Monday, 8 April 2013

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

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.

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