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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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 counterproductive.
• 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.
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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.
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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).
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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.
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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.
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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.
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Recommendations
1.
LDCs should be empowered to accept responsibility for an
LSE role, with a commercial return for such activity.
2.
The OEB should enhance LDC accountability by
publishing meaningful distribution rate comparisons.
3.
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.
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Recommendations
4.
The OEB should rapidly advance its schedule for
distribution rate reform, and should seriously consider a
yardstick approach to the establishment of rates.
5.
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.
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Recommendations
6.
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.
7.
The OEB should adopt a long term (6 years) regulatory
framework to encourage LDCs to invest in efficiency
improvements.
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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.
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