Canada: Hydro One’s Acquisition Of Norfolk Power, And The "Public Interest"

In January I commented on Hydro One's application to the Ontario Energy Board for regulatory approval to acquire Norfolk Power distribution. The Board had been asked by a ratepayer intervenor, with the support of a group of three electricity distributor intervenors (Essex Powerlines, Bluewater Power Distribution and Niagara-on-the-Lake Hydro), to direct further disclosure by Hydro One and Norfolk Power, and effectively to provide guidance on what is within "the public interest" test that will be applied by the Board to determine whether the transaction should be approved. The Board's decision has been issued, and it provides clarification, to some extent.

The application arises pursuant to the Ontario government's policy favouring consolidation of Ontario regulated electricity distributors, from more than 80 distributors to something significantly less. A recent report commissioned by the government proposes more than $1 billion in cost savings from efficiencies to be gained through electricity distributor consolidation. Norfolk Power was one of the first distributors put up for sale in response to this government policy, and Hydro One was the successful bidder. Concerns have arisen that Hydro One's aggressive acquisition behaviour to date might not be what is best for the sector or Ontario's electricity ratepayers.

Hydro One has offered an immediate 1% rate reduction, followed by a 5 year rate freeze, to Norfolk Power customers. Given Hydro One's relatively high distribution rates, driven by Hydro One's relatively high average cost per customer to serve, questions arise as to what happens after the 5 year rate increase holiday. Norfolk customers may be hit with significant increases. Hydro One has also offered to pay a $65 million (equivalent to 70% of the net book value of Norfolk Power) premium to Norfolk Power's shareholder to clinch the deal. This is an expensive carrot that other would-be distribution company consolidators could find hard to match. This is not the first - and all indications are not the last - generous acquisition offer by Hydro One. Hydro One, which is funded by borrowing on the credit of its owners, the taxpayers of Ontario, is already pretty busy building, and borrowing for, priority transmission refurbishment and expansion projects, and it is not clear why the Ontario government is endorsing, tacitly or otherwise, Hydro One's aggressive approach to local distributor acquisition.

The motion brought before the OEB highlighted two specific concerns:

  1. That the longer term rate impact could be negative for Norfolk Power customers, and the Board should consider that longer term impact in determining whether the proposed acquisition is in the "public interest".
  2. That the competitive "chill" which Hydro One's actions are causing in the nascent market for distributor consolidation may be contrary to the public interest in rational consolidation, as distinct from monopolization.

The OEB has traditionally applied a "no harm" test for approval of regulated distributor consolidations. Under this test, the board will approve a transaction if it is satisfied that the transaction will not have an adverse effect in terms of the factors identified in the board's statutory objectives. In its decision on the motion for disclosure, the Hearing Panel has clarified a few things about its view of the Board's test.

The Hearing Panel has indicated that, in applying the "no harm" test, it is appropriate for the Board to assess the cost structures which will be introduced as a result of the acquisition in comparison to the cost structures that underpin current rates. The Board noted that Hydro One and Norfolk Power had not provided evidence to demonstrate that a reduction in future costs would support the promised immediate 1% reduction and subsequent freeze in distribution rates. The Board agreed with the moving parties that this concern bears further consideration.

Hydro One and Norfolk Power have now filed more information in response to the decision about their assumptions regarding cost savings and transaction costs. The 3 distributor intervenors have also filed evidence that questions the veracity of the information and the estimates provided by Hydro One. The lines have thus been drawn for debate regarding whether anticipated cost savings are sufficient, and sufficiently demonstrated, to meet the "no ratepayer harm" test. Stay tuned on this debate as the hearing proceeds.

In respect of the impacts of the purchase price, the Hearing Panel has maintained what appears at first instance to be a narrower approach than advocated by the intervenors who argued for further disclosure. The Hearing Panel has indicated that it is appropriate to consider:

  1. Whether the premium to be paid would create a financial burden on the acquiring utility.
  2. Whether the premium to be paid would put upward pressure on rates (presumably either for the customers of the target utility or for those of the acquiring utility, or both).

Hydro One has already said that it will recover the purchase price premium through post-acquisition efficiencies and not through future rates, and has presented some information on its expected efficiency savings to fund not only the rate freeze and rate reduction but the purchase premium and transaction costs as well. The expert report filed by the three intervening distributors examines these assertions.

In addressing the argument that the Board should consider the potential "predatory pricing" impact of the premium offered by Hydro One for Norfolk Power, the Hearing Panel answered indirectly, suggesting that its scrutiny of anticipated revenues should inform buyers and sellers on how to price their transactions. The motion decision states:

In applying the "no harm" test, the Board will consider whether future revenue requirements will unduly burden rate payers. The market price of a utility company established between a willing buyer and a willing seller is informed by the anticipated future revenues that the purchased entity will generate. This means that the Board's consideration of future revenue requirements in the application of the "no harm" test should be an important factor that will be considered by willing buyers and willing sellers in the establishment of market value.

However, given the OEB's previously expressed imperative that purchase premiums are not recoverable in rates (they are a shareholder cost to be recovered through efficiencies rather than rate increases), there is no clear link between future rate revenues and acquisition pricing.

In considering certain unanswered interrogatories regarding Hydro One's communications with its shareholder; the Ontario government, the motion decision states:

...the Board also considers that the conduct or motivations of a seller leading up to the consolidation transaction are not relevant to the "no harm" test. The "no harm" test looks at the effect of a transaction, not the reason for or the process preceding the transaction. Accordingly, the Board does not consider the [interrogatories] relating to the overall merits or rationale for [Hydro One's] acquisition plans, including any related communications with government, to be relevant to this proceeding. [Emphasis added.]

This seems to indicate that the broader competitive implications of Hydro One's actions are not going to be considered by the Board. However, the decision also states:

The application of the Board's "no harm" test is intended to ascertain if the transaction will have an adverse effect in terms of the factors identified in the Board's objectives. The Board intends to do so by comparing prospective cost structures to existing cost structures and in consideration of non-financial impacts as well. [Emphasis added.]

What "non-financial" impacts might be considered by the Board, in reference to its statutory objectives? Hydro One and Norfolk Power would no doubt argue that the reference to "non-financial" impacts means such things as reliability of electrical distribution service and service quality for Norfolk and existing Hydro One customers. Arguably, however, the Board's statutory objectives related to the regulation of electricity include some broader concepts. One such objective is:

To promote economic efficiency and cost effectiveness in the generation, transmission, distribution, sale and demand management of electricity and to facilitate the maintenance of a financially viable electricity industry.

It could be argued that "economic efficiency and cost effectiveness in the...distribution of electricity" and/or "the maintenance of a financially viable electricity industry" supports consideration of whether "rationale consolidation" by a number of players is preferable to "monopolization" of the distribution sector supported by additional Hydro One debt.

Alternatively, if such considerations are beyond the scope of the OEB's mandate, perhaps they should be more carefully considered by the Ontario government.

A number of Ontario's distributors are certainly concerned.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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