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Thursday 19 May 2016

MUSKRAT FALLS AND VOODOO ECONOMICS

Back in November 2012, as the Dunderdale Government was about to conclude sanction of the Muskrat Falls project my brother, Brendan Sullivan, found himself among the handful of “naysayers” who could see through its economic folly.

Nalcor and the Dunderdale Government had concluded their end run around the PUB, having ring-fenced the two power options it wanted to give evaluation. Of course, the outcome was already predetermined, many of the assumptions favouring Muskrat Falls having been contrived. In the end, the charade served only to justify a truly “nutty” project. 

Brendan, a former provincial government economist, explained some of his concerns in a Blog Post entitled “Muskrat Falls and Voodoo Economics”. He wrote at least one other article in the Telegram.

Brendan passed away on Monday, after a long and heroic battle with a rare disease called Wegener’s Granulomatosis. I am re-posting the Piece today in his memory.

This Blog got started largely as a reaction to the arbitrary manner the Government was driving formal sanction of the Muskrat Falls project. It was a vent for outrage against stupidity and secrecy which evolved as a source of analysis and commentary on Muskrat and on other public policy issues. 

Brendan's views frequently crept into the articles I wrote. Almost daily, we parsed the information which Nalcor shared with the public, much of it misleading, inadequate, and always with an unmistakable “spin” designed only to reinforce its view. We felt strongly the Government didn't want the public to have the opportunity to analyse project economics and other details as much as they were expected only to believe.

In the more than thirty years Brendan and I developed and operated commercial real estate, condominium development, and retail businesses, there was one characteristic about which there was always clear agreement. We both felt it was a necessary element of business and life to be honest and forthright, and be prepared to say as much, even if, sometimes, the view seemed blunt or even harsh. The necessity for open and honest government was an integral part of this view.

I shall miss his humour, enormous intelligence, and most of all his penchant for absolute straightforwardness.

Brendan loved this province. As an economist and businessman, he was always greatly disturbed that politicians and public servants, who ought to have known better, engaged in such a wanton disregard for our financial future.

It probably won’t surprise you, given the more recent and disturbing revelations regarding the Muskrat Falls project, to which the public is awakening, his 2012 Post is just as relevant today as it was then.  May he rest in peace. - Des Sullivan

Here is Brendan’s Piece.   

MUSKRAT FALLS AND VOODOO ECONOMICS

Thursday, 29 November 2012

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).