Oram: Key's game of two halves over smelter

ROD ORAM
Last updated 05:00 07/04/2013
Smelter
Barry Harcourt/Fairfax NZ

Point of departure: The MV Tiwai Point with the aluminium works of the same name in the background.

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OPINION: The Prime Minister is playing two games with the Tiwai Point smelter: hardball with its owner, Rio Tinto; and softball with investors in Mighty River Power. He'll be in deep trouble if he drops either ball.

Key has told Rio his government won't subsidise the very low electricity prices the smelter needs to be profitable. He says the plant must stand or fall on its economic merits.

This should make investors in Mighty River Power very nervous. If the smelter closed quickly, the 14 per cent of national electricity supply it uses would flood the market. The electricity industry would suffer turmoil, generator closures and electricity price cuts.

But Key has soothing words for investors: Don't worry. If the smelter closes, it would do so over three to five years. Generators would have plenty of time to adjust. This implies his flagship policy of SOE sales would still fly.

So far investors have bought his line. The share price of Contact Energy has drifted only a little lower, suggesting investors aren't worried Mighty River Power's value will be compromised before or after its float next month.

Happily for Key, he is probably safe in the short term, the only game he knows. Rio has been trying since 2011 to sell its NZ smelter, along with its equally unattractive Australian aluminium plants. It might be some months away from making a final decision.

Rio has three options: to sell Tiwai Point for a knockdown price to a second-tier operator that would run it for the last few years of its life; keep it because of the quality of its output and the productivity and innovation of its workforce, but rack up more losses on it; or close it.

The odds on finding a credible buyer for the smelter are long. Dramatic shifts in the global aluminium market over the past decade have economically stranded the asset, as this column analysed last October 21. A copy is available here: http://on.fb.me/106agX8

Only a drastic cut in electricity price would make the smelter economic, or encourage a massive modernisation to extend its life. But Meridian Energy, its electricity supplier, knows how low it can go before it would be better off selling the electricity to other users.

Meridian's position makes good economic sense for the country. Using the smelter electricity across the economy would delay for years the sector's expenditure on new generating capacity. Meanwhile, users would benefit from lower prices.

Very little is known about the terms of Rio's contract with Meridian but it is clearly a good one for the generator. The electricity price is based on a formula involving world aluminium prices, the exchange rate and the consumer price index. This means Meridian shares to some extent Rio's bad and good times.

However, it is much more favourable to Meridian than the previous contract. Rio thinks Meridian should share more pain now and less of the upside later, judging by its public unhappiness with the long-term aspects of the 18-year contract, which came into effect this year.

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Why Rio signed such a deal in 2007 is best explained by the world at the time. Those were the crazy days before the global financial crisis when mining companies, and many others, believed they were riding an endless boom.

It was the year Rio lost its head in a bidding war for Alcan, the Canadian-based smelter. It paid US$38 billion, a 65 per cent premium over the inflated market price, financed almost entirely by debt. It was the biggest takeover ever in the mining sector and the burden has dragged it down ever since. Its aluminium assets are performing so poorly, some 80 per cent of its profits are coming from iron ore.

Rio is clear it wants out of its bad aluminium assets, and has taken a US$10b writedown on the worst of them, including Tiwai Point, to speed the process.

Of course it wants to make the best exit it can from New Zealand. Even small price concessions by Meridian would be valuable to it and a purchaser. But it has next to no leverage here, other than some over Key's flagship policy of SOE sales.

Judging by the tone of media reports, very few voters support taxpayer subsidies of the smelter. Even many people in Southland seem to accept the smelter has no future long term. Thankfully, its contribution to the local economy halved from 19 per cent of gross regional product to 10.5 per cent between 2005 and 2011 because of growth in dairying and other sectors, according to Venture Southland, the local government economic agency.

Also, the region has other job and economic opportunities in forestry, wood processing, horticulture, education, skills training and engineering, as a report by BERL showed last year.

Given Rio would be stuck with its Meridian contract if it couldn't sell the smelter, it would make more corporate and economic sense for Rio to close the smelter quickly rather than wind it down over three to five years.

It would need to cut a deal with Meridian to end their contract by paying, say, the equivalent of five years' electricity. It could then cease production and avoid ongoing losses.

It could also get on with its obligation to dismantle the plant and clean up the site. It has hefty provisions in its local accounts to do so. It prides itself on such good corporate citizenship around the world, as it trumpets in its 2012 sustainability report, available at http://bit.ly/10uzuNX.

Meanwhile Meridian would enjoy, say, five years of selling to other customers the electricity Rio has paid for but is not using.

Such a speedy exit would be good for Rio.

But it would be bad for Southland and Key's flagship policy.

Key can hope Rio won't act so precipitously or buy himself some certainty by doing a deal to keep Rio onside for the next few years.

But given the very clear opposition to subsidies he and Meridian have articulated so far, any concession to Rio now would be nasty politics and bad economics.

- Sunday Star Times

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