Leadership and Innovation in Energy Regulation:

An LDC Perspective

An address to the: 2008 Annual Conference – Ontario Energy Association

Sheraton Fallsview Hotel and Conference Centre Niagara Falls, Ontario, Canada

September 18, 2008

[Check Against Delivery]

By Max Cananzi

President and CEO

Horizon Utilities Corporation

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Leadership and Innovation Leadership and Innovation in Energy Regulation: in Energy Regulation: An LDC PerspectiveAn LDC Perspective

OEA Annual Conference, September 18, 2008Max Cananzi, CEO, Horizon Utilities Corporation

Thank you for that kind introduction.

It is a real pleasure being here today to provide an “LDC Perspective” on leadership and innovation in energy regulation.

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Many OEB initiatives, many accomplishments

Leadership and innovation in energy regulation in Ontario is alive and well.

I know that we can all think of areas that need improving.

Each of us as a stakeholder have our own point of view on how regulation has evolved in Ontario, whether it is evolving fast enough, in the right direction, and in fact whether it is effective or not.

We can criticize, and we often do, but if we step back and look at the big picture of what has been accomplished in the last 10 years, specifically in the electricity sector, we cannot deny that leadership has been evident.

Let me draw to your attention the Ontario Energy Board’s website. If you have never visited the OEB’s “key initiatives” website, seeing the vast number of initiatives underway and the extensive availability of information is worth the trip itself.

From the smallest LDC rate case to the IPSP hearing, I believe we all owe Howard, his board members and the board management and staff our gratitude for raising the bar on energy regulation.

Allow me to illustrate for you a few of the initiatives that I feel very strongly about that have helped move the regulatory ball forward for electricity distributors.

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Cost of service and cost allocation

While “cost of service and cost allocation” may seem mundane issues to celebrate, here is an initiative where the Board has transformed what was once a largely unregulated sector to one where disciplined rules and cost transparency are now the order of the day.

By 2010, all 80-plus electric LDCs will have gone through these principle-based rate re-basing and cost allocation exercises – by removing cross-subsidies and permitting a basis for comparison across LDCs, customers are the real beneficiaries.

My hope is that this will eventually lead customers to a more competitive assessment of LDC rates.

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Rate treatment for mergers and acquisitions

An area that I am particularly passionate about is the consolidation of our distribution sector.

I would not be overstating facts, however, if I say that consolidation in the electricity sector to date has been a disappointment. It is particularly disappointing since I believe that all mergers that I am aware of have successfully resulted in creating more financially stable companies, at lower cost, and better able to provide services.

The reasons for the lack of progress are varied and I do not intend to go into them as part of this presentation.

However, a substantial hurdle was lifted last year when the OEB recognized that focusing solely on customer benefits did not provide the incentive for shareholders to pursue mergers and acquisitions.

We now have a fair and balanced approach that benefits customers and shareholders, which is absolutely essential for a merger to make sense.

Shareholders are now incented to realize on consolidation savings as quickly as possible as they are permitted to retain the savings for a period of up to five years. The savings either on rebasing or after the five-year period are thereafter passed to customers.

In 2005, our Hamilton and St. Catharines merger generated significant consolidation savings. We were able to over-earn and in turn lowered customer rates.

We are currently involved in a merger proposal with Guelph Hydro that has a similar upside for customers and shareholders. We are seeking shareholder approvals this month. I hope that this time next year I will be able to tell you all about it.

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IFRS and regulatory accounting

A huge issue that is coming fast at us is IFRS and the impact on rate regulated entities.

When one considers the fact that IFRS does not have any special exemptions, standards, or guidance for rate regulated entities and that the initial reviews have identified some complex issues to be resolved, then January 1, 2011, suddenly does not appear to be very far away.

While serious work in this regard is just starting, I am pleased that the Board is tackling the transition to IFRS sooner rather than later.

The OEB, by taking a leadership role now, will allow our industry to be in a position make thoughtful decisions in 2009 for the IFRS implementation in 2010.

The transition is not to be taken lightly, but I am confident that if we work together we will get there in time.

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Benchmarking and incentive regulation

If, however, I were asked to pick one initiative that defines regulatory leadership, it would be the move towards incentive rate making or IRM. I wish to spend some time discussing this very important initiative for distribution utilities.

IRM is not without its risks, difficulties, and detractors. However, with more than 80 Ontario LDCs … ranging in size from less than 1,000 to over one million customers … the Board’s leadership on benchmarking and incentive regulation is exactly what is needed.

At Horizon, we see this initiative as evidence that the much promised and awaited “light-handed” regulation is now finally being delivered.

In 2008, approximately one-third of electric distribution utilities filed under a cost of service forward year model. The amount of resources this process consumed, not to mention the costs, is not sustainable.

From our perspective, a well functioning IRM framework is the kind of proxy for competition that protects the interests of customers and lowers the regulatory burden of running an LDC for shareholders. We are supportive of it and welcome the change.

However, since we are moving to an incentive framework with real financial consequences, it is imperative that the benchmarking methodology and application of data be sufficiently rigorous to provide fair and equitable treatment.

I was encouraged to hear that the OEB plans to have a further round of consultations. As the report currently stands, we have some concerns.

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IRM and “embedded” LDCs

One of my concerns deals with the least well understood aspects of the LDC sector – transmission connected LDCs versus “embedded” LDCs. Transmission connected LDCs own the operating costs of stations and circuit feeders whereas “embedded” LDCs, which generally utilize Hydro One stations and feeders, do not.

The consequence of this – and incidentally more of the 80 LDCs are like this than not – is that charges “embedded” LDCs pay Hydro One show up in the “cost of power” account rather than forming part of their operating cost for benchmark purposes.

As you can imagine, this does not make for an “apples-to-apples” comparison. The “embedded” LDC pictured here, serving about 1,000 customers in two tiny villages, is considered one of the best performing LDCs in Ontario.

Indeed, I think you will be surprised to learn that more than 50% of the top performing LDCs in the recent benchmarking results have less than 10,000 customers. The results are counterintuitive.

Before IRM has financial consequences for LDCs, I think the matter of comparative costs for embedded LDCsneeds to be examined more closely.

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IRM and sub-transmission costs

Municipal LDC’s customers on Hydro One’s “LV”lines

Municipal LDC’s licensed service territory

I use the word “sub-transmission” here because the correct term, low voltage or “LV”, is less clear to its function.

Here is another case where small “embedded” LDCs are not considered on a like-for-like basis with transmission connected LDCs.

In the example shown – a top benchmarked LDC – several of its industrial customers are connected directly to Hydro One’s sub-transmission feeders.

Because of how costs are accounted for, in my view, the benchmarking is distorted. The “embedded” LDC has the efficiency appearance of a high “energy billed” throughput, but none of the operating costs of serving these customers shows up on the LDC’s books for benchmarking. They recognize the revenue, but none of the costs.

Again, fairness and transparency dictate these issues need to be corrected before incentive rate making takes hold.

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IRM and northern LDCs

Canadian Shield – √ Canadian Shield – ?

In a province with as much geography as Ontario, I think we can all agree that LDCs on the Canadian Shield have higher costs – because of the rock and water – and that LDC benchmarking should take this into consideration.

The benchmarking results, however, give me some pause because “northern” LDCs are 35% of the top performers but account for only 20% of all LDCs.

While the northern “bonus” may be too generous, one problem that could be fixed with fine tuning appears to be the misapplication of the Shield benefit to some LDCs that are actually on agricultural lands … like the one on the right.

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IRM and capitalized maintenance

Emerging Development –Capital Intensive

Mature Development –Maintenance Intensive

With so many variables, capital spending can be difficult to benchmark. While it may be the case that few other jurisdictions do so, Ontario’s municipally delimited LDC boundaries create unique issues for benchmarking.

If Ontario had a small number of very large regional distributors with a healthy mix of new emerging and mature areas, large cities, small towns and rural areas – the case could be made the capital issues would be a wash between comparably-sized distributors.

But Ontario’s LDCs largely follow municipal boundaries that also demark high-growth suburbs from low-growth built-out cities.

This is a significant differentiator of LDC performance because the suburban high-growth LDC has high capital spending and the low-growth older city LDC has higher maintenance spending.

This, then, creates an “apples and oranges” comparison because only maintenance costs are factored into theOntario benchmarking framework.

I am not sure I have the full solution, but the existing benchmarking results may not be giving us a true picture of who are the most efficient LDCs.

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IRM and peer group benchmarking

Source: Yearbook of Electricity Distributors 2004- 2006 (OEB)

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$50

$100

$150

$200

$250

$300

$350

$400

All LDCs

$ / C

usto

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/ Ye

ar

Operations, Maint. & Admin. / Customer (2004-2006)Operations & Maintenance / Customer (2004-2006)

Administration / Customer (2004-2006)

Smallest Largest

The final benchmarking issue I have for you is how the use of peer groups is actually serving to protect the inefficiency of scale for small LDCs.

This is the case because the over 80 utilities in Ontario have been organized in peer groups that are differentiated by size and whether they are in the north or south geographically and not, as one would assume, based substantially on performance. The competition as to whether a utility is a superior performer or not is limited to competing within a peer group. Within a mediocre peer group, the best performing utility of that mediocre group now becomes a superior performing utility by virtue of being the best of a bad bunch.

The counterintuitive result is that a majority of “small” LDCs are rated top performers under this methodology. I find this puzzling since continuing to be a “small” LDC is a matter of choice for the shareholder. Real options areavailable for attaining efficient scale and lower costs for customers.

The graph’s three lines make this clear. The top trend line shows total “Operations, Maintenance and Administration” in Orange, with “Administration” in Blue in the middle, and “Operations and Maintenance” in green at the bottom.

The best thing the Board could do is benchmark Administration separately from Operations and Maintenance, rather than all OM&A together. The cost of O&M is largely flat, as the graph shows, and is not a significant basis for additional savings.

The real benchmarking opportunity for customer cost savings is in the high costs of administration for small LDCs. OEB benchmarking should be leading these LDCs to reduce back office costs by either outsource billing and collecting or merging with other LDCs to attain scale economies for customers.

By peer grouping LDCs by size, however, the effect is to isolate small LDCs from the need for scale and make it more difficult for large LDCs, with more efficient scale in Administration and O&M, to find additional savings opportunities.

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Vision:• Our vision is to be the leader in providing innovative

energy solutions to the communities we serve

Mission:• Our employees create value for shareholders,

customers and the communities we serve through the safe and reliable delivery of electricity and innovative energy solutions

To sum up my remarks, I would again like to congratulate Howard and the Board on the impressive work they have accomplished to date and encourage them to keep up the good work.

With respect to the regulation of LDCs, I want to say that we have a lot to be pleased with, but that the Board needs to be ever vigilant in ensuring the rigour and transparency of its initiatives if it is to ensure the results intended materialize.

On IRM specifically, once again, I am encouraged that a new round of stakeholder consultations will take place. The initiative is far too important to not get it right. We will only be too happy to participate.

Thank you for your attention and I would be pleased to answer any of your questions.