Change the world

News

28/05/2016

This article appeared in the latest Engineering News (Vol 36, No19) of 20 - 26 May 2016, written by Chris Ettmayr and NMMU's Director of the School of Economics, Development and Tourism, Hendrick Loyd.

http://www.engineeringnews.co.za/print-version/the-impact-of-local-content-rules-in-renewables-sector-questioned-2016-05-20

Economies around the world are demanding more energy, but the nature of the demand is changing, with preference given to energy sources that have a reduced environmental impact. A dichotomy arises for governments that need to increase generation while, at the same time, containing costs to remain attractive for inward investment.

Governments are increasingly deploying policy tools to meet these demands without creating negative welfare effects. South Africa has entered the green economy with the multiple objectives of developing new opportunities for local communities, creating jobs, forming new emerging enterprises and promoting broad-based black economic empowerment (BBEEE).

The Renewable Energy Independent Power Producer Procurement Programme (REIPPPP) is based on a 70-30 tender principle, whereby 70% is evaluated on price and 30% on socioeconomic criteria. Of the 30% for socioeconomic criteria, a total of 25% is allocated to local content requirements (LCRs), or the value of locally procured goods and services, compared with imported sources.

Setting LCRs is complex, as they can add value to an economy by increasing locally produced goods, boosting ‘infant industries’ and stimulating research and development (R&D) and innovation. However, they can also act as a trade barrier, distorting international trade and creating an inefficient allocation of resources.

The advantages include increasing demand for local manufacturing and labour, introduction new technologies and processes and increasing the tax base. However, there are also disadvantages, including inflationary pressures on pricing, misallocation of resources through incentives, negative impacts on trade and limited natural competition.

In some cases, LCRs have also been found to decrease employment, with complying firms employing fewer staff because of the increased expense of meeting the LCRs. Disrupted production and planning choices of manufacturers also increase costs. Brazil found, for example, that LCRs in the wind sector forced local manufacture of bulky, low sophistication goods, with a low transfer of technical skills and intellectual property remained low.

Imposing LCRs while limiting their negative welfare effect is possible in an economy that holds certain existing preconditions. Our research analysed the South African renewable-energy market to determine if the required preconditions existed in South Africa and what the impact of LRCs was on the sector. The results were triangulated by means of an international survey of renewable-energy experts to corroborate the results in terms of the local findings.

To avoid the negative effect that LCRs could create, the following preconditions need to be present in South Africa: a strong and growing renewable-energy market, government cooperation and incentives/subsidies, physical location and infrastructure, available skills and existing technical knowledge, and supply-side availability.

So, what were the findings in the South African market?

In terms of the market being strong, predictable and growing, respondents indicated that government should provide more long-term announcements on how it plans to develop and procure energy from independent power producers, which would give an indication on growth prospects and stability. Timelines and dates must also be strictly adhered to, as missing critical deadlines increases market uncertainty. Although 75.8% of respondents felt that the REIPPPP created sufficient market demand, only 33% of respondents indicated that the market was stable.

On access to finance, 68% of respondents felt that South African lenders were priced above their international counterparts, while 78.8% felt that accessing finance from local lenders that offered low-interest finance was difficult. The fluctuating exchange rate compounded the problem and raised project risk, which increased project price. Therefore, innovative funding mechanisms need to be explored to stimulate investments.

Indications are that government cooperation plays a significant role in stimulating investment in the renewables sector. However, it was felt that more targeted incentives were needed. It was felt that government should consider mechanisms such as the creation of manufacturing clusters, while also dealing with supply-side constraints.

South Africa’s LCRs have created new manufacturing entities and investment opportunities; however, respondents indicated that the investment and jobs created would mainly be short term and unsustainable – they would only be in place as long as the LCR was present because South Africa would not become a globally competitive renewable-energy equipment manufacturer without bringing in new innovation or technologies.

However, if LCRs were removed, investment would not necessarily increase and employment levels would not rise either. The removal of LCRs would allow for the price of renewables to be lowered, as the current indication is that LCRs add an average cost of 9.89%, which is passed on to the energy consumer. Sixty-seven per cent of the respondents felt that the price may even decrease further, as LCRs increased project risk.

South Africa’s suitability as a physical location for renewables was rated as excellent. The supporting infrastructure to transport goods by road, sea and air were all rated positively, but not rail, which is not generally used. A main problem detected with infrastructure was access to grid and connectivity, which is currently actively deterring investment in the renewable-energy sector. Grid access has to be prioritised and this infrastructure problem is impacting directly on future developments.

In terms of skills availability, South Africa possesses some technical skills to support this sector, but not always at the required level. Owing to scarcity, these skills come at a premium, especially the skills for engineering procurement and construction, operations and maintenance and manufacturing, and this increases project costs. In addition, the current level of R&D allocated to this sector is not high and this will further hamper the development of appropriately priced, skilled labour. A paradigm shift has been recommended for the South African government to consider spending on R&D and manufacturing cluster development, which would alleviate the skills problems as well as supply-side constraints.

Focusing specifically on supply-side issues, 62% of the respondents indicated that there were not enough local suppliers that are able to service the sector. From the available suppliers in the market, only 12% of the respondents felt that they could produce goods at a competitive price, while 15% of the respondents felt that local suppliers could produce goods at the required volume. In terms of the risk of not being able to meet delivery of goods, only 18% of the respondents felt that local suppliers would be able to absorb the risk and penalty of nonsupply.

Finally, in terms of BBBEE compliance, only 41% of the respondents believed that their suppliers were BBBEE compliant, which could present a major challenge for a policy such as local content. One possible solution could be the establishment of a manufacturing cluster, with 80.3% of respondents indicating that this could improve local supply capability.

In summary, and without arguing for or against LCRs, it is clear that South Africa has two solutions to pursue within the renewables sector, and when using national procurement that recommends local content conditions. If South Africa chooses to use LCRs, it would have to focus on improved market preconditions to ensure that they could be successfully implemented without negatively impacting on investment, price of goods and the creation of sustainable jobs. Localising a particular good may not always be feasible and LCRs should enhance existing manufacturing opportunities, as opposed to trying to create opportunities that do not exist. South Africa would do well to consider the value of localised content as well as the question of higher-end-value goods being localised, compared with cheaper and easy-to-manufacture goods.

Should LCRs continue to exist in their current form, dedicated monitoring and evaluation practices would have to be strengthened to prevent exploitative practices. The development of a monitoring and evaluation process should include the public so that broad consensus is achieved and buy-in for the principle of LCRs obtained from all affected citizens. Focus should also be placed on increasing foreign inward investment, with technology and skills transfer featuring more strongly in the tendering process.

Further investment and government support for the development of clusters and R&D centres would bring in foreign manufacturers, since the country would be competing on a cost basis as well as offering new technologies and innovations. This would allow for the market to decide where to invest, instead of being dictated to by policy, and the country would be able to hold a much higher value portion of the renewables manufacturing value chain. In this way, LCRs could be phased out over time in order to allow the market to adapt, and the cost of renewables would most likely fall.

Owing to certain key drivers not being present in the economy, the impact of LCRs has not been optimal. LCRs have been shown to be an unsustainable mechanism, as it is evident that LCRs increase the price of energy, which is passed on to the consumer. The welfare created for South Africa in terms of the creation of jobs and manufacturing development is, therefore, diminished.

There are suboptimal impacts on the welfare of the economy because of missing preconditions that would typically allow for the successful implementation of local content policy. South Africa must consider either strengthening LCRs through the provision of improved market conditions or withdrawing them over time, with a more focused effort being placed on R&D and innovation, in combination with cluster formations. This would allow local manufacturers to compete globally in an open trading field without artificial advantages created by protectionist measures. Pricing of renewable energy could then be driven downwards, accelerating market acceptance of this type of energy carrier.

Contact information
Prof Hendrik Lloyd
Acting Executive Dean: Faculty of Business and Economic Sciences