WILL THE PUB GO FAR ENOUGH ON RATE MITIGATION?

Guest Post by David Vardy

The PUB has been asked to make recommendations as to how increases in power rates arising from Muskrat Falls can be avoided, a daunting task indeed, but one for which they have been given a broad mandate.  They have just released an interim report on measures to increase revenues and reduce costs. Their work plan is quite ambitious and covers a wide range of options. The question is how far they will go and how receptive will government be to major changes?

Will they recommend the kind of surgery needed to right-size our electric power industry and to extirpate Nalcor as an unregulated monopoly? Will they go so far as to propose that Nalcor be removed from the power system after Muskrat Falls has been completed?

Measuring the problem

In measuring the magnitude of the shortfall between costs and revenues the PUB could have included a calculation of the shortfall. In so doing they must calculate the  annual “revenue requirements” arising from the current $12.7 billion cost estimate, along with likely fuel savings at Holyrood and the revenue impact of the 22.89 cent/KWh rates which Nalcor deems necessary for full cost recovery. In measuring the demands on the province the PUB should ensure that the full capital costs of the project are included, the cost of servicing debt and equity, the cost of principal repayment and the operating costs of the project. The PUB has stated the shortfall as $744 million annually, without providing the details of their calculation or whether it nets out fuel savings or export revenues from export commitments already made. In the attached Appendix I offer some comments on the calculation of the shortfall which suggest that $744 million may be on the low side.

One of the issues the PUB will have to deal with is the fact that in calculating cost Nalcor has adopted a hybrid system of accounting which combines "cost of service" accounting with accounting based on “escalating supply price”. The latter was adopted in order to reduce power rates in early years by shifting payment to the province for return on its equity investment to later years. By so doing they are relying on rising demand over time to bear the cost burden of equity capital. Without rising demand these costs will simply not be paid. To deal with this issue the PUB must place all cost estimates  on a “cost of service” basis, which is the basis on which the other costs in our electrical system are calculated. Simply put, this "cost of service" approach demands that all costs incurred in a given year be recovered from rates charged in that year, and not be shifted to future years and future generations.

In making the reference the government has confirmed that an increase in rates from 12.26 cents per KWh to 22.89 cents in 2021 is unacceptable. It is unacceptable in terms of affordability because it will impose a large burden on vulnerable citizens. Such an increase is also self-defeating because it will trigger a shift away from electricity which is likely to gather momentum as increases continue and accelerate.

Depending upon the long term elasticity of demand rate increases will cause demand to collapse so that Muskrat Falls power will not be used within the province. With falling local demand the power will be exported into export markets at rates well below cost. If rates rise people will make other investments to reduce their electricity costs, some will invest in heat pumps while others will invest in conservation. If the costs of Muskrat Falls are not recovered through higher rates the costs will have to be recovered through taxation. This means people will pay twice, first for Muskrat Falls through their taxes and second when they install alternatives to Muskrat Falls.

The Board will undertake research into demand elasticity and into innovative rate design but it is unlikely that sufficient higher revenues will be generated through higher rates. Additional revenues may indeed flow from electrification of motor vehicles and ports as well as from additional displacement of fossil fuels in residential and commercial heating. The danger of de-carbonization and electrification is that it may accentuate the existing winter peak in demand.

When it comes to revisiting the financial arrangements to reduce costs it is clear that the federal government must be prepared to make changes. The federal government must agree if high cost provincial equity is to be replaced with lower cost federally guaranteed debt. The federal government must agree to any changes in the financial arrangements which the province may propose to replace the intended revenues from rates which were integral to the financial plan and to the power purchase agreement.

It is not clear how far the PUB will go in fulfilling what is a broad mandate. We can hope they will tell government what they need to hear. Governments, both federal and provincial, need to renegotiate the power purchase agreement to acknowledge that a take-or-pay contract will not be able to extract enough revenues to pay the revenue requirements.

Guiding principles

 I suggest that the PUB consider the following guiding principles.

1.     First and foremost, in its deliberations the Board must be mindful of the impact of rising power rates on vulnerable people. Low income people and other vulnerable people on fixed incomes must not become victims of this ill-conceived megaproject.

2.    Second, the project was fundamentally an ill-conceived megaproject designed to create revolutionary change (“game changer”) in the provincial economy. It was a make-work project which follows a long succession of failed development schemes since Confederation. The ratepayer should not have to pay for this flawed project because it was never demonstrated to have met the test of section 3 (b) (iii) of the Electrical Power Control Act which calls for the system to be managed to

            “result in power being delivered to consumers in the province at the lowest possible    
             cost consistent with reliable service.”

3.    Third, we should avoid any solutions that pass additional burdens on to our children and avoid placing in jeopardy the heritage assets of future generations. We should not barter our natural resources, our fishery, minerals, oil and gas, royalty revenues from the Atlantic Accord, or the rights of future generations to Churchill Falls power after 2041. We should avoid solutions which extend the amortization period from 50 years to 100 years.

4.    Fourth, we should encourage regulated competition and terminate Nalcor’s exemption from the authority of the PUB. The powers of the PUB to protect the consumer should be restored.

5.    Fifth, the cost of power cannot be the basis for setting rates because if full cost were charged demand would collapse. The PUB should therefore consider the proposal advanced by Dr. Jim Feehan (“Connecting to the North American Grid: Time for Newfoundland to Discontinue Inefficient Price Regulation,” Canadian Public Policy, December 2016) where rates are set based on market rates in the mainland market to which we will be connected:

            "The fundamental proposition herein is that after connection to the North American              grid, the wholesale price of electricity in Newfoundland should be determined by the 
            external price…When the island grid is connected to North America ,economic 
            efficiency requires that the wholesale price reflect the opportunity cost of the energy 
            (pages 9 and 10)." 

This would represent a dramatic change in rate setting policy for our PUB but it is well accepted throughout North America. It would likely lead to lower, rather than higher, rates and would provide an incentive for Newfoundland and Labrador consumers to utilize Muskrat Falls energy rather than to wheel most of the power into mainland markets, but at great cost to the province’s taxpayers! 

6.    Sixth, the power purchase agreement should be renegotiated. The PPA was to be the anchor for the Muskrat Falls project and it was to be the mechanism whereby consumers would be held hostage to Nalcor. We learned during the Muskrat Falls Inquiry (Exhibit P-00043) how this was going to work.  The plan was that for  NL Hydro to generate the necessary revenues Government would

              "structure the electricity industry in the Province to ensure regulated ratepayers                    (the majority of whom are customers of Newfoundland Power) will be captive to     
              NL Hydro to the extent necessary to support these revenues."

The notion that the PPA will guarantee a rate of return on equity is flawed. Without demand for power there will be insufficient revenues to recover costs, including the return on equity, which tends to be treated in public utility accounting as a cost of doing business which will always be recovered. The business model upon which Muskrat Falls is built assumes there is a deux ex machina , or divine providence, which guarantees that the ROE is delivered. Perhaps the ROE is guaranteed for Emera but is it really guaranteed for the government of Newfoundland and Labrador, which will have invested $4 billion or more? The reality is that profitability cannot be ordained from on high, even by the House of Assembly!

It was always known that power rates would rise so it should be no surprise that both demand for energy and revenues will be adversely affected when rates rise. Nalcor CEO Stan Marshall’s, in a presentation at Memorial in February 2018 revealed that rates were going to 15.12 cents/KWh in 2021 even if the $7.4 billion costs estimated at the time of sanction had been achieved.  This is shown below in the last row of the table below where power rates rise from 11.7 cents per KWh to 15.12 cents even without cost overruns! 

7.     Seventh, the PUB should focus on major cost reductions in the power industry through a fundamental restructuring of the industry. A province with 500 thousand people does not need Nalcor, another Crown Corporation, on top of Newfoundland Power and NL Hydro. We need to open the door to competition and invest in low cost renewables with a small environmental footprint. The PUB must identify efficiencies in the power system, eliminate duplication of services within Nalcor but also within the whole system, whose revenue requirements will double to $1.6 billion unless drastic surgery is undertaken.  Nalcor must be dismantled!

Conclusion

 In conclusion the PUB has a broad mandate to recommend major changes. Only with major changes in our system can we cope with the massive costs which will fall upon us in 2021. At that time the cash infusion from construction will be replaced with the requirement for large cash payments, mostly in the form of interest to external lenders. Let us hope that the PUB will present the bold recommendations necessary to reform the electrical power system.  These recommendations should include dramatic reductions in the huge overhead costs which have been loaded on our system along with regulatory changes to protect the consumer. It should restore the powers of the PUB so that it can function as an independent regulatory body with the authority to discharge its statutory duties to deliver power at the “lowest possible cost consistent with reliable service”.

David Vardy

Appendix: Measuring the Shortfall

 In his update at Memorial University a year ago Stan Marshall presented the following chart, which showed the load growth projected, compared with the load growth assumed at the time of sanction. The update told us that we would need to charge 22.89 cents per KWh, beginning in 2021, to recover the cost of Muskrat Falls. In the chart there is a footnote which tells us that the demand projection is based on an assumed 2021 rate of 18 cents per KWh. 

I submitted an ATIPPA request which included (as question number 6) the following question:

            In the February 2018 chart the latest load growth data are based on a target rate of 
            18 cents/KWh, escalating at 2%thereafter. Page 28 of the same presentation shows 
            that a rate of 22.89 cents/KWh in 2021 and rising would be required to cover all 
            costs. What will be the revenues from rates and the deficit arising from the load 
            growth shown on page 25 and escalated each year from 18 cents/KWh by 2%from 
            2021 to 2070?

In the reply from Nalcor dated January 18, 2019 I was told they had “no responsive records”. In other words they could not tell me the shortfall arising from charging 18 cents/KWh compared with 22.89 cents/KWh which is purported to be needed for full cost recovery. Upon receiving the ATIPPA response I went back to Nalcor and asked them to provide me with the revenues from rates, the revenue requirements (i.e., the annual costs which must be recovered) and the shortfall not only in 2021 but in each of the ensuring 50 years.

The revenue requirement provided to me April 18, 2018 showed that for all three project components (the dam itself, the Labrador Island Link and the transmission line from Churchill Falls to Muskrat Falls) the total annual cost to be recovered in 2021 is $808 million.

In Stan Marshall’s presentation of February 2018 he disclosed a cost per KWh of 17.42 cents. Adjusted for line losses to Soldier’s Pond the output of Muskrat Falls is 4.6 billion KWh so multiplying this by 17.42 cents produces $801 million in 2021, remarkably close to the revenue requirements provided to me in ATIPPA response PB0242-2018 on January 18, 2018. Whether it is $808 million or $801 million it does not provide enough money to cover the province’s targeted rate of return (established in the power purchase agreement at 8.4%).

If that target is to be met then at least another $185 million must be added in 2021 to cover the full return on equity rather than shifting it to future generations. This addition is one of the steps which must be taken to restore full “cost of service” accounting. This raises the $808 million to $993 million. In my calculations I have deducted $150 million in fuel savings and $50 million for export revenues, leaving a shortfall of $793 million, based on estimated capital cost remaining at or below $12.7 billion.

The key question relates to elasticity and the PUB review will include further research on demand elasticity. Based on the information we have it is highly unlikely that revenues will generate more than an additional $100 million even if the rates are doubled. What I am saying is that the idea that 22.89 cents/KWh will recoup costs is a delusion.