As of December 2013 there were 73 local electricity distribution companies [“LDCs”] under the regulation of the Ontario Energy Board [“OEB”]. The size of these distribution companies varies widely, from Hydro 2000, with only 1,220 customers and 21km of network in the small town of Alfred, to Hydro One Networks, with 1.2 million customers and 120,000km of network across the province. While relative to other provinces this remains a large number, the current position is a significant reduction from the almost 400 electricity utilities existing in 1923.¹ Most LDC consolidations took place in the late 1990s when a temporary lifting of a provincial transfer tax encouraged municipalities to divest their distribution assets to Hydro One. Since then consolidations have been slower and taken place on the basis of voluntary reorganizations among neighbouring municipalities, for example Powerstream, Veridian Connections, Horizon Utilities, and more recently, Lakeland Power (See Figure 1).

The 2012 “Drummond Report” highlighted the potential cost savings of further consolidation of Ontario’s LDCs.³ Since then discussion about LDCs has focused on how to undertake such consolidation, with recommendations including a loosening of the transfer tax system to encourage consolidation similar to the late 1990s,⁴ as well as forced consolidation into regional distributors with a minimum of 400,000 customers.⁵ In addition, more recently, the Premier’s Advisory Council on Government Assets released a report (hereby known as the “Ed Clark Report”) recommending the consolidation of Hydro One Brampton with other GTHA⁶ distributors to produce a entity comparable in size to Toronto Hydro.⁷ The hope of the Advisory Council was that such a merger would trigger additional consolidation eventually resulting in only three to four provincial electricity distribution companies.⁸

This paper generally supports the consolidation of Ontario’s electricity LDCs but proposes an alternative method to the reorganization. The analysis centres on two issues: first, whether larger LDCs are in fact cheaper⁹ and second, whether private investment in LDCs has led to cost reductions. Based on the results of these examinations consolidating Ontario’s smallest LDCs into larger “regional” distribution companies [“RDCs”], and operating these RDCs as private concessions, similar to other provincial services like driver examinations,¹⁰ is believed to lead to the greatest possible savings. The author also believes this solution addresses the confluence of politics and industry forces defining energy regulation and overcomes the historical view that competition in this sector was impossible.

Question 1: Are Larger LDCs Cheaper?

There are many logically explainable cost differences between Ontario’s LDCs. For instance, LDCs covering a sparsely populated area will have higher per person maintenance costs given greater distances travelled by crew and potentially harsher weather conditions. Therefore, to draw meaningful conclusions about the relative cost efficiencies of LDCs it is better to focus on administrative costs.¹¹ Normatively, in an age of mobile communications, administrative costs should be more closely aligned between LDCs of differing size than O&M costs (See Figure 2).

Plotting Ontario’s LDCs on the basis of administrative costs per customer in comparison to total customer numbers illustrates a visible downward trend between LDCs with less than 25,000 customers to those with approximately 150,000 customers (see Figure 2). These results are consistent with earlier analyses which similarly showed a decreasing trend in costs, albeit with a subsequent increase in the average costs for the largest utilities.¹³ It is therefore possible that an inflection point exists and consolidation of the province’s larger LDCs may not lead to additional cost savings. However, consolidation of Ontario’s smallest LDCs (those with less than 25,000 customers) could yield annual administrative cost savings of over $40 million, given administrative costs comprise 40-60 per cent of such LDCs’ budgets.

Recommendation 1: Consolidate the Smallest LDCs Into Larger RDCs

While further analysis into the optimal size and number of RDCs would be preferred, it is unlikely the minimum threshold of 400,000 customers recommended by the Ontario Distribution Sector Review Panel’s 2012 report is required (see Figure 2).¹⁴ In addition, the recommendation in the Ed Clark Report for only three or four LDCs may also be sub-optimal. In northern and rural areas it is possible that 150,000 to 200,000 customers would be most cost effective solution, any bigger and potential diseconomies of scale may emerge.¹⁵ A greater number of RDCs than the 3 or 4 recommended by the Ed Clark Report will also help foster competition in the concession market (see Recommendation 2), allowing smaller operators to enter the bidding process and drive down costs between RDCs.

Question 2: Does Private Sector Involvement in LDCs Lead to Lower Costs?

Numerous scholars have broadcasted the potential cost savings of outsourcing the operations of public infrastructure to the private sector. Jose Gomez-Ibanez lists such savings as being in the range of 20-40 per cent.¹⁶ Sally Hunt also favours private involvement in the electricity sector, citing the fact no country has returned to regulated pricing since introducing competition.¹⁷ In Canada, the view that private sector involvement in public infrastructure is cheaper is more mixed. The Province of Ontario enjoys a lower cost of capital than any Canadian corporation so can develop more cost-effective solutions,¹⁸ and there have been mixed experiences with private operators of public services.¹⁹ According to the Auditor General of Ontario however, O&M costs over the 74 AFP²⁰ projects currently in operation were 27 per cent cheaper than the public sector estimate.²¹

In Ontario, while the majority of regulated LDCs are provincially, or municipally, owned, seven have, within the last 15 years, received private investment (see Figure 3). At less than 10 per cent of the province’s LDCs this is admittedly a small sample but does nonetheless provide an indication of the potential impacts of private involvement.

Of the seven ‘privatized’ LDCs only Algoma Power and Canadian Niagara are wholly-owned and privately operated so provide the strongest indication of the potential impact of privatizing LDC operations. Enersource is minority owned by Borealis, a division of the pension fund OMERS. Given Borealis’ lack of operational expertise this is less an example of privatized operations and rather an instance of private investment in a publically operated company. The analytical value of the remaining four LDCs lies somewhere in between. This middle position results from the municipality retaining primary operating responsibility, while seeking to partner with private operators to deliver operational efficiencies and improvements.²²

Using data from the OEB, the costs of each ‘privatized’ LDC were analyzed using three metrics:

the cost changes since receiving private investment compared with the average cost change for all Ontario LDCs over the same period [the “Cost Change Analysis”];²³

the administrative costs per customer for the ‘privatized’ LDCs compared with the administrative costs per customer for their peer group²⁴ [the “Per Customer Analysis”]; and

the administrative costs per kilometre of distribution line for each ‘privatized’ LDC compared with their peer group average [the “Per km Analysis”].²⁵

a) Cost Change Analysis

The administrative and O&M cost changes of LDCs since privatization were compared with the average provincial change over the same time period.²⁶ To remove the effects of volume-based cost changes, the percentage change in billed kilo-watt hours (kWh) within each LDC was deducted from the percentage cost change.^27,28 Both Algoma Power and Canadian Niagara (the two privately operated LDCs) have illustrated favourable cost changes since privatization relative to the provincial average. Since 2009, Algoma Power, while outperforming the provincial average in administrative cost changes by 18 per cent, has underperformed the provincial average on O&M costs by 2.5 per cent.²⁹ Canadian Niagara has outperformed the provincial average for both administrative and O&M costs since 2002, by 8 per cent and 40 per cent respectively. The results for the five LDCs with minority private ownership, but municipally-run operations, are less impressive. Only Westario Power and Entegrus outperformed the provincial average, and only with respect to one category each. For Enersource, Grimsby Power and Rideau St Lawrence the price changes have been significantly higher than the provincial average (See Figure 4).

b) Per Customer Analysis

This analysis compared the per customer administrative costs for each ‘privatized’ LDC with their peer group average. Combined with the “Per km Analysis”, this provides insight into whether ‘privatized’ LDCs operate more cost effectively (See Figure 5).

Five of the seven ‘privatized’ LDCs had lower administrative costs per customer than their peer group average. The two other LDCs, Algoma Power and Enersource, were significantly more expensive on a per customer basis than their peer group, 47 per cent and 37 per cent respectively. On average the ‘privatized’ LDCs were 3.1 per cent more expensive, but 2.5 per cent cheaper with Enersource excluded.

c) Per km Analysis

This analysis compared the administrative costs per km for ‘privatized’ LDCs with its peer group (See Figure 6).

In this analysis six of the seven ‘privatized’ LDCs were cheaper than their peer group average. Notably, Algoma Power and Canadian Niagara both exhibited savings of between 50-70 per cent over their respective peers. Only Enersource was more expensive than its peer group. On average the ‘privatized’ LDCs were cheaper than their peer group by 31.0 per cent, or 37.4 per cent with Enersource excluded.

While admittedly a small sample size, the results do suggest that while private ownership alone may not trigger cost savings, private involvement in LDC operations has led to cheaper costs (see Figures 3, 4 & 5). In support of this conclusion the anomaly of Algoma Power deserves greater discussion. While it is the most costly LDC in the province on a per customer basis it is also the LDC with the lowest population density and second largest area. Given however that Algoma Power has significantly outperformed the rest of the province in administrative cost changes (see Figure 4) since Fortis took ownership 5 years ago, it still supports private sector involvement in LDC operations.

Recommendation 2: Develop Operating Concessions for the RDCs

Operating concessions can achieve desired cost savings while also overcoming many of the roadblocks previously discouraging private sector involvement in the LDC sector. Such concessions overcome the lack of competition “in the market” by creating competition “for the market”.³⁰

First, the privatization of Ontario’s LDCs has been a politically sensitive issue. Three fears underlie this sensitivity: worries that privatizing distribution networks would lead to abuse of the natural monopoly through higher pricing,³¹ a reduction in non-user benefits associated with the service, and finally a loss of public control of vital infrastructure.³² While concession contracts cannot alter the physical monopoly of LDCs, they do create an alternative means of fostering competition. By tendering on a fixed price basis fears of cost abuse are muted, and the public will be assured of the most cost effective solution.³³ At the expiry of each contract term, a re-tendering process will ensure updated pricing and again assure the public of the most cost effective solution. In addition, concerns that tendering will lead to a loss of non-user benefits should be allayed by past examples of tendering which have avoided such losses. For example, the recent tendering of garbage removal in parts of the City of Toronto has led to both lower costs and improved service.³⁴ Finally, under operating concessions the municipalities would retain ownership of the LDCs and associated infrastructure, and merely enter into access arrangements with the private concessionaire (see Figure 7).

Second, Ontario’s transfer tax system has been a major barrier to LDC consolidation in the province.³⁵ Concession contracts would be most efficiently structured on terms of less than 50 years so no transfer tax issues would be triggered,³⁶ thereby avoiding this potential roadblock.

Third, concerns of ‘regulatory capture’³⁷ are minimized through concession arrangements because of the objective assessment and independent fairness processes involved. To additionally strengthen transparency in the system it would be preferable for the OEB to have public openings of concession bids, as is currently the practice in Chile for many of its public concessions.³⁸ Such transparency would further decrease the potential for “regulatory capture,” a much more probable risk under the current cost-of-service regulation.³⁹

Fourth, it has been feared that concession contracts in the electricity sector would not be able to capture technological improvements or would make regulatory oversight more difficult.⁴⁰ This may have previously been a valid concern but technology changes can now be accounted for through legal innovations like change orders and detailed performance indicators with associated penalties.⁴¹ Further, improvements in computerized monitoring (i.e. SCADA systems) permit regulators to monitor performance on a real-time basis thereby better ensuring contractual promises are met.

Finally, the tendering of Ontario’s LDC operations would likely generate significant interest from the private sector. In addition to Fortis and Corix, other Canada-based operators with the necessary qualifications would likely include ATCO, Emera, Enbridge and SNC-Lavalin. Moreover, given the IESO will provide a barrier between generators and distributors, there would be few reasons to prohibit electricity generators or foreign consortia from bidding as well.⁴²

Conclusion

Empirical results illustrate that significant annual cost savings would be realized through consolidation of Ontario’s smallest LDCs. While the emphasis has rightly been on encouraging consolidation, the focus of consolidation efforts should be on the Province’s smallest LDCs, rather than larger ones like Hydro One Brampton. Additionally, policy makers and advisors should be more innovative with the means of bringing about such consolidation, resisting the urge to resort to an outright sale to private investors. Private investment alone has not been shown to be the key driver of cost savings; rather it is private operatorship which has derived savings. Tendering of LDC operations to private concessionaires therefore provides a suitable solution to the roadblocks currently preventing consolidation. In particular, a concessions program would not require costly amendments to the tax legislation and would avoid the political controversy involved in sales of public assets. Ontario’s provincial government should therefore requisition the OEB and the Premier’s Advisory Council on Government Assets to study the feasibility of creating RDCs and tendering of management of such entities to private sector operators.

* Duncan Melville, CFA is a JD candidate at the University of Toronto. He is also a CFA Charterholder.

1. Murray Elston, Floyd Laughren and David McFadden, The Report of the Ontario Distribution Sector Review Panel (December 2012) at 5.
2. Ibid at 7.
3. Donald Drummond, Commission on the Reform of Ontario’s Public Services (2012) at 331 [Drummond Report], online: Ontario Ministry of Finance <http://www.fin.gov.on.ca/en/reformcommission/>.
4. Stephen Fyfe, Mark Garner and George Vegh, “Mergers by Choice Not Edict: Reforming Ontario’s Electricity Distribution Policy”, CD Howe Institute, Commentary No 376 (March 2013) at 21[Fyfe].
5. Murray Elston, Floyd Laughren and David McFadden, The Report of the Ontario Distribution Sector Review Panel (December 2012) at 39 [ODSRP Report].
6. Greater Toronto and Hamilton Area.
7. Ed Clark et al, “Striking the Right Balance: Improving Performance and Unlocking Value in the Electricity Sector in Ontario”, Premier’s Advisory Council on Government Assets (April 2015) at 13 [Ed Clark Report].
8. Ibid at 12.
9. This issue will be explored in less detail than the second question given the extensive literature on the subject, for example, see notes 4 – 5.
10. Driver Examination Services Project Agreement, online: Infrastructure Ontario <http://www.infrastructureontario.ca/templates/projects.aspx?id=2147488447&langtype=1033>.
11. Administrative costs comprise ‘billing and collection’, ‘community relations’, ‘administrative and general expenses’ and ‘advertising expenses’ as disclosed in the 2013 Benchmarking Update Report of LDCs.
12. 2013 Benchmarking Update Calculations, Ontario Energy Board (August 2014), online: <http://www.ontarioenergyboard.ca/OEB/Industry/Regulatory+Proceedings/Policy+Initiatives+and+Consultations/Renewed+Regulatory+Framework/Measuring+Performance+of+Electricity+Distributors>.
13. Fyfe, supra note 4 at 8.
14. ODSRP Report,supra note 5 at 29.
15. Fyfe, supra note 4 at 4.
16. Jose Gomez-Ibanez, Regulating Infrastructure: Monopoly, Contracts and Discretion (Cambridge: Harvard University Press, 2003) at 185 [Gomez-Ibanez].
17. Sally Hunt, Making Competition Work in Electricity, (New York: John Wiley & Sons, 2002) at 5 [Hunt].
18. Office of the Auditor General of Ontario, 2014 Annual Report of the Office of the Auditor General of Ontario at 197 & 208 [2014 Auditor General Report].
19. Ontario Chamber of Commerce, “Public Sector Problems, Private Sector Solutions” (2013), at 11, online: OCC <http://www.occ.ca/Publications/Public-Sector-Problems-Private-Sector-Solutions_Electronic.pdf>.
20. “AFP” means ‘alternative financing and procurement’.
21. 2014 Auditor General Report, supra note 18 at 199.
22. “Grimsby Power a Step Closer to Fortis Deal”, Niagara This Week (March 27, 2009), online: <http://www.niagarathisweek.com/news-story/3279191-grimsby-power-a-step-closer-to-fortis-deal/>.
23. OEB data goes back to 2002, for LDCs privatized between before 2002, 2002 has been used as the starting point.
24. The OEB benchmarks each LDC on a peer group basis which factors in geographic location of the LDC, the size of its customer base and the degree of undergrounding within its network.
25. While administrative costs should in theory be proportionate to the number of customers it was anticipated that there may be some cost variances based on the geographic area covered, therefore in order to make solid conclusions about the comparisons it was necessary to perform both a “Per Customer Analysis” and a “Per km Analysis”.
26. Comparing cost changes over the same period equalizes technological or operating innovations and inflation.
27. For instance, since privatization Algoma Power’s administrative costs have decreased by 5.0% while the volume of billed kWh has increased by 3.3%, therefore Algoma Power’s net change was -8.3%. Over the same period the average administrative costs across the province increased by 11.8% while the volume of billed kWh increased by 1.9%, therefore the provincial net change was 10.0%. To determine if the LDC outperformed the rest of the province the LDC’s net change was then deducted from the provincial net change. In this example, Algoma Power outperformed the provincial average by a spread of 18.3% (= 10% – (-8.3%)).
28. Previous comparisons of LDC cost changes since privatization were done on an absolute basis and failed to factor in volume based changes, for example see Murray Elston, Floyd Laughren and David McFadden, The Report of the Ontario Distribution Sector Review Panel (December 2012) at 23.
29. O&M cost increases are likely explainable by the fact that Algoma Power is the least densely populated of the province’s LDCs. Between 2009 and 2013 oil increased from $45 to more than $100. Given the increased distances covered by Algoma Power crew, energy prices comprise a larger portion of Algoma Power’s cost than other LDCs.
30. Paul Joskow, “Regulation of Natural Monopoly” in Mitchell Polinsky & Steven Shavell (eds) Handbook of Law and Economics, ed 1,Vol 2, (Amsterdam: Elsevier, 2007) 1227 at 1290.
31. Michael J. Trebilcock & Roy Hrab, “Electricity Restructuring: A Comparative Review”, Research Paper 41, online: University of Toronto (Faculty of Law) <http://www.law-lib.toronto.edu/investing/reports/rp41.pdf>.
32. Gomez-Ibanez, supra note 16 at 4-7.
33. It is likely adjustment for oil prices would be required – private operators cannot cost-effectively hedge this risk.
34. “Toronto has saved $11.9M through private garbage pickup”, CBC News (December 16, 2013), online: <http://www.cbc.ca/news/canada/toronto/toronto-has-saved-11-9m-through-private-garbage-pickup-1.2466736>.
35. Fyfe, supra note 4 at 21.
36. “Leases and the Land Transfer Tax Act”, Ontario Ministry of Finance Bulletin, LTT 6-2000 (September 2009), online: OMF <http://www.fin.gov.on.ca/en/bulletins/ltt/6_2000.html>.
37. ‘Regulatory capture’ refers to industry participants using regulation for their own benefit rather than for the public protection purpose it was designed to serve. It is an example of government failure. For greater discussion on ‘regulatory capture’ see George Stigler, “The Theory of Economic Regulation”, Bell J Econ Man Sci vol 2:1 (1971).
38. Andrew Hill, “Foreign Infrastructure Investment in Chile: The Success of Public-Private Partnerships through Concession Contracts”, Northwestern Journal of International Law & Business 32:1 165 at 180.
39. Gomez-Ibanez, supra note 16 at 35.
40. Ibid at 24-25.
41. For example see the Driver Examination Services Project Agreement, s 31, online: Infrastructure Ontario <http://www.infrastructureontario.ca/templates/projects.aspx?id=2147488447&langtype=1033>.
42. Hunt, supra note 17 at 6.