A friend of mine is married to an engineer. The other day I told her that, lacking any other evidence on capital needs, the Ontario Energy Board said in 2011 that the engineers in the electricity distribution companies should simply go out, look at their system, and see what work needed to be done. That would be the basis for their new capital budgets.
“I love my husband, but engineers are the best people in the world at finding legitimate ways to spend money.”
The result was the Big Build. Egged on by the OEB, distributors have gone on a spending spree. Electricity distribution infrastructure – assets that are supposed to last for 40 years or more – have almost doubled in ten years. 11% more customers; 96% more assets.
The numbers don’t lie. From 2005 to 2015, $17.8 billion in capital spending has resulted in $8.8 billion in assets (net of depreciation) being added to the distribution grid. That doesn’t count transmission infrastructure, or private investments.
Because of changes in accounting rules, and declines in market interest rates down to record low levels, the impact of that Big Build on rates has been hidden so far. That is about to change.
What’s worse, there’s more to come. Seeing no stop sign from their regulator or their shareholders, the distributors plan to keep pouring more money into capital assets. In the next six years, 2016-2021, their forecast is that they will spend another $12.8 billion, adding after depreciation another $7.2 billion to net distribution infrastructure.
The neat thing about capital spending, you see, is that the company doesn’t have to pay for it right away. They pay for it over the life of the asset, like a mortgage. (It’s a mortgage with an interest rate of about 7%, but it’s still like a mortgage. Just an expensive one.)
Oh, wait. Did I say “they”. My mistake. That should be “you”. The distributors aren’t going to have to pay for those assets for the next forty years. No, no, no.
The customers have to pay.
(Just in case you wondered, yes, the customers ALWAYS have to pay.)
Electricity distributors have to spend money on capital. It is the nature of their business: they run the capital infrastructure that gets electricity from the transmission grid to the end user. Maintaining, replacing and building capital assets is the essence of what they do.
There are basically four types of capital assets to be purchased:
- Expansion: the infrastructure needed to connect new customers to the grid.
- Sustainment: the infrastructure to replace old or broken assets, i.e. spending needed to maintain the same service.
- Service: new assets required because existing assets have to be moved or replaced for non-distribution reasons (like a road widening).
- Toys (sometimes referred to as General Plant): buildings, fleet, furniture and computers, central equipment, and new technologies.
In theory, the costs of Expansion capital are an investment that pays for itself, either with immediate reimbursement from developers, or with additional revenues from new customers. Service capital is also often wholly or partially reimbursed by other levels of government. Good Toys – ones that have been chosen based on a solid business case – will pay for themselves through increased revenues or decreased costs. They are the cheapest way to solve a problem, or improve efficiency, so they are by definition cost-effective. (Other Toys – also sometimes referred to as “Shiny Baubles” – have to be justified in other ways. There is a course in engineering school on that.)
The rest of capital is just an additional cost, but it doesn’t have to increase prices. If a utility is replacing an old building, or an old bucket truck, or old wires and transformers, the original costs have declined over time due to depreciation, so, adjusted for inflation, the new spending – if it’s done correctly – is just to bring costs up to where they were in the first place. In many cases, there is the potential for increased efficiency with the new assets, so it should be a win-win.
In fact, if a distributor’s customer growth rate is 1% (the Ontario average), it can replace older assets at a rate equal to about 130% of its annual depreciation, and still keep rate increases at or below inflation. If depreciation is $10 million this year, the distributor can spend $13 million on replacement assets, and customers will be fine. This can be done year after year.
This is not rocket science.
What Is Actually Happening?
All electric utilities have been increasing their capital spending for the last ten years, with the express encouragement of the Ontario Energy Board. Not only that, but they plan to continue to do so for the next several years, again with prodding from the regulator.
This effect is found in all parts of the industry, but it is most obvious in electricity distribution. As noted earlier, distributors have increased their net capital assets (called “net PP&E”) by $8.8 billion since 2005. In new plans provided to the OEB, distributors are forecasting similar increases over the next five years, likely another $7.2 billion added to net PP&E. Based on the current trajectory, net capital assets of distributors will be $25.1 billion by 2021. That’s about 2.6 times the level in 2005, for about 15% more customers.
What does that mean?
Well, the $8.8 billion of additional capital, on top of operating cost increases of more than $700 million, should have resulted in rate increases over the last ten years of 48%, a compound annual growth rate of more than 4% per year. In dollar terms, the distribution bill for the average Ontario customer should have increased from $548 per year in 2005 to $810 per year in 2015. Within the next five years, that should increase to about $1050 per year.
But wait. The OEB is going around telling people that they have kept distribution rates to the level of inflation for the last few years. How can that be? Are they lying?
No, they aren’t.
The answer is that, except for Hydro One (which marches to the beat of its own, unique, 4% per year drummer), distribution revenue per customer (a rough proxy for rates) has increased an average of 1.73% per year from 2005 to 2015, which is almost exactly the rate of inflation.
However, once you remove Hydro One from the data, two other things also become apparent.
First, over the last ten years, distributors have seen their interest costs drop by about $310 million per year due to lower market interest rates. Interest rates are at their lowest levels in memory, although they are not likely to remain there forever. This has generated an underlying decrease in rates of more than 10%.
Second, in the 2011-2015 period external changes to the accounting rules for distributors meant that their depreciation rates and other accounting “costs” had to change. This didn’t affect Hydro One at all, but for most of the rest of the distributors the effect was to reduce their costs, through an accounting change, by about $230 million each year. The still spent the same money, at the same time, for the same things. New accounting rules spread the cost over a longer period of time, making it look like their annual costs are lower. This has generated a further hidden rate decrease, about 7%.
These are savings that should have reduced rates, benefitting the customers. Between them, these two effects were like winning the lottery. The distributors didn’t do anything to save money; they simply lucked into reductions in their annual costs. These decreases were enough that rates could have stayed at almost the same level, with no increases, for that full ten years.
Instead of passing those savings on to customers, the distributors have used the money to fund capital costs, not just annually, but for many years to come. In effect, they said “With this extra $540 million a year, we can afford a much bigger mortgage. Let’s get an $8 billion new house.”
If you back out just these two fortuitous changes (there are others), the rate of increase of distribution costs over the last ten years – and therefore bills before these decreases – is about 4%, the same as Hydro One, and mostly driven by high capital spending. What has happened, in fact, is that distributors have been pumping money into capital assets, but the financial pain to customers that should have resulted has been masked by these other cost changes.
Interest rates are not going to go down any more, and there are no major accounting changes on the horizon. Now there will be nowhere to hide. The capital spending over the last decade is already starting to hurt, and ratepayers have to continue to pay for it for many more years. Continued capital spending at these record high levels is going to make it hurt even more.
And what is the regulator, the OEB, protector of the customerTM, saying about this?
“Don’t stop now. Keep spending.”
The Initial Problem
Some smartass (who may in fact have been one of my kids) once said that I never saw a spreadsheet I didn’t like. Certainly I have an unnatural need to put data into spreadsheets, so much so that I was once called a “closet economist”.
I deny that, but I do admit that it was a set of spreadsheet models that drove me to reach this sad conclusion: we have allowed capital spending to get out of control.
I am not a fan of bald opinions. I like to see facts, data, evidence. My experience is that you can find the truth better that way. We have data. We can see what it says.
In 2005, the electricity distributors spent a total of $869 million on new capital assets, which was about 137% of their depreciation that year, pretty close to a reasonable replacement rate. However, many distributors complained that, since they had just gone through a three-year rate freeze, they needed to spend more on capital. In 2006, they increased their capital spending by about 25%, and then in 2007 they increased it by another 25%. By that time, their capital spending was up to $1.347 billion, which was 190% of depreciation.
Over the next couple of years, Hydro One kept increasing its capital spending up to 227% of depreciation, but the rest of the distributors cut back a bit, to about 174%. Still high, but better.
Then, in 2010, there was another big jump. Hydro One continued plodding ahead slowly, but the remaining distributors bumped their capital spending up by another 31%.
There is a story behind that. The Electricity Distributors Association, in 2008-2010, put a big push on, with government and the regulator, for distributors to be allowed to increase their capital spending. The technique was simple: keep repeating the “need” to increase capital spending until everyone believes it must be true.
In 2011, a new Chair was appointed to the OEB, a former distribution company CEO who had also been active in the Electricity Distributors Association. That new Chair launched (or re-launched, more correctly) the Renewed Regulatory Framework for Electricity. One of its key tenets was continuation, even expansion, of the increased levels of capital spending seen in 2010.
By 2015, capital spending was up to $2.23 billion per year, 258% of depreciation. Even that wasn’t the whole story. Hydro One was still trundling along, and it was still at 226% of depreciation. The rest of the industry had increased its spending to 281% of depreciation. To put that in perspective, at that rate you can replace all of your assets – assets that have an average 40 year life or more – in less than 15 years, and still have money for growth as well.
What does this mean? From 2005 to 2010, Hydro One added $1.7 billion to its net assets, and the rest of the industry added another $1.4 billion. From 2010 to 2015, Hydro One added a further $1.9 billion, but the rest of the industry added a whopping $3.8 billion. Not only did they spend money on poles and wires, but it was also an opportunity to build hundreds of millions of dollars of new (and fancy) head office buildings, as well as purchase many new technologies that, for some inexplicable reason, don’t seem to reduce other costs.
We often treat Hydro One as the major culprit when it comes to distribution issues, and they do indeed have very high prices and problematic cost controls. On this one, though, it is now the rest of the distribution industry that has seen the writing on the wall, and decided that they can have as much capital to spend as they want.
In the venture capital game, there is a saying: “Take the money, stupid”. The same is true here. Capital spending is in vogue. Distributors have noticed, and are taking advantage of the opening. Who knows how long it will last?
And Then It Gets Worse
To understand the role of the OEB in all of this, you have to go back to the early days of the Renewed Regulatory Framework for Electricity.
When the distributors and their association were jumping up and down, in a frenzy about the need for more capital spending, some of the customers in the room wanted to see some evidence that there was a particular need for additional capital spending. The customers, before paying for the Big Build, wanted to see past capital spending data. The data was available, in various forms, for fifty years or more.
For example, if in the 70s there was a large buildout in capital spending, then it would be reasonable to expect that forty years later there would be a need for extra capital spending to replace those assets. Like kids in the baby boom, the assets would be getting old together. If a large number of assets are getting old at the same time, you will have a spending bulge. You could even calculate how much that bulge should be, and figure out ways to soften the blow.
Or, if there was evidence that for the most recent ten years there was underspending relative to long term averages, that would suggest a need for a short-term capital spending catch-up. If you spend less than you should for a while, eventually you have to spend more to catch up.
As noted earlier, this is not rocket science.
Instead, the OEB had the brilliant idea to require every distributor to do an asset condition assessment, and then prepare a formal, five-year distribution system plan (DSP). This is basically a five year plan for future capital spending.
To no-one’s surprise, the spending forecasts were big. Letting loose the engineers to assess what has to be spent on capital is like asking a priest how often you should pray. Even if they’re “right”, however that might be defined, their estimate is going to be a lot higher than what you get from anyone else.
Further, OEB told the distributors that, once they had their asset condition assessments, they had to consult with local customers to make sure the customers were onside with the spending plans. This has led to focus groups and surveys with questions like “If we have to spend more money on capital to prevent blackouts, do you think we should do that?”, and “Would you prefer that we replace older assets before they break down, or wait until they break and cause an outage before replacing them?”
(No, I am not making this up.)
No-one asked the questions “Should we increase your rates 10% to reduce your outages by one every three years?”, or “We normally don’t replace light bulbs and other non-essential assets until they fail; should we continue to do that?”
We now have distribution system plans for 43 of the 67 existing electricity distributors. If you plot their spending plans on a graph, relative to their past spending, you can generate a representative forecast of capital spending in distribution over the next five years.
Remember, annual capital spending in 2005 was $869 million, but by 2015 it had increased to $2.23 billion per year. We can look forward to capital spending in 2021, based on current plans, of about $2.2 billion, i.e. maintaining the current high spending rate. That should result in another $7.2 billion added to net distribution assets in just those six years, a further 75% increase relative to that 2005 base.
Oh, and one other thing I forgot to mention. The regulator says that if they want to spend more than their plans, they can come in any time for permission to do so. Just in case, you know.
What Can we Do?
This is where I’m supposed to provide a creative, insightful answer to this problem. This is where I say “If we just do X, all of these concerns will magically disappear”.
That is not to be.
We’ve already spent the money. We can’t get it back. We can’t sell the assets that we bought with that $17.8 billion. We’ve borrowed to pay for them (at a high rate of interest), and now we have to pay that off. There is no-one else to pay. The shareholders can’t pay, and even if they could, they are almost all governments, so if the shareholders pay, that still means us (or our kids).
Bottom line, we have to suck it up. We foolishly let our local utilities borrow on our credit cards to spend our money, and we let our regulator/protector be their cheerleader. Actions have consequences. Now we have to pay.
At best, what we can do is tell the utilities, and their owners, and the regulator, to stop spending money we don’t have on things we don’t need. Don’t make it any worse.
Will they listen? That I can’t tell you.
– Jay Shepherd, March 18, 2017