In two appeal decisions released this past week, the Ontario Divisional Court rejected the application of the "prudent investment test" to forecast costs under collective bargaining agreements negotiated between a utility and its unionized employees.

The prudent investment test is a regulatory principle that was first articulated by Justice Brandeis of the United States Supreme Court in the 1923 decision of Southwestern Bell Telephone Co. v. Public Service Commission. The purpose of the prudent investment test is to protect utility shareholders in respect of past investments in large capital projects that later prove to be unnecessary. Because of the long lead times for constructing infrastructure projects, courts and regulators have ruled that it would be unfair to utility shareholders to assess the prudence of the investment with the benefit of hindsight. Instead, managerial prudence is initially assumed and any subsequent challenges are assessed on the information available to a utility's management at the time the investment was made.

In their respective rate cases before the Ontario Energy Board, Ontario Power Generation (OPG) and Hydro One Networks Inc. (HONI) argued that the Board was required to presume the prudence of their claimed compensation costs. They argued that the costs were set by previously negotiated collective bargaining agreements and the Board was limited to assessing the options available to the utility at the time it entered into the agreements. As successors to Ontario Hydro, the utilities had historic collective bargaining agreements that in some cases had a no strike/lockout provision that required disputes to be settled by arbitration. Effectively, the utilities were arguing that the Board was required to defer to the settlement negotiated between the utility and its unions or, where no settlement could be reached, to the decision of the labour arbitrator.

The Board disagreed. Rather than being limited to assessment of the utilities options in the collective bargaining process, the Board held that it could rely on benchmarking studies that compared the performance of the utilities with their industry peers. These studies showed high staffing levels, excessive compensation and, in the case of OPG, that the performance of its nuclear business unit was poor. Accordingly, the Board disallowed $145 million in compensation costs for OPG and $31 million for HONI. In disallowing these costs in OPG's case, the Board recognized the constraints imposed by the utilities unionized workforces (and moderated its disallowance in this respect), but nevertheless determined that ratepayers should only be required to bear reasonable costs.

Each of the Board's decisions was appealed to the Divisional Court. The Court heard the two cases together and issued companion decisions dismissing both appeals. In endorsing the Board's decisions, the Divisional Court ruled that the Board, as a "market proxy", needs the ability to consider how each utility was performing in comparison to its peers and cannot be limited to the type of retrospective review advocated by the appellants. This is particularly important in circumstances where the agreements were negotiated between a regulated monopoly that passes its costs onto to customers and a "near second monopoly" on labour in form of the unions. If the Board was bound to the outcome of the collective bargaining process, it would not be able to perform its statutory function of promoting market efficiency and protecting consumers. Further, the Court noted that, unlike other cases where the prudent investment test applies, the total compensation costs are not set solely by the collective bargaining agreements and the utilities have the ability "to manage, on a go-forward basis, to reduce total compensation costs within the framework of those agreements."

The decisions discussed in this article are Ontario Power Generation v. Ontario Energy Board, 2012 ONSC 728 and Power Workers Union v. Ontario Energy Board, 2012 ONSC 1080. Glenn Zacher and Patrick Duffy acted as counsel for the Ontario Energy Board on the OPG appeal.

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