Energy #5 – Hydro One – An Enigma Wrapped in Inertia

The media are abuzz with the possibility that the Ontario government will privatize all or part of Hydro One, the “jewel” of Ontario’s Crown corporations. The government could reap “billions and billions” (as Carl Sagan used to say) to spend on things we need now.

If only it were such a jewel.

Hydro One’s franchises – monopoly distribution and transmission rights – are indeed jewels. The company itself? Not so much.

This is a company faced with a raft of problems, including operational management, strategic direction, and regulatory oversight. Those problems are central to the privatization question.

Background

Hydro One is one of the children of Ontario Hydro, a massive provincial Crown corporation that basically went bankrupt in the 90s, and had to be rescued by the provincial government. In a reorganization of its structure, Ontario Hydro was relieved of responsibility to pay back most of its debt. The debt that the old Ontario Hydro couldn’t handle – more than $20 billion – was taken over by the province, and is being paid for through various additional ratepayer charges over perhaps fifty years (actually, who knows how long).

The bulk of the remaining entity was then split into three new entities.

Ontario Power Generation was formed to own and/or manage the electricity generation facilities, which are mainly nuclear and hydroelectric today. The job of managing the system itself was given to the Independent Electricity System Operator, which now also controls procurement of conservation, and privately-owned generation, through its recent merger with the Ontario Power Authority.

The “wires” business went to Hydro One. That has two parts:

transmission (movement of electricity at bulk levels between various areas of the province, and to/from neighbouring jurisdictions), and

distribution (local delivery to end users).

Hydro One owns and operates about 95% of the province’s transmission system, using assets with a gross cost of $15.7 billion, and a current net book value of $10.2 billion. It charges customers a total of about $1.5 billion per year for transmission of electricity around the province.

Hydro One also owns and operates the distribution franchises for much of rural and small town Ontario, plus one large city, Brampton. As local distributor for those customers, Hydro One distributes about 3% of the province’s electricity in Brampton, and about 20% of the province’s electricity to over a million rural and small town customers. The Hydro One distribution business was originally limited to rural areas, but in 1999 and 2000 Hydro One purchased more than 90 local municipal utilities, including the Brampton utility, and in 2013 it launched another round of purchases.

Hydro One’s distribution business uses assets with an original cost of $10.8 billion, and a current net book value of $6.8 billion. It annually collects about $1.5 billion from customers for distribution services. With the exception of its low-cost Hydro One Brampton subsidiary, Hydro One has consistently had among the highest distribution rates in the province.

Operational Management Issues

Sometimes it seems like everyone has something critical to say about the management of Hydro One operations. It has been mired in controversy from the get-go, and in recent years there has been a parade of reports criticising both its operating decisions, and its results.

For example, the Ontario Ombudsman has recently looked at aspects of Hydro One’s billing of customers, calling the results “shocking”. The 7,900 complaints about billing problems in 2014 included many examples of five and six figure errors in bills for ordinary residential customers. In a Twitter war over the last several days with well-known analyst and journalist Tom Adams, the Ombudsman tried to downplay the criticisms. The fact remains that they were pretty intense.

Not a day goes by without someone complaining about Hydro One’s reliability. Of course, this is in part because Hydro One has a large rural component, creating special challenges relating to terrain, weather, and other things. However, for the significant number of Hydro One customers in small towns, outages also continue to be a source of regular concern.

More common still are criticisms of Hydro One’s employee compensation.

The annual “Sunshine List”, which shows the overall compensation (excluding pensions and benefits) for province government employees earning more than $100,000, is a constant source of embarrassment for Hydro One. The latest one, for 2013, shows more than 3,300 Hydro One employees above that $100,000 level. That’s more than 60% of their employees.

And this is not a new story. The problem of high pay for Hydro One employees has remained the same for a decade or more. It is so bad that other electricity distributors in the province face constant upward pressure on their wage rates, just to keep pace with the levels at Hydro One.

The pension component of compensation is even worse. The 2014 report by the Special Advisor on Pensions, Jim Leech, called the Hydro One and OPG plans “unsustainable”, noting that the cost of pensions for Hydro One is 27% of its base compensation levels, much more than private sector companies, other utilities, or the broader public service. (By contrast, Enbridge, another large utility, spends about 10% of base compensation on pensions.)

Periodically, studies have been done of Hydro One compensation levels. In every case, they have shown that the Hydro One levels are well above any benchmarks that are used. A recent Mercer study commissioned by Hydro One, for example, showed Hydro One base compensation at 10% above market levels. Various previous studies in 2009 through 2013 showed similar, mostly worse, results. For 2015, Hydro One expects to pay an average of $114,000 per employee. Enbridge, for example, will average $85,000 per employee in 2015. Other utilities in Ontario are at various levels, but outside of the major cities average total compensation is typically $100,000 per employee or less.

Compensation is just part of an overall issue of high costs, which are then reflected in Hydro One’s rates.

Transmission rates can’t easily be compared, because of the Uniform Rates methodology used by the Ontario Energy Board. Take it as given that Hydro One’s transmission costs are high.

For distribution, there are many comparators, and the results are not pretty. For a typical residential customer in the Hydro One territory, their annual distribution bill will be about double the average distribution bill for customers of the other 70 electricity distributors in the province. A customer in Ancaster, served by Hydro One, will pay $450 per year, while an identical customer a few blocks away in Hamilton will pay $340 per year. It is worse in the Kitchener area, where a Kitchener Hydro customer pays $285 per year, but the nearby Hydro One customer pays $650 per year. The same pattern is seen for all types of customers, all around the province. Schools and other public sector customers, as well as small businesses, are particularly hard hit by these cost disparities.

A key part of these differences is Hydro One’s poor productivity performance. The regulator did a detailed analysis of all distributors’ costs in 2013, and updated it in 2014. The study, which adjusted rigorously for the different local conditions faced by each distributor, found that, over 2011 to 2013, Hydro One’s distribution costs averaged 47.8% above a reasonable benchmark level. Only one distributor in the province was worse.

Strategic Direction – More Acquisitions

Into this mix comes the second area of problems, strategic direction.

While the provincial government is busy considering how to cash out all or part of Hydro One, the company itself has engaged in a carpet-bombing of the other, smaller distributors, offering high prices to their municipal owners to buy those distributors for cash. If rumours are correct, offers have been made to 40 or more of the other 70 distributors.

In each case, the acquisition strategy is the same. Offer a cash price that is 30-70% above the apparent value of the local utility, hoping the shareholder – the municipality – will not be able to refuse that cash windfall. In order to deal with the local political ramifications, Hydro One offers to reduce rates by 1% (which is negligible), and freeze them for five years. After that, though, all bets are off.

Two of these transactions have recently been approved, the acquisitions of Norfolk Power and Haldimand County Hydro. In both cases, Hydro One rates are substantially higher than the local rates customers have been paying. For five years, that won’t matter. In year six, it may be time to pay the piper.

This happened once before. In 1999 and 2000 Hydro One acquired about 90 small distributors. In 2006 it applied to “harmonize” their rates with the rest of its customers. The result? The rates for the acquired residential customers went up by between 68% and 850% (that is not a typo) by 2013, an average of almost 200%. Other customer classes had it even worse.

Why did this make sense for Hydro One? The answer lies in their “legacy” customers, the customers that they had before their buying spree. In the same period, legacy residential rates went up 50% to 55%. The reason that is so much lower is that the ability to load cost increases onto the backs of the acquired customers minimized the impact of those cost increases on the legacy customers. The legacy customers got rate increases of 3% per year, because the acquired customers got rate increases of 10% per year (to “catch up”).

As a strategy, it’s not completely nutty. If you are unable to get your annual costs under control, one way to deal with that is to acquire more customers, so that your average costs go down with the higher customer base. This is a common technique in consumer products companies, since many of their costs are not directly increased by increasing volumes. The same should be true with an electricity distributor.

Sadly, if you are the customer of the acquired utility, perfectly happy with the service you’re getting from your local distributor, at a relatively low cost, you may not be thrilled to have big rate increases in order to minimize the rate increases of customers in other towns. What is good for Hydro One may not be all that great for their new customers. If you’re a residential customer in Woodstock (next in line for acquisition), you may not want to have a new service provider whose current rates are 8% to 54% higher than your local provider, and has just applied for even bigger increases.

Luckily, some of the municipalities that have received these offers have simply refused to sell. They aren’t willing to take the money and run; they focus instead on the long term welfare of their residents. Others have said yes, again with good reason. Tens of millions of extra dollars from Hydro One can fund many other local priorities.

Regulatory Control

Hydro One’s rates and acquisitions are both regulated by the Ontario Energy Board – the OEB. As a regulator, the OEB is of course supposed to protect the customers, while still maintaining a viable utility industry. With Hydro One, they certainly try.

Unfortunately, controlling Hydro One is not as simple as “Just say no”.

On the distribution rates side, Hydro One starts with rates that are among the highest in the province, and then recently applied for five years of additional increases, at 6.3% average per year. You’d think that, given Hydro One’s terrible productivity performance, and already high rates, the regulator would look with a jaundiced eye at a request for even more big rate increases.

Of course, it’s more complicated than that. Hydro One, as with many other distributors, came in with a story of “aging infrastructure” that has to be replaced – at high cost – or the system will simply not work anymore. How much, you ask? Hydro One said another $3.4 billion has to be spent over the next five years on new capital assets. This is not for growth. This is mostly just to replace existing assets with new ones.

This argument – and regulatory problem – is not unique to Hydro One. Toronto Hydro has a similar application before the OEB right now. They want about $2.5 billion of capital approvals over five years. They even went a step further. They filed pictures of assets in poor condition.

The regulator is in a bind. The story they are being told by utility engineers is of infrastructure that is falling apart. If it is not replaced, they say, it will affect safety, and reliability, and long term cost. Short of hiring independent engineers to look at the spending proposals, what is the OEB to do? What if they say no, and then Hydro One, or Toronto Hydro, experiences reliability or safety problems? It will be the OEB’s fault, presumably.

The OEB thought it had the answer to this. In its most recent regulatory policies, it now requires independent benchmarking of costs for this kind of rate application. That would allow the regulator to test the reasonableness of capital plans against objective external data.

In Hydro One’s case, they simply didn’t bother to benchmark. Why would they? They already know their productivity performance is poor. Formal benchmarking would only make them look bad once more. Better to do nothing than to go looking for more bad news.

Instead, they focused on their “sky is falling” capital plan. Lacking benchmarking evidence, the OEB faced the same dilemma: how can you say no?

So, for page after page in their decision last week, they criticized Hydro One for poor productivity, and lack of benchmarking, and on and on. The words are unusually blunt.

And then? They gave Hydro One all of the capital budget they requested.

Their one attempt at resistance was to limit the rate increases to three years, rather than five as requested. However, since Hydro One prefers that anyway, and can come back later for further, even larger, increases for years four and five, that step isn’t really much of a negative. As one industry jokester said, Hydro One could be seen crying all the way to the bank.

(To be fair, this is not just a Hydro One issue. The OEB will have an even more difficult task with Toronto Hydro. In that case, the benchmarking evidence shows that they are already spending too much, but Toronto Hydro is still saying “we need to replace our capital or bad things will happen”. No-one knows how the OEB will respond to this conundrum.)

Part of the problem with regulating Hydro One is that they are, in some senses, “too big to fail”, but that is also tied into the notion that they are owned by the province. Surely, one might say, the province would not allow them to ask for additional money if it was not necessary? Despite recent toughness in dealing with OPG, the regulator is still understandably reluctant to be really tough with a utility like Hydro One.

The regulator has thus had considerable difficulty keeping Hydro One’s costs under control. You would think that, in those circumstances, the regulator would not let the province’s highest cost distributor buy lower cost distributors, at least not until Hydro One gets their own costs under control.

Hydro One appears to have found a way around that, too. By keeping rates for acquired customers low for five years, and then saying nothing about what will happen after that, they defer the “rate increase” problem to another day. That allows the regulator to approve the acquisition today (the customers are not being hurt today, only potentially later), consistent with the provincial government policy supporting voluntary consolidation of the industry.

It will then be up to the regulator later to try to stop big rate increases. Last time around, of course, that didn’t work out very well.

The sad truth is that the regulator has found controlling Hydro One to be a serious challenge, for quite legitimate reasons. The OEB has the power to do this, but the practical ramifications of taking a hard line – whether on spending or on acquisitions – are currently tying the OEB in knots.

And Privatization?

So now circle back to privatization. Whether you sell off all or part of Hydro One, there are two obvious questions. First, why would anyone want to buy into this mess? Second, how will the transaction affect the customers?

We have already seen some hand-wringing from Bay Street that Hydro One may not be worth as much as the government thinks, but that is just their way of starting the price negotiations. Any number of industry players will have a strong interest in Hydro One, precisely because it is a mess. Large, experienced utilities, like Fortis or Enbridge, or infrastructure investment companies, like Borealis, or pension fund equity groups, like Teachers, all think the same thing: they can run this company better. Costs can be driven down, and profits can be maximized. They already know how to do this. (They will be aware that the two unions at Hydro One are unusually powerful, but they have dealt with unions before. It is a challenge, sure, but not an impossible one. Unions still want a good long-term result.)

What that means is that purchasers will be lining up, as they are already, but none of those purchasers will be interested in being passive, just along for the ride. They will want to be able to take the reins and make significant changes. If the government is going to remain in charge, forget it. (Maybe they will take a small position in the short term, patiently waiting to be able to buy the rest.)

Assuming those industry-knowledgeable purchasers are invited to the party, this should be a good thing for the ratepayers. These purchasers will be able to improve Hydro One’s productivity, add economies of scale, and even increase reliability. Further, they already have good relationships with the regulator, who will be able to regulate a privately-controlled Hydro One much better than in the current situation. There is no obvious downside here.

Contrast this with the IPO model. In an IPO, passive investors take a piece of Hydro One, but the current management, still overseen by the government, remains in charge. For the customers, this is less attractive. The additional public scrutiny that comes with a stock exchange listing would be good, but the failure to bring in new utility expertise and control would be an unfortunate omission.

Thus, the push to privatize all or part of Hydro One can be seen as a golden opportunity. The $10-$20 billion cheque to the government, while certainly a lot of money, is really incidental. The opportunity actually being presented is to bring fresh, experienced ownership and management to the table to tackle Hydro One’s existing and well-known problems.

–  by Jay Shepherd March 26, 2015

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About Jay Shepherd

Jay Shepherd is a Toronto lawyer and writer. This site includes a series on energy issues, plus some random non-fiction on matters of interest. More important, it includes the Lives series, which bridge the gap between fiction and non-fiction, and now some short stories. Fiction is where I'm going, but not everything you want to say fits one form. I am not spending any time actively marketing what I write, but by all means feel free to share if you think others would enjoy reading this stuff.
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