Tom Adams
Speech
October 27, 2000

 

This speech, fully titled "Ontario’s Electricity Liberalization: From Promise to Crisis and Lessons for Atlantic Canada", was delivered by Thomas Adams⁽¹⁾, Executive Director, Energy Probe, for "Plugging in Atlantic Canada", a conference presented by the Atlantic Institute for Market Studies (AIMS) and the Electricity Consumers Alliance of Nova Scotia (ECANS).

 

Introduction

Ontario’s electricity restructuring is now beset by a range of significant problems that threaten its potential to deliver reasonably priced, reliable, and environmentally responsible power. Ordinary consumers in Ontario are going to be paying more for electricity. The paper attempts to explain the changes happening in Ontario’s electricity system and the effects of these changes, both in the lead-up to competition and once the province’s electricity market opens for competition. The paper further attempts to synthesize some lessons from the Ontario experience relevant to the question of how Atlantic Canada’s power systems might be further liberalized.

The reader may find the discussion of Ontario’s restructuring confusing to follow, in part because of the irreducible complexity of modern power systems, but also in part because the restructuring has become a crazy quilt of beneficial and harmful ideas stitched together without an easily discernible pattern. This thumbnail sketch of the restructuring may help you pick your way through the story.

By the mid 1990’s, Ontario Hydro was becoming financially and operationally dysfunctional. Recognizing that change was required, the newly elected Harris government sought input from a number of prominent business and academic leaders who recommended a competition-based alternative. Although some important limitations resulted from the early policy development decisions up to and including the passage of Ontario’s new energy legislation in 1998, most of the basic concepts advanced were sound. However, once the process of implementing the policies was undertaken, a number of errors have been made that, without mitigation, will impair the public interest. The future prospects for Ontario’s restructuring are difficult to speculate on but some clear lessons have already been demonstrated.⁽²⁾

 

What happened to the old Ontario Hydro?

Ontario Hydro collapsed under the weight of its liabilities. An abbreviated overview of the process of that collapse includes the following historic events:

Completion of the Darlington nuclear power station might be considered the beginning of the end of Ontario Hydro. The Darlington nuclear power station was completed in the years between 1989 and 1993 for a cost of $14.4 billion. According to the earliest published planning documents, the station was originally supposed to be completed for approximately $2.5 billion and completed in 1983. In addition to the enormous cost overruns, the station suffered from several major technical flaws on completion that severely compromised its output and income. Although supposed politically imposed delays in its construction are popularly blamed for Darlington’s cost overruns and delays, the only publicly available evidence of politically imposed changes in the construction schedule was Bill Davis’s order to accelerate construction following his election victory in 1981. Darlington was the leading cause of an increase in electricity prices in the period of 1989 to 1993 of over 20% in inflation adjusted terms. Nuclear production peaked in Ontario in 1994 and has generally declined since. Historic supporters of Ontario Hydro and its monopoly, such as the powerful industrial lobby group called the Association of Major Power Consumers in Ontario, began considering alternatives to Ontario Hydro supplies largely as a result of the electricity rate increases and falling natural gas prices during this period.

Maurice Strong chaired Ontario Hydro’s Board from 1993 until 1995. During this brief term of office, Mr. Strong implemented a series of major management changes, which on balance proved to be very beneficial to the public interest. At a press conference on March 9, 1993, he announced a range of initiatives, including: the first unscheduled closure of an Ontario Hydro nuclear reactor (Bruce unit 2), the end of Ontario Hydro’s massive 25-year expansion plan and the associated Environmental Assessment Act approval process (a plan that was originally slated to cost approximately $100 billion), the reduction of Ontario Hydro’s work force by about one third, and a rate freeze. Under Mr. Strong’s leadership, Ontario Hydro embraced sustainable development, including an extensive and successful internal energy conservation effort. Mr. Strong also directed Ontario Hydro to participate constructively in public discussions about competitive options for Ontario’s electricity future.

One of Mr. Strong’s most revolutionary changes was a simple structural reform: he reorganized Ontario Hydro into "business units", each of which traded – bought and sold goods and services – with the others. One stunning, and apparently unanticipated, effect of this restructuring was that the Nuclear-generation "business unit" fell several billion dollars short of cash in its first year – i.e., its revenues from power sales were enormously inadequate to pay its bills, primarily the debt incurred to build the nuclear stations. That revelation led to a series of "asset reevaluation" exercises that helped quantify the enormous amount of money that had been lost on Hydro’s nuclear construction binge.

Mr. Strong also made significant, although incomplete, reforms to Ontario Hydro’s accounting practices, reducing their deceptive nature. For example, he wrote off phony accounts receivable that Ontario Hydro had used to justify its investment in the retubing of the Pickering A nuclear reactors during the period 1983-1989.

Ontario Hydro was then in a very precarious position: its generation costs, and sales prices, were suddenly higher than the cost of generating power from newly built high-efficiency stations fueled with natural gas. Moreover, Hydro’s costs were dominated by so-called "fixed costs" like the mortgages on the nuclear stations – costs that had to be paid whether or not there was any demand for Hydro’s power. As a result, a drop in sales (e.g., if major customers began generating their own power) could easily cause a destructive feedback loop known as the "cost-price-demand spiral" or the "death spiral". Facing the threat of declining revenues, Ontario Hydro entered into secret contracts to sell heavily discounted power to its largest industrial customers in order to prevent the development of lower-cost generation by customers. Although this short-term expediency initiated a series of events that caused lasting damage to consumers and the environment, at the time, the move appeared necessary to ward off financial default. Mr. Strong also vigorously defended the Nuclear Liability Act in court. The Nuclear Liability Act – an expression of the antithesis of sustainable development — extinguishes all third party liability for suppliers to the nuclear industry and limits liability for nuclear operators to $75 million in the event of nuclear accidents. Despite these blemishes on his career, Mr. Strong guided Ontario Hydro in a new direction and ultimately contributed enormously to the economic and environmental welfare of Ontario.

The Advisory Committee on Competition in Ontario’s Electricity System – often referred to as the Macdonald Committee after its chairman Donald Macdonald – was convened by the Harris government soon after its election in 1995. The committee reported in early 1996 after receiving submissions from all organized groups with an interest in Ontario’s electricity future and many individual citizens.

A major event during the Advisory Committee on Competition deliberations was the decision by the Association of Major Power Consumers in Ontario to reverse its previous position for the Ontario Hydro’s monopoly and endorse a market-based alternative. A substantive element of this interest group’s position that helped to change the electricity policy debate was its public endorsement of the recovery of costs to cover Ontario Hydro’s financial deficiency from all consumers, including large industrial users.

The committee’s report recommended the breakup of Ontario Hydro, the privatization of major components of the power system, sweeping regulatory improvements, strengthened environmental rules, the creation of an independent agency responsible for power system reliability, the opening of the electricity market to competition, and a move away from the secret power discount deals designed to thwart competition.

Although Ontario Hydro’s main union, the Power Workers Union (CUPE 1000), opposed many competitive reforms, the attractiveness, practicality, and logical force of the Advisory Committee on Competition recommendations gathered so much support that the union was forced to temper its position. An influential coalition of interest groups called the Stakeholder’s Alliance for Competition (composed of groups including the Association of Major Power Consumers in Ontario, the Independent Power Producers Society of Ontario, and Hydro Mississauga) was formed soon after the release of the report to press for the implementation of the Advisory Committee’s report.

In August 1997, Ontario Hydro released the findings of an internal review of its nuclear program. The reporting committee, under the chairmanship of Carl Andognini, consolidated analysis of a large number of previously known performance and maintenance deficiencies. The committee (consisting of imported U.S. experts on nuclear-plant rescues) concluded that there were fundamental problems in the nuclear program’s administration. The report recommended the temporary closure of seven of the remaining 19 reactors then in-service. Ontario Hydro’s then president, Dr. Allan Kupsis, resigned in the wake of the report and Mr. Andognini was made responsible for the nuclear division of Ontario Hydro. Public confidence in Ontario Hydro was undermined by the release of the nuclear performance review. Ontario Hydro and other representatives of the Canadian nuclear industry claimed that the "lay-up," as it was called, of seven reactors was not related to safety deficiencies. However, the report was clear in outlining an organization where safety margins had been seriously compromised. Moreover, four of the seven reactors – the four at Pickering A – were closed coincident with the expiry of their federal operating licence. The licence had required upgrades to the antiquated emergency shutdown safety system by December 31, 1997. Ontario Hydro had not made the necessary upgrades to continue to comply with its licence condition. The "lay-up" of the Pickering reactors had clearly been driven by safety considerations.

In November 1997, the Ontario government released a white paper, called "Direction for Change: Charting a Course for Competitive Electricity and Jobs in Ontario", articulating its new electricity policy.⁽³⁾ The white paper was developed internally within government under the authority of Norm Sterling, then Minister of Environment and Energy, with input from the bureaucracy and provincial Tory party. The white paper embraced the concept of competition and adopted most of the proposals of the Advisory Committee on Competition. However, the white paper made two significant departures from the Committee’s recommendations. Whereas the Committee had recommended a separation of the power trading and power system reliability functions – an approach that has been adopted in California and has been implicated in some of the difficulties California has suffered during mid 2000 – the white paper, following the lead of successful jurisdictions like the State of Victoria in Australia, instead directed the formation of the Ontario Independent Electricity Market Operator which consolidates these functions. Another departure was that while the Committee recommended partial privatization of some of Ontario Hydro’s assets as a means to ensure real competition, the white paper stopped short of directing privatization and instead directed the creation of a single generation company with overwhelming market power – Ontario Power Generation. This direction was at odds with other elements of the white paper that supported competition and has proven to be a critical impediment to the development of real competition.

In January 1998, the provincial government established the "Market Design Committee", chaired by U of T Dean of the Faculty of Law, Dr. Ron Daniels, to implement the white paper and to provide recommendations for the design of a competitive electricity market in Ontario. Over its 13-month existence, the Market Design Committee issued four quarterly reports including a partial set of rules defining the new market.⁽⁴⁾

In October 1998, the government proclaimed Bill 35, the Electricity Act, ending the monopoly system for generating and selling electric power in Ontario. The bill was based on the concepts in the white paper and the early work of the Market Design Committee.⁽⁵⁾ Energy Probe’s main criticisms of Bill 35 were that it impaired the independence of the Ontario Energy Board and that it permitted financial irresponsibility in the Hydro successors. These concerns were dismissed by the government but are today among those at the centre of the problems with Ontario’s electricity reforms.

 

Ontario Hydro’s Successors

The passage of Bill 35 created five new entities from the former Ontario Hydro:

Ontario Power Generation (OPG)
Hydro One (H1)
Ontario Independent Electricity Market Operator (IMO)
Electrical Safety Authority (ESA)
Ontario Electrical Finance Corporation (OEFC)

Pursuant to the terms of Bill 35, all of these entities began their legal existence on April 1, 1999.

 

Ontario Power Generation

Ontario Power Generation (OPG) is the owner of all of the former Ontario Hydro’s power generation assets. OPG is a crown-owned company. In July, 2000 OPG announced that it had leased its Bruce nuclear complex to a consortium led by British Energy. After the lease transaction is completed, OPG will control about 65% of Ontario’s power market and all the major generation units that will set market prices. Under the terms of the lease agreement, OPG will maintain access to detailed technical reports on the condition of the Bruce reactors and their potential for power generation. This information may be useful in allowing OPG to continue to manage power prices in Ontario. Although required by the terms of the Market Power Mitigation Agreement to reduce its market share in Ontario, OPG is publicly committed to expansion into new electricity markets. The Ontario government continues to endorse OPG’s expansion, arguing that by keeping OPG big it will be able to "compete in the broader North American electricity market."⁽⁶⁾

Hydro One

Hydro One (H1) is the owner of all of the former Ontario Hydro’s transmission and distribution assets and the vast majority of the former Ontario Hydro’s telecommunication assets as well. Like OPG, H1 is government-owned. Unlike OPG, H1 now has a portion of its debt in the private, unguaranteed market. Protected by a tax holiday which was extended on September 29^th(7), H1 is expanding its distribution business through the acquisition of many municipally-owned distribution utilities.⁽⁸⁾

Independent Market Operator

The IMO is a monopoly charged with maintaining power system reliability and organizing and administering a spot market for electricity.⁽⁹⁾ The IMO’s decision-making powers are vested in its board of directors of up to 16, representing stakeholder interests and "independents". The Ontario Energy Board will review the costs the IMO incurs and the rates it charges to consumers. The largest component of the IMO’s charges will relate to the cost of transmission losses, transmission congestion, and buying specialized electrical services to help maintain reliability.

Ontario Electricity Financial Corporation

The Ontario Electricity Financial Corporation (OEFC) is the legal continuation of the former Ontario Hydro. The OEFC is an agency of the Province of Ontario and is responsible for servicing and retiring the former Ontario Hydro’s provincially guaranteed debt and managing certain other legacy liabilities.⁽¹⁰⁾

Electrical Safety Authority

The Ontario Electrical Safety Authority (ESA) took over responsibility of regulating electrical safety in Ontario, one of the special powers of the old Ontario Hydro. ESA operates as a stand-alone, financially self-sustaining safety business accountable to a board of directors made up of representatives from the electrical industry, the Ministry of Consumer and Commercial Relations, and the public.⁽¹¹⁾

Other key players in Ontario’s power system include the municipal distribution utilities, marketers, independent generators, power suppliers outside of Ontario, and the Ontario Energy Board.

Key Problems with Ontario’s Electricity Restructuring

When Ontario’s electricity restructuring was being guided by the leadership of Maurice Strong, Donald Macdonald and Ron Daniels, a possibility was created to undertake the restructuring in a way that would broadly benefit the public interest. Now, Ontario’s electricity restructuring is degenerating into a liability for consumers, taxpayers, and the environment. None of the problems threatening the ability of the restructuring to benefit the public interest are intractable. All but a few of these problems could have been fixed when they arose — some of them easily fixed. Many of these problems remain fixable although in some cases, time is running out. The future of Ontario’s electricity restructuring hangs on the outcome of these problems.

Several of these problems impair the investment climate in Ontario’s electricity sector.

 

Without a Market Opening Date the Market Can’t Open

Ontario’s electricity restructuring is proceeding right now without an officially announced date for market opening. The previous date of November 2000 was driven by the white paper commitment to open the market in 2000. As preparation for market opening proceeded, it became increasing clear that a 2000 opening would be impossible to achieve while maintaining the integrity of the power system. All parties directly involved with the restructuring process that I am aware of supported the delay of the November date and many breathed a sigh of relief.

Normally, the Minister of Energy would be responsible for announcing the revised date for market opening. However, the Minister has not done so.

The IMO released its Business Plan on Wednesday of this week and it contains an assumption for business planning purposes that the market will open in May 2001.

The Minister of Energy is responsible for a wide range of policy issues that are inextricably linked to the market opening date but remain to be resolved. These must be resolved in some reasonable and timely way before the preparations for market opening can be completed.

One major unresolved issue is how the retail electricity market will function. The IMO is accountable for the functioning of the wholesale market, and although responsibility for the functioning of the retail market could be taken on by the OEB or the Ministry, that assignment has not taken place. A prominent feature of the government’s electricity restructuring as articulated by its white paper has been the commitment to open the retail and wholesale markets together as was done in natural gas in Ontario in the 1980’s. For twenty years, Energy Probe has advocated retail and wholesale electricity competition. We saw the fairness and efficiency benefits in gas. As a result, we were enthusiastic supporters of the white paper on this point. However, with little progress resolving the issues surrounding retail competition, with regret I now believe that for the sake of saving the wholesale competitive market, it is necessary to separate retail and wholesale, opening wholesale in may and the retail market when it is ready.

The government has yet to decided how Ontario Hydro’s power purchase agreements will be renegotiated. Between 1989 and 1993, Ontario Hydro entered into a number of contracts to buy electricity from independent suppliers located in Ontario. Almost all of these contracts had terms of between 20 and 50 years. Taken as a group, the price Ontario Hydro agreed to pay under these contracts is about twice the value of the power today. In April 1999, the government estimated the net present value of the loss on these contracts to be $5.2 billion. It was recognized as early as Maurice Strong’s chairmanship that competitive restructuring would require renegotiations of the power purchase contracts. However, at this time, the Ontario government appears to have no workable plan for how this will be done. The cost impact for consumers and/or taxpayers is not known. The potential for independent power producers to participate in the competitive market is also not known. Because of the diversity of contracts and the fact that many of the independent power projects were project financed by syndicates, this renegotiation is one of the most complex issues the restructuring faces.

Recovery of the losses on power purchase agreements is only one element of the losses to be offset by a special electricity tax called the Debt Reduction Charge. When Ontario Hydro was broken up, it owed more money than it was worth. The move to competition revealed that a portion of the liabilities incurred in the previous monopoly environment, primarily for nuclear costs and power purchase agreements, that cannot be recovered at market prices. These liabilities are usually called "stranded costs" but are more properly referred to as stranded liabilities. The government has yet to decided how the Debt Reduction Charge will be collected.

Moving to competition has caused what might be considered transition costs. As a very rough estimate, these transition costs may be in the order of $500 million dollars. These costs pale beside the Ontario government’s official estimate of Ontario Hydro’s stranded liabilities of approximately $21 billion. About $13 billion of these are supposed to be collected from electricity sector companies in corporate taxes and dividends to government. The remainder of the costs – currently estimated at about $8 billion – are to be recovered through a Debt Reduction Charge that is to be levied on electricity consumed in Ontario. The mechanism for recovery has yet to be determined but watch for large industry to lobby for rules that will ensure that consumption of self-generated power avoids the charge. The Debt Reduction Charge was originally intended to expire in 8 years. However, given the lack of clarity around how the underlying issues will be resolved and the fundamental difficulties associated with finalizing nuclear costs, it seems reasonable to expect that the tax may extend beyond its promised expiry.

The government has yet to decide how tardy market participants essential to the functioning of the new electricity market, like some municipal utilities, will be encouraged to be ready.

With none of these issues being resolved in a timely way, the progress to market opening is impaired. Prospective market participants who do not know what dates they must meet cannot be expected to make complete preparations.

Lack of Financial Accountability

By 1998, the total interest-bearing debt of Ontario Hydro, which was all guaranteed by the Province of Ontario, stood at over $31 billion. One of the main objectives of restructuring Ontario Hydro was to eliminate the exposure to taxpayers for liabilities incurred by Ontario Hydro.

The legal successor of Ontario Hydro, called Ontario Electricity Financial Corporation (OEFC), holds and administers all of the government-guaranteed debt of the group. The public has been told that its role is to collect all excess cash from the operating successors, together with the proceeds of assets sold, and pay down the debt in an orderly fashion, thus reducing and eventually relieving the taxpayers of any risk or obligations related to Ontario Hydro and its successors. In aid of this objective, OEFC is supposed to receive a number of dedicated revenue streams generated from the electricity sector to extinguish its obligations.

Rather than working off the legacy of financial irresponsibility, it appears that OEFC is operating its finances in ways very similar to the old Ontario Hydro. OEFC failed to meet its statutory financial reporting deadline for its first fiscal year. Its first fiscal year ended on March 31, 2000 and according to the Electricity Act, OEFC is required to report within 90 days, which makes the reporting deadline July 1st. No public financial statements have yet been released. Energy Probe has sought an explanation or this deficiency by corresponding with OEFC’s chair six weeks ago but we have yet to receive an answer.

Energy Probe has obtained several financial reports for OEFC. In these reports, it appears that OEFC has experimented with a variety of reporting conventions. However, when consolidated accounts are recreated from the financial results of all of the Hydro successors, it is clear that OEFC is allowing the public exposure to electricity debt to grow significantly.

Instead of reducing the public’s exposure to electricity liabilities OPG and Hydro One are accumulating cash and making large, curious investments.

OPG is investing aggressively in the restart of the Pickering A nuclear station and the installation of pollution control equipment on its coal plants. The company claimed a year ago that the Pickering restart would cost $800 million. It is now widely expected that the restart program cannot be completed for less than $1 billion. When used nuclear plants of more recent vintage than Pickering A are trading sometimes in the range of $33 to $347 per installed kilowatt⁽¹²⁾, it is difficult to grasp OPG’s business case for spending $500 per installed kilowatt at Pickering. OPG announced in September 2000 that it would spend an additional $250 million on cleanup measures at its three coal plants in southern Ontario. The coal investment appears risky given that the cleanup measures will reduce only NOX emissions while increasing emissions of other noxious materials that appear likely to become regulated. I will comment later about how these investments, particularly the prospect of Pickering A’s restart is affecting the entry of generation investment in the competitive market.

Hydro One is the only entity now in the market buying distribution utilities in Ontario. As I will discuss later, there has been a high level of uncertainty about the value of these assets. This uncertainty has caused other parties to retreat from the market. Hydro One’s willingness to invest when others are reluctant has been aided by a special tax holiday it enjoys but also may be based on either knowledge of how policy issues will fall out that the rest of the market does not have or a more relaxed approach toward the disposition of funds.

Although Hydro One has defeased $1 billion of guaranteed debt by borrowing in the private market, the taxpayer is not really better off as our security is now encumbered.

Energy Probe’s analysis indicated that the total third party debt of the Ontario Hydro successor group grew by $1.23 billion in its first fifteen months.

Ontario Finance Minister Ernie Eaves claims a budget surplus for the government’s last fiscal year. We believe that the government’s budget numbers ought to reflect the taxpayer’s increased exposure to Hydro obligations. If that standard is applied, then it appears that the government’s budget was not balanced after all.

 

Click here to continue reading part 2