Mandatory localisation, the ‘10% rule’, a root cause of the low energy availability factor
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By Hügo Krüger and Sdumo Hlope
The mandatory localisation requirement, jokingly called “the 10% rule”, which is part of the Preferential Policy Framework Act (PPPFA) of 2000 is destructive to South Africa’s state-owned enterprises (SOEs).
The 10% rule refers to the practice where buyers are typically unwilling to engage with suppliers unless they perceive a personal benefit equivalent to at least 10% of the deal’s value.
Procurement regulations such as these were identified on page 60 of the recently published Vgbe Energy Report as a root cause of the low energy availability factor (EAF).
“The main root cause for the low EAF is the dysfunctional management system of Eskom. It is characterised by inefficient processes – especially in procurement – a lack of authority and an opaque decision-making structure,” it said.
The outcome of the PPPFA within Eskom Generation, as an SOE, leads to a situation where a purchase or repair becomes significantly more expensive when compared to similar activities at an independent power provider (IPP). This is mainly due to the PPPFA encouraging the involvement of local agents, even to the extent that they are specifying that they must be situated near power plants.
In addition to the PPPFA, one of Eskom’s tender requirements mandates prospective suppliers to comply with mandatory skills development and localisation. The requirements can even go to the extent that they mandate employing people and/or pay for bursaries for students.
They are expected to give details of their plans for localisation initiatives and specify the jobs to be created from the contract. In addition, suppliers in the vicinity of the power station being served are viewed “favourably” compared to suppliers that are further away. This, therefore, encourages potential manufacturers to set up pilot offices closer to the power station, adding the cost to the supply chain costs, or simply not tender at all.
However, despite often complying with the localisation and development requirements, there is no guarantee of receiving orders, because the supplier must compete with others. Additionally, it has been observed that even when companies attempt to collaborate with value-added agents near the site or establish manufacturing facilities nearby, they may fail to secure work if the buyer has alternative motives.
The practice of “localisation” increases the cost to Eskom and tends to discourage some qualifying original equipment manufacturers (OEM) suppliers in favour of a non-value-adding middleman.
Orders are frequently not awarded, resulting in the closure of localised plants, staff lay-offs and a general reluctance to engage with Eskom.
The PPPFA prohibits the preference of certain suppliers over others. Moreover, the additional challenge of a “Preferential Procurement” impact ranging between 10% and 20% on stringent procurement regulations further dissuades quality suppliers from participating in tenders. If they are unable, for any reason, to meet the BEE requirements, they will face a pricing or evaluation disadvantage of between 10% and 20% before even submitting their bid.
Such practices contribute to driving away reputable suppliers and, inevitably, lead to corruption when buyers bypass the crucial technical expertise responsible for safeguarding Eskom from procuring inferior and, sometimes, incorrect goods and services. This is because an SOE may become aligned with a particular supplier, making them the “preferred choice” and thereby shutting out competition.
Buyers should not possess the authority to circumvent valuable instructions provided by qualified engineers who are entrusted with the critical responsibility of protecting Eskom’s generation plants and ensuring compliance with technically sound procedures.
Perpetrators that make money out of the 10% rule understand that they do not need to meet all the technical specifications or demonstrate experience. Instead, they need only the right political connections to secure a contract. This compromises the integrity of the procurement process and undermines the purpose of having technical gatekeepers to ensure the quality and appropriateness of the goods and services procured by Eskom.
Furthermore, the lack of inherent experience and sufficient training for buyers and procurement teams, coupled with inadequate market testing, results in errors in requests for quotations and impractical gatekeepers. Incidentally, bids are frequently withdrawn and cancelled after months, only to be reissued later.
Local content minimum requirements are often not rigorously tested to determine if the market has the capacity and qualifications to comply with them. Even if they do, bidders may be hesitant to use local contractors for part of their supply scope when they can procure from their own prequalified companies, often at a lower cost and without taking risks on unfamiliar companies.
The practice has several adverse impacts on Eskom’s performance, as outlined in the following examples:
– In the past, there have been instances where Eskom was directed to procure boiler tubes through local agents who, in turn, demanded preferential payment terms but failed to fulfil their obligations to the suppliers. As a result, the agents would abscond, leaving the genuine suppliers financially burdened and unwilling to continue supplying Eskom, also leaving Eskom without the necessary components for critical maintenance.
– In the case of repairs, Rotek and Eskom often no longer provide work instructions, leading to a lack of clarity for the agents about the required tasks. This eliminates communication between the repairer and Eskom. If direct communication were re-established, the repairer might identify the operational issues causing failures and implement preventive measures. However, the intermediary localised BEE agent charges Eskom significantly more than the repair cost, with mark-ups reaching up to 1000% for purchases below R1 million.
– Eskom becomes vulnerable to significantly inflated prices due to the mark-ups. Additionally, Eskom loses any recourse to the repair company, as the agent lacks the capacity to underwrite guarantees and address defects.
– OEMs, who possess in-depth knowledge of Eskom's plant and requirements, may specify fit-for-purpose products. However, agents, often with inflated mark-ups, often request inferior products from non-OEMs, third party manufacturers, resulting in planned premature failures.
The issues are among the many that collectively contribute to financial losses, inefficiencies and potential compromises in the quality of goods and services procured by Eskom. Addressing the challenges is crucial for ensuring transparency, cost-effectiveness and the long-term reliability of Eskom’s operations.
Under the guise of “supporting local business”, plants are forced by the politicians, through the board, to buy local. Although noble, the localisation policy ignores basic practical realities such as the fact that South Africa industrialised around mining and, therefore, most of the manufacturing is in the Witwatersrand area. Most potential subcontractors and suppliers are in the vicinity of the airport, which is the first port of entry for most small and urgent cargo.
Why, for example, would a company, in Gauteng, manufacturing a wide range of products for various industries, suddenly have to set up a facility next to a coal plant for a contract that may be no more than 5% of its turnover?
Why should it not load the pricing with the overhead costs of the new facility which would then have some “preferential treatment” compared to far-out plants?
The mandatory localisation requirement is neither sustainable nor does it make good business sense for the SOE, especially considering that OEMs or main contractors typically provide guarantees for only 24 or 48 months. Beyond that period, Eskom assumes the risk for the life of the plant.
The impact of mandatory localisation on foreign companies is evident as they gradually cease bidding, hindering Eskom’s ability to procure the quality equipment essential for improving plant EAF, addressing the need at hand.
In the context of new generation capacity, it becomes unrealistic for the government to expect foreign manufacturers or specialised equipment providers, earning a modest profit margin of around 8% on exports, to commit to investing 30% of the sales price in the local market as is dictated by Eskom on behalf of the the Department of Trade, Industry and Competition via the National Industrial Participation Policy.
The companies are not in the business of venture capital or extensive investment, and committing such a significant percentage to “localisation” without commensurate profit raises serious concerns about the economic viability of the transaction. Any business with the intention of staying viable would hesitate to risk 30% of the sales price for anything less than a 30% profit.
As explained above, the mandatory localisation clause, originating from the PPPFA, reveals a series of unintended consequences that inevitably leads to an explosion of cost, a deterioration in quality control and a deferral of adequate maintenance. It is therefore a substantial root cause of load shedding and a contributing factor to the decline of South Africa’s SOEs in general.
To ensure the successful navigation of Eskom Generation within an unbundled framework, the adoption of a more pragmatic approach to localisation is imperative, or else it will be unable to stay in business when forced to compete against independent power providers.
Unworkable policies, such as preferential procurement, Treasury Note 3 and mandatory localisation, must undergo reform if Eskom is to recover and thrive once more.
Hügo Krüger, MSc in civil nuclear engineering and Sdumo Hlope, BSc in physics and chemistry and MSc in engineering mManagement. Input provided by TisaEnergy.
* The views in this column are independent of Business Report and Independent Media.
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