Retired senior finance executive, Bernard Lahey, and I have been in conversation around issues raised in my recent interviews on VOCM radio in Newfoundland and Labrador about the implications of Muskrat Falls for NL’s sovereignty. Bernard has graciously provided comments for publication here as a guest post.
Bernard holds a Bachelor’s degree in Economics from the University of Toronto and a Master’s degree in Economics from the University of Western Ontario. After starting his career as a member of the Research Department at the Bank of Canada in Ottawa, he joined the ministÃ¨re des finances du QuÃ©bec where he held various positions in the area of finance. In 1997, Bernard joined Hydro-QuÃ©bec where he worked in various capacities ranging from trading, to debt management and gradually rose through the ranks to be named Assistant Treasurer in 2005. Between 2007 and 2009, he oversaw operations of the currency desk at the Caisse de dÃ©pÃ´t et placement du QuÃ©bec. He returned to Hydro-QuÃ©bec in 2009 as CIO of the pension fund and has been retired since 2014.
I became aware of Bernard’s views about the Muskrat Falls development through the Uncle Gnarley website. I have reviewed his post on Uncle G here.
What follows are Bernard’s comments followed by some notes reflecting on those comments from me.
Thanks very much Tom for providing a summary of the issues discussed on your recent radio interview with Paddy Daly on VOCM Newfoundland and Labrador (NL). I agree whole-heartedly with your analysis.
However, I do have a number of quibbles to raise.
First, you have been one of the rare commentators to recognize and publicize the fact that the efficient operation of Muskrat Falls (MFGS) requires cooperation with energy produced at Churchill Falls (CFGS). MFGS is a run-of- the river dam. With no reservoir to speak of, energy production is a direct function of water flow. Stabilizing energy production at MFGS requires upstream coordination with CFGS, whose production is controlled by Hydro-Quebec (HQ). However, at this point, that particular issue is very far down on my list of MFGS worries. Ultimately, I don’t see any particular reason why a deal with HQ could not be negotiated. However, surely an important detail such as that should have been worked out prior to embarking on such an expensive endeavour. It is perhaps all the more surprising that the Harper Government would provide loan guarantees before the issue was addressed. On a number of occasions, you have raised the point that the Harper loan guarantee would inevitably serve to foment important interprovincial tensions. Not only was Quebec, through its participation in the federation, forced to in some sense subsidize a project that was designed to compete with HQ but, to add insult to injury, the success of the project was predicated on usurping HQ’s contractual rights to control water flow on the Upper Churchill.
A more general point, is the fact that these projects are a) extremely complicated and b) represent a financial risk that is far too large for a province like NL to bear. First, the technical part. There is no clear evidence that Nalcor has the experience to complete this project. As a federal taxpayer, it is particularly disconcerting that the Trudeau Government has decided to increase loan guarantees by close to $3 billion whereas NL doesn’t seem to know the total cost or indeed the expected completion date of the project. As I am sure you know, HQ employs a small army of experienced experts to oversee construction of major projects. Progress relative to plan and costs relative to budget are monitored closely. There is no point at which HQ would not be in a position to provide a detailed schedule of completion and a well-documented estimate of total cost. Perhaps even more important is quality control, which is so critical and yet is an art unto itself: experience is critical. The story of the installation of hundreds of kilometers of faulty transmission wires as reported in Uncle Gnarley is a major cause for concern. That is the very simplest part of the project, by far!
You are aware of my views with respect to CFGS. The total cost of the project, including transmission totalled close to 150% of NL’s GDP. That would be equivalent to present-day Ontario spending close to 1.2 trillion dollars on a single energy project. The point is that NL never had the financial capacity to bear that risk. In fact, it is often overlooked that, NL was not even a participant in the project. The financial risk of MFGS is much smaller but nevertheless significant: the most recent estimates are that cost could total as much as a third of NL annual GDP. That would be equivalent to Ontario investing about $250B in a single energy project. Actually the financial risk for NL is much greater than it would be for Ontario since the NL economy is already heavily leveraged to the energy sector. If my memory serves me right, the additional cost to NL Hydro of a 1$ increase in a barrel of oil was roughly a million dollars whereas the corresponding increase in royalties was on the order of 25 million dollars.
I think the most important issue that you raise relates to the burden that the financing of MFGS will represent for NL. Moreover, there is very little discussion, in NL or elsewhere, as to what exactly happens when the burden of debt becomes too great. In any event, it is clear from the transcript of the radio interview that Mr. Daly doesn’t seem to understand the typical consequences for sovereignty of a debt bailout.
As for the sustainability of NL’s debt – the numbers are grim.
According to RBC ( see Page 12 above), net debt as a % of GDP in NL has doubled in the last three years to reach almost 50%. Moreover, NL has significant borrowing requirements in future years, ($3.4B in 2016-17) because of a large deficit and refinancing of existing debt. Now remember, debt is one thing, but debt servicing is what matters. RBC estimates that debt servicing will rise from about $1 billion to around $1.2B in 5 years, which is manageable. However, these estimates are based on net debt of about $15B and assume that NL interest rates will remain low. Debt related to MFGS is not included in these figures.
https://www.nbc.ca/content/dam/bnc/en/rates-and- analysis/economic-analysis/new- found-land- budget.pdf
Particularly tragic in the case of NL is that all of this occurs in a Province which is already facing what amounts to a financial and economic crisis. According to the most recent forecast of RBC, the level of GDP in 2018 will be as much as 5% below the level prevailing in 2013 (see below). Key projects such as Hebron are being wound down. New projects are few and far between in the context of oversupplied commodity markets. Only recently it was announced that the much-vaunted mine expansion at Voisey’s Bay appears to have been put on ice. Newfoundland knows the drill when it comes to economic crises. The young and most talented tend to seek opportunities elsewhere. Newfoundland has among the worst demographics in Canada, with more people 65 and older than 14 or younger. Even before the commodity price meltdown, the demographic profile of NL was described as “scary” by former Premier Dunderdale.
There are some similarities between the situation in NL and that of some of the more heavily-indebted European countries. Their debt is issued in a currency that they do not control. Of course, as a member of the Canadian federation, investors will no doubt anticipate, and rightly so, an implicit federal backing, especially since the amounts are manageable in the grand scheme of things. For NL, a best case scenario is that the Federal Government recognizes its responsibility for enabling this project and simply assumes the guaranteed debt as its own. However, bailouts are a difficult operation to negotiate, notably because of the moral hazard problem. Typically the proverbial feet have to be held to the fire. NL would no doubt have to endure tremendous suffering prior to any decision on federal debt relief. Moreover, as in the case of Greece, austerity imposed in the event of a bailout can involve conditions that are worse than default. The timing of a debt crisis is impossible to forecast. The thing to watch is Provincial bond spreads. NL 30 year provincial bond spreads vs Ontario have risen from about 30 basis points (100 basis points equals 1%) at the beginning of 2016 to around 60 basis points today However, this widening mostly reflects NL’s deteriorating budget situation. For the moment, few investors are focussed on the impact of the situation at Muskrat Falls. If and when investors become doubtful of NL’s capacity to repay their debt, NL interest rates will spike and the crisis will be upon us.
(Reply comments from TA)
I have been a bit opaque in my public comments on the topic of the necessity of cooperation between HQ and Nalcor in order to operate Muskrat as intended. What I should have emphasized more is that HQ, by maximizing winter generation at CFGS, is already operating CFGS in a way that maximizes Muskrat’s physical winter generation. If Nalcor fully controlled CFGS, Nalcor could not do a better job than HQ does today. The problem I see is not a lack of coordination between CFGS and Muskrat but that Nalcor wants to draw upon HQ’s entire pool of generation for seasonal storage of excess non-winter Muskrat generation for redelivery to NL in winter without paying for that service. My complaint is that I think stealing bad. I am not worried about water flows at Muskrat.
On the issue of Muskrat fomenting conflict between NL and HQ, I initially believed that Williams, not Harper, was guided by malicious intent to foment interprovincial conflict. I have commented previously that a common road to power in NL is to have people believe that you alone can stand up to what far too many NLer’s think of as “those damn frogs”. Bernard’s comments remind me how egregiously irresponsible Harper was in offering the loan guarantee for Muskrat. Harper obviously promised the guarantee carelessly, in a fit of electoral panic, trying to burnish both his NL prospects and his Global Warming talking points. Once promised, he could not back away once he became aware of Quebec’s obviously legitimate concerns about the subsidy to NL. Bernard’s comments make me reflect again on how outrageous Harper’s mistake was: ignoring the guidance of the Constitution, meddling in provincial jurisdiction, undermining Quebec’s existing investments in an already flooded market, and picking a winner without the slightest due diligence. Muskrat was Harper’s worst decision as prime minister. Trudeau, by increasing the federal guarantee, missed a golden opportunity to have blamed Harper for the Muskrat mess by shutting down the project. Super dumb move by Justin, who is now as culpable as Harper.
In considering potential future impairments to NL’s sovereignty that might arise if the Muskrat mess ever becomes as bad as I fear, it strikes me as significant that the off-shore income NL derives today arose from a political deal that ceded the federal government’s constitutional jurisdiction over coastal waters. The constitutional rules about who controls coastal waters was ignored for the purposes of the deal, but constitution was not changed.