Jennifer Wells
Report on Business
June 1, 1999

Why did Mike Harris take a pass on his biggest privatization candidate – Ontario Hydro, the country’s largest electrical utility?

When Mike Harris strode to the apex of Ontario political power that summer of 1995, the agenda, as it was, was crystal clear. Centrally directed economies: bad. Turbo capitalism: good. The ideology was textbook – an affectless pursuit of deficit-slashing and ledger-balancing; the reduction of the high cost of government not just by paring services, but by swapping public debt for private equity.

There were targets eyed and pledges made. Example: In the Common Sense Revolution, his no-nonsense campaign platform, Harris plainly stated that the province’s Liquor Control Board would be privatized. End of story.

The privatization agenda would bring benefits in more ways than one. Reduced debt would mean, ultimately, taxpayer relief. Opening up public industry to private competition, creating what economists call an atomistic marketplace, would herald increased consumer choice and, perforce, lower prices. Win-win.

On the list of privatization candidates, there was none bigger, none mightier, than Ontario Hydro. The largest electrical utility in the country. The largest industrial in the country. A company with $44 billion in assets. Total revenues in fiscal ’94: $8.7 billion. Cash flow: $2.2 billion, which sounds rich, if only it weren’t for the $33 billion in government-guaranteed debt, which was costing the utility, let’s see, roughly $404,566 an hour to service.

In his pre-electioneering days, Harris had given a speech to the Independent Power Producers’ Society of Ontario. He pledged "expanded opportunities for private-sector co-generation along with open competition in power generation, transmission and retailing." Privatization was, as far as the business community was concerned, part of the mandate. A "fundamental restructuring," said Harris, was on its way. Bonus: The beginnings of an intense shakeup of the 90-year-old monopoly, including the reduction of staffing levels by more than 8,000 or so bodies and a $3.6-billion restructuring charge, had already been commenced by the predecessor NDP government under Hydro chairman Maurice Strong, who himself had said the utility must privatize or sink.

So, here we sit four years later, Harris having been given every opportunity to haul government out of Hydro. Instead, he took a pass. How come? Why did he fail the free-enterprise test?

The beginnings were so propitious. A mere month after Harris moved into the Premier’s office, his very good friend Bill Farlinger, the former chairman of accounting firm Ernst & Young and one of the key power brokers behind the Harris ascension, submitted a report that concluded Hydro should be privatized – fast. The report, commissioned by Strong, advocated not only privatization, but privatization of all Hydro’s assets, including nuclear. In the Common Sense Revolution, Harris had excluded nuclear from his privatization thinking. Now Farlinger was saying the "investment fraternity" was giving the green light to the entire slate of Hydro assets. Farlinger warned that if the government failed to move quickly, industrial electricity users, who had seen prices rise by 40% from the start of the decade, could either decamp or self-generate using nifty, relatively new gas turbine technology. The status quo, in which Hydro serviced 86% of the province’s electricity needs, would have to be broken.

In early November, now five months into the job, Harris did two things. He appointed Farlinger Hydro’s chairman, which, optically, ensured that privatization was in Hydro’s future, and he commissioned former federal Liberal energy minister Donald Macdonald to lead the Advisory Committee on Competition in Ontario’s Electricity System. The government wanted competition, it said, it just wasn’t sure how to get there. In working up a recipe, Harris asked the committee to keep an eye on the obvious: financial soundness and affordable electricity rates.

Macdonald and his six-member committee produced their 162-page report, A Framework for Competition, in May, 1996, which they promptly put before the province’s Ministry of Environment and Energy. The committee was precise in its recommendations: that the utility’s monopoly in electricity generation be eliminated, and that non-nuclear generating assets be separated into distinct operating entities and opened up to private equity investment. The committee advised that Hydro’s Niagara River assets, the hydroelectric beginnings of the company, be excluded, a prudent view given the thunderous historic significance of the Falls. As for nuclear, the Macdonald committee veered from Farlinger’s position in recommending that these generating assets be hived off into four companies, but maintained under public ownership.

The report’s main message was not open to interpretation. The generating facilities must, it said, "be sufficiently separated to prevent any one company, or any group of companies acting together, from being able to exercise undue market power."

Months passed. So many months passed after the Macdonald submission that a number of interest groups, including the Association of Major Power Consumers in Ontario (AMPCO) and the Alliance of Manufacturers & Exporters Canada, came together to form a stakeholders’ alliance to address what appeared to be an unseemly delay in the formulation of a government response. "We were concerned that an opportunity was going to be missed," says AMPCO president Arthur Dickinson. AMPCO’s membership – big industrial users such as Stelco and Falconbridge – takes up roughly 15% of Hydro’s annual electricity load, for which members pay more than $1 billion in total. "We felt it [the report] was very much along the lines of our own views as to how the restructuring of Hydro should proceed," says Dickinson. Bottom line, he says, is that his members anticipated that the private sector moving in would see electricity prices moving down by 10% or more.

It was, however, yet another report, this one by U.S. nuclear expert Carl Andognini, that caught the public’s attention in the summer of 1997. Andognini had been retained to provide a "brutally honest" assessment of Ontario Hydro Nuclear. In volume after volume, the woes of the province’s nuclear program were grimly documented. The reactors were chronic underperformers, everyone knew that, and it had long been suspected that the Candus couldn’t hope to achieve their 40-year life expectancy.

Now taxpayers heard how safety standards had been compromised and of managers who lacked "basic management and leadership skills." The report was littered with such hot-button phrases as "uncontrolled contaminated material" and "excessive human error rate." Bill Farlinger said that when he looked inside Nuclear he saw "some sort of special nuclear cult." Seven of the province’s 19 Candu reactors would be laid up as a result of the investigation, said Farlinger. And the problems that could be fixed would, he said, cost somewhere between $5 billion and $8 billion. There was no longer even the slightest hope that Hydro had an ounce of political capital left.

It would have seemed an opportune time for the government to make its intentions for Hydro known. Yet it wasn’t until November, 1997, that the government’s formal response to Macdonald’s efforts came clear when it tabled its white paper, the next big step toward competition and a precursor to Bill 35, the province’s new Energy Competition Act. The white paper veered from the Macdonald committee’s recommendations in just a couple of areas. But one was a whopper. While the monopoly’s generating assets would be separated from transmission and distribution – a move that was favoured by Macdonald et al. – it also said there would be no breakup within generation. The core of the company would remain, instead, a single, Crown-owned entity – nuclear, fossil, hydroelectric, the works.

Some observers were surprised, including, particularly, Donald Macdonald. Whatever happened? He posits the "demon in the works theory," that Hydro is so big, so self-perpetuating, so bureaucratic that the forces for progress were utterly co-opted. Still, he’s puzzled, he says, that a government that could have achieved the dual objectives of debt reduction and competition would just drive off the road the way it did. "What I don’t understand ideologically is why Harris wasn’t prepared to go for sale," he says. At a minimum, he says, the government could have put some assets – the Ottawa River dams, for example – on the market.

Instead, the government left the task of figuring out how to inject competition into an uncompetitive model to yet another group, this one called the Market Design Committee (MDC), a 14-member stakeholder panel appointed by the provincial Ministry of Energy. "One of the walls we came up against," says Tom Adams, executive director of Energy Probe, who sat on the MDC, "was it’s hard to make competition when one party, one player, will have about 80% of the market….The MDC found itself unable to fully develop competition and the rules for competition because of this structural problem."

The committee complained. The committee whined. It sought alternative policy wording. "The government," says Adams, "was just not going to be finessed on this thing. They were committed to the white paper." Why? "That," says Adams, "is one of the riddles in all of this." Was it the impenetrability of the Hydro bureaucracy, as Macdonald would have it? Was the Harris team taken off the free-enterprise path by a small, impermeable cluster of insiders?

Sean Conway, the Liberal energy critic in the last parliament, says there was a "consensus for change" in the legislature. Speaking from the current election campaign trail, he says the Harris electricity policy is a paradox. "On the one hand, they talked about competition in generation and the benefits it could deliver, yet they’ve absolutely refused to break up the Ontario Hydro monopoly."

In the end, Adams says Ontarians were dragged through a "slow, fitful" process toward depoliticizing the province’s energy sector. The AMPCOs of the province were, let’s say, displeased. "It undermines the whole notion of the competitive marketplace," says Arthur Dickinson.

It was into this rather abstract construct that Ron Osborne, freshly departed from Bell Canada, arrived on March 1, 1998. An accountant by trade, Osborne is a Brit best known for his leadership of Maclean Hunter – the publishing and cable company – and for his feisty attempt to foil a takeover by Ted Rogers. From MH, Osborne moved to BCE Inc., then to the helm of its Bell subsidiary, which, having been shaken from its own monopoly, was chewing through CEOs like a beaver through timber. Osborne put in five months.

Last June, three months after Osborne arrived at Hydro, Bill 35 was introduced. The die was cast. It fell to Osborne to oversee the bifurcation of Hydro’s assets: transmission from generation. "The government’s mind was made up," he says. His job was to implement the white paper.

Throughout the months that followed, he says, the issue of busting up the generating assets was revisited constantly. Osborne presents his argument for why the free marketers should not have their way: that there’s a major reallocation of generating assets going on in deregulated American markets, that some players are accumulating "large gobs of assets," that if Hydro were made small, it would lose. "Those assets will all migrate into the hands of the big guys and gals in this business….Quicker rather than more slowly in my view. And Ontario would end up with all its generating assets owned by non-Ontario-based companies." According to Osborne’s handler, he has a favourite saying: Eat somebody’s lunch or you are lunch.

"It seems to me that Mr. Osborne is thinking more in terms of [Hydro generation] than what is good for the customer," says Arthur Dickinson tartly. Osborne’s attitudes are, he says, "Neanderthal" and fail to address what was supposed to be the central issue: "How do we create a competitive electricity market that will benefit customers?"

It was up to the Market Design Committee to set some sort of framework for competition, staying within the restrictions of the white paper. Tom Adams calls the result, dubbed the Market Power Mitigation Agreement, one Band-Aid in a pile of Band-Aids. Under the agreement, Osborne must divest 4,000 megawatts of generating capacity within 42 months of the market being opened for competition, which is expected some time next year. Within 10 years, the generating capacity must be chopped by 15,000 megawatts, which means going from 86% of the market to 35%. The committee calls it "decontrol." How that’s achieved currently appears to be anyone’s guess.

Osborne talks of joint ventures and asset swaps and arrangements by which his company cedes operating control of a plant but retains ownership, thereby meeting the mitigation test. He says he wants to aggressively grow a North American base, particularly into the Northeast and Midwest, from an Ontario stronghold. "To be a major player in generation in the long term." The alternative is simply to watch capacity get chopped by more than half. "That’s not much of a game plan," he says. "You can’t expect people to invest in that plan. Who is going to invest in a company whose modus operandi is diminution?"

It still means that as of today, Osborne’s running a mammoth command-and-control monopoly, precisely the opposite objective that Harris said he was pursuing in 1995. And this "decontrol" business isn’t satisfying the private enterprisers. "That’s forever in the business world," says AMPCO’s Dickinson of the 10-year horizon. Says Osborne: "It is long enough in business terms, in commercial terms, to figure out what your strategy is."

Osborne can, easily enough, see what hasn’t worked. In California, which opened itself up to competition last year, the market model was so preferential to existing utilities that virtually no outside operators dared venture in, a circumstance that echoes for Sean Conway what may happen in Ontario. "By leaving all these generating assets all together, we are really impairing the competitive market in Ontario," says Conway, "and that’s a purely political choice."

Yet it gets to operate under the guise of a commercial enterprise. On April 1, Hydro was officially splintered into five successor companies. Two of these will be capitally structured corporations. The first, Osborne’s generating company, becomes Ontario Power Generation Inc., or Genco. The transmission and distribution assets – the wires – are being run separately as Ontario Hydro Services Co., or Servco, run by Eleanor Clitheroe, Hydro’s former chief financial officer. Additionally, the Ontario Electricity Financial Corp. will service and retire the provincially guaranteed debt of the former Hydro. In the case of Servco, by example, the $4.8 billion in debt assigned to the company exists in the form of promissory notes. Some time this year, Clitheroe intends to start a market-financing program, floating debt to the public and thereby refinancing those promissory notes with the financial corporation for Servco’s share of the debt.

Overseeing Servco and Genco is the Independent Electricity Market Operator, mandated to ensure fair and open market access. Lastly, the Electrical Safety Authority will oversee the installation and inspection of electrical equipment.

Osborne says his growth plan for Genco means that Ontario can "have its cake and eat it." What it looks like currently is that Genco can do just that, for while still ruling the market, its commercial status allows it to duck the Freedom of Information requirements that it was compelled to cede to as a Crown corporation. "You can’t find out what’s going on any more," complains Arthur Dickinson. "It’s like sitting in a card game and you find you’ve got a set of jokers in your hand."

In Osborne’s hand are assets valued at $8.5 billion. The debt apportioned to Genco that must be repaid to the Ontario Electricity Financial Corp. is $3.4 billion. Clitheroe’s wires company weighs in at $8.6 billion on the asset side, with the aforementioned repayment liability of OEFC of $4.8 billion. OEFC has on its books liabilities of $38.1 billion. Subtract from that the $8.2 billion to be repaid by generating and services, and another $8.9 billion to be serviced by the province, and the whole ball of wax deposits a "stranded" debt – that is, stuck with the taxpayer – of $20.9 billion. Of that, $7.8 billion is deemed "residual." That means that even if the revenue streams meet the projected targets, close to $8 billion is unaccounted for and may have to be covered by what the utility calls a Competition Transition Charge, but what its critics prefer to call a rate hike.

Myron Gordon, professor emeritus of finance at the University of Toronto, has been energetically critical of the way in which the numbers have been crunched. He says the asset valuation, particularly for Genco, is absurdly low. Gordon has repeatedly made the argument that a fair-market asset valuation for Genco, based on high performance assumptions for the Candus and a higher valuation for the Niagara Falls assets, is actually closer to $40 billion.

Gordon is no crank. The past president of the American Finance Association, he developed a financial model for determining fair profit rates for public utilities, the use of which has been mandated in the U.S. by the Federal Energy Regulatory Commission. "My suspicion is that he is simply not au fait on all the details," says Osborne of Gordon’s numbers. "At the end of the day, the valuations and the debt allocations were made by the province based on the advice they got from their advisers."

Does it matter? It does, says Gordon, if you believe that the people of Ontario will reap less for the publicly supported assets than is their due. Gordon doesn’t believe that Hydro, or whatever it’s called – certainly the new monikers don’t appear to have much brand-name potential – should be splintered at all. He thinks that with low interest rates and refurbished nuclear plants and the financial picture on the upswing – Hydro turned a $1.8-billion profit last year – taxpayers should stick with the monopoly they’ve got. "This," says Gordon, "is a gold mine."

Harris and his crew, of course, would have expected such views. What’s unexpected is that the utility is neither being kept whole as the monopolists would prefer nor thrust into a market model. What it has become is still not clear. "It’s one thing to be cautious," says Donald Macdonald. "It’s another to fail to be clear in where you want to go." And that, he says, is what it looks like at the moment.

Osborne cheerily cruises a series of nautical metaphors in response to a query of where exactly he’s headed. "Just set sail…not even out of the harbour yet….We’ve just cut the rope at the dock….We’re just about to see where the winds are."

It’s not at all clear that Genco has the skill sets to navigate this. As for Servco, there are rumours on what Macdonald calls the "bush telegraph" that Clitheroe’s on the hunt for acquisitions, again not what the competition crowd had in mind. "There’s the demon again," says Macdonald.

Ron Osborne knows there are expectations. "At the end of the piece, what the public needs to know and be satisfied about is that there is true competition, true choice." That is what Mike Harris promised four years ago. Four years later Ontarians are still waiting.