Termination dispute, overloaded: The staggering cost of Eskom vs BHP Billiton

6 May 2013

A dispute between Eskom and BHP Billiton regarding when to terminate the electricity supply agreement for the Hillside Potline 1 and 2 aluminum smelters in Richard’s Bay could have a worrying impact on Eskom’s balance sheet – and throw the income statement out of whack to the tune of billions of Rands. By CHRIS YELLAND.

Eskom and BHP Billiton are currently disagreeing over a technicality in the contract period for Hillside Potlines 1 and 2, which was signed into some years ago. Now, as the end of the contract period draws closer, the disturbing financial implications of the dispute are being thrown into relief.

It’s a complex issue, but can be broken down as follows. The electricity prices and contract period for Hillside Potlines 1 and 2 are defined in the main pricing agreement [1] and contract between Alusaf (subsequently Billiton, now BHP Billiton South Africa) and Eskom, signed in 1992.

The electricity supply period of the main agreement for Potlines 1 and 2 is 25 years, and ends in July 2020. The electricity price during the contract period [3] is not based on Eskom’s cost of production in any way, but is instead directly linked to the prevailing Rand / US dollar exchange rate and the price of aluminium in US dollars per ton.

Subsequently, a supplementary agreement [2] was signed in 2001 for an expanded electricity supply to cater for a third potline at the Hillside site.

While Eskom believes the supplementary agreement does not affect the contract period of the main agreement for Hillside Potlines 1 and 2, BHP Billiton believes the supplementary agreement extends the contract termination date of the main agreement for Potline 1 and 2 to June 2028, in line with that of Potline 3.

If BHP Billiton’s view is correct, this would have massive additional negative financial implications for Eskom in terms of continued losses on the sale of electricity to BHP Billiton for Potlines 1 and 2 for an extra eight years from 2020 to 2028.

On page 76 of its annual financial results [4] for the year ending 31 March 2012, Eskom declared “embedded derivative liabilities” of R5,5 billion, these being largely the estimated forward losses for the remaining period of the Hillside Potline 1 and 2 contract to July 2020.

This liability (estimated forward loss) was calculated as the difference between the electricity revenue from Potline 1 and 2 assuming Eskom’s standard Megaflex tariff and price trajectory to July 2020, and the revenue from Potlines 1 and 2 in terms of the main commodity-linked pricing agreement in place, assuming a R/US $ exchange rate and US $ aluminium price as at 31 March 2012 for the remaining period of the contract to 2020.

At the end of each financial year, Eskom recalculates and declares this liability for the remaining period of the Hillside Potline 1 and 2 contract in its balance sheet. Any change (increase or decrease) from that calculated at the previous financial year-end is then reflected as a loss or profit (respectively) in Eskom’s income statement for the year.

If the contact period for Hillside Potlines 1 and 2 extends beyond 2020 for a further eight years to 2028, as BHP Billiton claims, this liability of R5,5 billion could potentially double, depending on the Eskom Megaflex tariff price trajectory assumed over the period 2013 to 2028 and the R/US $ exchange rate and US $ price of aluminium at financial year-end.

The supplementary agreement [2] signed in 2001 would appear at first reading to support BHP Billiton’s view in this matter, and states: “This Supplementary Agreement is supplemental to and amends the main electricity supply agreement dated 11 November 1992 (the ‘Main Agreement’) between Eskom and Alusaf (Pty) Ltd”; and further: “This Supplementary Agreement shall come into force on the date of signing hereof, and shall... remain in force until 30 June 2028”. In respect of the main agreement signed in 1992, the supplementary agreement of 2001 further states: “Save as provided herein, the parties’ reciprocal rights and obligations in terms of the Main Agreement remain unaffected”.

In weighing the relative merits of Eskom and BHP Billiton’s positions, it should be noted that only parts of the main and supplementary agreements were released by Eskom following the Supreme Court of Appeal judgment [5] on the Promotion of Access to Information Act application by Jan de Lange and Media24. It is conceivable that the missing details of the agreements may favour Eskom’s or BHP Billiton’s interpretation.

An Eskom source has suggested, however, that the supplementary agreement is ambiguous on the matter to the extent that both Eskom’s and BHP Billiton’s lawyers disagree with each other’s interpretation. An independent legal/ ethical expert consulted by EE Publishers indicated that: “In cases of contractual ambiguity, and resulting differences of interpretation, the intentions of the parties at the time of signing the supplementary agreement may in fact be the deciding factor, rather than just the wording in the supplementary agreement itself. However in such cases, additional evidence would be required to substantiate and prove any such claimed intentions”.

In this regard, Eskom would presumably argue that the intention of the supplementary agreement was to provide a similar contract period for Potline 3 in the supplementary agreement (i.e. 25 years) as for Potline 1 and 2 in the main agreement (25 years), and that the intention was not to extend the contract period of Potline 1 and 2 from 25 years to 33 years.

It is well known that for several years Eskom has been engaged in efforts to renegotiate its commodity-linked special pricing agreements. In 2010, the agreements for BHP Billiton’s Mozal Potline 1 and 2 aluminum smelters in Mozambique and Anglo American’s Scorpion Zinc operation in Namibia and were successfully renegotiated to remove Eskom’s exposure to embedded derivatives, and Eskom is therefore no longer required to disclose the liabilities of forward losses on these contracts in its annual financial results.

However, the renegotiation of the Hillside Potline 1, 2 and 3 contracts was unsuccessful, perhaps breaking down as a direct result of failure to reach any agreement on the termination date of the Potline 1 and 2 electricity supply contract. In a Business Day article [6] on 3 April 2013, BHP Billiton South Africa Chairman Dr. Xolani Mkwhanazi went on record to state: “BHP Billiton expects our contracts to be honoured. We believe absolutely in the sanctity of all contracts”.

Following the breakdown in negotiations, on 17 October 2012 Eskom submitted an application to the National Energy Regulator of South Africa (NERSA) [7] for a review of the Hillside and Bayside commodity-linked electricity supply contracts. The review may provide an opportunity to test Eskom’s and BHP Billiton’s positions on the disputed termination date of the Potline 1 and 2 contract, as this was a key issue in the breakdown of Eskom’s efforts to renegotiate the contracts.

A NERSA view and ruling on the intentions of Eskom and BHP Billiton at the time of signing the supplementary agreement in 2001 may indeed be meaningful, because the National Electricity Regulator (NER), as the predecessor of the NERSA, specifically reviewed, approved and authorised the supplementary agreement [8] for the increased supply for Potline 3 in 2002.

However, a NERSA view and ruling now on the disputed contract termination date may not be entirely free of perceptions of conflicts of interest, because the CEO of the NER from 1999 to 2004 when the supplementary agreement was signed by Eskom and BHP Billiton (in 2001) and approved by the Regulator (in 2002) was Dr. Xolani Mkhwanazi. As detailed in a Mail & Guardian article [9] on 3 May 2013, Dr. Mkhwanazi subsequently joined BHP Billiton South Africa as COO of its aluminum business in 2005 and became chairman of BHP Billiton South Africa in 2008.

With the uncertainty and dispute surrounding the date of termination of the Hillside 1 and 2 electricity supply and pricing agreement, and the massive financial impacts, it remains to be seen whether Eskom will make any provision for increased liabilities and loss of profits in its financial results for the year ending 31 March 2013, which are currently scheduled to be announced on 10 July 2013.

The outcomes of the review of the commodity-linked pricing contracts and the disputed termination date of the Hillside Potline 1 and 2 contract clearly have significant wider economic impacts and relevance [10] at this time when South Africa is experiencing huge Eskom electricity price hikes significantly higher than the inflation rate, and electricity generation capacity shortages that restrict economic growth. DM

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