Someone called it “principled”, but that, although true, is probably an understatement. A better word for it is probably “bold”.
“It” is the Ontario Energy Board’s decision, released yesterday, on expansion of the natural gas system into unserved communities in small town and rural Ontario. The two main utilities, Union Gas and Enbridge, had proposed 68 expansions that, by themselves, would be uneconomic. However, under those proposals the existing natural gas customers would subsidize the 34,000 new customers, essentially forever, to the tune of more than $500 million.
The OEB said no.
In a decision that surprised many in the energy sector, the OEB said that they will allow utilities to charge location specific rates to customers in new communities, but they will not allow those expansions to be financed with subsidies from existing customers. If the new customers want gas service, the OEB said, they must be willing to pay the cost themselves.
The lack of natural gas service in many Ontario communities is a political hot-button. Places like Kincardine and Fenelon Falls see the lower monthly bills for space and water heating (using natural gas) in London and Mississauga, and wonder why they have to pay two or three times as much (for heating with electricity, propane and other more expensive fuels). They say, quite correctly, that if they had gas distribution infrastructure to their towns, that would be a significant economic boon to their residents.
In fact, the evidence in this proceeding supported that view. For just the 34,000 Ontario residents for whom new gas service was proposed, the net present value of the economic benefits (basically, lower heating bills), would be more than $700 million.
So why don’t more communities have natural gas? The answer is depressingly mundane. Under the current rules, Union and Enbridge charge what are called “postage stamp rates”, meaning that all customers pay bills calculated using the same set of underlying costs. If it costs more to serve a customer in Toronto than in Peterborough, that doesn’t matter. Both have their bills calculated on the same basis.
The problem is that serving Kincardine is as lot more expensive than serving London, because of the high cost to build gas transmission lines all the way to Kincardine. If you want gas service in London, the existing mains are a hundred meters away, if that. If you want gas service in Kincardine, the existing mains are a hundred kilometers away. If a utility has to spend a lot of money to serve a new customer, but can only charge the same rates as existing customers, they will lose money on that new customer.
The existing solution to this has been to ask the new customers to pay an upfront fee to be connected, sometimes as much as $20-30,000 per customer. Needless to say, most homeowners don’t have that kind of money. Faced with that option, they stick with propane or electric, even though over time paying the upfront cost would be cheaper.
Responding to the cries of unserved communities, the government announced in 2015 that it would provide up to $200 million of loans, and $30 million of grants, to help these communities get natural gas service. The government also wrote to the OEB, asking that the OEB look at the process for approving expansions of the natural gas system, to see if it could be adjusted to reduce barriers to expansion.
At the same time as this was happening, however, over in the Ministry of Environment and Climate Change, the Climate Change Action Plan was being developed. Under that plan, all fossil fuel use would have to be reduced. The best estimate was that natural gas use for space and water heating would have to be reduced by 40% by 2030.
The seeds of an interesting political and regulatory conundrum were being sown.
Union Gas made an application in 2015 for approval to serve 29 new communities, with an average of about 60% of the cost borne by existing customers rather than the new ones. Before that got too far advanced, the OEB realized that this issue was bigger than just one Union Gas application, particularly given the letter from the government. So, on their own the OEB initiated a generic hearing to reconsider the rules for expansion of the gas system.
In particular, the OEB wanted to find out what utilities, industry groups, and customers thought they should do with proposals for expansions that were otherwise uneconomic under the current rules.
What had, in the Union Gas proceeding, been a fairly contained discussion became a major case as a generic proceeding. A total of forty-three parties signed on as intervenors, representing a broad range of interests. This included seven utilities, five from Ontario and two from outside Ontario. It included eleven customer groups, representing interests as diverse as farmers, large industrial users, seniors, tenants, and landlords. There were eleven municipalities or municipal coalitions, and four groups representing First Nations. One environmental group participated, as did eight industry groups, representing a host of options, such as oil, propane, and renewables.
(Full Disclosure: I was counsel for the Ontario Geothermal Association, a renewables industry group, and my colleague Mark Rubenstein was counsel for the School Energy Coalition, a customer group.)
In addition to the proposal from Union Gas to expand to 29 communities, Enbridge then proposed 39 communities where they felt subsidized expansions would be appropriate. Combined, 34,000 new customers would have been added out of the approximately 1.4 million Ontario households not currently served by natural gas. Total subsidy requested by the two utilities, more than $500 million to be paid by existing customers to assist these new customers to have lower heating bills.
From the outset, the subsidy concept was opposed by a diverse group of intervenors: customer groups, competing energy sources (like propane and geothermal), environmentalists. They each had their own reasons for opposing the concept, but despite being strange bedfellows they sang various parts of the same tune: existing customers had to pay their own way, so they shouldn’t have to subsidize new customers; the regulator should not prefer one energy source over another; and promoting the expanded use of any fossil fuel is contrary to the direction of history.
On the other side, the utilities were clear that, without subsidies, they could not expand into these unserved communities. Supporting them were the municipalities and the First Nations, who were just as clear that they wanted to attack their energy costs through expansion of gas service, on a subsidized basis, to their areas. “Energy poverty”, a significant and growing issue in Ontario, was front and centre.
The OEB heard evidence from several groups, and from the utilities, and then received more than fifty submissions – several hundred pages – on the issues before them. Those submissions dealt with legal concerns (e.g. What is the OEB’s mandate in choosing between energy options?), technical energy policy issues (e.g. How do you calculate whether a proposed expansion is actually economic?), broader public policy issues (e.g. What are the solutions to energy poverty in rural and northern Ontario?), economic issues (e.g. How will the market respond to regulatory choices?), and environmental policy (e.g. How will the gas industry be affected by the public goal of reducing GHG emissions?).
Overlaying all of this was an unstated but hugely important meta-issue: How will the OEB maintain its independence and integrity in the face of what is clearly a highly complex but fundamentally political combination of issues?
When this process started, it was not clear that the result would be a regulatory decision of seminal and far-reaching importance. The OEB deals with expansion applications all the time, and they are non-controversial.
Here, too, the OEB could have made the decision in this case less controversial, opting to tinker with its existing rules just enough to allow a few more expansions to go ahead, without opening the floodgates to large scale subsidization. “Just give them a little bit” would have been the safest approach.
That’s not what they did.
In what can only be described as a bold decision, the OEB walked through the issues using fundamental regulatory principles as its measuring stick. At each fork in the analysis, the Board members asked what principles should apply, and then how should they be applied on the facts in this case.
So, on the question of whether existing customers should be required to subsidize uneconomic expansions, the OEB applied the principle of “benefits follow costs”. Customers of a monopoly service, the OEB said, should bear the reasonable costs to serve them. They should not be given a subsidy by other customers, who are not getting the benefit of those additional costs. Thus, said the OEB, if the new customers are getting $700 million of benefits, and the costs to serve them are much less than that, they should pay for the benefits they are getting.
But then, if there is no subsidy from existing customers, and the expansions are uneconomic at current rates, doesn’t that mean they won’t happen? For that, the OEB looked squarely at the concept of “postage stamp rates”. If the reason you can’t expand into Kincardine is that we, the OEB, will only allow you to charge the same rates as London, maybe we should remove that restriction. Is that a principle that we need to follow, or is it a barrier that we need to destroy?
The OEB decided that it is a barrier.
This leads to what are called “standalone rates”, meaning rates that are specific to the costs to serve a particular geographic area or a particular group of customers. If Union Gas can expand its service into Kincardine, but to pay for that expansion would require Kincardine rates to be higher than London rates, would that be OK? The OEB did the math. If they allowed rates for expansion areas of about $70 a month more than existing rates, those customers would get an average of $190 a month in savings from their existing costs for alternatives.
The barrier to entry, said the OEB, is postage stamp rates. That is what leads to asking homeowners in an expansion area to write five figure cheques for gas service. If, instead of writing those big cheques, those homeowners had a new monthly bill that, while higher than London, is lower than their current bill, will they sign up? Probably yes.
Thus, by freeing up the utilities to charge the expected cost to serve new communities, the OEB frees up those new communities to choose gas service if it is the best option for their needs.
This also solves another problem. It is a general principle that an economic regulator shouldn’t interfere in functioning competitive markets. Regulators like the OEB deal with monopoly power, but are expected to respect market competition. The principle is thus that the monopoly regulator should allow service providers to compete on a “level playing field” whenever possible.
Here, a subsidy for monopoly gas distributors would have tilted the playing field in their favour, and against the providers of heat via propane, oil, geothermal, electricity, and other means.
On the other hand, rejecting the subsidy concept, but allowing more palatable ways of charging full price to gas customers (through “standalone rates”), means that gas competes head to head with other options. If customers agree that gas is the better choice, it will out-compete its competitors. If paying full price for gas over the long term means that other choices are better, then those other choices will prevail. The market does some things well. This is one of them.
The other principle the OEB engaged is flexibility. There was a temptation for the Board panel to be very prescriptive in what it expects, or will allow. Instead, the decision makes clear that in each expansion application the OEB will look at what is fair and reasonable in that case. For example, things like the location-specific rates to be charged, or any contributions from the municipality (to support economic development) will be resolved on an individual basis. These things don’t all need to have detailed rules cast in stone. Once the principle is accepted that those who benefit, pay, then the utilities, local municipalities, businesses and residents are invited to develop a plan for each community that suits everyone’s needs.
All of this was done without one word about the political ramifications. The OEB – sometimes accused recently of being too attuned to the political winds – reverted to its independent, economic regulator roots.
Climate Change Action Plan? The OEB recognized that it will be an important influence on the natural gas industry, but concluded that its market-driven approach to community expansion will allow gas expansion to be influenced in a natural way by relevant government policies. No need to figure it all out now. It will evolve.
The government wants more municipalities to have gas? Great. We – the OEB – are not going to stand in the way. We’ve removed the main barrier by allowing standalone rates. If the government wants to provide subsidies, they can (with a recommendation that the subsidies be to homeowners for conversion costs, rather than payments to the gas utilities). We – the OEB – are not in the transfer payments business.
There are four main implications of this decision.
First, expansion of gas service into unserved communities will proceed, but at a much slower pace than the utilities had proposed. Utilities are by nature risk averse. At full cost, it is harder to get people to convert from propane or electricity to gas heating. Once converted, it is harder to get them to stay on gas. The price differential is simply not enough. Therefore, except in a few cases in which gas service is close to being economic at current rates, most of these 68 proposed communities will not likely get gas any time soon. Without the subsidies, the risk to the utilities will be too much for them to proceed.
Second, the gauntlet has been thrown down to competitive suppliers of heating options. The OEB heard serious negative feedback about existing supply options. The existing suppliers, and new entrants like geothermal, have received a loud public invitation to show that they can provide local energy service better than the natural gas distributors. Once price is taken out of the equation through standalone rates, the competitors to natural gas are being told to “put up or shut up”. How they respond, particularly in an era of climate change action, will be telling.
Third, the OEB has reasserted its role as an independent and professional economic regulator. If this is a portent of things to come, an OEB not seen as being swayed by the political trends of the day will be welcomed by many in the Ontario energy sector. Of course, it remains to be seen if this is a new direction, or an anomaly. What is certain is that many in the sector will be watching more closely than before, to see which way the OEB goes. (One industry insider referred to it as “Return of the Jedi”)
Fourth, the value of a generic hearing to deal with tough policy choices has once more been affirmed. In recent years, the OEB has moved away from generic hearings, because frankly it can cost a lot to have a comprehensive, evidence-based public analysis of policy options. Instead, the OEB has been using consultations and stakeholder sessions, in which everyone expresses their opinions, but there is no actual evidence put forth.
Had this proceeding been a consultation, the kind of bold and principled approach that we have seen would have been much less likely. It was only because of the hard evidence, tested through cross-examination, and the ability to engage in constructive and thorough dialogue in front of independent adjudicators, that a strong decision such as this was even possible.
Does this mean the OEB will have more generic hearings? Probably not, but they should. This is proof that they can work very well indeed.
All in all, a seminal decision. Used well, it could have serious positive benefits.
– Jay Shepherd, November 18, 2016