Article

Tax incentives are crucial to South Africa’s energy transition

A black umbrella in the middle of a desert, standing in the sand
Published Date
Nov 23, 2023
Related people
South Africa urgently needs to upgrade its energy systems and transition to renewable energy. Benjamin Mbana highlights how the country's tax system could play a crucial role in this transition.

South Africa has been in the grip of an energy crisis since so-called “load shedding” started in 2007, with the situation worsening over the past three years, with blackouts of up to 12 hours a day now a regular occurrence. Load shedding has a huge impact on business; when the power is switched off companies must choose between alternative energy sources (most commonly expensive diesel-run generators), or pausing or ceasing trade.

Businesses now want new ways of generating their own cheap and reliable renewable electricity, yet for many years these types of small-scale projects were too expensive. Through our work with clients, we see that newly introduced tax incentives as well as tax structuring for larger projects can play a critical role in getting these much needed projects off the ground.

Broken system

South Africa is still predominantly fueled by an aging fleet of coal fired power stations which produce around 70% of the country’s power generation capacity,1 and despite the country’s abundance of sunshine and wind, renewables made up just 1% of total power generation capacity in 2020.2

The country’s energy crisis has largely been blamed on the state monopoly power provider Eskom, which has been labeled as “broken” by media outlets and criticized for high levels of corruption and underinvestment.3 The country’s central bank estimates that blackouts could cost the economy up to R899m (USD$47m) a day in 2023,4 so it is perhaps no wonder that President Cyril Ramaphosa declared South Africa’s energy crisis a “national disaster” earlier this year.

New renewables incentive

The government is now looking at ways that it can diversify the country’s energy mix and move away from coal. As such it introduced changes to the tax system which became effective earlier this year to encourage small and medium sized businesses to invest in renewables.

Finance Minister Enoch Godongwana announced that the South African National Treasury was expanding section 12B of the Income Tax Act No 58 of 1991 (the Tax Act), originally introduced in 2016, to encourage rapid private investment to alleviate the energy crisis. Prior to this amendment, section 12B allowed businesses to deduct the costs of qualifying investments in wind, concentrated solar, hydropower biomass and photovoltaic (PV) projects over a one- or three-year period, depending on the energy generation capacity. This created a cash flow benefit in the early years of a project.

Tax breaks to encourage businesses to invest in renewables have been in place since 2016. But this extended scheme is considerably more generous and as such we have seen many more businesses become interested in how they can use the scheme to invest in small scale solar facilities or inverters.

The renewables incentive scheme allows businesses to deduct 125% of the costs of qualifying investments in the first year of the project with no threshold on generation capacity, which means they can get money back on their investment.

For instance, a company that buys solar panels worth R1m will qualify for a tax deduction of up to R1.25m during its first year of operation. The adjusted incentive is currently a temporary measure and only available for investments brought into use for the first time between 1 March 2023 and 28 February 2025. It is expected to cost the government around R5bn (USD266m) in 2023 to 2024.

We believe the scheme is a promising start in encouraging small and medium sized businesses to ramp up their renewables investments. We have seen considerable interest from clients, but the biggest hurdle remains financing. At present, this is mostly through bank loans but there are structuring opportunities in terms of which private capital funds can benefit from financing these projects, particularly if the scheme becomes a longer-term policy.

Larger projects

It is not just small and medium sized companies that are increasingly interested in investing in their own renewable generation. Large industrial companies typically have energy intensive operations that make big demands on the grid, and the majority are desperate to avoid costly shutdowns caused by blackouts.

These companies are reliant on financing from banks and international investors to fund solar panels, wind turbines, inverters or battery storage systems. But tax structuring is still a crucial part of making these deals financially viable.

We have seen considerable interest from mining companies in such projects, recently advising Rio Tinto on the installation of a 148 MW Solar PV project for Richards Bay Minerals, as well as Tronox on a 200 MW Solar PV project for Tronox Mineral Sands.

Many of the financing structures require a mix of equity, debt or similar instruments, that take the form of hybrid instruments such as preference shares. These instruments must comply with anti-avoidance rules contained in various sections of the Tax Act. If companies do not think about the tax implications of these structures at an early stage it can scupper an entire deal; we have seen several examples of banks, investors and target companies being forced back to the drawing board to restructure their transactions because large tax liabilities made these deals unworkable. As such, tax structuring always needs to be at the forefront of the discussions.

Change needed 

It remains to be seen how effective the government’s new tax policies will be in boosting South Africa’s private investment in renewable energy. But we believe that tax incentives and tax structuring will remain crucial to the private sector’s attempts to create its own new sources of clean power. What is clear is that the economy desperately needs change. Companies want reliable and cheap sources of power because without it, they and the economy simply cannot grow.

Footnotes

1. https://www.iea.org/countries/south-africa
2. https://www.iea.org/countries/south-africa
3. https://www.ft.com/content/ed8887a4-21b2-44db-9a67-bc6801c06a70
4. https://businesstech.co.za/news/energy/662515/stage-6-load-shedding-costs-south-africa-r900-million-a-day-sarb/

Content Disclaimer
This content was originally published by Allen & Overy before the A&O Shearman merger