By now every resident should be aware of the financial challenges facing our city. Starting in 2015 we were faced with a $23 million annual operating deficit. Considering the city’s operating expenses for 2017 was $155.8 million this is no small amount.
Over the 2017-2018 budget cycle that gap was narrowed by $7 million through tax increases and service cuts leaving the new city council a $16 million deficit. How we close the remaining gap is something every councilor and city administrator is preoccupied with. We will see tax increases of at least 4% per year for the next four years—far above the annual increases for a municipality which typically cover inflation. We will also see more service level cuts. Until the budget is balanced we are using reserve money to tide us over.
But how did we get here?
Medicine Hat is a unique in all of Alberta. We are the only city that owns its own natural gas production and distribution service and its own electric generation (GenCo) and distribution service.
The profits from our natural gas production and electric generation have been substantial. Over the years our natural gas production company was referred to as the Energy Division, Gas ProdCo, or Natural Gas and Petroleum Resources (NGPR).
The benefit to the city from these publicly owned companies is a cash dividend that is returned to the city. GenCo and NGPR return a portion of each of their yearly profits as their dividend.
Here is that combined dividend over the past 20 years in millions of dollars. This dividend was used to offset property taxes and utility rates. Money that otherwise would have been collected in taxes or utility rates was left in the bank accounts of Hatters. This line represents hundreds of millions of dollars left in your pocket. That is no small benefit.
In the column I'll explain the trend of the line, the spike, the dip and why any dividend recovery won't represent a return to the good old days.
The annual dividend in millions. It's sometimes hard to separate what each division returned as their individual dividend. For example the 2014-17 finance reports combines the dividends from NGPR, Genco, and Land Divisions. The annual reports from 2000-2013 occasionally list the dividend as solely from NGPR and sometimes combined with GenCo's, but this gives you a rough idea of how much money flowed in to offset taxes, utlity rates and community projects.
Yes, Medicine Hat has been blessed, but few blessings come without challenges. The two primary challenges have been:
How to provide suitable governance for these divisions?
How to spend this money?
Suitable Governance
What does suitable governance look like for a natural gas and oil exploration company and a public electric utility?
While other municipalities control similar companies at arms length as the primary or even sole shareholder Medicine Hat directly controls these divisions through city council. The advantage is that we have direct control over resources that belong to the city, the disadvantage is that those with direct control, ie city councilors, rarely have the background necessary for such enterprises.
Here is the governing board for Enmax, Calgary’s wholly owned electric utility subsidiary. Each board member has relevant experience for Enmax’s business, the same can’t be said for NGPR’s or GenCo's board of governors—city council. We were elected on political platforms—our visions for the city, not because of our expertise in the areas of oil and gas exploration or electric generation.
Recognizing this weakness successive city councils have endeavoured to improve governance of these divisions. For example, while city council still retains ultimate responsibility over NGPR the strategy for its growth is now also vetted by a panel of experts from the oil and gas field.
Council also often hires staff from the private sector. Most recently and notably:
CAO Merete Heggelund is a former VP for Statoil, the 11th largest company in the world and a leader in oil exploration.
Commissioner of Energy and Utilities Cal Lenz spent 26 years with ATCO as senior director of operations.
Brad Maynes, the General Manager of NGPR, has 30 years experience in the oil and gas industry.
All talented and capable people.
But in the private sector the market provides a natural check to keep companies sustainable and efficient whereas a city owned division is insulated from market pressures. So how can we be certain these divisions are running as efficiently as possible and returning the best value to city residents?
Starting just before the Great Recession of 2008, at the peak of oil prices in the 2000s, city council and senior administration began to have earnest discussions about the future of its energy and utility divisions.
A Guaranteed Dividend
At the Energy Committee meeting of June 26, 2007 a new policy to govern the Energy Division was discussed. The policy aimed to accomplish a few things.
Given the volatility of commodity prices the policy aimed to bring some year over year certainty to the annual dividend for budgeting purposes.
The historical graph illustrates the commodity's volatility.
Given the value of NGPR ($800+ million at its peak) the policy aimed to determine what should its shareholders (ie city residents) reasonably expect as a return.
The answer was to enshrine in policy an annual set dividend of 6.25% of equity or $24.5 million, which ever was greater. This would provide a guaranteed cash flow of $24.5 million to support taxes.
Judging from history up to that point this seemed reasonable and in line with dividends from other public utilities. (Though I don't know if other public utilities were forced to guarantee such returns.) Reading between the lines, the pressure to return this dividend was expected to push NGPR to stay sustainable and profitable.
The seeds of our current predicament can be seen in two factors in the discussion.
1. We, like most people, did not predict the phenomenal rise of natural gas production in the US through fracking. That development crashed commodity prices and continues to keep natural gas prices low. Here are the forecasted natural gas prices in 2006 versus what happened in the past decade.
Forecast in 2006.
Actual price of NG.
Actual price of NG.
2. The new policy guaranteed a dividend of $24.5 million. Regardless of whether the Energy Division made money it had to provide this dividend to the city.
In 2009 gas prices collapsed substantially reducing the equity of NGPR. Gas prices kept falling steadily eroding NGPR’s value. In 2011 NGPR lost $3 million. NGPR lost money again in 2012. It was struggling, but still had to return the $24.5 million dividend.
To ease the burden the dividend policy was amended in 2012. Now GenCo and NGPR would combine to provide the dividend. The policy did not change the guaranteed money to city coffers underscoring how much we depended on it to support taxes despite the strain it placed on NGPR. Notably, Councillor Turnbull resigned from the Energy Committee in early 2013 disagreeing over the strategy for NGPR during this time. His concerns were well founded.
In 2013 NGPR lost $13 million. Finally, facing the steady drain of cash from NGPR, in December 2013 the dividend policy was revised by city council, no longer guaranteeing $23 million to support taxes.
We moved some reserve funds from NGPR (as identified in the spike on the graph of our dividends in 2014) into a tax stabilization reserve. We used $40+ million in reserves to complete the budget cycle of 2015-2016. And at the beginning of the next budget cycle two years later we began the painful process of weaning ourselves off this dividend.
Back to the first graph. You'll notice that after a period of low returns the city saw a higher dividend last year. But now any profits from NGPR, GenCo or Land & Properties will be split between the tax stabilization reserve (to tide us over until we balance the budget) and the Heritage Savings Fund.
Could this have been reasonably avoided?
The decline of this once mighty division is remarkable. From 2000 to 2013 the annual reports trumpet the dividend each year. The trumpets fell silent in 2014. The word dividend does not appear a single time and was absent any explanation for its sudden disappearance. In 2008 NGPR reports a decade of doubling assets, tripling equity and cash on hand increasing fourfold. The next ten years have seen those gains wiped out.
There were councillors and administrators that sounded the alarm through the 2000s, but they were in the minority and thus were limited in their ability to affect change. But the growth of the Energy Division was so steady over such a long period that its collapse must have been hard to fathom.
Our reliance on the dividend to keep taxes low was a political choice. As early as 2001 the annual report recognized that Medicine Hat overly relied on this dividend. That compared to other cities we used taxes to support municipal services to a much smaller degree.
But that recognition translated little to our behaviour for the next 15 years as we continued to spend the profits to offset taxes instead of greater reinvestment in the Energy Division or greater savings. This choice was confirmed by many successive councils and thus endorsed by the citizens of Medicine Hat over and over. All of us must own this choice and its consequences.
But while the dividend policy passed in 2007 did not give NGPR much flexibility to weather the downturn in commodity prices, it was hardly the main factor in our current predicament.
To Spend or to Save?
If city councillors are not natural board members for business, we are perfectly suited to decide what to do with money. Afterall, the role of councillor is to articulate a vision for what to do with our communal funds. The basic question regarding our local natural gas abundance—how much to save and how much to spend—began with a series of choices for our community.
From the Esplanade Archives. (Used without permission. Let's see if Philip Pype, city archivist, notices. :))
The history of the Medicine Hat Advantage began humbly.
The initial goal of acquiring public rights to our natural gas was practical. A century ago city leaders claimed sole drilling rights because of regular mishaps from residents drilling for water and finding gas instead. The development to distribute natural gas and generate electricity was to simply meet local heating and electricity needs. The first choice was to offer both at cheaper prices to reflect our shared ownership.
The second choice was to use our abundant resource to spur job attraction and economic development. We offered discount rates on natural gas to attract industry here. It worked. Medicine Hat became an industrial hub and was soon called Pittsburgh of the West.
The final choice came regarding regarding taxes. Starting with the external sale of natural gas we began to use these profits to keep taxes low.
This totality of these choices are reflected in the recent history of how we used our profits.
$260,000,000 to keep taxes low. How low? The lowest in Canada in the 2000s. Here is one slide from the minutes of the Energy Committee from 2006.
Almost $200,000,000 for low gas and electricity rates. Between 1996 and 2006 the City estimated it subsidized the cost of natural gas from 75% to 200% for local residents.
We also used the money to provide a high quality of life for Hatters. Here is a chart from 2007 and the other ways we were ahead of other cities.
The money was used to fund numerous local projects: the Family Leisure Centre, Canalta Events Centre, the new Veiner Centre, the berms for flood protection, the Esplanade. We have overbuilt at times in anticipation of future needs. An extra floor, sitting empty, was added when we renovated the police station—solely for future expansion. An extra lane on Parkview Drive—in anticipation of future growth.
There is justification for all of these capital projects. Some may even save us money in the future, but few municipalities have the luxury to make decisions like we do.
The danger of course is that it’s easy take everything for granted. If we aren’t paying the market rate for natural gas there is less incentive to use it wisely. If we are enjoying plenty of new capital projects, but aren’t paying for it we may not value them.
It’s harder to appreciate something if we aren’t responsible for its true cost. Providing cheap utility rates is great, after all these shared resources were built for the benefit of Hatters, but we still have to pay market rates for replacement equipment and infrastructure. We still have to pay market rates for labour. That discount is short sighted and ultimately unsustainable.
Beginning in 2007 we started to charge market rates for natural gas. In 2015 we amended our policy to charge market rates for our electricity, but we still do not cover the full cost of our municipal services in taxes.
Did we save anything?
The city does have some reserves:
Community Capital: $ 24 m
Infrastructure Reserve: $ 16 m
Gas Depletion (to explore or acquire replacement gas and oil reserves): $ 60 m
Electric Equipment: $ 29 m
Tax Rate Stabilization: $ 19 m
Heritage Savings: $3 m
Unrestricted – NGPR: $ 100 m
Total: $251 m
This sounds like a lot of money, but it doesn't factor two future liabilities: gas well abandonment costs and municipal debt.
1. As our natural gas wells approach their end life the city must properly decommission each well. The cost of this future liability is very real. This is from our 2017 Financial Report.
In simpler language. We know how many wells we have. We know what it costs to decommission each well. We can reasonably predict inflation and thus future costs when abandonment becomes necessary. This means that our future estimated costs to decommission these wells will be $336,358,000. To meet this future liability we need $223,809,000 today with a set return of 5% annually.
We have not adequately saved for our abandonment obligations. We would need all the $100 million from NGPR's unrestricted reserve plus another $120 million (that we are currently short) to have the money we need. This is not something we can walk away from.
2. We also are carrying $321 million in municipal debt. 85% is on the utility side, not on the tax side. (Meaning the debt servicing costs come on your utility bill, not on your tax bill.) The projects funded with this debt have been to upgrade our utility infrastructure and have been necessary. This debt is typically described as good debt borrowed at low interest rates and paid back over the life of the equipment by the people that benefit from it. But debt is debt and must be taken seriously.
Regarding the historic natural gas field that the city sits above. It is estimated that the gas, if other assets are not acquired, will run out in 10 years.
The Legacy of the Medicine Hat Advantage
NGPR is currently in the middle of a growth strategy to find new oil reserves. This exploration is funded with reserves set aside for this purpose. The division could once again regain its footing and become profitable enough to cover our abandonment liabilities. GenCo is profitable and gives every indication it will remain a well run public utility.
But it is likely that the Medicine Hat Advantage as we have traditionally understood it—low taxes and low utility rates—is over. It's over because the advantage was not structured in a sustainable way. As we approach the end of this era for the Gas City what can we take away?
Early on the city did become the Pittsburgh of the West. But no single industry from that time is still operating. We have had the lowest taxes and lowest utility rates in the province for generations yet Medicine Hat consistently lags behind the rest of Alberta in economic growth.
If the legacy of the Medicine Hat Advantage is dubious perhaps the end of this era is not the end of the world. Yes, we will have to pay market rates for utilities and similar taxes to other cities, but the alternative was not the magic economic elixir we believed it was.
Obviously economic growth is not solely dependent on these factors.
There are no right or wrong decisions. There are choices with different tradeoffs. We choose to leave hundreds of millions of dollars in the pockets of Hatters over the past century. That is no small thing. We prioritized the now over the future. These are the choices we made. These are the consequences it came with.
Finally, nothing was done in secret. Almost all the information I've used in this column are found in annual reports and the minutes of the Energy Committee. Committee meetings that are open for anyone to attend.
A future column will look at where we go from here and what a sustainable Medicine Hat Advantage might look like.