Liberalization of Markets

Bad deal for Quebec – Hydro-Quebec’s planned purchase of NB Power only looks good until you factor in all the hidden costs

Hydro-Quebec has agreed to buy most of NB Power’s assets for $4.75-billion, according to a memorandum of understanding signed at the end of October. Unfortunately, the government-owned electric utility has not proven that the proposed transaction is a good deal for Quebec. Rather, my analysis tends to show that the opposite is true.

This amount paid by Hydro-Quebec should discharge NB Power’s outstanding debt at the close of the transaction. In addition, Hydro-Quebec will reduce, for the next five years, electricity rates applicable to medium and large industrial customers to the current Quebec level. NB Power’s other customers will benefit from a five-year rate freeze. Afterwards, the rates for all customers will be adjusted annually based on the consumer price index for New Brunswick.

These guarantees will apply only for a heritage pool of 4.5 TWh for industrial customers and of 9.5 TWh for all other customers (equivalent to the approximate quantity of electricity used annually by NB Power’s customers in the last few years). All electricity supplied in excess of the heritage pools will be priced at market rates.

In November, the New Brunswick government tabled in the legislature a report prepared by the international consulting firm NERA which estimated at $5.6-billion the net present value of the savings which will accrue to New Brunswickers under this proposal. If we accept this estimate, the total cost of the deal to Hydro-Quebec would be $10.35-billion.

In the first year after closing, NB Power’s customers will save slightly in excess of $100-million. The savings will increase each year and reach $225-million a year in 2014. The savings will continue to increase after that date, but at a slower rate, reaching $335-million a year by 2025. On a net present value basis, 84% of the savings will accrue after 2014. I completely agree with NERA’s assessment: “while the rate match and the rate freeze will last for five years, their impact will be permanent since they provide a lower base that persists over time.”

Five NB Power thermal generating plants, accounting for 48% of its production, are not included in the sale. The three smaller plants will be retired shortly after closing while the two largest will be operated by New Brunswick under a long-term agreement with Hydro-Quebec, which will have the option to retire them upon giving a one-year notice. In addition, the transfer of ownership of the Point Lepreau Nuclear Generating Station will be conditional upon the successful completion of the current refurbishing project.

After closing on Mar. 31, 2010, most of the electricity used in New Brunswick will still come from New Brun. swick-based power plants, at least in the immediate future. The cost to produce and distribute this electricity will not change significantly. Since three thermal power plants are being closed and Point Lepreau is out of commission for another year, Hydro-Quebec will probably supply the rest and adjust its exports to other territories accordingly. Without the proposed transaction, Hydro-Quebec would continue to export all its surplus electricity to neighbouring provinces and U.S. states at the prevailing spot prices as it has done successfully since the late 1990s.

The most severe world financial crisis in the last 80 years has created a new environment. The ensuing recession has reduced demand for electricity and has caused export prices to fall from the level seen in previous years. Since prices are lower, there will be little investment in new power generation capacity until prices are sufficient to justify it. Prices are therefore likely to increase fast once the economy has begun its recovery. It would not be prudent for Hydro-Quebec to sign a perpetual supply contract with New Brunswick which will produce more revenue only as long as export prices are depressed because of the current recession.

What about the future? In the last ten years, the price of electricity on the U.S. market has increased one more percentage point each year than the increase in the cost of living. This figure is in line with the assumption made by NERA, in its calculations, of a one-percentage-point hike in the cost of non-nuclear purchased power. It is also consistent with the escalation provisions of NB Power’s existing power purchase contracts and with the expectations for gas and coal reflected in forward prices and publicly available forecasts produced by the U.S. Department of Energy.

Any international agreement to reduce carbon emissions will push electricity prices even higher in North America. Seventy-one percent of the electricity produced in the United States is generated from fossil fuels. The memorandum of understanding, as written, will not allow Hydro-Quebec to recover from its New Brunswick customers the additional value created by a carbon-limiting international agreement.

Let us now compare the price of $10.35-billion offered by Hydro-Quebec for NB Power with the market value of similar electric utilities. The value of a business is equal to the sum of the market capitalization of the company and of its long term debt. To approximate the value of any firm, it is usual to compare it to its earnings before interest, income taxes, depreciation and amortization (EBITDA).

We have done this calculation for nine U.S. electric utilities similar in size to Hydro-Quebec. Their value, at the moment, varies between 6.4 and 8.5 times their respective EBITDA. Anybody who wants to take control of a company will be prepared to add a premium of approximately 30%.

In determining the appropriate multiple for NB Power, an allowance will be made for the relatively slow growth of the market, for the absence of significant expense savings under the proposed agreement, for the fact that New Brunswick will not tax Hydro-Quebec profits and for the significant strategic advantage gained from the control of NB Power’s transmission network and of its two interconnections with the United States. The existence of a long-term contract, which already gives Hydro-Quebec control over one of two interconnections with the United States, does reduce the financial advantage obtained from the proposed transaction.

The NB Power EBITDA for the last financial year ending March 31st, 2009, was $430-million. The price paid by Hydro-Quebec therefore represents 24 times this EBITDA, even if Hydro-Quebec is acquiring only half of NB Power’s generating capacity. Thus, the price is more than double NB Power’s probable value.

Despite the huge difference between the price offered and the real value of the assets being acquired, no allowance is made for the increase in electricity prices likely to result from the enforcement of a new international treaty significantly limiting carbon emissions. This deal is not acceptable as currently structured. The price is too high for the benefits to be obtained.

Claude Garcia is Associate Researcher at the Montreal Economic Institute.

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