Monday, 17 February 2020


Guest Post by David Vardy
Two major events signal the rising tension among the people of this province, fearful of their future. Since 2016 we have had 11 quarters in which the population has declined continuously, from 530,000 to 522,000. This is a measure of the angst over our serious fiscal plight and the prospects of dramatically higher power rates.  

The two events were the release of the final PUB report on rate mitigation and the second was the press conference by the Premier and Natural Resources Canada Minister Seamus O’Regan on negotiations toward rate mitigation. Both events focused on the return on shareholder equity. The PUB recommended that the province forgive payment of dividends on provincial equity. The joint press conference latched onto that option as a cure for Muskrat Falls, namely the writing off of dividends and financial restructuring.

Provincial Equity 
The province is taking most of the risks, even with the federal loan guarantee in place. The federal government has invested nothing yet in this project but the province has invested close to $5 billion in borrowed funds. Nalcor’s estimate of equity does not make provision for the cost of the borrowed funds which must be paid as soon as they costs are incurred, during construction as well as during commercial operations. This allowance for funds used during construction raises the province’s equity investment from $3.8 billion, Nalcor’s estimate, to $4.8 billion. The province must also provide equity funding for any additional cost overruns. Such overruns are likely to occur in relation to the delay in transmission software and the cost of repairing synchronous condensers. Disputes with contractors may also lead to further overruns. 

Restructuring Framework
The revenue requirements over the 50 year supply period, beginning with the first year of commercial operations, 2021 or later, will amount to $74.6 billion, based on the current cost recovery structure, which is a combination of “cost of service” and “escalating supply prices”. The province and the federal government are negotiating to restructure the financial arrangements through the following: 

✔  Adoption of the province’s rate mitigation plan released April 2019 and which stabilizes rates at 13.5 cents/KWh, rising annually thereafter based on an inflation index. 

✔  A modified cost of service approach which writes off $30 billion in dividends from generation assets (assets at the generation site and the transmission line from Muskrat Falls to Churchill Falls).  

✔  “Monetization” of the flow of dividends from the Labrador Island Link.  

✔  The power purchase agreement (PPA) will be abandoned and many of the project agreements will need to be revised. 

At this point it is unclear how this will be accomplished. The federal government has indicated willingness to make adjustments with respect to sinking fund payments up to the end of 2021 and in the cost overrun escrow account (COREA). Sinking funds involve the accumulation of funds before bond issues mature while the COREA payments ensure that the province’s equity is injected pari passu with capital expenditures. None of these adjustments really reduces the financial burden in any material way.  

Borrowed equity must be repaid
By agreeing to write off dividends the province is accepting one of the recommendations of the PUB. However this was an inevitable step given that the dividends were fictitious. Sadly the province cannot wave a magic wand and write off the cost of the borrowed funds, on which interest must be paid and whose principal must be repaid. These costs, relating to the generation assets, will amount to $200 million in the first full year of commercial operations. The $5 billion in equity is very real and the cost of the borrowed funds should have been included in the revenue requirements and added to the $726 million for 2021. Now it appears that the province must absorb these costs. 
Federal Finance Minister Bill Morneau
Federal Due Diligence
The federal government will insist on a full accounting of the costs before committing itself to further financial infusions. They will want to know if this is going to become a $16 billion project or whether the official cost estimate will stand. They will want a permanent solution and not a temporary fix. They will not write a blank cheque to cover the required operating deficit. They will want to examine all the options, including mothballing, if the cost of operations exceeds revenues. They will want to know what level of demand can realistically be expected over the next 30 years. 

The federal government now understands that the business plan for Muskrat Falls was fatally flawed by understated capital costs and exaggerated demand projections. There is a market for power but the demand is for low priced energy. Muskrat power will be sold at a huge discount from the actual cost. This discount negates the prospect of dividends. 

While the province now has no choice but to complete the project it may not be feasible to operate it. Government has to consider the options and one is to mothball the project rather than to operate it, if the federal government does not inject sufficient equity to make it viable. 

The Federal Finance Department will play a larger role in these discussions than in the past and they will want to deal with the full fiscal dilemma in which our province finds itself. They will not want to deal with Muskrat Falls in isolation from the larger structural deficit and the fundamental fact that while our revenues are relatively high, compared with other provinces, our expenditures are the highest of any province on a per capita basis. They will want to place conditions on any further financial support in order to impose fiscal discipline and expenditure retrenchment.  

In the absence of a plan to manage the fiscal deficit they will seek to put a bandage on the problem. Finance Minister Bill Morneau makes it clear that “As this proceeds, it is important to remember these are provincial Projects, in provincial jurisdiction, and the Province bears responsibility to ensure they are delivered economically.” He is saying that this is our problem and not Ottawa’s, which is disingenuous given Ottawa’s failure to exercise due diligence up to now in giving the loan guarantee and increasing it from $5 billion to $7.9 billion without a sound business model.  

There is no question that the right approach is to deal with Muskrat Falls as part of the larger budgetary problems facing our province. Muskrat Falls reflects a fundamental governance problem and the same governance and accountability issues lie at the root of our fiscal unbalance. Federal officials will want to take a comprehensive approach. Federal Ministers may not want to take the big picture approach and instead restructure the payments to push the problem into the future, particularly now they are bearing criticism for the escalation of the federal deficit. 

Lower Churchill Development Corporation (LCDC)
Are we bargaining from a position of weakness? The federal government will want to avoid an event of default which will trigger repayment of the $7.9 billion in federally guaranteed debt. The province always has the option of allowing a default by NL Hydro given that section 3.1 of the Hydro Corporation Act sets Hydro adrift without recourse to the province. By so doing they allow the federal government to take control of the assets. Such an event of default will force the province to bear the full cost of its $5 billion equity investment. It will increase net debt by the same amount because currently the financial assets offsetting our gross debt are based on the cost incurred rather than on the market value of our assets. It could trigger a serious downgrading by the fiscal rating agencies. This would be anathema to the federal government who would likely move in with a rescue operation to avoid the ignominy of default by a Canadian province and the financial burden of paying the bondholders. Any rescue funds will come bearing strict conditions on the management of our finances. 

There is no realistic alternative to a federal transfusion. The question for the federal government becomes how to structure it in a way which does not set a precedent which other provinces will want to follow. Perhaps the most direct approach is for the province to inject federal equity, some of which might replace provincial equity. For example the federal government might invest $5 billion, with $1 billion assigned to purchase provincial equity, thereby providing some relief to the province while injecting $4 billion as new federal equity. This would approximate the 1978 Lower Churchill Development Corporation model (LCDC) which called for 51% provincial equity and 49% federal equity. Using my illustrative example the province would have slightly more than $4 billion in equity while the federal government would hold slightly less than $4 billion.  

The Trans Mountain Pipeline is another model that may prove instructive. In May 2018, the federal government announced its intention to buy the pipeline from Kinder Morgan for $4.5 billion, and seek outside investors to complete the expansion. The federal government might join with the province to acquire Muskrat Falls and to restructure it with a view to inviting private investors to operate some or all of the project components. 

Restructuring as part of Fiscal Plan
Stan Marshall told the PUB in October that the financial arrangements were “hard-wired” and could not be changed. The recent announcement by the Premier and Minister O’Regan accepts that these “hard-wired” arrangements were unacceptable because neither ratepayers nor provincial taxpayers can deal with the enormous revenue requirements. However the challenge in putting the project on a sustainable basis will be enormous and has to be addressed as part of an overall fiscal plan to place the province’s finances on a sound footing. It is hard to imagine how this project can be the singular focus of the negotiations without embracing the full extent of the province’s obligations and responsibilities.  

Update Needed
We have not had a cost update on Muskrat Falls since 2017 and there are many factors driving further cost escalation, including claims filed by contractors such as Astaldi, combined with the delay in the transmission line and the problems with synchronous condensers. On top of that we have the reliability factors which the PUB is dealing with. In restructuring the finances of the project sufficient funds must be included to ensure that we have reliable power and that may demand a replacement for Holyrood. The cost of such a replacement should be included in the financial plan under discussion between the two governments.  

We need more complete information on the demand for power as well as updated costs. Demand projections continue to show shrinking demand which is not surprising considering our loss of population with 11 consecutive drops in population since 2016. NP reports that its load is decreasing. 

Fiscal Exposure of Province
Through its “rate mitigation plan” the province is now taking on the obligation to ensure that all revenue requirements are satisfied. This includes dividends of over $70 million in 2021 on the $865 million invested by Emera. The architects of the Muskrat Falls project claimed that there would be “no recourse to the province”.

Section 3.1 of the Hydro Corporation Act enables the province to shield itself from direct financial exposure outside of its own equity investment. This shield has now become collateral damage of the rate mitigation plan because we have now removed the shield, exposing us to more than $726 million in the first year of full commercial operation.

By so doing we have raised the stakes and increased our exposure! Why would we do that? We are now exposed to the full $74.6 billion in revenue requirements over the 50 year supply period. This is on top of our completion guarantee with base and contingent equity of $5 billion! 

The province’s decision to write off dividends on its generation equity was a foregone conclusion and it does not cure the problem. There is no new federal money on the table and a federal operating subsidy is unlikely. The federal government may simply tinker with the repayment schedule and defer the costs to future generations. This would be a big mistake. Anything short of a significant infusion will suffice. Whether it comes in the guise of “monetization” of dividends or federal equity is hardly the point.

The Federal Department of Finance will rightly ask the question as to whether any large financial support package for Muskrat Falls will cure the flawed business plan on which the project is founded, including lack of cost-compensatory demand for power. They will also argue that Muskrat Falls is part of an even larger fiscal problem and a holistic, rather than a piecemeal approach, is imperative. We can restructure the payments in many different ways, including the adoption of a modified “cost of service” approach, moving away from “escalating supply prices”. We can forego sinking fund payments and cost overrun escrow account (COREA) payments. We can reduce depreciation costs by extending the service lives of the generation and transmission assets.  

All of this is tinkering. Muskrat Falls is a big problem one whose magnitude we have yet properly to measure. We cannot manage what we cannot measure. We need much more than that and to be honest with ourselves we have to recognize that nobody has a panacea to offer. Our vast experience in this province with failed industrial enterprises, such as Labrador Linerboard, teaches us that governments are incapable of finding a cure for a fundamentally flawed business plan. Our landscape is scarred indelibly with a multitude of failed public enterprises. 

As we go forward it is important that governments consult with the public before major decisions are reached. We all know that a lack of transparency and due process compounded the bad decisions which led to Muskrat Falls. Let us not continue to make the same mistakes. All of the revenue, demand and cost assumptions should be made public and the public should know exactly what will be required from them as ratepayers and taxpayers.  

Both governments must conduct a full assessment of the costs of the project and seek a solution that is in the best public interest. In reviewing options they must make a determination on the following issues: 

What is the best estimate of the cost of the project? 

Is there sufficient compensatory (i.e., covering costs) demand to operate the project? 

Can costs be reduced through structural changes in the electric power industry, including the termination of Nalcor Energy and the elimination of its monopoly powers? 

What fiscal measures must the province take in order to ensure its solvency? 

What alternative arrangements can be made to satisfy energy commitments to Emera if Muskrat Falls were mothballed? 

Is the financial restructuring plan fair to future generations who have already been burdened with a large public debt? 

Up to this point government has failed to provide certainty and stability for ratepayers. Ratepayers remain perplexed as to how they should respond. Many have invested in heat pumps or downsized to smaller quarters to cope in response to rising power costs. Many have left the province. Many who stay will be paying twice for Muskrat Falls, first through higher taxes and power rates and second through their private investments to secure their own electric power security (e.g., heat pumps). This uncertainty will continue until such time as a credible plan for cost recovery is on the table. 

Citizens are too smart and too well informed to believe that they can escape the consequences of Muskrat Falls. They know that nothing that has been announced up to this date represents a solution. The options on offer are palliative, a placebo and certainly no panacea.

David Vardy