As a source of project finance expertise, South Africa tends to dominate its neighbours. But a looming crisis in power generation has left South Africa at the mercy of imports from its neighbours.

The episode is exposing serious weaknesses in the capabilities of state electricity company Eskom. It has also hit hard the country's mining industry, long the engine of domestic economic growth. The mining industry is operating at levels consistent with receiving 95% of supply, and deep-mine operators are particularly wary of a disruption to their ability to move staff between the surface and underground.

Eskom has long attracted admiration – and bewilderment – at the rates at which it can generate power. South Africa's extended inability to import oil and gas during apartheid made Eskom an expert at coal generation, and its still operates, with Kendal, one of the world's largest coal pants. Eskom still benefits from favourable rates on its coal supply contracts, though the rates at which it buys coal are shrouded in mystery.

The immediate cause of the crisis, according to Eskom, has been the disruption of coal supplies by wet weather, as well as a maintenance backlog. Eskom has also suggested that the South African government has been skimping on investment in the sector. The rolling blackouts – or load-shedding, as Eskom describes it – have unsettled end users.

For project developers, the current round of anguish will validate their complaints about operating in South Africa. The country's approach to adding generation capacity has been extremely lackadaisical, to put it gently. Eskom was originally to have been privatised, part of a 90s enthusiasm for private ownership that petered out as Eskom's unusual fundamentals became known.

Kelvin fails to inspire

However, during the period when privatisation was under consideration, capacity additions were limited, on the assumption that third-party generators would become a major presence in the market. Financings for power projects have been extremely limited, and only the unhappy saga of the Kelvin privatisation stands out.

AES bought 50% of Kelvin, a dilapidated 40-year-old coal-fired plant with a nominal capacity of up to 600MW, but an effective capacity of 300MW, from the city of Johannesburg in 20001. It paid $23 million for the stake in 2001, and closed a R375 million ($38 million at then-prevalent rates) non-recourse financing for the project with Rand Merchant Bank in September 2002.

The project had a 20-year power purchase agreement with the city, and thus allowed the new owner to avoid direct dealings with Eskom. But AES found it very difficult to operate the plant at a cost that would be close to the prices that Eskom offered. The outside investment prevented the project from being mothballed, but did not offer much of a prospect for greater involvement from IPPs.

In January 2003 AES, which was in the throes of a tidying-up of its financial and operational make-up, sold the project to CDC Globeleq, along with its Tanzanian Songas asset. Globeleq, in turn, refinanced the project later that year with a R350 million loan from Nedbank and Investec.

Globeleq, however, while it completed some limited upgrades, was never able to bring the plant's production up to economic levels. In late 2006 it returned the plant to its lenders, and in turn in June 2007 divested most of its power portfolio, which spanned Latin America, Asia and North Africa. The latest group to take on the plant is a consortium of Macquarie, Old Mutual Investment Group, Kagiso Trust Investment, Aldwych International, its partner the Netherlands Development Finance Company (FMO) and J&J Infrastructure Holdings.

The development looks promising, with a mixture of patient development bank equity, seasoned infrastructure investors, and Aldwych, the niche African private equity firm with stakes in Zambia's Copperbelt Energy Corporation and an IPP in Senegal. Aldwych's management has a familiarity with the asset going back to their time at AES. The recapitalisation closed in August 2007.

AES makes an inglorious return

The irony hardy needed spelling out when in the same month AES was named preferred bidder on a pair of power projects for which Eskom was to be the offtaker. On 27 August the Department of Minerals and Energy named it the preferred bidder on a 760MW plant in KwaZulu Natal Province and a 342MW plant in the Eastern Cape Province. The award was the culmination of a process that the DME started in 2004 to build extra capacity.

The DME left additions before 2008 in the hands of Eskom, but from the start of this year planned to increase outside participation, particularly in the field of gas-fired capacity. The two open-cycle projects would have sold power to Eskom under 15-year power purchase agreements. AES targeted financial close for the end of 2008, and hoped to have the plants running by the end of 2009.

This time, they progressed an even smaller distance than Kelvin. AES is understood to have mandated ABN Amro and Rand Merchant Bank to provide just under R6 billion in debt to back the projects, but its timing was unfortunate. Despite a three-month extension to the commercial close timeline, a series of factors, including the credit crunch, increased construction costs and the messy integration of ABN Amro and Royal Bank of Scotland, intervened. AES and its lenders are understood to have required changes in the tariff and in-service date on the projects to reflect the changes in conditions.

On 3 April, the DME said that AES has decided not too proceed with the tender, because it could not stick closely enough to the original terms of the bid. According to an AES statement, "changes to the project parameters and risk profile of the deal made pursuing these projects unattractive."

The DME plans to re-issue the tender within three months, and Suez Energy, the losing shortlisted bidder from the first round, is likely to be favourite. Sources inside the ministry have suggested in published reports that Suez might have been in a position to challenge the tender if Eskom or the DME deviated from the bidding documents.

The terror of tariffs

After the failure of the AES tender, Eskom and the DME now have to convince sponsors and bankers that their IPP framework will withstand the natural tensions between generators and the offtaker. The DME has said that Eskom will be the counterparty for all of the new wave of power projects, and that 30% of new additions would be coming from outside Eskom.

But South Africa's limited access to gas supplies is now starting to bite. The open-cycle plants, at least to start with, are all running on diesel, which has experienced large jumps in price. This not only affects the cost of outside power producers, poisoning relationships with Eskom, but also increases the cost of Eskom's own generation.

South Africa's generation mix (2004)
Fuel                            MW
Coal                           38,209
Nuclear                        1,800
Bagasse                           105
Hydro                              668
Gas turbines                     660
Pumped storage            1,580
Total                           43,022
Source: National Electricity Regulator

Eskom is now going through with an application to the National Energy Regulator of South Africa (NERSA) for higher tariffs. The figure that it asked for – 53% – has certainly gained attention. It says that even if the IPP programme takes off it will need to spend R1.3 trillion on new capacity, and will also need to reverse some of the lack of maintenance at South Africa's generating fleet.

In a previous round of consultations Eskom asked NERSA for an 18% increase – a demand that NERSA reduced to 14% in late October 2007. That was up from a planned 6%, working on the government's energy outlook for 2008/2009. NERSA, and government energy planning, have benefited from South Africa's sometimes lethargic growth over the last fifteen years – capacity additions have been less pressing because growth has been between two and three percentage points below forecasts.

The new tariff increases will be spread across a variety of users, and better-off customers are likely to feel the brunt. Like its Mexican state-owned counterpart, the CFE, Eskom has struggled to reconcile its cost of power with a social mandate that offers free or cut-priced power to poorer customers, using cross-subsidies from industrial and richer residential users. For instance, BHP Billiton, probably Eskom's largest single customer, will have outsize influence on the process, when compared to lenders agitating for more price transparency.

Borders and borrowing

Probably the best way to lend into South Africa's power sector is to finance a generator located abroad. For instance, Banco BPI and Calyon recently closed a 10-year $800 million financing for the Cahora Bassa hydro plant in Mozambique. The financing went through without any political risk cover.

The loan supports the acquisition of a 67% stake in the 2,075MW hydro project from the Portuguese government, and removes one of the last concrete remnants of Portugal's colonial presence in the country. Mozambique already owned 18% of the plant, which was completed in 1974, but over which Portugal retained control after independence.

Eskom has been an important part of the refurbishment of the dam and is its largest offtaker, buying 60% of the plant's capacity. Without the agreement, Mozambique would not have been able to pay the Portuguese government for the losses it occurred owning the dam during Mozambique's civil war. The agreement, which was signed in 2006 and took effect in December 2007, is designed to bring the electricity markets of Mozambique, South Africa and Zimbabwe closer together.

But the shortages in South Africa look set to exacerbate tensions with South Africa's neighbours, since Zambia and Botswana also buy power from South Africa, and have their own booming resource sectors. South African public opinion is already turning against large-scale exports. The neighbours' only main alternative, importing hydroelectric power from the Congo, remains a distant prospect.

The failure of the AES tender and the power shortages have concentrated attention in South Africa on a subject that its politicians have tended to leave to one side at the first sign of difficulties. Public-sector unions have been the main force behind opposition to Eskom's privatisation, and there is little sign that there exists any renewed impetus for a sell-off.

But Eskom's struggle to meet its supply obligations, and its hazy approach to dealing with supply costs offer an opportunity for reformers within the South African government to pursue unbundling with more vigour. The establishment of a regulator, and the bidding framework, which may have been the victim of market conditions rather than their own deficiencies, could yet be robust enough foundations for a second push at an IPP programme.