Energy #7: Death of a Presumption

It is not often that decisions of the Ontario Energy Board get appealed all the way to the Supreme Court of Canada.

In fact, it happens…well, never.

Today Canada’s top court released its first OEB-related decision in the Board’s 65-year history. The decision, reversing the Ontario Court of Appeal, and supporting the Board, may have important effects on energy regulation going forward.  Along the way, a legal presumption many believed applied is now gone.

Background

In 2011, a strong Board panel, made up of then-Chair Cynthia Chaplin, then-Member Marika Hare, and part-time Member Cathy Spoel, had to consider the rates to be charged by Ontario Power Generation for its nuclear and large hydroelectric generation. OPG asked for about $6.9 billion over two years, a 6.2% rate increase over previous levels.

At the heart of the hearing was benchmarking evidence that showed OPG’s nuclear costs – and particularly its compensation costs – to be significantly out of line with costs for comparable businesses throughout North America. In response, the Board disallowed $145 million of those costs, much less than many parties had proposed, but still lots. OPG and its unions bridled at this result, and everyone trundled off to court.

Was this the first time OPG’s high costs had come up?  Oh, no.  As early as the 1980s the government and many commentators, including the Board, expressed mounting concern over out of control costs of the predecessor company, Ontario Hydro. Then, however, the OEB did not have the power to order reduced rates, or lower costs (or anything else, really). The Board could look at evidence all they liked, and ask as many questions as they liked, and make whatever comments they liked.  Then Ontario Hydro would do exactly what they wanted.

The inevitable result of this lack of regulatory oversight and control was that, when the costs to build and operate the Darlington Nuclear Station spiralled into the stratosphere, Ontario Hydro became financially non-viable. In the private sector, you would say they were bankrupt.

Bankruptcy didn’t actually happen – at least, not technically. What happened instead was that, in a government-ordered re-organization at the end of the 1990s, Ontario Hydro was split into five entities, three of which were quite substantial: the IESO, to operate the main electricity system; Hydro One, to own and operate the wires business; and Ontario Power Generation, to own and operate the generating stations (nuclear, hydro, and, at that time, coal). In the re-organization, about $20 billion of Ontario Hydro’s debt in the public markets was shifted off their balance sheets, essentially because the operating companies could not continue if they had to pay that debt.

It was a lot like a bankruptcy.

Sadly, the new generation company, OPG, even without having to pay most of its debt, struggled to keep its costs in line. By 2006, the government decided that OPG should be treated as a fully-regulated utility, with the Board reviewing and approving its rates periodically. While the government built in many protections for OPG not normally enjoyed by regulated utilities (and it is in the process of considering more right now), OPG for the first time had to justify in public its high costs of generating electricity, and the regulator had the power to say yes or no.

Partly, this situation was a legacy of OPG’s uncontrolled past. Partly, as well, it was a legacy of its relationship with its unions, who over the years had gained great strength in their dealings with the company. Since 90% of OPG’s employees are in one or the other of their two unions, controlling compensation expense became increasingly difficult.

Enter the OEB. In 2007, OPG applied to the Board for its first regulated rates, asking for an extra $800 million over 21 months. This was a rate increase of almost 15%, all to cover what it said were cost increases over which it had no control.

A great ruckus ensued, including in the process detailed (mostly) public disclosure of costing, forecast and benchmarking information (essentially for the first time), and a lengthy oral hearing with public debate over the reasonableness of OPG’s proposal.

A critical element in the case was evidence that many of OPG’s costs, including nuclear costs, were well above what you would expect based on a review of similar utilities elsewhere. On some measures, OPG nuclear units were among the worst in North America, even without having to service the debt incurred to build them. In particular, compensation costs appeared to be higher than could be considered reasonable.

The Board noted its unhappiness with costs that benchmark well out of line with peers. However, perhaps conscious of the difficulties OPG was facing as a newly-regulated entity, the Board let most of the costs through. The rate increase was reduced from 15% to 8.5%, but most of that was for technical reasons not mainly driven by costs being too high.

In fact, ratepayer groups argued for annual reductions in operating costs of $250 million or more, mainly based on the benchmarking evidence and the declining productivity that seemed to be happening in parallel with cost increases.  The Board instead ordered a relatively small reduction, $35 million over two years, and otherwise accepted the operating costs proposed.

At the same time, the Board went through a lengthy analysis of the poor cost performance of OPG, including a number of very pointed charts and graphs comparing OPG to other generators. OPG was ordered to do more complete and thorough benchmarking of its costs. The Board’s analysis culminated in a warning:

“The Board will have an opportunity to re-examine this issue when the benchmarking
studies are updated in the next proceeding. At that time the Board will examine any
improvement or deterioration in production unit energy costs compared to other utilities, and the reasons for those changes.”

The Board went on to say that it expected “a significant improvement” in costs next time around.

The OEB Decision

Now fast forward back to 2011. OPG filed an application for a further increase of 6.2%, filing along with it the many benchmarking studies ordered by the Board in the previous decision.

The benchmarking studies showed that costs were well above reasonable levels, just as the Board and ratepayer groups had been saying. Of particular concern was that the $2.8 billion of proposed compensation costs seem to be hundreds of millions of dollars above market rates for similar positions, and no action appeared to have been taken to start to bring them back in line.

OPG, supported by its unions, responded with a curious (or perhaps sad) argument. It said that its compensation costs were the result of collective bargaining, and they were bound by their agreements with the unions. It was too late to fix those costs. They were already committed. They went on to claim – with much weeping and gnashing of teeth – that they “tried their best” to keep their compensation costs down, but the unions were just too strong, and they had no other option but to give the unions what they wanted.

No-one quoted the famous words of Brian Mulroney to John Turner (in a different context): “You had an option, sir. You could have said, I am not going to do it. This is wrong for Canada, and I am not going to ask Canadians to pay the price.”

Now, this argument that past commitments should be treated differently from future forecasts is not completely nutty. It has long been suggested that utility costs incurred or committed in the past have to be tested by a different standard, often called the presumption of prudence. At its simplest, this presumption is that, if money has already been spent, the regulator shouldn’t deny the utility recovery of those costs unless there is good reason to believe the original decision to spend it was unreasonable at the time. It is not enough that the results turned out to be worse than you would like. Bad results only result in a disallowance if they are the result of a bad decision.

The Board, in its decision, recognized this reality. They faced up to the fact that collective agreements would control some of the forecast compensation costs, and OPG was not free just to cut compensation overnight. Therefore, even though the evidence showed that annual compensation might be $200-300 million too high, the Board only reduced the compensation included in rates by $55 million in year one and $90 million in year two, for a total of $145 million.

The Supreme Court Speaks

That was in March, 2011. OPG and its unions – outraged at the effrontery of the regulator – appealed, and after decisions by the Ontario Divisional Court and the Ontario Court of Appeal, the Supreme Court of Canada (in a 6-1 decision) has now spoken, and it is final.

The Board was right.

As with most legal cases, much of the 90 page Supreme Court decision is taken up with analysis that is only really of interest to lawyers. The fact, for example, that the Board was allowed to defend its own decision in court (which was challenged by OPG and its union), is of some considerable importance for administrative law. It does not – this is just a guess – keep the average person up at night.

But two things do stand out in the court’s decision.

First, the court made definitive statements about the importance of the Board’s role in balancing the interests of consumers and utilities. Consumers are entitled to reasonable control of the prices they pay, but the Board must also ensure that the financial viability of the regulated energy sector is maintained.

In focusing on that balance, the court re-affirmed and gave strength to the principle that the Board acts as a proxy for competitive markets. The court said:

“The Board must ensure that it regulates with an eye to balancing both consumer interests and the efficiency and financial viability of the electricity industry. The Board’s role has also been described as that of a “market proxy”… In this sense, the Board’s role is to emulate as best as possible the forces to which a utility would be subject in a competitive landscape.”

This principle has always been true, but it is now confirmed by the Supreme Court of Canada, which will give it powerful weight.

Second, the court had to consider the so-called “presumption of prudence”. Many people in the industry have for years believed that it is unfair to use hindsight to judge past utility decisions. The presumption of prudence is intended to reduce this second-guessing. Past decisions are presumed to be prudent, unless evidence shows that they were made badly.

Not so fast, said the court. Yes, it is appropriate to look at past decisions through a different lens, but it is contrary to law to presume that any cost was prudently incurred. The Ontario Energy Board Act is clear: the onus is on the utility applying for rates to prove their costs are reasonable. The Board does not have the discretion to reverse that onus. It is a statutory requirement.

This, of course, has the potential to be a big deal. If past decisions had to be justified in the same way as future plans, utilities would be under considerable and continuing pressure to deliver results.  They could never say they tried, and leave it at that.  Like the competitive market, the regulator would judge them based on results, and accept no excuses.  It could be a significantly harsher world for them.

More likely, though, this will be interpreted by the Board (and other regulators across the country) as a more modest change. That is, the Board cannot start with an assumption that OPG’s past decisions were good.  That would reverse the onus.  It can still, however, look at those decisions through the eyes of the people making them at the time, and with regard to the information and options then available to them. The court’s commentary and explanation surrounding this would make that interpretation a reasonable one.

It is not the normal practice of regulators to actually assume the utilities are right (most presumptions being less real than they appear).  Thus, in the real world the removal of this presumption of prudence, while important, may have practical implications in only a few cases.

At a higher level, though, a very important regulatory principle has been established: no costs – not even committed ones – are excluded from the regulator’s mandate by legal presumptions. Regulators like the Ontario Energy Board are, via this decision, getting broader freedom to look at utilities’ costs. Of course, along with the increased authority comes an increased responsibility to focus on protection of the ratepayers.

Oh, and one other thing. My first published legal article was on the arcane subject of “Presumption of Death”. Thirty-five years later, I can now say that I have completed the circle, writing about “Death of a Presumption”.

All in a day’s work.

–  Jay Shepherd, September 25, 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 #7: Death of a Presumption

  1. Pingback: Energy #12 – The RRFE is Implemented | Articles and Stories

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