Thursday, 29 November 2012

Muskrat Falls and Voodoo Economics

The method that Nalcor is using to price the electricity from Muskrat Falls should be a major concern to the residents of the province. The cost to the ratepayer, in the first instance, will be kept artificially low to obscure the true cost of the project. Here are the reasons why you need to be concerned:

Nalcor (the unregulated owner) will sell Muskrat Falls power to Newfoundland and Labrador Hydro (a regulated subsidiary of Nalcor) under what is known as a Power Purchase Agreement (PPA). Under this agreement, electricity will be priced in constant dollars and will escalate annually by a figure adjusted for the rate of inflation. This is also known as “escalating supply pricing”. The project, then, would be paid for over a period of 57 years. In other words, the returns on the project are back-end loaded, the depreciation in particular, is calculated by using what is referred to as a sinking fund – the depreciation is written off much later, a procedure that is used by only a few provincially owned utilities in Canada.   The simple fact is that the provincial government, through Nalcor, is ‘kicking the can down the road’ and making it a problem for the next generation. Only government would engage in this practise. Private enterprise, especially those with public shareholders, like Fortis, would not.

In the early years the Muskrat Falls project will lose money under conventional pricing. Normally the cost of service (COS) pricing methodology is used. The COS method would see the project paid for over a much shorter period, depreciation would be calculated using a different method and future generations would not be compromised.

Nalcor submits that “this (PPA) approach avoids intergenerational inequity...” In other words Nalcor is suggesting that your children and grandchildren will be paying essentially the same price for power as you would today on an inflation adjusted basis. In fact, the opposite is true. Planning to pay for a project over 57 years in constant dollars means that there is no flexibility to adjust for technology changes over this period (witness the extent to which the emergence of natural gas is changing the pricing of electricity in the Northeast United States).

Manitoba Hydro International (MHI), the PUB’s chief consultant, also admitted, in its submission to the PUB, that “... uncertainties in power systems have been augmented by various factors such as advancements in technology, the increased complexity of system design and operation, the deregulation of the utility business, the increased utilization of intermittent energy sources and the imposition of more mandatory regulatory requirements.” 57 years is a long forecasting period to assume no technology change and, in any case, forecasts over this extended period mean very little, no matter how solid the assumptions. Moreover, significant capital may have to be expended over the next 30 or so years to repair or replace parts of the infrastructure.

Long term financing for projects such as Muskrat Falls is obtained by floating long term bonds. The maximum length of a bond is 30 years. We do not know if the escalating supply price method takes into account the level of interest rates beyond the initial bond term when this project will have to be refinanced, nor the cost of refinancing. One very knowledgeable person observed: “Who is going to lend money for a fixed rate of interest for 57 years?” I would be very surprised if the Federal Government loan guarantee extended beyond the initial period.

It is interesting to note that the transmission line from Muskrat Falls will be financed by a new corporate entity; Emera of Nova Scotia will be part owner. The conventional method or the cost of service (COS) approach is being applied for its pricing strategy. The reason: a PPA agreement wouldn’t pass muster under the Nova Scotia PUB Board. Emera shareholders wouldn’t go for it either!

Nalcor in its final submission to the PUB stated that “...the PPA approach...recovers all investment and operating costs and provides the shareholder (Nalcor) with positive cash flow every year. There is no subsidy in the early years, there is no foregone income...”. This is nonsense, especially when only 40% of the power will be sold. The PUB in its Report to Government on March 30, 2012 stated: “Nalcor explained that it does not intend to sell Muskrat Falls power for $214/MWh and instead will sell it to (Newfoundland) Hydro at $76/MWh.”  With a recently announced 25% increase in the capital cost of this project Muskrat Falls power will rise to approximately $267/MWh and $95/MHh respectively. Under this approach to pricing there will be a significant shortfall of cash in the early years and up to the point of break-even which some have suggested will be around the year 2028. Either the ratepayer pays or the taxpayer pays in the form of a subsidy directly to Nalcor. Alternatively, Nalcor will be paying a lot fewer dividends to the government – a subsidy by any other name.

We need to see the details of the Power Purchase Agreement. After all it is an agreement between two government- owned entities. The Minister needs to tell us why the PPA will not be subject to the Public Utilities Act. He needs to inform us why Nalcor will not be subject to the regulations of the PUB. He needs to tell us why he is engaging in voodoo economics to justify the Muskrat Falls project.

Written by Brendan Sullivan
(Brendan Sullivan is an economist and businessman in St. John’s).