New CF Renewal Deal Will Not Be Transformative
Premier Furey and his faithful followers are big on talking about $227 Billion. It’s a staggering sum to consider. Given the Province’s annual budget is about $10 Billion per year, it sounds as though there’s going to be money to burn. Many among the governing politicians and their cheerleading friends were saying this new deal will put Government into surplus and there will be more left to pay off long term debt and start a future fund.
Really? The simple answer is no.
Prudent people know the political puff-machine is turned up on 11. A much more reasoned, realistic and conservative parsing of the numbers with proper consideration of risks is required to find out what beneficial impact this deal might truly have on our future.
The public remembers the boom and bust of oil royalties when they first sprung up almost 20 years ago and they remember the terrible fraud of Muskrat Falls. They don’t want to be fooled again.
Strolling down the memory lane of big oil royalties is a particularly instructive way to get this assessment going. Increasing oil prices coincided with the oilfield projects reaching their high royalty payout phase in the mid-2000s. During the 8-year stretch from 2007 to 2014, GNL received on average $2.1 Billion in oil royalties per year.
Source:
| Fiscal Reference Tables 2023: Part 4 of 9 – Canada.ca |
| https://www.canada.ca/en/department-finance/services/publications/fiscal-reference-tables/2023/part-4.html#tbl18 |
For a short while there were budget surpluses and, caught off guard, the politicians actually used some of the surplus to reduce long-term debt. That accidental wisdom eventually gave way to spending the windfall on public sector wage increases, a host of capital projects, and the dreaded Muskrat Falls.
During the same period, the budget went from $5.7 Billion in 2007, to $7.9 Billion in 2014, demonstrating a dependence and expectation of $2 Billion or greater in oil royalties.
In the 9-years following, as oil royalties receded to an average level of $0.9 Billion per year, GNL struggled with the hard spending commitments and deep deficits that would follow.
A clear means of visualizing the nature of the deficit and the dependence on oil royalties is to look at the balance of budgets without the oil royalties as seen in the chart below.
The blue dashed line illustrates clearly that GNL quickly came to depend on oil royalties exceeding $2 Billion every year just to keep the budget at even. To do so was beyond risky, it was foolish: GNL spent its windfall as though it thought oil royalties would perpetually increase.
Do not mistake the period after 2018 as any sort of meaningful recovery. Many readers will recall that the spike in 2019 was an accrual accounting trick created when the federal government transferred the value of its shares in Hibernia to the Province and GNL had to record the entire value of the transfer in one year despite getting very little money from it. Post-2020, other special federal revenues associated with the pandemic further hide the depth of GNL’s budget problem. Serious policy wonks also point out that the cash deficit is much worse again than the accrual deficit.
The evidence shows there is a fundamental $2 Billion budget deficit problem in this Province before oil royalties partially close the gap. This doesn’t include the hundreds of millions of Muskrat Falls costs that are going unpaid every year as that is being kept at arm’s length at NL Hydro for the time being. It’s an ugly picture of what elected politicians do to assert their popularity and attempt to maintain power.
This brings us to the MOU with its promise of perpetually increasing revenues to the Province. Has Premier Furey overcome the errors of the past and delivered a transformational Holy Grail? If so, it would have to be better than what oil has done for the Province which for all its might hasn’t resolved GNL’s budget issues.
Having lived through this movie before, we should anticipate that the remake, like most remakes, won’t live up to the hype.
Firstly, it’s necessary to deflate all of the future Churchill Falls revenue by an assumed inflation factor so that we can observe the values as measured in dollars with today’s buying power. An inflation discount rate of 3% is used for this purpose (the days of economic stability and 2% inflation are over). This way, the future values will all have the same value as today’s dollars. After all, the 2075 revenue of over $8 Billion might look incredible but the cost of everything will be many times higher by then: minimum wage might be close to $100/hour, and a fast-food meal should be expected to cost one hour’s worth of that wage just as it does today and typically always has.
The chart below evaluates the Churchill Falls renewal revenue forecasted to flow to the GNL Treasury and shows what it equates to in 2024 dollars (as the MOU computes all values as 2024$, we’ll stick with that convention even though it’s already 2025). The lesser value of the optional Gull Island and CF2 Expansion projects are excluded.
Source: OurChapter_WebResource_EnergyAllocationBreakdown
The forecast is a snapshot absent any analysis of risks that may reduce its value. Remember how oil didn’t stay above $2 Billion per year? Chances are we need to exercise caution on the projection for the Churchill Falls renewal. When these sorts of numbers are cooked up, optimism often runs amok over sensibility to persuade the public of what wonderful and smart work the politicians are doing. Realism demands some probing to let the air out of the over optimistic assumptions.
The biggest area of concern is how the mysterious rate formula will work in the MOU to deliver the steadily rising forecasted revenue. The part that is flat on the inflation-adjusted at about $1 Billion steady is not the worry: it’s the period after that and the bump up event in 2036 that needs questioning.
The latter bump may appear small, but it is actually a whopping 46% increase in revenue from the prior year. It is undoubtedly tied to final commissioning of Gull Island and the CF2 expansion. This particular event appears to be evidence of the mysterious price escalation formula at work.
Enough has been said that we generally understand that one of the key elements of the rate formula is hydro plant replacement cost and that, as Hydro Quebec builds new hydro projects, CF rates will gradually rise to reflect a similar replacement cost. The 2036 bump is a part of that process. The very significant rise between 2049 and 2061 must presumably also be driven by HQs theoretical portfolio of costly hydro plants needed to meet their own load forecast demands.
This is, however, a very worrisome foundation. It assumes that today’s technology and markets will persist largely unchanged for decades without disruption and/or that HQ’s best alternatives to hydro plants will not be appreciably cheaper. This is a bad bet.
The MOU itself actually does include mention that technology and market risk pose uncertain threats. A more realistic view is to consider Gull Island and CF2 as potentially the last of their type. Why? Because technology disruptions are surely a case of “when” and not “if” they will happen. Successful technologies also tend to scale well and substantially reduce costs. The potential for breakthrough technologies to emerge and commercialize over the next 20 years is high.
To account for this risk, it would be wise to treat the inflation adjusted revenue gains above $1 Billion per year – the slow wave that begins 20+ years from now that rises toward $2 Billion – as highly improbable.
A plateau of about $1 Billion (2024$) in 2036 and onward could be as good as it gets. That would make the new CF deal about as valuable as oil royalties have been in the past decade.
We should seriously consider taking caution a step further. Let’s heed the warning buried in the MOU and assume that Gull Island and CF2 will not be built. This scenario has become all the more plausible in just the last two weeks since the Trump inauguration and with the prospect that Canadian politics will become similarly right-wing in the near future. Hydro Quebec’s export potential may be much more limited and competition from legacy energy sources will be stiff. Even the optimistic proponents of the renewal deal are likely harboring doubts about their new development plans by now.
In this scenario, that significant 2036 bump up in returns will not happen. This would presumably position returns on a lower plateau of approximately $700 Million (2024$) annually. That’s surely insufficient to close the current budget deficit.
Neither of these scenarios include an allowance for a third major caution: that NL Hydro must use some of the proceeds on the costs of Muskrat Falls. Once the current phase of Muskrat rate mitigation ends in 2030, NL Hydro will likely need to tap into Churchill Falls profits if only to cover the estimated $250 Million in annual bond interest costs, let alone pay down any debt. If not, Island ratepayers are going to have the highest electricity prices in the country. The politicians are going to have to keep the peace and cede some of the new Churchill deal toward Muskrat relief.
Applying all three of these cautions will bring the long-term inflation-adjusted benefits of the Churchill Falls renewal to less than $500 Million (2024$) annually.
Prudent planning should heed all of these cautions and rely only on the lower value for budgeting purposes. Should the future actually deliver more returns, then the extra funds should be used to address excessive debt, starting with that of Muskrat Falls.
The Churchill Falls renewal MOU is simply not going to have anywhere near the transformational impacts promised by Premier Furey. The real impact on the Treasury is far more modest and likely well below the level needed to address recurring annual deficits.
