Thomas Adams
Energy Probe
November 29, 1995

Paper for

The Institute of Electrical & Electronic Engineers (IEEE)
Power Engineering Society (Toronto section)

Future of The Electric Power Industry In Ontario

November 29-30, 1995
Royal York Hotel, Toronto

Transforming Ontario’s power system so it can sustainably lower rates and improve efficiency will require new methods of ensuring responsible behaviour. The province’s 89-year experiment using public ownership and self-regulation by the power industry to effect control has produced unacceptable results–high rates, bulging public liabilities, and failed investments. Self-regulation must be replaced by independent regulation. However, for independent regulation to be fully effective, Ontario will have to embrace electricity sector competition and sweeping privatization to eliminate the pervasive conflicts of interest.⁽¹⁾

Public ownership was once an accepted method of effecting control over key business enterprises in Canada. For example, until the creation of the Canadian Radio and Television Commission in 1968, the CBC regulated the broadcast industry in Canada. Confidence in government ownership as a means of protecting the public interest grew out of a culture of paternalism in public life that was left over from our history as a colony of England. Fortunately, small "r" republican notions of "checks and balances," previously considered to be suspiciously American, are taking root here. The ongoing global revolution which is converting monopolies and public ownership to competition and private ownership is coming to Canada, albeit a good deal later than elsewhere. Paradoxically, one of the leaders Canadians should now be avidly studying is our former colonial master, the U.K.

The U.K. has not only dismantled state ownership and monopolies in many key industries, but also has boldly established strong and effective regulation, often in innovative forms. In the electricity industry, power rates for all consumers have dropped since privatization. Homeowners now enjoy 10% lower rates relative to inflation. The biggest winners have been medium-size institutional and business users whose rates have dropped by 15%.⁽²⁾ Profits for most new electricity companies are robust, despite falling rates, revealing just how much consumers had been overcharged under the old system. Productivity has jumped, with the amount of power produced per employee almost doubling since privatization. Not only are customers seeing their electricity rates go down, but service has improved as well. Utilities that miss appointments, for example, pay the inconvenienced customer £20 (about $43). Disconnections for non-payment are down by 98.7% in the new profit-oriented system as a result of a variety of new payment options for customers behind in their payments. Reliability has been maintained, partly because the generation reserve capacity is large and growing.

Regulation has played a key role in the U.K.’s success in decreasing power rates, in increasing efficiency, and in improving the quality of service. The new regulatory system limits the rates utilities charge instead of the profits shareholders earn, giving utilities a powerful, profit-based incentive to cut costs. In order to prevent cost cutting from reducing the quality of service, the regulator tracks quantitative measurements of service quality, and imposes rules entitling individual consumers to recover financial penalties from utilities that fail to perform. The U.K. experience shows that privatization and regulation are not the strange bedfellows some may believe them to be. In fact, the surest way to get strong regulation is through privatization.

Privatization solves the fundamental conflict of interest that exists when government is both owner and regulator. Remove that conflict of interest, by separating government from industry, and the regulator gains freedom to do the job he should be doing: guard the public welfare.

The regulatory status quo in Ontario’s power sector suffers many conflicts of interest. Ontario Hydro’s most glaring conflict of interest is its regulatory control over municipal utilities, which buy and distribute 70% of Ontario Hydro’s output. Under Ontario Hydro’s mandating legislation, the Power Corporation Act, the rates charged by a municipal utility "are subject at all times to the approval and control" of Ontario Hydro’s board. Further, Ontario Hydro has the power to order a rate change "when in its opinion it is in the interests of the municipal corporations." Municipal utilities are regulated in secret and without right of appeal beyond Ontario Hydro’s own Board of Directors.

We do argue (for electricity and gas) that the environmental externalities which remain, after weeding out those externalities caused by allocative inefficiency, ought to be dealt with in regulatory fora outside rate regulation. Energy Probe’s argument that rate regulators are poorly placed to be environmental regulators is not an argument for weak environmental regulation. For example, Energy Probe is Canada’s leading advocate of stricter environmental and safety regulation for nuclear power.

Canada’s vast water resources are a case in point. Although laws are on the books governing our water and sewage utilities, the laws are systematically ignored. In British Columbia, for example, where fishermen two years ago took Vancouver to court to force it to obey the law, the provincial government, as is its right, took over this private prosecution "in the public interest." It then dropped it, allowing the dumping to continue. Regulation of water resources in other provinces is no less delinquent. Municipal water utilities routinely pollute in violation of the law, but provincial governments, which are responsible for the municipalities and for upholding the law, don’t say boo. And how could they, when they don’t prosecute their own equally culpable sewage plants? Provinces have another conflict of interest, too: Because they often fund improvements to sewage systems, court orders to clean up municipal plants can boomerang on them. Better by far to lie low, they reason, and ignore the problem. The result–visible degradation of public resources such as beaches, leading to a brisk coast-to-coast business in "No Swimming" signs each summer.–>

The Ontario Energy Board (OEB), in its latest report on Hydro rates, challenged this conflict of interest. The OEB found that the present arrangements are "increasingly anachronistic" and "designed to ensure that MEUs (municipal electric utilities) operate fairly within a monopoly electrical system, based on postage stamp rates." The report stated, "The Board does see a degree of conflict in the Hydro-MEU regulatory relationship."⁽³⁾

London Hydro, one of the most forward thinking utilities within the "Hydro family," has supported the OEB’s recommendation, officially condemning regulation by Ontario Hydro. London Hydro’s Strategic Plan (1996-2000), approved by its board on October 3, 1995 proclaims that "It is time to remove any regulatory authority by Ontario Hydro over MEU’s; a more open regulatory system under the Ontario Energy Board should be implemented."

Another profound existing conflict is Ontario Hydro’s effective regulation of its current or would-be competitors. Ontario Hydro regulates barriers to entry through its control over technical standards for grid connection, back-up power availability, transmission services availability, and rate discounts designed to thwart self-generation, fuel switching, or supplier switching. Without eliminating Ontario Hydro’s control over each of these areas, we will fail to achieve what should be one of our ultimate goals in electricity reform–a fully open, competitive commodity market for power.

Another conflict of interest exists in Ontario Hydro’s regulation of water flows in rivers and hydroelectric operations. Ontario Hydro, after it complies with its site licences and water power lease agreements, is effectively the regulator of water flows on Ontario’s developed watersheds. Ontario Hydro is the decision maker of our waterways, trading off the interests of hydroelectric production priorities against the interests of upstream and downstream water users. Such decisions require irreducibly complex trade-offs between competing interests–one of which is Ontario Hydro itself. Ontario Hydro has taken on the role of water regulator by default. We need a new regulatory paradigm for water control that provides all affected parties, whether power producers, riparians, or environmental authorities, with power to influence decisions in an accountable and independent process.

Yet another conflict of interest is Ontario Hydro’s regulatory authority over the installation standards and inspection of electrical equipment safety. Although this conflicted regulatory authority has not been implicated in anti-competitive actions to date, Ontario Hydro’s authority in this area must give some independently minded municipal utilities and potential industrial self-generators pause. Installation codes for electricity should be developed as they are for gas, under the responsibility of the provincial Ministry of Commercial and Consumer Relations. With an appropriate liability regime for inspection services, Ontario Hydro’s electrical inspections function could even be privatized.

Without privatization, regulation of publicly owned enterprises is burdened by conflicts at every turn. The OEB has never had binding authority over Ontario Hydro rates. Instead, it is empowered only to offer advice to government upon review of next year’s rates. The OEB has never had the right to regulate or even to comprehensively review capital programs. Often the OEB’s recommendations are ignored. Under the previous government, the OEB’s power was curbed even further. In 1993, the government shielded Ontario Hydro entirely from public accountability by exempting it from having to present its industrial rate discrimination plans to the OEB. In 1994 and 1995, respective Ministers specifically prevented the OEB from examining in any respect the most pressing and important issue in the electricity sector–privatization.

The OEB’s weak oversight of Ontario Hydro contrasts sharply with Ontario’s experience with regulation of the privately owned natural gas distribution industry. The OEB was the first regulatory authority in North America to allow competition in commodity gas sales to the whole market. Competition has been a massive and under-recognized success. It has saved Ontarians billions of dollars. For example, residential customers of Consumers Gas have seen their rates drop by 36% since 1984 after adjusted for inflation. While Ontario Hydro selectively ignores, and sometimes explicitly refuses to follow,⁽⁴⁾ the OEB’s findings, Ontario’s private gas utilities are highly responsive to them. In the gas sector, the OEB has the power and inclination to pursue its own initiatives, an example being the current generic review of system expansion policies. Unlike the annual electricity rate review, the OEB is under no artificial time constraints when examining gas issues. In gas, the combination of a competitive commodity market, private ownership of transmission and distribution, and effective public regulation has served the Ontario public exceedingly well.

When we are designing a new electricity system for Ontario, we need to be mindful of the words of Clint Eastwood (who is not often recognized for his contribution to regulatory theory.) Eastwood said, "A good man knows his limits," a philosophy that can be usefully applied here too. We have to recognize the limitations of monopoly regulation.

Regulation on its own can never force monopolies to innovate. The electricity sector today is like the telephone sector before deregulation when the only phone option available was basic black. Around the world, innovation has been suppressed by the electricity monopolies. The monopolies have failed to develop and adopt distributed generation and storage options, failed to exploit cogeneration opportunities, and failed to optimize electricity service provision by converging it with provision of other goods and services. Successful innovation is elicited from private initiative, whether from competition between private interests or from the profit motive in an incentive regulation scheme.

Regulation is a necessary accompaniment to privatization and competition, but it is not a substitute. Regulation without competition and private ownership is a very weak instrument for protecting consumers from the inefficiency of state-owned monopolies. Price cap incentive schemes, often applied to nonprofit Crown utilities to encourage efficiency gains, also perversely encourage creative bookkeeping. New Brunswick (N.B.) Power is under a price cap scheme. Rather than expensing outage costs like replacement power costs, interest costs, and depreciation charges of plants under planned and forced outages, N.B. Power capitalizes these costs as construction-work-in-progress. Current electricity ratepayers are not exposed to the full outage costs, since the costs are added to the utility’s debt. Future electricity ratepayers or taxpayers in New Brunswick will eventually have to pay for spending that was effectively concealed from current ratepayers. Furthermore, without shareholders to share the burden of imprudent capital and labour decisions (either by statute through regulation or by the harsh decisions of the market), regulators have little power beyond moral suasion and public embarrassment to discipline management and protect consumers.

Even where there is a genuine desire to reform, as was the case with Ontario Hydro under Maurice Strong during the past three years, many fundamental issues cannot be managed through internal reforms designed to make the utility more closely resemble a normal corporation. Ontario Hydro created generation business units and developed an internal power market through transfer pricing. Yet, incentives for good performance remain extremely limited, as do methods for balancing risks and benefits. The utility remains accountable only to cabinet ministers rather than accountable to customers, suppliers, and competitors. As long as government remains an owner, it will continue to be a conflicted regulator.

The U.K. reforms were driven by the recognition that competition, where it can flourish, is a far more potent cost-cutter and innovation stimulator than the toughest and wisest regulator. In the U.K., National Grid is a leader in twinning power transmission with fibre optic data capability. The labour intensity of the electricity business is down by half–far more than Maurice Strong’s reduction of one third, commendable though it was.

When we move to a competitive market, limiting market power in generation will be essential to ensure that competition serves the public interest. With real competition in generation, electricity regulators will have the benefits that gas regulators now enjoy in Ontario. Gas commodity competition has strengthened regulation by substituting market pricing for complex and questionable administered pricing. The job of regulators has been simplified and streamlined, allowing them to focus more attention on controlling and improving the natural monopoly aspects of the industry.

The most important method of limiting market power is to break up control of the existing generating assets. The worst mistake made in the U.K. power privatization was the decision to apportion the generation assets of the former state-owned monopoly to only three competing generating companies. There has been some evidence of market manipulation by the three largest producers. Fortunately, the market power of this triopoly is rapidly eroding. In the past five years, suppliers outside the big three have more than tripled their market share to 19%.⁽⁵⁾ In Ontario, competition should be kick-started by breaking the existing generating assets into several separate companies. In addition, transmission, distribution, and dispatch functions should be structurally separated and privatized.

Once sufficient diversity of ownership is created, transmission providers, distributors and dispatch providers must be regulated to ensure non-discriminatory access to power producers. Power producers outside Ontario, self-generators, and distribution utilities with generation facilities all need access equal to that offered to the new owners of Ontario Hydro’s stations.

While monopolies should be regulated, competition should be unregulated. An old, now discredited model of quasi competition–one of the first competition-oriented concepts to penetrate the bunker of the monopoly electricity business–provided regulated competition in power procurement. The U.S. 1978 Public Utilities Regulatory Policy Act (PURPA) was based on that model. Under competitive procurement, utilities have entered into longterm contracts with non-utility generators at fixed prices based on "avoided costs." The contracts themselves often provided the shadow equity for these projects, which were often very highly leveraged. "Avoided costs" have generally proved to be significantly above market price. Because of the long-term nature of these power purchase contracts, consumers have generally been major losers. Here, Ontario Hydro followed a similar model for the years 1989-1992. The market value of Ontario Hydro’s present non-utility generation portfolio is a liability which may be as large as $2 billion. The whole fiasco in the U.S. and Canada could have been avoided by empowering consumers to procure power on their own behalf.

Energy regulators in Ontario need to been given more concrete direction from the legislature. The purposes set out for the OEB in its mandating legislation are too vague. Regarding gas, the Ontario Energy Board Act directs the OEB only to "[fix] just and reasonable rates." For electricity, the OEB is directed only to hold a public hearing and report their findings to the minister. By comparison, the statutory duties of U.K. regulators of telecoms, gas, and electricity are expressly to protect consumers and to promote competition. Giving such a mandate to energy regulators in Ontario would significantly strengthen and focus the regulatory process.

Beyond dispersing the existing assets widely and eliminating artificial barriers to market entry, government should not attempt to artificially restrain the forms of commercial structure that may develop. Recent U.K. experience shows how the legal right of companies to engage in mergers and acquisitions can bolster the regulator’s hand and create a bonanza for consumers. In a hostile takeover attempt of Northern Electric, a distribution utility, by Trafalgar House last December, Northern attempted to stave off the attack by offering to boost shareholders’ profits through cost-cutting measures which the management had previously implied could not be done. The U.K. Office of Electricity Regulation, tipped off to the savings that management was hoarding, immediately cut the maximum price that the country’s distribution utilities can charge by between 11% and 17%. In April, the regulator followed up with another bonanza for consumers–additional delivery rate cuts of 10% to 13% and a four-year schedule of rate cuts at the rate of inflation minus 3% per year.

If artificial barriers to entry are removed and competition is left wide open following the breakup of Ontario Hydro’s assets, it is unlikely that damaging consolidation will reemerge. The gas industry, over the past ten years, has proved that, where it exists, competition increases diversity. If collusion occurs between electricity businesses, consumers can be protected by application of Canada’s Competition Act. Some consolidation is now happening in the U.K. to take advantage of the unfortunate fact that residential consumers remain the captives of regional distribution monopolies until 1998. A made-in-Ontario solution to this problem would be to follow our success in implementing gas commodity competition in 1985 where all consumers, regardless of size, were liberated right from the beginning. If the functions of transmission, distribution, dispatch, and generation become intermingled through ownership, regulatory measures may be necessary to prevent abuse of affiliate transactions between regulated and unregulated portions of the industry like those now in place for gas.

Ontarians should be mindful of two pieces of advice when creating a tough, effective regulatory regime for a reconstructed electricity industry. Over two hundred years ago, Adam Smith, commenting on guilds, an early form of monopoly, noted: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."⁽⁶⁾ More recently, Margaret Thatcher has observed, "Privatization itself does not solve every problem; though . . . it certainly exposed hidden problems which could thus be tackled. Monopolies or quasi-monopolies which are transferred to the private sector need careful regulation to ensure against abuses of market power, whether at the expense of competitors (if there are such) or of customers."⁽⁷⁾

1. This paper does not address the reinforcement of environmental and public health regulation that we believe should also accompany reform of Ontario Hydro.

2. Arthur Cooke (U.K. Office of Electricity Regulation), "Environmental and Consumer Protection in the Privatized UK Electricity Supply," in Europaeische Elecktrizitaetswirtschaft: 26/27 September 1995. On November 29, Gordon Homer reported to the IEEE conference, based on data from the U.K. Office of Electricity Regulation, that as of that week residential rates were down by 10.7% and medium industrial rates were down by 17%. Ontario Hydro’s Power Workers Union has taken out full page newspaper ads in recent weeks claiming that privatization has caused rates to be 20% higher than they would have been without privatization. The claim is based on a 1992 study by George Yarrow, which compared rates in 1992 with extravagant rate claims by the now disgraced Central Electricity Generating Board, made at a time it was trying to fight off privatization.

3. Ontario Energy Board, H.R. 23 Report of the Board, 31 August 1995, pp. 142-3.

4. Recent examples of OEB recommendations Ontario Hydro has specifically refused to comply with include recommendations 3.8 and 3.9 of HR 22 regarding heavy water production costs and accounting. The refusal is registered in a letter from Allan Kupcis of Ontario Hydro to the Brenda Elliott, Minister of Environment and Energy, November 9, 1995. In addition, Ontario Hydro’s response to the HR 22 recommendations was filed ten weeks after the date the OEB ordered it due.

5. S. C. Littlechild (U.K. Director General of Electricity Supply), "Privatization and Regulation of the U.K. Electricity Industry," Mont Pelerin Society Regional Meeting, Cape Town, South Africa, 10-13 September 1995.

6. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, (1776; reprint, New York: Collier, 1905), Book 4 207 (page citation is to the reprint edition).

7. Margaret Thatcher, The Downing Street Years, (New York: Harper Collins, 1993), 677.