Ontario is experiencing a slight uptick of merger activity in its electricity distribution utilities market. In April 2013, Hydro One Inc. (Hydro One) entered into an agreement with Norfolk County to acquire 100% of Norfolk Power Inc., and now awaits a decision from the Ontario Energy Board (OEB) on whether the merger has been approved. Hydro One is also said to be in discussions with Midland Power Utility Corporation and Oshawa Power & Utility Corp. about further potential purchases.

An increase of merger activity in the local distribution companies (LDC) sector marks a change from recent years. After the province experienced a frenzy of LDC consolidations in the late 1990s and early 2000s, which saw the number of LDCs drop from 307 to 89, merger activity in the LDC sector ground to a near halt.

Hydro One’s renewed interest in acquiring smaller LDCs comes on the heels of a report, Renewing Ontario’s Electricity Distribution Sector: Putting the Consumer First (the Report), put out by the Ontario Ministry of Energy’s Distribution Sector Review Panel (the Panel) in 2013. The Report concluded that the current number of LDCs operating in the province –80–was too many, and urged further consolidation in the sector to reduce costs and take advantage of scale economies. The Panel’s position was that 8 to 12 large regional distributors would be the optimal number to achieve these goals.

The Report made several recommendations as to how the province could best facilitate a transition from the current model to a regionally-structured one. Among other things, the Report recommended that:

  • the Ontario government give “clear and unambiguous direction to Hydro One Inc. to lead and engage in the discussion of the merger of its distribution assets with the appropriate interested utilities”;
  • the province enter into discussions with the federal government to facilitate the removal of barriers to private LDC investment;
  • LDC mergers no longer be subject to OEB review and approval;
  • LDCs be given a two-year period in which to voluntarily consolidate; and
  • the government pass legislation to force further LDC consolidation in the event that sufficient consolidation, or progress towards consolidation, had not been achieved by 2015.

Hydro One’s recent actions suggest that the Report’s recommendations have not fallen on deaf ears. It will be interesting to see whether and to what extent the Report’s other, more radical, recommendations also receive traction. Certainly, the implementation of a number of the Report’s proposals would be unqualifiedly positive. In particular:

  • The current regulatory policy that requires the OEB to approve all LDC mergers is unnecessary. Managers and shareholders of LDCs are in the best position to gauge whether a merger will be of net benefit to the company and its shareholders. Furthermore, the efficacy of the existing OEB review process is questionable, as evidenced by the toothless “no harm” test that the Board is required to apply, and the fact the Board has never in its history rejected a merger proposal.
  • The current federal and provincial tax policies relating to distribution utilities are harmful. The regulations permit tax-free mergers of LDCs owned by municipalities, or with Hydro One or Ontario Power Generation, but impose significant costs (in the form of “departure taxes” and “transfer taxes”) on private investors that acquire more than minority holdings in LDCs. These policies have succeeded in almost completely deterring private investment in the sector: aside from one LDC that is majority-owned by private investors, and a handful of LDCs in which private investors have acquired minority interests, Ontario’s LDCs are otherwise all owned by the province or municipalities. In light of the increasingly substantial capital needs of LDCs (to upgrade their existing infrastructure and invest in new technology), it would benefit all parties to enable private investors to invest in or own LDCs. From an investor perspective, LDCs tend to be considered attractive investments due to the stable rates of return that they generate.

It is less easy, however, to endorse the Panel’s other recommendations, particularly its suggestion that the province should be strongly encouraging mergers, or even more heavy-handedly, pursuing mergers by legislative edict. As CD Howe Institute’s report Mergers by Choice, Not Edict: Reforming Ontario’s Electricity Distribution Policy (the Institute Report) noted, there is good reason to be cautious about the Panel’s central claim that further consolidation in the industry will achieve efficiencies. As the Institute Report stressed, the data on LDCs from Ontario and elsewhere simply does not establish that a strong correlation between LDC size and efficiency exists.

Moreover, the fact that there has been so little merger activity in the LDC sector in recent years should be considered telling. As the Institute Report points out, LDCs would likely have amalgamated already if they had seen value in doing so:

presumably, the small utilities that remain are either efficiently run, sufficiently isolated to make them unattractive acquisitions, or are themselves hostile to being acquired by other municipally owned LDCs that they judge to be unattractive.

As such, the Institute Report concluded that the government should avoid getting into the business of making centralized decisions as to mandatory consolidations, and rather allow merger decisions to be driven by the specific, business-oriented plans of LDCs’ managers. To facilitate this process, policymakers should focus on ensuring that managers have all available options open to them, which, at a minimum, entails requiring regulators to back off and opening the doors to allow private investment to flow in.