When we heard that Eskom had lost in excess of R9bn in the year to 31 March 2009 we hardly skipped a beat. We figured the countrywide load shedding coupled with global recession would decimate profits at even the healthiest company. It’s only when we disc
The answer must lie hidden in an undiscovered chapter in South Africa’s industrial development policy guidebook. In their eagerness to lure multinational companies to our shores government (including state companies like Eskom) offered incentives that were difficult to resist. We assume this was the case when Australian-listed diversified miner BHP Billiton chose Richards Bay as a location for its Hillside and Bayside aluminium smelters. Eskom apparently signed long-term commodity-price linked contracts with BHP (and others) to offset the capital risks inherent in such projects. In other words, government used Eskom to divert investment risk from BHP shareholders to ordinary taxpayers! The contracts were “structured to benefit both parties by offering power companies the certainty of demand and thus underpinning their investment in power stations whilst offering industrial customers a guarantee of long-term and secure supply,” said BHP spokesperson, Bronwyn Wilkinson.
A bizarre security blanket
How does the ‘deal’ work? The layperson might never understand. Although the term “embedded derivative” is splashed across the group’s abridged financial statements and appears next to the bracketed R9.5bn in the group’s income statement, the financial machinations are never revealed. The group simply states that it “makes use of a valuation technique in terms of IFRS to determine the fair value of commodity linked embedded derivative contracts!” In the latest financial year this value was calculated using “inputs for aluminium prices, exchange rates, interest rates, production price indices and electricity tariffs.” They also reveal that the global financial crisis prompted them to incorporate additional risk adjustors including “liquidity, model risk and other economic factors.”
After stumbling through a few more paragraphs without gaining further insight into the financial instruments that cost Eskom so much we’ve become firm backers of calls for ‘simpler’ language in financial statements! The simplest explanation we can think of is that the price Eskom charges BHP (and others) for electricity is inversely linked to the price of aluminium. If aluminium prices go up – then Eskom gets paid more – and vice versa. Over the past two financial years government must be questioning the mutual benefit afforded by these contracts. The utility lost R1.5bn in its 2008 financial year too.
Eskom is worried. Group chairperson Bobby Godsell told Engineering News Online they would engage its commodity-linked customers with a view to achieving more equitable pricing. “Eskom values all of its customers, including customers with commodity-linked contracts,” said Godsell, before reminding readers that South African citizens would be happier with companies like BHP plying there trade here than not.
Facing up to the funding nightmare
Eskom faces an uphill battle to find the estimated R385bn to meet its 2020 power production target. The company has already had to scrap proposals for another nuclear power plants as costs escalate. For years its profits were diverted from essential power generation projects to its main shareholder for use elsewhere. And now, when it needs cash most, the group is struggling to keep its head above water due to ill-thought long-term derivatives contracts. One cannot help but suspect Eskom left a few essential facts out of the recent price hike motivations with the National Energy Regulator SA (Nersa). Hard-pressed private consumers are stumping up 30% (or more) extra for their power this year, while bulk users like BHP Billiton are effectively subsidised. Other major industrial users and neighbouring countries also benefit from significantly cheaper electricity.
Government is trying its best to support Eskom with its infrastructure backlog. In the latest budget ex-finance minister Trevor Manuel provided R60bn as an equity loan over two years with an additional R177bn in guarantees. But its clear Eskom will struggle to make up any shortfalls in the debt markets. Investors are already concerned about the spiralling debt overhang compromising the company’s existing bonds. Late last week ratings agencies – that had already downgraded Eskom’s credit rating – advised they would refrain from their next assessment until there was further clarity on its funding model. We expect further downgrades are in the pipeline.
Private company sees nothing wrong
Wilkinson, quoted by Reuters, said “the price BHP Billiton pays for power to the smelters is internationally competitive…” She warned that the contract shouldn’t be judged based on performance over a single year. But there are still questions that need to be asked. Why has Eskom used derivatives to hedge this contract in the first place? Surely the company could simply have agreed to a long-term structured price based on volumes consumed and the cost of electricity production. Even a few rand per year is better than pencilling in a giant ‘fair value’ loss. The problem is taxpayers could stump up even more for future losses while Eskom waits for this multi-decade contract to run its course.
And there’s even worse news for FAnews Online readers. While trawling through Eskom’s 2009 annual report we stumbled upon this gem: “The annual electricity price increase used to value the embedded derivatives, was the applicable tariff determined by Nersa on 25 June 2009 for the 2010 financial year, 25% plus CPI for the next two years and CPI thereafter.” Looks like electricity consumers are in for some big hikes over the next two years! You can look forward to electricity price increases more than four times inflation in 2010 and 2011!
Editor’s thoughts: Taxpayers have a right to be incensed when public companies like Eskom and South African Airways play the markets with their money. Financial instruments like those negotiated by Eskom (and by SAA in its recent fuel-hedging disaster) should be left to privately-funded financial institutions. Do you think Eskom should subsidise power for large industrial users? Add your comment below, or send it to gareth@fanews.co.za