Energy #6 – Surf’s Up

A very long time ago I was friends with a guy whose sole purpose in life was surfing. (Yes, people like that did exist. They are not an urban myth.)

His favourite story, which he repeated endlessly, was about a beach in Hawaii with “the best surf in the world”, the famous Banzai Pipeline (at the beach of the same name). The point of the story was not that the waves were actually the best. They were great, he would tell you, but perhaps not the very best. What was so great about Banzai Pipeline was its exclusivity. It was – and apparently still is – so dangerous that only the very best surfers can even attempt it.

I was reminded of his Banzai Pipeline story when I was looking recently at the impact of a new Ontario energy policy – Custom Incentive Regulation. Custom IR, or CIR as it is now affectionately known, may well be the Banzai Pipeline of the Ontario energy world. It is there for everyone, but actually available only for the elite few.

Here’s how the current system – called the Renewed Regulatory Framework for Electricity, or RRFE – works. Electricity distributors have three choices for how their distribution rates are set by the Ontario Energy Board: Annual IR, 4th Generation IR, or Custom IR.

Distributors choosing Annual IR get an annual rate increase of about 1%, and for that have minimal regulatory and paperwork requirements. They still have to file annual information, and many other things, because the Ontario electricity business is chock full of regulatory obligations, a veritable blizzard of paper. However, the regulatory costs are minimized.

Choosing 4th Generation IR, on the other hand, requires a detailed “rebasing” rate application (3,000-6,000 pages in total, at least a year of work) every five years, where rates are based on comprehensive one-year cost forecasts. For the four years after that, rates are set on a formula tied to inflation and productivity. A 4th Generation IR rebasing application typically costs $100,000 to $700,000, depending on its complexity.

Then there is Custom IR, an option in which a distributor applies for five years of future rates, with full five year cost, revenue and other forecasts (as well as other bells and whistles). This carries with it the highest regulatory costs, ranging up to $10 million or more, plus annual costs during the five year term.

In theory, each of Ontario’s 72 electricity distributors can choose each year which regulatory method they prefer. In fact, however, the regulatory costs associated with each option create a natural stratification of the methods based on the size of the distributor. Ontario electricity distributors range from 1,220 customers to 1.2 million customers, and serve areas as diverse as a single small community, or major urban areas. Bigger utilities have more money, and can choose more expensive options.

Further – and this is the important part – the result of this stratification is that bigger utilities get larger rate increases, whether or not those large rate increases are fair and reasonable. This is the unintended but very real consequence of allowing utilities to choose their regulatory method based on how much more money they want, and how much they are willing to spend to get it: different rules based on size and resources.

Given that background, the world has unfolded much as one would expect. The six largest distributors in the province – Hydro One, Toronto Hydro, Powerstream, Hydro Ottawa, Enersource, and Horizon – have all either applied under Custom IR, or announced their plans to do so. Only two of the rest (Kingston and Oshawa) have chosen that option. Everyone else is using Annual IR or Custom IR.

And this matters…why? Funny you should ask.

The easiest way to understand this is to look at the numbers. Fourteen distributors have so far gone through the first part of 4th Generation IR (the rebasing application). The weighted average increase they have received at rebasing is 3.8%. When you couple that with their formula increases over the following four years under 4th Generation IR, the result will be an average five year rate increase for those fourteen distributors of just under 10% (actually, 1.9% per year for five years).

Seven distributors have chosen Annual IR. While this is a year by year choice, the 1% annual rate increase means that if they stick with it for five years (perhaps unlikely), their five year rate increase will be just over 5%. However long they keep it, their rates will go up less, on average, than those on 4th Generation IR.

Now, what about Custom IR? Eight distributors have chosen this option, but only five have made their applications public so far. We are waiting for Hydro Ottawa, Enersource, and Kingston, all of whom will apply under Custom IR at various times this year.

For the ones that have applied or made their proposals public so far, their average five year rate increase is just over 40%, or about 7.0% per year compounded.

Doesn’t sound like much, right? Sadly, when you factor in the power of compounding, those five utilities are looking to Custom IR to get them an additional $1.7 billion dollars (no, that is not a typo) over that five year period, compared with the 4th Generation IR choice. That’s an extra $500 they will charge each of their residential customers if Custom IR achieves the results they want.

We don’t yet know what they will actually get in increases, of course. Horizon asked for more than 30% over five years, but ultimately reached a rate settlement for about 13%. Hydro One, on the other hand, asked for 44% over five years, and was awarded about 25% over three years, with the right to come back for more at that time. The others are just applications. New rates have not yet been determined.

Still, whatever the results, you can see why the bigger distributors consider Custom IR so attractive. That’s a lot of extra money to chase. If you have a choice between asking for $600 million of rate increases over the next five years, or $2.3 billion, which would you choose? (Of course, if your choice is from the point of view of the customer – which amount you prefer to pay – your answer may be different.)

Ah, but Custom IR comes at a cost. The average Custom IR application is costing just under $5 million in legal, consulting, and other regulatory costs, and that amount may increase. The average 4th Generation IR rebasing application costs about $400,000.

For a large utility, like Toronto Hydro, that difference doesn’t really matter. Even $5 million is less than 1% of annual distribution revenues. But for Oakville Hydro, or Cambridge Hydro, or others of that size, a $5 million bill is 15-20% of annual revenues. They can’t spend that much on a regulatory application. It’s out of the question.

So, like the Banzai Pipeline, surf’s up for some utilities, but others are not invited. Their invitation is in the mail (we have to be fair to everyone, after all), but they can’t really afford the price of admission. Some – like perhaps Oshawa and Kingston – will try to do it on the cheap, spending $1 million instead of $5 million to play (i.e. 4-5% of annual revenues), but most will simply have to watch from the beach as the elite surf the best waves.

Sounds like something that can be solved pretty simply, right? A law for the rich and a law for the poor? That’s no good. Get rid of the special deal for the big utilities. Make them live within the same constraints as everyone else.

Not so fast, my friend.

The three-option regulatory system in the Renewed Regulatory Framework is there for a reason. It provides flexibility to recognize that different utilities have different financial situations at any given time. The rules that apply to one may not be fair for another, and the regulator has to be conscious of those differences. Thus, there are two simple regulatory approaches available to everyone, but utilities with special issues have the option to put those issues before the regulator and have them considered.

Not only that, but “regulation is too expensive for us” is a plaint that falls on largely deaf ears, since government policy is that the current 72 distributors should be consolidating into a much smaller number of larger entities. We used to have more than 350 electricity distributors, almost one in every town. Over the last fifteen years, that has been reduced through mergers and acquisitions to 72, but some of those are still pretty small.

Running an electricity distribution system is not like running a local variety store. As distribution becomes more complex – with new technologies, new responsibilities, and greater customer demands – there may be a minimum size needed for a company to do it right. Under that theory, a company that can’t afford to do the regulatory process right may well also be too small to do the rest of the job right.

In principle, therefore, there are good reasons to have the flexibility inherent in the Custom IR option, and equally good reasons to look at cost-related complaints of unfairness with some caution.

That still leaves us with the problem that, in its current form, Custom IR is simply more money for the large utilities, and less for the smaller ones. Looked at another way, if you are served by a larger utility, your rates will go up much faster than if you are served by a smaller one. If a reasonably sized utility like Burlington or Thunder Bay can’t really afford to choose this option, even if it has specific needs that have to be addressed, perhaps there is something wrong with the model. And, if every large utility has to choose this model, whether they really need it or not, because inevitably they will end up with more money, that too is a problem.

To dissuade the big players from seeing this as simply the preferred route to more money, two things can be done. When Custom IR was originally proposed, it had two important components: benchmarking, and long term strategic planning. They could be re-emphasized.

For a distributor to ask for more money under Custom IR, they are supposed to provide benchmarking evidence demonstrating that their proposed spending and rate levels are consistent with similar distributors here or elsewhere. It is an indirect way of proxying market forces. The Ontario Energy Board has recently re-affirmed that principle in the Hydro One decision. The upcoming Toronto Hydro decision will provide a further opportunity for the regulator to discuss the importance and relevance of benchmarking. If you can ask for more money, but you won’t get it unless the empirical evidence supports it, maybe fewer large utilities will ask.

As well, Custom IR was intended for utilities whose short term spending needs would have long term benefits for their customers. The original proposal would have required a ten year Strategic Plan that showed exactly how the short term spending proposals provided longer term benefits, such as better reliability or lower rates. The regulator has not yet emphasized those long term benefits, but if larger utilities continue to propose high levels of spending, that may be an important addition to these applications.

Neither of those changes deal with the cost barrier, though. Indeed, both of them would add to costs, and thus could make Custom IR less accessible to some of the mid-size utilities that may need it.

There is no one solution to that. Applying for rates based on five years of forecasts is always going to be a difficult and technically complicated process, made more difficult by the absence of specific guidance from the regulator. Those who have entered this Custom IR process are spending millions of dollars on high-priced lawyers and consultants, whose $500 to $1,000 per hour billing rates can add up pretty fast.

That doesn’t mean the situation can’t be improved. Two changes might help.

First, the regulator could develop a clearer set of guidelines and requirements stipulating the essential elements of a Custom IR application. When this option was first introduced, the Ontario Energy Board expressly decided that they would not establish any guidelines. Instead, they decided to let the utilities develop their own approaches to this option, basically working from a blank page. This “inventing the wheel” approach is very flexible, but it is also very expensive for the utilities. Perhaps it’s time for the regulator to prescribe more tightly defined Custom IR requirements, which should reduce the cost.

Second, the regulator has been almost entirely agnostic as to the amounts utilities spend on lawyers and consultants. In part as a result of that passivity, and in part as a result of the small pool of good specialists in energy regulation, costs of those specialists have skyrocketed. Perhaps the time has come to look more closely at what utilities are paying for these advisors, and even establish limits as to the levels of these costs that can be recovered in rates. Maybe electricity distributors shouldn’t be paying their lawyers $1,000 an hour, and then asking the customers to cover that cost.

These would all be potentially useful improvements, but they don’t really solve the problem.

The real solution to both the high rates issue, and the cost to play issue, may lie in the regulator taking a tougher view of the Custom IR applications.

Right now, faced with larger utilities saying, in their Custom IR applications, “we have to spend all this extra money, or we’re all going to die”, it is hard for the regulator to say no. What if they do say no, and reliability degrades? Who will be blamed? The regulator? As long as that reluctance to say no remains, big utilities will spend whatever it takes to seek bigger budgets, and thus bigger rate increases, and the needs of smaller utilities will go unmet.

As soon as the regulator starts to say no more often, though, Custom IR may start to shift, maybe even evolve to be the flexible solution originally envisioned by policymakers, utilities and customer groups alike, a solution available to all utilities that really need it, but not to those who don’t.

   – Jay Shepherd, April 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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One Response to Energy #6 – Surf’s Up

  1. Michael Harding says:

    Well done Jay.

    Liked by 1 person

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