Energy #8 – Who Will Regulate Electricity Distribution?

Data can lie. I admit that. I’ve personally been the victim of lying, deceitful, and corrupt data in the past. Sometimes the data isn’t even trying to do anything evil, but there it is. Lies.

It is still true, though, that often you can learn a lot about a situation just by viewing the raw data with an open mind, and letting the connections and patterns reveal themselves to you.

A good example is electricity distribution in Ontario. Since the rate decisions of the Ontario Energy Board for Hydro One and Toronto Hydro have recently set some important precedents, this is probably a good time to step back and let the data speak to us.

What the data may be telling us – the jury is probably still out on this – is that the Ontario Energy Board has ceased to be, in any practical sense, the primary protector of electricity customers. If that is true, customers may have to think about what other avenues are available to them, if they truly want to protect their interests.

Following the Data

There are 69 electricity distributors connected to the Ontario electricity grid, now that the largest (and most expensive), Hydro One, has acquired three more of the smaller ones in 2014 and 2015. That total is likely to drop further in 2016, not just from the mega-merger of four of the larger distributors, but also from other acquisitions and mergers. By 2018, it would be surprising if there are more than 50 distributors, maybe even as low as 40.

The electricity distribution industry is not, however, a monolith. It is more fairly viewed as three different industries: 1) Hydro One (excluding Hydro One Brampton), 2) Toronto Hydro, and 3) everyone else. Once you split it up that way, some interesting facts emerge.

Good data is available for electricity distribution from 2005 to 2014, and it is possible with public information to make informed estimates for 2015 and 2016. For the period 2005 to 2016, the number of customers has increased by about 11%, and economy-wide inflation has been about 20%. Thus, if distributors are unable to deliver any productivity improvements, nor any economies of scale, the result should be increases in the money they collect from customers of about 31%. (Yes, I know I’m oversimplifying. Sue me.)

In fact, for that same period the industry’s distribution bills to its customers will increase by about 54%, and that rate of increase is accelerating. As a customer, you could reasonably ask the question: “WTF?!”

There are two caveats to those numbers, though.

First, in 2006 and 2007 there were some increases to rates and revenues that were unusual, an artifact of a prior rate freeze. That probably added a total of 5% to industry revenues. You can argue for or against the relevant policy, but it was in any case neither the regulator nor the distributors that did it. It was a government policy decision.

Second, and on the other hand, there was a major accounting change, implemented between 2011 and 2014, which reduced annual costs to distributors due to changes in depreciation and other assumptions. This did not change any actual spending patterns; just the pattern of inclusion of that spending in annual costs. This had the effect of artificially reducing costs by an average of about 5%, essentially offsetting the 2006/7 adjustments. Again, you can argue whether the change was a good idea, but it is clear that it was an event completely external to the electricity sector.

These two things didn’t offset exactly, by any means, and for some utilities the combined impact was, to use the technical term, wonky. That having been said, on an industry-wide basis the two largely offset each other, leaving us with an eleven-year data set that, while not perfect, is still useful.

So, does this mean that the “industry” got 23% (54% minus 31% inflation and growth) more rate increases than they need? The answer is actually no.

Which brings us back to the three components of the industry: Hydro One, Toronto Hydro, and everyone else.

Historically, Hydro One and Toronto Hydro deliver about 40% of the electricity to about 40% of the customers. With little blips up and down from year to year, this has been consistent from 2005 to date, and is likely to continue into the future. For that 40% of the business, Hydro One and Toronto Hydro collected about 53% of the revenues in 2005. By 2014, that was up to 55%, and that is forecast to increase to 58% of the total industry revenues in 2016 (and over 61% by 2019).

Conversely, the other sixty-seven distributors, the rest of the industry, consistently deliver about 60% of the electricity, to about 60% of the customers, but their share of the industry revenues has been declining. In 2005, it was 47%, and in 2016 it is expected to be 42%.

When we look at the three components of the industry, we can see why. Hydro One had customer growth of about 11%, half from acquisitions, and inflation of 20%, but its total revenues will increase, over the period 2005 to 2016, by about 80%. Toronto Hydro, also with customer growth of about 11% and inflation of 20%, will see its total revenues increase, over the period 2005 to 2016, by about 47% (although with the recent decision this will get much worse by 2019). The remaining 67 distributors will, collectively, see their total revenues increase by 38% over that 2005-2016 period.

This appears to show some form of pattern, but we also know that a bunch of other things were going on in that period. For example, conservation was picking up steam, with the result that average electricity use per customer declined by 13% across the province. Not all of that was more efficient light bulbs, and things like that. Some of it was changes in economic activity. Some of it was changes in customer mix, particularly in Toronto where its customer growth has been heavily weighted towards customers with lower levels of consumption.

In order to get value out of the data, it is therefore useful to disaggregate it a little further.

Two useful pieces of information are revenue per unit of electricity distributed (i.e. per megawatt-hour, or MWh), and revenue per customer. In effect, these are the average “prices” charged by distributors for their product, on a per-unit and per-customer basis.

For revenue per MWh, Hydro One was the most expensive in 2005, at about $35, followed by Toronto Hydro at $18 and the rest of the distributors at $16. Hydro One suffered from the rural nature of much of their system, while Toronto Hydro benefited from economies of scale in delivering to very large customers. This showed in the average electricity consumption per customer in 2005, where Toronto Hydro’s was almost twice that of Hydro One, and about 40% higher than the rest of the distributors.

In 2016, the pattern will be similar, but there are some shifts happening. Hydro One will still be charging the most to deliver electricity, at $60 per MWh, a 72% increase. Toronto Hydro will have the next largest increase, going up 62% to $30 per MWh. Part of that is Toronto Hydro’s shift to smaller average customers, while the remainder is the effect of conservation. The rest of the distributors will have somewhat better performance, going up 45% to $23 per MWh, mostly due to conservation impacts.

It is reasonable to infer from this that the rest of the distributors are finding greater efficiencies than Toronto Hydro and Hydro One. The latter two distributors are getting increasingly offside with the rest of the industry. They were already outliers. That performance deficit may be widening.

(It is also reasonable to assume from this that the customers are getting no benefit from conservation in their distribution rates. Their costs of the actual electricity – the commodity – will go down, but their reduced consumption is not being reflected in reduced distribution bills. This is not a surprise. If you still need the same wires to deliver fewer MWh, then the cost per MWh has to increase.)

The other metric is distribution revenue per customer. By itself, revenue per customer is not all that helpful, because it can be skewed easily by changes in customer mix. It is valuable, though, when cross-referenced to revenue per unit delivered. If both are moving in the same direction, they tend to validate each other. (Not perfect, but better than either alone.)

In 2005, Hydro One’s revenue per customer, at $729, was only about 2% above that of Toronto Hydro (at $713), but about 70% above the rest of the industry (at $430). The first comparison is not really useful, because Toronto Hydro had, on average, much larger customers. The second comparison – with the rest of the industry – has always been excused by the rural nature of the Hydro One system, although many other distributors also have some rural component. Nonetheless, it is generally accepted in the industry that Hydro One needs to charge more per customer.

Sadly, 2016 will see the comparison continuing to deteriorate, with both Hydro One and Toronto Hydro showing declining performance relative to the rest of the industry. Even with the dampening effect of some acquisitions (Hydro One is getting less rural, not more), Hydro One will have revenue per customer of almost $1200 in 2016, an increase of 63% over eleven years. Toronto Hydro, at more than $930 per customer, will have an increase of 31% since 2005, despite reductions in its average customer size, which should reduce revenue per customer. The rest of the industry will increase to about $540 per customer, a 25% increase over eleven years (i.e. just over inflation).

The revenue per customer figures tend to support the inference that both Hydro One and Toronto Hydro are heading off in a different direction from the rest of the electricity distributors in the province. The “industry” is doing fine; Hydro One and Toronto Hydro are not. For the customers, this is not a good sign.

Why is This Happening?

One possible answer is what brings us back to the title of this article: “Who Will Regulate Electricity Distribution?”

A distinctive element of both Hydro One and Toronto Hydro is that they have, for some years, made a point of relying on the Ontario Energy Board as the sole entity or influence responsible for controlling their rates. Most of their rate cases are adjudicated by the Energy Board in contested hearings, and the results are often favourable to the utility.

Most recently, Hydro One’s management asked for five years of sky-high increases, was criticized by the regulator for their application, but still received substantial increases for the first three years, with the right to come back for more later.

Toronto Hydro, in a decision released December 29th, was denied the 48% five year rate increase sought by management, but was allowed what, at this point, looks like 39% over five years. Like Hydro One, Toronto Hydro was given express permission to come back and ask for more for certain types of spending. In addition, Toronto Hydro was given a sharing mechanism that says, if they spend more than was allowed, and as a result earn less profits than they planned, they can demand half of that profit shortfall from their customers as an extra rate increase.

The overt reliance by these two distributors on the regulator to protect the customers is in contrast to many other distributors, whose rates are reined in at the first instance by their active and engaged shareholders (in almost every case, municipal councils). For at least some of those companies, their municipal politicians continue to see “hydro rates” as being part of their responsibility to their constituents. In cities like Kingston, Guelph, Hamilton, Windsor and London, local municipal councils will often resist attempts by utility management to seek large rate increases. If Guelph Hydro management, for example, proposed to seek rate increases of 48% over five years, there is little likelihood their shareholder, the City of Guelph, would allow it. This is undoubtedly one of the reasons why Guelph Hydro’s revenues per customer, and price per MWh, have both gone up at about half the rate of inflation over the last eleven years.

This is not, by the way, a strange result, when viewed through a longer term perspective.

Until 1999, local charges for electricity distribution were a responsibility of the local politicians. While the all-powerful Ontario Hydro had final say on rate levels, as a practical matter the real “regulator” was the municipal council in most cases. Local councils considered themselves politically accountable for the prices charged to their constituents from a company they owned. The fact that some municipal councils continue to exercise that control should not be considered a surprise. It is probably fair to say that, in their disinterested approach to distribution rates, the City of Toronto (owner of Toronto Hydro) and the Province of Ontario (owner of Hydro One) are the odd men out.

What Does This Mean?

The Ontario Energy Board is suffering its own unique malaise right now, much more complicated than can be seen from electricity distribution rates. If the Ontario Energy Board is no longer willing or able to protect customers from excessive rate increases, that is likely nothing more than a symptom of a more fundamental issue. Perhaps that will be the subject of another article in the future, but it is certainly beyond the scope of this current article.

In the meantime, we may be starting to see a shift in responsibility for regulation of electricity distribution rates. Where customers and utility shareholders continue to rely on the formal regulator, the Ontario Energy Board, it is not always clear that the regulator has the will or preference or policy inclination to keep management spending proposals, and therefore customer rates, under control. On the other hand, where (municipal) shareholders exercise control, in effect reverting to the practice fifteen or twenty years ago, the customers in at least some cases continue to be protected.

One key area in which this will quickly become an issue is the newly-privatized Hydro One. Already the most expensive electricity distributor in the province, Hydro One’s success as a privately-controlled company will depend on strong, thoughtful regulation. With no municipal council to take on that responsibility, it is not clear how regulation will actually be achieved. Perhaps the pension funds and other private owners will exercise some kind of cost control. Perhaps, on the other hand they will push for higher prices to drive higher profits. It is too early to tell.

For Toronto Hydro, there is no obvious answer. Toronto city council has shown no interest whatsoever in taking political responsibility for distribution rates, and there does not seem to be any public clamour to change that. There are more important issues in this city. The only hope is that, with privatization of some or all of Toronto Hydro, the new private owners will bring a private sector cost discipline. (Don’t hold your breath.)

For the 60% of the customers served by distributors other than Toronto Hydro and Hydro One, though, it may be wise for customers and their representatives not to put all of their eggs in the Ontario Energy Board basket any more. It may be that an increased focus on communicating with local councils about their constituents’ rates should be an additional, or even primary, strategy.

Collaterally, this raises an issue about the province’s desire to see consolidation in the electricity distribution sector. If it is indeed true that, through abdication of its role by the Ontario Energy Board, the customer’s only real protection against high rates has reverted to strong local councils, customers should be less accepting of the sale of their local utility to someone who lives elsewhere.  They may need local control more than ever.  This feeling has already emerged in some towns and cities, and could become more widespread if there are excessive bill increases in communities served by merged or acquired distributors.

Of course, the province could take a stronger approach, reinvigorating the Ontario Energy Board so that it takes back its mandate.

No sign of that just yet.

Jay Shepherd, January 24, 2016

 

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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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