24 March 2008

Toward a future that works: Hebron and old people

The comments made by the Auditor General in relation to prudent fiscal management are in many ways consistent with the views of our government. It has been and will continue to be a part of our mandate to manage and build a solid financial position to achieve a self-reliant Newfoundland and Labrador.

The volatility experienced in the non-renewable resource sector has provided significant revenues for the province. However, with this volatility comes vulnerability and the responsibility to manage these resources to maximize long-term benefits for all Newfoundlanders and Labradorians.

Finance minister Tom Marshall, news release, 25 March 2008

While the Public Accounts for Fiscal Year 2006 (year ended 31 March 2007) have been available for some time, the provincial auditor general only released his commentary [Link to report in pdf format]on the accounts on Monday. [Link to Volume 1 and Volume 2.]

Not surprisingly, his comments have garnered considerable media attention.

What he said is neither new nor surprising in most respects and in general, the Auditor General's report reinforces the basic theme of this series of posts:

  1. Spending increases are based almost entirely on highly volatile oil prices and are therefore not a reliable basis for high spending."The $280 million (40%) decrease in budgeted oil revenues for 2007 [actually FY 2006], along with the $562 million (54%) increase in budgeted oil revenues for 2008 [FY 2007], demonstrate the significant impact that volatility in the oil and gas sector can have on the Province."
  2. Spending in some areas has increased dramatically. Funding for the Department of Health and Community Services increased from $1,260,697 (30.7% of total expenses) in 1999 to $1,990,479 (37.1%) in 2007, while funding for the Department of Education increased from $761,010 (18.5% of total expenses) in 1999 to $1,106,596 (20.6%) in 2007. Funding for health and education made up 57.7% of the total expenses in 2007. Debt expenses for 2007 totalled $777 million (14.5% of total expenses), down from $947 million (17.7%) for 2006.
  3. Debt expenses consume a significant portion of annual spending. "While debt expenses have decreased, the Province still has the highest interest costs as a percentage of total revenues of any province in Canada at 14.1 per cent, resulting in fewer resources to allocate to programs and services."

The AG added some new details.  For example, while Bond Papers has already noted that the aging population will cause increased pressure on health care spending generally in the decades immediately in front of us, retirement benefits for government employees will add about $300 million in public liabilities by 2011 unless action is taken to fund them properly.

That's an interesting time period.

In that same time, the provincial government will commit at least that sum to fund the equity stake in Hebron, including acquisition costs and the energy corporation's share of expenses in getting the project to production.  It's at least that sum, since we have no idea what other costs are associated with the project for environmental and other liabilities.  We also don't know the value of the reduced royalty concessions the provincial government made for Hebron and we won't know them until the project is done.  At the same time, the provincial government will spend an additional $220 million and more for its stake in White Rose.

It doesn't take much imagination to see the scenario.  Provincial program spending has grown at pace with revenues, even though those revenues come chiefly from commodities the provincial government cannot rely on to hold up over time.  In addition to the unprecedented spending increases of the last four years, unfunded liabilities and the pressures resulting from demographic change will produce their own demands for increased spending in areas such as health care.

Now, at this point, it is worth bearing in mind that the demographic pressures are not new.  In the mid 1990s, the provincial government's analysis showed that demographic changes had three distinct facets which would have economic impact on the provincial government.

First, the population would drop in overall numbers due to outmigration, reduced fertility and death. 

Second, and related to that and to the baby boomer age cohort, there'd be a point in time where the active labour force is smaller than the dependent portion of the population.  We are at the leading edge of that period.

Third, within the province, migration was changing where people lived.

A smaller population, made up of a larger and larger group of seniors would increase demands from both acute and long-term health care.  At the same time, the provincial economy would not produce consistent revenues to pay for those added services unless there were some dramatic improvements in such things as productivity.  At the same time, government had to change the way it delivered services such as health care to avoid getting into a situation where it spent ever larger sums on one service and couldn't afford many other necessary things.  There were both challenges and opportunities, but they could be met successfully if tackled.

Undoubtedly at this point, some are pointing out that the cost of buying the equity position will outweigh the short term costs. That isn't necessarily accurate for at least three reasons.

First, the costs noted above are only the costs the provincial government has acknowledged publicly.  Other costs, such as environmental clean costs haven't even been acknowledged, let alone quantified.  The Auditor General notes that the Public Accounts already don't take full account of the environmental liabilities that already exist. 

Second, the equity stakes change the provincial governments cash flows, adding mandatory spending at a time when the provincial government may not have the cash to meet the existing, unsustainable spending commitments. White Rose and Hebron have fixed timelines and firm production targets.  They aren't hospitals where government can defer capital spending. If oil revenues drop as dramatically next year or the year after to the extent they did in 2006, the provincial government will have only three options:  cut programs, borrow or both. 

The provincial government won't be able to opt out of the capital commitments for the oil projects without, essentially, deferring the costs to the future.  If there isn't enough cash to fund the costs, then the provincial government will have to incur debt at whatever rates prevail at the time.

Third, the equity stakes actually produce relatively small net cash returns to the province, once oil starts flowing. Hebron equity will produce a gross revenue of about $1.5 billion over 20 years, bearing in mind of course that there are still unknown liabilities in the project.  Recall as well that this is an estimate, assuming an average price per barrel of oil (US$50) over the 20 years after the field comes into production.  The figure could be higher, but given past trends, the actual price  - and with it the province's revenue  - might be considerably lower.

Even if all that weren't true, the equity stake doesn't produce cash until after oil starts pumping and then only after initial costs are recovered.  cash will not start flowing, in other words until more than a decade from now, long after the added costs from the aging population have hit.  While the cash flow starts with the first barrel of oil, the initial production revenues simply go to replace the money spent already and if the provincial government actually funds the costs with bank debt, there really won't be any cash to direct to program spending or anywhere else.

All of which goes to show that the finance minister's comments in response to the Auditor General are somewhat at odds with the fiscal reality. Even a cursory reading of the AG's comments show that the province has grown increasingly vulnerable to commodity prices under the current administration due to the unprecedented spending growth.  At the same time, the debt burden continues virtually unchanged.

What the AG did not account for, nor should he, is the short- and medium-term financial impact of policies such as equity.  The current administration's election commitments called for increased spending and the introduction of new programs, like the pro-natalist policy, none of which were costed during the election. If that were not troublesome enough, the AG's observations released today merely continue the dangerous trend toward providing information to the public long after crucial budget decisions are made.

In the next post in this series, we'll take a look at an idea that may actually help to create a solid fiscal future for the province.



  1. Toward a future that works: we live in a fiscal house of cards
  2. Toward a future that works: what goes up, must come down

Next:  Toward a future that works:  a fiscal policy for responsible government