Energy #14 – Corporate Governance

It may have been the first time I’ve heard the word “effrontery” actually voiced orally.

The speaker was the Chairman of the Board of a small Ontario utility.  The subject was the Ontario Energy Board’s upcoming “guidance” to be given to utilities on how their boards of directors should be selected and supervised, and how those boards should carry out their responsibilities (called, in legal circles, “corporate governance”).

Since the OEB announced last year that their long-simmering foray into corporate governance was back on the rails, I have been talking to utility management and directors about it.  It has not always been pretty.  The word “effrontery” is one of the more printable terms I’ve heard.  (It derives, by the way, from the Latin word effrons meaning, literally – and I am absolutely not making this up – “without a forehead”.)

Anyway, the result was that I wrote my first try at this article in July, but before being published it was overtaken by events when the Milton decision came out.  I was then going to publish a revised version in September, but the OEB launched a series of consultations in this area, and I decided in fairness that I should hear what was being discussed.  Meanwhile, I continued to talk to utilities and their directors about the initiative.

Those reactions continued to question the OEB’s direction, and role, in what is undoubtedly an important area for Ontario utilities.  The question is whether it is, or should be, an equally important area for the regulator.

Background

Some background may be helpful.

At a stakeholder meeting in 2013, Ontario Energy Board Chair Rosemarie Leclair told utility and customer representatives that the OEB was planning to take a more active role in supervising the corporate governance practices of regulated entities.

No-one said anything.  It was as if she had used vulgar language, and everyone was trying to ignore it to avoid embarrassing her.  She was pretty new to the job at the time, and I think everyone just assumed that she didn’t yet know what areas were outside of her purview.

Afterwards, though, there was much shaking of heads, of the “She doesn’t understand” variety.

All was then pretty quiet for a couple of years, until 2016.  Things were happening, though, behind the scenes.  In 2015 KPMG was asked to do a review of how other energy regulators were supervising utility corporate governance (they aren’t … not in Canada, not in the U.S., not anywhere else).

Unhappy with the KPMG result, the OEB turned to always-cooperative Elenchus Research to provide an analysis of what the OEB could do to take more control over utility governance practices.  Finally, in 2016, the OEB has unveiled a consultation on corporate governance.  The direction is clear.  The OEB wants more control.

It has kicked off with separate meetings in September between the OEB and utilities, and then the OEB and customer groups.

There are two high level regulatory issues within this subject, each invoking a well-known regulatory buzz-word.  First, from the point of view of the utilities, there is the spectre of “micromanagement”.  Second, from the point of view of the customers, there is the bogey-man of “light-handed regulation”.  The OEB denies they are heading in either direction.  Not everyone believes them.

Related to these general regulatory issues are three more fundamental concerns.  Does the OEB have a legal mandate to regulate corporate governance?  If it does, does it have the expertise to do so?  Surrounding all of this, are the discussions by the OEB with utility executives reflective of the views of utility shareholders, who are ultimately in charge of the governance of the utilities they own?

Or, as one utility board member summed it up to me in November: “Have they gone completely nuts?”

Is There a Problem?

Let’s start with a basic question:  is there a problem with the corporate governance practices of regulated energy companies?  Do they, for example, select, train or supervise their boards of directors poorly, or fail to maintain proper procedures for ethical conduct, conflict of interest, and transparent decision-making?  Do their boards of directors have sufficient independence or, conversely, do they succumb to political influence, or the influence of their unregulated parent companies, in their decisions?  If they do any of these things, does that even matter?

The honest answer is, some utilities have good corporate governance, some not so good.  In this respect, they probably reflect any random cross-section of similar-sized private companies in the province.  Indeed, on average utilities probably do a better job of corporate governance than most private companies.

But, of course, it is not the averages that matter.  Utilities are given a public monopoly (to distribute gas or electricity, typically), and it is important that these utilities be run properly.   They are not like normal private companies, who are judged by the market, sometimes harshly.  The Ontario Energy Board, the regulator, acts as their market.

It was in part to improve utility governance (and also to promote consolidations and privatizations) that, in 1999, the Ontario government of the day decided that all municipal utility commissions would be required to incorporate as private business corporations under the Ontario Business Corporations Act.   Prior to that time, they were essentially arms of their local governments, and their governance practices … what’s the word? … sucked.   Sometimes overly political, sometimes nothing more than sinecures for local political contributors, sometimes just a cash cow for local government, the commissions were not always models of good corporate governance.

Importing the Corporate Law Rules

Moving to the framework of the Ontario Business Corporations Act (OBCA) imported a known and fairly rigorous structure, including not just the fiduciary duty and standard of care that were probably already applicable to the commissioners, but also a level of separation between shareholder and utility.  Further, the OBCA was and is itself based on a strong tradition of regulation of corporations and their practices.  Not only is there a broad basis of statutory rules, but in Ontario and elsewhere the principles in the OBCA have been considered by the courts tens of thousands of times.  While nothing is ever completely certain, in the OBCA we are at least dealing with a set of rules and principles that are well-known and understood.

Corporate law is set up to deal with the relationship between shareholder and company, the relationship between third parties and the company (and through the company, the shareholder), and collaterally the solvency or financial viability of companies.  It is supplemented by separate regulation dealing with taking money from the public as shareholders or debtors (the Ontario Securities Commission, or OSC) and, in special cases, the ability of financial institutions to meet their obligations (the Ontario Superintendent of Financial Institutions, or OSFI).  Corporate governance rules and principles are fundamentally structured to protect shareholders and creditors, i.e. those who provide the capital for the company.

This is not accidental.  To understand why this is true, you have to start by understanding that corporations are just pieces of paper.  Like the emperor’s new clothes, they don’t actually exist.  (Technically, they are “juristic entities”, which means they exist in the legal world, not in the real world.)  Thus, the only way they can operate in the real world is if they are imbued with real world powers, and their duties, responsibilities, liabilities and actions in the real world are set out in a formal code.  People can be held accountable for things.  Pieces of paper, not so much.

So the corporate law makes clear the rules relating to: how corporations make decisions and act on them; the rights and liabilities of the shareholders and creditors vis-à-vis the company and third parties dealing with the company; and so on.

What neither the OBCA, nor any of the corporate governance rules we already have, are intended to do is protect the customers or other stakeholders of companies.  Corporate law goes so far as to require certain levels of financial probity in companies (to protect shareholders and creditors), but has nothing whatsoever to say about how they run their business, or how they treat their customers or employees.  Zero.

In fact, the corporate rules run directly counter to the protection of the customer.  They require directors and, through them, management to act in the best interests of the corporation.  The sole arbiters of whether they are succeeding in that task is the shareholders, who appoint them.  Any resulting protection of the customers or the employees – even though it may actually happen – is serendipitous.  Customers and employees are protected through other areas of the law (consumer protection law, labour law, etc.).

The Role of the Regulator – Mandate

The first and most fundamental question about the role of the OEB in corporate governance is:  “Where is the OEB’s mandate to regulate or control utility corporate governance?”

OEB Staff and their consultants start from the theory that anything to do with the health and well-being of regulated utilities is within the mandate of the OEB.  That is, of course, not the law.

The OEB has three main mandates:  setting just and reasonable rates, licensing many of the participants in the energy sector, and enforcing rules either made by the OEB, or set out in other statutes.

Clearly a mandate to regulate corporate governance cannot be implied within the rate-setting mandate, and the enforcement power is limited to specific rules and requirements.  Unless the OEB establishes a binding Code on corporate governance (which would likely be challenged successfully in the courts), the enforcement power doesn’t help them.

That leaves the licensing power.  In theory, the OEB could require adherence to corporate governance standards as part of licences. If you want a licence, for example to be an electricity distributor, you have to govern yourself this way.

This would run into two problems.

First, presumably if you are requiring licensees to meet certain governance standards, that would have to include not just the regulated utilities, but also licensees that have unregulated energy businesses, such as private generation companies, or energy marketers, and so on.  Not only would they object, but it would be obvious that the licensing power is not intended to include such intrusive control.

Of course, if it is not intended to include that control for unregulated companies, why would it be intended to do so for regulated companies?  The only possible reason would be the mandate to regulate the rates of those companies.  As noted above, that clearly does not mandate control of corporate governance.

Second, and more problematic for the OEB, regulation of utility corporate governance cannot include any real consideration of other stakeholders, such as customers, without running afoul of the existing statutory rules relating to corporate governance.

For example, the fiduciary duty of directors is to the corporation.  That is a statutory requirement.  The OEB can’t change that.  It can express its interpretation that the best interests of the corporation includes the customers, but that has no force or effect.  If the OEB tried to enforce it, they would certainly be exceeding their mandate, and likely be wrong in any case.  The best interests of the corporation is, under the OBCA, enforced by shareholders or by the Director under that act.

Similarly, the shareholders are granted rights under the OBCA to select directors, and there is a rich area of law that they are entitled to exercise those rights in their own self-interest.  The OEB would be on very shaky ground in trying to restrict those rights, for example by requiring that certain nomination and appointment processes be followed.  The OBCA sets out those rules already.

OEB Staff point to court decisions like Toronto Hydro v. OEB, which upheld an order of the OEB that Toronto Hydro not pay dividends for a period of time without the approval of a majority of its independent directors.  This, the high water mark of OEB authority in this area, was still limited to a specific situation in which, acting arguably within its mandate to ensure the financial integrity of the particular utility, and based on evidence that there was an issue, the OEB ordered the utility (not the shareholders or the directors) to act in a certain way.  Even then, it is not at all clear that the decision would have been upheld on appeal.

To be fair, the OEB appears to have accepted the limitations on its mandate in this area.  While OEB Staff refused to disclose, during a public consultation, whether they have a legal opinion on their jurisdiction (I asked), they did make clear that the OEB is planning to provide “guidance” to utilities, without any binding force or other consequences.

(Asked if the upcoming guidelines would have any more effect than they would if they were guidelines from Electricity Distributors Association, a utility trade association, the answer – verbatim – was “not really, except of course that they would be from the OEB”.  To some, that could sound a lot like “wink, wink, nudge, nudge”.)

The Role of the Regulator – Value Added

But legal restrictions on the Board’s mandate in this area may not be the biggest problem.  In all my discussions with utilities and other energy stakeholders, the most common question asked has been:  “How can an organization that can’t get their own corporate governance right ever be relied on to give guidance to others?”

Harsh, but probably fair.

The OEB really has two strikes against it in the corporate governance department.

First, it ignored the express governance requirements of its own statute for several years, leaving the OEB without any effective governance structure for that entire period.

Second, when it re-established part of the statutory governance structure – the management committee – it is still composed of the Chair and the two Vice-Chairs, both of whom rely on the Chair to be re-appointed.  Further, the Chair has been re-constituted, contrary to the statute, as the CEO, thus affirming her role as management rather than governance, but she has no regular reporting process to any management committee or board of directors.

The end result is that the OEB now operates without any independent oversight of either their operations, or their strategies.  They only answer, if to anyone, to the Minister of Energy.  In short, their governance structure is much like the old municipal electric commissions, directly tied into the political structure.

This is particularly problematic because the whole purpose of the OEB is to be independent from government.   The government regularly touts that independence as protecting the public from government influence over the energy sector.  Yet in fact, the OEB has less independent governance than even the most poorly governed regulated utility.

(Contrast the OEB with the Ontario Securities Commission, where the board members constitute a board of directors to which the Chair reports.)

But the complaint that the OEB are not the people to provide governance guidance is not just “the pot calling the kettle black”.  It is also about expertise.

The OEB has some very knowledgeable and talented people, but their training is in economics, accounting, and engineering, areas that provide a foundation for economic regulation.  No-one at the OEB – not one person – can be considered an expert in corporate governance, and they usually don’t even have much knowledge of how utilities are actually governed today.  How many people at the OEB, for example, have even attended a board of directors meeting of a regulated utility?

The OEB recognized this in going out to consulting firms to get assistance.  The first, KPMG, is an accounting/consulting firm, but they were well placed to do a jurisdictional review in the energy sector.  They did that, but they were not asked to continue.

The second, Elenchus, provided a four-person team.  Two are former Vice-Chairs of the OEB, and trained by ICD.D in how to be good directors.  However, both would say that they are not corporate governance experts.  Only one member of the team is a lawyer, and his specialty is mergers and acquisitions.  While M&A lawyers have to know something about corporate governance, it is not their area of expertise.

There are recognized experts in corporate governance in many leading law firms, and elsewhere.  None are part of this consultation process.

The limited expertise of both OEB staff and the consulting team was brought front and centre in the consultations last fall.  The very first recommendation to the OEB from the consultants is that OEB corporate governance guidance be based on the guidance by the OSC (which protects shareholders and debtors), and OSFI (which protects the financial viability of financial institutions).  Presented with the reality that corporate governance principles that protect the customers would have to come from an entirely different perspective, they were nonplussed.  They simply did not understand the concept, even though this perspective issue is central to the duty of any fiduciary, including a director.

Light-Handed Regulation/Micromanagement

The OEB’s goal is a set of governance rules presented as (theoretically) non-binding guidance.   Utilities would be required to report annually and in detail on their compliance with the guidance, and the OEB would then audit their corporate governance reporting to ensure that it was accurate.  Periodically the OEB would send teams in to do a more detailed assessment of the corporate governance practices of individual utilities.  It is not clear who they would send, since clearly it could not be OEB staff.  Perhaps they plan to add to their staff, or perhaps they will simply rely on outside consulting firms.

All of this is, in theory, without any consequences for utilities that do not comply.

Well, not really.

It is carrot and stick.  The stick is that “poorly governed” utilities will be outed publicly by the OEB, the “governance experts”, as if they were made to stand in the stocks in the town square.

The carrot is that, if a utility is judged to be “well governed”, the OEB will embark on a less thorough review of their proposed rates (because, after all, the utility board of directors is looking after that already, right?).

The stick exceeds the Board’s mandate.  The carrot declines the Board’s mandate.

But legal technicalities aside, all good, right?

Again, not really.

The stick is, if you don’t have internal procedures consistent with our rules, we will punish you.  This is not the role of economic regulators.  If the Board were a government department, perhaps it could get away with setting rules on corporate governance (although it would probably be a bad idea).  As an economic regulator, the Board doesn’t deal with the internal workings of the regulated utility.  Its job is to deal with the interaction between the utility and its customers – whether dealing with rates, conservation programs, reliability, customer care, or otherwise.  It is a “market proxy”.

The Board, in its Renewed Regulatory Framework for Electricity, got one thing glaringly right:  outcomes.  Driven by the concept of the market proxy, the job of the economic regulator is to deal with outcomes.

It is not the Board’s job to stipulate how the outcomes are achieved.  That is the role of the utility.  The Board can set targets for rates or reliability, for example.  It cannot and should not stipulate that everyone must have an IVR system, or standardize on Microsoft Word, or use red maple poles.  If a utility can meet its targets without doing those things, that is the end of the matter.  (It is only when goals are not being achieved that things like “best practices” are even relevant to the regulator.)

The regulated energy sector has a term for a regulator encroaching on the role of the utility:  “micromanagement”.  The basic theory is that utility personnel are in the business of running a utility.  They have both more expertise and better information than the regulator, and so with rare exceptions will run the utility better than any regulator could.  “Tell us what results you want us to achieve”, the utilities say, “and assuming those results are reasonable, we’ll figure out how to get there.  Just leave us to do it.”

Thus, the stick in this exercise is an overreaching by the regulator, crossing a well-understood line – micromanagement – that is there for a good reason, and has stood the test of time.

The carrot, on the other hand, is “light-handed regulation”.  This apparently common-sense theory is that, like a doctor dealing with a healthy patient, the regulator doesn’t have to look as closely at a utility that is clearly better than its peers.

Customers generally don’t like light-handed regulation, because it seems like the regulator is not really meeting its full responsibilities with respect to some utilities.  How do you know the utility’s rates are OK if you don’t take a thorough look?

In fairness, the answer is that the level of investigation can be driven in part by external measures of success.  The critical element is that you set the intensity of your review not on the basis of operational factors, but on the basis of results.

A regulator has outcomes that it can assess using objective tools.  If rates are low, reliability and customer interaction are good, cost benchmarking is favourable, and asset condition is strong, this is probably not a utility that needs a CT Scan and an MRI.

The OEB’s scorecard approach is already moving in this direction.  “If you’re achieving objectively proven good results for your customers, we the regulator have met our goals, and we’re not going to try to fix what isn’t broken.”  While the scorecard system still needs work, there’s nothing wrong with the concept.

The concept of light-handed regulation goes off the rails, though, when it is tied to operational tests, rather than results.  Good results are what matters, and a utility achieving good results does not need the same level of diagnostics as one with issues.  That would be true, by the way, whether the utility has an independent and stellar board of directors, or whether they are effectively run through the local municipal offices (bad, very bad).  Results are results.

Thus, if the implicit promise of complying with the Board’s governance guidelines is light-handed regulation, that is essentially the Board refusing to do its job.  A utility with good governance and high rates needs regulatory attention, and not doing so is a regulatory failure (whether through laziness or stupidity or anything else, it doesn’t really matter).  A utility with lousy governance that delivers for its customers doesn’t need a full-scale regulatory onslaught.  Jumping on them is not only unfair, but a waste.

Who Are They Talking To?

Part of the problem here may be that the OEB is talking to utility management, and consultants, and themselves, and even sometimes (well, a little bit) to customer groups, but not to the owners of the utilities.

Corporate governance belongs, in a very real sense, to the owners of corporations.  Step one in any review process would have to be to go to the owners of utilities and talk to them.

What?  They haven’t talked to the municipalities and other owners of utilities? Apparently not.  (Or at least, if they have, they haven’t told anyone about it).

They have talked to utility management, particularly CEOs, but the OEB doesn’t appear to realize that CEOs and their shareholders have different perspectives on issues like this.

I talked to one CEO, for example, who told me quite frankly that while he can’t publicly support the OEB’s corporate governance initiative, privately he sort of likes it.  If the OEB does what it plans, he expects that he will have more influence over the selection, orientation and training of board members, the people to whom he reports.  His municipal owners will have less influence, because this will be seen to be a regulatory requirement.  It will expand the CEO’s freedom to manage as he sees fit, and reduce the extent to which his board questions what he’s doing.  His job is made easier due to decreased accountability to the shareholders.

It is likely that if you talk directly to a municipality that owns a utility, they will have a different view.  (And as for Enbridge Inc., for example, the publicly traded owners of Enbridge Gas Distribution and now Union Gas, they will certainly have a very different view.)

If the OEB wants to help the owners of utilities improve the governance of those utilities, the right thing to do is ask those owners how the Board can help.  The answer might well be positive.  Municipalities and others may value the input of the Board, consultants and customers, particularly if it is constructive and respectful of their rights.

On the other hand, the answer might be some polite, or less polite, variation on “Thanks for bringing this to our attention.  We’ll take it from here.”

What appears to have happened, instead, is that the OEB is simply moving forward as if the utility owners have no say in this.  It is unclear why that would make any sense.

Conclusion

The Ontario Energy Board’s foray into regulating corporate governance is likely a mistake on multiple levels.

That is not to say that they can’t do some good in this area, just because as the regulator they have an ability to get peoples’ attention.  However, until they recognize that the owners – whose issue it is – need to be at the centre of it, there is little likelihood they can be helpful.

Even in partnership with the utility owners, it is at least questionable whether the OEB should be spending its time barking at this particular squirrel.  The OEB has a lot of important things to do that are within its mandate, some of which are not getting sufficient attention due to finite resources.  Whatever value the OEB could add to the corporate governance issue, it may well be able to add more value in an area for which it actually has both legal responsibility and technical expertise.

– Jay Shepherd, January 7, 2017

 

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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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