Deregulating South Africa’s electricity market – Where to start? Where to next?
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South Africa continues to debate how to deregulate its electricity market to break the market dominance of Eskom, the vertically integrated national electricity giant, and solve the rolling blackouts that people suffer every day. Here we look at what actions the Government needs to take to create competition and a properly regulated trading mechanism, both of which are necessary to produce the best outcome.
To do so, we have brought together some of our leading experts on electricity market reform and on the issues that specifically face South Africa.
What follows is a summary of a conversation between two fellow London-based projects partners, Mark Walker and Chris Andrew, both with more than 20 years’ experience of working in this field in the UK, across Europe and elsewhere in the world. They were talking to partners Alessandra Pardini and Alexandra Clüver, and counsel Alexandra Felekis, project financing lawyers from our Johannesburg office who are leading our efforts to support investors, funders and sponsors in the market.
Which way is the Government looking to go in reforming South Africa’s electricity sector?
In February 2022 the Government of South Africa introduced a Bill amending the Electricity Regulation Act (2006) to support the transition of the country’s vertically integrated electricity industry, dominated by the state-owned company Eskom, to a multilateral and competitive one overseen by a transmission system operator (TSO).
The Bill also seeks to establish a new regulatory framework for the industry, with the regulator, NERSA, as custodian and enforcer of the regime.
The Bill is now before Parliament and all the indications are that the Government intends to pursue a hybrid market system allowing wholesale power to be traded in three ways, supposed to occur in parallel, via:
- regulated power purchase agreements (PPAs) where the Government or municipalities procure power through a competitive procurement process, municipalities or the TSO as the counterparty;
- a trading platform; and
- direct supply arrangements where private independent power producers or traders enter into long-term PPAs with end-users.
However, the precise shape these complex market reforms will take will be determined by market rules that have not yet been developed and may not emerge fully for up to another two years.
The Government has also long signalled its intention to break Eskom into its three constituent parts – generation, transmission and retail supply/distribution. Although this has yet to happen, the Government has incorporated the TSO, with NERSA set up to provide its transmission licence. However, it remains unclear if Eskom’s grip on 85% of the country’s generating capacity and 60% of the distribution network will remain.
Significantly, it has not opted to set up a pool system for electricity trading, something that has been a common initial feature in countries like England and Wales as a means to create a competitive market for power.
Does that direction look right?
Experience in other markets shows that the end goal has to drive the strategy from the outset. To do that, you need to step back and ask: what are the issues we are trying to solve?
Is it to bring new, much-needed generation and transmission capacity to the market? Is it to achieve genuine price competition? Is it to decarbonise our energy system? Or are we simply being driven by a desire to break up the Eskom monopolies?
Different visions may actually pull market reforms in totally different directions.
So, the starting point has to be: what is the vision?
You need a system architect to design a road map for deregulation so that you know the destination and then the strategy becomes the pathway to reaching that destination. It is implausible that all objectives can be achieved at once, and it will be a sequential process. At the moment it feels as if the “where” or the “what” is not entirely clear.
The crucial aspect of this is what happens to the generating capacity that Eskom currently dominates so heavily, with control of over 85% of the country’s generation.
Unless you can disaggregate this capacity by selling off assets to create real competition, you are left with Eskom setting its price without any incentive to become more efficient and invest in all the things that are needed to improve the inoperative electricity system in South Africa.
When you have a dominant provider of capacity and/or electrons, the market is going to be non-transparent and potentially insufficiently deep to sustain a forward price. In that sense, the fundamental premise of any market reform has got to be the break-up of the incumbent utility.
And you can’t rely on Independent Power Producers signing deals with energy-intensive users to produce the right level of competition, because, crucially, there is a very important societal aspect to this important process of market liberalisation. If the wealthy – whether corporates or individuals – are left to self-serve their electricity needs, it leaves the vast majority of the population to fend for themselves, with the danger that this could lead to a further breakdown of community.
South Africa presently suffers from a structural shortage of functional generation. This is an impediment to full competition, as it would seem necessary to ensure prices do not reach unacceptable levels (while still incentivising new generation).
Would a pool system of the sort that has been deployed in other markets be a better way to proceed and, if so, why?
Going for a pool system first, rather than proceeding straight to a hybrid or bilateral system, has many advantages with each generating unit being a separate economic entity within the pool system.
Why? Because that allows you to establish a merit order for the dispatch of your generating capacity and it also facilitates the break-up and sell-off of Eskom’s generating assets. If Eskom remains a major supplier of capacity, it’s not at all clear how a transparent merit order that will attract third party investment will be created quickly. In addition, the current shortage of functional generation capacity may hinder the emergence of a cost reflective merit order.
An effective pool system requires there to be proper competition in the generation of electricity to avoid the danger of the pool price being set above competitive levels. This is more readily achieved when there is a balance between supply and demand. In markets where this system has worked, the pool is usually managed by a distinct entity that has no economic interest in the generation, transmission or distribution of power.
Within the pool system, a spot market establishes which generators are called on to meet demand at any one time (the merit order) and at what price. Generators bid into the pool and those bidding at the lowest cost get called on first, setting the merit order. But it is the higher cost generators that are called on last to meet demand at any one moment that set the price (SMP) that all generators receive for their power. Ensuring there is significant disaggregation of generation capacity to multiple players (including by the transfer of Eskom’s generation assets) will mitigate against any risk that individual generators artificially set the price. This coupled with an availability payment to allow some cost recovery and encourage sufficient capacity to deal with demand peaks will assist in creating genuine market dynamics. In addition, a pool system needs to allow the ‘constraining on’ of generating plant to satisfy demand within a transmission constrained region and the ‘constraining off’ of generating plant where a plant cannot run because of a transmission constraint. Under the pool system in England and Wales generating plants that were constrained on received their bid price and generating plants that were constrained off received SMP less their bid price.
At the moment, it’s not clear how the Government would establish a transparent merit order within a bilateral or hybrid system or how the current bilateral arrangements would exist alongside or within a pool system. That will be determined by the market rules which, as noted before, haven’t yet been made available and may not be clarified for some time.
If Eskom’s generating assets are sold off and its role in distribution is separated out, it will allow the company to act as an unbiased Transmission System Operator. That would allow the capacity and experience within the company around grid balancing and transmission services to be in the right place to do this job with much greater efficiency. That being said, it is worth noting that the draft Bill assumes that the TSO will only be owned by Eskom in the short term – up to a period of five years; as such, at this stage, it is unclear how that function will be performed on an ongoing basis.
The sale of its generating assets would also raise much-needed capital, not only to pay for the restructuring of the market but also to finance the expansion of transmission assets that are already so badly needed and that will be vital as new renewable capacity is commissioned onto the system.
When the pool system was being contemplated for England and Wales, we saw some major concerns expressed around bringing in a competitive system. People worried it might be impossible to maintain security of supply in the midst of such change. In the end, there was sufficient supply margin at the time that there was no need to worry about upsetting the system.
In South Africa, the situation is quite different at a time when every electron is needed. Without a properly regulated pool or bilateral system, deregulation seems likely to require some sort of price cap (or an ability to constrain on generation on a cost reflective basis) to stop generators demanding whatever price they like. But as soon as you deploy a price cap, you are intervening in the market and so the benefits of the market that you are seeking are eroded.
That’s where the need for a system architect comes in – someone who is setting out to solve the specific, clearly identified problem at hand rather than just saying: “Everybody else is liberalising, we should do the same and keep our fingers crossed”.
What are the main challenges around raising capital for this important transition?
We’ve already noted how the sale of Eskom’s generating assets can be used to finance the restructuring of the market and the development of new transmission infrastructure. So, getting to a place where the company has no economic interest in generation looks like an interesting step that needs serious consideration.
The other thing to realise is that it is hard to raise project finance in a new market until you have certainty around the dispatch of generating capacity and around price discovery. Any changes can have the effect of stalling debt-financed investment or impairing it relative to what it would otherwise be.
When the pool was introduced in England and Wales, for instance, the market saw the emergence of contracts for difference, through which the majority of electricity trades were hedged (these arrangements, typically between generators and retail supply companies, provided for a strike price and difference payments were made either way depending on whether the pool purchase price fell above or below such strike price). These gave generators revenue certainty and suppliers avoided price volatility, allowing for more stability against which to raise finance. Similarly, the hedging of trading platform prices may be important in funding new generation in South Africa. As indicated above, an availability charge will also provide for some base cost recovery depending on its sizing.
But the critical general issue to remember around financing is that, right now, the entire world is in competition for capital. In addition, given financiers’ green requirements and reduced liquidity for financing coal generation, financing the continued maintenance and upgrade of South Africa’s predominantly coal-dependent generation capacity compounds this challenge.
If South Africa’s aim in restructuring its electricity market is to get the lowest levelised cost of electricity, you want to enable as much competition as possible to provide targets for that capital.
That requires a coherent energy restructure programme with strong regulation across the sector, because investors in utility assets want to de-risk as much as possible. The idea of suddenly finding themselves on the wrong side of a change in law is a critical issue for them.
What are the issues investors need to think about around change of law risks and what should the Government be looking to do to ameliorate them?
When you introduce a new energy system there will be a raft of changes you need to make around a whole range of issues, whether that’s around forecasting notifications, system balancing, or allocation of grid capacity, among many others. Some of these things simply do not exist today, and it is unlikely that any standard change of law clause drafted to protect investment today will cover them all.
So, for example, any energy-intensive users entering into long-term power purchase agreements today, when significant reform is coming at pace, must have a robust change of law regime in place to deal with the fact that the market restructuring will cause the anticipated risk/reward balance under the agreement to be significantly altered.
As part of their risk mitigation strategy, they need to acknowledge that there is a very strong likelihood that the parties to these agreements will need to renegotiate the terms of their agreements as the reform process being pursued by the Government becomes clearer.
The faster the Government can provide clarity on those aspects of its strategy that remain opaque, the better.