The Quest for McLeod’s ‘Deep Throat’

My wife often will ask ‘what do you enjoy
about those frequent visits with that old Uncle Gnarley?’

She does not hide the fact that she is
not enamored with the retired economist, believing him to be both opinionated,
and supercilious, with perhaps too strong a preference for the drink.  Overall, she considers Gnarley to be a
negative influence on her husband’s ‘pure disposition’. 

But what no woman can realize is that
there is a special breed of man who enjoys nothing more than
vigorous political debate, over a wee dram. 
I am one of this special breed, and politics is my blood sport.  After 10 years of dormancy, the province’s
political scene is now as exciting as the World Cup.   My wife’s protests are therefore like the
vuvuzela, annoying but easily relegated to the subconscious.

So I was slightly battered, but full of
enthusiasm, as I took the taxi down the shore to visit Gnarley.  Like any good athlete I was mentally
preparing for the upcoming debate. 
Considering the news of the past week, I suspected that this evening’s conversation
would be about the austerity budget delivered by the Premier.  I was, therefore, armed with statistics, and
opinions to ensure that a sensible debate would ensue. 

Like a kid in the candy store, I entered Uncle
Gnarley’s porch and peered into the kitchen. 
The old man was sitting at the table, working on his new Mac Book Pro.  His old pussy cat ‘Rosie’ was affectionately
sitting on his lap.  Although Uncle
Gnarley’s ambition for world domination extended only to Columbus Drive, one
could not help but draw the comparison to Ernst Blofeld himself.

Uncle Gnarley was so enthralled in his
work he did not even acknowledge my entrance.     

“Good evening Skipper”

“Nav”, he said, as he looked up: “this is truly
amazing.  Have you read it?”

“Yes. 
The austerity budget certainly signifies a fundamental shift in the
Province’s fortune, Uncle Gnarley.  I
would even say that it marks the end of the Progressive Conservative ‘Dan-ysty’
“.

Although the well-rehearsed opening
volley was intended to be the first strike of the evening it did not produce
the anticipated result. 

“Nav, tell me since when does a 1.6%
spending cut signal an austerity budget? 
Never mind I want to save that one for later.   I was actually enquiring about this McLeod piece on Muskrat Falls and the debt. 
Have you read it?”

Before I could answer the question Uncle
Gnarley continued.

“It is really an impressive piece and
this young McLeod should be commended for his initiative”.

It was difficult to not agree with my old
friend.   The McLeod / Bartlett tag team
has raised the bar for reporting in the Province.  McLeod’s coverage on Muskrat Falls was second
to none, and is a result of the passion which he certainly has for all things
political.  I am sure that his Christmas
card from the Premier comes delivered in a purple file.

“Nav, this notion that Muskrat Falls does
not contribute to our net debt does not sit well with me.  However, McLeod does provide a respectable
explanation as to why this is the case”.

I suddenly recalled reading the Blog Post by James McLeod which summarized the argument.

“Yes, Uncle Gnarley, the value of the
Muskrat Falls asset is used to offset the loans which are a liability to both
government and Nalcor.   The result is that although we are borrowing $8
billion dollars, through the accounting rules, it will not contribute to our net
debt”.

With that Uncle Gnarley got up from the
kitchen table and proceeded to the cupboard. 
The two familiar glasses were placed on the counter, and filled with
generous portions.  His curled lip was a
sure sign that here was something Uncle Gnarley wanted to get off his
chest. 

“So, Nav, if I get this correct… I can
borrow $790,000 dollars to build a yoga studio in Trepassey, and not worry, as I
have the asset to go against my net worth”.

I thought that this line of questioning
was strange considering my old friends former occupation “That is the way I
understand the calculations used by the accountants at work, Uncle Gnarley”

Uncle Gnarley just started to laugh. 

“Nav… 
did you just fall off the Turnip Truck?  
The balance sheet of the Provincial Government and Nalcor is much more
complex than the explanation provided to McLeod by the Department of
Finance.   There is a strict set of accounting
rules to be adhered to, which unlike the Premier’s view on Muskrat Falls, are
grounded in reality.  Accountants take
this stuff very seriously”.

With this I took my first drink.   My initial impression of the evening was
clearly misplaced.  Uncle Gnarley was in
fine form and the MacBook Pro was evidence that my old friend was also
researching in preparation for this evening’s encounter. 

The former professor was still always
ready to educate the ignorant.  He took a
pad of foolscap and a HB pencil down from the top of the fridge. 

“Nav, the Provincial Government are
putting equity into both the Muskrat Falls plant and the Labrador Island Link.  But let’s consider the Muskrat Falls Plant, or (MFCCo), only
 

            Total
Project Cost                               4.0 Billion

            Nalcor
Debt Portion                            2.6 Billion

            Provinces
Equity                                 1.4 Billion

Now, the Federal Loan Guarantee ensures
that the Provincial Government is not on the hook for Nalcor’s bad debts.  According to McLeod, the Province’s equity
investment will not contribute to the net debt of the province because there
is an associated asset value to offset it.  
This value is referred to as ‘Shareholder Equity’ on Nalcor’s financial
statements.  As the Department of Finance
and McLeod argue, the Shareholder Equity in Nalcor should equal the value of the
initial investment made by the Province. 
So, for the Muskrat Falls Plant (MFLCo) the initial balance sheet will
look like this”:

            Assets                                                  4.0
Billion

            Liabilities                                            2.6 Billion

          Shareholder
Equity                              1.4 Billion

 To which I dutifully replied, “That is my
understanding Uncle Gnarley”.

“That assumption is correct if the value
of the Muskrat Falls plant is what Nalcor assumes it to be.  But, in their preparation of their
consolidated accounting statements, Nalcor must adhere to the International
Financial Reporting Standards (IFRS) to determine the asset value.  Specifically, their subsidiary Newfoundland
and Labrador Hydro follow
IAS 16 for Property, Plant and Equipment.

Nav, as you can tell, I have been doing some
research into this matter.  In their 2011 Annual
Report Nalcor has stated that they use the “Cost Model” to determine the
original asset valuation.  In the cost
model, the valuation is the entire reasonable cost to bring the plant into
service, including all construction costs, equipment costs, interest during
construction and engineering.  This would
be the $4 billion”.

With that  comment, Uncle Gnarley passed me the MAc
Book pro bookmarked to the Nalcor 2011 Annual report. 

Now Nav, there is nothing wrong in this
assumption initially.  For the first year
of operation the cost model is a perfectly acceptable method of determining the
value of the Muskrat Falls asset.  But, as
I said before, accountants are serious people, who get very concerned about
unrealistic asset valuations which distort the balance sheets of
companies.  Arthur Andersen
ensured that accountants take this stuff very seriously. 

The simple argument put forth by the
Department of Finance, in McLeod’s blog, falls apart when the Muskrat Falls
asset must be revalued in the future. 
Accountants call this a ‘test for impairment’, when the asset value used
in the financial statements must be challenged as being reasonable.

Nalcor acknowledge that this has to be
done at the end of every accounting period. 

Nav, the method of determining the asset’s
fair value is a tricky business.  There are
many differing opinions on what the value should be. There are also many accountants who believe
that there may be different between the new IFRS rules, in comparison with the old
Canadian accounting rules (GAAP). 
However, it is clear that the asset value must be linked to the revenue
stream expected from the asset.”

With this I thought my old friend had
made a fatal mistake. 

“Well, Uncle Gnarley, Bill 61 ensured a
monopoly for Nalcor.  There is a
legislated revenue stream, which ensures that there is enough income to pay for
Muskrat Falls, and make a tidy profit for Nalcor besides.  Certainly, Bill 61 will protect the asset
value through any test for impairment”.

It was clear that I had impressed the old
economist.  He gave me the nod of
acknowledgement as he took a small drink. 

“Nav. .. a solid observation.  But this is where my research has shown this
may not, in fact, be the case.  The IFRS has produced a draft guidance
for regulated utilities which indicated that
the asset value may be determined based on the present value of the expected
cash flow.  However, there is strict
guidance that this method can only be applied if there is an overview by an
independent regulator.  Bill 61 removed
this power from the PUB.  Furthermore,
only reasonable charges can be considered to be recovered in the rates.  Items like a $400,000 mail out would not fit
this description.  Nor, likely, would the
$250 million spent on the Project, prior to 2008, which is currently intended to
be recovered in the rates.   

Most importantly, Nav, this guidance also
indicates that there can be an impairment or reduction in asset value, should
there be a likelihood of decrease in demand due to a future price spike. 

When
I read this entire draft guidance for regulated utilities, there is some doubt in my
mind whether Nalcor’s auditors would agree with the Muskrat Falls asset value
being determined from a revenue stream, which was legislated by Bill 61
alone”. 

“But
Uncle Gnarley although the Labrador Island Link will be regulated, the Muskrat
Falls Plant will be an unregulated subsidiary of Nalcor.  What impact does this have on your theory?”

“Nav…  that is the second time you have impressed me
this evening.   You are right.  Muskrat Falls is an unregulated utility.  Although it may eventually cost $4 billion to build
the plant, the value which Nalcor can carry on its books  may not be based on the Power Purchase
Agreement, but 
based on Fair Market Value.

 

Nav, doubtlessly, there is nothing fair about Bill 61.  Now, if the Muskrat Falls asset is valued at
fair market value there will certainly be an impairment charge.  You see fair market value should be based
upon the Energy Industry Association projections for wholesale electricity
prices, minus any transmission costs.  My quick calculations show that fair market value will be about 75% of the price which Nalcor will be
charging their valued customers.  A 25%
reduction in the asset value is therefore not an unrealistic outcome.    

This
may all be confusing, Nav, especially to your weak mind.  However, the fair market value can also be
determined as what the value of the asset may be in the event of resale.  Again, the potential resale value could not be
based on revenues entrenched in Bill 61. 
Any company that could possibly buy the Muskrat Falls plant might not because Bill 61 
would potentially jeopardise their FERC license to sell power into
the U.S
.  No company would risk their livelihood
to purchase a white elephant in the wilds of Labrador.

Finally
Nav, the asset value should not be based solely on the revenue from the 50 year
take or pay contract with Newfoundland and Labrador Hydro.  There is the slight issue that beyond 2035,
MFLCo will be selling the same power to NLH as what they are giving to Emera.  They either need to remove part of their
revenue, past 2035, or recognize the liability of additional generation they
will have to bring online.  Nalcor still
have not clarified how they will pay for this additional power”. 

 


With
that Gnarley had completed his dissertation. 
Exhausted he fell into his chair. 

“Uncle
Gnarley, this is all fine and dandy, but what does it all mean?”

With
that comment, Uncle Gnarley’s upper lip began to curl, again.  He was clearly not happy as he again reached
for his foolscap sheets.  “Nav.. I
acknowledge you are not an economist, but surely you understand basic math”

                                                                        Original                       Fair Market

            Assets                                                  4.0 Billion                  3.0 Billion (75%)

            Liabilities                                            2.6 Billion                  2.6 Billion      

            Shareholder
Equity                             1.4 Billion                  0.4 Billion

With
this reduction in shareholder equity in MFLCo, there will be no asset for the
Province to recognize when they do their own budget.  Magically, a $1 billion increase in the province’s
net debt will occur!”

It
was clear that the assumption that Muskrat Falls would never contribute to the
Province’s net debt could be affected by the interpretation of the global IFRS
accounting standards, which are yet to be issued, let alone applied.  I never thought an accountant could be so
powerful. 

“Uncle
Gnarley what about the $600 million the Province is putting into the Labrador
Island Link?”

“Nav,
the same principal applies.  Fair market
value needs to be adopted.  When you take
this $600 million in equity, which is 25% of the project cost, it could all
eventually be considered within the Province’s net debt.

Nav,
what is also forgotten by the politicians is that the majority of this equity
must be borrowed.  The people of
Newfoundland and Labrador will be spending well over $400 million over the life
of the project to service the debt required to provide the equity
investment.  This, too, should be factored
in. 


When
you combine all of this borrowing, the great Muskrat Falls project could contribute
upwards of $2.5 billion to the Province’s net debt.  As the IFRS rules are just now being rolled
out, it is uncertain where this will all land and be interpreted by
accountants.  All of this is potentially
a dog’s breakfast for the tax payers of the Province!”

This
was a very profound statement, which if Gnarley was correct, would show once
again how the simplification of a very complex project can lead to
confusion.  If only partially correct, it
was clear that the Premier can’t be certain that Muskrat Falls will not add to
the net debt of the Province in the future. 

“Gnarley….  I must ask, are you sure you are correct?”

“Jesus,
Nav… I am an economist not an accountant! 
Of course I am not sure.  But this
is what takes me back to our man McLeod. 
He has dug into an issue which could present itself to be a scandal for
this Government.  If the people of this
province knew that Muskrat Falls could potentially contribute $2.5 billion
dollars to our net debt, it would erode the remaining confidence we have in
this Government!”

With
this, I had a great revelation, and I blurted it out.

“McLeod
needs a ‘Deep Throat’!”

The
old man looked up at me with a smile. 
“Don’t we all, Nav… don’t we all”.

“No
Gnarley.  I am making reference to the
Watergate scandal of the Nixon administration. 
Bob Woodward and Carl Bernstein were political reporters with the
Washington Post.  They dug into and
reported into the emerging scandal.  But,
it was not until they had an FBI informant, referred to as ‘Deep Throat’, before
the scandal blew wide open.  It led to
Woodward being considered as one of the defining journalists of his generation”.

Gnarley’s
interest was pegged. “Nalcor and the Government must certainly have a position
paper on this issue.  They have likely
retained one of the four main accounting firms to review the management
structure of all these corporations. 
They must have existing briefing notes which they could have easily
given McLeod to explain all of this…  
It is, therefore, likely not as clear, nor as simple, as the politicians
make it out to be”. 

With
that he got up and made himself another drink. 
The familiar sight of Rosie perched on the window sill, and Gnarley
mixing himself a drink, was comforting to my tortured soul. 

“Uncle
Gnarley, with these rounds of cuts, there must be many employees at the
Department of Finance who may either be disgruntled, or simply consider it
their civic duty to clarify this situation. 
There must be a Mark Felt out there somewhere?  Whether you are right or just fear mongering the
people of the Province deserve to see the formal opinion of Nalcor’s auditor’s
and that of the Auditor General.  It is
even more troubling if this formal opinion does not presently exist!”

Gnarley
continued back to his computer, drink in hand. 

“Nav…
McLeod is a good reporter.  He needs to
continue to dig into this issue.  But, one
thing is certain, with the right ‘Deep Throat’ McLeod could go from a good
reporter to a great one”. 


******************************************
Editor’s Note: This Post was written by “JM”,
the anonymous researcher, writer and
presenter, to the PUB and in local
Blogs, on the Muskrat Falls Project. JM has written a
number of Uncle
Gnarley pieces, including, most recently, Gnarley’s
Theory of Political Devolution
, Parts I and II and The
Great Revolutionary from the Shore
. His latest Paper is entitled: Muskrat
Falls Revenue Stream: Fact or Fiction
  – Des Sullivan

Des Sullivan
Des Sullivan
St. John's, Newfoundland and Labrador, Canada Uncle Gnarley is hosted by Des Sullivan, of St. John's. He is a businessman engaged over three decades in real estate management and development companies and in retail. He is currently a Director of Dorset Investments Limited and Donovan Holdings Limited. During his early career he served as Executive Assistant to Premier's Frank D. Moores (1975-1979) and Brian Peckford (1979-1985). He also served as a Part-Time Board Member on the Canada-Newfoundland Labrador Offshore Petroleum Board (C-NLOPB). Uncle Gnarley appears on the masthead representing serious and unambiguous positions on NL politics and public policy. Uncle Gnarley is a fiscal conservative possessing distinctly liberal values and a non-partisan persusasion. Those values and opinions underlie this writer's views on NL's politics, economy and society. Uncle Gnarley publishes Monday mornings and more often when events warrant.

REMEMBERING BILL MARSHALL

Bill left public life shortly after the signing of the Atlantic Accord and became a member of the Court of Appeal until his retirement in 2003. During his time on the court he was involved in a number of successful appeals which overturned wrongful convictions, for which he was recognized by Innocence Canada. Bill had a special place in his heart for the underdog.

Churchill Falls Explainer (Coles Notes version)

If CFLCo is required to maximize its profit, then CFLCo should sell its electricity to the highest bidder(s) on the most advantageous terms available.

END OF THE UPPER CHURCHILL POWER CONTRACT: IMPROVING OUR BARGAINING POWER

This is the most important set of negotiations we have engaged in since the Atlantic Accord and Hibernia. Despite being a small jurisdiction we proved to be smart and nimble enough to negotiate good deals on both. They have stood the test of time and have resulted in billions of dollars in royalties and created an industry which represents over a quarter of our economy. Will we prove to be smart and nimble enough to do the same with the Upper Churchill?

1 COMMENT

  1. I think your comment "the simplification of a very complex project can lead to confusion" misses the mark. I would argue that it is the opposite that more clearly gets to the heart of the matter. That is, that it is the making of a simple issue very complex that is what is creating the confusion — and intentionally so. Once people are confused, it is easier to mislead, to hide the truth, to put opponents or those who might have a glimpse of the truth off balance and thereby easier to move ahead with one's own agenda…… That is what we have and that is what we have with all this talk of "net debt", whether MF affects "net debt", etc. etc. etc. ….. Obfuscation, at its best. Nevertheless, when you question the value of this so-called 'investment', you are getting close to the heart of the matter, and thereby at the very least skirting near the edges of the truth.