Investment Insight: Eskom's opportunity for new deal with aluminium smelter

Eskom, government, labour and South32 are facing a conundrum. South32’s 100 percent-owned Hillside Aluminium’s Potlines 1 and 2 are facing closure. In terms of the original contract Hillside Potlines 1 and 2’s contract with Eskom is likely to expire early next year while Hillside Potline 3’s contract expires in 2028.

According to well-respected Chris Yelland, managing director of EE Publishers, in an article published on Energize in 2013, the pricing agreement and contract period for Hillside Potlines 1 and 2 was signed in 1992, whereby the electricity supply period would end in July next year.

Subsequently, a supplementary agreement for Hillside 3 was signed in 2001. According to Eskom, the Hillside Potline 3 agreement does not affect the contract period of the main agreement for Hillside Potlines 1 and 2. Yelland said at the time that BHP Billiton (now South 32) is adamant that the supplementary agreement extends the contract termination date of the main agreement for Potline 1 and 2 to June 2028, in line with that of Potline 3.

It does seem that South32 has conceded that the pricing agreements and contracts for Hillside Potlines 1 and 2 would end next year. In February this year, Hillside Aluminium also issued employees with notices in order to cut Hillside’s 1?370 employees on a proposed restructure of the business. As many as 500 jobs were on the line, but around 400 employees chose either early retirement or voluntary retrenchment packages. To aim to cut jobs by more than 36?percent is significant and insightful.

Furthermore, according to South32’s financial results and outlook for the full year ended June 30, South32’s comment regarding Hillside Aluminium “we are advancing discussions with Eskom to agree a path forward to extend and consolidate our power contracts” applies.

The pricing agreements between Eskom and the aluminium smelters were kept under wraps for many years, but following the Supreme Court of Appeal judgment in March 2013 on the Promotion of Access to Information Act application by Jan de Lange and Media24 details of the agreements were disclosed.

The aluminium smelter contracts and formulas were published by Chris Yelland in an article published in Energize dated March 24, 2013, titled Analysis of the structure of Eskom’s special electricity pricing deals with BHP Billiton.

Eskom’s contracts with the aluminium smelters at Hillside and Mozal in Mozambique ripped the heart out of Eskom, specifically Hillside Potlines 1 and 2. Using Yelland’s formulas and calculating Eskom’s operating costs, excluding power bought from independent power producers and derivative contracts, I estimate that the income Eskom received from the aluminium smelters since 2013 was more than R30?billion short than what it cost Eskom. Yes, nearly what it cost the government to bail out SAA! Hillside Potlines 1 and 2 alone cost Eskom more than R15 billion.

Despite Eskom’s pleas to the National Energy Regulator of South Africa (Nersa) for a review of the electricity supply contracts, Nersa washed its hands while BHP Billiton showed that they could not care. According to Engineering News on March 6, 2016, Nersa’s head of electricity regulation, Thembani Bukula, told Parliament’s portfolio committee on energy: “As far as the complaint Eskom had laid with Nersa around the pricing of that and whether it is still in the public interest, that is still in process and it is going to be a long legal process, as BHP Billiton (now South32) would want it… It is clear Nersa can’t revoke a contract that two parties entered into. There is an irrevocability of the contract that needs to be taken into account, even if it is not in the public interest”.

The big question was the potential conflict of interest. As Yelland commented in 2013: “The chief executive of Nersa from 1999 to 2004 when the supplementary agreement was signed by Eskom and BHP Billiton (in 2001) and approved by the Regulator (in 2002) was Dr Xolani Mkhwanazi. Dr Mkhwanazi subsequently joined BHP Billiton South Africa as chief operating officer of its aluminium business in 2005 and became chairperson of BHP Billiton South Africa in 2008.”

Eskom cannot, should not and must be prohibited from entering into any electricity supply contract with any aluminium smelter or any other contracts unless Eskom’s operating costs per kilowatt-hour, excluding power purchases from IPPs, are covered and a cost of capital margin added to it.

When Eskom and South32 negotiate or renegotiate to agree a path forward to extend and consolidate Hillside Aluminium power contracts South32 will most probably try to steamroll Eskom by playing cards such as job losses in the value chain which South 32 estimates at 29?000. I think it is a threat rather than reality. Consider this:

The Hillside Potline 3 contract runs to June 30, 2028, and the effective subsidy received by the smelter is likely to increase to close to R1bn in 2028 from R200 – 300?million currently. Potline 3’s aluminium production will closely match domestic demand as of the 720?kilotons produced by Hillside, 500 tons are exported.

The other card South32 is likely to play is the potential loss in exports of $2bn (R29bn) per year. It should be seen in context as Hillside Potlines 1 and 2 use a combined 900MW at full capacity. They get it for around half of the actual costs. Closure of the two potlines will free up substantial power and give Eskom enough flexibility to stabilise the current system. Furthermore, selling the 900MW at market-related prices could boost Eskom’s cash flows, while at the same time lead to lower electricity prices.

Can Hillside Aluminium afford to pay for electricity linked to Eskom’s operating costs plus a margin? No, they are hardly at breakeven. Can South32 produce aluminium profitable at their 85?percent owned Worsley Alumina operation in Australia where they source the alumina for Hillside? No, the wholesale electricity price in West Australia was around 10 Australian cents per kW/h in 2018, equating to about 100 South African cents per kW/h. Hillside 1 and 2 pay about 30 SA cents per kW/h in South Africa.

What happened with Eskom’s electricity supply contracts with the aluminium smelters should serve as a blueprint of how state-owned entities and the government should not approach contracts of these natures. Leave it in the hands of professionals and keep politics and self-interest out of it. Yes, the electricity supply contracts with the aluminium smelters are as bad or even worse than SAA. Now is the time for Eskom to escape from some of them.