Tuesday, April 23, 2013

Stranded Debt - Abandoned Responsibility

On April Fools' Day, 1999, Ontario Hydro was broken up into five separate companies, including "the Ontario Electricity Financial Corporation (OEFC) to manage the legacy debt and other liabilities not transferred from the old Ontario Hydro to successor companies." [1]   

Each year that followed, from 2000 to 2011, the OEFC produced an annual report.
Then they stopped.
As I write this 612 days have passed since the OEFC last produced an annual report.

2012 Budget graphic (forecast removed)
During the summer of 2011 the Progressive Conservative (PC) were attempting to make the elimination of a debt retirement charge (DRC), introduced by the same legislation that divided up Ontario Hydro into 5 successor entities, an issue in the pending fall election in which they hoped to displace the governing Liberal party.  My review at the time indicated the PC's had a plausible argument.  Subsequently:
The budget graphic, upon reflection, is a reminder of how misunderstood the "stranded debt" (aka "Unfunded Liability") is.  The Electricity Act defines the stranded debt as "the amount of the debts and other liabilities [that] .. cannot reasonably be serviced and retired in a competitive electricity market".

The "residual stranded debt" is the share of the stranded debt that is not expected to be repaid by other "dedicated revenue streams" defined in the Electricity Act.
The Debt Retirement Charge (DRC) exists in order to service the residual stranded debt.

The concept of a stranded debt is now farcical to the point where the alleged financing authority, one that simply carries the credit credentials of a greater financing authority, cannot even produce a simple annual report.

History: Building the Debt

Ontario was an early adopter of public ownership of the electricity sector due largely to the actions of Adam Beck - the namesake of the current, and still publicly owned, generating stations on the Niagara river system.  Beck was the first chairman upon the establishment of the Hydro-Electric Power Commission in 1906 (later to become Ontario Hydro), with the notable slogans "the gifts of nature are for the public" and "Power at Cost".
graph corrected (for post 2008 years) August 10,  2013
Public power worked for Ontario through decades of growth, but by the second half of the 20th century growth rates were slowing while Ontario Hydro remained in growth mode. [3]

The Ontario Power Authority produced a background report shortly after it formed, in 2005; that report noted that up "Until the 1970s, power system planning was essentially an exercise to meet ever increasing demand". [4]

It was not long into the 1980's that the recognition of the impacts of slowing increases in demand were seen.  In 1982 the Chairman of Ontario Hydro, Hugh L. Macaulay, delivered a speech to the Empire Club of Canada which noted the cost pressures of rapid building combined with lower than anticipated demand increases:
So far, Hydro has been able to continue a pattern of keeping electricity rate increases at or below the rate of inflation. I say "so far" because, looking down the road, it is going to be more difficult to continue this pattern.  Right now, Hydro finds that electricity prices are in a squeeze between upward and downward pressures. Upward pressure because we went through a period of accelerated expansion during the sixties and seventies. We have, among other projects, three huge nuclear plants coming into service over the next ten years. The level of electricity sales that we anticipated when these stations were planned a dozen or so years ago has not fully materialized. And if we don't get revenues from sales, there is pressure to increase rates.
While the analysis was done and words followed accordingly, it is not apparent the organization could accept a future without growth - especially as over 9000MW of nuclear capacity was under construcion (Pickering B, Bruce B and Darlington).  Macaulay put faith in electrification displacing other energy sources, and Ontario Hydro started to be pressured to reduce spending on operations to compensate for continued revenue shortfalls, even as spending on new projects was increased by project delays during the high interest rate 80's.  Despite this, when Ontario Hydro released a long-term demand and supply plan late in 1989, titled "Providing the Balance of Power", growth was still expected.

Indexed pricing   - note trend is % of  2009 costs
By 1991 the forecast in 1989's report was demonstrably shown to be wrong: another head of Ontario Hydro spoke to The Empire of Club of Canada, with a message of declining productivity, lower profitability, and increasing rates softened by the message that "Hydro is well on its way to overcoming its edifice complex."

After the rate hikes and the completion of Darlington, came a rate freeze and increased scrutiny on the acquired debt.  Power at cost gave way to operating "like a business"[5]

Despite a rate freeze, the "contingent liability" that the province would report for, "mainly", Ontario Hydro declined from a height in 1992-93 until the company was broken up in 1999.

The final Annual report of Ontario Hydro showed a company reducing debt, albeit one with a deficit/deficiency of $2.738 billion in it's "Consolidated Statement of Financial Position."

Stranding the debt

There is an idea that the stranded debt is debt that Ontario Hydro lacked the capacity to pay off, but that is not the case.  
The "Stranded debt" is the difference between the liabilities of Ontario Hydro (which are balanced to the assets in the final Financial Statement), and a market valuation of the assets as they broke out into the 5 successor companies.
Graphic from AG's 2011 Annual Report
Market values are determined, in large part, by earnings - ie. a multiplier of different weights in different business sectors is applied to earnings before interest and taxes, etc.

While the debt was being incurred, Ontario Hydro operated under the "power at cost" directive.  
Operating under the authority of the Power Corporation Act, Ontario Hydro has broad powers to generate, supply and deliver electric power throughout Ontario. Under the Power Corporation Act, revenues of the corporation are applied to cover costs of operations including provision for debt retirement. Any residual amount is held in reserve to offset future costs and for debt redemption and cannot be distributed to the Province without legislative amendment to the Power Corporation Act.
Ontario Hydro was not supposed to have a market value - which is entirely different than stating it could not pay down its debt.

The break-up of Ontario Hydro was done in conjunction with the instigation of what was to be a competitive market for electricity in the province. The valuations of Ontario Hydro's successor companies should have been reflective of the equity stake that would allow an acceptable return on equity.

The benefits of a competitive marketplace were to provide the value for Ontario's ratepayers that would exceed the added payments to service the suddenly stranded debt.
The same act that broke up Ontario Hydro laid out a structure for servicing this stranded debt: some of these payments would come from revenue streams set out in The Electricity Act; primarily payment in lieu of taxes (PIL), and "electricity sector dedicated income" were planned to pay down the stranded debt. [1]
These tools were not expected to be sufficient, so a Debt Retirement Charge (DRC) was added to bills in Ontario for the portion of the stranded debt, or "unfunded liability", that forecast indicated could not otherwise by paid.

The Ontario Electricity Financial Corporation (OEFC) was tasked with managing the "debts of the former Ontario Hydro."  It issued it's first annual report in November of 2000, and delivered an annual report each year until 2011 - each year reporting the progress on paying down the stranded debt, but at not time communicating the remaining amount of the Residual Stranded Debt.
When the debt retirement charge was questioned, it slowly crept out that there was no accounting of the Residual Stranded Debt until Ontario's 2012 budget provided some figures.

The Competitive Market

  • The market opened in May of 2002.  
  • A couple of merchant generators joined in.
  • Rates spiked.
  • The Eves government froze rates - and implemented a "Market Power Mitigation Agreement" that would see $4 billion clawed back from Ontario Hydro's generation successor, Ontario Power Generation (OPG), by 2005 [6]
  • In fall 2003 the Liberal party is elected on a promise to eliminate coal-fired generation by 2007 ... and OPG takes a loss of $576 million on the anticipated early shutdown of coal [7]
    RSD figures from 2012 indicate it escalated $4.4 billion in 2003 [9]
  • In 2005 the government creates the Ontario Power Authority to provide integrated power system plans (none has ever been implemented) and carry out ministerial directives on contracting supply
  • March 24, 2005: the first Directive to the OPA from the Minister of Energy directs the contracting of 2500MW of supply - thus finishing off the possibility of merchant plants already made unlikely by the Eves action of rates
  • April 1st, 2005: Ontario Power Generation begins to be paid "regulated" rates for the production from it's largest hydroelectric, and all nuclear, generators. [6]
  • June 15, 2005: the second directive to the OPA from the Minister of Energy directs the OPA to negotiate comparable contracts with the ~1300MW capacity of merchant generation built prior to the CES contracts - this will leave only primarily publicly owned generators existing prior to market break-up exposed to the market rate
  • OPG writes off the Lennox Generating Station, recording an impairment charge of $202 million - with all other natural gas contracts either guaranteed rates (non-utility generators) or holding net revenue requirement contracts (CES), OPG concludes Lennox "would not be able to recover its carrying value from the wholesale electricity market in the future." [8]
It took essentially 3 years for all private sector generators to be awarded contracts protecting them from the risks of market rates.

Unfunded Liability / Unjustified Accounting

“All revenues from the DRC will go directly to the Ontario Electricity Financial Corporation to be used exclusively to service the residual stranded debt. Once the residual stranded debt has been retired, the DRC will end.”
- Minster of Energy announcing debt retirement charge in 2000 [1]

In his 2011 Annual Report, the Auditor General wrote:
Although DRC funds collected are separately disclosed in the OEFC’s financial statements, they are not segregated or separately accounted for with respect to the residual stranded debt, but are combined with the OEFC’s other revenue sources and used for general corporate purposes. Our view, which is supported by legal advice, is that section 85 does allow DRC funds to be used for any purpose that is in accordance with the objectives and purposes of the OEFC.
The response from the Ministry of Finance, included in the report, begins:
The Ministry of Finance (Ministry) concurs with the Auditor’s report with respect to the Ontario Electricity Financial Corporation (OEFC) being in compliance with the Electricity Act, 1998 (Act) in the use of Debt Retirement Charge (DRC) revenues. DRC revenues are used by the OEFC to perform its objectives under the Act, including servicing and retiring its debt and other liabilities.
It is extraordinarily doubtful that the Residual Stranded Debt was not reduced, in the years ending March 31, 2010 and March 31, 2011, for any reason related to OEFC responsibilities.  In 2009 and 2010 OPG and Hydro One both grew Shareholder's Equity valuations, and return of equities appear to have been comparable to 2005-2007, a period when the RSD was reduced.

Legally Questionable

The Auditor General's report noted legal issues involved in the utilization of revenues from the debt retirement charge, but it did not note the absurdity of the definition of the stranded debt when placed in the context of Ontario's electricity sector a decade and a half after the Electricity Act defined that debt as "the amount of the debts and other liabilities [that] .. cannot reasonably be serviced and retired in a competitive electricity market".

OPG's output has sold for $6 billion below valuation at average rates
There are now no market participants fully exposed to market pricing with the exception of OPG's unregulated hydro business, and in 2004 the Energy Minister stated one intention of legislation his government was introducing was that "Fixed prices for a large part of the energy consumed in the province would keep the overall blended price for electricity relatively stable.”

Since that legislation passed, regulating rates for OPG's largest hydroelectric, and all nuclear, production, there has been little semblance of a market that would encourage supply to be provided in an economically efficient manner.  The public generator, OPG, not only has its largest assets regulated at rates far below average, it may currently be the only generator exposed to the vagaries of market rates - and only its unregulated hydroelectric sector is exposed.

Put bluntly, in 2002 it was apparent OPG's revenue's in a market would likely be much higher, and in 2005 the market design was structured to ensure that OPG would be used to weight down overall pricing.
It is now known that the "debt and other liabilities" could have been serviced and retired.

Without justification for the stranded debt calculation, there cannot be validity to the debt retirement charge.


The term shell game is probably overused, but the term "shell" is particularly appropriate to this game.

The Debt Retirement Charge (DRC) was introduced to Ontario to fund a debt that was not the result of the public utility's ability to retire the debt, but a reflection of the devaluation required to ensure subsequent owners of the successor companies a return on their equity/investments.  This was a political decision, but it was understandable that electricity consumers bear the cost of the restructuring as ratepayers - isolating taxpayers despite the equally understandable argument that taxpayers should bear the burden of political decisions.

Whatever the DRC is being used for, it is more likely preventing competition in Ontario than it is bearing the cost of eliminating a monopoly's debt.

The DRC is not the only questionable mechanism in today's Ontario Electricity sector:

  • Effective July 2010 Ontario essentially introduced an 8% tax on electricity bills [10]
  • Effective January 2011, the government introduced an Ontario Clean Energy Benefit (OCEB) which provides a 10% discount on bills.

The government has choices to withdraw programs that punish ratepayers, and choices to withdraw programs that reward ratepayers.
The opportunity for rationalization exists.

I suspect we await the Ontario Electricity Financial Corporation 2011-2012 because the mandarins who have, in prior years, taken a couple of hours to update a couple of figures are having a hard time trying to care about a public accounting of the treatment of any revenue source, let alone one dedicated to debt retirement instead of empire building.

There are no individuals accepting responsibility for the approximately $1 billion a year in debt retirement charges.

Perhaps that is by design:
"The Corporation does not have employees" [11]    


[1] 2011 Annual Report: Office of the Auditor General of Ontario, secion 3.04
[2] The OEFC year still runs from April 1 - March 31, despite the fact the the IESO, Hydro One and Ontario Power Generation have all moved to reporting by calendar year.
[3] Referenced in Much To Do About Nothing: Electricity Policy In Ontario, including a chart of demand growth in the USA and a link to a less sophisticated chart from the Ontario Clean Air Alliance (see Figure 2 on pg 2)
[4] Overview of the Development of Power System Planning in Ontario
[5] The "like a  business" approach was a trend that caught up other areas of government too - such as the real estate holdings being put under a newly created Ontario Realty Corporation (since abandoned).
[6] OPG 2005 Annual Report
[7] OPG 2004 Annual Report
[8] OPG 2006 Annual Report
[9] The fiscal years are not equivalent, but are treated the same in comparing: OPG and Hydro One reports match calendar years, while OEFC reporting years end March 31st
[10] The provincial sales tax was not charged on electricity, but the federal Goods and Services Tax was - when the two were blended into one Harmonized Sales Tax, the tax impact of bills was to add 8%.
[11] From the OEFC website: "The Corporation does not have employees, although some OFA employees are designated as officers for executing agreements and other documents on the Corporation’s behalf. The OFA carries out the Corporation’s day-to-day operations under the supervision of the CEO and the Board. In addition, the Tax Revenue Division of the Ministry of Revenue collects certain payments on behalf of OEFC."


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