Business & Industry Eskom

Eskom’s deals leave us in the dark

Viola Manuel* | 26 Apr 2013 | M&G

The parastatal’s short-term view has led to profits in the beginning, but has come back to haunt it.

One cannot blame BHP Billiton for negotiating its electricity deal with Eskom. The Australian company had the foresight to see that, in the long term, the risk-sharing arrangement would work in its favour.

The essence of the agreement for the sale of electricity to the Hillside Smelter in Richards Bay in 1992 was that BHP Billiton would pay a tariff based on the current price of aluminium on the London Metal Exchange, and it would pay in dollars. This suited BHP because it sold the aluminium on the world market for dollars and the deal removed the foreign-exchange risk. And if world aluminium prices went down, so would its operating costs in South Africa.

In 1992 Eskom had surplus capacity and the dollar was worth less than R3. The deal brought increased electricity sales with very little in the way of increased costs, and it paved the way for a R60-billion investment and the jobs that it would bring. The deal made sense for Eskom and for South Africa at the time, but the problem was that the arrangement was valid for 25 years – it should have been clear to Eskom that its spare capacity would be absorbed long before the contract ended.

Profitable arrangement
In the early years, the arrangement was profitable for Eskom as the rand weakened. By 1998, $1 was worth R6 – Eskom had in effect doubled the electricity tariff to its special customer and there was new enthusiasm for aluminium smelters. In the same year came the first warning that Eskom’s spare capacity was disappearing as the economy grew. New power stations were needed and they would have to be in operation by 2007 to ensure a secure supply of power. Eskom’s request to start a new build programme was rejected by the government.

By now, the dollars were rolling in and both Billiton and Eskom wanted more action. This led to a new deal to build an aluminium smelter in Mozambique: Mozal I. The plan was to export electricity and earn dollars. Bauxite would be shipped in from Australia and the refined aluminium would be exported for sale.

Mozal I was a joint venture between BHP Billiton (with 47% of the shares), the Mitsubishi Corporation (25%) and South Africa’s Industrial Development Corporation (24%). Mozambique’s share was 4%.

Selling electricity for dollars got even better in December 2001 when the rand weakened to a record low of R13.84 to the dollar, producing windfall profits for Eskom as the effective tariff for electricity sold to Hillside had increased by more than 400%. This created further enthusiasm for smelters and soon there were plans afoot for a big new smelter in the Coega industrial area near Port Elizabeth, as well as a plan to increase the capacity of the Hillside smelter by about 30% to produce 700 000 tonnes of aluminium a year.

It is clear that BHP Billiton learnt from its experience, and the new tariff for the Hillside extension would no longer to be based on the London Metal Exchange dollar price for aluminium but on Eskom’s lowest night tariffs, which would be escalated in line with the producer price index.

That proved to be a great deal for BHP Billiton because the increase would be applied to a low base price and the producer price index increases proved to be more or less in line with inflation, whereas Eskom’s normal tariff increases would soon be increasing by multiples of the inflation rate.

Series of warnings
Then, in 2003-2004, came Mozal II. Also in 2003, the first of a series of warnings entered Eskom’s annual reports over the need to construct new stations. They were ignored by the government and by Eskom’s board. In fact, as late as 2006, the then minister of public enterprises, Alec Erwin, was still promising electricity for a new Coega smelter.

Despite the threat, Xolani Mkhwanazi, the chief executive of Nersa – the National Electricity Regulator of South Africa – from 1999 to 2004 approved the electricity deals for the smelters. He also approved the extension of BHP Billiton’s Hillside contracts by eight years to take them to 2028. Mkhwanazi has chaired BHP Billiton in South Africa since 2005.

By 2005, the national grid was under severe stress. There was very little spare capacity and the first blackouts came in November when the Koeberg nuclear power station went down after veld fires affected power lines. Then came the famous “bolt” incident that destroyed one of Koeberg’s turbines and brought load shedding to the Western Cape.

In January 2008, the gold and platinum mines were shut down for a week and power rationing started. At the end of 2008, former president Thabo Mbeki apologised for the government’s decision not to allow Eskom to build new power stations. He said Eskom had been right and the government was wrong.

So BHP Billiton is right when it points out that Eskom profited from the early years of the aluminium smelter contracts. Billiton did not complain then and Eskom should not complain now. The aluminium smelters subsidised other electricity consumers for 12 or so years and now those consumers are subsidising the aluminium smelters to the tune of several billion rand a year.

The Mozal contracts have been re-negotiated, but cheap hydroelectricity is available in Mozambique and it may prove to be a more reliable supplier than Eskom.

Guilty of short-term thinking
But Billiton will not budge on its Hillside contract, where it has no other electricity options. Most of the electricity supplied to Hillside is now charged at an estimated tariff of 22.6c per kilowatt hour at a time when domestic consumers are paying about R1.40 per kilowatt hour. This subsidy is sustaining the aluminium smelters at a time when the aluminium market is depressed.

This leaves us with a few questions. What did Eskom do with the profits it made during the early years of the contracts? We know that the proceeds were not invested in new generation capacity. The answer is that the money made Eskom look good, creating the impression of excellent management and justifying handsome salary increases and bonuses.

What is more difficult to answer is why the 25-year deals for Mozal I, Mozal II and the Hillside extension were approved when it was clear that Eskom did not have the generation capacity to deliver power for the duration. And even if Eskom was given the go-ahead to build new power stations, they would be very expensive and that would mean big increases in tariffs. Most of those who made the decisions were guilty of short-term thinking and have moved on (with golden handshakes).

The final question is whether the commercial model for Eskom is the right one. Did this model encourage short-term thinking? Were we not better off when the utility reported directly to Parliament? After all, Parliament is more representative than any appointed regulator, and its members ask the difficult questions.

*Viola Manuel is the executive director of the Cape Chamber of Commerce and Industry.

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