Tom Adams

October 7, 2002

 

The Line Between Legitimacy and Ignominy

Canadian Competitive Energy Summit 2002
September 24, 2002

Thank you for the opportunity to share some ideas with you on the subject of profiting in Ontario’s new electricity market. The purpose of this presentation is to discuss the conditions that are likely to support broad public acceptance of profitable electricity businesses. Businesses that expect to be in and out of our electricity market, businesses that are not making a lasting commitment to the market, will have little interest in the comments I am offering here. Instead, my comments are directed at those who expect to be around for the long haul to be a part of Ontario’s electricity future.

Looking at the title of this presentation, you might be excused in thinking to yourself, what can my company or my clients possibly learn about profit from a guy who works for a non-profit and who has never made five cents in profits from the electricity sector.

My message today is that profits for particular electricity businesses will only be broadly accepted as legitimate if the overall electricity market is considered legitimate. Electricity businesses hoping to prosper over the long haul in the new electricity market have an interest in helping to create and sustain a legitimate market.

My presentation will focus on five issues, some of which are generic concerns and some of which may be of interest only to some electricity firms: the need for depoliticization of the power system, the need to restore the credibility of the retail market, the need to upgrade metering, the need to support effective regulation, and the need for industry pressure to cut Crown corporation spending now driving taxpayer-backed debt up.

The electricity businesses that have been most active in shaping Ontario’s electricity future have so far been the commercial Crown corporation successors to the old Ontario Hydro – OPG and Hydro One. These entities appear to be single-mindedly focused on bulking up as much as possible. Most of Hydro One’s attention has been directed at vacuuming up distribution utilities, paying huge prices for these assets. Hydro One bought $385-million worth of distribution assets for $555 million. OPG’s attention has been directed at huge capital programs, primarily the Pickering A restart project and its program to increase the output from the Nanticoke and Lambton coal-fired stations. The Pickering A project was originally promised to have all four reactors in service by 2002 at a cost of $800 million. The current official outlook is for all units to be returned to service by some time in 2005 at a cost now estimated at $1.9 billion to $2.2 billion. OPG’s and Hydro One’s drive to expand has had important negative effects on Ontario’s electricity outlook.

Independent electricity businesses have grown too quiet in the debates over Ontario’s electricity future, particularly in their too-polite response to OPG’s and Hydro One’s expansion drive.

Competitive electricity markets face a major public relations challenge. Ignominy has haunted the energy sector, particularly since California’s botched liberalization attempt and Enron management’s assault on that company’s investors. These events have poisoned the public attitude towards what many people loosely call "electricity deregulation." In last Saturday’s National Post, David Frum observed that in recent times the broad worldwide consensus once in favour of freer markets has weakened. Terrible setbacks in energy markets have contributed to this retreat.

Paradoxically, like the groundswell against market economies now building in many parts of Latin America, it is a popular presumption in Ontario that government-owned, non-competitive, and centrally planned power systems are better, notwithstanding Ontario actual experience of public power. Any for-profit, competition-based alternative faces an uphill battle in demonstrating and being recognized for its superior potential to serve the public interest as compared with the previous centrally planned non-profit model. Part of the reason that this battle is up hill is because the former Ontario Hydro was so successful in appearing more successful than it really was. To illustrate Ontario Hydro’s impressive myth-making capacity, notice that many people still believe that Ontario used to have a power system based on the principle of power at cost. It is only through the miracles of creative accounting that the former Ontario Hydro was able to go through its entire history without a single annual loss before writeoffs and yet end up at its dissolution with a liquidation value estimated at negative $21-billion.

Ontario’s electricity reforms are only legitimate if these reforms result in a higher standard of public service over the long term than the system it has replaced.

I suggest that the public interest in electricity service is a function of four criteria:

1. Lowest sustainable rates;

2. Eliminate taxpayer liabilities;

3. Mitigate environmental harm;

4. Maintain system reliability.

How are we doing against these criteria?

First the good news. Ontario has made modest environmental gains in some specific areas. The two most significant are improved rules for nuclear waste funding and modestly tightened limits on emissions of smog precursors. Ontario’s new power market has made some reliability gains by introducing demand-responsive wholesale prices, much greater transparency around demand/supply balances, and stronger transmission inter-ties with neighbouring power systems.

You know that the news is not all good. With a heavy heart, I have to conclude that on balance, the overall record of the restructuring so far is unfavourable from a public interest perspective. After netting out my estimate of the Market Power Mitigation Agreement rebates, I calculate that ordinary consumers not signed with a marketer are now paying all-inclusive rates about 15% higher than under the old Ontario Hydro regime.

Taxpayer-backed electricity liabilities, which the government promised would begin shrinking and would soon disappear, are rising. Out of concern that the basic facts of this issue and the underlying problems related to taxpayer electricity debt are not widely enough understood, I want to spend a couple of minutes later in this presentation sharing with you my understanding of what is going on with our electricity debts.

The environmental record of Ontario’s power reforms is stained by OPG’s massive reinvestments in nuclear and coal generators. Ontario is on track to overshoot the emission limits set down in the new Canada-U.S. air treaty called the Ozone Annex.

The reliability of Ontario’s power supply is dangerously fragile. Had it not been for surplus power being available in neighbouring regions, Ontario would have suffered rolling backouts this summer. We had periods where our transmission system was operated beyond its rated capacity, where 16% of Ontario’s supply was imported. This desperate situation arose despite assurances from former Energy Minister Jim Wilson in the lead-up to market opening this May that Ontario would have a surplus and be a significant exporter. Ontario’s inability to meet its own needs with internal resources is very worrying.

Support Depoliticization

If we look beyond the myths, Ontario’s track record with its politicized power system was demonstrably unfavourable, except in the area of reliability, where the old Ontario Hydro’s performance was very good. After an official recognition, in the Harris government’s 1997 White Paper, of the failure of politically-controlled, centrally-planned administration of the power system, Ontario’s power market reforms slipped off the straight and narrow path away from depoliticization. Since May 2000, Ontario has slipped backward in the direction of politicization.

In May 2000, former Energy Minister Jim Wilson attacked the independence of the Ontario Energy Board, ordering the board to adjust its rate orders for municipal distribution utilities so that planned rate increases would be stretched out, perhaps past the next election.

In June 2000, Minister Wilson told the Association of Major Power Consumers in Ontario that the secret deals Ontario Hydro signed with selected large industrial customers to provide them with discounted power, would be extended into the new electricity market. Under Bill 35, the discount deals were set to expire when the competitive market opened. On top of contradicting his own legislation, Minister Wilson’s decision contradicted the recommendations of the Advisory Committee on Competition and the government’s commitments in the White Paper to allow all customers, regardless of size, equal and fair access to the market.

More recently, the government has been retreating from the planned privatization of Hydro One. Initially, the whole company was for sale, then 49%, and more recently the government has floated the idea of parting with only 9.9%. The government’s retreat is a sad development for the electricity market. The privatization of Hydro One would be broadly beneficial. Regulation, now conflicted by a web of government interests, would be clarified. New commercial parties would have a reason to inject their badly needed expertise and capabilities into meeting consumer needs and increasing the value of Hydro One’s assets. Successful privatization of Hydro One would benefit investor confidence in other elements of our power system.

Perhaps the worst possible outcome from Ontario’s backsliding toward politicization would be if we get to the stage where political decisions determine a who profits and how much. If profits are politically administered, the legitimacy of profit is fundamentally undermined. Slipping to the level of politically determined profits would also create conditions conducive to corruption.

If the structure of the market is sound, then vigorous pursuit of private interests can enhance the legitimacy of the market. Events surrounding the collapse of British Energy illustrate the point. On Sept. 12, American Electric Power Co. Inc., the owner of two of the U.K.’s largest power stations, and producer of 8% of the U.K.’s power, warned that a U.K. government rescue of the nuclear power generator British Energy PLC could have "serious repercussions" for future foreign investment in the U.K. energy sector if it is at the expense of other electricity producers. AEP is concerned that financial assistance for the company would prevent a much-needed reduction in U.K. power station over-capacity.

Here in Ontario, clean generators should be actively advocating for tougher emission rules for dirty generators. Instead, some clean generators have focused their lobbying on securing government protection for their profits, advocating rules that would compel customers to buy from designated generation. (Shades of British Energy.) All independent generators should be actively advocating against the restart of the Pickering A station.

The political dialogue surrounding our electricity reform process has deteriorated into a swamp of misinformation. It was not always thus. During the collapse of Ontario Hydro’s nuclear program in 1987, the Macdonald Committee process, the publication of the White Paper and the legislature’s development of Bill 35, the overall atmosphere of political discourse was generally constructive, even comparatively enlightened. How the discourse has changed!

In February, former energy Minister Jim Wilson published a study, with the endorsement of Fred Lazar, a professor of economics at York University, claiming "average electricity prices in Ontario’s new competitive market will, over time, be considerably lower than what they should have been under the old monopoly-based system." The first problem with that statement is that it is unfalsifiable. Although the former minister’s comments explicitly refer to overall rates, the scope of the study excluded consideration of the largest contributor to overall rate increases so far – increases in the distribution component of power bills. The truth is that power costs for ordinary customers have risen since the beginning of Ontario’s electricity reforms.

For his part, Mr. McGuinty has done little to raise the standard of the debate. In the midst of unprecedented power demands and a large dependence on imported power brought into Ontario to cover for a supply shortage that has brought our power system eyeball to eyeball with rotating blackouts, Liberal leader Dalton McGuinty says that we should close our coal-fired plants by 2007. Mr. McGuinty’s good intentions alone will not keep our lights on. These plants provide almost all of our dispatchable generating capacity and, in 2001, 29% of our energy. Although I fervently hope we can soon close Ontario’s coal plants, Mr. McGuinty offers no serious program capable of filling this gap. The only way to fill the gap is to restore investor confidence enough to get the paper power plants Ontario has in abundance, converted into real power plants. Mr. McGuinty’s interventions so far have done nothing to inspire investor confidence.

Mr. Hampton has distinguished himself as the loudest but weakest forecaster of Ontario’s power developments. As the market was opening, he warned at the top of his lungs that when the market opened, power would flood out of Ontario into the U.S., thereby driving up prices in Ontario. Here is what Mr. Hampton told anyone who cared to listen in a press release from January 23, 2002: "The new private owner will do what good for its shareholders – it will get the highest price possible, which is the American price. When a lot of our power is diverted to the United States there won’t be much for Ontario consumers – unless they want to match the American price." What actually happened after market opening was the opposite of what Mr. Hampton forecast. Power flooded into Ontario, mostly from the U.S., driving down prices here, much to the chargrin of Ontario-based generators.

This gloomy landscape of political spin needs to be challenged by people involved in the power system who understand how it works and what the electrical facts of life are.

Ontario’s power system needs depoliticization on many fronts. IMO board members should be directly elected by market participants. OPG and Hydro One should be privatized. I will make some remarks later on increasing the independence of the OEB.

Restoring Credibility to the Retail Market

Electricity retailers face a particular legitimacy challenge. So far in the market, purported customer solutions appear mostly to be attempts to take advantage of customer confusions.

The record of electricity marketers so far is unfavourable. Many, and perhaps most, customers who signed with electricity marketers prior to market opening thought they were getting lower cost power than they then paid.

Door-to-door representatives of energy marketers have been trained by their companies to get consumers to show their gas and electricity bills, thereby revealing the all-important customer identification number. In the past, there have been allegations of door-to-door sales agents obtaining access to customer identification numbers, forging the customer’s signature, and locking them into long-term energy deals. Customers trying to get out of unfavourable deals have had to obtain copies of their contracts from energy marketers, which has led to protracted disputes between marketers and their clients.

Disappointingly, Ontario has so far not seen any value-added bundling from marketers. Value-added bundling may ultimately be one of the only ways for energy retailers to really benefit their customers over the long term since almost all consumers are better off with unstable prices rather than paying insurance premiums for so called "price protection."

For many ordinary citizens, Ontario’s electricity market reforms means door-to-door marketing. For these consumers, marketers are the ambassadors of the new electricity market. The violations of the OEB’s Affiliate Relationship Code that have gone on, Toronto Hydro’s confusing branding of regulated and unregulated businesses, and repeated allegations of fraud by door-to-door sales agents give the overall restructuring a black eye.

Upgrade the Cash Register

Most consumers in the new market need intelligent, interval metering, capable of measuring usage at a high enough resolution so that they can be accurately billed. Providing this measurement service to consumers is probably going to be one of the most profitable business opportunities in the new market. Because of the purity of our spot market, our reliance on spot pass-through, and our seamless wholesale/retail markets, Ontario is uniquely positioned to lead the world in retail metering modernization.

If you are, or intend to be, a peaking generator, interval meters will directly compete against you.

Intelligent metering is the front line of customer protection. "Customer choice" without appropriate measurement constitutes a structural flaw in the market.

A variety of technology uncertainties make the future of metering hard to forecast. Is the best technology route based on one-way or two-way communications? What role for the Internet? What are the best ways to avoid obsolescence, like that which wiped out the old time-or-use meters? And perhaps the most significant question, how will advanced meters integrate with energy management systems?

Interval meters can help protect consumers from price excursions. It can also protect consumers from intra-class cross-subsidies. Ultimately advanced meters may be providing consumers with power quality and power reliability measurement.

Interval metering will benefit not just individual consumers but also the overall market. Widespread use of the meters will reduce the amplitude of price excursions, mitigate the abuse of market power, enhance supply reliability, cut societal capacity costs, encourage conservation, and lower LDC capital requirements from fine-tuned transformation requirements.

At least at their outset, interval meters will not be cost-effective for all customers. For example, small customers with standard marketer contracts will get no value.

A number of regulatory barriers are slowing the introduction of interval meters. Measurement Canada’s requirement for meter verification are one such barrier.

OEB’s Distribution System Code creates a maximum threshold for interval metering and also limits customer choice in meters. Under the code, existing customers >1 MW must have interval meters and new customers >500 KW must have interval meters. (DSC Section 5.1.3) However, LDC controls the metering and communications options. (DSC Section 5.1.6)

The OEB’s performance based ratemaking formula for LDCs creates a disincentive to expand the range and quality of services offered to consumers. To introduce interval meters for ordinary consumers utilities must file special applications.

Under the OEB’s rules, interval metering’s third party benefits are not recognized. Instead, customers requesting advanced meters must compensate the LDC for all sunk and incremental costs associated with that meter and the meter it replaces. (DSC Section 5.1.5)

Energy Probe champions the creation of a Retail Interval Metering Implementation Committee. This body would be mandated by the OEB and the Ministry of Energy to maximize the conversion of Ontario’s electricity meter stock to interval meters consistent with their cost effectiveness. We recommend that the composition of the body include representatives of the IMO, the OEB, the CEA and/or metering industry, Ministry of Energy, LDCs, and consumers (possibly also including marketers).

Support Effective Regulation

Effective regulation is an essential ingredient of a legitimate market.

The OEB needs legal independence from the provincial government. To achieve legal independence, Section 27 of the OEB Act must be repealed.

In addition, the OEB needs adequate resources to perform its work. Currently, the OEB staff are compensated at the pay scale of the Ontario public service, a requirement that makes it difficult for the OEB to attract and retain staff in highly technical positions.

Financial Update on Ontario Electricity Financial

Ontario Electricity Financial Corporation (OEFC), the legal continuation of Ontario Hydro, released its 2001-2002 financial results on Aug. 29. The financial results were released two months behind the schedule required by law, but this delay was much less that the delay in reporting during its first two years of operations. OEFC commenced with the breakup of Ontario Hydro in April 1999.

In its latest report, OEFC declares a loss of $69 million compared with a restated net income of $18 million last year. Prior to restatement, OEFC had claimed a net income of $244 million last year.

OEFC’s reported "unfunded liability" rose to $20.085 billion this year from $20.016 billion in 2001 – an increase from $19.433 billion in April 1999.

OEFC’s statement of "unfunded liability" should be treated as an estimate. The "unfunded liability" represents the net figure of OEFC’s total liabilities: mostly Ontario Hydro bond obligations, and its estimated costs for dealing with nuclear waste and getting out of high-priced power purchase contracts, some of which extend until 2042 – offset by notes receivable from the Province, Ontario Power Generation, Hydro One, and a small amount from the Independent Market Operator. Although, both OPG and Hydro One have seen their financial positions decline, the impact of these declines on the notes held by OEFC is difficult to judge.

OEFC’s financial losses were sustained despite the Ontario government’s decision last year to break one of its promises to ratepayers by accelerating the implementation of a special electricity tax earmarked for OEFC debt repayment to start collection prior to Market Opening. The Debt Reduction Charge (DRC) was first implemented on June 1, 2001, but renamed as the Wholesale Market Surcharge.

OEFC reports $524 million in accounts receivable from OPG and Hydro One as assets offsetting some of OEFC’s liabilities. These accounts receivable correspond to the retained earnings of OPG and Hydro One accumulated since their creation in April 1999. OPG has invested more than its total retained earning in the restart of the Pickering A nuclear station. Additional funds for the Pickering A project appear to have come from the liquidation of Mississauga hydro-electric assets, lease payments from Bruce Power, and deferring debt payments to OEFC. Hydro One has invested more than its retained earnings in the acquisition of municipal distribution utilities. Additional funds for Hydro One’s acquisitions appear to have come from the issuance of new debt, which has diluted the taxpayer’s interest in Hydro One.

This year, OEFC’s accounts receivable were adjusted downward by $122 million relative to last year. Further downward adjustment of OEFC’s accounts receivable cannot be ruled out.

Consumers were promised that the DRC would be temporary, in place long enough to recover Ontario Hydro’s unfunded liabilities. Since the unfunded liabilities are growing, the outlook for the DRC is that it will become a larger, longer lasting or permanent tax. In future, the rate charged for the Debt Reduction Charge is likely to increase from 0.7 cents/kWh to at least 1 cent/kWh.

OEFC has claimed since its first annual report to have a plan that shows the unfunded liability being eliminated. The plan is secret. In 2000, the Provincial Auditor asked that the plan be subject to independent review. The reviewer retained was Ernst & Young, the same company that signed off on Ontario Hydro’s financial statements, statements we now know were materially inaccurate. This year, OEFC claims that the date at which its unfunded liabilities are defeased has slipped from 2010 until 2012, but no supporting explanation is provided.

The continuing slide of OEFC’s financial performance represents a major threat to Ontario’s power market. The longer OEFC is allowed to ramp up debt, the higher rates will ultimately have to go for consumers. Rising OEFC debt is the direct result of two out of control Crown corporations pursuing expansion plans that do nothing to strengthen Ontario’s power market.

Conclusion

I hope there are voices in this room that will speak up more loudly in defense of Ontario’s new power market. Ontario’s electricity restructuring will not succeed unless it enhances the public interest. Among the necessary steps to enhancing the public interest are depoliticization of the power system, restoring the credibility of retail marketing, modernizing electricity metering in Ontario, achieving higher standards of independence and effectiveness in regulation, and cutting the Ontario taxpayer’s electricity liabilities.