Proximo Weekly: Putting the wheels back on South African power

The South African energy market is seeing a spike in interest in wheeling projects – energy projects developed by IPPs that ‘wheel’ power to offtakers located elsewhere via the national grid. The growing appetite follows the removal of several regulatory barriers that have, historically, made wheeling projects impractical, leading to the advent of a private power market operating in parallel to government-run energy procurement schemes.

Wheeling typically involves renewable energy projects, with onshore wind and solar PV likely to make up the majority of projects. These projects have very clear advantages for both offtakers and developers. The offtakers are typically large corporate entities or industrial users with significant energy needs and such offtakers stand to benefit from signing a corporate PPA with a renewables developer.

As Emma Roberts, a legal director at Pinsent Masons, suggests: “From an offtaker’s perspective, if they are looking at a wheeling arrangement, it is less about security of supply, which you would get more from on-site generation, and more looking at it from a business perspective in terms of how they can reduce the overall cost of electricity. Electricity prices are going up by 15-30% on average every year, so it is a significant driver for the corporates to sign corporate PPAs. With tariffs with a fixed escalation, there is more certainty about business costs going forward, as opposed to relying on utility supply with unknown escalations year-on-year.”

Under a corporate PPA, an offtaker is usually supplied with energy at a lower cost than power delivered by Eskom, South Africa’s national energy company. Unlike US or European markets, which often see corporate PPAs of ten years or less, South African corporate PPAs often last around twenty years, giving offtakers cost certainty surrounding power prices over a very long period. Offtakers are not, however, insulated from scheduled power outages – termed load shedding – after entering into a wheeling arrangement, as the power is ultimately provided by the developer to the general grid rather than directly to offtakers. Eskom shuts down parts of the grid during load shedding, cutting power to offtakers regardless of the existence of corporate PPAs.

For developers, wheeling projects are attractive due to the highly competitive nature of the Renewable Energy Independent Power Producer Programme (REIPPP), South Africa’s main vehicle for renewable energy procurement. REIPPP has been in existence for over a decade and has seen tariffs fall to exceptionally low levels over the course of five bid windows, with the lowest bids for Bid Window 5 coming in at just ZAR344.25 ($20.05)/MWh and ZAR374.79 ($21.84)/MWh for onshore wind and solar PV, respectively. While corporate PPAs are often tendered competitively and while such PPAs offer low prices for offtakers, developers can still see higher upside from a corporate PPA than under REIPPP, which offers a long-term PPA with Eskom. This is because individual corporate tenders are unlikely to attract quite the same volume of bidders as REIPPP and tariffs have the potential to be higher than REIPPP tariffs.

Among the first wheeling projects to become operational was a 10MW solar farm in the Northern Cape province, which came online in 2021. The project will supply power to Amazon Web Services and investors in the project include the Mahlako Energy Fund, SOLA Group, and African Infrastructure Investment Managers (AIIM), through the IDEAS Fund. A market source confirms that SOLA Group is currently in the midst of raising project finance debt for two 100MW solar PV wheeling projects, with financial close expected in the next few weeks. Lenders have been mandated and the transaction will be a club deal. The projects will be the first wheeling projects of this size to be backed by project finance debt in South Africa and will be early examples of large utility-scale wheeling projects. SOLA Group has signed a PPA with Tronox and the electricity will be used for Tronox’s mines and smelters.

A changing regulatory framework

It has, technically, been possible to develop a wheeling project in South Africa for some time. However, the regulation surrounding wheeling was so complex as to make it extremely difficult for a pipeline of wheeling projects to emerge. Projects with a capacity above 1MW had to apply for a generation licence from the National Energy Regulator of South Africa (NERSA). This process took approximately 120-220 days and required signed offtake and grid connection agreements to proceed with the application, which made project development extremely lengthy.

In addition, to secure a generation licence, projects had to demonstrate compliance with the Integrated Resource Plan (IRP), meaning that there had to be available capacity under the plan for wheeling projects. For a time, no capacity was allocated to IPPs outside government-run programmes like REIPPP, meaning that it was almost impossible to secure a generation licence for a wheeling project. The IRP was subsequently amended to make a limited amount of capacity available for wheeling projects, but this could be allocated to a government programme at any time.

In 2021, the government passed an amendment to Schedule 2 of the Electricity Regulation Act 4 of 2006 to raise the threshold for an exemption from having to apply for a generation licence from 1MW to 100MW. Projects now only have to apply to register with NERSA, a procedure that only takes 70-90 days and that has no requirement for a signed PPA or compliance with the IRP. As this effectively removed the most significant impediment to developing a utility-scale wheeling project, the wheeling project pipeline has grown substantially, with around 52 projects recently registered within 70 days. South African President Cyril Ramaphosa has also announced that the 100MW threshold will be removed and that there will be no maximum capacity for an exemption from a generation licence, effectively allowing wheeling projects of any size. Legislation to bring this into effect is expected at the end of September.

Despite the efficiencies made by a switch from a generation licence to a registration system, other permitting requirements can still make wheeling a little cumbersome in regulatory terms. Securing both environmental authorisation and grid connection remains time consuming, although the environmental authorisation process is not unique to wheeling projects. Grid connection does have some elements that are particular to wheeling. Developers must apply to Eskom for grid connection, an application which takes around 9-12 months to approve. Depending on the location of the project, the application could have to be made to the relevant municipality, as municipalities own local distribution networks and Eskom owns national transmission infrastructure. Most larger projects will, however, be situated outside city limits and will therefore apply to Eskom.

As part of the application, Eskom assesses the viability of the project connecting to the grid in the location preferred by the developer and calculates the probable cost of any upstream work required, as well as the cost of any upgrades to substations. These costs are passed through to developers directly and are set out in a cost estimate letter. If the developer concludes that the project is viable in light of the grid connection costs, Eskom will provide final figures for work done to the grid in a budget quote process, after which Eskom and the developer can enter into a grid connection agreement. The developer is liable for both the upfront costs of grid improvements and an ongoing wheeling charge for use of the grid infrastructure.

If the offtaker is located within a municipal jurisdiction, further documentation is required, even if the project connects to the grid through Eskom. The municipality and Eskom have to sign an agreement governing a reconciliation procedure in order to avoid a shortfall for the municipality. This is due to the fact that Eskom has received the benefit of the electricity added to the grid by the wheeling project, but it is the municipality that applies credit to the offtaker’s bill, given that the offtaker has paid the generator for this energy. Consequently, Eskom and the municipality must be involved in billing reconciliation. The electricity supply agreement between the offtaker and the municipality must also be amended to facilitate this.

New risks for market participants

Although South Africa has a maturing renewables market, even experienced developers and lenders have some new risks to consider in relation to wheeling projects. These risks must also be evaluated by corporate offtakers. One area of uncertainty is the wheeling charge, which can be raised by Eskom at any point during the life of a project and does not follow a fixed escalation schedule. For developers, this can erode a return on investment already reduced by initial grid connection costs, while lenders may find it difficult to ascertain in advance whether projects’ cashflows can service debt.

Offtakers are unlikely to agree to pay for all increases to the wheeling charge, as their primary motivation for signing a corporate PPA is to reduce energy costs. One solution is to have a ceiling for wheeling charges baked into the PPA, under which the developer must fund additional wheeling charges and above which the offtaker must absorb the costs. There is also some scope for a higher wheeling charge to be treated as a change of law. Change of law provisions in corporate PPAs often mandate risk sharing between the offtaker and the developer. Such solutions avoid one party taking all the risk, but developers, offtakers, and lenders must still face the unpredictability of wheeling costs.

Wheeling projects also carry the risk to developers that the cost of grid work will increase in Eskom’s budget quote process above the figure outlined in the cost estimate letter. Developers often bid for corporate PPAs while only in receipt of the cost estimate letter, creating potential for a disconnect between the PPA tariff and the total project cost. Lenders and developers alike must also assess the risk of PPA termination. Eskom’s PPA obligations are guaranteed by the government in programmes such as REIPPP and the government will buy out the project debt in the event of default by Eskom. By contrast, corporate offtakers will pay a penalty for early termination, but are unlikely to agree to pay off all project debt. Finding a new source of revenue and, therefore, a means of servicing debt becomes very complicated, as South Africa does not have a merchant energy market.

Load shedding can present further difficulties for wheeling projects. Roberts explains the risk to projects from load shedding as follows: “With South Africa’s load shedding, which can last up to eight hours a day when generation is severely constrained, not only is an offtaker that has signed a corporate PPA not receiving energy at its site for consumption, it is also either paying for back-up electricity supply or losing revenue through lost production. The offtaker is then being asked to pay for energy that is not allocated to it. If there is no energy drawn at the offtaker site, the offtaker will not be allocated credits by the municipality or Eskom for the electricity purchased under a wheeling corporate PPA. There is no guaranteed banking arrangement in South Africa and any banking of energy is agreed to by the distributor on a case by case basis.

“The distributor will reconcile the electricity that was physically consumed at the site in a month against the electricity wheeled under the corporate PPA and if consumption is lower than the amount of energy generated and exported onto the network by the generator to be wheeled to the offtaker, the distributor will not allocate the credits for such energy shortfall in that month. The offtaker will be paying for energy from the generator that for which they are not being credited for on their bill with the municipality. From a generator or a lender’s perspective, it is a significant risk if the offtaker does not agree to pay for energy that is not capable of being credited to its bill by the municipality due to any load shedding or other network outages affecting the offtaker’s point of consumption.”

The Proximo perspective

Removing capacity limits for wheeling projects and simplifying wheeling applications will bring notable benefits for South Africa’s energy market and its economy, which has been crippled by energy shortages. Fitch cites the country’s energy deficit as a key driver behind its expectation that economic growth will decelerate to 2.3% in 2022 and to 1.7% in 2024. Wheeling projects require very little expenditure from Eskom or the government and add capacity to the grid, all while delivering returns to developers and lenders, as well as cheap power to businesses – a growth stimulant. There is the possibility that wheeling will gradually cannibalise Eskom’s customer base, but South Africa is so desperate for power that this scarcely matters.

What is critical for wheeling is that bureaucratic regulation is streamlined. Lead times for grid connection and environmental authorisation remain long. Vast investment in grid improvements is needed if wheeling projects and other IPP projects are to avoid grid capacity limitations. Investec estimates that this investment will cost ZAR180 billion ($10.4 billion) if the government is to meet its energy procurement goals – a hefty price tag for an indebted Eskom and a fiscally constrained government.

It will be interesting to see how lenders accommodate the new risks of corporate PPAs when the first project financings for wheeling projects close. It is certainly possible that instruments such as DSRAs and cash sweeps might be needed to address risk in relation to sudden hikes in wheeling charges or PPA terminations. Strangely, while banks will not be asked to take merchant risk on financings for wheeling projects, a merchant market could actually provide greater security for lenders in the event of an offtaker default, as other revenue streams would be available. Lenders will have to adjust to evaluating the creditworthiness of corporate offtakers over the life of a long-term PPA, rather than considering credit ratings for Eskom and the government.

If the development of wheeling projects is to be further incentivised, it will be essential for the government and Eskom to mitigate risks caused by factors such as wheeling charges and load shedding. The unbundling of Eskom and the evolution of a merchant market would also lead to a more modern and efficient South African energy sector, to which wheeling projects may make an important contribution, in spite of lingering regulatory obstacles.

 

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