Investment and Uncertainty

1. Investment and Uncertainty Historical experience with power sector investments in South Africa and implications for current challenges Grové SteynGrove@TheKnowledgeBridge.com083 379 1735 Please see paper at: www.gsb.uct.ac.za/mir 30 May 2006

2. The Electricity Supply Commission • ESCOM was established on 6 March 1923. • Non-profit statutory corporation • Not accountable to parliament, reporting to line minister • Could veto municipal generation investment

3. ESCOM: Initial Strategy • Set out to establish itself as sole supplier of new capacity • Took over Colenso power station from Railways • Agreements that it would construct Congela and Salt River power stations • Vetoed future VFTPC stations: Witbank, Klip, Vaal (ESCOM Finance and own, VFTPC to build and operate) • Expropriated VFTPC on 1 July 1948 for £14.5million - largest transaction in South Africa's history

4. Investment: Upscaling and interconnection in 1960/70s. • Post war years • Skills and equipment shortages • Increased demand from gold mining and industry lead to rationing and load shedding. • Supply to mining shaped ESCOM culture • 1960s and early 1970s • Interconnection – national grid • Upscaling – economies of scale • Important implications for generation technology, plant sizing and locational decisions

5. Increased demand and investment in the 1970s

6. Increased demand and investment in the 1970s (2)

7. Increased demand and investment in the 1970s (3) • Oil crises • From 1972 to 1975, demand growth outstripped the rate at which ESCOM could add capacity. • Dramatically increased building programme • Matla, with six 600MW units, started in October 1974 • Drakensberg, with four 250MW units started in January 1975 • Duva, with a further six 600MW units started in November 1975 (decision shortly after the Portuguese lost political power in Mozambique) • Koeberg also finally started in August 1976 barely two months after the Soweto uprising.

8. Second Oil crises in 1979 • Demand growth increased to twelve percent, leading to alarming reduction in reserve margin • “No time to draw up new designs or go through long tendering processes” • Lethabo (3 708 MW) was ordered as a copy of Matla • Tutuka ordered (3 654MW) as a copy of Duva • The supply arrangements were negotiated with the same turbine and boiler contractors as were used with the original stations

9. Problems with up-scaling and capital costs • By middle 1970s it was taking fourteen years between the decision to construct a large six-unit coal fired station and the commissioning of the last unit. • Most of the capital expenditure occurred between year seven and eleven

10. ESCOM fixed assets under construction

11. Capacity crises and further investment in the early 1980s • Loss of the 1373 MW of contracted firm capacity from Cahora Bassa • Commissioning problems were experienced with the new 600MW sets at Matla and Duva • Unexpected deterioration of availability • From 85% in 1975, to 74.7% in 1980, and 71.9% in 1983 • Result of poor initial performance from the new large-scale generating sets • (Availability levels of over 90 percent during the 1990s when surplus capacity meant that the system was run at lower load factors) • Mostly problems at the three largest stations Arnot, Kriel and Matla

12. Availability of selected ESCOM power stations

13. Capacity crises and further investment in the early 1980s (2) • Supply crises • Unavoidable load shedding with goldmines • Left an indelible impression on the senior engineers - resolved to ensure that it should happen “never again” (Kok 1999, McRae 1997 and Rubberts 1997). • Again it was decided to accelerate plans for constructing generation plant. Ian McRae, recalls: “It would have been the biggest sin to have been responsible for holding back economic growth [by constraining electricity supply] so it was just go, go, go!” (1997).

14. Further orders in the early 1980s • By 1982 foreseeing capital expenditure programme of R65 billion which would treble its capacity to 70 000MW by end of the century (Ryan, 1982). • Placed boiler and turbine orders for three additional 4000MW class stations, Matimba, Kendal, and Majuba on the basis of the four tenders submitted for Matimba. Also signed a letter of intent for the turbines for a further station, Lekwe. • All these stations were to utilise “dry” cooling. • By end of 1983, ESCOM had generation plant totalling 22 260 MW under construction or on order. Equivalent to 97 percent of its total plant in commission.

17. ESCOM: Capital expenditure

18. ESCOM/Eskom’s prices

19. Eskom's investments, debt and financing costs

20. Cost contributions per kWh

21. Cost contributions per kWh (2)

22. Problems with system planning and project appraisal • Irreversability • Uncertainty and ignorance rather than “risk” • Incorrect use of discount rates • Overlooking the benefits of portfolio effects and diversity • Overlooking the value of flexibility and options

23. Strategies in the face of uncertainty and ignorance • Incertitude shifting • Incrementalism: “The science of muddling through” Lindblom (1959 and 1979) • effective response to complexity and uncertainty in the context of bounded rationality • poses a challenge to the mastery-via-understanding tradition of Western civilization

24. Strategies in the face of uncertainty and ignorance (2) • Flexibility (of an investment) • allows for trial and error learning (Collingridge, 1992) • enables adaptation to changing circumstances and therefore reduces the potential costs of errors (Collingridge and James, 1991). • Diversity (of a system) • promotes beneficial forms of innovation and growth • hedges against exposure to uncertainty and ignorance • mitigates the adverse effects of institutional ‘momentum’ and ‘lock-in’ in technological trajectories • accommodates disparate interests associated with social choice in modern pluralistic societies. Stirling (1998: 37)

25. Moral Hazard • A specific instance of the principal agent problem • From investigating health care insurance incentive problems • E.g. car insurance • Four elements of moral hazard: • Incertitude shifting • Principal agent relationship • Agent incentives diverging from principal interests • Information asymmetry (observability) problems

26. On Moral Hazard • Moral hazard is pervasive in the economy. It occurs whenever risk is present, individuals are risk averse, and “effort” is costly to monitor. And it arises not only in insurance markets, but also when insurance is provided by governments, through social institutions, or in principal-agent contracts. (1988: 384, emphasis added) Arnott and Stiglitz (1988)

27. Some findings • Information asymmetry: financial system and pricing does not reveal cost of electric power • Persistent Moral Hazard • Moral Hazard problem exists and is not recognised

28. Implications for policy • Persistent Moral Hazard means that the problem is bigger than you think. • Policies should focus on: • Moving exposure to real economic uncertainties back to firms and financiers • Reducing • ex ante information asymmetries with regard to investment exposure to real uncertainties and ignorance; and • ex post information asymmetries with respect to the subsequent performance of these investments. • Comprehensive public review of: Eskom’s governance and investment decision-making methodologies and procedures; and of its accounting and pricing policies required