While there is no question regarding the steady need for coal supply at present, the local sector is plagued by Eskom’s procurement and debt challenges, and the export market is trying to balance the costs associated with renewable energy innovation ahead of the 2050 global warming targets.

Coal is one of the largest and most affordable sources of energy, responsible for 38% of electricity generation globally. In South Africa, coal provides 83% of the power generated by Eskom, as well as being used as a heat producer in industrial processes such as in the manufacturing of cement, paper and steel. It is also turned into liquids and gases, used as fuel, or processed into chemicals to make other products. We unpack the dynamics of the South African coal mining sector.

South African coal
South Africa is endowed with an estimated 30 billion tonnes of coal, making up 3.5% of the world’s coal resources. SA miners make up 3.7% of global annual coal production. The 253 million tonnes of coal that SA produced in 2018 were used as follows (graphed below):

• 120 million tonnes in the generation of power by Eskom;

• roughly 40 million tonnes in the creation of gas, liquid and chemical products by Sasol;

• 70 million tonnes were exported; and

• other domestic industrial processes used the remaining 23 million tonnes.

Eskom’s procurement picture
Eskom currently has 13 operational coal-fired power stations and a further two under construction. More than 80% of coal produced in the country is mined in Mpumalanga with the rest mined in Limpopo, KwaZulu-Natal and the Free State. 11 of Eskom’s stations are based in Mpumalanga, within close proximity to coal mines, thereby minimising costs for coal transportation.

The domestic price of coal is mainly determined by Eskom (given its dominance in this market) who utilises three different contract structures and pricing mechanisms in purchasing coal. 33% of coal volumes are sourced via cost-plus coal contracts, 25% from fixed price coal contracts and 42% from short-term contracts (right chart below).

Cost-plus contracts (currently with Exxaro, Seriti Resources and South 32) are typically very long-term in nature, effectively holding Eskom responsible for ensuring the sustainability of the coal mine. Eskom pays for the cost of running the operation and the capital required, with a margin paid to the coal miner for operation and management. These mines are directly linked to the power stations, with some having conveyor belts running between mine and station to ensure a more optimal cost outcome.

Fixed price, long-term contracts are based on an agreed fixed or commercial price for coal and ensure the delivery of agreed volumes to Eskom. Here, the costs to run the operation are borne by the mine owner, as well as the capital needed. Eskom compensates the miner for the coal, with a margin that should compensate them for the operational and capital cost, however, there is pricing risk borne by the miner.

Short-term contracts were created to enable the government’s ambition for transformation, whereby the state was seeking to procure coal from majority black-owned miners. These contracts are similar to fixed price contracts but tend to be short-term in nature.

Eskom’s cost problem
Eskom reports that 52% of coal costs are made up of short-term contracts, contributing 42% of volumes. These contracts are much more costly for Eskom than the alternatives. Higher logistical costs are one of the predominant reasons. Mines belonging to new entrants in the industry are generally located further away from power stations that utilise their coal, with significantly increased transportation and logistical costs as a result.

Eskom is currently discussing reverting back to a lower cost option – where the bulk of volumes are sourced via long-term coal contracts – with a preference for coal delivered by conveyor. It is, however, not clear what will become of the new entrants that have been incentivised to enter the coal sector over the last while and may not be sustainable under such new arrangements.

Eskom requires an additional 1.3 billion tonnes of coal to cover all coal-fired power stations for a period of roughly 10 years. This is not catered for via the current contracts, which have reportedly secured sufficient coal supply until 2021. Eskom will need to recapitalise its cost-plus mines to ensure the security of coal supply at an optimal cost.

With Eskom facing a mounting debt burden, capital spend on coal mines has been reduced over the last number of years to meet debt servicing costs. Yet, as mining is a capital-intensive sector, any underspend on capital means that significant catch-up will be required to meet power station demands in the near future.

Sasol and other industrial demand
Sasol uses coal to manufacture liquid fuels and other chemical products through an integrated value chain. Its own mines produce around 40 million tonnes of coal and it acquires a further five million tonnes from third party producers. Sasol currently has enough coal supply from its own operations to meet its requirements until 2050.

The South African iron and steel industries also use coal, yet only 13% of coal produced globally can be used in steelmaking. This ‘special’ coal – referred to as coking coal – has a high calorific value.

Coking coal prices are primarily determined by global supply and demand dynamics and they are significantly higher than prices for the thermal coal utilised in electricity generation. The largest local consumer of coking coal, Arcelor Mittal, is in the process of restructuring its South African assets and is uncertain of how this will affect their future coal demand.

Climate change and future demand for coal
Thermal coal used in energy production has a major shortcoming in that this process is responsible for a third of global carbon dioxide emissions.

To meet the Intergovernmental Panel on Climate Change’s global warming target, all coal-fired power plants need to be closed by 2050. This implies that over a third of global power needs will switch from coal to other energy sources. These developments have significant implications for the 28% of South African coal supply that is shipped to the rest of the world.

The global thermal coal market can be split between the Atlantic and the Pacific, making up 20% and 80% of seaborne demand respectively (chart on previous page).

In the Atlantic market, coal is currently being displaced by lower carbon emitting substitutes for energy generation. The discovery of shale gas in the US has accelerated this displacement in favour of lower cost natural gas. In Europe, coal demand has declined over several years as old coal-fired plants are replaced with more renewable and nuclear power plants

In the Pacific, coal-fired power generation is relatively new, with the average age of coal plants less than 15 years old, compared to most in the Atlantic that are over 40 years old. Even with the current stated objectives of reducing carbon emissions, an additional 1.4 billion tonnes of coal will be required to meet increased demand from coal-fired power plants that are currently planned by governments in this region. Pacific demand growth results from strong regional economic growth and the emergence of a large, growing Asian middle class with increasing energy needs.

To ensure compliance with emission targets, Asian power producers are installing High Energy, Low Emissions (HELE) technology. This technology has the capacity to reduce up to 40% of carbon emissions (or up to 90% if the not currently commercially viable carbon capture is factored in). HELE technology has been successfully used in China and Japan to reduce carbon emissions. Coal, together with HELE technology, could become the lowest cost energy option for the Pacific, and far less harmful to the environment than current options.

HELE technology requires the use of higher quality thermal coal and South Africa predominantly produces low quality thermal coal, as is required by Eskom. While South Africa’s “good quality” coal is exported, it is not on par with Australian coal quality, which also benefits from a location advantage.

Exports from South Africa only make up 28% of production at present, but account for around 50% of coal miner profits as domestic coal is priced at a significant discount to the seaborne market.

Investment implications
The export market is navigating the requirement for a growing demand for electricity, while also endeavouring to reduce carbon emissions. Although this need has led to some innovation (HELE technology), this is an ever-evolving area and renewable energy continues to have the best environmental impact, albeit at a higher cost.

The South African coal sector is dominated by Eskom’s domestic procurement strategies. Eskom seems to be taking a longer-term view to coal procurement but is in significant financial distress and has limited ability to recapitalise the sector. Considering these dynamics, we have limited exposure to coal miners in our portfolios. However, Eskom’s strategic shift towards long-term coal contracts could present a positive opportunity for low cost domestic producers.