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Friday, April 15, 2011

The Lower Churchill - A tale of Two Agreements

Development of the Lower Churchill hydro project is top of mind in Newfoundland and Labrador these days. Thanks to a simple loan guarantee promised by the three major federal parties, not to mention Quebec’s near apoplexy over what amounts to one of many campaign promises that may never be fulfilled.

With a Provincial election slated for October former Premier, Roger Grimes, has also re-entered the fray by re- asserting that a deal he negotiated with Hydro Quebec several years ago was far better than the one his successor, Danny Williams, produced.

As the saying goes, the devil is in the details. Unfortunately details of both agreements sorely lacking leaving many to scratch their heads in confusion.

The current agreement, which is the subject of all those wails of anguish emanating from Quebec, is the Danny Williams edition. It would see Newfoundland and Labrador partner with Nova Scotia on an 80/20 cost shared basis to develop the 800 megawatt Muskrat Falls.

20% of the power would flow to Nova Scotia for the life of a 35 year agreement. Of the remaining 80% just over 300 megawatts would be used inside the Province with the remaining 300 or so sold on the open market. All revenues from those sales would accrue to Newfoundland and Labrador.

At the end of the agreement, the assets, including the Nova Scotia allotment, would revert back to Newfoundland and Labrador to do with as they wish.

It sounds like a reasonable arrangement but there are some, primarily in the Province’s opposition ranks, who question why power rates in Newfoundland and Labrador will be higher than those in Nova Scotia after the development comes online.

There may be some political meat on those bones, but in reality consumer power rates are determined by the utilities and regulators inside each Province and are dictated by many factors that go far beyond a specific project and its limited power output.

It may be an over simplification but essentially the agreement boils down to a simple narrative: Each Province pays a percentage of the development costs and shares a proportionate amount of the power for 35 years. At the end of the agreement the assets belong to Newfoundland and Labrador.

The Roger Grimes plan on the other hand is far less open to summarization, at least not with anything even remotely resembling a simple narrative.

According to Mr. Grimes, he would have developed the larger 2200 megawatt Gull Island site.

That deal would have seen the province borrow the development funding from Hydro Quebec in return for Quebec gaining sole access to the power source, minus Newfoundland and Labrador’s requirement for 300 megawatts or so, under a 30 year agreement.

For the life of the agreement Newfoundland and Labrador would be guaranteed $100 million per year in revenues. At the end the Province would stand to make $800 million each year on the power.

Some this might consider this reasonable, but what do the numbers, as great as they sound, really mean unless put into some sort of context.

Unfortunately context has not been forthcoming from Mr. Grimes. What results is a knowledge vacuum leading to wide spread speculation, not all of it pretty.

Putting aside operating expenses and using a simple approach for comparison, it isn’t difficult to get a picture of the scale of revenues Gull Island represents.
It’s known that Gull Island has a generating capacity of approximately 30% that of the existing Upper Churchill power station. By extension we can assume that gross revenue from the project would be in the order of 30% as well.

Since it’s been said that Hydro Quebec reaps about $1 Billion a year from the Upper Churchill while Newfoundland and Labrador (the owners) receive $100 million for a total of $1.1 Billion a year, at 30% of the size, Gull Island could be expected to generate about $330 million using today’s rates.

Using these numbers, if Newfoundland and Labrador is to receive $100 million a year it means Hydro Quebec would be the recipient of $230 million. Over the 30 year life of the agreement Hydro Quebec would receive only $6.9 Billion in return for financing an expected $6 to $7 Billion dollar project. Newfoundland and Labrador, over the same period would see $3.5 Billion.

Clearly this cannot be the case as rates will rise but the comparisons are valid between both projects.

Many in Newfoundland and Labrador may despise Hydro Quebec, with good reason, but love them or hate them nobody is likely to portray Quebec’s crown corporation as a charitable organization.

They are clearly not in the business losing money, or even investing simply to break even, so obviously Mr. Grimes’ estimates are based on rates far higher than exist today. The question then becomes how much higher might those rates go?

Clearly former Premier Grimes must, by the very nature of his assertions, have estimated that market rates would climb at least 130% over that 30 year period. He couldn’t have said Newfoundland and Labrador revenues in the end would be $800 million a year otherwise. It’s the only way his assertions hold water, well almost, but we’ll get to the other possibility later.

Remember, Gull Island is only 30% the scale of the Upper Churchill but to be worth the $800 million a year in revenues put forward it would have to be 70% the size. Since the river isn’t growing, to get from 30% to 70% only a sharp rise in market rates, at least 130%, would have to take place.

It may sound like a huge increase in rates but actually it’s rather conservative, less than 5% per year on average over the life of the agreement, even lower factoring in compounding affects over time.

This begs the question: If rates rise, even by this conservative amount, how much would Hydro Quebec actually stand to profit beyond their initial investment and a reasonable rate of return?

I’m betting most Newfoundlanders and Labradorians would love to know. Keep in mind that Hydro Quebec has clearly learned from the original Upper Churchill project just how profitable it can be when power prices rise dramatically while purchasing costs remain fixed, in the case of Mr. Grimes’ plan, fixed at $100 million per year for the life of the agreement regardless of market value.

Rising power rates could potentially (and would likely) see Hydro Quebec make far more from its loan to Newfoundland and Labrador than it would at standard borrowing rates. In fact it would likely be a great deal more than the Province would pay in interest by simply borrowing from a more traditional source.

Guesstimating what market rates will be in 6 months is difficult. Speculating with any kind of accuracy what they’ll be in 30 years is impossible. Only two things are certain. Rates will increase and Hydro Quebec wouldn’t guarantee a dollar figure like that without hedging their bets and making sure they get a handsome profit. It wouldn’t make any business sense for them to do otherwise.

In reality nobody knows just how high those rates might rise or how much Hydro Quebec might gain from such a deal but I’m sure it’s something Newfoundlanders and Labradorians would love to know.

Add to this the possibility that Hydro Quebec, under such an agreement, would be the sole creditor on the project. Given the right conditions this would mean they could take possession of the entire asset.

It isn’t hard to understand why the Grimes’ position might be so unnerving to people in the Province.

Of course all of this is all pure speculation based on the limited amount of information provided in those far too rosy snippets put forward by the former Liberal Premier.

For example, Mr. Grimes’ $800 million a year revenue figure (post loan agreement) might not have been based on Newfoundland and Labrador selling its power into the open market at all. He might have been suggesting that Hydro Quebec would continue to purchase the power and simply pay that flat amount as a fixed price to the Province while rates continue to rise and Hydro Quebec’s profits continue to grow exponentially.

Whether or not a fixed price agreement is what Mr. Grimes was trying to sell is a point that certainly requires clarification.

If the Upper Churchill contract taught Hydro Quebec anything it’s that Newfoundland and Labrador might indeed elect a government that would foolishly sign a potentially disastrous fixed price agreement.

That decade’s old contract has also left the people of Newfoundland and Labrador hoping with all their hearts never to elect such a government again.

We can only hope the lessons of the Upper Churchill were not completely missed by former Premier Roger Grimes and others inside the Liberal party of Newfoundland and Labrador.

While the jury is still out on both the Grimes and Williams approaches on the surface the current agreement brings to mind the adage.

“you get what you pay for”.

Mr. Grime’s approach on the other hand, whether rightly or wrongly, reminds me of a far different adage.

“Fool me once shame on you, fool me twice shame on me.”

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