The recent impasse between State-owned power utility Eskom and mining major Glencore’s Optimum Colliery has revealed more clearly the new ‘arm’s length’ relationship that Eskom wants with its coal suppliers, but it is unclear whether this path will suit either the energy giant or the coal sector, says global consultancy SRK Consulting.

According to SRK Consulting principal mining engineer Norman McGeorge, about 80% of Eskom’s supply comes from large coal producers that are tied to Eskom by cost-plus or long-term fixed-price contracts.

“These arrangements have successfully balanced the operating companies’ risk in launching and sustaining mining ventures with Eskom’s requirement for an affordable and reliable long-term supply of coal, McGeorge says, noting that these agreements usually comprise substantial upfront investment in the mine by the mining house and Eskom itself, and an offtake agreement that would secure the future of the colliery.

The revenues to the mining house are based on a return on the original capital invested, while the balance of the operating cost and replacement capital risk is assumed by Eskom. Such arrangements would typically run for 30 to 35 years, with an option to extend should the resource allow.

These contracts were mostly struck in the early 1980s and were structured to entice the mining houses to invest and achieve the lowest cost of coal for Eskom, compared with the free market pricing of coal, which is driven by supply and demand. The model also avoided the costs of transporting the coal as the power station and the colliery were located next to each other.

The rise of large and lucrative export markets for low-grade coal has now created more attractive prospects, with which Eskom is now struggling to compete. In addition, the operating costs of mining over the past 30 years have exceeded the average inflation costs.

“Eskom now argues that its cost-plus suppliers are not performing, and it is, therefore, not getting its coal at the cheapest possible cost, as it has to procure through expensive short-term contracts,” McGeorge says.

The energy giant now plans “arm’s length” relationships with coal suppliers, who will be selected through a tender system that is expected to drive down costs through competition.

“Finding these new suppliers, however, will be no simple matter. Given Eskom’s difficult financial position, it is not hard to see why they would like to ditch the cost-plus model and avoid any more responsibility to invest in new mines.

“But the large mining houses, even those with deep enough pockets to open new coal mines on their own, also have capital constraints. They will choose to invest in the project and commodity that is the most rewarding, as they have alternative investment options and domestic cost-plus coal supply contracts are unlikely to offer as good a return as some of the alternatives,” McGeorge asserts.

He points out that low-grade coal from many of South Africa’s export coal mines is now in much demand by power stations in countries such as India, which may pay three to four times as much as an existing domestic long-term fixed-price contract.

“The economic reality is that Eskom will have to pay more for its coal than it has in the past, putting further pressure on its already skyrocketing electricity prices,” McGeorge says.

The consequences of Eskom pursuing the “free market” route for its coal is likely to be felt quite soon, as a number of power station contracts are approaching their expiry dates.

“Coal-supply contracts at power stations such as Arnot and Hendrina – built about 40 years ago – have run their full contractual terms as well as their extension options. Decisions about extending the life of these power stations need to be made – balanced against the cost of replacing the facilities with new capacity in which alternative fuels also compete,” says McGeorge.

He adds that the next batch of power stations built by Eskom – Kriel in 1976, Matla in 1979 and Duvha in 1980 – is also reaching the end of its contracts and Eskom needs to make decisions about taking up the options to extend.

“Until Eskom nails down such extensions, however, the coal is unsecured and cannot be relied on – hence, the talk of looming shortages.

“The mines themselves are generally not short of coal resources; Matla colliery, for example, has some 225-million tons of economically mineable coal declared as reserves, which it mines at about ten-million tons a year, giving it at least another 20 years’ mine life. This is out of a resource base of one-billion tons. The position with other cost-plus power station contracts is similar,” McGeorge highlights, concluding that what has not been locked down are the capital projects needed to access the resources at the respective power stations – hence, the sometimes quoted perception that Eskom is running out of coal.