Energy #22 – Electricity Distribution: A Radical Proposal

This is a proposal to alter, in a fairly radical way, how electricity distribution rates are set in the province of Ontario.

The proposal is to shift to postage-stamp rates, i.e. everyone in the province with similar distribution requirements pays the same for their electricity distribution.  We essentially socialize the costs of electricity distribution, the same as we socialize many other costs that have a broad societal benefit (including electricity transmission and generation).

Benefits.  The goals are three-fold.

First, postage-stamp rates will change the equation for consolidation within the industry.  A merger or acquisition will not affect local rates.  Improvements in cost-effectiveness will benefit everyone in the province, whether directly involved or not.  Acquirors with high rates (hello, Hydro One) will no longer face a rate harmonization barrier, because no-one will have high rates.  Everyone will have the same rates.  Acquirors will have to demonstrate that they can control costs going forward, so that everyone benefits.

Second, this approach will change how individual distributors approach requests for budget increases.  Under this new paradigm, individual distributors will be asking for a bigger piece of a common pie.  The focus of their applications will have to be how they are improving outcomes for customers, relative not just to their own past history, but also to the rest of the industry.  Cost-benefit analysis will become more important, as will benchmarking to peers.  The available funds are no longer open-ended.  You get more only if you deserve more relative to your peers.

Third, the risk of the death spiral would be spread across the industry, instead of being borne by individual distributors.  Not only does this manage the risk, but it also strongly promotes joint action between distributions to counter this risk.  There is a lot to be said for a feeling of “we’re all in this together”.

In all respects, this is a fundamentally more customer-focused paradigm than the current system, although it is also intended to protect the utilities.

But how do you actually achieve this result?

My plan is to deal with this proposal in two steps, i.e. two articles.  This article sets out the basic approach being proposed.  Then, assuming there is feedback (I can only hope!), the second article a couple of months later will talk about how to overcome the many barriers to this kind of change.

The New System

There are two basic parts to this:  where do we want to end up, and what transitional steps are required to get there?

Let’s start with where we want to end up.

Under this proposal, the rates for each electricity distributor are the same.  That doesn’t mean that their net revenue is the same.  There are legitimate reasons why some distributors need more money than others to provide the same service.  We can’t just ignore that reality.

The postage-stamp system of ratemaking shifts the paradigm.  What individual distributors seek from the Ontario Energy Board is no longer rate approval.  Their rates will be the same as everyone else.  A “rate” application will become a revenue requirement application.

Standardized, Industry-Wide Rate Increase.  To get to this state, it is proposed that the OEB start each year (probably several months prior) by determining a percentage increase in distribution rates, and determining the industry-wide revenue requirement that results from that percentage increase.

The OEB would therefore have to figure out a reasonable increase in overall industry costs, and the changes in load that can be expected.  These two results would then determine the industry-wide revenue requirement.

Done properly, this comes about through a joint/generic hearing process each year, in which evidence is led by utilities and customer groups as to inflation and other cost pressures common across the sector, and special needs that may need to be addressed (a common cause problem with a particular kind of wire, for example). Load forecasts must also be debated, presumably with utilities going low and others forecasting much higher.

The first time this all happens, it will be a zoo.  After the second time, it will be less controversial.  Everyone will understand the parameters, and the Board will have little patience with those who want to re-argue the same points every year.  In the long run, dealing with these issues in a common proceeding is almost certainly a saving in regulatory costs, and an improvement in the quality of the results.

If I had to guess, I would say that the result will be a distribution-specific inflation/productivity (I minus X, for the cognoscenti) factor that is adjusted annually based on known external parameters, and becomes the expected increase in rates each year.  Similarly, a load forecast methodology will be agreed (or imposed), and applied by independent experts that the utilities and customer groups oppose at their peril.

Individual Distributor Applications – Cost of Service.  Suppose that the Board establishes a rate increase across the province of 2%, and determines that based on the expected load that means $3.5 billion is available for distributors.  Who gets that money?

My proposal is that we continue with a kind of IRM, but using revenue requirement rather than price cap.  Every five years, a distributor will come in for cost of service, with their share of the total pie based on their costs, and their performance.  For other years, they will have their share of the total pie determined based on a revenue cap IRM, either based on a formula (e.g. 70% of the approved annual increase) or based on a type of Custom IR approach.

Thus, Distributor A, in their cost of service year, will file an application saying that their share of the overall pie should not increase by 2% – the overall increase – but by 6%, because they have special cost pressures blah blah blah.

The Board will then look at their application, and ask the question:  “What are you doing for your customers that justifies more than 2%?”

In this environment, Distributor A understands that, to get more than 2%, they have to show that they are delivering more for their customers than their peers.  They have to show that their customer service is above average, and/or their reliability is above average, etc.  This is not about costs.  The Board will have already determined the reasonable cost increases across the industry.  Unless Distributor A can show that the cost pressures affect them differently than their peers (an uphill battle in most cases), or they are delivering better outcomes, they get 2%.

Let’s say Distributor A proves they are above average, so they get 4%.  Someone else has to be below average, and get less than 2% to balance out that extra money for Distributor A.  It is a zero-sum process, in which distributors are constantly vying to be the best (or not the worst) performers relative to their peers.

Revenues Do Not Equal Revenue Requirement.  Distributor A then has authority to get $100 million a year, but the standard rates for customers will produce revenue in their service territory of $120 million.  Distributor A has to pay $20 million (to be paid monthly) into the common pool so that the distributor nets $100 million after collecting rates and paying to the pool.  Conversely, Distributor B has authority to get $100 million a year in revenue requirement, but will recover from customers only $80 million.  Distributor B gets recovery of that shortfall from the pool, also monthly.

IRM Distributors.  For most distributors, of course, this year will not be a cost of service year.  For those distributors, their share of the common distribution rates pool will be their last approved revenue requirement, increased by a revenue cap percentage, and by that distributor’s share of the increase or decrease in load.

Distributor C, for example, is in an IRM year.  Their load (billing determinants) is expected to increase by a weighted average of 1% (which has been factored into the industry-wide load forecast by the Board), and their previously approved revenue requirement is $100 million.  Their share of the pool this year will be $102.4 million (1% increase for load, plus 70% of 2% for cost pressures).

Regulator Responsible for Total Approved Revenue Requirement.  For the regulator, this all means that there is a target total of revenue requirement increases across the industry.  As the applications come in, the Board will have to keep a running count of how much of the pool it is “spending” by authorizing revenue requirement applications.  If it allows too many distributors to get more than the amount of the rate increase plus load increase, it will find that it overspends the pool, and the industry-wide rates will not recover all of the costs.  While this can be adjusted in a subsequent year, there will be constant pressure on the regulator to keep cumulative revenue requirement increases in line with the objectively-determined overall increase.

If the OEB says that $3.5 billion of distribution rates is the right number, it will look bad if it authorizes $3.8 billion of actual distribution spending through the combined total of individual applications.

Impacts.  What are the effects of this equalized system?

One obvious result is that people and businesses are no longer penalized in distribution rates because of where they are located.  That high school in Ancaster that I have been going on about for more than a decade (some people say too much) will pay the same as the high school down the road in Hamilton.  More important, customers in low density areas like Innisfil will pay the same as those in Kingston, and when Innisfil density improves due to their known demographic trends, that will affect not just Innisfil rates.  Everyone will benefit.  Innisfil will effectively be subsidized, but over time that subsidy will decline.

Electricity will be treated, in this model, as a public service for which everyone has the same right, and the same cost.  The cost of the commodity, and the cost of transmission, are already the same.  Why not distribution?  In many respects, this follows on the Fair Hydro plan, although it takes it a step further.

Another result is that the biggest barrier to consolidation – rate disparities – is removed.  “No harm” will no longer include rates.  Customers in a local area cannot be harmed by the higher rates of an acquiror, because there will be no need for a future rate harmonization.  They already pay the same rates.

Costs will matter, of course, but only the net improvement as a result of a transaction.  This is consistent with the Board’s policy.  It has just never been able to get there, because rates are different around the province.

In this system, the costs and benefits of a merger are not a customer problem.  They are a shareholder problem…and opportunity.  What is important on consolidation will be whether the new entity will be more efficient relative to its peers.  Consolidation is a shareholder activity, so it is a shareholder result as well.  Good consolidations will result in more ability to get increased budgets, and thus grow the business.  Bad consolidations will diminish available funds.  In each case, it will be the shareholders that are impacted.

Of most importance, though, every cost of service rate application will be about why this particular distributor should get a disproportionate share of the common pool.  Today, a rate application is about how much the local customers should pay.  The available funds are largely open-ended, despite the Board’s attempts to keep them under control.

Under this new system, the available funds are not open-ended.  There is a fixed pool.  If a distributor asks for more than their proportionate share, someone has to get less.  Which distributor is more deserving?  That is a new question, never asked before.

(Is there a role in this system for variable ROE based on outcomes, as I have speculated previously?  I think that in this system, allowed ROE can be variable around a predetermined standard, depending on what is delivered to customers.  However, that may not be implementable in the first phase.  It is, however, probably worth considering as the system evolves.)

Conclusion.  This new system is therefore at its roots a customer-centric system.  What the customer across the province pays is determined objectively.  What any given distributor receives is based on their performance relative to their peers.  Their revenue is not driven by what their customers pay, but by how well they perform.

How To Transition to This System?

Let’s not fool ourselves.  Moving from geographically-derived distribution rates to postage stamp (socialized) rates means there will be winners and losers.

Who Benefits?  Objectively, for residential customers it would mean that 3.4 million customers get a rate increase, and 1.2 million customers get a rate decrease.  However, this is largely because of the move to all fixed charges.  When that impact is removed, the distribution of increases and decreases is more balanced, and the impacts on individual customers are small.

The imbalance is also true for small business customers, where 55% would have a decrease, and 45% would have an increase.  Again, the impacts on most individual customers are small.

What is perhaps more worrisome is that the main beneficiaries of this new system are the customers of Toronto Hydro and Hydro One (at least, some of them), because they have high rates today relative to their peers.  For the most part, the customers of utilities that have been able to distribute electricity at lower costs – small and medium sized municipalities – will be the ones that have rate increases.

Impacts of Harmonization.  On the other hand, in the longer term the effect of the system should be to reduce rates across the province by inter-utility competition for the rate pool.  Further, by making consolidation easier, this effect should be enhanced.

The OEB has had to deal with harmonization in the past.  As long as the differences are not too substantial (and they aren’t here, except in some unusual cases), this is something that can be phased in over a few years with no noticeable impact.

One thing that is worth noting is that the Fair Hydro Plan makes this an opportune time to implement such a system.  Fair Hydro mutes the differences in rates between distributors for many customers.  A transition in that context has less impact.

The Common Pool

The one thing that is left is the structure of the common pool.  Transmission has postage-stamp rates, but transmission charges are collected by IESO and distributed to the transmission companies.  There is a built-in mechanism to collect and distribute between the claimants on the pool.

Not so with distribution.  They are in the front lines, so they have in the past collected money on their own behalf, then kept it.

Obviously one way to create a common pool is to have distribution revenues go through IESO, as with transmission.  This has the advantage of simplicity, but it would require changes to the legislation.

Another option is to create deferral accounts for approved revenue greater or lesser than the revenue generated from rates (this probably has to be done in any case).  The balances in the deferral accounts could then be paid to or received from a common pool established by the OEB.  Would this require changes to the legislation?  Most likely, but it is less certain than if IESO is the intermediary.

Having said that, in my view this is not a change that the OEB should implement without government approval and legislative guidance.

There is a lot to be said for the OEB coming up with a policy alternative like this, and presenting it to government.  That is different from implementing this approach without government approval.  The role of the OEB is to implement its government-approved mandate.  That mandate does not include postage-stamp distribution rates.

If “just and reasonable rates”, and other policy goals, are best achieved by postage-stamp rates, the government should be told, even convinced, but in the end it is a legislative decision, not a regulatory decision.

Conclusion

In Ontario we have issues with barriers to consolidation of the distribution sector, and we have challenges getting electricity distributors to adopt a customer-focused, outcomes-based relationship with their customers.  We also have social and economic problems because of the large differences between distribution rates from one location to another.

If distributors all had the same rates, the last problem would be moot; consolidation would have one less barrier; and the customer-focused approach would be enhanced and encouraged.

This is therefore a proposal to implement postage-stamp distribution rates in the province of Ontario.

  –  Jay Shepherd, February 20, 2018

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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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2 Responses to Energy #22 – Electricity Distribution: A Radical Proposal

  1. Sharron says:

    Very interesting concept. How would the debt amounts of the various LDC’s to be adjusted as well I wonder?

    Liked by 1 person

  2. Jay Shepherd says:

    In this concept, the individual LDCs can still choose their own debt to equity ratio, as they do today, because the ROE would be based on a deemed ratio. If the LDC chooses to be more or less conservative, their achieved ROE will be adjusted commensurate with the risk they accept.

    Like

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