Any major change to the electricity pricing regime for mining major BHP Billiton’s aluminium smelters in Richards Bay will have a severe impact on the smelters’ commercial viability and sustainability, which could cause significant job losses and, therefore, have a major impact on the South African economy, the mining company states.

According to research done in 2012 by South African economic analysis and business modelling services consultancy Econometrix, the BHP Billiton Bayside and Hillside smelters jointly created 7 000 jobs in KwaZulu-Natal (KZN), primarily in the Richards Bay area, positively impacting on the livelihood of more than 33 000 people in northern KZN, BHP Billiton communications and external affairs VP Lulu Letlape tells Mining Weekly.

“A series of Econometrix reports have demonstrated that the aluminium smelters play an important role in the country’s industrialisation process and in the promotion of local downstream and sidestream beneficiation,” Letlape says.

The 2012 Econometrix report states: “The aluminium industry has given rise to a downstream industry. Sales to the downstream industry total 278 000 t, worth R6.7-billion. It is highly likely that, if the aluminium smelting industry had not developed in this country, the downstream industry would not have developed to the extent it has.”

However, energy analyst Chris Yelland believes that the BHP Billiton smelters are, in fact, subtracting value from the local economy, as these smelters are highly energy intensive and, according to him, no true beneficiation takes place.

“No bauxite is mined in South Africa and the conversion of bauxite into alumina is also done in Australia. The alumina is then shipped to Richards Bay, where it is turned into aluminium using reduced energy tariffs, after which the aluminium is exported once again. Producing aluminium is an energy-intensive process and, therefore, one could argue that BHP Billiton is in effect exporting electricity during a time when South Africa is experiencing a shortage,” Yelland says.

However, Letlape opposes Yelland’s view, stating that BHP Billiton currently supplies 70% of South Africa’s aluminium needs.

In October last year, State-owned power utility Eskom submitted a request to the National Energy Regulator of South Africa (Nersa) to review the appropriateness of its legacy contracts with BHP Billiton, which date back to 1992, when South Africa had a significant generation-capacity surplus. This review process is still continuing, with dates for public hearings on the topic not yet announced.

Eskom informed Mining Weekly that, as it was still waiting for Nersa to publish Eskom’s application on its website and set a date for the public hearings on BHP Billiton, the power utility was not in a position to comment on the impacts of the contracts at this stage.

The contracts covering the special pricing arrangements between Eskom and Hillside Aluminium for Potlines 1 and 2 were signed on November 11, 1992, and came into effect on July 30, 1995. The pricing contract was signed for a 25-year period, effectively expiring in 2020.

The negotiated pricing agreements deviate materially from any current standard Eskom tariffs. The energy and demand rates are directly proportional to the current aluminium price measured in dollars per ton and the rand:dollar exchange rate, Yelland explains.

“There is no escalation or link to either the US Producer Price Index (PPI), the South African PPI or to Eskom’s cost of generation or transmission and there are no top or bottom limits to the energy or demand price,” he adds.

Letlape adds that, as the contracts are linked to the price of alumina and the dollar exchange rate, according to the 2012 Econometrix report, “[as a result of] globalisation, prices are increasingly influenced by world pricing trends – prices progressively become more market related and in traded commodities become aligned to international prices and imported goods”.

She explains that the contracts were designed to promote industrial development and absorb some of the excess generation capacity when South Africa’s electricity reserve capacity was at more than 40%, following the construction of new power stations by Eskom in the late 1980s.

“Policymakers were of the opinion that Eskom would not be able to absorb the excess capacity through normal economic growth for many years, even decades,” she says.

The formula used to determine the electricity price for Potlines 1 and 2 was favourable for BHP Billiton and Eskom at the time, Yelland says.

“Through this contract, BHP Billiton managed to hedge the risk it faced as a result of the fluctuating price of aluminium. Linking the price of electricity to the aluminium price would mean that, when the price of aluminium dropped, the smelters’ electricity costs would also decrease, which would enable BHP Billiton to keep its profits constant,” he adds.

However, South Africa did not build new power generation capacity for a couple of decades, as expected, which meant that the surplus on which the contracts with BHP Billiton were based dropped significantly.

“Currently, there is a shortage of supply in electricity, which makes marginal costing inappropriate,” Yelland says, adding that, as the price of aluminium has dropped considerably, the rate of exchange is such that Eskom is receiving less than its primary energy costs.

“In recent times, the electricity price for Potlines 1 and 2 has been less than half of Eskom’s current average cost of supply and less than Eskom’s current cost of primary energy.”

In addition to the contract signed in 1992, another electricity supply contract, containing the special pricing agreements for Hillside Potline 3, was signed on December 10, 2001, with electricity supply starting on June 30, 2004.

“Unlike Hillside Potlines 1 and 2, the energy and demand rates for Potline 3 are not linked to the aluminium price in dollars per ton or to the rand:dollar exchange rate. Instead, the initial energy and demand rates are those of the 2001 Eskom Nitesave tariff, which increased at the beginning of each subsequent year after 2001 based on changes in the South African PPI,” says Yelland.

The effect of the negotiated price agreement for Hillside Potline 3 is to lock the energy and demand prices, starting at the 2001 levels that are widely acknowledged as being significantly below Eskom’s average cost of supply and, thereafter, to escalate the 2001 prices yearly only by the South African PPI, while the balance of customers in South Africa suffer massive yearly electricity price increases of many times the official inflation rate, as Eskom moves to cost-reflective pricing.

However, Letlape points out that the benefits of the contracts should be judged over their entire term as opposed to a single point in time.

“Eskom has also benefited significantly from the agreements. BHP Billiton’s assessment of the cumulative benefit to Eskom from 1995 to 2008, when Eskom had excess capacity, is in excess of R26-billion. Eskom would not have earned this profit, had the smelters not been built,” the mining company states.

A comparison of the tariffs paid by the smelters against the standard industrial tariff (Megaflex) from 1995 to 2010 showed that the contracts worked as designed. For much of the first half of that period, the smelters paid higher tariffs than those stipulated by Megaflex, in rand and cent terms, and for the remaining period the smelters paid lower tariffs than those stipulated by Megaflex.

“It was only from 2011, when Eskom’s prices rapidly escalated and the aluminium price fell, in line with collapsing world commodity prices, that the two tariffs went out of line. Future tariffs will be determined by future aluminium and rand: dollar rates,” Letlape explains, adding that BHP Billiton is confident that the aluminium smelters will continue to contribute positively to the South African economy and Eskom’s bottom line.”

Eskom is obliged to declare its estimated forward losses on the remaining extent of its contracts with BHP Billiton in its financial statement.

“On the basis of the remaining extent of the contracts, Eskom calculated a total estimated forward loss of R5-billion,” Yelland says.

Eskom determined the R5-billion by comparing the tariff that BHP Billiton will pay over the remainder of the contract, based on its current tariff and the assumptions made about the rand:dollar exchange rate going forward, with what the aluminium smelters would have paid, had they been on the Megaflex tariff that other large industrial companies pay, he explains.

However, Letlape adds that Eskom has also made it clear that these assumptions could change and Eskom could again gain from the contracts.

Further, there is also a dispute between Eskom and BHP Billiton regarding the termination date of the Potlines 1 and 2 contract. BHP Billiton argues that the contract period was extended by another eight years when the Potline 3 contract was signed, while Eskom believes the Potlines 1 and 2 contract ends in 2020.

“If one reads the Potline 3 contract, it does state that the new contract amends and replaces the previous Potlines 1 and 2 contract, which indicates that BHP Billiton might be correct. However, if this is the case, Eskom’s liability will be even higher than is currently estimated,” Yelland points out.

However, Nersa ensures that electricity tariffs are such that all reasonable costs incurred by Eskom are covered and, therefore, any loss Eskom will make is effectively carried over to electricity consumers.

“We currently pay higher electricity tariffs, as a result of a contract that is expected to result in a loss of R5-billion over the next eight years,” Yelland says.

However, BHP Billiton is oppo- sing the cancellation of the contracts, stating that “BHP Billiton believes in the sanctity of contracts and expects Eskom to uphold the contracts, which were entered into in good faith by both parties”.

Should the contracts be cancelled, operating the smelters would become much more expensive, making it difficult for BHP Billiton to stay in business, Yelland points out.

He adds that, in his opinion, it would not harm the South African economy if the smelters were to close down.

“South Africa does not have a surplus of electricity and, therefore, the basis on which the aluminium smelters were built and the contracts drawn up no longer exists. BHP Billiton’s aluminium smelters in South Africa and Mozambique use 9% of the kilowatt hours generated in South Africa and contribute 5.6% to the maximum electricity demand and yet they do not contribute significantly to the economy through beneficiation or job creation,” Yelland reiterates.

“Therefore, I would suggest that shutting down the operations, effectively releasing 9% of South Africa’s electricity, which can then be used by other operations, might in fact contribute more to the local economy,” he says.

However, Letlape emphasises the contribution BHP Billiton is making to the South African economy, adding that demand at BHP Billiton’s South African smelters – Hillside, which uses 1 140 MW, and Bayside, which uses 175 MW – together account for 3.2% of Eskom’s net installed capacity and 3.7% of its maximum demand.

“In addition to job creation, BHP Billiton spent R290-million on community development between 2008 and 2012, which includes education, health, sports and recreation and enterprise development,” the company states, adding that it continues to contribute signifi- cantly to ports authorities and spent R4.2-billion on local suppliers, including Eskom, in 2012.

The smelters also continue to make an important contribution to the South African economy and, at present, continue to fulfil their commitment to a 10% power reduction on a voluntary basis.

“There is also interruptibility provisions in the contracts with which BHP Billiton fully complies. Eskom load-sheds the smelters to assist in maintaining power supply in South Africa over peak periods with no compensation for loss of production during that period,” she adds.

“Further, BHP Billiton’s aluminium contribution to taxation amounts to 0.5%, or R12-billion, of South Africa’s gross domestic product; R550-million a year in corporate tax; a R1.5-billion yearly contribution to the tax base, including personal taxes; and an additional R230-million a year in the form of pay-as-you-earn tax, unemployment insurance and skills development levies.

“The aluminium operations also have a R4.4-billion positive impact on the current account balance of payments,” the 2012 Econometrix report states.