Ontario's Electricity Policy Environment Eerily Similar to TOPGAS Era

May 2011

• In the early 1980's, the interplay of high energy prices and a slowing economy resulted in more gas supply being offered to TransCanada than was needed by TransCanada to satisfy demand. This triggered the take-or-pay clause in its contracts from the late 1970's with Alberta producers. TransCanada accumulated a significant amount of prepaid gas that required increasing amounts of capital to finance.
• A consortium of banks created a vehicle that allowed TransCanada to move the take-or-pay gas off its balance sheet. The consortium came to be called TOPGAS.
• With market deregulation in the mid-1980's, legislation was introduced requiring new market participants to share in the cost of TOPGAS.
• Although Ontario's electricity market exists in a different time and a different place than the natural gas market of the late 1970's, elements of today's electricity policy environment seem very similar to the TOPGAS era.

In the late 1970's, the natural gas business in Canada was very different than the market we see today. At that time, TransCanada PipeLines was not just the only route for Alberta gas to flow to eastern Canadian markets, but the company was also the buyer and seller of virtually all of the gas flowing to those markets. TransCanada, as part of an integrated supply chain, bought gas from most gas producers in Alberta, transported the gas to eastern Canada, and sold the gas to local utilities like Union Gas, The Consumers' Gas Company (as Enbridge was then called), and other utilities. The utilities then sold the gas to their industrial, commercial and residential customers.

In both Canada and the US, the perception in the late 1970's was that we were running out of gas. In the US, schools were being closed in winter and the children sent home as there was not sufficient gas supply to heat the schools. What was clear to some, but not all, was that this was a regulation-induced shortage. Federal natural gas price regulation that kept prices low in the US meant that it was uneconomic for gas producers to produce gas for sale in interstate trade, so they didn't. Gas was a relatively low cost form of energy, but it wasn't always available, and regulators for a while were forced to establish schemes for rationing supply to high priority users. This problem was ultimately addressed by the Natural Gas Policy Act in 1978, which led to wellhead price deregulation in the US. It took seven more years before price deregulation arrived in Canada.

In this country, the price of gas in interprovincial trade was regulated by a federal-provincial agreement reached in 1975. Alberta set an Alberta Border Price for gas leaving the province. The federal government set a Toronto City Gate Price, which price included some federal taxes on top of the TransCanada Pipelines regulated cost of service for moving gas to Toronto, and the Alberta Border Price for the cost of the gas TransCanada bought for resale to the distributors. By adjusting the federal tax component in the landed cost of gas, the federal government could make the cost of gas in eastern Canada rise faster or slower than the rise in the Albert Border Price.

TransCanada PipeLines was in the unenviable position of having the responsibility of buying enough gas to supply 97% of the Canadian market at the end of its pipeline, even though it made no money on this activity. Faced with concerns in the late 1970's about whether there was enough gas available to meet market demands, TransCanada entered into a series of "area contracts" with gas producers. These contracts specified areas of Alberta and TransCanada committed that if the producer could find and produce gas in that area, TransCanada would take the gas. In addition, TransCanada committed that if it could not take the gas, it would pay for it anyway. This came to be known as a "take-or-pay" provision. It was intended that an area contract and a take-or-pay clause would provide producers with sufficient incentive and reduce the risk they faced, to explore for, develop, and produce new gas supplies.

At the same time, the prices for gas under the regulated scheme were rising. Oil price shocks in 1979 fed rising energy prices generally and contributed to a slowing of the economy, and eventually a severe recession in 1981-82. The slowing economy and higher energy prices were slowing the growth in energy demand. In addition, the higher prices for producers, together with area contracts, stimulated a surge of exploration activity and a sharp increase in new supply. It was not long before there was more gas supply being offered to TransCanada than it could take, which triggered the "take-or-pay" clauses in the gas purchase contracts.

Increasingly, TransCanada was accumulating a significant amount of "prepaid gas". While this was an asset on the balance sheet, it was requiring increasing amounts of capital to finance, and this in an era where interest rates were climbing.

It took an innovative piece of corporate financial engineering for TransCanada to get a consortium of banks to create a vehicle that would enable TransCanada to move this take-or-pay gas off its balance sheet, and stabilize its core business without the take-or-pay burden. The consortium came to be called TOPGAS. At its peak, the value of take-or-pay gas exceeded $3 billion, which was a lot of money in the early 1980's.

When natural gas pricing was finally deregulated in the mid-1980's, a very large TOPGAS obligation existed, just when TransCanada's market monopoly was being opened to competition. Eventually, TransCanada managed to take all the gas in their take-or-pay contracts, though the gas flowed many years after it was first paid for. Upon market deregulation, legislation had to be introduced to require new market participants to share in the cost of TOPGAS through a "take-or-pay levy", so that market competition would not ruin the TOPGAS structure, which had been designed in a different era.

So let's review the TOPGAS situation:

• A monopsonist buying agent was entering into open-ended contracts to take or otherwise pay for all the energy a supplier could connect.
• This was considered necessary to address a perceived shortage that had been created by prices that were held too low by regulatory action.
• At the same time these open-ended purchase contracts were being offered, the price available to suppliers was being increased by a regulatory agency to an above-market price, stimulating rapid increase in supply. Higher prices and open-ended contracts created a "gold rush" opportunity for suppliers.
• Sharply higher energy costs and general economic malaise were slowing the economy and the rate of growth of energy demand.
• The combination of these policies caused supply to overshoot demand in short order, creating a supply surplus. Contract terms meant that energy that could not be taken had to be paid for anyway, creating a significant financial obligation and a stranded asset.

Ontario's electricity market exists in a different time and a different place than the natural gas market of the late 1970's. But, elements of today's electricity policy environment seem eerily similar to the TOPGAS era. Philosopher George Santayana famously said, "Those who do not remember the past are condemned to repeat it."

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