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Monday 11 July 2016

STOPPING THE PROJECT NOW: Weighing the Options

Guest Post Written by David Vardy

When the government of the day sanctioned Muskrat Falls in December 2012 they subjected the province to enormous risks. They gambled the future of the province and inflicted what is proving to be great damage on a public which was far too trusting of their leaders. They bet the farm on increasing energy prices and we have as a society begun to suffer the consequences. 

Since 2012 the fiscal position of the province has eroded substantially, as indicated by the fact that the interest cost on our debt now exceeds our expenditures on education. Our per capita debt is higher than any other Canadian province and higher than beleaguered Puerto Rico. Our deficit, as a proportion of GDP, is 13 times that of the average Canadian province.  We are borrowing 35% of our total spending, a cash deficit of over $3 billion, at a rate which cannot be sustained.

The specter of our high debt load in 1933, which led to Commission of Government, is very real, not just a remote possibility. Government has embarked on a draconian program of tax increases, likely to be matched in the fall with equally severe cuts to our expenditures. These measures are necessary because of the legacy of the former administration, which sanctioned the foolhardy Muskrat Falls project. The new Liberal administration must now take the measures necessary to minimize the risk of the Muskrat Falls project if our fiscal independence is to be preserved.

Nalcor CEO Stan Marshall minced no words when he said that the Muskrat Falls project was “not the right choice for the power needs of the province”. He said that “$6.7 billion has been spent or is contractually committed.” Marshall said that we should have built generating capacity only according to our needs and not speculated on the future by building too much capacity. The assumption of continuously rising oil prices has been proven false by the advent of the shale gas revolution. He also said the demand projections for electricity were much too high. He concluded that “stopping the project is no longer a practical option”.

The Case for Suspending Site Work at Muskrat Falls
With the utmost respect, I believe that Mr. Marshall should reconsider his position with regard to continuation of the project. A case can be made for suspending work at the generation site while continuing only with the transmission component. My purpose here is to state the case as well as to argue that other options also be explored.

In his statement of June 24 Mr. Marshall disclosed that the generation component represents 52% of total project cost, amounting to $4.8 billion, while $2.3 billion has been spent and $0.9 billion has been committed but not spent. The projected balance remaining to be spent, not including financing costs, is $1.6 billion. For the transmission lines the amount spent is $2.4 billion and $1.3 billion has been committed but not spent, leaving $0.7 billion to be spent. Therefore the decision to suspend the generation component must focus upon 52% of the cost and not the full $11.4 billion cost projected by Nalcor in Marshall’s update of June 24, 2016. The $6.7 billion of committed costs included in that release includes both the generation and transmission components and it includes a combination of sunk costs and potentially negotiable costs.

A decision to suspend the generation component will require that some contracts be renegotiated, particularly the Astaldi contract, which is currently the subject of intense and protracted negotiation. We therefore start with the proposition that some of the contractually committed costs associated with generation are open to renegotiation and that costs which have not been committed or incurred can be avoided.

Ernst and Young reported in April 2015 that 
The MFG (Muskrat Falls Generation) civil works contract is the highest dollar value contract. The contract involves construction of a number of areas: intake and Powerhouse, Spillway and Transition Dams. The deliverables on this contract are required to allow progress on other contracts, e.g. installation and commissioning of the turbines and generators, installation of spillway and intake gates and the balance of plant contract.

We understand that Astaldi did not generate sufficient profit from this project in 2015, based on reports from the Astaldi CEO to his shareholders. What Astaldi is now seeking is to recoup some of the lost profit and to extricate itself from what has become a dilemma both for Astaldi and for Nalcor. Marshall said that his negotiating strategy is that the outcome should be a win-win situation and not a “zero-sum” game where one partner takes advantage of the other.

Nalcor could make Astaldi “an offer they cannot refuse”, one which would offer them a share of their expected profit while allowing them to walk away from the project. The avenue for such an exit is to buy out the contract by offering a share of the expected profit (but not all) along with cessation of further construction on site. This approach could be used as well to abort other contracts for the generation component.

Court Challenge by Hydro Quebec
Hydro Quebec has mounted a legal challenge to Nalcor’s ability to manage the water resources of the Churchill Falls reservoir and thereby to develop Muskrat Falls. The fundamental issue revolves around whether the renewal contract between CFL(Co) and Hydro Quebec continues to allow Hydro Quebec access to all power and energy, save for the 300 MW Recall power and the 225 MW Twin Falls block, after September 2016. 

Legal opinions differ and no final resolution is likely for years until the matter is heard by the Supreme Court of Canada. In the meantime the risk of spending money on the Muskrat Falls project is enormous. Stopping the project now, while taking action to preserve the generation assets, would reduce these risks.

A decision of the Quebec superior court is imminent. Whatever the decision may be it will cast a cloud of uncertainty over the financing for this project. Nalcor must have a plan to deal with any outcome in the courts, both the decision of the Quebec court and the ultimate ruling upon appeal to the Supreme Court of Canada. Suspension of the generation component may well be the best plan to minimize the risk of adverse rulings.

Homework needed in advance of negotiations with Federal Government
Mr. Marshall referred to negotiations with the federal government to reduce the financial burden on the province. A sympathetic Liberal government in Ottawa may be responsive to the burgeoning costs of Muskrat Falls, which have increased from $6.2 billion in 2010 to $11.4 billion today, an estimate that Marshall qualified as being just an estimate and likely to rise further. If these negotiations allow us, as a province, to borrow more money, we have to ask is that the best solution? It will continue to add to our public debt and future generations will still be obliged to pay. The project will continue to be a “boondoggle” and far from the best solution to our energy needs.

Before going to Ottawa on bended knee we must do our homework. This requires a realistic cost benefit analysis of stopping the generation component and continuing with the transmission line. We may have to find alternative energy for Nova Scotia to fulfill our commitments but the revised load growth numbers released by Mr. Marshall on June 24 disclose a dramatic reduction in the projected demand for electricity in this province. 

Aggressive demand side management can reduce the use of electricity for space heating, including a combination of retrofitting and use of heat pumps, which will more effectively respond to the peak load demands of winter heating than the sledgehammer that is Muskrat Falls.

Many of us have also argued that the need for reliability necessitates an energy source on the Avalon and that a well maintained thermal plant at Holyrood or some other alternative source of power will be needed after interconnection. This needs to be factored into the analysis. Only after the full analysis has been completed should we approach Ottawa.

A compromise solution between stopping or finishing the full project
It has been said we cannot afford to finish Muskrat Falls nor can we afford to stop it. What we need is something in between. The suspension of the generation component, while continuing with the transmission lines, offers a better solution. The transmission line will allow us to access the unused portion of the 300 MW block of Recall power and to purchase additional power from Churchill Falls. 

JM has posted extensive technical and financial analysis on this Blog regarding the project and he has argued that energy from Hydro Quebec should be purchased for transmission to the Island, along with Recall power.  Hydro Quebec’s returns for selling power in the US have fallen sharply with the shale gas revolution.  We can offer to match or exceed their unit revenue from US sales so that it will be in their profit-seeking best interest to meet our needs and to do so at a much lower cost than that of building Muskrat Falls.

Will we need the power after 2041?
There are those who will argue that, in the long run, inflation will erode the burden of the debt and our grandchildren will bless us for building this long-lasting renewable energy project. This line of reasoning ignores the simple reality that Muskrat Falls will come on stream, at the earliest, in the second quarter of 2020 and that, 21 short years later, in 2041, we will have access to low cost power from Churchill Falls, another renewable energy source. We will then have no need of power from Muskrat Falls so we cannot argue that it constitutes the lowest cost power or that it will be a blessing to our grandchildren. Nor can we argue that it will somehow strengthen our position with Quebec. We did not need to prove that an alternative route through the Maritimes could be built from a technical perspective. Other lines exist internationally and perform extremely well.

What needed to be proven was whether it could be built economically. The agreement with Emera which resulted in the sale of one billion kwh of energy with no energy charge to Nova Scotia, combined  with the sale of another 1.2-1.8 billion kwh at spot market prices, demonstrate absolutely the converse proposition, namely that it is not economically feasible or profitable. Furthermore, by overbuilding our capacity through such an expensive project we have reduced our need for Churchill Falls power, leaving us with an inability to take full advantage of the 5,428 MW from the Upper Churchill. Rather than strengthening our position with Quebec we have weakened it by building Muskrat Falls!

Assessment of Options
The assessment of options would best be undertaken by an independent third party who must be given full access to all contracts and other information. Ernst and Young might be able to perform part of this task but they will require support from a major engineering firm, other than the so-called “independent engineer,” who has been silent for too long.

The fundamental focus for assessing the options is future costs, not sunk costs. Sunk costs are relevant for historical analysis but not for making decisions on the future. We must focus on the future costs and revenues associated with completion versus those of stopping all or part of the project.

Ernst and Young’s April 2016 report said that only 40% of construction work had been completed, leaving a lot of room for further escalation, possibly to $15 billion or higher. The cost is likely to exceed $11.4 billion for a number of reasons. One is the cost of reaching a settlement with, or replacing, Astaldi. Another is the cost of remediating the North Spur and the methyl mercury problem. The third is the need to remedy the quality control problems that have occurred, leading to the collapse of concrete cribbing at the powerhouse and the loose strand of wire on 170 km of transmission wire.

The Muskrat Falls project was ostensibly designed to meet provincial needs but yet the final agreement with Emera committed more than half of the energy output for use in Nova Scotia. Mr. Marshall is now looking at other markets for firm power since the latest load growth projection has produced a more realistic and reduced estimate of local demand. 

This revised model is similar to the export-oriented approach to both Gull Island and Muskrat Falls adopted by the administration of Brian Tobin. It has the potential to generate higher revenues, as Marshall pointed out on June 24. Such an alternative business approach to continuation should be included in the evaluation of options, with export revenues used to offset the high costs of Muskrat Falls.

The suspension option removes the risk arising from the court action in Quebec, which could make it impossible to generate anything close to the 824 MW power capacity of Muskrat Falls and thereby turn the project into an even bigger “boondoggle”. It would also avoid the risk associated with the collapse of the North Spur through the liquefaction of quick clays underlying the Spur as well as the threat from methyl mercury arising from failure to clear cut the run-of-the-river Muskrat Falls reservoir. These risks associated with generation at the site are all avoided with the “transmission-only” option. It cannot be ignored that the North Spur and methyl mercury issues constitute huge political problems for government as they are seen as risking peoples’ lives and poisoning their food.

No stone unturned
The stakes are too high for us to continue blindly with this project. 

It was foolhardy of the previous administration to turn their back on the advice they received both from the PUB and the joint federal provincial environmental panel. It would be equally foolhardy for us today to take the position that the cost benefit analysis of the option to stop is as unknowable as the cost of “building a transmission line to the moon”. In the language of Donald Rumsfeld the issue is one of knowable unknowns not “unknown unknowns”. 

For the sake of our grandchildren, who will be expected to bear the cost of a mountain of debt, we must do the analysis and make a final decision on the basis of the best and latest information available. We owe it to them to make every effort to avoid the mistakes of the past, when decisions were made using false assumptions and inadequate evidence.