Analysis

What went wrong with the Eskom-BHP Billiton pricing deal?

(Written for Mining magazine, April 2013)

By Stef Terblanche

The highly publicised saga of the special electricity pricing deal between Eskom and BHP Billiton having gone sour is like a marriage on the rocks.

On several occasions in the past two decades the two companies shook hands on sweetheart deals that allowed BHP Billiton to pay a special preferential price for its electricity. 

The South African government at the time sought to attract big industrial investments. BHP Billiton, or its predecessor, Gencor, wanted a good return on its investment. Cheap surplus electricity could make it happen, so Eskom became the proverbial bride.

But conditions have changed dramatically since then, and now Eskom wants out.

Using a substantial amount of electricity at around 2,000MW of national power output for its Richards Bay smelters, or about 9% of Eskom’s total output for its South African and Mozambican smelters combined,  the rate BHP Billiton is currently paying is well below the cost of generating it.

BHP Billiton, however, argues that the true price can only be calculated over the full life of the contracts. Energy Intensive User Group (EIUG) chairman Mike Rossouw agrees with that view, saying it makes no sense to work only with a “snapshot price at a particular point in time”.

Nonetheless, with Eskom currently seemingly paying more to BHP Billiton for the coal needed to generate one kilowatt of electricity than what the mining group pays per kilowatt for electricity used in its aluminium smelters, Eskom is of the opinion that the consequences of the deal has become a huge burden.

Eskom found itself under ever more pressure after the 2008 electricity crisis to deliver sufficient electricity to keep the wheels of industry turning and the lights burning in South Africa. As a result the state power utility says since 2009 it tried to renegotiate the terms of the deals with BHP.

On May 30, 2010 BHP Billiton issued this statement: “Eskom and BHP Billiton today announced that they have reached agreement on an amended power supply contract for the Mozal aluminium smelter in Mozambique. Discussions relating to the contracts for the supply of electricity to the Hillside and Bayside smelters in South Africa will continue over the coming months with the intention of concluding binding agreements before the end of Eskom's 2010/11 financial year.”

The latter never happened, and now BHP Billiton has dug its heels in. A deal is a deal, and needs to be honoured, it says.

In the same statement BHP Billiton said while negotiations would continue, “the BHP Billiton smelter contracts at Hillside and Bayside in Richards Bay will remain firm and binding”. Eskom, it said, would in turn maintain its “interruptibility” at the smelters in line with the provisions of the contract. To save power at peak times, Eskom periodically shuts down power supply to the smelter, as with other intensive energy users.

Subsequently last October Eskom submitted an application to the National Energy Regulator of South Africa (Nersa) to review the terms of the preferential deals. At present the parties are not negotiating.

But it was the tenacious probing of an enterprising journalist and the eventual intervention of the courts that brought the full extent and the finer details – previously shrouded in secrecy - of this increasingly unhappy marriage out into the open last month. Dirty linen was displayed, the public gasped in horror, tongues were set wagging, and dire warnings of all kinds followed.

But exactly how did this all come about and what went wrong? Are there any lessons to be learnt by South Africa’s mining industry which is one of the largest consumers of electricity in the country?

Eskom says the mining industry takes about 15% of its output, but EIUG’s Rossouw says the entire industrial sector that includes mining and related activities such as smelters probably uses around 40%.

The deal uncovered

Having been aware of a secret deal between Eskom and BHP, Jan de Lange, a mining journalist with Sake24, became determined to uncover the deal after spotting a R9.3-billion loss attributed to “embedded derivatives” in Eskom’s 2009 results.

When both companies refused to divulge any details, Sake24 and its parent, Media24, went to court using the Promotion of Access to Information Act (PAIA) to try and obtain information from Eskom. Media24 won both the initial case and Eskom’s subsequent appeal.

Energy analyst and technology publisher Chris Yelland, who has written an extensive analysis of the issue, says the first deal concerning BHP’s Hillside Potlines 1 and 2 was concluded in 1992. At the time BHP Billiton was still known as Gencor. Electricity supply was still regulated by legislation that was replaced with new legislation after 1994 and which also replaced the old Electricity Control Council with the National Energy Regulator of South Africa (Nersa). Since 1995 Nersa among other things has to approve all electricity tariff issues.

Yelland says the original contract was signed on 11 November 1992 at a time when Dr. Ian McRae was the CEO of Eskom, and subsequently came into effect on 30 July 1995 at a time when Dr. McRae was the first chairman and CEO of the newly established Nersa.

When asked about this an Eskom spokesperson said the deal was concluded before Nersa came into being in 1995.

“Prior to that, the Electricity Control Board regulated some aspects of the electricity supply industry but was not an economic regulator and its approval for the negotiated pricing agreements at Hillside and Bayside was not required. Eskom did follow proper and appropriate governance processes in terms of the legislation,” said the spokesperson.

Rossouw is of the opinion that the contracts were signed at the time with the necessary approval of the relevant authorities regardless of whether it was Nersa or not.

A second agreement for Hillside Potline 3 was signed in December 2001 between Billiton and Eskom and was to come into effect by 30 June 2004, says Yelland. In a written reply to our questions, Eskom said “a supplementary Hillside agreement was signed in 2003 which was approved by the regulator”.

Nonetheless, this deal was differently structured from the first one. But it still kept the price BHP Billiton paid well below what the public was being charged after Eskom’s 2008 electricity crisis and its rolling blackouts as well as below Eskom’s cost to produce this power.

The Hillside Potline 3 agreement had a suspensive clause that the special pricing arrangement had to be approved by Nersa by no later than 18 December 2001. In a letter to BHP Billiton dated 5 February 2002, Eskom confirmed Nersa’s approval.

At the time, from 1999 up to 2004, Dr. Xolani Mkwhanazi was the CEO of Nersa which gave the approval to Eskom and Billiton. Not long afterwards, in January 2005, BHP Billiton appointed Dr Mkwhanazi as chief operating officer at Aluminium Southern Africa which operated its Richards Bay and Mozambican smelters. In October 2008 he became chairman of BHP Billiton South Africa, a position he still holds. Dr Mkwhanazi is also a past chairman of the Chamber of Mines.

Rising costs

Given the low cost of producing electricity at the time and the high aluminium prices, these deals were beneficial for both parties. But neither deal was structured to keep pace with Eskom’s 2008 crisis, its need for a fast-tracked generating capacity expansion programme, the steep rises in the cost of producing electricity, or the changes in the aluminium price.

Yelland says because of the way the deal was structured the electricity rates for the Hillside smelters “were not cost reflective in any sense”. The problem arose when Eskom's operating costs shot up by 168% from about 15c in 2007 to the current 47c/kWh.

These rates have now become less than half Eskom’s current average cost of supply, and less than Eskom’s current cost of primary energy.

Reporting on the matter after Media24 won the court cases, De Lange calculated that BHP pays 23c/kWh at its Hillside smelters and 34c at its Mozal smelter in Mozambique. In comparison factories pay R1.61 and households pay R1.40. Eskom says the average tariff paid by other large mining companies is 56c/kWh.

According to research undertaken by ENF Consulting on behalf of Sake24 for a number of years the rate BHP paid Eskom did not cover the cost of Eskom’s primary energy, that is, the coal it bought to produce the energy. Of the 125Mt of coal used by Eskom every year, some 18% (between 18Mtpa and 20Mtpa) is sold to it by BHP Billiton.

However with steep increases in the price of coal since 2008, and with much of the hedging against the market price with Eskom’s cost-plus contracts starting to fall away, Sake24’s research found that Eskom’s primary energy since 2008 has increased by around 25% per year from R23.7bn in 2009 to R36.6bn last year.

De Lange has calculated that BHP Billiton’s Hillside deal has already cost Eskom R10.7bn. That is where the public outcry arose. With the constant steep escalation in electricity tariffs for ordinary household consumers, the public believes it has been footing this bill.

And there is more to come. De Lange concludes that conservatively Eskom’s primary energy cost will most likely increase by a further 15% per year over the coming years.

However, calculating the exact cost to all parties concerned is a very complex affair, and as Rossouw and Dr Mkwhanazi have pointed out, it cannot be isolated at a particular point in time, but should be viewed within the context of the total life of the contract. The contracts are to run for 25 years.

Risk sharing

In an open letter published in Business Day on April 3, Dr Mkhwanazi stated BHP Billiton’s view that “the Eskom contracts were negotiated on a risk-sharing basis and in terms of a recognised international model”.

He said Billiton had invested more than R60bn in its aluminium business in Southern Africa in direct response to incentives of the South African and Mozambican governments to promote industrial development. The pricing agreements were concluded “to ensure the financial viability of the smelters over the long term” and to absorb Eskom’s excess capacity (about 35%) at the time.

Dr Mkhwanazi denied that the pricing agreements have been detrimental to Eskom and other consumers, saying that due to the structure of the agreements, BHP Billiton for many years paid above the standard electricity tariff for industry.

“During the period of the contracts, we have paid more for the electricity than the cost of supply. As a result of these contracts, Eskom has generated significant additional revenues and benefits, which have contributed to the cost of establishing the electricity generation and transmission infrastructure in South Africa.”

“BHP Billiton expects our contracts to be honoured. As a business, we have a responsibility to fulfil our obligations to our employees, customers, suppliers and shareholders and the broader community of Richards Bay and KwaZulu-Natal,” he said.

In any case, Mkhwanazi says, to help Eskom maintain a reliable supply of electricity in the country, BHP Billiton in 2008 mothballed two potlines at its Bayside smelter, while it allows Eskom to interrupt supply to its smelters periodically without compensation for lost production. BHP Billiton also continues meeting its 10% power-reduction target.

Lacked transparency

Perhaps the Achilles heel of these agreements was the complete lack of transparency despite the fact that it involved a state-owned company funded with public money.

When De Lange started probing the deal he did so in the public interest. The general point of view was that Eskom being a public company, and given the fact that the general public was forced to pay ever more for its electricity while BHP Billiton as one of the single biggest consumers of electricity was allowed to pay tariffs below cost, the agreements undermined the public’s interests. Regardless of merit, the popular view was that vast profits were being made at the public’s expense.

Commenting after winning the appeal case Media24’s attorney, Willem de Klerk, said that the court’s decision showed that large corporations doing business with state entities may expect their commercial dealings to be placed under the spotlight. Claiming prejudice to their business would not be sufficient to prevent it.

Standard practice

Various commentators, including Dr Mkhwanazi, have pointed out that such preferential pricing agreements are nonetheless standard practice internationally.

An example is the current negotiations taking place in New Zealand between the owners of the Tiwai Pt aluminium smelter and the state-owned Meridian Energy for a preferential pricing deal. Last year Rio Tinto said the smelter could close if it did not get cheaper power from Meridian Energy, which would lead to significant job losses and a blow to the local economy.

And the Chinese chrome processor, Afro-Chine Smelting, has announced it was about to build six chrome smelters in neighbouring Zimbabwe. Before making the announcement, the Chinese company had been negotiating with the Zimbabwe Electricity Transmission & Distribution Company for uninterrupted power supply to the smelters. It is believed that a preferential pricing arrangement may also have been part of these discussions.

What’s at stake?

Mhkwanazi had made it clear that BHP Billiton expects the contracts to be honoured. Equally, Eskom has made it clear it wants them to be reviewed and changed due to the dramatically changed conditions.

“If the contracts are changed unilaterally, everybody is going to lose. The government, Eskom, Nersa, BHP Billiton and Eskom’s existing customers will all lose,” says Rossouw.

The potential losses for Eskom are obvious against the background of its need to fund an expensive capacity expansion programme and massive escalation in the cost of energy. If it cannot recover a part of these costs from BHP Billiton, it may seek to once again pass on the cost to other electricity consumers, a move that Nersa could block as it has already done with Eskom’s industrial power buy-back programme.

In a worst-case scenario a lack of any solution to the problem could seriously affect Eskom’s ability to build the required new power stations on time to meet anticipated future electricity demand. Already there are disturbing warnings that the country could once again run into serious electricity supply problems this winter. Then the entire country will be on the losing side.

On the other hand, although BHP Billiton has denied in the past that it has any intention of pulling out of South Africa, some commentators have in recent weeks expressed the opinion that, if the preferential electricity pricing agreements are not honoured, BHP Billiton may simply shut down the smelters and leave.

If that were to happen it would adversely affect the 3,000 people employed at the smelters, or the 20,000 jobs in South Africa BHP Billiton says have been created from the aluminium investments. In addition, says BHP Billiton, these jobs affect the livelihoods of about 33,000 people, with economic income for about 90,000 dependents.

Shutting down these smelters would be a huge loss for the economy. Hillside is one of the world’s most advanced and efficient aluminium smelters, produces high quality primary aluminium and it is the largest producer of standard aluminium ingots in the southern hemisphere, says BHP Billiton. And Bayside is the only producer of value-added primary aluminium products in Southern Africa, all of it used by the local market.

“Any unilateral changes to a signed and agreed contract would send absolutely the wrong message to the investor community,” says Rossouw about the potential consequences for South Africa. Many other commentators have issued similar warnings, as did Dr Mkhwanazi.

“Business needs maximum encouragement and support to make these long-term investments for the benefit of society. Risks have to be balanced before investment takes place. Legal due process, adherence to the constitution, sanctity of contract, regulatory certainty, certainty around fiscal provisions at the outset, nonretrospectivity and security of tenure are all essential,” says Mkhwanazi.

So, is there a solution to what seems to be a serious impasse?

“Absolutely,” says Rossouw. “The solution is that the parties, namely government, Nersa, Eskom and BHP Billiton, must sit down and negotiate a practical solution which, as far as I know, they have never done. And if Nersa finds itself to be conflicted, they can make use of an arbitrator.”

For the sake of everybody concerned, hopefully this advice will not fall on deaf ears.


© Copyright 2013 Stef Terblanche – No article or part thereof may be reproduced, printed or published without the permission of the author, while recognition must be given to the author and the publication that first published it.