South Africa’s machinery and equipment industries have recently come under huge pressure. Falling demand after the 2008 financial crisis and rising energy costs have harmed the sector. These trends are concerning as the sector employs 10% of the country’s total manufacturing workforce.
Our research paper analysed the structural factors facing the industries and zoomed in on the foundries. This is because foundries are a key intermediate segment of the machinery and equipment industries value chain. They have been hardest hit by rising electricity costs.
Foundries manufacture metal components by pouring molten metal into moulds. The components are assembled into various high value products including cars, pumps, machines, mineral processing and earth handling equipment.
Rising power costs make up 16% of foundry input costs. This was before Eskom’s recent 19.9% tariff increase.
Between 2007 and 2016, 100 of South Africa’s 265 foundries were closed. 6000 direct jobs were lost. This also impacted on jobs and production in downstream machinery firms. Some downstream firms turned to importing foundry component inputs. Others stopped production and imported fully assembled products such as pumps and valves.
There are 165 foundries left in South Africa today down from 265 in 2007. Over 80% source their power from municipalities. Half of these operate in Ekurhuleni. This is a largely industrial metropolitan area bordering Johannesburg in the Gauteng province.
South Africa’s state owned power utility, Eskom, distributes 54% of national power to end users. Around 180 municipal power departments distribute the remaining 46%.
Municipal tariffs differ widely. Many are much higher than the equivalent tariff an Eskom customer pays. A medium sized foundry pays 30% more for electricity in Ekurhuleni per kilogram of output than a similar foundry sourcing power directly from Eskom. A small foundry pays 19% more.
These higher tariffs erode Ekurhuleni foundries’ profits and global competitiveness.
What drives municipal power tariff setting
The municipal finance system lies at the heart of this problem. They have to raise their own revenues even though central government partly funds them.
One source is through power sales. Ekurhuleni’s power sales make up 40% of total revenue compared to the second largest source, the 17% in fiscal transfers from national and provincial government. This dependency has provided a rational but perverse reason for raising municipal tariffs.
The National Energy Regulator of South Africa regulates electricity tariffs. They use a published methodology based on cost of supply. Municipalities purchase power from Eskom at wholesale prices. To this they add the municipal distribution infrastructure cost and an allowable profit margin.
Too few municipal power departments have conducted independent cost-of-service studies. Many lack the capacity to produce accurate power distribution cost data. Some are unable to plan and manage infrastructure budgets and operating systems. There has also been historical under-investment in distribution infrastructure. Often inadequate funding has been allocated to repairs and maintenance.
Technical support interventions from national government have so far failed to address these problems. Performance-based grants for distribution infrastructure upgrading was partly met through the Municipal Infrastructure Grant. But this is being reduced in the 2018 budget. The approach to distribution asset management programme (ADAM) initiative was adopted in 2012. This has failed to reverse the municipal distribution infrastructure backlog. And the programme appears to be unfunded currently.
The municipal financing system is being reformed but the process is slow suggesting that parts of our government system are blind to the damage being inflicted on the manufacturing sector by municipal power distribution inefficiency.
Given the slow pace of reform, policymakers should look for solutions elsewhere. First, the search must focus on ensuring municipal tariffs are cost reflective, and don’t reward poor planning and inefficiency.
This requires the physical and economic state of each municipal and Eskom managed electricity distribution infrastructure system to be monitored. The electricity tariff detail, the respective cost structures, outage performance, backlogs and investment plans should be publicly available to any consumer. Here, the Department of Water and Sanitation’s systems could be emulated. They run publicly accessible infrastructure condition monitoring systems. These are for water quality Blue Drop and sanitation conditions Green Drop.
Second, municipal infrastructure and maintenance investment programs such as ADAM should be better funded. And the National Treasury’s budget disciplining conditional grant and other policy instruments should be applied to speed a move to municipal cost based tariff setting.
Third, another solution could come out of the evolving energy market. South Africa’s energy generation surplus is set to rise in the next decade. Energy intensive sectors are already lobbying for special pricing agreements. Their architecture and targets will need careful consideration. The process must involve the Department of Trade and Industry, Economic Development Department and other industrial policy custodians.
Appropriate conditions should also be applied to recipients of special pricing agreements. These include conditions of passing the benefits of lower electricity prices through to downstream labour intensive sectors (such as foundries and machinery). It’s equally important that such conditions be enforced more robustly than in the past.
Fourth, it may take some time before the realisation of some of the structural reforms to the local government financing system. Therefore policy custodians involved in administering investment incentives should consider promoting energy intensive investments only in those municipalities with more reliable, sustainable and competitive power distribution infrastructure. A specific relocation incentive for those firms that are likely to fail due to unjustifiably high municipal power costs should also be considered.
Finally, new technologies such as distributed generation, rooftop PV panels, improved battery storage systems and “smart-grids” are already disrupting the structure and cost of distribution infrastructure. Their widespread adoption is likely to undermine the current system of local government financing, dependent as it is on electricity rents, long before the current fiscal financing reform timelines have any impact.
This article and the background paper was co-authored by Lauralyn Kaziboni, a researcher at the Centre for Competition, Regulation and Economic Development at the University of Johannesburg and Ian Steuart, senior economic development specialist at CowaterSogema International.