Introduction

They’re back! For those in Ontario’s electricity distribution sector  who thought that Hydro One would be out of the business of  buying municipally-owned local electricity distribution companies  (LDCs) following rumours of a potential sale, no such luck. Ed  Clark, Chair of the Advisory Council on Government Assets, has  signalled that the Council’s report will recommend separation  of Hydro One’s distribution and transmission assets; reduce  government ownership in the distribution side; and use the  process to spur consolidation of the “excess number of small  players” in Ontario’s electricity distribution sector.¹ Carmine  Marcello, CEO of Hydro One, followed this up by confirming that  he sees Hydro One’s role in the distribution sector as continuing  to be a “willing buyer where there is value for ratepayers and for  Hydro One itself.”² 

A Little History:

Slow-Motion Consolidation Ontario’s power sector was restructured around the year 2000,  requiring, among other things, municipalities to “corporatize”  their distribution assets. Many of these assets merged to  become bigger or were simply sold to Hydro One. During that  process, Ontario’s electricity distribution sector contracted from  over 300 distributors to around 90. Since then, a continuing trend  of mergers and sales has further reduced the number to a little  over 70 today. 

In December 2012, the provincially-appointed Distribution Sector  Review Panel issued a report calling for consolidation of the  sector. This included, as a last resort, forced amalgamations into  eight to twelve larger regional distributors. The backlash among  municipalities and numerous LDCs was immediate and the  Minister of Energy quickly assured the industry that there would  be no forced amalgamations or sales.

The Pace Picks Up

Despite the disavowal of the Distribution Sector report,  consolidation and efficiencies were on the front burner again.  Hydro One initiated discussions with numerous LDCs and  responded to requests for proposals to purchase utilities. Hydro  One offered premium purchase prices, small rate reductions and local presence. Other utilities cried foul, arguing that Hydro One  was using its size advantage unfairly, and that taxpayers were  ultimately subsidizing Hydro One’s bids. 

Hydro One subsequently signed agreements to purchase Norfolk  Power (announced April 2, 2013), Woodstock Hydro (May 21,  2014) and Haldimand County Hydro (June 10, 2014). At that  point, the long run-in to the recent municipal elections began and  any further potential deals were put on the back burner.

Would Hydro One be allowed to continue these types of bids?

The “No-Harm Test”: No Foul?

The Ontario Energy Board’s (OEB’s) July 2014 decision on the  acquisition of Norfolk Power gave Hydro One its hunting licence.  Acquisitions of LDCs must be approved by the OEB. In assessing  whether to approve such a transaction, the OEB applies a  “no harm” test. This test consists of whether the acquisition  would be consistent with the OEB’s objectives of protecting the  interests of consumers; promoting economic efficiency and  financial viability; promoting electricity conservation and demand  management consistent with government policies; facilitating a  smart grid; and promoting renewable generation consistent with  government policies. 

Two important features of the Norfolk deal were a one percent  rate reduction, frozen for five years for Norfolk customers, and  a premium in the purchase price over what other potential  purchasers were offering. Intervenors made a number of  arguments that the completion of the transaction would not  satisfy the no-harm test. These included potential large rate  increases at the end of the five-year period and higher rates not  only for Norfolk (eventually) but for all Hydro One customers as a  result of the premium in the purchase price.

The OEB rejected these arguments and found that, in applying  the no-harm test, it was not relevant to consider whether the  purchase price has been set at an appropriate level since future  rates would be determined without reference to the purchase  price paid. As to whether the purchase price was set at a level  that would create a financial burden on Hydro One, this too was  dismissed on the basis of the proportion of the purchase price to  Hydro One’s asset base ($39.1 million to $20.8 billion).

With the Norfolk decision, the OEB has given Hydro One licence  to roam Ontario armed with rate freezes and premiums.

Hydro One in Play?

In April 2014, the Ed Clark panel was appointed to “consider  various options to generate better returns and revenues to  maximize the value of” Hydro One (along with the LCBO and  Ontario Power Generation). Questions began to be asked  about the future of Hydro One and whether it would still be in  the acquisition game. Would Hydro One’s attention turn inward,  toward restructuring or possible sale?

In June, thousands of complaints by Hydro One customers around  billing practices were referred to the Ontario ombudsman, which  didn’t help the company’s image in wooing potential municipal  vendors.

In early October 2014, it was reported that the Electricity  Distributors Association (EDA), representing the LDCs (including,  at that time, Hydro One), was considering a plan to buy Hydro  One’s electricity distribution business.³ This plan involved some  LDC consolidation as well. In response, Hydro One resigned from  the EDA. 

Back in the Hunt

Now, with Ed Clark signalling that the restructuring of Hydro One  should be used as a catalyst for continuing consolidation of the  distribution sector, the hunt is on again. Carmine Marcello has put  the billing issues behind him and has announced his continuing  willingness to purchase LDCs. 

Game On!

What does this mean for municipally-owned LDCs? Now that  the municipal elections are over, those who were in discussion  with Hydro One can likely resume their discussions following the  installation of new councils. For those looking to sell, premiums  are still available.

The LDCs that are competing with Hydro One to acquire or merge  with other LDCs will have to offer a value proposition other  than premium prices and rate freezes. We have seen effective alternatives to the Hydro One approach. In Collingwood,  PowerStream became a 50/50 partner with the Town. In Brant  County, a sale to a neighbouring utility was considered desirable.

For an LDC that seeks to stay independent, there is no question  that the ground will continue to shift under its feet. The desire  of many municipalities to retain “their” utilities for reasons of  local presence, identity, control, independence, ongoing returns,  etc. should not be underestimated. At the same time, the sector  will continue to experience fundamental changes. Distributed  and behind-the-meter generation will put the traditional  ratemaking structure (based on electricity consumption) under  severe strain. Continuing government use of LDCs as agents of  conservation and demand management measures will provide  challenges and opportunities. Whether or not an LDC should be  active in renewable generation, water and wastewater, and other  unregulated activities must also be considered. While none of  this means that a sale or merger is inevitable, it does mean that  the ability to adapt to changing circumstances and adopt new  technologies and ways of doing business will be key.

Finally, for LDCs that seek to acquire Hydro One customers  and territory, this will likely be achievable only in the context of  creating value for the province and efficiencies for customers.  “Cherry picking” areas of customer concentration will be off the  table.

Meanwhile, the drumbeat of consolidation will continue to  emanate from Queen’s Park.