Cameco attempts to mitigate risks that may affect its future performance through a systematic process of identifying, assessing, reporting and managing risks of corporate significance.
Management and the board, both separately and together, discuss the principal risks of our businesses, particularly during the strategic planning and budgeting processes. The board sets policies for the implementation of systems to manage and monitor identifiable risks. The nominating, corporate governance and risk committee is responsible for the oversight of risk management. Management has developed and implemented an enterprise risk management system that reports quarterly to this committee and annually to the board. This enhances the directors' understanding of the principal business risks facing Cameco and improves the company's risk management systems. The reserves oversight committee oversees the estimation of our reserves and the risks inherent in this estimation. In addition, the audit committee monitors certain financial risks and the safety, health and environment committee reviews systems and performance related to safety, health and environmental risk.
The following discusses our approach to managing our most significant risks that may affect our future performance. Also, see the discussion of the company's risk factors contained in Cameco's annual information form and that are likely to influence investors' decisions to purchase or sell our securities. The annual information form is filed on SEDAR at sedar.com and available on the company's website at cameco.com.
BUSINESS RISKS
REGULATORY APPROVAL AND EXPEDIENCY
Regulators must approve the construction, startup, continued operation and decommissioning of most of Cameco's facilities. These facilities are subject to numerous laws and regulations regarding safety and environmental matters, including the management of hazardous wastes and materials.
Significant economic value is dependent on our ability to obtain and renew the licences and other approvals necessary to operate. Failure to obtain regulatory approvals or failure to obtain them in a timely manner would result in project delays or modifications, leading to higher costs. In the extreme, a project may be suspended or terminated, which would negatively impact future earnings and cash flow. For example, we have applied or will be applying for licence renewals and amendments for many of our uranium and fuel services operations.
In November 2004, we submitted an environmental assessment for an increase in the annual licensed capacity at McArthur River and Key Lake to 22 million pounds U3O8 per year from 18.7 million pounds. Currently, the CNSC is considering the appropriate process to complete its review of the potential impacts associated with this proposed expansion. Specifically, the CNSC is considering the significance of the local impact of the accumulation of trace elements in the effluent. We are looking at technical solutions to reduce and/or remove these trace elements from the effluent. We do not know which solutions will ultimately be used and as such we are unable to provide an estimate of cost for mitigation at this point.
We had expected to receive this licence amendment in 2005. If approval is received, we expect it will take about two years to ramp-up production to a sustained planned production rate of approximately 21 million pounds per year. This production rate may change as we gain experience in ramping up production at this operation. Our share of the planned annual production increase of 2.3 million pounds U3O8 is 1.6 million pounds. The financial impact of not receiving the licence sooner is the loss of potential sales revenue and earnings.
We decided in 2005 not to proceed with the SEU blending project at our Port Hope conversion facility. The resulting public communication process affected the regulatory approval process, all of which took longer than anticipated. As a result, we are using other SEU blending suppliers to meet Bruce Power's project schedule.
Going forward, we will take a more consultative approach to community relations. For example, we initiated a community consultation process for the Port Hope Vision 2010 project to get public input early in the planning stage. The consultation process alone will cost in excess of $200,000. The impact of addressing the potential recommendations resulting from the process will most likely add costs to the project, but we are too early in the process to quantify.
In 2006, we will apply for licence renewals for all three fuel services facilities. Each of the existing five-year licences expires in early 2007. If we do not receive our licences in a timely manner, this could result in a loss of production and potentially reduce earnings. The licence renewal process could also lead to amendments to the operating licences, which may result in higher costs or provide additional financial assurances for decommissioning.
In addition to its licence renewal, Zircatec will be applying for a licence amendment to allow the commercial manufacturing of the new fuel containing SEU. If Zircatec does not receive its licence amendment for new fuel, this would mean a loss of potential revenue and an inability to supply Bruce Power with SEU fuel. Bruce Power would have to continue to use natural UO2 fuel as there are no alternatives that can be used in the near term. This could lead to Bruce Power being de-rated, which would lead to lower output and possibly higher unit costs for Bruce Power. The effect to Cameco would be reduced earnings from Bruce Power.
We have also applied to expand the capacity of the Blind River refinery to support our agreement with Springfields and to add pollution control equipment at our incinerator. If we do not receive approval for the licence capacity expansion at Blind River, it would result in reduced production either at our Port Hope conversion facility or the Springfields facility. The combined production from the two facilities would be limited to 15 million kgU to 16 million kgU. One mitigation measure we have taken to address the risk of delay in regulatory approval is to increase our level of UO3 inventory.
Cameco is currently preparing supporting documentation for an operating licence application for the Cigar Lake project. CNSC staff and Cameco are also reviewing requirements to allow the transition from a construction to an operating licence. Specifically, we are discussing the process of commissioning the mining and ore processing equipment, after the CNSC is satisfied that the project can advance towards full-scale operation. Cameco needs to apply for an operating licence by early 2007 to allow for mine production in the first half of 2007. If these approvals are not received in a timely fashion, we would face a delay in commencing operations, which would result in the loss of sales and revenue. Cameco's share of production from Cigar Lake, at full production, is expected to be 9 million pounds annually. Through its experience in constructing and operating uranium mines in Saskatchewan, Cameco is familiar with the statutory, regulatory and procedural framework governing new mining projects in Saskatchewan. Based upon its experience to date, Cameco believes that all permits and approvals required for the construction and operation of the Cigar Lake mine will be obtained in a timely fashion.
At the Inkai project, there are two production areas currently in development (blocks 1 and 2). In 2005, the regulatory authorities approved the EA and design plan for a commercial processing facility in block 1 and we began construction. In 2007, we expect to complete and begin commissioning the commercial facility, subject to regulatory approvals. We expect commercial production in 2007. We will apply for a mining licence in 2007 for block 2. Commercial development of block 2 is planned for 2008. Production from block 1 and 2 is expected to total 5.2 million pounds by 2010. If these approvals are not received in a timely fashion, we could face a delay in commencing operations, which would result in the loss of sales and revenue. Cameco's share of production from Inkai, at full production, is expected to be 3.1 million pounds annually. Through its experience in constructing and operating the test mine, Cameco is familiar with the statutory, regulatory and procedural framework governing new mining projects in Kazakhstan and based upon its experience to date, Cameco believes that all permits and approvals required for operation of the new ISL mine will be obtained in a timely fashion.
Cameco expends significant financial and managerial resources to comply with laws and regulations. A standards and policy department was established in 2005 to enhance the integration of the safety, health and environmental management systems. During 2005, we adopted a new safety, health and environment policy which moves us beyond compliance to a leadership role.
ENVIRONMENTTAL REGULATIONS
Environmental regulation affects nearly all aspects of Cameco's operations, imposing very strict standards and controls. Regulation is becoming more stringent in Canada and the US. For example, changes to our operational processes are increasingly subject to regulatory approval, which may in turn result in delays due to the longer and more complex regulatory review and approval processes. These increasing requirements are expected to result in higher administration costs and capital expenditures for compliance.
Changes to environmental regulation could impose further requirements on companies involved in the nuclear fuel cycle. Such changes could include more stringent regulation on emissions and water quality standards, and on property decommissioning and reclamation. These changes could affect Cameco's operational costs, or future decommissioning costs, or lower production levels, negatively impacting future earnings and cash flow.
One example of a regulatory change that impacted our costs was the requirement to implement a quality management system (QMS) at all our Canadian sites including the head office. We implemented the QMS at our Canadian uranium operating sites and at the required head office departments by the end of 2005. In 2006, we are working to extend QMS to include our US sites and the Inkai project. The direct corporate cost of implementing QMS from 2003 to 2005 totalled approximately $1.2 million. There are also indirect costs related to the sites and corporate office. These indirect costs have not been tracked separately but are included in ongoing operating costs.
Cameco seeks to reduce its environmental impacts as one way to mitigate risks from changes in environmental regulations. For example, at the Port Hope conversion facility, emissions of uranium to air have been reduced by 88% since 1995 through the installation of new equipment and changes to operating procedures.
The historical trend toward stricter environmental regulation is likely to continue. Cameco is investing more capital to improve technical processes in order to lessen our environmental impact.
Going forward, since regulatory requirements change frequently, are subject to changing interpretations and may be enforced in varying degrees in practice, we are unable to predict the ultimate cost of compliance with these requirements or their effect on operations.
LIMITED NUMBER OF CUSTOMERS
The nuclear industry is highly consolidated. As a result, Cameco relies on a relatively small number of customers that purchase a significant portion of the company's uranium concentrates and conversion services. BPLP also relies on a number of major customers for its sales and Zircatec has a significant portion of its sales committed to BPLP and Bruce A Limited Partnership. The loss of any of these large customers, or the reduction in product purchases by these customers, could have a material adverse effect on Cameco's financial condition, liquidity and results of operations.
Uranium and Conversion Services
For the period 2006 through 2008, our five largest customers are anticipated to account for about 35% of our contracted supply of U3O8. For the period 2006 through 2008, our five largest UF6 conversion customers are anticipated to account for approximately 34% of our contracted supply of UF6 conversion services. Cameco is currently the only commercial supplier of UO2 for use in Canadian Candu heavy water reactors with sales to its largest customer, Ontario Power Generation (OPG), accounting for approximately 39% of the company's UO2 sales in 2005. For 2005, one customer of Cameco's uranium and conversion services amounted to $135 million or 16% of our combined revenue from those businesses.
We have worked hard to build long-term, trusting relationships with our customers. In addition, Cameco continues to implement a strategy that focuses on achieving longer contract terms. Today, new contracts tend to reflect delivery terms up to 10 years or more. Our current contract portfolio for uranium and conversion services has contract terms averaging about seven years. Cameco has never had a customer default while it was under contract to purchase uranium or conversion services.
While there are a small number of buyers for uranium and conversion services, there are also a small number of suppliers. As such, customers have limited opportunity to exclude the major producers from their contracting activities.
In 2004, the most recent data available by producer, world production was 105 million pounds U3O8. Eight producers including Cameco provided more than 80% of this production. World production for 2005 is estimated at 108 million pounds, up 3% from 2004, largely as a result of incremental increases in production at existing mines. Cameco accounted for 20% of world production in 2005.
There are four significant producers of UF6 conversion services in the western world. Cameco controls almost 40% of the production capacity.
Zircatec
Sales to Bruce Power represent almost all of Zircatec's sales. There are two suppliers of Candu fuel bundles and Cameco owns one of them. The capacity of the two producers currently exceeds demand but neither producer alone can supply all of the demand. As such, the buyers have a vested interest in ensuring both fuel suppliers remain in business.
Bruce Power
BPLP also relies on some major customers for its electricity sales. During 2005, electricity revenue from one customer of BPLP represented about 11% of BPLP's total revenue.
In Ontario, during periods of peak demand there is a shortage of electrical generation capacity and BPLP is well positioned as a baseload supplier and has the capacity to supply about 17% of Ontario's electricity.
RESERVE ESTIMATES
Our uranium reserves are the foundation of the company and fundamental to our success. Uranium reserves and resources are estimated on a number of variables and assumptions, including geological interpretation, commodity prices and operating and capital costs. If our reserves or resource estimates are inaccurate or reduced in the future, it could have an adverse impact on our future cash flows and earnings. For example, if there are fewer reserves at any site, our future earnings would decrease from reduced sales and higher depreciation costs. Depreciation of mine assets is generally calculated over the mine life. A decrease in actual reserves could decrease the mine life, which would result in increased depreciation expenses over the same period of time.
The mine life at McArthur River is not at risk as it has more than 20 years of reserves at the current production level. At Rabbit Lake, the current reserves sustain mill production until 2007. We are seeking to extend the mine life by conducting exploration drilling near the mine and have been successful in the past. At the Kumtor gold mine, the mine life has been extended by almost three years to 2013. The Boroo gold mine life has been extended by one year to 2011.
Cigar Lake is scheduled to come into production in 2007. After a ramp-up period of up to three years, Cigar Lake is expected to produce 18 million pounds U3O8 annually. At the end of 2005, Cigar Lake had 231.5 million pounds of proven and probable reserves. Cameco's share of production and reserves is 50%.
Inkai is expected to start commercial production in 2007. We expect Inkai to ramp-up to full production of 5.2 million pounds U3O8 per year by 2010. At the end of 2005, Inkai had 114.4 million pounds of proven and probable reserves. Cameco's share of production and reserves is 60%.
We have had two reserve reclassifications at McArthur River in 2003 and 2005. As discussed in the "Uranium Business" section of this MD&A, we are considering using the boxhole boring mining method rather than raise boring in upper zone #4 because it will allow development from a preferred location. Until Cameco has fully developed and tested the boxhole boring method, there is uncertainty in the estimated productivity. As a result, Cameco reclassified 108.2 million pounds U3O8 from proven to probable reserves at McArthur River (Cameco's share is 75 million pounds) in 2005. Cameco does not expect this change to significantly impact its long-term production plans. Production from this zone is scheduled to begin in 2012.
In addition, the revisions to the proposed mining plan for the upper zone #4 and re-interpretation of a small portion of zone #2 resulted in a decrease of 12.9 million pounds U3O8 (Cameco's share is 9 million pounds) in proven reserves at McArthur River in 2005.
In 2003, we reclassified 51.8 million pounds U3O8 of proven to probable reserves at McArthur River (Cameco's share is 36 million pounds). Cameco decided to review the reserves classification because of the uncertainty associated with the productivity of using other mining methods at McArthur River. We were considering, on a conceptual basis, using jet boring and boxhole boring mining methods. We have tested jet boring at Cigar Lake and boxhole boring at Rabbit Lake and Cigar Lake with successful results. Jet boring and boxhole boring have not been tested locally at McArthur River and for that reason the reserves were reclassified from proven to probable.
Reserve estimates are based on our knowledge, mining experience and analysis of drilling results. We estimate reserves and disclose them in a manner that conforms to industry practices and applicable regulations including National Instrument 43-101.
While we believe the reserve and resource estimates included are well established and reflect management's best estimates, by their nature reserve and resource estimates are imprecise and depend, to a certain extent, upon geological and statistical inferences which may ultimately prove inaccurate.
LABOUR RELATIONS
Cameco has unionized employees at its McArthur River mine, Key Lake mill and Port Hope conversion and fuel manufacturing facilities. The collective agreement for unionized employees at McArthur River and Key Lake expired on December 31, 2005. Cameco and union representatives are currently negotiating a new long-term agreement. The collective agreement covering unionized employees at the Port Hope conversion facility was ratified after a seven-week strike in 2004 and will expire on June 30, 2007. This strike resulted in a significant loss of planned UF6 and UO2 production. The collective agreement covering the unionized employees at Zircatec expires on June 1, 2007.
BPLP has 3,700 employees and most of them are unionized. The Power Workers' Union's collective agreement expires December 31, 2006. The Society of Energy Professionals' collective agreement, which began January 1, 2005, expires December 31, 2009. Under the 2005 restructuring agreements, all employees remain with BPLP and all employee costs are apportioned between BPLP and BALP.
The Kumtor mine is unionized and all of Centerra's national employees in the Kyrgyz Republic are subject to a collective agreement between the Kumtor Operating Company (KOC) and the Trade Union Committee. Centerra's labour relations to date have been generally good and there have been no work stoppages due to labour disputes. However, the Trade Union Committee has recently demanded substantial additional compensation and alleged violations of labour legislation by KOC. KOC does not believe that the Trade Union Committee's position has merit. However, KOC is in discussions with the Trade Union Committee with a view to resolving the outstanding issues amicably. The collective agreement expires at the end of 2006.
We cannot predict at this time whether we will be able to reach new collective agreements with our unionized employees without a work stoppage. Any lengthy work disruptions could affect our earnings adversely.
COUNTERPARTY RISK
Cameco's sales of uranium, conversion and fuel manufacturing services expose the company to the risk of non-payment. We manage this risk by monitoring the credit worthiness of our customers and seeking pre-payment or other forms of payment security from customers with an unacceptable level of credit risk. As of December 31, 2005, about 4% of Cameco's forecast revenue under uranium and conversion services contracts, for the period 2006 to 2008, is with customers whose creditworthiness does not meet Cameco's standards for unsecured payment terms. As well, Cameco's purchase of uranium product and conversion services, such as under the Russian HEU commercial agreement and Springfields toll-conversion agreement, exposes the company to the risk of the supplier's failure to fulfill its delivery commitment.
MARKET RISKS
PRODUCT PRICES
As a significant producer and supplier of uranium, nuclear fuel processing, gold and electricity, Cameco bears significant exposure to changes in prices for these products. A substantial downturn in prices will negatively affect the company's net earnings and operating cash flows. Prices for our products are volatile and are influenced by numerous factors beyond the company's control, such as supply and demand fundamentals, geopolitical events and, in the case of electricity prices, weather.
Uranium
Uranium spot prices have mostly been in a downturn since the company was formed in 1988. Beginning mid-2003, the uranium price increased rapidly, primarily as a result of market participants recognizing that secondary supplies would contribute less to future supply than anticipated. The following graph shows the month-end uranium spot prices since 1988 in current (i.e. non-inflation adjusted) dollars.
Deliveries under new contracts typically do not begin for up to four years. As a result, many of the contracts in our current portfolio reflect market conditions when uranium prices were significantly lower. Cameco's current contract portfolio has limited sensitivity to further increases in the spot price over the next three years. For information on Cameco's sensitivity to spot prices, see "Uranium Price Sensitivity 2006" and "Uranium Price Sensitivity Analysis 2006 to 2008" in this MD&A.
Our strategy for reducing our exposure to volatility in uranium prices is to maintain a long-term contract portfolio that is diversified by price mechanism and delivery date. About 60% of Cameco's contract portfolio has been priced in relation to a market price (spot or long-term) mechanism. Currently, we have been securing attractive floor prices, which provide significant downside protection in the future. The remaining 40% has been sold at a fixed price (usually adjusted for inflation) over the term of the contract. Today, new contracts tend to reflect contract terms of up to 10 years or more. For more information on uranium contracting, see "Uranium Strategies" in this MD&A.
Conversion Services
The majority of our conversion sales are at fixed prices with inflation escalators. In the short term, Cameco's financial results are relatively insensitive to changes in the spot price for conversion. The newer fixed-price contracts generally reflect longer-term prices at the time of contract award. Therefore, in the coming years, our contract portfolio will be positively impacted by higher fixed-price contracts.
Bruce Power
Similarly, Bruce Power reduces price volatility by committing sales under fixed-price contracts. BPLP has 13 TWh sold under fixed-price contracts for 2006. This would represent about 50% of Bruce B's generation at its planned capacity factor. A $1.00 per MWh change in the spot price for electricity in Ontario would change Cameco's after-tax earnings from BPLP by about $3 million.
In addition, the Bruce Power restructuring agreement provides for a floor price of $45.00 per MWh (escalated by inflation) for the electricity sold into the spot market. The floor price extends to 2019. The floor price has a true-up mechanism, which is settled on a monthly basis with a contingent support payment. The aggregate of contingent support payments is tracked, so that if in the following year(s), the market price exceeds the floor price, Bruce Power would have to pay back the difference between the market and floor price, up to a value not exceeding the current contingent support payment balance. If a repayment is made, this amount is then subtracted from the contingent support payment balance.
Gold
Centerra is totally exposed to the fluctuations in the spot market for gold. Centerra plans to leave its gold production unhedged due to the strong industry fundamentals which it expects to continue to put upward pressure on price.
The average spot price for gold increased to $445 per ounce in 2005 compared to $409 per ounce in 2004. For 2006, a $25.00 (US) per ounce change in the gold spot price would change Cameco revenue by about $21 million (Cdn), cash flow by about $20 million (Cdn) and net earnings by about $9 million (Cdn).
FOREIGN EXCHANGE RISK
Cameco sells most of its uranium and conversion services in US dollars while most of its uranium and conversion services are produced in Canada. As such, these revenues are denominated mostly in US dollars, while production costs are denominated primarily in Canadian dollars. As a result, Cameco's earnings are negatively affected by a strengthening Canadian dollar. During 2005, the Canadian dollar strengthened against the US dollar from $1.20 at December 31, 2004 to $1.17 at December 31, 2005.
We attempt to provide some protection against exchange rate fluctuations by planned currency hedging activity designed to smooth volatility. Therefore, our uranium and conversion revenues are partly sheltered against increases in the Canadian dollar in the shorter term. In addition, Cameco has a portion of its annual cash outlays denominated in US dollars, including uranium and conversion services purchases, which provide a natural hedge against US currency fluctuations. While natural hedges provide this protection, the influence on earnings from purchased material in inventory is likely to be dispersed over several fiscal periods and is more difficult to identify.
For more information on our foreign currency hedging program, see the "Foreign Exchange" section under "Uranium Business" in this MD&A.
Our foreign currency hedging program in 2005 provided an incremental $62 million in Canadian dollar revenue. After deducting carrying charges and income taxes, this resulted in an additional $31 million of net earnings.
For 2006, every one-cent change in the US to Canadian dollar exchange rate would change net earnings by about $4 million (Cdn).
POLITICAL RISKS
POLITICAL INSTABILITY RISK
Cameco's Inkai project is located in the Republic of Kazakhstan. All of Centerra's current gold production and reserves are derived from assets located in the Kyrgyz Republic and Mongolia. All three countries are developing countries that have experienced political and economic difficulties in recent years. Cameco's operations and assets are subject to potential risks from actions by governmental authorities or internal unrest.
Losses due to political instability could have an adverse impact on Cameco's future cash flows, earnings, results of operations and financial condition. The company has made an assessment of the political risk associated with each of its foreign investments and has purchased political risk insurance to partially mitigate losses.
In looking at political risk in the Kyrgyz Republic, Mongolia and the Republic of Kazakhstan, we have made reference to the Index of Economic Freedom. The Heritage Foundation, a US research and educational institute, in partnership with the Wall Street Journal, publishes the Index of Economic Freedom. The report is an in-depth analysis of 50 independent variables that contribute most directly to economic freedom and prosperity. The index measures factors such as corruption, trade barriers, fiscal burden of governments, rule of law and health, safety, environment and labour regulations in 161 countries. Cameco believes this analysis helps to quantify political risk in developing countries.
Kyrgyz Republic
The 2006 Index of Economic Freedom categorizes the Kyrgyz Republic as "Mostly Free," with a rank of 71 out of 161 surveyed countries. The Kyrgyz Republic has opened most of its economy to foreign investment and has adopted guarantees, consistent with international standards, against expropriation or nationalization.
To mitigate risk, when Cameco restructured its gold assets into Centerra, Kyrgyzaltyn, a Kyrgyz joint stock company whose shares are 100% owned by the government of the Kyrgyz Republic, agreed to retain an ownership interest and, today, owns about 16% of Centerra. The president of Kyrgyzaltyn is currently a member of Centerra's board of directors. The agreement also provides that Kyrgyzaltyn will maintain ownership of at least 5% of the outstanding common shares at the time the Kumtor restructuring closed, as long as the Kyrgyz government continues to control Kyrgyzaltyn.
In 2005, the Kyrgyz Republic went through a major change in its political life. On February 28, 2005, the 105 member two-chamber parliament ceased to exist and was replaced by a one-chamber parliament with 75 seats. The new one-chamber parliament has broader constitutional powers, with certain powers being relinquished to it by the president. These changes were made pursuant to constitutional referendums which were conducted in 2003.
There was political unrest in the lead-up to the new parliamentary elections, which were held on February 27, 2005. As a result, from February 22 to 26, 2005, the Kumtor mine was unable to move employees and supplies to and from the minesite due to roadblocks on public highways. The roadblocks ceased on February 27, 2005 and normal operations resumed on March 2, 2005, with production unaffected.
The parliamentary elections precipitated additional unrest, and on March 24, 2005, President Askar Akaev, who had first been elected to that position in 1990, resigned under allegations of election fraud. The newly elected parliament designated Mr. Kurmanbeck Bakiyev as the acting president. Subsequently, on July 10, 2005, Mr. Bakiyev won a presidential election and was inaugurated as the president of the Kyrgyz Republic for a five-year term. Mr. Felix Kulov has been appointed the prime minister.
Following the ouster of President Akaev, the new government began various investigations into the activities of the prior government and former President Akaev's assets. Centerra's wholly-owned Kyrgyz subsidiary, Kumtor Gold Company (KGC), was included in the list of assets subject to inquiry by a special commission formed for this purpose on April 18, 2005. The commission published a report in June 2005 on its findings that did not contain any allegations against Centerra or its subsidiaries.
The State Audit Chamber of the Kyrgyz Republic was asked by the previous parliament to provide clarification to it with respect to the Kumtor restructuring in 2004. In April 2005, KGC was requested to provide information with respect to the restructuring. KGC agreed to assist the Chamber in its review. Subsequently, in June 2005, the attorney general's office requested documents from the KOC and Centerra as part of a criminal investigation into the alleged abuses of power or authority by officers of the Kyrgyz government, Kyrgyzaltyn, KGC and KOC. The investigation was based on previous parliamentary resolutions opposing and challenging the Kumtor agreements and the legality of the restructuring. Centerra responded co-operatively to these requests. Centerra stated publicly that it was not aware of any basis for allegations of criminal conduct, and noted that the Kumtor restructuring had been approved by government decree and was supported by legal opinions of the Ministry of Justice on the authority of the government to enter into and complete the restructuring.
None of these inquiries and investigations have resulted in any material negative effect on Kumtor, and to Centerra's knowledge, are inactive or are currently not being pursued by the Kyrgyz authorities. President Bakiyev and Prime Minister Kulov have also stated on several occasions that the Kyrgyz Republic will honour its agreements with Kumtor and Centerra. Nonetheless, as the largest foreign investment enterprise in the Kyrgyz Republic, the Kumtor project continues to be the subject of political debate.
Although the election of Mr. Bakiyev as president and the appointment of Mr. Kulov as prime minister brought a measure of stability to the Kyrgyz Republic following the events of March 2005, the political situation in the country continues to evolve. There continues to be a risk of future political instability.
In July 2005, protesters, in an action related to the 1998 cyanide spill, illegally blocked access to the Kumtor mine alleging, among other things, a lack of compensation from the Kyrgyz government. In response to the roadblock the government created a State Committee to inquire into various aspects of the Kumtor operations and the consequences of the spill. Based on the inquiries of the State Committee, the government issued a decree in September, 2005, requesting, among other things, that certain government agencies enter into negotiations with KOC and ask that KOC provide new funds to compensate local residents. Throughout these negotiations KGC's position continued to be that the settlement agreement was a final settlement of all claims and that any new compensation was the responsibility of the government.
On November 14, 2005 there was a further illegal roadblock by protesters that blocked access to the mine. This roadblock was lifted on November 21, 2005 after further negotiations among the protesters, the government and KGC. As a result of these negotiations, the government acknowledged its responsibility for any new compensation relating to the spill. To assist the government in fulfilling its responsibilities, KGC agreed in principle to make interest-free advances of approximately $4 million (US) to the government.
In December, 2005, Centerra advanced $1 million (US) of this amount to the Issyk-Kul Social Fund. This money was distributed to members of the local communities by a committee created by the government to administer the distribution of compensation. This advance will be repaid from regular ongoing contributions made by KGC to the Issyk-Kul Social Fund pursuant to the Investment Agreement. KGC has proposed terms for further advances and their repayment and expects to reach agreement with the government in the near future. However, if the government and KGC are unable to come to an agreement with respect to further advances to fund compensation, there is a substantial risk of further protests and roadblocks.
Mongolia
The 2006 Index of Economic Freedom categorizes Mongolia as "Mostly Free," with a rank of 60 out of 161 surveyed countries. According to the International Monetary Fund, in Mongolia "the Law on Foreign Investment guarantees that foreign investors will not be nationalized and that foreign investors will have the right to dispose of their assets."
In 2000, the Mongolian People's Revolutionary Party ("MPRP") won a strong majority in the Mongolian legislature. It continued many of the reform policies and focused on social welfare and public order priorities. In the June 2004 election the MPRP lost its majority but regained it in January 2005 when several members of the coalition government joined the MPRP to form a coalition cabinet. Presidential elections were held in May 2005, and Mr. Enkhbayar from the MPRP was elected in the first round of voting. In late 2005, the coalition cabinet dissolved, and in early 2006, the government was reformed and is now dominated by members of the MPRP.
Mongolian minerals legislation is principally governed by the Minerals Law of Mongolia (the "Minerals Law"), which was enacted in 1997. The Minerals Law provisions apply to activities and relationships with respect to the exploration for and mining of all types of mineral resources other than water, petroleum and natural gas, although there are other legislative enactments that apply to minerals. In mid-2005, the government was considering proposals to amend the Minerals Law. These proposals had the potential to affect negatively the investment climate for the mining industry, especially foreign investors. The proposals principal effect would have been on new projects rather than existing projects, such as Centerra's Boroo project. It is not clear whether the newly formed government will proceed with any or all of these proposals, and if the government does proceed, whether they will have a negative effect on the Boroo or Gatsuurt projects.
The foreign investment climate in Mongolia and Kyrgyz Republic appear to be gradually improving, however to partially mitigate losses, Centerra continues to purchase political risk insurance.
Republic of Kazakhstan
According to the 2006 Index of Economic Freedom, Kazakhstan is categorized as "Mostly Unfree", with a rank of 113 out of 161 countries surveyed. The index also noted that Kazakhstan was among the 10 most improved countries. To mitigate risk at our Inkai project, we formed a strategic alliance, through a joint venture, with KazAtomProm, a state-owned entity of the Republic of Kazakhstan. Cameco has agreed to provide funding of up to $100 million (US) to the Joint Venture Inkai for project development. We have also agreed to invest at least $4 million (US) over the next four years on sustainable development activities. To date, the Kazakhstan government has supported the project. In the event of a dispute arising at our foreign operations at Inkai, the dispute will be submitted to international arbitration. Cameco also continues to purchase political risk insurance to partially mitigate losses.
Cameco and Centerra practise the principles of sustainable development – to be a leader in business ethics, workplace safety, environmental protection and community economic development. As a result, we believe our commitment to sustainable development will further enhance our goal of becoming a partner of choice for governments and state-owned enterprises where we operate.
RESTRUCTURING OF ONTARIO'S ELECTRICITY INDUSTRY
Through Cameco's investment in BPLP, we are exposed to various business risks associated with the generation and marketing of electricity. In Ontario, political risk results from uncertainty over the future direction of government energy policies. BPLP sells electricity into the wholesale spot market and the contract market.
In Ontario, the retail and wholesale power markets were deregulated in May 2002. Due to a number of factors, including weather, electricity spot prices climbed to an average of $83.00 per MWh in September 2002 compared to an average price before deregulation of about $38.00 per MWh. In response, the Ontario government abandoned the deregulation of the retail electricity market and froze retail market prices at $43.00 per MWh for smaller consumers. In April 2004, a new pricing plan was implemented which fixed the first 750 kWh of consumption at $47.00 per MWh and monthly consumption above that level at $55.00 per MWh. More recently, the government has moved to gradually introduce the "true cost" of electricity into the retail market using an annual adjustment mechanism.
To mitigate price increases, the government has caused its provincially owned utility OPG to provide fixed rates for large industrial electricity users to allow them a transition to a market rate.
In 2005, the government set an average price of $45.00 per MWh on the output of OPG's regulated assets, which include OPG's baseload nuclear and large hydro plants. The new prices took effect on April 1, 2005 and will stay in place until the Ontario Energy Board sets new prices, no earlier than March 31, 2008. The government also set a new price limit of $47.00 per MWh on most of the output from OPG's unregulated assets, which include 85% of OPG's coal fired and smaller hydro operations that are not included in its regulated assets. The price limit was to act as a transitional measure from April 1, 2005 to April 30, 2006.
In February 2006, the Ontario government extended the transition rate for OPG's unregulated assets for three years (2006 to 2008). The rate per MWh will be $46.00, $47.00 and $48.00 in each of the three years. Bruce Power expects this action may depress the wholesale contract market, which remains unregulated. BPLP sells all of its production into the wholesale contract and spot markets. Given the constant struggle between encouraging new supplies of electricity and providing low electricity costs to users, uncertainty for Ontario electricity generators continues.
BPLP engages in risk management activities, including trading of electricity and related contracts to mitigate these risks. BPLP receives a reliable stream of revenue from fixed-price contracts. Approximately 48% of BPLP's output was sold under fixed-price contracts in 2005. BPLP also sells electricity on the open spot market. Prices are determined by bids from suppliers and buyers that reflect changes in supply and demand by the hour. In addition, the Bruce Power restructuring agreement provides for a floor price of $45.00 per MWh (escalated by inflation) for the electricity sold by the Bruce B reactors into the spot market.
There is a risk that the Ontario government could regulate the wholesale market in the future. This would limit the upside potential for BPLP's revenue. Given the shortage of generating capacity in Ontario, the need to attract new investment and recent market structure changes made by the government, we believe the risk that the wholesale market will be regulated is low. Ontario imported 11 TWh in 2005, up from the previous year when imports totalled 9.7 TWh. The IESO is responsible for managing Ontario's bulk electricity system and operating the wholesale electricity market.
Ontario's demand for electricity continued to increase in 2005. Ontarians consumed a total of 157 TWh, an increase of just over 2% from 2004. This is partly due to increased load from air conditioners during the hot summer.
In February 2006, the IESO issued its first Ontario Reliability Outlook, which reports on progress of the inter-related generation, transmission and demand projects under way to meet future reliability needs of the province. The IESO noted that, "aging generating units, constraints on the transmission system, under investment in the past decade, the continued growth in demand, and the provincial government's coal replacement plan are factors contributing to the need for new facilities and increased demand response."
OPERATIONAL RISKS
OVERVIEW
Cameco's businesses are subject to a number of operational risks and hazards, including environmental pollution, accidents or spills; industrial and transportation accidents; fires; blockades or other acts of social or political activism; changes in the regulatory environment; impact of non-compliance with laws and regulations; natural phenomena; encountering unusual or unexpected geological conditions; and technological failure of mining methods.
We also contract for the transport of our uranium and uranium products to refining, conversion, fuel manufacturing, enrichment facilities and nuclear facilities in North America and Europe, as well as processing facilities in Kazakhstan, which exposes the company to transportation risks. The potential risk is damage to the environment from a transportation incident, which results in a spill of product. We may be held liable as owner of the product. This could damage our reputation, which could make it more difficult to ship our products.
Although we maintain insurance to cover some of these risks and hazards in amounts we believe to be reasonable, this insurance may not provide adequate coverage in all circumstances.
ENGINEERING AND TECHNICAL
Water Inflow
Due to the unique geological conditions of the deposits at McArthur River and Cigar Lake, some technical challenges exist, including the potential inflow of water into a mine. In April 2003, a water inflow into the McArthur mine suspended mining for nearly three months. Similar difficulties could result in lower uranium production levels. Our sales were not impacted as we made deliveries from inventory and purchased uranium. The impact to net earnings was an increase in costs of $24 million to rehabilitate the mine. As a result of the water inflow, we significantly increased our pumping and water treatment capacity which resulted in increased expenditures of almost $19 million.
Cameco has operational controls in place to reduce this uninsurable risk including detailed procedural training for all employees, equipment inspections and testing, weekly inspections by our engineers, quarterly third-party inspections by engineering consultants and, in the Cigar Lake mine design, the incorporation of watertight bulkheads.
Jet Boring Mining Method
At Cigar Lake, the major technical factors influencing the mining method selection include ground stability, control of groundwater, radiation exposure, and ore handling and storage. Various studies on ground conditioning and non-entry mining methods were conducted. A decade-long test mine program resulted in the selection and validation of the jet boring mining method.
The overall test mine program was considered successful with all initial objectives fulfilled. However, as the jet boring mining method is new to the uranium mining industry, the potential for unforeseeable technical challenges exist. We are confident that our engineers will be able to solve the challenges that may arise during the initial ramp-up period, but failure to do so would have a significant impact on Cameco. We could experience a delay in production startup, which would result in the delay of sales and revenue. Costs would likely rise as we examined solutions to deal with the technical challenges. Given that we cannot foresee what these solutions might be, we cannot predict the costs at this time.
Boxhole Boring Mining Method
We are testing the effectiveness of using the boxhole boring method at McArthur River to mine parts of the orebody. While we have confidence our engineers will be able to successfully test this mining method, failure to do so could significantly impact the company. We could see a decrease in production, which would result in a loss of sales and revenue.
Kumtor Highwall Ground Movement
The current pit design is a response to the pit wall failure in 2002 at the Kumtor mine, also referred to as the "highwall ground movement," which resulted in the temporary suspension of operations. While some ground movement is common, this was a significant and unexpected movement, which affected the pit wall over a vertical distance of 280 metres and caused one fatality. Although mine production resumed seven days later in an area away from the pit wall failure, the highwall ground movement led to a considerable shortfall in 2002 gold production because a high-grade zone was rendered temporarily inaccessible to mining. As of December 31, 2004, the entire area affected by the highwall ground movement had been mined out.
Following the highwall ground movement, Centerra's geotechnical consultant assessed the potential explanations for the pit wall failure and provided guidance with respect to remedial and long-term pit shape design criteria that would reduce the possibility of a recurrence. A detailed surface mapping program and geotechnical drilling program was designed and initiated to provide further information on the cause of the highwall ground movement. Evaluation of the data resulting from the additional investigation programs has led to a revision of the geological model in the area of the northeast wall and reformulated slope design criteria for the final pit. The integration of the revised geology into the slope design process has allowed Centerra to develop a revised mining plan based on the geotechnical consultant's recommendations, which provides for greater pit wall stability.
In February 2004, some movement in the southeast wall of the Kumtor open pit was detected by the monitoring system. A crack was also discovered at the crest of the wall. The affected area of the southeast wall extends over a face length of about 300 metres and a wall height of about 200 metres. This area has now been mined out. In February 2006, additional minor movement was detected. Remedial recommendations of Centerra's geotechnical consultants have been implemented. Kumtor will continue to closely monitor the southeast wall.
RECLAMATION AND DECOMMISSIONING
The company plans for the closure, reclamation and decommissioning of its operating sites. Decommissioning and reclamation costs may increase over time due to increasingly stringent regulatory requirements.
Periodically, Cameco re-estimates its total decommissioning and reclamation costs, based on current operations to date, for its operating assets. At the end of 2005, the total estimate was $239 million, which is the undiscounted value of the obligation. Most of these expenditures are typically incurred at the end of the useful lives of the operations to which they relate and, therefore, only a very small percentage of total estimated decommissioning and reclamation costs are expected to be incurred over the next five years. See note 7 to the consolidated financial statements.
At the end of 2005, Cameco's accounting provision for future reclamation costs totalled $168 million, which represents the present value of the $239 million mentioned above. To provide financial assurances for these costs, Cameco has provided letters of credit, where required. Cameco's LOCs totalled $207 million at the end of 2005, of which $203 million was related to reclamation and decommissioning activities.
Since 2001, all Cameco's North American operations have in place LOCs providing financial assurance, which are aligned with preliminary plans for site-wide decommissioning. Beginning in 1996, the company has conducted regulatory-required reviews of its decommissioning plans for all Canadian sites. These periodic reviews are done on a five-year basis, or at the time of an amendment to or renewal of an operating licence.
As part of the upcoming licence renewals for our Port Hope and Blind River operations, we will be reassessing our decommissioning estimates. This could result in the need for additional LOCs to cover the new estimates in 2006 or 2007.
SAFETY, HEALTH AND ENVIRONMENT
Cameco is subject to the normal worker health, safety and environmental risks associated with all mining and chemical processing. In addition, our workforce faces other risks associated with radiation related to uranium mining and milling, and fuel services operations.
Over the last few years Cameco has been implementing a QMS that recently also integrates our environmental management and health and safety management systems. The environmental management system for Cameco's uranium facilities at McArthur River, Key Lake, Blind River, Port Hope and Crow Butte are each ISO 14001 certified. The Smith Ranch-Highland mine in Wyoming and the Inkai test mine in Kazakhstan are in the process of obtaining ISO 14001 certification.
Monitoring and reporting programs for environmental, health and safety performance in all our operations are in place, to ensure that environmental and regulatory standards are met. For 2005, we invested about $20 million for environmental monitoring, protection, assessment and safety and health programs. Inspections and assessments are also designed to provide these assurances. Contingency plans are in place for a timely response to an environmental event.
ELECTRICITY BUSINESS
The capacity factor is directly related to the operating performance of Bruce Power's generating assets. The capacity factor for a given period represents the amount of electricity actually produced for sale as a percentage of the amount of electricity the plants are capable of producing for sale. Bruce Power's anticipated contribution to Cameco's financial results in a given year could be significantly impacted if the aggregate capacity factor is less than expected due to planned outages extending significantly beyond their scheduled periods or if there are unplanned outages for an extended period of time. The impact of lower capacity factor is reduced electricity sales and revenue.
For example, in 2005 we expected Bruce Power's average capacity factor for all six units to be 85% compared to the 80% that was ultimately achieved. This reduction in capacity factor is equivalent to about 2 TWh, which is additional output that could have been sold by Bruce Power. On the other hand, if there is reduced generation capacity available to the market, that will typically cause electricity prices to rise, which can partially offset the loss in sales volume.
Bruce Power manages this risk through preventive maintenance to improve overall equipment reliability, by adopting more efficient operational processes and by improving employee performance at all levels. In 2006, BPLP plans to invest $69 million in sustaining capital.