South Africa

Analysis: The Future of Eskom and South Africa’s coal sector will be nothing like its past

By Dirk De Vos 4 July 2016

The recent reports of how Tegeta Resources – a company whose main shareholders include the Gupta-owned Oakbay Resources and the President’s son, Duduzane Zuma’s Mabengela Investments – has been able to secure a very favourable coal supply deal and have it pre-paid are deeply disturbing. Eskom is not just some failing state-owned enterprise like SAA; it represents our total electricity sector. It sits at the foundation of our economy. We simply cannot afford to have the multiple failures in corporate governance that should be obvious for all to see. By DIRK DE VOS.

Of course, Eskom’s own responses to the reports, as well as those of Oakbay, have sought to defend the abysmal situation by pointing to apparently similar arrangements, including massive pre-payments, with other suppliers of coal in the past. So, when all plausible justifications are exhausted, the catch-all defence is that these types of cosy arrangements have been happening for a long time, so why is everyone so worked up about it now? Nazeem Howa, the CEO of Oakbay, is particularly fond of this type of argument and uses it whenever he can. Has the whole issue blown up just because, as he claims, vested white-owned business interests are threatened by a feisty newcomer to the sector that upends the way things have always been done?

That this non-argument appears to work in some quarters or even has a receptive audience is a topic of its own but it does open up the question as to what has been the basis of the arrangements between Eskom and its coal suppliers in the past and where these might be going into the future. The possible answers are cause for even greater concern because, as we shall see, the future of our country with Eskom as a utility based on coal fired power plants, and its symbiotic relationship with our coal mining sector, is a decidedly uncertain one. The whole Tegeta gambit is just a symptom of a far deeper problem – the underlying assumptions of our coal fired electricity system are falling away.

Briefly, Tegeta was set up to acquire the Optimum mines in Mpumalanga for about R2.3-billion (about $145-million). Optimum itself had been put into Business Rescue by its former majority shareholder, Glencore. Glencore, in turn, had only completed the process of acquiring Optimum from BHP Billiton in 2014, a process that had started in 2011 at a reported cost of $1-billion. We know from disclosures in the Business Rescue Plan that Optimum owed its banks about R2.5-billion and that since September 2014, Glencore and other minority shareholders, including Cyril Ramaphosa’s Shanduka Group, had advanced an additional R900-million in funding to plug the gaps.

We also know that there were various efforts at reducing costs and increasing efficiencies that had been launched without much success. So what was the problem? Well, a long-term supply contract signed in 1995 on a cost-plus basis to supply 5.5-million tons of coal per annum to Eskom’s nearby Hendrina power station at around R190/ton. In addition, Eskom had levied fines of R2-billion on Optimum for supplying either sub-grade coal or insufficient coal. Yet, just three years ago, Optimum was a profitable business. So what has happened since? Two things: the global price of coal has fallen through the floor and Eskom’s financial position, despite numerous bailouts, has deteriorated to the point where its debt is now junk status rated.

Eskom, the centrepiece of our mineral-energy complex, has bought roughly 120-million tons of coal a year and has a symbiotic relationship with the coal sector. Since the 1970s, Eskom has built its enormous power plants to be supplied by relatively low grade coal from collieries located close by so that the mined coal can be fed directly into the power stations on conveyor belts. In many of the cases, Eskom has invested or made a direct and significant contribution to the capital costs of a mine and, in return, secured a long-term cost-plus or fixed-price supply of coal from the mining companies. The table below is a summary of Eskom’s coal fired fleet, their coal requirements and their traditional long-term suppliers:

On their own, these fixed-cost long-term contracts were not that interesting commercially but if one included the export potential of higher grade export quality coal, then this arrangement worked well for everyone, if not the environment. Eskom, for its part, got a long-term supply of very cheap coal that only it could use and as a state-owned entity, could easily provide the capital needed to develop the mines at rates lower than the mining companies. The mining companies, for their part, secured a good part of the capital contribution needed to develop their coal mines from Eskom and ongoing revenues (albeit not very profitable) from selling lower grade coal to Eskom, but they could export what they did not have to sell to Eskom at the global prices that export grade coal could fetch.

To do this, a few things had to happen. First, perfecting a process known as “coal washing” – whereby low grade coal is processed into a high grade thermal product with a low ash content – leaving behind the middlings fraction of an even lower grade, and discarded coal. Second, building the infrastructure needed to export coal, namely the coal export terminal at Richard’s Bay, and the rail lines from these mines to Richard’s Bay. The rights to export through the Richard’s Bay Coal Terminal, via an allocation, is a consequence of the collective investment made in the 1970s by these coal mines to export South Africa’s coal to the world. Richard’s Bay Coal terminal has the capacity to export up to 91-million tons of coal per annum and in 2015, 75,4-million tons of coal was in fact exported. By acquiring Optimum, Tegeta secured the rights to export 8-million tons of coal through Richard’s Bay.

This overall scheme has recently fallen apart, driven by the slump in the price coal can fetch on world markets. There are several drivers of this that include a slowdown in China, a slower than expected increase in demand from India, but important, a move towards cleaner fuels and the exponential rise in the deployment of renewable energy. As the price of renewables continues to decline, the likelihood of coal prices ever recovering looks ever more remote. Many coal mines around the world look like stranded assets. Under Glencore, Optimum had ceased to export any coal at all.

The costs of mining, particularly in the Mpumalanga coal fields, is on the way up. After 40 years of mining, the resource starts to deplete, requiring additional capital investment to extract the remaining coal which is also lower quality. Labour costs associated with coal mining have increased by 10% per annum on a consistent basis.

Eskom has responded to the changing coal supply environment by reviewing all cost-plus agreements. Brian Molefe makes the analogy of wanting to buy bread and not owning the bakery. From now on, we are told, Eskom will only buy coal and not be involved in the financing of mining activities. According to Matshela Koko, Eskom’s group executive for generation, Eskom would need to find an additional R38-billion in the next five years to further capitalise the cost-plus mines. He also makes the point that this investment would flow to the traditional mining majors instead of to black owned emerging mining companies with whom Eskom wants to do business. These changes are already well under way as seen from the graphs below:

Proportion of short/medium and fixed/cost-plus contracts

Changing Eskom’s coal supply arrangements is not going to be easy. The new coal fields in Limpopo’s Waterberg region, where production costs are much lower, are not adequately linked to Eskom’s power stations, mostly in Mpumalanga, by rail. If Transnet, another State-Owned Enterprise, is to make the investment in the rail infrastructure, it would have to be on the basis that the coal railed is also able to be exported. But the once lucrative export market that would have justified this type of investment no longer exists. A study commissioned by Eskom showed that in 2012, the low cost of mining coal in the Waterberg went up to as high as R410/ton when transporting it to Eskom’s power plants in Mpumalanga is taken into account.

Perhaps the best demonstration of all this is at Eskom’s Arnot Power Station. It is here where Tegeta secured its pre-payment to supply coal from the Optimum Mine that it had just acquired at over R500/ton. Previously, this power station had been supplied in terms of a 40-year agreement with Exxaro to supply coal on a “cost-plus” agreement covering a return on investment and a management fee. Exxaro did not export any supply from its Arnot mine so its cost-plus supply had to be covered by Eskom alone. According to Eskom, at expiry of this agreement in December 2015, the costs of coal delivered from the Arnot mine was R1,132/ton. The Arnot mine has been operating for over 40 years and now needs substantial additional investment to get to the remaining coal at a reasonable cost. Eskom was not prepared to provide the necessary capital to do this and the result is that this mine had to close.

So, what about the Optimum mine? It too shows the signs of becoming depleted without further capital investment. Even with the Arnot supply agreement and the pre-payment, the Optimum mine is still not economically sustainable. Optimum still has to deliver just over 5 million tons per annum to Hendrina for R190/ton and its 1.2-million ton agreement to supply Arnot at a reported R500/ton represents just one third of Optimum’s total production capacity. So, while the Arnot power station agreement remains in place, Optimum is supplying all its coal to Eskom at an average price of just below R300/ton, better than the R190/ton agreement with Hendrina but still below the R400/ton that Glencore said was needed to have Optimum remain financially sustainable.

If this is correct, the only viable strategy for Tegeta is the following: roll over the short-term supply contract to the Arnot power station for additional periods at the same or better prices; hold out to 2018 when the Optimum/Hendrina contract expires and fight off or settle the R2-billion fine. Then, set about renegotiating the supply contract for Hendrina on much better terms, make the supply agreement to Arnot a long term one and force Eskom into making a capital contribution to reinvest in the mine. With Exxaro’s Arnot mine now closed, Eskom won’t have that many other options to secure the amount of coal it needs to run these two power stations. Tegeta’s negotiating position, on the other hand, will be strong.

South Africa will find itself in a paradox in which its own costs of coal production go much higher as the global price of coal continues to fall. The one clear advantage that Eskom has long had, abundant and cheap coal supplies, is in the process of disappearing. As Eskom has recently discovered, the demand for electricity is a function of the costs of supply. As the price for electricity increases, its big customers, notably those companies forming part of the Energy Intensive Users’ Group, have to reduce their consumption and any future investment plans.

What happens, we should ask ourselves, when Medupi and Kusile are finally commissioned beyond 2022 if there is no demand for the extra electricity that they can provide at a cost that they can supply it? It is no longer a silly question. According to another Eskom study in 2013, if the delivered cost of just its short-term contracts (representing 30-million tons per annum or a quarter of the total supply), were to be delivered at R600/ton, then its operating costs would increase by 5%. Factor in the expiry of longer-term, fixed-cost and cost-plus contracts on advantageous terms and there are serious consequences for the future price of electricity generated by Eskom’s coal fired power stations.

The trouble is that having Eskom providing the capital to finance its suppliers’ coal mines is now hard to justify. Even with the recent injections by the state namely the R23-billion equity injection and the conversion of a R60-billion subordinate loan to equity, its financial ratios continue to deteriorate. On top of additional borrowing of R50-billion in 2014/2015, it is in the process of raising more than that in the current financial year. This has been hard to do. Its debt has been downgraded to junk and its borrowing costs are now as much as 4% higher than that of the government’s own borrowing costs.

But if Eskom can no longer fund the capital costs of coal mining anymore, who will? Coal’s long-term economics look very poor and a concerted campaign against coal as a dirty fuel, also known as the war on coal, means that development finance institutions such as the World Bank along with other pension or sovereign wealth funds won’t touch it.

All this looks very much like a utility death spiral and that becomes squarely a problem for Treasury to solve, one way or another. Obviously, Eskom can’t go bust for as long as the South African government itself is not bankrupt. How Eskom is managing its borrowing requirements, its strategy in the capital markets, who its lenders are and the terms of its more recent borrowing needs careful examination. It bears mentioning that one of the most exposed lenders to Eskom is the Government Employees’ Pension Fund (GEPF) managed by the PIC, once headed up by Brian Molefe, Eskom’s current CEO. Even if the government does not explicitly guarantee all of Eskom’s debt, it does guarantee the performance of the GEPF itself.

This underlines the critical importance in getting Eskom’s board to function credibly and without any real or perceived conflict of interest. It should be obvious that it is simply unacceptable that Mark Pamensky, the Chief Financial Officer of Oakbay and the controlling shareholder of Tegeta is also on the Eskom board where he heads up its Investment and Finance Committee.

It should be obvious that the future of Eskom and the South African coal sector will look nothing like the past. We have to prepare for that. Finance Minister Pravin Gordhan’s stated intention to fix the boards of our State-Owned Enterprises is critical. Getting the right people on the board is just the first step. Securing full transparency on all of Eskom’s coal supply contracts and its coal procurement policy as well as getting full details on Eskom’s borrowing programme is just as important. Should Eskom claim confidentiality on any of these arrangements for commercial and strategic reasons, these claims should simply be rejected out of hand. The stakes for the future of our country are just too high. DM

Photo: Electricity pylons stand in Johannesburg, South Africa, 26 February 2009. EPA/JON HRUSA

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