NWT's Economic realities

As seen in EdgeYK in January 2016 - Sam Gamble

It’s the late afternoon of July 30th, 2014: the day of Yellowknife’s apocalypse thunderstorm.  From sunny skies to pitch black within minutes, street lights flip on at 4:30pm, a full six hours before the sun is due to set. Red lightning, falling ash and national news coverage — Yellowknifers will never forget it.

What the National Post dubbed “Yellowknife’s lost summer” was the NWT’s worst forest fire season in decades. The cost of fighting the forest fires was seven-and-a-half times greater than the historical average, but that wasn’t the only price. Low precipitation in 2014 led to lower water levels in 2015, severely affecting the NWT Power Corporation’s hydroelectric production. The result: diesel had to be trucked in at a premium to keep up with electrical demand. In response, the GNWT made a controversial decision to step in and give the Power Corp $29.7 million to keep rates steady. They cited the cost of living.

For most of my adult life, I have been watching Northerners make financial decisions like this, often based on intuitive notions of how our economy works. Often those intuitions don’t stand up under scrutiny. In this series, I present an alternative angle on the workings of our economy, with a focus on real estate. To those who agitate for a lowered cost of living, I contend that the most direct ways of doing this — terminating the largest transfer of wealth in modern NWT history, along with the government policies that fuel household overheads — will be unpalatable for many Northerners. I demonstrate that the Yellowknife rental markets, both residential and commercial, are dangerously concentrated and explain why that contributes to the cost of living.

I submit that our “resource-based” economy is not resource based at all, nor even a market economy. For Northern exceptionalists, I agree that the Northern economy is different from that of southern Canada, but I assert that it does have analogues elsewhere, particularly in the Persian Gulf. Regardless of the merits of one style of economy over another, we must understand the structure of our current economy if we are to make sound decisions.

Let’s start with what really makes the NWT so expensive:

The Cost of Living Debate

While politicians referred to the payment to the NWT Power Corporation as a one-time benefit, it will of course come out of unspecified government services, today or tomorrow. We may have robbed Hay River of an elementary school teacher, for instance, to pay for electrical costs in downtown Yellowknife commercial buildings. Perhaps a woman on the Ingraham Trail, whose family lives off the grid, will suffer longer health care wait times because of this decision.

My point, however, is that all this hand-wringing was wasted over one of the least significant aspects of our cost of living. While $29.7 million is a lot of money to transfer — more than the cost of running our newly-created Lands Department — it is dwarfed by the transfer of wealth going on in the real estate market every year.

Electricity costs make up 1.8 percent of our household budget, which is less than we spend on alcohol and tobacco. We can debate general living costs like groceries, electricity, shipping and affordable childcare until we’re blue in the face, but the big ticket item is the cost of housing our residents and businesses.

Housing costs make up the single largest proportion of the cost of living in Yellowknife. In 2012, Yellowknifers spent $27,423 per household on shelter costs (22.1 percent of total expenditures), whereas Canadian households overall spent $15,811. Shelter costs eclipse total personal taxes — federal and territorial — for the family. In other words, when housing prices move, it causes a disproportionately large change in the cost of living.

From 2006 to 2013, assessed values (the most complete record we have of Yellowknife’s real estate growth) increased by $1.1 billion (60 percent). This can be divided into new real estate (25 percent) and growth in existing real estate (75 percent). So in seven years, $851 million dollars in cost was added to Yellowknife residents and businesses. That’s an average of $122 million dollars per year, which is roughly equivalent to the combined annual cost of running the Legislative Assembly, Lands, the Executive, and Human Resources, with enough money left over to eliminate all territorial tobacco and fuel taxes.

The trouble is, about half of the people in Yellowknife are counting on that transfer of wealth to continue. The standard retirement plan for a Yellowknife government worker — or any other employee with a defined benefits plan — is to sell their home at a profit, use the proceeds to buy a house mortgage-free in southern Canada and pull an income from superannuation. To add further insult to renters, owners expecting this increase are willing to pay extra to get into the market, so prices just keep spiraling upward.  

Given that housing is our largest cost-of-living problem, and thus the smartest target for intervention, we must examine why renting is so expensive.

Monopoly Power in Yellowknife Real Estate

In 1859, discovery of the Drake Well near Titusville, Pennsylvania, sparked the first oil boom in the United States. The find encouraged a rush of speculators and businessmen to the area, including a 19-year old man named John D. Rockefeller.

Rockefeller’s insight was that refining, not drilling, held the promise of steady money. Within a few years of setting up a refinery in Cleveland he was one of the biggest refiners in the world. He obsessively drove down costs, cut deals with the railroads and bought out all competitors, until he became the world’s first billionaire.

In 1911, Standard Oil controlled 70 percent of the refined oil market in the U.S., and the American government finally invoked the Sherman Antitrust Act — the law that protects consumers by ensuring the market has enough supply competition. Standard Oil was broken into 34 different companies.

In Yellowknife, we see the law of supply and demand in action all the time. As wages rise or people move here, real estate prices go up. On the other side of the equation, when new houses come online, prices drop.

Most real estate reporting deals with the demand side of the market. What will be the effect of the Snap Lake Mine closure? How can prices go up when the population of Yellowknife isn’t growing?

Demand does play a part, but the big driver of housing costs is supply. This is because, in the short run, supply is fixed. Building a house can take years, while a new family can be added to Yellowknife by a two-hour flight from Edmonton. Yellowknife has a small pool of large landlords, and it is instructive to speculate about how our real estate market stacks up in its supply competition, using the methods of the US Department of Justice.

In modern times, the Antitrust Division of the US Department of Justice uses the Herfidahl-Hirschman Index (HHI) to determine whether an industry qualifies as a monopoly. The HHI ranges between 0 and 10,000, calculated by totaling the square of each firm’s market share. As the HHI increases towards 10,000, the market is less and less competitive. Unconcentrated Markets have a HHI below 1500, Moderately Concentrated Markets score between 1500 and 2500 and Highly Concentrated Markets — the ones that put consumers at risk — break the 2500 mark. Here in the Yellowknife residential rental market, we’re sitting at 4,800. By comparison, when John Rockefeller’s Standard Oil controlled an estimated 70 percent of the oil refining market, it had an HHI of 4,900.

YK’s Residential Market

As of April 2015, there are a total of 1,630 private apartment units for rent in Yellowknife. Our biggest landlord, Northern Properties, owns 1,070 — 65.6 percent of the market. Midwest Property Management, Yellowknife’s second largest private landlord, has about 230 residential units in Yellowknife — 14.1 percent of the market.

In Highly Concentrated Markets, any purchase that involves an increase in the HHI of between 100 points and 200 points raises significant competitive concerns, and warrants scrutiny. So if Northern Properties were to purchase an additional 50 units (as it did on November 1st, 2010 when it bought Three Lakes Village from Lanesborough REIT), the market HHI would increase by about 340 points — almost three and a half times greater than the trigger point for a review.

If natural reaction to monopolies is the increase of supply, one might ask why that isn’t that happening in the residential rental market.  Surely the rental rate bonanza should attract all kinds of new landlords to offer more units?

Ideally, Yellowknife would have about seven major landlords, ranging in market size between 9 percent and 24 percent of the market.  This would keep the HHI of Yellowknife’s rental market in the range of 1,000.

The Power of a Commercial Rental Market Monopoly

Monopoly power can be tackled, as the GNWT showed last year, making a startling example of the downtown office market.

About one million square feet of leasable space is currently available in downtown, government-grade buildings. Last year, prior to the new GNWT office building opening, the downtown office market HHI sat at 2,685. Unsurprisingly, when it came time for lease renewal in various offices, the major landlords were unwilling to adjust their rates downwards — even in a situation where an entire building was empty (Bellanca, with 52,000 square feet).

So the GNWT did what regular people can’t — they added 7.1 percent more office space to the market, reducing the market HHI by almost 150 points to 2,537 — which would still be categorized as highly concentrated.

Dream Office (previously known as Dundee and Bellanca) own the largest share of the higher-end downtown office market with 39.1 percent, and Northern Properties REIT is our second biggest downtown landlord with 24.3 percent.

If natural reaction to monopolies is the increase of supply, one might ask why that isn’t that happening in the residential rental market.  Surely the rental rate bonanza should attract all kinds of new landlords to offer more units?

The answer lies in construction costs.

City Hall and the Cost of Construction

Imagine the City of Yellowknife had passed a bylaw requiring all new houses to include a $5,000 garden gnome set. The cost of a new house built under this code would increase by $5,000 — but the implications would be much broader. All existing Yellowknife houses not sporting any of the little figurines would also increase in cost, because their replacement cost would now be $5,000 higher. Similarly, if garden gnomes had always been required in housing and the City removed the bylaw, housing costs in both existing and new houses going forward would be reduced.

This admittedly silly example highlights the role city hall, as the regulator of land use and construction within Yellowknife, can play in reducing the cost of housing though cheaper supply.

While a new homeowner only sees the purchase price for their new home, buried inside is not just the cost of construction but also what the City required the builder to include in the first place. While many requirements are health and safety issues, others reflect a city’s collective priorities — things like parking minimums, landscaping, energy efficiency, minimum lot sizes and garage placement, to name a few. While most of these requirements provide value to a homeowner, they all add to the cost of construction.

We’re not alone in this struggle — socially liberal cities tend to find themselves with conservative housing policies. A liberal city like San Francisco will often restrict new housing development and unwittingly keep adding to the cost of development until real estate prices skyrocket, forcing lower- and even middle-income people out of the area.

In the last few years, the City has brought in some excellent policies:

  • Allowing increased densities in the city centre
  • Allowing increased opportunities for infill housing
  • Bringing in the laneway housing bylaw
  • Loosening parking requirements
  • Maintaining predictable development requirements

While these policies may not seem like major changes, they are having the desired effect: an increase in the supply of housing. Over the last few years, we’ve seen hundreds of new units entering the market.

By getting rid of some garden gnomes, supply has increased. And while market observers may feel like the price of the new supply is high, let’s look at its effect on the resale market.

By far the biggest increase in supply has been the multi-family condominium market. (As interest rates rise, we’ll see more rental units emerging, too.) While new condominium units have come online at the higher end of the market, older apartment-style condominiums have decreased in price around 7 percent in the last few months. Eventually, as the large supply peters out, we will see older condominium prices begin to recover.

With this in mind, do Yellowknifers really want to lower the cost of living? The renters among us should say yes — get rid of those garden gnomes! The trouble is, Yellowknife homeowners have already paid for their garden gnomes, and they may not be ready to haul them to the dump.

City Hall is not the only arbiter of housing costs.

NWT Labour Issues

For the past eighteen months, my business partner Rob Warburton has been trying to give away $150,000. We had been approved for a $50,000 grant from the GNWT to install a new wood-pellet boiler in a recent condominium conversion project, but we couldn’t find a contractor to take on the work. It wasn’t that we couldn’t find a price we liked — we literally couldn’t even get a quote.

Dumping on the trades is a popular pastime, but the problem is too systemic to be about the quality of our tradespeople. Contractors must be making a rational decision not to take on our work, but what is that decision?

Industries can be roughly divided into two sectors: tradable and non-tradable. The tradable sector consists of industries that provide goods and services that can be easily imported or exported. A car in Yellowknife sells for roughly the price of a car in Edmonton plus the cost of shipping. Manufacturing, financial services, agriculture, mining, oil and gas, forestry, high tech, film & TV production — all are industries that are generally considered tradable.

Non-tradable industries need, realistically, to be carried out on location by local labour. These include government, health care, tourism, retail, education and, of course, construction.

Because construction is non-tradable, contractors can either staff their projects locally or try to attract southern labour, flying workers up and housing them here. Both alternatives are expensive and difficult, and result in a limited pool of employees. Given the contractor’s restricted labour resources, he or she must choose only a few projects to bid on, and the rational choice is to court the clients that pay the most: the government or the diamond mines.

Rob can’t get a quote for a boiler because his contract is considered too small and not as lucrative as a government or mining project, and the market isn’t flexible enough to bring in labour to take the smaller contracts.

Yellowknife Fever

Adding further fuel to the fire are government policies like the GNWT’s Business Incentive Policy (BIP), which awards local companies contracts even when their bids rise up to 20 percent higher than a southern source. For the 2014/15 fiscal year, the GNWT awarded $221 million of the $363 million budget to BIP-registered companies. The use of negotiated or sole source procurement amounted to $101 million. Each policy like this, combined with the sheer size of the dollar flows, has the effect of supercharging the non-tradable industries.

In 1977, The Economist coined the term Dutch disease, to describe the decline in the Dutch manufacturing sector after the development of a large gas field. The mechanism is this: a large development (usually in natural resources) causes a huge influx of foreign money. This money pushes the local currency up, making other tradable industries uncompetitive while creating a parallel boom in the non-tradable sectors.

Leading up to the 2015 federal election, NDP leader Thomas Mulcair brought up the idea of Dutch disease when discussing the Western Canadian oil and gas industry’s damage to the Central Canadian manufacturing industry, as it pushed up the Canadian dollar against the US dollar.

The NWT, and Yellowknife in particular, suffers from a version of Dutch disease, but here the mechanism is the labour market and the non-tradable industries, rather than exchange rates.

The NWT economy naturally favours non-tradable industries (more on this later), and government policies supercharge these industries to the point where previously non-tradable sectors have actually become tradable. The construction industry, where some developers import labour by using southern crews, while others now literally import the product, trucking in manufactured or modular homes, is a prime example of this.

A super-heated housing market is exacerbated by supply constriction, but the demand side of the market is determined mostly by income.

The NWT's External Income Source - Is the NWT a Rentier State?

Replace the sand for snow and stick a minus sign in front of the temperature, and I could easily be at an aurora tourism facility outside of Yellowknife. I am 10,000 km away, but Abu Dhabi feels eerily familiar. For the past two days, my wife and I have been guests in the capital of the United Arab Emirates on the invitation of the Crown Prince’s wife, Sheikha Salama bint Hamdan Al Nahyan.

My wife is working, but I am more or less free to look around and marvel at the similarities. Abu Dhabi nationalized their oil industry just as Yellowknife became the territorial capital, and its development has followed a similar pattern. The intervention of government into every aspect of the economy. The number of expats and economic immigrants who are on year seven of their three-year plan. The clear distinction between locals and foreigners. Local exceptionalism.

Our current economy best resembles what economists call a rentier state, a jurisdiction in which economic income meets three criteria: it relies on external sources, it goes primarily to the government, and it does not depend on the productivity of its residents.

Your typical rentier states are the Middle Eastern petro states — Qatar, Saudi Arabia, Kuwait — but can include other economic circumstances such as strategic location (Suez canal, military base location) and consistent forms of foreign aid.  

What exactly is rent?

In order to understand the rentier state, we have to use the word “rent” the way economists use it. The classic example of rent-seeking, according to Yale economist Robert Shiller, is that of a feudal lord who installs a chain across a river that flows through his land and then hires a collector to charge passing boats a fee (to rent the river section for a few minutes) before lowering the chain. There is nothing productive about the chain or the collector. The lord has made no improvements to the river and is helping nobody in any way, directly or indirectly, except himself.

Let’s take a look at the rentier state checklist as it applies to the NWT:

Origin of rent is external to the economy

Rentier economies receive a large portion of their income from an external source, and in the form of rent. This shouldn’t be confused with an economy that earns income through exporting a product or service.

Take the Bahamas, which earns more than half of its GDP from tourism. While its tourism income is from external sources — mostly American and Canadians escaping the winter — the source of income isn’t rent. The cost of going to the Bahamas on a vacation is payment for the flight, hotels, food, drinks, activities, and profit from the capital invested by the companies to provide those services.

On the other hand, if you look at Saudi Arabia’s oil industry, it sells oil at a price set by the world markets (around $40 per barrel in December), but its geology makes the cost of production much less than that of other oil producers ($10 – $20 per barrel). Through restriction of supply and accident of circumstance, Saudi Arabia earns between $20 to $30 per barrel in additional income, without providing any additional economic value.

The NWT receives a huge portion of its GDP (37.3 percent) from federal government transfers, which is a form of rent income. In comparison, Ontario receives federal government transfers equivalent to 3.1 percent of GDP. This is slightly less than Saudi Arabia’s rental proportion (43 percent) but more than the gulf states of Oman (34.5 percent), Qatar (23 percent) or the United Arab Emirates (22 percent).

The state is the recipient of the rent

Some rentier economies receive most of their rents in the private sector, but to qualify as a rentier state, the government must be the main recipient. In petro-states, for example, government-owned and controlled corporations receive the rents. Similarly, the Territorial government is granted much of the economic rent in the NWT.  

Few are involved in the production of rent

A key factor in rentier states is the number of people involved in the production of rent. The oil and gas industry in the Gulf is capital intensive but, beyond construction, provides little employment.  As a result, few people are involved in the production of rent.

Similarly, few people are involved in the production of rent within the NWT. While the GNWT is by far the biggest employer, most employees are involved in the distribution of the services paid for by the transfers —rather than in generating the transfers. The formula for transfer amounts depends mostly on the territory’s population, so a Northerner’s largest contribution is merely his or her existence.

The Dangers of a Rentier Economy

Most research around rentier states revolves around the question of why they seem to be underdeveloped economically and democratically, compared with other nations of similar income levels. Given their natural advantages, an economist’s expectation would be the opposite. Why are so many rentier states undemocratic with poor gender equality?

For one, rentier states face a greater potential for corruption than democratic market economies. While some risk factors in corruption are specific to petro-states with state-owned oil companies, one issue all rentier states face is the source of their income. Without the link between paying taxes and receiving government services, the connection between citizens and the government is indirect, and that lack of accountability can lead to undemocratic behavior. This is one of the reasons so many autocratic governments are tolerated in petro-states.

The GNWT relies on taxes for less than 20 cents of every dollar in its budget. In contrast, the inverse is seen in the 10 Canadian provinces, which receive on average 80 cents out of every dollar of revenue from taxation and fees for services provided to their residents.

This source issue can lead to excessive lobbying and transparency issues. Meanwhile, the public service’s stature as key employer adds to political pressures to distribute jobs in ways that have less to do with merit.

According to current research, rentier states display a common group of characteristics as a consequence of their structure:

  • The government is the largest and the ultimate employer
  • Citizenship has financial value
  • Economic activity shifts away from other tradable industries, and there is overheating in the non-tradable industries

The government as the largest employer

Of the 21,900 people employed in the NWT, the GNWT employs 5,450. That’s one out of every four employed people. Elsewhere in Canada, provincial or territorial governments employ 15 percent. An additional 16.2 percent work for another level of government, which puts the public service just over 40 percent in the NWT, while Canada-wide that number is 22.7 percent.

Citizenship as a financial asset

While a strong argument can be made to support affirmative action hiring for historically disadvantaged groups, it is hard to see “Indigenous Non-Aboriginal Persons” (commonly referred to as P2) as a disadvantaged group. In fact, we have the inherent advantage of familiarity with the North, and we are the most sought-after employees in most Northern industries. The P2 category forces the public service to compete with itself and offers financial benefits to those with the good fortune to be born in the North.

(Incidentally, if we are serious about lowering the cost of living, the last thing we need is a lot of protected industries, and yet here we are with a protected labour market, both in the public sector through the P2 category and in the private sector through BIP.)

The situation is amplified by Impact and Benefit Agreements and their demand for Northern hires. A large proportion of NWT residents are also owners of the various birthright corporations operating in the North.  

Other financial benefits also accrue to longer-term NWT residents. The NWT Student Financial Assistance Program offers larger benefits to residents who have lived in the NWT longer before post-secondary school, and it forgives loans after a student returns to the North for a minimum period.

Yellowknife fever revisited – overheated non-tradables

Because the NWT is a rentier state, it has a tendency to inflate the importance of the industries receiving rent (government). This leads to growth of the non-tradable industries (construction) at the expense of the tradable industries. As a consequence, the construction industry doesn’t see profits by developing new supplies of housing for either businesses or people.

Magnifying this effect is the other main source of external income to the NWT economy – extractive industries like mining and oil and gas – which also provide growth in non-tradable industries at a further expense to tradable industries.

The problem is further compounded by the fact that government policies designed to support the NWT economy provide financial incentives to all industries through the BIP program and negotiated/sole-sourced contracts, including those already overheated non-tradable industries such as construction. Mining companies have signed a series of Impact Benefit Agreements, with the same results.

Meanwhile in the labour market, the largest employer, which pays 25 percent of the workers in the territory, has placed restrictions on itself, driving up its own wage rate and indirectly affecting wages in other industries as well.

We started with the question of how to lower our cost of living, and we have followed that trail all the way through the structure of the Northern economy. Our expensive lives will not be lightened by simple fixes like subsidizing the Power Corporation in a dry year. The cost of living is a systemic issue that will require fundamentally changing the NWT economy, with all the transition costs that entails.

My hope is that this series will help inform discussions around Northern dinner tables and in the media with a higher standard for evidence. At the very least, any such discussions should be based on well-established economic principles and data. Without these, we will continue to reach blindly for solutions to problems we simply don’t understand.