Newfoundland’s Muskrat Falls Megaproject Fails Test of Intergenerational Ethics

The government of Newfoundland and Labrador is hell-bent on committing the province to build the Muskrat Falls generating station on the Churchill River in Labrador and a transmission system interconnecting Labrador to the island of Newfoundland and Nova Scotia. At a forecast capital cost that works out to over $9,700 for every man, woman and child in the province (assuming no cost overruns and crediting Emera’s contribution to the transmission plan){note that I made an error in crediting Emera’s investment and the corrected figure should be $12,000 per person}, the financial risk of this project for the future citizens of the province is unprecedented in Canada’s energy history. The proposed financial structure for the project raises serious concerns about intergenerational ethics.

Rather than follow the industry and regulatory accepted best practice for recovering costs of utility investments, the government of Newfoundland and Labrador, through its agent Nalcor, is proposing to innovate with a unique financial model for the generation component of the project. This proposed financial model inappropriately mixes elements of a power purchase agreement (PPA), often used in some elements of the utility industry, and government subsidies to create what Jane Jacobs described in her book Systems of Survival as a “monstrous hybrid”. This monstrous hybrid imposes escalating costs and obsolescence risks on consumers over the next 57 years.

More at risk than other Canadians, Atlantic Canadians are prone to getting stuck with the consequences of innovative energy project justifications. Atlantic provincial government, often in cahoots with the federal government, have often developed innovative financial models for the energy sector. Usually, the purpose is to promote riskier investments than could be justified using conventional approaches. Sometimes, such as with the franchise model innovated by the New Brunswick government in the late 1990s to promote natural gas distribution, the innovation fails spectacularly. Except for industrial consumers, New Brunswick natural gas consumers now pay by far the highest gas rates in North America. The growth rate for the local distribution utility is below a rate that is financially sustainable.

The accepted best practice by which utilities recover their costs requires that ratepayers pay for the operating costs, costs of capital, depreciation, and taxes for the useful investments that utilities make to serve their customers. Nalcor rejected this approach, often called Cost of Service (CoS), for the generation component of the project for two reasons. First, Nalcor has not identified markets to take all the power that it says it will generate from Muskrat Fall for the first many years of the facility’s productive life. Second, the prices it can expect from non-captive customers for the foreseeable future are nowhere near high enough to cover the real cost of power from the megaproject.

Among the reasons CoS is accepted as best practice across the utility world is because it tends to protect future consumers who might otherwise be left holding the bag for projects that become obsolete. Another superiority of CoS is that it makes only limited use of arcane assumptions and methodologies that are prone to manipulation. Another superiority of CoS is that sound utilities using it to pursue projects with sound economics are financeable on attractive terms without requiring subsidies.

When regulators allow utility stakeholders to fiddle with depreciation rates or allow inefficient expansion, future consumers can be unfairly treated, even under the CoS model. This is what actually happened with the now 55-year old TransCanada Pipelines (TCPL) Mainline. A legacy of regulatory carelessness allowed Mainline’s costs to be back-end loaded. Competition, initially from the bypass pipeline system Alliance-Vector and later from the development of massive shale gas capacity in Eastern North America have made sections of Mainline economically obsolete. Those current and future consumers physically dependent on underutilized sections of Mainline, particularly consumers in northern Ontario, are now in grave economic danger. A soul-searching proceeding on the future of Mainline and the fate of its captive customers will head into an oral hearing at the National Energy Board this June. The hearing is likely to be one of the most heated in the history of the NEB.

Searching for an approach that might justify pricing Muskrat Falls output at something that looked reasonable, Nalcor fixed on a PPA model. Under the PPA model chosen, the cost of power is mathematically levelized per unit of forecast consumption then escalated over 57 years.  Under Nalcor’s proposal,  rates on the island of Newfoundland will be lower in the near term and higher in later years as compared with the CoS model. The back-end loading proposed for Muskrat Falls is comparable to the intergenerational cost transfer than has been the case with Mainline. Like Mainline, Muskrat Falls is at risk of obsolescence.

Nalcor’s financial plan for Muskrat Falls would not be even close to being commercial financeable without government backstopping because of its terrible interest coverage ratios for the first 12 years of the project.

In its final submission, Nalcor argues that an advantage of its PPA scheme is that by transferring more cost to future generations the scheme improves fairness.

“In addition to providing consumers with stable rates for Muskrat Falls power in the early years of operations, this pricing approach avoids intergenerational inequity by ensuring that all existing and future consumers will pay the same price in constant or real 2010$ over the life of the project.” (p. 29)

Although arguing that its financial structure innovations solve an intergenerational deficiency of the CoS model, Nalcor fails to address the obsolescence risk that could create a stranded costs and severe hardship for future consumers.

PPA models are common in the electric utility industry but they create economic risks for ratepayers, particularly as they mature. When economic conditions change, as we have seen with the TCPL Mainline, back-end loaded financial instruments can severely harm consumers and even shareholders. In Newfoundland’s electric sector, where new technologies such as gas fracking and fuel cells could develop into competitive options, the value of Muskrat Falls power even a few years into the future is impossible for anyone to confidently forecast. Relying for investment and cost recovery purposes on forecasts of energy market conditions out 57 years into the future, as Nalcor does, is not an accepted utility practice.

To mitigate the severe risks for consumers of meeting forecasted load growth with PPA supplies, only to discover that load has been over-forecast, PPAs are almost exclusively used for short lead time options. In Nalcor’s case, it is using a PPA for a long lead-time facility.

Because of the risks associated with back-end loaded costs, utilities and regulators normally limit the term of PPAs. Terms of five to 20 years are typical. I am not aware of any fixed price PPAs of greater than 30 years that have been reviewed and approved in processes that grant substantial participation rights to consumers. During its senescence phase 20 years ago, the former Ontario Hydro saddled consumers with a handful of 50 year PPAs. Fortunately, Ontario Hydro only contracted for a small amount of energy under its extremely long term PPAs. Except for a few brief price spikes, almost all of the power being delivered so far from those long PPAs has cost consumers more than market value.

There is no precedent that I am aware of for a 57 year PPA as proposed by Nalcor.

PPAs are only in the public interest where the risks to future ratepayers are off-set by other risk offsets. The fundamental justification for PPAs is that they allow utilities to acquire generation resources where the costs are attractive but the risks would be too great to pursue the project within the regulated utility. Where the risks of capital cost escalation are high, or there is a significant possibility that the project might not be completed, or that its future productivity is questionable, it can be appropriate for a utility to lay off those risks on a commercial counter party with a higher risk tolerance.

Consistent with their duty to serve, properly managed utilities are risk averse. Too often, government-operated utilities do not behave this way.

What is innovative but ethically challenging about Nalcor’s financial scheme is that future consumers get all the disbenefits of a back-end loaded PPA without any of the potentially offsetting risk reductions. All cost escalation risks, completion risks, production risks, competing fuel cost risks, and load forecasting risks for the massive project rest on the shoulders of the few citizens of Newfoundland and Labrador.

Inadequate Review

The proposed Muskrat Falls development has not been properly reviewed.  The project review process is plagued by severe deficiencies arising from the short-term electoral interests of its government sponsors. Unsurprisingly, a long list of government agencies have come forward in support of borrowing a lot of money and building another megaproject.

The provincial government scoped the public hearing process that was supposed to review the project in such a way as to avoid discussion of the serious alternatives to Muskrat Falls. For example, the only alternative to Muskrat Falls that Nalcor considered to meet domestic demand out 57 years into the future does not include Churchill Falls power, which would be available to the province in vast quantities starting in 2041. The load forecast Nalcor used, even for its “isolated island” scenario, assumes that the utility’s practice of subsidizing electric heating continues.

During the hearing, concerned citizens could make submissions but could not cross-examine the proponent. When Nalcor ran the clock, the government refused the regulator’s request for more time, claiming that a decision is needed urgently. The regulator even allowed the utility to reply to interrogatories after final submissions were due — an unprecedented departure from due process in Canadian utility regulation.

The federal government has amplified the risk that an unworthy project will go ahead for Muskrat Falls by promising a loan guarantee for the project. Loan guarantees create moral hazards, especially for expensive, harebrained schemes.

Quebec Controls Muskrat Falls

In this previous web posting, I initiated a public discussion in Newfoundland and Labrador by pointing out that Nalcor’s production plans for Muskrat Falls contained major hydrology system and power system integration gaps.

The Manitoba Hydro International report subsequently substantiated my concerns over a power system integration gap. MHI did not address the hydrology system gap.

However, the evidence in the hearing subsequently revealed that Nalcor’s production plan for Muskrat Falls generation depends on using generation assets at Churchill Falls. Although these assets are controlled by Hydro Quebec until 2041, the hearing also revealed that Nalcor has no agreement with Hydro Quebec setting out how Nalcor’s planned use of the resources at Churchill Falls will be realized. When questioned on this deficiency, Nalcor only points out that there is a water management agreement in place that requires all provincial water users to collaborate in the use of the provinces water resources. Nalcor acknowledges that the water management agreement does not bind Hydro Quebec’s use of Churchill Falls.

In their submissions to the current review panel, the retired high-ranking civil servants David Vardy and Ron Penney commented on the integration gap in Nalcor’s production evidence. Vardy and Penney stated:

“We’re not comforted by the response that the (water) management agreement in place is the panacea.  Nor are we comforted by the plethora of  hydrological studies which make no reference to  the control exercised  by Hydro Quebec through the power contract.  While the pattern of production at Churchill Falls may match well with the power demands for Muskrat Falls, the Province requires greater certainty with respect to the management of water.  We are asking the Board to probe this  issue in their examination of Nalcor Energy and MHI.”

It speaks volumes that the neither Nalcor nor the lawyer designated to represent consumer interests commented in their final submissions to the Board on the fact that Nalcor’s plans rely on assets controlled by Hydro Quebec, but that no agreement is in place with that important party.

Conclusion

Nalcor is proposing to bet the future of the province’s ratepayers on a monstrous hybrid PPA for Muskrat Falls and a production plan that fails to account for the fact that Nalcor does not control key assets it plans to use. Either of these deficiencies alone fails the test of good utility practice. Together, they represent shocking irresponsibility.

The Churchill Falls experience was a lost opportunity for the province but it did not create a liability. Muskrat Falls is likely to turn into something far worse than Churchill Falls for the people of Newfoundland and Labrador.

Ethics matter in the design of cost recovery approaches for essential utility services. The interests of consumers in the distant future should be taken into consideration but are too easily and frequently ignored. Artificially cheap power now serves the short-term interests of the government sponsors for Muskrat Falls, but creates an intergenerational financial risk for consumers. The province of Newfoundland and Labrador should avoid the sad history of regulatory failure of the TCPL Mainline by stopping Nalcor’s ill-considered plan.

2 Comments

  1. Thank you, Mr. Adams, for capturing the essence of this issue. The proponents of Muskrat Falls are perpetuating a gigantic fraud on the people of this province, in my humble opinion, and we are being propagandized into believing it is a net benefit to our people. It can never become a net benefit, with the outlandish projections NALCOR is using to justify the project, and, their grossly deficient analysis of potential alternatives simply hides the fatal flaws in this project.

    We will pay dearly for this scheme, unless we can find a way to stop it in its tracks.

    Please support us in our efforts to do just that, for the sake of future generations!

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