Unlocking Private Sector Investment for Low-Carbon Transition in South Africa Assessing Investment Climate for Climate Investments World Bank Group JUNE 2019 Contents Acknowledgement....................................................................................................................................... 2 Executive Summary..................................................................................................................................... 3 1. Introduction ......................................................................................................................................... 7 1.1. Background .................................................................................................................................. 7 1.2. Analytical Framework ................................................................................................................. 8 2. Macroeconomic Conditions and Investment Climate ..................................................................... 10 2.1. Macro investment climate ........................................................................................................ 10 2.2. Climate risks, transition risks, and macroeconomic implications ......................................... 12 2.3. Climate transition opportunities .............................................................................................. 14 3. Transformative Policies and Regulatory Framework .................................................................... 16 3.1. Comprehensive policy package ................................................................................................ 16 3.2. Effective implementation of the carbon tax ............................................................................ 17 3.3. Getting fiscal framework right ................................................................................................. 18 4. Energy Sector Landscape and Recent Market Developments ....................................................... 20 4.1. Power sector landscape ............................................................................................................ 20 4.2. Renewable energy independent power producer procurement program (REIPPPP) ........ 24 4.3. Coal mining and industry sector landscape ............................................................................ 25 5. Challenges and Opportunities for Low-Carbon Investment .......................................................... 27 5.1. Current energy crisis ................................................................................................................. 27 5.2. Boosting investor confidence ................................................................................................... 28 5.3. Unbundling of Eskom ................................................................................................................ 29 5.4. Regulatory reforms to unlock private capital for renewable energy scale up ..................... 29 5.5. Raising build limits for renewables and accelerating battery storage deployment ............ 30 5.6. Developing renewable energy manufacturing industry and supply chain ........................... 31 5.7. Improving risk-return profiles through innovative financial solutions ............................... 32 5.8. Tapping low-carbon investment potential in heavy industry ............................................... 34 6. Policy Considerations........................................................................................................................ 38 7. References .......................................................................................................................................... 40 1 Acknowledgement This paper was prepared by a World Bank team led by Suphachol Suphachalasai (Environmental Economist, Climate Change Group), and included Nuwan Suriyagoda (Senior Renewable Energy Specialist) and Michael McCormick (Environmental Specialist, Climate Change Group). The paper was developed under the overall guidance by John Roome (Senior Director, Climate Change Group), Paul Noumba Um (Country Director), Erwin de Nys (Program Leader, Sustainable Development, South Africa), and Marcelo Mena Carrasco (Practice Manager, Climate Change Group). Through draft versions, the paper greatly benefited from comments and suggestions from Sebastien Dessus (Program Leader, Equitable Growth, Finance and Institutions, South Africa), Reynold Duncan (Lead Energy Specialist, Energy Practice), Frederic Verdol (Senior Energy Specialist, Energy Practice), Stephane Hallegatte (Lead Economist, Climate Change Group), and Daniel Besley (Senior Climate Change Specialist, Climate Change Group). The task team are grateful for feedbacks and comments from peer reviewers including Sebastien Dessus (Program Leader, Equitable Growth, Finance and Institutions, South Africa), Pedro Sanchez (Lead Energy Specialist, Energy Practice), Julie Rozenberg (Senior Economist, Sustainable Development Practice Group Chief Economist’s office), Ankur Sood (Investment Officer, IFC), and Ruth Hupart (Operations Officer, IFC). The task team greatly apricate valuable market insights and supporting information shared by Mike Mulcahy (Chief Executive Officer, Green Cape—South Africa) and Andrea L. Colon (International Director, Coalition for Green Capital). 2 Executive Summary 1. Just energy transition is key to South Africa’s inclusive and sustainable growth. The National Development Plan (NDP) develops a ‘2030 vision’ to guide the country’s sustainable development path, building on a transition to a low-carbon, resilient, and just society. Furthermore, South Africa has committed to a peak, plateau, and decline greenhouse gas emission trajectory in its first Nationally Determined Contribution (NDC) to the Paris Agreement1, which underpins the success of Sustainable Development Goals (SDGs). However, South Africa—a fossil fuel-based economy—faces significant trade-offs associated with pursuing its emission reduction objective. At the same time, the implementation of Paris Agreement by the international community puts pressure on the country’s major revenue source—coal exports. A successful just energy transition is desirable and needed; it rests on accelerating low-carbon investments that create new jobs and businesses, and supports economic diversification, while managing adverse impacts particularly job losses and ensuring that everyone in the society benefits from new opportunities. 2. It is necessary to unlock large pools of private capital and attract foreign investment to drive low-carbon transition. The NDC recognizes that catalyzing low-carbon investments is a challenge, and substantial finance and investment will be required in the long-term. South African institutional investors and non-bank financial institutions hold in excess of R10 trillion worth of assets, and the banking sector has over R5 trillion in assets under management. Tapping into such local capital and foreign direct investment is key to the low-carbon transition. To this end, South Africa would benefit from ensuring that it has a sound macroeconomic foundation that sustains economic growth, while being conducive for investors. Transformative policies and regulatory reforms are also essential to steer investments towards a climate-smart future. Furthermore, removing critical barriers that stand in the way of renewable energy development and de-risking clean energy investments would help propel the country’s low-carbon transition. 3. Despite downside risks, South Africa has strong macroeconomic fundamentals and commitment to improving the overall investment climate. South Africa has made a remarkable progress on poverty reduction, but inequality remains extremely high2. In recent years, economic growth has underperformed and the unemployment rate has increased, while lagging foreign direct investment and exports have shown signs of a decline in competitiveness3. To promote inclusive and sustainable growth and improve the investment climate, bold reform actions may be prioritized to overcome binding development constraints such as inadequate skills, weak business environment, regulatory obstacles to competition, limited integration into global value chains, inefficient logistics, inadequate investment in infrastructure, and policy uncertainty—identified in the Systematic Country Diagnostic and the Country Private Sector Diagnostic. 4. Climate change poses considerable systematic risks, thus needs to be urgently integrated into macroeconomic policy and planning. South Africa is highly susceptible to climate and disaster risks which are critical constraints to its inclusive and sustainable growth. Extreme weather events, such as severe drought and heavy rainfalls, have put basic services and 1 The Paris Agreement aims to keep a global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. 2 The poverty rate declined from 51% in 2006 to 40% in 2015, while Gini coefficient had remained between 0.63 and 0.65 during 2006-2015 (World Bank 2018). 3 South Africa average annual real GDP growth was 1.6% during 2012-2017. The unemployment rate had increased from 25% in 2012 to 27% in 2018 (StatsSA 2019; WBG 2019a). FDI inflows declined from 2.3% of GDP in 2013 to 0.4% of GDP in 2017 (UNCTAD 2019). 3 infrastructure under threat, and disproportionately affect the poor and most vulnerable4. Climate damages on infrastructure and economic sectors strain public budgets and reduce the attractiveness for private investors. Physical climate risks are significant and grows uncertain over time, while the impacts of fossil fuel use on human health, and water and air quality incur prohibitive social and economic costs. Besides, South Africa faces transition challenges, in terms of financial risks of fossil fuel exposure, as well as social risks of transition. If not addressed, climate-related risks could jeopardize South Africa’s economic growth and financial stability today. In the long-term, the cumulative cost of climate damages by mid-century could amount to US$37 billion in present value terms (National Treasury 2014), while the transition risk is estimated to be $120 billion by 2035 in present value terms (CPI 2019). 5. Harness transition opportunity—invest in resilient infrastructure and create market for low-carbon technologies to boost growth and strengthen the macro investment climate. Climate-smart transition offers new investment opportunities that constitute a new engine of economic growth. South Africa can take advantage of transition opportunities, such as creating markets for low-carbon technologies, new industries to support low-carbon supply chains, and new jobs in low-carbon industries. Large scale investments in energy and transport infrastructure are needed now, and in the future, to address infrastructure deficit, meet rapidly growing demand, improve connectivity, and sustain economic growth. At the same time, the right choice has to be made with regards to infrastructure investment—they should be climate-resilient and low-carbon, given the scale of climate and transition risks. Research shows that green and resilient infrastructure are affordable and need not cost more than other alternatives. The main challenge is to redirect large pools of private capital towards climate-smart investments with strong financial returns. 6. Implement carbon tax effectively and raise policy ambition, supported by a fiscal framework conducive for climate investments, as well as invest tax revenues to support just transition. A package of transformative policies and an enabling legal and regulatory framework are key to catalyzing low-carbon private sector investments. Setting the right price signal is necessary but not sufficient. Carbon pricing should be combined with environmental fiscal reform and complementary measures. Currently, carbon tax exemptions and a low escalation rate are provided to increase acceptability and minimize adverse economic and social impacts5. Moving forward, South Africa may consider raising policy ambition to achieve an effective tax trajectory that is robust and stable in order to spur low-carbon investments in line with long-term climate goals. In addition, South Africa would benefit from fine-tuning carbon tax and carbon budgets to ensure policy coherence and exploring the creation of emission allowances/reductions market. 7. The current energy crisis presents an opportunity for sector reform, regulatory changes, and use of innovative financial solutions to promote low-carbon private sector investments. Persistent load shedding has deteriorated power sector performance and stifled economic activity in South Africa, while soaring electricity price hampers industrial competitiveness and hurts consumers. Eskom’s financial health is central to power sector performance but remains fragile and unsustainable. It is of critical importance to stabilize Eskom’s financial situation to protect 4 Approximately 1,700 bridges, 900 dams, and about 900 powerline crossings are at risks of flooding. Droughts have already affected 15 million people in South Africa between 1980 and 2013 (DEA 2016). 5 Tax free allowances provide up to 90% exemption in most cases for fuel combustion, industrial energy use, and transport sectors, up to 95% exemption for mining, and energy processing and production sectors, and up to 95% exemption for industrial processes. This implies an effective carbon tax rate within the rage of R6-R42 per tCO2e (KPMG 2019; Curran 2018). The initial tax rate of R120 per tCO2e will increase by 2% per year above the consumer price inflation of the previous year until the end of 2022. After 2022, the tax rate will only increase by the consumer price inflation of the previous year (GoSA 2018) 4 South Africa’s sovereign credit rating and maintain investors’ confidence, to attract investment especially through the renewable energy independent power producer procurement program (REIPPPP). The energy crisis challenges the existing power sector model, and points to an opportunity for more private sector participation, particularly for clean and renewable energy investments. Policy Considerations Strengthening macro investment climate, promoting inclusive and sustainable growth To achieve inclusive and sustainable growth, and attract investment, South Africa is encouraged to prioritize bold reforms, address development constraints including climate risks, and harness transition opportunity: • Address binding development constraints including inadequate skills, weak business environment, regulatory obstacles to competition, limited integration into global value chains, inefficient logistics, inadequate investment in infrastructure, and policy uncertainty —identified in the Systematic Country Diagnostic and the Country Private Sector Diagnostic. • Fully integrate climate-related risks into macroeconomic policy and planning, including fiscal sustainability and financial stability, while coordinating actions across climate-sensitive sectors. • Harness transition opportunity—invest in resilient infrastructure, create markets for low-carbon technologies, develop low-carbon industries and supply chain to boost economic growth, provide jobs, and strengthen macro investment climate. • Develop analytical framework and tools for assessing macro-fiscal-financial outcomes of climate and transition risks and opportunities, cost-benefit of policy and reform options, and investment and funding needs to meet long-term development objectives. • Develop climate/transition-risk adjusted investment strategy and long-term action roadmap for climate-resilient, low-carbon growth. • Develop a national climate finance strategy and operational framework, including climate finance readiness, funding landscape, and tracking system. Implementing transformative policies and enabling regulatory framework To promote climate-smart investments, South Africa is encouraged to place emphasis on effective implementation of transformative policies and enabling regulatory framework, and raise the policy ambition over time in line with the country’s long-term climate goals: • Implement carbon tax effectively and institutionalize monitoring and evaluation mechanism to inform periodic review and update of carbon tax design. • Review carbon tax rate escalation and make plan to accelerate rate escalation to achieve desired emission reduction outcomes. • Use other fiscal instruments, such as fossil fuel subsidies reform, environmental fiscal reform, and/or corrective energy taxes, in tandem with carbon tax and as part of policy mix. • Strategically invest fiscal policy revenues to further support low-carbon and just transition • Fine-tune the designs of carbon tax, carbon budgets, and other instruments to ensure policy coherence, and plan for creating emission allowances/reductions market. • Develop a national climate budgeting and climate expenditure/finance tagging framework. 5 Policy Considerations (continued) Catalyzing private investments in clean and renewable energy, through power sector reform, lowering investment risks and barriers, and innovative financial solutions The current energy crisis presents an opportunity for sector reform and regulatory changes, as well as the use of innovative financial solutions to promote low-carbon private sector investments. Priority actions that South Africa may consider taking in the energy sector include: • Implement power sector reform and unbundling of Eskom’s generation, transmission, and distribution to promote private sector investment and competition in the sector. • Remove binding regulatory constraints in the Electricity Regulation Act to allow utility-scale independent power producers to sell power directly to municipalities and industries. • Relax the regulation to allow small-scale renewable projects up to 10 MW to operate without requiring a generation license, replacing the current requirement for all projects above 1 MW. • Increase annual build limits for renewable energy projects outlined in the Integrated Resources Plan (IRP) 2018 and expedite battery storage deployments to integrate renewables to the grid. • Develop renewable energy manufacturing industry and supply chains, while taking advantage of Special Economic Zones to support scale-up of local green economy manufacturing base. • Use innovative financial solutions to improve risk-return profiles of clean and renewable energy investments. Potential options include (i) use of concessional and blended finance to leverage private capital, (ii) bundle and securitize small-scale renewable energy projects to attract local banks and large investors, and (iii) utilize innovative green financing mechanisms to scale up energy efficiency and distributed generation. • Modernize existing buildings to scale-up energy efficiency solutions and develop ESCO market • Remove barriers to low-carbon investments in heavy industry, including lack of funding, limited borrowing capacity, high transaction costs for small projects, inadequate access to financial incentives, and lack of technical capacity/knowledge on low-carbon opportunities. 6 1. Introduction 1.1. Background 8. South Africa has made remarkable progress on poverty reduction, but inequality remains extremely high—an incomplete economic transition. In recent years, economic growth has slowed down, and the unemployment rate has increased, while foreign direct investment and exports have lagged showing signs of a decline in competitiveness6. To promote inclusive and sustainable growth and improve the investment climate, South Africa needs to take bold reform actions and address binding development constraints such as inadequate skills, weak business environment, regulatory obstacles to competition, limited integration into global value chains, inefficient logistics, inadequate investment in infrastructure, and policy uncertainty—identified in the Systematic Country Diagnostic and the Country Private Sector Diagnostic. South Africa has committed to reform measures to attract US$100 billion investment, as well as promote private sector investment in the domestic markets. 9. South Africa has laid a solid foundation of climate policies and strategies. The National Development Plan (NDP) provides a ‘2030 vision’ to guide South Africa’s sustainable development trajectory and advocates for a transition to a low-carbon, resilient, and just society. A number of policies and measures towards a greener economy were put forward, including less carbon intensive industrial processes and power generation, increased use of renewables, introduction of a carbon tax and carbon budgets, and green consumer behavior. The implementation of the NDP is elaborated in the National Climate Change Response Policy (NCCRP) and sectoral plans. Furthermore, South Africa has committed to a peak, plateau, and decline trajectory range in its first Nationally Determined Contribution (NDC) and is developing its Low Emission Development Strategy 2050. The NDC recognizes that catalyzing financing of and investment in low-carbon and climate-resilient transition is a key challenge, and significant finance and investment will be required in the long-term. 10. Achieving climate-smart, inclusive, and sustainable growth calls for unlocking private capital, attracting foreign investment, and effective transformative policies and regulatory reform. It is necessary for South Africa to unlock large pools of private capital and attract foreign investment to drive its low-carbon economic transition and achieve climate change targets. South African institutional investors and non-bank financial institutions hold in excess of R10 trillion worth of assets, and the banking sector has over R5 trillion in asset under management (South African Reserve Bank 2018). Tapping into these large pools of local capital and new foreign direct investment is key to the low-carbon transition. To this end, South Africa would benefit from ensuring that it has a sound macroeconomic foundation that can sustain economic growth and is conducive for investors. Effective implementation of transformative policies and regulatory reforms is also needed to steer investments towards a climate-smart future. Furthermore, steps should be taken to remove critical barriers that stand in the way of renewable energy development, as well as de-risk clean energy investments. 6 The poverty rate declined from 51% in 2006 to 40% in 2015, while Gini coefficient had remained between 0.63 and 0.65 during 2006-2015 (World Bank 2018). South Africa average annual real GDP growth was 1.6% during 2012-2017. The unemployment rate had increased from 25% in 2012 to 27% in 2018 (StatsSA 2019; WBG 2019a). FDI inflows declined from 2.3% of GDP in 2013 to 0.4% of GDP in 2017 (UNCTAD 2019). 7 11. The World Bank has developed this discussion paper in response to the government of South Africa’s request to analyze ways in which private capital flows can be catalyzed and leveraged for low-carbon investments. The government of South Africa (GoSA) has provided a number of finance instruments to enable investments in innovative projects/programs. However, given the scale of the investment needed to drive sustainable growth and to meet climate change targets, South Africa requires additional measures and resources that crowd-in private sector finance domestically and from abroad. In this context, GoSA requested World Bank’s support to analyze ways in which private capital flows can be further catalyzed and leveraged for investments in efficient, sustainable, and low-carbon infrastructure. This discussion paper is a direct response to the request and has been developed by a World Bank task team as part of the Advisory Services and Analytics work: South Africa Low-Carbon Finance Study. The objectives of this discussion paper are to (a) provide a basis World Bank’s engagement with GoSA on low-carbon transition, particularly through the climate change pillar of the South Africa Country Partnership Framework, and (b) align multiple World Bank’s Global Practices on their engagements on low-carbon transition, potentially through shaping a programmatic technical assistance involving relevant Global Practices and the Climate Change Group. 1.2. Analytical Framework 12. The analytical framework for assessing the investment climate for climate investments consists of the following three building blocks that are interlinked: (i) macroeconomic conditions, (ii) transformative policies and enabling regulatory framework, and (iii) project-level risk/return profiles and economics. These building blocks represent the key drivers of catalyzing private sector resources for low-carbon transition, with building block (i) to support the macro-level investment climate and promote investment in general and building blocks (ii) and (iii) to tilt investments towards low-carbon interventions (Figure 1). In other words, building block (i) addresses the ‘scale’ of private sector investment, while building blocks (ii) and (iii) deal with the ‘choice’ of investments. Figure 1: Key building blocks for catalyzing private sector investment for low-carbon transition Source: Authors 8 13. This paper aims to (i) assess investment climate, with an emphasis on low-carbon transition in the energy and industry sectors based on the above framework, (ii) review macroeconomic conditions, taking into account climate and transition risks, (iii) take stock of climate-related strategies, enabling policies and regulations, and barriers/risks to domestic and foreign investments, and (iv) provide a landscape of solutions to catalyze private capital flows and lower barriers/risks. The chapters of this paper are organized following the flow of its objectives outlined in this paragraph. The focus of this paper is on electricity generation sector and the industry sector. Over 90% of South Africa’s electricity generation is coal-based, and half of this is consumed by the industry sector. The sector is also the largest direct consumer of coal, absorbing about 40% of coal supply, in addition to coal-based electricity (IEA 2019). From GHG emissions’ perspective, over 85% of South Africa’s total GHG emissions is from electricity generation and the industry sectors. This trend is projected to continue toward 2050 in a business-as-usual scenario (DEA 2017; DEA 2014). 9 2. Macroeconomic Conditions and Investment Climate 2.1. Macro investment climate A sound macroeconomic foundation is essential to sustain economic growth and attract investment 14. South Africa aims to address the most pressing challenges of poverty and inequality through stimulating economic growth and job creation. The National Development Plan (NDP) sets a target for the South African economy to grow by 5.4% per year between 2012 and 2030, coupled with an increase in investment to 30% of GDP by 2030 (from 20% of GDP in 2012). The country also envisions an addition of 11 million jobs by 2030, and a drop of the unemployment rate from 25% in 2012 to 6% by 2030 (National Planning Commission 2012). The NDP is expected to deliver robust economic growth and job creation, which in turn eliminate poverty (reducing the proportion of households with a monthly income below R419 per person in 2009 prices from 39% to zero), and reduce inequality (the Gini coefficient to fall to 0.60 from 0.69). 15. Poverty has declined significantly, but inequality remains extremely high – an incomplete economic transition. The poverty rate declined from 51% in 2006 to 40% in 2015, while Gini coefficient had remained between 0.63 and 0.65 during 2006-2015 (World Bank 2018). Improved access to services (such as electricity, water, and sanitation), the public provision of over 4 million houses, and the expansion of the social wage have considerably improved living standards for millions of South Africans. Furthermore, progressive fiscal policy, access to finance, and jobs in the private and public sectors have been put in place to reduce inequality among the population. But inequality has risen since 1994, and South Africa remains one of the world’s most unequal countries. Creating jobs is critical to overcome the legacy of exclusion, reduce economic and social vulnerability, which in turn promote growth and investment (WBG 2018). To create more jobs, however, the economy needs to grow much faster than it has since 1994. 16. Economic growth has underperformed, and the unemployment rate has increased since 2012. South Africa’s economic growth has lagged, with 1.6% average annual growth of real GDP during 2012-2017. In 2018, the country briefly fell into a recession and the real GDP growth stood at 0.8% per annum (StatsSA 2019). South Africa’s per capita GDP growth has stagnated or even turn negative, as the country’s population growth outpaced its GDP growth. The sustained sluggish economic growth has not generated enough jobs, causing the unemployment rate to increase to 27% in 2018, compared to 25% in 2012. Furthermore, growth projections have been revised downward, and the South African economy is expected to grow at 1.3% in 2019—down from 1.8%—and 1.7% in 2020—down from 1.9% (WBG 2019a). 17. Foreign direct investment and exports have lagged, pointing to a decline in competitiveness. Foreign direct investment (FDI) inflows have been on a downward trend, declining from US$8.3 billion (2.3% of GDP) in 2013 to US$1.3 billion (0.4% of GDP) in 2017 (UNCTAD 2019). This is equivalent to 37% drop in FDI per year on average during 2013-2017. The total FDI inflow to developing economies increased by 2% in 2017, while it declined by 41% for South Africa (WBG 2019b). South Africa continues to have a strong manufacturing base in some sectors, but the country is losing its market share in several of its core export products. 18. Business climate has deteriorated over the past decade. The SACCI Business Confidence Index (BCI)—reflecting the market-related business climate and potential for private sector growth in South Africa—demonstrates a clear declining trend over the past decade. Although the BCI levelled 10 off in 2017, the business sentiment has not materially improved until now. Another business confidence index developed by the Bureau for Economic Research suggests a similar trend (BER 2019). In addition, South Africa ranked 82nd in the Ease of Doing Business ranking—far behind the country’s position ten years ago (WBG 2019c). 19. Despite downside risks, South Africa has strong fundamentals and commitment to improving investment climate. South Africa boasts the most advanced and diversified economy on the African continent. The investment climate is supported by stable institutions, prudent monetary policy, mature financial and services sectors, state-of-the-art telecommunication sector, an independent judiciary and legal sector committed to upholding the rule of law, and good infrastructure. South Africa’s president, Cyril Ramaphosa, has placed an emphasis on improving the investment climate and promote investment to turn around the economy and foster inclusive growth. The government has committed to reform measures to attract US$100 billion investment into South Africa, as well as promote private sector investment in the domestic markets. Figure 2: South Africa’s real GDP growth, FDI inflows, and business confidence (2012-17) Source: World Bank Group (2019d); UNCTAD (2019); and BER (2019) 20. To improve the investment climate and unlock private sector investment, South Africa needs to take necessary reforms and address critical development constraints. Addressing the constraints for private sector investment is a priority for South Africa, as the country taps higher growth potential that is needed to generate jobs, reduce inequality, and drive long-term competitiveness. The South Africa Country Private Sector Diagnostic (WBG 2019b) identified key constraints, including a weak business climate, regulatory obstacles to competition, availability of skills, limited integration into global value chains, trade logistics costs and weak connectivity, and policy uncertainty. In the infrastructure space, supply constraints in energy and inefficient logistics deter investment. The Systematic Country Diagnostic (WBG 2018a) echoed these critical constraints and emphasized the need for South Africa to address climate change-related risks. 11 2.2. Climate risks, transition risks, and macroeconomic implications Climate change poses considerable risks and is a critical constraint to sustainable economic growth 21. South Africa is highly susceptible to climate risks. While temperatures in South Africa are expected to increase, rainfall patterns remain highly uncertain. Climate models project that South Africa’s mean temperature will rise by about 0.5°C in coastal regions and 1°C in the interior in the coming decades. Toward the end of the century, average temperatures in the interior could increase by up to 4°C even under a best-case scenario (GoSA 2017). Relatively low levels of mean annual rainfall and uncertain precipitation patterns, combined with high demand for water driven by the mining sector and the agricultural sector, exacerbate South Africa’s arid condition and have important ramifications for water security. The estimated demand for water will reach 17.7 billion cubic meters in 2030, exceeding a supply of only 15 billion cubic meters—not considering the possible effects of climate change. 22. Extreme weather events put basic services and infrastructure under threat. Severe rainfall likely affects transport and power networks, and sewage and storm systems, contaminating water resources and increasing the threat of acid mine drainage. Almost 1,700 bridges, 900 dams, and about 900 powerline crossings are at risks of flooding. Droughts have already affected 15 million people in South Africa between 1980 and 2013 (DEA 2016). They are projected to continue compromising water supplies, negatively affecting agriculture, and causing farm closures. By 2050, the likelihood of severe drought could increase by 39% per year. Projections also point to increased frequency and severity of fires, and longer fire seasons. Climate and transition risks need to be addressed through the macroeconomic lens 23. Climate change has strong and immediate impacts on the macro investment climate. Climate change is affecting South Africa’s economic growth and social development today, and the impact will intensify for decades to come. Climate damages are disproportionately felt by the poor and vulnerable groups, and are potential sources of social conflict and migration. An increasing number and severity of extreme events have adverse impacts on food security and food prices, water resources, economic infrastructure, and human health and well-being (Chersich et al 2018, Masipa 2017, UNU-WIDER 2016, Conway et al 2015, Niang et al 2014, Ziervogel et al 2014). Direct damages to power generation and transport infrastructure from natural disasters are straining public budgets and reducing the attractiveness of these sectors for private investors (Hallegatte et al 2019). Climate change, if not addressed, will jeopardize South Africa’s aspiration on sustaining economic growth and improving inequality—both underlying the country’s investment climate. 24. Physical climate risks facing South Africa is significant, and the impacts on economic growth is growing and more uncertain over time. The 2015/16 drought is estimated to have reduced GDP by nearly 1.5% and employment by 1.3% (Ntombela et al 2016). Looking forward, under a global business-as-usual scenario, the impacts of climate change on overall economic growth in South Africa are predominately negative and become more pronounced over the long term. By 2050, the cumulative cost is estimated to be US$37 billion in net present value terms—equivalent to about 10% of the current GDP (National Treasury 2014)7. The magnitudes of impact and uncertainty decrease under a scenario with ambitious global climate action. Yet, South Africa is expected to adapt to sizeable risks and potential impacts even if the global average temperature rise is limited to 2°C 7This GDP loss estimate includes the effects of climate change on rising cost of rehabilitating road infrastructure, water availability and additional irrigation cost, agricultural yields, and international commodity prices. 12 or 1.5°C above the pre-industrial level (IPCC 2018). In addition, negative externalities associated with South Africa’s fossil fuel use—such as damages on health from air pollution, water quality, and environmental degradation—could cost the country as much as 6% of total GDP (Le Page et al 2019; Burton et al 2018). Figure 3: Climate-related risks and opportunities Source: TCFD (2017) 25. South Africa’s financial health and stability could be impacted by climate change. Many central banks have recognized the importance of understanding and planning for the increasing financial risks from climate change (ECB, 2019, NGFS 2018, Scott et al 2017). These risks include banks’ potential loan losses resulting from the business interruptions and bankruptcies caused by extreme events such as storms, droughts, and wildfires. Climate risks can lead to the erosion of collateral and asset values for financial institutions, while insurance liabilities are exposed to an increased frequency and severity of climate and weather-related events. There are also transition risks associated with the adjustment to a low-carbon economy, such as the unexpected losses in the value of assets or companies that depend on fossil fuels. In this context, long-term risks can have near-term consequences as investors reprice assets (Rudebusch 2019). 26. Climate change is a short-term macroeconomic issue that warrants robust macro-level monetary and fiscal policies. Climate-related risk exposures could threaten financial stability, and have relevant implications for macroeconomic policy (Lane 2017, Cœuré 2018). Climate-related financial risks could affect the economy through widened credit spreads (risk of default), precautionary saving, and even a financial crisis. There is also a need to adapt to larger and more frequent macroeconomic and financial sector shocks associated with climate change and disaster 13 risks. Adaptation spending is expected to increasingly divert resources from productive capital accumulation. Also, sizable investments and additional fiscal policies/reforms are necessary to reduce carbon emissions (Batten 2018). Overall, climate change has to be an integral part of macroeconomic considerations, including fiscal policy, monetary policy, and economic growth and productivity framework. 2.3. Climate transition opportunities Harness climate transition opportunities: promote the investment climate for climate investment 27. As the world moves to a low-carbon economy, South Africa face the challenge of managing transition risks. Trade-offs associated with a global low-carbon transition are particularly acute in South Africa. The country’s exposure to coal mining as a source of export revenues ($4.2 billion in 2017), as a fuel for domestic power generation (91% of total generation) and as a key employer in certain provinces presents significant transition risk. Between 2013 and 2035, South Africa faces transition risk of more than $120 billion in present value terms (CPI 2019). Currently planned investment decisions—favoring existing industries—could add more than $25 billion to the country’s transition risk. Such risk could strain the public finances, compromise the cause macroeconomic disruption through sovereign credit downgrade (due to Eskom’s fragile financial situation), and the government’s ability to pursue other development goals. 28. Economic diversification is key to taking advantage of the global low-carbon transition. South Africa is still heavily dependent on fossil fuels. It is among the largest exporters of coal globally, exporting 28% of its production. Diversifying energy consumption and production away from fossil fuels is important to reduce vulnerability to shocks from the global low-carbon transition. The government can take advantage of transition-related upside, such as new market opportunity for low-carbon technologies, minerals and materials used for those technologies, and the creation of new jobs in low-carbon industries. Successful diversification and international cooperation will need to strike a balance between phasing down traditional energy sectors that generate cash flow; avoiding lock-in effects from fossil fuel-dependent sectors and infrastructures; increasing economic flexibility and adaptability; and managing the social and political impact in declining industries, which could amplify social inequalities (WBG 2018a). 29. Climate-smart transition offers new investment opportunities and can create jobs. The NDC and the low emission development strategy 2050 have identified a range of new investment opportunities. The magnitude of climate-smart investment opportunities in South Africa is estimated to be US$ 588 billion between now and 2030 (IFC 2016). With respect to jobs, estimates of policies and measures to reduce emissions in line with South Africa’s climate goals show overall employment gains, although the number of workers employed in coal plants decreases as stations are decommissioned and corresponding mines close8. Currently, South Africa has approximately 35,000 jobs in the renewable energy sector, including around 15,000 in solar PV, 10,000 in wind, and 9,000 in CSP, with the remainder in small hydro and biofuel (Renewable Energy and Jobs Annual Review 2018) Looking forward, renewable energy and other initiatives have the potential to add over 8It is estimated that planned decommissioning of coal power stations (Camden, Grootvlei, Hendrina, Komati, and Kriel) collectively will result in the loss of around 30,000 coal sector jobs (Chamber of Mines 2018). In the long-term, meeting South Africa’s climate goal is projected to result in 20,000 less jobs in the coal mining sector by 2045, compared to a business as usual scenario (Strambo et al 2019). 14 400,000 jobs on a net basis9. Middle (grade 8-10) and secondary (grade 11-12) skilled labor groups are expected to experience the largest gains, but new jobs will be created across the board. By committing to a low carbon transition, South Africa would also increase welfare across all household groups, with the largest benefit going to poor households. (Energy Research Centre 2018). 30. Invest in green and resilient infrastructure to strengthen macro investment climate. Currently supply constraints in energy and inefficient logistics deter investment in South Africa. Large scale investments in energy and transport infrastructure are needed now and in the future to address the infrastructure deficit, meet growing demand, improve connectivity, and sustain economic growth. At the same time, the right choice has to be made with regards to infrastructure investment—they should be climate-resilient and low-carbon, given the scale of climate-related physical and transition risks. Infrastructure investment paths compatible with full decarbonization by the end of the century need not cost more than other alternatives. Investment needs remain between 2% and 8% of GDP on average for low- and middle-income countries, even under the scenarios that achieve climate change stabilization at 2°C (Rozenberg and Fay 2019). Also, more resilient infrastructure assets are affordable (Hallegatte et al 2019). The main challenge is to ensure sufficient investment overall, and at the same time redirect capital toward climate-smart investments. Green and resilient infrastructure strengthens macro investment climate, while robust policies and institutions are also essential to achieve a complete economic transition in South Africa. 9 These policies and measures include continuation of renewable energy promotion, and initiatives like the carbon tax, the post-2015 national energy efficiency strategy, the solar water program, and the biofuels mandate. 15 3. Transformative Policies and Regulatory Framework 3.1. Comprehensive policy package Transformative policies and enabling regulatory framework are necessary to steer investments toward a climate-smart future. 31. South Africa has laid a solid foundation of climate policies and strategies. The National Development Plan (NDP) provides a ‘2030 vision’ to guide South Africa’s sustainable development trajectory and advocates for a transition to a low-carbon, resilient, and just society. To this end, a number of policies and measures toward a greener economy were put forward, including less carbon intensive industrial processes and power generation, increase use of renewable energy, use of carbon tax and carbon budgets, and green consumer behavior. The implementation of NDP is elaborated in the National Climate Change Response Policy (NCCRP), sectoral plans, and the National Sustainable Development Strategy. Building on these, South Africa committed to a peak, plateau, and decline trajectory range in its first Nationally Determined Contribution (NDC) and is developing its Low Emission Development Strategy 2050. The NDC recognizes that catalyzing financing of and investment in low-carbon and climate-resilient transition is a key challenge, and significant finance and investment will be required in the long-term. 32. Setting the right price signal is key to unlocking climate-smart investments. Climate- smart strategies and planning are important foundations, and so are policies and incentives that encourage the implementation of planned actions. Furthermore, policies and incentives should be structured such that they trigger low-carbon investment decisions, as opposed to investing in baseline alternatives. Carbon pricing is a critical policy instrument, to address the market failure associated with climate change. Fossil fuel subsidies reform, energy pricing reform, energy taxes that reflect the full costs of environmental damages of energy use, emissions cap-and-trade, and performance-based payments are also part of potential policy mix that can help set appropriate price structure and send the right signal (Fay et al 2015; Parry et al 2014). When many policy instruments are deployed together, it is important to understand their interaction—complementarity and conflict—to achieve the optimal design and the desired policy outcomes. 33. Enabling regulatory framework and complementary measures are needed to support pricing instrument. Getting carbon/energy prices right is necessary, but not sufficient. Pricing policies have to be considered as part of a comprehensive policy and regulatory package, which is politically and socially acceptable, and ensures transformative changes in investment and consumption patterns. Building on the Electricity Regulation Act 2006 and the National Energy Act 2008, South Africa’s regulatory framework could be further evolved to accelerate investments in renewable energy and decentralized clean energy sources and develop legislative framework to support the adoption of electricity storage technologies that promote scaling-up of renewable electricity generation. Beyond the right regulatory framework, complementary measures are needed for policy effectiveness. These measures include, for example, efficiency/performance standards, green financial incentives, compensatory schemes for those adversely affected by policy, and communication and awareness raising to promote behavior change of the public. 34. Fiscal policy and reform have a central role to play in low-carbon transition that boosts economic growth. Fiscal instruments are among the most effective means to promote climate actions, while raising country’s revenues and human welfare (Pigato 2019; Fay et al 2015). 16 Environmental taxes on carbon, energy, and pollution leverage price signals to discourage the burning of fossil fuels and over exploitation of resources, while promoting investment in cleaner energy sources and more efficient energy use. In turn, the revenues generated by such taxes can be used to reduce other preexisting taxes or to finance spending on public goods and social protection. Environmental tax reform—combining environmental taxes with tax shifts, expenditure policies, and supplementary measures—can provide a conducive environment for low-carbon investments, and at the same time yield development co-benefits and increase economic activity. 3.2. Effective implementation of the carbon tax Implement carbon tax effectively and raise the ambition of tax rate escalation to spur low-carbon investments at the scale in line with NDC and long-term decarbonization goals. 35. South Africa is implementing a carbon tax. The carbon tax is the centerpiece of South Africa’s National Climate Change Response strategy, which forms the basis for the country’s NDC. It is also committed among the policy mix to meet emission targets in NDC. The carbon tax is in effect from June 1st, 2019 and starts at R120 per ton of carbon dioxide equivalent (tCO2e). The levy is on GHG emissions resulting from fuel combustion and industrial processes, and fugitive emissions for firms in the energy, industry and transport sectors, while initially exempting agriculture, forestry, and waste (GoSA 2018a). The carbon tax is designed as revenue-neutral during the first few years (Pigato 2019). One option for revenue recycling considered is to reduce the existing electricity levy in order to neutralize the impact on electricity prices. 36. Tax-free allowances are provided to increase acceptability and minimize adverse economic impacts. The design of the carbon tax includes a number of features to increase its acceptability and to limit the negative effects on the South African economy. Basic tax-free allowances for emissions, trade-exposure allowance, performance allowance, carbon budget allowance, and carbon offset allowance altogether provide up to 90% tax exemption in most cases for fuel combustion, industrial energy use, and transport sectors, up to 95% exemption for mining, and energy processing and production sectors, and up to 95% exemption for industrial processes. This implies an effective carbon tax rate within the rage of R6-R42 per tCO2e (KPMG 2019; Curran 2018). These allowances are to be gradually phased out. 37. Accelerate carbon tax rate escalation to incentivize low-carbon investments and achieve NDC goal. The initial tax rate of R120 per tCO2e will increase by 2% per year above the consumer price inflation of the previous year until the end of 2022. After 2022, the tax rate will only increase by the consumer price inflation of the previous year (GoSA 2018). The rate has become flexible and has been scaled down from an escalation of a fixed 10% per year in the original tax design. Linking the escalation to inflation weakens the connection to emission reduction pathway, while making it difficult for investors to predict given the uncertainty of long-term inflation rate. An escalation rate that is robust and stable is a crucial factor for long-term effectiveness of a carbon tax policy and could be brought in line with emission pathway stipulated in the NDC, and the long-term low-emission strategy. In addition, monitoring and evaluation mechanism for emission impact could be put in place, to inform periodic review and update of the tax design. 17 3.3. Getting fiscal framework right Use other fiscal instruments in tandem with carbon tax, and strategically invest policy revenues to further support low-carbon and just transition, as part of national climate budgeting framework. 38. Fossil fuel subsidies remain sizeable and impede other low-carbon transition efforts. Overall, the International Monetary Fund estimated that total fossil fuel subsidies in South Africa amounted to US$ 45 billion in 2015, equivalent to the country’s 14% of GDP (Coady et al 2019). There are several direct support measures for fossil fuel consumption and production in South Africa. In 2016, there was US$2.4 billion worth of tax exemptions for gasoline, diesel and kerosene, direct government funding and tax breaks for oil and gas exploration, and research and development (Climate Transparency 2018). In the same year, South Africa’s state-owned enterprises invested US$5.4 billion in upstream and midstream oil & gas, fossil fuel distribution and transportation, and fossil-fuel based electricity generation, while its public finance for fossil fuels totaled US$0.4 billion (Garg and Kitson 2015). These fossil fuel supports acted against other policy efforts that have been put in place for low-carbon transition. 39. Deploy fuel subsidies reform and corrective energy taxes as part of policy solutions. Fossil fuels are subject to large and pervasive ‘environmental tax gaps’ because end-user prices are set artificially low relative to the efficient price levels implied by the full cost of environmental externalities. These gaps are partly as a result of direct financial subsidies on energy, but largely due to the social costs of energy. In South Africa, the efficient gasoline price that reflects the production cost, external costs of congestion and accidents, climate externalities, and local pollution costs is estimated at US$1.40 per liter of gasoline. This compares to the actual price of US$0.90 per liter of gasoline in 2015 (Coady et al 2019). The efficient price of coal for power generation in South Africa (including supply cost, and climate and local externalities) is US$10/GJ, while the actual price in 2015 stood at US$3/GJ. 40. Target the use of tax revenue and savings from fuel subsidies reform to support sustainable growth, just transition, and further emission reductions. Carbon tax and energy taxes will generate revenues and fossil fuel subsidies reform create savings on the national budget that can be redirected to other productive use. Tax revenues can be invested in measures that lower risks and barriers to private sector investment in low-carbon options, and support retraining and reskilling of coal workers and others that are negatively affected by the transition. Savings from not subsidizing fossil fuels can be used to fund public services and infrastructures (social programs, water supply and sanitation, heath, education, clean energy, and public transportation system) that are environmentally sustainable and resilient to climate and disaster risks. The utilization of this revenue/saving could be integrated into the national climate budgeting and expenditure framework and aimed at leveraging private sector resources for further climate actions. 41. Ensure consistency between carbon tax and carbon budgets, while looking toward creating market. In addition to the carbon tax, South Africa plans to use company-level carbon budgets as part of the policy package to achieve NDC goals. The carbon budgets will provide GHG emissions allowance, against which emissions from the operations of a company will be tracked and become mandatory after 2020. While both carbon tax and budget approaches have merits and can be complementary, there are risks associated with applying both instruments to the same emissions simultaneously (PMR 2017). It is therefore important to understand how the two policies can be aligned to ensure that they function coherently in shaping South Africa’s low-carbon transition. Furthermore, South Africa could explore trading of the carbon budgets to mitigate emissions in a 18 cost-effective manner, as well as engage with international market mechanisms to incentivize emission reductions. 19 4. Energy Sector Landscape and Recent Market Developments 4.1. Power sector landscape Large-scale investment in power generation capacity will be necessary to meet South Africa’s future electricity needs and avoid supply shortfall due to decommissioning of its coal fleet. Private sector investment in affordable renewable energy will have a critical role to play in closing the capacity gap. 42. South Africa is at a crossroad to make an energy transition. The country has a window of opportunity now to transition to a low-carbon economy supported increasingly by renewables and shift away from fast-aging and underperforming coal infrastructure that threatens imminent economic and financial disruption. Over the decades, the South African economy has been heavily dependent on coal due to the country’s abundance of the resource. As a result, coal-fired power generation has dominated the lion share of the overall energy-supply mix and currently accounts for over 80% of the total installed capacity. The remainder of the electricity output is delivered through hydropower, diesel/gas (peakers), nuclear, as well as a fast-growing share of renewable energy installed through independent power producers (IPPs) including some decentralized off-grid power (Eskom 2018). The balance of the power supply comes from electricity imports (e.g. via Mozambique). Figure 4 – Eskom’s power generation asset portfolio Source: Eskom (2019) 43. The state-owned electric utility (ESKOM) generates over 90% of the total electricity supply. Eskom currently manages South Africa’s electricity market as a single-operator model (monopoly) and controls the generation and transmission including a minority share of the distribution market. The rest of the distribution network is owned and operated by 165 municipalities including some licensed distributors. Being the monopoly owner of the electricity grid, Eskom is responsible for supplying most of the base-load and peaking capacity critical for the functioning of the economy. Additionally, this network supplies a portion of electricity to some neighboring countries in the region. Figure 4 provides a snapshot of Eskom’s power infrastructure. 20 44. Eskom’s generation asset portfolio consists of 15 coal-fired power plants, most of which are located in Mpumalanga province including two in Limpopo. This regional concentration of coal assets also highlights the importance of mining sector jobs within these two provinces. In contrast, the majority of the country’s renewable resources and assets managed mostly by private developers are located in Northern, Western, and Eastern Cape provinces. Eskom’s non- coal-based assets include 4 gas/diesel peaking plants (2,426 MW) – Ankerlig, Acacia, Gourikwa, Port Rex; 2 hydro (600 MW) and 3 pumped storage plants (2,732 MW); 1 nuclear plant (1,860 MW); and 1 wind farm (100 MW). The Western Cape province hosts 3 of Eskom’s 4 peaking gas/diesel plants including 1 pumped hydro plant (Palmiet), and the only nuclear plant in the entire continent of Africa. Figure 5a. – Eskom’s coal-fired plants set for decommissioning Source: Verisk Maplecroft (2019), adapted from DoE (2019) Figure 5b. – Eskom’s plants age versus the median age (37 years) Source: Eskom (2019) 45. Operational inefficiency has caused frequent load shedding, while design flaws have delayed availability of newly built generation capacity. Most of Eskom’s existing coal assets have been poorly-maintained and their maintenance budgets have been cut by half in recent years (Verisk Maplecroft 2019). As a result, in February 2019, South Africa faced its worst blackouts since 2008 due to simultaneous breakdowns at multiple coal-fired power stations. This crisis was compounded by the impact of water and diesel shortages in the country that limited Eskom’s ability to operate its peaking plants, which are run at very high costs due to expensive diesel imports. In addition, Eskom’s newly built coal power plants, Medupi and Kusile, are facing major setbacks due to design flaws that 21 have resulted in budget overruns and additional delays. These two new plants (4.8 GW plated capacity each) are unlikely to deliver at their full capacities for several years, causing additional capacity constraints in the national grid. 46. A significant number of Eskom’s coal-fired generation assets are due to be decommissioned over the coming decades. Affordable renewable energy will have a critical role to play in closing the capacity gap. Seven of ESKOM’s fifteen coal-fired power plants (about 30% of its current and planned coal generation capacity) are due to be decommissioned by the end of the 2020s. Furthermore, five power plants accounting for an additional 40% of Eskom’s coal-fired capacity will reach the end of their useful plant life by the end of the 2030s (Figure 5a-b). Without adequate investments, South Africa is at risk of electricity supply shortages. As these ageing and unrehabilitated plants remain open past their intended decommissioning dates with sub-optimal performance, the risk of interruptions to the country’s power supply will increase significantly. Investing in new and affordable renewable energy alternatives can play an important part in contingency plan to address the imminent capacity shortages. 47. The latest 2018 Integrated Resource Plan indicates a major shift towards scaling-up renewables, albeit with additional coal and LNG. The policy-adjusted IRP-2018 draft signals a significant shift towards adding more renewables through wind and solar PV, as well as new allocations for distributed generation, mostly through embedded generation (Figure 6)10. Specifically, renewable goal for 2030 in IRP-2018 has been raised to 30,630 MW from 17,800 MW as originally set in IRP 2010. However, this IRP-2018 draft also includes liquefied natural gas (LNG) and new coal capacity that is expected to be added through the IPP procurement program. It also imposes annual build limits on solar PV (1000 MW/year) and wind (1600 MW/year). As such, the draft IRP- 2018 indicates a compromise to accommodate coal and gas, as opposed to planning under a least- cost plan scenario. Figure 6: IRP-2018 draft – installed capacity (MW) in policy adjusted scenario Note: Color code – Grey: current installed capacity; Yellow: committed/already contracted; Green: new capacity; Blue: extension of nuclear plant life; Red: new distributed generation capacity Source: DoE (2019); Green Cape (2019a) 10The IRP generally considers several scenarios, with the policy-adjusted IRP scenario being the primary plan. It is useful to note that the least cost scenario of IRP 2018 does not include new coal capacities, but it builds gas-fired capacities more aggressively. 22 Box 1: Policy and Regulatory Framework of South Africa’ Power Sector South Africa’s electricity sector is governed by key public institutions, policies, and the Electricity Regulation Act that guides the development of the power sector. The institutional framework consists of key public institutions that include the Department of Public Enterprises (DPE), the Department of Energy (DoE), the National Treasury (NT), the National Energy Regulator of South Africa (NERSA), the Department of Trade & Industry (DTI), and the Development Bank of South Africa (DBSA) as well as the Independent Power Producers Procurement Program Office (IPPPP Office). Eskom is the state-owned utility wholly-owned by the Government of South Africa. ESKOM is governed through the DPE, who acts as the shareholder ministry of Eskom and sets the National Energy Strategy. In addition, Eskom reports to the DoE, who sets the Energy Policy in South Africa. Eskom is the sole off- taker of all power produced in South Africa, including renewable energy Independent Power Producers (IPPs). Thus, Eskom plays an important role in the facilitation of renewable power. In this context, the NT plays a critical role in providing sovereign guarantees to IPPs on behalf of Eskom for signed Power Purchase Agreements (PPAs) to mitigate off-taker risks of Eskom. The NT also provides financial oversight to ensure overall stability of the power sector and manages public debt provided to SOEs including contingent liabilities (guarantees) which impact the government’s sovereign credit rating. The Electricity Regulation Act 2006 (ERA) governs the electricity sector. ERA establishes a national regulatory framework for the power sector and makes NERSA the custodian and enforcer of the national electricity regulation. In terms of promoting large-scale renewable energy development in South Africa, the ERA requires that any generation facility (public or private) selling electricity to a public entity requires a ministerial determination (permission) from DoE including obtaining a generation license from NERSA. This regulation currently prohibits IPPs from building generation plants to sell energy directly to cities or municipalities. However, in terms of small-scale distributed generation, a number of changes to the regulation are expected, given the latest updates to the policy-adjusted Integrated Resource Plan (IRP 2018) that aims to incorporate up to 500 MW in annual allocations for Small-Scale Energy Generation (SSEG) through solar photovoltaic (PV) and battery storage. NERSA determines electricity pricing and tariffs including Eskom’s revenu e requirements (tariff setting) based on the Electricity Regulation Act’s interpretations. Moreover, NERSA is responsible for the registration of IPPs, issuing generation licenses, establishing grid codes, providing regulatory rules and guidelines as well as promoting competition within the power sector. The policy and planning framework for the energy sector is governed by the Integrated Resource Plan (IRP) and National Development Plan (NDP). Under the Electricity Act of 2006, the DoE developed the first Integrated Resource Plan (IRP) in 2010 as the apex energy sector planning document. It outlined the preferred energy-mix to meet the electricity demand up to 2030. The IRP planning process consists of the following steps: (i) demand forecast, (ii) least-cost plan, (iii) capacity expansion plan, which leads to (iv) ministerial determinations, which leads to (v) formal procurements in MWs, based on allocations established through ministerial determinations. The latest revision, IRP-2018, has gone through a public comment process and a final version is expected to be published after cabinet approval in late 2019. These documents together have established energy sector targets that align closely with the Electricity Regulation Act and form the foundation to drive the IPPP Programs. The Independent Power Producers Procurement Program (IPPPP) was established in 2010 by the DoE as an urgent intervention to enhance South Africa’s power generation capacity. This led to the establishment of the IPPPP Office by the DoE in coordination with the NT and the DBSA. IPPPP Office’s primary mandate is to secure electricity through renewable as well as non-renewable energy sources from the Private Sector via IPPs. Through the IPPP Office, the Renewable Energy Independent Power Producers Procurement Program (REIPPPP) was established for the specific purpose of delivering on the Renewable Energy targets and objectives identified in the IRP and the NDP. In this context, the DTI is responsible for REIPPPP’s component on economic development to support industrialization through local content, black economic empowerment and the development of small businesses for renewable energy development. 23 48. South Africa has made good progress in establishing a renewable energy market, but more needs to be done to achieve the 2030 target of 30.6 GW set in the IRP-2018 plan. The ministerial determinations have been critical in giving effect to the planning framework of the IRP to help establish a robust renewable energy market in South Africa. The total of 14.7 GW—close to the renewable target stipulated in IRP 2010—has been determined and 6.4 GW has been procured to date (Figure 7). Of the 6.4 GW procured, 3.9 GW of renewable projects are already commissioned and connected to the national-grid. This currently accounts for around 7% of the country’s power mix. The revised IRP-2018’s planned renewable capacity additions indicate a promising outlook for future scale-up of renewables in the current energy-mix. However, this means that as much as 24.2 GW of renewable will have to be procured and commissioned to reach the new 2030 target of 30.6 GW. Figure 7 – Renewable procurements status under IRP-2018 (in MW) Source: Green Cape (2019a) 4.2. Renewable energy independent power producer procurement program (REIPPPP) The REIPPP program has proved a successful model for crowding in private sector investment in renewable energy. South Africa can build on this momentum to further scale-up the program. 49. The renewable energy market in South Africa has successfully attracted private sector investments, through the REIPPP program. The renewable energy market in South Africa has exploded over the last eight years after the introduction of the REIPPP program, launched through the IPPPP Office in 2010. As a result, the REIPPP program by establishing a series of procurements known as Bid Windows (BW) has had great success in attracting private sector developers and financing through a competitive and transparent bidding process. To date, these BWs consists of 5 utility-scale renewable energy project BWs (BW 1, 2, 3, 3.5, and 4) as well as 2 small-scale renewable energy project BWs (S1S and S2S). 50. The REIPPP program has generated reliable electricity supply and has reduced emissions. The REIPPP program has procured 6.4 GW of electricity from 112 renewable IPPs. Out of the utility-scale projects under BWs 1-4, 90 of the 92 projects have reached financial close including the last BW4 project in December 2018. Furthermore, of the 63 projects that have reached a commissioning date (fully operational), 62 projects have been operational for longer than a year and have proved to be very reliable in generating power supply. In addition, the REIPPP program has resulted in 33.2 million tons of CO2 emission reduction, as well as 39.2 million kilo liters of water savings achieved since the program’s inception. 24 51. The success of the REIPPP program has brought down the price of electricity in South Africa powered by renewable technologies. As evident in Figure 8, the prices of renewable electricity generation (through solar PV, wind, and CSP technologies) have significantly dropped over the course of the four BWs since November 2011. For example, the average tariff of wind power has declined from 1.51 R/kWh in 2011 to 0.62 R/kWh in 2015. The average tariff of solar PV has fallen sharply from 3.65 R/kWh in 2011 during BW1 to 0.62 R/kWh in 2015 during BW4. And the cost of concentrated solar power (CSP) has dropped as well, and stood at 2.02 R/kWh in 2015—higher than the costs of solar PV and wind. Figure 8: Average tariffs under the REIPPP program Source: CSIR Energy Centre (2016) 52. The next round of procurements through Bid Window 5 will be key to unlocking renewable energy investment at scale in South Africa. The next BW-5 of the REIPPP program will be critical to accelerating the pace of renewable energy implementation and to reaching the country’s ambition to meet its growing demand with affordable, reliable, and clean energy sources. DoE recently released a statement stating that the REIPPP program’s BW-5 would be announced immediately after the final gazetted (cabinet approved) version of the IRP-2018 is released. However, as an immediate next-step, DoE will have to issue new ministerial determinations to start implementing BW-5. This step will also send a strong market signal to the private sector to mobilize additional capital required for new renewable energy projects to be procured through the continuation of the REIPPP program. 4.3. Coal mining and industry sector landscape South Africa’s economic growth has traditionally been driven by its abundant coal resources. However, risks associated with coal transition looms large—from domestic as well as international perspectives. 53. South Africa is endowed with abundant coal resources. South Africa is endowed with an estimated 30 billion tons of coal representing 3.5% of the world’s coal resources. The country produces 3.3% of the world’s annual coal production and is ranked as the 6th largest coal-exporting 25 nation in the world with exports amounting to 6% of total global exports. 83% of the coal produced in South Africa is mined in the North Eastern Province of Mpumalanga with the residual produced in the Provinces of Limpopo, KwaZulu-Natal, and the Free State. However, coal reserves in Mpumalanga are dwindling and mining is shifting to Waterberg in Limpopo. The primary port for coal exports is Richards Bay Coal Terminal with a dedicated coal railway operated by Transnet. 54. Coal has been the backbone of South Africa’s economy, providing revenues and jobs. In 2016, South Africa produced 253.1 million tons (Mt) of coal, of which 181.4 Mt (72% of total) were sold and used domestically, while 68.9 Mt (28%) were exported. This amounted to R61.5 billion (US$4.3bn) in overall coal sales dedicated for domestic use, and R50.5 billion (US$3.6bn) in terms of export revenues, respectively (Chamber of Mines 2018). Thus, coal exports to international markets make up a lucrative source of foreign exchange revenue for the country’s economy. The coal industry provides both direct and indirect employment for as many as 250,000 people. In 2016, 77, 506 people were directly employed, representing 17% of total mining sector jobs, while indirect jobs totaled 173,093. It is estimated that planned decommissioning of coal power stations (Camden, Grootvlei, Hendrina, Komati, and Kriel) collectively will result in the loss of around 30,000 coal sector jobs. In the long-term, meeting South Africa’s climate goal is projected to result in approximately 20,000 less jobs in the coal mining sector by 2045, compared to a business as usual scenario (Strambo et al 2019). 55. South Africa’s electricity sector and coal mining sector are closely linked. As discussed at length in the previous section, the electricity sector of South Africa is dominated by coal-fired generation and is the largest consumer of coal. The heavy reliance of the power sector on coal highlights the importance of the local coal-based economy. Eskom is the single most important consumer of coal produced in South Africa. In 2015, the utility used the total of 115 Mt of coal for power generation. Furthermore, Eskom directly invests in coal operations, controls the price of domestic coal, and is vertically integrated along the coal supply chain. 56. The industry sectors are heavily dependent on coal. Industrial sectors in South Africa (such as liquid fuels manufacture sector, and the iron and steel industry) heavily rely on coal. These industrial sectors, together with electricity generation, account for more than 80% of domestic coal demand in terms of value and approximately 70% in volumes. The heavy industry is also the country’s largest consumer of electricity that is largely coal-dominant. In liquid fuels manufacturing and chemical processes, coal use accounts for 12% of total coal supply, worth R7.9 billion. In addition, the metals, machinery and equipment industry purchased R15.4 billion worth of coal, representing 22% of the coal supply. The iron and steel sector use imported coking coal and are highly susceptible to price and policy changes in the international market. 57. South Africa faces future market risks for coal exports. Demand for South African coal exports will diminish as stricter environmental laws and global climate mitigation efforts adversely impact future coal export revenues. Currently, India is South Africa’s biggest coal export market accounting for almost half of the total coal exports by volume. Nevertheless, India focuses on reducing its GHG emissions intensity of its GDP and committing to achieve 40% of its installed power capacity through non-fossil fuel energy resources by 2030. This signals a lower coal footprint in the future. Thus far, this has not affected South African coal exports. However, heavy dependence on India for coal export revenues in the long-term poses significant risks to the South African coal and mining industry, as well as the broader economy. Similarly, China once a major importer of South African coal has drastically cut their coal imports from South Africa to less than 1% in recent years. 26 5. Challenges and Opportunities for Low-Carbon Investment 5.1. Current energy crisis The current energy crisis presents an opportunity for sector reform that promotes private sector investment in renewable energy. 58. Persistent load-shedding has deteriorated power sector performance and stifled economic activity in South Africa. Since 2007, the electricity sector has experienced several demand and supply imbalances. Electricity consumers have faced multiple blackouts and outages and unplanned load shedding events, calling into question the security of supply to meet electricity demand. The Energy Availability Factors (EAF) of Eskom’s power generation fleet has dropped to record low levels. The EAF has been hovering below 70% as opposed to the minimum expected level of 80%. The week-on-week EAF of South Africa’s generation fleet continues to plunge to its lowest level in years, from 68% in week 43 of 2018 to 66% in week 44 of 2018 (Green Cape 2019a). This means that, on average, 25% to 30% of the currently installed infrastructure is not available for use due to operational inefficiencies. 59. A soaring electricity price hampers industrial competitiveness and hurts consumers. Heavy dependence on Eskom’s unreliable and expensive power has adverse impact on end-use electricity consumers across commercial and industrial sectors, as well as households. Figure 9 reveals that, while inflation has almost doubled since 2009, Eskom’s electricity prices have tripled over the same period. Under the recently submitted Multi Year Price Determination 4 (MYPD-4) application to NERSA in February 2019, Eskom is aiming to increase the electricity tariff by 15% each year from 2019/20 to 2021/22 and projecting 10% hikes annually for the subsequent two years. If approved, this would translate to an increase in Eskom tariffs of over 300% since 2009. Figure 9: Average Eskom tariff versus inflation Source: Statistics SA (2019); Eskom (2018) 60. Eskom’s financial heath is central to power sector performance but remains fragile and unsustainable. Eskom’s total debt is R419 billion (US$30 billion) as of November 2018. Eskom made a R2.3 billion loss in 2018 and its cash flows are insufficient to fund rising maintenance costs, large capital expenditures and debt repayments (WBG 2019b). At the same time, a poor credit rating and 27 challenges in governance restrict access to debt financing. Currently, Eskom is the government’s largest contingent liability and its financial position was one of the reasons for South Africa’s sovereign credit downgrades by two of the rating agencies. Eskom has recently received a number of implicit subsidies (Deloitte, 2017). The government granted Eskom a R60 billion shareholder loan which was converted to equity in 2015. A further R23 billion was injected in 2016. The government has also granted Eskom R350 billion worth of guarantees for its debt and R218 billion had been utilized by 2017. Eskom’s financial position is further undermined by increasing municipal debt. Since 2013, municipal payments decreased from 97% to 86%. Furthermore, as of November 2018, municipalities owed Eskom a total of R17 billion (Eskom, 2017). 61. The current energy crisis and Eskom’s sub-optimal power sector model all point to an opportunity to rapidly scale-up renewables and crowd-in private sector investment. The current energy crisis has prompted grid defections from many of Eskom’s electricity customers including large municipalities. This situation has also led to customers seeking alternative renewable solutions that challenge Eskom’s existing single-buyer model. The combination of Eskom’s high electricity tariffs, poor maintenance, persistent load-shedding, and low electricity availability factor all pose significant risks to the economy. Thus, Eskom’s single-buyer utility business model has reached a boiling point with severe liquidity challenges making it unsustainable to continue further without government intervention. Nevertheless, this crisis also presents a great opportunity for the private sector to provide energy security through programs such as REIPPPP that offer affordable and reliable power while crowding-in low-carbon private sector investments. However, a number of barriers and risks have to be addressed to attract additional private capital. 5.2. Boosting investor confidence It is of critical importance to improve Eskom’s financial standing to maintain investor’s confidence and attract additional investment to scale up the REIPPP program. 62. The importance of protecting the sovereign crediting rating. South Africa’s investment grade (BBB or above) sovereign credit rating allows it to borrow cheaply to fund investments, social spending and manage volatility in its trade balance. Losing that rating would have a negative impact on the country’s economy. In March 2018, Moody’s Investors Service concluded its review of South Africa’s sovereign credit rating following the accession of President Cyril Ramaphosa and kept the country at the investment grade rating of Baa3. Having already lost its investment grade ratings from Fitch in April 2017 and Standard & Poor’s in November 2017, retaining a Moody’s rating of Baa3 prevented a forced sell-off of South African sovereign bonds by investors whose mandates prevent them from holding sub-investment grade securities. It is of critical importance that South Africa protects and improve its sovereign crediting rating status to not only retain but also attract additional investment in important sectors such as energy and infrastructure. 63. Stabilize Eskom’s financial situation to maintain macroeconomic stability and investor confidence. Eskom’s total debt is around US$30 billion. Its failure to pay loans would trigger a downgrade of the sovereign credit rating resulting in a banking crisis while the company’s collapse would cause a serious economic disruption. Eskom’s deteriorating financial position (as growth of debt has far surpassed that of earnings) has increased the likelihood that its government guarantees will need to be called upon, causing rating agencies to be concerned of risks posed by Eskom to South Africa’s sovereign credit rating. To avoid any defaults by Eskom, the government may need to increase guaranteed debt to cover Eskom’s obligations, which negatively impacts the risk exposure on the public balance sheet. This adds pressure on the Rand as it increases the risk of Moody’s joining 28 the other major rating agencies in downgrading South Africa’s local debt to junk status (CPI 2019). As Eskom is the sole off-taker of power from all IPPs, its financial position also affects the country’s ability to attract private sector investments including FDI, which ultimately drives the REIPPP program. Therefore, carefully managing Eskom’s financial position is paramount for the South African economy. 5.3. Unbundling of Eskom Power sector reform and unbundling of Eskom in particular are necessary to promote private sector investment and competition in the sector. 64. Unbundling Eskom will accelerate private sector investments and competition. In December 2018, President Ramaphosa appointed a presidential task force to review strategic options for Eskom. In February 2019, based on the initial recommendations of the task force, the president announced his intention to unbundle Eskom. This will be done by creating an independent transmission and system operator (TSO) and splitting Eskom into three independent business lines under generation, transmission and distribution. Such a restructuring will not be easy as it would need to reduce reliance on government guarantees to access funding from capital markets without triggering any defaults. However, unbundling Eskom will facilitate sector competition and drive- down costs to promote optimal sector solutions that can crowd-in private sector expertise and investments through South Africa’s well-established IPPP program. Furthermore, as an unbundled independent generation company, Eskom will be able to compete with other IPPs to bid for renewable projects and explore additional revenue streams. Technical assistance may be necessary to facilitate the restructuring of Eskom. 65. Sector reform is urgently needed to set the power sector on a new path. It is important that South Africa moves forward on unbundling Eskom to liberate the power sector while transitioning to a low-carbon path. At the same time, Eskom’s multiple operational and financial emergencies cannot be solved without major investment. As a first-step, the immediate focus is to re- instate good maintenance practices, address key operational inefficiencies to save costs, and rebuild management and engineering capabilities. Eskom will also need to change its business model and renegotiate coal and diesel contracts, which will in turn create space for more renewables in the grid to supply low-cost power in the future. Such an approach will enable Eskom to relieve some pressure and explore new financial restructuring and debt-raising strategies. Concessional finance can also help in de-risking investments in low-carbon infrastructure, through public-private frameworks. 5.4. Regulatory reforms to unlock private capital for renewable energy scale up Remove the binding regulatory constraints in the Electricity Regulation Act to unlock private sector investments for utility-scale renewable energy projects including distributed generation. 66. Reform the Electricity Regulation Act to allow IPPs to sell power directly to municipalities and industries. Streamlining the process to enable IPPs to obtain generation licenses and ministerial determinations to directly sell power to municipalities can unlock private capital for renewables in South Africa. Currently the ERA prohibits municipalities and cities including industrial customers (e.g. coal mines) to directly procure and buy renewable power from IPPs without first obtaining a generation license from NERSA. Furthermore, NERSA does not issue licenses to IPPs if they have not already obtained ministerial determinations (permissions) from DoE. This is a binding regulatory constraint that impedes the development of utility-scale renewable projects 29 through IPPs11. Addressing this constraint will be a game-changer to crowd-in private capital and leverage large pools of institutional investments to scale-up low-carbon infrastructure projects in South Africa. Most recently, the Supreme Court of South Africa has decided to hear the landmark case between City of Cape Town and the Ministry of Energy and NERSA on June 18, 2019 pertaining to the municipality’s right to buy power directly through IPPs and circumvent Eskom as the sole off-taker. In addition, reform is needed to grant open access to Eskom’s grid (wheeling) to allow utility scale projects to sell directly to municipalities or large industrial consumers. 67. Relax the regulation to allow small-scale renewable projects up to 10 MW to operate without requiring a generation license. Currently, the ERA requires all IPPs to obtain generation licenses from NERSA for any renewable project above 1 MW capacity. However, based on recent recommendations from the president’s task force for reforming the power sector, the regulation will likely be relaxed to not require generation licenses for small-scale embedded generation (SSEG) projects up to 10 MW. The latest updates to the IRP-2018 also signals this regulatory change, indicating 500 MW in annual allocations from distributed generation through SSEG12. This push to increase distributed generation using SSEG will be a game-changer for IPPs to scale-up small-scale solar PV projects. Such a regulatory change will open up the distributed generation market and liberate a multitude of innovative investments that can take the pressure off the grid and improve energy supply security in South Africa. Local banks can play a major role in unlocking private capital for SSEG renewable projects and drive competition to deliver least-cost power solutions. 5.5. Raising build limits for renewables and accelerating battery storage deployment Be more ambitious on scaling up renewable energy and battery storage technologies in the IRP 2018, and move forward with further implementation of the REIPPP program. 68. Increasing the annual build limits of renewable energy in IRP-2018 would send a strong market signal to foreign and local investors. The latest IRP-2018 adds 1500 MW of new coal capacity via IPPs, while simultaneously putting annual new build limits on solar PV (1,000 MW per year) and wind (1,600 MW per year). In this scenario, the IRP-2018 fails to reflect a least-cost plan which would exclude any new coal capacity additions. Even though the IRP-2018 adds 12,830 MW in new renewable capacities compared to IRP 2010, it pushes back capacity additions of utility- scale solar PV and wind to accommodate new coal and gas capacities. However, to send a strong signal to investors and build momentum in the REIPPP program, South Africa may consider re- adjusting IRP-2018 by increasing the annual build limit for renewable projects to further mobilize private sector resources. In addition, new ministerial determinations critical for implementing BW- 5 of the REIPPP program can be prioritized to help achieve the ambitious renewable energy target of 30.6 GW by 2030 set in the revised IRP-2018 plan. 69. Accelerate the deployment of battery storage technologies to support renewable energy scale up. There is a great opportunity in South Africa to invest in battery storage at a larger scale to further accelerate renewable energy integration and strategically manage peaks and troughs in energy supply—storing energy from solar and wind, to be used when it is needed. The IRP 2018 identifies 5,000 MW of storage projects with 2,900 MW already shown as installed capacity, leaving a balance of 2,100 MW. However, this planned capacity is pushed back to be implemented only in 2022 (500 MW) and in 2029 (1,600 MW) primarily due to limited technical capacity. The IRP could 11 The exception to this is the REIPPP program where NERSA issued generation licenses based on DoE issuing determinations to the IPPPP Office to procure utility-scale renewable capacity from IPPs. 12 SSEG only uses the grid at the distribution network level (below the 38kV threshold). 30 be updated to accelerate the pace and increase the level of ambition for battery storage development, while displacing other fossil fuels-based generation options. This will help to accelerate the implementation of the REIPPP program by allowing greater flexibility and integration of renewable electricity into the grid. The government may explore procuring battery storage projects through the private sector or public-private partnership model to lower risk associated with new technology. Box 2: Role of FDI in the REIPPP program The REIPPP program has attracted R42.8 billion (US$3.1 billion) in FDI through its seven bid windows— BW1 – BW4, 1S2 and 2S2. Financing and investments (debt and equity) have originated from a variety of countries across the globe with Europe (Germany, France, Italy, Spain) and the USA representing the largest sources of finance (Figure 7). Furthermore, due to this FDI support, South Africa has been able to attract prominent global renewable energy project developers and Tier 1 component manufacturers such as Abengoa, Mainstream Renewable Power, Jinko, and Canadian Solar as well as South African developers such as Pele Green Energy, Aurora Power Solutions and Biotherm Energy (IPPP Office 2018). Figure 7 – Overview of Foreign Direct Investment in REIPPP program Source: IPPP Office (2018) Despite overall economic decline in South Africa, the share of foreign investment has increased and continues to garner investors’ confidence as evidenced in REIPPP’s recent bid windows. The R42.8 billion (US$3.1 billion) in total FDI amounts to 20% of the REIPPPP’s total investment of R209.4 billion (US$14.9 billion) invested in the South African economy. Therefore, the continuation of BW-5 will be critical for South Africa to keep attracting significant investment income as well as global expertise, essential to grow its nascent renewable energy industry and market. 5.6. Developing renewable energy manufacturing industry and supply chain Take a strategic approach on building a new industry and the supply chain to support the growth of the renewable energy sector. 70. The renewable energy manufacturing industry has a unique opportunity to develop a new engine of economic growth. The IRP 2018 has set ambitious targets of 17.7 GW for wind and 8.3 GW of solar PV by 2030. Achieving these goals require renewable energy equipment 31 manufacturing that supplies parts to support the expansion of the REIPPP program. Currently, two wind tower manufacturing facilities have already been set up in South Africa. In addition, a number of solar PV assembly and manufacturers have been set up primarily to support the REIPPP program. Furthermore, the local content requirement of REIPPP’s BW-4 and BW-5 aims to enforce local lamination and assembly in the solar PV manufacturing value chain. South Africa has been able to attract prominent component manufacturers such as Abengoa, Mainstream Renewable Power, Jinko, and Canadian Solar. In addition to jobs created by the manufacturing and supply chain of renewable energy, a large number of jobs are created in the services sector linked to this (e.g. developers, advisors, operational and maintenance providers). All things considered, the renewable energy transition offers a unique opportunity for South Africa to develop a new sector to support its future growth that in turn could help revitalize the mining industry, due to the increased demand for metals and minerals (WWF 2018b, WBG 2017). 71. Take advantage of Special Economic Zones (SEZs) to support early stage renewable industry development. The Department of Trade and Industry (DTI) has established a Special Economic Zone (SEZ) program, which seeks to establish a dedicated economic zone to support specific economic activities. The Atlantis SEZ for Green Technologies in Western Cape offers compelling support and incentives to manufacturers of green technologies, especially those supplying components to the REIPPP program. As a result of the Atlantis SEZ, the Western Cape province alone has realized around R500 million in investments in component manufacturing in the past few years. Thus, SEZs can play a huge role to promote early development of the renewable energy equipment manufacturing industry in South Africa. 5.7. Improving risk-return profiles through innovative financial solutions Utilize a mix of innovative financial solutions to incentivize low-carbon investments—lowering the risks, while making the investments more financially attractive. 72. Bid Window 5 of the REIPPP program offers a significant opportunity to crowd-in local institutional investments through South Africa’s well-developed domestic capital markets. South Africa has deep institutional investments in excess of R8.5 Trillion. Given the REIPPP Program’s success in using Bid Windows to develop a robust renewable market with competitive electricity prices and well-known project risk profiles, BW-5 is well positioned to tap into South Africa’s deep capital markets and attract long-term institutional investments. However, to date, only a small fraction of this institutional investments supports REIPPP projects. For example, the REIPPPP has procured 6,400 MW with a majority of RE projects already reaching financial close. Using a rough project cost calculation of R14 million to build 1 MW, the REIPPP Program’s total investment can be estimated to be equivalent to R89.6 Billion (6,400 MW * R14 million). Compared to the share of institutional capital of R8.5 Trillion available in the market, this R89.6 Billion investment amounts only to a small fraction. Thus, BW-5 provides an unprecedented opportunity to unlock these large pools of institutional capital. REIPPP’s BW 1-3 projects also create a new market for sale of equity and refinancing of debt on operational plants. 73. South Africa can benefit from the use of concessional and blended finance to leverage large pools of private capital. There are a range of market risks and barriers facing investments in renewable energy and battery storage technologies. These risks/barriers include, among other things, perceived financial and technology risks, high up-front capital costs, lack of affordable long- term financing, and inadequate access to additional financial support such as climate finance mechanisms. In this context, the Development Bank of South Africa (DBSA) with support from the 32 Green Climate Fund (GCF) has launched a private sector focused Climate Finance Facility (CFF) using a pioneering green bank model. The primary objective of the DBSA CFF is to de-risk and increase the bankability of climate and low-carbon projects in order to crowd-in private sector investment, as well as address critical market barriers such as those outlined above. In addition, the Facility aim to accelerate private sector climate investments to help other Southern African nations achieve their Nationally Determined Contributions (NDCs). Partnership between DBSA and other multi-lateral development banks (MDBs) can provide invaluable concessional and blended finance (blending of concessional capital with commercial capital from banking sector) to South Africa. 74. Bundle and securitize small-scale renewable energy projects to improve risk-return profile and attract large investors. A significant number of commercial and industrial (C&I) businesses are transitioning to solar PV solutions due to significant cost savings, maturity of the technology and ease of implementation. In 2018, almost 200 MWs worth of solar PV modules were sold or installed in South Africa. The market is expected to grow in 2019 and possibly exceed 1 GW of rooftop PV installed, partly due to continued load shedding and high electricity tariffs of Eskom. However, small-scale PV projects under 1 MW involve high transaction and borrowing costs. Therefore, bundling of rooftop PV is a financial mechanism for C&I businesses to cost-effectively finance systems under 1 MW. Commercial banks have a key role to play in this space to provide green financing, through bundling of smaller rooftop PV projects and contract standardization (e.g. PPAs). Such strategies help reach economies-of-scale, reduce transaction costs, and distribute risks through aggregation and securitization of assets. Such innovative mechanisms would also attract larger investors and project developers to crowd-in private capital to accelerate solar PV in South Africa. 75. Use innovative green financing mechanisms to scale up energy efficiency and distributed generation. There is an emerging opportunity in energy efficiency and modernization of existing buildings in South Africa. The green building and construction sectors have grown exponentially since 2010 and is expected to be valued at R13.6 billion by 2020 (WBG 2019b). Retrofitting of these existing buildings is to become the largest sub-sector within the green building industry by 2020, and Energy Service Companies (ESCOs) can play a big role in this area and provide services such as LED lighting, HVAC optimization, and smart metering (Green Cape 2019b). There are several innovative green financial mechanisms currently being tested in South Africa that have potential for scale-up (Green Cape 2019c; IFC 2019). These include, for example, green bonds, Property Assessed Clean Energy (PACE), Pay As You Save (PAYS), Power Purchase Agreements (PPAs): • Green and sustainability bond: These bonds are emerging as a powerful capital market instrument to raise funds, while supporting South Africa’s commitment to a low-carbon economy. The Johannesburg Securities Exchange has recently developed green bond framework, paving the way for future green bond issuances (IFC 2019). Clean renewable energy bonds in the United States is an example of a low-cost opportunity for public entities to issue bonds to finance renewable energy projects. In this case, the federal government lowers the cost of debt by providing a tax credit to the bondholders in lieu of interest payments from the issuer. • Property Assessed Clean Energy (PACE): PACE enables low-cost, long-term funding for energy efficiency, renewable energy and water conservation projects. PACE financing is repaid as an assessment on the property’s regular tax bill. It allows a property owner to finance the upfront cost of energy or other eligible improvements on a property and then pay the costs back over time through a voluntary assessment. The assessment is attached to the property rather than an individual entity's personal financial standing. 33 • Pay As You Save (PAYS): PAYS is a solution that allows businesses and homeowners to access energy efficiency upgrades and solar PV solutions with no upfront cost, regardless of income, credit history, or renter status. The upgrades or systems are paid for by the municipality, and the costs are then recouped through a fixed charge on the customer’s monthly bill. This charge is less than the estimated savings generated by the upgrades/system. Until the investment is recovered, the tariff or the PAYS charge automatically transfers to future customers at that site. • Power Purchase Agreements (PPAs) and Rooftop Rental: Regulations legislated for in Schedule 2 of the Electricity Regulations Act, 2006 (Act no. 4 of 2006) now allow for legal power purchase agreements (PPAs) to proceed. PPAs are long-term contracts between developers and PV system buyers, for the buyer to purchase electricity at a predetermined rate. There are zero upfront costs and the developer absorbs the cost proposal, design, construction, operation, and maintenance of the system. PPAs are a hedge against future electricity costs, and protect customers against uncertain electricity price hikes. The building roof must be leased for the duration of the solar PV system’s life span. 5.8. Tapping low-carbon investment potential in heavy industry Lift investment barriers in the industry sector to unlock demand-side low-carbon investments including efficiency improvement, own clean electricity generation, and fuel-switching. 76. Significant potentials exist for low-carbon investments in the heavy industry sector, through efficiency improvement and on-site renewable energy. Heavy industries in South Africa are large consumers of electricity and fossil fuels, and significant untapped potentials for energy efficiency and clean energy exist in the sectors. Overall, industry is estimated to deliver approximately 30% of the total reduction potential by 2030 and by mid-century. A range of specific technology options have been identified in industrial sectors of South Africa (DEA 2014). Figure 10 provides examples of low-carbon investments in selected South African industries. It shows several energy efficiency and clean energy options, indicative costs and payback period (DNA Economics 2017). However, low-cost options are not being implemented due to a host of barriers and risks facing the industrial companies, while additional policy support (such as more ambitious carbon tax) and financial incentives are necessary to enable more costly alternatives. These market and policy barriers have to be overcome to catalyze investments in low-carbon opportunities from industrial companies13. 77. Demand-side energy efficiency programs can increase profitability and competitiveness of South African industries. Demand side programs to reduce energy use within South Africa’s industrial base have the potential to decrease the country’s energy-intensity and reduce GHG emissions. They could also increase the competitiveness and profitability of industry, as the value of productivity gains and product quality can be 2.5 times the value of the energy savings (DNA Economics 2017). Industry (including mining) consumed 36% of total final energy in South Africa in 2015, followed by the residential and transport sectors, at 27% each (IEA 2019). Iron and 13Another option that can be explored is carbon capture and storage, which is not readily implementable in South Africa today and will require market enabling policies and regulations. 34 steel along with mining and quarrying are the largest energy consumers within industry, at 19% and 16%. Chemicals accounts for 12%, while non-ferrous metals and non-metallic both equal for 6%. While South Africa has made significant progress implementing energy efficiency since 2005— industry used energy 34% more efficiency in 2012 than in 2000—the energy intensity of manufacturing in South Africa was over twice the average level in the European Union in 2012. 78. Lift market and policy barriers to catalyze industrial companies’ investments in low- carbon opportunities. With respect to on-site renewable electricity generation at industrial complexes, the same challenges and opportunities in the power sector context apply. Power sector reform and unbundling of Eskom is necessary to promote private sector investment in clean and renewable energy. Binding regulatory constraint in the Electricity Regulation Act has to be removed to allow utility-scale IPPs to sell power directly to municipalities and industries, and regulatory change is needed to permit small-scale renewable energy projects up to 10 MW capacity without generation licenses. To promote roof top solar PV projects in the commercial and industrial sector, clear regulations for net meeting is needed. Innovative financial solutions to improve risk-return profiles of clean and renewable energy investments apply to industrial energy users as well. In addition, South Africa should lift other barriers to low-carbon investments in heavy industry, including lack of affordable long-term financing, limited borrowing capacity and perceived risks, high upfront capital costs and transaction costs, inadequate access to financial incentives, and lack of technical capacity/knowledge on low-carbon options. Figure 10: Examples of low-carbon investments in selected South African industries Scale of Indicative payback Description of low-carbon Type of investment (years) or cost investments investment (Rm) (R/tCO2e) Mining and Quarrying (including coal) Improve energy efficiency of mine haul Energy efficiency >1,000 6-10 years and transport operations - capex Electricity Onsite clean power generation >1,000 > 10 years generation Install energy efficient electric motor Energy efficiency >1,000 <3 years systems Electricity Cogeneration 100-500 6-10 years generation Improve energy efficiency of mine haul Energy efficiency 50-100 3-6 years and transport operations Use of 1st generation biodiesel (B5) for Fuel switch 50-100 <40 R/tCO2e transport and handling equipment Switching from diesel to electric haulage Fuel switch Unclear Unclear with overhead lines. Optimize existing electric motor systems Energy efficiency <50 3-6 years (controls and VSDs) Process, demand & energy management Energy efficiency <50 Unclear system. 35 Scale of Indicative payback Description of low-carbon Type of investment (years) or cost investments investment (Rm) (R/tCO2e) Energy efficient lighting Energy efficiency <50 Unclear Coal-to-Liquid and Gas-to-Liquid Improved heat systems Energy efficiency >1,000 > 10 years Energy monitoring and management Energy efficiency 100-500 3-6 years systems Improved process control Energy efficiency Unclear > 10 years Improved electric motor system controls Energy efficiency 100-500 > 10 years and VSDs Energy efficient utility systems Energy efficiency 100-500 3-6 years Increase onsite gas-fired power Electricity generation - using internal combustion >1,000 120-160 R/tCO2e generation engines Cement Improved process control Energy efficiency 50-100 > 10 years Waste heat recovery from kilns and Electricity 500-1,000 Unclear coolers/cogeneration generation Utilize waste material as fuel Fuel switch 50-100 <40 R/tCO2e Energy monitoring and management Energy efficiency <50 Unclear system Energy-efficient utility systems Energy efficiency <50 Unclear Improved electric motor system controls Energy efficiency <50 Unclear and variable speed drives Iron & Steel Top gas pressure recovery turbine Energy efficiency 100-500 6-10 years BOF waste heat and gas recovery Energy efficiency 500-1,000 6-10 years Improved electric motor system controls Energy efficiency 100-500 <3 years and variable speed drives Electricity State-of-the-art power plant >1,000 > 10 years generation Energy efficient boiler systems and kilns Energy efficiency 100-500 > 10 years 36 Scale of Indicative payback Description of low-carbon Type of investment (years) or cost investments investment (Rm) (R/tCO2e) Electricity Onsite clean power generation Unclear Unclear generation Energy efficient utility systems Energy efficiency <50 Unclear Improved process control Energy efficiency <50 Unclear Energy monitoring and management Energy efficiency <50 Unclear system Improved heat exchanger efficiencies Energy efficiency <50 > 10 years Source: DNA Economics (2017) 37 6. Policy Considerations 79. A robust macro investment climate, transformative policies, and low-risk investment opportunities in clean and renewable energy together will propel the country’s low -carbon transition. It is necessary for South Africa to unlock large pools of private capital and attract foreign investment to drive its low-carbon transition and achieve climate change targets. To this end, South Africa would benefit from ensuring that it has a sound macroeconomic foundation that sustains economic growth while being conducive for investors. Effective implementation of transformative policies and regulatory framework is also needed to steer investments towards a climate-smart future. Furthermore, actions should be taken to remove critical barriers that stand in the way of renewable energy development, as well as de-risk clean energy investments. Strengthening macro investment climate, promoting inclusive and sustainable growth 80. To achieve inclusive and sustainable growth, and attract investment, South Africa is encouraged to prioritize bold reforms, address development constraints including climate risks, and harness transition opportunity: • Address binding development constraints including inadequate skills, weak business environment, regulatory obstacles to competition, limited integration into global value chains, inefficient logistics, inadequate investment in infrastructure, and policy uncertainty— identified in the Systematic Country Diagnostic and the Country Private Sector Diagnostic. • Fully integrate climate-related risks into macroeconomic policy and planning, including fiscal sustainability and financial stability, while coordinating actions across climate-sensitive sectors. • Harness transition opportunity—invest in resilient infrastructure, create markets for low- carbon technologies, develop low-carbon industries and supply chain to boost economic growth, provide jobs, and strengthen macro investment climate. • Develop analytical framework and tools for assessing macro-fiscal-financial outcomes of climate and transition risks and opportunities, cost-benefit of policy and reform options, and investment and funding needs to meet long-term development objectives. • Develop climate/transition-risk adjusted investment strategy and long-term action roadmap for climate-resilient, low-carbon growth. • Develop a national climate finance strategy and operational framework, including climate finance readiness, funding landscape, and tracking system. Implementing transformative policies and enabling regulatory framework 81. To promote climate-smart investments, South Africa is encouraged to put emphasis on effective implementation of transformative policies and enabling regulatory framework, and raise the policy ambition over time in line with the country’s long-term climate goals: • Implement carbon tax effectively and institutionalize monitoring and evaluation mechanism to inform periodic review and update of carbon tax design. • Review carbon tax rate escalation and make plan to accelerate rate escalation to achieve desired emission reduction outcomes. 38 • Use other fiscal instruments, such as fossil fuel subsidies reform, environmental fiscal reform, and/or corrective energy taxes, in tandem with carbon tax and as part of policy mix. • Strategically invest fiscal policy revenues to further support low-carbon and just transition • Fine-tune the designs of carbon tax, carbon budgets, and other instruments to ensure policy coherence, and plan for creating emission allowances/reductions market. • Develop a national climate budgeting and climate expenditure/finance tagging framework. Catalyzing private investments in clean and renewable energy, through power sector reform, lowering investment risks and barriers, and innovative financial solutions 82. The current energy crisis presents an opportunity for sector reform and regulatory changes, as well as the use of innovative financial solutions to promote low-carbon private sector investments. Priority actions that South Africa may consider taking in the energy sector include: • Implement power sector reform and unbundling of Eskom’s generation, transmission, and distribution to promote private sector investment and competition in the sector. • Remove binding regulatory constraints in the Electricity Regulation Act to allow utility-scale independent power producers to sell power directly to municipalities and industries. • Relax the regulation to allow small-scale renewable projects up to 10 MW to operate without requiring a generation license, replacing the current requirement for all projects above 1 MW. • Increase annual build limits for renewable energy projects outlined in the Integrated Resources Plan (IRP) 2018 and expedite battery storage deployments to integrate renewables to the grid. • Develop renewable energy manufacturing industry and supply chains, while taking advantage of Special Economic Zones to support scale-up of local green economy manufacturing base. • Use innovative financial solutions to improve risk-return profiles of clean and renewable energy investments. Potential options include (i) use of concessional and blended finance to leverage private capital, (ii) bundle and securitize small-scale renewable energy projects to attract local banks and large investors, and (iii) utilize innovative green financing mechanisms to scale up energy efficiency and distributed generation. • Modernize existing buildings to scale-up energy efficiency solutions and develop ESCO market • Remove barriers to low-carbon investments in heavy industry, including lack of funding, limited borrowing capacity, high transaction costs for small projects, inadequate access to financial incentives, and lack of technical capacity/knowledge on low-carbon opportunities. 39 7. References Batten, S. 2018. Climate Change and the Macro Economy: A Critical Review, Bank of England Staff Working Paper 706, January 2018. Bureau for Economic Research. 2019. RMB/BER Business Confidence Index 2019, Stellenbosch University, Stellenbosch. Bohlmann, H. et al. 2019. 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