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Home My WebLink AboutIntertie Newspaper-Magazine Clippings 1995 3We ned you NOW NOW . 0 help — STOP ee THE: GLENNALLEN INTERTIE Alaska Center for the Environment - NONPROFIT ORG. ¥. 519 West 8th Avenue, Suite 201 os eee ~ Anchorage, Alaska 99501 =~: PERMIT NO 139° DAVID RAMSEUR 1440 E ST #1 ANCHORAGE AK 99501 B Here’s what you can do: 1. WE NEED YOU TO COME TO THE PUBLIC HEARING. Attendance is critical. We need. to show a huge public up: swelling of opposition to this project. All you neéd to do is stand up and say. you are against this project. Bring three : _... people with you! es Monday, December 4th 7 p.m. ; Downtown Holiday Inn : SUTTON: Tuesday, December Sth 7 p.m. Sutton Community Hall 2. CALL YOUR ELECTRICAL COOP and tell them you do not a want to pay to build this Project YOU DO NOT WANT YOUR RATES TO GO UP!” Chugach Electric Association 563-7494 © Matanuska Electric Association’ .745-3211 5 Important Facts about the Intertie - . The intertie, if built will destroy the scenic and wild beauty of the Matanuska_ “Valley, rated as one of the top ten.places to drive through by National Geographic. -. The new“‘conditions” placed on the intertie puts 80% of the costs’ on CEA ratepayers. That means we pay to build the intertie! « The Governor’s “working group” fell short of providing a complete review »» of. the situation: they failed to accurately reassess updated cost assessments : --. for Allison and Silver Lake hydroelectric alternatives “4. The feasibility study i is still incomplete as no one has taken into account the environmental and social cost of the intertie in the feasibility, claiming they ran out of time and resources: 3 Fhe intertiei is not a prudent economic c investment. The ‘Allison or Silver Lakes hydroelectric projects could provide Copper Valley: with what they’ need with less expense to the acc bre and the State. CALL ACE 274-3621 OR VACE 376-8223 FOR MORE INFORMATION The Sutton-Glennallen Intertie A Case Study in Circular Reasoning, Mistaken Assumptions, and Poor Use of Scarce Public Resources Prepared by: Mark A. Foster MAFA November 21, 1995 Rev. | The views and opinions expressed by the author herein have been independently developed and to not necessarily reflect the views, opinions, or policies of any client. Sutton-Glennallen Intertie Conclusion The proposed Sutton-Glennallen Intertie is a poor investment of scarce public capital dollars because it is unlikely to create economic wealth in light of the more economic alternatives that appear available to Copper Valley. Key Findings 3: 4. . The Intertie is not a prudent economic investment. The Intertie only appears to become economic under an optimistic set of assumptions that stretch out across the next fifty years. As such, it may well destroy public wealth because more economic power supply alternatives appear to be available. The optimistic set of assumptions required to justify the Intertie on paper, which would not be sustained under a “business case” approach include: e Optimistic and sustained demand growth; requiring PetroStar or a new major industrial facility to stay on the CVEA grid until well into the 2020’s. e That the State has an abundance of capital dollars so it doesn’t need to look for the project that makes the best use of its money The Governor’s “working group” fell short of providing adequate assurance that the project is a prudent investment of public dollars. The working groups’s recommendation for a ten year take or pay contract with PetroStar does not push the Intertie to a break-even proposition under the CH2M-Hill study. Chugach Electric residential ratepayers are slated to pay more; around 80% of the cost of the intertie, resulting in higher rates for them, modestly lower rates for CVEA residential ratepayers, and significantly lower rates for PetroStar. It is unclear what benefits the residential ratepayers of Chugach can expect from these higher rates. At the present time, the prudent approach to Copper Valley Electric’s power supply appears to be the pursuit of: e Incremental improvements in hydroelectric generation, such as Silver Lake or enhancements to Allison Lake, and e Replacement of existing inefficient diesel generating units with modern, efficient units. Mark A. Foster & Associates page 2 11/21/95 Sutton-Glennallen Intertie Introduction The justification for the Sutton-Glennallen Intertie is built upon a house of cards. The card at the bottom of that house is a legislative appropriation for a $35 million, zero interest, fifty year loan to Copper Valley for an electric Intertie between Sutton and Glennallen, subject to a feasibility study acceptable to the Commissioner of the Department of Community and Regional Affairs. Not surprisingly, the efforts to conduct an independent and unbiased feasibility study have been fraught with difficulty. Not the least of which has been the existence of various groups lined up in support of the Intertie, each churning out “justification” to support the project and assure themselves a piece of the pie, which in this case amounts to a $26 million grant.’ The CH2M-Hill Feasibility Study Update, the Governor’s “working group” recommendations, and comments made by government officials and electric cooperative representatives reveal their basic justification for the project is the existence of a conditional appropriation, not whether the project is economically feasible. A poor investment is still a poor investment whether you throw public money at it or not. As the appropriation is explicitly subject to a feasibility study, the Administration should ask the fundamental question: Is this a good use of State money? Under that test, the S-G Intertie fails as it is unlikely to yield benefits compared to other power supply alternatives. Unraveling the knots, one finds a long string of circular reasoning and mistaken assumptions used to justify the Intertie. They include the following: Circular Reasoning “We were only supposed to look at whether the intertie was feasible, not whether it was the best alternative”? e Economic feasibility requires that the “feasible” alternative be a better investment than the other alternatives. Alternatives are compared to find the best one. Anything else is a sham. e Intuitively people will invest in the alternative that will give them the best return, balanced against the risk. If there are three banks in town offering interest rates of 3%, 4%, and 7%, which one would you consider the best investment? Somehow the state bureaucrats have become confused and are basically recommending that the state invest in the bank with 4% despite the fact they were able to find an interest rate of 7% somewhere else. ¢ Investing in projects that are admittedly not the best alternative will likely destroy wealth over time, not create it. " At today’s interest rates for long-term investments, a $35 million, zero interest, fifty year loan is roughly equivalent to a $26 million grant. ? Public comments of Riley Snell, AIDEA and Mike Irwin, Commissioner of the Department of Community and Regional Affairs. Mark A. Foster & Associates page 3 11/21/95 Sutton-Glennallen Intertie “If we don’t spend it on this project, it will just get wasted on something else not as important.” e Without knowing what the “something else” is, it is impossible to know whether one alternative is more or less important than another. e This amounts to a “I’ve got mine” and “I don’t care who might need it more” attitude. e Even kids in kindergarten get past this shortsightedness when they learn to share and look for solutions where everyone can benefit. “This project is superior to other alternatives because it will have lower rates due to the state zero interest loan”* e This is simply a reflection of the self-fulfilling prophecy of the subsidy, not whether the particular project is a more efficient use of scarce public capital. e¢ A poor investment is still a poor investment whether you throw public money at it or not. “If Chugach Electric assumes 80% of the cost of the Intertie, the risk to Copper Valley Electric ratepayers will be reduced pe e Yes, but the risk is transferred to Chugach Electric ratepayers. It does not go away. e This amounts to a tax upon Chugach Electric customers to pay for Intertie jobs and marginally lower rates for Copper Valley Electric, especially users like PetroStar who have bargaining power to get significantly better rates than residential customers. e Finally, the overall risk that this project is not the best economic alternative, is not reduced. The risk is merely redistributed. If one person loses $100 it hurts a lot. If one hundred people loss $100, it hurts less individually, but the overall economy still loses. In the end, these nickel and dime taxes do add up. Mistaken Assumptions “Requiring a ten year commitment by PetroStar to purchase power makes the project 27,116 feasible e PetroStar is indeed critical to the economic feasibility of the project under the consultant study. e However, under the overly optimistic assumptions consultant study, a ten year commitment to buy power does not make the project feasible. PetroStar needs to stay on the Intertie for a cumulative total of around 25 years (past 2020) for the intertie to yield net economic benefits. A simple break-even analysis highlights this problem. > Assorted Intertie proponents. * Rational provided by the Feasibility Study Update, AIDEA, the Governor’s Working Group, and other proponents. Feasibility Study Update. ° Implicit finding of Governor’s Working Group. Mark A. Foster & Associates page 4 11/21/95 Sutton-Glennallen Intertie e Absent a commitment from PetroStar that it will stay on the intertie beyond the time when many have estimated the TransAlaska Pipeline will shut down, one has to rely on a “build it, they will come” mantra to believe that the intertie is feasible. e Even if you believe that significant growth is likely and will be sustained over several decades, smaller incremental approaches to meet that demand are likely to be a more prudent investment strategy.” “APUC will review the power sales agreements and determine the ultimate acceptability ee) of risk e At best, the APUC is likely to review the power sales agreement for whether customer classes are not unduly discriminated between, not whether the project is a good use of scarce public capital. e Even then, APUC precedents allow large industrial customers to get a discount if they can claim they have a cheaper alternative. Discounts to large customers aren’t free. The difference typically gets reassigned to the residential customers. “The consultant study reaffirmed that other alternatives, such as Silver Lake hydroelectric, are more costly than the intertie. aa e This is misleading at best. The feasibility study update reaffirmed that the old expensive designs for Allison Lake and Silver Lake appear more costly than the intertie under some scenarios. e The feasibility study update consultants acknowledged that less expensive hydroelectric designs could change those conclusions. e The real story is that hydroelectric power offers Copper Valley a competitive alternative that deserves an honest appraisal by the State. The Hydroelectric Story The consultants have simply taken the hydroelectric estimates from earlier cost estimate studies which in turn where based on designs from earlier studies. When one unravels the thread, the following emerges. The hydroelectric designs used for the cost estimates are based on drilling a whole in the bottom of the lake, a methodology more suited for larger scale developments like Bradley Lake. Preliminary value engineering strongly suggests that a siphon design would be better suited for the scale of the developments at Silver Lake and result in considerable cost savings. Silver Lake is a competitive alternative that deserves an honest appraisal - an appraisal that has not been done by the State. ” Compare a bet on the permanent fund to a bet on the intertie. If they both appeared to be equal in a net present value calculation, were would you put your money? The prudent investor would put the money into the permanent fund because it is a diversified portfolio with lower risk than a one shot capital project. * Finding of the Governor’s Working Group. * Press release which accompanied the Governor’s Working Group report. Mark A. Foster & Associates page 5 11/21/95 Sutton-Glennallen Intertie “Copper Valley residential ratepayers will see a significant benefit”!” ¢ The feasibility study update estimates that CVEA ratepayers benefits average over the first fifteen years of the intertie, around 1.1¢/kWh when compared to the diesel alternative." e But PetroStar is involved in negotiating a special power sales agreement for around 8¢/kWh, well below the average rate. e Every dollar of overhead that PetroStar avoids by negotiating a discount off the average rates is a dollar of overhead that will picked up by other customers - primarily residential and small commercial. e At best, under optimistic assumptions and a state grant worth $26 million, the intertie provides a very modest benefit to residential customers e The ratepayers that stands to benefit from the Intertie is PetroStar. “The appropriate discount rate is the estimated long-term real cost of money calculated based on real interest rates for long-term taxable bonds.’"” ¢ The discount rate used in the analysis has a significant impact on the findings." ¢ The discount rate used in the feasibility study update, 4.5%, is too low, because it ignores the real cost of money, including its opportunity cost. This significantly skews the results in favor of the Intertie. ws with Discount Rate Used in asibili d t e First, it implicitly and erroneously assumes that capital is plentiful. e The State of Alaska does not have an abundance of public dollars for capital spending.'* ¢ Since capital is scarce, the acceptance of a proposed investment that has a low prospective discount rate will inevitably cause the rejection or postponement of some other proposed investments with a higher rate of return. e Second, it implicitly assumes that each alternative has the same risk. e The use of the 4.5% discount rate in the CH2M-Hill feasibility study update would be characterized as “Neolithic” in business school today because it ignores risk.'® e The intertie is a single large capital outlay that is designed to take care of CVEA for 50 years. The alternative projects, hydro and diesel, can be added in smaller ° The litany from the electric cooperative. "' Consultant Study, ES-4, During the first 15 years of intertie operation, if Chugach picks up 80% of the cost of the intertie, CVEA’s rates would average 1.1 to 1.5 cents per kWh less than the diesel alternative. ". CH2M-Hill Feasibility Study Update 8 See CH2M-Hill Feasibility Study Consultant Study, ES-3. 4 This is particularly noteworthy since State of Alaska capital budgets have been slimmed down to the $100 to $150 million range in the past few years. 'S See Grant, Ireson, Leavenworth, Principles of Engineering Economy, 8th edition, Ronald Press, New York, 1990, Chapter on “Studies for Government Activities.” '6 See Lecture 2, page 2, Class Notes, BA 234, Corporate Finance, Professor Hayne Leland, Haas School of Business, University of California, Berkeley, 1995. Mark A. Foster & Associates page 6 11/21/95 Sutton-Glennallen Intertie increments to match demand as it arises. Utilities are finding that the value of flexibility to meet demand as it arises can be large and that standard net present value methods which discount each alternative at the same rate, effectively ignore flexibility and can be extremely misleading, typically overvaluing large projects with higher risk.'” e Third, the discount rate used ignores the opportunity costs outside the government. Desirable investment opportunities may be foregone by the private sector of the economy. Consider, for instance, certain investment opportunities that are being foregone by those paying taxes to fund a low return project. The appropriate discount rate should take into account the opportunity cost of displaced private spending.'® e Fourth, interest rates at which government can borrow money do not always reflect the adverse consequences of borrowing. Many borrowings have a concealed subsidy because of the exemption of interest on the debt from federal income taxes.'? Given the current level of interest in the national debt and its consequences, a project which will use government subsidies should recognize the opportunity cost of that borrowing. Ws Wi itivi i in th e — The Feasibility Study Update looks at discount rate sensitivity only on the downside of the inflation adjusted interest rates for long-term taxable bonds. This is extremely misleading and is likely to bias decision makers toward investments that will ultimately destroy public wealth, not create it. e The consultant study tested sensitivity by /owering the discount rate, suggesting first that there is no cost associated with nontaxable financing subsidized by the federal government.” e The consultant study even went to far as to use a discount rate of zero - which assumes that this project has no risk. In addition, it assumes that there is no opportunity cost for spending public capital on this project. This should receive an award for outstanding bias and a failing _grade in capital investment analysis. e Atthe very least, the sensitivity analysis of discount rates should have included discount rates well above 5%. Higher discount rates place the Intertie further and further behind other alternatives, essentially revealing that the benefits of the Intertie do not occur until considerably into the future. | World “Busin ” f e In the real world, the true long-term real cost of money is equal to the cost of capital adjusted for the project risk. Otherwise, the net present value method always favors juak bonds over treasuries! "7 See Thomas Kaslow and Robert S. Pindyck, “Valuing Flexibility in Utility Planning,” The Electricity Journal, March 1994, pp. 60-65. '8 See Economic Analysis of Public Investment Decisions, A Report of the Subcommittee on Economy in Government in the Joint Economic Committee, Congress of the United States, together with Separate and Supplementary Views. Washington, D.C.: U.S. Government Printing Office, 1968. '° Note that the state loan is insufficient to fund the entire cost of the intertie. Additional money will likely be raised through some form of subsidized loan from the government. ?° See Table 4, page 29 of the consultant study. Assuming federally subsidized “tax free” financing is free is short sighted given the efforts to cut the federal budget deficit which are likely to be felt in Alaska. Mark A. Foster & Associates page 7 11/21/95 Sutton-Glennallen Intertie Treasuries vs. Junk Bonds Present Value of Expected Proceeds per $1000 face value using the same discount rate Year Junk Bond (16% Coupon) Treasury Bond (7% Coupon) $160 $70 $160 $70 $160 $70 $160 $70 $160 $70 $160 $70 Present Value $1164 $794 (discounted at 12%) e Without any adjustment for risk between the alternative projects, the net present value approach always favors “junk bond” projects. e Inthe business world, discount rates (a.k.a. hurdle rates or minimum attractive rate of return) typically recognize the cost of debt, the opportunity cost of equity, and project risk. e In the late 1980’s, surveys of the hurdle rates used in private industry reveal averages in the 15% to 17% nominal range (11-13% when adjusted for inflation).”" © More recent studies have confirmed that managers regularly and consciously set hurdle rates that are often three or four times their weighted average cost of capital.” e In modern government finance, discount rates typically recognize the opportunity costs of capital and take into account project risk either through risk adjusted cash flows or risk adjusted discount rates. Neither approach was used in the Feasibility Study Update. “The intertie will improve reliability’ © Compared to what? e The S-G Intertie will only improve reliability if it is more reliable than another alternative. e The S-G Intertie might improve reliability to Glennallen, but it leaves in place an historically unreliable existing link between Glennallen and Valdez. e Given that Valdez is the larger load and a more likely source of industrial loads compared to Glennallen, local power supply resources located in and around Valdez may provide more overall reliability than the S-G Intertie.”* 2! See Lawrence H. Summers, “Investment Incentives and the Discounting of Depreciation Allowances,” in The Effects of Taxation on Capital Accumulation, ed. Martin Feldstein, University of Chicago Press, 1987. 2 See James M. Poterba and Lawrence H. Summers, “Time Horizons of American Firms: New Evidence from a Survey of CEOs,” MIT Working Paper, October 1991; Michael L. Dertouzos, Richard K. Lester, Robert M. Solow, and the MIT Commission on Industrial Productivity, Made in America, Harper Paperback, 1990, p. 61. > The litany from the electric cooperative. Mark A. Foster & Associates page 8 11/21/95 Sutton-Glennallen Intertie e PetroStar may wish to consider the value of reliable power if it sign s up for a purchase power agreement with the S-G Intertie.”® “The Intertie Capital Cost Estimate is robust"”* ¢ The Intertie Capital Cost Estimate appears low, given: e The size and variability of labor estimates that R.W. Beck found in its phone survey of contractors in its 1994 study. Adjusting for the mid-range of the these labor estimates raises the overall Intertie project cost roughly $15 million, resulting in an overall project cost in the range of 568 million, not the roughly $53 million used in the CH2M-Hill Feasibility Study Update.”” e The likely need for a Static VAR Compensator (SVC, roughly $5.6 million in 1993) to permit reliable transfers of power in excess of about 15 MW. Ironically, the high demand growth scenarios which appear to lend support to the Intertie may require the SVC, but its cost has not been included in this feasibility study, which is supposed to take into account a 50 year time horizon. e Even accepting the optimistic demand projections of the feasibility study update, these capital cost adjustments clearly put the Intertie out of the feasibility picture. *4 Some have argued anecdotally that the net flow over the existing link between Valdez and Glennallen is toward Glennallen and that the incremental improvements in reliability for Glennallen due to the S-G Intertie will exceed the incremental improvements in reliability for adding additional capacity in Valdez. Absent an analysis which places some discrete value on reliability, it is difficult to know whether the incremental difference in reliability between a hydro and diesel alternative vs. the S-G Intertie and diesel alternative is sufficient to overcome the other cost advantages of the hydro and diesel alternative given a reasonable set of assumptions. ?5 The Memorandum of Understanding dated October 31, 1995, between Chugach Electric, Copper Valley Electric, and PetroStar does not specifically address reliability. 6 Implicit assumption of CH2M-Hill Feasibility Study Update by accepting the R.W. Beck Estimate without review. *7 1995 dollars. Mark A. Foster & Associates page 9 11/21/95 Sutton-Glennallen Intertie The Past and Future The Past The Sutton-Glennallen intertie represents a long and dubious tradition that grew out of the hemorrhage of state spending from the oil boom. This has lead to an overcapitalized electric generation and transmission system due to extensive and excessive government funding based on feasibility studies fraught with optimism, circular reasoning, and mistaken assumptions. In light of dwindling state budgets, that tradition should be buried. The Future In contrast, our long-distance telecommunications network, which is of vital strategic importance to Alaska due to our vast distances and unique geography, is relatively undercapitalized. This is because the market is competitive and investors require a return on their investment. They need to find sufficient customer demand to generate enough revenue to earn the cost of capital of the firm plus the risk of the individual projects. In short, their projects have to make business sense in a divided market. If the State were serious about leveraging public capital to provide a real possibility of delivering significant public benefits into the next century, it would explore policies aimed at reducing the cost of capital and increasing the infrastructure investments of the telecommunications and information industry.” ?8 The externalities of investments in telecommunications tend to be rather significant. The National Telecommunications Information Administration (NTIA) grants made to communities in Alaska should provide ample local demonstration of targeted efforts. An example of a state that has recognized this and is working to translate the notion into action is Connecticut. There the regulatory commission has recommended that the equivalent of Alaska’s AIDEA be constituted and targeted at developing a superior telecommunication infrastructure in that state. Mark A. Foster & Associates page 10 11/21/95 Sutton-Glennallen Intertie Appendix resi i r! ie? That depends upon how tightly one draws the circle of things to consider. One particularly revealing test is to compare residential rates between the following scenarios: 1. Construction of the S-G Intertie with a $35 million loan at zero interest, with a fifty year payback. 2. Invest the $35 million in financial instruments and pay out the difference between earnings and the loan repayment as a dividend to Copper Valley Electric ratepayers. Assume power supply requirements are met by the diesel base case with reasonable financing by means other than “free state money.” a) Pay dividend to all ratepayers based on a flat rate per kilowatt hour, or b) Pay dividend to all residential ratepayers based on a flat rate per kilowatt hour (a variation on the Power Cost Equalization program) How do customer rates compare?” Positive numbers represent the net benefit of the Financial Investment Dividend + Diesel Alternative has over the Intertie Alternative. If the dividend were paid to all kilowatt hours equally, the Financial Investment Dividend + Diesel Alternative provides net rate benefits for many years. Financial Investment Dividend + Diesel Base Case vs. Intertie Investment Net Rate Benefits (All Customers) ¢/kWh Annual Amount 4.9¢/kWh $345 residential, $5300 commercial ~ 1.0¢/kWh $70 residential, $1060 commercial -1.0¢/kWh -$70 residential, -$1060 commercial If the dividend was paid to residential customers based on kilowatt hours, the Financial Investment Dividend + Diesel Alternative provides net rate benefits well into the next century. Financial Investment Dividend + Diesel Base Case vs. Intertie Investment Net Rate Benefits (Residential Customers) ¢/kWh Annual Amount 15.5¢/kWh $1100 residential 10.2¢/kWh $720 residential 5.7¢/kWh $404 residential In short, the S-G Intertie represents an investment whose primary beneficiaries are not residential ratepayers. © Estimate of the difference between intertie case and diesel case with a dividend from the financial investment. Based on R.W. Beck Study Estimates. Nominal dollars. Mark A. Foster & Associates page 11 11/21/95