South African Institute of Race Relations NPC

Submission to the Office of the Chief Procurement Officer, National Treasury, regarding the draft, Preferential Procurement Regulations, 2016, Johannesburg, 15^th July 2016

SYNOPSIS

Introduction

The National Treasury (the Treasury) has invited public comment on the draft Preferential Procurement Regulations of 2016 (the regulations). These regulations were published in the Government Gazette on 14^th June 2016, under the powers conferred on the Treasury by the Preferential Procurement Policy Framework Act of 2000 (the Act).

Public comment is due not later than 15^th July 2016. However, this period is too short to meet the constitutional requirement for proper public consultation.

This submission is made by the South African Institute of Race Relations NPC (IRR), a non-profit organisation formed in 1929 to oppose racial discrimination and promote racial goodwill. Its current objects are to promote democracy, human rights, development, and reconciliation between the peoples of South Africa.

The urgent need to increase opportunities for the disadvantaged

Some 22 years after the political transition in 1994, it remains vitally important to increase opportunities for the poor and unemployed: the truly disadvantaged in the country. This cannot be done without overcoming key barriers to upward mobility, which include:

- a meagre economic growth rate, now less than 1% of gross domestic product (GDP) a year instead of the 6% or more required;

- one of the worst public education systems in the world, despite the massive tax revenues allocated to it;

- stubbornly high unemployment rates on a broad definition (35% among South Africans in general and 67% among young people), made worse by labour laws that encourage violent strikes, deter job creation, and price the unskilled out of work;

- pervasive family breakdown, as a result of which some 70% of black children grow up without the support and guidance of both parents;

- electricity shortages and costs, compounded by general government inefficiency in the management and maintenance of vital economic and social infrastructure;

- a limited and struggling small business sector, unable to thrive in an environment of low growth, poor skills, and suffocating red tape; and

- a mistaken reliance on affirmative action measures, which (like similar policies all around the world) generally benefit a relative elite while bypassing the poor.

Constantly ratcheting up black economic empowerment (BEE) and other “transformation” policies, as the African National Congress (ANC) has been doing in recent years, will not help to overcome these problems. On the contrary, any further erosion of property rights and business autonomy will raise these barriers still higher. So too will any further exclusion of scarce skills and established business experience from the already floundering economy.

The often negative impact of existing preferential procurement rules

BEE preferential procurement in state tenders has often made for enormous wastefulness. Finance minister Pravin Gordhan lamented this in 2010, when he said that the government was paying more for everything, from pencils to building materials, than a private business would: “R40 million for a school that should have cost R15m, R26 for a loaf of bread that should have cost R7.”

In 2012 Gwede Mantashe, secretary general of the ANC, voiced a similar concern, saying that BEE companies must “stop using the state as their cash cow by providing poor quality goods at inflated prices”. He also criticised officials for “prioritising the enrichment of BEE companies through public contracts at the expense of…quality services at affordable prices”.

Later the same year, Mr Mantashe warned that the state would be ill advised to continue putting preferential procurement before service delivery. Said the ANC secretary general: “This thing of having a bottle of water that you can get for R7 procured by the government for R27 because you want to create a middle-class person who must have a business is not on. It must stop.”

The examples cited by both Mr Gordhan and Mr Mantashe involve contract prices roughly four times greater than market ones. Yet these examples arose under the current preferential procurement rules, under which BEE weightings are supposed to be very much smaller.

Under the Preferential Procurement Policy Framework Act of 2000 (the Act), a 90:10 formula applies to tenders worth more than a specified threshold (currently R1m). According to this formula, 90 points are allocated on price and 10 points for the BEE status of the tendering firm. This means that BEE firms can charge 10% more than others and still be awarded a contract. Under the current rules, a 80:20 formula applies to contracts below the specified threshold, so allowing BEE firms to charge 20% more and still win the tender. However, these authorised BEE weightings, of either 10% or 20%, have often failed to prevent the much higher price escalations cited by Mr Gordhan and by Mr Mantashe.

Once the threshold for the 80:20 formula is raised to R100m, as the regulations envisage, the scope for price escalation will greatly expand. This may bring additional benefits to a relatively small group of BEE business people, but it will also impose great costs on poor South Africans dependent on the government for vital goods and services. For the more the government spends on preferential tenders, the less revenue it will have left over to spend on service delivery elsewhere.

Content of the regulations

An almost 10 000% increase in a key threshold

As earlier noted, the Act authorises a 10% BEE weighting for contracts above a certain threshold and a 20% BEE weighting for contracts below that threshold. That threshold was initially set at R500 000, which limited the number of state contracts to which the 20% preference would apply. That threshold was doubled to R1m in 2011, which was itself a major change.

Under the regulations, the threshold is now to be increased a hundred-fold, or by 9 900%, so as to raise it from R1m to R100m. This means that a 20% BEE preference will apply to virtually all state procurement contracts worth less than R100m. A 10% BEE preference will apply to contracts valued above R100m. [Clause 5, Regulations] This will vastly increase the number of government contracts in which BEE firms will be able to charge 20% more and still be awarded the tenders. Based on previous experience, actual price escalations will often be significantly higher than this.

Local content requirements

According to the regulations, minimum local production and content requirements will apply wherever the Treasury has “designated” a sector for interventions of this kind. [Clause 9, regulations] In such sectors, any invitation to tender will have to be made subject to “a specific condition that only locally produced [or] manufactured goods, meeting the stipulated minimum threshold for local production and content, will be considered”. [Clause 9, regulations]

The Department of Trade and Industry (DTI) has already designated various sectors as ones in which local procurement is obligatory. These include buses, rail rolling stock, steel power pylons, electrical and telecommunications cables, and components for solar water heaters, along with canned vegetables, clothing, and footwear. Often the minimum local content required in these spheres ranges from 70% to 90%, and sometimes it goes as high as 100%. [DTI sectors and minimum thresholds for local content, 7 December 2011]

According to the DTI, the aim of these requirements is to boost the manufacturing sector and counter the de-industrialisation of South Africa. However, the department has yet to acknowledge how much the government itself has undermined the competitiveness of domestic manufacturing through its coercive labour laws and unrealistic BEE requirements, along with its failures to improve education, curb crime, or expand essential infrastructure quickly enough.

The DTI’s “solution” has simply added to the bureaucratic burden of doing business in the country. It is also likely to increase procurement costs where imported goods are cheaper or better than locally made ones. Now this flawed “quick fix” is to be applied by the Treasury as well, without the government’s making any attempt to overcome the most important barriers to the success of the manufacturing sector.

No obligation to consider “functionality”

The regulations define “functionality” as meaning “the ability of a tenderer to provide goods or services in accordance with specifications set out in the tender documents”. [Clause 1, Regulations] A tenderer which cannot comply with such basic requirements should not, of course, be considered for any state contract at all. Worryingly, however, the regulations do not require that tenderers be evaluated for functionality. Instead, they make it clear that organs of state may choose whether to embark on such an evaluation or not.

According to the regulations, “if” an organ of state decides to evaluate a tender on functionality, then it must do so on the basis of “objective” evaluation criteria that are clearly specified in the invitation to bid. [Clause 4, Regulations] However, as this conditional wording makes clear, there is no obligation on any organ of state to include an evaluation of functionality in any tender, no matter how big the price or how important the project may be.

Sub-contracts for BEE firms

According to the regulations, a “a minimum of 30% of the value of the contract” may have to be sub-contracted to small black firms (with annual turnover below R50m) in three sets of circumstances:

- where a tender includes this requirement as an “objective criterion”, in which case the tenderer may be awarded the contract even if it does not score the highest points on price and BEE status; [Clause 7, Regulations]

- where a tender includes this requirement as a “pre-qualifying criterion”, which will bar any tenderer failing to sub-contract in this way from being considered for the contract at all; [Clause 10, Regulations] and

- where the value of the contract exceeds R30m. [Clause 13, Regulations]

These provisions will greatly increase the scope for uncompetitive tender awards – especially as the 30% sub-contracting requirement is a “minimum” which may in practice be significantly exceeded. A tender could thus stipulate, for example, that 90% of the value of the contract must be sub-contracted to small black businesses, which might in fact have only a limited capacity to produce the required goods and services at cost-effective prices.

In addition, as noted above, where a sub-contracting requirement is included as an “objective” criterion, a tenderer will be able to win the contract even if it does not score the highest number of points on price and BEE status. This will further encourage wastefulness and undermine efficiency in state procurement.

‘Objective criteria’ defined in other ways as well

The regulations also define “objective criteria” in other ways. This is particularly important because, where objective criteria are stipulated in invitations to tender, contracts may be awarded to firms that have failed to score the highest points on price and BEE status.

According to the regulations, objective criteria may include “economic and financial projections regarding the capacity of the tenderer to deliver on the required goods and services”. [Clause 7(3)(b), Regulations] What this clause means – and how it would be applied in practice – is entirely unclear.

Under the regulations, objective criteria may also include: [Clause 7(3)(c) and (d), Regulations]

- “a quantity surveyor’s projection as to the time it is likely to take to complete an infrastructure project”; and

- “the anticipated lead-time to deliver the required goods or services”.

These criteria are easier to understand, but their salience is questionable. Why should a contract – say, for the construction of a new dug-out port in Durban – be awarded to a tenderer who has failed to muster the highest points (on price and BEE status) simply because “the anticipated lead-time to deliver the required goods and services” has been inserted into the invitation to bid as an “objective criterion”?

Other pre-qualification criteria

According to the regulations, other pre-qualification criteria may also be laid down. These may include, for example, “a stipulated B-BBEE status level as a contributor”. [Clause 10(1)(a), Regulations] An organ of state will thus be able to specify that it will contract solely with firms having a “level of BEE recognition” standing at “level 1” (which requires more than 100 points on the BEE scorecard), or “level 2” (which requires 95 to 100 points).

If such onerous requirements are imposed as pre-qualification criteria, this would exclude many of the country’s largest and most experienced firms – including almost all of the top 100 companies listed on the JSE – from bidding for state contracts at all. [2016 South Africa Survey, IRR, Johannesburg, 2016, pp350-353]

Since the examples provided by the regulations are not exclusive, other pre-qualification criteria could also be introduced. These could include a demand that firms must have 51% or more black ownership. (This is not an idle possibility, for Eskom already insists on 51% black ownership for its coal suppliers, even though the mining charter lays down a 26% BEE ownership requirement.)

If 51% BEE ownership is indeed identified by an organ of state as a “pre-qualifying” criterion, then a tender from a firm with BEE ownership at a level less than this would not qualify for consideration at all, irrespective of how cost-effective that tender might be. That the firm in question had met the 25% BEE ownership requirement laid down in the generic codes (or the varying ownership targets laid down in other sector codes) would also be irrelevant.

Unconstitutionality of the regulations

Section 217 of the Constitution states that, “when an organ of state…contracts for goods or services, it must do so in accordance with a system which is fair, equitable, transparent, competitive, and cost-effective”. As an exception to this general rule, the Constitution allows an organ of state to implement a procurement policy that provides for “categories of preference in the award of contracts”, and for “the protection or advancement of persons…disadvantaged by unfair discrimination”. [Section 217 (1) and (2), Constitution]

However, any measure aimed at “protecting” or “advancing” the unfairly disadvantaged must be rationally and reasonably connected to that objective. The regulations do not meet these tests. They will, of course, allow a relatively small number of black businesses to gain state tenders at inflated prices and irrespective of how inefficient they might be.

However, in allowing this, the new rules will greatly prejudice the great majority of disadvantaged South Africans, who depend on the state for vital goods and services. Such goods and services should always be provided in the most cost-effective and efficient way, so as to husband scarce public resources and ensure that these are spread as broadly as possible. The proposed new system is so damaging to the truly disadvantaged that it cannot be accepted as a rational or reasonable way of overcoming apartheid injustices.

The regulations also contradict another core principle underpinning the Constitution: the separation of powers. The Constitution vests the capacity to make new law in parliament, not the executive. But executive law-making inconsistent with the Constitution is the hallmark of these regulations, which (among other things):

- raise the threshold below which the 80:20 formula applies by close on 10 000%, from R1m to R100m;

- introduce mandatory local content requirements in all sectors designated by the Treasury;

- demand that between 30% and 100% of all contracts above R30m be sub-contracted to small black-owned firms;

- introduce similar sub-contracting requirements in a host of other spheres, and

- allow very many organs of state to set pre-qualification criteria – including a possible 51% BEE ownership requirement – in all the tenders they issue.

The regulations seek to bring about radical changes in the state’s preferential procurement system. At present, all that the Act allows is a 10% or 20% price advantage – for contracts worth more or less than R1m – for the historically disadvantaged. Major changes of the kind envisaged in the regulations cannot be made by ministerial fiat without infringing on the separation of powers. Hence, if the state’s preferential procurement rules are to be changed so comprehensively, this must be done via statute, not subordinate regulation.

No socio-economic impact assessment conducted

Since 1^st September 2015 (as President Jacob Zuma told the World Economic Forum in Davos in January 2016) all legislation and regulation must be subjected to a “socio-economic impact assessment” before it is adopted. This must be done in terms of the Guidelines for the Socio-Economic Impact Assessment System (SEIAS) developed by the Department of Planning, Monitoring, and Evaluation in May 2015. The aim of this new system is to ensure that ‘the full costs of regulations and especially the impact on the economy” are fully understood before new rules are introduced. [SEIAS Guidelines, p3, May 2015]

The Guidelines deal specifically with proposed new rules that aim to ‘achieve a more equitable and inclusive society”, but which “inevitably impose some burdens on those who benefited from the pre-existing laws and structures”. The document notes that “relatively small sacrifices on the part [of past beneficiaries] can lead to a significant improvement in the conditions of the majority”. However, “the challenge is to identify when the burdens of change loom so large that they could lead to excessive costs to society, for instance through disinvestment by business or a loss of skills to emigration”. [Guidelines, p11] It is precisely such major economic risks that the regulations raise.

According to the Guidelines, SEIAS must be applied at various stages in the policy process. Once new regulations (or other rules) have been proposed, “an initial assessment” must be conducted to identify different “options for addressing the problem” and making “a rough evaluation” of their respective costs and benefits. Thereafter, “appropriate consultation” is needed, along with “a continual review of the impact assessment as the proposals evolve”. [Guidelines, p7]

A “final impact assessment” must then be developed that “provides a detailed evaluation of the likely effects of the [regulation] in terms of implementation and compliance costs as well as the anticipated outcome”. When the regulation is published “for public comment and consultation with stakeholders”, the final assessment must be attached to it. Both the draft regulation and the final assessment must then be revised as required, based on the comments obtained from the public and other stakeholders. Thereafter, when the draft regulation is submitted for approval (in this case to the minister of finance), the final assessment, as thus amended, must be attached to it. [Guidelines, p7]

However, no SEIAS assessment of the regulations has been made available, as the Guidelines require. The regulations thus cannot be approved by the minister until all the relevant steps have been taken.

Socio-economic ramifications of the regulations

The regulations will have many damaging socio-economic ramifications. They will further encourage inflated pricing in virtually all state procurement. They will introduce mandatory local content requirements, which will push up costs still more whenever imported products are cheaper and better. They will require or promote the sub-contracting of between 30% and 100% of state contracts to black firms with limited experience and capacity. They could also push many of the most experienced companies right out of state procurement – especially if pre-qualification criteria are used to require 51% BEE ownership or high levels of BEE compliance which the new generic (and sector) codes make difficult to attain.

Any insistence on 51% BEE ownership as a pre-qualification criterion will be particularly damaging, as the costs of compliance will be high and the damage to investor confidence enormous. The mere possibility of this is particularly worrying when foreign direct investment (FDI) into South Africa has already dropped to its lowest level in ten years (according to the United Nations Conference on Trade and Development’s World Investment Report for 2016). [News24 13 July 2016]

If FDI diminishes still further, then economic growth – which is already unlikely to exceed 0.1% of GDP in 2016, according to the International Monetary Fund – could well turn negative, pushing South Africa into a damaging recession and increasing the risk of its international credit ratings being downgraded to sub-investment or “junk” status.

Mr Gordhan is already under great pressure to stave off damaging downgrades of this kind. If this is to be achieved, as international ratings agencies have made clear, the government must take effective measures to hold public spending in check. It must also implement reforms to ramp up economic growth. The regulations will put both these key requirements at risk.

Raising the growth rate critically depends on the government’s success in boosting business confidence and implementing key reforms. This in turns means that the regulatory shackles weighing on the private sector must be reduced, not made heavier still. Hence, instead of constantly increasing the BEE burden, it is time for the Treasury (and all other government departments) to call a halt.

When the ANC urged the introduction of BEE in 1994, it said this was aimed at ‘removing all the obstacles to the development of black entrepreneurial capacity and ‘unleashing the full potential of all South Africans to contribute to wealth creation’. BEE was never supposed to put a stranglehold on the economy, exclude the most experienced companies from participating in state procurement, or threaten property rights. Nor was it intended to keep ever more South Africans mired in poverty for the benefit of a relatively small and politically connected elite.

In addition, what “black” business most needs for increased success is not the damaging set-asides mooted in the regulations but rather a rapid rate of economic growth (ideally, 7% of GDP a year). This would see the economy doubling in size every ten years. This in turn would generate millions more jobs, and vastly increase domestic consumer demand.

At the same time, the quality of schooling must be greatly improved. Some 80% of public schools are dysfunctional, while roughly half the pupils who start school in Grade 1 drop out without ever reaching Grade 12. Mainly because their schooling has left them so poorly prepared, only 20% of the black South Africans who manage to enroll at universities are able to graduate in regulation time, while 40% drop out and never graduate at all.

The often dismal public education system, coupled with the country’s unemployment crisis, puts black entrepreneurs at a particular disadvantage. As research by the FinMark Trust has shown, the people most likely to succeed in business are those who come from stable two-parent families, have the benefit of solid schooling, obtain university degrees, work for a number of years in existing firms, have a strong entrepreneurial spirit – and branch out on their own when they already significant skills and experience on which to draw. If such entrepreneurs are to build up their businesses, they must also have the benefit of a rapidly expanding economy with low unemployment rates and growing consumer markets.

This is a proven formula for success. In South Africa, however, only 30% of black youngsters grow up in two-parent homes, while the great majority attend dysfunctional public schools which often fail to equip them even with the most basic skills. Not surprisingly, many then battle to find jobs. This is partly because South Africa’s growth rate has long been too low. Also relevant, however, are labour laws which raise entry level wages so high as to price the poorly skilled and inexperienced out of the jobs market.

These factors – coupled with a crippling burden of red tape, high crime rates, often poor infrastructure, and limited access to venture capital – combine to put black entrepreneurs at a severe disadvantage. These fundamental obstacles to their success cannot be overcome through a simplistic reliance on preferential state procurement. Moreover, what the regulations propose is particularly damaging as it will clearly inflate prices, erode quality, reduce growth, and decrease jobs – all of which will leave the truly disadvantaged even worse off than before. Such outcomes will also widen inequality and undermine social cohesion.

The regulations contradict at least three of the country’s four national priorities, as set out in the SEIAS Guidelines. These are “social cohesion, economic inclusion, and economic growth”. (The fourth priority, of environmental sustainability, is likely to be put at risk as well as poorer countries have less capacity to address environmental challenges.)

The regulations should thus be abandoned in favour of far more effective ways of promoting inclusive growth, stimulating job creation, and empowering the disadvantaged.

A new system of “economic empowerment for the disadvantaged”

Instead of adopting the regulations (and otherwise ratcheting up BEE requirements), the country needs to embrace a new system of “economic empowerment for the disadvantaged” or “EED”.

EED differs from BEE in two key ways. First, it no longer uses race as a proxy for disadvantage. Instead, it cuts to the heart of the matter by focusing directly on disadvantage and using income and other indicators of socio-economic status to identify those most in need of help. This allows racial classification and racial preferences to fall away, instead of becoming permanent features of policy. This in turn will reduce racial awareness and potential racial polarisation, helping South Africa to attain and uphold the principle of ‘non-racialism’ embedded in the Constitution.

Second, EED focuses not on outputs in the form of numerical quotas, but rather on providing the inputs necessary to empower poor people. Far from overlooking the key barriers to upward mobility, it seeks to overcome these by focusing on all the right ‘Es’. In essence, it aims at rapid economic growth, excellent education, very much more employment, and the promotion of vibrant and successful entrepreneurship. It also seeks to empower the disadvantaged in concrete ways by giving them access to state-funded education, health care, and housing vouchers, which will immediately help them meet these key needs within a competitive and cost-effective environment.

After decades of damaging BEE policies, it is time to call a halt. South Africa cannot hope to expand opportunities for the disadvantaged unless it raises the annual growth rate to 6% of GDP or more. A shift to EED will help achieve this. By contrast, the regulations (and other stepped up BEE policies) are likely to push the economy into persistent and destructive recession.

In a speech earlier this year, the deputy president, Cyril Ramaphosa, said that the government is “obsessed with empowering black South Africans” and is sometimes “fanatical” about it. If that is so, the ruling party cannot do better than endorse the EED idea. Unlike the regulations and other BEE policies, EED will be effective in empowering the many – and in putting the country on the path to inclusive growth and rising prosperity for all.

South African Institute of Race Relations (NPC)

15^th July 2016