THE recent decision by the National Energy Regulator of South Africa (Nersa) to grant Eskom an additional tariff hike next year to compensate it for additional costs highlights the need for regulators to avoid passing on overspending on infrastructure projects to consumers.

Nersa refused to compensate Eskom for cost overruns on power station construction, saying it would allow Eskom to recover only on spending that passed efficiency and prudence tests. This decision is an important warning to state-owned enterprises (SOEs) that they must prevent overruns on their spending as they will not automatically be able to recoup it via higher tariffs.

In the 2014-13 national budget, infrastructure spending is estimated to be R847bn over the next three years. Last year’s Budget Review identified an additional R3.6-trillion of infrastructure "mega-projects" under consideration for the next decade.

Public infrastructure projects of this magnitude raise questions about public-sector capacity and funding. An important issue for the regulators of the SOEs tasked with implementing many of the larger projects is how to appropriately price the services delivered to consumers and businesses. An added concern is how to account for the cost overruns that are a regular feature of infrastructure construction.

Since 2006, completed and incomplete infrastructure projects include the World Cup stadiums, the Gautrain, the Gauteng toll roads and the infamous Medupi and Kusile power stations. Each project had a different financing method. No matter the method, the similarity between the projects is that they all had substantial project overruns in both time and cost.

It is important to monitor the capital expenditure of an SOE when building infrastructure because the higher it is, the higher will be the revenue required to recover construction costs. Regulators are responsible for supervising this process. There are only two ways an SOE can recover revenue: by selling more output and by increasing the prices they charge consumers. Most SOEs will apply to their regulator to allow them to increase revenue by charging higher prices.

An example of increased capital expenditure being passed through to consumers due to project overruns is the Transnet New Multi-Product Pipeline. The project completion date was moved from 2010 to last year and the estimated total cost rose from R11.1bn in 2008 to R23.4bn in year 2010. The increased construction costs required Transnet to produce higher revenues to recoup its expenditure. Transnet applied to Nersa for an increase in its allowable revenue and thus an increase in the allowed tariff. The higher tariff was passed on to consumers.

Another cause for concern for regulators and consumers is that, once the infrastructure project is commissioned, funding must come either from consumers, through the user-pays principle, or the taxpayer. The term "user pays" refers to charging customers prices that reflect the costs of providing the goods or services. Producers must charge prices that reflect appropriate costs and consumers will benefit from the good/service provided at fair and efficient prices. Alternatively, funding of infrastructure projects comes directly from the government through the budget. This places strain on the government’s balance sheet and creates conflict with competing development goals. Money from the fiscus is often allocated to more urgent objectives. Therefore, the user-pays principle is deemed the most efficient. However, it becomes problematic for regulators, private investors and governments if users refuse to pay for the infrastructure. An example is the Gauteng e-tolls.

An improvement of Gauteng’s road infrastructure was undertaken by the South African National Roads Agency (Sanral). The government decided the funding would come from tolling rather than the tax base.

Economic theory tell us that as Gauteng’s roads are a pure public good, adequate communication with users is vital before a decision on financing is made. This allows users to factor future costs into their budgets. If this is not done, users will refuse to pay and funding will be delayed. This becomes problematic as delayed funding increases the interest repayments, which eventually gets passed on to consumers.

No referendum was held to see if Gauteng’s road users agreed with tolls as a way to fund the upgrade. Gauteng residents are forced to use the roads without reliable alternatives. The subsequent public resistance towards the project is well known. It has negatively affected Sanral’s balance sheet as the revenue expected from the operation of the project is not being collected. As a result, Sanral’s global and national ratings were downgraded in February 2012, further increasing the costs of financing its debt.

There are important lessons for regulators and SOEs from South Africa’s experience. First, given the huge project overruns in infrastructure projects, much greater care must be taken before contractors are chosen. Contractors must present clear cost and time forecasts based on thorough research. When individual projects are small, engineering, procurement and construction (EPC) contracts should be used to project manage cost overruns and other risks associated with project construction. Under EPC contracts, contractors absorb all the risks and failure to meet any contractual obligations which result in monetary liabilities incurred by the contractor. However, where projects are complex, a cost-plus structure must be used within reasonable limits.

In many cases, project overruns are reported as having been unexpected. This is evaluated only on project completion. The additional capital expenditure usually gets passed on to consumers. This should not automatically be allowed. Rather, the relevant regulators should conduct prudence tests of the cost and time delays to verify if the overruns are justified. Only when overruns are justified should the increased costs be passed onto consumers. Regulators should also look to cap overruns at a certain percentage to discourage projects from overrunning. This will create an incentive for both contractors and regulated utilities to be more careful in controlling costs. If a project overruns beyond the project cap, it must be followed by a prudence test before any extra expenses are passed onto consumers.

Partnerships between regulators and law-enforcement bodies are crucial. If a regulator finds that costs of an infrastructure project were artificially inflated, the regulator should report the contractor/utility to the Competition Commission or other law-enforcement bodies. This will ensure consumer protection and create disincentives for contractors and utilities to unnecessarily inflate costs.

Lastly, it is crucial to the success of the user-pays principle that funding methods are made transparent to all parties. This will avoid unnecessarily long pay-back periods, which inflate the costs of projects further. This is vital for projects that are pure public goods. The example of the Gauteng e-tolls should be a lesson for all stakeholders involved. Efficiency and transparency are both crucial in managing the financing and funding processes. Research at the inception phase must also be done to show the cost is affordable. Clear channels of communication must also exist between all stakeholders to take into account the affordability of the services to consumers.

By Zaakirah Ismails

ENRAGED: One of several e-toll protests by the public on the highways around Johannesburg in 2013. Picture: SUNDAY TIMES/KATHERINE MUICK –MERE

Ismail is with the economics and economic history department at Rhodes University