The Independent (Kampala)

13 April 2014

Uganda: How Kicking Out Umeme Hurts Uganda

MPs have generators and other coping resources if the energy sector fails but their voters and industrialists could incur ruinous costs

Parliament's recommendation to cancel the Ugandan government's contract with the country's main electricity distributor, Umeme, has reinvigorated the debate over the company's performance, as well as issues of sovereignty and national interest. The debate has been characterised by both misunderstanding and misinformation, sprinkled with a dash of deceit.

Umeme bears the brunt of the Ugandan public's frustration with power supply, but both the assignment of blame and the debate are myopic; Uganda's most severe challenges in the energy sector do not lie with Umeme.

In fact, the Umeme debate is a costly distraction from the sector's most pressing issues.

The cancellation of Umeme's contract would be very costly for the country and ordinary citizens who would suffer most. The question is why, considering Umeme's record of relatively impressive performance, is the company being hounded out of the Ugandan market? What will investors in capital-intensive sectors like energy, infrastructure and the nascent oil and gas sector, make of politicians' overtures to a policy of re-nationalisation?

Umeme; small part of energy sector:

When then-electricity public utility, the Uganda Electricity Board (UEB) was "unbundled" in 2001, three main arms of the sector; generation, transmission, and distribution, were created. They now run distinct successor companies.

Distributors, Umeme, are responsible for making new connections to the electricity grid, maintaining and repairing existing connections, and billing customers for electricity consumed. Because Umeme deals directly with electricity users, both individual and industrial, it becomes the public face of the energy sector. But Umeme only controls a portion of it. Without effective power generation, distributors are useless.

Thus, the generation sector is where much of the action, and much of the cost of lectricity, lies. Generation contributes at least 70% of the costs included in the electricity bill each customer receives. Uganda's energy generation potential is enormous, as the country is blessed to be the home of the Nile River, which provides massive hydropower potential. Much of thecountry's existing power generation infrastructure is old, however, and the delay of much needed hydroelectric projects has translated into higher costs.

Owen Falls Dam, now known as Nalubaale power station, was completed in 1954. During the colonial period, the Uganda Protectorate, with her advantageous positioning at the source of the Nile, was seen as the most promising generator of power in the region, although the British colonial government focused on developing industry in Kenya. The Owen Falls Dam, therefore, was originally designed in large part to supply Kenya. Owen Falls fell into severe disrepair in the 1970s, and was operating at less than half capacity when the National Resistance Movement came to power in 1986.

Investments in the past two decades, including the long-delayed Bujagali project, in addition to an expansion of Owen Falls, with Kiira power station coming online in 2003, have increased generation capacity. But generation remains below potential capacity and, with Uganda's rapidly growing population and economy, additional investments, such as those being made at Karuma, are required to ensure demand does not outstrip supply.

Like Owen Falls Dam, much of the existing electricity distribution system also dates back to the 1950s. This network relies heavily on open-wire cables. Open-wire cables are relatively inexpensive to install, but prone to damage and outages caused by short-circuiting. Corrosion of uninsulated conductors can also make maintenance quite costly. Trying to distribute power through an outdated network is like trying to fetch water with a reed basket: inefficient at best. This is just one of the challenges distributors face in Uganda, and distributors are tasked with maintenance, updating, and extension of the network.

After years of high losses, low collections and generally poor management of power distribution, the government of Uganda signed a support agreement with Umeme in 2004. At the same time, UMEME obtained a supply license and distribution license from the Electricity Regulatory Authority (ERA), a lease agreement with the Uganda Electricity Distribution Company Limited (UEDCL), and a power sales agreement with Uganda Electricity Transmission Company Limited (UETCL).

Umeme is thus like a building manager hired to collect rent from already unhappy tenants. While the manager can change the odd light bulb and maintain the cleanliness of the property, he should not be held accountable for the dilapidated condition of the landlord's property. But holding Umeme accountable for failures that are sector-wide, both historical and contemporary, is exactly what parliament is trying to do. The public is quick to follow suit, because it is Umeme that comes knocking at their door to collect.

But let's interrogate the key concerns raised by parliament. Key components of Umeme's contracts and negotiations, and those which are under most intense debate currently are a) buy-out provision in the case of early termination of contract, b) the escrow account, and c) performance targets.

Key points in the Umeme debate:

The buyout provision:

The buyout provisions cater for three types of termination: government initiated, Umeme initiated, and "natural termination". In each case, the government of Uganda pays Umeme.

In case of the first, the Ugandan government pays Umeme a percentage of un-depreciated investment capital. It pays between 106% and 120% of Umeme's net investment, depending on the year of contract termination. This payment includes compensation for future profits that government has forced Umeme to forego. In the case of the second, the government pays between 80% and 94% of net investment, again depending on the year of contract termination. Finally, in the case of the third, government pays 105% of net investment.

The Parliamentary committee that recommended termination of the Umeme contract described the concessions as "lopsided" and the buyout provisions as "abnormal". It made no reference to similar or related contracts elsewhere in Uganda, or beyond.

In fact, governments, especially in countries with high political or financial risk, must provide assurances on the security of investments in order to attract investors. Further, providing compensation for future profit foregone in the case of government default is standard practice. This kind of insurance policy, in the form of buyout provisions, is common for other investments in Uganda and in the sector in particular, including Bujagali.

Moreover, the investments made by Umeme, or any other distributor for that matter, are largely investments made in Uganda. These investments will continue to benefit the country even if Umeme is gone. To illustrate the point, consider this analogy. Imagine you own a large plot of land but have been unable to manage it. You have therefore hired someone with technical and financial expertise to invest in the planting and harvesting of your crop, say, maize. Your investor provides fertiliser for the soil, installs an irrigation system, and even constructs a processor. The land that had once sat fallow is now productive and profitable, thanks to her efforts. She takes home a portion of the profits, but also shares profits with her partners and stakeholders (including you) and increases the availability of nutritious food for the community.

Assuming you wanted to take over her now profitable business, would you simply throw her out? Probably not. You would repay her at least for the equipment she had installed on your land, and perhaps other less tangible investments. After all, they are investments made on your land that you will continue to benefit from. If you did go ahead to remove her without compensation, you would certainly have a very difficult time finding anyone to take her place. Word of your reputation with investors would spread fast.

In the absence of a buy-out clause in your contractual agreement, investors would not want to invest in your land or your power sector. Buy-out clauses are essential to attracting investment. Such provisions are especially critical in countries like Uganda that, for reasons fair or unfair, are considered medium or high in terms of political risk.

An argument can be made that the terms of the buy-out could have been better for the Ugandan government, but the simple fact is that the government agreed to these terms. An analogy again clarifies the point. Assume you were to sell your plot of land and agreed with a buyer on a price. If you later learn that you could have gotten more money for your land, something you would have known if only you had done proper research, the mistake can only be yours. You would have no basis for demanding more money from your buyer. Parliament is right to question the process through which contracts are drawn, but a mistake on the part of government, if indeed one was made, cannot itself be grounds for terminating the contract.

The escrow account:

Like the buy-out agreement, the escrow account reduces the risk that investors will incur losses imposed by government. The escrow account provides a source of revenue for Umeme to draw upon in the event that government defaults on electricity payments to government entities. Indeed, government has defaulted numerous times, demonstrating the importance of such a provision.

Historically, a lot of government public utilities have failed because of government non-payment for services. By December 2012, for example, government institutions owed National water & Sewerage Corporation (NW&SC) about Shs40 billion.

The Ministry of Defense, police, and prisons are the main consumers of electricity on the side of government, and also the primary defaulters. After Umeme shut off power to police due to non-payment in 2012, police responded by impounding Umeme vehicles.

The performance targets:

Another complaint leveled against Umeme by parliament is under-performance. Umeme negotiates performance targets with the Electricity Regulatory Authority (ERA), and these targets are re-negotiated every seven years. The first negotiation was in 2005, and the most recent was in 2012. The targets and figures listed in the ad-hoc committee report are outdated both because they include information only until 2011 and also because the targets themselves were renegotiated two years ago. Umeme's targets for the year 2012, the final year of the first period, and 2013 were the following:

The new targets for 2018 set even higher standards for losses, investment, and operating costs, and thus far Umeme is on track to achieve them. Losses today are at an all-time low of 20.5%, and collections nearing 100%, and connections exceed 220,000. The company has also installed 50,000 prepaid meters (Yaka). At least by the standards the ERA has set, Umeme is performing adequately.

Return to 'dark ages'

Having considered some of the main complaints voiced by MPs, let's turn to the consequences of their recommendation - to cancel the contract. The costs of a government-initiated cancellation of the contract are immense and numerous. The cost incurred by government to cover the buy-out payment, amounting to 120% of Umeme's investment to date, is only one such cost. The buy-out payment may in fact represent only a fraction of government's long-term losses.

Cancelling the contract with Umeme necessarily involves replacing the distributor. Having demonstrated willingness to terminate contracts, however, the Ugandan government is likely to have even less bargaining power than with the 2004 contract. Delays will likely ensue, and investors will demand insurance for what they will rightly perceive as a high likelihood that government will renege on its contractual word. These delays will affect distribution in the short term, and far worse service provision can be expected until the next contract is signed and at higher tariffs. Ordinary Ugandans will be literally left in the dark.

Rattling investor confidence not only affects the terms of future contracts with distributors, but also with investors elsewhere in the energy sector, including those investing in power generation.

Karuma is the next major hydropower plant, with expected installation capacity of 600MW. Uganda is counting on this plant to cover her rapidly expanding generation needs. After several years of delays and the collapse of negotiations with Norway's Norpak Power Ltd, Chinese company Sinohydro has been awarded the contract to construct Karuma. However, financial closure has not been reached. If Uganda reneges on the contract with Umeme, it is entirely possible the Karuma project will be delayed even further, in exactly the way Bujagali was. These are delays the energy sector, Ugandans, and Ugandan industries, can simply not afford.

Already, the recommendation of MPs to cancel the contract has likely shaken investor confidence. Umeme itself relies on investors and banks to either invest in or lend money for its operations. If Umeme's future is called into question, it will become more difficult for the company to meet its investment targets. Again, it is ordinary Ugandans who will suffer most.

The focus of the energy debate should not center on Umeme as a company or the particular agreement signed with government, but on policy and planning for the sector as a whole, with special attention to power generation. Umeme is a convenient and popular punching bag, one that politicians have been happy to hold before the public.

These same politicians are now baying for Umeme's blood, but their assault is short-sighted, even from a purely self-interested perspective. Remove Umeme and politicians themselves will take the blows of public frustration at an energy sector that will be on its knees.

Even those who want to replace Umeme - take a close look at the business interests of Umeme's strongest critics - will find themselves facing increased upstream costs. Public anger now will pale in comparison with what will happen if Umeme gets the boot. Distribution would likely collapse and investors across the sector would retreat or demand even higher premiums. The premium on investor risk will affect not only the electricity sector, but also the oil sector where the stakes are equally high.

The ultimate victim of this political witch-hunt is not actually Umeme, but the Ugandan public. That the Ugandan public has been tricked into championing its own future losses is most tragic of all. As parliamentarians park fancy cars in their new parking yard, cut their hair in parliament's new salon to the humming of generators, and enjoy pensions and pay raises that allow them to privately overcome the failures of the public sector, their constituents will be left powerless and Ugandan industries incurring potentially ruinously steep costs.

Having in just three years passed legislation curtailing freedom of assembly, dress, and association, among others, this parliament seems hell-bent on using the remaining two years to take the country back to the dark ages, quite literally.

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