Thomas Adams

February 3, 1998

Presented at

The Transition to Competition in Electricity: Overcoming New Challenges and Capitalizing on New Opportunities

This presentation focuses on three aspects of the market structure for Ontario’s new electricity sector: generation, dispatch, and distribution. My discussions of generation and distribution also address the policy issues surrounding privatization.

I think that we need to consider the structure of Ontario’s new electricity sector from a perspective that looks beyond the obvious of doing something good in the near term for customers, taxpayers, Ontario’s business climate, and also the natural environment. The exigencies of today–like how to discharge the uneconomic liabilities resulting from Ontario Hydro’s past and ongoing business mistakes, how to get electricity rates down to fair market prices, and how to wrestle monopoly powers away from Ontario Hydro-have a natural tendency to preoccupy our attention. I argue that we need to take a longer term perspective.

If history is our guide, it may be another 80 or 90 years before Ontario gets around to addressing the fundamental structure of its electricity system. Remaking our power system provides us with an historic opportunity to do something that will benefit Ontarians, for generations into the future. I suggest one of the organizing principles we should build into the new system is tight economic feedback loops which ensure that the consequences of actions are visited upon decision makers as quickly as possible. Absence of such loops caused Ontario Hydro’s downfall. Such feedback loops should produce information that can be used to continuously optimize operating decisions and constantly cross-checked the quality of each investment against reality. Energy Probe argues that the combination of privatization and competition for those functions that can be made competitive appears to be the best mechanisms to create a system based on tight feedback loops. There are also important ecological organizing principles that should apply to the new system but addressing them is beyond the scope of this presentation.

To create an economically sustainable structure, the electricity sector must be radically unbundled. I assume that Ontario Hydro will never voluntarily give up its ability to control the factors that sustain it. Rather, I assume that the monopoly will vigorously seek to defend as much of the status quo as possible.

Unbundling Ontario Hydro’s Generating Assets

For advocates of a competitive generation market in Ontario, the White Paper contains both a great disappointment and a great hope. The disappointment was the decision to leave the generation together in one big genco, a decision that has been panned by many, including me. The reasons I am disapprove of the one big genco proposal are that it potentially injures customers and is also a discouragement to potential new entrants to the Ontario electricity commodity market.

Could the new generating company’s market dominance be so great as to present a barrier to entry for prospective competitors in the Ontario electricity marketplace? Potential competitors should be wary of being up against a highly politicized and entrenched state enterprise. Private investors considering generating assets in Ontario can only be discouraged by the prospect that their main competitor will have a hotline to the Premier’s office and may be in a position to flood the market to depress price at some times while withholding supplies at other times to inflate price, all for its own institutional and commercial advantage.

The White Paper argues that there is a regulatory solution to the generating entity’s market power. After decades of experience in many energy regulatory forums, Energy Probe doubts that regulators will be able to reproduce the customer protection benefits of true competition. However, as a short term Bandaid, the government must ensure that the Ontario Energy Board is bolstered to control as best it can the market power of the genco.

The White Paper does contain a seed of hope that this excessive market power can be made to shrink over time. The White Paper is based in part on the sound principle that no participant in the electricity sector should be permitted to borrow with taxpayer-backed loan guarantees. This principle, if applied effectively, can cause an evolution towards effective competition in generation. If Ontario Hydro loses its monopoly and its loan guarantees, its borrowing could become so expensive that it would give the utility a strong incentive to liquidate undervalued assets in order to acquire cash for financing. Withdrawal of the loan guarantee, if the government does it right, is effectively a privatization policy without saying so.

Unfortunately, government officials have indicated that Ontario Hydro will be permitted to "roll over" its existing taxpayer-backed debt with new taxpayer-backed borrowing. I fear that the renewal of these taxpayer guarantees will needlessly delay the onset of fair competition. Furthermore, unless all of Ontario Hydro’s new borrowing is expressly and legally made subordinate to Ontario Hydro’s existing, taxpayer-backed debt-as a second mortgage is subordinate to a first mortgage-all new "unsecured" creditors will receive a de facto taxpayer guarantee on the lion’s share of their investment. Worse yet, Ontario taxpayers will in effect be responsible for losses incurred on future Ontario Hydro investments that are ostensibly made at the risk of unsecured lenders.

The solution has two parts: the Ontario government should immediately cut off all loan guarantees to Ontario Hydro for new borrowing-including borrowing for normal debt renewal or "roll-over"-and the government should ensure that all future Ontario Hydro borrowing is legally subordinate to the existing, taxpayer-backed debt. These steps should effectively prevent any efforts Ontario Hydro or its successors might make to expand or defend market share using taxpayer-backed financing. The White Paper suggests that the loan guarantees will continue to be available to Ontario Hydro until the year 2000. There is no logical reason to wait.

Cutting off the loan guarantee would create an effective discipline over Ontario Hydro’s spending. Cutting off the guarantee is a simple principle, publicly attractive, fiscally responsible, and consistent with Common Sense Revolution. I would suggest that everyone who sees their future in the power business in Ontario but not with Ontario Hydro or the future big genco should be lobbying for the loan guarantee to disappear right away.

Independent Dispatch

Independent dispatch is a necessary but not sufficient condition for a successful competitive power market. The IMO should be set up and made independent as quickly as possible. Until the market operator is made independent, Ontario Hydro’s corporate structure should be changed to make the current CMO as independent as possible. Within Ontario Hydro’s new corporate structure, the reporting relationship whereby the CMO has recently been transferred to be under the control of Ontario Hydro’s Executive Vice President for Development and Transition should be changed. One option would be to revert back to the previous arrangement, whereby the CMO was more independent and reported directly to the Ontario Hydro president (or acting president as is now the case). A superior option would be to have the CMO report directly to the chair of the Market Design Committee (MDC) and therefore to become independent immediately.

A challenge for the MDC will be to steer the IMO through a minefield of potentially distracting, initiative-sapping debates. Having observed the WEPEX process from a distance with dismay, a particular concern of mine is an unnecessary battle over the dispatch approach to use. Without good guidance from the MDC, we could see a bitter debate between the advocates of a physical spot market operated by the IMO and a market based on pure bilateral transactions without the IMO having pricing information to guide its short run decision making. Energy Probe recommends a voluntary spot market with a generation and transmission scheduling arrangement for those opting out. With such a dual market system, producers and consumers could discover for themselves whether they benefit from load balancing through a physical spot market or not. There is no reason the system operator should not schedule physical bilateral transactions for some parties without any knowledge of their short run opportunity costs, as long as it also provides the option of an efficient spot market for parties that wish it. As much as possible, the market should decide what trading systems to use. The dual market Energy Probe is recommending for Ontario, is now being examined in the UK(1), and is recommended by leading advocates from both sides of the so-called "poolco vs. bilaterals" debate in the U.S., William Hogan and Richard Tabors. Energy Probe has attempted to use the Technical Advisory Team (TAT) process-where we are the sole public-interest participant-to promote the dual market approach but we have found that the TAT process is not the appropriate forum for such decisions to be made.

The Future of Local Distribution: The "Pure Utility Model"

Among the many impressive statements in the White Paper is the policy of separating the naturally competitive from the naturally monopoly.

If we apply this concept rigorously and exhaustively to local distribution companies, where do we arrive? As a thought experiment, think of taking a distribution utility apart according to its essential functions. Building lines, managing tree growth near lines, washing insulators, and fixing lines when they are damaged: all of these are naturally competitive activities. Reading meters and performing customer accounting are also naturally competitive. Bill collection is naturally competitive. Selecting and installing meters is not even a proper job for utilities-rather it should be the business of consumers and marketers, with a government inspector checking up on their work. Even planning the construction of line can be done competitively. Privatization of important elements of the ultimate costs to consumers for distribution services while leaving the municipal utilities in public hands could be achieved by contracting out

If we keep applying this logic, I think we get down to one rarified residual monopoly once all the potentially competitive services are removed. That monopoly is the capital embedded in the lines. That is the "pure utility".

Many municipal utilities in Ontario see themselves in the new world as potential producers or buyers and sellers of commodity electricity. For historical reasons, some already do produce power. Others, seeing the high costs they are charged for power by Ontario Hydro, know they could do better. Although I am sympathetic to municipal utilities with ambitions to beat Ontario Hydro’s price, in a world of open competition, I think existing municipal generation interests should be privatized and distributors prevented from taking an interest in generation.

Buying and selling or generating and selling commodity electricity are inherently competitive businesses, and, in an open market, potentially risky ones too. Municipal utilities do not have properly accountable decision making structures to undertake these risks. Customers will take it in the neck for any mistakes their utilities commit. Distribution utilities will be in a conflict of interest in their roles as common carriers if they also have an interest in the commodity market.

Unbundling is just another bit of jargon utilities and their observers have fastened on to articulate some old fashion wisdom. This wisdom Robert Frost expressed best when he wrote, "Good fences make good neighbours." One neighbour owns the wires and the other neighbours use them. If each keeps to their place they should get along well.

Thank you.

1. 0On 5 November 1997, the UK Office of Electricity Regulation issued a "Review of Electricity Trading Arrangements" that includes a review of a potential dual market.