Political Economy of Ontarios Electricity Restructuring: Part One

1
Political Economy of Ontarios Electricity
Restructuring Part One

• School of Policy Studies
• Queens University
• Bryne Purchase

2
PRESENTATION OBJECTIVES PART ONE

• Look back at the changing governance structure of
  Ontarios electricity sector
• Structure of old Ontario Hydro
• Reasons for Change
• New Market Governance Structure (1999 and 2002)
• Errors in Execution and Design
• Political Economy of Electricity Markets and
  Prices

3
PRESENTATION OBJECTIVES PART TWO

• Focus on the Hybrid Market, its economic
  rationale, and its possible evolution
• Reminder of supply and demand fundamentals to
  2020
• The need for a capacity market in electricity
  sector
• Outline some market limiting factors.
• Concluding observations

4
Ontario Electricity Sector Old Governance

• Ontario Hydro (1906 1999)
• corporation centrally planned, built and operated
  Ontarios electricity supply
• vertically integrated monopoly
• generation
• (high voltage) transmission and,
• (rural) distribution.
• non-profit, providing power at cost
• largely self-regulated
• engineering dominated culture.

5
Ontario Electricity Sector Old Governance

• Ontario Hydro (1906 1999)
• Relationship to Ontario government
• no formal ownership of Ontario Hydro
• Province guaranteed OH debt
• Premier selects Chairman and the Board.
• Local Distribution Utilities
• in 1995 there were over 300
• primarily non-profit
• owned by municipalities
• OH involved in rural distribution.

6
Why Restructure?

• Confluence of three forces for change
• poor monopoly performance (Darlington and
  industrial consumers)
• ideas and circumstance (economic theory, CCGT
  technology and natural gas prices)
• ideological politics and money (Common Sense
  Revolution and Bay Street).

7
The New Governance (1999 2002)

• Separate monopoly wires (transmission and
  distribution) from competitive generation.
• Give Ontario Energy Board rate regulating
  responsibilities in monopoly wires.
• Create a competitive market in generation.

8
Restructuring Ontario Hydro
9
The New Governance

• Ontario Government
• takes ownership of OPG and Hydro One in debt for
  equity swap with OEFC
• makes all companies, including municipal
  utilities, for profit corporations
• creates corporate income tax regime for the
  electricity sector and,
• creates a Debt Retirement Charge.

10
Capitalizing of OPG and Hydro One

• Ontario Power Generation
• Total Value April 1, 1999 8.5 bn As
  at Dec. 31, 2005
• Total equity 5.1 bn Total equity 5.4
  bn
• Total debt 3.4 bn Total debt 3.9 bn
• Initial Capitalization
• 60 Equity, 40 Debt
• Hydro One
• Total Value April 1, 1999 8.6 bn As at
  Dec. 31, 2005
• Total equity 3.8 bn Total equity 4.7
  bn
• Total debt 4.8 bn Total debt 5.1 bn
• Initial Capitalization of Regulated Transmission
  and Distribution
• 36 common equity, 4 preferred shares, 60 debt

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Stranded Debt
April 1999 Estimate ( billions)
12
Closed System Directs Electricity Revenues To OEFC
DEBT AND LIABILITIES OF OEFC
Electricity Sector Dedicated Income
PILs from OPG, H-1, MEUs
Interest payments from OPG and IESO
Interest payments from Province on debt for
equity swap
Debt Retirement Charge (DRC)

• Ontario Hydro was legally continued as OEFC, a
  Crown Agency, in the Electricity Act, 1998

13
Provinces Income Statement
OEFCs payments-in-lieu of taxes from OPG, Hydro
One, and MEUs are consolidated as taxation
revenue.
OPG and Hydro One net income is consolidated as
income from investment in government enterprises
at 1,090 M
Debt Retirement Charge collected from consumers.
Proceeds from sale of NUG power
Draw down of NUG liability
Cost of NUG power purchases
14
OEFC Financial Results

• OEFCs unfunded liability (Stranded Debt)
  increased by about 1.1 billion from April 1,
  1999 to March 31, 2004. Main reasons for increase
• Underperformance of OPG, particularly related to
  underperformance and higher than planned costs in
  OPGs nuclear division
• OEFC funded the governments price freeze on
  electricity which cost about 900 million, and
  provision of temporary generation in summer 2003
  which cost 70 million
• Stranded debt is projected to decline to 19.3
  billion in 2005-06.

15
Fundamental Changes

• MOVED FROM
• Vertically integrated
• Self-Regulated Monopoly
• Tax Exempt
• 100 Debt Financed
• Government Guaranteed Debt
• Price Setting (Self-Regulated)
• Charged Bundled rates for generation, market
  dispatch, transmission, debt service

• TO
• Segregated Activities
• Competition / Independent Regulator
• Payments-in-lieu of Tax
• Commercial Debt/Equity Capital Structures
• Borrowing on Own Credit Worthiness
• Price Taking (Market / Regulated)
• Separate rates for generation, IESO,
  transmission, DRC

16
Second Thoughts The California Question

• Market opening in 2000 delayed by IMO software
  development problems.
• In 2001, an electricity pricing crisis in
  California market raises caution flag in Ontario.
• But Ontario was not California
• Adequacy of supply, Pickering A units (2000MW)
  would begin return to service in 2001
• Customers could buy a fixed price hedging
  contract from a retailer (25 did)

17
Second Thoughts The California Question

• But Ontario was not California
• Dominant OPG (75 of market) is government owned
  and owners should be enriched if prices rise
• OPG already had a price mitigating rebate (MPMA)
  in place
• Customers could enjoy a fixed price throughout
  year with only a year- end true-up (eg Toronto
  Hydro -25 of customers)
• Some price pressure released pre market opening
  no public response.

18
Implementation The Perfect Storm

• May 2002. Market opens. But
• Pickering A is an engineering and financial Black
  Hole
• OEB puts all default customers on spot market
  price
• Government/bureaucrats endlessly debate a
  contingency mitigation strategy
• New Premier an election is near panic is
  always close at hand
• Weather is a scorcher.
• November, 2002. Government fixes the price for
  small consumers at 4.3 cts/kwh.

19
Price Cap Policy Popular Misconceptions

• The spot market was not closed on the supply side
  generators still received market prices but
  private investors had shied away from Ontario in
  any case
• Large consumers (50 of consumption) were left
  out of the new 4.3 cts/kwh price cap.
• Price mitigation already existed (MPMA)
  essentially a blended price of OPG market and
  non-market assets.
• Option 1 The logical approach was to extend this
  concept (later actually adopted in the hybrid
  market).
• Option 2 The other option was to set a low price
  and play with the true-up mechanism by keeping
  the customers account open for an extended
  period (expecting market prices to fall over
  time). Built up a large negative variance in the
  first year.

20
In Retrospect Key Restructuring Flaws

• Errors of judgment
• Exposing small customers to spot market price as
  the default option.
• Not developing additional contingency measures or
  sending a directive to OEB re default customers.
• Errors of design
• Not immediately breaking up OPG
• Not taking nuclear problems seriously by creating
  a separate OPG nuclear company.
• However, Bruce lease was an unintentional
  design success.
• Not recognizing that nuclear generation (retrofit
  or new build) would not be viable in a real
  market setting.

21
Political Limits on Ontario Electricity Prices
(Markets)

• Evidence is that politicians do not like using
  price (markets) as a policy tool, except to
  freeze them or reduce them
• Through most of the 1990s the price of
  electricity in Ontario was frozen.
• The market opened in 2002, prices rose and the
  market closed shortly thereafter, with prices
  rolled back to 2001 levels.
• There are still a plethora of political
  constraints on the price of electricity in
  Ontario
• Maximum market clearing price
• Imports do not set the Ontario price
• OPGs baseload nuclear and hydraulic assets are
  regulated using unrealistically low rates of
  return on equity
• 85 of OPGs unregulated production is subject
  to a further 3 year revenue cap of successively
  4.6, 4.7 and 4.8 cents/kwh and,
• Environmental impacts of S02, NOX and C02 are not
  fully priced into the cost of electricity
  produced from fossil fuels.

22
Political Limits on Electricity Prices (Markets)

• These pricing limits represent billions of
  dollars of subsidy annually to Ontario consumers
  of electricity
• This subsidy encourages the consumption and waste
  of electricity, even as
• Ontario is facing a potential supply crunch and,
• Government touts conservation as a primary goal
  and,
• Government stresses the importance of consumers
  paying the true price of electricity!
• Why?

23
Political Limits on Electricity Prices (Markets)

• Two major arguments against using prices
  (markets) to drive a culture of energy
  efficiency
• impact on big industrial users and,
• Impact on low income people.
• Strange bedfellows but joined under the
  political banners of job protection and equity.
• Irony is that subsidizing electricity users is
• highly inequitable and,
• bad industrial policy for maintaining
  competitiveness and jobs corporate welfare can
  become a culture of dependency every bit as much
  as social welfare.
• Can policy be different? Yes it can!

24
Conclusions Using Price (Markets) to Promote
Energy Efficiency

• I recommend the following program
• Allow imports to set market prices
• Raise the regulated rate of return to OPG nuclear
  assets to reflect the true social costs/risks of
  its operations
• Allow OPGs baseload hydraulic assets to earn
  market prices
• Remove the revenue cap from OPGs non-regulated
  assets
• Impose appropriate fees for emissions (including
  carbon emissions) from fossil fired generating
  stations and,

25
Conclusions Using Prices (Markets) to Promote
Energy Efficiency

• In addition, I recommend
• Use the additional OPG and tax revenues
  (billions) to
• Reduce taxes and enhance transfers to low income
  Ontarians
• Increase targeted job training and relocation
  assistance in affected industries and
• Fund large tax benefits to corporations who can
  demonstrate that they lead their industry
  globally in energy efficiency.

26
Conclusions Using Prices (Markets) to Promote
Energy Efficiency

• Not a novel idea to raise energy prices and
  recycle the revenues. But never, in my
  experience, rigorously tried!
• What it lacks is an implementation program
  designed to reduce political risk. Recommend
• Gradualism raise price automatically every
  quarter over a specified period to the target
  level (true market price).
• Transparency keep the additional revenues in a
  dedicated fund out of the hands of OPG or the
  Ministry of Finance.
• Clear winners designate those to benefit from
  the added revenues and,
• Commitment - promise, in advance, how the
  estimated additional revenue will be used.
• Awaits a political entrepreneur who wants to
  lead, and not merely appear to lead, the parade!

27
Natural Gas Prices

• Sixty percent of cost of natural gas fired
  generation is for fuel
• Prices for a modern facility range from 5.5 to
  9.0 cents, based on natural gas prices of 4 to
  8 per mm BTU respectively

28
Spot Market Electricity Prices

• Monthly average prices have ranged from 3 to
  almost 10 cents/kWh with peaks in the summer and
  winter months