At the recent Nalcor AGM CEO Stan Marshall repeated his mantra that Muskrat Falls will “finish strong”. He said that its costs are comparable to, if not lower than, the unit costs of other Canadian energy projects. The Chief Financial Officer bragged about the growing asset base and spent little time warning of the large liabilities. When asked about dividends at the Muskrat Falls Inquiry the CFO said they were “rock solid”.
Nalcor’s annual report spoke in glowing terms about the project and about the profitability of Nalcor. The prospects of growing dividends were glowing. Suddenly the problems had vanished and we were living in a world of milk and honey. What had changed to spark this bright and cheerful outlook in the face of a financial disaster? Was Nalcor “gilding the lily” along with the politicians who are looking to sweep Muskrat Falls under the carpet in advance of imminent federal and provincial elections.
The Nalcor presentation to the many acolytes in the room at the Holiday Inn in St. John’s talked about the profitability of power exports. Nalcor put a positive spin on the revenues flowing from a large block of Recall power being exported through Quebec transmission lines. Nalcor wanted to talk about the $59 million in gross revenues and not upon the paltry $23 million after paying transmission and other costs. Upon questioning Marshall admitted that the 3.8 cents/KWh profit on the sale of 1.6 billion kilowatt hours of Recall power netted only 1.4 cents after transmission costs were taken out.
At the PUB hearing into rate mitigation Nalcor is reporting reductions in the annual costs arising from Muskrat Falls, below those reported previously. While the official capital cost of the project has not changed from the $12.7 billion reported by Stan in June of 2017 the forecast cost of servicing the capital costs has dropped. Why? What are the drivers to reduce costs? Higher export revenues are also being forecast to mitigate future power rates. Vast dividends are being forecast, dividends which can be used to reduce power rates and make ratepayers happy.
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| David Vardy |
Is Nalcor gilding the lily? Have they adopted a public relations strategy to downplay the costs of Muskrat Falls and lull us all into complacency over this monumental boondoggle? Are they undertaking creative accounting as new and lower revenue requirements are being revealed?
Marshall admitted in response to my questions at the AGM that the 17.42 cents/KWh for 4,641 GWh of Muskrat Falls he reported in his February 2018 presentation at Memorial University has not changed. He admitted that the project is too large for our needs and that the 17.42 cents is based upon use of the full output. In reality the unit cost is much higher!
In his 2018 presentation he forecast demand of only 1,324 GWh of the 4,641 GWh of Muskrat Falls power forecast to be available at Soldier’s Pond in 2021. If only half the power were used the cost would be twice 17.42 cents, namely 34.84 cents/KWh. When only 1,324 GWh are used on the Island the cost per unit becomes 61 cents/KWh!
The cost of power
This post is intended to disclose the unvarnished cost of Muskrat Falls, based largely on the 2018 presentation at Memorial as well as other more recent data, including Nalcor’s 2018 annual report released at the AGM in April of 2019 and responses to information requests submitted by the PUB at the rate mitigation hearing. Key data are as follows.
Key 2021 data from Stan Marshall’s presentation February 15, 2018:
Forecast retail rates
Forecast retail rate 22.89 cents/KWh (not including HST)
Forecast retail rate at sanction 15.12 cents/KWh
NP share of retail rate 4.43 cents/KWh
NP distribution cost $307 million
NLH share of retail rate 6.80 cents/KWh
Purchases, production and unit cost
Muskrat Falls purchased power cost for 1,324 GWh, spread over 6,935 TWh, 11.66 cents/KWh
Forecast load 6.935 TWh
Muskrat Falls production at Soldier’s Pond 4.641 TWh
Cost per unit of Muskrat Falls power 17.42 cents KWh
Combined generation and transmission cost for Muskrat Falls delivered Soldier’s Pond $808 million
Forecast demand
Total Island demand forecast for 2021 6.935 TWh and growing very slowly
Based on 22.89 cents/KWh this 6.935 TWh will cost $1.587 billion.
Muskrat Falls will supply 1,324 GWh and other sources the remainder, 5,611 GWh
Exports
Nova Scotia Block sales at no energy charge 1,166 GWh
Other export sales 2,151 GWh
The revenue requirements for the Island interconnected system will be $1.587 billion, including the $808 million for Muskrat Falls. In order to compare the unit generation and transmission cost of Muskrat Falls power with the unit cost for other power in the existing isolated island system we must remove both NP and NLH distribution cost which I have estimated at $326 million, yielding revenue requirement of ($1,587 million less $326 million = $1,261 million) or $1.261 billion. When we deduct the cost of Muskrat Falls power, $808 million, from this we get $453 million. Dividing this by the 5,611 GWh from sources other than Muskrat Falls we calculate a unit cost of non-Muskrat Falls power of 8 cents/KWh. This gives us a comparison of Muskrat Falls power at 61 cents/KWh with other power, mostly hydro power on the Island, at 8 cents. This illustrates just how big a shock Muskrat Falls brings to the economics of our power system!
In his post of April 15th PlanetNL draws upon the February 2018 Nalcor update and the new cost projections presented to the PUB. The February 2018 (page 23) update shows the Labrador Island Link comprising 36.6% ($3.7 billion) of overall direct project costs ($10.1 billion) excluding financing ($2.6 billion).
If we also apply this same 36.6/63.4 split of transmission to generation costs to the 61 cent per KWh cost of Muskrat Falls power we find that generation accounts for 39 cents and the LIL accounts for 22 cents. This makes it difficult to contend that the project is mostly transmission or to argue that the generation costs alone are within any reasonable range of acceptability.
The 2021 revenue requirements for the LIL (based on “cost of service” rate recovery), using the latest numbers supplied to the PUB for its rate mitigation hearing, are $380 million including financing costs. Applying the 36.6% to calculate the overall revenue requirement produces $1.038 billion as the 2021 revenue requirement. In fact this is a conservative estimate because it assumes that the minimum equity is 25% as required in the federal loan guarantee. When the $1.038 billion is adjusted upward to reflect the minimum of 35% equity for generation assets the revenue requirements far exceed $1 billion.
Even if we could use all of the power from Muskrat Falls it would cost us more than twice the cost per unit of the existing system, namely 17.42 cents/KWh compared with 8 cents/KWh. We have to cope not only with cost overruns at Muskrat Falls but also with the low demand which precludes economies of scale. Export sales help but unless sales are made at compensatory rates the burden of cost remains with Island ratepayers.
Nalcor has calculated the cost of Holyrood power at 15 cents/KWh. Muskrat Falls was promoted as a more cost effective source of power than Holyrood because of fuel savings. We were told that Muskrat Falls enabled us to keep dollars at home and not send them to the oil industry. Instead we built Muskrat Falls and now are in the hands of Wall Street who expect us to repay the borrowed money with interest. Fuel costs are more than offset by higher interest costs.
Back end loading
Nalcor uses a cost recovery mechanism for generating assets which is different from the mechanism used for the rest of our electrical power system. It is also different from the mechanism used to recover costs from the Labrador Island Link. It is different from the system normally used by the PUB in rate setting. Nalcor uses a traditional approach for the Labrador Island Link but a non-traditional approach for generation assets. If the traditional cost recovery system were used consistently the financing costs would be as much as $1 billion higher, using the targeted 8.4% return on equity. If rates in 2021 were calculated to recover the money borrowed by the province to finance its equity contribution they would be more than 10% higher than projected.
If traditional cost recovery had been applied, based on “cost of service”, the financial and other costs would be $1 billion higher, namely $3.6 billion instead of $2.6 billion, making it a $13.7 billion project. The principal difference between cost of service and “escalating supply price” recovery is that the return on the province’s equity is deferred, forcing the province to wait for its 8.4% ROE. This is intended to keep rates low and avoid early rate shock. The large cost overruns were so large as to drive up revenue requirements, notwithstanding the back end loading.
The higher financial cost arises from the exclusion of return on equity capital during construction, known as allowance for funds used during construction (AFUDC). I have recalculated the cost using the cost of service approach, from which I estimated the need for an additional $1,065 to be added to the financing costs bringing them from $4 billion to over $5 billion. This will also add to the cost of equity capital included in the annual revenue requirements.
The hybrid methodology used by Nalcor for generating assets shows that return on dividends are understated in the early years after commissioning. Nalcor’s response to information request PB-242-2018 shows that only $15 million is included in return on the province’s equity investment in the generating assets (Muskrat Falls itself plus the line from Churchill Falls to Muskrat Falls) of more than $3.2 billion. If we use 8.4% as the ROE established in the Power Purchase Agreement and apply it to the value of generating assets, adjusted upward to $4.265 billion to include AFUDC, the annual equity cost will be $358 million, of which only $15 million is recovered through rates in 2021 and $343 million is deferred into the distant future through the “escalating supply price” cost recovery mechanism. If we use instead the province’s borrowing rate of 4.6% then the equity cost will be $196 million and the deferred amount is $181 million.
Revised Revenue requirements
What are the revenue requirements after taking account of export revenues, fuel savings and the costs imposed on the province through back end loading? We begin with the numbers we have taken from the Nalcor presentation of February 2018. Stan Marshall confirmed at the AGM that the 17.41 cents/KWh has not changed, nor has the output of the plant net of line losses, namely 4.641 TWh. This tells us that the starting point is $808 million.
At the AGM I asked about the export of 1.6 TWh disclosed in the 2018 Nalcor Financial Report and which generated net revenues of $23 million, well below the gross revenues of $59 million, for an average net return in Canadian dollars of 15 cents/KWh. If this is applied to the exports of 2,151 GWh shown in the February 2018 update we get a return of $32 million. Recognizing that the transmission cost for sales to Nova Scotia may be less than those paid for export of Recall power I have adjusted this up to $50 million. The cost of number 6 fuel at Holyrood in 2018 was estimated at $150 million. This is the number I have used for fuel savings.
I have made an adjustment to the revenue requirement in 2021 to reflect the cost of provincial equity in the generation assets (including the line from Churchill to Muskrat Falls), which is a present charge on provincial taxpayers. I have used not the 8.4% return but rather the province’s borrowing rate of about 4.6%, which adds $181 million.
In summary the revenue requirements to be raised either through rates or rate mitigation are close to $800 as follows:
Response to information request PUB-Nalcor 56 reads as follows:
“The estimate of $60 to $70 million to reduce domestic electricity rates on the Island Interconnected System by one cent per kWh is a reasonable guideline to consider in the discussions and analysis for rate mitigation.”
This suggests that if rates go up by 1% then revenues will increase by up to $70 million. It also suggests that if rates are kept at 12.6 cents/KWh instead of rising to 22.89 cents/KWh then the cost of rate mitigation will be about $700 million. It does not admit the possibility that higher rates will generate little or no revenue and that elasticity of demand may be much higher than is assumed by Nalcor. Perhaps the PUB should build up its own estimate of the shortfall to be mitigated rather than rely on the formula given in this RFI.
Conclusion
The public debate around rate mitigation revolves around forgiveness of dividends as a means of resolving the financing demands of Muskrat Falls. There are two problems with this. The first is that the province has already assumed responsibility for the more than $3.2 billion invested as provincial equity in generating assets. This is a given. The second is that revenues will not come close to recovering dividends based on reasonable assumptions around elasticity of demand.
In estimating elasticity of demand we must understand that previous empirical research in this province has relied mostly upon small increases or decreases. As we take quantum steps along the demand curve there will likely be abrupt changes from past experiences which may make previous elasticity estimates of doubtful value.
When I speak of “gilding the lily” I am referring to the tendency to downplay the burden of Muskrat Falls. When citizens understand that the cost per KWh is 61 cents they will also understand that recovery through rates was never an option and that the notion of dividends is preposterous. High energy costs do not generate dividends.
On April 13 the Globe and Mail reported that “Renewable energy hits its stride,” citing cost reductions in solar and wind power as well as in energy storage.
The viability of renewable energy and its global surge underpins bullish enthusiasm for
companies such as Brookfield Renewable Partners LP, Algonquin Power, Northland Power and Boralex Inc. – Canada’s leading green energy producers, which are positioning themselves for strong growth in wind and solar power across the world…
In December, the Alberta Electricity System Operator – which runs the province’s grid – announced that it had entered into three wind contracts for a total of 763 megawatts at an average cost of 3.9 cents/kWh. The Alberta government announced in February it
had contracted for 100 MW of solar capacity at a price of 4.8 cents/kWh.
Prices are even lower in parts of the United States. Idaho Power stunned the energy industry two weeks ago by announcing a deal for 120 MW of solar power at a record-low price of just 2.2 US cents/kWh.
New York-based Lazard Ltd., a financial-advisory and asset management firm, produces an annual survey of average electricity prices around the globe, a work that is considered the bible among industry executives because it calculates the levellized cost of electricity – the average price needed to break even over the life of a project. The takeaway from the most recent survey, released in November: Prices of electricity from large-scale solar and wind projects had declined to the point that, even without subsidies, they were at or below the cost of power from conventional sources such as coal, nuclear and even natural gas in some locations.
According to Lazard, the low end cost for onshore wind is US$29/MWh, compared with an
average marginal cost of US$36 for natural gas. The cost of utility scale solar is almost identical to that of gas, Lazard said….
The levellized cost of wind power has dropped to a third of what it was in 2009, while solar costs have come down by a factor of eight, Lazard reported…
Investors have been rewarded. Over the past five years, Brookfield Renewable units have
delivered total gains of 74 per cent, including dividends. That’s more than double the total return for the S&P/TSX Composite Index over the same five-year period.
Northland Power delivered gains of 79 per cent over five years, also with dividends, while
Algonquin Power delivered an astounding 154 per cent – all of which suggests that renewable energy is enjoying some momentum…
But the appeal of renewable energy producers is strong, particularly for risk-averse investors who like to see strong profitability and steady payouts. In most cases, these companies are generating stable cash flows from long term contracts. And they’re paying big dividends, which is especially nice when interest rates are low and the economic outlook is cloudy.
Dividends are driven by low cost power, not by power which costs 61 cents/KWh. Muskrat Falls cannot compete, nor can Gull Island power. Let us not compound our Muskrat mistakes by trying to build Gull Island.
The fact that a power purchase agreement ordains a rate of return of 8.4% on generation assets is nothing but an absurdity, magnified by the lack of future demand at compensatory rates. Despite the supremacy of parliament the House of Assembly cannot by legislative fiat turn a failing energy plan into a profitable venture.
Muskrat Falls must not be pushed under the rug in this pre-election debate. Citizens must insist that the truth be told, the unvarnished truth and nothing but the truth.
David Vardy
