Political Economy of Ontarios Electricity Restructuring

1. Political Economy of Ontario�s Electricity Restructuring: Part One School of Policy Studies Queen�s University Bryne Purchase

3. PRESENTATION OBJECTIVES: PART TWO Focus on the Hybrid Market, it�s 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 Ontario�s 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 BACKGROUND NOTES In 1995, Government appointed the Macdonald Commission - reported findings a year later. This was followed in 1997 by the White Paper, Direction for Change: Charting a Course for Competitive Electricity and Jobs in Ontario, launched a major reform of the electricity sector. The White Paper was followed by the Energy Competition Act, 1998, that among other things ended the Ontario Hydro monopoly and reorganized the former Ontario Hydro into five separate corporations: Ontario Power Generation (OPG) is the successor to generation business. Its initial capitalisation on April 1, 1999 included $5.1 bn in equity and $3.4 bn in debt, for a total enterprise value of $8.5 bn (OPG�s total assets were $14.9 bn, and other liabilities totalled $6.4 bn (including $4 bn in nuclear liabilities)) Hydro One (HOI) is the successor to transmission, distribution and energy services businesses. Its initial capitalisation on April 1, 1999 included $3.8 bn in equity and $4.8 bn in debt, for a total enterprise value of $8.6 bn (HOI�s total assets were $9.6 bn, with other liabilities totalling $1 bn) Ontario Electricity Financial Corporation (OEFC) is responsible for servicing debt and certain other liabilities of the former Ontario Hydro. Independent Electricity Market Operator is the successor to the central market operations and is responsible for ensuring the safe and reliable operation of the electricity grid The Electrical Safety Authority performs the electrical safety functionsBACKGROUND NOTES In 1995, Government appointed the Macdonald Commission - reported findings a year later. This was followed in 1997 by the White Paper, Direction for Change: Charting a Course for Competitive Electricity and Jobs in Ontario, launched a major reform of the electricity sector. The White Paper was followed by the Energy Competition Act, 1998, that among other things ended the Ontario Hydro monopoly and reorganized the former Ontario Hydro into five separate corporations: Ontario Power Generation (OPG) is the successor to generation business. Its initial capitalisation on April 1, 1999 included $5.1 bn in equity and $3.4 bn in debt, for a total enterprise value of $8.5 bn (OPG�s total assets were $14.9 bn, and other liabilities totalled $6.4 bn (including $4 bn in nuclear liabilities)) Hydro One (HOI) is the successor to transmission, distribution and energy services businesses. Its initial capitalisation on April 1, 1999 included $3.8 bn in equity and $4.8 bn in debt, for a total enterprise value of $8.6 bn (HOI�s total assets were $9.6 bn, with other liabilities totalling $1 bn) Ontario Electricity Financial Corporation (OEFC) is responsible for servicing debt and certain other liabilities of the former Ontario Hydro. Independent Electricity Market Operator is the successor to the central market operations and is responsible for ensuring the safe and reliable operation of the electricity grid The Electrical Safety Authority performs the electrical safety functions

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 Establishing OPG�s capital structure involved developing a DCF as part of a fundamental review of business plan, key financial drivers and competitive and regulatory environment Variables affecting OPG�s Free Cash Flow (ie company�s earnings before servicing debt and any dividends): Demand (1% growth per annum) Supply (function of availability of all capacity in market and availability and reliability of nuclear generating assets � assumed capacity factor of 85%) Price OPG receives � function of supply and demand variables � RW Beck engaged � in 1998 wholesale price expected to decrease in near to mid-term (3.5 cents/kWh) with introduction of competition and return of new capacity � one cent increase in price equates to $8 billion increase in valuation Market Share � assumed OPG able to replace its Ontario market capacity with other capacity and achieve similar returns on replacement assets Operating, Maintenance and Administration costs � assumed top quartile operating performance April 1, 1999 Target Credit Rating: A (Current S&P rating: BBB+/developing) On April 1, 2005, OPG�s nuclear and large hydroelectric assets began receiving an average regulated price of 4.5 cents/kWh, based on recovery of operating and capital costs including a 5% return on equityEstablishing OPG�s capital structure involved developing a DCF as part of a fundamental review of business plan, key financial drivers and competitive and regulatory environment Variables affecting OPG�s Free Cash Flow (ie company�s earnings before servicing debt and any dividends): Demand (1% growth per annum) Supply (function of availability of all capacity in market and availability and reliability of nuclear generating assets � assumed capacity factor of 85%) Price OPG receives � function of supply and demand variables � RW Beck engaged � in 1998 wholesale price expected to decrease in near to mid-term (3.5 cents/kWh) with introduction of competition and return of new capacity � one cent increase in price equates to $8 billion increase in valuation Market Share � assumed OPG able to replace its Ontario market capacity with other capacity and achieve similar returns on replacement assets Operating, Maintenance and Administration costs � assumed top quartile operating performance April 1, 1999 Target Credit Rating: A (Current S&P rating: BBB+/developing) On April 1, 2005, OPG�s nuclear and large hydroelectric assets began receiving an average regulated price of 4.5 cents/kWh, based on recovery of operating and capital costs including a 5% return on equity

11. Stranded Debt Chart illustrates graphically derivation of stranded debt and residual stranded debt As at April 1, 1999, OEFC had old Ontario Hydro legacy debt and other liabilities of $38.1 billion $30.5 billion in long and short term debt $ 4.3 billion in power purchase agreement liabilities $ 2.4 billion in unfunded provision for nuclear liabilities $ 0.9 billion in short term liabilities and interest payable The value of the former Ontario Hydro was established at $17.2 billion ($8.6 for Hydro One, $8.5 for OPG and $.1 for the IESO) The difference between the OEFC�s debt and liabilities and the value of the successor companies, known as the stranded debt, was $20.9 billion. Stranded Debt represents the debt and other liabilities that cannot be serviced and retired in a competitive market. The difference between the amount of stranded debt and the dedicated revenue streams is the residual stranded debt. This represents the liabilities which do not have any offsetting current asset or dedicated revenue stream -- serviced by a Debt Retirement Charge. One of the policy decisions was whether the DRC should be fixed or vary with the amount of residual stranded debt (decision was to fix DRC at .7 cents/kWh) DRC is estimated to be in place until 2012 � 2020 -- stranded debt defeased when the Minister of Finance determines that the value of OEFC�s assets and dedicated revenues are sufficient to offset the value of the remaining liabilities.Chart illustrates graphically derivation of stranded debt and residual stranded debt As at April 1, 1999, OEFC had old Ontario Hydro legacy debt and other liabilities of $38.1 billion $30.5 billion in long and short term debt $ 4.3 billion in power purchase agreement liabilities $ 2.4 billion in unfunded provision for nuclear liabilities $ 0.9 billion in short term liabilities and interest payable The value of the former Ontario Hydro was established at $17.2 billion ($8.6 for Hydro One, $8.5 for OPG and $.1 for the IESO) The difference between the OEFC�s debt and liabilities and the value of the successor companies, known as the stranded debt, was $20.9 billion. Stranded Debt represents the debt and other liabilities that cannot be serviced and retired in a competitive market. The difference between the amount of stranded debt and the dedicated revenue streams is the residual stranded debt. This represents the liabilities which do not have any offsetting current asset or dedicated revenue stream -- serviced by a Debt Retirement Charge. One of the policy decisions was whether the DRC should be fixed or vary with the amount of residual stranded debt (decision was to fix DRC at .7 cents/kWh) DRC is estimated to be in place until 2012 � 2020 -- stranded debt defeased when the Minister of Finance determines that the value of OEFC�s assets and dedicated revenues are sufficient to offset the value of the remaining liabilities.

12. Closed System Directs Electricity Revenues To OEFC Ontario Hydro was legally continued as OEFC, a Crown Agency, in the Electricity Act, 1998: OEFC was structured to be a self-sustaining entity to receive various cash flows and extinguish its liabilities by means of its revenues and cashflows Revenues and cashflows are entirely from the electricity sector (closed system) Principal and interest payments from OPG, Hydro One and IMO (now IESO) payments-in-lieu of taxes from OPG, H-1, and Municipal Electric Utilities MEUs) electricity sector dedicated income (net income of the companies above the financing costs for the Province�s debt for equity swap) Debt Retirement Charge (DRC) on electricity consumptionOEFC was structured to be a self-sustaining entity to receive various cash flows and extinguish its liabilities by means of its revenues and cashflows Revenues and cashflows are entirely from the electricity sector (closed system) Principal and interest payments from OPG, Hydro One and IMO (now IESO) payments-in-lieu of taxes from OPG, H-1, and Municipal Electric Utilities MEUs) electricity sector dedicated income (net income of the companies above the financing costs for the Province�s debt for equity swap) Debt Retirement Charge (DRC) on electricity consumption

13. The electricity sector has a direct impact on the Province�s fiscal position -- Province consolidates the revenues and expenditures of Ontario Electricity Financial Corporation (OEFC) � and also records as revenue the net incomes of OPG and Hydro One Any changes in the following items have a dollar-for-dollar impact on the Province�s bottom line: Net income of OPG and Hydro One (net income is basically revenues less costs) Electricity sector taxes, including the Debt Retirement Charge (DRC) and payments in lieu of taxes (PILs) from OPG, Hydro One and MEUs Electricity price subsidies or transitional payments provided to electricity consumers Any negative variation of electricity sector net income and taxes from the Budget Plan means either a higher deficit and/or lower program spending The electricity sector has a direct impact on the Province�s fiscal position -- Province consolidates the revenues and expenditures of Ontario Electricity Financial Corporation (OEFC) � and also records as revenue the net incomes of OPG and Hydro One Any changes in the following items have a dollar-for-dollar impact on the Province�s bottom line: Net income of OPG and Hydro One (net income is basically revenues less costs) Electricity sector taxes, including the Debt Retirement Charge (DRC) and payments in lieu of taxes (PILs) from OPG, Hydro One and MEUs Electricity price subsidies or transitional payments provided to electricity consumers Any negative variation of electricity sector net income and taxes from the Budget Plan means either a higher deficit and/or lower program spending

14.  OEFC Financial Results OEFC�s initial unfunded liability of $19.4 billion differs from the $20.9 billion stranded debt because additional assets from Ontario Hydro were transferred to OEFC in 1999. (primarily an account change) Main reasons for increase in stranded debt include the following: Underperformance of OPG, particularly due to cost overruns and delays on the Pickering A return to service project, and underperformance and higher than planned costs in OPG�s nuclear division. (as outlined in KPMG Financial Review of Operations released March 15, 2004) OEFC took on additional responsibilities � OEFC funded the previous government�s price freeze on electricity which cost about $900 million, and provision of temporary generation in summer 2003 which cost $70 million. Electricity sector reforms include eliminating the previous government�s electricity price freeze, full recovery of power purchase contract costs from consumers, and regulated prices for OPG nuclear and large hydroelectric plants. The Government�s electricity reforms improved OEFC�s results in 2004-05 and OEFC�s debt recovery plan is expected to be back on track going forward:OEFC�s initial unfunded liability of $19.4 billion differs from the $20.9 billion stranded debt because additional assets from Ontario Hydro were transferred to OEFC in 1999. (primarily an account change) Main reasons for increase in stranded debt include the following: Underperformance of OPG, particularly due to cost overruns and delays on the Pickering A return to service project, and underperformance and higher than planned costs in OPG�s nuclear division. (as outlined in KPMG Financial Review of Operations released March 15, 2004) OEFC took on additional responsibilities � OEFC funded the previous government�s price freeze on electricity which cost about $900 million, and provision of temporary generation in summer 2003 which cost $70 million. Electricity sector reforms include eliminating the previous government�s electricity price freeze, full recovery of power purchase contract costs from consumers, and regulated prices for OPG nuclear and large hydroelectric plants. The Government�s electricity reforms improved OEFC�s results in 2004-05 and OEFC�s debt recovery plan is expected to be back on track going forward:

15. Fundamental Changes Underlying the restructuring was a view that the electricity market would be driven primarily, if not solely, by market forces. This was reflected in the key financial objectives: Investment driven by short-term market price signals � new investment largely gas-fired Level playing field for private and government-owned companies Clear business mandates for the successor companies to OPG Business-like investment decisions Financial soundness with stranded debt repaid from the sector Consumers offered contracts with competitive retailers or smoothed billing, transitional consumer protection through an average revenue cap for about 75% of OPG production of 3.8 cents/kWh, delivered via annual rebates Underlying the restructuring was a view that the electricity market would be driven primarily, if not solely, by market forces. This was reflected in the key financial objectives: Investment driven by short-term market price signals � new investment largely gas-fired Level playing field for private and government-owned companies Clear business mandates for the successor companies to OPG Business-like investment decisions Financial soundness with stranded debt repaid from the sector Consumers offered contracts with competitive retailers or smoothed billing, transitional consumer protection through an average revenue cap for about 75% of OPG production of 3.8 cents/kWh, delivered via annual rebates

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 customer�s 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 1990�s 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; OPG�s baseload nuclear and hydraulic assets are regulated using unrealistically low rates of return on equity; 85% of OPG�s �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 OPG�s baseload hydraulic assets to earn market prices; Remove the revenue cap from OPG�s 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 Natural Gas Prices � At the time of the initial restructuring, all new investment was expected to be from gas-fired generation. Underpinning this expectation was the view that gas prices would remain stable and relatively low. This view informed the model that was put in place. Throughout the 90�s, gas prices were relatively stable. Since then, prices have become increasingly volatile. October 2005 gas prices were over US$13 (versus US $3.60 at market opening). North American Supply of Natural Gas Natural gas supplies expected to remain tight, with prices likely to be volatile, for the foreseeable future Major sources of new natural gas supply require long lead time and significant capital expenditures Mackenzie Delta expected to cost $4 � 5 billion ($US) and 4 � 5 years to develop Alaskan Prudhoe Bay expected to cost $20 billion ($US) to develop and more than a decade to develop Liquified Natural Gas (LNG) exports from overseas expected to cost $3 � 7 billion ($US) and likely to take until at least 2009 � 2012 before it can make major contribution to supply In BTU (British Thermal Unit) terms, the US natural gas supply shortfall in 2010 is estimated to be 1.5 times the current level of oil imports from Saudi Arabia (equivalent to 1.8 million barrels per day)Natural Gas Prices � At the time of the initial restructuring, all new investment was expected to be from gas-fired generation. Underpinning this expectation was the view that gas prices would remain stable and relatively low. This view informed the model that was put in place. Throughout the 90�s, gas prices were relatively stable. Since then, prices have become increasingly volatile. October 2005 gas prices were over US$13 (versus US $3.60 at market opening). North American Supply of Natural Gas Natural gas supplies expected to remain tight, with prices likely to be volatile, for the foreseeable future Major sources of new natural gas supply require long lead time and significant capital expenditures Mackenzie Delta expected to cost $4 � 5 billion ($US) and 4 � 5 years to develop Alaskan Prudhoe Bay expected to cost $20 billion ($US) to develop and more than a decade to develop Liquified Natural Gas (LNG) exports from overseas expected to cost $3 � 7 billion ($US) and likely to take until at least 2009 � 2012 before it can make major contribution to supply In BTU (British Thermal Unit) terms, the US natural gas supply shortfall in 2010 is estimated to be 1.5 times the current level of oil imports from Saudi Arabia (equivalent to 1.8 million barrels per day)

28. Spot Market Electricity Prices Natural gas prices can have a direct impact on electricity prices since gas-fired plants typically set the market clearing price in Ontario during peak periods of demand. Six months after market opening, Government stepped in with a fixed price for consumers. This highlights the difficulty for governments in riding out a cycle, particularly with an election in the offing. The graph shows the Ontario monthly average electricity price. Prices in July and August reached over 8�/kWh. Throughout 2004 and 2005, with the return of Pickering A Unit 4 and two units at Bruce Power, prices have moderated significantly (with a 2004/2005 average price of 5.36�/kWh). The summer of 2005 saw prices hit record levels due to abnormally hot temperatures and high natural gas prices.Natural gas prices can have a direct impact on electricity prices since gas-fired plants typically set the market clearing price in Ontario during peak periods of demand. Six months after market opening, Government stepped in with a fixed price for consumers. This highlights the difficulty for governments in riding out a cycle, particularly with an election in the offing. The graph shows the Ontario monthly average electricity price. Prices in July and August reached over 8�/kWh. Throughout 2004 and 2005, with the return of Pickering A Unit 4 and two units at Bruce Power, prices have moderated significantly (with a 2004/2005 average price of 5.36�/kWh). The summer of 2005 saw prices hit record levels due to abnormally hot temperatures and high natural gas prices.