Friday, 14 December 2012

Finance Minister Does Not Understand Risk

The Budget Update, delivered yesterday, December 13, 2012, by the Finance Minister, acknowledges the mulitude of risks attacking the declining health of the Province's Teasury; otherwise, it ignores them.  He gives no advice to the Government either, as it trundles towards sanctioning an outsized and risky megaproject.  The Minister is not a decision maker.  He should go.

Many great projects get passed over because the risk/reward ratio is simply unattractive.  In business, it is a fact of everyday life.  On paper, an idea may first appear sound; the assumptions are reasonable, cash flow analysis is excellent, pro forma rate of return, on both equity and investment, are within an acceptable range, financing is available on reasonable terms.  Then a decision is made to scrap the idea! Why? What went wrong? The answer is sometimes even good investment ideas get placed on the backburner.  Regardless of how inherently sound they may be, they carry risk, sometimes too much risk. 

Given the Finance Minister's tale of woe, let's consider this theme further.

A prudent company will not only assess the intrinsic viability of a proposed investment, it will consider the company’s ability to deal with the consequences of failure.  Stuff happens, much of it beyond our control. The practice of risk management will identify the most serious potential problems and propose safeguards against trouble.  It might, for example, compel an investor to let a greater number of shareholders participate.  Alternatively, the project might get scaled down or cancelled altogether.  The state of the international economy may be a threat; public debt may be already too high.  The size of the labour pool or the availability of essential technical skills may be inadequate.  Wage inflation, caused by an overheated economy, may result in significant cost overruns and necessitate more capital or cause lower returns. Could I be referring to the Muskrat Falls Project?
If the decision is not to proceed, a logical question to ask is whether the particular service/product can be gotten another way.  “Lowest cost option” is a goal of every business.  It is a benchmark against which the next most acceptable alternative can be measured.  In other words, an entrepreneur doesn’t risk the shop to achieve the optimum result when a modest compromise is available.

If you recall, Nalcor’s proposal ostensibly provides a $2.2 billion  saving relative to the ‘isolated island’ option.  The DG-3 numbers added $1.2 to the capital cost plus nearly $1 billion financing costs, during construction, which were deliberately excluded. Of course, arguably, costs within the ‘isolate island’ option are higher also, but that Option, an incremental response to more current demand forecasts, has been completely ignored.  Still, risk assessments can occur only if there is full disclosure.   
While most people view government borrowing with apathy, we ought to remember that governments and as a consequence, their constituents too, are impacted by changing market conditions. These days virtually every national news report names a government that is dealing with financial distress. The origin of the problem, if traced, can be linked to the lack of appropriate consideration of risk and the failure to make major financial decisions on a timely basis. 

As if to confirm such a failure, the Minister of Finance, only now, in the ninth month of the fiscal year, is ready to acknowledge what has been evident from the beginning.  And, still he has no decisions at hand.

The scourge of democracies is that access to debt permits governments to postpone prudent decision making in the expectation that a later government will impose the fiscal discipline they lack. In common parlance, we call it ‘kicking the can down the road’.  In this Province, we have been doing that for years.  The current government is one of two that has enjoyed high revenues, yet, still cannot muster the willingness to resolve an operating deficit that has already become 'structural'.   
Public servants can tally up the cost of public demands; but establishing benchmarks and setting limits (management) is the job of a government. 

In this context, any risk assessment of the Muskrat Falls Project will recognize our small population and the size of our current fiscal challenges.
Our Provincial debt is $10.8 billion, $21,600 for every man, woman and child. Muskrat Falls, which initially is expected to supply a mere 15% of electricity needs, will bring our per capita debt to over $35,000.  Is this what you had in mind in closing the door on less risky options? The local economy suffers from a very narrow base. Offshore oil revenues are actually closer to 50% of total revenues than the oft touted one-third figure, when you consider personal income taxes and other indirect revenues that would not get collected, in the absence of oil.

Lower world oil prices, this year alone, has already pushed the operating deficit to $725.8 million; unexpected delays with the Terra Nova oil platform achieving full production or some other unforeseen issue  could expose bigger fiscal problems.  Our neighbour to the south stands at a precipice called the ‘fiscal cliff’.  The jury is still out as to whether the Eurozone’s weakest economies will be salvaged. Economic hiccups, in China, have already claimed its first causality with a local connection, the Cliff Resources Bloom Lake Expansion. Others are worried. These risks are completely beyond our ability to influence.  But, our ability to spend is not!

One black swan would place us on the precipice of our own fiscal cliff, two would tip us over.  This small population has no cushion with which to break the fall.

As we slide inexorably towards MF sanction, our economic vulnerabilities are more exposed than ever.
Perhaps, we are just larger than ourselves. 

If it had a convincing story to tell, the Government would not minimize disclosure, pillory critics or refuse essential parliamentary debate. Risk assessment is no laughing matter; except to those who don’t worry because it is not their dime. The bond rating agencies will not be pleased.

A prudent banker would show this Finance Minister the door.