Energy #21 – Guelph Hydro: Fifteen Claims

Since my article on November 5th analysing aspects of the Guelph Hydro Alectra merger, a number of readers in Guelph have asked me to look at the transaction further, particularly in light of the lengthy report tabled December 1st to Guelph City Council.

The best way to do that is to look at the actual agreements.  That way the information is clear and precise, and is not filtered by the perspectives of those providing the information.

I asked the Mayor, the CAO, Guelph Hydro and Alectra for the agreements, but was told by Guelph Hydro CEO Pankaj Sardana (who was apparently designated to respond on everyone’s behalf) that the agreements are not final, and so cannot be shared.  I believe they have, however, been circulated to the Guelph Hydro and Alectra boards of directors, to City Council, and others, so they can’t be that confidential (40-60 people have probably seen them by now).

Further, under OEB rules they will have to be made public when OEB approval is sought, although of course by then they will be signed, and Guelph will be legally obligated to complete the deal.  Public disclosure at that point doesn’t really help anyone.

It thus appears that the primary reason to withhold public disclosure now must be so that the public doesn’t have all of the details of the transaction.

That is unfortunate, but it is what it is.  I will have to provide my commentary based on the report to City Council.

That report comes from a specific, pro-merger perspective.  For example, the Guelph Hydro lawyers providing the legal analysis are the same firm that represented Alectra in their merger application before the Ontario Energy Board.  While I’m sure they are trying to be objective (and they are a good firm that I know well), they have an obvious point of view.  No matter how well they may eliminate their bias in fact, it is pretty difficult for them to remove the perception of non-objectivity.

The commentary below takes several of the claims in the report to City Council, fifteen in all, and assesses how they match up with the facts.

I repeat my earlier comment that I do not have an opinion on this transaction.  This article is intended to provide information and analysis, but any interpretation that suggests I think the transaction is good, or not good, would be incorrect.  I strongly believe that it is the residents of Guelph whose opinion matters.  My opinion – even if I had one – does not.

Claim #1:  A merger between Guelph Hydro and Alectra is better for Guelph residents in the long term than Guelph Hydro remaining a standalone utility.

This claim is likely to be correct.

However, it is also highly problematic, because this comparison asks the wrong question.

Guelph Hydro as a standalone utility is probably not a viable long-term option.  As the electricity distribution sector expands and becomes more complex, smaller distributors will have a hard time keeping up.  Further, they will have a hard time recruiting the best people, which will put them even more behind the curve. In these respects, the discussion of “Utility 2.0” in the report and attachments is largely accurate.  We are entering a period of change.

Guelph Hydro is big enough to be a very good utility today.  As expectations on, and challenges facing, distributors increase in the next decade or so, Guelph Hydro will probably be at a disadvantage unless it increases in size through merger or acquisition.

This means that comparing any merger proposal to the standalone option starts out stacked in favour of the merger.  Size is going to matter.  Standalone is effectively a straw man.  It is not going to happen.

The fair comparison would be a merger with Alectra vs. a merger with Cambridge or Kitchener or Waterloo or Milton or Halton Hills or Oakville or Burlington, or even several of them.  The problem is that the residents of Guelph don’t know whether those possibilities were considered and, if so, what stood in the way of reaching agreement on any of those potential merger directions.

Without that information, it is impossible to know whether the Alectra merger is better than other  viable alternatives.  The public doesn’t know what other alternatives were available, and/or considered.  (It’s a secret.  Largely for legitimate reasons, but it’s still a secret.)

The only comparison given is to an option that is not viable.  Take this deal, or die.  That is not really useful.

Claim #2:  “Guelph Hydro will pay the City a special dividend of $18.5 million immediately prior to closing, without adversely affecting its regular annual dividend.”

The implication is that this is a benefit from the transaction.  It is not.

The “special dividend” has to be paid to adjust the debt equity ratio of Guelph Hydro to roughly 60/40, the standard for Ontario distributors.  Guelph Hydro is currently managed conservatively, and so is underleveraged.  It doesn’t need a merger to pay $18.5 million out to the City, thus increasing Guelph Hydro debt and decreasing equity.  It could do that today.  The effect would in all respects be exactly the same.

It is called a dividend only because that is the legal form that is used to effect the change.  It is not like a normal annual share of profits.  It is a catch up of prior year profits that have been left in the company and accumulated as equity.  It is not coming from Alectra.  It is coming from Guelph Hydro’ cash on hand, which at the end of 2016 was $22 million.

Where the analysis by the advisors says “Guelph is better off financially under a merger with Alectra  than on a standalone basis with ~$29 in additional cash through closing adjustments and dividends”, that is just bad math.  The $18.5 million dividend is not an improvement in the City’s financial position, and the $10.1 million in extra future dividends (see below) is speculative at best.

The City is not better off initially under this transaction.  That is just not correct.

Claim #3:  “Dividends are projected to exceed dividends under the “maintain full ownership” option by $10.1 million.”

It is not possible to confirm this.

Past dividends by Guelph Hydro to the City have been $3 million per year, and there is no reason to think that would end.  Based on current estimates of Alectra combined income, a 4.63% ownership by Guelph, and 60% payout, dividends look to be about $2.2 million per year to Guelph in the short run.

Without the backup calculations for the $10.1 million figure, it is not really possible to get to anything like that on the basis of public information.

Claim #4:  “GMHI will receive one permanent seat on Alectra’s board, and will have the right to appoint an independent director.”

This is correct, but it is important to understand what it means.  It is one, not two.

Guelph will appoint one member on the 13-member Alectra board.  It cannot be a councillor or the Mayor.  It must be an independent, and it is one person.

Further, it is important to note that the Alectra board doesn’t have the same close oversight of management as is currently the case with the Guelph Hydro board.  For example, Alectra is right now before the Ontario Energy Board seeking a 2018 rate increase of 1.3% to 4.2%, depending on rate class.  That request was not approved by the Alectra board.  That decision – what rates to request – has been delegated to Alectra management.

There is no information on whether the executive management team of Alectra will include anyone from Guelph.  I suspect it will not.

Claim #5:  “There are important restrictions on transferring shares, and therefore indirectly on privatization, in the USA.”

Assuming the new USA (unanimous shareholders’ agreement) is substantially the same as the existing one, this statement is correct.  Any significant minority of shareholders can block or slow down any process of privatization of Alectra.  (Some of the details of this agreement remain confidential, even today, but for good reasons.)

It is also true that some of the municipalities that own shares of Alectra are currently opposed to selling shares to the private sector.  Alectra has a small percentage of shares already held by an investment bank, for the OMERS pension plan, and some shareholders don’t want that non-municipal ownership increased.

There will, however, be strong pressure to privatize or partially privatize in order to monetize the value of the shares of Alectra.  At some point, high priced offers will be made by companies like Enbridge, and EPCOR, and others.  It is not reasonable to expect that Alectra – or any other distributor, merged or standalone – will remain municipally-controlled forever.

Claim #6:  “Rate increases are projected to be more moderate than they would be under the “maintain full ownership” scenario.”

This is probably not true.

As I have noted in my previous article, Guelph Hydro has a better record of controlling rate increases than Alectra does, and that goes back many years.

That is likely to continue into the future.  In their merger application, Alectra filed a forecast showing expected rate increases over the ten year “sitout” period of an average 1.74% per year (Exhibit JTC1.3 in that proceeding, for those keeping score).  That included a first year increase of 2.79%.

Alectra’s actual application for their first year rate increase is now in, and it is very close to that, an average of 2.84% for the three general service classes (residential, small business, and commercial/industrial).  Some of this is based on a predetermined formula which they can’t change, and the rest is extra money they have requested for additional spending they want approved. These new rates are not yet approved, but Alectra is pressing hard.

(I have excluded Horizon, because they are required to reduce their rates in 2018 due to an agreement reached with customers in 2014).

Guelph Hydro has also applied for 2018 rates, using the same formula.  Their average distribution rate increase will be 0.23%.  The reason is that, while they used the same formula as Alectra, they didn’t ask for any extra money.  Guelph Hydro has historically been able to live within its regular budget, without extras, and still make a good profit.

Alectra has made clear that they expect to seek extra money for additional spending each and every year during their ten year sitout period.  In total, they forecast that they will want approval for $500 million or so of incremental capital spending during that period, although that will change as circumstances dictate.

They don’t actually need the money, because they will have more than enough from the savings arising out of their merger.  Under the rules, though, they can keep the merger savings, and ask for extra rate increases to spend more as well.  There is no reason to think their tactics will change after bringing Guelph into the fold.

The graph at page 25 of the advisors’ report, which shows lower distribution revenue per customer under the merger scenario, appears to be based on inappropriate assumptions.  The basis of those assumptions has not been made public.  Where in that report at page 28 the advisors say Guelph customers can expect “Rate Increases Below Inflation”, that statement is inconsistent with the evidence of Alectra in their own merger application.

It is therefore more likely that rate increases will be higher under a merged utility than under a standalone utility, but it is really difficult to forecast the amounts with any level of accuracy.

Claim #7:  “A Southwest Operations Centre will be preserved at the location of Guelph Hydro’s current offices with a minimum commitment of 10 years.”  

This is almost certainly true.

The standard approach to mergers in Ontario, which Alectra uses well, is to promise a strong presence in the acquired area for a period of time.  This reduces the feeling that the local community will be served by outsiders.  This approach has been central to every past merger application I’ve seen.

On the other hand, in the longer term it will not make sense to keep a major operations centre in every Alectra community.  Some will have to eventually lose their local operations for Alectra to operate efficiently.  Ask the City of Markham, one of the original merger partners that formed Powerstream, how many Alectra employees are still based there.

Claim #8:  “Guelph Hydro employs about 130 people. About 70 of those existing positions have been identified as needing to remain in Guelph. About half of the remaining positions would be offered relocation opportunities starting in 2019, with the majority of moves happening between 2020 and 2022. The other positions are expected to be addressed through attrition, voluntary retirement, or voluntary separation wherever possible.”

These ratios are consistent with Alectra’s past approach, and so are likely to be correct.

Of the current 130 employees, 70 (mostly tool in hand employees) will remain in Guelph, which minimizes travel time to job sites.  30 others will be offered jobs within Alectra, but only if they are willing to work in Hamilton or Mississauga or Vaughan.  The other 30 will be without a job.

Claim #9:  “Alectra will establish the GRE&T Centre in Guelph as a platform for supporting transformation in the electricity industry by accelerating integrated energy solutions. The GRE&T Centre will have eight to ten new full-time positions, with $5 million of capital spending in the first three to five years of the merger, and $3 million in annual operating spending within two years of the merger.”

This is true, but it may look better than it actually is.

First, it is a relatively small commitment, $3 million a year for a utility with +$600 million in annual revenue, i.e. under ½ of 1%.

Second, and perhaps more important, the former Powerstream Head Office was, in the Alectra merger, renamed the “Sustainability and Innovation Office”.  This large (92,000 square feet) office building near Highway 400 in Vaughan, which can house 270 people, will clearly be the centre for most sustainability and innovation activities.  Decision-making, of course, will be centralized in the Alectra Corporate Office in Mississauga, which is also a large (79,000 square feet) office building that can house 200 people or more.

There is little doubt that some initiatives will be carried out in Guelph, if for no other reason than Alectra promised that.  If Guelph thinks that it will be the centre of a major hub of innovation and other green activity, that may be wishful thinking.  The GRE&T Centre (“great”, get it?) has a very pretty (green) business plan, but its substance may be substantially less than the hype suggests.

Claim #10:  “Alectra will meet or exceed service standards and reliability for electricity distribution customers in Guelph Hydro’s current service territory.”

This is also true.

As noted in my previous article, both Alectra and Guelph Hydro are well run utilities.  On both reliability and customer service, Guelph has generally been better, but both are good.  For example, Guelph currently gets about 200 phone calls on the average day, and about 5 of those have to make a second or third call to get their problem resolved.  At the Alectra service levels, about 35 would have to make that second or third call.

Claim #11:  Guelph customers will share in the $32.3 million OM&A and capital savings from the merger, as well as in the $426 million in savings from the original Alectra merger. (See Att-2, page 5).

This does not appear to be true.

Under the rules of the Ontario Energy Board, all savings for the “sitout” period go only to the shareholders.  That includes the savings for the original Alectra sitout period.  None of these savings go to the customers.  There does not appear to be any basis for saying that they will, and the report is almost certainly wrong on this point.

Claim #12:  From 2026-2041, customers will receive $73.7 million in savings from the merger. (See Att-2, p. 5).

This may or may not be true.

First, it is too far in the future to project, and second, the basis of the calculation has not been made public.

In the past, the customers of the Powerstream merger partners do not appear to have benefitted from the mergers, since their average rate increases were higher than those of Guelph, which did not have any mergers.  Horizon customers, on the other hand, did apparently benefit from the merger between Hamilton and St. Catharines.

Thus, the jury is out on this one.

Claim #13:  GMHI will benefit from greater growth in the value of its investment due to the scale of Alectra and its focus leading industry change.

There is no reason to believe this is true.

It is true that, compared to standalone, growth in value is likely to be better with a merged entity.  There is no evidence to suggest that merger with Alectra, as opposed to merger with someone else, will produce better growth in value.  Generally speaking, growth in value of a wires company is driven by demographics.  Some of Alectra has reached lower rates of customer and business growth, while Guelph and other municipalities that are not part of Alectra can look forward to quite high future growth.  Which will grow more:  Hamilton and Mississauga, or Guelph and Milton?

Whether Alectra is “leading industry change” is a matter of opinion.  Alectra is certainly active in the corridors of power, and has some influence.  Many others in the Guelph-centred region are also active and influential.  It would not be fair to say Alectra is the “leader”.  It might be fairer to say they are an important player.

Claim #14:  “All customers of a consolidated utility are expected to benefit from lower distribution rates than what they would have to pay as customers of their respective utilities.”

This is probably not true.

As I demonstrated in my previous piece, at the time rates are harmonized, the Guelph small business and commercial/industrial customers are likely to experience high rate increases, since their rates are quite low right now.  Where Alectra says that it will not harmonize rates if this is the impact, that is not consistent with their past history.

Because we can’t see the agreements, we don’t know if the City of Guelph has any veto over large increases to customers in Guelph.

Claim #15:  Guelph customers will experience a lengthy list of customer service and other improvements, shown at page 29-30 of Att-2, the advisors report.

This seems to be somewhat oversold.

When you go down the list of supposed benefits from the merged utility, it would appear that virtually all of them are already in place at Guelph Hydro.  It is not clear where actual improvements are being proposed.  Are there any?

 

As is so often the case when companies that have a business goal are trying to get the public onside, a picture is painted that is the prettiest version of the transaction.  Claims are made, rosy forecasts are delivered as if factual, small things are treated as big, and any details that could undermine the narrative are either not made public, or glossed over.

That appears to be the case here.  This may be a good deal.  There are arguments on both sides.  However, it is important that those assessing the situation start with the actual facts, not hopes and dreams and maybes.

Or sales pitches.

  • Jay Shepherd, December 9, 2017
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Lives #4 Update – Susan Grows Up

[This is a follow-up to the fourth in my “Lives” series, “Anne’s Secret”, published three years ago.  As with all of this series, the basic story is true.  I’ve changed the names, and some of the details, so that the individuals are not easily identifiable.  However, I’ve stayed true to the essence of what happened.  The point is what can be drawn from the story, and that part is 100% true.]

“I figured it out when it struck me that you can’t speak Mandarin worth shit, mom”.  It was summer time.  Susan had only turned eighteen three days before.  Danielle was home from law school, trying to find a position with a law firm on graduation, and getting ready for her final year.  She and Susan were spending a lot of time in heated debates about the problems of the world.

Anne had no idea that Susan had also been thinking about other things.

Susan went on.  “I did the math,” she said.  “When you were supposedly on the Chinese Olympic team, your native language in China – at least, the one a state-run athletics academy would have used – was Mandarin.  Your Mandarin is worse than my Cantonese, mom.  And you know how bad that is.”

She paused.  “On the other hand, you speak excellent Cantonese.  That could only happen if you grew up Hong Kong.  But, at that time, if you lived in Hong Kong, you couldn’t be on a Chinese Olympic team.”

“There’s only one conclusion.  You were never in the Olympics, were you?  It was a lie.  All of it, completely made up.”

Susan, just about to head off to university herself, had the advantage of two highly intelligent parents.  Her scholarship to study sciences at University of Toronto was not really a surprise.  Even her older sister admitted Susan was the smartest one in the family.

So, the next step in her logic was also not a surprise.  “I think it’s time you told me the rest of the story, mom.  I already figured out the first part for myself.  I know there must be more.  What is the truth that your Olympics story has been hiding?”

When Anne and Ron took me out to dinner a couple of weeks ago, it was Anne who repeated this conversation, essentially verbatim.  Ron sat quietly, as Anne spoke about these things to me for the first time in almost thirty years.

They knew, of course, that I had written an article on their dilemma with their kids (and each other).  In it, I described the lie Anne had been living for all of her decades in Canada, claiming to have been an Olympic gold medalist from China in the eighties, when in fact she had been a high class Hong Kong prostitute.  When their teenage daughter started to ask questions about Anne’s Olympic experience, Anne confessed the truth to her husband, Ron, for the first time after twenty-five years of marriage.  But, on the advice of their older daughter Danielle, they decided not to tell the then fifteen year old Susan until she was older.  That meant they didn’t tell Danielle either.  The secret remained between Anne, Ron…and me.

Three years later, and the question was put again.  Was it time to tell their kids about Anne’s real past?

As Anne told me the story over dinner, the silent Ron looking on, they went back to Danielle and reminded her that there was a secret still untold.  Although Danielle – soon to be a lawyer like her father – already knew that Susan was hot on the trail of the truth, she continued to believe that Ron and Anne should keep quiet.

“Don’t rock the boat,” she told her parents.  “So Susie is curious.  Let her be.  No good can come of this.  Trust me.”

“And frankly,” she added, “I for one don’t ever want to know.  Not now.  Not later.  Have you ever thought that, at some point, Susie and I will have to decide whether to tell your horrible secret – whatever it is – to our own kids?  The awful truth about their grandmother?  Better we don’t know.”

They had a long talk with Danielle, not just that day but over multiple days.  Danielle kept coming back to her “perfect family” mantra.  “Don’t screw up a good thing,” she said over and over again.

As the uncharacteristically quiet Ron looked on, Anne described to me their back and forth between each other about whether to tell Susan.

“Ron hates even thinking about this,” said Anne, “let alone talking about it with me.  The thought of opening up to our little girls about my life – my real life – made both of us very unhappy, to say the least.  Ron, maybe even more than me.

“But the more I thought about it, the more my secret history was weighing me down.  I was tired of lying.  And – well, you’ve known Ron longer than I have.  He believes in the truth.  ‘When in doubt, just tell the truth’, he always says.”

While Anne and Ron were struggling over whether it was time to tell the truth, Susan was still asking questions.  Three years earlier, she had agreed to hold off, to wait for her parents to decide it was time.  Now, she was less willing to wait.

Now, she felt she had earned the right to hear the truth.

So they told her.

It turned out to be a family meeting, with Danielle relenting and deciding to hear the story after all.  Anne describes the atmosphere is “very tense”.  She and Ron had talked at length about how to tell the story.

In the end, she went with her instincts.

“I was never in the Olympics.  Susie, you were right.  It was a lie.”  She paused, then got to the punch line:  “All those years, when I said I was an Olympic athlete, I actually lived in Hong Kong.  I was a prostitute.”

Anne describes how she stopped, and let it sink in.  She looked at Ron, but he was looking down at the floor, not at either Anne or the kids.  She knew he wanted to speak, but was fighting it.

“You know, Mom,”  said Susan, “you can’t just leave it at that.  You have to tell us about it.  You have to tell us your story.”

Danielle nodded in agreement.  “I hate to say it, but Susie’s right.  Once you start to tell us, you have to tell us all of it.”  Ron looked up at that, and Anne says she knew he wanted to stop her.  He didn’t want to know the whole story.

But it came out, in part through Anne’s willingness to unburden, and in part through questioning and prodding by Susan and Danielle.

That first discussion only lasted an hour, but it seemed much longer.  She talked about growing up poor in Hong Kong, her father a waiter, her mother trying to raise six kids.  Paying for school was a challenge, sometimes even providing a good meal for the family was a challenge.  Sometimes they had scraps from the restaurant.  Her father worked sixty or seventy hours a week.  Her mother, even more.  Life was hard.  There were few ways out.  Even for a pretty girl like Anne.

Anne didn’t try to make excuses, but she did tell what it was like to grow up poor, back then.

The real discussions came the next day.  Susan and Danielle had talked about it for hours the night before, and they had questions.

They found Anne “hiding”, as they put it, in the backyard.  For hours they peppered her with questions, wanting details, wanting to understand better their mother’s life.  Ron sat in for some of it, but he said he couldn’t take so much, and anyway it turned out to be what Anne describes as “more of a mother-daughter conversation”.

Anne was relieved that the tone was neither accusatory, nor shocked, nor disapproving.  Danielle and Susan, now 25 and 18, were asking about the story of a young woman who, then, was the same age they are today.   A woman who, in her later life, they had come to admire.

They were asking questions about being a young woman in the world.  They were asking about predation by men, about female empowerment, about the tradeoffs you make in life, about making hard decisions.  They wanted to know details:  about pimps and “managers”, about the different types of customers.  About birth control, and abortion.  Are rich men and poor men so different, they asked.  What is the line between sexual harassment and sexual aggressiveness and sexual relationships?  How is sex with love different from sex without love?  What about violence?

How did you feel, mom, they asked again and again.

At one point, Anne asked them “Are you trying to learn enough to become successful prostitutes?”  To which Susan replied “Well, who better?  You were an Olympic-level hooker, right mom?”  As Anne retold it later, it didn’t seem funny to Ron and I, but she says it threw the three of them into an uncontrolled laughing attack.

Once the floodgates opened, some of the questions cut close to home.  Danielle asked – bluntly – how much marrying Ron was about coming to Canada and having a better life.  In that private moment with her daughters, Anne tried to explain how you can be pragmatic, and still be in love.  As she said it to Ron and I at dinner, it sounded even to her like she was rationalizing, but it was how she felt, then and now.  To her surprise, both daughters understood immediately, and didn’t think she was rationalizing at all.

“Everyone knows how much you love Dad,” said Danielle.  “Who could miss it?  It’s obvious.”

They also asked hard questions about the lessons they could take for their own lives.  Have times changed, they asked?  Are men different now, here in Canada, or are we going to be faced with the same issues that you had as a teenager in Hong Kong?   Can we really have independent careers, as we plan, or will society and child-rearing still require us to hitch our economic stars to successful men?  Is anything really different today?

Danielle is now back for her last year of law school.  Next summer she will start working for one of the multinational law firms.  Susan is now in residence at University of Toronto, and complaining weekly about how much better the food is at home than at school.  She plans to be a biochemist.

Ron will turn sixty in a few months.  He tells me that, overall, he’s pretty happy about his life.

I asked him only once – at least recently – how he feels about Anne’s past.  His answer has changed.  “Three years ago, I was pretty upset – with Anne, with you, with the world.  You know what?  All that stuff that happened before I knew Anne – sure, I would have liked her to have trusted me with the truth.  On the other hand, we’ll never lie to each other again, will we?  And, really?  Would my life be any better if I had known back then?  I doubt it.”

Anne is still living a lie, of course.  Now five people know the truth – Ron, Anne, Danielle, Susan, and I.  Everyone else still believes she was in the Olympics, although she doesn’t talk about it any more.

All four of them have moved on to focus on the part of their lives that really matters – the present, and then the future.   They have accepted the truth of history, but in their minds it is now truly history.

Life has its little coincidences, too.  Ten years ago, when Danielle was still a teenager, and had no inkling that there might be a secret in her mother’s past, she described to me how she thought about her future:

“The past is important, for sure.  But it’s not life.”

  • Jay Shepherd, November 18, 2017
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Energy #20 – An Open Letter to Guelph Hydro Customers

Alectra Utilities and Guelph Hydro are discussing a merger, the headlines say.

Already there is a flurry of information available to local Guelph residents about those discussions, and the many benefits of joining the Alectra fold.  For the most part, that information is carefully curated by Alectra, or other merger proponents, to show the transaction and its aftermath in a positive light.

I don’t have a view one way or another on the proposed merger.  Although in my day job (energy regulation lawyer representing customers) I have learned a great deal about both utilities, I think it’s premature to express an opinion until the details of the actual deal are known.  Even then, it is the opinion of Guelph residents that really matters. Mine, not so much.

I do, though, have a view about the information that is provided to local residents so that they can form their own opinion.  Guelph residents should have all the facts, not just a sales pitch.

To that end, this article tries to provide a dispassionate take on some of the issues that could inform local opinion.

What Are the Issues?

The customer-related benefits of a merger between Guelph Hydro and Alectra Utilities will generally be characterized as follows:

  1. Lower Rates.  There will be scale and other economies as a result of the merger that will translate into lower rates for customers.
  2. Better Service.  A larger organization will be better run, with the result that reliability, customer service, and other customer priorities will improve.
  3. It’s Inevitable.  Guelph Hydro has to merge with someone, or it will be unable to meet future regulatory requirements for local utilities.  Alectra is their natural partner.

All three benefits seem intuitive, and are cited in most utility mergers, but in each case the devil is actually in the details.  None is actually true in every merger, and it is not obvious that they will be true for Guelph Hydro customers.

Lower Rates

There are really three questions associated with the “lower rates” argument:

  • Will there be cost efficiencies?
  • When will customers get the benefit of cost efficiencies?
  • Will the cost efficiencies actually translate into lower rates for all customers?

Cost Efficiencies.  The most useful data is the history of rate increases for Guelph and for the Alectra predecessors.  Two of those Alectra companies, Powerstream and Horizon, were formed from mergers.  Powerstream is made up of five companies, formed in three merger transactions.  Horizon is made up of two companies.

If you use Guelph Hydro as the baseline, residential annual distribution bills went up 20.6% from 2005 (the first year we have comparable actual rates) to 2018 (current proposed rate in their rate application).  That is an annual rate of 1.57%, or just under the rate of inflation.

Guelph Hydro small business and commercial/industrial customers did much better, showing 12 year decreases of 16.5% and 5.9% respectively.

For the Horizon residential customers, they did better than Guelph Hydro.  Customers in St. Catharines had increases of 15.6% over that period, which works out to 1.21% annually.  Customers in Hamilton had increases of 9.8% over that period – less than 1% per year.

By contrast, the Horizon small business and commercial/industrial customer did poorly.  Small business customers from both merged areas had increases of over 60%.  Commercial/industrial customers had increases of 84% in Hamilton, and 102% in St. Catharines.

The Powerstream residential customers did not fare well.  Customers in Richmond Hill and Aurora did fine, at less than 1% per year.  Customers in Barrie ended up at about 1.09% per year.  Customers in Markham, though, have done worse than Guelph – 22.8%, or 1.72% per year.   And for those residential customers in Vaughan, their rates have increased more than 49%, a rate of 3.39% per year.

By contrast, the Vaughan small business and commercial/industrial customers did a little better, with increases of 22.5% and 27.4%, but still much worse than Guelph Hydro, or inflation.  Richmond Hill and Aurora small business and commercial/industrial customers had increases of less than 1% per year, while Markham customers had increases of more than 40%, and Barrie had 33% for small business, and just about inflation for commercial/industrial.

For those who like spreadsheets (like I do), here is the table of the results:

Distribution Rate Increases 2005-2018

Utility

Rate Zone

Residential

Small Business

Comm/Ind

Guelph All

20.56%

-16.51%

-5.94%

Horizon Hamilton

9.78%

60.04%

83.95%

  St. Catharines

15.64%

61.95%

102.29%

Enersource All

34.90%

21.58%

8.58%

Powerstream Richmond Hill

7.58%

9.54%

-1.18%

  Vaughan

49.01%

22.50%

27.44%

  Markham

22.77%

41.36%

43.81%

  Barrie

14.03%

33.27%

20.80%

  Aurora

8.70%

7.57%

6.38%

Brampton All

12.70%

-0.90%

13.61%

The various differences are a function of initial rate levels (see below).  What the overall figures show is that, for some of the merged residential customers in the two Alectra companies with a merger history, there have been some reductions in rates, but they have not been substantial.  On a weighted average basis, Powerstream and Horizon residential customers have rates today that are $6 a month lower than they would have been on a standalone basis (that is, compared to Guelph).  That is the twelve year impact of the mergers for those customers.  For small business and commercial/industrial customers, on the other hand, they had net increases in rates as a result of the merger activity.

Will this history translate into rate savings for Guelph Hydro customers?  It may, but Guelph will only be about 5% of the merged company.  Its impact on costs will therefore be muted.  Even if there are substantial operational cost savings, only 5% of those savings will ultimately benefit some of the Guelph customers.  The other 95% will go to the rest of the Alectra customers.

Timing of Customer Benefit.  The rules of the utility merger game have recently changed.  In the past, merged distributors implemented a five year rate freeze, providing immediate benefits for customers while the cost efficiencies were being realized.  The Powerstream and Horizon transactions all happened under that rule.

The new rule, starting in 2016, is that any savings from a merger go to the shareholders of the merging companies for the first ten years.  The customers get their regular rate increases, and the merged company can ask for more, even if it doesn’t really need the money.  (Alectra expects to get extra shareholder benefits of more than $425 million over the ten years from their recent merger, over and above normal profit levels.)

Alectra has already announced that they plan to seek rate increases in excess of inflation for the next ten years.  Will that apply to Guelph customers?  They haven’t said.

If Alectra seeks rate increases in excess of inflation for Guelph customers as well, that would make them higher than Guelph Hydro rate increases have been for the last decade.  It is therefore not clear that, during this upcoming ten year period, Guelph rates after an Alectra merger will be better than had Guelph Hydro remained independent.

Will All Customers Actually Benefit?  If there are cost efficiencies, and if customers have the patience to wait the ten years, will all customers benefit.  The answer is, some will and some will not.  The main driver of that result will be the rates for customers today.

Start with residential.  The average residential distribution rates for Alectra customers are 9.9% lower than Guelph Hydro customers.  Each month a Guelph Hydro customer pays about $2.86 more than an Alectra customer with the same electricity use.  (Guelph Hydro customers actually use about 11% less electricity, so their distribution bills are about the same, but this will matter less and less over time.)

Eventually, the residential rates will have to be harmonized.  Given the small size of Guelph relative to the rest of Alectra, the average residential customer could see a reduction of up to $2.72 per month in ten years, when their rates are harmonized with other Alectra customers.

As noted above, this may be wholly or partially offset by higher spending in the meantime, but it is not really possible to predict that.  What would Guelph Hydro spend in the next ten years on a standalone basis?  We have no way of knowing.

If residential customers may eventually get a small benefit after ten years, the same is not true of commercial/industrial and small business customers.

A typical commercial or industrial customer in Guelph currently pays on average about $160 a month less than an equivalent customer in Alectra (despite the substantial past rate increases for these customers in the Alectra areas).  This could be a factory, or a small plaza, or an office building, or – close to my heart – a high school.  Sooner or later, their rates have to be harmonized with the Alectra levels, and they will get an extra increase of $152 per month, or just over $1800 per year.  This is on top of all the normal increases for the next ten years.

Small business customers are in the worst position.  Guelph small businesses currently pay about 39% less than Alectra small businesses for electricity distribution.  That difference, $23.13 per month, will have to be corrected at the end of year ten.  As with commercial/industrial customers, they will bear the hit of rate harmonization, to the tune of a $264 per year permanent upward adjustment.

The simple answer, therefore, is that even if there are cost efficiencies, the proportion of those cost efficiencies that benefit Guelph Hydro, if any, will not benefit everyone.  Residential customers may have a small benefit.  Small business, commercial and industrial customers likely will not.

Rate Conclusion.  Will there be lower rates for Guelph Hydro customers?  There is no clear answer.  What we do know, based on past history and current forecasts, is that any rate reductions from the merger will be limited, deferred, and available only to some customers.

Better Service

The prospect of better service for Guelph Hydro customers as a result of the merger is less complicated than the rate issue.  The Ontario Energy Board publishes scorecards for every electricity distributor, showing how they are doing on the key measurements of things important to customers, such as reliability and service quality.

We can compare scorecards.  It’s easy.  2016 Scorecards have recently been published.

Reliability.  There are two reliability metrics:  how often is the average customer interrupted (frequency), and how many minutes each year are you without power (duration)?

On frequency, Alectra customers average 1.05 interruptions per year.  This mainly measures the physical quality of the system.  Guelph Hydro customers are slightly worse, at an average of 1.34 interruptions per year.  The industry average is 1.00, so both could improve, but Guelph needs more improvement.  Guelph ranks 48th out of 65 electricity distributors in the province;  Alectra ranks 37th .

The results are the opposite when it comes to duration.  This mainly measures repair response times.  Alectra customers average 47.4 minutes each year without power.  Guelph Hydro customers average 42.6 minutes per year.   The industry average is 73.2 minutes per year, so both are very good performers, but Guelph is slightly better.  In rankings, Guelph is 25th and Alectra is 28th .

Customer Service.  On customer service, there are five metrics:  connecting new customers, on time appointments, answering phone calls, accuracy of bills, and resolving issues with customers on the first try (called “first contact resolution”).

On connecting new customers, both Alectra and Guelph Hydro do that very well:  99.6% and 99.5% of the time, respectively, they connect customers when they say they will.  Compare that to 98.3%, which is the overall industry average.

Similarly, both are good at showing up for appointments:  99.58% for Alectra, and 99.7% for Guelph Hydro.  Once again, both above the 98.99%  level for the industry.

When it comes to their call centres, though, Guelph does quite a bit better, answering 86.7% of customer phone calls within a reasonable time.  This compares to the Alectra average of 80.95%.    The industry average is 84.67%.

The difference between their telephone accessibility performance is fairly large.  To give you an idea of the impact, Guelph Hydro handles about 45,000 telephone calls per year.  At the lower Alectra performance level for call answering, an incremental 2600 customer calls each year in Guelph would not get answered within a reasonable time, i.e. about ten every business day.

Both utilities have excellent billing accuracy:  99.95% for Guelph, and 99.58% for Alectra.  The industry average is 99.41%.

Finally, on first contact resolution, Guelph Hydro has one of the best records in the province, 99.98%.  Of their 45,000 calls each year, all but ten or less have their problem resolved in that call.   The Alectra first contact resolution average is only 82.27%, which would translate in Guelph into almost 8,000 customers each year having to call back or wait for further clarification on their query.

Conclusion on “Better Service”.  The scorecard comparison, therefore, does not indicate that Alectra provides better service than Guelph Hydro.  Both provide generally excellent service, but if there’s an edge, it goes to Guelph Hydro.  The evidence doesn’t indicate that a merger will result in better service for Guelph Hydro customers.

Guelph Hydro is generally known to be a well-run utility.  It serves its customers well, it maintains and operates its system to high standards, and it delivers a very good return to its shareholder, the City of Guelph.  In fact, on that scorecard measure, Guelph Hydro does much better than Alectra.  Guelph Hydro’s most recent profit level was 10.58%;  Alectra’s profit averaged 7.79%.

It’s Inevitable

Sooner or later, Guelph Hydro will probably become part of a larger electricity distributor.  It could be a small addition to a much larger entity, like Alectra or Hydro One.  It could be a main partner in a merger of similar-sized utilities.

It is not likely to stay independent forever.  The pressure in the industry is towards consolidation.

On the other hand, Guelph Hydro is not in a position where it must move quickly.  The healthy profit level allows dividends of $3 million per year to the City (at the current standard level of 50% of earnings).  By contrast, at the Alectra profit level the near term dividends would be more like $2.2 million, so there is not likely to be an immediate benefit to the City from the merger.  Of course, in the longer term growth may be greater in the other areas of Alectra, compared to Guelph, creating additional opportunities for the City to profit through growing dividends.

It is also not self-evident that Alectra is the “natural suitor” for Guelph Hydro.  The previous approach to Guelph Hydro from Horizon (before it became part of Alectra) had the advantage that there was potential for geographic consolidation over time of the area in between them.  Some of that is still the case, but the centre of gravity (and focus) of Alectra is still more north of Toronto, not west.

The more logical consolidation for Guelph has always been Cambridge, Kitchener, Waterloo, Milton, Halton Hills and Guelph.  The problem with that potential merger has for years been local personalities and demands by individual cities to have control.  While that situation may not last forever, past attempts at partnership, even on smaller aspects of the business, have not always been successful.

The alternative “natural” merger for Guelph is Burlington, Oakville, Milton, Halton Hills and Guelph.  Personalities may impede that as well, but it is still a good fit from a geographic and demographic point of view.

So, is a merger with someone inevitable?  Probably the answer is yes.  Is a merger with Alectra inevitable?  The fair answer to that is probably no.

Conclusion

Guelph residents are going to hear a lot of things over the coming weeks about the proposed merger between Guelph Hydro and Alectra.  There will be pros and cons to the deal, once the terms have been finalized.

When Guelph residents are asked their opinion – as they should be – they will need to know all the facts.  This summary is intended to provide some of those facts.

  • Jay Shepherd, November 5, 2017
Posted in Energy | Tagged , , , , | 8 Comments

The Scalable Universe

There are some subjects that tend to make you feel stupid.  Cosmology is one of those subjects.  And, as I have found out, at cosmology’s limits, the philosophy of cosmology is even more difficult still.

It doesn’t matter how smart you are.  You could have the maximum luck from the genetic lottery.  Your mother and father could both be highly intelligent, for generations back.  Instead of being from tall people, and maybe being in the NBA, you are from smart people, so you’re smart.  Great luck for you.

Cosmology will still make your mind go numb.  Unless you’re one of the select few that understand that kind of stuff, you’re toast.

It doesn’t mean you stop trying.  Many people who enjoy intellectual pursuits try to understand that difficult area.  Alas, it is very hard.

But one of my hobbies is reading about science:  Discover, Scientific American, American Scientist, and so on, plus books, journal articles, the works.  I enjoy it, like surfing or mountain climbing, but for the brain.  (I admit I participate in surfing and mountain climbing somewhat less than reading science.)

I have no training in science (or most anything else, as my kids will be quick to point out), but generally I can understand the stuff I read on scientific topics.  In large part, it is either intuitive, or you can figure it out if you’re willing to spend the time.  I don’t need to know the details of how to do a dig, for example, to understand the richness of archeological finds, and at least some of what they tell us about humanity.  When I read about the evolution of marine mammals, it doesn’t take a marine biologist to map that knowledge to the day to day life we face right now.  And climate change?  Sure, some of it is complicated, but the basic concepts are both simple and understandable.  In none of those cases do I understand them like an expert does, but given a good explanation, I can understand them well enough.

And then I come up against cosmology, and the physics on which it is based.  Cosmology is just really, really hard.  M-theory? (My son understands it, and tried to explain it to me once, but it leaves me floundering.)  Observing – today – events that happened billions of years ago, due to the speed of light?  (Yes, I get the concept.  It is just not part of my normal reality.)

I read A Brief History of Time, Stephen Hawking’s most famous book, and I can’t tell you the number of times I scratched my head and said “What on earth is he talking about?”  Of course, maybe my problem was the “on earth” in my question.  It was still…well, you get the idea.

And every time I read about cosmology, at least for the last ten years or more, I have had the same set of questions.

Before I pose those questions – hopefully for some real scientists to answer – I want to give a clear disclaimer.

Lots of time, over my life, I have looked at fact situations or concepts and had a moment in which I thought I saw an answer no-one else saw.  This happened more often when I was younger, of course, but it still happens today.

Now, when I think I see something “new”, I have learned to first ask some questions.  The immediate, most important question is:  Am I an expert in this field?  If I am – energy regulation, perhaps – there is at least some possibility that I have spotted something no-one else has seen.  I may have a new insight.  Great.  (Not as often as I tend to think, of course, but at least sometimes.  Not never.)

But if I am not an expert in a field, the odds that I have an insight that is truly “new” go way down.  The odds are not zero.  It happens.  It is, however, a surprise when it does. (Calculus has the concept “the limit as x approaches zero”, which is used as a proxy for zero in some equations.  The probability of me having a new insight outside of my areas of expertise is somewhere near that number.)

When I read expositions of the physics of the universe, or cosmological analyses, I often have the same thought.  That is:  Why are you (i.e. scientist, author) not thinking of these questions in a different dimension, in which the universe is not only infinitely large in our normal three dimensions, but also infinitely scalable?  (Most recently, this question popped up when I read the very readable book Astrophysics for People in a Hurry, by Neil de Grasse Tyson.)

Why can’t that muon you are studying, which has many attributes you understand, but many you don’t, be itself an entire universe?  Why can’t our universe, with all of its open questions, be a muon in another, infinitely larger universe?  Why aren’t we looking for the answers to the uncertainties of our universe – the singularity and where it came from, dark matter and energy, strings – by reference to universes infinitely larger and smaller than ours, of which we are a part, or which are a part of ours?  Why isn’t Einstein’s “spooky action at a distance” (entanglement) not explained by the fact that, in a larger universe, the distance between those same things – far away in our universe – is negligible?

Yes, yes, I know.  I’m not the first to think of this.  I have read concepts such as these in science fiction novels, some fifty years old or more.  They are not new.  In a very real sense, they are the type of creative ideas that teenagers will have.  (What do you mean, I never grew up?!)

But that doesn’t really answer my question.  I have read hundreds of articles and books about the physical structure of the universe, and not once have I read a serious analysis explaining why larger and smaller scales cannot be an answer to the questions we have.

Whenever I read about quantum mechanics, for example, no-one ever talks about how it is anomalous, even counter-intuitive, at the scale of our universe, but may well be quite sensible at the scale of a universe within a muon.  Nor do I ever hear of anyone speculating that the questions in the physics of the cosmos could be conceptually similar to the questions that would arise if our universe is a small part of a much larger universe.

I’ll give you an example.  In his truly wonderful Massey Lectures, published as the book The Universe Within, Professor Neil Turok says

“The competition between the cyclic and the inflationary universe models highlights one of the most basic questions in cosmology:  did the universe begin?  There are only two possible answers: yes or no.”

When I read this, my mind was immediately screaming:  Neither!

Maybe the real answer is “sort of”.  If our universe is really part of an infinitely larger universe (or a nest of universes, each infinitely larger or smaller than the other), then the implications of the question change.

The question implies:  did we start out of nothing, or something?  The answer could be neither.  Our universe exists because of something that took place in a larger universe.  In that universe, that event, and our universe, are insignificant to the point of being almost non-existent.  In ours, it is the entire beginning.  Our universe in turn is, quite unknowingly, creating much smaller universes that to us would be insignificant.

If we can really imagine the concept of the multiverse, in which our universe is one of an infinite number of parallel universes, existing side by side but distinguished by different paths taken an infinite number of times, why can we not also imagine an infinity of universes larger and smaller than ours?  This, indeed, would be the logical conclusion of the concept of infinity.  There is no reason to think it is limited to a parallel plane.  If universes can diverge over the fourth dimension – time – why can’t they diverge over the first three dimensions as well?  (Or any additional dimensions after four, but don’t get me started.)

I want to be very clear about this.  I have no expertise whatsoever about cosmology, so any ideas I have run a 99% chance of being wrong (I rounded down, not up).

That having been said, this constant anomaly that I “see” in everything written in the field is bugging me no end.  What am I missing?  Why is this explanation not at least as good as M-theory, for example, a theory so inelegant it appears almost artificial?

Of course, I didn’t stop with the question.  I have tried to do some research, non-scientist though I am.  I have looked at many sources that do deal with the possibility of scalable universes, but not one of them takes the idea seriously.

In virtually every case, they come to the conclusion that this is not a question that can be studied by scientists, because there is no empirical data against which to test the hypothesis.  They say it could indeed be true, but so what?  If it is true, we have no way of knowing that it is true, and we are equally unable to disprove that it is true.  Scientists only deal with empirical reality.  Something that can be neither proved nor disproved cannot be part of the scientist’s reality.

At the beginning of this article, I talked about the philosophy of cosmology.  Scientists – at least the ones I have read – say that this question of the scalable universe is a question for philosophers, not scientists.  It is like trying to decide if there is a god.  Scientists don’t do that for a living.  They are not philosophers.  They only deal with things that can be proved.

In some respects, I understand that answer completely.  However, I think I have to reject it.

Essentially every part of what we today call science – biology, chemistry, physics, everything, including all of their most mundane components – has at one time or another in the past been the purview of philosophers rather than scientists.

It was philosophers who first speculated on how the human body works.  Then, as methods were developed to test ideas of biology, a science was born.  Things as simple as mechanics – forces, and how things move – started in the minds of philosophers, and were only handed over to the scientists when there were experiments to run, empirical analysis to do.  The history of philosophy is a history of people grappling with difficult concepts, and ultimately figuring out how to test their thinking in the real world.  Philosophers handing off to scientists.

Or, perhaps more correctly, conceptual scientists handing off to empirical scientists.

Many parts of physics existed only as untestable concepts, until philosophers or scientists developed ways to test them.   They weren’t rejected by everyone because there were no tests to see if they were true.  The nascent concepts were each treated as something for which a test had not yet been found.

Some scientists will argue that, for example, the existence of planets around other stars was, until relatively recently, not part of science.  It was a matter of speculation, by philosophers, writers of science fiction, and other non-scientists, but it was not part of science.  We had no way of determining whether it was true or not, so why would a scientist waste their time on it?

In reality, some scientists made it their goal to find a way of discovering planets around other stars, and through creativity, insight, and then experimentation, they found those planets.

I don’t understand why there are not scientists, right now, trying to bring the scalable universe from philosophy to science, conceptualizing and then testing ways of determining if that might explain some aspects of our universe.  Is it too hard?  Is it too far out there, or too far into the future of cosmology?  Do we already know that it will be a long time before we can pursue this question?

This article is therefore a plea to the real scientists out there.  I’ve tried to learn enough to figure this out.  I don’t have enough grounding in math to figure it out that way.  (I understand some algebra, and even a few of the concepts in calculus.  However, every Greek symbol after Pi and Delta just makes me gag.)  I’ve tried to stretch my mind to accommodate the non-mathematical concepts.  Every time I do, I run into this conundrum.  Where is the barrier to solutions based on scale?  How is it different from any of the other big questions on the edges of cosmology or physics?  Why aren’t we even asking the question?

Or, have we asked it and answered it, and I just didn’t notice?

Please help.

  • Jay Shepherd, October 14, 2017
Posted in Uncategorized | Leave a comment

Energy #19 – Regulatory Capture

This article was originally supposed to be about the Fair Hydro plan, and in particular the regulatory failures that led to the political need for it.

As so often happens, events overtook my plan.  While I was looking at the empirical data explaining that regulatory failure, the Ontario Energy Board did some things that took me in a new direction.

The OEB is more and more exhibiting the signs of regulatory capture.

Note that I said the OEB, by which I mean the regulator as an entity.  The adjudicative panels at the OEB, i.e. the Board members, have often shown strong independence.  On the other hand, senior management of the OEB – those who are setting policy and regulatory direction – show bias in favour of the views of the industry they regulate.

Further, instead of moving to head off that problem, the OEB is going in the opposite direction, proposing to increase the ability of utilities to influence OEB policies and directions, and decrease the ability of customers – those who pay for everything – to provide balance and perspective.

What is Regulatory Capture?

Now, before you get all hot and bothered, and want to storm the ramparts, let’s look more closely at regulatory capture.  “Bias” sounds really bad.  (Or maybe really, really bad.)  It’s actually not quite as bad as it first appears.

Still bad.  Just not AS bad.

Regulatory capture is sometimes compared to Stockholm syndrome, but it’s not quite the same.

Usually attributed to Nobel laureate George Stigler, the term “regulatory capture” refers to the situation in which the regulator’s independence has been compromised by the influence of the industry it regulates.  Stigler’s extreme view was that capture was inevitable, because regulation exists primarily to benefit the private interests being regulated, such as utilities.  As decades of debate over the subject have evolved the concept, most theorists no longer agree with Stigler that private interests will necessarily crowd out the public interest in every case.  However, most also agree that it is a common problem for regulators.

In vastly oversimplified terms, there are three types of regulatory capture.

The classic definition describes a full or complete capture, in which the industry regulated basically dictates what the regulator does and says.  This can be because of bribery or other corruption, for example, or just complete subservience.  This has happened to many regulators in the past.  Some purists consider this the only true regulatory capture.  Others, like Scott Hempling, believe that corruption is different from capture, and should not be included under the same umbrella.

There isn’t the remotest evidence that the OEB has been captured in this extreme sense.

The other two types of capture are more ubiquitous, and are more relevant to the OEB situation.

Cultural capture occurs when the regulator and the regulated industry become so close that the independence of the regulator is undermined.  Phillip Wallach, in an excellent article reviewing a book of essays, Preventing Regulatory Capture (Carpenter/Moss, ed.), describes cultural capture thus:

“The main mechanisms of this cultural capture will be: group identification, in which regulators come to identify themselves with regulated firms and their employees, sometimes because of the existence of revolving doors; deference to high-status regulated executives; and deference to those with whom one has face-to-face relationships, because of empathy or the desire to avoid conflict.”

This is not really surprising.  Regulation, including economic regulation of a monopoly through an administrative tribunal, is based on the concept that experts in a particular field are the best people to understand the intricacies of regulating that field.  What that means is that the talent pool the regulator draws from is often the very entities it regulates.  What’s more, the social circles of the regulated and the regulator will overlap, sometimes extensively.

None of this is inherently bad.  In fact, often former utility staff who work for the regulator are the best people to do the regulating.  They really know what it’s like inside a utility.  Anyone who has argued a case before an adjudicator with a utility background knows that they can be very effective precisely because they don’t wear rose-coloured glasses.  They’ve seen the good, and the bad, up close.

Closeness between the regulator and the regulated is therefore quite normal, even expected.  It is only when it morphs into a set of blinders that it becomes a problem.

The third type of capture is informational capture, sometimes called “weak capture”.

Regulators make decisions and develop policies based on information.  Regulated industries have an asymmetry of information, in that the utilities or other regulated entities have most of the information.  As a result, the information the regulator gets is often from those it regulates.  Informational capture arises when the regulator ceases to be sufficiently skeptical about the information it is getting, and reduces its emphasis on obtaining information, verification and input from other sources.

Information capture is sometimes seen as driven by expertise.  It is not just that the utilities have control of most of the relevant information.  They are also experts in the field, so the information they deliver, and how they characterize it, is taken – consciously or subconsciously – as reliable expert analysis.  That is, they not only control the information, but how and when it is delivered.  Their lack of independence is ignored.

The OEB exhibits some of the indicia of the second and third types of regulatory capture.

What is the Evidence of Capture of the OEB? – Part 1: Rates

Start at the empirical level.  On the electricity side the regulated utilities are for the most part getting what they want, with some resistance from adjudicators (Board members) in litigated cases, but with minimal resistance from the senior management of the OEB in development of policies and rules.

(Note that this is not as apparently true on the gas side.  The reasons for that are complex, and more suited to a separate article.)

The starting point for any economic regulator, whose central job is to regulate rates, is…(wait for it)…rates.

Of course, as has often been noted the actual distribution revenue per customer in Ontario from 2005 to 2016 (the range of years for which we have good, and comparable, information) has increased by 25.6%, from $548.60 per customer in 2005 to $672.26 in 2016.  That is a compound annual growth rate (CAGR) of 2.1% per year.  Inflation over the same period (GDP IPI FDD) was 23.17%, or 1.9% per year, so the rate increases are apparently a little high, but not outrageous.

There are two reasons why this initial conclusion is misleading.

First, distribution revenue per customer is only a good proxy for rates if the customer mix remains the same, and rates have increased roughly the same for all classes.  Neither is true.

Residential customers, the ones with the lowest revenues, increased from 89% to 90% of total customers, meaning the overall increase is slightly understated.  (Comparisons by rate class are from 2006 to 2016, because 2005 public data does not include this metric.)  On the other hand, the rate of increase of revenues from residential customers increased much more rapidly than for non-residential.  For residential, increases in distribution bills were at a rate of 4.66% per year CAGR.  This is despite the fact that residential average use dropped by 13.6%, from about 818 kWh per month to 707 kWh per month.  On a unit cost basis, the cost to deliver one kWh to someone’s home has increased from 2.78 cents to 5.08 cents, an increase of 82.7%, or 6.22% per year CAGR, more than three times the rate of inflation.

When residential customers say they are using less, and paying more, they are not lying.

For non-residential customers, there was a decrease in distribution bills over that same period of about 1.89% per year CAGR.  Average use by business customers has only dropped 2.9% over that period, since use is driven more by economic activity than by efficiency.  However, OEB cost allocation policies have resulted in increases in the share of costs allocated to the residential customers, largely because the business customers had been paying more than their fair share (likely a legacy of the former municipal influence on rates).

The other reason the 2.1% overall CAGR is misleading is that it came during a period when external factors were acting to push distributor costs down by substantial amounts:

  • Interest rates dropped from an average of 8.57% in 2005 to less than half that in 2016. When factored into both debt and equity costs, the impact of this reduction on the highly capital intensive utilities is around $650 million, or about 19% reduction in overall costs.
  • An accounting change meant that most distributors had a drop in their depreciation rates, with an industry-wide impact of about $400 million, i.e. around 10% reduction in costs.
  • The distribution sector in 2005 was characterized by a large number of smaller distributors, with many built-in inefficiencies. Mergers and consolidations have resulted in substantial savings in many areas, most notably for the Powerstream, Horizon, Entegrus and Toronto LDCs.  This is not possible to estimate properly, but is certainly in the $100s of millions annually.

Some part of these impacts, as well as others like the declining tax rates over the same period, would be captured in the inflation comparison.  Some, on the other hand, would not.  It is reasonable to guess that, but for these listed impacts, the rate increases allowed by the OEB over that period totalled more than 4% CAGR, i.e. more than twice the rate of inflation.

Protecting the customer is job one for an economic regulator like the OEB.  In a decade in which known costs for distributors dropped by 30-40%, more than a billion dollars, it is not credible to say that allowing rate increases in excess of inflation amounted to “protecting the customer”.

Is the same true for transmission and for prescribed generation (OPG), the other areas regulated by the OEB?

Transmission rates are the easiest.  I couldn’t find 2005 and 2006 Uniform Transmission Rates (I know, just lazy, really), but since 2007 the rates have increased 45%, i.e. an average of 4.25% per year.

Of course, the decline in interest rates benefitted the transmission companies in the same manner as the distribution companies, but the benefits of changing accounting rules for depreciation, and M&A activity, did not affect them significantly.  Since the interest rate increase is partially captured in inflation, it is no surprise that the 4.25% per year rate increase is similar to the real underlying distribution rate increase.  The adjusted rate increase for transmission is likely somewhat higher, perhaps as much as 5% CAGR, but even without adjusting for the interest rate decline it would still be very high.

Now turn to OPG.  In 2007, before its rates were regulated by the OEB, the nuclear rate was $49.50 per MWh, and the hydroelectric rate was $33.00 per MWh.  The rates in 2016 were $72.30 per MWh and $44.55 per MWh respectively, increases of 46% and 35%.  On a CAGR basis, they are 4.3% and 3.4% per year.  This is despite sometimes aggressive adjudicated results from Board panels, including one cutback that went all the way to the Supreme Court of Canada for a decision.

This does not include the future increases currently proposed by OPG, which would see the nuclear rate increase by +10% per year for the next ten years, and the hydroelectric rate by 1.5% (although they would be blended).

Like transmission, OPG has benefitted from declining interest rates, but not really from M&A or depreciation changes.

All of this is to say that, for the more than two-thirds of the typical electricity bill that the OEB regulates, it has allowed increases that are effectively more than double the rate of inflation for the last decade.

Thus, on the most basic test – rates – the OEB likely fails.

This is not direct evidence of regulatory capture, of course, but it does appear that “someone’s got some ‘splainin’ to do”, as they say.  We certainly have to dig a little deeper.

Unfortunately, digging doesn’t produce better results.

What is the Evidence of Capture of the OEB? – Part 2: The Big Build

I’ve written earlier this year about the Big Build, in which the OEB has allowed wires companies to expand their capital infrastructure by massive amounts over the last decade, and continues to do so today.   Capital spending in excess of apparent requirements is at least $6 billion in distribution alone, and transmission is also substantial.  In fairness, the capital spend of OPG probably cannot be laid at the OEB’s doorstep.  Their hands have been tied on that one.

Now, this is not another opportunity for me to rant about capital spending, and the huge future debt being piled on customers over the last decade.

I’m tempted.  But no.

What this is about is regulatory capture, so the Big Build is interesting in this context mostly for demonstrating to whom the OEB listens when it is developing and implementing policies.

The Big Build started with the utilities saying they needed more money for capital.  The utilities didn’t come to the Board with empirical evidence that they needed to ramp up their capital spending.  Oh, no.  They, and their trade associations, and their favourite consultants, just kept repeating it as a mantra, over and over again.  We need more.  No evidence.  Just repetition.

The OEB is chock full of economists, so they are very familiar with the Averch-Johnson effect, first introduced in 1962, and today a still debated but generally accepted basic paradigm in utility regulation.  What Professors Averch and Johnson posited, and demonstrated, was that companies that are regulated based on a rate of return tend to over-build.  Sometimes it is conscious, and sometimes subconscious, but in fact they will chase profits.  Since profits come from rate base, they will build as much rate base as they possibly can.

Further, as subsequent research has shown, if the return on capital for the regulated entity is high relative to what the shareholder can earn elsewhere (as is the case in the Ontario wires sector, where the shareholders are mostly municipalities), the tendency to over-build is increased.

Since this built-in bias was well-known to the OEB when they were hearing all this sturm und drang (what, would you have preferred “weeping and gnashing of teeth”?) about capital needs, they should have been skeptical.  When the customer groups asked to see empirical evidence of increasing needs, a truly independent regulator would have been leading the charge to get that evidence.  “Why do you need more money now?” they should have said.

Instead, the OEB asked a different question:  “How do you want to spend this extra money?”  Rather than look analytically at overall capital needs, the OEB asked for Distribution System Plans, otherwise known as wish lists.

Now, in principle there is nothing wrong with Distribution System Plans.  Every distributor should have one.  (In fact, they shouldn’t have to be told, but that’s a whole other story.)  What’s wrong is that the OEB started from the premise that if the utilities said they had to boost their capital spending, that must be correct.  They are the ones that know their systems, right?

The OEB’s policy response to the utility “we need more capital” message has consistently been to believe the message, and implement policies (incremental rates to fund capital spending, anyone?) that provide more money for that purpose.

When a regulator believes what the regulated companies say, despite no supporting evidence, that is a classic indicator of regulatory capture.  That is particularly true in a subject area where, according to well-accepted regulatory principles, it is likely that the utilities will have an underlying bias, and thus may not be objective.

The likeliest reason for the Big Build was regulatory capture.

What is the Evidence of Capture of the OEB? – Part 3: Policy Development

Less empirical, but still illuminating, is how the OEB goes about developing new policies.  You would expect that a regulator that believes “outcomes” are the most important goal (they are) would start by talking to customers.  The opposite is in fact true.  They start by talking to the utilities.

Just a couple of examples will demonstrate this.

At a recent OEB meeting, a senior executive of the OEB told us that residential customers were not concerned about the Board’s recent change to all fixed distribution rates.

I was surprised, so I asked where that information came from.  After some hesitation, we were told “We talked to the EDA [Electricity Distributors Association], who speak for their customers.”

When I noted that speaking to the distributors – who asked for this change in the first place – is not the same as speaking to the customers, the executive said “Oh, and we noted that there were no complaints at the Community Days around the province.”

I said “Did you go to any of the Community Days?”  When the response was no, I explained that I went to several of them, and the most common complaint of customers was the impact of the new all fixed rates on tenants and seniors.  You couldn’t miss it.  Some of those customers were very upset about it.

Deer caught in the headlights.  They simply didn’t know what the customers thought, and they assumed that the utilities were communicating on behalf of the customers.

Really?

Another example arises out of a similar situation.  The Board is proposing to change the structure of distribution rates for business customers, in order to deal with behind the meter generation and the potential for erosion of distribution revenues.  To develop the new policy, they consulted with everyone, but they didn’t like the answers proposed.  Then, they spoke to the distributors, reached a consensus with them, and approved the new policy internally.

Then they went to talk to the customers to tell them what they planned.

Duh.

Turns out, what they had already decided (before talking to the customers) was in fact a bad idea.  It completely missed the fact that solar behind the meter – really the main point of the change – operates at a 15-20% capacity factor, so that their proposed new charges would make rooftop solar completely uneconomic for businesses.  (Sorry, Mr. Energy Minister.)  It also completely missed the fact that it would catch (and penalize) peak-shaving by larger users with gas cogeneration, something that is specifically incented by the province under the Industrial Conservation Initiative, and desperately needed.  (Sorry again, Mr. Energy Minister.)

How do you establish a new policy on rates, involving hundreds of millions of dollars a year of additional charges, without at least investigating how customers will be affected by the policy?  The answer is, if you are too eager to believe what the regulated utilities tell you, that’s what can happen.

And that sounds a lot like regulatory capture.

A much bigger example is changes in the last couple of years to the Board’s M&A policy (called MAADs, an increasingly appropriate acronym).

Under the old policy, the Board tried to encourage consolidation amongst electricity distributors by offering a five year grace period (a rate freeze, in effect) after a merger.  The theory was that mergers should produce substantial savings, and for the first five years the savings would go to cover transaction costs, and then provide a financial reward to the shareholders.  Customers would benefit right away from the freeze, but would not participate in the main benefits from the merger until after five years.  A number of successful mergers took place on this basis.

The utilities, however, complained that their incentive was too small to promote consolidation, even with pressure from the province on the utilities to merge.  The utilities wanted more financial incentives to go to them, and less benefits to their customers.

The OEB complied.  With limited discussion (except with the utilities, of course), the OEB said that the period over which the benefits would go to the utility shareholders would be increased to ten years.  Not only that, but there would no longer be a rate freeze.  Now, the utilities would continue to get rate increases based on a formula, so the customers would get nothing at all in that period.  Further, if the utilities wanted to spend extra money on capital, they could get that from the customers too, including the additional profits that come from investing in more capital.  All of this, without any reference to the actual costs to run the merged utility, which were expected to decline.

The result?  Mergers like the recent Alectra combination, which created the second largest distributor in the province.  The shareholders of the merging utilities are expected to be rewarded with an extra $425  million, starting essentially right away.  The customers will only start to get benefits from the merger ten years later (so they say).  Meanwhile, they will suffer through more rate increases in excess of inflation, year after year.

The new MAADs policy is just another example of the OEB believing the utilities, and fashioning policies to respond to what the utilities want.  At the expense of the customers.

Regulatory capture.

There are lots of other examples, some of them obvious, some of them more esoteric.  A pattern emerges.  The OEB either responds to complaints of utilities with a new benefit for them, or it thinks up something on its own and checks with the utilities to make sure it works for them.

It would be easy to overstate this, and that would not be fair.  The OEB carries out many consultations, including many with customer groups.  Customer groups often – usually, in fact – have sufficient resources to participate effectively, and do so.  In many of those processes, the OEB takes note of customer concerns and adjusts policies accordingly.

But there are a disconcerting number of examples where it is apparent that what the utilities want in a policy is what will happen.

Preventing Regulatory Capture

There has been an enormous amount written, by academics and others, on the ways to prevent regulatory capture.  This was especially the case after the financial crisis of 2008-9, which many ascribed to regulatory failures in the financial industry rooted in regulatory capture.

The ways to fight regulatory capture can be loosely divided into two categories:  structure and process.

Scott Hempling has written extensively about methods to avoid regulatory capture by shoring up the structure of the regulator.  For example, he talks about the importance of empowering the personnel of the regulator, including in particular ongoing professional development, so that professionalism and personal responsibility generate a natural barrier to regulatory capture.

Hempling also talks about the regulator ensuring that it frames the agenda, and that its regulatory stance is proactive rather than simply responsive to utility applications.  He notes that regulators who are the most independent are the ones that get out in front of issues, and then allocate sufficient internal resources that they can control the agenda right through policy development and implementation.

For the most part, the OEB is already doing the things that Hempling suggests.  While some have complained that OEB staff are not sufficiently empowered (and that is probably true to a certain extent), on balance the structural defences are in place at the OEB.

Others who talk about structural solutions emphasize clarity in the legislation.  Still others have suggested that the legislature should actually appoint an officer to oversee the independence of regulatory bodies, much like an Auditor-General or an Ombudsman, but directed to administrative tribunals.

These are of only marginal relevance to the OEB.

On the process side, the primary theme is systems or approaches to ensure customer voices are heard more clearly and more often.  Professor Daniel Schwarcz of the University of Minnesota, an insurance regulation specialist, believes that the key ways that a regulator can fight regulatory capture are a) encouraging and resourcing independent customer representatives, and/or b) appointing and empowering independent consumer advocates.  Many other commentators and regulatory specialists, in a diverse range of regulatory areas, echo these suggestions.

Professor Elizabeth Madill of Stanford suggests something similar in the realm of judicial review.  If access to the courts by customers and other interest groups is expanded and facilitated, she says, that can act as a check on regulatory capture of agencies.

Sadly, the OEB is moving in the opposite direction.  In a new policy, just announced, the OEB will limit the voices of customers even more than in the past.  Further, those voices will be focused on the bigger, litigated cases, just the ones where regulatory capture has been less of a problem (in part because of the participation of customer groups).

(This new policy, which has not been the subject of any consultation with customers, will be dealt with in a future article.)

Thus, it can be expected that regulatory capture will, if anything, get worse at the OEB.

Conclusion

The OEB, like any other regulator, has good and bad aspects.  On some key metrics, the OEB is not delivering as it should for the customers, and the primary reason for that is probably undue influence by the regulated utilities, i.e. regulatory capture.

The OEB and the provincial government may want to take note of what has happened to the National Energy Board (NEB) over the past decade.  As the Federal Government’s NEB Modernization Panel recently explained in their Final Report, many Canadians have lost confidence in the NEB, precisely because they feel it has been captured by the industry it regulates. The road back for the NEB to rebuilding the trust of the public, particularly those who are most directly impacted by its decisions, could be a long uphill struggle.  Realistically, it may never happen.

Better the OEB fix the nascent problem it has now, while it is still not too late, as opposed to exacerbating it, perhaps beyond repair.

  • Jay Shepherd, October 4, 2017

 

Posted in Energy | Tagged , , , , , , , | 2 Comments

Small Business Tax Avoidance Proposals

[This is my analysis of current government proposals to change the private corporation tax rules, limiting certain tax planning schemes.  It has also been filed as a submission to the Minister of Finance.]

Background and Summary

I own a small professional business – a law firm – that is incorporated, but I am not using or planning to use any of the tax minimization techniques that are the subject of the government’s current small business tax proposals.

Unlike most small business owners, however, I also have a fairly thorough knowledge of the tax system, because for more than a decade in the eighties and nineties I made my living as a tax lawyer designing tax planning strategies, mostly for small and medium-sized businesses and their owners.  I also taught tax planning at the law school, and to junior tax lawyers taking the CICA (now CPA) In-Depth Tax Course.  While I don’t give tax advice today, the comments below are informed by my experience helping hundreds, maybe thousands, of Canadian business owners reduce their taxes.

Four main tax changes are being proposed, all with the avowed intent of reducing the ability of “wealthy Canadians” to pay less tax, through incorporated companies, than they would pay without the use of a corporate structure.

To test the proposals, it is necessary to look at two aspects.  First, does each proposal address an inherent “unfairness” in an effective but practical way?  Second, do the proposals correctly reach the targeted individuals, or do they also catch in their net others they should not be attacking?

The proposals are mostly sound.  However, as with many aspects of the Income Tax Act, the devil is most certainly in the details.

This analysis deals with each of the four proposed changes in turn.

The main recommendations that flow from this analysis are the following:

  1. Provide a complete exemption to the dividend sprinkling rules for any family member with a significant role in the business of another family member.
  2. Apply the dividend sprinkling rules only to dividends received by a family member in excess of $25,000 per year.
  3. Review potential unintended consequences of the sprinkling rules on estate freezes and similar structures.
  4. Proceed with the surplus stripping rules as proposed.
  5. Withdraw the proposed passive investment rules, or in the alternative limit them to passive investments in excess of those prudently retained for the active business (150% of the replacement value of the business assets, or 200% of the business liabilities).
  6. Withdraw the limits on the lifetime capital gains exemption relating to trusts and minors or, in the alternative, increase the LCGE limit to at least $3 million.

Dividend Sprinkling

Context.  The Canadian tax system has progressive tax rates based on individual income.  Each individual is presumed to have an ability to pay that is driven by their own personal income, not the income of their family members or colleagues.  With minor exceptions this assumption reflects reality, and most of those exceptions are covered by rules to correct for their impacts.

As a result, the system has to include rules against shifting income to family members and others in ways that mean ability to pay is masked.  If Person A earns $250,000 a year, they can afford $80,000 in taxes, the theory goes.  If Person A is allowed to treat their own income as $50,000 earned by each of five family members, their combined tax is only $40,000, even though their ability to pay is $80,000.  The system can’t function properly if you can hide your true tax situation through redirection of income.  There are already a number of rules designed to prevent this.

One rule that was left open allowed a person who owned and operated a private corporation to issue shares to adult children.  Income would be taxed at a low rate in the corporation, as is normally the case.  If all the income were paid out to the real owner in dividends, the total tax at both corporate and individual levels would be roughly the same as if the income had been earned directly.  The tax break in the corporation is temporary, designed to allow the company to reinvest in growing the business.

However, by paying the income out to children with lower incomes (i.e. sprinkling), tax would be at a lower rate.  The overall tax paid on the income is reduced.

The new proposals add an incremental tax on those dividends, except to the extent that the children have contributed capital or services to the business and as a result the dividends are reasonable.

Analysis.  In principal, this is eminently fair.  Pretending that income belongs to children when it really belongs to the parent is something that should be prevented, if for no other reason than it is intentionally misleading.

There are three situations, though, in which the Minister should reconsider how this is to work.

First, the paradigm on which the proposals are based is that the “real” owner of the business is the parent.  In today’s economy, it is often the case that a parent is involved in their child’s business, whether as financier, partner, advisor, or provider of creditworthiness.  This is an increasing trend.   Where that relationship exists, the proposals could result in a punitive tax where one is not appropriate.

A simple example is the parent who owns one class of shares of their child’s small business corporation, thus showing the bank that the parent is actively involved, and in the process allowing the business to access bank and other credit.  The child owns the other class of shares.  In practice, the intent is that all dividends will be paid on the child’s shares, who is the actual owner of the business.  The shares for the parent are just an accommodation (or, just for show, if you’re cynical).  I know of several situations like this right now.

As currently structured, the government’s proposals may tax some of the dividends as if they in substance belonged to the parent, when that is simply not the case.

A similar result can arise when a parent brings an adult child into their own business as a kind of apprentice, planning that over time the child takes over.  Dividend payments in those circumstances may be influenced by tax impacts, but also and usually more importantly by personal and business considerations.

The solution to these concerns is to provide that the new rules will not apply where the child is a significant contributor to the business, for example providing similar contribution to the parent.  If parent and child both work full-time in the business as key principals, or if the child works more than the parent, the dividends paid by the corporation would be exempt.  Once that is shown to be true, the structure is no longer for tax avoidance, but rather has a business purpose.  Finance and CRA should continue their longstanding policy of not second-guessing the business judgments of small business owners.

This would go a step beyond the reasonableness test.  It would recognize that, where tax planning is not a primary driver, the CRA should simply leave the small business owner alone.  It has the added advantage that, in the majority of cases where more than one family member owns a business, the new rules would be excluded entirely.  This simplifies the Act and targets the new rules more closely to those who abuse the system.

Second, the new dividend sprinkling rule should have a de minimis test, primarily to ensure that these new rules don’t waste government money and enrich tax advisors, but focus instead on closing loopholes.

There is a rule, for example, that salaries paid to family members of a business owner are only deductible by a corporation if they are reasonable.  That rule dealt with the prevailing “sprinkling” strategy of the day.

Not in that rule, but much like a rule (at least in the 1980s), was that salaries to adult family members would not be challenged CRA if they were $15,000 per year or less.  This assessing practice, which is now probably closer to $25,000 or $30,000, is just a practical reality.  CRA cannot spend oodles of money claiming that a twenty-five year old daughter is not adding $20,000 of annual value to the company by providing advice to her mother, the owner.  It would cost CRA more to collect the small tax differential than it’s worth.  As well, this assessing practice saves the small business owners a lot of unnecessary grief.

The same reasoning applies to dividends.  Aggressive dividend sprinkling is an unfair advantage, and there is usually enough tax differential involved that the reasonableness test can be used.  Small dividends from a parent’s company to adult family members represent minimal tax leakage, and maximum enforcement cost.  Who is to say that a thirty-year-old daughter who is a medical student shouldn’t be paid through dividends to sit on an advisory board for her parent?  Do you really want to take that one to court?

My suggestion is that, for children over the age of twenty-five, the new rules only apply if the dividends paid in a year are $25,000 or more.  Anything below that is presumed to reflect the inherent value in having family members engaged in the business.  This has the added benefit that the smaller the business, the more likely this de minimis rule is applied.  That means that the extra tax will apply most often to those who are in fact “wealthy Canadians”, and for others their lives will be made simpler.

Third, there are many corporate structures in which shares are held by family members, or trusts, and the motivation is almost entirely rational family ownership, not tax planning of income.  The estate freeze is the classic example.  In many of these structures, there is no intention to pay dividends to the family members or trusts.  They are holding shares to facilitate an eventual intergenerational transfer of the business.

A problem could arise, though, if the corporation has to carry out a reorganization or similar transaction.  In many of those situations, the law deems transfers of shares to be dividends, even though at the end of the day the economic position of the shareholder is unchanged.

The government’s proposals do not appear to deal directly with this problem.  It would be helpful if, before the proposals are brought forward in legislation, the Department of Finance goes over the various scenarios that might apply, whether in estate freeze situations or otherwise, and ensures that the sprinkling rules don’t produce unintended consequences.  At this point, it is not clear that they have done that.

Passive Income

Context.  The government is concerned that private companies will accumulate retained earnings that are taxed at the lower corporate tax rate, and then reinvest those after-tax earnings in passive investments.  Because the tax is lower in corporations, the amount that can be reinvested is higher than an individual would have available to them in similar circumstances.  This gives the private company an unfair advantage, even if later, when the money is paid out to shareholders, it is subject to an extra tax cost.

The government is proposing to impose an extra tax on these passive investments in corporations, to remove this advantage.  The proposal is still a little murky, because the final approach has not been determined.  The outline, however, is known.

Analysis.  This is not a good idea, for two main reasons.

The vast majority of businesses that have passive investments do so as a cushion for the inevitable downtown.  Like it or not, most businesses have some cyclical aspects to them, whether they be lumpy cash flow, susceptibility to economic cycles, or just the ebb and flow of the seasons or customers’ buying patterns.  A well-run business will have a bank line to smooth the day to day ups and downs, and savings that can be drawn on when things get really bad.

In addition, some small businesses try to have a sinking fund that they build over time to replace major capital assets.  A fishing captain needs to spend $250,000 on a boat in thirty years.  Saving a little each year – building a nest egg – is the smartest way to finance all or part of that cost.  That is especially true if the goal is to maintain the business for subsequent generations.

Any extra tax on passive investments amounts to a penalty for prudent long term cash management.  A front end tax means that the amount that is available to support the business, or invest in new business assets, is substantially reduced.  Or, from the business owner’s perspective, he or she has to work harder or longer to save up the same amount of money in the business.  A back end tax means that investments used to strengthen the economic viability of the business are ultimately penalized.

The other reason is that a tax on passive investments will almost certainly change how business owners deploy their money.  It will mean they are less likely to invest in new machines and other production type equipment with cash, since building up the cash will generate a penalty.  They will borrow for that kind of assets.

On the other hand, when they do have excess money, they will invest in general plant:  buildings, land, etc.  Why would you rent your factory when you can direct your savings into the mortgage payments on a factory, and hold a long-term investment without the penalty tax?

If they can’t invest their money in appreciating general plant, then the alternative is to take the money out of the company and invest it personally.  Sounds OK, right?  No, it isn’t.  Money invested outside of the company will be invested with a different purpose, and will be more susceptible to erosion due to personal spending choices.  The business will be weaker, and in the long term will suffer.

The ability to reinvest earnings in passive investments is a key part of running a business.  If the government wants to prevent abuse of this flexibility, it should set a limit on passive investments that are considered to be part of the business, e.g. twice the level of liabilities, or 1.5 times the replacement value of the business assets.  Those passive investments should be exempt from punitive taxation.  If businesses are used as a smokescreen to get favourable tax treatment for a true passive portfolio, that will still be limited, since investments above the exempt level would still be taxed more heavily.

Removing Funds from Corporations Tax Free

Context.  The government is concerned that, through a series of indirect transactions, a business owner can take money out of their company tax-free by converting salary or dividends into capital gains.  The technique, called “surplus stripping”, is partially blocked by existing rules.

However, those tricky tax planners have figured out some ways to avoid those rules.  These methods are generally only viable if the money involved is substantial, because the legal and accounting costs to set this up can be pretty high.

Analysis.  The government is legitimately limiting the ability to avoid tax when the surplus is taken out of a company.  While the proposals could result in some double taxation (capital gains and dividends) if an avoidance transaction is unsuccessful, that is treated as a risk that arises in aggressive tax planning.  I agree.

The main difficulty here is that this is a complex area, and the tools available to the tax planners outstrip the ability of the government to shut down all avenues of tax minimization.    It is likely that this will continue to be a cat and mouse game well into the future.  Tax planners have no limits on their creativity.  They are already designing ways around these new rules.

Lifetime Capital Gains Exemption

Context.  The lifetime capital gains exemption (LCGE) allows individuals to earn a capital gain on shares of a private corporation that carries on an active business.  Currently the maximum you can claim under this rule, in your lifetime, is about $835,000, or $1 million for a farm.  The purpose of the rule is to recognize that small business owners take big risks, and on the sale of their shares should be allowed an extra tax benefit commensurate with those risks.

It has long been common practice for entrepreneurs to ensure their close family members have shares, so that when the business is sold each family member can earn a tax-free gain.  Sometimes this is simply to split the gain between family members for personal reasons.  More often, though, it is to multiply the individual limit by the number of family members.  If there are five family members, for example, a gain of up to $4,175,000 can be received by the family tax-free.

Many serial entrepreneurs put shares of their company into a family trust for their kids, often while the kids are still minors.  If the business doesn’t fare well, the cost of the setup is low.  If the business succeeds, on the sale of the shares there is big pot of money available in the trust for the kids’ futures.

The multiplication of the LCGE, and the use of family trusts to hold the proceeds, have both long been accepted by the government.  Indeed, from time to time requests to increase the dollar limit on the LCGE have been answered by the fact that, for many small business owners, the limit is really much higher.

The government now wants to change the LCGE in three ways:

  • Shares subject to the dividend sprinkling rules would also be ineligible for LCGE.
  • All capital gains on shares while a person is under 18 would be ineligible for LCGE.
  • Gains on shares held through family trusts would be ineligible for LCGE.

Analysis.  This alters decades of express policy allowing flexibility in the use of the LCGE.  While in general controlling LCGE abuses has merit, there are at least three reasons why the current proposals will do more harm than good.

First, the prohibition against using a family trust will result in small businesses issuing shares directly to kids, whether minor or adult.  There is a different psychology where a child actually owns shares in a parent’s business, rather than having an interest through a family trust.  The actual ownership of shares can create feelings of entitlement, challenges to parental authority, and legal disputes.  Shareholders’ agreements and other expensive tools to limit those impacts are not well-aligned for that purpose.

The end result is that the no-trusts rule will likely result in the sustainability of many small businesses being undermined by infighting and other negative impacts.

This is true even if the shares are issued to minors, with the added problem that denying LCGE to minors solely because of their age is almost certainly contrary to the Charter of Rights.  This is especially true since there is proposed to be an anti-avoidance rule – reasonableness – that would otherwise protect the fisc.  If a benefit to a minor is otherwise reasonable, how is it constitutional to apply punitive tax treatment to that benefit only because of their age?  Any nexus between tax leakage and the taxpayer is already shown not to be present.  There is no legitimate policy reason why the same reasonable benefit to a 17 year old and to a 19 year old should be taxed differently.

Second, the new rules fail to recognize that, for many small business owners, they take risks and drive the Canadian economy in large part to create a legacy for their family.  For some, they are looking to pass their business on to their kids.  For others, involving their kids indirectly in their business is a powerful way of helping them grow up.  For still others – and particularly for new immigrant families – the risks of a small business are worth it only because of the owner’s responsibilities to his or her family.

The proposed new rules say, in pretty stark terms, “your business is just about you, and should have nothing to do with your family.”

In my view, it is simply bad public policy to ignore the legacy-driven strength of many small businesses.  Anything that undermines public support for that legacy hurts the small business owner, and through them the economy.

Third, if these proposals are to proceed the lifetime limit probably should be reconsidered.

The LCGE has been successful in part because the entrepreneur sees the pot of gold at the end of an often stressful and high-risk rainbow.  This is not wealth, in the sense most people think of it.  It used to be called, in the vernacular, “f**k you money”.   The small business owner works eighty hours a week, puts second and third mortgages on the family home, and endures sleepless nights, all in pursuit of financial freedom, the proverbial ability to say “f**k you”.   It means earning the right not to allow anyone else to decide how you live.

$835,000 no longer qualifies as f**k you money.   Years ago, the conceptual number was $1 million.  Today, maybe it is four or five times that, maybe a little less, but it is certainly not $835,000.

This has not been a problem, in part because so many small business owners were able to multiply the taxable gain to reach $2-3 million.  If that is no longer possible, the incentive value of the LCGE is dramatically reduced.  At some point, it becomes a wasted tax expenditure, a tax cost with no concomitant economic benefit.

The solution is that, if the LCGE is to be tightened as proposed, the lifetime limit should be increased to at least $3 million.

Conclusion

Taxpayers and their advisors have in some cases taken sufficiently full advantage of the small business tax rules that unfair tax outcomes have occurred.  It is legitimate for the government to seek to limit that.

However, the current proposals from the government should, in my view, be re-thought so that they are more carefully targeted, and they don’t stifle entrepreneurship in the pursuit of tax fairness.

   –  Jay Shepherd, September 21, 2017

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Parenting

WARNING:  This article may contain twists and turns that you were not expecting.

I was in a very nice restaurant with three friends, having dinner.  It was about seven o’clock, maybe a little earlier.  Because the place was full, we were in the bar area, but it was still very nice.

Honestly, I was trying to focus on the conversation amongst my friends.  It was actually quite engrossing; a riff on the convoluted psychological makeup of Trump supporters, and how they were similar to Bernie supporters, or something like that.

I really tried; I’m not exaggerating.  I was interested and, at least for some of the time, fully engaged.

On the other hand, anyone who has spent “quality” social time with me will know that I have a tendency to get distracted if I see something intriguing happening around me.

Just ask my kids.

What was playing out at the next table was a vignette that insisted on getting my attention.  Three adults – two men and a woman – at the table.  No food, just alcoholic beverages (a beer, a glass of red wine, and some mixed drink with a lime in it).   The men were in their mid-thirties or so, one a little older, the other a little younger.  The woman, who had a laptop open in front of her, was probably late twenties.

The dynamic of the three was clear.  The younger of the two men was the boss, and the other two worked for him.  He was a big, confident man.  Fit, strong-looking, with a powerful voice and an imposing visage.  He was giving instructions (at one point dictating invoices, for example, which the woman was producing) and eliciting dialogue from the others on decisions he was planning to make.  It was quite respectful, but there was no doubt the hierarchy of the three.  It was a friendly business meeting, but still a meeting.  The boss was unquestionably the dominant personality in the group.

Periodically the meeting was interrupted by phone calls.  The boss took them, dealt with them quickly, and then came back to the meeting.  Everything was proactive on his part.

Orbiting these three adults like a somewhat erratic comet was a seven-year-old girl, full of energy, hair flying, interacting with the servers, with other customers, and with the three adults.  Particularly, I should add, the boss, who was obviously her father.

The servers, all female, were doting on her.  While her father was trying to run a meeting, they were getting her ice cream, and soft drinks, and just making sure she was happy.  When she was ready to eat the ice cream they helped her commandeer a table next to her dad so she could focus on the treat, and stay close, but not interfere in the meeting.

The father was the best.  Without missing a beat in his meeting, or his phone calls, he kept his daughter in his focus.  He was joking with her, happy to be with her.  Not thirty seconds went by that he wasn’t talking to her, giving her his attention.

It is a difficult thing to do, run a meeting, deal with customers and suppliers on the phone, and interact with a child at the same time, but he did it, and it wasn’t just for show.  When she interrupted to ask for more attention, he gave it freely.  There was little doubt where his priorities were.  More than once he simply stopped what he was doing to play with her for several minutes at a time.

His daughter was not necessarily happy that she only had part of his attention, but she was accepting what she had, and she was enjoying at least that part.

Observing what was happening, you could empathize with the father as well.  On the one hand, clearly he was running a business that was demanding all of his attention.  On the other hand, his seven year old was there, and she was also demanding all of his attention.  He was juggling both, generally successfully, but with the emphasis on his daughter when the choice had to be made.

Life can certainly suck.  Sometimes you have to handle all of your priorities at once.

In the middle of playing with her father, the girl suddenly shouted “Mommy, mommy, mommy,” and ran towards the door.  Then, just as quickly, she ran back to her dad saying “Mommy’s here”.  He got up, took her out of the bar, and when he came back ten minutes later, he was alone.

“Her mom has finally been able to finish work, so she’s taken Diana to Starbucks.”  He was relieved, but not necessarily in a positive way.  He had enjoyed being with his daughter, even while having a meeting.  It was just taxing.

So far, so good.

Then, he had to add: “My wife should be looking after her more, but she wants to work, and I can’t really stop her.  I can look after the money – for her, for the kids.  There’s more than enough.  My business is solid.  My wife is just not willing to be their mother full time.  She feels a need to get back into her profession, be successful.  Sometimes I have to be the parent.”

The other two looked at him – a bit dully, I would say, but remember that he’s their boss.

Their silence prompted him to say more.  “I want my three daughters to have a stimulating home life.  My wife is smart, well educated, a respected professional.  She should be making sure that they are always challenged intellectually.  I don’t want my daughters to be limited in their lives.  They should think:  the sky’s the limit.”

“But,” he says, “my wife is more concerned about her own career than about making sure our daughters are brought up right.”

The woman was looking down at her laptop, but then she looked up. “How are you balancing your business with her career?”  The comment was perhaps gutsy – not consistent with her previous subservient attitude – but he didn’t jump all over her.

“In the end,” he said, “I have a business to run.  That’s what puts food on the table.  My wife has to understand that the kids are her responsibility.  She was OK with my oldest daughter, who’s now in high school.  It wasn’t even too bad with my middle daughter.  But, with Diana she doesn’t seem to have the same focus on her parenting role.  I don’t know what to do sometimes.”

So, stop right there.

This is not time you have heard a father who loves his kids, but is tone-deaf to their real needs, or to the concept of shared parenting.

On the other hand, you were a little shocked that he would have such backward views.  I have described him as a well-off, urban father in his thirties with a spouse who works as a professional.  Yuppies, in other words.  Yuppie fathers are not supposed to say things like that.

You also assumed the ethnicity of the people in the story.  At the very least, you assumed they were white.  That was part of the reason why you were shocked.

But that is not the case, not in this story.  The two employees were white.  The father/boss was black, as was his daughter and his wife.

Aha.

You see, that changes everything for you, doesn’t it?  Now you are no longer shocked.  Now, you “understand” why the father/boss had such gender biased views of the parenting roles he and his wife should play.  Now, the fact that he wants his daughter to be empowered is a credit to him.  Kudos to the black father who wants his daughters to have everything in life.

Racism is about expectations.

This article is not actually about parenting;  it’s about racism.

I lied.

Just as disclosing that the father and daughter were black affects your view of the situation, so would saying that the mother was wearing a hijab.  The same would be true if the family were described as Filipinos, or as Hispanic.

I didn’t give them an ethnic label in this story, and as a result almost every reader of this article assumed they were white.  The effect was to engender feelings of surprise that the father would be as sexist as he was.

Expectation:  white people are not as sexist as non-whites.

So now, once you have your implicit assumption put to you, will you embrace it?  Will you agree that white people are not as sexist as non-whites?

The answer, for most of you, is that you will resist with all your might.  That sort of statement is racist.  Canadians don’t believe things like that.

A few of you might fight back, saying that yes, statistically people in some ethnic groups are more consumed by outmoded gender rules.  Yes, men in the black community are more likely to be sexist.  Or Muslim men.  Or Filipino men.  Or Hispanic men.  (I could go on.  Not white men, of course.  No, no, non.)

But let’s assume for the moment that those “statistics” are true.  (Just assume it.  Humour me.)  Does that mean that it is appropriate to expect a black man to be sexist, but not a white man?

Eight nanoseconds of reflection will show that is not true.  Everyone reading this knows at least one black man who is a fully engaged and interactive father, an equal parent to his kids.  Everyone reading this knows at least one white man who takes the more traditional (British, French, German, Hungarian, Polish…you name it) parenting role, i.e. being a parent is something that women do.

Biases come in all shapes and sizes.  In all cases, they are expectations that, because of some attribute or another (skin colour, ethnicity, religion, etc.), a person will have some other attribute or predilection.  We know intellectually that the connection between the stereotype and the assumption is generally not true (except sometimes in a probabilistic sense, and often not even then).

We still have the biases, though.  We still expect people to be a certain way because of the colour of their skin, or the language they speak, or the ethnic background they possess.

We assume because we are lazy.  We don’t want to be.  When it is pointed out, we recoil, and try to avoid the truth.

The fact is, though, that in this story your perceptions almost certainly changed as soon as race, or religion, or national origin, was added to the story.  It doesn’t even matter your own ethnicity, or religion, or background.  Adding a descriptor like race changed things.  (Yes, there are exceptions.  Are you really one of them?)

But here’s the worst part.  I saw this story unfold in real time, so the race of the father and daughter were not a surprise.  Did I already have the racial bias embedded in my expectations as I was watching?  The answer is:  How would I ever know?  To me, it seemed to be just people acting in the sorts of ways that people do.  A father enjoying time with his daughter, while juggling his business responsibilities.

In Canada, a black boss or a black father, or both, is nothing unusual.  We see it all the time (in contrast, perhaps, to some other parts of the world).  When the situation unfolded, those things appeared to be irrelevant.

Then, when the father revealed his true views of the situation, was it surprising?  Certainly it was.  He seemed like he was so in tune with his kid.

But, was it less surprising because he was black?  Did I subconsciously see his words later as “expected”, because of his skin colour?  The answer is, I don’t think so, but how on earth would I know?

Racism is not just refusing to rent your apartment to someone because of their race or religion or ethnicity.  It is not just choosing the white person for the promotion over the non-white.  It is not just streaming the white or Asian kid into the academic courses and the black or Hispanic kid into the trade-oriented courses.

Racism is about expectations.  If we want to challenge racism, whether in ourselves or others, we must first challenge those underlying expectations in ourselves, whenever we encounter them.

Of course, those expectations don’t always wear name tags.  We sometimes have to look hard to find them.

  –  Jay Shepherd, September 4, 2017

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