Thomas Adams
Energy Analects
July 31, 1998

Ontario’s new energy legislation, now through second reading in the house, sets the stage for competition in electricity production and marketing, expansion of gas trading in Ontario, separation of competitive and monopoly activities, and strong public regulation of energy monopolies. While the legislative program is strong, the government’s financial analysis of Ontario Hydro’s liabilities and its plan for discharging those liabilities is weak.

 

There is much to praise in Ontario’s new energy legislation:

The legislation contemplates disclosure requirements for environmental performance and new mechanisms to maintain or improve environmental performance.

 

Using "virtual" taxation, the new legislation will eliminate the inefficient tax holidays for public utilities, levelling the playing field between public and private enterprises.

 

Municipalities will have a direct interest in seeing the stranded liabilities paid off, since they will receive the proceeds of the virtual taxation once those liabilities have been discharged.

 

The Ontario Energy Board receives extensive new powers to directly investigate potential violations of its rules.

 

The OEB is empowered to monitor and regulate not just the cost of monopoly distribution service to customers but also the quality of that service, protecting customers from any utility efforts to cut costs at the expense of service.

 

The legislation makes a good break with parliamentary fiscal tradition by specifically permitting the creation of a special purpose account to deal with Ontario Hydro’s liabilities.

 

The legislation creates an independent electrical safety authority. Historically, there were clear cases of Ontario Hydro using its control over electrical inspection to harass competitors, perhaps the most egregious example of which was the small district heating cogen facility owned by Trigen and London Hydro where Ontario Hydro’s inspectors ordered upgraded features not used at Ontario Hydro’s own facilities.

 

The legislative package gives rise to a number of issues that hold the potential for good or bad outcomes, depending on how they are managed.

 

A particularly serious concern is potentially conflicted roles for the OEB. The legislation would empower the OEB to create rules governing the conduct of parties it regulates, grant the board licensing authority over parties, and allow it to adjudicate rates and other matters. Potential conflicts between these different functions need to be considered.

 

To receive a licence to trade gas or electricity, a commercial party might be required to reveal to the OEB’s licensing director details about its company’s capabilities and intentions. If this same commercial party were to intervene on some regulatory matter before the board, it might be concerned about the adjudicator’s independence if confidential business information became known to the panel hearing the case.

 

To prevent conflicts from impairing the functioning of regulation, roles should be clearly demarcated. Separation within the OEB between the director of licensing and the rule makers from the rest of the adjudicators might be necessary.

 

Another potential stumbling point relates to the Independent Market Operator. The composition of the IMO’s board of directors is not specified in the legislation. The MDC has recommended an interested, "stakeholder" board. This approach is not specified in the legislation, but if it is adopted the IMO may be weakened.

 

The IMO will have regulatory powers, including the power to make rules and impose financial penalties on market participants, which runs contrary to the belief that regulatory bodies composed of parties with financial interests in the outcome of decisions can not be independent. A potential saving grace is that the decisions of the IMO are generally subject to OEB oversight, but this is a thin thread to rely on. A better solution would be for the minister to appoint to the IMO only those who do not have commercial interests in the outcomes of their decisions.

 

Another delicate area relates to the extinguishment of contracts with customers to which either Ontario Hydro or the municipal utilities areparties. These contracts include cogeneration avoidance agreements, contracts for subsidized power, and other such tools of the monopolists. If the contracting parties other than Ontario Hydro or the municipal utilities want out of these contracts then it is perfectly acceptable for government to extinguish the deals. Government has the right, like any owner, to direct the companies it has created and effectively owns in the manner it wishes. Getting rid of the deals in question will help advance the cause of competition. Except for cases where the non-governmental party is happy to terminate the arrangement, out of respect for the law, government should not be abrogating contracts, even if the circumstances under which the contracts were signed have changed. It may be necessary to compensate injured contracting parties to obtain their consent to collapse the deals.

There are also some areas where the approach adopted in the legislation is either wrong or does not go far enough.

 

The legislation does not grant the OEB the power to order divestiture of non-monopoly enterprises and functions. The OEB would be better able to police market power and intra-corporate transfers of costs if it had the power to order divestiture. Particular generating facilities that might play a key role in price formation might be candidates for divestiture, as would gas or electric utility affiliates operating in non-monopoly businesses, if necessary to promote competition and to prevent cross-subsidies. The Board may not have to exercise this power often, but having it may improve the Board’s ability to influence utilities in the public interest.

 

The ownership structure set out for the IMO is for it to be a non-share capital corporation, a surprising choice given the government’s unhappy experience with the Toronto District Heating Corporation. TDHC is deeply encumbered in debt with little prospect for returning the principle, is not renewing its physical plant, has not been able to modernize its system to incorporate cogeneration, and has been wracked by failed privatization efforts. The accountability problem resulting from no clear ownership structure has contributed to all of these problems. The IMO should have a clear ownership structure to encourage accountability.

 

Weak Stranded Cost Analysis

 

In early July, the Ontario Ministry of Finance released the long awaited results of a study it has done on financial issues associated with the electricity reform process, particularly stranded liabilities. The study is based on extensive consultation with stakeholders as well as expert advice from Queen’s University economist Bryne Purchase, and the firms Goldman Sachs, CIBC Wood Gundy, and Midland Walwyn. The performance of the Ministry of Finance so far suggests that management of financial issues may prove to be a bruise on the electricity reform peach.

 

The study itself, however, is blemished by factual problems that indicate careless work. For example, in a discussion of vesting contracts, the study incorrectly asserts that vesting contracts were used to protect the UK coal industry during electricity restructuring.

 

Ontario Hydro reports, and Ministry of Finance’s stranded cost paper accepts without comment, a current radioactive waste disposal and decommissioning liability of $2.8 billion, a figure predicated on the ability of the nuclear fleet to operate for 40 years at high capacity factors. In fact, realistic estimates of the remaining life of Hydro’s 12 active reactors suggests a current liability perhaps twice or three times higher. Annual contributions, reflecting the remaining service life, require drastic adjustment, yet the Ministry of Finance accepts the current contributions as appropriate.

 

A compounding problem not even addressed in the study is that the "provision" on Hydro’s books for radioactive waste disposal and decommissioning is an accounting line item only with no cash to show for it. The fact is that the cash collected for disposal and decommissioning was consumed by Ontario Hydro, and replenishing the reserve will be costly.

 

The Ministry’s plan for a volumetric stranded cost recovery charge has several flaws, not least of which is its name – the "Competitive Transition Charge" – which suggests that competition caused these costs, rather than simply revealed them. The charge is to be payable by all users, which is fine in principle but problematic in the case of customers of Cornwall Electric who were never a part of the Ontario Hydro system. The most basic problem with the volumetric charge proposal is that it is inefficient because it distorts the marginal price paid by consumers.

 

The Ministry of Finance expects its administratively determined, official stranded cost will be announced in December. It is hard to imagine how the current process of behind-closed-doors discussions and desk studies can, in the absence of privatization, arrive at a figure that will prove realistic and reliable.

 

According to the Ministry of Finance, valuation of the new commercialcompanies created out of Hydro, Genco and Servco, will be made based in part on the business plans of those organizations. Even a casual survey of Ontario Hydro’s past business plans compared to actual results reveals such a vast chasm between plan and practice that one can only be very concerned about continued reliance on this source.

 

The Ministry of Finance study skirts the subject but the likelihood is that taxpayers will get stung for Ontario Hydro’s past mistakes. The new legislation specifically envisions the Ontario government taking on some of Ontario Hydro’s obligations. The new Ontario Hydro Financial Corporation will borrow under the direction of the cabinet, raising the possibility of future claims by creditors against the public purse even where borrowings are not specifically guaranteed by the province.

 

(Mr. Adams is a consultant with Borealis Energy Research Associates, a principal client of which is the environmental organization Energy Probe, which he represents as executive director.)