Construction Industry in South Africa 2010

Ivan Diaz 16360613

phi.designer@gmail.com Cell: 0826529423

Subject: Economics for Managers Number of pages: 10 pages

Due date: 23th of August of 2010 Group: MBA Modular E1 2010 Lecturer: Prof Andr Roux Research, Report, Template

Office use only: Date received:

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iii Table of contents

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INTRODUCTION THE CONSTRUCTION INDUSTRY IN SOUTH AFRICA THE INDUSTRY CHALLENGES AND POLICIES Barriers to entry the market BEE policy implementation Industry lack of skills Sustainable development CONCLUSION REFERENCES

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iv List of tables Figure 3.1: DBSAS consolidated capital cost FIFA 2010 stadiums. 4

1 1 INTRODUCTION

It might be still quite soon to assess the overall impact and benefits that, as a nation, South Africa will retain by having successfully hosted the 2010 FIFA World Cup TM, but what is indisputable, is the fact that the works delivered by the construction industry were remarkably impressive, under international standards, and these will remain as landmarks for the collective memory, as a reminder of the capacity of South African people is capable of doing when striving to achieve a common goal. According to the Organization for Economic Cooperation and Development, [OECD](2010) the national economy has started to show signs of positive growth as consumer expending has resumed; the global environment starts to show less harsh economical conditions; trade volumes begin to pick up, and output of capital investment goods is expected to growth after 2010. Together with these signs of arousing economical performance, the construction industry in South Africa seems to finally rose from many years of sluggish growth, and from a sectorial perspective, is starting to over perform the manufacturing and mining industry. The booming in the construction industry triggered, both directly and indirectly, by this event was not limited to South Africa but extended thought to the region. Materialized in huge communication projects such as the submarine optic fiber cable connecting the African continent to India, the Middle East, Europe and Brazil, as well as infrastructure investment in the neighbor countries; as was the case of Mozambique who invested heavily on rehabilitation of railway and general roadwork network, resulting not only in improved interregional trade capacity but also in a wide range of employment and market opportunities (Government preparation 2010) Both, the momentum created by the large governmental and private investment for the 2010 World Cup event, and the strong macro-economic policy framework that has characterized South African fiscal policy for the last two decades, allowed the country to cope relatively well with the global economical meltdown. Nevertheless, it was not with out highlighting the significant unemployment issues and the critical need to maintain a policy that ensures sustainable growth and creates enough incentives to attract investment in labor-intensive projects with a superior managerial perspective.

2 2 THE CONSTRUCTION INDUSTRY IN SOUTH AFRICA

In a developing country such as South Africa, the construction industry plays a major role as a mechanism to reduce poverty and unemployment levels. According to the OECD (2008) this sector accounts for about 3.8 per cent of the national GDP and employing nearly 750,000 people, this industry is the third major employer sector in the country, and is the fourth employer of workers with no formal education, after agriculture, household and mining. Therefore the responsibility the construction industry bears is great, from delivering projects and services that are sustainable in the largest sense to creating innovative solutions that are fit-for-purpose and economically viable to operate, adding, as a result, value to all stakeholders. Preceding 2010, in a pursuit to develop the construction industry in South Africa, the government established a fiscal strategy of infrastructure investment that included under its scope: rail freight services enhancement, energy supply increase, communication infrastructure upgrading, transportation capacity improvement, airport capacity enlargement, and different refurbishing works together with new construction projects for the sporting venue facilities to host the Soccer World Cup event. All of this, according to the Government Communication and Information System [GCIS](2010), with the purpose to contribute R 51,1 billion to the countries GDP, create more than 80.000 jobs in the hospitality industry, and a further 116.000 in the construction industry. Great effort was put into expanding the transportation infrastructure, which included the expansion of the International airports of Johannesburg and Cape town, the construction of a green field airport project in Durban and the expansion and refurbishing of other seven domestic terminals. The network of roads and railways required to make the connections to these buildings more efficient, also generated a further thrust in the inflow of capital invested for projects such as the Gautrain speed train and the enhancement of several major highways across the country. The tourist and hospitality sector were also greatly benefited from the thriving industry and inherited several four and five start hotels all across the country, numerous resorts and casinos were approved for construction, as well as several projects to improve connectivity between Cape Town, Namibia and the Kruger National Park to maximize business opportunities (GCIS 2010). The development of this sector is projected to accelerate, but the macro-economical policy of large fiscal stimulus may still be required, for at least, until the private sector recovers strongly enough to keep up with the expected growth trend, given that, the civil sector is by nature highly dependent on government spending and any decline of this type of incentives will have a great impact on the employment and growth performance levels. Nevertheless, this fiscal stimulus its starting to raise concerns upon private investors, since evidence of inflated costs and speculative prices of construction materials and services, has been

3 driven by the increased demand generated by government spending, negatively affecting the intended growth, due to the fact that, the private sector is not able to compete with purchasing power against the government, and the increased production cost goes directly in detriment of its expected return margins. On top of that, the office, retail and commercial sub-sector are also beginning to show evidence of saturation of space supply (BOUTEK 2004), which can translate into a slow decrease on demand from the other sectors of the economy. It is important to mention, that the relatively good performance of the market has not rely only in the huge concentration of effort from the government to spur the economical development via the construction industry through out the 2010 scenario, but a key roll to prevent the economy from collapsing was played by the conservative fiscal policies and the strong performance of the financial sector, based on diverse circumstances such as the low levels of bad debt loan, the South African banks strong historical profitability and the low direct exposure to the troubled assets from US and EU (OECD 2010). 3 3.1 THE INDUSTRY CHALLENGES Barriers to entry the market

Due to the legislated bidding process to award construction contracts, and the relatively short length of time of the projects, the construction industry is characterized by a transitory market concentration, which unintentionally creates in this way, a dynamic in which a couple of large wellestablished construction firms, due to their specific accumulated expertise, are the only ones capable to bid for particularly important size projects (OECD 2008). This ends up driving the market into a high level of concentration, relegating small companies to seek profit or sustain their business from a marginal outskirt of the mainstream market. Vertical backward integration practices also characterize this market, where a handful of large companies dominate the entire production chain and services supply, from the extraction of construction materials to all sorts of sub-sectors created at the other end of the construction process; making even more difficult for new, small or foreign companies to enter and compete in the market and increasing on the other hand the possibility of synchronized behavior inside the long production process as it facilitates information sharing. (OECD 2008) The size and complexity of the infrastructure required by the nation, further promotes the concentration of the market, by demanding from the contractors to create joint ventures as a mechanism to allow them to reduce the risk involved and effectively tackle the complexity of these projects. However, according to the findings of a study prepared by the OECD-Policy Roundtables, (2008), this mechanism is rather most often used by the large well-established contractors and not by the easily presumed small companies who could very well take advantage of such venture

4 strategies to joint efforts and better compete in the market. As a result, the combination of the nature of the business, the size of the projects demanded and the fiscal regulations to adjudicate contracts combined, facilitate the creation of cartels, which promote the manipulation of prices, market allocation and collusive conducts, and in many instances abuse their inference on the market by limiting the supply of materials, arranging exclusive deals or practicing exclusionary practices to guarantee their privileged position in the market. A relevant example, currently under investigation by the Development Bank of South Africa [DBSA] (2006) (cited in OECD 2008, p. 147), is the total cost of building the 2010 FIFA World Cup stadiums and how it dramatically increased from the initial budget estimated in 2003 and the requested budget on 2006. Differences in costs are shown in Table 1. Even when this increase can be attributed to the size and complexity of the venues designed, and the fact that these were planned as permanent structures instead of temporary ones, there is a general concern about the large variability in the construction cost. Table 3.1: DBSAS consolidated capital cost for the construction and refurbishment of FIFA 2010 stadiums

Source: OECD, Policy Roundtables - Construction Industry, 2008: 147. If part of the increase cost were effectively attributable to the onerous design of the venues, one would have to consider the fact that many of the primary design features are set before any accurate cost analysis is concluded. Accordingly, given that more often than not, the scope of work is drastically reduced, with the reciprocal diminishing of the consultants marginal profits, design teams are often disinclined to redesign and readjust the main design parameters, fueling a cycle in which, due to the narrow marginal profits, the consulting companies cant afford to invest in improved tools and innovative integrated procedures, which would make the design process much more accurate and cost effective.

5 3.2 BEE policy implementation

Like all affirmative action policies implemented around the world, BEE seeks to regulate the allocation of scarce opportunities in many areas including: education, employment, or business in order to increase the representation of persons belonging to certain groups which were previously unfairly excluded Fryer and Loury (cited in Khatletli 2008, p. 285). Ironically, in this industry, the delivery is expected to come from the well-established historically white-owned companies, which due to the barriers of entry mentioned before, are virtually the only ones capable to provide relevant expertise and training, which is projected to be transferred to the emerging black contractors as part of the BEE policy (Khatletli 2008). The governmental strategy is to increase black participation through policies and regulations that stimulate the creation of joint ventures between large firms and small contractors, putting pressure on the larger company to formalize the contract in a way that allows and secures participation of previously disadvantage people. Unfortunately, the industry has not been able to transfer this expertise and set of skills at the pace demanded, almost certainly because of the way contracts get structured, given that management power and enterprise knowledge is not properly and equally shared between all members of the venture. Under this scheme, the responsibility of success on the intended training and skills transfer is delegated to the main contractor, which works as an agent on behalf of the regulator. Of course this scenario, is not risk free, and many times derives into a deteriorated distortion of the genuine beneficiaries expected from the intended policy, and through different mechanism only a superficial inclusion of black participation is actually executed in the contract (Khatletti 2008). It is of course, particularly difficult for the government to monitor and assess the actual implementation of this scheme on all contracts and verify that the main contractor is acting in a well-intended manner. This is worsened by the fact that, the larger company has advantage on the level of information in the way the contract is being executed, and not in all cases its interests are in line with the policys objectives, which are based in the theory that the main contractor, acting in self interest, would look after the higher positive impact in the long run, by investing in the transferring of skills, knowledge and technology to its subcontractors and partners, and not on a short narrowed vision, where this transfer is not executed. In many cases, complex ingenious contractual structures are designed, so that in paper, the structure of the contract and the unfolding of the responsibilities between the main contractor and the required sub-contracting firms comply with BEE policies. Nevertheless, what is actually happening under the table is a set of decisions that guarantee that the well-established firm is in reality receiving full profits from the agreement and maintains full control of the operation, either by internal arrangements or by relying on third-parties fully managed or owned by the well-established

6 companies. In this way, the small firm will never gain the required expertise or play a significant role in the development of the project, limiting its responsibilities to peripheral functions, depending on the technical and operational know how of the main contractor. 3.3 Industry lack of skills

The construction environment in South Africa is not currently booming, but there is still a vast demand for infrastructure development, the economy has performed in a relatively stable way during the last few years and there has been a general increasing investment trend. The Achilles heel of the industry is the shortage of highly skilled labour to proficiently supply these needs. Unfortunately, the industry has historically faced a huge shortage of specialized skills, which together with periods of prolonged periods of low industry demand and unattractive wages in the local sector have also had a major impact, forcing many knowledgeable professionals to leave the sector in search of better opportunities elsewhere (BOUTEK 2004). While larger contractors can afford to sponsor professional training for their personnel in exchange for contractual commitment to their company, the limited number of projects and the high market concentration, does not facilitate the retention of experienced labor nor does it allow the opportunity for inexperienced professionals in the smaller firms to achieve the necessary expertise. Small firms, face the challenge of the high levels of expertise and diverse assortment of skills required to successfully compete in the local, regional and global markets. Not only do the smaller players lack this skilled labour but also find it harder to attract it, rendering the firm unable to race against the big well-established companies, while they lack the qualifications to comply with the regulatory requirements to tender for contracts in the mainstream market, missing the capability required to develop and improve on their working skills and accumulate knowledgeable experience. The diverse group of professionals required in this sector to supply strategic solutions to the market needs, renders it as one of the most important employers in the entire industry. This segment requires consultants capable to transform those requirements into workable and efficient infrastructures and buildings; demands individuals able to create innovative projects that respect and give sustainable use of the natural, human, technological and economical resources; prepare tender proposals and plan their execution; produce conscious risk assessment analysis; administrate and manage construction activities; develop efficient and sustainable operation and maintenance plans (BOUTEK 2004), whilst generating value to all stakeholders. Therefore, a dynamic and diverse group of professionals is a crucial condition to deliver the required supporting infrastructures of an industry capable to compete and adjust to the rapid changes and challenges of the local environment and the ever-growing influence of the global

7 market, providing sustainable development and economical national growth. 3.4 Sustainable development

Even though, the South African government is not only committed to comply with its sustainable development goals, but has shown leadership within the region in the attentiveness to align its immediate developing needs without compromising those of future generation, as any other developing country, global issues such as climate change are not yet a priority in the government agenda, and little or no tangible action has yet materialized on regulations to put a price on carbon footprint or stimulate the industry to make higher use of renewable resources and improve their production process. Developing countries face immediate critical challenges such as unemployment, vast inequity issues, large poverty levels and high crime rates. For this reason, the challenge for these countries is to find a progressive and congruent coherence between the internal short-term priorities and the global long term ones. Regulations influence this context in a complex dynamic way, by inducing a battle of interests between immediate remediation and the long-term sustainable growth. Moreover even when policies and international agreements have been established, much of the implementation and efforts required to put all of this in practice, remains short of achievement and real tangible results. Being South Africa, the most industrialized country in the whole continent, it is also the single largest contributor of green house gases, mainly because of the dependency of its industry on energy derived from coal burning (OECD 2010). This is a critical competitive handicap, and while the government searches for incentives to maintain a sustainable growth and attract foreign investment to the industrial sector, the primary reliance of energy from this unsustainable resource needs to be evaluated against the impact on the long-term impact. The construction industry plays and important role in tackling down this issue, since, the energy required for producing and transporting materials to construction sites, and the energy consumption during the construction, operation and maintenance of buildings makes up to nearly half of the total green house emission in a years time. This complex activity consumes vast quantities of non-renewable resources; produces large volumes of air and water pollution, generates waste of non-recyclable or costly to recycle material, and high levels of contaminants, whilst transforming and changing entire ecosystems and human environments.

8 4 CONCLUSION

The construction industry plays an unquestionable vital function in the South African economy. It is the sector responsible for engineering a vast number of complex buildings and interconnected systems that provide the infrastructure required for the sustainable development of the nation and the region as a whole. Its activity, greatly impacts the entire ecosystem and the communities it serves, bringing progress, equity, public services, enhancement in life quality and opportunities for growth. There are however, a large number of challenges facing the successful growth and development of the industry in the country. A great effort from all stakeholders still needs to be undertaken to properly align all different interests and tackle critical issues such as the environmental impact, human development, training and education, knowledge and expertise transfer and improvement in the quality of the services delivered by this sector. The effort entails an integrated holistic approach to deliver products and services under a long-term sustainable perspective. On the environmental side, the relatively cheap electricity prices tend to be seen as an element that subsidizes the lack of efficiency and energy waste, increasing the carbon emission component since no concrete incentives or penalties exist. As a result, the market shows little interest to seek innovative solutions aiming to achieve a significant improvement in the construction process and operation of the buildings. Policies that encourage efforts to decrease the dependency on cheap coal burning should be reinforced and the exploration process to uncover alternative sources spurt, given that South Africa is not only a large emitter already, but will eventually lag behind as a competitive industrial country in the global market. Measures such as eliminating the energy subsidies for some industrial sectors, introduce carbon tax and carbon capture mechanisms, amongst others, would not only have long term beneficial results on the environment and population well being, but will boost innovative initiatives, force productivity measures and increase industrial development, while opening new business and market opportunities for a new born industry that circles around these issues, striving to enhance human skills, economical sustainability, procure for equality and give good use to the environment. On the other hand, the construction industry, with its centralized outline and strong established entry barriers, does not allow for competitive growth and does not stimulate investment on innovation. The regulator should generate incentives for the industry to decrease these barriers to entry the market and broader the opportunities and boost competitiveness, increase reliance on new renewable raw construction materials, and fortify a framework in which the revenues created are fairly distributed and managed in a more responsible way. Due to the complexity and the extent of these problems at various human and economical

9 dimensions, most certainly, the macro-economical policies will have to target the challenges as a whole, since these are all interconnected issues that interact, counter balance and affect one another, they must be dealt with taking in consideration both the short and the long term balance. This will serve to ensure immediate relief to current critical issues while keeping in line with a broader perspective for sustainable growth and be directed towards employment creation, labour and environmental standards improvement, private and public interests alignment and create mechanisms to improve technical and expertise transfer.

10 REFERENCE CSIR (BOUTEK). 2004. A Review of the South African Construction Industry, Part 3: The Built Environment Professions. March. [Online] Available: http://www.buildnet.co.za/akani/2004/02.html Accessed: 3 August 2010. Ferreira, PM. 2008. Global Players in Africa: Is there scope for an EU-China-Africa partnership? July. [Online] Available: http://www.ieei.pt/files/6PMFerreira.pdf Accessed: 2 August 2010. Government of the Republic of South Africa. 2010. South Africa 2010, Government preparation. [Brochure]. Government Communication and Information System (GCIS) Khatletli, N., Root, D. 2008. Managing pre-contractual and post-contractual opportunism in BEE delivery in PPPs. [Online] Available: http://www.grif.umontreal.ca/pages/conferencegrif08/25Khatleli.pdf Accessed: 4 August 2010. OECD. 2008. Competition in the construction Industry. December. [Online] Available: http://www.oecd.org/competition/roundtables Accessed: 3 August 2010. OECD. 2010. OECD Economic Surveys: South Africa. July. [Online] Available: http://www.oecd.org/document/21/0,3343,en_2649_33733_45637781_1_1_1_1,00.html Accessed: 2 August 2010. (*) Books consulted as background and general information not cited, paraphrased or quoted: Hawkins, P., Lockwood, K. 2001. A strategy for attracting foreign direct investment. September. [Online] Available: http://www.essa.org.za/download/papers/001.pdf Accessed: 2 August 2010. Stakeholder Forum. 2010. International Governance for Sustainable Development and Rio+20. London: 3 Bloomsbury Place. Semakula, K. 2008. Best practices in promoting investment for development: with special reference to infrastructure development in Sub-Saharan Africa. February. [Online] Available: http:// www.oecd.org/dataoecd/3/18/40319638.pdf Accessed: 4 August 2010. Sewpaul, J. 2007. Overview of the Construction Industry South Africa. September. [Online] Available: www.export.gov/build/groups/public/@eg.../eg_main_020664.pdf Accessed: 3 August 2010.