Last week, the Premier’s Advisory Council on Government Assets released its long-awaited recommendations for Hydro One, the provincially-owned transmission and distribution business. The Wynne government announced immediately thereafter that it would adopt the recommendations in full. Given these closely coordinated announcements, and the fact that the panel was empowered to negotiate on behalf of the province during the course of its work, it is clear that the Wynne government worked closely with the Panel behind the scenes to shape the final recommendations.
While the government, with Clark’s assistance, has now set out the policy direction regarding Hydro One, the battle to implement that policy has only just begun. In many respects, this implementation phase may represent an even greater challenge. Clark’s proposals clearly engage the diverse interests of a wide group of public and private sector stakeholders, including customers, municipal councils, utility employees, labour unions, potential investors in Hydro One, and, indeed, the more than sixty other electricity distributors which are not a party to either of the two transactions announced last week. The government and the parties to the two transactions clearly have their work cut out.
Their task is made more challenging by the fact that the transactions are proceeding at a time when electricity rates are increasing, largely because of the commitments made in respect of renewable energy and ongoing investment in distribution and transmission infrastructure.
Although the Hydro One IPO does not require approval by the Ontario Energy Board, a merger of the GTHA distributors would, in the absence of an exemption, need such approval. An OEB hearing regarding the GTHA distributor merger would be the most interesting proceeding of its type since the acquisition of Consumers’ Gas Company Ltd. by British Gas plc over 25 years ago during the early days of the Rae government.
Motivation Behind Hydro One IPO
The government’s narrative is fairly clear: the IPO of Hydro One will enable the redeployment of capital towards other projects and will facilitate a much-needed business transformation within the company; the consolidation of Hydro One Brampton and the three other distributors will yield operational efficiencies and be a “catalyst” for further consolidation in the sector; and the OEB will continue to protect consumers and to regulate the rates of Hydro One and other distributors. As compelling as this narrative might be, it is one that will play out over a very long timeframe. Business transformation and operational integration take time.
Indeed, the OEB’s recently revised policy regarding the rate-setting implications of mergers in the distribution sector accepted that consolidation may not yield net savings (efficiency gains minus recoverable transaction and transition costs) for ratepayers for five years or even longer. This reality highlights the need for all parties to the two transactions to manage expectations among customers and other stakeholders over the longer term.
With respect to Hydro One, the Clark report contemplates that the post-IPO Hydro One will be equipped to reduce costs and expand the utility’s “business opportunities”. The emphasis on reducing costs echoes the conclusions in the recent OEB’s decision, released just a few weeks before the Clark report, regarding Hydro One’s application for 2015 distribution rates. That decision provides a rather damning account of Hydro One’s failure to embrace the concept of continuous improvement and to demonstrate customer value and robust infrastructure planning.
Accordingly, both the Clark report and the OEB decision suggest that the Board of Directors must lead a business transformation within Hydro One, particularly on the distribution side, to improve operational performance. There is a strong argument that this transformation should be the near-term priority of the Board rather than the pursuit of undefined “new business opportunities”. A strong focus on reducing costs and improving customer service would be key to restoring the trust of customers and maintaining the confidence of investors. That transformation will not be easy and will test the government’s promise to refrain from meddling in the management of the company.
Hydro One Distribution will be back before the OEB in 2017 and undoubtedly the regulator will be expecting credible commitments and, hopefully, demonstrable improvements in the areas of asset management, reliability and customer service.
Electricity Sector Consolidation
Underlying nearly all of Clark’s recommendations was an interest in spurring the consolidation in the electricity distribution sector. Clark explicitly rejected the proposal from some distributors that they be given the opportunity to acquire contiguous distribution assets from Hydro One. This rejection doesn’t necessarily mean that such sales by Hydro One are off the table; but it does appear to mean that it will be left to the new Board of Directors to determine whether any such proposals make sense from a valuation and business perspective.
In the absence of a near-term opportunity to acquire Hydro One assets, the key question for the other distributors and their municipal shareholders is whether they want to sell or merge and, if so, to or with whom. One key consideration in that decision-making process should be the proposed modifications to the transfer tax regime, since those changes may attract private equity players to the field. Another might be an assessment of whether the distributors have the capacity to address the broader structural changes underway in the distribution sector and whether the municipality has the appetite to assume the risk that those changes may entail. But perhaps the overriding consideration should be precisely the one that the province posed in respect of its own assets – namely, would the municipal shareholder (and its citizens) be better off unlocking the value of its interest in its distribution company and redeploying that capital to other public purposes.