Eskom slumps to record R9,7bn loss on big coal, metals-linked derivatives swing

This makes for scary reading! Frank

Eskom slumps to record R9,7bn loss on big coal, metals-linked derivatives swing

By: Terence Creamer

27th August 2009

State-owned power utility Eskom slumped to its worst ever loss of R9,7-billion in its 2008/9 financial year to end March, primarily on higher coal costs and a massive fair value loss on embedded derivatives, associated with pricing agreements the utility has with metals smelters in South Africa and Mozambique.

Had it not been for the big swing in the loss associated with metal-price-linked contracts, the Eskom's operating loss for the year was a considerably lower R3,1-billion.

But the results were also negatively affected by a 2,4% falloff in sales of electricity to 214 850 GWh, partly the result of load shedding and partly a consequence of the slowdown in demand brought on by the recession.

Eskom, which employs 37 857 people and has a total of 4,3-million customers, had a nominal capacity is 44 193 MW and net maximum capacity is 40 503 MW.

CEO Jacob Maroga indicated that actions were being taken in a bid to try and return the business to a breakeven position during the current 2009/10 financial year.

COAL CRUNCH

Eskom spent a whopping R25,4-billion on coal in the period, some R7-billion more than the R18,3-billion spent on the primary-energy source in 2007/8. It bought 133-million tons, 13-million tons more than the 120-million tons of 2008, and burnt 121-million tons, a level likely to be repeated in the current financial year.

The higher expenditure was mainly the result of Eskom's use of short-term contracts, deployed to rebuild stockpiles that had been depleted to unacceptable levels, and helped precipitate the load-shedding crisis of early 2008. Moreover, this restocking was implemented at a time when the export coal price was peaking at above $100/t.

Stock levels were now running at a far more comfortable 41 days as compared with the 13 days of stocks at the peak of the 2008 crisis.

The additional costs were also a consequence of the fact that the existing power-station fleet, which was having to be run harder owing to capacity shortfalls, was burning more coal than that contracted for with the dedicated, or tied, collieries. More coal also had to be transported from distant mines, which had added considerably to logistics costs.

Coal cost savings of R4-billion were being targeted for the current financial year, as Eskom gave greater priority to engagements with the coal-mining industry to better manage these costs. A national coal forum had been established to reduce the coal costs to Eskom and coal costs had already started to moderate.

Eskom was concerned, however, that there was currently insufficient coal-mining capacity in South Africa for long-term supply contracts to be concluded, as new mines had not been opened.

DISCOUNTED POWER CHALLENGE

A far more difficult problem to resolved, however, was the one relating to the discounted electricity prices to aluminium and ferrochrome producers - contracts that had been negotiated at a time when the utility was power flush and which effectively transformed South Africa into a major world aluminum producer in a matter of a few decades.

But as Eskom's reserve margin had declined and the country had experienced blackouts, the utility has been keen to extricate itself from the deal, which it viewed as unsustainable and in conflict with its shareholder's stated position that all State-owned enterprises move to end embedded-derivatives contracts that could cause undue earnings volatility.

In the year to March 31, Eskom's commodity-linked pricing contracts with aluminum producer BHP Billiton (which were based on London Metal Exchange prices adjusted for the rand: dollar exchange rate) as well as other smaller arrangements, had deepened the losses by a whopping R6,6-billion.

"Correcting embedded derivatives is a big issue," Eskom CEO Maroga told Engineering News Online, while chairperson Bobby Godsell added that Eskom would be engaging its commodity-liked customers with a view to achieving more equitable pricing.

Godsell stressed that it stilled valued its commodity-linked customers, but stressed that the contracts were concluded a long time ago and under very different circumstances.

"These customers have long-term as well as short-term interests and we will simply sit down with them and explain why these contracts are problematic, not only in price, but also because of the accounting uncertainty that they impose that makes proper strategic management of resources very difficult.

"We will look at both the form and the content of the contracts and I would hope that we could come to a good long-term basis of doing business," Godsell said.

NOT SUSTAINABLE

In the context of a R385-billion, five-year capital investment roll-out, the scale of the loss was viewed as "unsustainable" by Eskom, which still had an R80-billion funding shortfall for its Medupi, Kusile and Ngula projects.

The much discussed funding plan - which was meant to be finalised soon, given that Eskom wanted clarity ahead of the September deadline for its full submission to the regulator of a new tariff application under the second multiyear tariff determination period (MYPD-2) - would be key to placing the utility back on a sustainable footing.

Earlier, the National Energy Regulator of South Africa granted Eskom an "interim" 31,3% increase in its electricity tariff while it awaited the funding plan and the MYPD-2 application.

Eskom has continually stressed the need for an average tariff that reflected the full cost of electricity, as well as to support a build up of reserves to help it fund the capital expansion.

But business and labour have argued for a "smoothing" of such increases, suggesting that a spike would have devastating consequences for the economy and employment.

For that reason, the funding plan envisaged will probably not have an over-emphasis on revenue generated from tariffs alone, with the financing gap being closed through a combination of equity or near equity, government guarantees, commercial and development-finance debt, as well as consistent and transparent tariff increases.

Government had already provided R60-billion in the form of a subordinated loan with equity characteristics, and had made a further R176-billion available in the form of guarantees.

A development bond, which would enable South Africans to invest in the expansion of their energy system, was also being considered – with Martin Creamer.