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RESPONSE TO PUB ORDER 117/06
PUB Order 117/06 – Directive 4
4. Manitoba Hydro shall file with the Board the following information and reports by no
later than April 30, 2007:
i) A risk analysis report that analyses and quantifies MH’s $2.2B loss estimate
for a five year drought, including marketing, operational and financial risks
and the potential impact of drought shortfall import costs such as those
experienced in 2003/04.
ANALYSIS OF FINANCIAL LOSS DUE TO EXTENDED PERIODS OF DROUGHT
Introduction
Manitoba Hydro has indicated in PUB proceedings beginning in 2002 that the cost of a five
year drought could be as high as $2 billion with an additional $0.2 billion in financing cost
bring the total to $2.2 billion. This report provides a quantitative analysis of the potential cost
of such a drought event updated for 2006 conditions.
The $2.2 billion estimate was based on 2002 estimates of export prices and market
conditions. The current analysis using 2006 estimates indicates that the $2.2 billion estimate
is conservative and that there is potential for drought cost to be as high as $3.5 billion for a
set of adverse events.
Historic Drought Periods
There have been several occurrences of severe drought in the Manitoba Hydro system over
the last 93 years of record. This is illustrated in the figure below which shows the variation in
flow related revenue for the years 1912 to 2004 as derived from a simulation analysis. For
illustrative purposes the year 2008/09 was selected as the sample load year and the cost
variation in nominal dollars relative to average is shown for each of the flow conditions if
they occurred in 2008/09.
Variation In Flow Related Revenue
Millions of Dollars
400
200
0
-200
-400
-600
-800
1912 1920 1928 1936 1944 1952 1960 1968 1976 1984 1992 2000
1916 1924 1932 1940 1948 1956 1964 1972 1980 1988 1996 2004
Historic Flow Year
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The SPLASH computer model is used to simulate operation of the system of hydroelectric
plants and reservoirs on a monthly time step with the objective of meeting firm load
requirements while maximizing export revenues. It is assumed that each of the historic flow
years could occur in 2008 and the potential financial consequence of each flow occurrence is
analyzed. The net revenue for each year is derived from the sum of all export revenues offset
by the cost of import energy, the variable costs of fuel and operations for thermal generation
and the cost of water rental. All other costs and revenues are fixed in that they do not vary
with flow conditions, and therefore these can be excluded from consideration in analyzing
drought. The variation in revenue is derived by comparing the net revenue from each flow
occurrence to the average flow related revenue derived from the average of all 93 flow
conditions. This average of 93 flow conditions is consistent with the estimates utilized in
preparation of the Integrated Financial Forecast (IFF).
It is illustrated in Figure 1 that there are several drought periods in the historic flow record.
The low flow period of 1987 to 1992 is a five year period that was chosen to be
representative of a severe five year drought in the 2002 estimate of $2.2 billion. This drought
period was chosen because it occurred relatively recently and during a period when more
reliable water flow records were available. A more severe drought period of seven years
duration occurred from 1937 to 1943 and this period is also analyzed in this report. It is noted
that the 2003/04 drought was a severe one year event but it is not part of a series of
consecutive years that result in an extended drought similar to the two severe drought periods
highlighted above.
Five Year Drought
The drought cost analysis for the five year low flow period from 1987 to 1992 assumes that
these flows would occur in the years 2008/09 to 20012/13. The analysis is consistent with
assumptions of export prices and system generation that are utilized in IFF06. The cost of
drought is derived utilizing the SPLASH simulation model by comparing the net revenues
that can be expected from the overall average of all 93 flow conditions to the net revenue for
the five year drought period. The reduction in net revenue relative to the expected condition
is defined as the cost of drought. The results of the analysis are provided in Tables 1a and 1b
below.
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Table 1a
IFF06 Impact Of Five Year Drought - At Expected Prices
For Year Ending March 31:
Forecast Year 2009 2010 2011 2012 2013 Total
Water Flow Year 1988 1989 1990 1991 1992
Millions of Dollars
Revenue
Extra provincial Sales -221 -219 -189 -141 -158 -929
Expense
Water Rental (Hydro) -26 -31 -18 -17 -15 -107
Fuel & Power Purchased 269 383 72 100 46 871
Net Income -464 -572 -243 -224 -189 -1,693
(excluding interest cost)
Table 1b
IFF06 Impact Of Five Year Drought - Changes in Energy
For Year Ending March 31:
Forecast Year 2009 2010 2011 2012 2013 Total
Water Flow Year 1988 1989 1990 1991 1992
Energy at Generation - GWh
Hydro Generation -7743 -9241 -5487 -4970 -4511 -31952
Extra provincial Sales -4006 -4036 -3620 -2839 -3085 -17586
Fuel & Power Purchased 3736 5205 1868 2131 1426 14366
As shown in Table 1b, the quantity of hydroelectric generation is reduced by up to 9,241
GW.h per year for a total of 31,952 GW.h over the five year period. This reduction in
hydroelectric generation results in reduced export sales and an increase in thermal generation
and import energy.
The first component of cost of drought is loss of export revenue due to reduced water flows.
This component contributes a total of $0.929 billion to the cost of a five year drought due to
a loss of 17,586 GW.h in extra provincial sales. The second large component is the fuel and
power purchased (imported). This component contributes $0.871 billion due to an increased
volume of 14,366 GW.h for this component. Water rental costs are an offsetting factor and
this component reduces drought cost by $0.107 billion during the five year drought period
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due to reduced hydroelectric energy generation of 31,952 GW.h. The overall cost of a five
year drought is estimated to be $1.693 billion for a drought beginning in 2008/09. This
analysis does not include additional financing costs that would be incurred due to increased
borrowing requirement.
The $1.693 billion reduction to net export revenues from a five year drought at expected
export prices results in a $2.764 billion negative impact on retained earnings by the end of
the forecast period (2016/17) due to the additional financing costs. Incremental annual rate
increases of 3.26% (in addition to those included in IFF06-3) beginning in 2008/09 and every
year thereafter are required in order to achieve the same level of retained earnings as in a
base case scenario by the end of the forecast period (2016/17). The following graphs show
the impacts on the electric operations key financial indicators:
Impacts on Net Income
Base Electric Forecast - MH06-3 5 year drought
$400
$300
Millions of dollars
$200
$100
$0
($100)
($200)
($300)
($400)
($500)
($600)
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
Impacts on Interest Coverage Ratio
Base Electric Forecast - MH06-3 5 year drought
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
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Impacts on Debt Ratio
Base Electric Forecast - MH06-3 5 year drought
100%
95%
90%
85%
Percentage
80%
75%
70%
65%
60%
55%
50%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
Seven Year Drought at Expected Prices
The drought cost analysis for the seven year low flow period from 1936/37 to 1942/43
assumes that these flows would occur in the years 2008/09 to 2014/15. A similar analysis to
the five year drought was undertaken to determine the change in net revenue between
expected conditions and low flow conditions over a sequence of years. The results of the
analysis are provided in Table 2 below.
Table 2
IFF06 Impact Of Seven Year Drought - At Expected Prices
For Year Ending March 31:
Forecast Year 2009 2010 2011 2012 2013 2014 2015 Total
Water Flow Year 1937 1938 1939 1940 1941 1942 1943
Millions of Dollars
Revenue
Extra provincial Sales -131 -64 -155 -254 -241 -264 -33 -1142
Expense
Water Rental (Hydro) -14 -9 -16 -28 -32 -32 -6 -136
Fuel & Power Purchased 50 18 50 238 393 379 13 1143
Net Income -167 -74 -190 -465 -603 -611 -40 -2,149
(excluding interest cost)
The cost of a seven year drought is $2.149 billion, which is $0.456 billion higher than the
$1.693 billion cost of a five year drought, exclusive of additional financing costs.
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Seven Year Drought with High Export Prices
Export and import prices higher than expected would increase the cost of drought. An
analysis of a seven year drought with high export and import prices results in a drought cost
of $2.46 billion. The results of the analysis are provided in Table 3 below.
Table 3
IFF06 Impact Of Seven Year Drought - At High Prices
For Year Ending March 31:
Forecast Year 2009 2010 2011 2012 2013 2014 2015 Total
Water Flow Year 1937 1938 1939 1940 1941 1942 1943
Millions of Dollars
Revenue
Extra provincial Sales -118 -41 -141 -254 -241 -264 2 -1057
Expense
Water Rental (Hydro) -14 -9 -16 -28 -32 -32 -6 -136
Fuel & Power Purchased 76 39 83 309 503 490 39 1539
Net Income -179 -72 -209 -536 -712 -722 -31 -2,460
(excluding interest cost)
In the above analysis, the market prices associated with the high scenario of export and
import prices are about 35% higher than expected market prices which are based on best
estimates.
The $2.460 billion reduction to net export revenues from a 7 year drought in a high export
prices scenario results in a $3.515 billion negative impact on retained earnings by the end of
the forecast period (2016/17) due to the additional financing costs. Incremental annual rate
increases of 4.06% (in addition to those included in IFF06-3) beginning in 2008/09 and every
year thereafter are required in order to achieve the same level of retained earnings as in a
base case scenario by the end of the forecast period (2016/17). The following graphs show
the impacts on the electric operations key financial indicators:
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Impacts on Net Income
Base Electric Forecast - MH06-3 7 year drought
$400
$200
Millions of dollars
$0
($200)
($400)
($600)
($800)
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
Impacts on Interest Coverage Ratio
Base Electric Forecast - MH06-3 7 year drought
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0.00
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
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Impacts on Debt Ratio
Base Electric Forecast - MH06-3 7 year drought
110%
100%
Percentage
90%
80%
70%
60%
50%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017
Fiscal Year Ending
Other Factors Influencing Drought Risk
The above analysis of the cost of drought was for a case of high export and import prices due
to market conditions such as higher fuel prices. However, another factor related to the export
market that also has the potential of increasing the cost of drought is shortage pricing. In the
2003 drought Manitoba Hydro experienced higher than expected costs of purchases due to
shortage pricing. This was due to the limited number of entities in the bilateral market from
which to purchase power. Once they became aware of Manitoba Hydra’s requirement to
purchase energy due to drought conditions, these entities extracted a premium due to
shortage.
The market has changed since 2003 with the ability to transact more anonymously with the
MISO market since 2005. The broader footprint of MISO should theoretically reduce the
effect of shortage pricing. However, this has not eliminated the risk since there is a
transmission bottleneck for energy supply to be able to reach northern MISO if large
quantities of energy are required to flow north to Manitoba. Therefore until additional
transmission investment is made in the US, Manitoba Hydro may not be able to fully benefit
from the broader market as there will continue to be limited transmission capability for
transmitting significant quantities of energy into northern MISO from locations further south
and east.
With the implementation of locational marginal pricing (LMP) in MISO, it is possible that
the cost of congestion management may be extremely high and financial transmission rights
may not be available to hedge against this risk. In addition, since Manitoba Hydro is an
external participant, there is a risk that MISO may not allow the purchase of large quantities
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of energy because the market was set up as a balancing market for relatively small quantities
of direct energy purchases and sales. Most transactions were anticipated to be bilateral
contracts.
Shortage pricing is not anticipated to be a factor for natural gas in the financial markets since
Manitoba Hydro’s requirements are very small relative to availability. Manitoba Hydro can
guarantee a supply of natural gas by paying $5 to 10 million for gas storage at Dawn in
Ontario, and consequently would be subject to only the prevailing market price for natural
gas. In addition to the supply situation, it should be recognized that the commodity price of
natural gas could by coincidence be exceptionally high during a particular drought period.
This would increase the financial loss due to drought.
Currency exchange rate is another factor that has the potential of affecting risk exposure due
to drought. A low Canadian dollar relative to US currency increases the magnitude of the
financial impact of drought because it increases export revenues in Canadian dollars that can
be lost and increases the cost of imports. The recent increase in the value of the Canadian
dollar has reduced the risk exposure due to drought.
Summary
This report provides a quantitative analysis of the potential cost of a five year drought that
has been referenced in PUB proceedings. This analysis utilizes 2006 assumptions that were
utilized in IFF06 such as expected export prices and import and thermal generation costs.
The five year drought results in a $2.764 billion negative impact on retained earnings by the
end of the forecast period (2016/17) inclusive of additional financing costs.
There is a risk that droughts more severe than the five year drought can occur and also a risk
that market prices for export and import may be higher than the expected case. As a first
sensitivity analysis, the severity of the drought was increased by selecting a seven year
drought. This more severe drought results in a further decrease in net export revenues by $0.5
billion in comparison to net export revenues for the five year drought. The analysis of impact
on retained earnings which include additional financing costs was not undertaken for this
case.
A further sensitivity analysis for the seven year drought with coincident high export and
import costs results in a $3.51 billion negative impact on retained earnings by the end of the
forecast period (2016/17) inclusive of additional financing costs.
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This report indicates that the $2.2 billion estimate for drought risk, which has been used in
PUB proceedings since in 2002, has increased with updated conditions as of 2006. The
updated analysis indicates that the potential loss due to drought can be as high as $3.5 billion
for a set of adverse events.
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