation is 4.3% and if inflation was expected to grow at 4.5% before the shock, it would now be expected to grow at 4.7%. The elasticities are computed by comparing every response variable s baseline simulation path with its shocked simulation path. Elasticity is defined as the percentage change in the response variable relative to the percentage of the shock applied. The dynamic elasticities are determined along the simulation path, whereas elasticities at convergence are the long-run elasticity (Klein, 1982: 135). Given the small sample size it is difficult to ensure convergence within the sample. To facilitate the detection of convergence, Hodrick-Prescott (HP) filters were applied and the smoothed dynamic elasticities were graphed. However, the first value of the HP filter represents the short-run impact and the last value represents the long-run impact. The time paths of elasticities of the major response variables for a particular shock are presented in Appendix A3. Economy-Wide Econometric Sensitivity Analysis In this section, the short-run and long-run impact of an increase in electricity prices on some major macro variables in the economy is analysed. The estimated long-run economy-wide production function shows that the economy is well automated as the share of capital in the production process is about 74% while labour takes 26%. Therefore, given the structure of the model presented in this study, the trend at which the impact of an increase in electricity prices will take on some major variables will depend much more on the share of capital and labour in the production process. Table 1.2 presents the short- and long-run impact of an increase in electricity based on the four scenarios explained above. Due to the slow adjustment processes embedded in the economy as a result of the huge structural constraints, the short-run implications of electricity price hikes are not as severe as the long-run implications. The magnitude and direction of the short-run responses also differs among some major variables considered. Therefore, short-run implications in some instances may not provide the real impacts on some macro variables in the system. Despite this slow adjustment towards the long-run, an increase in the price of electricity by 24.8% (Scenario 1) will negatively impacted on consumer inflation during the short-run. Consumer prices

21 will, however, deviate from its short-run path by about 4.3%. Due to this, the exchange rate will depreciate by about 5.1% as inflation differentials widen. The net effect of a higher inflation and exchange rate depreciation will lead to a fall in exports by about.33%. Whilst imports is expected to rise due to about.1% increase in output (GDP) and the higher inflation, the short-run exchange rate effect seems to outweigh them. Therefore, the short-run imports will fall by about 1.5%. Given this increase in electricity prices, the user cost of capital to firms will implicitly rise through the exchange rate depreciation, which tends to capture the foreign component of firms cost structure. Despite this transmission, the short-run domestic investment will remain buoyant at 6.4%. The rise in output by about.1% is attributed to the slow adjustment processes embedded in the system. The feedback on output in the short-run, when prices increase, may be very slow resulting into a positive response. Household consumption expenditure will fall moderately by.3% and real wages will increase by.4% due to the cushioning effect from output. In the long-run, as the economy adjusts fully to the shock in electricity prices, the real effect begins to materialize. The impact on inflation will moderate to about 2% deviation from its long-run path when electricity prices are increased by 24.8% over a three year period. Domestic investment and employment will fall by about.9 and.12%, respectively and the combined effect will result into output falling by about 1.1% from its long-run path. The continued depreciation of the exchange rate in the long-run by about 3.3% will have a negative impact on domestic investment but a very mild impact on exports. The latter impact (exports) might have been cushioned by the moderate inflation differentials but the output effect on imports will come to the fore in the long-run with a 2.5 % decline. Household consumption expenditure and real wages will continue to fall in the long-run by about 1.7% and.7%, respectively due to falling output and real interest rate

22 Table 1.2: Economy-Wide Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Household Consumption Real Wages Exports Imports Exchange Rate (R/$) Consumer Inflation Scenario % -1.1% -.9% -1.7% -.7% -.1% -2.5% 3.3% 2% Scenario 2 -.1% -.8% -1.3% -1.15% -.5% -.5% -1.5% 2.2% 1.25% Scenario 3.4%.25%.35%.37%.17%.1%.41% -.35% -.11% Scenario 4.26% 1.8% 2.7% 2.5% 1.3%.2% 2.7% -2.5% -.75% Scenario % -.9% -1% -1.4% -.6% -.8% -2% 2.7% 1.6% Short-run Scenario 1 -.6%.11% 6.4% -.32%.4% -.33% -1.5% 5.1% 4.3% Scenario 2 -.4%.6% 1.7% -.17% -.1% -.2% -.8% 2.7% 2.3% Scenario 3 -.1% -.3% -.34% -.6% -.3% -.1% -.3%.9%.7% Scenario 4 -.1% -.5% -1.5% -.5% -.6% -.9% -.2%.5% -.41% Scenario 5 -.5% -.8% 4.2% -.26%.3% -.28% -1.24% 4.2% 3.5% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 19

23 As different price scenarios (i.e. 15, 1 & 8 percent) are applied to the system, the long-run impacts become less and less severe (Table 1.2). At the 1% increase in electricity prices per year over a seven year period, the long-run response on the macro variables will begin to take a positive direction. For instance, consumer inflation will fall by about.1% from its longrun path; likewise will the exchange rate appreciate by about.4% when price increases are spread over 7 years at 1%. This implies that if Eskom has taken a different route in its pricing policy by spreading out the increase in electricity prices over a longer period the effect on the economy would have been less severe or even positive. This trend does not apply to some macro variables in the short-run except for inflation, exchange rate, imports and exports, which all respond directly to changes in prices. Given the slow adjustment process featured in the short-run other variables in the system react quicker and more severely to a shock that is spread out over a longer period. For instance, output will increase by about.1% with a 24.8% increase in electricity prices over a three year period while over a longer period of 1 years with an 8% increase output will fall by about.5% (See Appendix A6 for NERSA and baseline scenarios results). Sectoral Econometric Sensitivity Analysis As mentioned earlier, the sectoral models developed in this study assume that both households and firms face the same final prices and a disaggregated sectoral model was adopted. Therefore, the response of major sectoral variables to any shock in the system will depend on the relative share of inputs (labour & capital) used in the production process. These inputs, however, have captured implicitly the energy intensity in production. In this milieu, eight sectors of the economy where data was available are considered and the following sectoral impacts of an increase in electricity prices are presented. (See Appendix A6 for NERSA and baseline scenarios results) Manufacturing Sector Impacts The manufacturing sector remains one of the major sectors of the South African economy with about 18% contribution to total value added. The estimated long-run production function for manufacturing revealed the share of capital and labour in the production process to be 8% and 2 percent respectively. Table 1.3 presents both the short and long-run impacts of an increase in electricity prices on major variables within the manufacturing sector. Given the short-run inflationary impact of about 4.3% associated with the 24.8% rise in electricity prices over a three year period, investment in manufacturing will decline by about 2.1% as cost of capital tends to rise. Based on this, output and employment in the sector will fall by.5% and.25% respectively. As unemployment increases within the sector, coupled with a fall in productivity, real wages will decline by about.26%. Exports of manufactured goods during the short-run period will decline by about.6% while imports will follow the same trend of about 1.8%. The decline in exports despite the depreciation of the exchange rate (rand) revealed more severe effects of - 2 -

24 inflation which leads to a negative net impact. Imports are expected to rise due to higher inflation and exchange rate depreciation, but this is outweighed by the negative effect on output. Table 1.3: Manufacturing Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports Scenario 1 -.2% -1.9% -2.5% -1.9% -.5% -2.2% Scenario % -1.2% -1.6% -1.2% -.2% -1.4% Scenario 3.2%.2%.4%.17%.3%.27% Scenario 4.17% 1.9% 2.7% 1.8%.1% 1.86% Scenario % -1.6% -2% -1.5% -.3% -1.8% Short-run Scenario % -.54% -2.1% -.26% -.58% -1.8% Scenario % -.31% -1.2% -.14% -.32% -1% Scenario 3 -.6% -.16% -.42% -.1% -.8% -.4% Scenario 4 -.5% -.17% -.3% -.8% -.5% -.31% Scenario % -.48% -1.8% -.23% -.47% -1.6% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 In the long-run, as inflation subdues the fall in exports moderates to about.5% while imports will also fall by about 2.2% on the back of a continued fall in output. The fall in output of 1.9% in the long-run remains the combined effect of falling domestic investment of about 2.5% and employment of about.2%, which are being driven by rising cost of inputs by firms. When different price scenarios were applied to the system the manufacturing sector reacted positively in both the short-run and the long-run. In the short-run major variables within the sector continues to indicate negative elasticities but with milder effects as prices is spread out over a longer period. However, with a 1% increase in electricity prices over a three year period, the long-run responses will begin to be positive and higher over an extended period. Mining Sector Impacts The estimated long-run production function of the mining sector also revealed the huge importance of capital stock in the production process. The share of capital is reported to be about 71% while labour takes about 29%. Due to the nature and structure of this sector commodity prices also play a significant role in the long-run determination of output

25 As shown in Table 1.4 the long-run impact of an increase in electricity prices on major variables within the mining sector tends to be relatively significant. In the long-run, given subdued inflation and a depreciated rand exports will decline by about.25% when the price of electricity increases by 24.8% over three years - indicating a much bigger effect of inflation in the sector. Due to the higher cost of capital, investment in the sector will fall by 3.8%; likewise will be the level of output. Employment and real wages will fall by about 1.6% and 4.1% respectively. The short-run implications associated with the 24.8% rise in electricity prices over a three year period will lead to investment in mining increasing moderately by about.25%. Based on this, output and employment in the sector will fall by.4% and.3% respectively. Real wages, however, will decline by about.3% while exports and imports will also follow the same trend estimated at about.7% and 1.3% declines, respectively. Table 1.4: Mining Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports Scenario 1-1.6% -3.8% -3.8% -4.1% -.25% -4.3% Scenario 2 -.9% -2.1% -2.2% -2.4% -.2% -2.5% Scenario 3.36%.8%.43% 1% -.9%.9% Scenario 4 1.9% 5.2% 3.5% 6.2% -.4% 5.9% Scenario % -2.9% -3% -3.2% -.22% -3.3% Short-run Scenario % -.44%.25% -.3% -.7% -1.3% Scenario 2 -.7% -.9%.22% -.1% -.4% -.6% Scenario 3.2%.3% -.6% -.6% -.9% -.13% Scenario 4.6%.8% -.3% -.7% -.2%.1% Scenario 5 -.2% -.26%.2% -.4% -.8% -.94% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 The different price scenarios applied to the system revealed trends similar to those analysed in the previous section. Agricultural Sector Impact The response of the agricultural sector to an electricity price hike shock is relatively significant in both the short-run and long-run period. Given an estimated 65% share of capital in the long-run production function, an increase in the price of electricity by 24.8% over a three year period will result in output falling by about 1.5% and.8% in the long-run and short-run,

26 respectively (Table 1.5). The sector s buoyant response of investment (-3.4%) to the shock in the short-run can be attributed to the fact that replacement of capital is quicker than in other sectors due to its seasonal nature. In the long-run, investment will decline by about 2.2%. Due to the inelastic nature of the demand for labour in agriculture, the long-run response of employment to an electricity price hike shock is negligible. Although, in the short-run, due to the huge impact on investment a decline of about.3% in employment will be recorded if the electricity price is increased by 24.8%. However, the responses of exports and imports will also be negative due to the output and price effects. Exports in the short and long-run will decline by about.7% and.34% respectively. The huge impact on imports both in the short and long-run can be mainly attributed to the output effect. Table 1.5: Agricultural Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports -.6% -1.5% -2.2% -1.3% -.34% -4.7% Scenario 1 -.3% -.99% -1.35% -1.28% -.19% -2.8% Scenario 2 -.6%.27%.6%.25% -.5% 1.2% Scenario 3.6% 2.2%.8% 2.1% -.4% 5.8% Scenario 4 Scenario 5 -.4% -1.24% -1.75% -1% -.27% -3.6% Short-run -.3% -.84% -3.4% -.27% -.7% -3.5% Scenario % -.35% -1.5% -.3% -.36% -1.9% Scenario 2 -.3% -.12% -.4% -.5% -.15% -.8% Scenario 3.4% -.1% -.26% -.1% -.1% -.8% Scenario 4 Scenario % -.64% -2.6% -.21% -.55% -3% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Other price scenarios applied to the system follow similar trends as analysed in the previous sections. Both the short and long-run impacts will become less severe as increases in electricity prices are spread over a longer period of time. Construction Sector Impact The response of the construction sector to the electricity price hike was found to be relatively small, despite the large share of capital (71%) used in the production process. Although the effect of user cost of capital in the long-run investment function is small this might have been caused by the fact that the energy use in this sector is the lowest

27 In this milieu, when the price of electricity is increased by 24.8% over a three year period, investment in the sector will decline by about.8% in the long-run and this will lead to output falling by about.7%. Employment and real wages will also fall by about.2% and.53%, respectively (Table 1.6). Table 1.6: Construction Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports -.2% -.7% -.8% -.53% Scenario 1 -.5% -.44% -.2% -.31% Scenario 2.12%.35%.17%.25% Scenario 3.27% 2.2% 1.6% 1.5% Scenario 4 Scenario % -.55% -.5% -.4% Short-run Imports.1%.5%.4%.3% Scenario 1.7%.3%.22%.2% Scenario 2.5%.1%.7%.1% Scenario 3.1%.1%.3%.1% Scenario 4 Scenario 5.1%.4%.34%.3% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 In the short-run, the impact will remain positive due to the slow adjustment path towards the long-run. Output and investment will increase by only about.5 and.4%, respectively, when electricity prices are increased by 24.8%. Employment and real wages will also rise by about.1 and.3%, respectively. Under different price scenarios the construction sector will react positively. This means that as the price hikes are spread out over a longer period both the short and long-run impacts will become less and less severe. The external segment (exports and imports) in this sector were excluded due to a lack of adequate data. Electricity, Gas & Water Sector Impacts In this sector, over 8% of output comes from electricity while the remaining 2% goes to gas and water. In the estimated long-run production function, capital stock has about a 6% share in the production process while labour have 4%. Given the relevance of Eskom in this sector - sole supplier of electricity - and the fact that its capital investment needs to be financed through revenue generation, electricity prices will play a big role in their investment decision

28 In this regard, electricity prices are found to have a positive and significant impact in the longrun investment function. An increase in the price of electricity by 1% will lead to an increase of about.35% in the level of investment in the sector over the long-run. Putting the above into the entire macro system and applying a shock of 24.8% to electricity prices over a three year period, the impact on the electricity, gas & water sector is positive in both the short and long-run. In the short-run, investment will increase by about 88% and this will lead to output rising by about 3% (Table 1.7). Employment and real wages will grow by 2.7% and 2.5%, respectively. The huge impact recorded for investment is attributed to the direct effect of the electricity price shock. The increase in exports is the net effect of increased inflation and a depreciated rand indicating the latter (rand) effect to be bigger. Under different price scenarios, the short-run responses are in line with what was expected. Increasing electricity prices over a longer period will have less of a positive impact on the sector. Table 1.7: Electricity, Gas & Water Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports 9.6% 11.5% 9.5% 9.7% -2% 9.8 Scenario 1 -.2% -.24% -3% -.2% -1.2%.3% Scenario 2.9% 1.1% 1.8% 1%.9% -.69% Scenario 3 6.9% 8.3% 14.8% 7.5% 4% -.37% Scenario 4 Scenario 5 5% 6% 3.7% 7.5% -1.5% 6.1% Short-run 2.7% 3% 88% 2.5% 1.3% 1.5% Scenario 1 1.1% 1.2% 26%.8%.3% 1% Scenario 2.34%.4% 2.4%.19%.5% 1.2% Scenario 3.15%.14% -9.3% -.5% -.7% 1.4% Scenario 4 Scenario 5 2.3% 2.6% 63% 1.3% 1.26% 1.8% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 In the long-run, when the economy has adjusted fully to the shock, investment will increase by about 9.5% and output by 11.5%. Employment and real wages will, however, grow at about 9.5% each. The small short-run impact on employment and output can be linked to the slow adjustment process in the system. Under various price scenarios, the long-run responses will seem to follow different paths. Over the short term (3 year period) and long term (1 year period) the responses are positive and significant. In the medium term (5 to 7 year period) the responses will be negative and or

29 insignificant. This indicates that the electricity price increases by Eskom will have positive long-run effect within the sector if spread over a three or ten year period. But this may not be the case at the macro level. Wholesale & Retail Trade Sector Impacts The estimated long-run production function for the wholesale & retail trade sector revealed an equal importance of capital stock and labour in the production process. The shares of the two inputs are reported to be 5% each. As presented in Table 1.8, the long-run impacts of an increase in electricity prices on major variables within the wholesale & retail trade sector tends to be relatively significant. In the long-run, exports will increase by about.7% when the price of electricity increases by 24.8% over three years. This indicates a much bigger effect of exchange rate depreciation in the sector. Due to the higher cost of capital, investment in the sector will fall by 1.7%; likewise will be the level of output (1.2%). Employment and real wages will fall by about.5% and 1.2%, respectively while imports will decline by about.76%, mainly due to the output effect. The short-run implications associated with the 24.8% rise in electricity prices over a three year period will lead to investment in the sector to increase by about.75%. On this ground, output, employment and real wages in the sector will increase by.43%,.15% and.4%, respectively. Exports will decline by about.5, mainly due to the price effect while imports will increase by about.4%. Table 1.8: Wholesale & Retail Trade Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports -.54% -1.2% -1.7% -1.2%.7% -.76% Scenario % -.8% -.14% -.76% -.7% -.5% Scenario 2.11%.24%.27%.24% -.7%.14% Scenario 3.8% 1.8% 2.1% 1.8% -.5% 1.1% Scenario 4 Scenario % -.98% -1.4% -.96%.7% -.62% Short-run.15%.43%.75%.39% -.5%.36% Scenario 1.5%.14%.12%.13% -.3%.15% Scenario 2 -.1% -.1% -.17% -.4% -.9% -.1% Scenario 3 -.5% -.1% -.5% -.9% -.5% -.1% Scenario 4 Scenario 5.12%.32%.45%.3% -.46%.28% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario

30 Under the various price scenarios, the short-run responses react negatively to the shocks when price increases are spread over longer period. This shows that the short-run adjustment in the wholesale & retail trade sector are quicker with longer shocks than with short ones. Transport and Communication Sector Impact In the transport and communication sector, an estimated 58% share of capital input is used in the production process while labour input takes 42%. Therefore, the response of this sector to the shock to an electricity price hike is relatively significant. Being one of the sectors with the highest energy intensity, an increase in the price of electricity of 24.8% over a three year period will result in output falling by about 2.6% in the long-run while the short-run response to this will still be positive (.2%) due to the sluggish adjustment embedded in the system (Table 1.9). Table 1.9: Transport and Communication Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports -.7% -2.6% -3.1% -1.9% -.3% -.5% Scenario 1 -.4% -1.5% -1.9% -1.17% -.16% -.34% Scenario 2.21%.5% -.38%.42%.3%.2% Scenario % 3.5% 2.9% 2.85% -.9% 1.2% Scenario 4 Scenario 5 -.5% -2% -2.5% -1.5% -.2% -.41% Short-run.4%.2% -1.2%.4% -.5%.7% Scenario 1.1%.6% -.74%.9% -.27%.38% Scenario 2 -.3% -.2% -.4% -.5% -.13%.1% Scenario 3 -.9% -.1% -.6% -.14% -.16% -.1% Scenario 4 Scenario 5.2%.12% -1.1%.25% -.4%.6% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Investment in the short and long-run will decline by about 1.2% and 3.1%, respectively. The employment impact in the short-run will be minimal with an estimated growth of about.4% but in the long-run the real effect will materialise and decline by.7%. Looking at the exports component, the effect of inflation is more pronounced than the exchange rate effect, bringing the short-run and long-run exports down by about.5% and.3%, respectively. Imports on the other hand will be driven mainly by the level of output

31 The different price scenarios applied to the system revealed similar trends as in the wholesale and retail trade sector. Financial Sector Impact The financial sector remains the biggest sector in the South African economy with more than a 23% contribution to total value added. The estimated long-run production function for this sector revealed about 64% share of capital input used in the production process. Table 1.1 presents both the short and long-run impacts of an increase in electricity prices on major variables within the financial sector. Investment in this sector will decline respectively by about.7% and 1.1% both in the short and long-run when electricity prices increase by 24.8% over a three year period. The impact on employment in the short-run will be negligible but in the long-run it will decline by about.23%. The effect of this on output will be negative in both the short and long-run period, declining by about.6% in the latter period. Table 1.1: Financial Sector Impacts of an Increase in Electricity Prices Long-run Employment Output Investment Real Wages Exports Imports -.23% -.62% -1.1% -.7%.52% -1.45% Scenario 1 -.1% -.4% -.7% -.47%.3% -.9% Scenario 2.12%.9%.13%.11%.3%.32% Scenario 3.19%.76% 1%.9% 2.6% 1.7% Scenario 4 Scenario 5.15% -.5% -.9% -.6%.43% -1.1% Short-run.2% -.5% -.72% -.7%.85% -1.8% Scenario 1.1% -.3% -.4% -.4%.47% -1% Scenario 2.2% -.4% -.17% -.4%.2% -.32% Scenario 3.2% -.7% -.2% -.8%.25% -.16% Scenario 4 Scenario 5.2% -.5% -.62% -.7%.7% -1.5% The long-run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 The increase in exports in both periods is mainly a function of a depreciating currency while imports are driven by the direction of output. When different price scenarios are introduced to the system the financial sector reacts positively in both the short-run and the long-run

32 1.4. Computable General Equilibrium (CGE) Approach to Analysing the Impact of Electricity Hikes This approach looks at the short and long-run impacts of electricity price hikes on the economy in a static system. The University of Pretoria CGE model of South Africa (UPGEM model) is used and four short-run simulations and four long-run simulations were tested. In both the short-run and the long-run, electricity prices were exogenously increased by 24.8% (scenario 1), 15% (scenario 2), 1% (scenario 3) and 8% (scenario 4) to ascertain the impacts of electricity price increases on the macro and sectoral economy. In Appendix B, the report provides a description of the UPGEM model, the closure rules, calculation of Equivalent Variation (EV) values, a summary of the model limitations, as well as the simulation design. An inflation rate of 6% was assumed when testing the impact of real electricity price increases on the South African economy. This is based on the long-run trend value of inflation as depicted in Appendix A5. A typical short-run closure is applied, as discussed in Appendix B. The length of the short-run is not explicit, but usually seen as between 1 and 3 years (Horridge 2). As mentioned earlier, all the results in this section are reported as percentage point changes from the base scenario. In other words, the results are not forecasts of various economic variables, but rather deviations due to increases in the price of electricity. Economy-Wide Computable General Equilibrium Analysis Table 1.11 shows the short-run and long-run macroeconomic impact of electricity price increases on the South African economy, under the scenarios discussed above. Any electricity price increase above inflation will lead to a real devaluation of the currency. For example, a 24.8% increase in the price of electricity would lead to a.34% real devaluation of the currency. Electricity is used as an input in the production process, thus an increase in the price of electricity will increase the price of production, reducing the competitiveness of industries in South Africa, relative to the rest of the world. Furthermore, the terms of trade, where terms of trade is the ratio between export prices and import prices, will weaken. The real devaluation will lead to an increase in the domestic currency price received for exports. This will, for exporting industries, counter the price increase impact on production costs. However, the real devaluation will increase the price of imports in terms of the domestic currency, and therefore the price of imported inputs in the production process, as well as the price of imported household products. This will create further pressure on production costs. The net impact will be that relative import prices increase more than the relative increase in export prices. The increase in production costs will adversely affect the gross operating surplus of industries, decreasing gross operating surplus by 2.13% under a 24.8% increase in the price

33 of electricity. Real household consumption expenditure will also decrease, mainly due to the negative employment impacts (Table 12). As gross operating surplus decreases, and industry production decreases (Table 11), employment will decrease. In the case of a 24.8% electricity price increase, skilled employment would decrease by.86% (number of workers) and unskilled employment (number of workers) would decrease by.77%. employment will negatively affect real household consumption expenditure (.85% for a 24.8% increase). Since gross operating surplus and real household consumption decrease, government income will decrease. If we assume a neutral government budget, real government demands will also decrease. The net impact of electricity price increases of 24.8%, 8%, 1% and 15% on the real gross domestic product (GDP) will respectively be a decrease of.48%,.9%,.13% and.25%. Table 1.11: Economy-Wide Impacts of an Increase in Electricity Prices Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Real devaluation Terms of trade Gross operating surplus Real household consumption Aggregate capital stock Real GDP Average real wage Unskilled employment Short-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Real devaluation Terms of trade Gross operating surplus Real household consumption Aggregate real government demands Real GDP Skilled employment Unskilled employment In the long-run, the currency will devalue more than in the short-run due to an electricity price increase above inflation. Since capital is allowed to move, it could be expected that capital will flow away from electricity intensive sectors. This could amplify the initial short-run impacts. Since industries not only face higher input costs and a loss of competitiveness, but also scarce capital, the real currency is expected to devalue and the terms of trade as defined in the previous section is expected to weaken more in the long-run than in the short-run. For a 24.8% electricity price increase, gross operating surplus decrease by 2.13% and real household consumption decrease by.85% in the short-run. However, in the long-run gross operating surplus would decrease by 2.33% and household consumption would decrease by 2.37%. In the long-run capital is variable, thus the impact on gross operating surplus is somewhat weakened due to the ability to move capital to higher yielding industries or by - 3 -

34 reducing investment. For a 24.8% increase in the price of electricity, aggregate capital stock is expected to decrease by 1.82% in the long-run. On the other hand, real household consumption would be negatively affected through the long-run employment impact (lower unskilled employment and lower real wage), as well as economy wide price impacts. The net long-run impact of electricity price increases of 24.8%, 8%, 1% and 15% on real gross domestic product (GDP) will respectively be a decrease of 1.3%,.18%,.28% and.53%. Sectoral Computable General Equilibrium Analysis All sectors use electricity directly or indirectly as an input, therefore an increase in the price of electricity, would increase the cost of production, leading to a loss of competitiveness, and as a result, some industries would reduce output (A complete description of industries are included in Appendix C and detailed results are provided in Appendix D). Due to the multiindustry disaggregation in the CGE approach, the impacts of the price hikes are presented according to variable changes by sectors. Output (GDP) Impacts Table 1.12 provides an impact range, with an upper bound impact and a lower bound impact, based on sub-industry impacts, of the electricity price increases on the nine Standard Industrial Classification (SIC) sectors. Disaggregated 39 sub-industry output changes are provided in Table D1. As expected, the industries with the highest electricity intensity will adjust output the most. In the short-run, industries that would reduce output by more than.5%, if the price of electricity increases by 24.8%, are Gold (.9%), Iron and Steel (1.95%), Non-ferrous Metal (.71%), Radio (.57%), General Government (.85%) and Health Services (.88%). The first four industries could be classified as electricity intensive industries. Furthermore, the Health Services contraction indicates the negative impact of higher electricity prices on household spending, as well as the impact of slower economic growth on the ability of government to spend on health and social services. General government spending is also negatively affected, given the assumption that government adjusts spending based on revenue collected. Revenue collected will be lower due to the employment impacts (see the next section), slower economic growth, as well as lower gross operating profit. Lastly, all things being equal, the direct increase in the price of electricity will have a negative impact of 4.9% on electricity output as the quantity of electricity demanded decreases. In some sectors the upper boundary is positive. There might be some marginal output increases in the Field and Horticulture industries (in all scenarios less than.2%), mainly due to factor movements away from electricity intensive industries. However, these changes are negligible. Also, a negligible increase of.1% (under a 24.8% increase) are seen in the Crude, Petroleum and Gas sector as there might occur some substitution away from electricity given the higher electricity price. The only notable output increase is the Other

35 Manufacturing industry increasing output by.16%. Although electricity is an input in the production of Other Manufacturing products, the relative electricity intensity in this sector is lower than in the other manufacturing industries. This will result in higher relative profitability and a resulting movement of factors to the Other Manufacturing industry. Table 1.12: Sectoral Output Impacts Long-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Short-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, realestate and business services Community, social and personal services Upper Upper In the long-run, output in 31 of the 39 industries would be expected to decrease if the price of electricity is increased above inflation. The industries that would reduce output the most are the Iron and Steel (5.29% for a 24.8% increase), Non-ferrous Metal (4.63% for a 24.8% increase), Electricity (6.79% for a 24.8% increase) and Health Services (2.91% for a 24.8% increase) industries. The Iron and Steel and Non-ferrous Metal industries are capital and

36 electricity intensive industries and an increase in the price of electricity would lead to an outflow of capital from these industries. An increase in the price of electricity would also lead to a decrease in the quantity of electricity demanded, leading to a reduction in electricity output, ceteris paribus. As shown in Table 1.7, real household consumption is expected to decrease, lowering demand for services in the Health Services industry. The Other Mining industry output would increase (.81% for a 24.8% increase), as capital is transferred from the other, more electricity intensive mining industries. Also, for a 24.8% increase in electricity prices, the Textiles (.13%), Other Machinery (.16%), Electrical Machinery (.5%), Wood, Paper and Pulp (.3%) and Other Manufacturing (1.9%) industries are expected to increase output as capital flow to these relatively low electricity intensive manufacturing industries. However, these industry increases in output would not be sufficient to offset the output decreases in the other industries and the overall impact on production, as reflected in the GDP (Table 1.7), would be negative. Employment and Wage Impacts Employment impacts would follow the changes in output, induced by the increase in the price of electricity. Electricity intensive industries would reduce output due to higher production costs and as a result employ fewer workers. In the short-run, the electricity price increases would have a direct negative impact on the quantity of electricity demanded. As a result, electricity output would decrease and employment in the electricity sector (Table 1.13) would also decrease, all things being equal. The output reduction would lead to a reduction in the demand for downstream intermediate products. Coal is extensively used in the generation of electricity in South Africa. Due to the lower demand for coal, employment in this industry would be expected to decrease by.59%. As expected, the industries with the highest reduction in output would release the most workers. Industries that reduce output by more than.5% if the price of electricity increases by 24.8% would reduce employment by 1.37% (Gold), 3.94% (Iron and Steel), 2.58% (Nonferrous Metal),.73% (Radio),.96% (General Government) and 1.79% (Health Services). Labour intensive industries have a relatively small impact on production, as shown in Table D1 (Appendix D). However, the relatively small impact leads to a relatively large impact on employment, due to the labour intensive nature of these industries. Labour intensive industries that would reduce employment by more than.5% under a 24.8% electricity price increase are Livestock (.94%), Other Agriculture (.78%), Footwear (.7%), Water (2.17%), Communication services (.77%) and Real Estate (.69%). As shown by the upper boundary in the Agriculture, Hunting, Forestry and Fishing sector in Table 1.13, there would be some employment increases in the Field and Horticulture industries (in all scenarios less than.1%), mainly due to output increases. However, it could be expected that these industries would become more labour intensive as the price of

37 electricity increases, leading to a higher than proportional increase in employment. Also, an employment increase of.7% (under a 24.8% increase) is seen in the Crude Petroleum and Gas sector since production is slightly expanded under the higher electricity price. The only notable employment increase is the Other Manufacturing industry increasing employment by.32%, following the increase in output of.16% under a 24.8% electricity price increase. Table 1.13: Sectoral Employment Impacts Long-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Short-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper If the price of electricity increases, it could be expected that industries will to some extent substitute electricity intensive capital for labour and that capital will flow to more labour intensive industries. Table 1.13 shows the long-run industry employment impacts on unskilled labour for the SIC sectors. Unskilled labour is allowed to vary in the long-run due to the high

38 structural unemployment of unskilled workers in South Africa. In 3 of the 39 sub-industries, changes in unskilled employment will follow changes in output (Table D3). The other nine industries (Irrigated Field, Dry field, Coal, Textiles, Chemicals and Rubber, Other Nonmetallic Mineral Products, Other Metal Products, Transport Equipment, Construction and General Government) would record an increase in unskilled employment as these industries substitute capital for labour. However, none of these industries would increase unskilled labour by more than.7% for a 24.8% electricity price increase, and the net impact on unskilled labour would be a decrease in employment of 1.32% (Table 1.11). The industries releasing the highest percentages of unskilled workers are Iron and Steel (4.55% for a 24.8% increase), Non-ferrous Metal (3.73% for a 24.8% increase) and Electricity (5.8% for a 24.8% increase). In the long-run wages are the market clearing agent for skilled employment. In other words, the number of skilled workers is fixed (Appendix B2). This reflects the idea that the size of the skilled labour market is determined by factors outside the model. On the other hand, unskilled workers and unskilled wages are allowed to vary due to the high unemployment of unskilled workers in South Africa. It could therefore be expected that the wage impact due to higher electricity prices on skilled labour would be higher than the impact on the wages of unskilled labour. This is reflected in Table Statistics South Africa (StatsSA), in the national Social Accounting Matrix (SAM), classifies all occupations into eleven groups (StatsSA 24). This is in accordance with the South African Standard Classification of Occupations (SASCO). This analysis follow the same classification and a full description of all occupations are available in StatsSA (24). If the price of electricity increases, wages across all occupations decrease, with a smaller decrease in relative unskilled occupations and higher decreases in skilled occupations. More specifically, skilled occupations in electricity intensive sectors, such as technicians (3.59% for a 24.8% increase) would experience the largest decrease in wages while unskilled labour in labour intensive sectors, such as domestic workers (1.63% for a 24.8% increase) and elementary occupations 91.63% for a 24.8% increase) would experience the smallest decrease in wages. Table 1.14: Wage impacts by occupation Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Legislators Professionals Technicians Clerks Service workers Skilled agricultural workers Craft workers Plant and Machine operators Elementary occupations Domestic workers All Unspecified occupations

39 The wage impacts by population group are shown in Table As a larger percentage of African workers are economically active as unskilled labour, the adverse impact on their wages would be the smallest (2.46% for a 24.8% increase). Table 1.15: Wage impacts by population group Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 African Coloured Indian White On the other hand, as a larger percentage of White workers are economically active as skilled workers, the impact on their wages (3.1% for a 24.8% increase) would be the largest for the population groups under consideration. Wage impacts, by population group, are disaggregated to skilled wage impacts in Table As discussed, the impacts on skilled labour across all population groups are larger than the wage impacts on unskilled labour across all population groups. Table 1.16: Skilled wage impacts by population group Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 African Coloured Indian White White skilled workers would, for a 24.8% increase in the price of electricity experience a 3.26% decrease in skilled wages, while African workers would experience a 3% decrease. Coloured and Indian workers would experience a 3.4% and 3.16% decrease, respectively. Forty eight and a half percent of highly skilled and skilled African compensation are earned in the Trade and Government, Health and Social Services industries (StatsSA 24). The employment impacts in these sectors were relatively smaller than in the Manufacturing sector where 18% of White highly skilled and skilled workers earned compensation (StatsSA 24). Given the fixed long-run skilled employment, the short-run employment changes by occupation, as result of electricity price increases, are shown in Table Employment across all occupations will be affected negatively if the price of electricity increases above the inflation rate

40 Table 1.17: Occupational employment impacts Short-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Legislators Professionals Technicians Clerks Service workers Skilled agricultural workers Craft workers Plant and Machine operators Elementary occupations Domestic workers All Unspecified occupations Least affected are skilled agricultural workers, since the Field and Horticulture industries report a small increase in employment. However, the negative employment impact on the Livestock, Forestry and Other Agriculture industries would outweigh the small positive employment impact on skilled agricultural workers and the net impact of a 24.8% electricity price increase would be a decrease of.58% in employed skilled agricultural workers. Most affected are the craft workers (1.1% for a 24.8% increase), with around 7% of craft workers employed in the mining, manufacturing and construction industries (StatsSA 24). These are the industries that would reduce employment significantly if electricity prices increase. Employment in the other occupations would decrease between.73 and.87% for a 24.8% electricity price increase. Table 1.18 shows the employment impact of electricity price increases by population group. The employment impact would be negative across all population groups. The Indian and Coloured population groups (.69% and.72% for a 24.8% increase) are the least affected by the electricity price increases, while the African and White population groups (.86% and.88% for a 24.8 increase) are the most affected. Table 1.18: Employment impacts by population group Short-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 African Coloured Indian White Approximately 47% of Coloured workers work in the Agricultural, Trade, Transport and communication industries (StatsSA 24), while approximately 42% of Indian workers are employed in the Trade, Transport and Communication and Financial industries. These industries would reduce output with an electricity price increase, but the reduction would be relatively smaller than in the other industries. In contrast, approximately 47.5% of African workers are employed in the Government, Health and Social services, Manufacturing and Mining industries, while approximately 4% of White workers are employed in the

41 Manufacturing and Government, Heath and Social services industries. These industries would reduce output relatively more than the other industries due to an electricity price increase Conclusion This chapter has analysed the impact of an increase in electricity prices on the overall macro and sectoral economy using both the TSME and CGE models. The simulation results from the TSME model revealed the macro implications of the current wave of electricity price increases (25% average) over the next three years. In the long-run, household consumption, GDP, and investment will be mostly affected by the hike. The.12% decrease in employment over the long-run could be huge in terms of the number of people added to unemployment in the country. During the short-run, the impact will be mostly on household consumption and exports, mainly due to the direct effect of the inflation. Under the various price scenarios, the impacts become less severe on the macro variables as prices are spread out over a longer period of time. At the sectoral level, the sectors that will shed most jobs in the long-run due to the 24.8% hike in electricity prices are; the mining sector (-1.6%), transport & communication sector (-.7%) and wholesale & retail trade sector (.54%). The same trend also goes with GDP impact. These sectors are also the top three sectors with the highest energy intensity. The electricity, gas & water sector on the other hand will boost jobs within the sector in the long-run by about 9.6%. This is due to the positive impact that electricity prices will have on the sector s capital investment. However, the employment impact during the short-run across sectors will be positive except for manufacturing, mining and agriculture. On the other hand, the simulation results from the CGE also revealed similar negative impacts on the macro economy. Overall, in the short-run, real gross domestic product decreased, the currency weakened, gross operating surplus was lower, aggregate real household consumption decreased and skilled as well as unskilled unemployment increased. The impact on household welfare was found to be regressive and negative. Most of the shortrun macroeconomic impacts were reinforced in the long-run, with a real devaluation in the currency, weakening in the terms of trade, decrease in gross operating surplus, progressive decrease in real household consumption, as well as a decrease in real gross domestic product, wages and employment. Also, in the long-run the aggregate capital stock was expected to decrease

42 Chapter 2 Evaluation of the Impact of Price Increases on the Cost Structure of the Various Sectors and Industries Executive Summary The survey carried out revealed a negative impact of electricity price increases on the cost structure of the various sectors and industries in South Africa. About 64% of retail merchant owners surveyed believe that the increasing electricity price hikes have affected their bottom line, with 72% saying that their electricity costs have risen to between 1 and above 3% since 28. Overall, 73% of CEOs and Senior Managers (small, medium, large) surveyed believe that the ever increasing electricity price hikes have also affected their bottom line, with only 18% managing to pass the rising costs onto their customers. In addition, a majority of respondents (68%) were concerned by the fact that municipalities are increasing electricity prices by a greater amount than levied by Eskom to their clients - mainly industry and more affluent suburbs

43 2.1. Introduction This chapter aims to assess and evaluate the impact of electricity price hikes on the economy and business activities within South Africa. Section 2 looks at the inflationary implications of the series of electricity price hikes since 28. The electricity crisis of January 28 prompted the need for Eskom to expand its generating capacity, which led to the SOE being granted tariff increases far beyond those we have been accustomed to, negatively affecting the country s inflation profile. Section 3 examines the role of municipalities as the principal distributors of electricity. What is important to note in this section is the fact that municipalities charge higher prices than Eskom, especially for industries and more affluent suburbs, which has made doing business harder. Section 4 looks at the energy intensity of the different sectors of the economy. This section highlights the negative impact that electricity disruptions (due to years of underinvestment in infrastructure) have had on intensive sectors such as mining and manufacturing, ultimately affecting overall economic performance. Lastly, Section 5 looks at empirical evidence on the impact of electricity price hikes on different industries across the South African economy. A survey was conducted across 8 companies (small, medium, large) from a diverse pool of industries Role of Electricity in CPI Dynamics This section assesses the impact of electricity tariff increases on the main measure of inflation. Prior to 28, electricity price increases have been quite modest; in fact, South Africa had one of the lowest electricity prices in the world. This in turn meant that these price increases had virtually no impact on inflation. However, the opportunity cost of keeping electricity prices low was that little or no investment into generating capacity was made, especially at a crucial time when the country registered growth in excess of 5%, and South Africa was fast becoming an attractive destination for foreign direct investment (adding strain on existing capacity). In a turn of events, the intensity of load shedding in January 28, which almost crippled the mining and manufacturing sectors (in particular following the week of a total shutdown); and the resultant electricity crisis, led to a need for much higher increases, at levels triple those which we had been accustomed to. The ever increasing costs of Eskom s planned expansion of generating capacity have had severe inflationary consequences and electricity price increases remain a potent factor likely to continue exerting upward pressure. Looking at Figure 2.1 below, since mid 28, administered prices (especially electricity) have played a pivotal role in shaping the country s - 4 -

44 inflation profile, with series of price hikes in excess of 2%. This coincidentally unravelled at a time when rising food and petrol costs were also playing havoc on domestic inflation, which led to a series of interest rate hikes, in order to curb runways prices. Figure 2.1: Consumer Price Inflation However, post the global recession, inflation dropped significantly, and South Africa s headlines inflation rate has remained well below the upper limit of the 3-6% target for eleven consecutive months and the short to medium term inflation outlook remains positive. On the negative, administered prices seem to be the major pertinent risk to this positive inflation outlook. As shown in the graphs below, administered price inflation is well above the 3-6% target band, at an annual rate of 8.5% in December 21. Inflation for regulated administered prices grew by 8.4% y/y for the same period

45 2.3. Secondary Impact: Role of Municipalities While Eskom provides an estimated 95% of all electricity used in South Africa, the SOE s direct clients are mainly industry and municipalities. For the end consumer and greater business South Africa, the cost of electricity will depend on the municipality that provides the service, as they price differently. Furthermore, even though municipalities, especially larger ones, are believed to purchase electricity from Eskom at a discount, evidence shows that they are increasing electricity prices by a greater amount than that of Eskom to their clients. Furthermore, electricity charges for the more affluent regions tend to be higher in order for the municipalities to subsidize the poorer communities who qualify for free basic electricity. Municipalities are therefore able to price their electricity increases in such a manner as to keep their revenues afloat. And as much as the National Electricity Regulator (NERSA) issues guidelines (effective in July of each year) to municipal price hikes, they cannot enforce them. A case in point: in February 21, Eskom was granted an effective 25 percent annual tariff increase for the next three years in order to raise funds towards its R4 billion plus CAPEX programme. According to NERSA guidelines, municipalities were to increase their prices by an extra 15 to 16 percent. However, as at 1 July 21, the average municipal electricity tariff increase was an extra 21%, with the highest being a 39% increase from Nala Local Municipality (Figure 2.2). Looking at a breakdown of the main metropolitan municipalities tariff increases for the 21/11 financial year (implemented 1 July 21): The Buffalo City municipality was granted a 22% increase, and of that, the low end consumers are charged 62.59c/kWh (prepaid), while high end consumers and commercial clients are charged 86,3c/kWh and 11.c/kWh. The City of Cape Town was awarded a 24.58% increase, and of that the commercial tariff charged includes a basic charge of R444.85/month and an energy charge of 77.66c/kWh. Industrial tariff rates include a basic charge of R74.9/month, an energy charge of 4.72c/kWh and a demand charge of R121.16R/kVa. The City of Tshwane was awarded a 19% increase; of that the low end consumers are charged 92.93c/kWh. Conventional commercial tariffs include an R419.86/month basic charge and an energy charge of 69.2c/kWh. Industrial tariffs on the other hand include a basic charge of R953.12/month, an energy charge of 32.63c/kWh and demand charge of R16.89/kVa. The City of Johannesburg (City Power) was granted a 22% increase, with commercial tariffs ranging from R342./month and R869.23/month (basic charge) and energy charges ranging between 83.24c/kWh and c/kWh (summer and winter). The basic charge on industrial tariffs range between R152.17/month on low voltage and R214.3/month on medium voltage

46 Ekurhuleni municipality was awarded a 28.9% increase, and of that the low end consumer rate is 97.c/kWh (prepaid), which includes a fixed charge of R17.42/month and capacity charge of R1,94/month. Industrial rates include a fixed charge of R769.5/month and a demand charge of between 67.2/kVa and 56./kVa (high and low season). ethekweni municipality was granted a 28% increase, with the following tariff prices: High demand season: Peak of c/kWh and off peak at 47.1c/kWh Low demand season: Peak of 65.33c/kWh and off peak at 44.49c/kWh Lastly, the Nelson Mandela Bay metro was granted a price hike of 22%, and of that low end consumers are charged 56.63c/kWh, while high end consumers are charged 74.42c/kWh. Figure 2.2: Municipal Electricity Price Increases (Additional to Eskom 24.8%) July 21 The above tariff distinctions show clearly that the more affluent consumers and businesses are faced with crippling price increases, which as a result affects their bottom-line (as expressed by a large number of respondents in our internal survey (Section 5)). Furthermore, the South African economy lost over 1 million jobs during the depth of the recession, and even though the pace has decreased, the economy has continued shedding jobs. This has increased the likelihood of more people qualifying for free basic electricity, prompting the municipalities to request higher increases, in order to accommodate the rising number of those in need of a subsidy. As shown in Figure 2.2 and Tables 2.1 (a), (b), (c), (d) and (e), the additional charges by municipalities are substantial, in some cases reaching as high as 4%

47 Table 2.1_A: NERSA Approved Municipal Tariffs Implemented July 21 Percentage Name of M unicipality In cre ase Abaqulusi 19. AECI ( M odderfontein) 24.8 AECI Heartland (U m b o gin tw in i) 25. AECI Heartland Som erset W e s t ( Private Distributor) 25. Albert Luthuli 19. Amahlathi 22. Ba Phalaborw a 28. Baviaans 12. Beaufort w e s t Bela Bela 19. B e rgrivie r 15. Bitou 22. Blouberg 18. Blue Crane 22. Breede River W inelands 22. Breede V alle y 19. Buffalo City 22. Cam deboo 28.9 Cape Agulhas 22. Cederberg 22. CENTLEC Kopanong, Mohokare Naledi 28.9 CENTLEC Mangaung 28.9 Central Karoo 19. City of Cape Tow n 24.6 City of Matlosana 22. City of Tshw ane 19. City of Um hlathuze 28. City Pow er 22. Dihlabeng 19. Ditsobotla 21. Drakenfontein 2. edum be 19. Ekurhuleni 28.9 Elias Motsoaledi

48 Table 2.1_B: NERSA Approved Municipal Tariffs Implemented July 21 Percentage Name of M unicipality In cre ase Elundini 22. em adlangeni 19. Em akhazeni 24. Em alahleni 19. Em alahleni Eastern Cape 2. Em fuleni 18.4 E m n a m b ith i/ La d y s m ith 1 8. Em thanjeni 19. endum eni 25. Ephraim M ogale 28. ethekw ini 28. Gam agrara 19. Gariep 15. Ga Segonyana 14. George 22. Govan M beki 19. Great Kei 28.9 Greater Kokstad 19. Greater Taung 11.1 Greater Tzaneen 23.3 Hantam 15.3 Hessequa 2. Hibiscus Coast 19. Ikw ezi 2. Ikw anca 2. In x u b a Ye Them ba 19. Ith ala Ezakheni/M adadeni 19. Ith ala Isithebe/Mandini 19. Kail Garieb 25. kam iesberg 22. Kannaland 22. Kareeberg 18. Karoohoogland 2. Kgatelopele 19. Kgetleng 24.3 Khai M a 15.3 Khara Hais 28. King Sabata

49 Table 2.1_C: NERSA Approved Municipal Tariffs Implemented July 21 Percentage Name of M unicipality In cre ase Kynsa 2. Kouga 2.8 Kungwini 25. KwaDukuza 19. Laingsburg 22. Lekw a 19. Lekw a Teemane 22. Lephalale 15. Lesedi 22. Letsemeng 18. Lukhanji 28. Madibeng 18. M afube 19.1 M agareng 19. M akana 21. M akhado 22. M aletsw ai 2. Maluti Aphofung 19. M am usa 19.3 Mandeni 19. Mantsopa 19. Maquasi Hills 15. M asilonyana 19. M atatie le 19. Matjhabeng 19. M atzikam a 15.3 M bizana 19. M bom bela 19. M EGA 19. M erafong 14. M etsim aholo 19. M idvaal 28.9 M odim olle 22. M ogalakoena 22. Mogale City 19. M ole m ole 19. Mookgopong 19. Moqhaka 19. M ossel Bay 25. M pofana

50 Table 2.1_D: NERSA Approved Municipal Tariffs Implemented July 21 Percentage Name of M unicipality In cre ase M sukaligw a 2. Msunduzi 22. Mthonjaneni 19. M usina 19. N ala 39. N aledi 22. Nama Khoi 22. N dlam be 19. Nelson Mandela Bay M etro 22. N ew castle 15. N gw athe 19. Nkandla 24. N ketoana 22. Nokeng Tsa Taem ane 25. Nquthu 19. Nxuba 22. Oudsthoorn 22. O verstrand 22. Phokw ane 18.6 Phumelela 3. Polokw ane 19. Prince A lbert 2. Ram othsere M oiloa Zeerust 18.9 Randfontein 23.7 Renosterberg 2. Richtersveld 22. Rustenburg 19. Sakhisizw e 19. Saldana Bay 22. Sasol Sasolburg 19. Sasol Synfuel 23.5 Senqu 19. Setsoto 2. Siyancum a 19. Solplaatjie 22. Ste lle nbosch 24.9 Steve Tshw ane 22. Sundays River 22. Sw artland 24. Sw e lle ndam

51 Table 2.1_E: NERSA Approved Municipal Tariffs Implemented July 21 Percentage Name of M unicipality Incre ase Thabazim bi 19. Theewaterskloof 26. Them belihle 22. Tlokw e 18.1 Tokologo 25. Tongaat Hulett 25. Tsatsabane 21. Tsolw ana 2. Tsw elopele 2. Ubuntu 19. Ulundi 22.5 Um ijindi 31. Umkhanyakude 28.9 Um lalazi 19. Um ngeni 19. Um sobom vu 19. Um tshezi 25. Um voti 22. Umziwabantu 19. Uphongolo 28.9 V entersdorp 19. Victor Khanye 19. West Rand Power Distributors 19. W estonaria 22. Witzenburg 22. Source: Calculated from NERSA 1 July 21 Flow through impact of electricity price increases Looking at the flow through impact of the above municipal electricity tariff increases on the consumer; a survey was conducted amongst small retailers across middle income communities within South Africa (Table 2.2_A to C). Overall, 64% of retail merchant owners surveyed believe that the increasing electricity price hikes have affected their bottom line, with 72% saying that their electricity costs have risen to between 1% and above 3% since 28. The survey also shows that profit margins have been affected by increased electricity tariffs, with a majority of respondents recording a sensitivity rate of between 6% and above 15%

52 Table 2.2_A: Retail Survey Results Has the price hike affected your bottom line? Yes No INDUSTRY Hair and Beauty Salon 2 2 Laundry Services/Dry Cleaners 1 1 General Dealers 2 2 Fast Foods/Bakeries 5 3 Resturant/Bar 4 2 Internet Café/IT 5 Electrical Appliances 2 Water Purifiers/Cooler 1 Mechanical Repairs 1 1 Medical 2 Retail Clothing 3 1 Transport/Logistics 1 Speciality Stores 2 Electricity costs in relation to total costs (annual average from 28) <1% 1% - 2% 21% - 3% >3% INDUS TRY Hair and Beauty Salon Laundry Services/Dry Cleaners 1 1 General Dealers Fast Foods/Bakeries Resturant/Bar Internet Café/IT Electrical Appliances 2 W ater P urifiers /C ooler 1 M echanical Repairs 2 1 Medical 1 1 Retail Clothing 4 Transport/Logistics 1 S pec iality S tores 1 1 Sensitivity of profit to electricity price hikes (annual average from 28) - 5% 6% - 1% 1% - 15% > 15% INDUS TRY Hair and Beauty Salon Laundry Services/Dry Cleaners 1 1 General Dealers 1 3 Fast Foods/Bakeries Resturant/Bar Internet Café/IT 1 1 Electrical Appliances W ater P urifiers /C ooler 1 M echanical Repairs 2 1 Medical 1 1 Retail Clothing Transport/Logistics 1 S pec iality S tores

53 The survey results also show that 61% of respondents have not managed to pass on the energy costs to the end consumer, but have opted to adopt energy savings practices. This is due to the timing of the electricity price increases, which coincided with the recession, where a majority of retailers experienced a shrinking customer base, limiting the extent to which they can raise prices. Table 2.2_B: Retail Survey Results Have you managed to pass the rising costs to your customers? Yes No INDUSTRY Hair and Beauty Salon 1 3 Laundry Services/Dry Cleaners 2 General Dealers 2 2 Fast Foods/Bakeries 2 6 Resturant/Bar 2 4 Internet Café 1 3 Electrical Appliances 2 Water Purifiers/Cooler 1 Mechanical Repairs 2 Medical 1 1 Retail Clothing 2 2 Transport/Logistics 1 Speciality Stores 1 1 Have electricity price hikes encouraged energy saving innovations? Yes No INDUSTRY Hair and Beauty Salon 2 2 Laundry Services/Dry Cleaners 1 1 General Dealers 2 2 Fast Foods/Bakeries 6 2 Resturant/Bar 3 3 Internet Café 3 2 Electrical Appliances 1 1 Water Purifiers/Cooler 1 Mechanical Repairs 2 Medical 2 Retail Clothing 3 1 Transport/Logistics 1 Speciality Stores 1 1 Other key findings from the survey revealed that a large majority of retailers expressed concern regarding inconsistencies within their electricity bills. Not only are there fluctuations from month to month, but some have stated that the amounts charged do not correspond with their electricity usage, impacting heavily on their cost base. Secondly, day-to-day business - 5 -

54 operations have been negatively affected by the continued disruptions in electricity supply, with many (61%) unable to switch to alternative sources of energy. Table 2.2_C: Retail Survey Results Have electricity price hikes encouraged the use of alternative sources of energy? Yes No INDUSTRY Hair and Beauty Salon 1 3 Laundry Services/Dry Cleaners 2 General Dealers 2 2 Fast Foods/Bakeries 4 4 Resturant/Bar 3 3 Internet Café 2 3 Electrical Appliances 1 1 Electrical Appliances 1 1 Water Purifiers/Cooler 1 Mechanical Repairs 1 1 Medical 1 1 Retail Clothing 1 3 Transport/Logistics 1 Speciality Stores Energy Intensity of Sectors The South African economy is facing the cumulative effects of years of underinvestment in critical socio-economic infrastructure. The country s infrastructure gap has emerged as a result of the cumulative impact of decades of underinvestment in infrastructure spends across both economic and social infrastructures. As illustrated in Figure 2.3, below, ever since the mid-197s infrastructure investment as a percentage of GDP has fallen steadily

55 Figure 2.3: South African Infrastructure Investment as % of GDP Over the past 5 years, fixed investment has primarily been led by the private sector (Figure 2.4) while the government and its institutions lagged behind in upgrading the domestic infrastructure (including roads, energy). Figure 2.4: Fixed Investment Trends in South Africa , 25, s n ilio m R 2, 15, 1, 5, Governm ent Public Corporations Private Sector Source: SARB

56 Possibly one of the most damaging policy failures of the recent past has been the absence of medium to long-term planning for socio-economic infrastructure. This has most poignantly manifested itself in the recent electricity crisis. The electricity crisis in the 1st quarter of 28 and subsequent need for electricity rationing resulted in a significant disruption in economic activity (Figure 2.3), in particular within the mining and the manufacturing sectors. Both sectors were the culprits for the slowdown in GDP growth in the 1st quarter of 28, due to the high energy mix in relation to their total inputs (Figure 2.4). The electricity crisis in the 1st quarter of 28 and the subsequent need for electricity rationing resulted in a significant disruption in economic activity, as illustrated in Figure 2.5, below, in particular within the mining and the manufacturing sectors. Both sectors were hit hard by the unexpected electricity disruption contributing to the slowdown in GDP growth in the 1st quarter of 28. Figure 2.5: Trends in Growth Rates of GDP and Electricity Demand, South Africa, Notwithstanding the devastating short-term economic impact of the energy crisis in 28, the sudden collapse of electricity provision affected the country s long-term economic prognosis. Firstly, Eskom has introduced demand rationing measures in order to suppress electricity usage until the planned additional capacity kicks in over the next decade. Figure 2.5 shows a clear correlation between economic growth and electricity consumption and thus rationing will continue having a negative impact on the country s growth trajectory

57 The sources of the country s electricity constraint stem from the serious neglect of the generating capacity over the years, even after government was warned by Eskom in 1998 of the impending supply shortage. The country s failure to ensure sufficient growth in electricity capacity was underpinned by the underestimation of South Africa s economic growth during this current decade (as earlier stated, the current decade has stood up quite favourably in comparison with the 197s through to 199s). Furthermore, electricity prices have remained very low in the past, which has done little to attract private sector entrants to add to capacity. Figure 2.6: Value of electricity used expressed as a percentage of intermediate inputs Source: Chamber of Mines & Statistics South Africa (StatsSA) The graph shows that the mining sector is more electricity intensive than the manufacturing industry Empirical Survey of Impact of Electricity Price Increases This section attempts to analyse the economic impact of electricity price hikes on economic and business activities within South Africa. The analysis is based on a national survey which was conducted across diverse industries and firms within the various sectors of the economy Overall, 73% of CEOs and Senior Managers (small, medium, large) surveyed believe that the ever increasing electricity price hikes have affected their bottom line, with only 18% managing to pass the rising costs on to their customers. In addition, a majority of respondents (68%) were concerned by the fact that municipalities are increasing electricity prices by a greater amount than levied by Eskom to their clients - mainly industry and more affluent suburbs

58 Economic theory tells us that should this persist, business profitability will ultimately be affected, as conditions become tougher. Companies might resort to shedding more jobs not to the mention the negative welfare effects. Key findings Small-Sized Companies Electricity costs have been relatively low since the beginning of the price hikes in 28 for small sized companies within the services industry. This can be attributed to the fact that the tertiary sector is less energy intensive than both the primary and secondary sectors of the economy. As a result, profits are relatively inelastic with regard to electricity price increases. However, half of the respondents surveyed said that the series of price hikes have encouraged energy savings innovations (Table 2.3). Table 2.3: Small-sized Company Survey Results E le c tric ity c o sts in re la tio n to to ta l c o sts (a n n u a l a v e ra g e fro m 2 8 ) < 1 % 1 % - 2 % 2 1 % - 3 % > 3 % I N D U S T R Y F i n a n c i a l S e r v i c e s 3 A d v e r t i s i n g & D e s i g n 1 S e n s i t i v i t y o f p r o f i t t o e l e c t r i c i t y p r i c e h i k e s ( a n n u a l a v e r a g e f r o m 2 8 ) - 5 % 6 % - 1 % 1 % % > 1 5 % I N D U S T R Y F i n a n i c a l S e r v i c e s 3 A d v e r t i s i n g & D e s i g n 1 H a s t h e p r i c e h i k e a f f e c t e d y o u r b o t t o m l i n e? Y e s N o I N D U S T R Y F i n a n c i a l S e r v i c e s 1 2 A d v e r t i s i n g & D e s i g n 1 H a v e y o u m a n a g e d t o p a s s t h e r i s i n g c o s t s t o y o u r c u s t o m e r s? Y e s N o I N D U S T R Y F i n a n c i a l S e r v i c e s 3 A d v e r t i s i n g & D e s i g n 1 H a v e e l e c t r i c i t y p r i c e h i k e s e n c o u r a g e d e n e r g y s a v i n g i n n o v a t i o n s? Y e s N o I N D U S T R Y 1 2 F i n a n c i a l S e r v i c e s A d v e r t i s i n g & D e s i g n 1 H a v e e l e c t r i c i t y p r i c e h i k e s e n c o u r a g e d t h e u s e o f a l t e r n a t i v e s o u r c e s o f e n e r g y? Y e s N o I N D U S T R Y F i n a n c i a l S e r v i c e s 3 A d v e r t i s i n g & D e s i g n

59 Medium-sized Companies Seventy eight percent of respondents within medium sized companies cited that electricity costs in relation to total costs are below 1%. However, concerns have been expressed about the cumulative costs over the next three years. In the manufacturing sector, 4% of the respondents said that their electricity costs are between 1% and 2% of total costs and that they foresee energy costs becoming bigger than their wage bill within the next three years (Table 2.4). Six out of nine respondents said that their profits are relatively inelastic to electricity price increases (falling between % and 5%), while the rest, mainly within the manufacturing sector, recorded a sensitivity rate of between 6% and above 15%. All of the respondents surveyed said that the series of price hikes have encouraged energy savings innovations, with a majority using alternative sources of energy mainly to ensure a consistent supply of energy. Table 2.4: Medium-sized Company Survey Results E le c tric ity c o sts in re la tio n to to ta l c o sts (a n n u a l a v e ra g e fro m 2 8 ) I N D U S T R Y < 1 % 1 % - 2 % 2 1 % - 3 % > 3 % Financial S ervices M anufacturing 3 2 IC T 2 C onstruction 2 S e n sitiv ity o f p ro fit to e le c tric ity p ric e h ik e s (a n n u a l a v e ra g e fro m 2 8 ) I N D U S T R Y - 5 % 6 % - 1 % 1 % % > 1 5 % Financial S ervices M anufacturing IC T 2 C onstruction 2 H a s th e p r i c e h i k e a ffe c te d y o u r b o tto m l i n e? I N D U S T R Y Y e s N o Financial S ervices M anufacturing 3 2 IC T 1 1 C onstruction 1 1 H a v e y o u m a n a g e d to p a s s th e r i s i n g c o s ts to y o u r c u s to m e r s? I N D U S T R Y Y e s N o Financial S ervices M anufacturing 2 3 IC T 1 1 C onstruction 2 H a v e e l e c tr i c i ty p r i c e h i k e s e n c o u r a g e d e n e r g y s a v i n g i n n o v a ti o n s? I N D U S T R Y Y e s N o Financial S ervices M anufacturing 5 IC T 2 C onstruction 2 H a v e e l e c tr i c i ty p r i c e h i k e s e n c o u r a g e d th e u s e o f a l te r n a ti v e s o u r c e s o f e n e r g y? I N D U S T R Y Y e s N o Financial S ervices M anufacturing 3 2 IC T 1 1 C onstruction

60 Large-sized Companies In large sized organisations, 4 out of 9 of the respondents recorded their electricity costs in relation to the total to be between 1% and above 3%, with an even higher number stating that their profits are highly sensitive to electricity price hikes (Table 2.5). The biggest concern within this segment of business South Africa is that municipal electricity tariff rates are higher than those of Eskom, especially as their business operations are within the more affluent business districts. Many of the respondents have not been able to engage in energy savings innovations, for various factors, including that the rate at which the electricity costs have changed, it has not been possible to change to alternative sources yet. Secondly, the continued electricity rationing, especially within the manufacturers, coupled with inconsistencies within electricity distribution, has discouraged any energy savings innovations and rather prompted the use of alternative sources of energy. Table 2.5: Large-sized Company Survey Results E l e c t r i c i t y c o s t s i n r e l a t i o n t o t o t a l c o s t s ( a n n u a l a v e r a g e f r o m 2 8 ) I N D U S T R Y < 1 % 1 % - 2 % 2 1 % - 3 % > 3 % F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g 4 1 IC T 1 T r a n s p o r t 1 H o s p it a lit y 1 S e n s i t i v i t y o f p r o f i t t o e l e c t r i c i t y p r i c e h i k e s ( a n n u a l a v e r a g e f r o m 2 8 ) I N D U S T R Y - 5 % 6 % - 1 % 1 % % > 1 5 % F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g IC T 1 T r a n s p o r t 1 H o s p it a lit y 1 H a s t h e p r i c e h i k e a f f e c t e d y o u r b o t t o m l i n e? I N D U S T R Y Y e s N o F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g 5 IC T 1 T r a n s p o r t 1 H o s p it a lit y 1 H a v e y o u m a n a g e d t o p a s s t h e r i s i n g c o s t s t o y o u r c u s t o m e r s? I N D U S T R Y Y e s N o F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g 5 IC T 1 T r a n s p o r t 1 H o s p it a lit y 1 H a v e e l e c t r i c i t y p r i c e h i k e s e n c o u r a g e d e n e r g y s a v i n g i n n o v a t i o n s? I N D U S T R Y Y e s N o F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g 4 1 IC T 1 T r a n s p o r t 1 H o s p it a lit y 1 H a v e e l e c t r i c i t y p r i c e h i k e s e n c o u r a g e d t h e u s e o f a l t e r n a t i v e s o u r c e s o f e n e r g y? I N D U S T R Y Y e s N o F i n a n c i a l S e r v i c e s 1 M a n u f a c t u r i n g 2 3 IC T 1 T r a n s p o r t 1 H o s p it a lit y

61 2.6. Conclusion Historically, South Africa has one of the lowest electricity prices in the world and it is unquestionable that prices need to become competitive in order for Eskom to source funding for its R4 billion plus building programme. However, it is evident that the series and magnitude of price hikes have dealt a huge blow to business South Africa, which could ultimately result in job losses and company closures, before the additional capacity is generated

62 Chapter 3 Macroeconomic Impact of Eskom s Six-Year Capital Investment Programme Executive Summary Eskom s planned six-year capital investment programme is targeted to boost generation, transmission and distribution of electricity in the economy. However, this will have a direct and indirect positive impact on the growth and development of the country. The economic impact analysis provided in this chapter of Eskom s capital expansion revealed a positive impact on major macro variables (i.e. GDP, employment and investment) in the economy. Under a dynamic system (model), the 18% increase in capital investment in the electricity sector over a six-year period will have an indirect impact on inflation leading to a decline of about.1% over the long-run. This will lead to about.7%,.1% and.6% increase in output (GDP), employment and investment, respectively. On the other hand, similar but more robust impacts are revealed under a static system (CGE). An 18% increase in capital expenditure will over the long-run lead to about.75% and.79% decline in GDP and skilled employment, respectively. The bigger impacts in the CGE model are linked to its static nature. Over time the share of investment in the electricity sector to total investment in the economy is relatively small Introduction Over the years the South African economy has been sustaining itself with the existing energy infrastructure built before 1994 without investing in additional capacity to meet the growing demand of the population. This development has created a huge constraint on the growth prospect of the country. However, the need to increase energy capacity in the country became very urgent ten years post democracy. The state-owned utility company, Eskom, which is in the process of generating revenue, has also drawn up a six-year capital investment programme to increase the energy capacity of the country. In this chapter, the impact of Eskom s six-year capital expenditure on the macro and sectoral economy is explored. The two basic approaches (TSME and CGE model) as explained in Section 1.1 were adopted. In both the short-run and the long-run, capital stock/gross investment in the electricity sector is exogenously increased by 18%. In detecting the 18% shock, a base year was set at 21 when Eskom s total asset value was R million (Eskom 21). Therefore, the six-year

63 capital expenditure programme - after adjusting for inflation (6%) and depreciation rate (1%) - is cumulatively added to the asset value leading to an 18% average real growth. The impact of the 18% shock is less in the TSME model, due to its dynamic nature. The share of capital investment in the electricity sector to total capital investment in the economy is very insignificant over time. Therefore, an 18% shock in this sector will not have a significant impact on major macro variables. The rest of the chapter is structured as follows, Section Two analyses the impact of the capital expenditure using a time-series macro-econometric model while Section Three s analysis follows the CGE approach. Section Four provides an overall conclusion of the chapter. The model specifications remain the same as presented in Chapter Time-Series Macro-Econometric (TSME) Approach to Analysing the Impact of Capital Expenditure As mentioned earlier, the model specification and all estimated equations remain the same as presented in Chapter 1. This approach looks at the short and long-run impacts of an increase in Eskom s capital expenditure on the economy in a dynamic system. It takes into consideration the dynamic adjustment processes and provides a contemporaneous feedback of any shock to the entire system. In order to capture the impact of Eskom s capital expenditure on the entire economy, fixed investment in electricity, gas & water sector is assumed to be exogenous in the model over 8% of fixed investment in this sector comes from electricity. The idea being that capital expenditure will translate into some form of capital stock over time and given the fact that the current capital stock is the sum of existing capital stock (taking into consideration the rate of depreciation) and current investment. The short-run and long-run simulations are tested by shocking fixed investment in electricity, gas & water sector by 18% per year over a six-year period. All the results are reported as percentage changes (elasticity) from the baseline scenario as explained in Chapter 1. Economy-Wide Econometric Sensitivity Analysis In this section, the short-run and long-run impact of an increase in capital expenditure by Eskom on some major macro variables in the economy is analysed. As mentioned earlier, all the estimated equations remain the same as presented in Chapter 1. However, the explicit assumption made in this chapter is the exogenous nature of fixed investment in the electricity, gas & water sector

64 Table 3.1 presents the short and long-run impact of an increase in capital expenditure by 18% per year over a six-year period. As expected, the impacts are positive on the major macroeconomic variables except for some short-run impacts, which could be attributed to the slow adjustment processes embedded in the system. The positive impact of an increase in capex was found to be less significant than the negative impacts of an electricity price increase. The reason for this is that the price increases have a direct impact on inflation and serves as a linkage between the demand-side and supply-side of the economy. On the other hand, the capex increase has an indirect impact on inflation via excess demand (difference between domestic expenditure and production) in the economy. Table 3.1: Economy-Wide Impacts of an Increase in Eskom s Capital Expenditure Long-run Short-run Employment.1%.2% Output.7%.1% Investment.6% 1.8% Household Consumption.9%.4% Real Wages.5%.4% Exports %.7% Imports.7%.1% Exchange Rate (R/$) -.18% -.12% Consumer Inflation -.1% -.11% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. In the long-run, total investment will rise by about.6% leading to an output (GDP) increase of about.7% as a result of an 18% capex increase over a six-year period. Due to this, employment and real wages will increase by about.1% and.5% respectively. Consumer inflation will deviate from its long-run path by about.1%. This is attributed to the much higher impact on GDP than domestic expenditure, which resulted in a declining excess demand. As inflation shrinks and GDP rises, the exchange rate (rand) will appreciate by about.18% in the long-run. Given the net impact of falling inflation and rand appreciation the long-run exports will remain unchanged while imports will rise by about.7% due to output increases. The short-run impacts on total investment will be more robust at about 1.8% due to the direct capex injection. The impact on the exchange rate and inflation will also be positive and in line with its long-run path

65 Sectoral Econometric Sensitivity Analysis Following the disaggregated sectoral model adopted in Chapter 1, the response of major sectoral variables to the shock in Eskom s capital expenditure will depend on the relative share of inputs (labour & capital) used in the production process. Table 3.2 presents the result of an 18% increase in capital expenditure on sectoral variables over a six-year period. Given the indirect linkage between investment in the electricity sector and investment in the other sectors, the impact of the shock on other major variables was not strong. In other words, the impact of the shock on other sectors is felt through aggregate demand and supply. Sectors that tend to response stronger in the long-run in terms of investment are also those that have the highest energy intensity. The financial service and construction sector investment will in the long-run increase by only about.5% and.3%, respectively. These are the sectors with the lowest energy intensity. Table 3.2: Sectoral Impacts of an Increase in Eskom s Capital Expenditure Long-run Employment Output Investment Real Exports Imports Wages Manufacturing.1%.7%.8%.7% -.1%.8% Sector Mining Sector -.4%.3%.15%.2%.3%.7% Agricultural Sector Construction Sector Electricity, Gas & Water Sector Wholesale & Retail Trade Sector Transport & Communication Sector Financial Service Sector.4%.7%.12%.6%.1%.5%.2%.1%.3% % 1.5% 1.8% 1.5% -.2% 6%.2%.5%.8%.4% -.1%.4% -.3%.4%.13%.3% %.5% -.1%.3%.5%.3% -.3%.3% Short-run Manufacturing.6%.1%.5%.1%.2%.5% Sector Mining Sector -.1% -.14% -.7%.2% -.1% -.1% Agricultural Sector Construction Sector Electricity, Gas & Water Sector Wholesale & Retail Trade -.4% -.9% -.4% -.2% -.2%.6% % % -.1% %.14%.1%.16%.5% -.3%.3%.6%.3%.5%.2%.2%

66 Sector Transport & Communication Sector Financial Service Sector.16%.7%.8%.2%.1% -.1% % %.2% % -.2%.5% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Based on the above scenario, the long-run output in the electricity sector will increase by about 1.8% due to the direct impact of the investment shock. The impact on output in the different sectors of the economy will indirectly feed in through falling inflation as excess demand shrinks. Therefore, the price block (inflation) serves as a linkage between the various sectors in the economy and the sensitivity on inflation from each sector will partly be reflected in output. Output in the agricultural and manufacturing sectors will increase by about.7% each in the long-run. Output responses in other sectors of the economy will not be economically significant with the construction sector posing almost no impact in the long-run. Employment and real wages in the electricity sector will rise by about 1.5% each in the longrun. Given the small impact on output in other sectors, long-run employment change will be negligible. The impact of real wages will follow the direction of output as increased output leads to increased productivity. Exports will decline in the sectors where the effect of the exchange rate is stronger than that of inflation. Although, the impacts are relatively insignificant, exports in the manufacturing, wholesale & retail and financial sectors will decline in the long-run by about.1% and.3%, respectively..on the other hand, imports will be much more driven by the trend in output. The short-run implications also remain negligible and due to the slow adjustment process embedded in the system the impacts may not be easily visible. The response of the shock in the mining and agricultural sector was negative across the board while no change in output, employment and real wages will be recorded in the construction and financial sectors Computable General Equilibrium (CGE) Approach to Analysing the Impact of Capital Expenditure Following the approach adopted in Chapter 1, this section looks at the short and long-run impacts of the capital expenditure programme on the economy in a static system. The University of Pretoria CGE model of South Africa (UPGEM model) was used and the shortrun and long-run simulations were tested. In both the short-run and the long-run, capital stock in the electricity sector was exogenously increased by 18%. The impacts of capital expenditure in the electricity sector on the macro and sectoral economy are considered. In Appendix B, the report provides a description of the UPGEM model, the closure rules, calculation of Equivalent variation (EV) values, a summary of the model limitations, as well as the simulation design

67 As was the case in the previous chapter, all the results in this section are reported as percentage point changes from the base scenario. In other words, the results are not forecasts of various economic variables, but rather deviations due to increases in the capital expenditure. Economy-Wide Computable General Equilibrium Analysis Table 3.3 shows the short-run and long-run macroeconomic impact of capital expenditure increases on the South African economy, under the scenario discussed above. In the short run, increased capital expenditure will result in a real devaluation of the currency. Increased capital expenditure will increase the demand for imports, especially inputs used in the capital expenditure process. This increased demand will result in an increased supply of rand, weakening the real value of the currency. However, in the long run, the increased capital expenditure is expected to increase the productive capacity of the country, improving the competitiveness of industries in South Africa, and therefore in the long run an appreciation of the currency is expected. The terms of trade, which is the ratio between export prices and import prices, will weaken in the short run as well as in the long run. The real devaluation in the short run will lead to an increase in the domestic currency received for exports. This will, for exporting industries, counter the price impacts of increased capital expenditure. However, the real devaluation will increase the price of imports, in terms of the domestic currency, and therefore the price of imported inputs in the production process, as well as the price of imported household products. The net impact will be that relative import prices will increase more than the relative increase in export prices. In the long run, the real appreciation of the currency, as well as higher real household consumption, will increase the demand for imports. Also, the real appreciation will decrease the rand value received for exports, and the net impact will be a weakening in the terms of trade. Table 3.3: Economy-Wide Impacts of an Increase in Electricity Prices Long-run 18 percent Real devaluation -.18 Terms of trade -.13 Gross operating surplus.56 Real household consumption 1.22 Aggregate capital stock.52 Real GDP.75 Average real wage 1.5 Unskilled employment.79 Short-run 18 percent Real devaluation.13 Terms of trade

68 Gross operating surplus.39 Real household consumption.46 Aggregate real government demands.45 Real GDP.45 Skilled employment.4 Unskilled employment.55 The increase in capital expenditure will, in the short run (.39%) and in the long run (.56%) increase gross operating surplus. Capital is variable in the long run, thus the impact on the gross operating surplus is somewhat strengthened due to the ability to move capital to higher yielding industries, or by increasing investment. Real household consumption will increase by.46% in the short run, mainly due to the positive employment (number of workers) impacts. As industries increase their output (Table 3.5), more workers will be employed. In the long run, skilled labour is exogenous, but skilled wages are allowed to adjust. This will then reinforce the real household consumption increase in the long run (1.22%) as unskilled employment (number of workers) as well as skilled wages increase. Because the gross operating surplus and real household consumption will increase, government revenue will also increase in the short run. If we assume a neutral government budget, real government demands will also increase. For an 18% increase in capital stock in the electricity sector, aggregate net capital stock in the economy is expected to increase by.52% in the long-run. The impact on real GDP should be positive, since consumer spending, gross operating surplus, aggregate capital stock and government demands are expected to increase. The impact of a capital expenditure increase of 18% on the real gross domestic product (GDP) will be an increase of about.45% in the short run and.75% in the long run. Sectoral Computable General Equilibrium Analysis All sectors use electricity, directly or indirectly, as an input, therefore increased capital expenditure in the electricity sector, leading to increased capacity to produce electricity, will have an impact on all the industries of the economy. Furthermore, various industries will be directly affected through an increased demand for inputs used in capital expenditure as well as increased demand for the inputs used to produce electricity. It is therefore expected that some structural changes will take place in the economy. (Complete descriptions of industries are included in Appendix C and detailed results are provided in Appendix D2). Due to the multi-industry disaggregation in the CGE approach, the impacts of the capital expenditure are presented according to variable changes by sectors. Output (GDP) Impacts Table 3.4 provides an impact range, with an upper bound impact and a lower bound impact, based on sub-industry impacts, of the capital expenditure increases in the nine Standard Industrial Classification (SIC) sectors. Disaggregated 39 sub-industry output changes are provided in Table D

69 In the short run, all industries are expected to increase output as a result of the increased capital expenditure in the electricity sector. In the Agriculture, Hunting, Forestry and Fishing sector, the impact will be positive, but marginal, with output increasing between.9% and.21%. In the Mining and quarrying sector, Coal output is expected to increase.75%, as the increased output in electricity increase the demand for coal. Gold production, an electricity intensive industry, is expected to increase by 1.34% as electricity supply is increased. In the Manufacturing sector, labour intensive industries are expected to increase output marginally between.1% and.3%. However, electricity intensive industries will increase output up to 2.6% (Iron and Steel). Also, the increased demand for Iron and Steel as a direct result of the capital expenditure programme will increase the profitability of this industry. The increase in capital expenditure is expected to increase electricity sold by 5.65% ceteris paribus, while construction is bound to benefit directly from the expenditure and increase output in the short run by.12%. This relatively small increase might be an indication of some crowding out in the construction sector. The capital expenditure in the electricity sector could be expected to increase construction prices, thereby moderating construction demand in other sectors. General government spending (.45%) is positively affected, given the assumption that government adjusts spending based on revenue collected. Revenue collected will be higher due to the employment impacts (see the next section), higher economic growth, as well as higher gross operating profit. Table 3.4: Sectoral Output Impacts Long-run Impact 18 percent range Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper 1.82 Manufacturing Upper Electricity, gas and water supply Upper Construction.15 Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and household goods; Upper catering and accommodation Transport, storage and communication Upper 1.11 Financial intermediation, insurance, real-estate and business services Community, social and personal services Short-run Upper Upper Impact 18 percent range Agriculture, hunting, forestry and fishing Upper.21.9 Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper

70 .4 Construction.12 Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and household goods; Upper catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real-estate and business services Community, social and personal services Upper Upper In the long run, output in 37 of the 39 industries is expected to increase if increases in real capital expenditure are analysed. Also, short run output increases are reinforced in the long run in 31 of the 39 industries. In the long run, capital stocks are allowed to adjust, and to move to higher yielding industries. As electricity becomes more abundant it could be expected that capital stocks might flow towards more electricity intensive industries. This is evident as the 8 industries, that perform better in the short run than in the long run, are relatively less electricity intensive than the other industries in that specific SIC sector. Other mining (-.4%) and other manufacturing (-.25%) will, in the long run, reduce output. Industries that will increase output in the long run by less than the increase in output in the short run are Textiles (.14%), Other Non-metallic Mineral products (.25%), Other Metal Products (.34%), Other Machinery (.22%), Electrical machinery (.35%) and Transport equipment (.3%). On the other hand, industries that will increase output by more than two percentage points in the long run are Iron and Steel (4.7%), Non-ferrous Metal (3.51%) and the Electricity industry (5.88%) ceteris paribus. Employment and Wage Impacts Employment impacts will follow the changes in output, induced by the increase in capital expenditure in the electricity sector. Industries will increase output due to increased availability of electricity and as a result employ more workers. In the short run, industries that will increase employment by more than 1% for an 18% increase in capital expenditure are the Coal industry (1.82%), the Gold industry (2.4%), Iron and Steel industry (5.31%), Nonferrous Metal industry (3.5%) and Water industry (2.1%). Coal is an important input in the production of electricity, and the increase in electricity production will increase the demand for coal. The next three industries are electricity intensive industries and will directly benefit from increased electricity production, while water is an important input in mining and heavy industries. The increased production in these industries will increase the demand for water. The only industry recording a marginal decrease in employment is the construction industry (-.1%). This reflects the possible crowding out effect due to higher construction prices as discussed in the previous section. In the long run, skilled employment is fixed and the change in the number of workers is unskilled workers. In 29 of the 39 industries, the employment impact will be smaller in the long run than in the short run. This is due to labour market differentiation where skilled labour is fixed and skilled wages are adjusted upwards. Industries that will increase unskilled

71 employment in the long run by a higher percentage than in the short run are industries that will experience a capital inflow in the long run; mainly service industries and consumer goods industries. Two industries will reduce unskilled employment in the long run (Other Mining and Other Manufacturing); following the reduction in output in the long run. The model specifies a constant elasticity of substitution (CES) relationship between primary factors. In the model, rates of return (in the short run) and capital stock (in the long run) are allowed to vary. CES is seen as an appropriate functional form in all industries except the electricity industry. In the electricity industry, the capital stock is exogenously increased in the short run and in the long run, and the model will yield a reduction in employment in the electricity sector as labour is replaced by capital. However, it is more likely that the relationship will follow the Leontief functional form, where labour will increase if the use of capital increases. As a result, employment impacts in the electricity sector cannot be adequately explained by the model and the cumulative positive employment impact presented in this chapter could be seen as a conservative estimation of employment gains. Table 3.5: Sectoral Employment Impacts Long-run Agriculture, hunting, forestry and fishing Mining and quarrying Manufacturing Electricity, gas and water supply Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and household goods; catering and accommodation Transport, storage and communication Financial intermediation, insurance, real-estate and business services Community, social and personal services Short-run Impact range Upper Upper Upper Upper Upper Upper Upper Upper 18 percent n/a Impact range 18 percent Agriculture, hunting, forestry and fishing Upper.6.35 Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper 2.1 n/a Construction.2 Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and household goods; catering and accommodation Upper Transport, storage and communication Upper

72 Financial intermediation, insurance, real-estate and business services Community, social and personal services Upper Upper In the long-run wages are the market clearing agent for skilled employment. In other words, the number of skilled workers is fixed (Appendix B2). This reflects the idea that skilled labour is determined by factors outside the model. On the other hand, unskilled workers and unskilled wages are allowed to vary due to the high unemployment of unskilled workers in South Africa. It could therefore be expected that the wage impact due to capital expenditure on skilled labour would be higher than the impact on the wages of unskilled labour. This is reflected in Table 3.6. Statistics South Africa (StatsSA), in the national Social Accounting Matrix (SAM), classifies all occupations into eleven groups (StatsSA 24). This is in accordance with the South African Standard Classification of Occupations (SASCO). This analysis follow the same classification and a full description of all occupations are available in StatsSA (24). In Table 3.6 it is shown that skilled workers will experience real wage increases between 1.2% and 1.6% for an 18% increase in capital stock in the electricity sector. Unskilled real wages are expected to increase by between.6% and.9%. Table 3.6: Wage impacts by occupation Long-run 18 percent Legislators 1.55 Professionals 1.6 Technicians 1.58 Clerks 1.59 Service workers 1.16 Skilled agricultural workers 1.4 Craft workers.9 Plant and machine operators.86 Elementary occupations.78 Domestic workers.68 All Unspecified occupations.72 The wage impacts by population group are shown in Table 3.7. As a larger percentage of African and Coloured workers are economically active as unskilled labour, the positive impact on their wages would be the smallest (around 1.13%). Table 3.7: Wage impacts by population group Long-run 18 percent African 1.13 Coloured 1.12 Indian 1.26 White

73 On the other hand, as a larger percentage of White workers are economically active as skilled workers, the impact on their wages (1.34%) would be the largest for the population groups under consideration. Wage impacts, by population group, are disaggregated to skilled wage impacts in Table 3.8. As discussed, the impacts on skilled labour across all population groups are larger than the wage impacts on unskilled labour across all population groups. Table 3.8: Skilled wage impacts by population group Long-run 18 percent African 1.28 Coloured 1.33 Indian 1.43 White 1.42 White skilled workers would, for an 18% increase in capital stock experience a 1.42% increase in skilled wages, while African workers would experience a 1.28% increase. Coloured and Indian workers would experience a 1.33% and 1.43% increase, respectively. Given the fixed long-run skilled employment, the short-run employment changes by occupation, as a result of increased capital expenditure, are shown in Table 3.9. Employment across all occupations will be affected positively if capital expenditure is above the inflation rate. Table 3.9: Occupational employment impacts Long-run 18 percent Legislators.41 Professionals.44 Technicians.38 Clerks.42 Service workers.49 Skilled agricultural workers.47 Craft workers.24 Plant and machine operators.65 Elementary occupations.57 Domestic workers.49 All Unspecified occupations.46 All eleven occupational groups will have a net positive impact on employment, ranging between.24% (Craft workers) and.65% (Plant and Machine operators) for an 18% increase. This employment breakdown is in line with employment and output production changes by sector. For example, Gold and Coal mining will significantly increase output and employment, in line with the.65% increase in plant and machine operators. On the other hand, the construction industry will marginally increase output and marginally decrease employment, in line with the relatively low increase of.24% in craft worker employment

74 Table 3.1 shows the employment impact of electricity price increases by population group. The employment impact will be positive across all population groups. Employment, in the short run, for the African group of workers will increase the most (.5%) of all the population groups. Table 3.1: Employment impacts by population group Long-run 18 percent African.5 Coloured.41 Indian.41 White.4 Approximately 47.5% of African workers are employed in the Government, Health and Social Services, Manufacturing and Mining industries. These industries would increase output relatively more than the other industries due to the capital expenditure increases in the electricity sector Conclusion This chapter analysed the impact of an increase in Eskom s capital expenditure on the overall macro and sectoral economy using both the TSME and CGE models. The simulation results from the TSME model revealed the macro implications of the six-year capital expenditure programme. In the long-run, major macro variables (i.e. household consumption, GDP, and employment) will be positively affected by the increased investment. Although the positive impacts of the shock is very insignificant, due to the relatively small share of electricity investment in total investment in the economy. The price block, which serves as a linkage between the different segments of the economy, is not directly linked to investment in electricity. However, a weak transmission mechanism of the shock on the macro and sectoral economy is detected both in the short-run and long-run. At the sectoral level, the electricity sector will boost employment by about 1.5% in the longrun. Impacts on other sectors in terms of job creation will remain negligible. The same trend also goes with GDP impact but with a higher magnitude. On the other hand, the simulation results from the CGE revealed similar but more robust positive impacts on the macro economy. Overall, in the short-run, real gross domestic product increased, the currency appreciated, gross operating surplus was higher, aggregate real household consumption increased and skilled as well as unskilled unemployment increased. Most of the short-run macroeconomic impacts were reinforced in the long-run, with a real appreciation in the currency, strengthening in the terms of trade, increase in gross operating surplus, increase in real household consumption, as well as a increase in real gross domestic product, wages and employment

75 Chapter 4 Net Impact of the Increase in Electricity Prices and Eskom s Six-Year Capital Investment Programme Executive Summary The net impact of an increase in electricity prices and Eskom s capital expenditure continues to be negative on major macro variables (i.e. GDP, employment and investment) in the economy. This can be attributed to the direct effect that electricity prices have on inflation. Under a dynamic system (model), the 24.8% increase in electricity prices over a three-year period and 18% increase in capital expenditure over six-year period (Scenario 1) will directly impact on inflation leading to about 1.9% increase over the long-run. This will lead to about 1%,.1% and.8% declines in output (GDP), employment and investment, respectively. On the other hand, a similar impact is revealed under a static system (CGE). Applying Scenario 1 will over the long-run period lead to about.28% and.53% declines in GDP and skilled employment, respectively. The short-run implications of the price hikes in a dynamic model are not very robust, due to the slow adjustment processes that are embedded in the economy, whereas in the static system robust short-run implications are captured Introduction The electricity price impact analysed in Chapter 1 is expected to reflect a huge negative effect on the macro and sectoral economy, whereas, a positive effect on the economy will occur when Eskom s six-year capital investment comes to the fore given the analysis reported in Chapter 3. However, the magnitude of the price impacts on major variables was found to be more pronounced than that of the capex impacts. In this chapter, the net impact of the Eskom s electricity price hikes and the six-year capital expenditure on the macro and sectoral economy is explored. The two basic approaches (TSME and CGE model) as adopted in Chapters 1 & 3 are followed in this chapter. The two approaches will simultaneously shock the macro system in the order followed in the previous chapters. The rest of the chapter is structured as follows, Section Two analyse the net impact of the electricity price hikes and Eskom s capital expenditure using a time-series macro-econometric model while Section Three s analysis follows the CGE approach. Section Four provides an

76 overall conclusion of the chapter. The model specifications remain the same as presented in Chapters 1 & Time-Series Macro-Econometric (TSME) Approach to Analyse the Net Impact of Electricity Price Hikes and Eskom s Capital Expenditure Following the same techniques as adopted in the previous chapters the model specification and all estimated equations remain the same. However, this approach looks at the short and long-run net impacts of electricity price hikes and an increase in Eskom s capital expenditure on the economy in a dynamic system. It takes into consideration the dynamic adjustment processes and provides a contemporaneous feedback of any shock to the entire system. In order to capture the net impact on the entire economy, fixed investment in Electricity, Gas & Water sector is assumed to be exogenous in the model (see Chapter 3). Therefore, a simultaneous shock on electricity prices and gross investment in the electricity sector are applied to the system in order to derive the net impacts on major macro variables in the economy. Five short-run simulations and five long-run simulations are tested, based on the price scenarios adopted in Chapter 1. The distinction between the scenarios applied in this chapter is that each price scenario is augmented with the shock on capital expenditure (see the definition of the various scenarios in Appendix A4). The short-run and long-run simulations are tested by simultaneously shocking fixed investment in the electricity, gas & water sector by 18% per year over a six-year period with the various price scenarios. All the results are reported as percentage changes (elasticity) from the baseline scenario as explained in Chapter 1 and the transmission mechanism of the shocks applied are the same as explained in previous chapters. Economy-Wide Econometric Sensitivity Analysis In this section, the short-run and long-run net impact of an increase in electricity prices and Eskom s capital expenditure on some major macro variables in the economy is analysed. Table 4.1 presents the short and long-run net impact based on the four scenarios explained above. The short-run implications of electricity price hikes and capex increases remained less severe than the long-run implications as discussed in Chapter 1. Since the magnitude of the negative impacts of electricity price hikes is significantly higher than the magnitude of the positive impacts of capex increases, it is expected that the net impacts will remain negative but milder. As discussed earlier, this significant difference in magnitude is linked to the different impact of the shocks on inflation

77 The model continues to feature a slow adjustment in the long-run due to the structural constraints embedded in the economy. Therefore, a simultaneous increase in the price of electricity by 24.8% and an 18% capex increase (Scenario 1) will impact negatively on consumer inflation during the short-run. Consumer prices will, however, deviate from its shortrun path by about 4.2%. Due to this, the exchange rate will depreciate by about 5% given the widened inflation differential. Exports will fall by about.3% while imports will fall by about 1.5% due to the larger effect of the exchange rate depreciation. The short-run domestic investment will be more pronounced at 8.2% due to the capex injection. Changes in output remains the same at about.1%, which is attributed to the slow adjustment processes embedded in the system. Household consumption expenditure will fall moderately by.3% and real wages will increase by.8%. As the economy adjusts fully to the simultaneous shocks in the long-run, the impact on inflation will moderate to about 1.9% - deviation from its long-run path - when Scenario 1 is applied. Domestic investment and employment will fall by about.8% and.1%, respectively, and the combined effect will result in output falling by about 1% from its long-run path. Exports will fall by about.1% due to the continued depreciation of the exchange rate while the output effect on imports will come to the fore in the long-run with a decline of about 2.4%. Household consumption expenditure and real wages will continue to fall in the long-run by about 1.6% and.6%, respectively

78 Scenario 1 Scenario 2 Scenario 3 Scenario 4 Table 4.1: Economy-Wide Net Impacts of an Increase in Electricity Prices and Eskom s Capital Expenditure Long-run Employment Output Investment Household Consumption Real Wages Exports Imports Exchange Rate (R/$) Consumer Inflation -.1% -1% -.8% -1.6% -.66% -.9% -2.4% 3.1% 1.92% -.8% -.71% -1.24% -1.6% -.45% -.5% 1.43% 2% 1.15%.5%.27%.41%.46%.22%.1%.5% -.53% -.21%.3% 1.9% 2.8% 2.6% 1.35%.2% 2.8% -2.32% -.85% Scenario 5 -.1% -.83% -.94% -1.31% -.55% -.8% -1.93% 2.52% 1.5% Short-run Scenario 1 -.6%.1% 8.2% -.32%.8% -.32% -1.49% 4.98% 4.19% Scenario 2 -.4%.5% 3.5% -.17%.3% -.19% -.79% 2.58% 2.19% Scenario 3 -.1% -.4% 1.46% -.6%.1% -.9% -.29%.78%.59% Scenario 4 -.1% -.6%.3% -.5% -.2% -.8% -.19%.38% -.52% Scenario 5 -.5% -.9% 6.% -.26%.7% -.27% -1.23% 4.8% 3.39% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario

79 As different price scenarios (i.e. Scenarios 2, 3 & 4) are applied to the system, the long-run impacts become less and less severe (Table 4.1). This trend remained the same with the scenarios presented in Chapter 1, even in the short-run. This implies that a different pricing option by Eskom might have had a less severe or even a positive impact on the economy. Sectoral Econometric Sensitivity Analysis Adopting the same technique used in developing the sectoral models as described in the previous chapters, the net impacts of an increase in electricity prices and the increase in Eskom s capital expenditure are detected on the eight sectors of the economy. Manufacturing Sector Impacts Table 4.2 presents both the short and long-run net impacts of an increase in electricity prices and capital expenditure by Eskom on major variables within the manufacturing sector. In Scenario 1, given the short-run inflationary net impact, investment in manufacturing will decline by about 2% as a significant reduction in the cost of capital may not occur due to the positive effect of capex. Therefore, output and employment in the sector will remain negative, falling by.5% and.24%, respectively. Net impact on real wages will remain the same as in Table 2 (Chapter 1), declining by about.26%. On the trade flows, exports during the shortrun period will decline by about.56% while imports will also follow the same trend of about 1.75%. Table 4.2: Manufacturing Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Employment Output Investment Real Wages Exports Imports -.19% -1.83% -2.42% -1.83% -.6% -2.12% Scenario % -1.13% -1.52% -1.13% -.3% -1.32% Scenario 2.3%.27%.48%.24%.2%.35% Scenario 3.18% 1.97% 2.78% 1.87%.9% 1.94% Scenario 4 Scenario % -1.53% -1.92% -1.43% -.4% -1.72% Scenario 1 Scenario 2 Scenario 3 Short-run -.24% -.53% -2.5% -.26% -.56% -1.75% -.13% -.3% -1.15% -.14% -.3% -.95% -.5% -.15% -.37% -.1% -.6% -.35% Scenario 4 -.4% -.16% -.25% -.16%.2% -.26% Scenario % -.47% -1.75% -.23% -.45% -1.55% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario

80 In the long-run, as inflation becomes subdued, the fall in exports will remain moderate at about.6% while imports will also fall by about 2% on the back of a continued fall in output. Output will fall by about 1.8% in the long-run, which remains the combined effect of a fall in domestic investment of about 2.4% and in employment of about.19%. Applying different price scenarios to the system the manufacturing sector continues to react positively in the short-run and the long-run in a similar fashion as explained in Chapter 1. Mining Sector Impacts As shown in Table 4.3 the long-run net impacts of an increase in electricity prices and capital expenditure by Eskom on major variables within the mining sector remain negative and significant. In the long-run, exports will decline by about.2% when Scenario 1 is applied to the system indicating a continued bigger effect of inflation in the sector. Investment in mining will fall by 3.7%, likewise the level of output. The net effects on employment and real wages will remain the same at about -1.6% and -4.1%, respectively. The short-run implications associated with Scenario 1 will lead to investment in mining increasing by about.18%. Output and employment in the sector will fall by.6% and.4%, respectively, due to the negative effect of the capital expenditure increase on the sector. Real wages, however, will increase by about.17% while exports and imports will fall by about.8% and 1.4%, respectively. Table 4.3: Mining Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Employment Output Investment Real Wages Exports Imports -1.6% -3.77% -3.7% -4.8% -.22% -4.23% Scenario 1 -.9% -2.7% -2.1% -2.38% -.17% -2.43% Scenario 2.36%.83%.53% 1.2% -.6%.97% Scenario 3 1.9% 5.23% 3.6% 6.22% -.37% 5.97% Scenario 4 Scenario % -2.87% -2.9% -3.18% -.19% -3.23% Scenario 1 Scenario 2 Scenario 3 Short-run -.41% -.58%.18%.17% -.8% -1.4% -.17% -.23%.15%.1% -.5% -.7% -.8% -.11% -.13%.14% -.1% -.23% Scenario 4 -.4% -.6% -.37%.13% -.21% -.9% Scenario 5 -.3% -.4%.13%.16% -.9% -1.4% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario

81 The different price scenarios applied to the system revealed trends similar to those described in Chapter 1. Agricultural Sector Impact Given the response of the agricultural sector to the shocks in electricity prices and capital expenditure presented in Chapters 1 & 3, the net impact of these shocks is presented in Table 4.4. In Scenario 1, the fall in output will moderate to about 1.4% and.9% in the longrun and short-run, respectively. In line with the explanation presented in Chapter 1 investment in the short-run will decline by about 3.8% while in the long-run a decline of about 2% will be recorded. The long-run net impact on employment in Scenario 1 will remain the same at about.6% due to the negligible effect of the capex increase (Chapter 3). In the short-run, employment will decline further by about.34% given the negative capex impact. Exports and imports in the long-run will decline by about.3% and 4.6%, respectively. This impact is milder on imports than exports during the short-run period (Table 4.4). Table 4.4: Agricultural Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Employment Output Investment Real Wages Exports Imports -.6% -1.43% -2.8% -1.24% -.33% -4.65% Scenario 1 -.3% -.92% -1.23% -1.22% -.18% -2.75% Scenario 2.%.34%.18%.31% -.4% 1.25% Scenario 3.6% 2.27%.92% 2.16% -.3% 5.85% Scenario 4 Scenario 5 -.4% -1.17% -1.63% -.94% -.26% -3.55% Scenario 1 Scenario 2 Scenario 3 Short-run -.34% -.93% -3.8% -.29% -.72% -3.44% -.18% -.44% -1.9% -.32% -.38% -1.84% -.7% -.21% -.8% -.7% -.17% -.74% Scenario 4 -.4% -.19% -.66% -.12% -.18% -.74% Scenario % -.73% -3.% -.23% -.57% -2.94% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Other price scenarios applied to the system follow similar trends as described in Chapter

82 Construction Sector Impact The net impact of the simultaneous shocks on the construction sector remained relatively unchanged when compared to the electricity price impact presented in Chapter 1. Although the impact of the electricity price hike is relatively small the unchanged net impact can be attributed to negligible effects of a capital expenditure shock on the sector. In this milieu, when Scenario 1 is applied, investment in the sector will decline by about.5% in the long-run and this will lead to output falling by about.7%. Employment and real wages will also fall by about.2% and.53%, respectively (Table 4.5). Table 4.5: Construction Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Employment Output Investment Real Wages Exports Imports -.2% -.7% -.5% -.53% Scenario 1 -.4% -.44%.1% -.31% Scenario 2.14%.35%.2%.25% Scenario 3.27% 2.2% 1.63% 1.5% Scenario 4 Scenario % -.55% -.2% -.4% Scenario 1 Scenario 2 Scenario 3 Short-run.1%.5%.39%.3%.1%.3%.21%.2%.%.1%.6%.1% Scenario 4.1%.1%.2%.1% Scenario 5.1%.4%.33%.3% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 In the short-run, output and investment will increase by only about.5% and.4%, respectively, when Scenario 1 is applied. Employment and real wages will rise by about.1% and.3%, respectively. Under different price scenarios the construction sector will react positively, as explained in Chapter 1. Electricity, Gas & Water Sector Impacts The net impact of an increase in electricity prices and capital expenditure by Eskom will remain positive and elevated in the electricity, gas & water sector. As discussed in Chapter 1,

83 given the relevance of Eskom in this sector, electricity prices play a big role in the long-run investment function. Therefore, applying Scenario 1 to the entire macro system - where investment in the Electricity, Gas & Water is made exogenous - the short-run output will increase by about 3.1% (Table 4.6). Employment and real wages will grow by 2.8% and 2.7%, respectively. An increase in exports will continue to be caused by the net effect of increased inflation and a depreciated rand, indicating the latter (rand) effect to be bigger. Under different scenarios, the short-run responses follow similar trends as those presented in Chapter 1. Table 4.6: Electricity, Gas & Water Sector Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Employment Output Investment Real Wages Exports Imports 11.1% 13.3% 11.2% -2.2% 15.8% Scenario 1 1.3% 1.56% 1.3% -1.4% 6.3% Scenario 2 2.4% 2.9% 2.5%.7% 5.31% Scenario 3 8.4% 1.1% 9.% 3.8% 5.63% Scenario 4 Scenario 5 6.5% 7.8% 9.% -1.7% 12.1% Scenario 1 Scenario 2 Scenario 3 Short-run 2.84% 3.1% 2.66% 1.8% 1.2% 1.24% 1.3%.96%.8%.8%.48%.5%.35%.55%.7% Scenario 4.29%.24%.16%.43% 1.1% Scenario % 2.7% 1.46% 1.76% 1.5% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 In the long-run, output will increase by about 13.3% while employment and real wages will grow at about 11% each. Exports will, however, decline by about 2.2% while imports will grow at about 16% on the back of output increase. Under various price scenarios, the long-run responses are similar to those of Chapter 1. Wholesale & Retail Trade Sector Impacts As shown in Table 4.7, the long-run net impacts of an increase in electricity prices and capital expenditure on major variables within the wholesale & retail trade sector remained relatively significant. In the long-run, exports will increase by about.6% when Scenario 1 is applied to the system. Investment in the sector will fall by about 1.6% and output by 1.15%

84 Employment and real wages will fall by about.5% and 1.16%, respectively, while imports will decline by about.72%, mainly because of the output effect. In the short-run, under Scenario 1, investment in the sector will increase by about 1% while output will grow by about.5%. On this ground, employment and real wages in the sector will increase by.18% and.44%, respectively. Exports will decline by about.5% while imports will increase by about.4%. Table 4.7: Wholesale & Retail Trade Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long run Employment Output Investment Real Wages Exports Imports -.52% -1.15% -1.62% -1.16%.6% -.72% Scenario % -.75% -.6% -.72% -.8% -.46% Scenario 2.13%.29%.35%.28% -.8%.18% Scenario 3.82% 1.85% 2.28% 1.84% -.51% 1.14% Scenario 4 Scenario % -.93% -1.32% -.92%.6% -.58% Short run.18%.49% 1.5%.44% -.48%.38% Scenario 1.8%.2%.42%.18% -.28%.17% Scenario 2.2%.5%.13%.5% -.7%.1% Scenario 3 Scenario 4 -.2%.5% -.2% -.4% -.3% -.8% Scenario 5.15%.38%.75%.35% -.44%.3% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Under the various scenarios, the responses again follow patterns similar to those explained in Chapter 1. Transport and Communication Sector Impact Given that this sector is highly energy intensive, the net impact of an increase in the price of electricity and capital expenditure by Eskom (Scenario 1) will result in output falling by about 2.5% in the long-run while the short-run response will be an increase of about.2% (Table 4.8)

85 Table 4.8: Transport and Communication Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long run Employment Output Investment Real Wages Exports Imports -.7% -2.56% -2.97% -1.87% -.3% -.5% Scenario 1 -.4% -1.46% -1.77% -1.14% -.16% -.34% Scenario 2.21%.54% -.25%.45%.3%.21% Scenario % 3.54% 3.3% 2.88% -.9% 1.21% Scenario 4 Scenario 5 -.5% -1.96% -2.37% -1.47% -.2% -.41% Scenario 1 Scenario 2 Scenario 3 Short run.2%.27% -1.12%.6% -.49%.69%.17%.13% -.66%.29% -.26%.37%.13%.5% -.32%.15% -.12%.9% Scenario 4.7% -.3% -.52%.6% -.15% -.2% Scenario 5.18%.19% -1.2%.45% -.39%.59% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Investment in the short and long-run will decline by about 1.1% and 2.97%, respectively (Scenario 1). The employment impact in the short-run will be more robust with an estimated growth of about.2% but in the long-run the real effect will materialise and a decline of.7% is likely. The short-run and long-run exports will be down by about.49% and.3%, respectively. Imports on the other hand will record an increase of about.7, in the short-run and a decline of about.5, in the long-run. The different price scenarios applied to the system revealed patterns similar to those that are explained in Chapter 1. Financial Sector Impact In this sector, the net impact of an increase in electricity prices and capital expenditure by Eskom will result in investment declining respectively by about.7% and 1%, both in the short and long-run, when Scenario 1 is applied (Table 4.9). The impact on employment in the short-run remained negligible but in the long-run it will decline by about.24%. The output effect will also be negative, both in the short and long-run period, with about.5% and.59% declines, respectively

86 Table 4.9: Financial Sector Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long run Employment Output Investment Real Wages Exports Imports -.24% -.59% -1.5% -.67%.49% -1.42% Scenario 1 -.4% -.37% -.65% -.44%.27% -.87% Scenario 2.11%.12%.18%.14%.27%.35% Scenario 3.18%.79% 1.5%.93% 2.57% 1.73% Scenario 4 Scenario 5.14% -.47% -.85% -.57%.4% -1.7% Short run.2% -.5% -.7% -.7%.83% -1.75% Scenario 1.1% -.3% -.38% -.4%.45% -.95% Scenario 2.2% -.4% -.15% -.4%.18% -.27% Scenario 3 Scenario 4.2% -.7% -.18% -.8%.23% -.11% Scenario 5.2% -.5% -.6% -.7%.68% -1.45% The long run values are depicted using the Hodrick-Prescott trend value. Negative values represent a decline while positive values represent an increase. Note: Scenario 5 is an extended case of Scenario 1 Exports increase in a similar fashion as in Chapter 1 in both periods, so does the growth in imports. Applying the different scenarios to the system, the financial sector will react positively in both the short-run and the long-run Computable General Equilibrium (CGE) Approach to Analyse the Net Impact of Electricity Price Increases and Increased Capital Expenditure This approach looks at the net impacts of electricity price increases and increased capital expenditure on the South African economy in a static system. The University of Pretoria CGE model of South Africa (UPGEM model) was used and four short-run simulations and four long-run simulations were tested. In both the short-run and the long-run, electricity prices are exogenously increased by 24.8% (Scenario 1), 15% (Scenario 2), 1% (Scenario 3) and 8% (Scenario 4), while capital stock in the electricity sector are exogenously increased by 18% (see the definition of the various scenarios in Appendix A4). The impacts of electricity price increases and capital expenditure on the macro and sectoral economy are considered. In Appendix B, the report provides a description of the UPGEM model, the closure rules, calculation of Equivalent variation (EV) values, a summary of the model limitations, as well as the simulation design

87 As in Chapters 1 & 3, all the results are reported as percentage point changes from the base scenario. In other words, the results are not forecasts of various economic variables, but rather deviations due to increases in the price of electricity. Economy-Wide Computable General Equilibrium Analysis Table 4.1 shows the short-run and long-run macroeconomic impacts of electricity price increases as well as increased capital expenditure in the electricity sector, on the South African economy, under the scenarios discussed above. Any electricity price increase above inflation in the long run will lead to a real devaluation of the currency. For example, a 24.8% increase in the price of electricity (Scenario 1) would lead to a.34% real devaluation of the currency. However, an 18% increase in capital stock will lead to a.18% appreciation of the currency. The net impact of a 24.8% electricity price increase will be.58% devaluation of the currency. If the electricity price increase is 8%, the appreciation due to capital expenditure will dominate the devaluation caused by the price increase, resulting in a net appreciation of.4%. As discussed in the previous chapters, the terms of trade (where terms of trade is the ratio between export prices and import prices) will weaken, given an electricity price increase or increased capital expenditure. These two effects will therefore reinforce each other and the combined impact on the terms of trade for a 24.8% increase in the price of electricity will be -.27%. The gross operating surplus will decrease if electricity prices increase, but increase if capital expenditure increases. The combined impact will be positive on gross operating surplus for an electricity price increase of 8%, but negative for a 1%, 15% or 24.8% increase in the price of electricity. Similarly, in the long run, the impacts of electricity price increases and impacts of increased capital expenditure are in opposite directions for real household consumption, aggregate capital stock, real GDP, average real wage and unskilled employment. If the price of electricity is increased by 24.8%, the price increase impacts will dominate the capital expenditure impacts across macro aggregates, except the terms of trade. However, if the price is increased by 8%, capital expenditure impacts will dominate the price increase impacts and all aggregates will increase, except the terms of trade. If the electricity price is increased by 1%, the gross operating surplus will decrease by.1% as the increase in production costs will adversely affect the gross operating surplus of industries, while the other macro aggregates (except terms of trade) will increase. If the price is increased by 15%, all macro aggregates will decrease except real GDP (.22%) and unskilled labour (.1%). All the impacts, for a 24.8% electricity price increase, are stronger in the long run than in the short run because capital is allowed to adjust and flow to higher yielding industries

88 Table 4.1: Economy-Wide Net Impacts of an Increase in Electricity Prices and Capital Expenditure Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Real devaluation Terms of trade Gross operating surplus Real household consumption Aggregate capital stock Real GDP Average real wage Unskilled employment Short-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Real devaluation Terms of trade Gross operating surplus Real household consumption Aggregate real government demands Real GDP Skilled employment Unskilled employment In the short run, all of the scenarios will yield a real devaluation of the currency and a weakening in the terms of trade. Also, for all the scenarios, electricity price impacts will dominate the capital expenditure increase impacts on the gross operating surplus, resulting in a combined negative impact on gross operating surplus, where the loss in gross operating surplus increases as the electricity prices are increased by a higher percentage. Real household consumption, in line with employment impacts, is expected to decrease for a 24.8% price increase, while the adverse impact of a price increase of 8%, 1% or 15% on real household consumption will be smaller than the positive impact of an 18% increase in capital stock on real household consumption. If we assume a neutral government budget, real government demands would also decrease for a 24.8% price increase, but real government demands would increase for any of the other price scenarios. Similarly, the combined impact under a 24.8% electricity price increase on real GDP would be negative, but positive for an 8%, 1% or 15% price increase. Lastly, in the short run, skilled employment would be positively impacted if electricity prices are increased by 8% or 1% and capital stock is increased by 18%, but it will be negatively impacted if electricity prices are increased by 15% or 24.8%. Also, unskilled employment will be negatively impacted if electricity prices are increased by 24.8% and capital stock is increased by 18%

89 Sectoral Computable General Equilibrium Analysis All sectors use electricity directly or indirectly as an input, therefore an increase in the price of electricity will increase the cost of production, leading to a loss of competitiveness, and as a result, some industries will reduce output (A description of industries are included in Appendix C and detailed results are provided in Appendix D3). All sectors use electricity directly or indirectly as an input, therefore increased capital expenditure in the electricity sector, leading to increased capacity to produce electricity, will have an impact on all industries of the economy. Furthermore, various industries will be directly affected through an increased demand for inputs used in capital expenditure as well as increased demand for the inputs used to produce electricity. It is therefore expected that some structural changes will take place in the economy Due to the multi-industry disaggregation in the CGE approach, the impacts of the price hikes are presented according to variable changes by sectors. Output (GDP) Impacts Table 4.11 provides an impact range, with an upper limit impact and a lower limit impact, based on sub-industry impacts, of the electricity price increases on the nine Standard Industrial Classification (SIC) sectors. Thirty nine disaggregated sub-industry output changes are provided in Table D3.1. As expected, the industries with the highest electricity intensity will be affected the most. Please take note that electricity price increases and capital expenditure increases will affect industries through different channels. Some industries will experience higher variability in output changes due to the combined impact of the two shocks. The following table provides an impact range for each sector, but the upper and lower ranges do not automatically represent the same industry across all electricity price increases with a sector. For example, in the long run, the lower boundary for a 24.8% increase in the price of electricity is determined by the Iron and Steel industry, as the production of Iron and Steel are electricity intensive and sensitive to electricity price changes. However, the Iron and Steel industry determines the upper boundary for an 8% increase, as in increase in the availability of electricity and the increase in demand for Iron and Steel due to the capital expenditure programme outweigh the increase in the price of electricity. In the short run, the adverse impact of a 24.8% price increase combined with an 18% increase in capital stock could be illustrated by the combined impact on output per industry. For an 8% or 1% price increase, the combined impact on all 39 industries will be an increase in output. But, if the price is increased by 15% 37 industries would increase output and if the price is increased by 24.8%, 27 industries would increase output, while 12 industries would reduce output. Since a neutral government budget is assumed, the industries that would be most adversely affected are the General Government (-.4%) and Health Services (-.47%). The Health Services contraction indicates the negative impact of higher electricity prices on household spending, as well as the impact of slower economic

90 growth on the ability of government to spend on health and social services. General government spending is also negatively affected, given the assumption that government adjusts its spending based on revenue collected (See Chapter 3). However, if the electricity price is increased by 1%, General Government (.21%) and Health Services (.16%) would expand output. The only sector where the capital expenditure increase will outweigh the electricity price increase across all tariff increases is the Mining and Quarrying sector. In the long run, 17 of the 38 industries (General Government in the long run are exogenous and determined by factors outside of the model) will reduce output if the electricity price is increased by 24.8%. However, almost all industries will expand output under an 8%, 1% or 15% electricity price increase. In 25 industries, the short run effect on output will be reinforced in the long run as capital is allowed to flow to higher yielding industries. Industries that will reduce output by more than 1% due to an electricity price increase of 24.8% are Iron and Steel (-1.22%) and Non-ferrous Metals (-1.12%). For an electricity price increase of 24.8%, industry decreases in output would be sufficient to offset the output increases in the other industries and the overall impact on production, as reflected in the GDP (Table 4.1), would be negative. Table 4.11: Sectoral Output Net Impacts Long-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Short-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper Construction

91 Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and household goods; catering and accommodation Transport, storage and communication Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Upper Upper Employment and Wage Impacts In the short run, employment impacts would follow the changes in output, induced by the increase in the price of electricity and the capital expenditure increase. The only exception is Construction, where output is expected to increase due to the increased capital expenditure, if the price of electricity is increased by 8%, 1% or 15%. However, for the same price increases, employment will be reduced by.13%,.15% and.19%. As discussed in the previous chapter, the increase in capital expenditure might lead to crowding out in the Construction sector. As demand for Construction increases, prices would increase and Construction in other sectors might become less attractive. Also, capital expenditure in the other sectors tends to be more labour intensive than in the electricity sector. Most of the employment gains under a 24.8% price increase will be in the Coal industry (1.23%) and Iron and Steel (1.37%). On the other hand, the highest percentage employment losses could be expected in the General Government (.46%) and Health Services (.96%). The combined impact on total employment will be employment losses for skilled labour as well as unskilled labour. Table 4.12: Sectoral Employment Net Impacts Long-run Impact range Scenario 1 Scenario 2 Scenario 3 Scenario 4 Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper.26 n/a.3 n/a.32 n/a.33 n/a Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Short-run Impact Scenario 1 Scenario 2 Scenario 3 Scenario

92 range Agriculture, hunting, forestry and fishing Upper Mining and quarrying Upper Manufacturing Upper Electricity, gas and water supply Upper -.16 n/a.86 n/a 1.4 n/a 1.62 n/a Construction Wholesale and retail trade; repair of motor vehicles, motor cycles and personal and Upper household goods; catering and accommodation Transport, storage and communication Upper Financial intermediation, insurance, real estate and business services Community, social and personal services Upper Upper Labour intensive industries experience a relatively small impact on production. However, the relatively small impact leads to a relatively large impact on employment, due to the labour intensive nature of these industries. Labour intensive industries that would reduce employment after a 24.8% electricity price increase are Livestock (.42%), Other Agriculture (.18%), Footwear (.27%), Water (.27%), Communication Services (.24%), Financial Institutions (.15%) and Real Estate (.96%). As discussed in the previous chapter, the model specifies a constant elasticity of substitution (CES) relationship between primary factors. As a result, employment impacts in the electricity sector cannot be adequately explained by the model and the cumulative positive employment impact could be seen as a conservative estimate of the combined potential employment gains. Table 4.12 shows the long-run industry employment impacts on unskilled labour for the SIC sectors. Unskilled labour is allowed to vary in the long-run, due to the high structural unemployment of unskilled workers in South Africa. As in the short run, employment impacts will follow output changes in the long run. Most notable are the relatively large unskilled employment gains, for an 8%, 1% or 15% electricity price increase, in the Iron and Steel industry as well as the Non-ferrous Metal industry, reversing to unskilled employment losses in excess of.5%. In the long-run wages are the market clearing agent for skilled employment. In other words, the number of skilled workers is fixed. This reflects the idea that the number of skilled labour is determined by factors outside the model. On the other hand, unskilled workers and unskilled wages are allowed to vary due to the high unemployment of unskilled workers in South Africa. It could therefore be expected that the wage impact due to higher electricity prices on skilled labour would be higher than the impact on the wages of unskilled labour. This is reflected in Table Statistics South Africa (StatsSA), in the National Social Accounting Matrix (SAM), classifies all occupations into eleven groups (StatsSA 24). This

93 is in accordance with the South African Standard Classification of Occupations (SASCO). This analysis follows the same classification and a full description of all occupations is available in StatsSA (24). If the price of electricity increases by 24.8% or 15%, wages across all occupations decrease (except skilled agricultural workers for a 15% increase). The highest percentage job losses for a 24.8% increase will be in Technicians (2.1%) and Craft workers (2.26%). However, if the price of electricity increases by 8% or 1%, combined with the capital expenditure, wages across all occupations are expected to increase since the capital expenditure increase is expected to dominate the price increases. Table 4.13: Wage Net Impacts by Occupation Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Legislators Professionals Technicians Clerks Service workers Skilled agricultural workers Craft workers Plant and Machine operators Elementary occupations Domestic workers All Unspecified occupations The wage impacts by population group are shown in Table As a larger percentage of African workers are economically active as unskilled labour, the adverse impact on their wages would be the smallest (-1.33% for a 24.8% increase). Table 14: Wage Net Impacts by Population Group Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 African Coloured Indian White On the other hand, as a larger percentage of White workers are economically active as skilled workers, the impact on their wages (-1.67% for a 24.8% increase) would be the largest for the population groups under consideration. Table 4.15: Skilled Wage Net Impacts by Population Group Long-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 African Coloured Indian White

94 Wage impacts, by population group, are disaggregated to skilled wage impacts in Table As discussed, the impacts on skilled labour across all population groups are larger than the wage impacts on unskilled labour across all population groups. The adverse wage impact of an electricity price increase would dominate the positive impact of capital expenditure for price increases of 15% and 24.8%. However, skilled wages are expected to increase across all population groups if the electricity price increases by 8% or 15%. White skilled workers would, for a 24.8% increase in the price of electricity experience a 1.84% decrease in skilled wages, while African workers would experience a 1.72% decrease. Coloured and Indian workers would experience a 1.71% and 1.73% decrease, respectively. 48.5% of highly skilled and skilled African compensation are earned in the Trade and Government, Health and Social Services industries (StatsSA 24). The employment impacts in these sectors were relatively smaller than in the Manufacturing sector where 18% of White highly skilled and skilled workers earned compensation (StatsSA 24). Given the fixed long-run skilled employment, the short-run employment changes by occupation as a result of electricity price increases and capital expenditure increases, are shown in Table Employment across all occupations will be affected negatively if the price of electricity increases by 24.8%. The adverse impact of a price increase of 8% or 1% would be dominated by the positive impact of capital expenditure across all occupations, except Craft workers (-.8% for a 1% increase). Table 4.16: Occupational Employment Net Impacts Short-run Scenario 1 Scenario 2 Scenario 3 Scenario 4 Legislators Professionals Technicians Clerks Service workers Skilled agricultural workers Craft workers Plant and Machine operators Elementary occupations Domestic workers All Unspecified occupations Craft workers will be the most affected by price increases (see Chapter 1 & 3), with around 7% of Craft workers employed in the Mining, Manufacturing and Construction industries (StatsSA 24). These are the industries that would reduce employment significantly if electricity prices increase. Table 4.17 shows the employment impact of electricity price increases by population group. The employment impact would be negative across all population groups for a 24.8% price increase. The combined impact of an electricity price increase and capital expenditure will be the smallest for the Black population group (-.23%) and around -.4% and -.46% for the other three population groups

95 Table 4.17: Employment Net Impacts by Population Group Short-run 24.8 percent 8 percent 1 percent 15 percent African Coloured Indian White These employment impacts follow changes in industry employment. Approximately 47% of Coloured workers work in the Agricultural, Trade, Transport and Communication industries (StatsSA 24), while approximately 42% of Indian workers are employed in the Trade, Transport and Communication and Financial industries. By contrast, approximately 47.5% of African workers are employed in the Government, Health and Social services, Manufacturing and Mining industries, while approximately 4% of White workers are employed in the Manufacturing and Government, Heath and Social Services industries Conclusion This chapter analysed the net impact of an increase in electricity prices and capital expenditure on the overall macro and sectoral economy using both the TSME and CGE models. The simulation results from the TSME model revealed the net implications of the current wave of electricity price increases (25% average) over the next three and the six-year Eskom capital expenditure programme (18% annual average) on the macro economy. In the longrun, household consumption, GDP, and investment will continue to be most severely affected by the price hikes. In Scenario 1, the price impacts are found to be higher than the capex impacts. During the short-run, the impact continues to be mostly affecting household consumption and exports, mainly due to the direct effect of the inflation. As different price scenarios are applied, the impacts become less severe on the macro variables as prices are spread out over a longer period of time. At the sectoral level, the sectors that will shed most jobs in the long-run if Scenario 1 is applied are; the mining sector, transport & communication sector and wholesale & retail trade sector. The same conclusion was reached with respect to the GDP impact. The electricity, gas & water sector, on the other hand, will continue to boost jobs within the sector in the longrun. On the other hand, the simulation results from the CGE also revealed similar negative impacts on the macro economy when Scenario 1 was applied. Overall, in the short-run, real gross domestic product decreased, the currency weakened, gross operating surplus was lower, aggregate real household consumption decreased and skilled as well as unskilled

96 unemployment increased. Most of the short-run macroeconomic impacts were reinforced in the long-run, with a real devaluation in the currency, weakening in the terms of trade, decrease in gross operating surplus, progressive decrease in real household consumption, as well as a decrease in real gross domestic product, wages and employment

97 Chapter 5 Impact of the Increase in Electricity Prices and Eskom s Six-Year Capital Investment programme on Poor Households Executive Summary Given the importance of energy in the economy, it is expected that any positive or negative shock in this sector will have direct implications for the well-being of the people. However, an inadequate supply, or lack of access to energy, will continue to trap the marginalised people in poverty as opportunities to create wealth in the economy will be limited. On the other hand, increasing user charges on electricity in order to be able to supply sustainable electricity may be harmful to individuals, households and firms in the economy, particularly those in lower income groups. Based on the econometric results of the static (CGE) model, increasing electricity prices by 25% will impact negatively on household consumption with the poorest households most severely hit. In the short-run, consumption in the poorest households will decline by about 1.2% while the richest households will reduce their consumption by about.6%. In the longrun, poorest and richest households consumption will fall further by about 2% and 2.6%, respectively. With regard to Eskom s capital expenditure programme, the impact of an 18% capex increase will impact positively on household consumption. Poor households will increase their consumption by about 1% in the short-run while the rich households consumption will increase marginally by about.2%. In the long-run, the poor and rich households consumption will increase by about 1.2% each. Therefore, the net impact of increases in electricity price and capex will remain negative both on the poor and rich households. The impact of the increase in electricity prices and capex on the poor was investigated through the number of jobs created/lost in the process. About 1,25 jobs out of the 18,635 total job losses (as a result of the 25% 5-year and 6% 5-year price increases) comes from the poor population while about 466 jobs out of the 847 jobs created (as a result of the 6-year 18% annual capex increase) goes to the poor population. In this regard, the overall net impact will be most severely felt by the poor population. To mitigate this negative impact, NERSA has put in place measures that will soften the burden on the poor. The Inclining Block Tariff (IBT) was promulgated by NERSA as part of the MYPD2 decision

98 5.1. Introduction The poor in the society constitutes a substantial portion of the population, especially in South Africa. Therefore, any policy initiative that does not take into consideration the impact on the poor may face considerable socio-political resistance in achieving its desired objectives. The huge gap between the rich and the poor in South Africa remains one of the highest in the world and this call for cautious policy interventions on the part of the government. Energy remains a critical input in the production of goods and services. It is a necessary parameter to be put in place in order to achieve a desired level of output. Therefore, an increase in the price of electricity is in essence, not only directly affecting households but also increasing the cost of production, which will eventually leads to higher prices of goods and services, especially the cost of the essential products. For instance, a rise in the cost of food products will impact directly on poor households as food takes the largest portion of their disposable income. Eskom s position to increase the price of electricity in order to be able to provide a sustainable supply of electricity through the capex programme is not a sufficient condition in alleviating poverty in the country. Increasing capital expenditure will have a positive impact on the economy but this will not offset the severe impact of the increase in electricity prices. In this chapter, the impact of an increase in electricity prices and capital expenditure on the poor is analysed. The rest of the chapter is structured as follows; Section two analyse the macroeconomic impact from the poorest to the richest households while Section Three looks at the impact on the poor through job creation. In Section Four, the mitigating measures put in place by NERSA are summarised and a critical review of these are analysed. Section Five concludes the analysis Impact on the Poor through Household Consumption Based on the econometric results of the static (CGE) model, increasing electricity prices by 25% will impact negatively on household consumption with the poorest households most severely hit. On the other hand, increasing capital expenditure by 18% will have a positive impact on household consumption. The classification of households is taken from the StatsSA classification (StatsSA 24). As shown in Figure , LSM1 represents the poorest households while LSM12 represents the richest households. Electricity Price Increases: Household Consumption Impacts The short-run real household consumption changes as a result of electricity price increases are shown in Figure 5.1. The burden of the electricity price increases would not be shared proportionally amongst households. and middle income groups, especially LSM1 LSM8 would reduce real household consumption by between 1.2% and 1.2% for a 25% increase. From LSM8 upwards, real household consumption would continue to decrease, but

99 at a slower rate. The higher the income of a household, the smaller the percentage of income which is spent on electricity, with LSM12 experiencing the smallest real consumption contraction of.67%. It could therefore be argued, based on real household consumption that the impact of an electricity price increase could be regressive. Figure 5.1: Short-run real household consumption impacts. LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent The Equivalent Variation (EV) values have been calculated in UPGEM as discussed in Appendix B3. Under electricity price increases all consumers experience a decrease in utility as shown in Figure 5.2. However, the electricity price increases are clearly regressive in nature since poorer households would suffer higher utility losses. For example, LSM1 experience an income equivalent welfare loss of approximately 9.31%, while LSM12 suffer a welfare loss of around 4.97% for a 25% electricity price increase. This regressive nature of the electricity price increase is due not only to the higher share of income that poor households spend on electricity, but also due to the general economic impacts of the price increases

100 Figure 5.2: Short-run household equivalent variation LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent The long-run real household consumption changes as a result of electricity price increases are shown in Figure 5.3. All household groups would decrease real household consumption. However, it is clear from Figure 5.3 that the long-run burden of the electricity price increases would not be shared proportionally amongst households. Figure 5.3: Long-run real household consumption changes LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent LSM1 would decrease real household consumption by almost 2% for a 24.8% increase in electricity prices. This is due to the relatively high percentage of income spent on electricity, as well as the adverse impact of the price increases on unskilled labour and unskilled labour wages. As unskilled employment and wages decrease (Table 1.11), households have less money available to spend. As discussed in the previous chapter, the adverse impact on

101 skilled wages will be larger than the adverse impact on unskilled wages. Since there is a general correlation between skill levels and compensation levels, the impact on households ability to consume will increase from H2 onwards. Therefore, in the long-run the electricity price increases would progressively decrease real consumer spending. Figure 5.4: Long-run household equivalent variation LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent Calculating the EV values, all consumers would experience a decrease in utility as shown in Figure 5.4. However, the electricity price increase is clearly progressive in nature since richer households suffer higher utility losses. For example, LSM12 experience an income equivalent welfare loss of approximately 19%, while LSM2 suffer a welfare loss of around 16% for a 25% electricity price increase. This progressive long-run impact of the electricity price increase is due to the wage impact on skilled wages. The adverse impact on unskilled labour is in part captured by the decrease in EV values for LSM1 which is higher than the decrease for LSM2, LSM3 or LSM4. Capex Increases: Household Consumption Impacts The short-run real household consumption changes as a result of capital expenditure increases are shown in Figure 5.5. The gains from increased capital expenditure in the electricity sector will not be shared proportionally amongst households. and middle income groups, especially LSM1 LSM8 will increase real household consumption by between 1.5% and.65% for an 18% increase

102 Figure 5.5: Short-run real household consumption impacts LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM12 Percentage change percent percent From LSM8 upwards, real household consumption would continue to increase, but at a slower rate. Two economic impacts contribute to the progressive shape of the overall impact. The first impact is the relative increase in the abundance of electricity for household consumption. Poorer households tend to spend a larger percentage of their income on electricity, with LSM1 experiencing the largest real consumption increase. Secondly, the impact of increased economic activity on employment levels tends to favour the lower income groups. The most significant increases in output and employment are found in, relatively unskilled, labour intensive industries, such as mining and heavy manufacturing (see Table 3.4 & 5). Figure 5.6: Short-run household equivalent variation 12 Percentage change percent percent LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM

103 The EV values have been calculated in UPGEM as discussed in Appendix B3. Under capital expenditure increases all consumers experience an increase in utility as shown in Figure 5.6. Furthermore, the capital expenditure increases are clearly progressive in nature since poorer households would experience higher utility gains. For example, LSM1 experience an income equivalent welfare gain of approximately 7.8%, while LSM12 face a welfare gain of around 2% for an 18% increase in capital stock. This progressive nature of the electricity price increase is due not only to the higher share of income that poor households spend on electricity, but also due to the general economic impacts of the capital expenditure increases. The long-run real household consumption changes as result of capital expenditure increases are shown in Figure 5.7. All household groups would increase real household consumption. It is clear from Figure 5.7 that the long-run household consumption increases would be shared almost proportionally amongst households. Figure 5.7: Long-run real household consumption changes Percentage change percent percent.2 LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM12 LSM1 would increase real household consumption by 1.25% for an 18% increase in capital expenditure. This is due to the relatively high percentage of income spent on electricity, as well as the positive impact of the capital expenditure on unskilled labour and unskilled labour wages. As unskilled employment and wages increase, households have more money available to spend. However, the net impact of the capital expenditure in the long run will be shared relatively proportionally across all income groups

104 Figure 5.8: Long-run household equivalent variation Percentage change percent percent LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM12 Looking at the EV values all consumers would experience an increase in utility as shown in Figure 5.8. The capital expenditure impact is relatively proportional in nature since all households gain utility between 8.5% and 9.7% for an 18 percent increase in capital expenditure. For example, LSM12 experience an income equivalent welfare gain of approximately 8.8%, while LSM2 gain welfare around 9.2% for an 18% capital expenditure increase. Net Impact of Electricity Price and Capex Increases on Household Consumption The short-run real household consumption changes as result of electricity price increases and increased capital expenditure are shown in Figure 5.9. In previous sections, it was shown that the impact of electricity price increases in the short run would be regressive. In other words, the burden of electricity price increases on the economy would disproportionably fall on poorer households. Also, the gains from increased capital expenditure would follow a progressive pattern, where poor households gain more than richer households. The combined impact of price increases and increased capital expenditure is shown in Figure 5.9. It is clear, across all price increases, that the progressive impact of the capital expenditure dominates the regressive impact of price increases. The combined impact is therefore progressive and positive for price increases of 8%, 1% or 15%. If the price of electricity is increased by 25%, the impact would still be progressive, but welfare reducing (where real household consumption is seen as a proxy for welfare)

105 Figure 5.9: Short-run real household consumption impacts 1.8 Percentage change LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent -.6 The EV values show that, under an electricity price increase of 25% and increase capital expenditure of 18%, all consumers experience a decrease in utility, as shown in Figure 5.1. However, the combined impact is clearly progressive in nature since richer households would suffer higher utility losses. For example, LSM1 experience an income equivalent welfare loss of approximately 1.5%, while LSM12 suffer a welfare loss of around 3.1%. Figure 5.1: Short-run household equivalent variation 8 6 Percentage change LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent -4 The long-run real household consumption changes as a result of electricity price increases and increase capital expenditure are shown in Figure As discussed in the previous section, the long run impact of an electricity price increase on real household consumption

106 would be progressive due to the employment impacts. Also, it was shown that the long-run impact of increased capital expenditure on real household consumption would be relatively proportional. Figure 5.11: Long-run real household consumption changes Percentage change LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent All household groups would decrease real household consumption under a 25% increase in electricity prices, but the impact would be progressive as richer households are more affected than poorer households. A 15% increase in electricity prices would also be progressive, with a relatively small increase in real household consumption for LSM1 to LSM8. LSM9 to LSM12 will reduce real household consumption. If electricity prices are increased by 8% or 1%, real household consumption across all households would increase relatively proportionally. Figure 5.12: Long-run household equivalent variation Percentage change LSM1 LSM2 LSM3 LSM4 LSM5 LSM6 LSM7 LSM8 LSM9 LSM1 LSM11 LSM percent 8 percent 1 percent 15 percent

107 In the long-run, equivalent variation values for the different household income groups will follow real household consumption and be relatively proportional for 8% and 1% electricity price increases, but progressive for 15% and 25% electricity price increases. However, a 25% price increase would be welfare reducing Impact on the Poor through Job Creation Based on the econometric results of the dynamic (TSME) model the impact of the increase in electricity prices and capex on the poor was investigated through the number of jobs created/lost in the process. It is expected that the majority of the poor citizens belongs to the semi and unskilled labour force while the majority of the rich are skilled. It is estimated that about 55% of total employment in the country are semi and unskilled and the remaining 45% are skilled. Therefore, 55% of the total jobs lost or created come from the poor population. As presented in Table 5.1 & 5.2, about 1,25 jobs out of the 18,635 total job losses (as a result of the 25% 5-year and 6% 5-year price increases) come from the poor population while about 466 jobs out of the 847 jobs created (as a result of the 6-year 18% annual capex increase) go to the poor population in the long-run. In this regard, the overall net impact will be most severely felt by the poor population. Table 5.1: Indicative Job Losses/Gains as a Result of Electricity Price Increase Long-run 25% 5yr & 6% 5yr 25% 3yr & 11% 7yr 25% 3yr & 6% 7yr 1% 1yr Total job losses/gains -18,635-15,247-12,76 2,541 Poor population job losses/gains -1,25-8,386-6,988 1,397 Short-run Total job losses/gains -5,929-5,82-5,82-1,27 Poor population job losses/gains -3,26-2,795-2, Calculated based on NERSA price scenarios presented in Appendix... Following the baseline price scenario as explained in Chapter 1 - a 1% price increase over a longer period of time - an additional 2,541 jobs will be created in the economy in the long-run. About 1,397 of these jobs will benefit the poor. In addition to this, the capex increase will raise the total number of jobs created to 3,388 in the long-run. The short-run impact of a 1% price increase over a longer period will be negative thereby leading to a negative net impact of an increase in electricity prices and capex

108 Table 5.2: Indicative Job Losses/Gains as a Result of Capex Increases Long-run Short-run Total job losses/gains Poor population job losses/gain In this regard, the negative net impact of the increase in electricity price (in line with the NERSA scenarios) and capex on the economy and poor households could have been circumvented if a lower price path (1%) over a longer period of time was adopted Mitigating Measures of the Negative Impact of Electricity Price Increases on the Poor To mitigate this negative impact, NERSA has put in place measures that will soften the burden on the poor. The Inclining Block Tariff (IBT) was promulgated by NERSA as part of the MYPD2 decision. The IBT is a tariff where higher consumption is at higher price (NERSA, 21). This is to ensure that low income (poor) customer enjoy a tariff subsidisation, easy tariff communication as well as retaining Eskom revenue neutrality. A summary of the IBT rates is presented in Table 5.3. Table 5.3: NERSA Approved Inclining Block Tariff (IBT) for Residential Customers Source: NERSA 21 Eskom s implementation of the IBT was two-fold: For account customers, the above IBT was implemented. For pre-paid customers, the weighted average increases - the percent variance between the home light 29/1 average prices compared to the IBT average prices - was implemented