Eskom set to shape coal industry for consumers’ benefit

Eskom aims to shape and transform the coal industry as a core part of its mandate, writes Matshela Koko.

The South African coal industry is made up of export and domestically consumed coal totalling almost 200 million tons in the 2015/16 financial year.

As of March 31, the total export of coal, according to Transnet, was 75 million tons, while the largest domestic consumer Eskom consumed 119 million tons, equivalent to R45 billion.

Eskom’s 60 percent market share makes it the dominant player in the country and a major global consumer of coal.

Eskom primarily sources 51 percent (R23bn) of its coal from a small group of key suppliers that comprises Anglo Thermal Coal, South32, Exxaro and Glencore. These firms have a historical competitive advantage having largely had capital investment financed off the back of Eskom’s balance sheet while enjoying advantageous cost-plus contracts.

Despite these firms being heavily reliant on Eskom, an analysis of the credit rating of the above companies reveals that they now largely enjoy superior credit ratings compared with Eskom’s so-called current junk status (excluding improvement in its rating due to government support).

Dependent

The key question is why do these firms have better credit terms given that they are significantly dependent on Eskom for their cash flows and financial fortunes? Is this due to higher margins being charged to Eskom or better balance sheet management or diversified export revenue?

Interestingly, Tony Weber, the chief executive of Universal Coal, a large coal supplier, indicated that coal was sold to Eskom at superior margins calling it “a magical place to be”.

Additionally, it should be noted that costs at cost-plus mines have been increasing at above industry rates, resulting in Eskom spending more on coal than initially budgeted for. For example, Eskom will need to spend an additional prohibitive R38bn in the next five years to further capitalise the cost-plus mines.

Despite the significant investment and cost increases, these cost-plus mines are generally underperforming with only 71 percent of contracted volumes being supplied.

Key questions need to be asked as to how these companies have been allowed to gain such favourable terms. If one is looking for corporate capture then could it not be found in the historic cost-plus transactions of Eskom with these mining companies? This is the ongoing legacy of the pre-1994 economy that we have not sufficiently worked to dismantle and have at times been frightened to confront.

Surprisingly, the focus has not been on the 51 percent (R23bn) of coal bought from large suppliers but rather the 1.96 percent (R880 million) from one of our new suppliers, Tegeta Exploration and Resources. Tegeta has been singled out for criticism, while our large suppliers who have far higher costs are not questioned.

For the record, the Tegeta coal costs are in line with similar suppliers that supply coal the Majuba power station, namely: Shanduka, Glencore-owned Xstrata and WesCoal. All Tegeta coal contracts with Eskom have been extensively audited by various agencies, including the Office of the Auditor-General and the Treasury.

The same level of scrutiny is not applied to the real large cost-plus miners.

Eskom, as a regulated state-owned entity, has an obligation to ensure that national assets are effectively utilised, especially in the current cost-constrained environment.

Historically, Eskom financed the coal industry through the cost-plus contract structure where the state-owned utility paid for the actual cost of mining operations, plus an agreed profit margin.

The fact is Eskom had no control of mining operations, the coal quality or the geology of the coalfields. As the primary local consumer, Eskom provides stability and consistent demand during periods of coal volatility. In simple terms, Eskom finances the local coal industry, enabling them to attain windfall prices from the export market.

However, mining firms have not significantly transformed the industry. These firms preferred to sell coal to China and India and started to demand that Eskom pay export prices for non-export quality coal. This led to the discussion to have coal declared a strategic asset in order to cap local pricing.

Moreover, all of Eskom’s revenue is regulated by the National Energy Regulator of SA (Nersa) unlike the above companies, which operate in a deregulated industry that enables them to freely set pricing.

By regulating Eskom only, this means that Eskom will need to fully embrace its role as quasi-regulator of the coal industry due to its dominant participation and investment support. To date Eskom has not played this role and did not pass on its significant regulatory risk to other industry participants. Ultimately, Eskom had to absorb the primary energy cost increases. Major repercussions of this situation are the deterioration of Eskom’s balance sheet, resulting in its poor credit rating and tariff increases.

Risk mismatch

Unfortunately, these are the only two alternatives Eskom has to manage this risk mismatch. The mining firms do not have these risks placed on them and are, therefore, able to attain superior margins and ultimately attain a superior credit rating.

Ideally, the risk mismatch should be shared among all in the industry. Eskom is now rightly taking an increasingly assertive role to transform the industry, while ensuring optimal coal prices and delivery terms. Eskom will, therefore, via its revised contracting approach need to effect economic transformation of the industry.

A number of mechanisms are being reviewed to determine the optimum tactics to effect the required and urgent change to enhance the potential of emerging miners, ensure greater risk sharing, while enhancing engagement with all suppliers. In this regard, Eskom will seek to increase competition in the industry and also engage with new industry players.

Our key requirement will focus on miners who can provide coal at the right costs. Furthermore the rationale for this is based on cost-plus miners clearly stating that all mine assets belong to Eskom. Eskom is also responsible for all operational costs and capital investments thereby indicating its asset ownership. To prove this, Exxaro stated in this year’s annual report “Eskom owns all assets at Arnot mine and is responsible for the mining and closure costs”.

Anglo American has announced that it will embark on a new strategy to restructure its balance sheet and sell-off non-core assets. This new strategy will entail an exit from coal mining and will lead to a sale of their global coal assets, including its South African coal operations. These local operations are, however, based on cost-plus contracts and, therefore, Eskom technically owns part of, if not the majority of, operating assets and the mining infrastructure, while Anglo owns the mining rights and some of the surface rights.

As such, Eskom and Anglo will need to engage in order to effect radical transformation through the potential new owners. An example of this could be through selling to an existing state-owned mining company; Anglo could cede mining rights to this company, while Eskom cedes physical assets and mining infrastructure. There are other options, however, the key objective is to ensure that there is a radical change from the current status.

Transform

Based on the above, Eskom will now more vigorously shape and transform the industry as a core part of its mandate. This is important as Eskom is mandated to ensure optimal usage of national assets (coal), especially where it has financed and developed the requisite infrastructure for this industry to develop. This will have a significant impact on the structure of the industry as the status quo cannot be justified and is not sustainable.

Lastly and most importantly, these changes are aimed to benefit the consumer with lower tariff increases. This would support much needed economic growth beyond the current gross domestic product growth projection of 0.8 percent and help tackle our socio-economic challenges.

* Matshela Koko is Eskom’s group executive for generation.

** The views expressed here do not necessarily reflect those of Independent Media.

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