A Look at Electric Utility Consolidation in Ontario

May 2012

• There is a general sense that consolidation of the electric utility sector could lower costs, and the report of the Commission on the Reform of Ontario's Public Services recommended consolidation along regional lines to create economies of scale.
• There are some key impediments to consolidation: municipalities forfeiting a secure revenue stream, a 33% transfer tax, and the perception that government-provided electricity services is the natural order of things.
• Aegent estimates that if consolidation of the sector can reduce the total cost of distribution by 5%, then that would save utility customers on average 0.13 cents per kWh on their total electricity bill.

Consolidation is a common business strategy. Sometimes combining many smaller companies into fewer large ones can create economies of scale in administration and business processes. Sometimes, bringing together related or overlapping responsibilities under one roof can eliminate duplication of effort and create synergies.

Both types of consolidation have been the topics of discussion in the electricity sector of late, as the Ontario government takes steps to promote consolidation among electricity distributors, and introduces legislation to combine two key agencies, the Independent Electricity System Operator and the Ontario Power Authority.

Utility Consolidation

Ontario's history of municipally-owned electricity distribution utilities led to a situation where at one time there were about 300 electric utilities in the province. Over the last decade, there has been a degree of consolidation in this business. Hydro One, the provincially owned distributor, acquired several smaller rural utilities. Some municipal utilities merged with neighbours to form regional utilities, like Powerstream which serves the area north of Toronto. Yet there still exists about 80 electric utilities in Ontario, most still owned, directly or indirectly, by municipal governments. By contrast, there are two dominant natural gas utilities, which are both investor-owned, and only two municipally-owned gas distributors.

There is a general sense that consolidation of the utility sector could lower costs. The recent report of the Commission on the Reform of Ontario's Public Services, ("The Drummond Report") recommended that the province "Consolidate Ontario's 80 local distribution companies (LDCs) along regional lines to create economies of scale". The most obvious potential source of costs savings would be from operating synergies. For example, one set of corporate executives in one corporate head office instead of two or three; one billing system to handle hundreds of thousands of accounts instead of several different billing systems each handling tens of thousands.

There are potential indirect savings as well. For example, electric utilities are regulated by the Ontario Energy Board and the requirement to regulate a large number of smaller utilities is onerous and raises the cost of regulation, a cost ultimately borne by the consumer. While larger utilities may add complexity to the regulatory task, there is likely to be a gain in efficiency when regulating fewer, more sophisticated entities. There are some key impediments to consolidation of the utility sector. Municipal utilities provide typically a steady dividend to the municipality, and in these times, a significant and secure revenue stream is difficult to part with.

Under current regulations, municipalities face a 33% transfer tax if they sell their stake in their local utility. The Drummond Report and others have commented on how removal of this tax could remove a barrier to sector consolidation. Another significant barrier to consolidation is the traditional attachment municipalities feel toward their electric utility. The provision by municipal government of services to residents is a concept close to the heart of most politicians and citizens. For as long as anyone can remember, those services have included snow removal, garbage removal, water and electricity. Even the Drummond Commission commented on electricity distribution in its report on the "reform of Ontario's public services". For many, that electricity is a service provided by the government is the natural order of things, and putting the electricity service in the hands of some entity more removed from government likely seems to many city councillors a dereliction of duty. Of course, this ignores the fact that in most cases, the gas utility is not a municipal responsibility. The only distinction is that electricity always has been, while gas never has been (as far as anyone can remember). Risk is perceived whenever there is a change in the status quo.

The fact remains that, as the gas utilities demonstrate, there is no necessity for a local municipality to operate a utility. No matter the ownership, the electric utility would be subject to rate regulation by the Ontario Energy Board, and so it is not as though a municipal owner is required to keep rates in check. In the case of smaller municipalities especially, municipal ownership likely keeps the utility too small to achieve optimum efficiency of scale.

The rates charged by the local electricity distribution company represent less than 40% of a consumer's bill. If consolidation of the sector can reduce the total costs of distribution by 5%, then Aegent estimates that would save LDC consumers on average 0.13 cents per kWh on their total electricity bill (before HST). In context, Aegent expects the total cost of the electricity bill to increase by over 5 cents per kWh over the next 5 years. Therefore, potential LDC cost savings may offset 2% of the expected increase.

The fragmentation of the LDC sector is the result of the long history of government control of the sector. There is however, another hidden cost associated with this degree of government control, and it is perhaps the greatest cost of all. Direct government ownership of much of the sector lies at the heart of the perception that the government is naturally responsible for electricity supply. This encourages government involvement in decision-making at a level that is simply not seen in other sectors like natural gas. Many would argue that the long-term, capital intensive nature of the energy business, and particularly electricity, is not well served by decision-makers who must answer to voters in a short 4-year election cycle. Rather, the industry would be better served by a model that focuses on operating electric utilities according to sound business principles and practices in order to derive greater benefits for consumers.

While utility consolidation does not in itself require the sale of the utility to private equity, some consolidation would likely be of that nature. But even if consolidation only occurred among neighbouring municipalities to create regional utilities, it would tend to remove the utility one more step from the direct influence of one municipality, a little further out of reach of the local politician and towards a more business-based operation.

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