Eskom, BHP Billiton and the secret electricity pricing deals…

April 28th, 2011, Published in Articles: Energize

by Chris Yelland, managing director, EE Publishers
 

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Within a few weeks, Judge Kgomo of the South Gauteng High Court will rule on whether Eskom must hand over certain documents requested by Media 24 in terms of the Promotion of Access to Information Act that would reveal details of secret pricing deals with BHP Billiton that have long been held to be confidential. However the matter may not end here, but could be heading for the Constitutional Court.

 

It is well know that in the 1990s, at a stage when there was a generation capacity surplus in South Africa, 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.
 
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 complex, secret formula based on a number of fluctuating variables 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 special pricing deals were concluded in terms of a prevailing industrial policy and strategy at that time, where the low marginal cost of supplying electricity to energy-intensive industry, using the surplus 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 reality of course turned out to be 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 dedicated coal mines located close to the power stations. 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 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 country 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 nuclear 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 supply contracts.
 
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 5x 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.
 
But these massive prices increases do not apply to the select few with long-term, commodity-linked pricing agreements with Eskom. Despite threats by Eskom to sue, it was revealed in parliament in April 2010 that Motraco, the electricity distribution agent 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.
 
But it is 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 and Anglo American appear to be resisting the renegotiation of such advantageous pricing agreements.
 
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.
 
Understandably, public interest in the commodity-linked pricing deals is at an all-time high. Why are the details of the 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 few foreign companies 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 to take advantage 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?
 
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.
 
This emerged during a court application launched by financial journalist Jan de Lange and his employer, Media 24, in terms of the Promotion of Access to Information Act (PAIA) to force Eskom to provide documents disclosing the commencement and termination dates of BHP Billiton’s Hillside and Mozal commodity-linked pricing contracts, the names of the Eskom and BHP Billiton signatories to the agreements, and the details of the pricing formulae used.
 
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 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.
 
Advocates Gilbert Marcus SC and Stephen Budlender, both acknowledged constitutional law experts and counsel for Media 24, argued that it was clearly in the public and national interest for the details of the secret price deals to be made known, and that the damage that BHP Billiton claimed it would suffer in respect of its competitive position was not only grossly overstated, but also invalid. The judge’s ruling in this matter is awaited with interest.
 
But the counsel for Media 24 further argued that if their interpretation of section 37(1)(a) and 46 of PAIA was not accepted by the court, and Judge Kgomo accordingly ruled against Media 24, then they would challenge these sections of PAIA as being unconstitutional and therefore invalid. So if Media 24 and Jan de Lange do not get their way, the matter may indeed be heading for the Constitutional Court, with a long legal battle ahead.

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