Buy smelters, mothball, save power Eskom

2015-02-16 11:53

Eskom currently provides a large amount of electricity to aluminium smelters in SA and Mozambique at less than half what it costs to produce, putting pressure on its finances and the electricity supply in SA. Eskom should buy these smelters, which are now housed in BHP Billiton spin-off company South32 and mothball them, save money and stop our loadshedding.

It is estimated that South32’s aluminium smelters in Mozambique (Mozal) and SA (Hillside and Bayside) use 9% of the kilowatt hours of electricity generated in SA and contribute 5.6% to maximum electricity demand. This electricity is being supplied at rates much lower than what it costs Eskom to produce due to outdated contracts that were signed when Eskom was producing a surplus and when aluminium prices were high. The price is estimated to be less than half of what it costs to produce power in general and a fraction of what it costs to run the diesel power plants at Ankerlig and Gourikwa (up to 10 times the cost of normal power generation).

The older contracts (signed in 1992) are linked to aluminium prices in dollar terms, while the newer contracts (signed in 2001) are based on a low starting value, increased by the producer price index (PPI) each year.

The problem is that since the contracts were signed, it has become much more expensive for Eskom to generate power and consumers are paying much more for electricity, especially over the past 6 years. During loadshedding, power generation becomes much more expensive due to diesel power plants being run at excessive cost. Further, aluminium prices are almost 40% lower than their highs in 2008. Eskom estimates that the contracts will cost it R9.3bn over the next 13 years and carries this as a liability in its balance sheet. The amount that Eskom stands to lose from these contracts is in fact much higher than R9.3bn because without these contracts, it would be able to sell electricity at a profit and not just at cost price (which I assume the R9.3bn is based on).

Eskom has applied to the National Energy Regulator of SA (NERSA) to investigate the contracts with the hope that the regulator will allow them to be adjusted to more economic terms for the electricity producer. However, NERSA is yet to make a ruling, years after being asked to do so. At the same time, BHP Billiton is opposing the cancellation or review of these contracts and even disputes NERSA’s mandate to investigate the contracts.

There have been previous calls for these aluminium smelters to be closed because of the impact on the power network and the negative impact on Eskom’s finances. However, BHP Billiton has resisted this, claiming that it would result in job losses, loss in exports and loss in tax revenue.

As it stands, it does not look like the situation will improve until 2028 when the contracts run out. BHP Billiton or the new owners of South32 are unlikely to budge on these very attractive contracts as it would make Mozal, Hillside and Bayside unviable and may force their closure. NERSA is also unlikely to have the teeth to force these contracts to be negotiated, although this remains a possibility. So what to do?

I believe that a possible solution, which requires thinking out of the box would be for Eskom to bid for the Southern African aluminium assets in South32. This may cost them a pretty penny, possibly R40bn - R50bn, but could make a great deal of financial sense, even in the short term. As the owners of these assets, Eskom could decide to mothball the smelters until it’s generation capacity has sufficiently picked up and until aluminium prices have risen sufficiently to make their operations economically viable (when paying market rates for electricity).

There would be positive and negative implications of such a decision. On the positive side, it would:

  • Free up between 5% and 9% electricity capacity in SA, effectively meaning the end of loadshedding;
  • Allow Eskom to stop running its Diesel power stations at Ankerlig and Gourikwa, which could save them up to R1.5bn per month (they have already requested an reported R20bn in funding from government to cover diesel cost in the near-term);
  • Allow Eskom to remove the R9.3bn liability on its balance sheet;
  • Boost Eskom’s income statement as it would be able to sell the excess capacity at market-related rates;
  • Reduce the pressure on the SA industrial sector; and
  • Reduce negative sentiment of potential new foreign investors in SA due to concerns over electricity supply.

On the negative side:

  • This could cost Eskom up to R50bn – however, the removal of the R9.3bn liability, the savings from not running the diesel power stations and the ability to sell electricity at market related rates, could pay for this in less than 2 years (and the mothballed plants would still have value); and this is still much cheaper than building a coal power station at between R100bn and R200bn;
  • There would be job-losses at the smelters, which could be up to 2400 people in SA – however, they could offer these employees lucrative packages and retraining opportunities at a fraction of the costs that they will save; and there would be a reduced risk of losing jobs in SA due to loadshedding discouraging investment;
  • SA will have to import more aluminium and there would be a negative impact on the balance of payments – however, this is likely to be temporary as the mothballed smelters could be brought back online when generation capacity improves (Medupi and Kusile are online) and aluminium prices rise; and
  • Government’s tax revenue could shrink – but this could be countered by less pressure on economic activity due to loadshedding and could be temporary (for the same reason as stated above).

It is my opinion that the positives far outweigh the negatives. What is even more important is that the positive impact could be felt immediately after the smelters are mothballed. There is no need to wait for generation capacity to be built. I think that this is a very interesting idea that Eskom should explore with immediate effect.

What do you think of this idea? Do you think we should in effect be exporting electricity at a huge loss? Would it concern you that Eskom has to receive additional funding to make such a purchase and would in effect be running aluminium smelters (even if they are mothballed)? Do you not think we should jump at this opportunity? Let me know what you think.

In the mean time, keep your talking straight!

Marius Strydom is the owner of MLAX Consulting

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