Efficiency in the Electricity Distribution Sector

Efficiency in the Electricity Distribution Sector A Presentation to the Ontario Energy Board by Veridian Corporation Delivered by John Wiersma, President & CEO February 18, 2004

Presentation Overview • Historical Context • Resource Adequacy – A New Obligation for Distributors • Further Distributor Consolidation – Harvesting Economies of Scale While Improving Service Levels and System Planning • Barriers to Efficiency • Incentives to Promote Efficiency • Recommendations

Historical Context • Over 100 years ago each municipality had responsibility to secure an adequate power supply for its own needs. • With the advent of larger scale hydro-electric generation and long distance transmission, the Hydro Electric Power Commission of Ontario (HEPC) was formed. • Ownership of the HEPC was vested in the municipally owned utilities and the HEPC itself, which served rural and some direct customers.

Historical Context • The municipal utility ownership of the HEPC was re-enforced by the following: • Equity contributions embedded in the cost of power charged to the municipally owned utilities. • Return on equity credited to the municipally owned utilities. • Municipal utility representatives on the HEPC Commission. • A collective sense of responsibility for Resource Adequacy.

Historical Context • Ontario’s electricity system evolved from: • a closely integrated co-operative between the HEPC and the municipally owned utilities to • a highly centrally-controlled Ontario Hydro with no municipal utility ownership and little municipal utility input into planning decisions or corporate financing decisions. • The close interface which had developed between the customers and the municipally owned electric utilities was no longer brought to bear on provincial power system planning and financing, and replaced with other determinants of a political nature.

Historical Context • Today retailers are the only parties that take responsibility for resource adequacy, by ensuring a portfolio of contracts and spot market purchases to meet the needs of their customers. • There is no party that takes responsibility for ensuring supply for default customers, leading to wild price gyrations in the market place. • This approach to power system planning is unsustainable and leads to an investment community that is nervous and apprehensive about making new investments in the electricity sector.

Resource Adequacy - A New Obligation - • We believe that the obligation for resource adequacy for default supply customers must be returned to the the local distribution companies (LDCs) as it was over one-hundred years ago. • Generation sources of the future are moving away from large scale plants to a multitude of smaller scale forms of generation and demand side management initiatives, with less reliance on the distribution system.

Resource Adequacy - A New Obligation - • LDCs have a much better understanding of the needs of their respective service areas and should evolve into complete utilities, including the assumption of a Load Serving Entity (LSE) role. • LSEs must ensure that all customers have arrangements for supply through spot, mid-term and long term positions in the marketplace, or through generation of their own. • Our position is that LSE franchises should be assigned to all LDCs with the option for LDCs to sell their franchise to another LDC or retailer, or to surrender their franchise to the OEB.

Resource Adequacy - A New Obligation - • Our position is provided in much more detail in the Distributors’ Electricity Efficiency Policy (DEEP) group proposal which has been prepared by a coalition of LDCs, including Veridian. • The DEEP group’s paper will be presented on day three of this oral consultation process.

Further Distributor Consolidation- Harvesting Economies of Scale - • With the corporatization of LDCs and their participation in the market place, the administrative functions associated with billing, settlement, general administration and engineering have become a significant portion of Operating, Maintenance and Administration (OM & A) costs. • Our experience is that about 46% of these costs relate to functions that can be centralized to derive economies of scale. The remainder relate to field operations activities. • Functions benefiting from centralization include billing, customer care, system control and dispatch, general administration, etc. Costs related to these activities are heavily skewed to fixed overhead costs with a relatively small portion being variable in nature.

Further Distributor Consolidation- Harvesting Economies of Scale - • The economies of scale achievable through mergers and acquisitions is significant since most of the fixed costs are already in place and the cost of servicing incremental customers is small. • A full generic cost of service study segregating fixed and variable administration costs of a locational and non-locational nature would help to reveal the tremendous potential for savings that might be achieved through consolidation. • Veridian Connections was able to achieve OM&A savings of approximately $22 per customer within 3 years of consolidating seven utilities into one.

Further Distributor Consolidation- Harvesting Economies of Scale - • More savings will be achieved through the adoption of best practices and further attrition of the work force, facilities, equipment and inventories through natural means. • Veridian’s savings to date represent a reduction in OM&A of about 12%. A further reduction of 10% is projected to be achieved during 2004.

Further Distributor Consolidation- Harvesting Economies of Scale - • Veridian welcomes the OEB’s review of efficiencies in the electricity distribution sector. • It is unconscionable for LDCs and the OEB to leave untapped consolidation savings on the table at the expense of uninformed electric customers. • We believe that consolidation must take place without further delay, through appropriate economic incentives.

Further Distributor Consolidation- Improving Service Levels - • In Veridian’s experience there were quantum improvements in service levels as a result of consolidation. These include: • Implementation of a 7 x 24 hour control room and dispatch centre. • Automation of the distribution system to accelerate restoration time. • The establishment of a modern sophisticated call centre. • Greater expertise in wholesale and retail settlement and retailer hub services. • Greater expertise in regulatory and accounting support. • Improved creditworthiness through formal bond ratings.

Further Distributor Consolidation- Improving System Planning - • Distribution system planning, unlike other municipal services, is not discreet in nature and can be done over much larger areas than municipal boundaries. • Each municipal boundary produces inefficiencies, such as duplication in distribution feeders of different voltages and inefficient distribution system capacity allocation across service area boundaries. • Frequently system capacity is available in an LDC’s service area but not in a neighbouring Hydro One area. The reverse can also be true.

Further Distributor Consolidation- Improving System Planning - • The result is that untapped spare capacity is often left unused at the franchise boundaries. • Many LDCs are deeply embedded in the Hydro One system and the distribution functions are the joint responsibility of the LDC and Hydro One. • Since low voltage costs are not currently assessed to LDCs, Hydro One pays for the full cost of its distribution to the LDC without any cost recovery.

Further Distributor Consolidation- Improving System Planning - • Regional wide planning for new capacity for network connected Transformer Stations often requires the co-operation of several benefiting LDCs. • Joint action on Transformer Station planning is problematic and would be simpler if it was just between Hydro One and a single LDC.

Barriers to Efficiency - Poor Accountability - • The Badali report referred to huge variations in distribution charges across the province. • Distribution charges are deeply embedded in the bill and customers don’t have a good mechanism to compare their distribution bill to a distribution bill of another LDC • The lack of good customer information on comparable distribution bills leads to an erosion of accountability for rates to the customers. • Rates are artificially based on each LDC’s assets and operating costs in 1999, which makes comparisons between distributors problematic.

Barriers to Efficiency- Flawed PBR Design - • There is no accounting for the validity or lack of validity of the 1999 rate base - it is an artificial starting point. • Prudent LDCs with low rates and low re-investment rates in their system were left with a low rate base and the inability to extricate themselves from low returns in their business. • Imprudent LDCs with high rates and high re-investment rates in their system were left with a high rate base with higher returns than necessary and little incentive to reduce re-investment rates. • The latter utilities have little incentive to merge with the former, thereby frustrating consolidation

Barriers to Efficiency- Transfer Tax Issues - • The application of the transfer tax to the monetization of surplus real estate which occurs as a result of consolidation is counter-productive. • Veridian consolidated the operations of two service centres into one for the Ajax-Pickering area, only to find it had to set aside about $1 million in transfer tax on a $3 million disposal of the former Pickering Hydro Service Centre. • Surplus asset divestments should be transfer tax exempt.

Barriers to Efficiency- Political Control - • Political control often supersedes reasonable rates and higher service levels when consolidation is contemplated. • The LDC is seen as a heritage asset and low commercial returns are accepted by the municipal shareholders to preserve the political identity of the LDC.

Incentives to Promote Efficiency- Expedited Rate Reform - • LDCs must be on an equal footing so that accurate comparisons can be made between LDCs: • The OEB should conclude its review of Hydro One’s Low Voltage Rates and these should be passed on to embedded LDCs. • Rate reform should take place as quickly as possible. • Yardstick rate regulation should be pursued, with common distribution rates for LDCs with common load densities (i.e. MW of peak load/km2).

Incentives to Promote Efficiency- Expedited Rate Reform - • Once the rate regime has been corrected, consolidation will take place with the most inefficient LDCs becoming acquisition targets or merger partners with more efficient LDCs. • In the case of LDC sales, both the seller and buyer will find incentives to consolidate. • On the seller side it will be the liquidation of an asset and elimination of a potential liability, and on the buyer side it will be the monetization of efficiency improvements in the acquisition target.

Incentives to Promote Efficiency- Opportunity in LSE Option - • The opportunity of being an LSE must be of sufficient commercial value to receive take up by LDCs. • The commercial opportunity in operating an LSE will drive further consolidation and the outcome of consolidation will be further efficiencies.

Incentives to Promote Efficiency- Regulatory Certainty - • The OEB must adopt a rate design framework to provide for adequate returns to shareholders so that sufficient numbers of LDCs remain in the business. • Currently there is little incentive for optimizing capital expenditures since there it is not known if and how the Board will factor these investments into future rates. This must be addressed. • Once the correct framework is in place the OEB must maintain it for a sufficient length of time (6 years) to allow the industry to achieve efficiencies in the business. • The regulatory framework must be predictable.

Recommendations • LDCs should be empowered to accept responsibility for an LSE role, with a commercial return for such activity. • The OEB should enhance LDC accountability by publishing meaningful distribution rate comparisons. • The OEB should treat all LDCs in a uniform manner by allowing Hydro One to charge low voltage distribution costs to embedded LDCs, on the condition that LDC rates are adjusted to reflect these new costs.

Recommendations • The OEB should rapidly advance its schedule for distribution rate reform, and should seriously consider a yardstick approach to the establishment of rates. • The OEB should collect information from LDCs on fixed and variable OM&A costs and categorize these costs as location or non-location specific, to quantify the benefits of consolidation.

Recommendations • The OEB should analyze LDC data and report 5-year trends on capital expenditures net of developer contributions, to hold LDCs accountable for re-investments in distribution infrastructure. • The OEB should adopt a long term (6 years) regulatory framework to encourage LDCs to invest in efficiency improvements.

Closing Comments • We appreciate the opportunity of providing input to the challenge to make the Distribution Sector more efficient. • We would be pleased to provide more specific information on our consolidation success and to participate in further dialogue on how to consolidate the distribution sector in order to improve efficiency and service levels.

Efficiency in the Electricity Distribution Sector