It is well-known that in the 1990s, when there was a generation capacity surplus in South Africa, Eskom entered into secret commodity linked electricity pricing and supply agreements with a number of large, energy intensive users, including BHP Billiton’s Hillside, Bayside and Mozal aluminium smelters, and Anglo American’s Skorpion Zinc.

In essence, Eskom would not determined the price of electricity on a transparent, cost-reflective basis, but through a complex, secret formula based on a number of fluctuating variables such as the aluminium price on the London Metals Exchange, the dollar-rand exchange rate and the US producer price inflation rate.

The special pricing deals were concluded in terms of the prevailing industrial policy and strategy at the time, where the low marginal cost of supplying electricity to energy intensive industries, 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 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 built for decades.  Management complacency set in and no provision was made in electricity tariffs for future capacity needs or replacing 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 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 capital costs, unfavourable exchange rates, volatile commodity prices, difficult borrowing conditions and higher cost of debt. Pressure on Eskom and the country to reduce its carbon footprint and the prospect of a carbon tax are 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% a year for the next three years, indicate an average Eskom price increase of five time over the seven-years from 2008 to 2014. The recently published, policy-adjusted, 20-year, national Integrated Resource Plan for electricity indicates further increases significantly above the inflation rate can be expected between 2015 to 2021.

But these massive 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 12c/ kWh for its electricity – significantly below Eskom’s operating cost of 28c/kWh, while the average price being charged by Eskom to its customers in 2010 was about 32c/kWh. Yet with Eskom’s current average selling electricity price now at about 50c/kWh, the price BHP Billiton is paying remains a secret, and the special deal for its Hillside aluminium smelter only expires in 2028.

But it is no secret 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 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 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 hardly surprising BHP Billiton and Anglo American appear to be resisting the renegotiation of such advantageous pricing agreements.

While some argue the losses on embedded derivatives are merely projected and unrealised paper losses, they have a very real impact as a liability on the balance sheet that lowers Eskom’s credit rating, increase the cost of debt and inhibit 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.

Understandably, public interest in the commodity linked pricing deals is at an all-time high. Why are the details of the deals 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 below cost to convert it 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?

The strangest thing about all this is that despite Eskom and BHP Billiton “playing possum” and hiding for years behind claimed confidentiality and non-disclosure requirements in their agreements, there may be no such confidentiality clauses in the contracts after all. And this despite Eskom and BHP Billiton often citing contractual confidentiality to justify their covert 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.

This emerged during a court application launched by financial journalist Jan de Lange and his employer, Media24, 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 signatories and details of the pricing formulae used.

At the hearing 11 April 2010, the incredulous judge shook his head in disbelief as he heard the tortured claims and explanations from Eskom and BHP Billiton’s poker-faced counsel that the confidentiality and nondisclosure requirements cited as grounds for refusing access to the information requested were not actually formal clauses within the written, multibillion-rand pricing contracts after all, but were instead simply verbal agreements and understandings between the parties.

Advocates Gilbert Marcus and Stephen Budlender, both acknowledged Constitutional law experts and counsel for Media24, 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 BHP Billiton claimed it would suffer was not only grossly overstated, but also invalid.

But Media 24 further argued that if their interpretation of section 37(1)(a) and 46 of Paia was not accepted by the court, they would challenge these sections as being unconstitutional and invalid. So if Media24 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. DM

Chris Yelland is the managing director of EE Publishers.