Monday, 29 July 2019


Guest Post by David Vardy
Measuring and Managing the Fiscal Impact of Muskrat Falls

Is it possible for us to manage the fiscal burden of Muskrat Falls? Moody’s downgrading of our credit rating raises serious questions as to whether we can handle this massive burden. It was Premier Dwight Ball, speaking at the St. John’s Rotary Club, who said “you cannot manage what you cannot measure”.  This is a variation on a quote from W. Edwards Deming, the father of modern quality management theory.  Can we really find a remedy to the problem if we cannot diagnose it and measure it? Surely the burden can be measured.

The PUB is relying on Nalcor’s revenue requirements in 2021 as a measure of the burden to be carried. We know that this does not take into account the 8.4% rate of return on equity on the generating assets in Labrador, an equity burden already being carried on the books of the province but deferred for future recovery from ratepayers.

By my reckoning (see Appendix)  this alone adds about $300 million to Nalcor’s latest estimate of revenue requirements (see Final-Response-PB-954-2018.pdf  in response to my ATIPPA request), namely $726 million in 2021, bringing the shortfall to be mitigated to over $1 billion, a staggering burden for a province already struggling with its huge debt and its high operating deficit which remains at a perilously high level. Unless we can measure the full magnitude of the burden how can we manage or mitigate it?

Rate Mitigation Plan
The province’s rate mitigation plan is an admission that the project is a failure and that it is non-compensatory. In other words it will not recover the enormous costs, amounting to about a billion dollars annually, the repayment of which begins in the first full year of operation. The question was put to the Deputy Minister of Finance at the Muskrat Falls Inquiry whether the federal loan guarantee, in combination with the power purchase agreement, places an obligation on the province to pay these revenue requirements if NL Hydro is unable to recover them from ratepayers. She declined to answer the question but her response was insightful.

She said that her focus is on the rate mitigation plan of the government, which is aimed at finding $726 million in 2021. It needs to be repeated that this number does not include the full cost of servicing the province’s equity investment. The deputy minister told the Commissioner that the government is responding to the anticipated shortfall through the rate mitigation program, confirming the public’s perception that government accepts this shortfall as a financial obligation which must be fulfilled by the taxpayer if the ratepayer cannot bear the full burden.

Government’s plan for mitigating the understated shortfall is found at Exhibit P-04325 of the Muskrat Falls Inquiry. We will not engage in a detailed critique of the plan in this post but it needs to be said that most of the “mitigation” pool is highly uncertain. Much of this money will be diverted from core social programs, notwithstanding the fact that some of the funds will flow from Nalcor’s oil revenues. Some will come from the federal government. Even these federal funds, arguably, are funds which could have been applied to social needs of higher priority in the province.

Some of the rate mitigation will likely come by deferring the expensing of costs into the future. The real annual cost of Muskrat Falls far exceeds the $726 million cited in Nalcor’s latest estimate of revenue requirements. The money that the province has borrowed to invest in Muskrat Falls is included in the province’s debt. This amount is then deducted from the debt when calculating net debt as it is considered to be a financial asset, meaning that the province can sell it for its book value if it is in need of cash. The book value of our equity in the project is based on its cost. The borrowed equity money is counted as a debt but then a corresponding financial asset is recorded which wipes the slate clean. The key litmus test is whether the equity value, based as it is on cost incurred, can be recovered by sale and used to pay our debts. This would not be a problem if demand was robust and if the cost of power was competitive.

Obligations Placed on Hydro
Grant Thornton, in a report for the Muskrat Falls Inquiry dealing with both the federal loan guarantee and the power purchase agreement, identified a major question. The question posed by Grant Thornton, the forensic auditors to the Muskrat Falls Inquiry (MFI), is:  how will NL Hydro meet its obligations under the power purchase agreement if ratepayers cannot pay the added costs. This incapacity to repay arises largely from the unrealistically high demand projections, in tandem with the unrealistically low cost estimates.

The Deputy Minister of Finance was asked at the Inquiry to answer Grant Thornton’s question but she could give no clear answer. While the Deputy Minister did not give a direct answer to the question (on page 38 of the Grant Thornton report at P-00454) she indicated that the province is acting to ensure that no shortfall arises. 
Denise Hanrahan, Deputy Minister, NL Department of Finance
What happens when NL Hydro is unable to make the payments to Muskrat Falls Corporation demanded under section 14.1 of the power purchase agreement (P-00457)? The province is acting through its rate mitigation program to ensure that the demands placed upon it by section 3 of Schedule “A” of the federal loan guarantee (P-00065) are satisfied, namely to  “Ensure that, upon MF achieving in-service, the regulated rates for Newfoundland and Labrador Hydro (''NLH") will allow it to collect sufficient revenue in each year to enable NLH to recover those amounts incurred for the purchase and delivery of energy from MF, including those costs incurred by NLH pursuant to any applicable power purchase agreement ("PPA") between NLH and the relevant Nalcor subsidiary or entity controlled by Nalcor that will provide for a recovery of costs over the term of the PPA”

These include payment of all annual costs that Nalcor has estimated in its 50 year forecast of revenue requirements, beginning in 2021 at $726 million. While for 2021 the total revenue requirements are $726 million they add up to $72.5 billion in dollars of the day over the 50 (actually 49) year period ending 2069.

There is a cabinet document signed by former Natural Resources Minister Jerome Kennedy and dated April 2, 2012 (on the MFI website at P-00529, page 3)  that confirms the commitment of the province to: “Ensure that Newfoundland and Labrador Hydro's (NLH) regulated rates provide sufficient revenue in each year to recover all Project costs (all capital and related financing costs including a return to the Project owners, operating and maintenance costs, payments under any applicable aboriginal Impact and Benefit agreements, water lease and management costs, and applicable taxes and fees.” Is this a categorical imperative or is it a “best efforts” clause? If sufficient revenues do not flow to Hydro, notwithstanding that the province fulfilled all its commitments under the loan guarantee, are we still liable? Does our liability include responsibility to ensure that Emera receives its 8.5% dividend on its investment in the LIL? 

These post-construction financial obligations adding to $72.5 billion over 50 years go beyond the obligations arising from the construction of the project itself. The full magnitude of these obligations should be confirmed by the Muskrat Falls Inquiry.

The people of the province need to understand that the obligations accepted by the province far exceed its guarantee to provide all the equity, both base equity and contingent equity. While the federal loan guarantee, section 4.6 (i), pledges only the assets of Nalcor subsidiaries which are borrowing the money and not those of non-borrowers, the province’s obligations are far more extensive. The federal loan guarantee is described in the cabinet submission at P-00529 page 2 as one to which there was “no recourse” to the province in the event of default.

Recourse to the province
The Cabinet Submission   (P-00529, page 2) makes this very clear:  “The non-recourse structure will mean the Project assets will be pledged as security, but that neither Nalcor nor Government would be liable, nor would the non-Project assets of either be at risk in the event of a default. This approach is commonly used in the energy and infrastructure sectors, wherein project sponsors provide the equity and lending institutions provide non-recourse loans that are typically serviced entirely from project cash flows and secured by the project assets alone, with no recourse back to project sponsors (refer to the Other Jurisdictions section below for an example of a similar financing structure used for a large hydroelectric project - Lower Mattagami in Ontario).”

While none of NL Hydro’s assets have been pledged as collateral and while Hydro is not a borrower under the federal loan guarantee the province has accepted very onerous obligations which the current administration is seeking to satisfy through its rate mitigation program. The notion of non-recourse is therefore misleading. The province is taking action to ensure that NL Hydro will meet its full obligations, thereby taking on the massive burden of $72.5 billion dollars over 50 years, including Emera’s tax free return on equity.

A cabinet submission dated August 31, 2011 and signed by former Natural Resources Minister Shawn Skinner (P-00043, page 3) describes the intent of government’s “commitment letter” to provide equity financing for Muskrat Falls to:

“Ensure that NL Hydro's regulated rates provide sufficient revenue in each year to recover Project costs. This commitment has two elements. First, it confirms that the costs to be recovered will include all capital and related financing costs including a return to the shareholder (Nalcor), operating and maintenance costs, payments under any applicable Impact and Benefit agreements, water lease and management costs, and applicable taxes and fees. Second, by confirming that NL Hydro's regulated rates will generate the required revenues, it implicitly confirms that Government will structure the electricity industry in the Province to ensure regulated ratepayers (the majority of whom are customers of Newfoundland Power) will be captive to NL Hydro to the extent necessary to support these revenues.” (My bolding.)

This is a clear statement of the intent to place all of these obligations on ratepayers by making them “captive to NL Hydro”. If they cannot be made “captive” then is the taxpayer on the hook? The answer can be found in government’s willingness to accept the burden of the shortfall between what can be extracted from captive ratepayers and the amount needed to pay for the project. 

What impact will this have on our social programs? Has the province investigated the option of simply defaulting rather than accepting this huge burden? Has the province advanced an alternative proposal to renegotiate the terms of the federal loan guarantee and to abandon the power purchase agreement as a flawed attempt to make our citizens captive to Nalcor for 50 years? It was flawed for many reasons, including the failure to anticipate the combined effect of demand elasticity and massive cost overruns. Will the Commissioner recommend such a proposal and will the Commission assess the option of default?

If we are to manage wisely we need first to measure the magnitude of the problem along with our fiscal capacity to cope with the burden. Who is measuring the problem and who is assessing the options? The answer given by the Deputy Minister of Finance and by the government of the province provides no assurance that anyone in authority has assessed any option other than “rate mitigation”.

The rate mitigation plan offers no comfort that this is a measured response to a problem that has become even more challenging as a result of our unsurprising downgrading by Moody’s.

Has Moody’s fully assessed the problem? Their credit report, surprisingly, fails to mention the fact that the “rate mitigation” plan is an open admission that the project is not cost-compensatory or self-supporting. The plan is an admission that the province is effectively writing off its equity and thereby will ultimately add the equity investment of $4-5 billion to its net debt. Are we also accepting responsibility to continue to operate the facility and to guarantee a rate of return to Emera as well as to fulfill our obligations to supply a large block of power, including the original Nova Scotia block as well as market power under the Energy Access Agreement?

David Vardy 

Calculation of 2021 Revenue Requirements

How much should be added to Nalcor’s revenue requirements as reported in PB-654-2018 to account for the cost of the province’s equity investment in generation assets? The simple approach is to take the value of generation assets as reported to me by Nalcor in an email from Karen O’Neill dated March 19, 2018 (below) and filed by the Muskrat Falls Concerned Citizens’ Coalition as Exhibit P-01557 of the Muskrat Falls Inquiry and multiply it by the 8.4% established as the internal rate of return under the power purchase agreement. The value of the generation assets (MF + LTA) reported below is $3.2 billion and the value of the 2021 return on equity is calculated at $269 million. When added to the $726 million the revised revenue requirement becomes $995 million. The second estimate is slightly higher, namely $326 million which, when added to the $726 million produces a revised revenue requirement of $1,052 million.
The second approach is to estimate the return on generation equity using Nalcor’s estimates of the return on equity in the Labrador Island Link (LIL). Nalcor’s return on equity for the equity investment in the Labrador Island Link (LIL) is shown in PB-654-2018 as $136.854 million. This is the return on a combined equity investment of $1.6 by Emera and GNL. In order to calculate the return on equity for generation assets in Labrador (Muskrat Falls generation, MF, and the link between Churchill Falls and Muskrat Falls known as Labrador Transmission Assets, LTA) we have taken the ratio of direct capital cost for MF + LTA combined to LIL costs from the latest oversight committee report (1.724) and multiplied it by $136.854 to provide an estimate of return on generation equity  ($235.936 million on GNL equity investment of $3.2 billion) assuming that the equity/debt ratio is the same as it is for the LIL.

But we know that the minimum equity for generation assets is 35% compared with 25% for the LIL, or 1.4 times as much (0.35/0.25=1.4) so we multiply the $235,936 by 1.4 to get $330.311 million as an estimate of the return on equity for generation assets. Recognizing that the rate of return for generation equity (8.4%) is slightly less than that set for the LIL (8.5%) we adjust this estimate  (0.084/0.085 = 0.988) to get $326.347 million as our estimate of the return which must be added back to place the estimate on a cost of service basis. When we add $326 million to the 2021 revenue requirements of $726 million shown in PB-654-2018 we get $1.052 million.