Thursday, 7 November 2019


Guest Post by David Vardy
How many people in this province believe we are heading for a fiscal cliff? How many are aware of how precarious our position has become as a result of our high public spending, combined with the tragic decision to build Muskrat Falls? What are the options available to us? This post will review some of the options, including early negotiations on a possible power contract with Quebec after 2041 and the prospects of enhanced federal support. My intention is to bring some of these options to light for respectful, informed dialogue. With final reports due soon from both the Muskrat Falls Inquiry and the Public Utilities Board there is a plethora of evidence and ideas. Sadly the greatest dearth of research relates to the fiscal impact of Muskrat Falls, which is the real elephant in the room.

The Liberal government raised taxes and fees when they first came into government but they have done little on the expenditure side. Public discussion of late has focused on the equalization program which is intended to equalize the fiscal capacity of the provinces. Yet we currently receive no equalization. When oil revenues fell the province maintained its high expenditures and ratcheted up its overall (current and capital account) deficit. We borrowed to replace the reduced offshore royalty revenues and have failed to bring expenditures under control.

The Leader of the Opposition has proposed a referendum on equalization in order to improve the province’s bargaining position with the federal government. However the equalization program is locked in for five years, capped at $20 billion with Quebec receiving two thirds of the total equalization pie. It is hard to take the referendum proposal seriously. It is tantamount to voting for a pay increase which somebody else will pay, namely taxpayers across Canada.
Divestiture Option
What are the options available to deal with our fiscal situation? Should we sell off Muskrat Falls? Should we build a case for more federal help? Should we attempt to generate cash today by renegotiating the Churchill Falls contract so that power sales after 2041 can produce cash in provincial hands today? Or must we simply tighten our belts and allow rates to double?

The Frontier Centre for Public Policy (FCPP) has released an evaluation of Nalcor’s hydroelectric assets in a paper by Ian Madsen entitled “As Falls Muskrat Falls,So Falls Nalcor: A Valuation & Strategic Appraisal Of Newfoundland &Labrador’s Electric Utility”. This FCPP paper examines privatization and divestiture of Nalcor as an option to deal with the province’s fiscal crisis. It concludes that a large write down of asset value would be required in order to privatize Nalcor. This means that the province would have to absorb most of the existing debt, including the debt of Muskrat Falls, in order to make divestiture feasible.

The FCPP favours privatization of crown corporations as a matter of policy but they are not optimistic that it will be any kind of panacea for the province’s fiscal dilemma. However they speak positively of the value of the province’s investment in Churchill Falls: “the present value of its share of Churchill Falls’ future impressive repriced power sales is substantial, and can be used to refinance the company to make such a divestiture a success. It can be collateral that could be offered to Ottawa, or an acquirer.”

While a restructuring of Nalcor is necessary “it is unreasonable to expect provincial, let alone Canadian taxpayers to fund such a restructuring if the provincial government does not contribute to the restructuring itself.” Clearly the FCPP does not support federal subsidies as a means of solving our fiscal crisis. However they do see Churchill Falls as an important asset and a potential source of fiscal relief not only after 2041 but even today.

The Federal Options: Dignity vs Nuclear
Not all think tanks think alike. The Schroeder Institute has a different view from that of the Frontier Centre about the role of the government of Canada and the role they can play in coming to our rescue. This view builds upon the well-known concept that the Confederation contract creates an obligation for the federal government to come to the aid of a financially distressed province. This unwritten obligation is supported by actions taken in 1993 to provide succour to the Romanow government in the province of Saskatchewan.

A number of proposals have been advanced which hinge upon the 65 year power contract between CFLCo and Hydro Quebec. Writing on the CBC website, Bob Hallett of the Shroeder Policy Institute has proposed what he calls the “Dignity Option”, which he contrasts with the “Nuclear Option”. This is based on the loss which Newfoundland and Labrador has sustained in economic rent since Churchill Falls over the 42 years the contract has been in effect. Canada would pay the province $900 million a year because it failed to ensure that CCFCo (Brinco) would have access to Quebec’s high voltage transmission lines in order to sell its power to markets outside Quebec. In the Schroeder Institute proposal Canada would also absorb $500 million in interest on federally guaranteed debt and assume interim responsibility for principal repayment. After 2041, GNL would repay the $8 billion principal on the federally guaranteed debt. Without such federal intervention the province would not be able to pay either the interest on debt or to meet principal repayment obligations. It would be forced to default.

The “Nuclear Option” is the more dramatic option. The province would default on its obligations to pay interest on any of its debt or to make principal repayment. It would lose its credit rating along with access to financial markets. It would be forced to curtail services in order to eliminate its $1 billion operating deficit and its $1 billion capital deficit. The federal government might be forced to take action to avert bankruptcy by a Canadian province and to prevent the ripple effect on other provinces and on the Government of Canada. Hallett cites the Saskatchewan experience of 1993 where the province faced severe pressure but avoided the “Nuclear Option” by working with the Government of Canada to design a plan for fiscal recovery through provincial cutbacks and increased federal payments.

Clearly the Schroeder Institute believes that GNL cannot handle the current fiscal situation without increased federal support. The evidence presented to the PUB during their rate mitigation hearing confirms that more federal support is needed. The largest single rate mitigation measure proposed to date is one whereby the province foregoes its dividends, thereby shifting costs from the ratepayer to the taxpayer.

This is not a solution; not even a placebo. The additional $1 billion annually in the cost of providing electricity, known as revenue requirements, is too much for a small province to bear, with its shrinking population and its high dependence on volatile oil and gas revenues. Yet there can be no free lunch. The province cannot expect to fund programs more generously than other provinces and yet expect the national government to bail us out.

The Quebec Option
In a 59 page submission to the PUB entitled “Management of Muskrat Falls’ Excess Costs Using Future Electricity Sales from Churchill Falls after 2041”, by “RBB” (anonymous) has proposed a number of mechanisms whereby the province can turn its ownership of two thirds of the shares in Churchill Falls into cash long before 2041.

 “By September 01, 2041 the Newfoundland share of the 34 TWh yearly electricity production will revert to Newfoundland & Labrador. The Newfoundland ownership of the CF(L)Co is 65.8% and approximately 21 TWh of supplementary energy will be available to Newfoundland. This electrical energy represents more than 4 times the annual production of Muskrat Falls. At a present value of between $0.03 per kWh and $0.06 per kWh in 2041, this production is worth between $630 millions and $1.2 billions per year and perhaps more. Churchill Falls has been rightly called the golden goose of Newfoundland and Labrador. This will be similar to inheriting more than four projects like Muskrat Falls in one shot, all paid for, all reliably operating.” (pages 18-19) RBB estimates GNL’s 65.8% share of Churchill Falls to be worth more than $15 billion today.

He proposes a negotiating strategy for GNL to adopt with the province of Quebec whereby GNL receives cash today in order to relieve its present financial plight. The first component involves taking Churchill Falls power purchased from Quebec and using it to level out the flow of power from Muskrat Falls as well as to export the power through the Labrador Island Link and the Maritime Link. Power could be accessed on an exchange basis with no immediate cost as future power returned to Hydro Quebec is traded for delivery of Churchill Falls power today.

The second component is to sell power to Quebec in 2041 and beyond for cash today. He estimates that a ten year extension of the contract would generate $200-$300 million annually in additional revenues. This annual payment could be increased by extending the length of the new contract.

The third component advanced by RBB is the sale of part of the province’s shares in Churchill Falls, to take effect on September 1, 2041, which is the date on which the 65 year power contract expires. RBB acknowledges that the sale of equity may be contentious. It is the second component, the present sale of future power for cash today, upon which RBB principally relies.

In order to determine how power tomorrow translates into cash today both parties need to anticipate demand for and supply of power 22 years into the future, along with future power rates, projected by RBB at $60-$90/MWh.  “In practice the price will probably evolve from the current ~$0.03 per kWh and increase slowly towards the above high end values of the order of $0.09 per kWh reached in 2006-2008 era.” (Pages 37-38) They also need to agree on the appropriate discount rate. This creates a high level of risk and uncertainty. Are there measures which can be taken to mitigate or hedge the risk? Can a level playing field be created, one in which GNL is not on its knees and desperate to reach an agreement in order to avoid closing hospitals and schools and to avoid the doubling of power rates?

Are secret negotiations already happening?
During his testimony before the PUB Nalcor CEO Stan Marshall confirmed that negotiations were taking place with Quebec. He also said that Quebec would want to reduce the uncertainty surrounding the future long before 2041. He did not disclose the nature of these negotiations but he did say that the recent decision of the Quebec Superior Court relating to the Renewal Contract for the last 25 years of the Churchill Falls power contract left a number of matters, including water management on the Churchill River, to be negotiated between the parties. He said that there were discussions “involving a minimum of four provinces” and the federal government relating to power development. He also mentioned Gull Island. We can reasonably assume that the negotiations now taking place involve a number of players and will likely take considerable time. Yet they place a lot of risk on the province.

The stakes in all of these discussions are high. The matters under negotiation are complex. It is important that we do not make major concessions on our legacy assets (including Churchill Falls and our offshore resources) in order to avoid taking responsible fiscal decisions. We need to separate our immediate fiscal pressures from long term decisions that impact future generations. Sensitive negotiations cannot be conducted in public. Yet some parameters must be established and our citizens need to know what they are.

With the great uncertainty surrounding the completion of the Muskrat Falls project we must beware of a fire sale. We also need to gain a better understanding of the value of Churchill Falls in 2041, bearing in mind the rapidly reducing cost of renewable energy other than large hydro projects. Hydro Quebec will be well prepared to renegotiate the Churchill Falls power contract as must we. We need to stabilize the project and place our fiscal house in order rather than to negotiate from a position of desperation. We should not be hoping that some kind of miraculous Gull Island deal will save our bacon. Indeed it is questionable how much more the GNL should be investing in this project having spent over $140 million up to the end of 2018. Remember the Muskrat Falls project was sanctioned only after the province spent five years trying unsuccessfully to develop Gull Island.

In his testimony to the Muskrat Falls Inquiry energy economist A J Goulding commented upon our province’s export prospects for hydroelectric power: “Because of the distance resources from NL must travel to supply into larger export markets, NL resources must be significantly cheaper than local or more adjacent resources to cover the cost of transmission. Furthermore, resources with similar or better cost structures exist closer to the target markets. Finally, procurement initiatives in the Northeast US are often designed to favor (to the extent possible under US Federal law) in–state or in-market resources. Taken together, these factors suggest that new NL renewable resources are unlikely to be competitive in export markets” (source: CIMFP Exhibit P-o4457 at page 60).

Can we make a case that Canada has an obligation to NL for having failed to support wheeling of Churchill power through Quebec? Beaudoin argues that there are a number of technical reasons why Quebec could not have provided a power corridor with Quebec, including the following: “The power corridor idea would have required avoiding the non-synchronized Alternating Current (AC) grid in Québec to enable electrical synchronization with the New England and Ontario grids. That configuration would have removed Hydro-Québec as a partner in this project.” (source: RBB Submission to PUB at pages 19-20).

The intransigence of Quebec was used to justify the building of Muskrat Falls. Are we now going to use it as a bargaining tool with Ottawa?

We can be certain that the federal government will not entertain a “bailout” without sacrifice by the province. To do so would be to reward profligacy. Instead we can expect that Canada will demand responsible financial measures be taken before agreeing to absorb interest payments on federally guaranteed debt.

Churchill Falls may be our “golden goose” but we cannot negotiate with Quebec on our knees. With uncertainty as to when Muskrat Falls will be ready for operation it is far too early to talk about divestiture. We have first to take measures to deal with our overall deficit. We must prepare ourselves with a clear set of objectives for any negotiations with Quebec and/or Ottawa and there must be public dialogue to establish the parameters for those negotiations.

David Vardy