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Jun 29, 2012

Planned ISMO unlikely to be panacea for power sector’s woes

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The proposal to introduce an independent system and market operator (ISMO) into South Africa’s power generation sector seems to have found favour with government. However, it remains to be seen whether an ISMO would help to resolve the country’s electricity woes by encouraging and benefiting private-sector involvement and keeping electricity prices low or further disrupt the electricity sector.

The creation of an independent system operator is premised on the belief that shifting system operation functions away from power utility Eskom would assure independent power producers (IPPs) of fair competition and access to the monopoly transmission system, thus encouraging IPP presence in the sector. Market operation functions would reside with the independent system operator, resulting in the creation of an ISMO.

The extent to which the private sector would benefit from such as system, how- ever, is questionable. The contracts being signed by Eskom with IPPs raise questions about whether private-sector interest is being sidelined, since the contracts involved ‘take or pay’ elements. This means that Eskom will pay for the power generated by the IPP, even if it does not take all the power that is produced. As the owner of the transmission system and the procurer of power, Eskom does not stand to gain by denying IPPs access to the transmission network. More simply put, IPPs do not stand to lose anything from the absence of independent system operations.

Currently, facilitation of IPP procure- ment through the National Treasury’s Public-Private Partnership Unit seems to be running smoothly, obviating the need for the ISMO’s market role.
So, if the intention of establishing an ISMO immediately is to eliminate the dispatch risk for IPPs in the absence of separation of the transmission function from Eskom, there is no reality to this at present. Eskom will still provide key grid connectivity in the medium term and the status quo will remain. There is no proposal to unbundle Eskom that we know of that gives any sense that the ISMO’s role will be advantageous other than merely in name.

The introduction of an ISMO is also seen as having advantages for electricity prices. It has been argued that, for Eskom to build the required new generation capacity, steep electricity increases will be required, resulting in a negative impact on the economy. Eskom’s ability to build cheaper power plants, in any case, has been put in doubt because of the cost over- runs for the Medupi and Kusile power stations, so there may be some truth to this assumption.

But, as things stand, an ISMO is unlikely to change the current price performance of IPPs; the only change will be the address where IPPs will have to send their bill. If you consider the recent renewables bid, IPPs will certainly compete with one another during the tendering process. However, prices are capped for different renewables technologies. Some will come under the cap or be on a par, and Eskom will have to pay. But where is the real benefit of lower electricity prices? In fact, the ISMO will only end up creating limited competition for an undeveloped electricity market among IPPs only. Eskom will continue to operate without being challenged by market players to enhance its performance.

Further, electricity prices quoted by IPPs would depend on several factors, including the type of procurement process, the efficiency of the procurement process, fuel markets, regulatory tools to create better incentives for efficient production of power and the supply-demand imbalance. So there is no guarantee that the ISMO will lead to lower electricity prices.

There is also the question of how the ISMO will be funded. Given the functions to be performed by the ISMO, it would not have a huge asset base. Its balance sheet would be small, making it difficult to raise capital. A small balance sheet will also reduce confidence in the ISMO’s ability to carry the risks associated with power procurement. The ISMO, as the power procurer, may have difficulty realising contracts with IPPs, unless there is strong payment security from the ISMO or the power purchase agreement is bankable. Since this is unlikely to be the case, given the ISMO’s balance sheet, from an IPP perspective, dealing with an ISMO implies higher risks than dealing with Eskom. Higher risks will translate into a higher risk premium in contracting with an ISMO.

Unlike typical power sector reforms elsewhere in the world, the creation of an ISMO in South Africa is not driven by a desire to improve efficiency through restructuring and competition. Instead, the driving factor behind the ISMO in South Africa is the immediate challenge of underinvestment in new generation capacity by the private sector and the country’s low reserve margin.

The rationale for the ISMO is more political than economic. It is hoped that, by reducing Eskom’s influence, the ISMO will improve governance and the performance of the electricity market. The ISMO may well create an added layer of bureaucracy and an added cost to the system. Shifting billing addresses does not suggest improvements in electricity planning, better demand and supply scheduling, nor cost-effective generation capacity.

Clearly, the creation of the ISMO, in the absence of an overall policy decision on the structure of the electricity industry, is unlikely to help the industry. The ISMO may turn out to be a false solution while the trouble lies elsewhere in the system.

While an ISMO is important for facilitating the introduction of IPPs, in the sense that it brings about transparency, accountability and a level playing field for power producers, given its proposed timing, the absence of larger reforms in the sector and no changes in governance, the ISMO is unlikely to be the saviour of the sector.

Edited by: Martin Zhuwakinyu
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