Monday, 17 December 2012

A Cautionary Note to EMERA On Muskrat Falls

If Emera sanctions the Muskrat Falls (MF) Project, its ‘sweet heart’ $600 million deal on the Labrador Island Link (LIL) will not just be plain sailing from here.  Yes, Bruce Huskilson, Emera’s President and CEO, is likely mesmerized with phone calls from NL’s Minister of Natural Resources Minister, Jerome Kennedy, demanding an immediate decision.  That is what politicians do.  Projects, like MF, are but ‘playthings’ for governments. 

Huskilson should be unavailable, for the next year or so, at least, until the NS UARB has rendered a decision on the Maritime Link (ML).  Why? Emera’s sanction of the LIL does not guarantee sanction of the ML.  The advantages which Emera’s skilful negotiators won, against Nalcor’s bureaucrats, could be all for naught.
By the standard of public utility companies, Emera is relatively small. A market cap of just $4.2   billion is even smaller than Fortis’ $6.45 billion. Investment Fund Managers from the Canada Pension Plan to a plethora of ‘safe harbour’ investors are income dependent and rely upon Emera’s risk-free dividend cheques and modest growth.  Emera wants to grow faster, through its LIL and ML investments and by collecting fees, wheeling to third parties, anticipated surplus MF power. Relative to Emera’s size, the LIL and ML projects are outsized and far too risky.
Emera has agreed to invest $600 million for ownership of 29% of the LIL.  In return, it is ‘guaranteed’ a 7% rate of return, legislated by the Government of NL; Nalcor will pick up the cost overruns.  On the surface, the deal seems attractive and straight forward.

And, you may well ask, why worry, if Emera has control over the ML decision? It can control the outcome.  Actually, that’s not quite right.  Nova Scotia’s UARB will determine whether the ML is NS’s lowest cost option and it will prescribe a rate of return, which will determine the ML’s viability.
UARB hearings will not begin until mid-2013, plenty of time for a lot of changes to occur; for cost overruns to appear on the Labrador parts of the Project if NL proceeds alone, for the impact of the ‘shale gas’ revolution in the U.S. to offer more proof that hydro mega projects are passé for now, for Hydro Quebec to make Emera an offer that trumps the cost of MF power.  Afterall, HQ did confirm the declining value of the U.S. market with its Vermont deal last year. And, HQ has surplus power. An offer from HQ may represent the ‘lowest cost’ option; that is what the NS UARB is mandated to decide. 
Is that all?  Indeed, no. As attractive as a 7% return might seem in a market in which Government Bonds offer less than 2%, what is the problem?

First, the Government of NL is not the right fit for a company like Emera; NL’s high risk behaviour is incompatible with Emera’s low risk profile, as a utility.  Fortis Inc.’s Stan Marshall knew that, many months ago.  Fortis is regarded as the ‘home team’ in this Province. Yet, the company would not go near MF, as Nalcor’s minority partner, with a barge pole.  Emera, too, should have chosen better than Nalcor.
You probably think I am going to go into a diatribe about Nalcor’s lack of expertise to do MF (which would be true) or that I am going to cite the legal problems of SNC Lavalin’s former senior executives (they have many), that we should be running for the exits, rather than deal with a group constantly under threat from Quebec’s ‘Hammer Squad’. I’m not going to inform  Emera’s Board of Directors what it can read in the paper.

How a company deals with risk is often what makes them grow or destroys what they have already built.  Emera’s “Opt In” strategy is perfect for that Company. But, if it sanctions the Labrador Island Link before a final decision is made on the ML, it will have voided the advantage its negotiators won.
In addition, Emera has Nalcor picking up 100% of cost overruns; it is a reflection of the fact that Emera recognized such a risk from which it needed to shield the company.  Emera knows that overruns plague virtually every mega project and that MF will be no different.  What Emera is forgetting is that the NL Government is in no position to sustain big cost overruns, either. 

Likely, the company’s executives are not ignorant of the budgetary mess into which NL has gotten itself. A deficit of $725 million, this year, and a worse forecast next year. The kitty, in which it was saving part of the equity requirement for MF, is now getting smaller and smaller.

NL’s current high public debt combined with a ‘structural’ deficit means it will also have to borrow its equity and borrow all cost overruns, too. Structural deficits, by their nature, repeat themselves.  All this borrowing will cripple the Government.  With the FLG, NL will find it difficult to finish the Project; without the FLG, it will be impossible.

The Government now notes that a third of budgeted revenues are sourced from offshore oil; the real number is likely more than one-half, when personal income taxes, HST and other correlated revenues are included. Hence, two black swans, cost overruns and lower oil prices, represent, for NL, a ‘fiscal cliff’ that should not be underestimated by anyone, including Emera.    
Chris Huskilson should take a lesson from recent NL history. Successive governments of this Province, spent years, and millions of dollars, attacking the Upper Churchill Contract in the Law Courts.  A transmission line from Labrador to Quebec was the Contract’s saviour; that physical link gave it “inter-provincial” status, removing it from the singular authority of the NL Legislature. Without the ML, MF is not an “inter-provincial” undertaking; the Supreme Court of Canada cannot determine a link where none exists. Hence, MF, in these circumstances, will be ‘provincial’ and at the mercy of the NL Legislature.  That is one risk Emera’s bankers and its shareholders should not fail to appreciate.

As in Greece, when a Government gets in trouble, a solution must be found. A future NL government, beset with huge cost overruns on MF, will be forced, with a growing public outcry, to reduce services, pare the public service and pays less to those public servants that it keeps.  It will look for creative ways to dig the Province out of a mess. If Emera thinks, for one second, that its investment is safe, in such circumstances, Bruce Huskilson is very naïve. To a government in trouble, Emera’s 7% will have the same status as other low hanging fruit.
Today, Emera’s Board should be feeling pretty good about its “Opt In” position in the MF Project.   It should not be hurried by the NL Government, at least, not until the UARB has handed down a decision; by then, some of the gaping holes in the FLG “Term Sheet” will have been filled in, an analysis by a rating agency will be available,  the Independent Engineer will have had a look at the multitude of “Conditions Precedent” to provisioning the FLG and by then, too, it will have a sense of whether the federal bureaucrats have structured, in the FLG, something unachievable, letting the Feds off the hook.

Viewed from here, Emera’s courtship with Nalcor might have given birth to a ‘sweet-heart’ deal.  But, if the company forgets its risk-averse, dividend loving shareholders, sanctioning the LIL now, will be the beginning of a very unhappy marriage.