by Reimar Kroecher and Eoin Finn
For most of its existence, BC Hydro, a publicly owned utility company, operated on a non-profit basis. Enough revenue was collected to cover costs and its customers benefitted from low rates. If there were any profits, they were reinvested into BC Hydro.
Sometime shortly before Gordon Campell’s Liberals swept into power in 2001, the NDP government had a change of mind and decided to demand a $300-million dividend from BC Hydro. Although criticizing the NDP for this while in opposition, the Liberals collected $5.8 billion in dividends during their stay in power. The Campbell government also dictated that all new power was to be purchased from private producers (IPPs) at rates far above the rates at which BC Hydro could produce it! That squeezed BC Hydro’s finances from two sides: high dividend payments to government and expensive power to be purchased from IPPs.
The obvious way out was to increase electricity rates substantially, but the BC Utility Commission, on orders from the provincial government, approved only modest increases. The members of the commission are government appointees, puppets in the eyes of many researchers. A second way out was to go into debt by selling more BC Hydro bonds. That was also disallowed because as BC Hydro’s debt increases, the triple A rating for all provincial debt could be lost and interest rates might rise as much as one and one-half percent. To get out of this dilemma, BC Hydro decided to introduce “Deferred Expenses” – treating expenses as if they are assets – in its accounts. The easiest way to understand this accounting concept is to look at the example of a house:
Mr. B owns a house and sublets it to Mr. H who rents it out to a large number of Mr. B’s friends. Mr. B does not want any return, so the rents are kept low enough to cover costs and there is no profit for Mr. B. He is happy and his friends like him.
The house is worth $100,000. The mortgage (debt on the house) is $80,000 so Mr. B’s equity is $20,000 ($100,000 minus $80,000) The ratio of debt divided by equity is four to one. The yearly income from the house is $30,000, exactly equal to the yearly expenses.
Now Mr. B has a change of heart and wants a dividend of $4,000 while at the same time the expenses on the house go up to $34,000. “Well,” says Mr. H, “we will increase the rent to collect $38,000 per year and Mr. B will get his $4,000 dividend and I will get $4,000 to cover the extra expenses.” “No,” says Mr. B, “my friends would be unhappy and would not like me anymore.” “Well,” says Mr. H, “we will borrow the money by increasing the mortgage by $8,000.” “No says Mr. B, “the bank would think I am a bad credit risk. My debt to equity ratio is four to one now and it would go higher than four to one;” 88,000 divided by 20,000, which is 4.4.
However, Mr. H has a plan: “We will ditch the internationally accepted accounting standards (IFRS), which don’t allow “Deferred Expenses” and instead use the more permissive American Accounting standards (FASB) which do allow such deferrals.” So here is what they do: they take $10,000 of the expenses and treat them as an investment in the house. They might take the gardening expense and maybe some pressure washing and gutter cleaning and claim that these are really not an expense this year, but improve the value of the house by that much. They also borrow $8,000 from the bank, by increasing the mortgage.
Now the house is worth $110,000, the debt (mortgage) is $88,000, the equity is $22,000 and the debt to equity ratio is four to one; $88,000 divided by $22,000. Clearly, Mr. B’s friends are happy because the rent has not increased. Mr. B is happy because he gets his $4,000 dividend while his debt to equity ratio has not increased. He maintains his AAA credit rating. Mr. H is happy because he can cover the extra expense of $4,000.
Both Mr. B’s dividend of $4,000 and the extra expenses of $4,000 were paid for by increases in the debt, yet the debt to equity ratio did not increase.
In this example Mr. B is the BC government, Mr. H is BC Hydro and Mr. B’s friends are the ratepayers. The house is equivalent to the various assets of BC Hydro. So we see that the dividends the province collected were paid by increases in BC Hydro’s debt. The same applied to its rising expenses. In fact, during the last 10 years, BC Hydro debt went up by some $10 billion, even though no new generating facilities were built. At the same time, using “Deferred Expenses,” the ratio of debt to equity did not go up so the government could continue to claim its annual dividend.
FASB, the American accounting standard, has two conditions: a) Deferred Expenses must be approved by an independent regulator, and b) they may not be deferred longer than 10 years. On government orders, BC Hydro blissfully ignored both of these. Deferred Expenses is an accounting trick that can mask the financial difficulty a company faces. However, it is not the only accounting trick concocted by the previous Liberal government. When BC Hydro requested rate increases of 9% and was only allowed 3%, it was instructed to show in its books what it requested, not what it actually received. So the books show 6% fictitious revenue that was never received!
It should be obvious that, when a company pays both for dividends and rising expenses by increasing its debt, and on top of that creates fictitious revenue it never received, year after year, that company is on a fast track to financial ruin. In BC Hydro’s case, that ruin could be prevented by the following policies:
- No more dividends to the province for quite a few years.
- Realistic electricity rate increases that cover expense increases.
- An end to “cooking” the books and a switch back to internationally-accepted accounting standards. The books of BC Hydro right now are worthy of consideration for the Governor General’s award for fiction.
- Replacing the current BC Hydro Board of political appointees with a new board of experts, whose mission should be to nurture BC Hydro back to financial health and to manage it in the best interests of ratepayers, not government. This new board must stop political meddling.
- Cancel Site C.
If it continues on this course, financial insolvency is a near-certainty for BC Hydro, whose financial health will not be improved by borrowing at least another $9 Billion to complete Site C. Spread over the expected 70-year life of the dam, it will have to pay over $20 billion in interest payments on that debt. It must also pay back the borrowed $11 billion and pay the operational and maintenance costs totalling over $9 billion more. All totalled, the revenue from 70 years of power sales must cover at least $41 billion of these costs, excluding dividends to governments. To break even on that investment, it must sell all of Site C’s 5 terawatt-hours of energy at around $120 per megawatt-hour, 50% higher than today’s average consumer rate. But all indications are that there will be no domestic demand at all for this massive amount of extra power and the only option will be to export it at bargain basement prices.
The trifecta of sticky problems with this are that BC’s consumer demand has been decreasing as power rates rise, Alberta’s rates are now far lower than BC’s and wholesale power prices in the US have dipped below $30. If 100% of Site C’s power is to be exported at those prices, losses on the project could well balloon to over $23 billion, or $11,500 out of the pocket of every BC ratepayer. And that’s assuming borrowing rates stay below 4% for the entire 70-year period. Site C is indeed a very large gamble.
As a result of rapidly rising debt with no corresponding increases in real assets, equity will go negative. As that point, BC Hydro will be near-worthless and big, private-sector corporations will pounce and buy it for a pittance. Like vultures in a tree, eying a sick animal, they have been licking their chops for years to get their hands on North America’s best hydro facilities. Once privatized, rates will be set by demand and supply. There will be no publicly-minded utility commission. And the people of the province will have lost one of their best assets and control of our electricity rates.
Eoin Finn is a 40-year Vancouverite, a retired KPMG Management Consulting partner and a contributor to BCUC’s recent Site C review. He holds a Ph.D in Physical Chemistry and an MBA in International Business. Reimar Kroecher, MA in Economics, taught Economics at Langara College for 30 years. He is currently retired and lives in North Vancouver. For more information: citizensforpublicpower.ca
photo montage by Tom Voydh