Terry Paddon, the province’s Auditor General will be stepping down at the end of the month. His swan song was the recent release of his annual report to the House of Assembly, on the Audit of the Financial Statements of the Province of Newfoundland and Labrador, for the year ended March 31, 2017.
In light of the parlous fiscal state of the Province one has to ask if he told the truth, the whole truth and nothing but the truth?
Did he speak truth to power in a language that both citizens and their elected representatives can understand? In particular, how did he deal with the Muskrat Falls project?
How a Revenue Shortfall becomes a Regulatory “Asset”
Bonnie Lysyk, the Auditor General for Ontario, recently released a special audit report, entitled the Fair Hydro Plan: Concerns About Fiscal Transparency, Accountability and Value For Money. The special report relates to Bill 132, the legislation for the Fair Hydro Plan under which electricity bills of all residential, and some small-business ratepayers, would be lowered by 25% on average.
Bill 132 will enable hydro bills to be reduced by 25% reducing them below the cost of the electricity used, yet those generating the power will continue to charge full costs, leaving government to borrow the cash to pay for the shortfall. The Ontario AG is concerned that the government has created a non-transparent mechanism to prevent these extra costs from impacting on its budget deficit and its net debt.
She said “the government is making up its own accounting rules” and that “the creation of a regulatory asset legislated in the Fair Hydro Act violates the government’s own accounting policies, developed in accordance with Canadian Public Sector Accounting Standards.” The majority of the 25% rate reduction is in the form of deferred costs estimated to add an extra $2.5 billion annually until 2027. The revenue shortfall becomes a regulatory asset for ten years and then becomes an additional cost which will be an added burden to Ontario ratepayers and taxpayers.
The result of this byzantine financing is that the AG has filed qualified financial statements. Her report is quite explicit in decrying the approach taken by government to create the rate reduction, without recording the cost in the Ontario deficit or in its net debt. The AG indicates, surprisingly, that government took these measures with the full knowledge that the public accounts would have to be qualified.
Truth to Power
Has the Auditor General for NL spoken truth to power with the same clarity as the Ontario AG? My public service career has taught me that in speaking truth to power the message has to be clear and direct. Subtlety does not work. The AG says that “the Province’s economic forecast is based on assumptions and future expectations and, like any forecast, is subject to considerable risk and change.” (My bolding). He says that “Given that the current forecast is based on an assumption of steadily increasing oil prices up to 2022-23, there is risk that the forecast revenue growth may not be achieved. (My bolding). Do these warnings go far enough or are they too subtle? You decide.
In reading the AG’s report released on October 24, 2017 it is clear that the NL AG is concerned about the large and mounting deficit. It is clear that he believes the fiscal forecast to 2022-23 to be optimistic on the revenue side, projecting higher oil prices into the future than those experienced over the past two years. The forecast assumes that revenues will rise by $1.1 billion, with no specifics to substantiate the numbers. At the same time the projections show a greater measure of fiscal restraint on the expenditure side than we have witnessed in recent years. Are these projections based on specific plans or do they represent wishful thinking, easily circumvented when pressures to spend inevitably escalate with the approach of the next election?
The AG shows how badly we compare with the other provinces when we compare our deficit as a percentage of GDP in his Chart 2, below. Only the province of Alberta has a deficit which approaches ours, when shown in proportion to GDP. However per capita debt in Alberta remains well below ours ($5,131 for Alberta compared by RBC with $28,948 for NL) and Alberta continues to operate without imposing a provincial sales tax. Clearly our beleaguered province is in a league of its own!
While the AG’s report is comprehensive there are key issues which I would have liked him to explore in greater detail. These include the following:
1. How much money will we be borrowing from the financial markets of the world and will our cost of capital rise significantly above the interest rate paid by other provinces? We tend to focus too much on the current account deficit and too little on the overall deficit, including current and capital account. In recent years borrowings to finance “equity” contributions to Muskrat Falls have been large and this will continue for at least the next three years.
2. Why did the 2016-17 results on operating account improve so dramatically over the previous year? How much of this was the result of increased taxes and fees versus expenditure cuts? Are the projections for the current year realistic?
3. What has government done to improve its forecasting of oil prices.
4. Should we be using the depletion of our natural resources through resource royalties to fund operating programs? Why have we not created a heritage fund or used the oil revenues to repay our debt?
5. What are the prospects for the province to reenter the equalization program, in light of the fact that we have been removed because our natural resource revenues, albeit significantly reduced, continue to be above the national average?
6. Clearly the fiscal crisis which we face is principally an expenditure problem, as illustrated by the following Chart 7 from the AG’s report.
What are the key expenditure options which government must consider in order to achieve an acceptable fiscal balance?
7. The following table is taken from the Public Accounts for the year ended March 31, 2017:
The unfunded pension liability has risen from $3.3 billion to $4.9 billion. This unfunded liability, along with group health and life insurance retirement benefits, continue to add to the net debt of the province. Have the measures taken by government been successful in curtailing further growth?
I turn now to the Muskrat Falls project and to the Observations made by the Auditor General. Observations 10 and 11 are as follows:
He goes on to make the following comments on the top of page 16:
On the face of it this is simply a statement of fact but, delving more deeply, one has to wonder if the AG should have gone further, as did his Ontario counterpart in examining the similarly byzantine financial arrangements contrived by the Ontario government.
Remember the power purchase agreement, which was part of the Muskrat Falls financial framework, depends on an inappropriate relationship between a fully regulated utility, namely NL Hydro, which is a wholly owned subsidiary of the non-regulated parent company, Nalcor Energy, and the parent company itself.
Remember that the government in 2012 enacted new legislative amendments to strengthen the monopoly position of Nalcor, forcing Newfoundland Power and other large power customers to buy power only from Nalcor and denying them access to lower prices in a competitive marketplace. These restrictions fly in the face of the open access policies which are prerequisite to our access to North American electrical energy markets.
Remember as well that the financing for the generation assets of Muskrat Falls was based upon the backend loading of costs, foisting costs upon future ratepayers, as has been done under the Fair Hydro Act in Ontario and by BC Hydro. (See articles by Rick McCandless
BC Hydro has been deferring the expensing of costs to reduce short term rates. In the words of McCandless:
Nalcor Energy is considered to be a Government Business Enterprise (GBE) whose direct debt is fully supported by ratepayers, so it is considered “self-sustaining”. Its debt is not included in the net debt of the province. The corollary of this is that if it is not fully supported by ratepayers its debt should be included in the net debt of the province. I am referring here to the $7.9 billion in federally guaranteed debt.
The “equity” borrowed and injected by government is a different matter. It is deemed to be offset by a financial asset, namely the value of the shares, and these are measured at the cost incurred for their construction. If they were measured at market value, and if market value were less than cost, then there would have to be a write down. In the extreme case where the assets are worth nothing there would be no offset to the borrowed equity and the province’s net debt would increase by the full value of the equity borrowed and injected into Nalcor. The value of this equity is $4 billion, based on construction cost, calculated by taking the estimated capital cost of $12.7 billion and deducting Emera’s $800 million equity, as well as $7.9 billion of federally guaranteed debt.
AG Terry Paddon is assuming that if Nalcor can generate increased revenues by simply raising rates then it will be able to service its dividend obligations and operate as a “self-sustaining” business entity. My concern is that the whole PPA arrangement neglects demand elasticity and fails to recognize that the enterprise cannot be self-sustaining. It also ignores the demographics and limited disposable income of ratepayers.
Only if demand is totally inelastic (coefficient of demand = 0) will revenues increase proportionately with rates. Estimates of demand elasticity cited in the Site C inquiry tend to be around -0.4, which means that, with a doubling of rates, demand for energy declines by 40%. Revenues will increase only slightly, by only $100 million a year when the additional system costs imposed by Muskrat Falls add $800 million on top of the existing $700 million revenue requirement to operate the existing system. If a higher absolute value for elasticity
is used then revenues from ratepayers would decline as rates are increased. The outcome would be a precipitous drop in demand as well as in ratepayer revenues!
The Premier has announced a “rate mitigation” program. This is what the AG has to say on this subject?
So even if government does not embark upon an explicit program of rate mitigation the PPA will not by any stretch be “self-sustaining”. The AG is recognizing the problem as a taxpayer problem only when government policy explicitly transfers the problem from the ratepayer to the taxpayer explicitly through “rate mitigation”. The reality is that ratepayers will not be able to shoulder the cost of Muskrat Falls, nor indeed will our limited fiscal capacity enable taxpayers to assume these costs. The time has come to recognize the reality of these problems. We do not have the luxury of deferring the problem.
The AG does recognize that if “expected future revenues are less than the cost of the asset” then the “value of the asset would be reduced, resulting in an increase in the Provincial deficit and the Net Debt.” In my opinion this shortfall is a matter of certainty, given the facts as we know them. In fact I have long argued that our net debt is vastly understated by valuing the financial assets which represent the equity in Nalcor at cost and not at market value.
In the Glossary to the AG’s report on page 78, Financial Assets are defined as “assets of a government (such as cash, investments, loans and account receivable) that could be used to discharge existing liabilities or finance future operations.” In other words they must be liquid assets which can be offered as “legal tender”. Government's investments in Muskrat Falls are nothing of the sort!
The AG states that “the existing Muskrat Falls business, regulatory and financing structure ensures costs, expenses or allowances related to the project will be recovered, in full, from ratepayers in the Province.” I totally disagree with this statement for the reasons I have given above, and as confirmed by PlanetNL’s posts on this Blog.
I disagree equally with the second sentence of the paragraph on the top of page 16 which reads: “Because this structure ensures there will be sufficient revenue generated from ratepayer over the life of the project to cover the capital and operating costs of Muskrat Falls, it is unlikely that the Muskrat Falls assets would be considered impaired in value on the financial statements of Nalcor.” For reasons well explained by PlanetNL such impairment is a virtual certainly.
Should the AG have taken the bold step of blowing the lid on the fallacy of the self-supporting business model and power purchase agreement for Muskrat Falls and followed in the footsteps of his courageous counterpart Bonnie Lysyk, the AG for Ontario? I leave it up to you to decide.