Aluminum smelters and opportunity cost

One of the great hoary examples of economic models totted out from time to time by the local economic nationalists is Iceland. There are a few different reasons why Iceland has become the NL economic nationalist poster child but one of them has to do with aluminum smelters and electricity.

The argument is a simple one: you need an aluminum smelter, bauxite (aluminium ore) and cheap electricity to make aluminum. Lower Churchill is all about cheap electricity. Therefore let's build smelters, import bauxite and get into the aluminum business.

There's no doubt that Iceland is in the aluminum business and that their business is going to get bigger. In January, the government of Iceland officially approved an Environmental Operating Permit (EOP) for the Alcoa Fjardaal smelter project.

Besides that, talks continue on a possible smelter on Bakki by the town of Húsavík in North Iceland, Alcoa, Nordurthing municipality and the Ministry of Industry. They have decided to continue with feasibility studies and start on the third and last phase of the MOU in co-operation with Landsvirkjun and Landsnet. If constructed, this one will be powered by renewable geothermal energy.

These, and other projects, will create thousands of person-years (PYs) of work. Incidentally, they are also the source of much controversy among the population. Local NL boosters who blindly point to Iceland as an economic example neglect to mention that there is hard opposition to these projects from a significant part of the Icelandic population.

Be that as it may, there is still more to this industry than meets the eye. One is the number of idle smelters in the US that are no longer producing because of their increased cost of electricity. These smelters have already been built but have been mothballed because they are uneconomical to operate unless and until their energy prices go back down.

But none of this answers the question of what's wrong with this province getting in the aluminium business. After all, Iceland is and it's working out for them.

The real question that needs to be answered is not why can't we be more like Iceland. The real question is why is Iceland in the aluminum business?

And the answer to that is simple: Opportunity Cost. For Iceland, the generation and use of electricity for smelters has no opportunity cost and is the best use for it.

In economics, opportunity cost is the cost of something in terms of an opportunity forgone. If you choose to turn down a $10/hour job in favour of keeping your $8/hour job, the opportunity cost to you is $2/hour. In effect, you are giving away $80 every 40 hour week.

In the case of Iceland, they already have enough electricity for their own use. So any additional electricity they produce is surplus to their current domestic needs. And since Iceland is an island, they do not have the option of exporting anywhere; they don't consider long underwater transmissions lines to be sensible in their case.

So if they produce electricity cheaply, and they do, then smelters are a fine way to use it. What other choice do they have?

The case here in Labrador is different. To get into the aluminum smelting business, we have to build smelters, import bauxite and then, on top of that, sell the electricity cheaply enough to make the project economic for the producer.

Can we do that? Sure we can. We can easily sell off any generated electricity cheaply enough to make a project economical. But at what opportunity cost?

If you look at my previous post detailing the economic analysis of Quebec smelters, you see that the Quebec government is paying a subsidy of almost $300,000 per year per job (for 760 jobs) for 35 years. Do the math and you come up with a subsidy of $7,980,000,000 over the life of the project. The government says there are economic spinoffs and there are some. But those spinoffs will not come close to $8 billion over that time period.

That is the choice the government is making. They would prefer to sell out to the political expediency of pointing to an aluminium smelter rather than simply sell the electricity and have an additional $8 billion to invest in economic development or social programs or infrastructure. Even just road building and improvements would have a much great beneficial economic impact than these smelters.

And that's the opportunity cost. By choosing to subsidize a a smelter through low electricity prices over selling that same electricity at market prices, the opportunity cost to Quebec is $8 billion. In effect, they are giving away that money for no good reason.

In Iceland, smelters is a smart choice because they have no other options for the electricity they generate. In Quebec, which can export electricity to the US or Ontario at market costs, reserving it for domestic smelters at subsidized prices incurs a horrific opportunity cost.

In this province, enticing smelters with subsidized electricity rates is, in local parlance, a giveaway. In fact it's worse - it's paying industry to use our electrical resource for a few paltry jobs and it's an economic goof of Smallwoodian proportions.

When will we learn?

"They are out there begging for power"

The title of this post is a categorical statement made by Sue Kelland Dyer in conversation with Randy Simms on VOCM Open Line in the context of a discussion on why we couldn't sell electrical power at market rates to Ontario. Instead, she says, industries are so desperate for power that we should use power as bait for the local situating of industry.

No evidence was offered; no case studies presented; no details were provided.

In fact, she demanded evidence for the contrary position.

The only suggestion she offered was this sweeping generalised unsubstantiated assertion that because "they" are begging for power then we must rope in these unspecified "they" to finance the lower Churchill projects within some indefinite timeline on the condition that they locate their industry here.

This is preferable, she says, to moving forward financing the project through power sales.

After all, she says, Quebec has three smelters. Why not us?

To be fair she is not the only person making this argument. More than a few local economic nationalists, most notably at this snake's nest of foolish circular and ill-considered positions of all kinds, parrot this position.

In the interest of clarifying the issue, may I suggest a quick review of this information proffered by the Montreal Economic Institute. A respected economic analysis think tank, the MEI points out that subsidies for Alcan aluminum smelters recently announced by the Quebec government are a loss to Quebec society.

They go on to outline in a report authored by Gérard Bélanger and Jean-Thomas Bernard, professors of economics at Laval University, that:

... recent agreements in the aluminum sector and others under preparation fail to take account of basic economic logic and will harm Quebec’s economic development for decades to come unless the government follows a different path.

That sounds bad and sounds like something to be avoided. What are they talking about? Well, in February, two orders in council from the Quebec government gave official stature to a hefty subsidy to Alcan as part of an aluminum smelter project in the Saguenay-Lac-Saint-Jean region.

To create 740 jobs, the government is giving up $2.7 billion in revenues in exchange for a $2-billion investment by Alcan, the two researchers estimate. The total cost to the government of the subsidy to Alcan equals nearly $274,338 per job each year for 35 years.

That's worth repeating: $274,338 per job. Per year. For each of every of the next 35 years. For each of the 740 jobs "created".

So that's the answer to how and why Quebec gets all those smelters - they pay for them!

The rejoinder from the local economic nationalists will be a vague "economic spin-off" point. Let's put that one to bed right now. The report goes on to note that:

The true cost of the electricity provided under this deal can be measured by its opportunity cost to the Quebec government. Opportunity cost is a term used by economists to denote the most advantageous alternative solution. What it means in this instance is the export price that could be obtained by selling our electricity on the market to our U.S. neighbours.

The reason used most often to justify government assistance is economic spin-offs. The justifications provided in this case by ministers Raymond Bachand and Pierre Corbeil come from calculations filled with double counting and neglectful of alternatives. An analysis of other solutions that could be considered shows that the government is giving up at least $2.7 billion.

This amount could have been used, for instance, to improve Quebec’s highway network, an investment that would generate far more in direct and indirect economic spin-offs than the $2 billion pledged by Alcan.

So no more giveaways - let's pay industry to take the power away.

Finally, if you follow this debate long enough, you will hear somebody say, with all possible conviction, that exported electricity only creates jobs elsewhere but never here. This study addresses that argument too noting that:

It should be understood that all spending generates economic spinoffs, whether conducted by government (in health, education, income security or other areas) or by the private sector (assuming individuals and businesses end up with greater disposable income due to lower taxes).

It is thus false to state that “exported electricity does not create jobs in Quebec” as argued by the Aluminum Association of Canada in an advertisement that ran in several newspapers.

That pretty well covers it.

So if you don't pour the money into subsidizing jobs, how could you effectively use that money instead? Again, this report has that covered noting that, to start:

The same amount could go, for example, toward improving Quebec’s highway network, generating far more direct and indirect economic spinoffs than Alcan’s $2 billion. A similar analysis could be applied to other public or private spending.

So you have to ask: Why are we better off to hold up the development of the Lower Churchill project on the condition of attracting massive industry a la Quebec rather than simply selling the power at market rates?

Clearly it's not better.

Supply Chain: The Transportation of Energy

This piece was previously published earlier this year in the energy supplement of Atlantic Business Magazine.

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The curious paradox of the energy market is that supplies are seldom located very close to demand; the industry term for that is stranded. So, as an energy-rich region develops its sources, the challenge becomes what to do with the stranded energy - how to get it to customers

The practical problem for Atlantic Canada as an energy supplier is that it lies some distance from the largest energy-consuming markets.

The solution depends on which form of energy you want to sell. The obstacles are variously technical, economic and/or political.

Natural Gas

Natural gas has a well-developed transportation infrastructure in the Maritimes. The Sable Offshore Energy Project, for example, transports natural gas by underwater pipeline to a shore facility for processing and then to the US through a larger pipeline network into Maine. That’s possible because of the proximity of Sable to land, the absence of iceberg hazard to the pipes and the relatively short distance to the US.

In the Newfoundland and Labrador offshore, estimates of discovered gas range up to 9 trillion cubic feet (tcf) on the Grand Banks and the Labrador shelf, with a possible additional 36tcf or more in undiscovered conventional resources. Undiscovered unconventional resources consist of gas that is known to lie underground and has been penetrated by drilling, but lies in rock types that have not yet seen large scale commercial production.

The substantial distance from source to closest landfall and the risk of iceberg scour are impedients to a sea floor pipeline to on-shore processing facilities. Generally, the solutions proposed so far focus on sea-based transportation of either LNG (liquified natural gas) liquified at sea or CNG (compressed natural gas).

LNG is natural gas cooled at the production source to 160 Celsius to reach a liquid state. At 1/600th of its original volume, it is then shipped to a re-gasification plant closer to market. There, it is returned to gaseous form for delivery to customers, generally through pipelines but also by truck. It is the international standard for transportation and shipping of natural gas.

But LNG facilities for liquification and re-gasification are enormously expensive, and LNG has never been produced on an offshore platform.

CNG, on the other hand, is simply natural gas that is compressed to reduce volume but remains in gas form – essentially form ready for consumer use. CNG is easier to produce and easier to handle. Of course you produce it – it’s a product; the word is being used in the general sense of producing any product and not in the specialised oil and gas, sense. CNG vessels can fill up at the field, using a relatively low cost offshore mooring buoy, and then steam directly to market without needing re-gasification. This is what the literature says. . they mean low-cost compared to a $500mill+ liquification facility

There remains considerable difference in opinion regarding Atlantic Canada’s supply forecasts to 2020. These are dependent on international factors such as gas prices, stability of supply and international demand as well as domestic factors such the cooperation of local political actors. The forecasts range from no production to an optimistic possible high of 2.3 Bcf/d in 2020.

Although commercial development of Newfoundland and Labrador’s stranded gas is not anticipated before 2020, the industry has been exploring transportation options and opportunities while the provincial government is busily finalizing a natural gas royalty regime.

Several companies in particular are studying natural gas transportation and have different takes on it.

Newfoundland LNG takes a conventional approach and has announced plans to build North America's first LNG storage and transshipment facility at Grassy Point on Placentia Bay in southeastern Newfoundland. This St. John's based company is expecting a burgeoning market for LNG transshipment facilities for overseas imports entering the North American marketplace because of the economics of the LNG trade in the Atlantic Basin.

The facility would include eight 160,000 cubic metre storage tanks, three jetties with berthing facilities capable of mooring 265,000 cubic metre LNG cargo ships, and a tugboat basin along one of North America's deepest ice free ports. It will not include re-gasification facilities because of the lack of local end use markets.

The project, which is expected to accommodate up to 400 vessels per year, is slated to begin construction next summer and come into service in late 2010.

An emerging player in the international gas transport business is EnerSea Transport of Houston, Texas. They claim to have developed the first cost effective CNG marine transport and storage system. Called VOTRANS (Volume Optimized Transport and Storage), the prototype is an ocean going gas delivery system comprising large diameter pipes contained within insulated structures integrated onto specially designed and constructed ships or barges. Their Atlantic Canadian presence is the St. John’s based EnerSea Canada, a highly active player in the Newfoundland and Labrador R&D community.

A home-grown variation on CNG is a concept championed by Trans Ocean Gas, also based in St. John’s. They have designed and patented fibre-reinforced modular plastic pressure vessels that can be fitted on ships, barges or trucks. Destructive burst testing on full scale fibre reinforced plastic pressure vessels will be conducted at Atlantic Steelworks facility in Sheet Harbour NS this fall.

The company has also announced an extension to their concept taking out patents for a plastic vessel designed to transport pressurized LNG, a high density liquefied natural gas form created by combining low temperatures with relatively low pressures.

Whatever the transportation solution adopted by the market factors such as strong natural gas prices over the long term, establishment of a royalty regime, continued exploration of new basins, uncertainty of LNG imports to the U.S. from overseas and the province's relative proximity to the U.S. market, all bode well for the development of the province's natural gas reserves.

Hydro

In the long term, the region’s largest single source of new energy is the proposed Lower Churchill development in central Labrador. This recently announced $9 billion hydro-electric project would produce roughly 4000 MW of energy every year that the facility remains in working order and water continues to flow.

Unlike oil, this source of energy is virtually infinite. Its operating costs are comparatively low, although the capital costs are comparable to offshore oil or higher.

But the question of getting it to market is fraught with political and technical challenges and is realistically limited to three options: selling generated power to Quebec, wheeling it through Quebec or developing the co-called “Anglo-Saxon route”.

The political problem with selling Lower Churchill power to Québec is the infamous 1969 Upper Churchill pact between former Newfoundland premier Joey Smallwood and his Québec counterpart, Jean Jacques Bertrand. At the time, Québec refused to provide a transmission right of way to the US.

A deal was signed requiring Newfoundland to sell power to Hydro Québec at a predetermined low price while Québec was free to resell the power to American buyers for whatever price the market would bear. When the 1970s energy crisis and inflation caused prices to soar, the result was a $14 billion windfall for Quebec between 1976 and 1995, while Newfoundland made do with $2 billion in net profit according to Newfoundland government estimates. The deal expires in 2041.

That history ensures that any deal that involves selling power to Québec will be a tough political sell in Newfoundland and Labrador. Compounding this difficulty is a declaration by Premier Williams that there could be no Lower Churchill deal with Québec unless Upper Churchill was revisited. But after more than 20 years of failed interprovincial litigation aimed at just that end, Québec remains disinclined to re-open the previous deal.

The second option, wheeling the power through Québec, is being actively pursued. Two choices present themselves. The first is that Québec would agree to transmit the power along their own lines for a fee. The Newfoundland and Labrador government has submitted a request to the government of Québec for quotes on power transmission.

However, because Québec is working to develop its own hydro projects, there may be no capacity left to carry additional power from Churchill Falls. That leaves the option of Québec granting permission for Newfoundland and Labrador to construct transmission lines through the province to the US or Ontario. Last estimates put that additional capital cost at $3 billion.

Finally, there’s the much-debated “Anglo-Saxon route” or Maritime route. First explored by Smallwood in 1964 to thwart Québec’s ‘revenge of geography’, this option involves running power lines east through Labrador, under the straits to the northern tip of the island of Newfoundland, down the west coast, under the gulf straits to the Maritimes and then finally into the US - all in order to bypass Québec territory.

Smallwood’s best estimate concluded that this route would cost almost $1 billion and would raise the price of electricity so much that it could no longer be sold at a competitive rate in the US market. No doubt today’s costs would be much higher.

And so Atlantic Canada grapples with the energy paradox. Having a source, even in abundance, is only the first step to viable development. There must also be effective ways of moving energy to market, so that it is competitively priced when it get there. Fortunately, there are always people, companies and universities in Atlantic Canada ready to generate and invest in innovative solutions to do that.