Russell Wangersky was right when he said in the Telegram on
October 27, 2018 that Muskrat Falls is “a win for investors but the risk’s on
us”, the ratepayers. “The fundamental
assumption in the financing of the project is that the revenues charged to
island ratepayers for the generation and transmission of Muskrat Falls power
will flow unfettered to the lenders to satisfy debt payments.”
In this post I examine the underpinnings of this “fundamental
assumption”, beginning with the take-or-pay power purchase agreement (PPA), the
role of equity and the concept of freedom of choice. Does the PPA lock us in to
an abusive relationship, not for 65 years but for 50? Is it another Churchill
Falls Agreement which strips us of our rights? In my next post I will ask if
the PPA makes Muskrat Falls self-supporting and whether revenues from rates
will cover all costs and generate dividends for the government of Newfoundland
and Labrador (GNL).
Power Purchase Agreement
The PPA is an agreement signed November 29, 2013 which
guarantees that NL Hydro (NLH) will purchase a defined amount of energy from
Muskrat Falls Corporation (MFC) over a 50 year “Supply Period”. NL Hydro must
purchase this power regardless of the level of demand for power in the
province. Both companies signing this PPA are subsidiaries of Nalcor Energy.
They are not “at arm’s length” from each other. Regulators are very wary of
transactions between related companies and for good reason. When I was chair of
the PUB we reviewed transactions between Newfoundland Power (NP) and other
Fortis subsidiaries to ensure that costs charged were no higher than they would
have been if NP had been procuring the same services in a competitive
marketplace.
Section 5.1 of the Hydro Corporation Act reads: “The objects of the corporation are to
develop and purchase power on an economic and efficient basis …” NLH was set up
to make power available on an economic and efficient basis to serve the people
of the province. The object of MFC is to recover the cost of building Muskrat
Falls.
By signing the PPA NLH has abrogated the rights of our
citizens to benefit from other more affordable sources of energy over the next
50 years. The PPA locks the province into old technology in a world where
technology is improving more quickly than at any time in human history and this
is particularly true for technology relating to energy and communications.
The PPA, combined with the 2012 amendments to legislation
governing electric power supply, enshrines Nalcor’s position as an unregulated
monopoly. This abridges the freedom of our citizens to participate in the
benefits of a free market economy, which has generated more economic growth
over the past 100 years than any other economic paradigm.
There is a trend toward increasing competition in the energy
sector, notwithstanding the power of behemoths of electricity represented by
crown corporations across Canada such as Hydro Quebec, Manitoba Hydro and BC
Hydro. At a time when growing competition is reducing the cost of power across
North America our province is returning to the industrial structure of 19th century monopolies, before regulation
evolved as a surrogate, albeit imperfect, for free market competition.
The PPA is established as an asset to be monetized through the
federal loan guarantee, thereby enabling Nalcor to secure loans of $7.9 billion
dollars.
How can two crown corporations, with conflicting objects, both
owned by citizens of the province, usurp so many of the rights of citizens in a
democratic society? Surely the PPA should be challenged by a class action on
behalf of consumers? The PPA is an attempt to lock consumers into a situation
where sufficient revenue will be extracted from them to ensure that those who
lend the money and those who guarantee it will bear no risk. How will consumers
and citizens react to this contemptuous treatment, knowing that their rights
may be abridged even as they supposedly continue to enjoy rights and freedoms
guaranteed in the Canadian Charter of Rights and Freedom?
Were those who orchestrated this debacle successful in
undermining the rights of citizens and turning citizens into automatons, with
no freedom of choice? The answer is no. As of this point in time we continue to
enjoy freedom of choice, which is fundamental to our democracy and to the
functioning of our free market economy.
Risk and Equity
We turn now to the economics of the PPA, beginning with the
concept of return on equity (ROE). Equity is the capital investment which
investors commit to an enterprise or project. Those who invest equity are fully
exposed when things go wrong. They bear the losses if the project or enterprise
turns sour. In the context of a limited liability company the risk is limited
to the assets of the corporate entity, whether public or private.
If, on the other hand, the enterprise is successful the owner
of the enterprise will enjoy the profits and will be rewarded for taking the
risk. John Crosbie once quoted T. S. Eliot who said “Only those who would risk
going too far can possibly find out how far you can go” to suggest that
government should embrace the risk of Muskrat Falls. Perhaps Eliot, the
Anglican prelate, poet and banker, was simply saying we should challenge
ourselves in our daily lives and did not intend to endorse such worldly
“boondoggles as Muskrat Falls”?
In the world of business, profits are not guaranteed. You pay
your money and you take your chances. In the world of public utilities it is a
little different. Return on equity capital is treated more as a cost than as a
residual. It is factored into the “revenue requirement” which is jargon for the
annual cost of a service such as telephone or electricity provided by a public
utility. Dividends become for utilities a cost factor although for their
shareholders they are revenue. When customers and shareholders are one and the
same the dividends are extracted from one pocket as a cost and placed in the
other as revenue. If the customer is without means then dividends can neither
be extracted nor returned!
In a regulated world, public utility commissions across North
America set an allowed or “regulated” return on equity, as a stepping stone to
setting the return on regulated rate base. The rate base is the value of all
assets used and useful in providing service and is financed by a combination of
equity and debt. The cost of debt is usually easily measured and is the
interest cost of servicing the debt.
Interest and principal repayment are usually secured by a
mortgage on property and are considered to be well secured, as they are the
next to be paid after payment of operating expenses. Interest on debt will be
paid as a first claim on the assets of a company. The return on equity is not
secured, other than by trust in the sagacity and foresight of the investor.
Regulators set an allowed rate of return on equity which is
included with the cost of debt servicing in calculating a regulated rate of
return on rate base. Often regulators will create a range or small band of
after tax profits which is deemed “acceptable”. If the return exceeds the top
of the range they can demand that the utility make a refund. If the return
falls short then the utility has to absorb the cost because it is unusual for
regulators to impose retroactive rate increases.
The point is that in the world of regulation, from which
Nalcor and MFC are regrettably excluded, public utilities are not “guaranteed”
a rate of return. Instead they are “allowed” to earn a return. The reason is
that regulators and utilities can only estimate or guess what future demand for
electricity will be. Usually regulators are dealing with a period of two to
five years. Rarely do they make decisions based on 50 year projections.
The Consumer Still has Freedom of Choice
The PPA is based on a return of 8.4% on equity. To what extent
is this rate of return guaranteed? The reality is that consumers are still able
to make choices. They can leave the province. They can modify their behaviour
by using alternatives to electricity, particularly for heating living and
working spaces. Economists have measured elasticity of demand and found that if
people expect that rate increases will continue they will shift to other forms
of energy. If they consider rate changes to be temporary they will ignore them.
In the case of Muskrat Falls it is highly likely that elasticity will be high
and people will switch in response to rate increases, given that the project
will not be completed for another two years and the costs of the project are
well known. Expectations are that a succession of rate increases is virtually
inevitable.
Conclusion
Russell Wangersky concludes his Saturday October 27 piece by
saying:
Eventually, the billions of debt will be paid, and the project
might be able to start paying dividends to residents of the province.
Throughout the sad saga of Muskrat Falls Russell, has by his probing insights,
demonstrated excellence in investigative reporting. With the highest deference
and respect to Russell and in response to his closing comments I say: Russell,
do not bet your pension on “payment of billions in debt”! Yes the bondholders
will be paid but most likely by the guarantor, the federal government.
“Paying dividends to residents of the province”? Not likely! If dividends are going to be paid
they will first be taken out of your pocket through higher rates and as a cost
of service before they can be returned to your other pocket as a “profit”. The
notion of dividends is a “delusion,” if not a deceit. Our politicians will be selling our citizens
short if they think people can be so easily deluded!
Will ratepayers challenge the PPA as being detrimental to the
interests of consumers? Should the
Consumer Advocate, on behalf of electrical consumers, launch a class action to
challenge the impropriety of this take-or-pay contract between a regulated
utility and the company with which it has negotiated a power purchase agreement,
both of which are owned by Nalcor? The contracting parties are clearly not at
arm’s length. Does the contract interfere with the rights and freedoms of
ratepayers by monetizing a contract on their behalf, effectively imposing a
pre-payment obligation upon ratepayers, without their agreement? In Part 2 I
will deal with the economics of Muskrat Falls and show why it is unlikely the
project will cover its annual costs let alone dividends.
