Thursday, 13 June 2019


Guest Post by David Vardy

Department of Finance Bypassed
Former Finance Minister Cathy Bennett told the Muskrat Falls Inquiry this week that upon her appointment to the Finance portfolio in 2015 she discovered the Department had been marginalized. Bennett said she was not going to allow it to continue. She invoked the Financial Administration Act (FAA) which provides broad powers to the Minister. She said that where there is conflict with Nalcor and its governing legislation, the Energy Corporation Act (ECA)  the FAA will trump the ECA.

Nalcor had been successful in bypassing not only the Department of Finance but also the Executive Council Office as well. Previous premiers had allowed the Nalcor CEO direct access to the Premier’s office and this allowed the Nalcor CEO to tell provincial officials that his actions had been approved by the Premier so they had better watch out. Most of these meetings went without formal record, unlike the Cabinet system where the Clerk issues official records of Cabinet decisions.

Vic Young urges fiscal review
An Exhibit (P-00924) made public by the Muskrat Falls Inquiry discloses that former NL Hydro CEO Vic Young wrote to Nalcor CEO Ed Martin to emphasize the importance of measuring the impact of Muskrat Falls on the fiscal position of the province. “Given the magnitude of the numbers, it is imperative that the potential impact on the fiscal position of the Province be at the top of the decision making chain...even more important than power rates at this stage. It is the Province that needs the potential financial consequences independently assessed (independent from Nalcor) and it is this independent financial review that should be tabled and debated in the House of Assembly so that the people of the Province do not end up with a big negative fiscal surprise, as they did with Churchill Falls. Government must, therefore, be brutally frank and transparent about the potential fiscal risks and presumably Tom Marshall will start that process in his upcoming budget...just a personal view! Vic” 
Vic Young
There is no evidence that the financial review recommended by Vic Young was ever undertaken. Nor was it clear that the government was given all the information it needed to understand the impact of the project on the finances of the province, more important in Mr. Young’s view than power rates. We have heard that the quantitative risk analysis which recommended that a strategic risk reserve be included in the cost estimate was not provided to the province. Nor was it provided to the Board of Directors of Nalcor.

Failure to disclose
The Inquiry has interviewed a number of former Ministers and Board members to determine if cost overruns from the date of sanction to the financial close of the project a year later were reported and whether they knew that the cost estimate on November 29, 2013, the date of financial close was higher than the estimate on December 17, 2012, the date of sanction. The testimony reveals that information on cost overruns was tightly held and not disclosed to Nalcor’s Board or to the government. The record also shows that Nalcor was not providing cost data to the federal government and to its Independent Engineer on a timely basis.

The Commission has been assessing why the cost overruns took place and how effectively the project was managed. The work of its forensic auditor has played an important role in examining construction costs and identifying witnesses.

Byzantine financial arrangements
This post deals with the unusual financial arrangements by which the project is being financed and the mechanisms for recovering costs through power rates. These are quite different from the approach taken by regulated utilities that come under the supervision and oversight of the PUB. They have not been clearly explained or understood.

The difference relates principally to the recovery of equity costs. It is well known that the province has committed itself to a “completion guarantee” which calls upon them to provide whatever equity financing is required to complete the project. At the time of sanction the amount of provincial equity required was $1.9 billion. It is now approximately $4 billion and would be $2.9 billion higher if not for the second loan guarantee.

The bondholders who funded what is now $7.9 billion in debt expect to get their interest return on an annual basis. While we are told that the $4 billion in provincial equity will be repaid and that dividends are “guaranteed” this is far from a certainty. In the case of the equity invested in the power plant and in the transmission line between Churchill Falls and Muskrat Falls the rate of return on equity is set at 8.4%.

In theory, the recovery of the equity and dividends depends upon the take-or-pay power purchase agreement (PPA) between Hydro and the Muskrat Falls Corporation (MFC). In reality it depends upon the ability of NL Hydro to recover sufficient revenues to recover all costs and to allow for dividends. In practical terms this depends on the demand for electricity. With declining provincial population the growth in demand is highly unlikely to reach the target set by Nalcor. A PPA cannot “guarantee” a rate of return which depends on the fundamental economic viability of the project. In a private enterprise economy the notion of a guaranteed return on equity is an oxymoron.

The business case for this project was weak from the beginning. With the doubling of capital costs it is highly unlikely there will be any dividends. The investment is highly speculative and represents a high risk for a small province with a very narrow economic base. In all likelihood government will eventually convert all or part of its investment into a contribution-in-aid of construction, a direct subsidy. This has already been raised as an option in the PUB Inquiry into Rate Mitigation.

I can find no evidence that Cabinet was informed of the unusual cost recovery methodology upon which the financing of Muskrat Falls is grounded. This hybrid cost recovery system was disclosed at the 2012 PUB hearing but it is not clearly described in the documents disclosed by the Inquiry. Its purpose is to reduce power rates in the early years using a methodology known as “escalating supply prices” under which the real cost per unit of energy remains the same after adjusting for inflation. In order to recover costs it depends upon significant growth in demand and it is only if that growth takes place will the return on equity of 8.4% be paid. If the growth in demand does not occur then there will be no return on equity and the value of the assets will have to be written down.

The Muskrat Falls Inquiry is searching to find out what Ministers and other public officials were told. What will they discover when they probe into the arcane financing of the project and the extravagant claims that it would yield rich dividends into the future?

When Cathy Bennett was asked this week whether she was familiar with this cost recovery scheme she indicated that she did not know about it. Ms. Bennett had long served as Board member and acted as chair for a period of time. How many other Board members were unaware of the high risk associated with the province’s equity investment into this highly speculative project? How many Ministers were aware of just how fragile those dividends were?

Understatement of Capital Costs
Another important anomaly that emerges from this hybrid cost recovery scheme relates to an understatement of the costs of the project. Under the escalating supply price methodology the return of the 8.4% is “baked into” the annual revenue requirements. The latest cost estimate is $12.7 billion, including direct costs of $10.1 billion plus financing costs of $2.6 billion. This $2.6 billion is intended to reflect the cost of committing funds during the construction phase and before any revenues are generated. The $2.6 billion includes the cost of interest during construction (IDC) but it does not include the full cost of equity capital invested in the project.

The Labrador Island Link (LIL) is the transmission line connecting Muskrat Falls with Soldiers’ Pond outside St. John’s. It is financed with a combination of equity from Emera Energy and equity from the Government of Newfoundland and Labrador. For the LIL Nalcor has included interest during construction as well as an allowance for equity funds used during construction (AFUDC), which follows normal cost recovery practice. In contrast,  generation assets are funded solely by the GNL but Nalcor assigns a zero cost for equity during construction. This leads to an understatement of financing costs of approximately $1 billion and an understatement of total project cost in the same amount. Please refer to the technical Appendix for a more complete explanation.

At the Muskrat Falls Inquiry each day brings new revelations that the project was flawed in both conception and execution. The financial review recommended by Vic Young is as relevant as ever, too. Today, just as it was the case prior to sanction, we still need to understand the impact of the project on the finances of the province and the role played by a PPA between two Crown Corporations who are not at arm’s length from each other. We need to understand how the province’s credit rate will be affected when the province is forced to acknowledge that the project is not self-supporting. When the value of the province’s equity is written down, most likely to zero, we need to know how this will affect our borrowing cost and our access to financial markets.

The Muskrat Falls Inquiry is faced with a daunting task in the light of the government’s failure to provide effective oversight over the project. Nalcor had a responsibility to provide full disclosure to its Board and to its shareholders, the people of the province and its government. Government too had a responsibility to inform itself of the risks and to conduct an assessment of the impact of the project and the unorthodox cost recovery scheme employed. The failure to disclose brings with it enormous consequences for the present along with an urgent need for greater transparency and improved governance in the future.

David Vardy

Appendix A: Technical Appendix on Financing Costs

Each day brings revelations from the Muskrat Falls Inquiry about how the project is pillaging the provincial Treasury and impoverishing the province and its people. Each day we hear of cost overruns. We hear each day about the disputes with Astaldi, SNC Lavalin, General Electric and others and about massive overruns and project delays. Many of the problems can be traced back to underestimation of costs, whether through deliberate design or ineptness. Does this understatement of costs extend to financing as well as construction costs?

We hear little about project financing during construction even though these costs are reported to be $2.6 billion or more than 20% of the $12.7 billion estimated project cost. Reports refer instead to the $6.2 billion at sanction or the $10.1 billion reported by Stan Marshall in 2017, without adding the cost of financing during construction. These financing costs include interest during construction (IDC) and allowance for funds used during construction (AFUDC). In their September 2017 report the Muskrat Falls Oversight Committee (OC) describes these costs. In their words IDC is “the interest that will accrue on funds borrowed to construct the project”. AFUDC is “the return that will accrue on equity invested to fund project construction”.

These interest costs and return on equity are costs of construction and separate from the servicing costs incurred after the start of commercial operations of the assets. These capital servicing costs during operation represent the Lion’s share of annual costs and this is normal in a hydroelectric project.

The Oversight Committee tells us that IDC will cost $1.48 billion while AFUDC will be $440 million, together comprising 72% of the $2.6 billion in financing costs. No AFUDC costs are recorded for the power plant (MF) or the transmission line between Muskrat Falls and Churchill Falls (LTA or Labrador Transmission assets).

Generation assets are financed under a different cost recovery scheme than the transmission line from Muskrat Falls to St. John’s, known as the Labrador Island Link (LIL). The LIL is financed under traditional “cost of service” which requires that all costs be accounted for in the year they are incurred. For the generation assets equity costs are recovered over a 50 year period. In the words of the Oversight Committee: “The MF/LTA cost recovery is based on an increasing price and increasing volume of electricity, and is therefore lower in the early years and higher in the later years.”

Statement of the construction cost of the project should not be conflated with cost recovery as the Oversight Committee has done when they say: “Within that cost recovery an 8.4% Internal Rate of Return (IRR) on equity invested is generated over the term of the power purchase agreement with NLH, but AFUDC does not accrue.” Nalcor and the Oversight Committee assume that the opportunity cost of the $3.2 billion invested by the province in generation assets is zero in their calculation of project capital cost. This $3.2 billion represents two thirds of the project’s total equity of $4.8 billion. If 100% of the project were financed by equity and if “AFUDC does not accrue” then would it be accurate to say that financing costs were zero?

The Oversight Committee has accepted $440 million as a measure of the AFUDC based on the $1.7 billion equity invested in LIL assets. Using this base of $440 million it is possible to infer what the AFUDC might be on the generation assets, based on two known factors. The first is that the direct capital costs of the LIL are 72% higher than corresponding generation costs. The second is that the minimum equity requirement for generation is 35% compared with 25% for the LIL, or 40% higher. If we take $440 million and multiply it by 1.72 and 1.40 we get $1,059.

My conclusion is that the financing costs during construction are understated by as much as a billion dollars. This would make the financing costs $3.6 billion and raise the capital cost of the project to $13.7 billion.

The byzantine cost recovery scheme makes it difficult for the public to understand the full cost of this project and the impact it will have on ratepayers and taxpayers. The stated purpose was to avoid rate shock in the early years before the vaunted surge in demand takes place. The hybrid system should not be used to understate the full cost of the project.

David Vardy