050910 Electricity pylons carry power from Cape Town's Koeberg nuclear power plant July 17, 2009. South Africa will need 20 gigawatts (GW) of new power generation capacity by 2020 and would require double that amount a decade later to meet rising demand, the country's power utility said September 7, 2009. Picture taken July 17, 2009. REUTERS/Mike Hutchings (SOUTH AFRICA ENERGY BUSINESS)

In his annual statement in 1992, Eskom chairman John Maree noted that Alusaf had announced it was proceeding with the establishment of a new aluminium plant, which was expected to be a major export revenue producer. “Their decision to expand was influenced by the fact that the cost of electricity in South Africa is one of the lowest in the world and that Eskom is prepared to take a business-like and flexible approach to tariffs applicable to large new customers.”

The “business-like approach”, to which Maree was referring, is the basis of the now infamous energy supply contract between Eskom and BHP Billiton’s aluminium smelters.

A report produced by Chris Yelland of EE Publishers, which is based on details supplied by Eskom in terms of an order by the Supreme Court of Appeal, indicates that the smelters at Richards Bay and Maputo, are paying around R4.65 billion a year for electricity that is costing Eskom approximately R8.6bn to produce.

Yelland has calculated that the smelters are supplied with 1 428 million kilowatt-hours (kWh) of energy each month. He further calculates that BHP Billiton is charged an average of 27.15c a kilowatt-hour.

The calculations are based on an analysis of the contracts that were made public following legal action by Media24. In terms of the first of the three contracts, which was signed in 1992, the price charged to Hillside Potline 1 and 2 in Richards Bay is determined by a combination of the international aluminium price and the dollar/rand exchange rate.

In terms of that contract the smelters are currently being charged 20.88c a kilowatt-hour, according to Yelland.

A second contract was signed in 2001 and is based on Eskom’s Nitesave tariff with annual increases linked to South Africa’s producer price index (PPI). In terms of that contract, the price currently being charged to Hillside Potline 3 is 26.43c a kilowatt-hour.

In terms of the third contract signed in 2010, for Mozal Potline 1 and 2, Eskom is supplying energy at 31.19c a kilowatt-hour. Annual increases are linked, not to South Africa’s PPI, but to the US PPI.

Each of these generous contracts runs for 25 years. Little wonder that Maree wrote back in 1992: “Existing customers have a positive view of Eskom’s service and tariffs and many who are not presently our customers would like Eskom to be their electricity supplier.”

In hindsight it is difficult to understand what the thinking was behind the generosity involved in the supply to BHP Billiton – or Gencor as it was known in the 1990s. The fact that a number of individuals, such as finance director Mick Davis and legal counsel Kevin Morgan, who were key to Eskom in the early 1990s, subsequently moved to Gencor/BHP Billiton has been noted.

In addition Xolani Mkhwanazi, who as chief executive of the National Energy Regulator of SA (Nersa) signed off on the Hillside Potline 3 contract, is the chairman of BHP Billiton South Africa.

It is also suggested that the terms of Gencor’s contracts to supply coal to Eskom’s power stations were a factor.

But it is possible that the most accurate explanation is to be found in a combination of Eskom management hubris at the time and the different conditions that prevailed in 1992.

As the Eskom annual reports at the time highlight, there was no thought that the country would suffer shortages of electricity. Sufficient investment in capacity and a seeming unlimited supply of cheap coal meant that management’s focus was on the critical issue of securing customers for cheap electricity.

The aluminium smelters, which relied on imports of alumina, were seen as a way of adding value to coal and then exporting that value-added product. In the process, it provided some employment opportunities and much needed foreign exchange. Of course, without cheap electricity this proposal made no sense.

In 1992, the customer focus was heightened by the first decline in electricity sales since World War II. The 0.5 percent decline, which was suffered despite Eskom’s vigorous efforts to provide electricity to a much larger proportion of the population, was due to the 2 percent slump in gross domestic product that year.

An Econometrix report on the local aluminium industry, which was commissioned by BHP Billiton last year, argues that the electricity shortages currently being suffered are part of a supply side problem.

“The region has more than adequate quantities of the major inputs required, namely coal and labour and in the case of Mozambique hydro power and gas. The focus should be on urgently increasing long-term supply by increasing capacity in order to meet future demand rather than a long-term demand side constraint.”

However, the report does not address the fact that, given the challenges facing Eskom’s long-term supply of cheap coal, its ability to increase capacity even with new power stations does not seem guaranteed.

To be expected, the report warns against challenges to the contract that might be made by Nersa and talks about the negative impact this would have on the country’s credibility as an investment destination.