On July 3, 2014, the Ontario Energy Board (OEB) released its decision approving Hydro One Inc.’s (Hydro One) proposed acquisition of all of the issued and outstanding shares of Norfolk Power Inc. (Norfolk Power), a municipally owned utility that operates an electricity distribution system in Norfolk County, Ontario, as well as the transfer of Norfolk Power’s electricity distribution system to Hydro One Networks Inc. (HONI).
Brief background on consolidation in Ontario’s LDC sector
The OEB’s decision in Norfolk should be read in the context of the current state of Ontario’s electricity distribution system, which is divided between a number of provincially licensed electricity distributors, generally referred to as “local distribution companies” or LDCs most of which are municipally owned. In April 2012, Ontario’s Minister of Energy established the Ontario Distribution Sector Review Panel with a mandate to “conduct an analysis of the current system with a view to determine what financial advantages and savings could be realized, particularly for rate payers, from consolidation of Ontario’s local distribution companies”. The Panel’s report, released December 13, 2012 and entitled “Renewing Ontario’s Electricity Distribution Sector: Putting the Consumer First” is summarized here.
As noted in the Panel’s report, the last major wave of LDC consolidation in Ontario occurred in the late 1990s, reducing the number of separately owned LDCs from 307 to 89. The Panel’s report made several key recommendations, including consolidating Ontario’s LDCs into eight to twelve larger regional distributors. The Panel's report stated that such a consolidation would facilitate cost savings in the order of $1 billion, net, over 10 years, while equipping tomorrow’s LDC’s to respond to the reinvestment requirements and the technological changes and opportunities expected for the sector. The Panel recommended voluntary, commercially driven, consolidations followed, if required, by legislation mandating completion of the consolidation process. A few months after the issuance of the Panel’s report Ontario’s Ministry of Energy issued a letter indicating that it favours voluntary consolidation of Ontario regulated electricity distributors but that it would not force it upon the sector. Consolidation is not without controversy and it is opposed by some from within and outside the LDC sector.
Many LDCs and their municipal shareholders are now left to weigh their options on their own, often in the face of both mounting pressure for new capital investment in the electricity distribution system itself and the rapid pace of technological innovation. Technological innovation in the energy sector at large (including the increasing deployment of distributed generation) may erode the customer base and revenues of certain LDCs by decreasing customer consumption (a significant driver of LDC revenue historically). A number of those challenges are summarized here.
Background on the OEB’s Norfolk application
The OEB eventually approved the transaction, subject to certain conditions including an 18-month time period within which to complete the acquisition. The OEB also approved a proposal for a 1 per cent reduction in rates, relative to 2012 base levels, for existing Norfolk Power customers, which is explored further below.
Summary of the OEB’s decision on the Norfolk application
The OEB noted the Panel’s report at the outset of its decision, stated that it was aware of negotiations currently taking place concerning the consolidation of other distributors and expressed its expectation that its decision in Norfolk would inform parties contemplating future consolidations. In that sense, the OEB is clearly signalling that it is aware of the current efforts to consolidate the LDC sector and the desire of many in the sector for guidance from the regulator on its views regarding the public interest in consolidation activity.
With respect to application itself, the OEB applied the “no harm” test in much the same fashion as it has applied it to past transactions, meaning that the OEB must be satisfied that the proposed transaction will not have an adverse effect in relation to any of the five objectives under section 1 of the Energy Board Act. The OEB focused its attention on the first two objectives (which refer to consumer protection and economic efficiency) and noted that there was no issue with the other three objectives (promotion of electricity conservation and demand management, implementation of a smart grid in Ontario and promoting the use and generation of electricity from renewable energy sources).
The OEB’s decision examined whether the proposed consolidation would have the effect of reducing the underlying cost structures involved with distributing electricity to Norfolk ratepayers. In making this assessment, the OEB noted that the large difference in size and scope of HONI and Norfolk Power made it impossible to determine the effect of the acquisition on the cost structures by simply comparing the rates of the two distributors.
Several intervenors appeared before the OEB opposing the application and argued that in applying the “no harm” test and assessing the potential impact of the transaction on Norfolk ratepayers, the OEB should consider the following:
- Historically, ratepayers of utilities acquired by Hydro One have experienced an increase in rates.
- HONI’s current operations, maintenance and administration (“OM&A”) cost per customer is higher than that of Norfolk Power.
- HONI’s application for 2015-19 rates, currently before the OEB, shows significant increases in HONI rates, which will affect future Norfolk Power rates.
- Hydro One has not substantiated adequately the various types of projected savings due to the acquisition.
The OEB rejected all four of the intervenors’ arguments, accepting instead Hydro One’s contentions that the larger electricity distributor resulting from the acquisition would likely result in lower OM&A and capital costs from efficiencies due to geographic integration, economies of scale, administrative, managerial and planning integration, and lower financing costs. The OEB did note that it could not accurately assess Hydro One’s projected cost savings as Hydro One did not provide a detailed breakdown of its calculations. The Board also made clear its expectation that:
- The proposed 1 per cent reduction in Norfolk rates for five years does not address the “no harm” assessment as it is not driven by any contemplated change in the underlying cost structure (thereby signalling that cost structures beyond the period of the proposed rate freeze will be assessed in future rate applications).
- An assessment of projected cost structures is required.
- At the time of rebasing of rates, Hydro One will propose rate classes for Norfolk customers that reflect costs to service the Norfolk service area, as affected by the productivity gains arising from the consolidation.
While it is basic regulatory law that one hearing panel cannot bind a future hearing panel, the Board has made clear its expectation that rate freezes and token rate reductions will not meet a “no harm test,” and that more sustainable efficiencies must be demonstrated and are expected to benefit the ratepayers of the acquired LDC.
The total purchase price for Norfolk Power amounted to $93 million, which included a “purchase price premium” of $39.1 million over the $53.9 million book value of Norfolk Power’s assets. The intervenors argued that the significant purchase price premium would potentially compromise the rational consolidation of the LDC sector as it “...would cause Hydro One Inc. to become a dominant buyer,” and this would be contrary to the public interest in a competitive and diverse consolidation process. The OEB rejected this argument on the basis that the premium was not a relevant consideration since such premiums are never allowed to be included in rates. In a policy set in 2007, the Board indicated that distributors applying for approval of a consolidation transaction may defer the rate rebasing of the consolidated entity for up to five years after the date of closing. The purpose of such a deferral is to allow the consolidated distributor to offset its transaction costs by reaping additional profits from the resulting cost savings. The OEB accepted the applicants’ proposal to defer rate rebasing until the approval of 2020 rates. In other words, the purchase price premium would be borne entirely by the shareholder. (Hydro One) and not recovered from ratepayers through increased electricity rates. Hydro One is, of course, wholly owned by the Province of Ontario. The Board also rejected consideration of the broader public interest in a rational and competitive consolidation process as beyond the scope of its considerations, determining instead that it would defer to the negotiations between a willing buyer and seller, subject to foreknowledge of the Board’s expectations in respect of future cost structures and rates (essentially signalling that the Board will expect sustainable and demonstrable cost reductions).
Implications from the Norfolk decision — A new “Market” standard for LDC consolidations?
It should be noted that Hydro One’s acquisition of Norfolk Power resulted from a competitive bidding process. In a typical competitive bid prospective buyers must submit sealed offers to a seller in a “blind auction” process in which they do not know the contents of any other bid. The process is intended to yield an optimal result for the seller with respect to purchase price and contractual terms. In terms of process, a seller typically provides a form of share purchase agreement with instructions to bidders to provide a revised version containing the terms upon which they are prepared to complete the transaction. Usually, a “seller friendly” form of share purchase agreement is issued, which contains terms that favour the seller (in some cases, those terms can greatly favour a seller). The structure of a competitive blind auction can yield two results: (i) discourage prospective buyers from making extensive changes to the terms of the draft purchase agreement in order to prevail as the preferred proponent, and (ii) encourage prospective buyers to include “sweeteners” (e.g., additional promises or commitments) to induce a seller to choose their bid over another, especially in circumstances where the difference in purchase prices between competing offers is negligible.
The share purchase agreement for Norfolk Power filed in connection with the application contained employment and location guarantees for employees of Norfolk Power (and its subsidiaries) for a period of one year following the closing date, support for local community events in Norfolk County, maintaining a local presence (i.e., maintaining the central operating facility and all operations within Simcoe, Ontario) for a minimum period of three years following the closing date, maintaining Norfolk Power’s capital expenditure budget and forecast for a period of three years following the closing date and, as noted above, a 1 per cent reduction of rates for Norfolk County customers for a period of 5 years following the closing date until HONI’s rates are re-based in 2020.
From a policy perspective it can be difficult to reconcile how employment and location guarantees, commitments to maintain a local office presence (e.g., the former “head office” of the LDC) and promises to continue a certain level of capital expenditures within the acquired service territory facilitate a rationale consolidation of the LDC sector. By their nature, these provisions would appear (on their face) to undermine some of the very efficiencies that could be realized through consolidation, such as reduced headcount and centralized back office functions, at least for as long as those provisions in the purchase agreement remain in force.
Subsequent developments — proposed acquisition of Brant County Power Inc. and Woodstock Hydro Services Inc.
Two further LDC acquisition transactions have recently been announced after Norfolk Power: Cambridge and North Dumfries Hydro’s application to purchase Brant Country Power (Brant County) and Hydro One’s application to purchase Woodstock Hydro Services (Woodstock Hydro).
The purchase agreements for Woodstock Hydro and Brant County filed with the OEB contain the same provisions found in the Norfolk County deal, as described above; in addition, the purchase agreement for Woodstock Hydro refers to a new operations centre to be located in the City of Woodstock and, in the case of Brant County, the employment and location guarantees last for three years and 18 months respectively (as opposed to one year for Norfolk Power), and the commitment to maintain a local presence in Brant County lasts for five years (the application for Brant County does not contain a rate reduction of 1 per cent as with Norfolk Power and Woodstock Hydro but rather contains a four year rate freeze until that utility’s rates are rebased in 2019).
The OEB’s decision in Nofolk, in largely disregarding issues arising from (i) the size of the purchase price, (ii) the use of “sweeteners,” and (iii) the broader public interest in a competitive consolidation environment, will likely result in de-emphasizing concerns around regulatory approval in the structuring of offers for LDCs. Some caution on the part of would-be acquirers is warranted, though, since the OEB was clear that it expects that cost structures and associated rate impacts on acquired utilities will reflect efficiencies upon rebasing; accordingly, too many current “sweeteners” may well erode the acquiring shareholder’s ability to recover future purchase price premiums.