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.