Eskom, BHP Billiton and the secret commodity-linked electricity pricing deals

February 14th, 2012, Published in Articles: Energize

A presentation to the South African National Energy Association
 
by Chris Yelland, EE Publishers

Johannesburg, May 2011
 
Chairman of SANEA, ladies and gentlemen,
 
I would like to thank SANEA for the invitation to present this evening.

And this especially at a time when the media in the UK is becoming increasingly discredited and demonised in the ongoing scandal involving Rupert Murdoch’s “evil empire”, the closure of the News of the World, and now the arrest of journalists from the Sun, amid evidence of hacking, illegal phone tapping and bribery of the police by journalists. Media criticism in the UK is largely coming from a public outraged with media ethical violations.

In the USA, however, criticism of the media is quite different, coming more from media analysts and intellectuals in respect of the cosy, synergistic and uncritical relationship that is said to have developed between the mainstream media, the federal government and its national security apparatus in the wake of the destruction of the World Trade Centre in New York, and the global war on terrorism. The criticism is about “embedded” journalism; a media that is too compliant in regurgitating statements by government and corporate spokespersons; a media that has been infiltrated by former security advisors and the like. It is a criticism of the so-called “patriotic” media.
 
In South Africa, it is quite different again, with criticism of the media mainly coming from government, the ruling party and its structures, and the various powers that be both in the public and private sectors – criticism by the so-called government / big business coalition. Here the criticism is more directed at an investigative media intent on exposing hypocrisy, fraud and corruption, which of is course denied vehemently or underplayed by government and big business as the work of a so-called “unpatriotic” media that focuses on the bad news rather than the good; a media whose investigative instincts and work impinges on the dignity and privacy of the targets. Or so it is claimed.
 
But the fundamental ethical requirements of the media, whether in the UK, the USA or South Africa remain unchanged, namely:

  • Telling the truth;

  • Remaining independent; and

  • Being accountable; while

  • Minimising collateral harm and damage

Unfortunately all the claimed failures of the media to meet the ethical standards expected of it, both internationally and locally, add grist to the mill of those in South Africa intent on curbing the free flow of information and imposing external (government) regulation and oversight of the media, even where there are functional self-regulatory processes in place that could easily be strengthened, and this would enjoy the the support of the media.
 
I speak here of the proposed Media Tribunal Bill and the Protection of Information Bill, which I believe that if passed unchallenged in the Constitutional Court, will significantly reduce your rights to know what is happening, to be informed, and to make informed decisions. By this I mean the right of access to information held by the state, public bodies and private bodies that is entrenched in Section 32(1) of the Constitution of South Africa, and which reads:
 
“Everyone has the right of access to: 
(a)  any information held by the state; and
(b)  any information that is held by another person and that is required for the exercise or protection of any rights.”
 
Section 32(2) of the constitution further requires that national legislation be enacted to give effect to the right of access to information, and this has been done by the promulgation of the Promotion of Access to Information Act of 2000 or PAIA as it is known for short.
 
PAIA deals with the rights of all persons to access information held by both public and private bodies; it lays down the procedural requirements to be followed for access to information; and it balances the right of access to information with other rights, including privacy and dignity, while allowing for reasonable limitations of the right of access to information to alleviate the financial and administrative burden of the state.
 
I will now focus these constitutional and legal issues in respect of the specific matter of Sake 24 and Jan de Lange vs. Eskom and BHP Billiton – namely the secret commodity-linked electricity pricing deals.
 
But before I do, I think we need to consider some background.
 
Gencor, Billiton and BHP Billiton
 
In a bygone era, Generale Mynbou, or General Mining, was a product of Afrikaner Economic Empowerment (AEE) as opposed to the better known Black Economic Empowerment (BEE) with which we are more familiar today.
 
Not unsurprisingly, just like some of the emerging BEE companies of today, General Mining had coal mining interests and was a major coal supplier to the national electricity supply utility controlled by the government of the day.
 
In 1980, General Mining merged with the rather English, Union Corporation, to form Gencor, and its relationship as a coal supplier to Eskom continued and strengthened.
 
In 1994, Gencor bought the mining interests of the Anglo-Dutch company Billiton, and underwent a major restructuring to become a global resource company listed on the London stock exchange under the name of Billiton plc.
 
BHP Billiton was subsequently created in 2001 through the merger of the Australian Broken Hill Proprietary Company (BHP) and Billiton plc.
 
Today, BHP Billiton is a global diversified natural resources company headquartered in Melbourne, Australia, with a major management office in London. It is the world’s largest mining company measured by revenue and as of February 2011 was the world’s third-largest company measured by market capitalisation.
 
In Southern Africa, BHP Billiton has major aluminium operations in Mozambique and Richards Bay, and its Hillside, Bayside and Mozal smelters make up about 5,7% of South Africa’s electricity demand.

The secret commodity-linked electricity pricing and supply agreements

It is well know that in the 1990s, around the time when Billiton was formed, there was a generation capacity surplus in South Africa, and Eskom entered into secret commodity-linked electricity pricing and supply agreements with a limited number of large, energy-intensive users of electricity, including BHP Billiton’s Hillside, Bayside and Mozal aluminium smelters, and Anglo American’s Skorpion Zinc.
 
The agreements
 
In essence, the price of electricity supplied in terms these special deals would not be determined by Eskom on a transparent, cost-reflective basis, but through a secret formula based on a number of fluctuating variables that are independent of the cost of electricity generation in South Africa, such as the aluminium commodity price on the London Metals Exchange, the US dollar / SA rand exchange rate, and the US PPI inflation rate.
 
The rationale
 
The special pricing deals were concluded in terms of a prevailing industrial policy and strategy at that time, where the low marginal cost of supplying surplus electricity to energy-intensive industry, using the excess generation capacity of the country’s “highly efficient” electricity utility, was seen as playing a competitive advantage to attract foreign capital investment, create jobs and improve the balance of payments by exporting the commodities produced.
 
The appeal for aluminium producers like BHP Billiton was that it hedged their risks of significant aluminium market price fluctuations by linking the price of electricity as a major cost input with the US dollar market price of aluminium, while securing the exceptionally low prices of electricity prevailing in South Africa at the time in conditions when supply significantly exceeded demand.
 
The reality
 
The reality of course was somewhat different. Eskom was not extraordinarily efficient after all, but relied instead for its artificially low electricity prices on the primary energy and plant capital costs of a bygone era.
 
Long-term “cost-plus” coal supply contracts had been negotiated years ago with companies such as Gencor, with dedicated coal mines located close to the power stations. The excess generation capacity was also built years ago when exchange rates were much more favourable and plant capital costs much lower. The surplus generation capacity resulted in no new power plants being required to be constructed for decades.  Management complacency set in, and no provision was made in the electricity tariffs for future capacity needs and the replacement of Eskom’s aging generation fleet.
 
In the meantime, the operating environment has changed beyond recognition. The days of excess generation capacity passed, and inadequate generation reserve margins placed increasing production pressures on aging power plant. Maintenance suffered, while power shortages now loom for years to come.

The current situation

South Africa currently faces an inevitable and massive new-build programme in an uncertain economic environment characterised by high generation plant capital costs, unfavourable exchange rates, volatile commodity prices, difficult borrowing conditions and higher costs of debt. Pressure on Eskom and the country to reduce its carbon footprint, and the prospect of a carbon tax, is also forcing consideration of higher capital-cost generation technologies with lower carbon emissions, such as clean coal burning technologies, nuclear power and renewable energy.
 
At the same time, higher demand by developing countries such as India for low-grade South African coal – Eskom’s primary energy source – is putting upward pressure on coal market prices, with local coal producers pushing to renegotiate expiring long-term “cost plus” supply contracts.
 
The price trajectory
 
Eskom’s electricity prices have risen sharply in response to the new-build programme and increasing capital, primary energy and staff costs. Average annual Eskom price increases of 27%, 31%, 25% and 25% in the years 2008 to 2011, and further increases of 25% per annum for the next three years from 2012 to 2014, indicate an average Eskom price increase of five times over the seven year period from 2008 to 2014. The recently published, policy-adjusted, 20-year, national Integrated Resource Plan for electricity, IRP 2010 – 2030, indicates that further price increases significantly above the inflation rate can be expected for the years 2015 to 2021.
 
This price trajectory has become so burdensome to mining, industrial, manufacturing, commercial, agricultural and domestic customers that there have been urgent calls for the pricing methodology of the National Energy Regulator of South Africa to be reviewed. In his recent state-of-the-nation address, President Zuma indicated that this review of NERSA’s pricing methodology is now in progress, and that the government has asked Eskom for proposals on how to reduce the rate at which its prices are increasing.
 
The lucky few
 
But these massive prices increases do not apply to a select few with long-term, commodity-linked pricing agreements with Eskom, and in particular, to BHP Billiton. Despite threats by Eskom to sue the DA, it was revealed in parliament in April 2010 that Motraco, the electricity transmission company owned by Eskom that supplies electricity to BHP Billiton’s Mozal aluminium smelter, was paying some R0,12 per kWh for its electricity – significantly below Eskom’s operating cost of R0,28 per kWh for the year ending 31 March 2010, while the average price being charged by Eskom to its customers in that year was about R0,32 per kWh. Yet with Eskom’s current average selling electricity price now at about R0,50 per kWh, the price being paid by BHP Billiton for electricity remains a secret, and the special pricing deal for its Hillside aluminium smelter only expires in 2028!
 
Eskom’s burden
 
While the details of the special pricing deals remain secret, it no secret that the special pricing deals have become a huge financial burden to Eskom, from which it is desperately trying to extricate itself.
 
New accounting practices now require Eskom to disclose in its annual financial statements the estimated projected forward losses for the remaining years of the commodity-linked pricing contracts, and the changes in these estimated projected forward losses, which are now somewhat obscurely referred to in the financials as “losses on embedded derivatives”.
 
At Eskom’s financial year end dated 31 March 2009, these estimated losses for the remaining years of the contracts resulted in a liability on the balance sheet of R8,3-billion. A year later, after successfully renegotiating the Mozal secret pricing deal, the liability on the remaining projected forward losses was stated in Eskom’s balance sheet as R4,7-billion. 
 
It is thus hardly surprising that BHP Billiton appears to be resisting the renegotiation of such advantageous pricing agreements for its Hillside smelter.
 
While some argue that the losses on embedded derivatives are merely projected and unrealised paper losses, in fact they have a very real impact as a liability on the balance sheet that lowers Eskom’s credit rating, increases the cost of debt and inhibits Eskom’s ability to borrow. Furthermore, every year, a portion of the estimated total forward losses on the remaining years of the contracts converts into a real operating loss (or profit) depending on the actual electricity prices paid during the year in terms of the secret pricing formula.
 
The public interest
 
Understandably, public interest in the commodity-linked pricing deals is at an all-time high during these times of severe electricity shortages.

Some questions the public would like to know the answers to include:

  • Why are the details of the commodity-linked electricity deals with a select few kept secret, while all other domestic, commercial, agricultural, industrial and mining customers pay transparent tariffs that are openly published?

  • Why should a foreign company get electricity at below cost, while local customers face massive increases that effectively subsidise the losses Eskom incurs on the secret deals?

  • Why should thousands of GWh of locally produced electricity be sold below cost for export by a foreign-owned company in the form of aluminium ingots, while security of supply in South Africa is threatened and local industry is starved of electricity?

  • Does it really add value to the South African economy when bauxite is mined and refined to alumina elsewhere, then shipped to South Africa with the specific intent to take advantage of subsidised electricity purchased at below cost to convert alumina into aluminium ingots for export?

  • Does aluminium production in this way really contribute to jobs in South Africa, when staffing at the smelters is relatively low, and there are no upstream and few downstream value-adding activities?

The Sake 24 application for access to information

Some years ago, Sake 24 and its financial journalist, Jan de Lange, made an application to Eskom as a public body for details on the secret commodity-linked electricity supply contracts in terms of the Promotion of Access to Information Act.
 
The initial request was for access to the full Eskom supply contracts for BHP Billiton’s Mozal and Hillside electricity supply.
 
This first request for information by Sake 24 was refused by Eskom, and this was then followed by a further request by Sake 24 for access to significantly reduced information, and specifically:

  • The names of the signatories to the Mozal and Hillside contracts

  • The dates of commencement and termination of the Mozal and Hillside contracts

  • Details of the commodity linked pricing formulae for the Mozal and Hillside contracts

This request was then also refused by Eskom.
 
The court action launched by Sake 24 to force Eskom to provide the information requested

Sake 24 and Jan de Lange then launched a court action also in terms of the Promotion of Access to Information Act in an effort to get a court order that would force Eskom to provide the limited information of its second request.

Confidential or not?
 
But the strangest thing about all this is that despite Eskom and BHP Billiton “playing possum” and hiding for years behind claimed confidentiality / non-disclosure requirements in the commodity-linked pricing agreements, there may in fact be no such confidentiality clauses in the contracts after all.
 
And this despite Eskom and BHP Billiton often citing contractual confidentiality to justify their secretive behaviour, with suggestions that there would be a breach of contract, and that BHP Billiton would suffer significant legally actionable damages if Eskom were to reveal the details of the electricity pricing agreements between the parties.
 
It turned out on the day in court that the claimed confidentiality clauses that had been included by BHP Billiton in its court papers were not confidentiality clauses from the Mozal and Hillside contracts after all, but were confidentiality clauses from an unrelated Eskom contract with another prospective client.
 
At the hearing before Judge Kgomo in the South Gauteng High Court on 11 April 2011, the incredulous judge shook his head in apparent disbelief as he then heard the tortured claims and explanations from Eskom and BHP Billiton’s poker-faced counsel that the confidentiality and non-disclosure requirements cited as grounds for refusing access to the information requested were not actually formal clauses within the written, multi-billion rand, commodity-linked pricing contracts after all, but instead simply verbal agreements and understandings between the parties.
 
Outcome of the court action launched by Sake 24
 
On 5 August 2011, Judge Kgomo handed down a judgement in the South Gauteng High Court on the court action launched by Sake 24, and ordered Eskom, BHP Billiton and their business associates to hand over all the documents requested by Sake 24 in terms of a Promotion of Access to Information Act (PAIA) application which would reveal details of secret commodity-linked electricity pricing deals that have long been held to be confidential.
 
Through the judgement and court order, Sake 24 won access to everything it asked for, namely:

  • The names of the signatories to the Eskom’s secret Mozal and Hillside electricity supply contracts

  • The dates of commencement and termination of the above contracts

  • The full details of the secret electricity pricing formulae in the above contracts

Sake 24 also won full costs of the court action.
 
However, quite typically, in further delaying actions, BHP Billiton has since applied for leave to appeal the judgement, while Eskom continues to hide behind the skirts of BHP Billiton in refusing to provide the information requested by Sake 24, and which the court subsequently ordered be handed over to Sake 24.
 
The Appeal Court has not yet granted leave to appeal, and the outcome of BHP Billiton’s applcation is awaited with interest.
 
So what is the relevance of the secret commodity-linked pricing agreements today?
 
In my presentation I have already provided a list of questions and issues arising from the secret commodity-linked electricity pricing deals, in which the public has a strong interest. I do believe the issues are still valid, and very much in the public interest today.
 
At this very time, Eskom is urging large and small electricity customers to reduce electricity usage or face the consequences of forced blackouts and load shedding.
 
Eskom is also incurring significant operating cost increases through the need to run its diesel-powered open-cycle gas turbines (OCGTs) in the Western Cape for extended periods to meet electricity demand.
 
Further operating costs are being incurred by Eskom for compensation to those customers involved in the demand market participation (DMP) programme, where customers are paid to reduce load and/or operate their own standby generators when the Eskom system is tight.
 
Eskom has also been delaying maintenance on its fleet of generators in efforts to reduce planned outages and keep the lights burning, a strategy that is unsustainable and ultimately self-defeating, because deferred maintenance inevitably increases unplanned outages in due course.
 
Yet at the same time Eskom continues to supply vast amounts of electricity amounting to some 5,7% of demand to BHP Billiton’s Mozal and Hillside smelters, at below cost, in terms of the secret commodity-linked electricity pricing deals. This electricity is then effectively exported around the world in the form of aluminium ingots, with little or no value-add as you will see bekow.
 
A recent report in MiningMx, by the very same Jan de Lange referred to previously, indicates that despite its massive electricity consumption delivered at below cost by Eskom, BHP Billiton’s Mozal and Hillside aluminium smelters still ran at a loss of half a billion rand for the six month period ending December 2011, and that these losses are likely to continue and to increase.
 
The losses were sustained at average an aluminium price of $2391 per tonne during these six months. Since then the price has dropped to around $2100 per tonne, and some analysts are suggesting prices dropping further to $1500 per tonne for the next two years in the light of increasing exports of aluminium by China.
 
According to the report by De Lange, over the last 20 years “China built 119 of the 133 new aluminium smelters in the world, and the emerging giant became a net exporter of aluminium in 2006 for the first time”.
 
But because the price of electricity supplied by Eskom to Hillside is linked to the US dollar price of aluminium, the impact of a reduction in the price of aluminium will be a growing loss on embedded derivatives for Eskom.
 
While BHP Billiton’s losses will have been hedged to some extent through the secret commodity-linked pricing deals, Eskom bears the brunt and picks up the cost of the losses caused by a reduction in the US dollar market price of aluminium, which is passed through to the “not quite so privileged” electricity customers, including you and me!
 
In summary
 
Eskom is capacity constrained and cannot afford to supply vast quantities of electricity at below cost.
 
Neither can Eskom afford to subsidise electricity for export to foreign countries.
 
Electricity customers and the South African economy can no longer bear the dramatically rising electricity prices caused in part by electricity shortages exacerbated by supplying large quantities of electricity below cost to Mozal and Hillside. 
 
South Africa is a long way from the supplies of bauxite and alumina, and a long way also from the major world markets for aluminium.
 
South Africa offers no competitive advantage to aluminium smelters, and this can be seen from the losses being incurred by the BHP Billiton’s Mozal and Hillside smelters, as well as the losses being incurred by Eskom in terms of the secret commodity linked electricity pricing deals.
 
I would like to suggest to President Zuma, if I may be so bold, that he should respectfully ask BHP Billiton to do its shareholders, Eskom and South Africa a big favour and close its loss making, electricity guzzling Mozal and Hillside aluminium smelters.
 
Perhaps Eskom should also suggest to President Zuma that this would be just one way in which it could help contain and reduce the damaging rate-of-increase in Eskom electricity prices that mining, industrial, manufacturing, commercial, agricultural and domestic customers are experiencing.
 
In so doing, this would release precious generation capacity that would enable productive local enterprises with upstream and downstream value-adding potential to expand, provide jobs and contribute to the fiscus.
 
Conclusion
 
In conclusion, I would like to leave you with a final thought as to why I think it would indeed be a good thing for the details of the secret commodity-linked pricing deals to be made public, and it is this:
 
These long-term secret deals were concluded in the early 1990s, some twenty years ago, and extend to 2028, some 17 years from now, a total of 37 years! The people who negotiated and signed the deals will have long departed from the scene by then, and if kept secret, the new entrants will have no real understanding or knowledge of the details of the deals and the mistakes embedded therein.
 
So instead of being able to learn from the mistakes of the past and from the flaws in the commodity-linked pricing formulae, these costly mistakes and flaws will be effectively buried. And what is to stop them from being repeated?
 
Ladies and gentlemen, thank you for your attention.