Assessing the impact of Transnet's and Eskom's infrastructure investment programmes on the capital goods sector

Abstract

Transnet and Eskom have embarked on a R160.8 billion capital expenditure (capex) programme to improve South Africa's logistics and energy infrastructure over the next 5 years. Although considerable backward linkages will be created in the process of procuring goods and services needed in the construction and operation of the planned projects, a significant portion of investment will be lost because of having to import foreign skills and components that are unavailable locally. It has thus become a government priority to increase local content in the procurement process. Drawing on a series of interviews with leading suppliers involved in the capex programme, this article assesses the impact of such expenditure on the domestic capital goods sector and the constraints that militate against increased local participation.

Keywords:

• Capital goods
• state-owned enterprises
• Transnet
• Eskom

1. INTRODUCTION

The government's Accelerated and Shared Growth Initiative for South Africa (ASGISA, drafted in 2006) prioritises support for economic sectors that show they can generate employment and stimulate rapid growth over the long term in the country. The capital goods industry is one such sector. Capital goods are products that have value for a specific industry because they can directly enhance the production process and generate additional revenue through further commercialisation and application in other industrial sectors. The sector is made up of suppliers that vary in size and scope, but which all play a fundamental role in the production process of any firm or industrial activity. The sector's expansion and growth and the dynamism of the suppliers who comprise it depend on domestic demand factors. The higher and more stable the domestic demand factor, the greater the direct and indirect macroeconomic spinoffs (Corporate Strategy and Industrial Development, 2006; Walker & Minnitt, 2006).

The ASGISA identifies the main demand dynamic in the economy in the next 5 years as major infrastructure spending across key industrial sectors in the economy: the state-owned enterprises (SOEs), the private sector (specifically mining), and the government's general public works programme. Such spending will have a strong impact on the economy, particularly the backward linkages (i.e. the supply chain between an industry and its suppliers) created in the process of procuring capital equipment and service inputs needed in the design, construction, management and ongoing operation of the planned projects. While most inputs (such as machinery and equipment and electrical equipment) will be sourced from the manufacturing sector, the metal products, construction and transport sectors also stand to benefit, either directly or indirectly (Department of Public Enterprises [DPE], 2005b).

Although the capital goods sector has lost many manufacturing skills and capabilities over the past two decades as a result of severe cut-backs in investment and broad industry restructuring, the infrastructure investment programmes, particularly the R160.8 billion programme planned by Eskom and Transnet, are the catalyst to activate latent capabilities, encourage new firms, and facilitate large-scale skills development throughout South Africa (Department of Trade and Industry [DTI], 2007). However, the extent to which these goals are realised and local firms are able participate in the various projects depends not only on the end-user firms' procurement patterns and their decision to source locally rather than import, but also on local firms' competitiveness and ability to meet end-user requirements.

Consultation with a sample of participants and stakeholders already involved in Eskom and Transnet's capital expenditure programmes reveals that industry challenges, constraints and bottlenecks are affecting local firms' ability to participate effectively and meaningfully in the various projects. From a policy point of view it is important to understand what these problems are and what interventions are needed to alleviate them.

The aims of this paper are, first, to provide insight into the impact that changing demand patterns caused by Eskom and Transnet's capital expenditure programmes will have on key product groupings in the capital goods sector and, second, to review the extent to which local firms can capitalise on the opportunities triggered by such spend and the interventions needed to solve the associated problems. Section 2 that follows describes the capital goods sector and the importance of local demand factors in facilitating its growth and dynamism. It looks at the impact of fluctuating demand patterns in South Africa and the new role envisaged for the SOEs in the economy, particularly with regard to reviving latent capabilities in the capital goods sector. It highlights the areas of Eskom and Transnet's capital and operational expenditure (capex and opex) programmes that stand to benefit the most from the increased expenditure. Section 3 examines critical debates about the competitiveness of local suppliers and their ability to harness opportunities, drawing on findings from 20 interviews with key participants already involved in the capex programme (specialised service providers, manufacturers of large items of capital equipment, manufacturers of niche components, and refurbishment operations) and an extensive review of literature on the interface between SOEs and the supplier industry. The results of a Strengths−Weakness−Opportunities−Threats (SWOT) analysis conducted on the capital goods sector supporting the SOEs is provided in Section 4, and Section 5 concludes.

2. OVERVIEW OF THE CAPITAL GOODS SECTOR

2.1 Capital goods and services

The term ‘capital goods’ has been defined above. While the word ‘capital’ implies that the goods will have a certain degree of monetary value, scale and strategic value, in reality the sector produces an assortment of goods that vary in size, technology intensity and assembly complexity. Most capital goods are high-tech and niche-oriented, designed to meet specific industry or production challenges; however, the sector also produces low-tech and medium-tech goods. In terms of their end use, capital goods are basically intermediate products, used in sequence or combination with each other to fulfil a certain function or carry out a certain task. Taken on its own, however, each piece of capital equipment is a complete system in its own right, manufactured and assembled using a combination of components of varying sizes and technological complexity. While capital goods are generally regarded as being tangible products, the sector also includes technical and engineering services that form an integral part of an industry's value chain and are increasingly being offered by goods suppliers together with a particular piece of equipment (Corporate Strategy and Industrial Development, 2006; Walker, 2006).

Most firms comprising the capital goods (and services) sector fall into the manufacturing sector, where machinery and equipment and electrical equipment account for the largest proportion of inputs. The supply chain supporting the capital goods and services industry can be seen as two tiers of companies, depending on whether they provide inputs directly or indirectly (i.e. via an intermediary or aftermarket sales) to the end users (Figure 1).

Figure 1: Generalised structure of the capital goods and services industry

Tier 1 firms include in-house specialist suppliers, large project engineering and construction service providers, original equipment manufacturers (OEMs), suppliers of niche inputs (such as explosives and chemicals), and agents and distributors. Tier 2 firms include engineering and consulting firms providing services in one or two specialised areas (often subcontracted to a project engineering house), component manufacturers, and upstream suppliers of basic consumables needed to manufacture niche inputs. Although supplier companies are distributed throughout South Africa, most of the capital goods and services companies are in Gauteng Province. Most of the manufacturing firms are in Ekurhuleni and the specialist engineering and consultancy firms are mostly in the northern and central regions (Figure 2).

Figure 2: Location of Ekurhuleni and City of Johannesburg, Gauteng Province

2.2 Rationale for growing and supporting the capital goods sector

It is well established in the literature that the production of machinery and equipment (i.e. capital goods) lies at the heart of industrial development and plays a determining role in the evolution of an economy – from primary resource-dependent growth to higher-tech, knowledge-based sustainable growth and development. The experiences of Finland, Sweden, the USA, Canada, Germany and Japan – countries that have successfully captured changing domestic demand requirements to facilitate industrial development – attest to what is possible if the right policies and conditions are in place to facilitate long-term sustainable economic growth on the back of a strong and dynamic capital goods sector (see Rosenberg, 1963; Porter, 1990; Blomström & Kokko, 2002; De Ferranti et al., 2002; Abdi, 2004; Gür, 2004; Taka, 2004; Hausmann et al., 2005).

The unique developmental aspect of the capital goods sector is the ‘know-how’ component embodied in the final products manufactured by the various firms. These intangible assets, the knowledge and skills acquired in the process of developing products, can be applied to similar activities (along the value-added chain) and also to non-related but technologically similar activities, and thus lead to new higher-tech activities (Vuori & Ylä-Antilla,1992; Sybille, 1998). South Africa is unlikely to catch up with other countries unless it moves beyond its current export of primary and semi-processed resources (which are finite, static and susceptible to cyclicity and long-term real price decline) to dynamic, less price-sensitive, technology-based manufactures such as those of the capital goods sector (Lall, 2001; Hausmann & Klinger, 2006; Walker, 2006; DTI, 2007).

2.3 The performance of the sector

The South African capital goods sector has recovered somewhat in recent years following the effects of very weak domestic demand linked to low levels of investment spending in the 1980s and 1990s, most notably by the public sector (Hirsch, 2004; Roberts, 2004; Machaka & Roberts, 2006). The gradual contraction in demand over this period, particularly for new generation capacity from Eskom and replacement locomotives and improved logistics infrastructure from Transnet, severely eroded many manufacturing skills and capabilities that had emerged as a consequence of government expenditure in these areas in the 1960s and 1970s. Only a small base of such expertise currently remains. The sustainability of this base is threatened by a shortage of skills, a rising trade deficit (although exports in the capital goods sector have been increasing in recent years, there has been a concomitant increase in imports), and low overall levels of innovation and research and development (Taka, 2004; Walker & Minnitt, 2006).

The recovery of the capital goods sector is expected to increase and even accelerate in the next few years as a result of the government's decision to become more ‘developmental’ in its involvement in the economy. Specifically, the government aims to increase the current contribution of public-sector investment by 20 per cent to create a base from which to attract additional investment, ‘crowd in’ private sector resources, and stimulate spillover effects throughout the economy, particularly in the development of new firms, black economic empowerment (BEE) deals, and the export capabilities of companies. The SOEs are seen as the main tool for doing this (DPE, 2005a,b). At present only two are involved – Transnet and Eskom have submitted 5-year investment programmes with targeted projects to the DPE and are establishing contracts with specialist consultants and equipment suppliers throughout the country.

3. IMPACT OF CHANGING DEMAND PATTERNS IN THE SOEs

The combined expenditure by Eskom and Transnet over the period 2006–2011 was projected to be around R244.8 billion, with R160.8 billion to be spent on capital improvements (infrastructure and equipment) and approximately R84 billion on operational activities.1 Projects are both new-build (greenfield) and refurbishment (brownfield). The two SOEs' local and foreign content varies according to the type, scale and value of the projects they undertake, the design specifications and strategic importance of equipment, the existing base of local suppliers and their ability to meet specified requirements, and the SOEs' procurement practices. Their expenditure is intended to address South Africa's severe backlog of logistics and energy infrastructure and capacity requirements. Tables 1 and 2 present a breakdown of the capex and opex and notable projects planned by the two SOEs over the next 5 years.

Table 1: Breakdown of Eskom's and Transnet's capex plans

	Capital expenditure
	Eskom	Transnet
Value	R150 billion for the period 2006–2011. Between 2006 and 2025 an estimated R500 billion to R1 trillion could be spent in the energy sector	R78 billion for the period 2006–2011
Projected import leakage	Total approximately 41.92%:	Total approximately 45%:
	Power generation – 47.4%, transmission – 25%, distribution – 15%	Rail – 50%, port operation – 20%, ports – 80%, Petronet – 50%, Transwerk – 20%
Objective	To increase energy supply by 22 000 MW, increasing total capacity to 61 000 MW, and to improve transmission and distribution in South Africa	Improve logistics infrastructure and equipment in South Africa and the delivery of services to clients
Breakdown of spend	Power generation – R106 billion, transmission – R20 billion, distribution – R21 billion, other – R3 billion	Rail (Spoornet and Transwerk) – R38.9 billion, ports (SAPO and NPA) – R28.5 billion, pipelines (Petronet) – R9.96 billion
Composition of projects	New-build:	Rail:
	• 2×1050 MW open-cycle gas turbines at Mossel Bay and Atlantis – R3.5 billion	• Infrastructure – R9.83 billion
	• Ingula pump storage scheme – R9 billion	• Locomotives and wagons – R24.47 billion
	• 4500 MW Medupi coal-fired power plant at Lephalale – R70 billion	• Machinery and equipment – R4.61 billion
	• New coal-fired power station (Project Bravo), Witbank – R84 billion	Ports:
	• A 3600 MW nuclear power station, Western Cape – R110 billion	• Port facilities – R15.12 billion
	• Pebble bed modular reactor – R26 billion	• Building and structures – R3.26 billion
	Refurbishment:	• Machinery and equipment – R9.67 billion
	• Camden, Grootvlei & Komati power stations – R12 billion	Pipelines:
		• Pipeline network – R9.67 billion
		• Building & structures – R91 million
		• Machinery & equipment – R197 million
NPA, National Ports Authority; SAPO, South African Ports Operations.

Table 2: Breakdown of Eskoms' and Transnet's opex plans

	Operational expenditure
	Eskom	Transnet
Spend	Annual estimated spend on three main divisions (based on 2004 figures): R11.439 billion	Annual estimated spend for external activities (based on 2004 figures): R5 billion
Breakdown of spend	Power generation – R4.2 billion:	Energy – R2.0 billion:
	• Turbine maintenance – R989 million	• Diesel – R1.146 billion
	• General maintenance – R814 million	• Electricity – R775.46 million
	• Boiler and mill maintenance – R495 million	• Petrol – R69.74 million
	• Auxiliary plant maintenance – R389 million	• Other – R57.64 million
	• Nuclear – R361 million	Operational commodities – R2.4 billion:
	• Consulting – R291 million	• Component repairs – R1 billion
	• Protection, control and measuring – R273 million	• Rolling stock maintenance – R408 million
	• Waste management – R250 million	• Wheels – R300 million
	• Miscellaneous – R179 million	• Permanent way rental – R230 million
	• Business services – R156 million	• Traction & wagons – R92 million
	Transmission – R1.5 billion:	• Stevedore – R73 million
	• Transformers – R349 million	• Operating service & outsourcing – R62 million
	• Line construction – R225 million	• Project equipment – R58 million
	• Network primary plant – R115 million	• Brake shoes – R53 million
	Distribution – R5.8 billion:	• Other – R69.2 million
	• Electrification & reticulation – R 1.586 billion	• Cargo handling equipment – R43 million
	• Miscellaneous – R639 million	Infrastructure, Transport & Buildings – R1.5 billion:
	• Fleet – R548 million	• Transportation & vehicles – R674 million
	• Consulting – R387 million	• Turn outs – R148 million
	• Information technology services – R368 million	• Permanent way – R137 million
		• Signalling – R90 million
		• Other – R451 million

3.1 Backward linkages to the capital goods sector

Provisional economic assessments of the direct and indirect impacts of Eskom and Transnet's investment programmes emphasise that, besides the manufacturing sector (machinery and equipment, electrical machinery, etc.), civil engineering and construction, metal products, coal mining, finance and business services, transport equipment (motor vehicle parts and accessories), basic iron and steel, and manufactured metal products all stand to benefit from the backward linkages that will be created (DPE, 2005b). The supply chain supporting the SOEs is large and the majority of equipment suppliers to the SOEs have a long history of involvement with the respective SOEs. The following section reviews the degree of local participation in the various projects underpinning Eskom and Transnet's capex programmes and ongoing opex and product groupings with the greatest potential for further development.

3.1.1 Local participation potential in Eskom's projects

The local supply base providing capital goods and service inputs to the power industry is extensive, and while the generation stage accounts for some of the largest and most capital-intensive products and the majority of inputs, there are significant local competencies and an overlap of suppliers in the transmission and distribution stages.

3.1.1.1 Demand for generation inputs

Most electricity in South Africa is produced in coal-fired power stations, each of which has critical components, subsystems and support systems – a transformer, a transmission and distribution yard, generating units (boiler subsystem, turbine subsystem, generator and a control and instrumentation system), and various auxiliary systems (flue gas treatment plant, demineralisation plant, coal plant, draught air system, condensing plant, pumps, etc.). The size of the power station and the number of generating units are determined by the required output of the plant. Approximately 5000 components and inputs and over 10 000 suppliers may be directly and indirectly involved in the design, construction and operation of a power station.

Capital equipment is provided to Eskom by local and international companies that vary in size and scope. To date, most of the contracts awarded as part of Eskom's capex programme have been to Tier 1 and Tier 2 firms, most of which are concentrated in Gauteng, particularly Ekurhuleni, and mostly for the de-mothballing and return-to-service of the Camden, Grootvlei and Komati power stations. While Eskom will project manage the de-mothballing projects, with support from various consulting companies and OEMs, the bulk of the refurbishment work will be undertaken by local OEMs, subcontracting work as needed to other local firms. The rest of the contracts for the new-build projects, particularly to Tier 2 firms, have yet to be awarded.

An important government objective is to reduce the degree of import leakage from the purchase of inputs (goods and services) abroad – estimated at 47.7 per cent in power generation. While some components, by virtue of their specialised, strategic, high-cost, high-value status, will always be imported, some whose capabilities used to exist can be revived where new opportunities exist further down the value chain that require targeted interventions to realise (DPE, 2005b).

3.1.1.2 Foreign/local content

Depending on the design specifications, a new-generation coal-fired power station can cost in the order of R26 billion. The boiler and turbine subsystems are the largest-cost items, together accounting for approximately 72 per cent of total capex. Instrumentation and control (I&C), the establishment of the coal supply yard, and the overland conveyor system collectively account for 9 per cent of the costs, while civil work, technical building equipment, water treatment and generator transformer account for R2.6 billion.

Local content varies across the different systems. Firms say they tend to rely more heavily on imported technology and processes for primary equipment than for auxiliary equipment. For the generator transformer, no local content is achievable, while 10 per cent can be achieved in the installation and assembly of the high-pressure steam turbine. For I&C systems, 10 per cent local content can be achieved. Local content in primary equipment is highest in boilers, where 41 per cent of a new-build contract can be undertaken locally because there is a small base of expertise in the manufacture of selected high pressure parts. Between 50 and 80 per cent local content can be achieved in new-build auxiliary equipment (such as fans, air heaters and precipitators). Overall, local content in new-build activities is highest in service-related activities such as construction and structural engineering and as much as 90 per cent can be undertaken locally.

Suppliers point out that the potential for increasing the participation of local firms in the capex programme is greatest in the refurbishment projects, and between 65 and 70 per cent local content can be achieved in places. Refurbishment is considerably cheaper (40−60 per cent) than building a new power station since existing structures are retained. Core components are replaced with modern alternatives, cutting-edge technologies are incorporated and new control systems are added.

Discussions with leading OEMs involved in the local power generation sector revealed that local competencies exist in products such as heating tapes, air intake systems for turbines, mill liner replacement, large motors for fans, high pressure valves, medium-voltage switchgear, and low-voltage and high-voltage cables. Possibilities are strong for the expansion of local capabilities in these areas to improve local content value over the short to medium term. Targeted investment is needed in conjunction with interaction with end-users to ensure requirements are met without compromising on quality and delivery time.

Similarly, suppliers believe local participation is also likely to be much greater in ongoing operational activities. Many OEMs have responded to the decline in demand for manufactured equipment over the years by diversifying their activities to include providing replacement parts and performing maintenance. Eskom's annual expenditure on operational activities provides an indication of the sources of demand for products and services beyond the 5-year timeframe of the capex programme and the opportunities for local participation. Operational expenditure by Eskom over the next 5 years will be highest in the maintenance of turbines, boilers and mills, generator transformers and I&C. The local and foreign content varies across these product groupings, with the greatest backward linkages being achievable in I&C and boilers (65 per cent). For generator transformers, 40 per cent can be undertaken locally, and 45 per cent for turbine maintenance. In auxiliary equipment, local content potential in opex activities is approximately 75 per cent.

In terms of opportunities, therefore, the capex programme must be seen as merely the start – increasing opex and refurbishment expenditures will provide a secure platform for industry development (Figure 3).

Figure 3: Opportunities for supplier involvement

Emphasis needs to be placed first on advancing and developing capacities in ongoing refurbishment and maintenance, particularly of strategic and high-value products that currently have a high import leakage – turbines, generator transformers, boilers and I&C – and that could be reduced by at least 10 per cent in the medium term; and second on strengthening those product groupings where there are latent or dormant manufacturing capabilities such as in boilers, forced-draught axial flow type fans, and control system assembly and adaptation. Investment is needed in professional and artisan skills, new manufacturing facilities, and testing equipment to make such activities viable and sustainable. Although lead times for establishing such operations locally vary between 2 and 4 years, suppliers are willing to enter into partnership agreements with end-users to work towards fulfilling local requirements at a cost-effective and internationally competitive standard. Investment risk will be minimised if a collaborative and partnership approach is adopted. According to specialist OEMs, it is unlikely that manufacturing plants for high-performance turbines and generator transformers, which require large economies of scale to sustain activities and proximity to main centres of demand, will ever be successfully localised in South Africa.

3.1.1.3 Demand for transmission and distribution inputs

Around 80 per cent of Eskom's R15.4 billion capex on distribution will be spent on lines and cables, substations, reticulation, and refurbishment and control systems, of which 85 per cent can be sourced locally. Product groupings that offer the greatest potential for increased local participation, particularly at the provincial and municipal level in the coming years (because existing equipment is outdated and there is a need to standardise across networks), include switchgear, circuit breakers, isolators and vacuum interrupters.

In terms of opportunities beyond the capex programme, in 2004 Eskom spent R1.5 billion (10.6 per cent of Eskom's total) on transmission, with the bulk of expenditure being allocated to transformers, line construction and network primary plant. Its expenditure on distribution activities is highest across the utility, with R5.8 billion spent on opex in 2004 (Eskom, 2005). Electrification and reticulation accounted for the largest area of expenditure. Investment in skills, as well as stable levels of demand, is needed to ensure the long-term development of a base of suppliers to provide transmission and distribution capital goods and services.

3.1.2 Local participation potential in Transnet's projects

A core objective of Transnet over the next few years is to radically realign its strategic direction with the country's economic requirements, particularly with regard to decreasing the cost of doing business and increasing the efficiency of exports. Projects underpinning the programme are focused on expanding and replacing existing infrastructure and modernising equipment across the SOE's various divisions. In addition to improving operational efficiency through capital investment, Transnet is embarking on a programme of internal restructuring, particularly with regard to the management of its supply chain and procurement process. Its estimated annual opex on external activities over the next 5 years is approximately R5 billion, which will mean an additional R25 billion flowing through the economy. The largest areas of expenditure are energy, operation commodities (including repairs, maintenance and rental), infrastructure, transport and buildings.

Since rail (49 per cent) and port (29 per cent) projects account for the largest proportion of Transnet's capex, the following sections explore their impact on key product groupings within these two areas of investment in more detail.

3.1.2.1 Demand for port inputs

Investment at the ports is focused on increasing capacity in order to handle rapidly increasing volumes of traffic and improve cargo handling efficiency. Of the R18.6 billion allocated to the National Ports Authority, 40 per cent will be spent on upgrading Durban Harbour, followed by expansions and upgrades at Ngqura Harbour, Richards Bay Coal Terminal, Saldanha Port and Cape Town Container Terminal. The South African Ports Operations has been allocated R6.3 billion to improve container handling facilities at the ports. As much as 80 per cent will be spent on acquiring new cranes and refurbishing existing cranes, straddle carriers, and other associated equipment (Transnet, 2005).

Product groupings that stand to benefit from changing demand patterns within the South African Ports Operations and the National Ports Authority include technical design and project management services, civil engineering and construction expertise, equipment and basic material inputs. Projects are in various stages of execution and most of the contracts for construction and civil work have been awarded. The majority of the firms involved are Tier 1 and Tier 2 firms providing a range of OEM or service/consulting functions. There is a considerable degree of partnership or outsourcing and joint ventures between large and small firms involved in the port activities. Most of the large firms are based in Gauteng (Ekurhuleni) or overseas and have smaller partners at the ports. Of the 30 companies already involved in the various port projects, only 10 have head offices outside Ekurhuleni, at the coast (Port Elizabeth, Cape Town, East London, Durban). Most of these are small assembly operations, civil engineering firms, or branches of leading consulting firms. Suppliers, however, questioned the degree of value added by the various partnerships and joint ventures, particularly those involving foreign firms and local small, medium and micro enterprises (SMME) or BEE firms.

3.1.2.2 Foreign/local content

In terms of the split between foreign and local procurement arising from the port capex, approximately 90 per cent will be spent locally on services such as project management and engineering, construction and material inputs such as cement and steel. The balance will be spent on sourcing specialised services, such as dredging, from abroad as well as other inputs unavailable locally.

Foreign content is higher in port equipment (58 per cent) than in the infrastructure expansion projects due to the small base of local capabilities in the area of container handling manufacture. While local capabilities in the design, manufacture, erection and operation of port equipment existed in the late 1970s, curtailment in demand for both new and refurbished equipment over the past two decades has steadily eroded such expertise. Despite the resulting current export leakage, there is significant latent expertise in the South African heavy engineering and structural steel sector capable of ensuring that any future assembly and manufacture of such equipment can be undertaken locally. First, however, critical development and procurement issues pertaining to cost and quality, the speed of the rollout, and the lead times required to develop the requisite skills for such projects have to be resolved.

3.1.2.3 Demand for rail inputs

Transnet's capex spend on rail will mainly be focused on replacing and expanding capacity in business areas: infrastructure (rail track and systems), fleet improvement (rolling stock), and in-house capacity for refurbishment, upgrading and maintenance.

The railway equipment manufacturing, operating and services industry in South Africa employs about 40 000 people and generates annual exports exceeding R1 billion. It is made up of large, medium and small firms that provide products and services of varying complexity and sophistication. Approximately 100 local companies are involved in the industry (Transnet, 2005). A significant number of product groupings in the capital goods sector stand to benefit from the increased demand for products and services related to rail infrastructure upgrades (such as signalling systems, rails, central control components, switch machines and consulting services). In terms of investment in fleet upgrade and expansion programmes, the product grouping that stands to benefit the most from changing demand patterns is locomotives.

3.1.2.4 Foreign/local content

Import content varies across the various rail-related projects. The local content of rail infrastructure and equipment is around 60 per cent, with components such as rails and electronic systems dominating the import profile. Local content is much higher in the execution and design of the upgrades, with around 80 per cent achievable on some contracts because there is an existing base of firms with competencies in construction, management and maintenance of rail infrastructure, signalling, permanent way components, and provision of raw material inputs. Moreover, as labour can comprise as much as 60 per cent of rail expansion activities, unskilled and semi-skilled employment opportunities in the vicinity of the projects are high.

The local content potential is much lower in the fleet upgrading process. Spoornet's locomotive and wagon fleet is old and outdated. Much of the investment in locomotives is therefore being directed towards upgrading the general freight locomotives and acquiring new locomotives for the heavy haul and high-density lines. A new-generation locomotive costs between R35 and R50 million depending on the specifications. The current order for 110 new electric AC/DC locomotives for the coal-link corridor between Ermelo and Richards Bay will amount to around R3.5 billion over 5 years. In the main cost areas, the bulk of expenditure is on electricals (50 per cent), followed by mechanical (30 per cent), and service (10 per cent) requirements. Estimates are that 50 per cent of such goods and services will be imported. There is significant potential to reduce import leakage in new-build locomotives from 50 per cent to 30 per cent in the next 5−6 years, given the base of existing capabilities and the information and technical sharing that will result from the collaboration between Toshiba engineers and specialists and local locomotive manufacturers. Suppliers caution that developing and sustaining these capabilities requires a minimum annual demand of about 50 new locomotives, which can be made possible if infrastructure demands in the country are coordinated in the medium to long term. Opportunities created through the New Economic Partnership for Africa's Development will also offer new markets for local firm involvement.

Capabilities also exist in the local capital goods sector for upgrading and refurbishing locomotives and vital components, and as much as 75 per cent can be undertaken locally. Firms say these capabilities could be enhanced if certain products (such as brake valves and traction motors) currently imported or refurbished locally are actually manufactured in South Africa. Stable demand and investment in testing and manufacturing equipment will be critical to such a process. While products such as ablution systems, stoves and windows can also potentially be manufactured locally in the future, much closer collaboration and interaction between Spoornet and the supply chain is needed, not only to identify new business opportunities but also to resolve critical product-related challenges the industry faces (quality, delivery and volume, etc.) that deter it from procuring locally.

4. SWOT ANALYSIS

A SWOT analysis of the capital goods industry supporting the SOEs was carried out to assess firm dynamics and supplier capabilities, challenges and constraints facing firms, and the role of the SOEs in driving the growth process. Findings were drawn from face-to-face and telephonic interviews with suppliers, interaction with SOE personnel, and various discussion documents.

4.1 Opportunities and strengths

The R160.8 billion capital expenditure planned by Transnet and Eskom over the next 5 years is projected to contribute around 1.5 per cent annually (based on 2004 figures) to the Gross Domestic Product and to contribute significantly to employment creation, particularly in the construction sector. Other sectors, notably manufacturing, metal products and transport, stand to benefit from the backward linkages created by increased demand for components, replacement parts and original equipment manufactures, and specialist design, management and consulting services. Given the scale and scope of the planned SOE expenditure – the largest ever planned by the public sector in South Africa – and the fact that it comes after years of insignificant and low investment, it is critical that it be effectively leveraged to achieve both ASGISA's goals and the DTI's Economic Cluster objectives in terms of industrial growth, increased exports, employment creation, skills development and equality in the workplace.

South African firms have a history of providing inputs to power, rail and port operations, and there is a base of many niche capabilities from which a focused supplier development strategy could develop. Recognising this, in 2007 the DPE developed an industrial policy component to support and encourage the localisation of SOE products. The importance of leveraging public procurement through such Competitive Supplier Development Programmes is also acknowledged by the DTI in its National Industrial Policy Framework (DTI, 2007) and Industrial Policy Action Plan. Suppliers in the capital goods sector, moreover, stand to benefit directly from the DTI's recently launched Enterprise Investment Programme, particularly the subcomponent directed towards manufacturing.

One of the distinctive features of the supply industry supporting the SOEs is that they are ‘survivors’ and have managed the fluctuations in demand through diversification, pursuit of export markets and lateral migration. Many see the capex programme as an opportunity to activate latent capabilities, revive the apprentice scheme, and pursue new product lines, and they are willing to absorb, learn and adapt foreign technologies to facilitate import substitution, and to enter into partnerships (particularly with BEE and SMME firms) to broaden economies of scale and develop skills. Many firms are investing in improved production methods and expanding operations so they can position themselves more competitively to secure projects both locally and, in future, elsewhere in the subcontinent. Suppliers already involved in the capex programme said much more local content is achievable locally than what technical experts in the SOEs expect or project, in both the short term and the long term.

Despite these strengths and opportunities, however, there are weaknesses and threats at the broad industry level as well as between suppliers and end-users that may hamper the effective leveraging of the SOEs' capex and opex in the short, medium and long term.

4.2 Weaknesses and threats

One constraint to expanding niche capabilities in the capital goods and services sector is the nature and size of the local market, which may not be able to support the economies of scale needed to replace imports. To be economically viable, high-tech, large-scale, capital-intensive equipment such as turbines and power generators require large economies of scale and accessibility to the main markets. Suppliers of such equipment see the distance to and from these markets as a major disincentive to relocating strategic manufacturing operations to South Africa. Furthermore, the fact that the main manufacturing ‘hub’ is situated inland in Gauteng, far from the coast and ports, has major implications for meeting international ‘just-in-time’ delivery requirements. Dependence on road transport rather than rail is also seen as a major disincentive given the size of the parts (a turbine rotor can weigh up to 60 tons).

At the same time, challenges in the broader business environment are making it difficult for local firms to take advantage of new opportunities and capitalise on their collective strengths. These challenges are notably in the areas of fiscal and foreign exchange regulations, tariff barrier differences across imported components and assembled equipment, access to working capital, certification and testing facilities, import parity pricing on critical inputs such as steel and scrap metal pricing, and skills shortages. With regard to skills, it is argued that an ensured demand would enable firms to project skills requirements better and develop longer-term training programmes.

Perhaps the biggest challenge and threat to the future vibrancy and expansion of the supplier industry is the interface between the end-users (SOEs) and suppliers. Poor communication of information about local market opportunities and projects between SOEs and suppliers undermines the capex programme's potential. Forums are regularly held between suppliers and main stakeholders to discuss the progress of the project rollout and address industry-wide issues. However, suppliers question the effectiveness of such an approach. They feel that many of the issues they raise are not being treated with the seriousness they require and that there is a general lack of awareness of the scope of industry capabilities and requirements. To be more effective, supplier forums need to be preceded by one-on-one interactions between SOE procurement and technical experts and the suppliers to formulate a more accurate picture of supplier capabilities, end-user expectations, technical requirements and partnership possibilities. Future meetings should include government personnel, and supplier workshops should be held to communicate resolutions from meetings and to advance constructively with leveraging procurement plans. The situation is aggravated by the poor level of information sharing between other government departments and industry sectors, particularly regarding scheduling of projects, demand synergies, and the timeframes required to develop new skills and build new equipment. This has implications for the achievement of mandates and the fulfilment of ASGISA goals.

One of the most important factors influencing dynamics within the capital goods sector is the actual procurement process. The procurement relationship governs the terms on which vertical linkages occur between firms for the sourcing of goods and services in the supply chain. As the principle end-users, Eskom and Transnet effectively ‘govern’ this chain. The increased emphasis on cost reduction and maximising efficiencies within these SOEs in recent years has significantly altered the nature of the procurement process. Contracts for new-build operations are usually organised into packages and outsourced to OEMs following a lengthy tender process. The criteria and weighting procedure in the tendering process have changed over the years. While factors such as cost, competitiveness and customer influence traditionally played a significant role in the awarding of contracts, increasingly additional factors such as quality, performance guarantees, existing or potential order books, OEM and in-house engineering capability, and technical alternatives, local content and BEE participation are playing greater roles. ‘Total cost of ownership’ is also becoming the key criterion for selecting suppliers. Contracts for smaller items such as cable replacement and installation may be comparatively shorter, and different suppliers may be used from one contract to another.

The procurement decision-making process is either centralised or decentralised to the level of individual operations depending on the nature of the end-user. In both instances there appears to be a drive to reduce the number of vendors and increase the level of outsourcing. Most outsourced contracts (aside from day-to-day activities such as cleaning, printing, information technology, etc.) are focused on project and asset management, maintenance, repair, and replacement of spare parts. These developments have had a fundamental impact on the nature of firm competition and rivalry at all levels in the capital goods sector. End-users are demanding more from their suppliers than simply the delivery of stock products and spares; they want partners with the experience and the expertise to provide solutions. Suppliers involved in the SOE supply chain maintain that, while they are willing to adapt to these changing demands and enter into long-term partnerships with end-users, they require surety of business and longer-term contract agreements in order to do so. Currently the short duration of contracts (2 years) and poor communication of expectations at supplier workshops prevents the local supply base from realising its full potential.

The changing environment, particularly with regard to procurement and supply chain management within the SOEs, is also having major repercussions through the supply chain. The pressure of rollout and the need to procure offshore to source cutting-edge technologies unavailable locally (either because the industry has died or because the local market demand is insufficient to sustain such activities) is having a major impact on the local supplier base's potential to evolve and expand. Many suppliers (both large and small) are unaware of end-user expectations regarding the procurement process and requirements, and feel threatened by the increasing emphasis on cost and the failure to understand the timeframes required to rebuild lost local capabilities or activate latent ones. Local firms no longer believe that an installed base and brand history is sufficient to secure tenders.

Many OEM and component suppliers involved in the capex programme maintain that the term ‘local content’ is too broadly interpreted by end-users and that there is not enough emphasis on procuring ‘locally manufactured’ goods. Firms interviewed argued that end-users use the term ‘local content’ interchangeably to refer either to the extent to which a product is ‘locally manufactured’ or the proportion of equity ownership of a firm. Suppliers assert that while certain high-tech products (such as turbines and generators) will always be imported for strategic and risk-averting reasons, there are some products where much higher local content can be achieved than is projected or believed by possible by end-users. They feel there is no added benefit in being able to offer a larger proportion of local manufacturing or repairs if the weighting criteria are fixed at a particular percentage. At the same time, many of the larger suppliers have acquired equity partners and changed owners over the past few years and have the requisite BEE status to compete for tenders on a local ownership basis. However, the entry of foreign suppliers who establish partnerships with local firms to secure the local ownership requirements is viewed as a major threat to established businesses and sends a confusing message to the capital goods sector with regard to growing the industry through increased ‘local content’. Intervention is needed to interpret and define ‘local content’ and should perhaps include a local value-added dimension as a weighting criterion.

Beyond taking a new look at the definition of ‘local content’, a shift is also needed regarding the timeframe for reviving and growing the capital goods sector. Too much emphasis is currently placed on the 5-year capex programme rather than on capitalising on the opportunities for supplier development in refurbishment and ongoing operational activities. The urgency of rollout, together with the need to install cutting-edge technologies and employ high-tech specialists (unavailable locally), will account for the significant leakage of expenditure abroad during the capex programme. However, much greater local content can be achieved in the refurbishment (only three power stations are being refurbished as part of the capex programme, but many others will be approaching their mid-life in the next 5–10 years and will require extensive overhauling and replacement of parts), after-market services and maintenance market. The backward linkage opportunities that will come up in the medium to long term (i.e. 10–20 years) following the initial capex programme tend to be overlooked. Yet the size and scope of long-term opex by the two SOEs far outweighs the initial 5-year expenditure on infrastructure development and equipment upgrading. Opex will need to be spent on both the existing installed base of equipment in the SOEs and the new array of equipment and facilities built as part of the capex programme, and this is where local capabilities need to be developed in order to harness such opportunities. Interventions need to be put in place to ensure that local firms secure such future opportunities even if the capex tender goes to a foreign OEM.

To reassure end-users, who require cost-competitive, high-quality, reliable goods and services, the capabilities of local firms will also need to be benchmarked. In this way, not only will suppliers be able to identify their weaknesses and develop strategies to gradually improve their competitiveness (both locally and eventually in the export market), but end-users will be able to grade requirements according to their importance and value and will be better positioned to decide whether to go local or international.

5. CONCLUSION

From the above analysis it is evident that although there is significant potential within the capital goods sector to realise many of the goals of AGSISA and the DTI Economic Cluster over the short, medium and long term, particularly when it comes to stimulating new firm development, reviving latent capabilities, broadening equity representation and facilitating skills development, the sector is facing a number of critical challenges – problems and bottlenecks that make it difficult to realise these benefits.

The importance of local demand in furthering production capabilities and enhancing the export potential of firms engaged in the capital goods sector cannot be emphasised enough. In addition, deepening and broadening existing capabilities, reviving lost ones and activating latent ones, also requires skills development, access to competitively priced raw material inputs, and logistics and testing and certification facilities. Such measures require direct government intervention as they will not necessarily come from market forces.

While domestic market demand, historically from the mining industry and more recently from the SOEs, is an important source of sales for many suppliers engaged in the capital goods and service sector, conditions have worsened for the industry over the past decade because of weak economic growth, low levels of investment, increased levels of import penetration, and the absence of a clearly articulated and implemented government and parastatal procurement policy favouring domestic manufacturing. Moreover, a failure to grasp the nature of the demand−supply relationship, the extent of local capabilities, and the challenges and constraints experienced by various participants in the capital goods sector suppliers have militated against the establishment of a long-term supplier development strategy.

To clear the way forward, policy-makers need to emphasise the importance of coordinating government agencies and parastatals, encouraging industry sector collaboration, benchmarking local industry capabilities, encouraging skills development, and re-examining the SOE procurement process.

The author wishes to thank the Department of Public Enterprises for commissioning the study and the Corporate Strategy & Industrial Development research programme at the University of the Witwatersrand where the research was undertaken. This paper was presented at the DPRU/TIPS (Development Policy Research Unit, University of Cape Town/Trade and Industrial Policy Secretariat) conference ‘Accelerated and Shared Growth in South Africa: Determinants, Constraints and Opportunities’, Johannesburg, 18–20 October 2006.

Notes

¹This paper reflects the revised capex figures released by the DPE in August 2006.