Thomas Adams
Energy Analects
December 5, 1997

The Ontario Government’s new White Paper, Direction for Change: Charting a Course for Competitive Electricity and Jobs in Ontario, is a marvellous achievement that if properly implemented will help cap liabilities against the public purse, lower electricity prices, and promote productive investment to the power sector. To guide the work that needs to be done to implement this vision, Ontario would do well to follow the successful approach to power reform used by the State of Victoria in Australia.

The keystones of Ontario’s new electricity policy are:

• Customers, regardless of size, will be able to choose their power supplier in 2000.
• Ontario Hydro’s monopoly and competitive enterprises will be separated. Ontario will split the utility into three government-owned companies – two commercially oriented companies to hold its generating assets and its transmission and rural distribution operations and a third, non-profit Crown corporation to independently manage the transmission grid to allow non-discriminatory access for producers and consumers. Rates for transmission and distribution services will be independently regulated.
• Power generating companies will compete for business.
• Current subsidies to the public power sector — taxpayer-backed loan guarantees, tax holidays and permanent dividend holidays — will end, thereby levelling the field with the likes of gas utilities, independent power producers, and energy conservation service providers.

For all its strengths, the White Paper on its own still doesn’t provide enough assurance for developers of competitive alternatives to Ontario Hydro to make investment decisions. To break the dam on investment, the government will have to bring in legislation that inspires the confidence of financial decision makers.

So far, the financial community has remained suspiciously silent in response to Hydro Chairman Bill Farlinger’s assertions that the value of Ontario Hydro is maximized by keeping the assets bundled together. One wonders where the analysts are hiding who in recent weeks have praised the corporate unbundling of NOVA Corporation and Noranda Inc. The logic behind the NOVA and Noranda breakups applies with even greater force to Ontario Hydro.

With the government now committed to taking the uneconomic portion of Ontario Hydro’s liabilities off the books of its successor companies, the financial incentive for those inside the utility now is to maximize the flow of cash into the productive assets regardless of liabilities incurred. Ontario Hydro’s "revelation" in August that its nuclear plants were in trouble was not just a statement of the obvious but a scheme to secure a cash infusion. In light of the White Paper, which Ontario Hydro would have known about in August, the Nuclear Asset Optimization Plan (NAOP) looks like an effort to grab more public cash while it is still available. Effectively, NAOP is a request for incremental public investment in nuclear power, starting with $1.6 billion. If NAOP is approved, Ontario Hydro’s ability to hang on to market share improves; if it is ultimately turned down, the utility is left in the position it was in prior to August with seven reactors not worth operating and 12 others hurting for maintenance. The only sensible way to determine whether more nuclear investment should be committed is to let willing investors decide. Much to its credit, Ontario Hydro’s main union, the Power Workers Union, has proposed a form of nuclear repair investment privatization.

The White Paper’s commitment to stop guaranteeing new debt is one of its highlights. The pernicious effect of the loan guarantees, as an effective subsidy to risk, is a key cause of the collapse of Ontario’s electricity system. Unfortunately, Ministry of Finance officials, who should be on top of the loan guarantee issue, indicated at the press conference launching the White Paper that they had not considered whether the unguaranteed debt would be preferred to guaranteed debt, whether the entitlements of holders of both types of debt would be pooled, or whether unguaranteed debt ought to be subordinate to guaranteed debt.

Another issue that Finance officials had not decided was whether roll-over borrowings would be guaranteed. In order to protect Ontario taxpayers now holding the bag for Ontario Hydro’s mistakes, all debt issued by Ontario Hydro or its remnants starting immediately should be unguaranteed and subordinate to existing debt. Taxpayers should not be forced to continue as involuntary investors by cosigning for such a suspect enterprise.

The market power of one big generator created out of Ontario Hydro is a weakness in the government’s approach. Despite the assertion in the paper that there were "extensive discussions" with stakeholders over the decision to leave all Ontario Hydro’s generation together, all the major non-Ontario Hydro and non-union stakeholders have complained about this point.

The Toronto Star editorial board has taken the astonishing position that Ontario Hydro just needs more time to work out its problems before competition is introduced. If the Toronto Star’s editorial position is based on anything more than reactionary support for the Hydro status quo, the editorialist must believe that Ontario Hydro has turned the corner and is on the road to recovery. On the contrary, there is every indication that Ontario Hydro will have grave difficulty keeping the lights on this winter, that supply security may weaken further next summer and next winter, and that the financial writeoffs we have seen in the last four years — $5.03 billion net of profits — are just the beginning.

Power Reform Down Under Shows the Way for Ontario

The experience with power sector reform in Victoria provides three key lessons for Ontario in implementing the White Paper. Whereas the White Paper is mum on privatization in Ontario, privatization in Victoria was the key that unlocked billions of dollars in value hidden in the power system. Ontario will need to maximize every value that exists in our system to offset the monumental liabilities our Ontario Hydro has rung up. Second, while the Ontario government opted to leave all Ontario Hydro’s generation in one enterprise, privatization in Victoria was a successful device to break the market power of producers and lower rates. Third, the reform process in Victoria provides a good outline of how to keep the reform process on track and above the heads of the interest groups that will seek to divert or obstruct implemention of the government’s principles.

There are many close parallels between the condition of the power system in Victoria prior to the reforms and prevailing conditions in Ontario.

In 1992 the economic situation in Victoria was in crisis: A left of centre Labour government ran up state debt to the highest per capita level of any state in Australia. In 1991, the Labour government was forced to partially privatize a half-built 1 000 megawatt station (Loy Yang B) in order to introduce better labour practices, deal with cost overruns and to relieve pressure on the state’s borrowings. Power prices were rising. The State Electricity Corporation of Victoria (SECV), like Ontario Hydro, was mismanaged, operated in an environment of secrecy, and lacked accountability.

A new Conservative government was elected in 1992 and among its policies to arrest the economic decline of the state, it decided to completely restructure and privatize the electricity industry.

The model was similar to that proposed by the government of Ontario: an independent system operator responsible for operating the wholesale electricity market; separation of generation, transmission, distribution; creation of retail supply as a competitive sector, ringfenced away from the monopoly distribution businesses; amalgamation of inefficiently small local distribution businesses; phased introduction of customer choice with full access for domestic customers by Jan. 1, 2001; establishment of franchise fees and a small energy levy to recover stranded costs and pay down debt; creation of an independent economic regulator; and integration of the competitive state market with competitive markets being established in neighbouring states.

But Victoria went further in two key areas: the generation sector was split to create the maximum achievable amount of competition; and the whole sector was privatized as an integral part of the restructuring process.

The reform process was completed remarkably quickly. The reform design was announced at the beginning of 1994; the creation of the new entities was completed in mid 1994; the wholesale market also commenced operation in mid 1994; the privatization process commenced in mid 1995 with all the distribution businesses sold in the second half of 1995. All the generators (except one small gas generation business) and the transmission grid were sold during 1996 and 1997. A long term contract with Loy Yang B was restructured to bring this company into the competitive market. The first step into a national electricity market was implemented in May 1997 and this has been successfully operating for the past seven months.

The results have been impressive. Privatization has unlocked previously hidden value: In excess of $21 billion ($Aus) in value will be achieved from the complete privatization programme. This has been significantly in excess of estimates prior to privatization and compares favourably to a book value of $10.5 Billion in 1994 and SECV’s debt of $9.5 billion. The Auditor General reports that savings from debt retirement exceeded the dividends and other revenues foregone by the state by $718 million in 1997/98.

Several factors led to the high privatization values achieved. The decision to open the market to off-shore bidders created a much more active bidding process than otherwise would have existed. Disaggregation of the generators has increased value by creating entities small enough that many Australian and overseas companies could bid for them. This resulted in a highly competitive sales process. Other significant factors contributing the privatization success were a predictable and stable regulatory environment for the monopoly transmission and distribution assets; a favourable interest rate and bank lending environment; and a willingness by both foreign and domestic purchasers to pay premiums to gain experience in a highly competitive environment.

Victoria’s electricity supply situation today is strong. The newly privatized generators have effectively increased the capacity of the existing stations by over eight per cent through reliability improvements. The result has been falling prices. While prices are expected to rise towards the cost of new entry generation (currently estimated at $39 per megawatt-hour), wholesale electricity prices now are in the region of $22 per megawatt-hour, while spot prices in the pool have recently averaged as low as $10. Despite these falling prices, there is strong competition from the private sector to build new capacity which initially are expected to be highly-efficient gas cogeneration plants.

Prices to consumers are falling. Domestic tariffs are to drop by nine per cent in real terms between 1996 and 2001 before these customers are allowed into the competitive marketplace. Small business tariffs will fall by 22% between 1996.

Victoria’s experience is almost universally viewed as a huge success. Other states and the National Electricity Market Company are using the Victoria model as the basis for their systems.

Establishing a competitive and properly regulated electricity system while facing up to and managing the system security, safety and financial problems with Ontario Hydro is a huge and complex undertaking. There are insufficient skills and experience presently within the sector necessary to operate in a competitive market. The technical expertise is locked up within Ontario Hydro. Inevitably, vested interests will try to influence the process for their own benefit. Ontario cannot afford to undergo a protracted reform process with outcomes driven by vested interests rather then the interest of the entire province.

Victoria’s reform process proved the value of strong independent leadership responsible for careful, objective analysis. It also proved the value of extensive consultation within the sector on the detailed design of the reforms. The views of the world’s leading consultants were sought while expertise within the SECV was harnessed to further the objectives of the government. In Victoria, management of the reform process was undertaken within a single government agency which contracted with expert consultants who were required to complete the restructuring within a limited time period and in accordance with the government’s objectives. Ontario should do the same.

(Tom Adams is a consultant with Borealis Energy Research Associates, a principal client of which is the environmental organization Energy Probe, which Mr. Adams represents as executive director.)