Gil Dalton is a former executive vice-president and chief financial officer of Baine Johnson Limited, partner at Ernst Young, and a past chair of the Board of Regents of Memorial University.
This memorandum of understanding (MOU) is driven primarily by the historical and current critical capacity problems of Hydro-Quebec. The need for cash by Newfoundland and Labrador is also important, but it is not critical.
While the MOU addresses four projects, the most important one to focus on is Churchill Falls, which means replacing the old contract with a new new power purchase agreement (PPA).
An analysis of the three other projects (CF Upgrade, CF Extension and Gull Island) is not exceptionally difficult and is more routine than the new Churchill Falls agreement, viewed from the perspective of owners, investors, and lenders on issues such as pricing, future demand, and capital requirements.
The pricing formula in the MOU for all projects including the three new ones after 2041 does not reflect fair market values and thus should not be acceptable to the Government of Newfoundland and Labrador on behalf of the people of the province. What is needed is a reset mechanism as more clearly set out below.
There are two fundamental issues not covered or not covered adequately in the MOU that should be pre-conditions of any agreements entered into under the MOU. Neither would prevent entering into the proposed PPAs, assuming the principle of alignment with fair market prices was appropriately adhered to. These fundamental issues relate to:
equity and equity exit provisions, and
change in the water rights regime.
I would hope that the proposed new agreements that are to flow from this MOU are done correctly, having regard to all the significant additional input that has come from around the province including the comments contained here. If this is accomplished, it could result in a win-win deal with HQ that could certainly be transformative for this province. As I see it right now, further changes are needed, to reach that goal.
The projects in the MOU
The MOU addresses four projects:
cancellation and Renewal of the existing Churchill Falls contract and ancillary agreements, collectively called the original deal,
an upgrade of the existing Churchill Falls turbines, called the update project,
construction of a new power plant next to the existing Churchill Falls power plant and related transmissions lines, called the expansion project, and
construction of a new power plant, reservoir with dams and dykes, at Gull Island.
MOU Driving Force
The major driving force for this MOU is the critical capacity constraints that HQ faces in building new power generation in Quebec. In this regard, I understand that HQ itself feels that new power sources in Quebec would likely be in the range of $160 per Mwh or 16 cents per Kwh. In Newfoundland and Labrador, we need to have top of mind the fact that power from Labrador constitutes approximately 12 to 13 % of all power used in Quebec. Just imagine what an absolute mess HQ would find itself in regarding electrical services to the Quebec population and their business community if a new deal for Labrador power were not reached pursuant to this MOU. To not understand this situation, and the leverage it gives us, would be unforgivable.
In addition to those capacity constraints, the demand for electricity is sky-rocketing, something I will discuss below. All things considered the urgency of this MOU is significantly more on the HQ side than on Newfoundland and Labrador’s side.
I have no problem in doing a deal with HQ that is good for them and fair for Newfoundland and Labrador. But right now, such a deal does not appear to be in this MOU as it currently stands. More importantly, it seems to me that the government of Newfoundland and Labrador has failed to understand the strength of its hand in negotiating this deal.
If we do a deal that is not at fair market value, then there will definitely be a winner and a loser and as I see it, the loser in this MOU is the people of Newfoundland and Labrador.
All my comments aim at helping the people of our province, who own this resource, to understand how critical this deal is and how, if followed, it will surely lead us down a road that substantially takes away what we should be entitled to as owners. If we don’t get it right now, we will have to wait another 50 or 60 years to get another crack at it. I hope the public gets the message here, because if they don’t, or if they just ignore it because of all the other daily living issues that crowd into our every day lives, then we will have lost.
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New Energy from this MOU
Essentially, the Gull Island Project is the only new energy creation on the Churchill River under this MOU, as it includes the only new reservoir being added for water storage. The current Upper Churchill Plant plus both the Upgrade and the Extension are all just converting energy stored in the existing Smallwood Reservoir to electricity. This means that all the Upgrade and the Extension projects are doing is increasing the rate of generation or the speed of generation from the stored water energy in the Smallwood reservoir. This is not necessarily a bad thing as it provides greater flexibility in handling peak load requirements as well as other emergency power allocations. The major beneficiary, by far, of these 2 projects is to help Quebec solve its capacity problem during peak load requirements. This is fine and I mention this only to highlight the particular leverage that we (NLH) have from a negotiating perspective in reaching a fair deal for the province. It also indicates the leverage regarding equity and equity exit provisions and water rights discussed later in this memo.
Pricing
Setting aside the original deal for a moment, the other three projects are new. Pricing on completion and commissioning is based on cost which includes debt service costs plus a return on equity of 8% or 9%.
While it is generally normal in large capital projects to have initial pricing based on cost plus escalation, it is neither normal nor acceptable particularly to the resource owners (the people of Newfoundland and Labrador) to be locked into such a pricing formula over the long term.
My suggestion is that there be a reset of the base to independently determined fair market value every five years. The escalation percent should be applied to this new base for the next five years. This reset would ensure that the resource owner is only exposed for five years to major changes in market rates reflecting significant changes in demand. The reset could be positive or negative but on balance it would make sure that we are getting a fair market price. After all, on balance over time, demand for electricity is likely to increase substantially. Such a reset would be compatible with the desired principle from Newfoundland and Labrador’s perspective to use market prices in the MOU.
The Original Deal
The most important and critical part of the MOU is how the parties handle the 1969 power contract. The other three projects would be new capital projects which will have a forecasted cost and forecasted revenue based on a pricing formula of cost plus 2% escalation. All of this can be analysed and together with availability of capital and the assessment of the risks involved (technical, financial and others). Then, pursuant to such analysis an appropriate business decision can be made on a go/no go basis. Business leaders, investors and lenders are used to making these types of decisions every day of the week.
However, the original deal is a different quintal of fish, which is why we have to be so careful with this part of the MOU and the resultant new PPA. The existing power plant is at a completely different stage in its life, where all the original debt has been paid off and the only expenses going forward are the ongoing operating expenses and asset maintenance expenses.
Yet, the operating life and revenue generating capabilities of this asset remain substantial. It is capable of producing electricity for many, many more years. This is the stage of a project or enterprise that in the financial and investment world would commonly referred to it as a cash cow.
Why then, are we so willing to do a deal which appears to pass so much of the inherent value of this cash cow to Hydro Quebec? That is how I interpret the transactions laid out in the MOU. Again, I am not against getting a new deal with HQ but we must be totally sure we get the best deal for Newfoundland and Labrador.
I know, based on the MOU, that we get extra revenue in the next 17 years (up to 2041) over and above what we would get under the old contract price. However, this suggests to me that Newfoundland and Labrador is using this MOU and new PPAs as an opportunity to either
arrange new financing and masking the cost (pay back) of financing in the new blended contracted price, or
getting an advance on future revenue payments to be offset by discounts on future revenue (reduced pricing).
Both of these are just two sides of the same coin. They represent a form of borrowing and pay back from future revenue streams. The principle is fine if the details of the calculation of payback is made clear. [Editor’s note: this is exactly what Quebec did here and Newfoundland and Labrador accepted. The original contract pricing effectively remains in place and Hydro-Quebec redistributed some revenue from a post-2041 renewal to sweeten the front-end of the contract and let the Newfies pretend the old contract is gone.]
We know what the extra amounts that are being paid to Churchill Falls (Labrador) Corporation in the years 2025 to 2041 (in the form of loans or advances) … can be imputed from the MOU (Schedule G). The problem is in determining what the loan repayment or discounted price is. If it is considered a loan, then the net present value (npv) of the loan repayments should equate to the npv of the loan advancement. If it is an early advance on revenues, the npv of the future discounts should equate to the npv of the advances.
The issue for me is that a discount has to be applied against something in order to find out what it is. Normally, it is the original price. In this case, it should be fair market price at that time. What will the fair market price of electricity be in 2041? It is only a guess right now.
To my way of thinking, the price in the new PPA for post-2041 Churchill Falls energy should start out equal to the Gull Island price in 2041 and then follow the same reset pricing methodology described earlier from that point forward. The discount referred to above should be applied to this fair market value price in order to determine payback.
The cost of the financing element or discount which is built into the MOU pricing structure for the new Churchill Falls PPA needs to be determined and clarified. Unless this breakdown is done and transparently explained to the public, the whole exercise is a mystery. It is not fair to the people of the province to be enticed with big dollar amounts and schedules of all the supposed new cash coming our way and be told by their government that they are getting a good deal without back up or full explanation. It is just not acceptable. When will government or Newfoundland and Labrador Hydro clarify this matter? Without this, we are left hanging without having the proper details and the facts needed to decide if it is a good deal or not.
Most people would be happy with good deal with Hydro-Quebec. I am sure that with all the details on the table, we can find a win – win deal for both Quebec and Newfoundland and Labrador Hydro. Why then is the MOU making this part of the deal so cloudy? We need substantial additional info, in order to do the proper analysis to find out is this a good deal or not.
My concern is that this new financing or advance, as the case may be, over the next 16 years will be the most expensive debt ever. So far, the answer to my concern is not clear and it continues to be masked in the financial renewal configuration of this MOU deal. The $33.5B which is the npv of the payments by HQ to CF(L)Co over the entire contract life (2025 to 2075) is not explained sufficiently to determine how it is calculated and how fair market rates for post-2041 power is reflected in this number.
It seems to me that with the electrical and other resources we have in this province, we don’t have to give away the farm in order to get at a reasonable cost financing equivalent to that built into this MOU
Demand for Electricity
Demand for electricity is rising rapidly throughout North America and the world. This is driven, to a large extent but not entirely, by the advent of Artificial Intelligence (AI) and the high consumption of power needed in large data centres in order to meet AI computing needs.
We are only at the starting gate of this new computing era and its associated demand escalation. These data centres love to locate close to large power generation sites and I understand that these large data centres in the US are currently paying about US$95USD - roughly CAN$128 - per Mwh. Where do you think it will be in 2041?
Quebec sees this, and if we provide them with mountains of cheap power to the detriment of our province (price wise) they will be the ones attracting those significant investments to their province. Quebec has over time played the electricity card to great advantage but it should not be to the detriment of Newfoundland and Labrador via the transfer of the strategic economic benefits, currently in our hands, to Quebec under this MOU, that in 2041 should be ours. Essentially, HQ and the Government of Quebec would be using our power, generated in our province, to attract all this future investment to their province in competition with us.
It makes me wonder why can’t we do this ourselves and get the significant investments in Labrador. Maybe we could develop a whole new city in Labrador all based on the attraction of cheap long term electrical power. Just look at Aberdeen Scotland and Stavanger Norway to see how their proximity to energy - North Sea Oil - transformed those cities. We just have to remember that this deal is strategic.
New Attitude
Electricity in this discussion is not just about selling at a fair price. It is such a strategic asset, owned by the people of Newfoundland and Labrador. Our negotiations with HQ in this regard should reflect this thinking and the substantial leverage we hold. Why are we so lacking in self confidence that we think we have to ask others to come in and do these big projects for us and in so doing, significantly transfer the strategic benefits to someone else. Maybe we should hire the best in the world to help us do this and in the process learn from the best. That’s how we can become the best.
I know that financing big projects can be difficult for a small population. But others have done it. Just look at country of Norway, roughly 5,000,000 population in the whole country, with its oil and gas resources as well as electricity generation. They brought in the best and learned from the best so that they are now one of the best in the world at tackling these issues. Maybe we need an attitude change.
However, we are now involved in trying to do a fair deal with Quebec, so we have to see this through. If a fair deal can result from these current negotiations, then great, let’s do it, but it has to be a fair deal.
Fundamental Issues
Let’s now tackle the fundamental issues.
Equity Investment and Equity Exit Provisions
I would like to mention another matter not covered in the MOU. In long term joint venture contracts, especially as in this case where one party is also the major off-taker of the joint venture’s product, it is normal for that party to take an equity position in the venture itself. The equity percentage is something for negotiation.
The 40% equity position Hydro-Quebec will take in Gull Island is too high. A 25% position would be more appropriate in this case. In fact, it should be a pre-condition that NL Hydro hold not less than a 75% equity interest in all entities operating on the Churchill River. On the Gull Island project, this would be easy to accomplish. With regard to Churchill Falls, getting to that 75% equity position would mean that HQ would have to convert 9.2% of its 34.2% equity in CF(L)Co into redeemable debt. The conversion and redemption details together with a negotiated interest rate that reflects the risk profile of the debt should all be negotiated and form part of the detailed legal agreements.
On the matter of taking an equity position, it would give that particular joint venture party a seat on the board because they would have significant interest in seeing and having input into how the enterprise operates. To such a joint venture partner, a project like this is important because the product flow (in this case electricity) undoubtedly forms a significant part of their supply chain.
However, when the contract ends those requirements generally fall away. There would normally be an exit provision where the majority partner would generally have an option, but not the obligation, to acquire the exiting party’s equity at fair market value. That would value would be negotiated or independently determined.
The option would likely not be exercised if the contract is renewed, even in this case, where there is no automatic renewal [that we know of - ed.]. Such an exit provision enables the exiting partner to move on and provides the majority and continuing partner with the ability to entice a new future partner or customer with an equity position. This equity and equity exit matter should be a high priority and pursued in the new contracts. Such a clause was not in the original Churchill Falls agreement but possibly could have been.
Bottom line:
We have to keep in mind that it is one thing to enter into PPAs at fair market prices, but equity is forever without appropriate exit provisions.
We should not sign any agreements without ensuring a minimum 75% equity for NL Hydro together with appropriate equity exit provisions and I refer to this as Pre-condition #1.
I also suggest that with the above noted equity changes, that the $3.5B on a npv basis paid to NL Hydro should become $4.5B.
Water Rights
The foundation for any hydro electricity project is water rights. It underpins everything else. I think Newfoundland and Labrador needs an overall change in the methodology on how it handles water rights for hydro electric projects throughout the province.
My suggestion here is that all water rights for hydro generation in the province should be provided to NL Hydro (100% publicly owned Crown corporation) on terms satisfactory to both parties and including rents and royalties as appropriate. NL Hydro would then have the right to license these rights to the entities operating on the river and charge a negotiated license fee. This would greatly improve overall flexibility where there are two or more operating facilities on the river system.
More importantly, the licenses granted by NL Hydro should expire on the date that the long term respective PPA to which it applies expires. A new license can always be put in place if there is a go forward new PPA entered into. If this is not done, the province could be left hanging out there with water rights that exist and are held in an entity. NL Hydro may not be able use them for the purpose of attracting future new users and most likely would have to pay exorbitant consideration to get these rights back. In the worst case, there may be legal action with no guarantee of success. Such a change in the provincial water rights regime for hydro-electric projects should be Pre-condition #2.
Nothing in these two pre-conditions prevents the entering into the new PPAs. Quebec gets the access to long term power capacity which is their fundamental objective in this MOU from their perspective. Quebec gets to enjoy all the benefits of their equity investment during the term of their long-term contract. Quebec will get a fair market price for their equity investment at the end of its long-term contract. All the entities operating on the river get access the to all water rights needed to ensure 100% full performance of the underlying long-term contract obligations.
To my way of thinking there is absolutely nothing unfair about this methodology.
Different Termination Dates
The PPA termination date for the renewal of Churchill Falls agreement including the Upgrade and Extension is 2075 while the Gull Island termination date is 2085. My comments above on water rights, if followed would be able to handle this no problem. However, should the proposed new PPA not be renewed automatically in 2075, the water rights could become a significant issue depending on relationships at the time.
I seriously think the province and NL Hydro should consider the model suggested earlier, with NL Hydro being the initial grantee of all water rights who would license others operating on the river.
Conclusion
This deal as set out in the MOU, if it finds its way, as is, into the legal agreements yet to be completed will - long before it gets even 10% the way through - cause all Newfoundlanders and Labradorians to have the same feeling of regret and disillusionment that have consumed us for the last 56 years about the original Churchill Falls deal. I firmly believe that.
What the general public needs to know is:
This MOU does not even attempt to address the foundational problems that flowed from the old deal (Equity and Equity Exit issues and particularly water rights). To proceed without fixing these fundamental problems, I feel will be almost like virtually taking the Churchill River and moving it across the border into Quebec.
While using nice comforting language and principles about finally using fair market pricing, the MOU just does not do that.
The advanced payments (between 2025 and 2041), while it could in principle be OK if properly explained and supported, seems to be just an attempt to hide from the people of Newfoundland and Labrador the real issue, namely continuing to give to HQ access to Churchill Falls electricity at cheap prices that are clearly not related to fair market prices).
Stepping back for a moment, this leads me to believe that the people behind this deal just show large dollar amounts and billions in extra cash in the hope that it blinds people into accepting the deal.
We are smarter than that.
Please don’t be fooled into thinking that this is the best deal for Newfoundland and Labrador.
The nagging recurring thought for me is why was this project not included in the federal list of major projects in the national interest to be acted upon federally . Is it is too premature as the MOU is not a contract yet OR does the federal government see the issues being raised by the opponents as valid and problematic for the province in the future? Has anyone federally examined the MOU in depth ? Admittedly I may have missed the explanation for non inclusion at this time.
The Liberal government is touting the money that is to come for many promises being made
But they are proposing spending money we don’t have … yet … and may never see.
Only 2 likes and no comments yet! Oh ye of little faith. Are we NLers not smarter than this, to not see this blunder and change course.
I give this paper a 90 % marking, whether that is a A or A+. It makes many fine points.
To those who say nay, off with their heads. I mean are we not as smart as the residents of Quebec?
Maybe not yet, but every journey begins with the first step, like an attitude change, then the government change, and the MOU change.