The potential sale by the province of all, or a portion of, Hydro One by way of private sale or initial public offering (or both) is sparking renewed interest in the broader consolidation of local distribution companies in Ontario, most of which are owned by municipalities or, in the case of Hydro One, by the Province. One key aspect that will need to be explored within the broader context of consolidation is the valuation of LDCs themselves.
Blind Auction Process and Historical Value Setting
Recent consolidation activity in Ontario’s LDC sector involved the acquisition of Norfolk Power and Haldimand Hydro by Hydro One, the acquisition by Cambridge and North Dumfries Hydro of Brant County Power and Hydro One’s proposed acquisition of Woodstock Hydro Services. As we previously discussed in our article “Hydro One’s Acquisition of Norfolk Power, and the “public interest”, these recent transactions were the result of a competitive bidding process known as a “blind auction”, where the number and identity of bidders is unknown to all participants other than the selling shareholder and its advisors. A blind auction process is intended to yield an optimal result for the seller with respect to purchase price and can also incentivize prospective buyers to include “sweeteners” (e.g., additional promises or commitments) to induce a seller to choose its bid over another. The purchase prices for Norfolk Power, Haldimand Hydro, Woodstock Hydro and Brant County Power that resulted from the blind auction process included significant premiums above the “net book value” of the assets of those utilities, approximately 42% in the case of Norfolk Power, 32% in the case of Haldimand Hydro, 56% in the case of Woodstock Hydro and 40% in the case of Brant County Power. The successful bids also included additional contractual promises and commitments from the purchasers of those utilities to the divesting municipality.
A typical definition of a properly functioning market is one that is open and unrestricted between informed and willing buyers and sellers who are under no compulsion to act. As noted above, the number and identity of bidders in connection with the sale of Norfolk Power, Woodstock Hydro and Brant County Power is not publically known. However, the existence of a “transfer tax” on municipalities that divest their LDCs to buyers other than to other municipally-owned LDCs or Hydro One would logically result in an auction process dominated by those public sector participants. In that sense, it may be fair to state that the purchase prices for Norfolk Power, Woodstock Hydro and Brant County Power may not be reflective of a “pure” enterprise value of those utilities, one that would be arrived at using the open and unrestricted model. The additional contractual promises and commitments noted above may also result in additional distortions to value and price that are unreflective of a pure market model.
As we previously noted in our article “The OEB approves Hydro One’s acquisition of Norfolk Power: A new market standard for the next wave of LDC consolidation in Ontario?” the Ontario Energy Board (in approving the acquisition of Norfolk Power) rejected the argument from the intervenors that significant the purchase premium paid for Norfolk Power would result in Hydro One becoming the “dominant buyer” and would therefore compromise the rational consolidation of the LDC sector on the grounds that any purchase price premiums paid by acquirors over book value are not allowed to be included in electricity rates. Hydro One was the successful proponent in three of the four LDC acquisitions referred to above, and, given its size vis a vis other municipally owned competitors (and the potentially narrow field of bidders), may further distort the LDC valuations that have emerged to date.
Orderly LDC Consolidation and Pricing
Economic theory tends to focus on the open and unrestricted model as yielding the optimal result for both the buyer and the seller (in other words, at the time the deal is made, buyers generally want to know they are not overpaying for assets while sellers want to know that they are not needlessly selling at a discount). So why does price matter in the context of broader LDC consolidation? One may be tempted to look at the historical prices of Norfolk Power, Woodstock Hydro and Brant County Power as establishing a benchmark range for LDCs (i.e., 40% – 56% above “net book value”). However, if we make the reasonable assumption that those auction processes were dominated by other LDCs and Hydro One (and if we assume the Province eliminates the “transfer tax” to encourage an open and unrestricted bidding process, something which has been strongly hinted at recently) such historical LDC pricing may be of limited relevance. Prices may be higher or lower – we simply do not know as there is not enough information flowing from an optimal market model.
While a potential sale of a portion of Hydro One through an IPO may arguably facilitate some level of market pricing for LDCs (assuming the offering is made widely) a partially privatized Hydro One may not be an optimal proxy for the rest of the sector as it includes 97% of the Province’s transmission capacity and its cost structure is higher than the rest of the sector in certain respects (at the very least those factors would need to be accounted for in any comparison).
In addition to other benefits, the orderly consolidation and continued viability of the LDC sector could be well served by introducing a greater degree of private participation, not only in terms of more reliable LDC valuations but also through continued and sustained investment in a sector that is confronting unprecedented technological transformation and shifts in demand. As we previously noted in “Hydro One's proposed privatization: Knowing the past, understanding the present and a glimpse into a possible future” – the limited report by the Premier’s Advisory Council on Government Assets noted that “…The system needs more capital, which is unlikely to be available from the public sector owners given other pressing needs.” LDCs will be facing a number of challenges and opportunities in the upcoming years (i.e., capital re-investment, distributed generation, micro-grid management, to name a few). Private sector owners of LDCs (especially those with long term investment strategies) may be more incented to tackle these challenges and capitalize on opportunities for future growth.