Guest Post by David Vardy
major events signal the rising tension among the people of this province,
fearful of their future. Since 2016 we have had 11 quarters in which the
population has declined continuously, from 530,000 to 522,000. This is a
measure of the angst over our serious fiscal plight and the prospects of
dramatically higher power rates.
two events were the release of the final PUB report on rate mitigation and the
second was the press conference by the Premier and Natural Resources Canada Minister
Seamus O’Regan on negotiations toward rate mitigation. Both events focused on
the return on shareholder equity. The PUB recommended that the province forgive
payment of dividends on provincial equity. The joint press conference latched
onto that option as a cure for Muskrat Falls, namely the writing off of
dividends and financial restructuring.
province is taking most of the risks, even with the federal loan guarantee in
place. The federal government has invested nothing yet in this project but the
province has invested close to $5 billion in borrowed funds. Nalcor’s estimate
of equity does not make provision for the cost of the borrowed funds which must
be paid as soon as they costs are incurred, during construction as well as
during commercial operations. This allowance for funds used during construction
raises the province’s equity investment from $3.8 billion, Nalcor’s estimate,
to $4.8 billion. The province must also provide equity funding for any
additional cost overruns. Such overruns are likely to occur in relation to the
delay in transmission software and the cost of repairing synchronous
condensers. Disputes with contractors may also lead to further overruns.
revenue requirements over the 50 year supply period, beginning with the first
year of commercial operations, 2021 or later, will amount to $74.6 billion,
based on the current cost recovery structure, which is a combination of “cost
of service” and “escalating supply prices”. The province and the federal
government are negotiating to restructure the financial arrangements through
of the province’s rate mitigation plan released April 2019 and which stabilizes
rates at 13.5 cents/KWh, rising annually thereafter based on an inflation
modified cost of service approach which writes off $30 billion in dividends
from generation assets (assets at the generation site and the transmission line
from Muskrat Falls to Churchill Falls).
of the flow of dividends from the Labrador Island Link.
power purchase agreement (PPA) will be abandoned and many of the project
agreements will need to be revised.
this point it is unclear how this will be accomplished. The federal government
has indicated willingness to make adjustments with respect to sinking fund
payments up to the end of 2021 and in the cost overrun escrow account (COREA).
Sinking funds involve the accumulation of funds before bond issues mature while
the COREA payments ensure that the province’s equity is injected pari passu
with capital expenditures. None of these adjustments really reduces the
financial burden in any material way.
equity must be repaid
agreeing to write off dividends the province is accepting one of the
recommendations of the PUB. However this was an inevitable step given that the
dividends were fictitious. Sadly the province cannot wave a magic wand and
write off the cost of the borrowed funds, on which interest must be paid and
whose principal must be repaid. These costs, relating to the generation assets,
will amount to $200 million in the first full year of commercial operations.
The $5 billion in equity is very real and the cost of the borrowed funds should
have been included in the revenue requirements and added to the $726 million
for 2021. Now it appears that the province must absorb these costs.
|Federal Finance Minister Bill Morneau|
federal government will insist on a full accounting of the costs before
committing itself to further financial infusions. They will want to know if
this is going to become a $16 billion project or whether the official cost
estimate will stand. They will want a permanent solution and not a temporary
fix. They will not write a blank cheque to cover the required operating
deficit. They will want to examine all the options, including mothballing, if
the cost of operations exceeds revenues. They will want to know what level of
demand can realistically be expected over the next 30 years.
federal government now understands that the business plan for Muskrat Falls was
fatally flawed by understated capital costs and exaggerated demand projections.
There is a market for power but the demand is for low priced energy. Muskrat
power will be sold at a huge discount from the actual cost. This discount
negates the prospect of dividends.
the province now has no choice but to complete the project it may not be
feasible to operate it. Government has to consider the options and one is to
mothball the project rather than to operate it, if the federal government does
not inject sufficient equity to make it viable.
Federal Finance Department will play a larger role in these discussions than in
the past and they will want to deal with the full fiscal dilemma in which our
province finds itself. They will not want to deal with Muskrat Falls in
isolation from the larger structural deficit and the fundamental fact that
while our revenues are relatively high, compared with other provinces, our
expenditures are the highest of any province on a per capita basis. They will
want to place conditions on any further financial support in order to impose
fiscal discipline and expenditure retrenchment.
the absence of a plan to manage the fiscal deficit they will seek to put a
bandage on the problem. Finance Minister Bill Morneau makes it clear that “As
this proceeds, it is important to remember these are provincial Projects, in
provincial jurisdiction, and the Province bears responsibility to ensure they
are delivered economically.” He is saying that this is our problem and not
Ottawa’s, which is disingenuous given Ottawa’s failure to exercise due
diligence up to now in giving the loan guarantee and increasing it from $5
billion to $7.9 billion without a sound business model.
is no question that the right approach is to deal with Muskrat Falls as part of
the larger budgetary problems facing our province. Muskrat Falls reflects a
fundamental governance problem and the same governance and accountability
issues lie at the root of our fiscal unbalance. Federal officials will want to
take a comprehensive approach. Federal Ministers may not want to take the big
picture approach and instead restructure the payments to push the problem into
the future, particularly now they are bearing criticism for the escalation of
the federal deficit.
Churchill Development Corporation (LCDC)
we bargaining from a position of weakness? The federal government will want to
avoid an event of default which will trigger repayment of the $7.9 billion in
federally guaranteed debt. The province always has the option of allowing a
default by NL Hydro given that section 3.1 of the Hydro Corporation Act sets
Hydro adrift without recourse to the province. By so doing they allow the
federal government to take control of the assets. Such an event of default will
force the province to bear the full cost of its $5 billion equity investment. It
will increase net debt by the same amount because currently the financial
assets offsetting our gross debt are based on the cost incurred rather than on
the market value of our assets. It could trigger a serious downgrading by the fiscal
rating agencies. This would be anathema to the federal government who would
likely move in with a rescue operation to avoid the ignominy of default by a
Canadian province and the financial burden of paying the bondholders. Any
rescue funds will come bearing strict conditions on the management of our
is no realistic alternative to a federal transfusion. The question for the
federal government becomes how to structure it in a way which does not set a
precedent which other provinces will want to follow. Perhaps the most direct
approach is for the province to inject federal equity, some of which might
replace provincial equity. For example the federal government might invest $5
billion, with $1 billion assigned to purchase provincial equity, thereby
providing some relief to the province while injecting $4 billion as new federal
equity. This would approximate the 1978 Lower Churchill Development Corporation
model (LCDC) which called for 51% provincial equity and 49% federal equity.
Using my illustrative example the province would have slightly more than $4
billion in equity while the federal government would hold slightly less than $4
Trans Mountain Pipeline is another model that may prove instructive. In May
2018, the federal government announced its intention to buy the pipeline from
Kinder Morgan for $4.5 billion, and seek outside investors to complete the
expansion. The federal government might join with the province to acquire
Muskrat Falls and to restructure it with a view to inviting private investors
to operate some or all of the project components.
as part of Fiscal Plan
Marshall told the PUB in October that the financial arrangements were
“hard-wired” and could not be changed. The recent announcement by the Premier
and Minister O’Regan accepts that these “hard-wired” arrangements were
unacceptable because neither ratepayers nor provincial taxpayers can deal with
the enormous revenue requirements. However the challenge in putting the project
on a sustainable basis will be enormous and has to be addressed as part of an
overall fiscal plan to place the province’s finances on a sound footing. It is
hard to imagine how this project can be the singular focus of the negotiations
without embracing the full extent of the province’s obligations and
have not had a cost update on Muskrat Falls since 2017 and there are many
factors driving further cost escalation, including claims filed by contractors
such as Astaldi, combined with the delay in the transmission line and the
problems with synchronous condensers. On top of that we have the reliability
factors which the PUB is dealing with. In restructuring the finances of the
project sufficient funds must be included to ensure that we have reliable power
and that may demand a replacement for Holyrood. The cost of such a replacement
should be included in the financial plan under discussion between the two
need more complete information on the demand for power as well as updated
costs. Demand projections continue to show shrinking demand which is not
surprising considering our loss of population with 11 consecutive drops in
population since 2016. NP reports that its load is decreasing.
Exposure of Province
its “rate mitigation plan” the province is now taking on the obligation to
ensure that all revenue requirements are satisfied. This includes dividends of
over $70 million in 2021 on the $865 million invested by Emera. The architects
of the Muskrat Falls project claimed that there would be “no recourse to the
3.1 of the Hydro Corporation Act enables the province to shield itself from
direct financial exposure outside of its own equity investment. This shield has
now become collateral damage of the rate mitigation plan because we have now
removed the shield, exposing us to more than $726 million in the first year of
full commercial operation.
so doing we have raised the stakes and increased our exposure! Why would we do
that? We are now exposed to the full $74.6 billion in revenue requirements over
the 50 year supply period. This is on top of our completion guarantee with base
and contingent equity of $5 billion!
province’s decision to write off dividends on its generation equity was a
foregone conclusion and it does not cure the problem. There is no new federal
money on the table and a federal operating subsidy is unlikely. The federal
government may simply tinker with the repayment schedule and defer the costs to
future generations. This would be a big mistake. Anything short of a
significant infusion will suffice. Whether it comes in the guise of
“monetization” of dividends or federal equity is hardly the point.
Federal Department of Finance will rightly ask the question as to whether any
large financial support package for Muskrat Falls will cure the flawed business
plan on which the project is founded, including lack of cost-compensatory
demand for power. They will also argue that Muskrat Falls is part of an even
larger fiscal problem and a holistic, rather than a piecemeal approach, is
imperative. We can restructure the payments in many different ways, including
the adoption of a modified “cost of service” approach, moving away from
“escalating supply prices”. We can forego sinking fund payments and cost
overrun escrow account (COREA) payments. We can reduce depreciation costs by
extending the service lives of the generation and transmission assets.
of this is tinkering. Muskrat Falls is a big problem one whose magnitude we
have yet properly to measure. We cannot manage what we cannot measure. We need
much more than that and to be honest with ourselves we have to recognize that
nobody has a panacea to offer. Our vast experience in this province with failed
industrial enterprises, such as Labrador Linerboard, teaches us that
governments are incapable of finding a cure for a fundamentally flawed business
plan. Our landscape is scarred indelibly with a multitude of failed public
we go forward it is important that governments consult with the public before
major decisions are reached. We all know that a lack of transparency and due
process compounded the bad decisions which led to Muskrat Falls. Let us not
continue to make the same mistakes. All of the revenue, demand and cost
assumptions should be made public and the public should know exactly what will
be required from them as ratepayers and taxpayers.
governments must conduct a full assessment of the costs of the project and seek
a solution that is in the best public interest. In reviewing options they must
make a determination on the following issues:
is the best estimate of the cost of the project?
there sufficient compensatory (i.e., covering costs) demand to operate the
costs be reduced through structural changes in the electric power industry,
including the termination of Nalcor Energy and the elimination of its monopoly
fiscal measures must the province take in order to ensure its solvency?
alternative arrangements can be made to satisfy energy commitments to Emera if
Muskrat Falls were mothballed?
the financial restructuring plan fair to future generations who have already
been burdened with a large public debt?
to this point government has failed to provide certainty and stability for
ratepayers. Ratepayers remain perplexed as to how they should respond. Many
have invested in heat pumps or downsized to smaller quarters to cope in
response to rising power costs. Many have left the province. Many who stay will
be paying twice for Muskrat Falls, first through higher taxes and power rates
and second through their private investments to secure their own electric power
security (e.g., heat pumps). This uncertainty will continue until such time as
a credible plan for cost recovery is on the table.
are too smart and too well informed to believe that they can escape the
consequences of Muskrat Falls. They know that nothing that has been announced
up to this date represents a solution. The options on offer are palliative, a
placebo and certainly no panacea.