Thursday, 20 June 2019


Guest Post by David Vardy
Recent disclosures at the Muskrat Falls Inquiry confirm that the project is on track to become a financial tsunami. Former Finance Minister Cathy Bennett told the Muskrat Falls Inquiry that the Department of Finance was marginalized in the decision-making process. This was confirmed by former Deputy Minister Donna Brewer when she was on the stand this week. Yet the provincial government played a pivotal role in the financing of Muskrat Falls. In fact this pivotal initiative was the biggest gamble ever taken by this province.

Base and contingent equity committed
At the outset the province provided the base equity, with the understanding that the flow of dividends would be delayed for decades, placing the burden of borrowing $5 billion in base equity squarely on the taxpayer. The federal government took the assets as security so they are not available to the province.

Second the province committed itself to finance any cost overruns with unlimited equity that they would have to borrow, with no fiscal analysis of the risk. At the date of project sanction on December 17, 2012 the required equity was $1.9 billion. Without the second federal loan guarantee it would have been close to $8 billion.

50 year payback period
The Muskrat Falls Inquiry has heard tons of evidence on construction costs. They have heard less on financing costs and on how we are going to pay for the project. During the eight years of construction, financing costs have been accumulating year after year, mostly interest, and will be included in the amount to be recovered, through a combination of higher rates and taxes.

After commercial operations begin Nalcor will seek to recover $10.1 billion in construction costs, plus $3.6 billion in financing costs during construction, for a total of $13.7 billion. The payback period begins when full power starts to flow and operations begin. When construction is complete the annual costs, known as “revenue requirements”, have to be paid. These annual costs include interest on debt, repayment of principal, as well as return on equity or dividends.  They must be recovered through power bills or higher taxes.
Donna Brewer, Former Deputy Minister (Finance)

These payments are similar to the monthly home mortgage payments which depend upon the interest rate and the term of the mortgage or the payback period. For Muskrat Falls the decision on the payback period played a big role in determining annual costs and the rates required to cover them. Nalcor also had to decide on whether rates should rise over time, remain level or decline.

In the case of Muskrat Falls Nalcor decided to take a different approach in setting rates than is normal.  Nalcor decided to adopt a longer payback period, 50 years rather than 20-30.  They also convinced the province to forego a return on its equity investment in the early years and this shifted the balance of cost recovery to later years. The result is a pattern of rates that is lower in the early years and higher in later years, reversing the normal pattern of rates. The normal pattern is based on charging costs as they appear and not deferring them to future generations. The return on equity capital is a cost of providing services and is normally charged fully each year and is included in rates. The approach chosen for Muskrat Falls defers these costs to future generations.

Back end loading a departure from normal practice
This “back end loading” of cost recovery is intended to reduce rates in the early years below what they would traditionally have been. With the traditional approach, rates would be high at the beginning but would decline toward the end of the payback period. For Muskrat Falls, rates will rise in nominal terms and remain constant in real terms per unit of energy. With level rates in real terms repayment of costs must occur late in the payback period. Rates will be “back end loaded” rather than loaded toward the early years, as was the case for example with Bay D’Espoir.

For the Labrador Island Link (LIL) between Muskrat Falls and St. John’s the traditional approach has been followed. For the power plant (MF) and the other transmission assets in Labrador (LTA) they have chosen what we call the “Muskrat Falls formula” for setting rates. The construction costs of building generation assets (MF + LTA) are twice as high as those of the Labrador Island Link (LIL) so these costs are dominant in rate-setting. This means that annual revenue requirements will rise over time as is the pattern with the Muskrat Falls formula. The risk is that the load may not rise sufficiently to cover the rising annual costs. If this happens then the costs will be stranded and will be unable to be recovered.

Interim Banker Role of province
In addition to the $7.9 billion federal loan guarantee and the injection of $5 billion in provincial equity the province also plays another key role which has been largely ignored. Financing over a 50 year time horizon poses large challenges. The province has agreed to become the “interim” banker, waiting decades for its return on equity capital and speculating on a massive increase in demand. This results in initial rates being 30% lower than they would be under traditional rates.

Muskrat Falls is unlikely ever to become self-supporting. Government’s equity will have to be written off, thereby converting the equity into a subsidy or grant. The Muskrat Falls “formula” depends upon growing demand over a period of 50 years and is back end loaded. This means that most of the costs are recovered over the final 30 years and not over the first 20 years. This shifts the burden for cost recovery to future generations.

On top of this the financial costs are understated as was shown in my post last week and are close to a billion dollars higher than the reported $4 billion. Instead of $12.7 billion the real project costs are closer to $13.7 billion, without accounting for any settlement of the disputes with Astaldi or General Electric.

Future dividends rely upon escalation in demand for power
The power purchase agreement relies upon increasing demand for power and the willingness of ratepayers to pay twice as much for power as they currently pay. Without population growth, or growing electrification of our economy, costs will be stranded. This will force the province to write off its massive investment and thereby increase our net debt.

Former CEO Ed Martin told the Inquiry dividends can be used for rate mitigation and that net benefits from the project can be used to reduce rates. The notion that the project could generate dividends of 8.4% or more is not based on reality. Any dividends would have to come from ratepayers, adding to already unaffordable rates. The power purchase agreement cannot “guarantee” dividends. The shareholder invests equity in the hope of earning a return but there is no way to guarantee a return.

The return depends upon the strength or elasticity of demand and upon growth in population. New demand for electricity such as electrification of vehicles and further penetration of electric space heating will depend upon our ability to offer low cost power. With high generation and transmission cost Muskrat Falls cannot offer competitive power rates.

Higher financial costs will exceed fuel savings. The massive payment obligations will transfer far more personal disposable income to bondholders and banks than Holyrood paid to the oil barons. The direct, indirect and induced impact on the local economy will be negative.

With limited personal disposable income it is inconceivable that the project will pay interest cost, repay the debt, recover operating and maintenance cost and also distribute dividends to shareholders. The dividends will have to come from you and me.

The business plan relied upon escalating demand and stable rates. Instead we are witnessing shrinking demand and surging costs. The promise of dividends to come rings hollow in the land!

Rate Mitigation
Rate mitigation has a hollow ring to it when you consider that money to keep rates low will be transferred from social programs or else stolen from future generations. If rate mitigation comes in the form of eliminating dividend payments this will effectively write down the value of the assets. When this is done the net debt of the province will rise because the value of the financial assets used to lower rate debt will be reduced or eliminated. The former Deputy Minister of Finance admitted, in response to a question from the Muskrat Falls Concerned Citizens’ Coalition that the equity investment poses a risk that the promise of dividends may not be reliable and that a write down is a possibility, depending upon how government chooses to mitigate rates.

Does our exposure go beyond the equity or are we protected against default on the debt by the “non-recourse” provisions of the federal loan guarantee? The Muskrat Falls Concerned Citizens’ Coalition asked the former Deputy Minister of Finance if the province may be forced to indemnify the federal government in the event of a default. Given” non-recourse” funding under the federal loan guarantee, are there conditions where the province must indemnify the federal government for the failure of Nalcor or any of its subsidiaries to meet its debt servicing obligations?

The Coalition also asked what would happen if NL Hydro cannot provide sufficient revenues to meet its financial obligations under the power purchase agreement. Must the province provide the funding?  NL Hydro is not one of the Nalcor subsidiaries whose debt is federally guaranteed and for which financing was provided without recourse to the province. The witness was unable to answer these probing questions, confirming that the Department of Finance was kept out of the negotiations. 

The biggest gamble in our history
The risk exposure of the province may not be limited to its $5 billion equity investment. It may include the $7.9 billion in federal debt as well. We now know that financial costs have been underestimated and that the full project cost is $13.7 billion. This amount is close to the size of our net public debt; to date the cost of Muskrat Falls is not included in the net public debt. The Public Accounts show that as of March 31, 2018 the net debt was $14.7 billion.  

The Inquiry has a mandate to assess the risks of the project and to consider “the need to balance the interests of ratepayers and the interests of taxpayers in carrying out a large-scale publicly funded project.” We understand that phase three of the Inquiry will be the venue for considering recommendations and potential solutions. We will be looking to the Inquiry to probe the extent of the province’s financial exposure, in order to measure the magnitude of the problem we face and to make recommendations on how the burden might be relieved without shifting the cost to future generations.

The absence of the Department of Finance from the negotiations leading to project sanction, and from financial close a year later, will cost the province dearly. It is a tragedy that institutions established to provide vigilance and supervision did not sound the alarm before it was too late. Instead our public institutions allowed us to risk the future of the province in the biggest gamble in our beleaguered history.

David Vardy