A Shock to the System

The switch is finally being thrown to privatize Ontario Hydro.
A historic change -- but don't count on it meaning cheaper power

Globe and Mail - Thursday, January 25, 2002 - page 41
By Jamie Swift

The Bruce Nuclear site is its own city-state, with 56 kilometres of roads, a fire station, an inventory of more than 300 species of wildlife-and a security perimeter featuring a pressure-sensitive anti-terrorist fence. This is, after all, the world's largest nuclear-power establishment, and the storage facility-more plainly, the dump-for all the low-level radioactive waste generated by Ontario's 40-year adventure with nuclear power.

At the 3,100-megawatt Bruce B plant, which provides enough power to supply Toronto, hard-hatted workers use adult-size tricycles to shrink travel times in a turbine hall on the scale of the West Edmonton Mall. At every turn, the place testifies to the no-expense-spared giganticism of Ontario Hydro, historically the country's largest Crown corporation and the very embodiment of public enterprise in Canada's most populous province.

But Sir Adam Beck, who founded Hydro in 1906 to save consumers from being gouged by private power companies, would turn in his grave if he could see who's ensconced at Bruce Nuclear now: Bruce Power, a subsidiary of British Energy, itself a product of Thatcher-era privatizations in the U.K. The Conservative government has turned the eight reactors over to the dreaded private sector. And if Beck knew that even the province's transmission system, Hydro One, will be sold off in 2002, well, he might be spinning fast enough to generate a little electricity himself.

The hand-over of the Bruce plant was one of the first steps in what's arguably the biggest political and economic reform in the history of Ontario: a stop-start, helter-skelter scheme to let the market decide how electricity is generated, transmitted and priced. The change affects every municipality and every consumer-residential or business-in the province, not to mention power-industry players ranging from "micro hydro" start-ups to the Goliaths of American energy.

So it's big, and it's coming soon-the "market opening" is set for May 1, after several delays. But only the government's December decision to bite the bullet and privatize Hydro One brought the commercialization of Hydro onto the front page. There's an elusive aspect to the makeover, even for someone as inside-the-loop as former NDP finance minister Floyd Laughren, who was Ontario's longest-serving MPP before Premier Mike Harris named him chairman of the Ontario Energy Board. "In all my years of public life," says Laughren, "I have never witnessed so little comment or resistance to such a massive public policy change."

Beck famously committed Ontario Hydro to Power at Cost-and indeed, the province's rates have long been among the world's cheapest. Of course, for better or worse, Hydro was a monopoly. It generated virtually all the power in Ontario and also owned the high-voltage part of the "wires" business. Only when the wires reached the cities did Mother Hydro let go: The job of moderating the voltage and distributing power was left to publicly owned, non-profit utilities accountable to municipal councils. A famous boast of Beck's-"Nothing is too big for us. Nothing is too expensive to imagine"-was borne out with a vengeance in the nuclear era. Hydro's nuclear program produced a battery of 20 reactors and a 38-billion debt, as well as a litany of safety problems and a blithe indifference toward accountability. By the late '90s, Hydro had a debt/equity ratio well over 90%. Power prices spiralled up nearly 40% in a three-year period after the bills for the Darlington nuclear plant east of oronto hit Hydro in 1989. Manufacturers put off expansions; some said they'd leave the province altogether.

Something had to be done to bring Hydro to heel: Everyone from radical greens to radical free-enterprisers agreed on this.

In 1992, the Rae NDP government brought in globetrotting executive Maurice Strong to clean house. Strong erased the nuclear-construction impulse by abolishing the engineering and construction division, along with several thousand jobs. Rate increases flat-lined.

Rae didn't get to enjoy the political benefits of reining in Hydro, however: The June, 1995, election catapulted Mike Harris into the corner office at Queen's Park. If the NDP had put the brakes on Hydro, how far would an avowed public-sector downsizer like Harris go? The new Conservative Premier appointed Bill Farlinger, the former chairman of Ernst & Young, to the chairmanship of Hydro a few months after the election. That Farlinger was both a Harris friend and fundraiser and an outspoken advocate of privatizing Hydro said volumes. Hydro was on the block.

Yet it's taken more than six years to announce the Hydro One IPO and to get just one element of the generating system into private hands. What accounts for the holdup?

The short answer is proudly provided by Energy Minister Jim Wilson: "It's the most complicated thing that the government will ever undertake." Liberal energy critic Sean Conway adds, more skeptically: "When the ideologues get at this from 30,000 feet you get one impression, but the devil is in the details."

It took until 1998 for the Tories to pass the Energy Competition Act, which broke up Ontario Hydro into several successor companies. The largest, with revenue of $6 billion and assets of $17 billion in 2000, is Ontario Power Generation Inc. (OPG), which owns the hydro dams, nuclear plants and fossil-fuel generating stations. OPG must reduce its proportion of the province's generating capacity from its 1998 position of more than 85% to less than 35% within 10 years of the market opening.

Hydro One, meanwhile, with assets of $10 billion and revenue of $3 billion in 2000, owns and runs the transmission system. Despite the break-it-up impetus behind the new scheme of things-not to mention the déjà vu of mounting debt-Hydro One has quickly spent $523 million buying up 88 municipal utilities.

A third child of Hydro is the Ontario Electricity Financial Corporation, which holds $21 billion of the $38 billion in government-guaranteed debt left behind-"stranded"-by the old Hydro. The reasoning here is that no one in their right mind would be interested in buying assets that were dragging this sort of liability around. Instead, the debt will be paid off with the proceeds of the Hydro One IPO, OPG asset sales, and payments from utilities and residential customers-$7 a month for a typical household, which uses 1,000 kilowatt/hours per month.

All these changes did nothing, of course, to define an open market. This is where the word "deregulation"-summoning spectres from California and Alberta of soaring prices, blackouts and bankruptcies-is cause for confusion. The new approach actually combines more regulation with less central planning. The Ontario Energy Board (OEB) notwithstanding, the old Ontario Hydro regulated itself. The normally anti-bureaucracy Tories have since 1998 roughly tripled the staffing and budget of the OEB. But the OEB will not regulate the price of power. That will be left to the market.

The actual mechanics-safety, reliability-of the $10-billion-a-year market will, however, have an overseer, the Independent Electricity Market Operator (IMO). This fourth offshoot of Ontario Hydro is, in turn, governed by a board divided between stakeholder and independent representatives (almost all of the latter hail from Bay Street).

In the new open market, any number of electricity generators will sell into the grid for both fixed, contract prices (this power comes mostly from nuclear and hydro plants) and changing-by-the-hour spot market prices (mostly from coal- and gas-fired plants). On the buying side will be utilities, major power-consuming companies and a new breed of electricity retailers. "Over time, [commercial] customers will learn how to buy electricity either by signing long-term contracts or taking the risk of buying in the spot market," says Ron Osborne, the CEO of Ontario Power Generation. "Gradually, those skill sets will migrate down to the residential market." The IMO has published a two-inch-thick set of rules that each participant-generators, wholesalers and retailers-must comprehend. Residential consumers have been learning about the new era from door-to-door marketing pitches by OEB-licensed electricity retailers. These outfits include offshoots of both Hydro One and (frequently) one's local utility. Brand-new players include energy firms from the U.S. (Mirant, to name one), the U.K. (Centrica's Direct Energy) and Canada (TransAlta, Enbridge).

The government ordered the utilities to be the first over the top in this new, commercialized world. Attrition has been drastic, reducing the utilities' ranks from about 300 non-profits to 94 for-profits. Some surrendered to Hydro One; others quickly united, faced with the Tories' promise to heavily tax any mergers that took place after November, 2000. Even after that rationalization, many have struggled to be ready for the open market-which is a key reason it didn't come about in November, 2000. The decision to go ahead on May 1 was made despite the OEB's conclusion that 43 smaller utilities still won't be ready.

The utilities' transformation turned out to be a shock for Queen's Park too. The province got spooked in 2000 when it realized that, to make the 9.8% return approved by the OEB, the utilities would have to jack up distribution rates by as much as 30%. The government quickly moved to have the OEB limit rate increases.

If that intervention was a signal that the government's free-market fervour was not perfect, more was to come. At first, Hydro's fate seemed clear. A report by Farlinger, a committee headed by former federal energy minister Donald Macdonald, and a stakeholder Market Design Committee had all, in sequence, essentially said: Sell it. Top power consumers, the likes of Dofasco and GM, had agitated for a breakup from day one through the Association of Major Power Consumers in Ontario (AMPCO).

But how to do it? Simply parcelling off chunks of OPG and Hydro One to the highest bidder might earn top marks from privatization purists. But did atomizing Hydro make sense just as the power market was becoming bigger-the whole northeastern part of the continent-and likely future competitors were getting bigger too? Ontario, after all, wanted to sell more power to the U.S.-it's "the whole premise of market opening," says one Hydro insider-and in 1997 it decided to beef up connections to neighbouring jurisdictions by 40%. At Hydro One, CEO Eleanor Clitheroe was pushing an ambitious vision of a cross-border player that would acquire transmission assets in the fragmented U.S. northeast. And in early days at OPG, Osborne was adamant that selling off his company wholesale would mean a takeover by non-Ontarian interests. He spoke of OPG swapping-or just leasing-some assets in Ontario and picking others stateside, so it would still be a contender in the new, larger market.

Bruce Nuclear, the one facility that OPG had "decontrolled" by the end of 2001, is in fact leased. One could ask, after all, why anyone would even consider buying an aging nuclear plant outright. The fallout from Three Mile Island and Chernobyl; a blank reactor order sheet in Canada for the last 25 years; and a staggering dependency on public subsidy together drove a stake through the heart of nuclear power. That's the conventional wisdom, anyway; but a couple of firms don't agree with it. One is British Energy: Its specialty is taking over nuclear plants from weary public operators. It moved further into North America after a post-deregulation excess in British generating capacity reduced its profits. Another is Chicago-based Exelon. The two companies are partners in AmerGen Energy, which bought Three Mile Island for $23 million (U.S.), about 15% of book value.

Provincial Energy Minister Jim Wilson says firmly that there will be no "fire sales" of OPG assets. As for Bruce Nuclear, "The opinion of financial houses internationally and domestically is that it was a good deal." But the government refuses to release background studies by Goldman Sachs and the Canadian Imperial Bank of Commerce, saying disclosure would be "injurious" to its financial interests.

Under the deal, Bruce Power operates the plant and sells the power until 2018-although it can bail out any time after 2006 if it decides it's not making enough money. OPG retains responsibility for the cost of nuclear waste management and disposal as well as plant decommissioning (put at $7.5 billion for the Bruce plants). Bruce Power's initial lease payments are $625 million. Additionally, it will contribute to waste-disposal costs and pay an annual rent-estimated at $150 million this year-based on its revenue.

In addition to running Bruce B, Bruce Power will pony up $340 million to resurrect-by 2003, it hopes-two of the four reactors at Bruce A. This is part of the deal's attraction to Ontario: "We didn't have the money that's being spent to bring back the reactors that could be brought back," says Wilson. OPG is, however, spending $1.3 billion to refurbish the Pickering nuclear plant east of Toronto.

Privatization typically sparks protests. But Ontario Hydro gave public enterprise such a bad name that it has been left with few supporters. One of the problems Ontario NDP leader Howard Hampton has faced in trying to raise an alarm over Hydro is that the unions that once vociferously opposed privatization are now on board, as equity participants in Bruce Power. The Power Workers' Union, whose former president John Murphy is now vice-president of human resources at OPG, will take a stake of up to 4% by 2003.

So the leading voice against Hydro privatization is not a union or nationalist type but a former president of the American Finance Association for whom the Bruce lease was the opening salvo in a war on common sense. University of Toronto finance professor Myron Gordon's analysis of public-vs-private Hydro boils down to this: Consumers will inevitably pay more for private power because their bills will reflect the return on capital demanded by private investors. Gordon calls the Bruce lease an "outrageous gift" to British Energy. "The Bruce has not been privatized. Only the profits have been privatized." (The firm cleared $90 million in its first six months at Bruce.)

As the private sector took over at Bruce Nuclear, the power consumers in AMPCO weren't concerned, like Gordon, that privatization was proceeding too hastily. They were alarmed that it wasn't going quickly enough. OPG did not seem in any hurry to sell off assets. And if OPG retained its dominance, the big promise of commercialized power-lower prices-was not going to materialize. Andrew Roman, a lawyer specializing in energy at Miller, Thomson in Toronto, represented would-be buyers who were turned off by the delays in the market opening and OPG's tightfistedness with information.

"Here you have signed away your life in blood if you disclose anything," says Roman, "and you get stuff you could read in The Globe and Mail and annual reports. There isn't any information to determine what the sales and profits are likely to be if you buy certain assets." Some buyers feared that even if they did close a deal, OPG would have its way in the market. "Competition experts say you need a minimum of five players, all of approximately equal size, to make a market competitive," says Roman. "If you have one giant and four pygmies, it doesn't work."

AMPCO members made their feelings known in the way they had in Ontario Hydro's last days-they might, they said, have to move operations out of Ontario if power was too expensive. In 2000, the Tories ordered OPG to extend cut-rate deals that some 15 to 20 companies enjoyed: They'd get another four years of discounts after market opening. The names of the companies and their rates were kept secret. "The business lobby and AMPCO were the Revolutionary Guard of this policy," remarks Sean Conway. "But some of the first bits of the medicine they got, they didn't like."

And so the worm had turned. Dofasco, a leading advocate of privatization, had growing doubts about where its idea was heading. Not only was Hydro not being broken up, but the whole debate was increasingly framed in terms of a unified power market for all of northeastern North America.

"We don't want our competitiveness to be driven by how hot it is in New York," said Gord Forstner, Dofasco's director of communications and public affairs, last summer. "If we've enjoyed a competitive advantage because we've got lower-cost electricity, why would we want to give away our competitive advantage?"

Although much more of the cost of a power bill is in generation rather than transmission, the battle royal broke out not over OPG but over Hydro One-because it was the part in play.

One option for Hydro One was selling it-and there were buyers interested in some or all of it, including the privatized British transmission firm National Grid and the Ontario Teachers' Pension Plan Board. But the assumption was that there would be an IPO, in support of Clitheroe's plan to build an Ontario-based regional contender. The deal would be a whopper.

But in the spring of last year, Dofasco, other AMPCO members and RBC Capital Markets started advocating a different approach-turning Hydro One into a non-profit corporation. It was late in the day to propose such a radical shift in course. But the proponents had clout. RBC is, after all, the biggest broker on Bay Street, and the plan's advocate, RBC chairman Tony Fell, is a Tory fundraiser and legendary dealmaker. RBC did not, however, have a line on any of the fees and commissions that would arise from an IPO-hence its zeal for an alternative. Faced with the schism in the business community, Harris quietly told SuperBuild Corp., the government's infrastructure-renewal agency, to weigh the options.

The non-profit Transco, as Fell dubbed it, would have a board stocked with big power consumers. It would keep rates low for corporate and household customers alike. Transco would be launched with bonds, not equity. The difference would be another $3.8 billion available to pay down the stranded debt. AMPCO vouched for the idea by trying to prick Hydro One's balloon: Why should we subsidize Hydro One's expansion in the States, Dofasco asked, while we're still stuck with the debt hangover from Hydro's last spree? (Hydro One, notably, has already ventured into a risky new business with the formation in 2000 of Hydro One Telecom Inc., which piggybacks a fibre-optics network on the transmission system.)

The Ontario government's unsettled state of mind finally broke in The Globe and Mail in November.

The IPO supporters, led by Salomon Smith Barney Canada chairman Stanley Hartt-another renowned dealmaker with Conservative credentials-fired back at the Fell camp that going non-profit would be a giant step backward on the road to commercialization. Rather than acting entrepreneurially, a non-profit Hydro One would be a captive of the major power consumers on its board, and wouldn't be able to raise capital to update or expand its network. That, in turn, would discourage generation investment-as would Transco's dedication to keeping prices low. Ontario would be left behind in the new world of power.

Queen's Park tried to argue that the future of Hydro One could be decided independently of the market opening. But most new power players were out of patience. Hydro One chairman Sir Graham Day, knighted for his role in privatization in the U.K., pointed out that he would no longer be the man for the job. The coup de grâce came from TransAlta CEO Steve Snyder. TransAlta had taken Ontario's commitment to commercialization seriously, setting up as a retailer, investing in generation and kicking the tires at OPG. Then came the delays in market opening. The mixed signals about the OPG selloff. The difficulties Snyder had negotiating with Hydro One to hook up his new $450-million generating plant in Sarnia. And now this: a hush-hush scenario to not privatize Hydro One after all. Snyder said TransAlta was finished investing in Ontario until Queen's Park made up its mind.

On the eve of his retirement from the legislature, Premier Mike Harris proudly announced "the largest privatization in Canadian history." The largest IPO, too. Hydro One is expected to bring in $5.5 billion. The Dec. 12 announcement no doubt calmed Steve Snyder, but it only excited Bay Street. Front-runners for roles in the IPO syndicate are firms that have already worked on the Hydro One file: CIBC World Markets, BMO Nesbitt Burns and Scotia Capital-in other words, most of the Canadian bank-owned brokers besides RBC-as well as Goldman Sachs & Co., Salomon Smith Barney and Merrill Lynch Canada. (The latter set could end up with big roles. Myron Gordon observes: "If Hydro One comes out with $5 billion in stock and another $5 billion in debt, Bay Street cannot handle that. The issue right now is between Bay Street and Wall Street: Who gets the commission?") The government hopes to name the successful bidders by Jan. 31.

The experience of large privatizations-forgetting Air Canada but emphasizing Britain's National Grid-points to popularity and appreciating value for Hydro One stock. In a time of low returns, a regulated monopoly is inviting indeed. But many details have to be settled. Will shares be made attractive and easy to buy for the Ontario public, creating an atmosphere of stock-market democracy? And how high a percentage of fees will be paid to brokers for selling the public its own company? At 3% on $5.5 billion, it's $165 million; at 5%, $275 million.

With the IPO course at Hydro One set, the focus shifts back to sales at OPG. Ron Osborne indicates the wait is over for would-be buyers. "By the time the market opens, we'll have gone a long way to creating our own competition," he says.

But not everything is for sale. OPG has on the block some of its coal-fired stations and one set of hydro plants, on the Mississagi River, which account for about 7% of OPG's hydro capacity.

As for new generating capacity, the Ministry of Energy counts 3,500 megawatts coming on line by 2003-3,100 MW of it (nearly equal to Bruce B) in combined cycle natural gas (CCNG) technology. Leading the way are two Toronto-area plants being built by the U.S. firm Sithe Energies at a cost of $1.5 billion. Other firms with CCNG projects are TransAlta, fellow Alberta utility giant Atco Power and globe-spanning American power-plant developer AES Corp.

Gord Forstner has another way of looking at power besides Dofasco's: He's on the board of Burlington Hydro, a municipal utility. On that front, the worries are "rate shock" and volatility: A peak month could see homeowners hit by bills several times higher than what they're used to paying, and the next month getting a refund.

The Conservative government, which will likely face an election within a year after the market opening, knows that the one thing that will concentrate the minds of voters on the question of whatever became of Ontario Hydro is a sudden spike in the power bill. Mike Harris, Ron Osborne, Eleanor Clitheroe and Jim Wilson all say that prices will be lower than they would have been "under the old monopoly system"-an unprovable point, of course. No one can state flatly that commercialized power will lead directly to lower prices.

Over all, however, the electoral tea leaves are not too discouraging: Both the slow economy and the timing of the opening-in spring, a time of little air conditioning or heating-mean lower consumption. So the system, which may by then be drawing power from a revived Pickering nuclear plant, won't be stressed when the switch to start the new era finally is thrown.

Still, running an electrical system predicated on ever-increasing demand has tripped up Ontario before. Given that the province does have enough generating capacity to meet current needs, addressing the future with conservation measures would be an alternative to relying strictly on building more polluting, nonrenewable-resource-consuming gas plants. Asked about the idea, Energy Minister Wilson says that "the private sector asked us to get out of large-scale government conservation programs." Those efforts "may have made the odd person feel good, but they had absolutely no effect."

Under the ancien régime, Ontario Hydro, the utilities and the Ministry of Energy all periodically espoused the virtue of conservation. But a system predicated on profit-making and ever-rising demand, from the local utilities on up, seems unlikely to ever resign itself to selling less power.

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