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Free SA’s electricity sector

By Antonio Ruffini, Editor, ESI Africa

The global trend, including in many African countries, is for deregulation of electricity markets. South Africa has lagged behind.

This is largely due to a broader philosophy of South Africa’s government both present (post 2007) and past (pre 1994) which has tended to favour a significant amount of state control and central planning. As the Austrian economist Ludwig von Mises (1881 – 1973), a critic of socialist paths of economic development, said, “The paradox of planning is that it cannot plan, because of the absence of economic calculation. What is called the planned economy is no economy at all. It is just a system of groping around in the dark. There is no question of a rational means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action.”

He could have used South Africa’s electricity sector to illustrate his point. The Free Market Foundation, an independent non-profit organisation that promotes a free and open society, in South Africa notes that the pre-1994 government overestimated the demand for electricity and built excessive generation capacity, resulting in the mothballing of power stations. While the cost of baseload generation capacity in the country where the capital is long sunk has remained low, that of the return to service power stations Camden, Grootvlei and Komati is understood to be about R1.08/kWh. Thus taxpayers and consumers of electricity in South Africa have had to pay twice for an earlier massive but not unexpected miscalculation.

Eustace Davie

Director of the Free Market
Foundation, Eustace Davie.

South African electricity sector government policy documents of the late 90s discussed increasing the role of the private sector in the provision of electricity, including allowing trading between willing parties. A cabinet-approved 1998 government white paper proposed giving customers the right to choose their electricity supplier, the introduction of competition into the industry, especially the generation sector, the permitting of open non-discriminatory access to the transmission system and the encouragement of private sector participation in the industry.

None of this has happened, in spite of a long foreseen electricity shortage crisis coming to a head a decade later when the grid almost suffered a system wide failure. Today South Africa has an inadequate supply of electricity.

Director of the Free Market Foundation, Eustace Davie, says that there are independent power producer (IPP) base load projects that could have been in place by now. “It is indicative that there has been no real will to solve the problem as soon as possible. Instead of building smaller power stations that could be brought on stream more rapidly, Eskom is building two massive power stations that are plagued by cost and construction-time overruns, resulting in electricity shortages and higher costs.”

By building smaller power stations he does not mean the addition of open cycle gas turbine peaker power plants that should only be used to cover emergencies and not the general supply of electricity. Eskom’s estimated fuel costs for its financial year 2011/2012 (made in 2009) were coal costs of R146,000 per GWh compared with nuclear fuel at R59,000 per GWh and open cycle gas turbine fuel at R2,333,000 per GWh.

Davie argues that the National Energy Regulator of South Africa (Nersa) has the essential task of introducing competition and real price formation into the South African electricity market to ensure blackouts do not occur and that economic activity is not limited. “This can be done by licensing IPPs without delay to provide the additional generation capacity that is required to increase South Africa’s electricity reserve margin.”

He also says that expecting Eskom to act as the sole purchaser of electricity from IPPs is inequitable and places an unnecessary burden on the public enterprise. Currently the renewable independent power producer programme has Eskom as the purchaser of the electricity to come from these IPPs. One of the reasons the cross-border Mmambula coal mining and power project based in Botswana that hoped to supply electricity to South Africa did not take off, in spite of the supply and demand being there, is that Eskom saw itself as being in no position to take the risk of committing to a long term power purchase agreement. “It is better by far to give IPPs the choice to sell electricity across the grid directly to customers in addition to the possibility of selling to Eskom if they can come to an agreement.”

This brings to the fore the need for an independent grid operator, and while Davie says the idea of an independent system and market operator being mooted for South Africa is the correct direction, the flawed approach in the draft legislation is not. “A truly independent grid operator must own the assets and until such time Nersa would have the responsibility of adjudicating fair and reasonable charges for transmission of electricity over the grid.”

The free market philosophy is very much that competition is always and everywhere the only real method of keeping prices low while ensuring continuity and sustainability of supply. “This function cannot be performed with any measure of exactness by a statutory body which cannot possibly have access to all the information necessary to make such a decision. The reason is that a price set too low causes shortage of supply, while a price set too high results in excessive production. It is only in the daily activities within the market that prices can adjust by fractions to constantly take into account changes in circumstances.” Thus

Davie argues, “Nersa has an impossible task. The regulator is being asked to set prices that should be set by consumers buying from competing suppliers. No regulator can determine the right prices to ensure efficient generation, transmission and distribution of electricity. With the right electricity market structure the impossible task will disappear.” Davie says an illustration of the distortion in the electricity market is that few companies in the private sector would ever dream of increasing their prices at the rate of Eskom’s past and recently requested increases, and announce such plans to their customers.

Eskom’s actual increases to date and the requested multi-year price determination (MYPD3) increase would have seen the price of electricity go up by 574% from 2009 to 2018; this compared with a cumulative inflation increase over the same period of 168%. Customers would change to alternative suppliers and, though electricity prices are increasing from an artificially low position, arguably that point will be reached, or would be, were Eskom not a statutory monopoly. None of this is Eskom’s fault, Davie says, as it is simply acting according to the circumstances in which it finds itself. It is often argued that for a commodity that can’t be easily stored in large volumes, with transmission and distribution grids being natural monopolies, there is a limit to free market solutions.

It is argued that large projects such as big hydroelectric schemes are best suited to longer term investment and pay-backs of 40 years or more, a timeframe which almost no private sector investors are willing to encompass. It is argued that access to electricity is such a vital socio-economic and national development driver that it should be seen as a loss leader investment, something only governments would undertake – a clear example being rural electrification schemes to sub-economic population groups. Thus there appear to be limits to free market solutions in the sector.

ESI Africa put those challenges to Davie, and his responses from a free market perspective are presented later in the article. Firstly though, Davie and the Free Market Foundation point to a strong body of evidence that backs up the free market viewpoint for deregulating the electricity sector. It has been done elsewhere and it works. “South Africa is not unique. Other countries have also had vertical electricity monopolies and until the late 1980s this was assumed to be the most efficient way to produce and supply electricity. This included all the existing European Union (EU) countries. When the EU countries opened up electricity to competition, including access to transmission grids, prices fell by up to 20% depending on the level of openness.”

When the UK broke up its electricity monopoly, prices took 20 years to double. The US has also embraced open electricity markets with a multiplicity of competitors, while the integrity of the grid is managed by the non-profit North American Electric Reliability (NERC). Another example is New Zealand, an isolated country, which in 1993/1994 removed statutory monopolies in distribution and retailing, and today sees some two million customers, in the residential, commercial, agriculture and industrial sectors served by 20 retail brands for electricity supply, competing in a market operated by seven service providers.

There is one grid owner, which receives power from five major and eight smaller grid-connected generators and along with local distributed generation supplies consumers via 29 distribution companies and 105 embedded networks. In response to the challenge on electricity being a nonstorable commodity wheeled by a natural monopoly, Davie remarks, “The example always used to question the free market model for electricity trade is the California electricity crisis of 2000 when that state suffered a shortage of electricity, following partial deregulation. However, it was not the free market that failed, but the opposite, a state distortion of the free market, that led to the shortage.

California legislated into place low electricity prices and traders bought electricity from power plants in California, which had more than enough capacity to supply that state, and sold it outside the state where prices were higher. California ended up with an electricity shortage because the deregulation was only partial and companies such as Enron were able to take advantage of this.” A more recent example of a market distortion in the supply of electricity due to state intervention is the possibility of negative pricing in Scandinavia due to some countries having the obligation to take up all the renewables produced under their tariff mechanisms, but there being insufficient export markets to take up that power at certain times.

On the question of the transmission network being a natural monopoly, Davie mentions the EU electricity policy which says that without effective separation of networks from activities of generation and supply, in other words unbundling, there is an inherent risk of discrimination not only in the operation of the network but also in the incentives for vertically integrated undertakings to invest adequately in their networks. “It is the role of the regulator to ensure that electricity wheeling tariffs remain fair and reasonable.” Regarding the desirability of ensuring access to electricity for all and rural electrification, Davie’s response is straightforward. “Government collects tax and allocates this to such socio-economic welfare investments. The government should set its goals for electrification and then get suppliers to bid so that it achieves the desired goals in the most cost effective manner.”

Once the mandate is set market efficiencies can be used. It is only when non-transparent cross subsidisation occurs that there are distortions. In consideration of long-term projects such as large hydroelectric schemes Davie says, “There is one advantage of government involvement in such projects, and that is they can ram them home, and ride roughshod over environmental and other concerns.” Probably the best case in point currently is Ethiopia’s Gibe III hydroelectric project. It is environmentally controversial and it is questionable whether a private sector grouping would be able to see it through in the face of the opposition to the project. Here the determination of the Ethiopian government is an advantage in seeing it through.

Beyond that, however, Davie uses the example of the philosophy of positive non-interventionism, an economic policy of Hong Kong implemented in 1971 by John Cowperthwaite, who observed that the economy was doing well in the absence of government intervention. Cowperthwaite argued that the government needed a demonstrable competitive advantage to justify every intervention into the economy, and that very few of these demonstrable advantages existed.

The stance was that if some significant new project needed to be built, the private sector would do it. Hong Kong established itself as a model for economic growth, developed first-world standards of living and attracted large amounts of foreign investment. In the 1970s the private sector built a 1.8 km tunnel connecting the island of Hong Kong with Kowloon on the mainland. Prior to that cross-harbour vehicular traffic depended on ferries, and it demonstrates that given the right incentives the private sector will establish infrastructure projects on a mega-scale.

The rigidity of regulation in South Africa’s electricity sector also bears fruit in the R50 billion of investment that is required to refurbish the country’s existing distribution networks. At this stage, the municipalities continue to underinvest in their electricity distribution infrastructure while the situation worsens.

Here too the consumers could benefit from a distribution model closer to that of New Zealand. Davie says, “That South Africa has not suffered rolling blackouts in the past years conceals more than it reveals. Major harm has been suffered through manufacturing and mining investment not being carried out, the stalling of real estate development, the reduction in gross domestic product (GDP) and foreign direct investment, and jobs lost due to the withholding of electricity supply from developers.”

He strongly urges that Eskom be required to build no more power stations after Medupi and Kusile and that power in the future be provided by IPPs, and that the grid be freed up to enable trading between willing buyers and willing sellers of electricity. “At this stage in South Africa’s development, it is crucial that legislation and regulations should accommodate the development of an active electricity market. It is the only way that true efficiency in the utilisation of available electricity can be brought about.

The activities of wholesalers and direct forward selling and purchasing of electricity on an active market improves capacity utilisation considerably and helps to balance demand and supply on the system. A further step in refining the electricity system will be the introduction of smart grids. Installation of smart grid technology might be several years away but the changes would be a necessary precursor to the establishment of fully modern generation, transmission and distribution of electricity in the country.”

The entrance of the renewables IPPs into the South African market and the plans for bidding to be opened for base load capacity is a step in the right direction. So too is the recognition of the necessity of an independent system and market operator, but in general South Africa has made too little progress in the deregulation of its electricity sector compared with other parts of the world. In the case of electricity, if there had been an open and competitive market functioning in the country, excessive generating capacity would not have been built in the 1980s.

If there had been, the cost of the mistake would not have been borne by electricity consumers but by the companies owning the generating plants. If an open and competitive electricity market had been established in the 1990s, South Africa would not currently be experiencing a shortage of electricity.